DIGITALFX
INTERNATIONAL, INC.
Filed
Pursuant to Rule 424(b)(3)
Registration
No. 333-136855
PROSPECTUS
SUPPLEMENT NO. 2
(To
Prospectus dated June 5, 2007)
This
is a
prospectus supplement to our prospectus dated June 5, 2007 relating to the
resale from time to time by selling shareholders of up to 21,152,595 shares
of
our Common Stock. On November 14, 2007, we filed with the Securities and
Exchange Commission a Quarterly Report on Form 10-QSB. The text of the Quarterly
Report on Form 10-QSB is attached to and made a part of this prospectus
supplement. The exhibits to the Quarterly Report on Form 10-QSB are not included
with this prospectus supplement and are not incorporated by reference
herein.
This
prospectus supplement should be read in conjunction with the prospectus and
any
prior prospectus supplements, and this prospectus supplement is qualified by
reference to the prospectus and any prior prospectus supplements, except to
the
extent that the information provided by this prospectus supplement supersedes
the information contained in the prospectus or any prior prospectus
supplement.
The
securities offered by the prospectus involve a high degree of risk. You should
carefully consider the “Risk Factors” referenced on page 4 of the prospectus in
determining whether to purchase the Common Stock.
The
date of this prospectus supplement is November 16, 2007.
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
WASHINGTON,
D.C. 20549
FORM
10-QSB
QUARTERLY
REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES
EXCHANGE ACT OF 1934
For
the Quarterly Period Ended: September 30, 2007
Commission
File Number:
000-27551
DIGITALFX
INTERNATIONAL, INC.
(Exact
name of small business issuer as specified in its charter)
Florida
|
|
65-0358792
|
(State
or other jurisdiction of
|
|
(IRS
Employer
|
incorporation
or organization)
|
|
Identification
No.)
|
3035
East Patrick Lane, Suite 9
Las
Vegas, Nevada 89120
(Address
of principal executive offices)
(702)
938-9300
(Issuer’s
telephone number)
Check
whether the issuer: (1) filed all reports required to be filed by Section 13
or
15(d) of the Exchange Act during the past 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 is a shell company (as defined in Rule 12b-2 of
the
Exchange Act).
YES
o
NO
x
As
of
November 12, 2007, 24,165,575 shares of the registrant’s common stock were
outstanding.
Transitional
Small Business Disclosure Format (Check One):
|
YES
o
NO
x
|
TABLE
OF CONTENTS
|
|
Page
|
|
|
|
PART
I
|
Condensed
Financial Information
|
|
|
|
|
Item
1.
|
Condensed
Financial Statements
|
|
|
|
|
|
Condensed
Consolidated Balance Sheet (Unaudited)
|
2
|
|
|
|
|
Condensed
Consolidated Statements of Operations (Unaudited)
|
3
|
|
|
|
|
Condensed
Consolidated Statement of Stockholders’ Equity (Unaudited)
|
4
|
|
|
|
|
Condensed
Consolidated Statements of Cash Flows (Unaudited)
|
5
|
|
|
|
|
Notes
to Condensed Consolidated Financial Statements (Unaudited)
|
6
|
|
|
|
Item
2.
|
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
|
27
|
|
|
|
Item
3.
|
Controls
and Procedures
|
46
|
|
|
|
PART
II
|
Other
Information
|
|
|
|
|
Item
1.
|
Legal
Proceedings
|
47
|
|
|
|
Item
2.
|
Unregistered
Sales of Equity Securities and Use of Proceeds
|
48
|
|
|
|
Item
6.
|
Exhibits
|
48
|
PART
I.
DigitalFX
International, Inc. and Subsidiaries
Condensed
Consolidated Balance Sheet
September
30, 2007
(In
thousands, except share data, unaudited)
Assets
|
|
|
|
|
|
|
|
|
|
Current
assets:
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
2,274
|
|
Accounts
receivable
|
|
|
97
|
|
Inventories,
net
|
|
|
932
|
|
Prepaid
bandwidth charges, affiliate
|
|
|
322
|
|
Prepaid
expenses and other assets
|
|
|
826
|
|
Convertible
secured promissory note
|
|
|
225
|
|
Deferred
income taxes, net
|
|
|
111
|
|
|
|
|
|
|
Total
current assets
|
|
|
4,787
|
|
|
|
|
|
|
Investments,
net
|
|
|
1,489
|
|
Property
and equipment, net of accumulated depreciation and amortization of
$482
|
|
|
722
|
|
Deposits,
merchant processors
|
|
|
712
|
|
Other
assets
|
|
|
22
|
|
Deferred
income taxes, net
|
|
|
1,411
|
|
|
|
|
|
|
Total
assets
|
|
$
|
9,143
|
|
|
|
|
|
|
Liabilities
and Stockholders’ Equity
|
|
|
|
|
|
|
|
|
|
Current
liabilities:
|
|
|
|
|
Accounts
payable
|
|
$
|
734
|
|
Accrued
expenses
|
|
|
903
|
|
Deferred
revenue
|
|
|
297
|
|
Accrued
commissions
|
|
|
1,627
|
|
|
|
|
|
|
Total
current liabilities
|
|
|
3,561
|
|
|
|
|
|
|
Commitments
and Contingencies
|
|
|
|
|
|
|
|
|
|
Stockholders’
equity:
|
|
|
|
|
Preferred
stock, $0.01 par value, 5,000,000 shares authorized, no shares issued
and
outstanding
|
|
|
-
|
|
Common
stock, $0.001 par value, 100,000,000 shares authorized, 24,139,703
shares
issued and outstanding
|
|
|
24
|
|
Additional
paid in capital
|
|
|
10,980
|
|
Other
comprehensive loss
|
|
|
(130
|
)
|
Accumulated
deficit
|
|
|
(5,292
|
)
|
|
|
|
|
|
Total
stockholders’ equity
|
|
|
5,582
|
|
Total
liabilities and stockholders’ equity
|
|
$
|
9,143
|
|
See
Notes to
Condensed
Consolidated Financial Statements
DigitalFX
International, Inc. and Subsidiaries
Condensed
Consolidated Statements of Operations
(In
thousands, except share and per share data, unaudited)
|
|
Three Months Ended September 30,
|
|
Nine Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
|
|
$
|
5,425
|
|
$
|
7,109
|
|
$
|
17,987
|
|
$
|
16,232
|
|
Cost
of revenues
|
|
|
910
|
|
|
1,497
|
|
|
2,782
|
|
|
3,272
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross
profit
|
|
|
4,515
|
|
|
5,612
|
|
|
15,205
|
|
|
12,960
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commission
expenses
|
|
|
2,365
|
|
|
3,188
|
|
|
7,880
|
|
|
7,582
|
|
Other
operating expenses
|
|
|
3,539
|
|
|
2,030
|
|
|
8,780
|
|
|
4,328
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
income (loss)
|
|
|
(1,389
|
)
|
|
394
|
|
|
(1,455
|
)
|
|
1,050
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expenses
related to exchange transaction
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
(635
|
)
|
Other
income (expense), net
|
|
|
71
|
|
|
(55
|
)
|
|
203
|
|
|
(46
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income
(loss) before provision for income taxes
|
|
|
(1,318
|
)
|
|
339
|
|
|
(1,252
|
)
|
|
369
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Provision
(benefit) for income taxes
|
|
|
(337
|
)
|
|
139
|
|
|
(281
|
)
|
|
168
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income (loss)
|
|
$
|
(981
|
)
|
$
|
200
|
|
$
|
(971
|
)
|
$
|
201
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income (loss) per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
(.04
|
)
|
$
|
.01
|
|
$
|
(.04
|
)
|
$
|
.01
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fully
diluted
|
|
$
|
(.04
|
)
|
$
|
.01
|
|
$
|
(.04
|
)
|
$
|
.01
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average shares outstanding:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
|
|
|
22,094,617
|
|
|
|
|
|
20,597,256
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fully
diluted
|
|
|
|
|
|
24,831,236
|
|
|
|
|
|
23,141,961
|
|
See
Notes to Condensed Consolidated Financial Statements
DigitalFX
International, Inc. and Subsidiaries
Condensed
Consolidated Statement of Stockholders’ Equity
(In
thousands, except share data, unaudited)
|
|
Common
|
|
Common
|
|
Additional
|
|
Other Comprehensive
|
|
Accumulated
|
|
|
|
|
|
Shares
|
|
Stock
|
|
Paid-In Capital
|
|
Loss
|
|
Deficit
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance,
January 1, 2007
|
|
|
23,280,563
|
|
$
|
23
|
|
$
|
9,403
|
|
$
|
(20
|
)
|
$
|
(4,321
|
)
|
$
|
5,085
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Issuance
of common stock
for
services
|
|
|
10,000
|
|
|
-
|
|
|
185
|
|
|
-
|
|
|
-
|
|
|
185
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercise
of warrants
|
|
|
700,529
|
|
|
1
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
1
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercise
of options
|
|
|
148,611
|
|
|
-
|
|
|
36
|
|
|
-
|
|
|
-
|
|
|
36
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair
value of vested options
|
|
|
-
|
|
|
-
|
|
|
394
|
|
|
-
|
|
|
-
|
|
|
394
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Excess
tax benefit related to stock options and warrants
exercised
|
|
|
-
|
|
|
-
|
|
|
962
|
|
|
-
|
|
|
-
|
|
|
962
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair
value adjustment on investment, net of tax
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
(109
|
)
|
|
-
|
|
|
(109
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Foreign
currency translation adjustment
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
(1
|
)
|
|
-
|
|
|
(1
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss for the nine months ended September 30, 2007
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
(971
|
)
|
|
(971
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance,
September 30, 2007
|
|
|
24,139,703
|
|
$
|
24
|
|
$
|
10,980
|
|
$
|
(130
|
)
|
$
|
(5,292
|
)
|
$
|
5,582
|
|
See
Notes to Condensed Consolidated Financial Statements
DigitalFX
International, Inc. and Subsidiaries
Condensed
Consolidated Statements of Cash Flows
(In
thousands, unaudited)
|
|
Nine
Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
Operating
activities:
|
|
|
|
|
|
|
|
Net
income (loss)
|
|
$
|
(971
|
)
|
$
|
201
|
|
Adjustment
to reconcile net income (loss) to net cash (used in) provided by
operating
activities:
|
|
|
|
|
|
|
|
Depreciation
and amortization
|
|
|
225
|
|
|
97
|
|
Equity
based compensation expense
|
|
|
394
|
|
|
184
|
|
Deferred
income taxes
|
|
|
(291
|
)
|
|
(91
|
)
|
Common
stock
issued for services
|
|
|
|
|
|
-
|
|
Changes
in assets and liabilities:
|
|
|
|
|
|
|
|
Accounts
receivable
|
|
|
(48
|
)
|
|
(185
|
)
|
Inventory
|
|
|
(797
|
)
|
|
(26
|
)
|
Prepaid
expenses and other assets
|
|
|
(774
|
)
|
|
(683
|
)
|
Accounts
payable and accrued expenses
|
|
|
958
|
|
|
1,681
|
|
Due
to affiliate
|
|
|
(187
|
)
|
|
203
|
|
|
|
|
|
|
|
|
|
Net
cash provided by (used in) operating activities
|
|
|
(
1,306
|
)
|
|
1,381
|
|
|
|
|
|
|
|
|
|
Investing
activities:
|
|
|
|
|
|
|
|
Purchase
of investments
|
|
|
(1,691
|
)
|
|
-
|
|
Purchase
of convertible secured promissory note
|
|
|
(225
|
)
|
|
-
|
|
Purchases
of property and equipment
|
|
|
(297
|
)
|
|
(167
|
)
|
|
|
|
|
|
|
|
|
Net
cash used in investing activities
|
|
|
(2,213
|
)
|
|
(167
|
)
|
|
|
|
|
|
|
|
|
Financing
activities:
|
|
|
|
|
|
|
|
Proceeds
from issuance of common stock, net
|
|
|
38
|
|
|
625
|
|
Payments
on note payable
|
|
|
-
|
|
|
(50
|
)
|
Distributions
to shareholders
|
|
|
-
|
|
|
(265
|
)
|
|
|
|
|
|
|
|
|
Net
cash provided by (used in) financing activities
|
|
|
38
|
|
|
310
|
|
|
|
|
|
|
|
|
|
Foreign
currency translation
|
|
|
1
|
|
|
(10
|
)
|
|
|
|
|
|
|
|
|
Change
in cash and cash equivalents
|
|
|
(3,480
|
)
|
|
1,514
|
|
Cash
and cash equivalents, beginning of period
|
|
|
5,754
|
|
|
265
|
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents, end of period
|
|
$
|
2,274
|
|
$
|
1,779
|
|
|
|
|
|
|
|
|
|
Supplemental
Cash Flow Information:
|
|
|
|
|
|
|
|
Cash
paid for income taxes
|
|
$
|
116
|
|
$
|
-
|
|
Cash
paid for interest
|
|
$
|
-
|
|
$
|
11
|
|
Non-Cash
Investing and Financing Activities:
|
|
|
|
|
|
|
|
Tax
benefit related to stock options and warrants exercised
|
|
$
|
962
|
|
$
|
-
|
|
Reclassification
of deposits to fixed assets
|
|
$
|
373
|
|
$
|
|
|
Tax
effect of loss on investment
|
|
$
|
93
|
|
$
|
-
|
|
See
Notes to Condensed Consolidated Financial Statements
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
Note
1.
The
Company and Basis of Presentation
Company
DigitalFX
International, Inc. (the “Company”), a Florida C corporation, is a holding
company, and creator of digital communications and social networking solutions,
as showcased on its social network http://www.helloWorld.com operated by our
wholly-owned subsidiary, DigitalFX Networks, LLC.
The
Company develops, hosts and markets proprietary communication and collaboration
services, and social networking software applications, including video email,
video instant messaging and live webcasting. The portal utilizes a
commercial-free, subscription-based Application Service Provider (ASP)
model.
The
Company sells subscriptions to its portal through a unique multi-tiered
affiliate program using non-related independent distributors, known as
“Affiliates.” The Company also markets subscriptions directly to “Retail
Customers” who purchase them for their personal use. In addition to offering
portal subscriptions, the Company sells select products to these Affiliates
through its U. S. subsidiary VMdirect, LLC and its wholly-owned U.K. and Ireland
subsidiaries to assist them in building their businesses and in selling
subscriptions to the portal.
The
Company has developed an additional portal called First Stream through which
subscriptions are offered by certain qualified affiliates to small and medium
sized businesses. These are sold through DigitalFX Networks, LLC.
The
condensed
consolidated
financial statements include the accounts of the Company, VMdirect, L.L.C.
(“VMdirect”) and its wholly-owned U.K. and Ireland subsidiaries, and the
Company’s wholly-owned Nevada subsidiaries. Inter-company transactions and
balances have been eliminated.
These
interim condensed consolidated financial statements are unaudited, but in
the
opinion of management of the Company, contain all adjustments, which include
normal recurring adjustments, necessary to present fairly the financial position
at September 30, 2007, the results of operations for the three and nine months
ended September 30, 2007 and 2006 and the cash flows for the
nine
months ended September 30, 2007 and 2006. The Company’s audited financial
statements as of and for the years ended December 31, 2006 and 2005 are included
in its 10-KSB filing dated March 19, 2007.
The
results of operations for the three and nine months ended September 30, 2007
are
not necessarily indicative of the results of operations to be expected for
the
fiscal year ending December 31, 2007.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
Merger
and Stock Split
On
June
15, 2006, Qorus.com, Inc., an inactive Florida corporation (“Qorus”) with no
current operations, issued to the Company’s members 1,014,589 shares of Series A
Convertible Preferred Stock, par value $0.01 per share, of Qorus (the “Preferred
Stock”), which were converted into 1,057,547,456 shares of Qorus’ common stock
(“Conversion Shares”). The number of shares of Preferred Stock issued to the
Members and the number of Conversion Shares gives effect to the issuance of
289,292 membership units by VMdirect for an aggregate purchase price of $625,
a
transaction that was completed immediately prior to the Closing. The transaction
has been accounted for as a reverse merger (recapitalization) with the Company
deemed the accounting acquirer, and Qorus the legal acquirer. As such, the
financial statements herein reflect the historical activity of VMdirect since
its inception, and the historical stockholders’ equity of VMdirect has been
retroactively restated for the equivalent number of shares received in the
exchange after giving effect to any differences in the par value offset to
additional paid in capital. Subsequent to the consummation of this transaction,
Qorus changed its name to DigitalFX International, Inc.
On
August
1, 2006, the Company affected a 1 for 50 reverse stock split. The effect of
this
stock split has been retroactively reflected in the financial statements as
if
the stock split occurred at the beginning of the earliest period
reported.
Note
2.
Accounting
Policies
Use
of Estimates and Assumptions
The
condensed financial statements are prepared in accordance with accounting
principles generally accepted in the United States of America. Preparing
condensed financial statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions that affect
the
reported amounts of assets and liabilities at the date of the financial
statements, and the reported amounts of revenues and expenses during the
reported period. Examples of significant estimates used in preparing the
accompanying condensed financial statements include, but are not limited to:
the
fair value of investments in non-marketable securities; the carrying value
of
notes receivable; the carrying value of long-lived assets; useful lives of
property and equipment; revenue recognition; and the valuation allowances for
receivables, inventories and sales returns, and the value of stock options
issued for the purpose of determining stock-based compensation. Actual results
and outcomes may materially differ from management’s estimates and
assumptions.
Cash
and Cash Equivalents
The
Company considers all highly liquid investments with remaining maturities of
three months or less when acquired to be cash equivalents. The Company holds
its
cash in what it believes to be credit-worthy financial institutions.
At
September 30, 2007, the Company had $712 of funds held by credit card merchant
processors as reserves against any possible charge backs and returns on credit
card transactions related to customer disputes that are not offset against
the
Company’s daily sales deposit activity. These amounts are reflected as Deposit,
Merchant Processors on the Company’s balance sheet.
Investments
The
Company accounts for its investments in equity securities under SFAS 115,
“Accounting for Certain Investments in Debt and Equity Securities.” Investments
in equity securities are carried at fair value with the unrealized gains or
losses, net of tax, included as a component of accumulated other comprehensive
income in stockholders’ equity. Realized gains and losses and declines in value
considered to be other than temporary on available for sale securities are
included in other, net.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
The
fair
values for marketable equity securities are based on quoted market prices.
The
carrying value for non-marketable equity securities investments in private
companies is based on cost, which approximates fair value. In determining
whether a decline in value of non-marketable equity securities investments
in
private companies is other than temporary, the assessment is made by considering
available evidence including the general market conditions in the investee’s
industry, the investee’s product development status, the investee’s ability to
meet business milestones and the financial condition of the investee. When
a
decline is considered other than temporary, the Company recognizes an impairment
loss in the current period’s operating results in the period of
decline.
Revenues
The
Company generates revenue through (i) sales of affiliate business packages
and
selling aids to affiliates which include cameras, sales literature, and training
videos, and the initial month’s subscription to our internet-based suite of
products which includes a wide spectrum of streaming video content and an
integrated suite of streaming media applications, including video email, video
chat, and live web-casting, (ii) sales of monthly subscriptions to retail
customers and affiliates with a wide spectrum of streaming video content as
well
as an integrated suite of streaming media applications, including video email,
video chat, and live web-casting, (iii) sales of branded apparel and
merchandise, and (iv) hosting conferences and events.
Affiliate
Business Packages
The
Company recognizes revenue from the sales of the cameras and selling aids
within
the business package, including shipping revenue, in accordance with SAB
No.
104, when persuasive evidence of an order arrangement exists, delivery has
occurred, the sales price is fixed or determinable and collectibility is
reasonably assured. Generally, these criteria are met at the time the product
is
shipped to customers when title and risk of loss have transferred. Sales
of the
above products, ranging in price from $79 to $
1,999
(pricing not in thousands),
entail
no post-customer support or delivery of any other items. Allowances for
estimated subsequent customer returns are provided when revenues are recorded.
Costs incurred for the shipping and handling of its products are recorded
as
cost of sales.
The
Company recognizes revenue from sale of the affiliate’s initial month’s
subscription to the internet-based suite of products in accordance with
generally accepted accounting principals and based on the fair value of such
suite of products. Fair value is determinable because the subscription fee
is
thereafter billed monthly at a fixed rate based on the level of service
selected. Access to the internet-based studio suite of the products is delivered
together, and the individual products within the suite cannot be sold
separately. Access is delivered immediately upon sign up and order
acceptance.
A
monthly
subscription is cancellable at any time. The relevant subscription fee is fully
refundable if such cancellation is made in writing in accordance with the
Company’s policies but only for the current month.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
Monthly
Subscriptions
The
Company recognizes revenue from sales of a month’s subscription to retail
customers and sales to affiliates for their recurring subscription to the
internet-based suite of products in accordance with generally accepted
accounting principals and based on the fair value of such suite of products.
Fair value is determinable because the subscription fee is billed at a fixed
rate based on the level of service selected. Funds collected in advance of
the
billing period are deferred. A monthly subscription is cancellable at any time.
The Company records an allowance for potential chargebacks on subscription
fees
based on an analysis of historical data for the four months preceding the date
of measurement. The accuracy of these estimates is dependent on the rate of
future chargebacks being consistent with the historical rate. Increases or
decreases to the sales allowance are charged to revenue.
Apparel
and Merchandise
The
Company also sells select products to affiliates to assist them in building
their businesses and in selling subscriptions to the portal. Revenue for these
sales including shipping revenue are recognized when all the criteria of SAB
No.
104 described above are met, which is generally upon shipment.
Conferences
and Events
The
Company also earns fees for certain events it hosts such as sales and training
conferences and seminars. Revenue is recognized when all of the criteria of
SAB
No. 104 described above are met, which is generally after the event has
occurred. Amounts collected prior to the event are reflected as deferred
revenue, and recognized after the event has occurred.
Shipping
and Handling Fees
Shipping
and handling fees are billed to customers and included in revenue. The related
costs are included in cost of goods sold. Shipping and handling costs are
charged to expense as incurred. Total shipping and handling costs of $104,
$329,
$97 and $251 are included in cost of goods sold for the three and nine months
ended September 30, 2007 and 2006, respectively.
Product
Returns and Cancellations
Affiliate
business packages and merchandise returned within the first 30 days of purchase
are refunded at 90 percent of the sales price. Returned products that were
damaged during shipment to the customer are replaced immediately at the
Company’s expense.
The
sales
allowance is a monthly estimate of refunds to be issued on affiliate business
packages that have been shipped but are still subject to our return policy
at
month end. The allowance is based on an analysis of the historical rate of
credits and refunds, using the latest four months activity. Increases or
decreased to the sales allowance are charged to revenue.
Monthly
subscription services are provided immediately upon enrollment and continue
until cancelled. The recurring subscription can be cancelled at any time in
writing. An allowance is recorded for potential subscription chargebacks based
on an analysis of historical data for the four months preceding the date of
measurement.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
Stock-Based
Compensation
The
Company periodically issues stock options and warrants to employees and
non-employees in non-capital raising transactions for services and for financing
costs. The Company adopted SFAS No. 123R, “Accounting for Stock-Based
Compensation” effective January 1, 2006, and is using the modified prospective
method in which compensation cost is recognized beginning with the effective
date (a) based on the requirements of SFAS No. 123R for all share-based payments
granted after the effective date and (b) based on the requirements of SFAS
No.
123R for all awards granted to employees prior to the effective date of SFAS
No.
123R that remain unvested on the effective date. The Company accounts for stock
option and warrant grants issued and vesting to non-employees in accordance
with
EITF No. 96-18: “Accounting for Equity Instruments that are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” and
EITF 00-18 “Accounting Recognition for Certain Transactions involving Equity
Instruments Granted to Other Than Employees” whereby the fair value of the stock
compensation is based on the measurement date as determined at either a) the
date at which a performance commitment is reached, or b) at the date at which
the necessary performance to earn the equity instrument is
complete.
Earnings
(Loss) Per Share
Statement
of Financial Accounting Standards No. 128, “Earnings per Share,” requires
presentation of basic earnings per share (“Basic EPS”) and diluted earnings per
share (“Diluted EPS”). Basic earnings (loss) per share is computed by dividing
earnings (loss) available to common stockholders by the weighted average number
of common shares outstanding during the period. The weighted average number
of
shares outstanding has been retroactively restated for the equivalent number
of
shares received by the accounting acquirer as a result of the Exchange
transaction as if these shares had been outstanding as of the beginning of
the
earliest period presented. The 964,657 shares issued to the legal acquirer
are
included in the weighted average share calculation from June 15, 2006, the
date
of the exchange agreement.
Diluted
earnings per share reflects the potential dilution, using the treasury stock
method, that could occur if securities or other contracts to issue common stock
were exercised or converted into common stock or resulted in the issuance of
common stock that then shared in the earnings of the Company. In computing
diluted earnings per share, the treasury stock method assumes that outstanding
options and warrants are exercised and the proceeds are used to purchase common
stock at the average market price during the period. Options and warrants will
have a dilutive effect under the treasury stock method only when the average
market price of the common stock during the period exceeds the exercise price
of
the options and warrants.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
Potentially
dilutive securities were included in the calculation of diluted earnings per
share for the three and nine months ended September 30, 2006, but were not
included in the calculation of loss for the three and nine months ended
September 30, 2007 because the Company incurred a loss during such periods
and
thus their effect would be anti-dilutive, and basic and diluted loss per share
are the same.
The
following is a reconciliation of the calculation of basic and diluted earnings
per share for the three and nine months ended September 30, 2006.
|
|
Three
Months Ended
September
30, 2006
|
|
Nine
Months Ended
September
30, 2006
|
|
|
Income
(Numerator)
|
|
Shares
(Denominator)
|
|
Per-Share
Amount
|
|
Income
(Numerator)
|
|
Shares
(Denominator)
|
|
Per-Share
Amount
|
|
Basic
earnings per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income
|
|
$
|
200
|
|
|
22,094,617
|
|
$
|
0.01
|
|
$
|
201
|
|
|
20,597,256
|
|
$
|
0.01
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Effect
of Dilutive Securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options
and warrants
|
|
|
-
|
|
|
2,736,619
|
|
|
-
|
|
|
-
|
|
|
2,544,705
|
|
|
-
|
|
Diluted
earnings per share
|
|
$
|
200
|
|
|
24,831,236
|
|
$
|
0.01
|
|
$
|
201
|
|
|
23,141,961
|
|
$
|
0.01
|
|
Options
to purchase 276,500 shares of common stock at $7.75 per share were outstanding
during the three and nine months ended September 30, 2006 but were not included
in the computation of diluted earnings per share for these periods because
the
options’ exercise price was greater than the average market price of the common
shares during these periods, and their effect would be anti-dilutive.
Member
Incentives
The
Company’s commission structure is based on a multi-level affiliate program.
Commissions are recorded for sales, including commissions based on bonus points
assigned to products which are independent of the product’s price. Commissions
totaled $2,365, $7,880, $3,188 and $7,582 for the three and nine months ended
September 30, 2007 and 2006, respectively, and are included in the accompanying
consolidated statements of operations.
Income
Taxes
VMdirect
had 11 individual members until June 15, 2006. After the exchange transaction,
DigitalFX became the sole member of VMdirect. Federal income tax obligations
for
the period through and including June 15, 2006 were passed through to the
previous members of VMdirect, and the Company recorded no provision for such
taxes for the period ended March 31, 2006. The Company has agreed with the
previous members of VMdirect that the Company will not make any distributions
to
pay tax liabilities, if any, on income earned prior to June 15, 2006.
Consequently, the taxes, if any, on the income of VMdirect through June 15,
2006
are payable individually by each member.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
The
Company accounts for income taxes and related accounts under the liability
method. Deferred tax liabilities and assets are determined based on the
difference between the financial statement and tax bases of assets and
liabilities using enacted rates expected to be in effect during the year in
which the basis differences reverse.
Effective
January 1, 2007, the Company adopted Financial Accounting Standards Board
Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN
48”).
—an
interpretation of FASB Statement No. 109, Accounting for Income
Taxes
.
The
Interpretation addresses the determination of whether tax benefits claimed
or
expected to be claimed on a tax return should be recorded in the financial
statements. Under FIN 48, we may recognize the tax benefit from an uncertain
tax
position only if it is more likely than not that the tax position will be
sustained on examination by the taxing authorities, based on the technical
merits of the position. The tax benefits recognized in the financial statements
from such a position should be measured based on the largest benefit that has
a
greater than fifty percent likelihood of being realized upon ultimate
settlement. FIN 48 also provides guidance on derecognition, classification,
interest and penalties on income taxes, accounting in interim periods and
requires increased disclosures. At the date of adoption, and as of September
30,
2007, the Company does not have a liability for unrecognized tax
benefits.
The
Company files income tax returns in the U.S. federal jurisdiction. The Company
is subject to U.S. federal income tax examinations by tax authorities for
periods after June 16, 2006, the date at which the Company completed its reverse
merger transaction. In addition, the Company files income tax returns in the
United Kingdom and Ireland for the foreign subsidiaries located in these
jurisdictions. The Company is subject to tax examinations by tax authorities
in
these jurisdictions, however, as of September 30, 2007, there are no open
foreign tax audits or inquiries relating to the Company’s foreign
subsidiaries.
The
Company’s policy is to record interest and penalties on uncertain tax provisions
as income tax expense. As of September 30, 2007, the Company has no accrued
interest or penalties related to uncertain tax positions.
Foreign
Currency Translation
The
functional currency of our UK subsidiary is the pound sterling and the
functional currency of our Ireland subsidiary is the euro. The foreign
subsidiaries’ asset and liability accounts are translated for consolidated
financial reporting purposes into U.S. dollar amounts at period end exchange
rates; investment, revenue and expense accounts are translated at the average
rates during the period in accordance with
SFAS
No.
52,
Foreign
Currency Translation
The
effects of foreign currency translation adjustments are included in
stockholders’ equity as a component of “Other comprehensive income” in the
accompanying balance sheet.
Comprehensive
Loss
SFAS
No.
130, “Reporting Comprehensive Income,” established rules for the reporting and
display of comprehensive income and its components. SFAS No. 130 requires
unrealized gains or losses on the Company’s foreign currency translation
adjustments and investments in available for sale securities to be reported
as a
separate component (comprehensive loss) of stockholders’
equity.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
The
components of comprehensive loss are as follows:
|
|
Three Months Ended September 30,
|
|
Nine Months Ended September 30,
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
|
|
|
|
Net
Income (loss)
|
|
$
|
(981
|
)
|
$
|
200
|
|
$
|
$(971
|
)
|
$
|
201
|
|
Foreign
Currency Translation
|
|
|
1
|
|
|
(10
|
)
|
|
(1
|
)
|
|
(10
|
)
|
Unrealized
gain (loss) on investment, (net of taxes of $93)
|
|
|
76
|
|
|
-
|
|
|
(109
|
)
|
|
-
|
|
Comprehensive
Income (Loss)
|
|
$
|
(904
|
)
|
$
|
190
|
|
$
|
(1,081
|
)
|
$
|
191
|
|
Recent
Accounting Pronouncements
In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which
provides enhanced guidance for using fair value to measure assets and
liabilities. SFAS No. 157 provides a common definition of fair value and
establishes a framework to make the measurement of fair value in generally
accepted accounting principles more consistent and comparable. SFAS No. 157
also
requires expanded disclosures to provide information about the extent to which
fair value is used to measure assets and liabilities, the methods and
assumptions used to measure fair value, and the effect of fair value measures
on
earnings. SFAS No. 157 is effective for financial statements issued in fiscal
years beginning after November 15, 2007 and for interim periods within those
fiscal years. The Company does not believe the adoption of SFAS No. 157 will
have a material, if any, effect on its consolidated results of operations,
financial position, or cash flows.
In
February 2007, the Financial Accounting Standards Board (FASB) issued FASB
Statement No. 159, “The Fair Value Option for Financial Assets and
Financial Liabilities — Including an amendment of FASB Statement
No. 115” (FAS 159). FAS 159, which becomes effective for the
company on January 1, 2008, permits companies to choose to measure many
financial instruments and certain other items at fair value and report
unrealized gains and losses in earnings. Such accounting is optional and is
generally to be applied instrument by instrument. The company does not
anticipate that election, if any, of this fair-value option will have a material
effect on its consolidated financial position, results of operations, cash
flows
or disclosures.
Note
3.
Product,
Customer and Geographic Information
SFAS
No.
131, “Disclosure about Segments of an Enterprise and Related Information,”
establishes standards for the reporting of business enterprises of information
about operating segments, products and services, geographic areas and major
customers. The standard for determining what information to report is based
on
operating segments within DigitalFX International that are regularly reviewed
and used by the chief operating decision-maker in evaluating financial
performance and resource allocation.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
DigitalFX
International’s chief operating decision-maker is considered to be the chief
executive officer (CEO). Based on the financial information reviewed by the
CEO,
the Company has determined that it operates in a single operating segment,
specifically, digital web-based communications services.
The
following table presents revenue by product category for the three and nine
months ended September 30, 2007 and 2006.
|
|
Three
Months Ended
|
|
Nine
Months Ended
|
|
Revenue:
|
|
September 30,
2007
|
|
September 30,
2006
|
|
September 30,
2007
|
|
September 30,
2006
|
|
Affiliate
business packages
|
|
$
|
876
|
|
$
|
2,360
|
|
$
|
3,852
|
|
$
|
6,630
|
|
Upgrades
to business packages
|
|
|
184
|
|
|
632
|
|
|
868
|
|
|
1,187
|
|
Subscription
fees for access plans and administrative tools
|
|
|
4,267
|
|
|
3,272
|
|
|
12,931
|
|
|
7,017
|
|
Merchandise
and Shipping fees
|
|
|
98
|
|
|
337
|
|
|
336
|
|
|
737
|
|
Other
revenue
|
|
|
-
|
|
|
508
|
|
|
-
|
|
|
661
|
|
Total
Revenue
|
|
$
|
5,425
|
|
$
|
7,109
|
|
$
|
17,987
|
|
$
|
16,232
|
|
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
The
breakdown of revenues generated by geographic region for the three and nine
months ended September 30, 2007 and 2006 is as follows:
|
|
Three
Months Ended
|
|
Nine
Months Ended
|
|
|
|
September 30,
2007
|
|
September 30,
2006
|
|
September 30,
2007
|
|
September 30,
2006
|
|
|
|
|
|
|
|
|
|
|
|
United
States, Canada & Mexico
|
|
|
93
|
%
|
|
90
|
%
|
|
92
|
%
|
|
88
|
%
|
United
Kingdom/Europe
|
|
|
2
|
%
|
|
3
|
%
|
|
2
|
%
|
|
3
|
%
|
Australia
|
|
|
4
|
%
|
|
6
|
%
|
|
5
|
%
|
|
8
|
%
|
New
Zealand
|
|
|
1
|
%
|
|
1
|
%
|
|
1
|
%
|
|
1
|
%
|
|
|
|
100
|
%
|
|
100
|
%
|
|
100
|
%
|
|
100
|
%
|
Assets
and liabilities located in countries outside the United States were not material
at September 30, 2007.
The
breakdown of revenues generated by customer type for the three and nine months
ended September 30, 2007 and 2006 is as follows:
|
|
Three
Months Ended
|
|
Nine
Months Ended
|
|
|
|
September 30,
2007
|
|
September 30,
2006
|
|
September 30,
2007
|
|
September 30,
2006
|
|
Affiliates
|
|
|
89
|
%
|
|
95
|
%
|
|
91
|
%
|
|
95
|
%
|
Retail
customers
|
|
|
11
|
%
|
|
5
|
%
|
|
9
|
%
|
|
5
|
%
|
|
|
|
100
|
%
|
|
100
|
%
|
|
100
|
%
|
|
100
|
%
|
Note 4.
Convertible
Secured Promissory Note
On
June
8, 2007, the Company entered into a Subscription, Loan and Rights Agreement
(the
“SaySwap Agreement”) with SaySwap, Inc. (“SaySwap”) pursuant to which the
Company agreed to purchase a Senior Secured Convertible Promissory Note (the
“SaySwap Note”) issued by SaySwap in the principal amount of $225, and a warrant
(the “SaySwap Warrant”) to purchase 26.1 shares of SaySwap’s common
stock.
The
SaySwap Note accrues interest at a rate of 8% per annum and has a maturity
date
of April 24, 2009 , provided, however, that if SaySwap consummates a qualified
financing (as defined in the SaySwap Note), SaySwap is required to repay the
outstanding principal amount and all accrued interest on the SaySwap Note within
10 days of the consummation of such qualified financing. The Company may
also
declare
the outstanding principal and accrued interest due and payable
in the
event of a default under the SaySwap Note. The SaySwap Note is convertible,
at
the Company’s option, into shares of SaySwap’s common stock, at any time prior
to 30 days before the maturity date or three days before the consummation of
a
qualified financing. As security for SaySwap’s obligations under the SaySwap
Note, SaySwap also granted to the Company a first priority security interest
in
all of SaySwap’s assets.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
The
SaySwap Warrant entitles the Company to purchase 26.1 shares of SaySwap’s common
stock at a per share price of $3,831. The SaySwap Warrant expires on May 31,
2010.
Pursuant
to the terms of the SaySwap Agreement, the Company is entitled to demand that
SaySwap register the shares of SaySwap’s common stock issuable upon conversion
of the SaySwap Note or exercise of the SaySwap Warrant (the “Underlying SaySwap
Shares”) at such time that SaySwap files a registration statement with the
Securities and Exchange Commission.
Note
5.
Investments
Investments
consist of the following at September 30, 2007:
|
|
Cost
|
|
Unrealized
Loss
|
|
Net
|
|
Fusion Telecommunications Int’l
Inc.
|
|
$
|
700
|
|
$
|
(202
|
)
|
$
|
498
|
|
CJ
Vision Enterprises, Inc
|
|
|
816
|
|
|
-
|
|
|
816
|
|
Transparensee
Systems, Inc.
|
|
|
175
|
|
|
-
|
|
|
175
|
|
|
|
$
|
1,691
|
|
$
|
(202
|
)
|
$
|
1,489
|
|
Fusion
Telecommunications Int’l Inc.
On
May
11, 2007, the Company entered into a Subscription and Rights Agreement with
Fusion Telecommunications International, Inc. (“Fusion”) pursuant to which it
purchased, for aggregate consideration of $700, 7 units consisting of an
aggregate of 700 shares of Fusion’s Series A-2 Cumulative Convertible Preferred
Stock (“Series A-2 Preferred Shares”) and warrants to purchase 421,687 shares of
Fusion’s common stock. The 700 Series A-2 Preferred Shares are convertible into
an aggregate of 843,374 shares of Fusion’s common stock. The warrants have a
term of 7.5 years and are exercisable at the per share price of $0.83. Fusion
has agreed to register the shares of Fusion’s common stock underlying the Series
A-2 Preferred Shares and the warrants.
On
May
23, 2007, the Company entered into a Private Label Purchase Agreement (“Private
Label Agreement”) with Fusion pursuant to which Fusion will, in collaboration
with the Company, develop customized software solely for the Company to
facilitate the integration of Fusion’s advanced unified messaging and digital
telephone service into the Company’s web 2.0 offerings for enterprises and
individuals, and will provide certain additional services as set forth in the
Private Label Agreement. The Private Label Agreement has an initial term of
5
years and automatically renews for two-year terms thereafter unless terminated
by either party pursuant to three months written notice prior to the expiration
of the applicable term. The Company has agreed that customers acquired by the
Company will be activated on Fusion’s network and will remain on Fusion’s
network during the term of the Private Label Agreement. The Company is also
required to pay for services prior to initial delivery and to maintain a
pre-payment balance. The parties have agreed to pay for the resources they
contribute to the development of the customized software.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
Simultaneously
with the execution of the Private Label Agreement, Fusion entered into a
Software Escrow Agreement pursuant to which Fusion deposited with the escrow
agent all technical information that would be required to permit the Company
to
continue to exercise its rights in the event Fusion ceases to operate its
business, Fusion enters bankruptcy or insolvency proceedings, or Fusion
materially breaches the Private Label Agreement, and a letter of direction
authorizing Fusion’s underlying supplier to enter into an agreement with the
Company to provide the services directly to the Company under the same
circumstances.
Upon
the
occurrence of an event of default, either the Company or Fusion is entitled
to
terminate the Private Label Agreement and to exercise all available remedies.
Upon the Company’s default, Fusion is also entitled to suspend the provision of
services and to declare all outstanding amounts due and payable. Upon Fusion’s
default, the Company is also entitled to obtain release of the materials held
in
the escrow account.
At
September 30, 2007, the fair value of the Company’s common share equivalents in
Fusion was $498. As the decline in the fair value of the Company’s investment is
considered temporary, the Company recorded an unrealized loss on its investment
of $202 ($109, net of tax), as a component of accumulated other comprehensive
loss in the accompanying statement of stockholders’ equity.
CJ
Vision Enterprises, Inc.
On
June
1, 2007, the Company subscribed to purchase 72 shares of the Series A Redeemable
Convertible Preferred Stock of C J Vision Enterprises, Inc. (“CJVE”), and
deposited with CJVE the aggregate purchase price of $216. CJVE’s Series A
Redeemable Convertible Preferred Stock will be convertible on a one-for-one
basis into shares of CJVE’s common stock, will accrue dividends at a rate of 8%
per annum, payable in kind, will be mandatorily redeemable on the fifth
anniversary of the date of issuance, and will have a liquidation preference
of
$3,000 per share plus accrued and unpaid dividends which will be senior to
the
liquidation preference for CJVE’s common stock. On June 15, 2007, the Company
purchased from CVJE 20 shares of the common stock of CJVE for aggregate
consideration of $600. The Company and CVJE are currently negotiating definitive
agreements which will document the terms and conditions of the Company’s
investment in CJVE.
At
September 30, 2007, the Company’s investment in CJVE is carried at cost of $816,
which approximates its fair value.
Transparensee
Systems, Inc.
On
June
8, 2007, the Company purchased a Convertible Promissory Note (the “Transparensee
Note”) issued by Transparensee in the principal amount of $175. The
Transparensee Note may not be prepaid, accrues interest at a rate of 4.85%
per
annum and has a maturity date of the earlier of May 14, 2008 or when, upon
or
after the occurrence of an event of default under the Transparensee Note, such
amounts are declared due and payable by the Company or made automatically due
and payable in accordance with the terms of the Transparensee Note. Provided
that Transparensee obtains the requisite approvals for the creation and
designation of a new series to be designated Series A Preferred Stock, the
Transparensee Note is automatically convertible, on the maturity date, into
shares of Transparensee’s Series A Preferred Stock at a per share price of
$2.075, or upon the consent of the requisite shareholders of Transparensee.
In
addition, upon the consummation of a change in control of Transparensee, the
Transparensee Note automatically converts into shares of Transparensee’s common
stock at a per share price of $2.075. In the event that the Transparensee Note
is automatically converted into shares of Transparensee’s Series A Preferred
Stock or common stock, the Company has agreed to enter into a lock-up agreement
for a period of 180 days in connection with Transparensee’s intended initial
public offering.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
The
Transparensee Note is also convertible, at the Company’s option, into shares of
Transparensee’s common stock, at a per share price of $2.075, and the Company
has agreed to enter into a lock-up agreement for a period of 180 days in
connection with such optional conversion upon Transparensee’s intended initial
public offering.
Transparensee
agreed to indemnify the Company, up to a maximum of $75 pro rated over the
initial term of the License Agreement, from infringement claims with respect
to
the licensed software and losses arising in connection therewith. The Company
agreed to indemnify Transparensee in connection with claims with respect to
any
modifications made by the Company to the licensed software, and losses in
connection therewith.
Concurrent
with the purchase of the Promissory Note, the Company also entered into a
Software License and Services Agreement (the “Transparensee License Agreement”)
with Transparensee Systems, Inc. (“Transparensee”), pursuant to which the
Company acquired a non-exclusive license to use Transparensee’s proprietary
search engine software and to resell the products derived from such software
pursuant to the provisions of a separate reseller agreement, and agreed to
obtain certain integration services from Transparensee. The Company is required
to pay fees for the license and integration services as set forth in the
Transparensee License Agreement. The Transparensee License Agreement has a
term
of two years from the date on which the Company’s system is activated with
Transparensee’s software running on it, and is automatically renewed for
additional two-year terms unless the Company provides notice to Transparensee
of
its intention to terminate the Transparensee License Agreement at least 30
days
prior to the expiration of any term.
On
June
8, 2007, the Company also entered into a Reseller Agreement with Transparensee
pursuant to which the Company was appointed as an authorized, non-exclusive
reseller of the licensed software and related documentation. The Company was
also granted a non-exclusive license to use, install and operate the licensed
software for the purposes of testing and evaluation, training of the Company’s
personnel and affiliates, and demonstrating and promoting the licensed software
to potential end-users. The Company shall receive a percentage of the gross
revenue received from product orders. The term of the Reseller Agreement is
the
same as the term of the Transparensee License Agreement.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
Note
6.
Property
and Equipment
Property
and equipment at September 30, 2007 consists of the following:
Furniture
and fixtures
|
|
$
|
47
|
|
Computers
and equipment
|
|
|
441
|
|
Purchased
software
|
|
|
716
|
|
|
|
|
1,204
|
|
Less:
accumulated depreciation and amortization
|
|
|
(482
|
)
|
|
|
$
|
722
|
|
All
property and equipment above is depreciated over a three year life. Depreciation
and amortization expense for the three and nine months ended September 30,
2007
and 2006 was $87, $225, $37 and $97, respectively.
Note
7.
Equity
Transactions
On
February 22, 2007, the Company issued 10,000 shares of its common stock valued
at $32 ($3.20 per share) to a consultant for services provided.
On
November 6, 2007, the Company entered into
an
agreement
with
Richard J. Milham, Jr. and Blue Trident Enterprises, LLC
pursuant
to which the Company
granted
50,000
shares
of its common stock
valued
at
$154 ($3.08 per share) in exchange for services provided. The effective
date of this agreement was September 30, 2007.
As
the
50,000 shares of the Company's stock have been granted but not issued as of
September 30, 2007, these shares
are
excluded from the Company’s calculation of outstanding shares of common stock
for this period.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
Note
8.
Stock
Options and Warrants
Options
The
Company’s 2006 Stock Incentive Plan was adopted by our board of directors and
became effective in August, 2006. The total number of shares reserved for
issuance under this plan was 1,537,501. The number of shares reserved for
issuance under the 2006 Stock Incentive Plan is subject to an annual increase
on
the first day of each fiscal year during the term of the 2006 Stock Incentive
Plan, beginning January 1, 2007, in each case in an amount equal to the lesser
of (i) 1,000,000 shares of common stock, (ii) 5% of the outstanding shares
of
common stock on the last day of the immediately preceding year, or (iii) an
amount determined by our board of directors. Any shares of common stock subject
to an award, which for any reason expires or terminates unexercised, are again
available for issuance under the 2006 Stock Incentive Plan. Our board of
directors did not increase the total number of shares reserved for issuance
under the 2006 Stock Incentive Plan for the fiscal year beginning January 1,
2007.
The
2006
Stock Incentive Plan will terminate after 10 years from the effective date,
unless it is terminated earlier by our board of directors. The plan authorizes
the award of stock options, stock purchase grants, stock appreciation rights
and
stock units.
The
2006
Stock Incentive Plan provides for the grant of both incentive stock options
that
qualify under Section 422 of the Internal Revenue Code and nonqualified stock
options. Incentive stock options may be granted only to our employees or to
employees of any of our parents or subsidiaries. All awards other than incentive
stock options may be granted to our employees, officers, directors, consultants,
independent contractors and advisors or employees, officers, directors,
consultants, independent contractors and advisors of any of our parents or
subsidiaries. The exercise price of incentive stock options must be at least
equal to the fair market value of our common stock on the date of grant. The
exercise price of incentive stock options granted to 10% shareholders must
be at
least equal to 110% of that value. The exercise price of nonqualified stock
options will be determined by the administrator of the plan when the options
are
granted. The term of options granted under our 2006 Stock Incentive Plan may
not
exceed 10 years and typically vest over four years, with 25% of the options
vesting after 12 months and 75% vesting monthly over the remaining three
years.
For
the
three and nine months ended September 30, 2007 and 2006, the value of options
and warrants vesting during the period was $129, $394, $161 and $184,
respectively, and has been reflected as compensation cost. As of September
30,
2007, the Company has unvested options with an intrinsic value of $625 and
future compensation expense totaling $ 1,560 which will be reflected as
compensation cost in future periods as the options vest over the next 48
months.
As
of
September 30, 2007, 823,000 options to purchase shares of common stock were
outstanding under the 2006 Stock Incentive Plan. As of September 30, 2007,
586,791 options to purchase shares of common stock granted outside of the 2006
Stock Incentive Plan were outstanding.
Warrants
On
December 31, 2005, the Company granted warrants to purchase 1,551,535 shares
of
common stock at an exercise price of $0.26 in connection with professional
services performed by various consultants. The warrants were granted under
Individual Stock Purchase Warrant Agreements which expire on December 31, 2010.
The warrants vested immediately at the grant date, with the exception of 378,664
shares, of which 48,380 shares vested and 330,284 shares were cancelled during
the year ended December 31, 2006.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
As
of
September 30, 2007, there were warrants outstanding to purchase 303,257 shares
of common stock at $0.262 per share.
Valuation
Assumptions
The
fair
value of options and warrants were estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions for the nine months ended September 30, 2007 and 2006:
Dividend
yield
|
|
|
-0-
|
Risk-free
interest rate
|
|
|
4.50%
- 4.64%
|
Expected
volatility
|
|
|
42.00%
- 50.00%
|
Expected
life of options
|
|
|
4-
6 years
|
Note
9.
Related
Parties
On
January 29, 2007, the Company entered into an Amended and Restated License,
Hosting and Services Agreement (the “Amended Agreement”) with RazorStream. The
Amended Agreement amends and restates the Licensing, Hosting and Services
Agreement effective May 1, 2005, between the Company and
RazorStream.
Pursuant
to the terms of the Amended Agreement, RazorStream will provide hosting,
maintenance and support services for each individual website operated by the
Company or any third party authorized by the Company. While the initial term
of
the Amended Agreement ends on January 15, 2008, the Amended Agreement remains
operative thereafter unless terminated by either party upon 60 days prior
written notice. Under the terms of the Amended Agreement, for each individual
website operated by the Company or any third party authorized by the Company,
RazorStream (a) charges the Company $5 per new subscriber account exceeding
20,000 accounts (purchasable in 20,000 account increments); (b) is entitled
to
(1) ten percent (10%) of the Company’s total gross revenue from all active
subscriber accounts, with a minimum amount of $0.69 per each such subscriber
account per month, and (2) some portion of revenue to be mutually agreed upon
by
the parties for all advertising-based “free” subscriber accounts (which we do
not currently provide), provided, however that such terms will provide for
a
minimum amount of $0.25 per each such subscriber account per month (which cost
we will account for as marketing expense); and (c) effective February 1, 2007,
is entitled to a minimum guarantee of $50,000 per month that is non-refundable
but that will be credited against the above fees. The Company may, from time
to
time, engage RazorStream for non-recurring engineering services at a rate of
$200 per hour. The fees above apply independently to each individual website
operated by the Company or any third party authorized by the Company, and no
fees charged with respect to any individual website, and no subscriber account
applied with respect to any individual website, shall be aggregated with any
fees or subscriber accounts, respectively, applied to any other
website.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
The
Amended Agreement also provides the Company with a non-exclusive, royalty-free,
worldwide, perpetual license to use and otherwise exploit the technology
described in an exhibit to the Amended Agreement, including in source code
format, any corrections, modifications and custom enhancements thereto, and
any
interfaces necessary for and documentation related to the technology’s
functionality. The license portion of the agreement is available whether or
not
RazorStream provides its services under the agreement, and applies to each
individual website operated by the Company or any third party authorized by
the
Company.
In
connection with the services discussed above, the Company incurred expenses
of
$586, $1,631, $496 and $895 during the three and nine months ended September
30,
2007 and 2006, respectively. Prepaid bandwidth charges of $322 as of September
30, 2007 represents hosting, maintenance and support services paid in advance
to
RazorStream. These amounts will be amortized as the services are
utilized.
Note
10.
Income
Taxes
The
Company’s provision for income taxes at December 31, 2006 was based on income
for the period from June 16, 2006 to December 31, 2006. The Company’s income tax
provision was computed based on the federal statutory rate, as adjusted for
permanent items. No tax provision was recorded for the nine months ended
September 30, 2006 because the income tax obligations for this period were
passed through to the members of VMdirect. Deferred taxes were recorded as
the
result of a change in the Company’s tax status based on temporary differences
existing at June 16, 2006.
The
provision
(benefit)
for
income taxes consists of the following for the three and nine months ended
September 30, 2007:
|
|
Three Months Ended
September 30, 2007
|
|
Nine Months Ended
September 30, 2007
|
|
|
|
|
|
|
|
Current
tax provision - federal
|
|
$
|
202
|
|
$
|
970
|
|
-
foreign
|
|
|
-
|
|
|
-
|
|
Deferred
tax provision- federal
|
|
|
(520
|
)
|
|
(1,232
|
)
|
-
foreign
|
|
|
(19
|
)
|
|
(19
|
)
|
Income
tax provision (benefit)
|
|
$
|
(337
|
)
|
$
|
(281
|
)
|
A
reconciliation of the statutory federal income tax rate to the effective tax
rate is as follows for the three and nine months ended September 30,
2007:
|
|
Three Months Ended
September 30, 2007
|
|
Nine Months Ended
September 30, 2007
|
|
Income
before income tax provision
|
|
$
|
(1,318
|
)
|
$
|
(1,253
|
)
|
|
|
|
|
|
|
|
|
Expected
tax (federal statutory rate 34%)
|
|
|
(448
|
)
|
|
(426
|
)
|
Permanent
differences
|
|
|
111
|
|
|
145
|
|
|
|
|
|
|
|
|
|
Income
tax provision (benefit)
|
|
$
|
(337
|
)
|
$
|
(281
|
)
|
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
The
Company did not record any valuation allowance against deferred tax assets
at
September 30, 2007. Management has determined, based on the Company’s history
and expectations for the future, that operating income of the Company will
more
likely than not be sufficient to fully recognize these deferred tax assets.
In
the nine months ended September 30, 2007, the Company recorded a tax benefit
of
$962 for stock options tax benefits in excess of recorded compensation deduction
as an addition to paid-in capital.
The
Company did not record a provision for income taxes for the nine months ended
September 30, 2006 because federal income tax obligations for this period were
passed through to the members of VMdirect. The pro forma net income taxes and
pro forma net income below reflect the effect as if the Company had been taxed
in accordance with Subchapter C of the Internal Revenue Code (a “C” Corporation)
for the three and nine months ended September 30, 2006.
Income
taxes:
|
|
|
Three Months Ended
September 30, 2006
|
|
|
Nine Months Ended
September 30, 2006
|
|
As
reported
|
|
$
|
139
|
|
$
|
168
|
|
Pro
forma
|
|
$
|
139
|
|
$
|
380
|
|
|
|
|
|
|
|
|
|
Net
income
|
|
|
|
|
|
|
|
As
reported
|
|
$
|
200
|
|
$
|
201
|
|
Pro
forma
|
|
$
|
200
|
|
$
|
(11
|
)
|
Net
income per share
|
|
$
|
0.00
|
|
$
|
0.00
|
|
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
Note
11.
Commitments
and Contingencies
Legal
Proceedings
From
time
to time, we may be involved in litigation relating to claims arising out of
our
operations in the normal course of business. Except as is described below,
we
are not currently party to any legal proceedings, the adverse outcome of which,
in management’s opinion, individually or in the aggregate, would have a material
adverse effect on our results of operations or financial position.
On
August
4, 2005, VMdirect
filed
a
lawsuit in the District Court of Clark County, Nevada, against a former employee
alleging
a number of complaints including fraud, breach of oral contract, intentional
interference and negligent interference, and seeking compensatory and punitive
damages in amounts to be proved at trial, rescission of the oral contract
relating to the defendant’s equity interest in VMdirect, injunctive relief,
punitive damages, attorneys’ fees, disgorgement of ill gotten profits, revenues
and gain, and restitution. VMdirect hired the defendant in May 2001 as a project
manager in reliance upon the defendant’s representations regarding his skill in
handling the job duties. In May 2002, VMdirect agreed to provide the defendant
with a small portion of the equity interest in VMdirect, which was expressly
conditioned upon the defendant working full time and in good faith for no less
than 3 years after May 2002. VMdirect terminated defendant’s employment on
August 10, 2004 due to his continuous lack of diligence and unsatisfactory
job
performance as well as his creation of a hostile and adversarial work
environment.
On
August
5, 2005, VMdirect was served with a lawsuit filed in the District Court of
Clark
County, Nevada, which counterclaim was amended on March 27, 2006, by this same
former employee for alleged breach of employment contract and wrongful
termination, and seeking general damages in excess of $10,000, special damages
for lost wages and converted monies in the amount of $270,000, special damages
for the equity interest in VMdirect in an amount to be determined, punitive
or
treble damages as allowed by law, attorneys’ fees and the dissolution of
VMdirect. This former employee alleges that the grant of the equity interest
in
VMdirect had no conditions, and that VMdirect has engaged in a campaign to
defame said former employee.
A
petition to consolidate these cases was
filed
on
September 20, 2005 and is currently pending before the courts. On May 5, 2006,
the Company’s legal counsel representing the Company in this matter filed a
motion to dismiss the defendant’s amended counterclaim, which motion was denied
on June 21, 2006. The Company’s legal counsel representing the Company in this
matter subsequently filed an answer to the defendant’s amended counterclaim on
July 18, 2006, denying all liability.
On
October 5, 2007, the Company reached a settlement with this former employee
in
which the Company agreed to pay this former employee the sum of $37,500 by
November 5, 2007. This settlement has been accrued in the accompanying financial
statements for the period ending September 30, 2007.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
On
February 7, 2007, VMdirect and DigitalFX Solutions, LLC, a Nevada limited
liability company and one of our wholly-owned subsidiaries (“DigitalFX
Solutions”), jointly filed a lawsuit in the Superior Court of the State of
California for the County of Los Angeles against a former affiliate of VMdirect
alleging a number of complaints including unfair business practice,
misappropriation of trade secrets, slander, intentional interference with
contractual relationship, intentional interference with prospective economic
advantage and breach of contract, and seeking compensatory and punitive damages
in amounts to be proved at trial, injunctive relief and attorneys’ fees and
costs. The defendant became an affiliate of VMdirect in May 2006 and agreed
to
adhere to VMdirect’s Code of Ethics for affiliates. Upon signing up as an
affiliate, defendant represented that he was capable of bringing a substantial
number of new affiliates to VMdirect, and in reliance on this representation,
VMdirect agreed to provide certain privileges to defendant including posting
of
training materials on VMdirect’s website. VMdirect also agreed to work with
defendant to develop training materials. Although VMdirect paid for all of
the
costs of developing the materials and its personnel actively participated in
the
development of such materials, defendant demanded aggregate compensation of
$300,000 for creating the training and motivational materials after they were
completed. After VMdirect did not pay this fee to defendant, defendant requested
that VMdirect stop using the materials, began disparaging VMdirect and its
officers, and engaged in cross-recruiting affiliates from other VMdirect
networks, a practice prohibited by VMdirect’s Code of Ethics for its affiliates.
VMdirect then terminated defendant’s distribution network and believes that
defendant continues to use VMdirect’s proprietary trade secrets to recruit
affiliates to join other network marketing companies that compete with
VMdirect.
On
March
6, 2007, we, along with VMdirect and DigitalFX Solutions, were served with
a
cross complaint for damages filed in the Superior Court of California for the
County of Los Angeles, by this same former affiliate for alleged breach of
contract, fraud-intentional misrepresentation, fraud-intentional
concealment/omission, fraud-false promises, negligent misrepresentation and
infringement of the rights of publicity and privacy, and seeking general,
exemplary and punitive damages in amounts to be determined at trial and an
order
enjoining our use of his name, image, photograph and likeness for any purpose
without his written consent. This former affiliate alleges that the officers
of
VMdirect agreed to grant him 60,000 shares of our common stock, agreed to pay
him a percentage of sales to small businesses and enterprises in connection
with
his creation of certain training materials, agreed to pay for the costs of
all
training materials created by him and agreed that all training materials which
contained his likeness would remain his intellectual property. This former
affiliate also alleges that it was expressly agreed that a copy of such
materials would be made available to him for posting as promotional materials
on
his own website and that his consent for VMdirect to use his image and likeness
on its websites would be revocable at any time.
On
March
6, 2007, legal counsel for the same former affiliate filed a Notice of Removal
of Action with the United States District Court of the Central District of
California seeking to remove the case from the Superior Court of California
to
the United States District Court.
Our
legal
counsel filed a motion to remand the case back to the Superior Court of
California which motion was granted.
On
August
31, 2007, the former affiliate applied on an ex parte basis for a temporary
restraining
order
("TRO")
to
have
VMdirect remove from its website the training materials featuring the former
affiliate and to have VMdirect and DigitalFX Solutions stop using those training
materials
altogether.
The application for TRO was denied. However, the judge did set for hearing
on
September
20, 2007 the issue of whether a preliminary injunction should issue against
VMdirect
on
this
same matter. At the hearing on September 20, 2007, the former affiliate raised
the
issue
that
neither VMdirect nor DigitalFX Solutions are qualified to do business in
California.
Hearing
on
this
new issue was continued until November 1, 2007.
At
the
hearing on November 1, 2007, the court took under submission the issue of
whether VMdirect and DigitalFX Solutions
may
defend
themselves against a preliminary injunction that arises from a cross-complaint
even if they are not qualified to do business in California. The court has
not
yet ruled on this issue.
Also,
DigitalFX
Solutions is in the process of becoming qualified to do business in California
so that it
may
proceed with its action against the former affiliate.
Management
believes there exists no basis for the former affiliate's claims and intends
to
defend this matter vigorously.
In
the
event our management’s assessment of the case is incorrect, the economic
impact on us would be insignificant and would not materially affect our
operations.
DigitalFX
International, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(In
Thousands, Except for Share and Per Share Data)
Three
and Nine Months Ended September 30, 2007 and 2006
(unaudited)
Operating
Leases
The
Company leased two adjacent facilities under non-cancelable operating leases
that expired on January 31, 2007. In February 2007, the Company consolidated
these leases into one and renewed for twelve months at a monthly rental of
$17.
On
January 1, 2007 the Company entered into a lease for lodging space in New York
City for a term of nine months, ending September 30, 2007 at a monthly rental
of
$10. In August 2007, the lease was renegotiated. The new term is for one year
commencing September 1, 2007 through August 31, 2008 at a monthly rental of
$6.
On July 1, 2007 the Company entered into a lease for office space in Westlake
Village, CA for a term of three years, ending June 30, 2010 at a monthly rental
of $3.
Rent
expense for the three and nine months ended September 30, 2007 and 2006 was
$99,
$275, $23 and $67, respectively.
ITEM
2.
|
MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
STATEMENTS
|
Forward-Looking
Statements
Statements
made in this Form 10-QSB (the “Quarterly Report”) that are not historical or
current facts are “forward-looking statements” made pursuant to the safe harbor
provisions of Section 27A of the Securities Act of 1933, as amended (the “Act”),
and Section 21E of the Securities Exchange Act of 1934, as amended (the
“Exchange Act”). The Company intends that such forward-looking statements be
subject to the safe harbors for such statements. The Company wishes to caution
readers not to place undue reliance on any such forward-looking statements,
which speak only as of the date made. Any forward-looking statements represent
management’s best judgment as to what may occur in the future. These
forward-looking statements include the plans and objectives of management for
future growth of the Company, including plans and objectives related to the
consummation of acquisitions and future private and public issuances of the
Company’s equity and debt securities. The forward-looking statements included
herein are based on current expectations that involve numerous risks and
uncertainties. Assumptions relating to the foregoing involve judgments with
respect to, among other things, future economic, competitive and market
conditions and future business decisions, all of which are difficult or
impossible to predict accurately and many of which are beyond the control of
the
Company. Although the Company believes that the assumptions underlying the
forward-looking statements are reasonable, any of the assumptions could be
inaccurate and, therefore, there can be no assurance that the forward-looking
statements included in this Form 10-QSB will prove to be accurate. In light
of
the significant uncertainties inherent in the forward-looking statements
included herein, the inclusion of such information should not be regarded as
a
representation by the Company or any other person that the objectives and plans
of the Company will be achieved. The Company disclaims any obligation
subsequently to revise any forward-looking statements to reflect events or
circumstances after the date of such statement or to reflect the occurrence
of
anticipated or unanticipated events.
References
to the “Company” refer to DigitalFX International, Inc. The words or phrases
“may,” “will,” “expect,” “believe,” “anticipate,” “estimate,” “approximate,” or
“continue,” “would be,” “will allow,” “intends to,” “will likely result,” “are
expected to,” “will continue,” “is anticipated,” “estimate,” “project,” or
similar expressions, or the negative thereof, are intended to identify
“forward-looking statements.” Actual results could differ materially from those
projected in the forward looking statements as a result of a number of risks
and
uncertainties, including but not limited to: (a) our failure to implement our
business plan within the time period we originally planned to accomplish; and
(b) other risks that are discussed in this Form 10-QSB or included in our
previous filings with the Securities and Exchange Commission
(“SEC”).
Description
of Business
Corporate
History
DigitalFX
International, Inc. was incorporated in the State of Florida on January 23,
1991. Prior to November 2001, we provided intelligent message communications
services to enterprises in the travel and hospitality sectors. In November
2001,
we sold substantially all of our assets to Avery Communications, Inc. after
which we continued without material business assets, operations or revenues.
On
June 22, 2004, we consummated the transactions contemplated by a Securities
Purchase Agreement (the “Purchase Agreement”) dated June 10, 2004, by and among
the Company, Keating Reverse Merger Fund, LLC (“KRM Fund”), Thurston Interests,
LLC (“Thurston”) and certain other shareholders of the Company. The transactions
resulted in a change of control whereby KRM Fund became our majority
shareholder. From November 2001 through June 15, 2006, we were a public “shell”
company with nominal assets.
On
May
23, 2006, we entered into an Exchange Agreement (the “Exchange Agreement”) with
VMdirect, L.L.C., a Nevada limited liability company (“VMdirect”), the members
of VMdirect holding a majority of its membership interests (together with all
of
the members of VMdirect, the “VMdirect Members”), and KRM Fund. The closing of
the transactions contemplated by the Exchange Agreement occurred on June 15,
2006. At the closing, we acquired all of the outstanding membership interests
of
VMdirect (the “Interests”) from the VMdirect Members, and the VMdirect Members
contributed all of their Interests to us. In exchange, we issued to the VMdirect
Members 1,014,589 shares of our Series A Convertible Preferred Stock, par value
$0.01 per share (the “Preferred Shares”), which, as a result of the approval by
a substantial majority of our outstanding shareholders entitled to vote and
the
approval by our board of directors on June 22, 2006, of amendments to our
articles of incorporation that (i) changed our name to DigitalFX International,
Inc., (ii) increased our authorized number of shares of common stock to
100,000,000, and (iii) adopted a 1-for-50 reverse stock split, on August 1,
2006
converted into approximately 21,150,959 shares of our common stock on a
post-reverse stock split basis.
At
the
closing, VMdirect became our wholly-owned subsidiary. The exchange transaction
was accounted for as a reverse merger (recapitalization) with VMdirect deemed
to
be the accounting acquirer, and the Company deemed to be the legal
acquirer.
Business
Overview
We
are a
digital communications and social networking company that, directly and through
a multi-tiered affiliate program, offers a suite of proprietary digital
communication tools, including video email, video instant messaging, live
webcasting, podcasting, blogging, and digital vault storage. Our social
networking website, www.helloWorld.com, operated by our wholly-owned subsidiary
DigitalFX Networks, LLC, a Nevada limited liability company, targets users
from
ages 18 to 65. The site features a full suite of digital communication tools,
and affiliates and retail customers pay a monthly subscription fee to use the
tools and participate in the social network. Additionally, our website,
www.vmdirect.com, operated by our wholly-owned subsidiary VMdirect, offers
affiliates the tools necessary to effectively market and distribute our digital
communication tools.
Our
multi-tiered affiliate program drives the growth of our business. Rather than
using traditional advertising and marketing methods, we chose to create a
multi-tiered affiliate program to develop new customers. Affiliates earn retail
commissions on a monthly residual basis by acquiring new retail customers for
us. Affiliates earn additional commissions from the sales activities of
affiliates who they personally enroll. These rewards are extended for up to
eight generations of affiliates, meaning that an affiliate earns a commission
on
the sales of the affiliates they have personally enrolled as well as on the
sales of second-, third-, and fourth-generation affiliates, potentially eight
levels deep. Our affiliate compensation plan is structured on a 3x8 matrix,
meaning affiliates can each enroll three affiliates underneath themselves,
before they begin to build their next organizational level. The layers of three
continue down a total of eight levels.
The
market for our services is relatively new and rapidly evolving and growing.
Social networking and streaming media are areas of high interest, dominating
both the consumer and financial press. According to the Aberdeen Group, the
streaming media industry is expected to grow from $2 billion in 2004 to an
estimated $12 billion by 2008. We expect that the annual rate of growth of
adoption of streaming media tools in 2007 will exceed 2006 as more users become
comfortable with this technology, the Internet and personal computer
usage.
Social
networking sites are also among the fastest growing Web destinations. In May
2006, the top 10 social networking sites combined for over 1/3 of total unique
Internet visits. Other trends in our favor include the dispersion of families
and friends around the country and globe who want to visually communicate on
a
regular basis and the desire of many companies to reduce resources spent on
employee air and automobile travel. We differentiate ourselves from other social
networking sites by allowing our members to retain copyright and ownership
of
all the content that they have created.
Results
of Operations
Three
Months Ended September 30, 2007 Compared with Three Months Ended September
30,
2006
Revenues
decreased $1,684,000 or 24% to $5,425,000 in the quarter ended September 30,
2007 from $7,109,000 for the corresponding period in 2006.
Recurring
revenue from all customers for monthly subscriptions to our Studio suite of
products increased $995,000 or 30% in the corresponding period from $3,272,000
to $4,267,000. This increase was due to a 34% increase in our customer base
from
22,715 at September 30, 2006 to 30,375 at September 30, 2007.
Offsetting
this growth, revenue from affiliate enrollment packages decreased $1,484,000
from $2,360,000 to $876,000. This decrease was due to the mix of packages
selected and to the fact that we had 26% fewer enrollers in the corresponding
quarters. August and September 2006 were strong enrollment months due primarily
to momentum that was building into our October 2006 “Feel the Power” conference.
This momentum stalled from December 2006 through September 2007 due to the
technical issues with the 5.0 version of our Studio suite of products discussed
earlier. The other reason for the volume decline in enrollment revenue is the
fact that the average recorded revenue on packages purchased decreased from
$447
to $241 in the corresponding quarters. We have four business packages available
to affiliates for purchase ranging in price from approximately $79 to $1,999.
Enrollments changed from 23% at the higher levels to 9% for the quarter ended
September 30, 2007. This appears to indicate that affiliates are initially
committing less investment until they are able to devote sufficient time to
the
business opportunity.
Year-on-year,
however, our active affiliate base increased 12% from approximately 12,800
members at September 30, 2006 to over 15,000 at September 30, 2007.
Additionally,
revenue from merchandise sales, freight out and event registration decreased
$747,000 from $845,000 to $98,000 in the corresponding quarters. The majority
of
this relates to the timing of our annual sales conference. In 2007, this event
occurred in early November while in 2006, the Company held two sales
conferences, one in May and one in September.
Gross
profit decreased $1,097,000 to $4,515,000 in the quarter ended September 30,
2007 from $5,612,000 for the corresponding period in 2006. Gross profit as
a
percentage of net sales was 83% for the quarter ended September 30, 2007 and
79%
for the corresponding period in 2006. Gross profit for the quarter ended
September 30, 2006 contained results of our sales conference event which
produced break-even results. As noted above, our 2007 sales conference occurred
in early November. The result of this timing difference was a lower reported
margin for the three months ended September 30, 2006 by 4 percentage
points.
Commissions
and bonuses paid to affiliates decreased $823,000 or 26% to $2,365,000 in the
quarter ended September 30, 2007 from $3,188,000 in the corresponding period
in
2006. As a percentage of net sales, commission expenses were 44% for the quarter
ended September 30, 2007 and 45% in the corresponding quarter in 2006. This
decrease is related to the shift to lower enrollment levels for business
packages as discussed above.
Operating
expenses include Product Development, Marketing, Customer and Technical Support,
General and Administrative, and non-cash costs related to the vesting of stock
option and warrant grants. Total Operating Expenses increased $1,509,000 or
75%
to $3,539,000 in the quarter ended September 30, 2007 from $2,030,000 for the
corresponding period in 2006. As a percentage of net sales, operating expenses
increased from 29% in the quarter ended September 30, 2006 to 65% in the
corresponding period in 2007. The increased spending was associated with start
up costs for sales of our products to: 1) small and medium-sized businesses
through DigitalFX Networks, LLC ($150,000), 2) major enterprises through
DigitalFX Solutions, LLC ($130,000), and 3) European expansion ($412,000).
Additionally, we incurred incremental costs of being a public company
($120,000), technical/customer support expansion and software systems
($175,000), marketing and training programs ($175,000), other staffing additions
and salary changes ($255,000) and other expenses.
Operating
income (loss) declined by $1,783,000 from $394,000 in the quarter ended
September 30, 2006 to a loss of $1,389,000 in the corresponding period in 2007.
This reduction was due primarily to revenue loss on the mix of affiliate
enrollment packages and increased operating expenses as described above.
Other
income (expense), net was $71,000 in the quarter ended September 30, 2007
as
compared to ($
55,000
)
in the
corresponding quarter in 2006. This change primarily relates to an increase
in
interest income from $14,000 for the quarter ended September 30, 2006 to
$71,000
for the quarter ended September 30, 2007.
Provision
(benefit) for income taxes was ($337,000) for the three months ended September
30, 2007 as compared to $139,000 for the corresponding period in 2006. Federal
income tax obligations for the period through and including June 15, 2006 were
passed through to the previous members of VMdirect, and the Company recorded
no
provision for such taxes for those periods.
Net
income (loss) decreased $1,181,000 from $200,000 in the quarter ended September
30, 2006 to ($981,000) in the corresponding period in 2007 as a result of the
combination of factors discussed above.
Nine
Months Ended September 30, 2007 Compared with Nine Months Ended September 30,
2006
Revenues
increased $1,755,000 or 11% to $17,987,000 in the nine months ended September
30, 2007 from $16,232,000 for the corresponding period in 2006. Recurring
revenue from all customers with monthly subscriptions to our Studio suite
of
products increased $
5,914,000
or 84%
in the corresponding period from $7,017,000 to $
12,931,000.
The
increase in recurring revenue directly relates to a 34% increase in our customer
base from 22,715 at September 30, 2006 to 30,375 at September 30,
2007.
Revenue
from affiliate enrollments decreased $2,278,000 during this period from
$6,630,000 to $3,852,000. While the number of affiliates that signed up during
the nine months ended September 30, 2007 versus the corresponding period
in 2006
was up slightly, this was partially offset because the average price of all
enrollments decreased from $498 to $286 reducing net business package revenue
by
$2,780,000 and upgrade revenue decreased $320,000 from $1,187,000 for the
nine
months ended September 30, 2006 to $
868,000
in the
corresponding period in 2007.
Additionally,
revenue from merchandise sales, freight out and event registration decreased
$1,062,000 from $1,398,000 to $336,000 in the corresponding period. The majority
of this relates to the timing of our annual sales conference. As discussed
above, the 2007 event occurred in early November while in 2006, the Company
held
two sales conferences, one in May and one in September.
Gross
profit increased $2,245,000 to $15,205,000 in the nine months ended September
30, 2007 from $12,960,000 for the corresponding period in 2006. Gross profit
as
a percentage of net sales was 85% for the nine months ended September 30, 2007
and 80% for the corresponding period in 2006. This was primarily due to the
timing of our sales conference events as discussed above and cost reductions
on
inventory items. Because the 2006 sales conference events produced break-even
results, our reported margin for the nine months ended September 30, 2006 was
lower by 3 percentage points. Our sales conference for 2007 was held in early
November.
Commissions
and bonuses paid to affiliates increased $298,000 or 4% to $7,880,000 in the
nine months ended September 30, 2007 from $7,582,000 in the corresponding period
in 2006. This increase is primarily related to sales volume growth. As a
percentage of net sales, commission expenses were 44% for the nine months ended
September 30, 2007 and 47% in the corresponding period in 2006. This primarily
relates to our commission structure, which pays certain bonuses and commissions
based on the level that new affiliates enter the program. As previously noted,
more affiliates signed up at lower levels during the nine months ended September
30, 2007 versus the corresponding period in 2006.
Operating
expenses include Product Development, Marketing, Customer and Technical Support,
General and Administrative, and non-cash costs related to the vesting of stock
option and warrant grants. Total Operating Expenses increased $4,452,000 or
103%
to $8,780,000 in the nine months ended September 30, 2007 from $4,328,000 for
the corresponding period in 2006. As a percentage of net sales, operating
expenses increased from 27% in the nine months ended September 30, 2006 to
49%
in the corresponding period in 2007. The increased spending was associated
with
start up costs for future sales of our products to small and medium-sized
businesses through DigitalFX Networks, LLC ($430,000), to major enterprises
through DigitalFX Solutions, LLC ($310,000), and to additional European
countries ($817,000). Other items include: the incremental costs of being a
public company ($412,000), technical/customer support expansion and software
systems ($564,000), other staffing additions and salary changes ($802,000),
increased merchant fees directly related to sales volume ($209,000), expanded
marketing and training programs ($415,000) and employee stock option expense
($209,000).
Operating
income (loss) declined by $2,505,000 from $1,050,000 in the nine months ended
September 30, 2006 to an operating loss of ($1,455,000) in the corresponding
period in 2007. This reduction over the corresponding period in 2006 was the
result of the increases in operating expenses, net of an increase in sales
and
gross profit improvement as described above.
Other
income (expense), net was $203,000 in the nine months ended September 30, 2007
as compared to ($681,000) in the corresponding period in 2006. This decrease
primarily relates to expenses of $635,000 related to the 2006 exchange
transaction which are included in other income (expense) for the nine months
ended September 30, 2006. In addition, other income (expense), net for the
nine
months ended September 30, 2007 included $195,000 of interest income as compared
to $23,000 for the nine months ended September 30, 2006.
Provision
(benefit) for income taxes was ($281,000) for the nine months ended September
30, 2007 as compared to $168,000 for the corresponding period in 2006. Federal
income tax obligations for the period through and including June 15, 2006 were
passed through to the previous members of VMdirect, and the Company recorded
no
provision for such taxes for those periods.
Net
income (loss) decreased $1,172,000 from $201,000 in the nine months ended
September 30, 2006 to a net loss of $(971,000) in the corresponding period
in
2007 as a result of the combination of factors discussed above.
Liquidity
and Capital Resources
Our
cash
requirements are principally for working capital and strategic investments.
Historically, we funded our working capital needs through the sale of equity
interests and through additional capital contributions by our former
members.
For
the
nine months ended September 30, 2007, cash used by operating activities was
$
1,306,000
and
consisted of net loss of $971,000, increased by non-cash items of $
513,000
and
decreased by $848,000 due to changes in other operating assets and liabilities.
The latter consisted of increases in accounts receivable of $48,000, prepaid
expenses of $774,000, and inventory of $797,000, net of increases in accounts
payable and accrued expenses of $771,000.
For
the
nine months ended September 30, 2006, cash provided by operating activities
was
$1,381,000 and consisted of net income of $201,000, increased by non-cash items
of $190,000 and increased by $990,000 due to changes in other operating assets
and liabilities. The latter consisted of increases in accounts receivable of
$185,000, inventory of $26,000, and other assets of $683,000, offset by
increases in accounts payable and accrued expenses of $1,884,000.
Investing
activities during the nine months ended September 30, 2007 and 2006 totaled
$2,213,000 and $167,000, respectively. In 2007, this included loans and
investments in strategic partners of $1,916,000 and software license purchases
and capital expenditures of $297,000. In 2006, this included capital
expenditures for video equipment and software licenses.
Financing
activities during the nine months ended September 30, 2007 and 2006 consisted
of
proceeds from the issuance of common stock ($
34,000
in 2007
and $625,000 in 2006), proceeds from the exercise of warrants ($4,000 in
2007),
payments on note payable ($50,000 in 2006) and distributions to shareholders
($265,000 in 2006).
On
December 22, 2006, we entered into a Securities Purchase Agreement with Kingdon
Associates, Kingdon Family Partnership, L.P. and M. Kingdon Offshore Ltd. (the
“Investors”) pursuant to which we agreed to sell to the Investors an aggregate
of 1,000,000 shares of our common stock at a per share price of $4.75 for gross
proceeds of $4.75 million. The transactions contemplated by the Securities
Purchase Agreement closed on December 27, 2006, with net proceeds to us of
approximately $4.36 million, after payment of commissions and expenses, which
are being used for general working capital purposes.
We
expect
that we will have adequate working capital to continue to grow our operations
and develop our products, international markets and business plan as
anticipated. While there is currently no definitive plan of debt or equity
financing, there is no assurance that external financing will be available
if
needed in the future, or if available, that it would be available on terms
acceptable to us.
Our
business benefits from low capital expenditure requirements. Our capital
expenditures in 2007 have primarily been for the completion of our business
software implementations. Purchases for the rest of the year will include
business software for international operations and additional computer
equipment.
Off-Balance
Sheet Arrangements
We
have
no off-balance sheet arrangements or financing activities with special purpose
entities.
Credit
Facilities
In
Fiscal
2005, we set up a business credit line with Wells Fargo Bank for $65,000 at
an
annual percentage rate of 12.75%. Our MasterCard account is linked to this
line
of credit which we utilize on a monthly basis. The balance is paid off in full
on a monthly basis when due.
Backlog
Backlog
is only relevant to our affiliate business packages and merchandise sales,
as
all subscription services are delivered upon enrollment or at monthly renewal.
We do not believe that backlog is a meaningful indicator of future business
prospects due to the short period of time from affiliate business package and
merchandise order to product shipment. Most products are shipped one to two
days
from the date ordered and monthly transactions are cancelable with no notice,
therefore, backlog information is not material to an understanding of our
business.
Geographic
Information
The
breakdown of revenues generated by geographic region for the nine months ended
September 30, 2007 and 2006 is as follows:
|
|
September 30,
2007
|
|
September 30,
2006
|
|
|
|
|
|
|
|
United
States, Canada & Mexico
|
|
|
92
|
%
|
|
88
|
%
|
United
Kingdom
|
|
|
2
|
%
|
|
3
|
%
|
Australia
|
|
|
5
|
%
|
|
8
|
%
|
New
Zealand
|
|
|
1
|
%
|
|
1
|
%
|
|
|
|
100
|
%
|
|
100
|
%
|
Critical
Accounting Policies
We
prepare our Consolidated Financial Statements in conformity with accounting
principles generally accepted in the United States, which require us to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and revenue and expenses during the year. Actual results could
differ from those estimates. We consider the following policies to be most
critical in understanding the judgments that are involved in preparing our
financial statements and the uncertainties that could impact our results of
operations, financial condition and cash flows.
Revenue
Recognition
We
generate revenue through (i) sales of affiliate business packages and selling
aids to affiliates which include cameras, sales literature, and training videos,
and the initial month’s subscription to our internet-based suite of products
which includes a wide spectrum of streaming video content and an integrated
suite of streaming media applications, including video email, video chat, and
live web-casting, (ii) sales of monthly subscriptions to retail customers and
the recurring subscription to affiliates to the internet-based suite of products
identified above, (iii) sales of branded apparel and merchandise, and (iv)
hosting conferences and events.
Affiliate
Business Packages
We
recognize revenue from the sales of the cameras and selling aids within the
business package, including shipping revenue, in accordance with SAB No. 104,
“Revenue Recognition,” when persuasive evidence of an order arrangement exists,
delivery has occurred, the sales price is fixed or determinable and
collectibility is reasonably assured. Generally, these criteria are met at
the
time the product is shipped to our customers when title and risk of loss have
transferred. Products usually ship within 48 hours of the customer’s on-line
order. We consider all deliverables of this element of the package to be met
at
this point. Costs incurred for the shipping and handling of our products are
recorded as cost of sales as incurred.
Allowances
for subsequent customer returns of affiliate business packages are provided
when
revenues are recorded. Affiliate business packages returned within the first
30
days of purchase are refunded at 90 percent of the sales price. Returned
products that were damaged during shipment to the customer is replaced
immediately at our expense. On a monthly basis, we calculate a sales allowance
which is an estimate of refunds for package returns that are within the 30
day
time frame that have not yet been returned or processed. The estimate is based
on an analysis of the historical rate of package returns using data from the
four months preceding the date of measurement. We have found that this method
approximates actual returns for the next 30 days. Increases or decreases to
the
sales allowance are charged to revenue.
The
Company recognizes revenue from sale of the affiliate’s initial month’s
subscription to the internet-based suite of products in accordance with
generally accepted accounting principals and based on the fair value of such
suite of products. Fair value is determinable because the subscription fee
is
thereafter billed monthly at a fixed rate based on the level of service
selected. Access to the internet-based studio suite of the products is delivered
together, and the individual products within the suite cannot be sold
separately. Access is delivered immediately upon sign up and order
acceptance.
A
monthly
subscription is cancellable at any time. The relevant subscription fee is fully
refundable if such cancellation is made in writing in accordance with the
Company’s policies but only for the current month. The Company provides a
reserve for potential chargebacks on cancellations.
Monthly
Subscriptions
We
sell
subscriptions for our internet-based studio suite of products through a unique
multi-tiered affiliate program using non-related independent distributors,
known
as affiliates. We also market subscriptions directly to retail customers who
purchase them for their personal use.
We
recognize revenue from sales of a month’s subscription to retail customers and
sales to affiliates for their recurring subscription to the internet-based
suite
of products in accordance with generally accepted accounting principals and
based on the fair value of such suite of products. Fair value is determinable
because the subscription fee is billed at a fixed rate based on the level of
service selected. A monthly subscription is cancellable at any
time.
If
cancelled within the first 30 days after enrollment, 90% of the fee is refunded,
pro-rated for the number of days not used during the month. If a subscription
is
cancelled after the first month of service, a full refund is issued for the
month if the cancellation is received in writing within 48 hours of the renewal
billing. No refund is issued if a subscription is cancelled more than 48 hours
after the renewal billing for the month. We record an allowance for potential
subscription chargebacks based on an analysis of historical data for the four
months preceding the date of measurement. We apply a percentage to subscription
revenue that is subject to chargebacks within the first 30 days of enrollment
or
48 hours of renewal. The accuracy of these estimates is dependent on the rate
of
future cancellations being consistent with the historical rate. Increases or
decreases to the sales allowance are charged to revenue.
Apparel
and Merchandise
We
also
sell select products to affiliates to assist them in building their businesses
and in selling subscriptions to the portal. These products include cameras,
branded apparel and other merchandise. Revenue for these sales, including
shipping revenue, are recognized when all the criteria of SAB No. 104 described
above are met, which is generally upon shipment.
Conferences
and Events
We
also
earn fees for certain events we host such as sales and training conferences
and
seminars. Revenue is recognized when all of the criteria of SAB No. 104
described above are met, which is generally after the event has occurred.
Amounts collected prior to the event are reflected as deferred revenue, and
recognized after the event has occurred.
Allowance
for Doubtful Accounts
Our
receivables consist entirely of receivables from credit card companies, arising
from the sale of product and services to our customers. We do not record an
allowance for doubtful accounts on these receivables, as monies processed by
credit card processors are collected 100% within three to five
days.
Inventories
Inventories
are valued at the lower of cost or market. They are written down, as required,
to provide for estimated obsolete or unsalable inventory based on assumptions
about future demand for our products and market conditions. If future demand
and
market conditions are less favorable than management’s assumptions, additional
inventory write-downs could be required. Likewise, favorable future demand
and
market conditions could positively impact future operating results if
written-off inventory is sold.
Investments
The
Company accounts for its investments in equity securities under SFAS 115,
“Accounting for Certain Investments in Debt and Equity Securities.” Investments
in equity securities are carried at fair value with the unrealized gains or
losses, net of tax, included as a component of accumulated other comprehensive
income in stockholders’ equity. Realized gains and losses and declines in value
considered to be other than temporary on available for sale securities are
included in other, net.
The
fair
values for marketable equity securities are based on quoted market prices.
The
carrying value for non-marketable equity securities investments in private
companies is based on cost, which approximates fair value. In determining
whether a decline in value of non-marketable equity securities investments
in
private companies is other than temporary, the assessment is made by considering
available evidence including the general market conditions in the investee’s
industry, the investee’s product development status, the investee’s ability to
meet business milestones and the financial condition of the investee. When
a
decline is considered other than temporary, the Company recognizes an impairment
loss in the current period’s operating results in the period of
decline.
Stock-Based
Compensation
We
periodically issues stock options and warrants to employees and non-employees
in
non-capital raising transactions for services and for financing costs. We
adopted SFAS No. 123R, “Accounting for Stock-Based Compensation” effective
January 1, 2006, and are using the modified prospective method in which
compensation cost is recognized beginning with the effective date (a) based
on
the requirements of SFAS No. 123R for all share-based payments granted after
the
effective date and (b) based on the requirements of SFAS No. 123R for all awards
granted to employees prior to the effective date of SFAS No. 123R that remain
unvested on the effective date. We account for stock option and warrant grants
issued and vesting to non-employees in accordance with EITF No. 96-18:
“Accounting for Equity Instruments that are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services,” and EITF 00-18
“Accounting Recognition for Certain Transactions involving Equity Instruments
Granted to Other Than Employees” whereby the fair value of the stock
compensation is based on the measurement date as determined at either a) the
date at which a performance commitment is reached, or b) at the date at which
the necessary performance to earn the equity instrument is
complete.
We
recognize compensation cost for equity-based compensation for all new or
modified grants issued after December 31, 2005. In addition, commencing January
1, 2006, we recognized the unvested portion of the grant date fair value of
awards issued prior to adoption of SFAS No. 123R based on the fair value
previously calculated for disclosure purposes over the remaining vesting period
of the outstanding stock options and warrants.
We
estimate the fair value of stock options pursuant to SFAS No. 123R using the
Black-Scholes option-pricing model, which was developed for use in estimating
the fair value of options that have no vesting restrictions and are fully
transferable. This model requires the input of subjective assumptions, including
the expected price volatility of the underlying stock and the expected life
of
stock options. Projected data related to the expected volatility of stock
options is based on the average volatility of the trading prices of comparable
companies and the expected life of stock options is based upon the average
term
and vesting schedules of the options. Changes in these subjective assumptions
can materially affect the fair value of the estimate, and therefore the existing
valuation models do not provide a precise measure of the fair value of the
Company’s employee stock options.
Recent
Accounting Pronouncements
In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which
provides enhanced guidance for using fair value to measure assets and
liabilities. SFAS No. 157 provides a common definition of fair value and
establishes a framework to make the measurement of fair value in generally
accepted accounting principles more consistent and comparable. SFAS No. 157
also
requires expanded disclosures to provide information about the extent to which
fair value is used to measure assets and liabilities, the methods and
assumptions used to measure fair value, and the effect of fair value measures
on
earnings. SFAS No. 157 is effective for financial statements issued in fiscal
years beginning after November 15, 2007 and for interim periods within those
fiscal years. The Company does not believe the adoption of SFAS No. 157 will
have a material, if any, effect on its results of operations, financial
position, or cash flows.
In
February 2007, the Financial Accounting Standards Board (FASB) issued FASB
Statement No. 159, “The Fair Value Option for Financial Assets and
Financial Liabilities — Including an amendment of FASB Statement
No. 115” (FAS 159). FAS 159, which becomes effective for the
company on January 1, 2008, permits companies to choose to measure many
financial instruments and certain other items at fair value and report
unrealized gains and losses in earnings. Such accounting is optional and is
generally to be applied instrument by instrument. The company does not
anticipate that election, if any, of this fair-value option will have a material
effect on its (consolidated) financial condition, results of operations, cash
flows or disclosures.
Qualitative
and Quantitative Disclosures About Market Risk
We
currently have limited financial market risks from changes in foreign currency
exchange rates or changes in interest rates and do not use derivative financial
instruments. For the nine months ended September 30, 2007, 3% of total revenue
is denominated in British pounds, 8% in Australian dollars and 1% in New Zealand
dollars. In the future, we expect to enter into transactions in additional
currencies. An adverse change in exchange rates would result in a decline in
income before taxes, assuming that each exchange rate would change in the same
direction relative to the U.S. dollar. In addition to the direct effects of
changes in exchange rates, such changes typically affect the volume of sales
or
foreign currency sales price as competitors’ products become more or less
attractive.
RISK
FACTORS
YOU
SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS AND ALL OTHER INFORMATION
CONTAINED IN THIS REPORT BEFORE PURCHASING SHARES OF OUR COMMON STOCK. INVESTING
IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. IF ANY OF THE FOLLOWING
EVENTS OR OUTCOMES ACTUALLY OCCURS, OUR BUSINESS OPERATING RESULTS AND FINANCIAL
CONDITION WOULD LIKELY SUFFER. AS A RESULT, THE TRADING PRICE OF OUR COMMON
STOCK COULD DECLINE, AND YOU MAY LOSE ALL OR PART OF THE MONEY YOU PAID TO
PURCHASE OUR COMMON STOCK.
RISKS
RELATING TO OUR BUSINESS
Our
operating results may fluctuate significantly based on customer acceptance
of
our products.
Management
expects that we will experience substantial variations in our net sales and
operating results from quarter to quarter due to customer acceptance of our
products. We rely on sales by our affiliates to generate significant revenues
for us. If customers don’t accept our products, our sales and revenues would
decline, resulting in a reduction in our operating income.
Customer
interest for our products could also be impacted by the timing of our
introduction of new products. If our competitors introduce new products around
the same time that we issue new products, and if such competing products are
superior to our own, customers’ desire for our products could decrease,
resulting in a decrease in our sales and revenues. To the extent that we
introduce new products and customers decide not to migrate to our new products
from our older products, our revenues could be negatively impacted due to the
loss of revenue from those customers. In the event that our newer products
do
not sell as well as our older products, we could also experience a reduction
in
our revenues and operating income.
As
a
result of fluctuations in our revenue and operating expenses that may occur,
management believes that period-to-period comparisons of our results of
operations are not a good indication of our future performance.
While
we previously achieved an operating profit, we have a history of operating
losses and there can be no assurance that we can achieve, maintain or increase
profitability.
While
we
previously achieved operating profits, we did not achieve an operating profit
for the nine months ended September 30, 2007, and we have a history of operating
losses. Given the competitive and evolving nature of the industry in which
we
operate, the technical difficulties we recently experienced with version 5.0
of
the Studio product, and potential technical difficulties we may encounter in
the
future, we may not be able to achieve, sustain or increase profitability and
our
failure to do so would adversely affect our business, including our ability
to
raise additional funds.
We
may not be able to effectively manage our growth.
Our
strategy envisions growing our business. To date, our growth has been derived
primarily from the growth of our multi-tiered affiliate base and we intend
to
continue to employ this growth strategy. To manage anticipated growth, we plan
to expand our technology to handle increasing volume on our websites and to
expand our administrative and marketing organizations to accommodate larger
numbers of our affiliates. We must also effectively manage our relationships
with the increasing number of retail customers/users of our products. We will
need to hire, train, supervise and manage new employees. These processes are
time consuming and expensive, will increase management responsibilities and
will
divert management attention. Any growth in or expansion of our business is
likely to continue to place a strain on our management and administrative
resources, infrastructure and systems. We cannot assure you that we will be
able
to:
|
·
|
sufficiently
and timely improve our technology to handle increasing volume on
our
websites;
|
|
·
|
expand
our administrative and marketing systems effectively, efficiently
or in a
timely manner to accommodate increasing numbers of our affiliates;
or
|
|
·
|
allocate
our human resources optimally.
|
Our
inability or failure to manage our growth and expansion effectively could result
in strained affiliate and customer relationships based on dissatisfaction with
our service to these groups, our failure to meet demand for our products and/or
increased expenses to us to resolve these issues, and a consequent significant
decrease in the number of our affiliates and end users. Any significant decrease
in our affiliate base or the number of retail customers, or the election of
new
affiliates to sign on for lower level packages would result in a decrease in
revenues.
If
we continue to experience technological difficulties with our products our
affiliate base could shrink, customer growth could decrease and our business
could suffer.
In
November 2006, we released the 5.0 version of our product called The Studio
that
included expanded functionality and features. The testing we conducted did
not
reveal various technical difficulties that remained with the product. In
addition, the 5.0 version rolled out in November 2006 did not contain all of
the
enhancements that our affiliates were expecting due to development delays.
The
result was a product with lower than expected functionality and operating
difficulties. As a result of these issues, our affiliate network has not
marketed our products and the business opportunity as widely as projected in
our
plan. While we have taken steps to ameliorate these difficulties, to the extent
that enhancements to the products we release or new products have technical
difficulties, the reputation of our products could suffer, our affiliate base
could shrink and our ability to generate new customers, and consequently
revenue, would be negatively impacted. Our ability to grow our business would
also be negatively impacted.
Ninety-five
percent of our revenues for the nine months ended September 30, 2007 have been
derived from sales of our products and services to our multi-tier affiliates,
and our future success depends on our ability to continue the growth of our
affiliate base, as well as to expand our retail subscriptions and initiate
advertising revenue.
To
date,
our revenue growth has been derived primarily from the growth of our
multi-tiered affiliate base. Rather than using traditional advertising and
sales
methods, we chose to create a multi-tiered affiliate program to develop new
customers. Affiliates earn retail commissions on a monthly residual basis by
acquiring new customers for us. Affiliates earn additional commissions from
the
sales activities of affiliates who they personally enroll. These rewards are
extended for up to eight generations of affiliates, meaning that an affiliate
earns a commission on the sales of the affiliates they have personally enrolled
as well as on the sales of second-, third-, and fourth-generation affiliates,
potentially eight levels deep. Our affiliate compensation plan is structured
on
a 3x8 matrix, meaning affiliates can each enroll three affiliates underneath
themselves before they begin to build their next organizational level. The
layers of three continue down a total of eight levels.
Our
success and the planned growth and expansion of our business depend on us
achieving greater and broader acceptance of our products and expanding our
customer base. There can be no assurance that customers will subscribe to our
product offerings or that we will continue to expand our customer base. Though
we plan to continue to provide tools to our affiliates to enable them to
generate sales, we cannot guarantee that the time and resources we spend on
these efforts will generate a commensurate increase in users of our product
offerings. If we are unable to effectively market or expand our product
offerings, and if our affiliate enrollment does not continue to grow, we will
be
unable to grow and expand our business or implement our business strategy.
This
could materially impair our ability to increase sales and revenue and materially
and adversely affect our margins, which could harm our business and cause our
stock price to decline.
Our
future success depends largely upon our ability to attract and retain a large
active base of affiliates who purchase and sell our products. We cannot give
any
assurances that the productivity of our affiliates will continue at their
current levels or increase in the future. Several factors affect our ability
to
attract and retain a significant number of affiliates, including:
|
·
|
on-going
motivation of our affiliates;
|
|
·
|
general
economic conditions;
|
|
·
|
significant
changes in the amount of commissions
paid;
|
|
·
|
public
perception and acceptance of direct
selling;
|
|
·
|
public
perception and acceptance of us and our
products;
|
|
·
|
the
limited number of people interested in pursuing direct selling as
a
business;
|
|
·
|
our
ability to provide proprietary quality-driven products that the market
demands; and
|
|
·
|
competition
in recruiting and retaining active
affiliates.
|
Our
ability to conduct business, particularly in international markets, may be
affected by political, economic, legal and regulatory risks, which could
adversely affect the expansion of our business in those
markets.
Our
ability to capitalize on growth in new international markets and to maintain
the
current level of operations in our existing international markets is exposed
to
risks associated with international operations, including:
|
·
|
the
possibility that a foreign government might ban or severely restrict
our
business method of selling through our affiliates, or that local
civil
unrest, political instability or changes in diplomatic or trade
relationships might disrupt our operations in an international
market;
|
|
·
|
the
possibility that a government authority might impose legal, tax or
other
financial burdens on affiliates, as direct sellers, or on our company
due,
for example, to the structure of our operations in various
markets;
|
|
·
|
the
possibility that a government authority might challenge the status
of our
affiliates as independent contractors or impose employment or social
taxes
on our affiliates;
|
|
·
|
our
ability to staff and manage international
operations;
|
|
·
|
handling
the various accounting, tax and legal complexities arising from our
international operations; and
|
|
·
|
understanding
cultural differences affecting non-U.S.
customers.
|
We
currently conduct activities in Australia, Canada, Ireland, Mexico, New Zealand,
the United Kingdom, Germany and Spain. We have not been affected in the past
by
any of the potential political, legal or regulatory risks identified above.
While we do not consider these risks to be material in the foreign countries
in
which we currently operate, they may be material in other countries where we
may
expand our business.
We
are
also subject to the risk that due to legislative or regulatory changes in one
or
more of our present or future markets, our marketing system could be found
not
to comply with applicable laws and regulations or may be prohibited. Failure
to
comply with applicable laws and regulations could result in the imposition
of
legal fines and/or penalties which would increase our operating costs. We may
also be required to comply with directives or orders from various courts or
applicable regulatory bodies to conform to the requirements of new legislation
or regulation, which would detract management’s attention from the operation of
our business. Further we could be prohibited from distributing products through
our marketing system or may be required to modify our marketing
system.
Our
services are priced in local currency. As a result, our financial results could
be affected by factors such as changes in foreign currency exchange rates or
weak economic conditions in foreign markets. We do not currently engage in
hedging activities or other actions to decrease fluctuations in operating
results due to changes in foreign currency exchange rates, although we may
do so
when the amount of revenue obtained from sources outside of the United States
becomes significant.
We
also face legal and regulatory risks in the United States, the affect of which
could reduce our sales and revenues.
Our
marketing program is subject to a number of federal and state regulations
administered by the Federal Trade Commission and various state agencies in
the
United States, directed at preventing fraudulent or deceptive schemes by
ensuring that product sales are made to consumers of the products and that
compensation, recognition, and advancement within the marketing organization
are
based on the sale of products rather than investment in the organization or
other non-sales-related criteria. These regulatory requirements do not include
“bright line” rules and are inherently fact-based. Thus, even though we believe
that our marketing program complies with applicable federal and state laws
or
regulations, we are subject to the risk that a governmental agency or court
could determine that we have failed to meet these requirements in a particular
case. Such an adverse determination could require us to make modifications
to
our marketing system, increasing our operating expenses. The negative publicity
associated with such an adverse determination could also reduce affiliate and
end user demand for our products, which would consequently reduce our sales
and
revenues.
If
we incur substantial liability from litigation, complaints, or enforcement
actions resulting from misconduct by our multi-level affiliates, our financial
condition could suffer.
Although
we use various means to address misconduct by our multi-level affiliates,
including maintaining policies and procedures to govern the conduct of our
affiliates and conducting training seminars, it is still difficult to detect
and
correct all instances of misconduct. Violations of our policies and procedures
by our affiliates could lead to litigation, formal or informal complaints,
enforcement actions, and inquiries by various federal, state, or foreign
regulatory authorities against us and/or our affiliates. Litigation, complaints,
and enforcement actions involving us and our affiliates could consume
considerable amounts of financial and other corporate resources, which could
have a negative impact on our sales, revenue, profitability and growth
prospects.
We
have
not been, and are not currently, subject to any material litigation, complaint
or enforcement action regarding affiliate misconduct by any federal, state
or
foreign regulatory authority.
We
may be unable to compete successfully against existing and future competitors,
which could decrease our revenue and margins and harm our
business.
The
digital communications and social networking industries are highly competitive.
Our future growth and financial success depend on our ability to further
penetrate and expand our user base, as well as our ability to grow our revenue
models. Our competitors possess greater resources than we do and in many cases
are owned by companies with broader business lines. For example, we encounter
competition in the social networking space from www.myspace.com, a company
acquired by News Corporation, and we offer video instant messaging services
similar to those offered at www.skype.com, a subsidiary of eBay, Inc. There
can
be no assurance that we will be able to maintain our growth rate or increase
our
market share in our industry at the expense of existing
competitors.
We
may not be able to adequately protect our intellectual property rights which
would affect our ability to compete in our industry.
Our
intellectual property relates to the initiation, receipt and management of
digital communications. We rely in part on trade secret, unfair competition,
trade dress and trademark law to protect our rights to certain aspects of our
intellectual property, including our software technologies, domain names and
recognized trademarks, all of which we believe are important to the success
of
our products and our competitive position. There can be no assurance that any
of
our trademark applications will result in the issuance of a registered
trademark, or that any trademark granted will be effective in thwarting
competition or be held valid if subsequently challenged. In addition, there
can
be no assurance that the actions taken by us to protect our proprietary rights
will be adequate to prevent imitation of our products, that our proprietary
information will not become known to competitors, that we can meaningfully
protect our rights to unpatented proprietary information or that others will
not
independently develop substantially equivalent or better products that do not
infringe on our intellectual property rights.
We
could
be required to devote substantial resources to enforce and protect our
intellectual property, which could divert our resources from the conduct of
our
business and result in increased expenses. In addition, an adverse determination
in litigation could subject us to the loss of our rights to particular
intellectual property, could require us to grant licenses to third parties,
could prevent us from selling or using certain aspects of our products or could
subject us to substantial liability, any of which could reduce our sales and/or
result in the entry of additional competitors into our industry.
We
may become subject to litigation for infringing the intellectual property rights
of others the affect of which could cause us to cease marketing and exploiting
our products.
Others
may initiate claims against us for infringing on their intellectual property
rights. We may be subject to costly litigation relating to such infringement
claims and we may be required to pay compensatory and punitive damages or
license fees if we settle or are found culpable in such litigation. In addition,
we may be precluded from offering products that rely on intellectual property
that is found to have been infringed by us. We also may be required to cease
offering the affected products while a determination as to infringement is
considered and could eventually be required to modify our products to cease
the
infringing activity. These developments could cause a decrease in our operating
income and reduce our available cash flow, which could harm our business and
cause our stock price to decline.
We
may have to expend significant resources developing alternative technologies
in
the event that third party licenses for intellectual property upon which our
business depends are not available or are not available on terms acceptable
to
us.
We
rely
on certain intellectual property licensed from third parties and may be required
to license additional products from third parties in the future. There can
be no
assurance that these third party licenses will be available or will continue
to
be available to us on acceptable terms or at all. Our inability to enter into
and maintain any license necessary for the conduct of our business could result
in our expenditure of significant capital to develop or obtain alternate
technologies and to integrate such alternate technologies into our current
products, or could result in our cessation of the development or sales of
products for which such licenses are necessary.
We
may be unable to attract and retain qualified, experienced, highly skilled
personnel, which could adversely affect the implementation of our business
plan.
Our
success depends to a significant degree upon our ability to attract, retain
and
motivate skilled and qualified personnel. In particular, we are heavily
dependent on the continued services of Craig Ellins and the other members of
our
senior management team. We do not have long-term employment agreements with
most
members of our senior management team, each of whom may voluntarily terminate
his or her employment with us at any time. Following any termination of
employment, those employees without employment agreements would not be subject
to any non-competition covenants or non-solicitation covenants. The loss of
any
key employee, including members of our senior management team, could result
in a
decrease in the efficacy with which we implement our business plan due to the
loss of our experienced managers, increased competition in our industry and
could negatively impact our sales and marketing operations. Our inability to
attract highly skilled personnel with sufficient experience in our industry
could result in less innovation in our products and a consequent decrease in
our
competitive position, and a decrease in the quality of our service to our
affiliates and end users and a consequent decrease in our sales, revenue and
operating income.
Our
senior management had limited experience managing a publicly traded company
prior to serving as our executive officers. This limited experience may divert
our management’s attention from operations and harm our
business.
Our
management team had limited experience managing the reporting requirements
of
the federal securities laws. Management will be required to implement
appropriate programs and policies to comply with existing disclosure
requirements and to respond to increased reporting requirements pursuant to
Section 404 of the Sarbanes-Oxley Act. These increased requirements include
the
preparation of an internal report which states the responsibility of management
for establishing and maintaining an adequate internal control structure and
procedures for financial reporting and containing an assessment, as of the
end
of each fiscal year, of the effectiveness of the internal control structure
and
procedures for financial reporting. Management’s efforts to familiarize itself
with and to implement appropriate procedures to comply with the disclosure
requirements of the federal securities laws could divert its attention from
the
operation of our business. Management’s failure to comply with the disclosure
requirements of the federal securities laws could lead to the imposition of
fines and penalties by the Securities and Exchange Commission (“SEC”) or the
cessation of trading of our common stock on The American Stock Exchange
(“AMEX”).
If
we are not able to respond to the adoption of technological innovation in our
industry and changes in consumer demand, our products will cease to be
competitive, which could result in a decrease in revenue and harm our
business.
Our
future success will depend, in part, on our ability to keep up with changes
in
consumer tastes and our continued ability to differentiate our products through
implementation of new technologies. We may not, however, be able to successfully
do so, and our competitors may be able to implement new technologies at a much
lower cost. These types of developments could render our products less
competitive and possibly eliminate any differentiating advantage that we might
hold at the present time.
RISKS
RELATING TO OUR COMMON STOCK
There
is limited trading, and consequently limited liquidity, of our common
stock.
Prior
to
August 23, 2007, bid and ask prices for shares of our common stock were quoted
on the OTC Bulletin Board under the symbol “DFXN.” On August 23, 2007, our
common stock began trading on the AMEX. Although our common stock is quoted
on
the AMEX, there is limited trading of our common stock and our common stock
is
not broadly followed by securities analysts. The average daily volume of our
common stock as reported on the OTC Bulletin Board and AMEX for the three-month
period ended September 30, 2007 was approximately 35,000 shares. Consequently,
shareholders may find it difficult to sell shares of our common
stock.
While
we
are hopeful that we will command the interest of a greater number of investors
and analysts, more active trading of our common stock may never develop or
be
maintained. More active trading generally results in lower price volatility
and
more efficient execution of buy and sell orders. The absence of active trading
reduces the liquidity of our common stock. As a result of the lack of trading
activity, the quoted price for our common stock on the AMEX is not necessarily
a
reliable indicator of its fair market value. Further, if we cease to be traded,
holders of our common stock would find it more difficult to dispose of, or
to
obtain accurate quotations as to the market value of, our common stock, and
the
market value of our common stock would likely decline.
The
market price of our common stock is likely to be highly volatile and subject
to
wide fluctuations, and you may be unable to resell your shares at or above
the
price at which you purchased such shares.
The
market price of our common stock is likely to be highly volatile and could
be
subject to wide fluctuations in response to a number of factors that are beyond
our control, including announcements of new products or services by our
competitors. In addition, the market price of our common stock could be subject
to wide fluctuations in response to a variety of factors,
including:
|
·
|
quarterly
variations in our revenues and operating
expenses;
|
|
·
|
developments
in the financial markets, and the worldwide or regional
economies;
|
|
·
|
announcements
of innovations or new products or services by us or our
competitors;
|
|
·
|
fluctuations
in merchant credit card interest
rates;
|
|
·
|
significant
sales of our common stock or other securities in the open market;
and
|
|
·
|
changes
in accounting principles.
|
In
the
past, shareholders have often instituted securities class action litigation
after periods of volatility in the market price of a company’s securities. If a
shareholder were to file any such class action suit against us, we would incur
substantial legal fees and our management’s attention and resources would be
diverted from operating our business to respond to the litigation, which could
impact our productivity and profitability.
Substantial
future sales of our common stock in the public market could cause our stock
price to fall.
Upon
the
effectiveness of any registration statement that we may file with respect to
the
resale of shares held by our shareholders, a significant number of our shares
of
common stock may become eligible for sale. The sale of these shares could
depress the market price of our common stock. Sales of a significant number
of
shares of our common stock in the open market could harm the market price of
our
common stock. A reduced market price for our shares could make it more difficult
to raise funds through future offerings of common stock.
On
November 30, 2007, upon the expiration of the lock up agreements restricting
sales by the selling shareholders listed in the prospectus included on the
post-effective amendment to the registration statement on Form SB-2 we filed
with the SEC on May 22, 2007, additional shares of our common stock will be
eligible for unrestricted resale. As additional shares of our common stock
become available for resale in the open market (including shares issued upon
the
exercise of our outstanding options and warrants), the supply of our publicly
traded shares will increase, which could decrease its price.
Some
of
our shares may also be offered from time to time in the open market pursuant
to
Rule 144, and these sales may have a depressive effect on the market price
of
our shares. In general, a person who has held restricted shares for a period
of
one year may, upon filing with the SEC of a notification on Form 144, sell
into
the market shares up to an amount equal to 1% of the outstanding
shares.
The
sale of securities by us in any equity or debt financing could result in
dilution to our existing shareholders and have a material adverse effect on
our
earnings.
Any
sale
of common stock by us in a future private placement offering could result in
dilution to the existing shareholders as a direct result of our issuance of
additional shares of our capital stock. In addition, our business strategy
may
include expansion through internal growth, by acquiring complementary
businesses, by acquiring or licensing additional brands, or by establishing
strategic relationships with targeted customers and suppliers. In order to
do
so, or to finance the cost of our other activities, we may issue additional
equity securities that could dilute our shareholders’ stock ownership. We may
also assume additional debt and incur impairment losses related to goodwill
and
other tangible assets if we acquire another company and this could negatively
impact our earnings and results of operations.
We
have not paid dividends in the past and do not expect to pay dividends for
the
foreseeable future, and any return on investment may be limited to potential
future appreciation on the value of our common stock.
We
currently intend to retain any future earnings to support the development and
expansion of our business and do not anticipate paying cash dividends in the
foreseeable future. Our payment of any future dividends will be at the
discretion of our board of directors after taking into account various factors,
including without limitation, our financial condition, operating results, cash
needs, growth plans and the terms of any credit agreements that we may be a
party to at the time. To the extent we do not pay dividends, our stock may
be
less valuable because a return on investment will only occur if and to the
extent our stock price appreciates, which may never occur. In addition,
investors must rely on sales of their common stock after price appreciation
as
the only way to realize their investment, and if the price of our stock does
not
appreciate, then there will be no return on investment. Investors seeking cash
dividends should not purchase our common stock.
Our
officers, directors and principal shareholders, controlling approximately 73%
of
our outstanding common stock, can exert significant influence over us and may
make decisions that are not in the best interests of all
shareholders.
Our
officers, directors and principal shareholders (greater than 5% shareholders)
collectively control approximately 73% of our outstanding common stock. As
a
result, these shareholders will be able to affect the outcome of, or exert
significant influence over, all matters requiring shareholder approval,
including the election and removal of directors and any change in control.
In
particular, this concentration of ownership of our common stock could have
the
effect of delaying or preventing a change of control of us or otherwise
discouraging or preventing a potential acquirer from attempting to obtain
control of us. This, in turn, could have a negative effect on the market price
of our common stock. It could also prevent our shareholders from realizing
a
premium over the market prices for their shares of common stock. Moreover,
the
interests of this concentration of ownership may not always coincide with our
interests or the interests of other shareholders, and accordingly, they could
cause us to enter into transactions or agreements that we would not otherwise
consider.
Anti-takeover
provisions may limit the ability of another party to acquire us, which could
cause our stock price to decline.
Our
articles of incorporation, as amended, our bylaws and Florida law contain
provisions that could discourage, delay or prevent a third party from acquiring
us, even if doing so may be beneficial to our shareholders. In addition, these
provisions could limit the price investors would be willing to pay in the future
for shares of our common stock.
ITEM
3.
CONTROLS
AND PROCEDURES
As
of
September 30, 2007, the end of the period covered by this report, the Company
conducted an evaluation, under the supervision and with the participation of
the
Chief Executive Officer and Chief Financial Officer, of the Company’s disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) under
the
1934 Act. Based on this evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that the Company’s disclosure controls and
procedures are effective.
There
was
no change in the Company’s internal control over financial reporting during the
Company’s most recently completed fiscal quarter that has materially affected,
or is reasonably likely to materially affect, the Company’s internal control
over financial reporting.
PART
II
ITEM
1.
LEGAL
PROCEEDINGS
Except
as
described below, we are not involved in any legal proceedings that require
disclosure in this registration statement.
From
time
to time, we may be involved in litigation relating to claims arising out of
our
operations in the normal course of business. Except as is described below,
we
are not currently party to any legal proceedings, the adverse outcome of which,
in management’s opinion, individually or in the aggregate, would have a material
adverse effect on our results of operations or financial position.
On
August
4, 2005, VMdirect filed a lawsuit in the District Court of Clark County,
Nevada,
against a former employee alleging a number of complaints including fraud,
breach of oral contract, intentional interference and negligent interference,
and seeking compensatory and punitive damages in amounts to be proved at
trial,
rescission of the oral contract relating to the defendant’s equity interest in
VMdirect, injunctive relief, punitive damages, attorneys’ fees, disgorgement of
ill gotten profits, revenues and gain, and restitution. VMdirect hired the
defendant in May 2001 as a project manager in reliance upon the defendant’s
representations regarding his skill in handling the job duties. In May 2002,
VMdirect agreed to provide the defendant with a small portion of the equity
interest in VMdirect, which was expressly conditioned upon the defendant
working
full time and in good faith for no less than 3 years after May 2002. VMdirect
terminated defendant’s employment on August 10, 2004 due to his continuous lack
of diligence and unsatisfactory job performance as well as his creation of
a
hostile and adversarial work environment.
On
August
5, 2005, VMdirect was served with a lawsuit filed in the District Court of
Clark
County, Nevada, which counterclaim was amended on March 27, 2006, by this
same
former employee for alleged breach of employment contract and wrongful
termination, and seeking general damages in excess of $10,000, special damages
for lost wages and converted monies in the amount of $270,000, special damages
for the equity interest in VMdirect in an amount to be determined, punitive
or
treble damages as allowed by law, attorneys’ fees and the dissolution of
VMdirect. This former employee alleges that the grant of the equity interest
in
VMdirect had no conditions, and that VMdirect has engaged in a campaign to
defame said former employee.
A
petition to consolidate these cases was filed on September 20, 2005 and is
currently pending before the courts. On May 5, 2006, the Company’s legal counsel
representing the Company in this matter filed a motion to dismiss the
defendant’s amended counterclaim, which motion was denied on June 21, 2006. The
Company’s legal counsel representing the Company in this matter subsequently
filed an answer to the defendant’s amended counterclaim on July 18, 2006,
denying all liability.
On
October 5, 2007, the Company reached a settlement with this former employee
in
which the Company agreed to pay this former employee the sum of $37,500 by
November 5, 2007. This settlement has been accrued in the accompanying financial
statements for the period ending September 30, 2007.
On
February 7, 2007, VMdirect and DigitalFX Solutions, LLC, a Nevada limited
liability company and one of our wholly-owned subsidiaries (“DigitalFX
Solutions”), jointly filed a lawsuit in the Superior Court of the State of
California for the County of Los Angeles against a former affiliate of VMdirect
alleging a number of complaints including unfair business practice,
misappropriation of trade secrets, slander, intentional interference with
contractual relationship, intentional interference with prospective economic
advantage and breach of contract, and seeking compensatory and punitive damages
in amounts to be proved at trial, injunctive relief and attorneys’ fees and
costs. The defendant became an affiliate of VMdirect in May 2006 and agreed
to
adhere to VMdirect’s Code of Ethics for affiliates. Upon signing up as an
affiliate, defendant represented that he was capable of bringing a substantial
number of new affiliates to VMdirect, and in reliance on this representation,
VMdirect agreed to provide certain privileges to defendant including posting
of
training materials on VMdirect’s website. VMdirect also agreed to work with
defendant to develop training materials. Although VMdirect paid for all of
the
costs of developing the materials and its personnel actively participated in
the
development of such materials, defendant demanded aggregate compensation of
$300,000 for creating the training and motivational materials after they were
completed. After VMdirect did not pay this fee to defendant, defendant requested
that VMdirect stop using the materials, began disparaging VMdirect and its
officers, and engaged in cross-recruiting affiliates from other VMdirect
networks, a practice prohibited by VMdirect’s Code of Ethics for its affiliates.
VMdirect then terminated defendant’s distribution network and believes that
defendant continues to use VMdirect’s proprietary trade secrets to recruit
affiliates to join other network marketing companies that compete with
VMdirect.
On
March
6, 2007, we, along with VMdirect and DigitalFX Solutions, were served with
a
cross complaint for damages filed in the Superior Court of California for the
County of Los Angeles, by this same former affiliate for alleged breach of
contract, fraud-intentional misrepresentation, fraud-intentional
concealment/omission, fraud-false promises, negligent misrepresentation and
infringement of the rights of publicity and privacy, and seeking general,
exemplary and punitive damages in amounts to be determined at trial and an
order
enjoining our use of his name, image, photograph and likeness for any purpose
without his written consent. This former affiliate alleges that the officers
of
VMdirect agreed to grant him 60,000 shares of our common stock, agreed to pay
him a percentage of sales to small businesses and enterprises in connection
with
his creation of certain training materials, agreed to pay for the costs of
all
training materials created by him and agreed that all training materials which
contained his likeness would remain his intellectual property. This former
affiliate also alleges that it was expressly agreed that a copy of such
materials would be made available to him for posting as promotional materials
on
his own website and that his consent for VMdirect to use his image and likeness
on its websites would be revocable at any time.
On
March 6, 2007, legal counsel for the same former
affiliate filed a Notice of Removal of Action with the United States District
Court of the Central District of California seeking to remove the case from
the
Superior Court of California to the United States District Court. Our legal
counsel filed a motion to remand the case back to the Superior Court of
California which motion was granted.
On
August
31, 2007, the former affiliate applied on an ex parte basis for a temporary
restraining
order
("TRO")
to
have
VMdirect remove from its website the training materials featuring the
former
affiliate and to have VMdirect and DigitalFX Solutions stop using those
training
materials
altogether.
The application for TRO was denied. However, the judge did set for hearing
on
September
20, 2007 the issue of whether a preliminary injunction should issue against
VMdirect
on
this
same matter. At the hearing on September 20, 2007, the former affiliate
raised
the
issue
that
neither VMdirect nor DigitalFX Solutions are qualified to do business
in
California.
Hearing
on
this
new issue was continued until November 1, 2007.
At
the
hearing on November 1, 2007, the court took under submission the issue
of
whether VMdirect and DigitalFX Solutions
may
defend
themselves against a preliminary injunction that arises from a cross-complaint
even if they are not qualified to do business in California. The court
has not
yet ruled on this issue.
Also,
DigitalFX
Solutions is in the process of becoming qualified to do business in California
so that it
may
proceed with its action against the former affiliate.
Management
believes there exists no basis for the former affiliate's claims and
intends to
defend this matter vigorously.
In
the
event our management’s assessment of the case is incorrect, or the former
affiliate actually obtains a favorable judgment for the claimed
damages, the economic impact on us would be insignificant and would not
materially affect our operations.
ITEM
2.
UNREGISTERED
SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
On
July
24, 2007, Gary Freeman, a consultant, exercised (on a cashless basis) a
previously issued warrant for 10,139 shares of our common stock with an exercise
price of $0.26 per share. Accordingly, the aggregate exercise price of
approximately $2,654 was paid through the surrender and cancellation of 639
shares with a fair market value on the date of exercise of $3.96 per share,
which resulted in the issuance of 9,500 shares of our common stock.
On
July
25, 2007, Kristian Diakov exercised (on a cashless basis) a previously issued
warrant for 106,563 shares of our common stock with an exercise price of $0.26
per share. Accordingly, the aggregate exercise price of approximately $27,892
was paid through the surrender and cancellation of 6,727 shares with a fair
market value on the date of exercise of $4.00 per share, which resulted in
the
issuance of 99,836 shares of our common stock.
On
August
20, 2007, Gary Freeman, a consultant, exercised (on a cashless basis) a
previously issued warrant for 10,245 shares of our common stock with an exercise
price of $0.26 per share. Accordingly, the aggregate exercise price of
approximately $2,682 was paid through the surrender and cancellation of 745
shares with a fair market value on the date of exercise of $3.00 per share,
which resulted in the issuance of 9,500 shares of our common stock.
On
September 20, 2007, Gary Freeman, a consultant, exercised (on a cashless basis)
a previously issued warrant for 10,295 shares of our common stock with an
exercise price of $0.26 per share. Accordingly, the aggregate exercise price
of
approximately $2,695 was paid through the surrender and cancellation of 795
shares with a fair market value on the date of exercise of $3.40 per share,
which resulted in the issuance of 9,500 shares of our common stock.
In
connection with the above stock issuances, except as otherwise disclosed we
did
not pay any underwriting discounts or commissions. None of the sales of
securities described or referred to above was registered under the Securities
Act of 1933, as amended (the “Securities Act”). Each of the purchasers fell into
one or more of the categories that follow: one of our existing shareholders,
one
of our creditors, one of our current or former officers or directors, one of
our
employees, one of our service providers, or an accredited investor with whom
we
or one of our affiliates had a prior business relationship. As a result, no
general solicitation or advertising was used in connection with the sales.
In
making the sales without registration under the Securities Act, we relied upon
the exemption from registration contained in Section 4(2) of the Securities
Act.
ITEM
6.
EXHIBITS
See
attached Exhibit Index.
SIGNATURES
In
accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
|
DIGITALFX
INTERNATIONAL, INC.
|
|
|
|
Date:
November 14, 2007
|
By:
|
/s/
Lorne Walker
|
|
|
|
Lorne
Walker
|
|
|
Chief
Financial Officer
|
Exhibit
Index
Exhibit
Number
|
|
Exhibit
Title
|
|
|
|
3.2
|
|
Amended
Bylaws effective June 29, 2007.
|
31.1
|
|
Certification
by Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a)
under
the Securities Exchange Act of 1934, as amended.
|
31.2
|
|
Certification
by Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a)
under
the Securities Exchange Act of 1934, as amended.
|
32.1
|
|
Certification
of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
|
32.2
|
|
Certification
of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
|
Digitalfx International, Inc. (AMEX:DXN)
Historical Stock Chart
From Jun 2024 to Jul 2024
Digitalfx International, Inc. (AMEX:DXN)
Historical Stock Chart
From Jul 2023 to Jul 2024