NOTES TO UNAUDITED CONSOLIDATED
FINANCIAL STATEMENTS
MARCH 31, 2017
NOTE 1 – DESCRIPTION
OF BUSINESS AND BASIS OF PRESENTATION
The Company is a Delaware
corporation, incorporated on July 17, 1987 and has been engaged in the intellectual property monetization business since 2008.
As used herein, the “Company”
refers to Quest Patent Research Corporation and its wholly and majority-owned and controlled operating subsidiaries unless the
context indicates otherwise. All intellectual property acquisition, development, licensing and enforcement activities are conducted
by the Company’s wholly and majority-owned and controlled operating subsidiaries.
The accompanying unaudited
consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the US (GAAP)
for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, these interim
financial statements do not include all of the information and notes required by GAAP for complete financial statements. All adjustments
(consisting of normal recurring items) necessary to present fairly the Company’s consolidated financial position have been
included. These interim financial statements should be read in conjunction with the consolidated financial statements and accompanying
notes included in our Annual Report on Form 10-K for the year ended December 31, 2016. Operating results for the interim periods
presented herein are not necessarily indicative of the results that may be expected for any other interim period or for the entire
year.
NOTE 2 – SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES
Principles of consolidation
and financial statement presentation
The consolidated financial
statements are prepared in accordance with U.S. generally accepted accounting principles (“US GAAP”) and present the
consolidated financial statements of the Company and its wholly owned and majority owned subsidiaries as of March 31, 2017.
The consolidated financial
statements include the accounts and operations of:
Quest Patent Research Corporation (“The Company”)
|
Quest Licensing Corporation (NY) (wholly owned)
|
Quest Licensing Corporation (DE) (wholly owned)
|
Quest Packaging Solutions Corporation (90% owned)
|
Quest Nettech Corporation (wholly owned)
|
Semcon IP, Inc. (wholly owned)
|
Mariner IC, Inc. (wholly owned)
|
IC Kinetics, Inc. (wholly owned)
|
The operations of Wynn
Technologies Inc. are not included in the Company’s consolidated financial statements as there are significant contingencies
related to its control of Wynn Technologies Inc. The sole asset of Wynn Technologies Inc. is US Patent No. RE38,137E. Wynn Technologies
Inc. cannot transfer, assign, sell, hypothecate or otherwise encumber US Patent No. RE38,173E without the express written consent
of Sol Li, owner of 35% of Wynn Technologies Inc., unless, as of the date of such transfer, assignment, sale, hypothecation or
other encumbrance, Mr. Li has received a total of at least $250,000.
The Company accounts for
its 65% interest in Wynn Technologies, Inc. under the equity method whereby the investment accounts are increased for contributions
by the Company plus its 60% share of income pursuant to the contractual agreement which provide that Sol Li retains 40% of the
income, and reduced for distributions and its 60% share of losses incurred, respectively, with the restriction whereby the account
balances cannot go below zero.
Significant intercompany
transaction and balances have been eliminated in consolidation.
Use of Estimates
In preparing financial statements
in conformity with accounting principles generally accepted in the United States of America, management is required 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 and revenue and expenses during the reporting period. Actual results could differ from
those estimates.
Derivative Financial
Instruments
The Company evaluates the
embedded conversion feature within its convertible debt instruments under ASC 815-15 and ASC 815-40 to determine if the conversion
feature meets the definition of a liability and, if so, whether to bifurcate the conversion feature and account for it as a separate
derivative liability. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is
initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the
statements of operations. For stock-based derivative financial instruments, the Company uses a Black Scholes model, in accordance
with ASC 815-15 “Derivative and Hedging” to value the derivative instruments at inception and on subsequent valuation
dates. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as
equity, is evaluated at the end of each reporting period. Derivative instrument liabilities are classified in the balance sheet
as current or non-current based on whether net-cash settlement of the derivative instrument could be required within 12 months
after the balance sheet date.
Fair value of financial
instruments
Fair value is defined as
the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. A
fair value hierarchy is used which requires an entity to maximize the use of observable inputs and minimize the use of unobservable
inputs when measuring fair value. See Note 4 for information about derivative liabilities.
The fair value hierarchy
based on the three levels of inputs that may be used to measure fair value are as follows:
Level 1
– Quoted
prices in active markets for identical assets or liabilities.
Level 2
– Observable
inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; or other inputs that are observable
or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3
– Unobservable
inputs that are supported by little or no market activity and that are financial instruments whose values are determined using
pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of
fair value requires significant judgment or estimation.
The carrying value reflected
in the consolidated balance sheets for cash and cash equivalents, accounts receivable, accounts payable and accrued expenses and
short-term borrowings approximate fair value due to the short-term nature of these items.
Inventor/Former Owner
Royalties and Contingent Legal/Litigation Finance Expenses
In connection with the investment
in certain patents and patent rights, certain of the Company’s operating subsidiaries may execute related agreements which
grant to the inventors and/or former owners of the respective patents or patent rights, the right to receive a percentage of future
net revenues (as defined in the respective agreements) generated as a result of licensing and otherwise enforcing the respective
patents or patent portfolios.
The Company’s operating
subsidiaries may retain the services of law firms that specialize in patent licensing and enforcement and patent law in connection
with their licensing and enforcement activities. These law firms may be retained on a contingent fee basis whereby such law
firms are paid a percentage of any negotiated fees, settlements or judgments awarded.
The Company’s operating
subsidiaries may engage with funding sources that specialize in providing financing for patent licensing and enforcement. These
litigation finance firms may be engaged on a non-recourse basis whereby such litigation finance firms are paid a percentage of
any negotiated fees, settlements or judgments awarded in exchange for providing funding for a legal fees and out of pocket expenses
incurred as a result of the licensing and enforcement activities.
The economic terms of the
inventor agreements, operating agreements, contingent legal fee arrangements and litigation financing agreements associated with
the patent portfolios owned or controlled by the Company’s operating subsidiaries, if any, including royalty rates, contingent
fee rates and other terms, vary across the patent portfolios owned or controlled by such operating subsidiaries. Inventor/former
owner royalties, payments to non-controlling interests, contingent legal fees expenses and litigation finance expenses fluctuate
period to period, based on the amount of revenues recognized each period, the terms and conditions of revenue agreements executed
each period and the mix of specific patent portfolios with varying economic terms and obligations generating revenues each period.
Inventor/former owner royalties, contingent legal fees expenses and litigation finance expenses will continue to fluctuate and
may continue to vary significantly period to period, based primarily on these factors.
Going Concern
As shown in the accompanying
financial statements, the Company has an accumulated deficit of approximately $15,646,000 and negative working capital of approximately
$3,590,000 as of March 31, 2017. Because of the Company’s continuing losses, the working capital deficiency, the uncertainty
of future revenue, the Company’s low stock price and the absence of a trading market in its common stock, and the ability
of the Company to raise funds in equity market or from lenders is severely impaired. These conditions raise substantial doubt as
to the Company’s ability to continue as a going concern. Although the Company may seek to raise funds and to obtain third
party funding for litigation to enforce its intellectual property rights, the availability of such funds is uncertain. The financial
statements do not include any adjustments that might result from the outcome of this uncertainty.
NOTE 3 –DEBT
The following table shows
the Company’s debt at March 31, 2017 and December 31, 2016.
|
|
March 31,
|
|
|
December 31,
|
|
|
|
2017
|
|
|
2016
|
|
Debt:
|
|
|
|
|
|
|
Loans payable – third party
|
|
$
|
163,000
|
|
|
$
|
163,000
|
|
|
|
|
|
|
|
|
|
|
Loan payable – related party
|
|
|
|
|
|
|
|
|
Gross
|
|
|
2,618,065
|
|
|
|
2,618,065
|
|
Accrued Interest
|
|
|
128,985
|
|
|
|
62,348
|
|
Unamortized discount
|
|
|
(594,678
|
)
|
|
|
(616,176
|
)
|
Net loans payable – related party
|
|
$
|
2,152,372
|
|
|
$
|
2,064,237
|
|
The loan payable –
third party is a demand loan made by former officers and directors, who are unrelated third parties at March 31, 2017, and December
31, 2016, in the amount of $163,000. The loans are payable on demand plus accrued interest at 10% per annum. These third parties
are also shareholders, but their stockholdings are not significant.
The loan payable –
related party at March 31, 2017 represents the principal amount of the Company’s 10% note to United Wireless Holdings, Inc.
(“United Wireless”) in the amount of $2,618,065 pursuant to securities purchase agreement dated October 22, 2015 more
fully described in our Annual Report on Form 10-K for the year ended December 31, 2016. On March 16, 2017, the Company received
a letter from counsel to United Wireless claiming that the Company is in violation of the requirements of the registration rights
agreement dated October 22, 2015 on the grounds that the Company did not update the registration statement in November 2016. The
damages are computed at 1.5% of the aggregate purchase price paid for such securities, which was $250,000 on the date the registration
statement ceases to be effective and each 30 days thereafter. Based on the formula in the registration rights agreement, United
Wireless may claim that the Company owe damages of $3,750 per month, starting with November 11, 2016. The note payable to United
Wireless has been classified as a current liability as of December 31, 2016. Because of its stock ownership in the Company and
its right to elect a director of the Company, United Wireless is treated as a related party. Prior to the consummation of the
transactions described in this Note 3, the Company had no relationship with United Wireless.
NOTE 4 –DERIVATIVE
LIABILITIES
Because there is not a fixed
conversion price, remaining compliant with the reserve requirement under the United Wireless note is outside of the control of
the Company. Although there is a limit on the number of shares issuable under the note, absent an increase in the stock price or
an increase in authorized shares, there are potentially not enough authorized shares to satisfy the exercise of the options, thus
the Company determined the options qualify as derivative liabilities under ASC Topic 815. On January 22, 2016, the Company reclassified
all non-employee warrants and options as derivative liabilities and revalued them at their fair values at each balance sheet date.
Any change in fair value was recorded as other income (expense) for each reporting period at each balance sheet date.
As of March 31, 2017, and
December 31, 2016, the aggregate fair value of the outstanding derivative liability was approximately $90,000 and $140,000, respectively.
The Company estimated
the fair value of the derivative liability using the Black-Scholes option pricing model using the following key assumptions during
the period ended March 31, 2017:
|
|
|
Period Ended March 31,
|
|
|
|
|
2017
|
|
Volatility
|
|
|
|
405 % - 440%
|
|
Risk-free interest rate
|
|
|
|
1.36%
|
|
Expected dividends
|
|
|
|
-%
|
|
Expected term
|
|
|
|
3.50 – 3.75 years
|
|
The following schedule
summarizes the valuation of financial instruments at fair value in the balance sheets as of March 31, 2017 and December 31,
2016:
|
|
Fair Value Measurements as of
|
|
|
|
31-Mar-17
|
|
|
31-Dec-17
|
|
|
|
Level 1
|
|
|
Level 2
|
|
|
Level 3
|
|
|
Level 1
|
|
|
Level 2
|
|
|
Level 3
|
|
Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
None
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Total assets
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Option derivative liability
|
|
|
-
|
|
|
|
-
|
|
|
|
90,000
|
|
|
|
-
|
|
|
|
-
|
|
|
|
140,000
|
|
Total liabilities
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
90,000
|
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
140,000
|
|
The following table sets
forth a reconciliation of changes in the fair value of derivative liabilities classified as Level 3 in the fair value hierarchy:
|
|
Significant Unobservable
Inputs
(Level 3)
as of
March 31,
2017
|
|
Beginning balance
|
|
$
|
140,000
|
|
Change in fair value
|
|
|
(50,000
|
)
|
Ending balance
|
|
$
|
90,000
|
|
NOTE 5 – STOCKHOLDERS’
EQUITY
Issuance of Common Stock
and Options
Pursuant to the restated
employment agreement dated November 30, 2014, the Company issued to its chief executive officer a stock grant for 30,000,000 shares
which vested on January 15, 2015. For the period ended March 31, 2015 the Company recognized compensation expense of $63,000, representing
closing price of the common stock on the grant date. There was no stock-based compensation expense for the three months ended March
31, 2017 or 2016.
As of March 31, 2017, there
was no unamortized option expense associated with compensatory options.
A summary of the status
of the Company's stock options and changes is set forth below:
|
|
Number of Options
(#)
|
|
|
Weighted Average Exercise
Price
($)
|
|
|
Weighted Average Remaining Contractual
Life
(Years)
|
|
Balance - December 31, 2016
|
|
|
50,000,000
|
|
|
|
0.03
|
|
|
|
3.75
|
|
Granted
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Exercised
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Expired
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Cancelled
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Balance - March 31, 2017
|
|
|
50,000,000
|
|
|
|
0.03
|
|
|
|
3.5
|
|
Warrants
A summary of the status
of the Company's stock warrants and changes is set forth below:
|
|
Number of Warrants
(#)
|
|
|
Weighted Average Exercise
Price
($)
|
|
|
Weighted Average Remaining Contractual Life
(Years)
|
|
Balance - December 31, 2016
|
|
|
65,000,000
|
|
|
|
0.004
|
|
|
|
1.17
|
|
Granted
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Cancelled
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Expired
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Exercised
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Balance - March 31, 2017
|
|
|
65,000,000
|
|
|
|
0.004
|
|
|
|
0.92
|
|
NOTE 6 – NON-CONTROLLING
INTEREST
The following table reconciles
equity attributable to the non-controlling interest related to Quest Packaging Solutions Corporation.
Balance as of December 31, 2016
|
|
$
|
2,487
|
|
Net income attributable to non-controlling interest
|
|
$
|
1,359
|
|
Balance as of March 31, 2017
|
|
$
|
3,846
|
|
NOTE 7 – RELATED
PARTY TRANSACTIONS
The Company has at various
times entered into transactions with related parties, including officers, directors and major shareholders, wherein these parties
have provided services, advanced or loaned money, or both, to the Company needed to support its daily operations. The Company discloses
all related party transactions.
During the three months
ended March 31, 2017 and 2016, the Company contracted with an entity owned by the chief technology officer for the provision of
information technology services to the Company. For the three months ended March 31, 2017 and 2016, the cost of these services
was approximately $545 and $600 respectively.
NOTE 8 – COMMITMENTS
AND CONTINGENCIES
Employment Agreements
Pursuant to a restated employment
agreement, dated November 30, 2014, with the Company’s president and chief executive officer, the Company agreed to employ
him as president and chief executive officer for a term of three years, commencing January 1, 2014, and continuing on a year-to-year
basis unless terminated by either party on not less than 90 days’ notice prior to the expiration of the initial term or any
one-year extension. The agreement provides for an initial annual salary of $252,000, which may be increased, but not decreased,
by the board or the compensation committee. In March 2016, the Company’s board of directors increased the chief executive
officer’s annual salary to $300,000, effective January 1, 2016. The chief executive officer is entitled to a bonus if we
meet or exceed performance criteria established by the compensation committee. In August 2016, the Company’s board of directors
approved annual bonus compensation equal to 30% of the amount by which our consolidated income before income taxes exceeds $500,000,
but, if the Company is subject to the limitation on deductibility of executive compensation pursuant to Section 162(m) of the Internal
Revenue Code, the bonus cannot exceed the amount which would be deductible pursuant to Section 162(m). The chief executive officer
is also eligible to participate in any executive incentive plans which the Company may adopt.
Inventor Royalties, Contingent
Litigation Funding Fees and Contingent Legal Expenses
In connection with the investment
in certain patents and patent rights, certain of the Company’s operating subsidiaries executed agreements which grant to
the former owners of the respective patents or patent rights, the right to receive inventor royalties based on future net revenues
(as defined in the respective agreements) generated as a result of licensing and otherwise enforcing the respective patents or
patent portfolios.
The Company’s operating
subsidiaries may engage third party funding sources to provide funding for patent licensing and enforcement. The agreements
with the third party funding sources may provide that the funding source receive a portion of any negotiated fees, settlements
or judgments. In certain instances, these third party funding sources are entitled to receive a significant percentage of any proceeds
realized until the third party funder has recouped agreed upon amounts based on formulas set forth in the underlying funding agreement,
which may reduce or delay and proceeds due to the Company.
The Company’s operating
subsidiaries may retain the services of law firms in connection with their licensing and enforcement activities. These law
firms may be retained on a contingent fee basis whereby the law firms are paid on a scaled percentage of any negotiated fees, settlements
or judgments awarded based on how and when the fees, settlements or judgments are obtained.
Depending on the amount
of any recovery, it is possible that all the proceeds from a specific settlement may be paid to the funding source and legal counsel.
The economic terms of the
inventor agreements, funding agreements and contingent legal fee arrangements associated with the patent portfolios owned or controlled
by the Company’s operating subsidiaries, if any, including royalty rates, proceeds sharing rates, contingent fee rates and
other terms, vary across the patent portfolios owned or controlled by the operating subsidiaries. Inventor royalties, payments
to noncontrolling interests, payments to third party funding providers and contingent legal fees expenses fluctuate period to period,
based on the amount of revenues recognized each period, the terms and conditions of revenue agreements executed each period and
the mix of specific patent portfolios with varying economic terms and obligations generating revenues each period. Inventor royalties,
payments to third party funding sources and contingent legal fees expenses will continue to fluctuate and may continue to vary
significantly period to period, based primarily on these factors.
In March 2014, the Company
entered into a funding agreement whereby a third party agreed to provide funds to us to enable us to implement a structured licensing
program, including litigation if necessary, for the Mobile Data. Under the funding agreement, the third party receives an interest
in the proceeds from the program, and we have no other obligation to the third party. In April and June 2014, as part of a structured
licensing program for the Mobile Data portfolio, Quest Licensing Corporation brought patent infringement suits in the U.S. District
for the District of Delaware against Bloomberg LP et. al., FactSet Research Systems Inc., Interactive Data Corporation, SunGard
Data Systems Inc. and The Charles Schwab Corporation et. al. These cases have been consolidated for trial. In June and August 2016,
Quest Licensing Corporation entered into a settlement agreement with SunGard Data Systems Inc. and FactSet Research Systems Inc.
As of the date of filing the third party litigation has advanced approximately $3,000,000 in litigation fees, costs and expenses.
Under the terms of the funding agreement, the third party funder is entitled to a priority return of funds advanced from any proceeds
recovered. The Company’s management fees and management support services expenses relate to this agreement.
Patent Enforcement and
Other Litigation
Certain of the Company’s
operating subsidiaries are engaged in litigation to enforce their patents and patent rights. In connection with these patent
enforcement actions, it is possible that a defendant may request and/or a court may rule that an operating subsidiary has violated
statutory authority, regulatory authority, federal rules, local court rules, or governing standards relating to the substantive
or procedural aspects of such enforcement actions. In such event, a court may issue monetary sanctions against the Company
or its operating subsidiaries or award attorney’s fees and/or expenses to a defendant(s), which could be material, and if
required to be paid by the Company or its operating subsidiaries, could materially harm the Company’s operating results and
financial position. Since the operating subsidiaries do not have any assets other than the patents, and the Company does not have
any available financial resources to pay any judgment which a defendant may obtain against a subsidiary, such a judgement may result
in the bankruptcy of the subsidiary and/or the loss of the patents, which are the subsidiaries’ only assets.
On January 19, 2017, the court in the Mobile Data Portfolio
litigation granted the defendants’ motion for summary judgment of non-infringement, which Quest Licensing Corporation has
appealed. Following the court’s decision granting the defendant’s motion for summary judgment, the defendants moved
for an award of attorneys’ fees under Section 285 of the patent act which provides that “the court in exceptional
cases may award reasonable attorney fees to the prevailing party.” Although the motion, if granted, would result in a judgment
against Quest Licensing Corporation, such subsidiary does not have the financial resources to enable it to pay any judgment which
may be rendered against it, and, the defendants may seek to enforce their judgment by seeking to foreclose on the patents owned
by the subsidiary or seek to force the subsidiary into bankruptcy and purchase the patents in the bankruptcy proceeding, either
of which could result in a default under the Company’s agreement with United Wireless. The possible amount of any judgment
cannot be estimated and the funding source for the litigation will not provide the Company with funds to pay an adverse judgment.
The Company believes that it has valid defenses to the claim for attorneys’ fees.