UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Commission file number: 000-27305
TELKONET, INC.
(Exact name of registrant as specified in its charter)
Utah
(State or other jurisdiction of incorporation or organization)
87-0627421
(IRS Employee Identification No.)
20374 Seneca Meadows Parkway
Germantown, MD 20876
(Address of principal executive offices)
(240) 912-1800
(Issuer’s telephone number)
Securities Registered pursuant to section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-know seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes xNo
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(b) of the Act. o Yes xNo
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and
Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90 days. x Yes oNo
Check if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained in this form, and no disclosure will be
contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See the definition
of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
o Large Accelerated Filer x Accelerated Filer o Non-Accelerated Filer
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) o Yes xNo
Aggregate market value of the voting stock held by non-affiliates of the registrant as of March 1 2006: $155,184,856
Number of outstanding shares of the registrant’s par value $0.001 common stock as of March 1, 2006: 46,316,539.
TELKONET, INC.
FORM 10-K
INDEX
Part I
Item 1.
Description of Business
Item 1A.
Risk Factors
Item 1B.
Unresolved Staff Comments
Item 2.
Description of Property
Item 3.
Legal Proceedings
Item 4.
Submission of Matters to a Vote of Security Holders
Part II
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Registrant's Purchases of
Securities
Item 6.
Selected Financial Data
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Item 8.
Financial Statements
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A.
Controls and Procedures
Item 9B.
Other Information
Item 10.
Directors and Executive Officers of the Registrant
Item 11.
Executive Compensation
Part III
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Certain Relationships and Related Transactions
Item 14.
Principal Accounting Fees and Services
Item 15.
Exhibits and Financial Statement Schedules
Part IV
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PART I
ITEM 1.
DESCRIPTION OF BUSINESS.
General
Telkonet, Inc. was formed in 1999 to develop products for use in the powerline communications (PLC) industry. PLC products
use existing electrical wiring in commercial and residential buildings to carry high speed data communications signals, including the
Internet. Since the Company’s formation, it has focused on development and marketing of its PLC technology.
The Company’s PLC technology, the “Telkonet iWire System(TM)” product suite (formerly referred to as the PlugPlus™ product
suite), consists of four primary components, the Gateway, the eXtender, the Coupler and the iBridge. The Gateway, the hub of the
Telkonet iWire SystemTM product suite, is a modular, self-contained unit that accepts data from an existing network on one port and
distributes it via a second port. The Gateway integrates a communications processor that runs a series of proprietary applications under
Linux. The signal generated by the Gateway can be directly coupled into low voltage wiring via the Coupler, which interfaces directly
between the Gateway and the building’s electrical panel. Multi-panel buildings typically require multiple Couplers, which are connected
to the Gateway via inexpensive coaxial cable and concentrated using standard radio frequency splitters. A suite of software applications
running on the Gateway can perform communications functions or system management functions. The iBridge serves as the user’s
network access device and connects to a user’s personal computer through a standard Ethernet cable. The iBridge’s AC line cord serves as
its power source as well as its network interface. The eXtender is used to extend the reach of the Gateway in larger buildings or campus
environments.
The Telkonet iWire System™ product suite delivers data to the user at speeds in excess of 7 Mega bits per second (Mbps), with
burst speeds of 12.6 Mbps. The Telkonet iWire System™ product suite is installed by connecting an incoming broadband signal (DSL, T-
1, satellite or cable modem) into the Gateway and connecting the Gateway to a building's electrical panel using one or more Couplers.
Once installed, the Gateway distributes the high-speed Internet signal throughout the entire existing network of electrical wires within the
building. The user may access a high-speed Internet signal by plugging the iBridge into any electrical outlet and connecting a personal
computer to the iBridge using the computer's built-in Ethernet port. Multiple personal computers connected t o the iBridge can
communicate with one another and can share a single broadband resource via the Gateway.
The Company is a member of the HomePlug(TM) Powerline Alliance, an industry trade group that engages in marketing and
educational initiatives, and sets standards and specifications for products in the powerline communications industry.
The Company’s principal executive offices are located at 20374 Seneca Meadows Parkway, Germantown, Maryland 20876.
Business History
In January 2002, the Company announced that it had shifted its management emphasis from research and development to product
sales and marketing in order to move its initial proprietary products into the commercial market. In January 2002, the Board of Directors,
Founders and executive management of the Company also reassessed the Company’s capital structure. In order to attract additional
management and marketing expertise, and to raise the necessary capital for manufacturing, sales, and marketing, the Board of Directors
approved a plan authorizing the repurchase of certain shares of, and options to purchase, Telkonet common stock held by each of David
Grimes, L. Peter Larson and Stephen Sadle who, at the time of the stock repurchase, each owned in excess of five percent of the issued
and outstanding capital stock and were directors and executive officers of Telkonet. The net effect of the recapitalization was to reduce
the number of shares of issued and outstanding common stock from approximately 22,100,000 shares to 13,900,000 shares.
In May 2002, the Company concluded an offering of Series A convertible debentures pursuant to which the Company raised
approximately $1.7 million dollars for working capital purposes. In the fourth quarter of 2002, the Company announced the successful
installation of its PlugPlus™ product suite at a historic inn in Augusta, Georgia and installation of a product field trial in Wilmington,
North Carolina.
I n the first quarter of 2003, the Company concluded an offering of Series B convertible debentures pursuant to which the
Company raised approximately $2.5 million dollars for working capital purposes. The Company also executed a strategic alliance
agreement with Choice Hotels International (NYSE: CHH), one of the largest hotel franchise companies in the world, pursuant to which
Telkonet agreed to become a Choice Hotels-endorsed vendor.
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In the second quarter of 2003, the Company concluded an offering of Senior Notes pursuant to which the Company raised
approximately $5,000,000, exclusive of placement costs and fees. The proceeds of the Senior Note offering were designated for working
capital purposes.
In January 2004, the Board of Directors determined to permit the Senior Noteholders, for a limited period of time, to convert
their Senior Notes into the Company's common stock at a conversion price of $2.10 per share. In connection with this transaction, Senior
Noteholders converted Senior Notes having an aggregate principal value of $2,539,000. As of December 31, 2005, t h e aggregate
outstanding balance on the Senior Notes, including principal and accrued but unpaid interest, was $102,000.
In February 2004, the Company completed a private offering of its common stock resulting in net proceeds of $12.8 million. The
Company sold 6,387,600 shares of its common stock in the private offering. The proceeds of the private placement were designated for
working capital purposes.
In October 2005, the Company announced that it completed a convertible senior debt financing of $20 million. The $20 million
is for general working capital needs. The convertible notes bear interest at a fixed rate of 7.25%, payable in cash or, under certain
conditions, Telkonet common stock, and call for monthly principal installments beginning March 1, 2006. The convertible senior notes
were purchased by two institutional investors in the face amount of $10 million each.
I n January 2006, the Company acquired, for $9 million, a 90% interest in Microwave Satellite Technologies (MST), a
communications technology company that offers complete sales, installation, and service of Very Small Aperture Terminal (VSAT) and
business television networks, and is a full-service national Internet Service Provider (ISP). This acquisition will allow the Company to
provide a “triple-play” solution to HDTV, VoIP telephony and Internet subscribers. The $9 million purchase price is payable $1.8 million
in cash and 1.6 million unregistered shares of the Company’s common stock, the $900,000 of the cash portion of the purchase price was
paid at the closing and the remaining $900,000 is payable in January 2007. With respect to the stock portion of the purchase price,
400,000 shares of Telkonet common stock were paid at the closing and the remaining 1,200,000 shares are currently held in escrow and
shall be released upon the achievement of 3,300 “triple play” subscribers over a three year period. The Company plans to expand MST's
existing operations, which currently are concentrated in Manhattan, throughout New York and increase its presence in other major
metropolitan cities using the New York system as a template.
Competition
The HomePlug(TM) Powerline Alliance has grown over the past year and now includes many well recognized brands in the
networking and communications industries. These include Linksys (a Cisco company), Intel, GE, Motorola, Netgear, Sony and Samsung.
While these companies may choose to move into the commercial market at a future date, they do not presently represent a direct
competitive threat to Telkonet since they only market and sell their products in the residential sector.
Notwithstanding the present absence of direct competitors, there can be no assurance that the HomePlug(TM) Powerline Alliance
members, or any other company will not develop PLC products that compete with Telkonet’s products in the future. Some of these
potential competitors have longer operating histories, greater name recognition and substantially greater financial, technical, sales,
marketing and other resources than Telkonet. These potential competitors may, among other things, undertake more extensive marketing
campaigns, adopt more aggressive pricing policies, obtain more favorable pricing from suppliers and manufacturers and exert more
influence on the sales channel than Telkonet can. As a result, Telkonet may not be able to compete successfully with these potential
competitors and these potential competitors may develop or market technologies and products that are more widely accepted than those
being developed by Telkonet or that would render Telkonet’s products obsolete or noncompetitive.
Management has focused its sales and marketing efforts primarily on the commercial sector, which includes office buildings,
hotels, schools, shopping malls, commercial buildings, multi-dwelling units, government facilities, and any other commercial facilities
that have a need for Internet access and network connectivity. The Company has also focused on establishing relationships with value
added resellers. Telkonet continues to examine, select and approach entities with existing distribution channels that will be enhanced by
the Company’s offerings. The Company also intends to focus future sales and marketing efforts in Europe, South America, Asia and the
Pacific Rim.
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Raw Materials
The Company has not experienced any significant or unusual problems in the purchase of raw materials or commodities. While
the Company is dependent, in certain situations, on a limited number of vendors to provide certain raw materials and components, it has
not experienced significant problems or issues purchasing any essential materials, parts or components. The Company obtains the
majority of its raw materials from the following suppliers: Avnet Electronics Marketing, Digi-Key Corporation, Intellon Corporation, and
Parkview Metal Products. I n addition, Superior Manufacturing Services, a U.S. based company, provides substantially all the
manufacturing and assembly requirements for the Company.
Customers
The Company is neither limited to, nor reliant upon, a single or narrowly segmented consumer base from which it derives its
revenues. Presently, the Company is not dependent on any particular customer under contract. However, in 2005, the Company
sold certain rental contract agreements to Hospitality Leasing Corporation, which sale represented approximately 18% of total revenues.
I n 2004, revenues from another customer represented approximately 19% of total revenues. The Company’s primary focus is in the
hospitality, multi-dwelling units, government and international markets.
Intellectual Property
The Company has applied for patents that cover its unique technology, and has utilized the recently announced advancements in
transmission speeds to build its next generation of products. The Company continues to identify, design and develop enhancements to its
core technologies that will provide additional functionality, diversification of application and desirability for current and future users. It is
the intent of the Company to protect this intellectual property by filing additional patent applications. The Company also has multiple
registered and common law trademarks that it uses in the conduct of its business. The Company is presently not a party to any intellectual
property licensing agreements.
In September 2003, the Company received approval from the U.S. Patent and Trademark Office for its “Method and Apparatus
for Providing Telephonic Communication Services” patent.
In December 2005, Telkonet was granted United States Patent 6,975,212 by the U.S. Patent and Trademark Office. The patent is
titled “Method and Apparatus for Attaching Power Line Communications to Customer Premises.” This patent covers the Telkonet
Coupler, which is a unique technique used by the Company to interface and couple its communication devices onto the three-phase
electrical systems that are predominate in commercial buildings and facilities worldwide. In addition to the foregoing, in 2005, Telkonet
filed three new patent applications related to its PLC technology.
Notwithstanding the issuance of this patent, there can be no assurance that any of the Company’s current or future patent
applications will be granted, or, if granted, that such patents will provide necessary protection for the Company’s technology or its
product offerings, or be of commercial benefit to the Company.
Government Regulation
We are subject to regulation in the United States by the FCC. FCC rules permit the operation of unlicensed digital devices that
radiate radio frequency (RF) emissions if the manufacturer complies with certain equipment authorization procedures, technical
requirements, marketing restrictions and product labeling requirements. An independent, FCC-certified testing lab has verified that our
PLC product line complies with the FCC technical requirements for Class B digital devices. No further testing of these devices is required
and the devices may be manufactured and marketed for commercial and residential use.
In Europe and other overseas markets, the Company’s products are subject to safety and RF emissions regulations adopted by the
European Union (EU) for Information Technology Equipment. In March 2005, the Company received final Conformite Europeene (CE)
certification, which is required for the Company to freely market and sell its products within the EU. As a result of the certification, the
Company’s products that will be sold and installed in EU countries will bear the CE marking, a symbol that demonstrates that the product
has met the EU’s regulatory standards and is approved for sale in the EU.
Future products designed by the Company will require testing for compliance with FCC and EU regulations. Moreover, if in the
the Company's
future, the FCC or EU change their respective regulatory requirements, further testing and/or modifications to
products may be necessary to comply with such changes.
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Research and Development
During the years ended December 31, 2005, 2004 and 2003, the Company spent $2,096,104, $1,852,308 and $1,370,785,
respectively, on research and development activities. In 2005, research and development activities included ( a ) Quality of Service
(QoS) for VoIP service for both commercial and FIPS 140-2 product applications, (b) design of next generation high-speed development
platform, (c) design, prototype and release of a new Integrated Coupler Breaker product line, (d) design and development of second
generation automated test equipment for manufacturing Telkonet's products, (e) automated Software Quality Assurance (SQA) regression
testing. In 2004, research and development activities included (a) development of a reduced cost (“G3”) iBridge/eXtender, (b) router
software development, and (c) advanced encryption support. In 2003, research and development activities included ( a ) improved
network capabilities with the introduction of the Company’s secondary gateway, (b) the introduction of an encrypted product feature
to enhance security functions, (c) improved ability to remotely monitor network status, (d) the addition of a Virtual Local Area Network
(VLAN) support function for enhanced integration of subscriber management and billing systems, and (e) development of the reduced cost
iBridge/eXtender products.
Long Term Investments
Amperion, Inc.
O n November 30, 2004, the Company invested $500,000 in Amperion, Inc., a privately held company, in exchange for
11,013,215 shares of Series A Preferred Stock, which represents an equity interest in Amperion of approximately 4.7%. Amperion is
engaged in the business of developing networking hardware and software that enables the delivery of high-speed broadband data over
medium-voltage power lines. The Series A Preferred Stock has a preferential right to receive dividends and with respect to liquidation.
The Series A Preferred Stock also votes as a single class with the shares of common stock and Class C common stock, except with respect
to certain extraordinary matters, including an amendment to Amperion’s certificate of incorporation, an increase in the number of
authorized shares of preferred stock, the issuance of any class of stock having parity with or rights superior to those of the Series A
Preferred Stock and certain material transactions, in which case, the Series A Preferred Stock must approve such extraordinary action
voting as a separate class. The Company has the right to designate one member of Amperion’s seven-person board of directors. The Board
of Directors has designated Warren “Pete” Musser, the Chairman of the Board of Directors of Telkonet, to fill this position. Each share of
Series A Preferred Stock is entitled to one vote per share. The Company accounted for this investment under the cost method, as the
Company does not have the ability to exercise significant influence over Amperion’s operating or financial policies. T h e Company
determined that its investment in Amperion was impaired based upon forecasted discounted cash flow and has written-off 80%, or
$400,000, of its investment based on management assessment. The remaining value of the Company’s investment in Amperion is
$100,000 at December 31, 2005.
BPL Global, Ltd.
On February 4, 2005, the board of directors approved an investment in BPL Global, Ltd. (“BPL Global”), a privately held
company. During the year-end December 31, 2005, the Company funded, in the aggregate, $131,000 of the approved committment. This
investment represents an equity interest of approximately 6.21% at December 31, 2005. BPL Global is engaged i n the business of
developing broadband services via power lines through joint ventures in the United States, Asia, Eastern Europe and the Middle East.
The Company accounted for this investment under the cost method, as the Company does not have the ability to exercise significant
influence over operating and financial policies of BPL Global. The Company reviewed the assumptions underlying the operating
performance and cash flow forecasts in assessing the carrying values of the investment. The fair value of the Company's investment in
BPL Global remained at $131,000 as of December 31, 2005.
Environmental Matters
The Company does not anticipate any material effect on its capital expenditures, earnings or competitive position due to
compliance with government regulations involving environmental matters.
Employees
As of March 1, 2006, the Company had eighty-three (83) full time employees, which were comprised of sixty-six (66) full-time
employees of Telkonet and seventeen (17) employees of MST. The Company anticipates that it will hire additional key staff throughout
2006 in the areas of business development, sales and marketing, and engineering.
Backlog
A s o f December 31, 2005 and 2004, revenues to be recognized under non-cancelable leases (backlog) was approximately
$2,411,000 and $933,000, respectively. The associated remaining weighted average lease term was approximately 31 months for both
years. In January 2006, the Company consummated a non-recourse sale of certain rental contract agreements (backlog) of approximately
$918,000. Of the remaining $1,493,000 backlog, $498,000 will be recognized as revenue in 2006 while the remaining $995,000 will be
recognized in 2007 through 2010.
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Financial Information About Geographic Areas
To date, the majority of the Company's revenue has been derived from United States sources although the Company does
recognize revenue from international sales. International sales represented 25% and 10% of the Company's total revenue in 2005 and
2004, respectively. Telkonet's international sales presently are concentrated in Canada, Latin America and Western Europe, however,
Telkonet continues to expand into other markets worldwide. The table below sets forth the Company's net revenue in the United States
and Worldwide.
Year Ended December 31,
Percentage
Change
2004
Percentage
Change
197% $ 630,957
812%
67,695
256% $ 698,652
574% $
-
646% $
2003
93,660
-
93,660
2005
$ 1,871,241
617,082
$ 2,488,323
United States
Worldwide
Total
ITEM 1A.
RISK FACTORS.
The risks and uncertainties described below are those that the Company currently deems to be material and that it believes are
specific to the Company and the industry in which it competes. In addition to these risks, the Company’s business may be subject to risks
currently unknown to the Company.
The Company has a history of operating losses and an accumulated deficit and expects to continue to incur losses for the
foreseeable future.
Since inception through December 31, 2005, the Company has incurred cumulative losses of $42,987,553 and has never
generated enough funds through operations to support its business. The Company expects to continue to incur operating losses through
2006. The Company’s losses to date have resulted principally from:
·
·
·
·
research and development costs relating to the development of the Telkonet iWire SystemTM product suite;
costs and expenses associated with manufacturing, distribution and marketing of the Company’s products;
general and administrative costs relating to the Company’s operations; and
interest expense related to the Company’s indebtedness.
The Company is currently unprofitable and may never become profitable. Since inception, the Company has funded its research
and development activities primarily from private placements of equity and debt securities, a bank loan and short term loans from certain
of its executive officers. As a result of its substantial research and development expenditures and limited product revenues, the Company
has incurred substantial net losses. The Company’s ability to achieve profitability will depend primarily on its ability to successfully
commercialize the Telkonet iWire SystemTM product suite.
Potential fluctuations in operating results could have a negative effect on the price of the Company’s common stock.
The Company’s operating results may fluctuate significantly in the future as a result of a variety of factors, most of which are
outside the Company’s control, including:
·
·
·
the level of use of the Internet;
the demand for high-tech goods;
the amount and timing of capital expenditures and other costs relating to the expansion of the Company’s operations;
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·
·
·
·
price competition or pricing changes in the industry;
technical difficulties or system downtime;
economic conditions specific to the internet and communications industry; and
general economic conditions.
The Company’s quarterly results may also be significantly impacted by certain accounting treatment of acquisitions, financing
transactions or other matters. Such accounting treatment could have a material impact on the Company’s results of operations and have a
negative impact on the price of the Company’s common stock.
The Company’s directors and executive officers own a substantial percentage of the Company’s issued and outstanding common
stock. Their ownership could allow them to exercise significant control over corporate decisions.
As of March 1, 2006, the Company’s officers and directors owned 26.4% of the Company’s issued and outstanding common
stock. This means that the Company’s officers and directors, as a group, exercise significant control over matters upon which the
Company’s stockholders may vote, including the selection of the Board of Directors, mergers, acquisitions and other significant corporate
transactions.
Further issuances of equity securities may be dilutive to current stockholders.
Although the funds raised in the Company’s debenture offerings, the note offerings and the private placement of common stock
are being used for general working capital purposes, it is likely that the Company will be required to seek additional capital in the future.
This capital funding could involve one or more types of equity securities, including convertible debt, common or convertible preferred
stock and warrants to acquire common or preferred stock. Such equity securities could be issued at or below the then-prevailing market
price for the Company’s common stock. Any issuance of additional shares of the Company’s common stock will be dilutive to existing
stockholders and could adversely affect the market price of the Company’s common stock.
Our significant indebtedness and interest payment obligations may adversely affect our ability to obtain additional financings,
service other existing debt, use our operating cash flow in other areas of our business, or otherwise adversely affect our operations.
I n October 2005, the Company completed a $20 million convertible senior debt financing to two institutional investors in
exchange for $20 million, in the aggregate pursuant to which the Company issued senior convertible notes. The convertible senior notes
accrue interest at 7.25% per annum and call for monthly principal installments beginning March 1, 2006. The convertible senior notes,
coupled with our other outstanding indebtedness, could make it difficult for us to obtain additional financing when, and if, needed. In
addition, the significant interest payment obligations on the convertible senior notes could make it difficult to service our other
outstanding indebtedness. Both the failure to obtain additional financing and the default on existing indebtedness could have a negative
impact on the Company's business and results of operations.
Our convertible senior debt financing contains loan covenants relating to revenue targets and other restrictions which may
reduce our operating cash.
The documents executed in connection with the $20 million convertible senior debt financing, contain certain covenants that
require the Company to achieve minimum revenue of $3 million for the period October 1, 2005 through March 31, 2006 and $2 million
for each fiscal quarter thereafter in 2006. The covenant requires that the Company pay an accelerated principal payment of up to
$1 million on a pro rata basis calculated based upon the percentage shortfall between actual revenues and the quarterly targeted revenues.
Failure to meet these revenue targets could reduce our operating cash and have a negative impact on the Company's business and results
of operations.
If we acquire any companies or technologies in the future, they could provide difficult to integrate, disrupt our business, dilute
stockholder value and adversely affect our operating results.
I n January 2006, the Company acquired a 90% interest in Microwave Satellite Technologies (MST), a communications
technology company that offers complete sales, installation, and service of VSAT and business television networks, and is a full-service
national Internet Service Provider (ISP). The failure of the Company to successfully integrate MST, or any Company acquired by
Telkonet in the future, to Telkonet's business, could have a negative impact on the Company's results of operations.
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Recent accounting pronouncements may impact our future financial position and results of operations.
There have been new accounting pronouncements or regulatory rulings that will have an impact on our future financial position
and results of operations. For instance, on December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement
No. 123 (revised 2004), "Share-Based Payment", which is a revision of FASB Statement No. 123, "Accounting for Stock-Based
Compensation". SFAS 123(R) supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees", and amends FASB
Statement No. 95, "Statement of Cash Flows". Generally, the approach in SFAS 123(R) is similar to the approach described in Statement
123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be
recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. We expect to adopt SFAS
123(R) effective January 1, 2006 under the modified-prospective method. The adoption of SFAS 123(R)'s fair value method will have a
significant impact on our results of operations, although it will have no impact on our overall financial position. With the adoption of
SFAS 123(R), we expect to record stock-based compensation of approximately $2 million in 2006. Our estimate of stock-based
compensation expense is affected by our stock price, the number of stock-based awards we may grant in 2006, as well as a number of
complex and subjective valuation assumptions including, but not limited to, the volatility of our stock price, interest rates and employee
stock option exercise behaviors.
The exercise of options and warrants outstanding and available for issuance may adversely affect the market price of the
Company’s common stock.
As of December 31, 2005, the Company had outstanding employee options to purchase a total of 10,151,078 shares of common
stock at exercise prices ranging from $1.00 to $5.97 per share, with a weighted average exercise price of $1.85. As of December 31, 2005,
the Company had outstanding non-employee options to purchase a total of 1,841,774 shares of common stock at an exercise price of $1.00
per share. As of December 31, 2005, the Company had warrants outstanding to purchase a total of 1,230,000 shares of common stock at
exercise prices ranging from $1.00 to $5.00 per share, with a weighted average exercise price of $4.31. The exercise of outstanding
options and warrants and the sale in the public market of the shares purchased upon such exercise will be dilutive to existing stockholders
and could adversely affect the market price of the Company’s common stock.
The powerline communications industry is intensely competitive and rapidly evolving.
The Company operates in a highly competitive, quickly changing environment, and the Company’s future success will depend
on its ability to develop and introduce new products and product enhancements that achieve broad market acceptance in commercial and
governmental sectors. The Company will also need to respond effectively to new product announcements by its competitors by quickly
introducing competitive products.
Delays in product development and introduction could result in:
·
·
·
loss of or delay in revenue and loss of market share;
negative publicity and damage to the Company’s reputation and brand; and
decline in the average selling price of the Company’s products.
Government regulation of the Company’s products could impair the Company’s ability to sell such products in certain markets.
FCC rules permit the operation of unlicensed digital devices that radiate radio frequency emissions if the manufacturer complies
with certain equipment authorization procedures, technical requirements, marketing restrictions and product labeling requirements.
Differing technical requirements apply to “Class A” devices intended for use in commercial settings, and “Class B” devices intended for
residential use to which more stringent standards apply. An independent, FCC-certified testing lab has verified that Telkonet’s iWire
SystemTM product suite complies with the FCC technical requirements for Class A and Class B digital devices. No further testing of
these devices is required and the devices may be manufactured and marketed for commercial and residential use. In addition, the
Company's products are subject to safety and RF emissions regulations adopted by the European Union (EU) for Information Technology
Equipment. In March 2005, the Company received final Conformite Europeane (CE) certification, which is required for the Company to
freely market and sell its products in the EU. Additional devices designed by the Company for commercial and residential use may be
subject to FCC and EU rules. Moreover, if in the future, the FCC, EU or any other regulatory body changes its technical requirements
for our products, further testing and/or modifications of the Company's products may be necessary to comply with such changes. Failure
to comply with any existing or future applicable technical requirements could impair the Company’s ability to sell its products in certain
markets and could have a negative impact on its business and results of operations.
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Products sold by the Company’s competitors could become more popular than the Company’s products or render the Company’s
products obsolete.
The market for powerline communications products is highly competitive. The Company believes it has the only commercial
integrated three phase solution for “in-building” distribution of broadband utilizing the electrical wiring infrastructure. Certain
HomePlug(TM) Powerline Alliance members offer similar PLC solutions for the residential market. Although the HomePlug (TM)
Powerline Alliance members do not presently compete with the Company in the commercial market, there can be no assurance that the
HomePlug(TM) Powerline Alliance members or any other company will not develop PLC products that compete with the Company’s
products in the future. Some of these potential competitors have longer operating histories, greater name recognition and substantially
greater financial, technical, sales, marketing and other resources. These potential competitors may, among other things, undertake more
extensive marketing campaigns, adopt more aggressive pricing policies, may obtain more favorable pricing from suppliers and
manufacturers and exert more influence on the sales channel than the Company can. As a result, the Company may not be able to
compete successfully with these potential competitors and these potential competitors may develop or market technologies and products
that are more widely accepted than those being developed by the Company or that would render the Company’s products obsolete or
noncompetitive. The Company anticipates that potential competitors will also intensify their efforts to penetrate the Company’s target
markets. These potential competitors may have more advanced technology, more extensive distribution channels, stronger brand names,
bigger promotional budgets and larger customer bases than the Company does. These companies could devote more capital resources to
develop, manufacture and market competing products than the Company could. If any of these companies are successful in competing
against the Company, its sales could decline, its margins could be negatively impacted, and the Company could lose market share, any of
which could seriously harm the Company’s business and results of operations.
The failure of the Internet to continue as an accepted medium for business commerce could have a negative impact on the
Company’s results of operations.
The Company’s long-term viability is substantially dependent upon the continued widespread acceptance and use of the Internet
as a medium for business commerce. The Internet has experienced, and is expected to continue to experience, significant growth in the
number of users. There can be no assurance that the Internet infrastructure will continue to be able to support the demands placed on it by
this continued growth. In addition, delays in the development or adoption of new standards and protocols to handle increased levels of
Internet activity or increased governmental regulation could slow or stop the growth of the Internet as a viable medium for business
commerce. Moreover, critical issues concerning the commercial use of the Internet (including security, reliability, accessibility and quality
of service) remain unresolved and may adversely affect the growth of Internet use or the attractiveness of its use for business commerce.
The failure of the necessary infrastructure to further develop in a timely manner or the failure of the Internet to continue to develop
rapidly as a valid medium for business would have a negative impact on the Company’s results of operations.
The Company may not be able to obtain patents, which could have a material adverse effect on its business.
The Company’s ability to compete effectively in the powerline technology industry will depend on its success in acquiring
suitable patent protection. The Company currently has several patents pending. The Company also intends to file additional patent
applications that it deems to be economically beneficial. I f the Company is not successful in obtaining patents, it will have limited
protection against those who might copy its technology. As a result, the failure to obtain patents could negatively impact the Company’s
business and results of operations.
Infringement by third parties on the Company’s proprietary technology and development of substantially equivalent proprietary
technology by the Company’s competitors could negatively impact the Company’s business.
The Company’s success depends partly on its ability to maintain patent and trade secret protection, to obtain future patents and
licenses, and to operate without infringing on the proprietary rights of third parties. There can be no assurance that the measures the
Company has taken to protect its intellectual property, including those integrated to its Telkonet iWire SystemTM product suite, will
prevent misappropriation or circumvention. In addition, there can be no assurance that any patent application, when filed, will result in an
issued patent, or that the Company’s existing patents, or any patents that may be issued in the future, will provide the Company with
significant protection against competitors. Moreover, there can be no assurance that any patents issued to, or licensed by, the Company
will not be infringed upon or circumvented by others. Infringement by third parties on the Company’s proprietary technology could
negatively impact its business. Moreover, litigation to establish the validity of patents, to assert infringement claims against others, and to
defend against patent infringement claims can be expensive and time-consuming, even if the outcome is in the Company’s favor. The
Company also relies to a lesser extent on unpatented proprietary technology, and no assurance can be given that others will not
independently develop substantially equivalent proprietary information, techniques or processes or that the Company can meaningfully
protect its rights to such unpatented proprietary technology. Development o f substantially equivalent technology by the Company’s
competitors could negatively impact its business.
10
Table of Contents
The Company depends on a small team of senior management, and it may have difficulty attracting and retaining additional
personnel.
The Company’s future success will depend in large part upon the continued services and performance of senior management and
other key personnel. If the Company loses the services of any member of its senior management team, its overall operations could be
materially and adversely affected. In addition, the Company’s future success will depend on its ability to identify, attract, hire, train, retain
and motivate other highly skilled technical, managerial, marketing, purchasing and customer service personnel when they are needed.
Competition for these individuals is intense. The Company cannot ensure that it will be able to successfully attract, integrate or retain
sufficiently qualified personnel when the need arises. Any failure to attract and retain the necessary technical, managerial, marketing,
purchasing and customer service personnel could have a negative effect on the Company’s financial condition and results of operations.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
ITEM 2.
PROPERTIES.
The Company presently leases 11,600 square feet of commercial office space in Germantown, Maryland for its corporate
headquarters. The Germantown lease expires in November 2010. The Company also leases 1,800 square feet of office space in White
Marsh, Maryland, where it operates a portion of its sales and marketing activities. The White Marsh lease expires in May 2007. The
Company also leases a corporate apartment in Germantown, Maryland on a month-to-month basis for an executive officer.
In March 2005, the Company entered into a lease agreement for 6,742 square feet of commercial office space in Crystal City,
Virginia. The majority of the Company’s sales organization is located at the Crystal City facility. The Crystal City lease expires in March
2008.
MST, an entity controlled by the Company as a result of a January 2006 stock purchase, presently leases 12,600 square feet of
commercial office space in Hawthorne, New Jersey for its office and warehouse spaces. This lease expires in April 2010.
ITEM 3.
LEGAL PROCEEDINGS.
None.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On December 9, 2005, the Company held its annual meeting of stockholders at which the Company’s stockholders were asked to
elect seven (7) directors to serve on the Company’s Board of Directors and ratify the appointment of the Company’s independent
accountants for 2005. The following directors were elected at the annual meeting based on the number of votes indicated below. Each
director was elected to serve until the next annual meeting of stockholders or until his successor is elected and qualified.
Director Name
For
Against
Abstain
Broker Non-votes
Warren V. Musser
33,192,391
Ronald W. Pickett
33,264,857
Stephen L. Sadle
33,257,667
Thomas C. Lynch
33,523,803
James L. Peeler
Thomas M. Hall
33,534,573
33,536,073
Seth D. Blumenfeld
33,262,997
0
0
0
0
0
0
0
11
518,356
445,890
453,080
186,944
176,174
174,674
447,750
0
0
0
0
0
0
0
Table of Contents
The other matters presented at the meeting were approved by the Company’s stockholders as follows:
Matter Voted Upon
For
Against
Abstain
Broker Non-votes
Ratification of Independent
Accountants
33,604,555
78,030
28,162
0
PART II
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES.
On January 24, 2004, the Company’s common stock was listed for trading on the American Stock Exchange (AMEX) under the
ticker symbol “TKO.” Prior to January 24, 2004, the Company’s common stock was quoted on the OTC Bulletin Board under the
symbol “TLKO.OB.” As of March 1, 2006, the Company had 253 stockholders of record and 46,316,539 shares of its common stock
issued and outstanding.
The following table documents the high and low sales prices for the Company’s common stock on the AMEX for the period
beginning January 24, 2004 through December 31, 2005. The information provided for the period prior to January 24, 2004 was
obtained from the Yahoo! Finance web site.
Year Ended December 31, 2005
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
Year Ended December 31, 2004
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
High
$6.85
$5.34
$5.60
$5.23
$5.48
$5.32
$3.50
$5.98
Low
$3.66
$2.61
$3.11
$3.51
$2.54
$3.00
$2.20
$2.61
The Company has never paid dividends on its common stock and does not anticipate paying dividends in the foreseeable
future.
During the three months ended December 31, 2005, the Company agreed to issue 9,000 shares of common stock to Ronald W.
Pickett, the Company’s President and Chief Executive Officer, pursuant to his employment agreement dated January 20, 2004.
During the three months ended December 2005, the Company also issued an aggregate of 363,636 shares of common stock to
Ronald W. Pickett, the Company's President and Chief Executive Officer, in connection with Mr. Pickett's conversion of Series B
Debentures. The Company also issued an aggregate of 48,858 shares of common stock in payment of accrued interest on the Series B
Debentures. In addition, the Company issued an aggregate of 200,000 shares of common stock upon the exercise of warrants at $1.00
per share upon conversion of the notes.
During the three months ended December 31, 2005, the Company issued 30,000 shares of common stock to Seth Blumenfeld, a
member of the board of directors, pursuant to the terms of the Professional Services Agreement dated July 1, 2005.
This issuance of foregoing shares was made in reliance on the exemption from registration provided by Section 4(2) of the
Securities Act of 1933 and/or Rule 506 of Regulation D promulgated thereunder.
12
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ITEM 6.
SELECTED FINANCIAL DATA
The following table sets forth selected financial data for the last 5 years. This selected financial data should be read in
conjunction with the consolidated financial statements and related notes included in Item 15 of this Form 10-K.
Year Ended December 31,
(in thousands, except per share amounts)
2005
2004
2003
2002
$
Total revenues
Operating loss
Net loss
Loss per share - basic
Loss per share - diluted
Basic weighted average common shares outstanding
Diluted weighted average common shares outstanding
Working capital
Total assets
Short-term borrowings and current portion of long-term
debt
Long-term debt, net of current portion
Stockholders’ equity (deficiency)
2,488 $
(15,307)
(15,778)
(0.35)
(0.35)
44,743
44,743
12,061
23,291
6,350
9,617
5,315
698 $
(13,112)
(13,093)
(0.32)
(0.32)
41,384
41,384
12,672
15,493
—
588
13,646
94 $
(6,564)
(7,657)
(0.37)
(0.37)
20,702
20,702
5,296
6,176
15
3,132
2,388
— $
(3,155)
(3,778)
(.22)
(.22)
17,120
17,120
(894)
295
310
863
(1,527)
2001
(Restated)
—
(1,577)
(,1,716)
(0.08)
(0.08)
21,974
21,974
(502)
236
400
126
(414)
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
The following discussion and analysis of the Company’s financial condition and results of operations should be read in
conjunction with the accompanying financial statements and related notes thereto.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of
America requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and
accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our financial statements including those
related to revenue recognition, guarantees and product warranties and stock based compensation. We base our estimates on historical
experience, underlying run rates and various other assumptions that we believe to be reasonable, the results of which form the basis for
making judgments about the carrying values of assets and liabilities. Actual results could differ from these estimates. The following are
critical judgments, assumptions, and estimates used in the preparation of the consolidated financial statements.
13
Table of Contents
Revenue Recognition
For revenue from product sales, the Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104,
Revenue Recognition (“SAB104”), which superceded Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements
(“SAB101”). SAB 101 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an
arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectibility is reasonably assured.
Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the
products delivered and the collectibility of those amounts. Provisions for discounts and rebates to customers, estimated returns and
allowances, and other adjustments are provided for in the same period the related sales are recorded. The Company defers any revenue
for which the product has not been delivered or is subject to refund until such time that the Company and the customer jointly determine
that the product has been delivered or no refund will be required. SAB 104 incorporates Emerging Issues Task Force 00-21 (“EITF 00-
21”), Multiple-Deliverable Revenue Arrangements. EITF 00-21 addresses accounting for arrangements that may involve the delivery or
performance of multiple products, services and/or rights to use assets.
For equipment under lease, revenue is recognized over the lease term for operating lease and rental contracts. All of the
Company’s leases are accounted for as operating leases. At the inception of the lease, no lease revenue is recognized and the leased
equipment and installation costs are capitalized and appear o n the balance sheet as “Equipment Under Operating Leases.” The
capitalized cost of this equipment is depreciated from two to three years, on a straight-line basis down to the Company’s original
estimate of the projected value of the equipment at the end of the scheduled lease term. Monthly lease payments are recognized as rental
income.
Guarantees and Product Warranties
FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others” (“FIN 45”), requires that upon issuance of a guarantee, the guarantor must disclose and recognize
a liability for the fair value of the obligation it assumes under that guarantee.
The Company’s guarantees issued subject to the recognition and disclosure requirements of FIN 45 as of December 31, 2005
and 2004 were not material. The Company records a liability for potential warranty claims. The amount of the liability is based on the
trend in the historical ratio of claims to sales, the historical length of time between the sale and resulting warranty claim, new product
introductions and other factors. The products sold are generally covered by a warranty for a period of one year. In the event the
Company determines that its current or future product repair and replacement costs exceed its estimates, an adjustment to these reserves
would be charged to earnings in the period such determination is made. During the year ended December 31, 2005, the Company
experienced approximately three percent of units returned. Using this experience factor a reserve of $24,000 was accrued. Prior to the
fiscal year of 2005, the Company had not established historical ratio of claims, and the cost of replacing defective products and product
returns were immaterial and within management's expectations, accordingly there were no warranties provided with the purchase of the
Company's products during the year ended December 31, 2004.
Stock Based Compensation
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure-an
amendment of SFAS 123." This statement amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative
methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In
addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and
interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used
on reported results. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method
prescribed in APB Opinion No. 25 and related interpretations. Accordingly, compensation expense for stock options is measured as the
excess, if any, of the fair market value of the Company's stock at the date of the grant over the exercise price of the related option. The
Company has adopted the annual disclosure provisions of SFAS No. 148 in its financial reports for the years ended December 31, 2005,
2004 and 2003 and will adopt the interim disclosure provisions for its financial reports for the subsequent periods.
On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123R (revised 2004),
"Share-Based Payment" which is a revision of FASB Statement No. 123, "Accounting for Stock-Based Compensation". Statement 123R
supersedes APB opinion No. 25, "Accounting for Stock Issued to Employees", and amends FASB Statement No. 95, "Statement of Cash
Flows". Generally, the approach in Statement 123R is similar to the approach described in Statement 123. However, Statement 123R
requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement
based on their fair values. Pro-forma disclosure is no longer an alternative. On April 14, 2005, the SEC amended the effective date of
the provisions of this statement. The effect of this amendment by the SEC is that the Company will have to comply with Statement 123R
and use the Fair Value based method of accounting no later than the first quarter of 2006. The Company has previously issued employee
stock options for which no expense has been recognized, and which will not be fully vested as of the effective date of SFAS No. 123R.
The Company has assessed the impact SFAS 123R and believes the impact of adopting SFAS No. 123R, based on our unvested options
outstanding at December 31, 2005, will be to increase our pre-tax stock-based compensation expense in 2006 by approximately $2
million.
14
Table of Contents
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
Revenues
The Company’s revenue consists of direct product sales and a rental (lease) model in the commercial, government and
international markets. The table below outlines product versus rental (lease) revenues for comparable periods:
Year ended December 31,
2005
2004
Variance
$1,769,727
718,596
$2,488,323
71% $ 477,555
29% 221,097
100% $ 698,652
68% $1,292,172
32% 497,499
100% $1,789,671
271%
225%
256%
Revenue:
Product
Rental (lease)
Total
Product revenue
Product revenue principally arises from the sale of iBridges and other Telkonet iWire SystemTM components directly to
customers. Revenues to date have been principally derived from the Commercial (Hospitality and Multi-Dwelling) and International
business units. The Company anticipates continued growth in Commercial and International product revenue in the Value Added
Reseller purchase programs. The Company expanded its international sales and marketing efforts upon receiving its European
certification (CE) in March 2005. The Company expanded its sales and marketing efforts in the government sector in connection with
the receipt of the FIPS 140-2 certification received in July 2005.
I n December 2005, the Company consummated a non-recourse sale of certain rental contract agreements and the related
capitalized equipment which were accounted for as operating leases with Hospitality Leasing Corporation. The remaining rental income
payments of the contracts were valued at approximately $732,000, including the customer support component of approximately
$205,000 which the Company will retain and continue to receive monthly customer support payments over the remaining average
unexpired lease term of 26 months. In December 2005, the Company recognized revenue of approximately $439,000 for the sale,
calculated based on the present value of total unpaid rental payments, and expensed the associated capitalized equipment cost, net of
depreciation, of approximately $267,000 and expensed associated taxes of approximately $40,000.
Rental (lease) revenue
The increase in rental (lease) revenue was primarily due to the increase in non-cancelable leases. Accordingly, revenues
associated with these leases are recognized ratably over a three to five year lease term. Revenues to be recognized under these non-
cancelable leases (backlog) was approximately $2,411,000 including a non-recourse sale of $918,000 certain rental contract agreements
in January 2006. The weighted average remaining lease term was approximately 31 months as of December 31, 2005. The associated
unamortized capitalized costs in connection with these leases was approximately $664,000 or 26% of revenue backlog.
Cost of Sales
Cost of Sales:
Product
Rental (lease)
Total
Year ended December 31,
2005
2004
Variance
$1,183,574
533,605
$1,717,179
67% $ 459,225
74%
83,634
69% $ 542,859
96% $ 724,349
38% 449,971
78% $1,174,320
158%
538%
216%
15
Table of Contents
Product Costs
Product cost primarily includes Telkonet iWire System TM product suite equipment cost and installation labor. The related
product cost i n connection with the non-recourse sale of approximately $766,000 of rental contract agreements amounted to
approximately $267,000 of previously capitalized equipment cost and other related cost.
Rental (lease) Costs
Lease Cost primarily represents the amortization of the capitalized costs which are amortized over the lease term and include
Telkonet equipment, installation labor and customer support. This increase compared to the prior year quarter is commensurate with
the increase in leases.
Gross Profit
Gross Profit:
Product
Rental (lease)
Total
Product Costs
Year ended December 31,
2005
2004
Variance
$ 586,153
184,991
$ 771,144
18,330
33% $
26% 137,463
31% $ 155,793
4% $ 567,823
47,528
62%
22% $ 615,351
3,098%
-35%
395%
Gross profit associated with the product revenues for the year ended December 31, 2005 improved over the prior year
primarily as a result of reduction of equipment costs and of improved installation processes, including upfront site surveys and
standardized training.
Rental (lease) Costs
Gross profit associated with the rental (lease) revenue decreased as a result of the build-out of the customer support services.
Operating Expenses
Year ended December 31,
2005
2004
Variance
Total
$ 16,077,912 $ 13,268,067 $ 2,809,845
21%
Overall expenses increased for the year ended December 31, 2005 over the comparable period in 2004 by $2,809,845 or 21%.
Excluding the fee paid pursuant to certain agreements with consultants of $2,500,000 expensed in the year end December 31, 2004, the
increase for the year ended December 31, 2005 over the prior year amounted to $5,309,845 or 49%. This increase was principally due
to salary and travel costs related to increased sales and marketing functions and office rent related to the Germantown, MD and Crystal
City, VA leases. The number of employees increased from 48 at December 31, 2004 to 66 at December 31, 2005. In addition, the
Company wrote-off $400,000 of the carrying value of its investment in Amperion through a charge to operations during the year end
December 31, 2005.
Product Research and Development
Year ended December 31,
2005
2004
Variance
Total
$ 2,096,104 $ 1,852,309 $
243,795
13%
16
Table of Contents
Research and development costs related to both present and future products are expensed in the period incurred. Total
expenses for the year ended December 31, 2005 increased over the comparable prior year by $243,795 or 13%. This increase was
primarily related to an increase in salaries and related costs associated with the addition of employees and costs related to CE, FIPS
140-2 and other required certifications of the Company’s product.
Selling, General and Administrative
Year ended December 31,
2005
2004
Variance
Total
$ 12,041,661 $ 7,663,369 $ 4,378,292
57%
Selling, general and administrative expenses increased for the year ended December 31, 2005 over the comparable prior year
by $4,378,292 or 57%. This increase i s related to an increase in payroll and associated costs for sales and marketing resources,
advertising, trade shows, and office rent and related facility costs.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003
Revenues
Revenue:
Product
Rental (lease)
Total
Product revenue
Year ended December 31,
2004
2003
Variance
$ 477,555
221,097
$ 698,652
68% $
32%
100% $
88,403
5,257
93,660
94% $ 389,152
6% 215,840
100% $ 604,992
440%
4,106%
646%
Product revenue principally arises from the sale of iBridges and other Telkonet iWire SystemTM components directly to
customers. Revenues have primarily been derived from the Hospitality and Multi-Dwelling business units. The Company has
expanded its marketing efforts in the International and Government markets and anticipates full deployment of its product upon
successful product certification in each of these respective markets.
Rental (lease) revenue
As of December 31, 2004, revenues to be recognized under non-cancelable contracts (backlog) was approximately $933,000
with a weighted average remaining term of approximately 31 months. The remaining costs to be amortized in connection with these
contracts is approximately $451,000.
Cost of Sales
Cost of Sales:
Product
Rental (lease)
Total
Product Costs
Year ended December 31,
2004
2003
Variance
$ 459,225
83,634
$ 542,859
96% $ 101,171
38%
3,485
78% $ 104,656
114% $ 358,054
66%
80,149
112% $ 438,203
354%
2,300%
419%
The Company emerged from its development stage as of December 31, 2003. Therefore, there were no comparable costs of
sales in the prior year. Product cost primarily includes Telkonet iWire SystemTM product suite equipment cost and installation labor.
17
Table of Contents
Rental (lease) Costs
During the year, revenue from the Company’s rental (lease) sales model was derived principally in the Hospitality and Multi-
Dwelling markets.
Gross Profit
Gross Profit:
Product
Rental (lease)
Total
Year ended December 31
2004
2003
Variance
$
18,330
137,463
$ 155,793
4% $ (12,768)
62%
1,772
22% $ (10,996)
31,098
(14%)$
34% 135,691
(12%)$ 166,789
244%
7,658%
1,517%
The Company improved installation processes and began operational improvements which resulted in increased gross margins.
Operating Expenses
Year ended December 31
2004
2003
Variance
Total
$ 13,268,067 $ 6,553,335 $ 6,714,732
102%
Overall expenses increased for the year ended December 31, 2004 over the prior year by $6,714,732 or 102%. Excluding the
fee paid pursuant to certain agreements with consultants of $2,500,000 which was expensed during the second quarter, the increase for
the year was $4,214,732 or 64%. This increase is principally due to payroll and related costs for administrative sales and marketing,
non-employee compensation for services, advertising and trade show attendance, and rent and related relocation costs for our corporate
and sales offices.
Product Research and Development
Year ended December 31
2004
2003
Variance
Total
$ 1,852,309 $ 1,370,785 $
481,524
35%
Company-sponsored research and development costs related to both present and future products are expended in the period
incurred. Total expenses for the year ended December 31, 2004 increased over the comparable prior year by $481,524, or 35%. This
increase was primarily related to an increase in salaries and related costs associated with the addition of two full-time employees and
costs related to independent lab testing and certification of the Company's product.
Selling, General and Administrative
Year ended December 31
2004
2003
Variance
Total
$ 7,663,369 $ 4,089,172 $ 3,574,197
87%
Selling, general and administrative expenses increased for the year ended December 31, 2004 over the comparable prior year
by $3,574,197 or 87%. The increase is related to an increase in payroll and associated costs for management, sales and marketing
resources, advertising and trade show attendance and related relocation costs for corporate and new sales offices.
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Table of Contents
Liquidity and Capital Resources
As of December 31, 2005, the Company's current assets exceeded its current liabilities by $12,060,807, with cash and cash
equivalents representing $8,422,079 a n d Restricted Certificate of Deposit representing $10,000,000 of the current assets as of
December 31, 2005.
While the Company believes it has sufficient capital to meet its working capital requirements for the next twelve months,
additional financing may be required in order to meet growth opportunities in financing and/or investing activities. If additional capital
is required and the Company is not successful in generating sufficient liquidity from operations or in raising sufficient capital resources
on terms acceptable to the Company, this could have a material adverse effect on the Company’s business, results of operations,
liquidity and financial condition.
The recent acquisition of Microwave Technologies, Inc. (MST) and its related planned roll-out requires capital equipment,
which if financing is not available may limit the rate upon which roll-out occurs. The Company is exploring several of its options such
as lease financing or strategic partnerships to provide the necessary funding which may or may not occur.
In January 2004, the Board of Directors determined to permit the Senior Noteholders, for a limited period of time, to convert
their Senior Notes into the Company's common stock at a conversion price of $2.10 per share. In connection with this transaction,
Senior Noteholders converted Senior Notes having an aggregate principal value of $2,539,000.
In February 2004, Telkonet completed a private placement of its common stock resulting in net proceeds to the Company of
approximately $12.8 million. The Company sold 6,387,600 shares of its common stock at a discount of 18% to the average market
price of the Company’s common stock for the preceding 30 days.
In March 2004, the Company received $3.9 million upon the exercise of 4,235,007 warrants to purchase the Company’s
common stock. Additionally, $200,000 of debentures were converted into 324,000 shares of the Company’s common stock.
In October 2005, the Company completed a convertible senior debt financing of $20 million, exclusive of placement cost and
fees. The Company intends to use the $20 million for general working capital needs. The convertible notes bear interest at a fixed rate
of 7.25%, payable in cash, plus equal monthly principal installments beginning March 1, 2006. The maturity date is 3 years from the
issuance of the notes. At any time or times, the noteholders are entitled to convert any portion of the outstanding and unpaid note
amount into fully paid and nonassessable common shares at a conversion price of $5 per share. At any time at the option of the
Company, the principal payments due under the notes may be paid either in cash or in common stock at the lower of $5 or 92.5% of the
average recent market price of the Company's common stock. At any time after six months should the stock trade at or above $8.75 for
20 of 30 consecutive trading days, the Company can cause a mandatory redemption and conversion to shares at $5 per share. At any
time, the Company can pre-pay the notes with cash or common stock. Should the Company pre-pay the notes other than by mandatory
conversion, warrant coverage to the noteholders increases from 25% to 65% for the amount pre-paid at a strike price of $5 per share.
In addition to standard financial covenants, the Company has agreed to maintain a letter of credit in favor of the noteholders
equal to $10 million which is renewed annually. Once each of the notes decline below $15 million, the balance on the letter of credit is
reduced by $.50 for every $1 amortized. Also, the Company is required to achieve minimum revenue of $3 million for the period
October 1, 2005 through March 31, 2006 and $2 million for each fiscal quarter thereafter in 2006. The covenant requires that the
Company pay an accelerated principal payment up to $1 million on a pro rata basis calculated based upon the percentage
shortfall between actual revenues and the quarterly targeted revenues. The Company may, at its option, repay all or any part of the
outstanding debt represented by the Senior Convertible Notes in Company common stock. Once the Senior Convertible Notes are
repaid, the funds underlying a Certificate of Deposit in the amount of $10 million, which has been posted as collateral for the Letter of
Credit, will be available for operating purposes.
The Company filed a registration statement to cover the future issuance of shares which may be issued upon conversion of the
notes and/or warrants. The registration statement was declared effective by the Securities and Exchange Commission on December 13,
2005.
During the year the Company received $852,638 proceeds from the exercise of employee and non-employee stock options
and $321,900 from exercise of warrants.
19
Table of Contents
Inflation
We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our
costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price
increases. Our inability or failure to do so could adversely affect our business, financial condition and results of operations.
Off Balance Sheet Arrangements
In October 2005, the Company entered into an irrevocable letter of credit with a bank for $10 million as collateral for the $20
million Senior Convertible Notes. A $10 million Certificate of Deposit is pledged as collateral for the irrevocable letter of credit
agreement. The letter of credit is automatically renewable annually as required in the loan covenant. As of December 31, 2005, the $10
million Restricted Certificate of Deposit is recorded in the accompanying consolidated balance sheet as a current asset.
Acquisition or Disposition of Plant and Equipment
During the year ended December 31, 2005, fixed assets increased $336,448 or 48% which is primarily related to furniture and
fixtures in the Crystal City, Virginia office, sales support software and computer equipment related to new employees. The Company
does not anticipate the sale or purchase of any significant property, plant or equipment during the next twelve months, other than
computer equipment and peripherals to be used in the Company’s day-to-day operations.
In April 2005, the Company entered into a three-year lease agreement for 6,742 square feet of commercial office space in
Crystal City, Virginia. Pursuant to this lease, the Company agreed to assume a portion of the build-out cost for this facility
MST presently leases 12,600 square feet of commercial office space in Hawthorne, New Jersey for its office and warehouse
spaces. This lease will expire in April 2010.
New Accounting Pronouncements
In March 2005, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 47, “Accounting for
Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143,” which requires an entity to recognize a
liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably
estimated. The Company is required to adopt the provisions of FIN 47 no later than the first quarter of fiscal 2006. The Company does
not expect the adoption of this Interpretation to have a material impact on its consolidated financial position, results of operations or
cash flows.
In May 2005 the FASB issued Statement of Financial Accounting Standards (SFAS) No. 154, “Accounting Changes and Error
Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS 154 requires retrospective application to prior
periods’ financial statements for changes in accounting principle, unless it is impracticable to determine either the period-specific
effects or the cumulative effect of the change. SFAS 154 also requires that retrospective application of a change in accounting principle
be limited to the direct effects of the change. Indirect effects of a change in accounting principle, such as a change in non-discretionary
profit-sharing payments resulting from an accounting change, should be recognized in the period of the accounting change. SFAS 154
also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a
change in accounting estimate effected by a change in accounting principle. SFAS 154 is effective for accounting changes and
corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and
corrections of errors made in fiscal years beginning after the date this Statement is issued. The Company does not expect the adoption
of this SFAS to have a material impact on its consolidated financial position, results of operations or cash flows.
On February 16, 2006 the Financial Accounting Standards Board (FASB) issued SFAS 155, “Accounting for Certain Hybrid
Instruments,” which amends SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS 140, “Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS 155 allows financial instruments that have
embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects
to account for the whole instrument on a fair value basis. SFAS 155 also clarifies and amends certain other provisions of SFAS 133
and SFAS 140. This statement is effective for all financial instruments acquired or issued in fiscal years beginning after September 15,
2006. The Company does not expect its adoption of this new standard to have a material impact on its financial position, results of
operations or cash flows.
20
Table of Contents
Disclosure of Contractual Obligations
Contractual obligations
Total
Less than 1 year
$20,100,000
$6,350,000
Payment Due by Period
1-3 years
$13,750,000
-
-
-
$1,715,000 (1)
$514,000
$785,000
$416,000
-
-
-
-
-
-
-
-
Long-Term Debt
Obligations
Capital Lease
Obligations
Operating Lease
Obligations
Purchase Obligations
Other Long-Term
Liabilities Reflected on
the Registrant’s Balance
Sheet Under GAAP
3-5 years
More than 5 years
-
-
-
-
-
-
-
-
Total
$21,815,000
$6,864,000
$14,535,000
$416,000
(1) Operating lease obligations includes approximately $352,000 of future lease obligations, primarily related to office and warehouse
space, in conjunction with the January 2006 acquisition of Microwave Satellite Technologies, Inc.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Short Term Investments
We held no marketable securities as of December 31, 2005. Our excess cash is held in money market accounts in a bank and
brokerage firms both of which are nationally ranked top tier firms with an average return of approximately 300 basis points. The
certificate of deposit, which is restricted and currently held as collateral for the Letter of Credit in connection with the $20 million senior
convertible notes, accrues interest with an average return of approximately 400 basis points. Due to the conservative nature of our
investment portfolio, an increase or decrease of 100 basis points in interest rates would not have a material effect on our results of
operations or the fair value of our portfolio.
Investments in Privately Held Companies
W e have invested in privately held companies, which are in the startup or development stages. These investments are
inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages
and may never materialize. As a result, we could lose our entire initial investment in these companies. In addition, we could also be
required to hold our investment indefinitely, since there is presently no public market in the securities of these companies and none is
expected to develop. These investments are carried at cost, which as of March 1, 2006 was $131,000 and $100,000 in BPL Global and
Amperion, respectively, and at December 31, 2005, are recorded in other assets in the Consolidated Balance Sheets. The Company
determined that its investment in Amperion was impaired based upon forecasted discounted cash flow. Accordingly, the Company
wrote-off 80%, or $400,000, of the carrying value of its investment through a charge to operations during the year ended December 31,
2005. The fair value of the Company’s investment in BPL Global, remained at $131,000 as of December 31, 2005.
ITEM 8.
FINANCIAL STATEMENTS.
See the Financial Statements and Notes thereto commencing on Page F-1.
I T E M 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.
None.
21
Table of Contents
ITEM 9A.
CONTROLS AND PROCEDURES.
A s o f December 31, 2005, the Company performed an evaluation, under the supervision and with the participation of
management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its
disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended.
Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls
and procedures are effective in timely alerting them to material information required to be included in the Company’s periodic filings
with the U.S. Securities and Exchange Commission. There were no significant changes in the Company’s internal controls or in other
factors that could materially affected or are reasonable likely to materially affect, the Company’s internal controls subsequent to the date
of the most recent evaluation.
22
RUSSELL BEDFORD STEFANOU MIRCHANDANI LLP
CERTIFIED PUBLIC ACCOUNTANTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Table of Contents
Board of Directors
Telkonet, Inc.
Germantown, MD
We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial
Reporting, that Telkonet, Inc. and its wholly-owned subsidiary (the Company) maintained effective internal control over financial
reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective
internal control over financial reporting and for its assessment of the effectiveness o f internal control over financial reporting. Our
responsibility is to express a n opinion on management's assessment and an opinion on the effectiveness of the Company's internal
control over financial reporting based on our audit.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over
financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal
control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a
reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting
principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain t o the
maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention
or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the
financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of
any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Telkonet, Inc. and its wholly-owned subsidiary maintained effective internal control over
financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control
Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our
opinion, Telkonet, Inc. and its wholly-owned subsidiary, maintained, in all material respects, effective internal control over financial
reporting as of December 31, 20005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheets of Telkonet, Inc. and its wholly-owned subsidiary as of December 31, 2005 and 2004, and the related
consolidated statements of losses, stockholders' equity, and cash flows for the three-years ended December 31, 2005, and our report
dated February 2, 2006 expressed an unqualified opinion on those consolidated financial statements,
/s/RUSSELL BEDFORD STEFANOU MIRCHANDANI LLP
Russell Bedford Stefanou Mirchandani LLP
Certified Public Accountants
McLean, Virginia
February 2, 2006
23
Table of Contents
ITEM 9B.
OTHER INFORMATION.
None.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
PART III
The following table furnishes the information concerning the Company’s directors and officers during the fiscal year ended
December 31, 2005. The directors of the Company are elected every year and serve until their successors are duly elected and
qualified.
Name
Ronald W. Pickett
Frank T. Matarazzo
John Cramp
E. Barry Smith
Stephen Sadle
James Landry
Warren V. Musser
David Grimes
Thomas C. Lynch
Dr. Thomas M. Hall
James L. “Lou” Peeler
Seth Blumenfeld
Age
58
44
50
55
60
50
79
67
63
54
72
65
Title
President, Director & Chief Executive Officer
President & Chief Executive Officer, Microwave Satellite Technologies,
Inc.
Chief Operating Officer
Chief Financial Officer
Senior Vice President & Director
Chief Technology Officer
Chairman of the Board (3)
Director (1)
Director (2), (3)
Director (2), (3)
Director (2)
Director (1)
(1) Mr. Grimes died on September 27, 2005. Mr. Blumenfeld was elected to Mr. Grimes’ vacant board seat on December 9, 2005.
(2) Member of the Audit Committee
(3) Member of the Compensation Committee
24
Table of Contents
Ronald W. Pickett—President, Chief Executive Officer & Director
Mr. Pickett has served as the Company’s Chief Executive Officer since January 2003. In addition, he has fostered the
development of Telkonet since 1999 as the Company’s principle investor and co-Founder. He was the Founder, and for twenty years
served as the Chairman of the Board and President of Medical Advisory Systems, Inc. (a company providing international medical
services and pharmaceutical distribution) until its merger with Digital Angel Corporation (AMEX: DOC) in March 2002. A graduate of
Gordon College, Mr. Pickett has engaged in various entrepreneurial activities for 35 years. Mr. Pickett has been a director of the
Company since January 2003.
Frank T. Matarazzo—President & Chief Executive Officer, Microwave Satellite Technologies, Inc. (MST)
Mr. Matarazzo has been the President and Chief Executive Officer of Microwave Satellite Technologies, Inc. since its
inception in 1982. Mr. Matarazzo has directed the growth and development of the Microwave Satellite Technologies, Inc. (MST) and
designed and constructed the first private cable television systems operated by MST and continues to be involved in all technology
deployed at MST. Mr. Matarazzo’s experience includes employment for Conrac Avionics, as a prototype design engineer, working on
the development of the guidance/navigation systems for military fighter planes as well as the development and construction of the FM
communication systems and engine interface units for the Space Shuttle Columbia. He is known in the private cable television
industry, having both written articles for trade publications and served as a technical consultant to municipalities on the subject of
satellite delivered information systems.
John Cramp—Chief Operating Officer
Mr. Cramp has served as the Company’s Chief Operating Officer since December 2005. Prior to this appointment, Mr. Cramp
served as the Company’s Executive Vice President of Government Sales. Before joining Telkonet in May, 2005, Mr. Cramp served as
President and CEO and Director of Seneca Corporation, a privately-held information technology company, from October 2004 to April
2005. Mr. Cramp served as Chief Executive Officer and Director of CardSystems Solutions, Inc., an Electronic Payment Company,
from 1998 to 2004 and was Executive Vice President and COO from 1997 to 1998. Prior to joining CardSystems, Mr. Cramp was Vice
President of Information Management Consultants Inc., a systems integration and software development company. From 1990 to 1995,
Mr. Cramp was President and CEO (in 1995) of Simpact Inc., a privately held data communication products and services company.
Prior to 1990, Mr. Cramp spent over 10 years in the computer industry in management roles with Encore Computer, Wang
Laboratories and Data General. Mr. Cramp earned a BA from Franklin and Marshall College in 1977.
E. Barry Smith—Chief Financial Officer
Mr. Smith has served as the Company’s Chief Financial Officer since February 2003. Mr. Smith is a CPA and senior financial
executive with diverse experience in both public and private companies. From September 1987 to February 2003, Mr. Smith was
employed as a financial partner to, or retained as a consultant with, Safeguard Scientifics or its subsidiary companies. Mr Smith’s
background also includes big-four public accounting experience with the accounting firm o f Deloitte & Touche. Mr. Smith’s
experience also includes serving as Vice President of Finance & Administration for US Golf Management (a public/private golf course
and restaurant management company), Vice President of Finance for International Communications Research (a market research and
database services company), and Treasurer for The Chilton Company (a publishing company).
Stephen L. Sadle—Senior Vice President, Co-Founder & Director
From 1999 until he joined Telkonet in 2000, Mr. Sadle served as Senior Vice President and General Sales Manager of
Internos (a provider of web-based vertical extranet applications). From 1986 until 1999, Mr. Sadle was Vice President of Business
Development and Sales for the Driggs Corporation, a major heavy and infrastructure contracting firm interfacing with government and
the private sectors. From 1970 until 1986, Mr. Sadle was President of a successful infrastructure construction and development
company in the Washington, D.C. metropolitan area. Mr. Sadle has been a director of the Company since November 1999.
25
Table of Contents
James F. Landry—Chief Technology Officer
Mr. Landry has served as the Company’s Chief Technology Officer since December 2004 and Vice President of Engineering
from September 2001 to May 2004. Before joining Telkonet, Mr. Landry was a Senior Member of 3Com Technical Staff since 1994.
Mr. Landry has over 20 years experience in developing communications hardware for the enterprise/carrier market with 3Com, US
Robotics, Penril Datacomm and Data General. While at 3Com/US Robotics, he was responsible for the development of the entire
xDSL product line as well as a number of modems and interface cards. At Penril, he served as the product development leader for the
Series 1544 multiplexer/channel bank and at Data General he was technical leader of system integration for ISDN, WAN. Mr. Landry
brings a wealth of practical design leadership and a solid history of delivering products to the marketplace. Mr. Landry holds four US
patents.
David W. Grimes—Co-Founder & Former Director
From 1992 until he joined Telkonet in 1999, Mr. Grimes served as Chief Engineer for Final Analysis, Inc. and led the design
and development of the Low Earth Orbit constellation of 38 satellites for use in global store and forward communications. From 1989
to 1992 he was the Engineering Division Director a t EER Inc. and supervised over 100 engineers and technicians on electrical
mechanical and thermal tasks for Goddard Space Flight Center. From 1982 to 1989 Mr. Grimes served as Chief Executive Officer of
Transpace Carriers Inc., a venture to commercialize the Delta launch vehicle. From 1963 to 1982, Mr. Grimes was a Senior Executive
with NASA, heading the $200 million per year Delta Program. Mr. Grimes is a recognized expert in space and ground communications
systems and brings this expertise to bear on the implementation of the hybrid telephony and high speed Internet technology. Mr. Grimes
has been a director of the Company since November 1999. Mr. Grimes died September 27, 2005.
Warren V. Musser—Chairman of the Board of Directors
Mr. Musser, has taken over 50 companies public during his distinguished and successful career as an entrepreneur, and Mr.
Musser is the founder and Chairman Emeritus of Safeguard Scientifics, Inc. (a high-tech venture capital company, formerly Safeguard
Industries, Inc.). Mr. Musser is currently the Managing Director, The Musser Group (a business consulting firm) and Founder &
President, Musser and Company, Inc. (an investment banking firm). In addition, Mr. Musser is a Director of Internet Capital Group,
Inc. (a business-to-business venture capital company), and Mr. Musser is a Director and Vice Chairman o f Nutri/System, Inc
(Nasdaq:NRTI). (a weight management company) and Co-Chairman of Eastern Technology Council (a business advisory firm). Mr.
Musser serves on a variety of civic, educational and charitable boards of directors, and serves as vice president of development, Cradle
of Liberty Council, Boy Scouts of America; vice chairman of The Eastern Technology Council; and chairman of the Pennsylvania
Partnership on Economic Education. Mr. Musser has been a director of the Company since January 2003.
Thomas C. Lynch—Director
Mr. Lynch is Senior Vice President and Director of The Staubach Company’s Federal Sector (a real estate management and
advisory services firm) in the Washington, D.C. area. Mr. Lynch joined The Staubach Company in November 2002 after 6 years as
Senior Vice President at Safeguard Scientifics, Inc. (NYSE: SFE) (a high-tech venture capital company). While at Safeguard, he
served nearly two years as President and Chief Operating Officer at CompuCom Systems, a Safeguard subsidiary. After a 31-year
career of naval service, Mr. Lynch retired in the rank of Rear Admiral. Mr. Lynch’s Naval service included chief, Navy Legislative
Affairs, command of the Eisenhower Battle Group during Operation Desert Shield, Superintendent of the United States Naval
Academy from 1991 to 1994 and Director of the Navy Staff in the Pentagon from 1994 to 1995. Mr. Lynch presently serves as a
Director of Pennsylvania Eastern Technology Council, Armed Forces Benefit Association, Catholic Leadership Institute, National
Center for the American Revolution at Valley Forge and Mikros Systems. Mr. Lynch has been a director o f the Company since
October 2003.
Dr. Thomas M. Hall—Director
Dr. Hall is the Managing Member of Marrell Enterprises, LLC (a company that specializes in international business
development). Dr. Hall serves on the board of directors of Coris International SA (a Paris-based insurance services company with
subsidiaries in 36 countries). For 12 years (until 2002), Dr. Hall was the chief executive officer of Medical Advisory Systems, Inc. (a
company providing international medical services and pharmaceutical distribution). Dr. Hall holds a bachelor of science and a medical
degree from the George Washington University and a master of international management degree from the University of Maryland. Dr.
Hall has been a director of the Company since April 2004.
26
Table of Contents
James L. “Lou” Peeler—Director
Mr. Peeler was a founder and member of the board of Digital Communications Corporation (DCC), which evolved into
Hughes Network Systems (HNS), a provider of global broadband, satellite, and wireless communications products for home and
business, such as DirecTV and DIRECWAY. Mr. Peeler retired as executive vice president of operations in 1999 after 27 years of
service and is presently a member of the Advisory Council to Hughes Network Systems. Mr. Peeler also served on the Board of
Directors of Hughes Software Systems (HSS). Prior to the founding of DCC, he was vice president of Engineering for Washington
Technological Associates (WTA) (a satellite communications development company), where he was instrumental in the development
of rocket and satellite communications and instrumentation equipment. Mr. Peeler received a bachelor of science degree in electrical
engineering from Auburn University. Mr. Peeler has been a director of the Company since April 2004.
Seth D. Blumenfeld—Director
Mr. Blumenfeld served as President of International Services for MCI International (a provider of telecommunication
services) from 1998 until his retirement in January of 2005. Mr. Blumenfeld was President and Chief Operating Officer of several of
MCI's international subsidiaries from 1984 to 1998. Mr. Blumenfeld earned his Doctorate Jurisprudence from Fordham University Law
School in 1965. He practiced law on Wall Street prior to serving as infantry captain for the U.S. Army in Vietnam. From 1976 through
1978, Mr. Blumenfeld lived in Japan. Mr. Blumenfeld's involvement on professional boards and community associations have included
Executive Committee member of the United States Council for International Business, Member of the Board of Directors of the United
States Telecommunications Training Institute, Member of the State Department Advisory Council on International Communications
and Information Policy, Member of the University of Colorado Institute for International Business Board of Advisors, Member of the
American Graduate School of International Management (Thunderbird) Board of Advisors, Member of the Advisory Board of Visitors
to Fordham University School of Law, and honorary Chairman of the Connecticut Association of Children with Learning Disabilities.
Audit Committee
The Company maintains an Audit Committee of the Board of Directors. For the year ended December 31, 2005, Messrs. Hall,
Lynch and Peeler served on the Audit Committee. The Company’s Board of Directors has determined that each of Messrs. Hall and
Lynch is a “financial expert” as defined by Item 401 of Regulation S-K promulgated under the Securities Act of 1933 and the
Securities Exchange Act of 1934. The Company’s Board of Directors also has determined that each of Messrs. Hall, Lynch and Peeler
are “independent” as such term is defined in Item 7(d)(3)(iv) of Schedule 14A promulgated under the Securities Exchange Act of 1934.
The Board of Directors has adopted an audit committee charter, which was ratified by the Company’s stockholders.
Compensation Committee
The Company maintains a Compensation Committee of the Board of Directors. For the year ended December 31, 2005,
Messrs. Hall, Lynch and Musser served on the Compensation Committee. The committee held two meetings during 2005.
Section 16(a) Beneficial Ownership Reporting Compliance
David Grimes, a former director of the Company, failed to file on a timely basis certain reports required by Section 16(a) of
the Exchange Act. Mr. Grimes failed to file 43 reports resulting in 43 transactions not being reported on a timely basis. Mr. Grimes’
estate filed a Form 5 on February 10, 2006 to make corrective disclosure with respect to these transactions.
Code of Ethics
The Company has also adopted a Code of Ethics that applies to the Company’s principal executive officer, principal financial
officer and those persons performing similar functions, including those employees of the Company with senior financial roles. A copy
of the Company’s Code of Ethics was filed as Exhibit 14 to the Company’s Annual Report on Form 10-KSB for the year ended
December 31, 2003 (filed with the Securities and Exchange Commission on March 30, 2004). In addition, the Company will provide a
copy of its Code of Ethics free of charge upon request to any person submitting a written request to the Company’s Chief Executive
Officer.
ITEM 11. EXECUTIVE COMPENSATION.
The following table sets forth all compensation actually paid or accrued by the Company for services rendered to the
Company for the years ended December 31, 2005, 2004 and 2003 to the Company’s Chief Executive Officer, the Company’s four most
highly compensated executive officers other than the Chief Executive Officer who were serving as executive officers of the Company
as of December 31, 2005, and those persons for whom disclosure would have been required but for the fact that they were not serving
as an executive officer of the Company as of December 31, 2005.
27
Table of Contents
Summary Compensation Table
Annual Compensation
Long Term Compensation
(a)
Name and Principal
Position
(b)
Year
(c)
(d)
(e)
Salary ($) Bonus ($) Other Annual
Compensation
Payouts
(h)
LTIP
Payouts
(i)
All Other
Compensation
Awards
(f)
Restricted
Stock
($)
(g)
Securities
Underlying/
Options
SARs
(#)
Ronald W. Pickett
President & Chief
Executive Officer
Frank T. Matarazzo
President & Chief
Executive
Officer, MST (2)
John S. Cramp
Chief Operating
Officer
Howard Lubert
Former Chief
Executive
Officer
2003
91,538
2004
100,089
-
-
2005
102,340
200,000
2003
2004
2005
2003
2004
-
-
-
-
-
-
-
-
-
-
2005
135,288
6,731
2003
162,083(3)
-
-
Stephen L. Sadle
Sr. Vice President
2004
130,000(3)
2003
130,000
Jim Landry
Chief Technology
Officer
E. Barry Smith
Chief Financial Officer
2004
171,983
6,538
2005
171,872
10,000
2003
160,000
10,000
2004
172,514
15,000
2005
176,508
15,000
2003
115,539
-
2004
171,983
15,000
2005
171,872
15,000
28
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
64,460 (1)
107,779 (1)
163,319(1)
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
900,000
-
-
100,000
250,000
-
500,000
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
Table of Contents
(1) In each year ending December 31, 2005, 2004 and 2003, Mr. Pickett earned 36,000 shares issued under the Company’s Employee
Stock Incentive Plan as additional compensation pursuant to his employment agreement. The fair market value of these shares upon
issuance was $163,319, $107,779 and $64,460, respectively. Mr. Pickett has deferred the receipt of his 2004 and 2005 shares
although the value of such shares is reflected in this table. The number of restricted shares held by Mr. Pickett at December 31, 2005,
was 108,000, and the aggregate value of these restricted shares of common stock as of December 31, 2005, was $448,200.
(2) In January 2006, the Company acquired a 90% interest in MST, a corporation wholly owned by Frank T. Matarazzo, prior to the
acquisition. No compensation was paid by Telkonet to Mr. Matarazzo for the years ended December 31, 2005, 2004 and 2003.
(3) Mr. Lubert’s compensation includes $177,083 of the Company’s common stock acquired by Mr. Lubert upon the exercise of
options exercised in conjunction his resignation in June 2003. The Company paid Mr. Lubert’s salary through December 14, 2004
which was accrued in 2003 at an annual rate of $130,000.
Option/SAR Grants In Last Fiscal Year
The following table sets forth information concerning stock options granted in the fiscal year ended December 31, 2005, to
the persons listed on the Summary Compensation Table.
Name
(a)
Ronald W. Pickett
Frank T. Matarazzo
John S. Cramp
Stephen L. Sadle
James Landry
E. Barry Smith
Number of Securities
Underlying Options/SARs
Granted
(#)
(b)
0
0
500,000
0
0
0
Percent of Total
Options/SARs
Granted to
Employees In
Fiscal Year
(c)
0%
0%
37%
0%
0%
0%
Exercise Or
Base Price
($/sh)
(d)
n/a
n/a
$3.04
n/a
n/a
n/a
Expiration Date
(e)
n/a
n/a
5/1/2015
n/a
n/a
n/a
29
Table of Contents
Aggregated Option/SAR Exercises In Last Fiscal Year And Fiscal Year End Option/SAR Values
The following table summarizes information relating to stock option exercises during the year ended December 31, 2005
by those persons listed on the Summary Compensation Table.
Shares Acquired
on Exercise
(#)
(b)
Value Realized
($)
(c)
-0-
-0-
-0-
-0-
-0-
-0-
-0-
-0-
-0-
-0-
31,000
110,050
Number of
Unexercised
Securities
Underlying
Options/SARs at
FY-End (#)
Exerciseable/
Unexerciseable
(d)
Value of
Unexercised
In-The-Money
Options/SARs
at FY-End ($)
Exerciseable/
Unexerciseable
(e)
-0-
-0-
-0-
-0-
50,000/
450,000
900,000/
-0-
350,000/
150,000
441,000/
-0-
-0-
-0-
-0-
-0-
55,500/
499,500
2,835,000/
-0-
857,500/
105,000
1,389,150/
-0-
Name
(a)
Ronald W. Pickett
Frank T. Matarazzo (1)
John S. Cramp
Stephen L. Sadle
James Landry
E. Barry Smith
Director Compensation
Telkonet reimburses non-management directors for costs and expenses in connection w i t h their attendance and
participation at Board of Directors meetings and for other travel expenses incurred on Telkonet’s behalf. Telkonet compensates each
non-management director (excluding Mr. Musser): $4,000 per month, 10,000 vested stock options per quarter and $1,000 for each
committee meeting of the Board of Directors such director attends, except that Mr. Musser, as Chairman of the Board of Directors,
is compensated $8,333 per month (consisting of monthly payments in the amount of $4,000, which payments are consistent with the
monthly payments made to the other non-management directors, and $4,333.33 per month, which payments are in lieu of the 10,000
vested stock options per quarter and $1,000 for each committee meeting that the other non-management directors receive).
Payments to Mr. Musser for Board services were made to The Musser Group pursuant to a consulting agreement described below
under the heading “Certain Relationships and Related Transactions.”
Employment Agreements
Stephen L. Sadle, Senior Vice President, is employed pursuant to an employment agreement for a three-year term that
commenced January 18, 2003 and renewed for a one-year term through January 17, 2007 and provides for an annual salary of
$130,000 and bonuses and benefits based upon Telkonet’s internal policies. Mr. Sadle’s annual salary was increased to $171,872 in
2004.
James Landry, Chief Technology Officer, has been employed since September 24, 2001 with an annual salary of $160,000
with bonuses and benefits based upon Telkonet’s internal policies. Mr. Landry’s annual salary was increased to $176,508 in 2004.
Ronald W. Pickett, President and Chief Executive Officer, is employed pursuant to an employment agreement for an
unspecified term that commenced January 30, 2003 and provides for an annual salary $100,000, 3,000 shares of the Company’s
common stock per month for each month of his employment and bonuses and benefits based upon Telkonet’s internal policies. Mr.
Pickett’s annual salary was increased to $102,340 on August 1, 2004 and he received a bonus of $200,000 for the year ended
December 31, 2005. In January 2006, Mr. Pickett’s salary was increased to $250,000 with an incentive bonus up to $150,000. The
incentive portion of the salary will be awarded based on the successful achievement of $15 million in revenues in 2006 and a cash
flow break even run rate by the fourth quarter, 2006.
30
Table of Contents
Frank T. Matarazzo, President and Chief Executive Officer, MST, is employed pursuant to an employment agreement for a
three-year term that commenced February 1, 2006 and provides for an annual salary of $250,000 and bonuses and benefits based
upon MST’s internal policies.
E . Barry Smith, Chief Financial Officer, is employed pursuant to an employment agreement for a one-year term that
commenced February 17, 2003 and renewed for a one-year term through February 16, 2007 and provides for an annual salary of
$130,000 and bonuses and benefits based upon Telkonet’s internal policies. Mr. Smith’s annual salary was increased to $171,872 in
2004.
Howard Lubert, former Chief Executive Officer, was employed pursuant to an employment agreement for a two-year term
that commenced January 1, 2003 and provided for an annual salary of $130,000 and bonuses and benefits based upon Telkonet’s
internal policies. Mr. Lubert resigned effective June 16, 2003, however, i n connection with Mr. Lubert’s separation from the
Company, Telkonet agreed to pay Mr. Lubert’s salary through December 14, 2004.
In addition, under the Stock Incentive Plan, stock options are periodically granted to employees at the discretion of the
Compensation Committee of the Board of Directors. Executives of Telkonet are eligible to receive stock option grants, based upon
individual performance and the performance of Telkonet as a whole.
Compensation Committee Interlocks and Insider Participation
In September 2005, the Board of Directors nominated and approved a Compensation Committee which consisted of
Messrs. Musser and Lynch and Dr. Hall. Prior to September 2005, Telkonet did not have a Compensation Committee. However,
Messrs. Lynch and Peeler and Dr. Hall, all of the independent members of the Company's Board of Directors, fulfilled the functions
of a Compensation Committee. None of these individuals was, or has been, an officer or employee of Telkonet or any of its
subsidiaries, nor does any of these individuals have a relationship that would constitute an interlocking relationship with executive
officers or directors of Telkonet or another entity.
Board Compensation Committee Report on Executive Compensation
Report of the Compensation Committee
Notwithstanding anything to the contrary set forth in any of Telkonet's previous filings under the Securities Act of 1933
or the Exchange Act that might incorporate future filings or this proxy statement, the following report shall not be deemed to be
incorporated by reference into any such filings. In addition, the following report shall not be deemed to be "soliciting material" or
"filed" with the SEC.
The base salary, bonus, benefits and other compensation payable to Telkonet's executive officers for the year ended
December 31, 2004 were fixed under written employment agreements (except for Mr. Landry, who does not have an employment
agreement) described above under the heading Employment Contracts and Termination of Employment Arrangements.
Prior to establishing Mr. Pickett's compensation pursuant to his employment agreement (as well as the compensation of
the other executive officers), the Board of Directors reviewed compensation recommendations prepared by Telkonet's human
resources director, which recommendations provide information regarding compensation at the tenth to fiftieth percentiles in peer
companies. The Board of Directors believes that Mr. Pickett's executive compensation is commensurate with his peers in
comparable companies. In 2004, the Telkonet Board of Directors determined to increase Mr. Pickett's compensation from
approximately $92,000 to $101,000 to give effect to a one-time adjustment for company-paid medical benefits in accordance with
Mr. Pickett's employment agreement. Thereafter, all employees, including Mr. Pickett, are required to pay 25% of their respective
medical premiums as part of a cost containment initiative.
Messrs. Lynch and Peeler and Dr. Hall have the power to administer the Amended and Restated Stock Incentive Plan,
which stock options may be granted to officers, directors, employees, advisors and consultants who render services to Telkonet.
For the fiscal year ended December 31, 2004, no awards were made to the executive officers pursuant to the Amended and
Restated Stock Incentive Plan, except that Mr. Pickett, pursuant to the terms of his employment agreement, was awarded 3,000
restricted shares of Telkonet's common stock per month which vest immediately, and Mr. Landry received an stock option award
to purchase 250,000 shares of Telkonet's common stock, based on his years of contribution to the development of Telkonet's
technology and his promotion to the position of Telkonet's Chief Technology Officer.
By,
Thomas M. Hall
Thomas C. Lynch
James L. Peeler
31
Table of Contents
Performance Graph
Set forth below is a line graph comparing the cumulative total return on Telkonet’s Common Stock against the cumulative
total return of the Market Index for the American Stock Exchange (U.S.) (“AMEX”) and for the peer group “Communications
Services, within the Standard Industrial Classification Code category, (SIC) Code 4899”, for the period beginning August 15, 2002
and each fiscal year ending December 31 thereafter through the fiscal year ended December 31, 2005. Because Telkonet’s common
stock was not widely traded prior to August 15, 2002, the graph does not show the total return on Telkonet’s common stock prior to
August 15, 2002. The total returns assume $100 invested on August 15, 2002 with reinvestment of dividends.
ITEM 12.
STOCKHOLDER MATTERS.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
The following table provides information concerning securities authorized for issuance pursuant to equity compensation plans
approved by the Company’s stockholders and equity compensation plans not approved by the Company’s stockholders as of
December 31, 2005.
Number of securities to
be
issued upon exercise of
outstanding options,
warrants and rights
Weighted -average
exercise price of
outstanding options,
warrants and rights
Equity compensation plans approved
by
security holders
Equity compensation plans not
approved
by security holders
Total
(a)
15,000,000
933,327
15,933,327
(b)
$1.56
$3.64
$1.72
Number of securities
remaining
available for future issuance
under equity compensation
plans
(excluding securities reflected
in
column (a))
(c)
-
-
-
The following table sets forth, as of March 1, 2006, the number of shares of the Company’s common stock beneficially
owned by each director and executive officer of the Company, by all directors and executive officers as a group, and by each
person known by the Company to own beneficially more than 5.0% of the Company’s outstanding common stock. As of March 1,
2006, there were no issued and outstanding shares of any other class of the Company’s equity securities.
32
Table of Contents
Name and Address of Beneficial Owner
Shares Beneficially Owned
Percentage of Class
Officers and Directors
Ronald W. Pickett, President and CEO
20374 Seneca Meadows Parkway
Germantown, MD 20876
Frank T. Matarazzo, President and CEO, MST
259-263 Goffle Road
Hawthorne, NJ 07506
John S. Cramp, Chief Operating Officer
20374 Seneca Meadows Parkway
Germantown, MD 20876
E. Barry Smith, Chief Financial Officer
20374 Seneca Meadows Parkway
Germantown, MD 20876
Stephen L. Sadle, Senior Vice President
20374 Seneca Meadows Parkway
Germantown, MD 20876
James Landry, Chief Technology Officer
20374 Seneca Meadows Parkway
Germantown, MD 20876
Warren V. Musser, Chairman
20374 Seneca Meadows Parkway
Germantown, MD 20876
David Grimes, Former Director
20374 Seneca Meadows Parkway
Germantown, MD 20876
Thomas C. Lynch, Director
20374 Seneca Meadows Parkway
Germantown, MD 20876
Dr. Thomas M. Hall, Director
20374 Seneca Meadows Parkway
Germantown, MD 20876
James “Lou” L. Peeler, Director
20374 Seneca Meadows Parkway
Germantown, MD 20876
Seth D. Blumenfeld
20374 Seneca Meadows Parkway
Germantown, MD 20876
All Directors and Executive Officers as a Group
33
2,699,699
400,000(1)
75,000(2)
441,000(3)
4,389,514(4)
434,200(5)
2,237,027(7)
1,575,405(8)
100,000(9)
667,790(10)
84,400(11)
40,000 (12)
13,642,035
5.8%
0.9%
0.2%
0.9%
9.3%
0.9%
4.6%
3.3%
0.2%
1.4%
0.2%
0.1%
26.4%
Table of Contents
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
Includes 400,000 shares of the Company’s common stock issued to Mr. Matarazzo in conjunction with the Company’s
January 2006 acquisition of a 90% interest in Microwave Satellite Technologies, Inc. As part of the purchase price, an
additional 1,200,000 shares of the Company’s common stock are held in escrow,issuable upon the achievement of
certain performance targets and excluded from this table.
Includes options exerciseable within 60 days to purchase 75,000 shares of the Company’s common stock at $3.04 per
share.
Includes options exerciseable within 60 days to purchase 441,000 shares of the Company’s common stock at $1.00 per
share.
Includes options exerciseable within 60 days to purchase 900,000 shares of the Company’s common stock at $1.00 per
share.
Includes options exerciseable within 60 days to purchase 250,000 and 100,000 shares of the Company’s common stock
at $1.00 and $3.45 per share, respectively.
Includes options exerciseable within 60 days to purchase 500,000 shares of the Company’s common stock at $1.00 per
share.
Includes options exerciseable within 60 days to purchase 2,000,000 shares of the Company’s common stock at $1.00 per
share.
Includes options exerciseable within 60 days to purchase 825,000 shares of the Company’s common stock at $1.00 per
share. The remaining 75,000 unvested options were cancelled.
Includes options exerciseable within 60 days to purchase 20,000 and 80,000 shares of the Company’s common stock at
$2.00 and $3.45 per share, respectively.
Includes options exerciseable within 60 days to purchase 80,000 shares of the Company’s common stock at $3.45 per
share.
Includes options exerciseable within 60 days to purchase 80,000 shares of the Company’s common stock at $3.45 per
share.
Includes 10,000 shares of the Company’s common stock to be issued within 60 days pursuant to a Professional Services
Agreement.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
In September 2003, the Company entered into a consulting agreement (renewable annually) with The Musser Group to compensate
Mr. Musser in the amount of $100,000 per year for his services to the Company as a director. Mr. Musser, Chairman of the Board
of Directors, is the sole principal of The Musser Group, which is owned by Mr. Musser’s wife. For the years ended December 31,
2005, 2004 and 2003, the Company paid and expensed $100,000, $100,000 and $33,333, respectively.
On July 1, 2005, Mr. Blumenfeld was retained as a consultant to Telkonet pursuant to a Professional Services Agreement
between the Company and Mr. Blumenfeld. Pursuant to the terms of the agreement, Mr. Blumenfeld received 10,000 shares of
Company stock upon execution of the agreement, 10,000 shares of Company stock per quarter for the first year (for a total 50,000
shares in the first year) and 5,000 shares of Company stock per quarter thereafter plus a five percent (5%) commission (payable in
cash or Company stock) on international sales generated by him with gross margins of 50% or greater. The stock awarded to Mr.
Blumenfeld pursuant to the agreement is restricted stock. The agreement has a one year term, which is renewable annually upon
both parties' agreement.
In December 2005, the Company issued an aggregate of 363,636 shares of common stock to Ronald W. Pickett, President
and Chief Executive Officer of the Company, a convertible debenture holder in exchange for $200,000 of Series B Debentures.
The Company also issued an aggregate of 48,858 shares of common stock in exchange for accrued interest of $26,872 for Series B
Debentures. In addition, the Company issued an aggregate of 200,000 shares of common stock upon the exercise of warrants at
$1.00 per share upon conversion of the notes.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The following table sets forth fees billed to the Company by our auditors during the fiscal years ended December 31,
2005 and 2004 Additionally, the Company incurred approximately $200,000 associated with its Sarbanes-Oxley compliance
review.
1. Audit Fees
2. Audit Related Fees
3. Tax Fees
4. All Other Fees
Total Fees
December 31, 2005
$
119,090
62,825
1,175
December 31, 2004
$
63,875
23,900
5,000
$
--
183,090
$
--
92,775
34
Table of Contents
Audit fees consist of fees billed for professional services rendered for the audit of the Company’s consolidated financial
statements and review of the interim consolidated financial statements included in quarterly reports and services that are
normally provided by Russell Bedford Stefanou Mirchandani LLP in connection with statutory and regulatory filings or
engagements.
Audit-related fees consists of fees billed for assurance and related services that are reasonably related to the
performance of the audit or review of the Company’s consolidated financial statements, which are not reported under “Audit
Fees.”
Tax fees consists of fees billed for professional services for tax compliance, tax advice and tax planning. The tax fees
relate to federal and state income tax reporting requirements.
All other fees consist of fees for products and services other than the services reported above.
Prior to the Company’s engagement of its independent auditor, such engagement is approved by the Company’s audit
committee. The services provided under this engagement may include audit services, audit-related services, tax services and
other services. Pre-approval is generally provided for up to one year and any pre-approval is detailed as to the particular service
or category of services and is generally subject to a specific budget. Pursuant to the Company’s Audit Committee Charter, the
independent auditors and management are required to report to the Company’s audit committee at least quarterly regarding the
extent of services provided by the independent auditors in accordance with this pre-approval, and the fees for the services
performed to date. The audit committee may also pre-approve particular services on a case-by-case basis. All audit fees, audit-
related fees, tax fees and other fees incurred by the Company for the year ended December 31, 2005, were approved by the
Company’s audit committee.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
PART IV
The following table sets forth selected unaudited quarterly information for the Company’s year-ended December 31,
2005 and 2004.
Net Revenue
Gross Profit
Provision for income taxes
Net loss per share -- basic
Net loss per share -- diluted
Net Revenue
Gross Profit
Provision for income taxes
Net loss per share -- basic
Net loss per share -- diluted
QUARTERLY FINANCIAL DATA
(unaudited)
March 31, 2005
June 30, 2005
September 30,
2005
December 31,
2005
$
$
$
$
$
$
$
$
$
$
246,188 $
88,798 $
- $
(0.07) $
(0.07) $
472,947 $
120,791 $
- $
(0.08) $
(0.08) $
621,923 $
212,749 $
- $
(0.08) $
(0.08) $
1,147,265
348,806
-
(0.12)
(0.12)
March 31,
2004
June 30, 2004
September 30,
2004
December 31,
2004
140,099 $
5,695 $
- $
(0.09) $
271,903 $
12,774 $
- $
(0.11) $
79,335 $
10,462 $
- $
(0.06) $
207,315
126,862
-
(0.06)
(0.09) $
(0.11) $
(0.06) $
(0.06)
35
Table of Contents
The following table sets forth selected unaudited valuation and qualifying account information for the Company’s
year-ended December 31, 2005, 2004 and 2003.
SCHEDULE II- VALUATION AND QUALIFYING ACCOUNTS
(unaudited)
DESCRIPTION
Allowance for
doubtful accounts:
Year ended
December 31,
2005
2004
2003
Reserve for product
returns:
Year ended
December 31,
2005
2004
2003
Balance
BEGINNING OF
YEAR
CHARGED TO
COSTS AND
EXPENSES
DEDUCTIONS
BALANCE, END
OF YEAR
$
$
13,000
7,000
0
0
—
—
$
$
39,710
30,637
7,000
24,000
—
—
36
$
$
(22,710)
(24,637)
0
0
—
—
$
$
30,000
13,000
7,000
24,000
—
—
Table of Contents
The following exhibits are included herein or incorporated by reference:
Exhibit Number Description Of Document
3.1
3.2
4.1
4.2
4.3
4.4
4.5
4.6
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
14
21
23
24
31.1
31.2
32.1
32.2
Articles of Incorporation of the Registrant (incorporated by reference to our Form 8-K (No. 000-27305),
filed on August 30, 2000 and our Form S-8 (No. 333-47986), filed on October 16, 2000)
Bylaws of the Registrant (incorporated by reference to our Registration Statement on Form S-1 (No. 333-
108307), filed on August 28, 2003)
Form of Series A Convertible Debenture (incorporated by reference to our Form 10-KSB (No. 000-27305),
filed on March 31, 2003)
Form of Series A Non-Detachable Warrant (incorporated by reference to our Form 10- KSB (No. 000-
27305), filed on March 31, 2003)
Form of Series B Convertible Debenture (incorporated by reference to our Form 10-KSB (No. 000-27305),
filed on March 31, 2003)
Form of Series B Non-Detachable Warrant (incorporated by reference to our Form 10- KSB (No. 000-
27305), filed on March 31, 2003)
Form of Senior Note (incorporated by reference to our Registration Statement on Form S-1 (No. 333-
108307), filed on August 28, 2003)
Form of Non-Detachable Senior Note Warrant (incorporated by reference to our Registration Statement on
Form S-1 (No. 333-108307), filed on August 28, 2003)
Amended and Restated Telkonet, Inc. Incentive Stock Option Plan (incorporated by reference to our
Registration Statement on Form S-8 (No. 333-412), filed on April 17, 2002)
Employment Agreement by and between Telkonet, Inc. and Stephen L. Sadle, dated as of January 18, 2003
(incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on August
28, 2003
Employment Agreement by and between Telkonet, Inc. and Robert P. Crabb, dated as of January 18, 2003
(incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on August
28, 2003)
Employment Agreement by and between Telkonet, Inc. and Ronald W. Pickett, dated as of January 30,
2003 (incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on
August 28, 2003)
Employment Agreement by and between Telkonet, Inc. and E. Barry Smith, dated as of February 17, 2003
(incorporated by reference to our Registration Statement on Form S-1 (No. 333-108307), filed on August
28, 2003)
Employment Agreement by and between Telkonet, Inc. and Frank T Matarazzo, dated as of February 1,
2006
Professional Services Agreement by and between Telkonet, Inc. and Seth D. Blumethel, dated July 1, 2005
(incorporated by reference to our Form 10-Q (No. 000-27305), filed on November 9, 2005.
MST Stock Purchase Agreement and Amendment (incorporated by reference to our 8-K filed on February
2, 2006) (No. 001-31972)
Code of Ethics (incorporated by reference to our Form 10-KSB (No. 001-31972), filed on March 30, 2004).
Telkonet, Inc. Subsidiaries
Consent of Registered Independent Certified Public Accountants
Power of Attorney (incorporated by reference to our Registration Statement on Form S-1 (No. 333-
108307), filed on August 28, 2003)
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Ronald W. Pickett
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of E. Barry Smith
Certification of Ronald W. Pickett pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
Certification of E. Barry Smith pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
37
Table of Contents
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
TELKONET, INC.
/s/ Ronald W. Pickett
Ronald W. Pickett
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the dates indicated.
Name
Position
Date
/s/ Warren V. Musser
Warren V. Musser
/s/ Ronald W. Pickett
Ronald W. Pickett
/s/ E. Barry Smith
E. Barry Smith
/s/ James Landry
James Landry
/s/ Stephen L. Sadle
Stephen L. Sadle
/s/ Dr. Thomas M. Hall
Dr. Thomas M. Hall
/s/ James L. Peeler
James L. Peeler
/s/ Seth D. Blumenfeld
Seth D. Blumenfeld
/s/ Thomas C. Lynch
Thomas C. Lynch
Chairman of the Board
March 16, 2006
Chief Executive Officer &
Director
March 16, 2006
Chief Financial Officer
March 16, 2006
Chief Technology Officer
March 16, 2006
March 16, 2006
March 16, 2006
March 16, 2006
March 16, 2006
March 16, 2006
Senior Vice President &
Director
Director
Director
Director
Director
38
Table of Contents
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FINANCIAL STATEMENTS AND SCHEDULES
DECEMBER 31, 2005 AND 2004
FORMING A PART OF ANNUAL REPORT
PURSUANT TO THE SECURITIES EXCHANGE ACT OF 1934
TELKONET, INC.
F-1
Table of Contents
TELKONET, INC.
Index to Financial Statements
Report of Independent Registered Certified Public Accounting Firm
Consolidated Balance Sheets at December 31, 2005 and 2004
Consolidated Statements of Losses for the Years ended December 31, 2005, 2004 and 2003
F-3
F-4
F-5
Consolidated Statements of Stockholders’ Equity for the Years ended December 31, 2005, 2004 and
2003
F-6 - F-8
Consolidated Statements of Cash Flows for the Years ended December 31, 2005, 2004 and 2003
F-9 - F-10
Notes to Consolidated Financial Statements
F-11 - F-32
F-2
Table of Contents
RUSSELL BEDFORD STEFANOU MIRCHANDANI LLP
Certified Public Accountants
REPORT OF INDEPENDENT REGISTERED CERTIFIED PUBLIC ACCOUNTING FIRM
Board of Directors
Telkonet, Inc.
Germantown, MD
We have audited the accompanying consolidated balance sheets of Telkonet, Inc. and its wholly-owned subsidiary
(the "Company") as of December 31, 2005 and 2004 and the related consolidated statements of losses, stockholders' equity,
and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements
based upon our audit.
We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board
(United States of America). Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the
financial position of Telkonet, Inc. and its wholly-owned subsidiary as of December 31, 2005 and 2004, and the results of
its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with
accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board
(United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005,
based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission and our report dated February 2, 2006 expressed an unqualified opinion on
management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an
unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
MIRCHANDANI LLP
Mirchandani LLP
/s/RUSSELL BEDFORD STEFANOU
Russell Bedford Stefanou
McLean, Virginia
February 2, 2006
F-3
Table of Contents
ASSETS
TELKONET, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2005 AND 2004
Current Assets:
Cash and cash equivalents
Restricted Certificate of Deposit
Accounts receivable, net of allowance for doubtful accounts of $30,000 and $13,000
at
December 31, 2005 and 2004, respectively
Inventories (Note B)
Prepaid expenses and deposits
Total current assets
Property and equipment, at cost (Note C):
Furniture and equipment
Less: accumulated depreciation
Total property and equipment, net
Equipment under operating leases, at cost (Note D):
Telecommunications and related equipment, at cost
Less: accumulated depreciation
Total equipment under operating leases, net
Other assets:
Long-term investments (Note E)
Financing Costs, net of accumulated amortization of $73,499 and $0 at December 31,
2005
and 2004, respectively (Note F)
Deposits
Total other assets
Total Assets
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued liabilities (Note M)
Customer deposits held
Senior notes payable, current portion (Note G)
Convertible debentures, current portion (Note F)
Deferred revenue
Total current liabilities
Long-term liabilities:
Convertible debentures, net of discounts (Note F)
Senior notes payable (Note G)
Deferred lease liability
Total long-term liabilities
Commitments and contingencies (Note N)
Stockholders’ equity (Note H)
Preferred stock, par value $.001 per share; 15,000,000 shares authorized; none issued
and outstanding at December 31, 2005 and 2004
Common stock, par value $.001 per share; 100,000,000 shares authorized; 45,765,171
and 44,335,989 shares issued and outstanding at December 31, 2005 and 2004,
respectively
Additional paid-in-capital
Accumulated deficit
2005
2004
$
8,422,079 $ 11,838,702
--
10,000,000
119,191
1,475,806
360,880
20,377,956
63,147
1,873,718
124,852
13,900,419
1,041,137
323,667
717,470
789,099
124,669
664,430
704,689
137,739
566,950
525,664
75,329
450,335
231,000
500,000
1,145,911
154,216
1,531,127
--
76,288
576,288
$
23,290,983 $ 15,493,992
$
1,821,872 $
86,257
100,000
6,250,000
59,020
8,317,149
1,195,924
32,975
--
--
--
1,228,899
9,616,521
--
42,317
9,658,838
137,910
450,000
30,911
618,821
--
--
--
--
45,765
48,256,784
(42,987,553)
44,336
40,811,208
(27,209,272)
Stockholders’ equity
Total Liabilities and Stockholders’ Equity
13,646,272
5,314,996
23,290,983 $ 15,493,992
$
See accompanying notes to consolidated financial statements
F-4
Table of Contents
TELKONET, INC.
CONSOLIDATED STATEMENTS OF LOSSES
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
Product Revenues, net
Rental Revenue, net
Total Revenue
Product
Rental
Total Cost of Sales
Gross Profit (Loss)
Operating Expenses:
Research and Development (Note A)
Selling, General and Administrative
Consulting Fees (Note H)
Impairment write-down in investment in affiliate (Note E)
Non-Employee Stock Options and Warrants (Note I)
Depreciation and Amortization
Total Operating Expense
Loss from Operations
Other Income (Expense):
Other Income (Note F)
Interest Income
Interest Expense
Total Other Income (Expenses)
2005
2004
2003
$
1,769,727 $
718,596
2,488,323
477,555 $
221,097
698,652
1,183,574
533,605
1,717,179
459,225
83,634
542,859
88,403
5,257
93,660
101,171
3,485
104,656
771,144
155,793
(10,996)
2,096,104
12,041,661
-
400,000
1,354,219
185,928
16,077,912
1,852,309
7,663,369
2,500,000
-
1,180,875
71,514
13,268,067
1,370,785
4,089,172
-
-
982,390
110,988
6,553,335
(15,306,768)
(13,112,274)
(6,564,331)
8,600
166,070
( 646,183)
(471,513)
--
128,938
(109,324)
19,614
--
20,297
(1,113,902)
(1,093,605)
Loss Before Provision for Income Taxes
Provision for Income Tax (Note K)
(15,778,281)
--
(13,092,660)
--
(7,657,936)
--
Net Loss
$ (15,778,281) $ (13,092,660) $ ( 7,657,936)
Loss per common share (basic and assuming dilution) (Note L)
$
(0.35) $
(0.32) $
(0.37)
Weighted average common shares outstanding
44,743,223
41,384,074
20,702,482
See accompanying notes to consolidated financial statements
F-5
Table of Contents
TELKONET, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
Balance at January 1, 2003
Shares issued for cash at $2.00 per
share, net of costs
and fees
Shares issued for employee stock
options exercised at
approximately $1.01 per share
Shares issued to a director for
employee stock options
exercised at $.50 per share
Shares issued in exchange for non-
employee options
exercised at $1.00 per share
Shares issued to consultants in
exchange for services
at approximately $2.13 per share
Shares issued to noteholders for
warrants exercised
at $1.00 per share
Shares issued to noteholders for
warrants exercised
at $.50 per share
Shares issued to noteholders for
cashless warrants
exercised
Shares issued in exchange for
convertible debentures
(Note F)
Shares issued in exchange for
accrued interest on
convertible debentures (Note F)
Shares issued for warrants
exercised at $1.00, in
exchange for Senior Notes (Note
G)
Write-off of beneficial conversion
features and warrants
attached to convertible
debentures in connection with
conversion of Debenture-1 and
Series B debentures (Note F)
Shares issued to an employee in
exchange for services
at approximately $1.79 per share
Stock options and warrants granted
to consultants in
exchange for services rendered
(Note I)
Stock based compensation for the
issuance of warrants
in exchange for financing costs
(Note I)
Beneficial conversion feature of
convertible debentures
(Note F)
Value of warrants attached to
convertible debentures
(Note F)
Preferred
Shares
Preferred
Stock
Amount
Common
Shares
Common
Stock
Amount
Additional
Paid in
Capital
Accumulated
Deficit
Total
- $
- 15,721,131 $ 15,721 $ 4,916,433 $ (6,458,676)$(1,526,522)
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
333
-
666
-
666
-
109,333
109
110,724
-
110,833
315,000
315
157,185
157,500
-
187,499
189
187,311
-
187,500
-
149,498
150
318,955
-
319,105
- 3,599,250
3,599 3,595,651
- 3,599,250
-
500,000
500
249,500
-
250,000
-
317,239
317
(317)
-
-
- 7,217,836
7,218 3,799,882
- 3,807,100
-
525,403
525
280,209
-
280,734
- 2,011,000
2,011 2,008,989
- 2,011,000
-
-
- (2,342,949)
- (2,342,949)
-
36,000
36
64,433
-
64,469
-
-
-
-
-
- 1,013,262
- 1,013,262
-
-
-
-
87,217
-
87,217
- 1,761,675
- 1,761,675
-
265,425
-
265,425
Net loss
Balance at December 31, 2003
-
- $
(7,657,936) (7,657,936)
-
- 30,689,522 $ 30,690 $16,474,251 $(14,116,612)$ 2,388,329
-
-
-
F-6
Table of Contents
TELKONET, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
Balance at January 1, 2004
Shares issued for employee stock
options exercised
at approximately $1.08 per
share
Shares issued in exchange for
non-employee options
exercised at $1.00 per share
Shares issued to consultants in
exchange for services
rendered at approximately
$3.07 per share
Shares issued for senior note
conversion at $2.10 per
share (Note G)
Shares issued in connection with
private placement at
$2.00 per share, net of costs
Shares issued to consultants for
warrants exercised at
$2.54 per share
Shares issued to noteholders for
warrants exercised at
$1.00 per share
Shares issued to noteholders for
cashless warrants exercised
Shares issued for cashless
exercise of underwriter warrants
Shares issued in exchange for
convertible debentures at
$0.50 per share (Note F)
Shares issued in exchange for
convertible debentures at
$0.55 per share (Note F)
Shares issued in exchange for
accrued interest on convertible
debentures (Note F)
Shares issued to an employee in
exchange for services at
approximately $2.99 per share
Shares issued to consultants in
exchange for consulting
fees at $2.50 per share
Founders shares returned and
canceled in connection
with January 2002 capital
restructure
Write-off of beneficial
conversion features and warrants
attached to convertible
debentures in connection with
conversion of Debenture-1 and
Series B debentures (Note F)
Stock options and warrants
granted to consultants in
exchange for services rendered
(Note I)
Net loss
Preferred
Shares
Preferred
Stock
Amount
Common
Shares
Common
Stock
Amount
Additional
Paid in
Capital
Accumulated
Deficit
Total
- $
- 30,689,522 $ 30,690 $16,474,251 $(14,116,612)$ 2,388,329
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
540,399
540
582,358
-
582,898
-
328,333
328
328,005
-
328,333
-
63,566
63
196,252
-
196,315
- 1,209,038
1,209 2,537,791
-
2,539,000
- 6,387,600
6,388 12,720,455
- 12,726,843
-
50,000
50
126,950
-
127,000
- 4,000,950
4,001 3,996,949
-
4,000,950
-
-
203,751
204
(204)
165,116
165
(165)
-
-
-
-
-
124,000
124
61,876
-
62,000
-
200,000
200
109,800
-
110,000
-
42,999
43
23,233
-
23,276
-
36,000
36
107,743
-
107,779
- 1,000,000
1,000 2,499,000
-
2,500,000
-
(705,285)
(705)
705
-
-
-
-
-
-
-
(134,666)
-
(134,666)
-
-
- 1,180,875
-
1,180,875
-
- (13,092,660) (13,092,660)
Balance at December 31, 2004
- $
- 44,335,989 $ 44,336 $40,811,208 $(27,209,272)$ 13,646,272
See accompanying footnotes to consolidated financial statements
F-7
Table of Contents
TELKONET, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
Preferred
Shares
Preferred
Stock
Amount
Common
Shares
Common
Stock
Amount
Additional
Paid in
Capital
Accumulated
Deficit
Total
Balance at January 1, 2005
Shares issued for employee stock
options exercised at
approximately $1.19 per share
Shares issued in exchange for
non-employee options exercised
at approximately $2.07 per
share
Shares issued to noteholders for
warrants exercised at
$1.00 per share
Shares issued to noteholders for
cashless warrants exercised
Shares issued to an employee in
exchange for services at
approximately $4.65 per share
Shares issued to director in
exchange for services rendered
at approximately $4.26 per
share
Shares issued to consultants in
exchange for services rendered
at approximately $4.28 per
share
Shares issued in exchange for
convertible debentures at $0.55
per share (Note F)
Shares issued in exchange for
interest expense on convertible
debentures (Note F)
Beneficial conversion feature of
convertible debentures (Note F)
Value of warrants attached to
convertible debentures (Note F)
Stock options and warrants
granted to consultants in
exchange
for services rendered (Note I)
Net loss
Balance at December 31, 2005
- $
-
-
-
-
-
-
-
-
-
-
-
-
-
- $
- 44,335,989 $ 44,336 $40,811,208 $(27,209,272)$ 13,646,272
-
415,989
416
496,077
-
496,493
-
172,395
172
355,973
-
356,145
-
-
321,900
322
321,578
36,150
36
(36)
-
-
321,900
-
-
36,000
36
163,283
-
163,319
-
30,000
30
127,766
-
127,796
-
1,968
2
9,000
-
9,002
-
363,636
364
199,636
-
200,000
-
-
-
51,144
51
28,080
-
28,131
-
-
- 1,479,300
-
1,479,300
- 2,910,700
-
2,910,700
-
1,354,219
-
- (15,778,281) (15,778,281)
-
- 45,765,171 $ 45,765 $48,256,784 $(42,987,553)$ 5,314,996
- 1,354,219
-
-
-
See accompanying footnotes to consolidated financial statements
F-8
Table of Contents
TELKONET, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
Increase (Decrease) In Cash and Equivalents
Cash Flows from Operating Activities:
Net loss from operating activities
Adjustments to reconcile net loss from operations to cash used in
operating
activities:
2005
2004
2003
$ (15,778,281) $ (13,092,660) $
(7,657,936)
Amortization of debt discount - beneficial conversion feature of
convertible
debentures (Note F)
Amortization of debt discount - value of warrants attached to
convertible
debentures (Note F)
Amortization of financing costs
Other income in connection with derivative warrant liabilities (Note F)
Stock options and warrants issued in exchange for services (Note I)
Common stock issued in exchange for services rendered (Note H)
Common stock issued in exchange for conversion of interest (Note F)
Common stock issued in exchange for consulting fees (Note H)
Write-off of financing costs in connection with conversion of
convertible
debentures (Note F)
Depreciation, including equipment under operating leases
Impairment write-down in investment in Amperion (Note E)
Increase / decrease in:
Accounts receivable, trade and other
Inventory
Prepaid expenses and deposits
Deferred lease liability
Deferred revenue
Accounts payable, accrued expenses and customer deposits, net
Net Cash Used In Operating Activities
Cash Flows From Investing Activities:
Costs of equipment under operating leases
Purchase of property and equipment, net
Investment in Restricted Certificate of Deposit
Investment in Amperion and BPL Global (Note E)
Net Cash Used In Investing Activities
Cash Flows From Financing Activities:
Proceeds from sale of common stock, net of costs and fees
Repayments of stockholder advances
Proceeds from issuance of convertible debentures, net of costs and
fees (Note F)
Repayment of convertible debenture
Proceeds from issuance of senior notes, net of costs and fees (Note G)
Repayment of senior notes
Proceeds from exercise of warrants (Note H)
Proceeds from exercise of employee and non-employee stock options
and warrants
(Note H)
Repayments of loans
Repayments of capital leases
Net Cash Provided By Financing Activities
Net Increase (Decrease) In Cash and Equivalents
138,406
21,888
655,261
198,805
73,499
(8,600)
1,354,219
300,117
28,131
10,152
-
-
1,180,875
304,094
23,276
89,434
-
-
1,013,262
383,574
280,735
-
2,500,000
-
-
430,104
400,000
-
143,358
-
204,749
110,988
-
(56,646)
(568,726)
(173,366)
-
-
122,186
(5,596,485)
(4,950)
(1,265,202)
(23,150)
30,911
-
587,848
(9,583,560)
(491,776)
(514,903)
-
(500,000)
(1,506,679)
(33,888)
(103,033)
-
-
(136,921)
-
-
12,726,843
-
-
-
-
-
4,127,950
666
(122,830)
2,027,100
-
5,000,000
-
3,999,250
911,230
-
(15,000)
17,751,023
6,660,784
298,311
(310,000)
-
10,892,497
5,159,091
(56,044)
397,912
(313,956)
11,406
59,020
679,230
(12,086,032)
(458,271)
(336,448)
(10,000,000)
(131,000)
(10,925,719)
18,780,590
(10,000)
-
(350,000)
321,900
852,638
-
-
19,595,128
(3,416,623)
Cash and cash equivalents at the beginning of the year
Cash and cash equivalents at the end of the year
11,838,702
8,422,079 $ 11,838,702 $
5,177,918
18,827
5,177,918
$
See accompanying footnotes to consolidated financial statements
F-9
Table of Contents
TELKONET, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
Supplemental Disclosures of Cash Flow Information:
Cash transactions:
Cash paid during the period for interest
Income taxes paid
Non-cash transactions:
Issuance of stock options and warrants in exchange for services
rendered (Note H)
Issuance of stock warrants in exchange for financing costs (Note I)
Common stock issued for services rendered (Note H)
Common stock issued in exchange for interest (Note F and H)
Common stock issued in exchange for consulting services (Note H)
Common stock issued in exchange for Senior Note (Note G and H)
Common stock issued in exchange for conversion of convertible
debenture (Note F and H)
Common stock issued in exchange for notes payable (Note H)
Write-off of beneficial conversion feature for conversion of debenture
(Note F)
Write-off of value of warrants attached to debenture in connection
with conversion (Note F)
Notes payable issued in connection with capital lease, net of
repayments (Note N)
Impairment write-down in investment in affiliate (Note E)
Beneficial conversion feature on convertible debentures (Note F)
Value of warrants attached to convertible debentures (Note F)
2005
2004
2003
$
40,645 $
100,608 $
-
-
135,879
-
1,354,219
-
300,117
28,131
-
-
200,000
-
1,180,875
-
304,094
23,276
2,500,000
2,539,000
172,000
-
1,013,262
87,217
383,574
280,735
-
2,011,000
3,807,100
7,500
-
-
134,135
2,046,479
531
296,470
-
400,000
1,479,300
2,910,700
-
-
-
-
15,000
-
1,761,675
265,425
See accompanying notes to consolidated financial statements
F-10
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE A-SUMMARY OF ACCOUNTING POLICIES
A summary of the significant accounting policies applied in the preparation of the accompanying consolidated financial
statements follows.
Business and Basis of Presentation
Telkonet, Inc. (the "Company"), formerly Comstock Coal Company, Inc., was formed on November 3, 1999 under the laws
of the state of Utah. The Company was a “development stage enterprise” (as defined by Statement of Financial Accounting
Standards No. 7) until December 31, 2003. The Company is engaged in the business of developing, producing and marketing
proprietary equipment enabling the transmission of voice and data over electric utility lines.
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Telkonet
Communications, Inc. Significant intercompany transactions have been eliminated in consolidation.
Concentrations of Credit Risk
Financial instruments and related items, which potentially subject the Company to concentrations of credit risk, consist
primarily of cash and cash equivalents. The Company places its cash and temporary cash investments with credit quality
institutions. At times, such investments may be in excess of the FDIC insurance limit. The allowance for doubtful accounts
was $30,000 and $13,000 at December 31, 2005 and December 31, 2004, respectively.
Cash and Cash Equivalents
For purposes of the Statements of Cash Flows, the Company considers all highly liquid debt instruments purchased with a
maturity date of three months or less to be cash equivalents.
Restricted Certificate of Deposit
Restricted Certificate of Deposit at December 31, 2005 consists of a $10,000,000 certificate of deposit pledged as collateral
for an irrevocable letter of credit agreement. This letter of credit agreement is automatically renewable annually as required
in the $20,000,000 Convertible Senior Notes loan covenant. (Note F). The certificate of deposit provides for approximately
4% interest payable at maturity.
Property and Equipment
Property and equipment is stated at cost. Depreciation is calculated using the straight-line method over the estimated useful
lives of the assets. The estimated useful life ranges from 3 to 5 years.
Long-Lived Assets
The Company has adopted Statement of Financial Accounting Standards No. 144 (SFAS 144). The Statement requires that
long-lived assets and certain identifiable intangibles held and used by the Company be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Events relating to
recoverability may include significant unfavorable changes in business conditions, recurring losses, or a forecasted inability
to achieve break-even operating results over an extended period. The Company evaluates the recoverability of long-lived
assets based upon forecasted discounted cash flows. Should an impairment in value be indicated, the carrying value of
intangible assets will be adjusted, based on estimates of future discounted cash flows resulting from the use and ultimate
disposition of the asset. SFAS No. 144 also requires assets to be disposed of be reported at the lower of the carrying amount
or the fair value less costs to sell. At December 31, 2005, the company has determined that its investment in Amperion Inc.
has been impaired based upon forecasted discounted cash flow and has written off 80%, or $400,000, of its investment based
on management assessment (Note E).
F-11
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE A-SUMMARY OF ACCOUNTING POLICIES (Continued)
Inventories
Inventories consist primarily of Gateways, Extenders, iBridges and Couplers which are the significant components of the
Telkonet solution. Cost is determined by the first-in, first-out method. (Note B).
Income Taxes
The Company has implemented the provisions on Statement of Financial Accounting Standards No. 109, "Accounting for
Income Taxes" (SFAS 109). SFAS 109 requires that income tax accounts be computed using the liability method. Deferred
taxes are determined based upon the estimated future tax effects of differences between the financial reporting and tax
reporting bases of assets and liabilities given the provisions of currently enacted tax laws.
Net Loss Per Common Share
The Company computes earnings per share under Financial Accounting Standard No. 128, "Earnings Per Share" (SFAS
128). Net loss per common share is computed by dividing net loss by the weighted average number of shares of common
stock and dilutive common stock equivalents outstanding during the year. Dilutive common stock equivalents consist of
shares issuable upon conversion of convertible notes and the exercise of the Company's stock options and warrants
(calculated using the treasury stock method). During 2005, 2004 and 2003, common stock equivalents are not considered in
the calculation of the weighted average number of common shares outstanding because they would be anti-dilutive, thereby
decreasing the net loss per common share.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect certain reported amounts and disclosures. Accordingly, actual results could differ
from those estimates.
Revenue Recognition
For revenue from product sales, the Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104,
Revenue Recognition (“SAB104”), which superceded Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
Statements (“SAB101”). SAB 101 requires that four basic criteria must be met before revenue can be recognized: (1)
persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and
(4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding
the fixed nature of the selling prices of the products delivered and the collectibility of those amounts. Provisions for
discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same
period the related sales are recorded. The Company defers any revenue for which the product has not been delivered or is
subject to refund until such time that the Company and the customer jointly determine that the product has been delivered or
no refund will be required. SAB 104 incorporates Emerging Issues Task Force 00-21 (“EITF 00-21”), Multiple-Deliverable
Revenue Arrangements. EITF 00-21 addresses accounting for arrangements that may involve the delivery or performance of
multiple products, services and/or rights to use assets.
For equipment under lease, revenue is recognized over the lease term for operating lease and rental contracts. All of the
Company’s leases are accounted for as operating leases. At the inception of the lease, no lease revenue is recognized and the
leased equipment and installation costs are capitalized and appear on the balance sheet as “Equipment Under Operating
Leases.” The capitalized cost of this equipment is depreciated from two to three years, on a straight-line basis down to the
Company’s original estimate of the projected value of the equipment at the end of the scheduled lease term. Monthly lease
payments are recognized as rental income. The Company has sold a portion of its lease portfolio in December 2005 and
substantially all the remaining portfolio during the first quarter 2006. The related equipment was charged to cost of sales
commensurate with the associated revenue recognition (Note D and P).
F-12
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE A-SUMMARY OF ACCOUNTING POLICIES (Continued)
Guarantees and Product Warranties
FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others” (“FIN 45”), requires that upon issuance of a guarantee, the guarantor must disclose
and recognize a liability for the fair value of the obligation it assumes under that guarantee.
The Company’s guarantees issued subject to the recognition and disclosure requirements of FIN 45 as of December 31,
2005 and 2004 were not material. The Company records a liability for potential warranty claims. The amount of the liability
is based on the trend in the historical ratio of claims to sales, the historical length of time between the sale and resulting
warranty claim, new product introductions and other factors. The products sold are generally covered by a warranty for a
period of one year. In the event the Company determines that its current or future product repair and replacement costs
exceed its estimates, an adjustment to these reserves would be charged to earnings in the period such determination is
made. During the year ended December 31, 2005, the Company experienced approximately three percent of units returned.
Using this experience factor a reserve of $24,000 was accrued. Prior to the fiscal year of 2005, the Company had not
established historical ratio of claims, and the cost of replacing defective products and product returns were immaterial and
within management's expectations, accordingly there were no warranties provided with the purchase of the Company's
products during the year ended December 31, 2004.
Advertising
The Company follows the policy of charging the costs of advertising to expenses incurred. The Company incurred
$657,794, $499,874 and $136,758 in advertising costs during the years ended December 31, 2005, 2004 and 2003,
respectively.
Liquidity
As shown in the accompanying consolidated financial statements, the Company has incurred a net loss of $15,778,281,
$13,092,660 and $7,657,936 for the year ended December 31, 2005, 2004 and 2003, respectively. The Company's current
assets exceeded its current liabilities by $12,060,807, with cash and cash equivalents representing $8,422,079 and
Restricted Certificate of Deposit representing $10,000,000 of the current assets as of December 31, 2005.
Research and Development
The Company accounts for research and development costs in accordance with the Financial Accounting Standards Board's
Statement of Financial Accounting Standards No. 2 ("SFAS 2"), "Accounting for Research and Development Costs.”
Under SFAS 2, all research and development costs must be charged to expense as incurred. Accordingly, internal research
and development costs are expensed as incurred. Third-party research and developments costs are expensed when the
contracted work has been performed or as milestone results have been achieved. Company-sponsored research and
development costs related to both present and future products are expensed in the period incurred. Total expenditures on
research and product development for 2005, 2004 and 2004 were $2,096,104, $1,852,308 and $1,370,785, respectively.
Comprehensive Income
Statement of Financial Accounting Standards No. 130 ("SFAS 130"), "Reporting Comprehensive Income," establishes
standards for reporting and displaying of
comprehensive income, its components and accumulated balances.
Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and
distributions to owners. Among other disclosures, SFAS 130 requires that all items that are required to be recognized under
current accounting standards as components of comprehensive income be reported in a financial statement that is displayed
with the same prominence as other financial statements. The Company does not have any items of comprehensive income
in any of the periods presented.
Reclassifications
Certain reclassifications have been made in prior year's financial statements to conform to classifications used in the current
year.
F-13
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE A-SUMMARY OF ACCOUNTING POLICIES (Continued)
Stock Based Compensation
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure-
an amendment of SFAS 123." This statement amends SFAS No. 123, "Accounting for Stock-Based Compensation," to
provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based
employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results. The Company has chosen to continue to
account for stock-based compensation using the intrinsic value method prescribed in APB Opinion No. 25 and related
interpretations. Accordingly, compensation expense for stock options is measured as the excess, if any, of the fair market
value of the Company's stock at the date of the grant over the exercise price of the related option. The Company has adopted
the annual disclosure provisions of SFAS No. 148 in its financial reports for the years ended December 31, 2005, 2004 and
2003 and will adopt the interim disclosure provisions for its financial reports for the subsequent periods.
Had compensation costs for the Company's stock options been determined based on the fair value at the grant dates for the
awards, the Company's net loss and losses per share would have been as follows (transactions involving stock options issued
to employees and Black-Scholes model assumptions are presented in Note I):
Net loss - as reported
Add: Total stock based employee compensation expense as reported
under
intrinsic value method (APB. No. 25)
Deduct: Total stock based employee compensation expense as
reported under
fair value based method (SFAS No. 123)
Net loss - Pro Forma
Net loss attributable to common stockholders - Pro forma
Basic (and assuming dilution) loss per share - as reported
Basic (and assuming dilution) loss per share - Pro forma
2005
2004
$ (15,778,281) $ (13,092,660) $
2003
(7,657,936)
-
-
-
(7,830,385)
(2,440,097)
(5,211,112)
$ (18,218,378 $ (20,923,045) $ (12,869,048)
$ (18,218,378) $ (20,923,045) $ (12,869,048)
(0.37)
$
(0.62)
$
(0.35) $
(0.41) $
(0.32) $
(0.51) $
On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123R (revised
2004), "Share-Based Payment" which is a revision of FASB Statement No. 123, "Accounting for Stock-Based
Compensation". Statement 123R supersedes APB opinion No. 25, "Accounting for Stock Issued to Employees", and
amends FASB Statement No. 95, "Statement of Cash Flows". Generally, the approach in Statement 123R is similar to the
approach described in Statement 123. However, Statement 123R requires all share-based payments to employees, including
grants of employee stock options, to be recognized in the income statement based on their fair values. Pro-forma disclosure
is no longer an alternative. On April 14, 2005, the SEC amended the effective date of the provisions of this statement. The
effect of this amendment by the SEC is that the Company will have to comply with Statement 123R and use the Fair Value
based method of accounting no later than the first quarter of 2006. The Company has previously issued employee stock
options for which no expense has been recognized, and which will not be fully vested as of the effective date of SFAS
No. 123R. The Company has assessed the impact SFAS 123R and believes the impact of adopting SFAS No. 123R, based
on our unvested options outstanding at December 31, 2005, will be to increase our pre-tax stock-based compensation
expense in 2006 by approximately $2 million.
Segment Information
Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related
Information" ("SFAS 131") establishes standards for reporting information regarding operating segments in annual
financial statements and requires selected information for those segments to be presented in interim financial reports issued
to stockholders. SFAS 131 also establishes standards for related disclosures about products and services and geographic
areas. Operating segments are identified as components of an enterprise about which separate discrete financial information
is available for evaluation by the chief operating decision maker, or decision-making group, in making decisions how to
allocate resources and assess performance. The information disclosed herein materially represents all of the financial
information related to the Company's principal operating segment.
F-14
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE A-SUMMARY OF ACCOUNTING POLICIES (Continued)
New Accounting Pronouncements
I n March 2005, the FASB issued FASB Interpretation (FIN) No. 47, “Accounting for Conditional Asset Retirement
Obligations, an interpretation of FASB Statement No. 143,” which requires an entity to recognize a liability for the fair value
of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. The
Company is required to adopt the provisions of FIN 47 no later than the first quarter of fiscal 2006. The Company does not
expect the adoption of this Interpretation to have a material impact on its consolidated financial position, results of operations
or cash flows.
In May 2005 the FASB issued Statement of Financial Accounting Standards (SFAS) No. 154, “Accounting Changes and
Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS 154 requires retrospective
application to prior periods’ financial statements for changes in accounting principle, unless it is impracticable to determine
either the period-specific effects or the cumulative effect of the change. SFAS 154 also requires that retrospective application
of a change in accounting principle be limited to the direct effects of the change. Indirect effects of a change in accounting
principle, such as a change in non-discretionary profit-sharing payments resulting from an accounting change, should be
recognized in the period of the accounting change. SFAS 154 also requires that a change in depreciation, amortization, or
depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate effected by a
change in accounting principle. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years
beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in
fiscal years beginning after the date this Statement is issued. The Company does not expect the adoption of this SFAS to
have a material impact on its consolidated financial position, results of operations or cash flows.
On February 16, 2006 the FASB issued SFAS 155, “Accounting for Certain Hybrid Instruments,” which amends SFAS 133,
“Accounting for Derivative Instruments and Hedging Activities,” and SFAS 140, “Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities.” SFAS 155 allows financial instruments that have embedded derivatives
to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account
for the whole instrument on a fair value basis. SFAS 155 also clarifies and amends certain other provisions of SFAS 133 and
SFAS 140. This statement is effective for all financial instruments acquired or issued in fiscal years beginning after
September 15, 2006. The Company does not expect its adoption of this new standard to have a material impact on its
financial position, results of operations or cash flows.
NOTE B - INVENTORIES
Inventories are stated at the lower of cost or market determined by the first-in, first-out (FIFO) method. Inventories primarily
consist of Gateways, Extenders, iBridges and Couplers which are the significant components of the Telkonet solution.
Components of inventories as of December 31, 2005 and 2004 are as follows:
Raw Materials
Finished Goods
$
2004
2005
748,110
598,335 $
877,471 1,125,608
$ 1,475,806 $ 1,873,718
F-15
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE C - PROPERTY, PLANT AND EQUIPMENT
The Company’s property and equipment at December 31, 2005 and 2004 consists of the following:
Development Test Equipment
Computer Software
Leasehold Improvements
Office Equipment
Office Fixtures and Furniture
Total
Accumulated Depreciation
2005
2004
$
$
96,967 $
142,894
209,911
360,527
230,838
1,041,137
(323,667)
717,470 $
74,920
62,919
203,948
235,114
127,788
704,689
(137,739)
566,950
Depreciation expense included as a charge to income was $185,928, $71,514 and $35,920 for the years ended December
31, 2005, 2004 and 2003, respectively.
NOTE D - EQUIPMENT UNDER OPERATING LEASES
Equipment leased to customers under operating leases is recorded at cost and is depreciated on the straight line basis to its
estimated residual value. Estimated useful lives are two to three years. Equipment under operating leases at December 31,
2005 and 2004 consist of the following:
2005
2004
Telecommunications and related equipment
Less: accumulated depreciation
Capitalized equipment, net of accumulated
depreciation
Less: estimated reserve for residual values
Capitalized equipment under operating leases, net
$
$
789,099 $
(124,669)
664,430
--
664,430 $
525,664
(75,329)
450,335
--
450,335
In December 2005, the Company consummated a non-recourse sale of certain rental contract agreements and the related
capitalized equipment which were accounted for as operating leases with Hospitality Leasing Corporation. The remaining
rental income payments of the contracts were valued at approximately $732,000, including the customer support component
of approximately $205,000 which the Company will retain and continue to receive monthly customer support payments
over the remaining average unexpired lease term of 26 months. In December 2005, the Company recognized revenue of
approximately $439,000 for the sale, calculated based on the present value of total unpaid rental payments, and expensed
the associated capitalized equipment cost, net of accumulated depreciation, of approximately $267,000 and expensed
associated taxes of approximately $40,000.
The following is a schedule by years of minimum future rentals on non-cancellable operating leases as of December 31,
2005, including certain rental contract agreements sold to Hospitality Leasing Corporation in January 2006 (Note P):
2006
2007
2008
2009
2010
$1,416,000
442,000
315,000
165,000
73,000
$2,411,000
F-16
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE E - LONG-TERM INVESTMENTS
Amperion, Inc.
O n November 30, 2004, the Company entered into a Stock Purchase Agreement (“Agreement”) with Amperion, Inc.
("Amperion"), a privately held company. Amperion is engaged in the business of developing networking hardware and
software that enables the delivery of high-speed broadband data over medium-voltage power lines. Pursuant to the
Agreement, the Company invested $500,000 in Amperion in exchange for 11,013,215 shares of Series A Preferred Stock
for an equity interest of approximately 4.7%. The Company has the right to appoint one person to Amperion’s seven-person
board of directors. The Company accounted for this investment under the cost method, as the Company does not have the
ability to exercise significant influence over operating and financial policies of the investee.
It is the policy of the Company to regularly review the assumptions underlying the operating performance and cash flow
forecasts in assessing the carrying values of the investment. The Company identifies and records impairment losses on
investments when events and circumstances indicate that such decline in fair value is other than temporary. Such indicators
include, but are not limited to, limited capital resources, limited prospects of receiving additional financing, and limited
prospects for liquidity of the related securities. The Company determined that its investment in Amperion was impaired
based upon forecasted discounted cash flow. Accordingly, the Company wrote-off $400,000 of the carrying value of its
investment through a charge to operations during the year ended December 31, 2005. The remaining value of the
Company’s investment in Amperion is $100,000 at December 31, 2005.
BPL Global, Ltd.
O n February 4, 2005, the Company approved its investment in BPL Global, Ltd. (“BPL Global”), a privately held
company. During the year-end December 31, 2005, the Company has funded an aggregate of $131,000 of this commitment.
This investment represents an equity interest of approximately 6.21% at December 31, 2005. BPL Global is engaged in the
business of developing broadband services via power lines through joint ventures in the United States, Asia, Eastern
Europe and the Middle East. The Company accounted for this investment under the cost method, as the Company does not
have the ability to exercise significant influence over operating and financial policies of the investee. The Company
reviewed the assumptions underlying the operating performance and cash flow forecasts in assessing the carrying values of
the investment. The fair value of the Company's investment in BPL Global, Ltd. remained at $131,000 as of December 31,
2005.
NOTE F - CONVERTIBLE PROMISSORY NOTES PAYABLE
A summary of convertible promissory notes payable at December 31, 2005 and 2004 is as follows:
Convertible Senior Notes payable (“Convertible Senior Notes”), accrue interest
at 7.25% per annum and provide for equal monthly principal installments
beginning March 1, 2006. Maturity date is in October 2008. Noteholder has
the option to convert unpaid note principal together with accrued and unpaid
interest to the Company’s common stock at a rate of $5.0 per share at any
time.
Debt Discount - beneficial conversion feature, net of accumulated amortization
of $89,163 and $0 at December 31, 2005 and 2004, respectively.
Debt Discount - value attributable to warrants attached to notes, net of
accumulated amortization of $175,958 and $0 at December 31, 2005 and
2004, respectively.
Convertible notes payable (“Series B Debenture”), in quarterly installments of
interest only at 8% per annum, unsecured and due three years from the date of
the note with the latest maturity February 2006; Noteholder has the option to
convert unpaid note principal together with accrued and unpaid interest to the
Company’s common stock at a rate of $.55 per share six months after
issuance. All of the Series B Debenture were repaid or converted to the
Company’s common stock as of December 31, 2005.
Debt Discount - beneficial conversion feature, net of accumulated amortization
of $49,243 and $49,249 at December 31, 2005 and 2004, respectively.
2005
2004
$
20,000,000 $
(1,390,137)
(2,743,342)
15,866,521 $
$
-
-
-
-
-
-
210,000
(49,243)
Debt Discount - value attributable to warrants attached to notes, net of
accumulated amortization of $22,847 and $22,841 at December 31, 2005 and
2004, respectively.
Total
Less: current portion
-
$
$
15,866,521 $
(6,250,000)
9,616,521 $
(22,847)
137,910
137,910
-
137,910
F-17
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE F - CONVERTIBLE PROMISSORY NOTES PAYABLE (Continued)
Aggregate maturities of long-term debt as of December 31, 2005 are as follows:
Fiscal Year
2006
2007
2008
Amount
$ 6,250,000
7,500,000
6,250,000
$20,000,000
Convertible Senior Notes
During the year ended December 31, 2005, the Company issued a convertible senior debt financing of $20 million
(“Convertible Senior Notes”) to sophisticated investors in exchange for $20,000,000. The Company received proceeds of
$18,780,590, net of costs and fees in the amount of $1,219,410. The Convertible Senior Notes accrue interest at 7.25%
per annum and call for monthly principal installments beginning March 1, 2006. The maturity date is 3 years from the
issuance of the notes. At any time or times, the Noteholders shall be entitled to convert any portion of the outstanding
and unpaid note amount into fully paid and nonassessable Common Shares at $5 per share. At any time at the option of
the Company, the principal payments may be paid either in cash or in common stock at the lower of $5 or 92.5% of the
average recent market price. At any time after six months should the stock trade at or above $8.75 for 20 of 30
consecutive trading days, the Company can cause a mandatory redemption and conversion to shares at $5 per share. At
any time, the Company can pre-pay the notes with cash or common stock. Should the Company pre-pay the Notes other
than by mandatory conversion, the Company must issue additional warrants to the Noteholders covering 65% of the
amount pre-paid at a strike price of $5 per share. In addition to standard financial covenants, the Company has agreed to
maintain a letter of credit in favor of the Noteholders equal to $10 million (Note A). Once the Note declines below $15
million, the balance is reduced by $.50 for every $1 amortized. The Company also has covenants requiring a minimum
revenue test of $9 million through 2006, measured quarterly. In accordance with Emerging Issues Task Force Issue 98-5,
Accounting for Convertible Securities with a Beneficial Conversion Features or Contingently Adjustable Conversion
Ratios ("EITF 98-5"), the Company recognized an imbedded beneficial conversion feature present in the notes.
The Company allocated a portion of the proceeds equal to the intrinsic value of that feature to additional paid in capital.
The Company recognized and measured an aggregate of $1,479,300 of the proceeds, which is equal to the intrinsic value
of the imbedded beneficial conversion feature, to additional paid in capital and a discount against the Notes issued during
the year ended December 31, 2005. The debt discount attributed to the beneficial conversion feature is amortized over
the Notes maturity period (three years) as interest expense.
In connection with the placement of the Notes in October 2005, the Company has also agreed to issue one million
warrants to the Noteholders exercisable for five years at $5 per share. The Company recognized the value attributable to
the warrants in the amount of $2,919,300 to a derivative liability due to the possibility of the Company having to make a
cash settlement, including penalties, in the event the Company failed to register the shares underlying the warrants under
the Securities Act of 1933, as amended, within 90 days after the closing of the transaction. The Company accounted for
this warrant derivative in accordance with EITF 00-19 Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company's Own Stock. The warrants were included as a liability and valued at fair market value
until the Company met the criteria under EITF 00-19 for permanent equity. A registration statement covering the
convertible notes issued, along with the shares underlying the warrants, was filed with the Securities and Exchange
Commission on Form S-3 on November 23, 2005 and was declared effective on December 13, 2005. The warrant
derivative liability was valued at the issuance date of the Notes in the amount of $2,919,300 and then revalued at
$2,910,700 on December 13, 2005 upon the effective of the Form S-3. The Company charged to Other Income in the
amount of $8,600 and the derivative warrant liability was reclassified to additional paid in capital at December 13, 2005.
The Company valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the
following assumptions: contractual terms of 5 years, an average risk free interest rate of 4.00%, a dividend yield of 0%,
and volatility of 76%. The $2,919,300 of debt discount attributed to the value of the warrants issued is amortized over
the Notes maturity period (three years) as interest expense.
Convertible Debentures
During the year ended December 31, 2001, the Company issued convertible promissory notes (the "Debenture-1") to
Company officers, shareholders, and sophisticated investors in exchange for $940,000, exclusive of placement costs and
fees. The Debenture-1 accrues interest at 8% per annum and is payable and due three years from the date of the note with
the latest maturity date of November 2004. Noteholder has the option to convert any unpaid note principal together with
accrued and unpaid interest to the Company's common stock at a rate of $.50 per share six months after issuance. In
accordance with Emerging Issues Task Force Issue 98-5, Accounting for Convertible Securities with a Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios ("EITF 98-5"), the Company recognized an
imbedded beneficial conversion feature present in the Debenture-1 note.
F-18
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE F - CONVERTIBLE PROMISSORY NOTES PAYABLE (Continued)
Convertible Debentures (Continued)
The Company allocated a portion of the proceeds equal to the intrinsic value of that feature to additional paid in capital.
The Company recognized and measured an aggregate of $837,874 of the proceeds, which is equal to the intrinsic value
of the imbedded beneficial conversion feature, to additional paid in capital and a discount against the Debenture-1
issued during the year ended December 31, 2001. The debt discount attributed to the beneficial conversion feature is
amortized over the Debenture-1's maturity period (three years) as interest expense.
In connection with the placement of the Debenture-1 in 2001, the Company issued warrants granting the holders the
right to acquire 940,000 shares of the Company's common stock at $1.00 per share. In accordance with Emerging Issues
Task Force Issue 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments ("EITF - 0027"), the
Company recognized the value attributable to the warrants in the amount of $77,254 to additional paid in capital and a
discount against the Debenture-1 issued during the year ended December 31, 2001. The Company valued the warrants
in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual
terms of 3 years, an average risk free interest rate of 4.25%, a dividend yield of 0%, and volatility of 21%. The debt
discount attributed to the value of the warrants issued is amortized over the Debenture-1's maturity period (three years)
as interest expense.
During the year ended December 31, 2002, the Company issued additional convertible promissory notes (the
"Debenture-1") to Company officers, shareholders, and sophisticated investors in exchange for $749,100, exclusive of
placement costs and fees. The Debenture-1 accrues interest at 8% per annum and is payable and due three years from
the date of the note with the latest maturity date of May 2005. Noteholders have the option to convert any unpaid note
principal together with accrued and unpaid interest to the Company's common stock at a rate of $.50 per share six
months after issuance.
In accordance with Emerging Issues Task Force Issue 98-5, Accounting for Convertible Securities with a Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios ("EITF 98-5"), the Company recognized an
imbedded beneficial conversion feature present in the Debenture-1 note. The Company allocated a portion of the
proceeds equal to the intrinsic value of that feature to additional paid in capital. The Company recognized and measured
an aggregate of $693,018 of the proceeds, which is equal to the intrinsic value of the imbedded beneficial conversion
feature, to additional paid-in capital and a discount against the Debenture-1 issued during the year ended December 31,
2002. The debt discount attributed to the beneficial conversion feature is amortized over the Debenture-1's maturity
period (three years) as interest expense.
In connection with the placement of the Debenture-1 notes in 2002, the Company issued warrants granting the holders
the right to acquire 749,100 shares of the Company's common stock at $1.00 per share. In accordance with Emerging
Issues Task Force Issue 00-27, Application of Issue No. 98-5 To Certain Convertible Instruments ("EITF -0027"), the
Company recognized the value attributable to the warrants in the amount of $56,082 to additional paid-in capital and a
discount against the Debenture-1 issued during the year ended December 31, 2002. The Company valued the warrants
in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual
terms of 3 years, an average risk free interest rate of 1.67%, a dividend yield of 0%, and volatility of 26%. The debt
discount attributed to the value of the warrants issued is amortized over the Debenture-1's maturity period (three years)
as interest expense.
Series B Debentures
In October and December 2002, the Company issued convertible promissory notes (the "Series B Debenture") to
Company officers, shareholders, and sophisticated investors in exchange for $472,900, exclusive of placement costs and
fees. The Series B Debenture accrues interest at 8% per annum and is payable and due three years from the date of the
note with the latest maturity date of December 2005. Noteholders have the option to convert any unpaid note principal
together with accrued and unpaid interest to the Company's common stock at a rate of $.55 per share six months after
issuance.
F-19
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE F - CONVERTIBLE PROMISSORY NOTES PAYABLE (Continued)
In accordance with Emerging Issues Task Force Issue 98-5, Accounting For Convertible Securities With A Beneficial
Conversion Features Or Contingently Adjustable Conversion Ratios ("EITF 98-5"), the Company recognized an
imbedded beneficial conversion feature present in the Series B Debenture note. The Company allocated a portion of
the proceeds equal to the intrinsic value of that feature to additional paid in capital. The Company recognized and
measured an aggregate of $147,859 of the proceeds, which is equal to the intrinsic value of the imbedded beneficial
conversion feature, to additional paid-in capital and a discount against the Series B Debenture issued during the year
ended December 31, 2002. The debt discount attributed to the beneficial conversion feature is amortized over the
Series B Debenture's maturity period (three years) as interest expense.
In connection with the placement of the Series B Debenture notes in 2002, the Company issued warrants granting the
holders the right to acquire 472,900 shares of the Company's common stock at $1.00 per share. In accordance with
Emerging Issues Task Force Issue 00-27, Application Of Issue No. 98-5 To Certain Convertible Instruments ("EITF -
0027"), the Company recognized the value attributable to the warrants in the amount of $68,595 to additional paid-in
capital and a discount against the Series B Debenture issued during the year ended December 31, 2002. The Company
valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the following
assumptions: contractual terms of 3 years, an average risk free interest rate of 1.67%, a dividend yield of 0%, and
volatility of 26%. The debt discount attributed to the value of the warrants issued is amortized over the Series B
Debenture's maturity period (three years) as interest expense.
I n January and February 2003, the Company issued convertible Series B Debentures to Company officers,
shareholders, and sophisticated investors in exchange for $2,027,100, exclusive of placement costs and fees. The
Series B Debentures accrue interest at 8% per annum and are payable and due three years from the date of the note
with the latest maturity date of February 2006. Noteholders have the option to convert any unpaid note principal
together with accrued and unpaid interest to the Company's common stock at a rate of $.55 per share six months after
issuance.
In accordance with Emerging Issues Task Force Issue 98-5, Accounting For Convertible Securities With A Beneficial
Conversion Features Or Contingently Adjustable Conversion Ratios ("EITF 98-5"), the Company recognized an
imbedded beneficial conversion feature present in the Series B Debenture note. The Company allocated a portion of
the proceeds equal to the intrinsic value of that feature to additional paid in capital. The Company recognized and
measured an aggregate of $1,761,675 of the proceeds, which is equal to the intrinsic value of the imbedded beneficial
conversion feature, to additional paid-in capital and a discount against the Series B Debentures issued during the year
ended December 31, 2003. The debt discount attributed to the beneficial conversion feature is amortized over the
Series B Debentures maturity period (three years) as interest expense.
In connection with the placement of the Series B Debenture notes in January and February 2003, the Company issued
warrants granting the holders the right to acquire 2,027,100 shares of the Company's common stock at $1.00 per share.
In accordance with Emerging Issues Task Force Issue 00-27, Application Of Issue No. 98-5 To Certain Convertible
Instruments ("EITF -0027"), the Company recognized the value attributable to the warrants in the amount of $265,425
to additional paid-in capital and a discount against the Series B Debentures issued during the year ended December 31,
2003. The Company valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and
the following assumptions: contractual terms of 3 years, an average risk free interest rate of 1.25%, a dividend yield of
0%, and volatility of 26%. The debt discount attributed to the value of the warrants issued is amortized over the Series
B Debentures maturity period (three years) as interest expense.
F-20
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE F - CONVERTIBLE PROMISSORY NOTES PAYABLE (Continued)
During the year ended December 31, 2003, the Debenture-1 noteholders demanded registration of that number of common
shares of the Company sufficient to cover the conversion of their debentures and exercise of the attached warrants.
Accordingly, the Company notified the Series B Debenture noteholders, Senior noteholders (Note G) and warrant holders
with piggy-back registration rights of their right to participate in the registration. During the year ended December 31, 2003,
the Company issued an aggregate of 7,217,836 shares of common stock in connection with the conversion of $1,627,100
aggregate principal amount of the Debenture-1 and $2,180,000 aggregate principal amount of the Series B Debentures. The
Company also issued an aggregate of 525,403 shares of common stock in exchange for accrued interest of $195,148 and
$85,586 for Debenture-1 and Series B debenture, respectively. (Note H).
During the year ended December 31, 2004, the Company issued additional 324,000 shares of its common stock in
connection with the conversion of $62,000 aggregate principal amount of the Debenture-1 and $110,000 aggregate principal
amount of the Series B Debentures. The Company also issued an aggregate of 42,999 shares of common stock in exchange
for accrued interest of $23,276 for Debenture 1 and Series B Debentures. (Note H). All of the Debenture-1 were converted to
the Company’s common stock as of December 31, 2004. During the year ended December 31, 2005, the Company issued an
aggregate of 363,636 shares of common stock and $10,000 of cash to its Series B Debenture holders in exchange for
$200,000 and $10,000 of debt, respectively. The Company also issued an aggregate of 51,114 shares of common stock in
exchange for accrued interest of $28,131 for the Series B Debentures. All of the Series B Debentures were repaid or
converted to the Company’s common stock as of December 31, 2005.
In connection with the conversion of Debenture-1 and Series B Debentures, the Company wrote off the unamortized debt
discount attributed to the beneficial conversion feature and the value of the attached warrants in the amount of $134,135 and
$531, respectively, during the year ended December 31, 2004 and an additional $2,046,479 and $296,470, respectively,
during the year ended December 31, 2003.
The Company amortized the Convertible Senior Notes, Debenture-1 and the Series B Debenture debt discount attributed to
the beneficial conversion feature and the value of the attached warrants, and recorded non-cash interest expense in the
amount of $337,211, $32,040 and $744,695 for the years ended December 31, 2005, 2004 and 2003, respectively.
NOTE G - SENIOR NOTES PAYABLE
I n the second quarter of 2003, the Company issued Senior Notes to Company officers, shareholders, and sophisticated
investors in exchange for $5,000,000, exclusive of placement costs and fees. The Senior Notes are denominated in units of
$100,000, accrue interest at 8% per annum and are due three years from the date of issuance with the latest maturity date of
June 2006. Attached to each Senior Note are warrants to purchase 125,000 shares of common stock. The warrants have a
three-year contractual life and are exercisable immediately after the issuance of the Senior Note at exercise price of $1.00 per
share. The Senior Notes are secured by a first priority security interest in all intellectual property assets of the Company. The
Company plans to use the Senior Note proceeds for expansion of sales, marketing and strategic partnership programs,
building required infrastructure and for working capital.
In September 2003, certain Senior noteholders elected to surrender their Senior Notes as consideration for the exercise of
warrants to purchase shares of common stock of the Company. The Company issued an aggregate of 2,011,000 restricted
shares of common stock for warrants exercised at $1.00 per share, in exchange for $2,011,000 of Senior Notes. In January
2004, certain senior note holders elected to convert $2,539,000 of their senior notes into 1,209,038 shares of common stock
of the Company, at a conversion price of $2.10 per share (Note H). During the year ended December 31, 2005, the Company
repaid $350,000 of Senior Notes in cash. The remaining outstanding balance of senior notes as of December 31, 2005 and
2004 was $100,000 and $450,000, respectively.
NOTE H - CAPITAL STOCK
The Company has authorized 15,000,000 shares of preferred stock, with a par value of $.001 per share. As of December 31,
2005, 2004 and 2003, the Company has no preferred stock issued and outstanding. The company has authorized 100,000,000
shares of common stock, with a par value of $.001 per share. As of December 31, 2005, 2004 and 2003, the Company has
45,765,171, 44,335,989 and 30,689,522 shares, respectively, of common stock issued and outstanding.
F-21
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE H - CAPITAL STOCK (Continued)
During the year ended December 31, 2003, the Company issued 109,333 shares of common stock for an aggregate purchase
price of $110,833 to certain employees upon exercise of employee stock options at approximately $1.01 per share.
Additionally, the Company issued 187,499 shares of common stock for an aggregate purchase price of $187,500 to
consultants upon exercise of non-employee stock options at approximately $1.00 per share. The Company also issued 333
shares of common stock for $666 of cash, net of costs and fees.
During the year ended December 31, 2003, the Company issued 315,000 shares of common stock for an aggregate purchase
price of $157,500 to one of the Company's directors upon exercise of employee stock options exercised at $0.50 per share
During the year ended December 31, 2003, the Company issued an aggregate of 149,498 shares of common stock, having an
aggregate fair market value of $319,105, to consultants in exchange for services rendered, which approximated the fair value
of the shares issued during the period services were completed and rendered.
During the year ended December 31, 2003, the Company issued an aggregate of 7,217,836 shares of common stock to its
convertible debenture holders in exchange for $3,807,100 of debt (Note F). The Company also issued an aggregate of
525,403 shares of common stock in exchange for accrued interest of $280,734 for Debenture 1 and Series B Debentures
(Note F).
During the year ended December 31, 2003, the Company issued an aggregate of 3,599,250 and 500,000 shares of common
stock for warrants exercised at $1.00 and $0.50 per share, respectively.
During the year ended December 31, 2003, the Company issued an aggregate of 2,011,000 restricted shares of common
stock for warrants exercised at $1.00 per share, in exchange for $2,011,000 of Senior Notes (see Note G).
During the year ended December 31, 2003, the Company issued an aggregate of 36,000 shares of common stock to an
employee in exchange for $64,469 of services rendered, which approximated the fair value of the shares issued during the
period services were completed and rendered. Compensation costs of $64,469 were charged to operations.
During the year ended December 31, 2004, the Company issued 540,399 shares of common stock for an aggregate purchase
price of $582,898 to certain employees upon exercise of employee stock options at approximately $1.08 per share.
Additionally, the Company issued 328,333 shares of common stock for an aggregate purchase price of $328,333 to
consultants upon exercise of non-employee stock options at approximately $1.00 per share.
During the year ended December 31, 2004, the Company issued an aggregate of 63,566 shares of common stock, having an
aggregate fair market value of $196,315, to consultants in exchange for services rendered, which approximated the fair value
of the shares issued during the period services were completed and rendered.
During the year ended December 31, 2004, the Company issued an aggregate of 1,209,038 of restricted shares of common
stock upon the election of certain senior note holders to convert their senior notes into equity at a conversion price of $2.10
per share (Note G).
During the year ended December 31, 2004, the Company issued 6,387,600 shares of its common stock for an aggregate
purchase price of $12,726,843, net of costs and fees.
During the year ended December 31, 2004, the Company issued an aggregate of 4,000,950 shares of common stock upon the
exercise of warrants at approximately $1.00 per share and an aggregate of 368,867 shares of common stock in exchange for
448,407 outstanding warrants.
During the year ended December 31, 2004, the Company issued an aggregate of 50,000 shares of common stock to
consultants pursuant to warrants exercised at $2.54 per share.
F-22
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE H - CAPITAL STOCK (Continued)
During the year ended December 31, 2004, the Company issued an aggregate of 324,000 shares of common stock in
connection with the conversion of $62,000 aggregate principal amount of the Debenture-1 and $110,000 aggregate
principal amount of the Series B Debentures. The Company also issued an aggregate of 42,999 shares of common stock in
exchange for accrued interest of $23,276 for Debenture 1 and Series B Debentures (Note F).
During the year ended December 31, 2004, the Company issued an aggregate of 36,000 shares of common stock to an
employee in exchange for $107,779 of services rendered, which approximated the fair value of the shares issued during the
period services were completed and rendered. Compensation costs of $107,779 were charged to operations.
In March 2004, the Company entered into consulting agreements (the “Agreements”) with Aware Capital Consultants, Inc.
and Scarborough, Ltd. (“Consultants”). Pursuant to the Agreements, the Company issued an aggregate of 1,000,000 shares
of its restricted common stock to Consultants in exchange for professional services rendered and to be rendered. In
accordance with Emerging Issues Task Force Issue 96-18, Accounting for Equity Instruments That Are Issued to Other
Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (“EITF 96-18”), the measurement date
to determine fair value was the date at which a commitment for performance by the counter party to earn the equity
instrument was reached. The Company valued the shares issued for consulting services at the rate which represents the fair
value of the services received which did not differ materially from the value of the stock issued. Compensation cost of
$2,500,000 was charged to operations during the year ended December 31, 2004.
The Company reorganized its capital structure in January 2002 whereby the Company agreed to repurchase common stock
held by the founders of the Company. All founders shares were returned and canceled in March 2002, except for 705,285
shares which remained outstanding, but were subject to repurchase by the Company pending receipt of the share certificate
evidencing those shares. During the year ended December 31, 2004, the remaining 705,285 shares of founder’s stock were
returned to and canceled by the Company.
During the year ended December 31, 2005, the Company issued an aggregate of 415,989 shares of common stock for an
aggregate purchase price of $496,493 to certain employees upon exercise of employee stock options at approximately $1.19
per share. Additionally, the Company issued an aggregate of 172,395 shares of common stock for an aggregate purchase
price of $356,145 to consultants upon exercise of non-employee stock options at $2.07 per share (Note I).
During the year ended December 31, 2005, the Company issued an aggregate of 1,968 shares of common stock, having an
aggregate fair market value of $9,002, to consultants in exchange for services rendered, which approximated the fair value
of the shares issued during the period services were completed and rendered. Compensation costs of $9,002 were charged
to operations during the year ended December 31, 2005.
The Company issued an aggregate of 321,900 shares of common stock to its convertible noteholders upon the exercise of
warrants at $1.00 per share. The Company also issued 36,150 shares of common stock in exchange for 50,000 cashless
warrants exercised (Note I).
The Company issued an aggregate of 36,000 shares of common stock to an employee in exchange for $163,319 of services
rendered, which approximated the fair value of the shares issued during the period services were completed and rendered.
Compensation costs of $163,319 were charged to operations during the year ended December 31, 2005.
The Company issued an aggregate of 30,000 shares of common stock to a member of the board of directors in exchange for
$127,796 of consulting services rendered, which approximated the fair value of shares issued during the period services
were completed and rendered. Compensation costs of $127,796 were charged to operations during the year ended
December 31, 2005.
During the year ended December 31, 2005, the Company issued an aggregate of 363,636 shares of common stock to its
convertible debenture holders in exchange for $200,000 of Series B Debentures. The Company also issued an aggregate of
51,114 shares of common stock in exchange for accrued interest of $28,131 for Series B Debentures (Note F and J).
F-23
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE I - STOCK OPTIONS AND WARRANTS
Employee Stock Options
The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s
common stock issued to employees of the Company under a non-qualified employee stock option plan.
Options Outstanding
Options Exercisable
Exercise Prices
$ 1.00 - $1.99
$ 2.00 - $2.99
$ 3.00 - $3.99
$ 4.00 - $4.99
$ 5.00 - $5.99
Number
Outstanding
5,813,578
2,136,000
1,716,500
185,000
300,000
10,151,078
Weighted
Average
Remaining
Contractual
Life (Years)
6.96
7.76
8.76
9.20
9.07
7.54
Weighted
Average
Exercise Price
$ 1.00
$ 2.28
$ 3.31
$ 4.45
$ 5.22
$ 1.85
Number
Exercisable
Weighted
Average
Exercise Price
5,751,078
1,044,250
502,083
14,250
35,750
7,347,411
$ 1.00
$ 2.25
$ 3.44
$ 4.51
$ 5.14
$ 1.37
Transactions involving stock options issued to employees are summarized as follows:
Outstanding at January 1, 2003
Granted
Exercised (Note H)
Cancelled or expired
Outstanding at December 31, 2003
Granted
Exercised (Note H)
Cancelled or expired
Outstanding at December 31, 2004
Granted
Exercised (Note H)
Cancelled or expired
Outstanding at December 31, 2005
Number of
Shares
Weighted
Average
Price Per Share
1.00
1.22
1.01
1.00
1.19
3.06
1.08
1.74
1.61
3.97
1.18
3.74
1.85
1,950,000 $
7,202,333
(109,333)
(750,000)
8,293,000 $
2,108,000
(540,399)
(245,834)
9,614,767 $
1,325,000
(415,989)
(372,700)
10,151,078 $
The weighted-average fair value of stock options granted to employees during the years ended December 31, 2005, 2004
and 2003 and the weighted-average significant assumptions used to determine those fair values, using a Black-Scholes
option pricing model are as follows:
Significant assumptions (weighted-average):
Risk-free interest rate at grant date
Expected stock price volatility
Expected dividend payout
Expected option life (in years)
2005
2004
2003
4.50%
71%
-
5.0
1.35%
76%
-
5.0
1.13%
118%
-
10.0
If the Company recognized compensation cost for the non-qualified employee stock option plan in accordance with SFAS
No. 123, the Company’s pro forma net loss and net loss per share would have been $(18,218,378) and $(0.41),
respectively, for the year ended December 31, 2005; and $(20,923,045) and $(0.51), respectively, for the year ended
December 31, 2004 and $(12,869,048) and $(0.62), respectively, for the year ended December 31, 2003.
F-24
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE I - STOCK OPTIONS AND WARRANTS (Continued)
Non-Employee Stock Options
The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s
common stock issued to the Company consultants. These options were granted in lieu of cash compensation for services
performed.
Options Outstanding
Options Exercisable
Exercise Price
$ 1.00
Number
Outstanding
1,841,774
Weighted
Average
Remaining
Contractual Life
(Years)
6.34
Weighed
Average
Exercise Price
$ 1.00
Number
Exercisable
1,758,441
Weighted
Average
Exercise Price
$ 1.00
Transactions involving options issued to non-employees are summarized as follows:
Outstanding at January 1, 2003
Granted
Exercised (Note H)
Canceled or expired
Outstanding at December 31, 2003
Granted
Exercised (Note H)
Canceled or expired
Outstanding at December 31, 2004
Granted
Exercised (Note H)
Canceled or expired
Outstanding at December 31, 2005
Number of
Shares
Weighted
Average
Price Per Share
1.00
1.00
0.96
-
1.00
3.45
1.00
1.00
1.07
3.45
2.07
-
1.00
1,555,000 $
1,900,000
(187,500)
-
3,267,500 $
60,000
(328,331)
(1,000,000)
1,999,169 $
15,000
(172,395)
-
1,841,774 $
T h e estimated value of the non-employee stock options vested during the year ended December 31, 2005 was
determined using the Black-Scholes option pricing model and the following assumptions: expected option life of 4
years, a risk free interest rate of 4.35%, a dividend yield of 0% and volatility of 71%. The amount of the expense
charged to operations in connection with granting the options was $1,191,767, $1,130,780 and $982,390 during the year
ended December 31, 2005, 2004 and 2003, respectively.
Warrants
The following table summarizes the changes in warrants outstanding and the related prices for the shares of the
Company’s common stock issued to non-employees of the Company. These warrants were granted in lieu of cash
compensation for services performed or financing expenses and in connection with placement of convertible
debentures.
Warrants Outstanding
Warrants Exercisable
Exercise Prices
$ 1.00
$ 2.97
$ 5.00
Number
Outstanding
195,000
35,000
1,000,000
Weighted
Average
Remaining
Contractual
Life (Years)
0.35
0.38
2.82
Weighed
Average
Exercise Price
$ 1.00
$ 2.97
$ 5.00
Number
Exercisable
195,000
35,000
1,000,000
Weighted
Average
Exercise Price
$ 1.00
$ 2.97
$ 5.00
1,230,000
2.36
$ 4.31
1,230,000
$ 4.31
F-25
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE I - STOCK OPTIONS AND WARRANTS (Continued)
Warrants (Continued)
Transactions involving warrants are summarized as follows:
Outstanding at January 1, 2003
Granted
Exercised (Note H)
Canceled or expired
Outstanding at December 31, 2003
Granted
Exercised (Note H)
Canceled or expired
Outstanding at December 31, 2004
Granted
Exercised (Note H)
Canceled or expired
Outstanding at December 31, 2005
Number of
Shares
Weighted
Average
Price Per Share
$ 0.84
1.01
0.92
-
1.01
-
0.99
1.00
1.12
4.85
1.00
1.00
4.31
3,531,460
8,591,800
(6,963,770)
-
5,159,490 $
-
(4,468,590)
(115,000)
575,900 $
1,040,000
(371,900)
(14,000)
1,230,000 $
The Company capitalized financing costs of $87,217 for compensatory warrants granted in connection with placement of
convertible debentures during the year ended December 31, 2003. The financing cost was amortized over the life of the
convertible debentures and all unamortized financing cost was expensed upon the conversion of the convertible
debentures during the year ended December 31, 2003. The Company did not granted any warrants during the year ended
December 31, 2004. The Company granted 1,000,000 warrants to Convertible Senior Notes holders (Note F) and 40,000
compensatory warrants
the year ended December 31, 2005. The estimated value of
compensatory warrants granted and previously granted warrants vested during the period ended December 31, 2005 was
determined using the Black-Scholes option pricing model and the following assumptions: contractual term of 3 years, a
risk free interest rate of approximately 4.50%, a dividend yield of 0% and volatility of 71%. Compensation expense of
$162,453, $50,096 and $30,872 was charged to operations for the year ended December 31, 2005, 2004 and 2003,
respectively.
to non-employees during
NOTE J - RELATED PARTY TRANSACTIONS
In January 2003, the Company entered into an informal agreement with Warren V. Musser, Chairman of the Board of
Directors, pursuant to which the Company agreed to pay Mr. Musser a commission equal to 8.0% of the aggregate value
of Series B Debentures purchased by persons referred to Telkonet, Inc. by Mr. Musser. Pursuant to this agreement, Mr.
Musser received $8,000 during the year ended December 31, 2003.
In January 2003, the Company entered into an informal agreement with Howard Lubert, Telkonet's formed Chief
Executive Officer, pursuant to which the Company agreed to pay Mr. Lubert a commission equal to 8.0% of the aggregate
value of the Series B Debentures purchased by persons referred to Telkonet, Inc. by Mr. Lubert. Pursuant to this
agreement, Mr. Lubert received $12,000 during the year ended December 31, 2003.
F-26
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE J - RELATED PARTY TRANSACTIONS (Continued)
In January 2003, the Company entered into an employment agreement with Ronald W. Pickett, President and Chief
Executive Officer of the Company, to provide for an annual compensation of $100,000 and 3,000 shares of restricted
stock from the Employee Stock Option Plan for each month that he serves as President. As of December 31, 2005, 2004
and 2003, the Company has provided for the issuance of 36,000 shares of its common stock to Mr. Pickett each year
(Note H).
I n September 2003, the Company entered into a consulting agreement that provides for annual compensation of
$100,000, payable monthly, with The Musser Group, an entity controlled by the Company's Chairman of the Board of
Directors, for certain services. As of December 31, 2005, 2004 and 2003, an aggregate of $100,000, $100,000 and
$33,333 of consulting fees was charged to income pursuant to the agreement, respectively.
I n July 2005, the Company entered into a Professional Services Agreement for international consulting with Seth
Blumenfeld, a member of the board of directors. Pursuant to the terms of the agreement, Mr. Blumenfeld received
10,000 shares of Company stock upon execution of the agreement, 10,000 shares of Company stock per quarter for the
first year and 5,000 shares of Company stock per quarter thereafter plus a five percent (5%) commission. The stock
awarded to Mr. Blumenfeld pursuant to the agreement is restricted stock. The agreement has a one year term, which is
renewable annually upon both parties' agreement. As of December 31, 2005, the Company issued 30,000 common shares
and an aggregate of $127,766 was charged to operations.
I n December 2005, the Company issued an aggregate of 363,636 shares of common stock to Ronald W. Pickett,
President and Chief Executive Officer of the Company, a convertible debenture holder in exchange for $200,000 of
Series B Debentures. The Company also issued an aggregate of 48,858 shares of common stock in exchange for accrued
interest of $26,872 for Series B Debentures. In addition, the Company issued an aggregate of 200,000 shares of common
stock upon the exercise of warrants at $1.00 per share upon conversion of the notes. (Note F and H).
NOTE K - INCOME TAXES
The Company has adopted Financial Accounting Standard No. 109 which requires the recognition of deferred tax
liabilities and assets for the expected future tax consequences of events that have been included in the financial
statement or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference
between financial statements and tax bases of assets and liabilities using enacted tax rates in effect for the year in which
the differences are expected to reverse.
A reconciliation of tax expense computed at the statutory federal tax rate on loss from operations before income taxes to
the actual income tax expense is as follows:
Tax provision computed at the statutory rate
Deferred state income taxes, net of federal income tax
benefit
Book expenses not deductible for tax purposes
U.S. NOL created from stock option exercise
U.S. deferred tax liability for beneficial conversion feature
Change in valuation allowance for deferred tax assets
Income tax expense
F-27
2005
2004
$ (5,522,000) $ (4,583,000) $ (2,680,000)
2003
(525,000)
19,000
-
15,000
-
5,000
(463,000)
518,000
(404,000)
-
-
617,000
5,973,000 4,972,000 2,058,000
--
$
-- $
-- $
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE K - INCOME TAXES (Continued)
The Company has provided a valuation reserve against the full amount of the net deferred tax assets, because in the opinion
of management, it is more likely than not that these tax assets will not be realized. Approximately $877,000 of the valuation
allowance relates to stock option expense for which subsequently recognized tax benefits will be allocated to Additional Paid
in Capital.
Deferred income taxes include the net tax effects of net operating loss (NOL) carryforwards and the temporary differences
between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax
purposes. Significant components of the Company's deferred tax assets are as follows:
Deferred Tax Assets:
Net operating loss carryforwards
Warrants and non-employee stock options
Investment in Amperion
Other
Total deferred tax assets
2005
2004
$
15,015,000 $
684,000
152,000
487,000
16,338,000
8,983,000
379,000
-
459,000
9,821,000
Deferred Tax Liabilities:
Beneficial Conversion Feature of Convertible Debentures
Property and equipment, principally due to differences in
depreciation
Total deferred tax liabilities
Valuation allowance
Net deferred tax assets
(527,000)
(17,000)
(66,000)
(593,000)
(15,745,000)
-- $
(32,000)
(49,000)
(9,772,000)
--
$
At December 31, 2005, the Company has net operating loss carryforwards of approximately $39,100,000 for federal
income tax purposes which will expire at various dates from 2020 through 2025.
The Company’s NOL and tax credit carryovers may be significantly limited under Section 382 of the Internal Revenue
Code (IRC). NOL and tax credit carryovers are limited under Section 382 when there is a significant “ownership change”
as defined in the IRC. During 2005 and in prior years, the Company may have experienced such ownership changes.
The limitation imposed by Section 382 would place an annual limitation on the amount of NOL and tax credit carryovers
that can be utilized. When the Company completes the necessary studies, the amount of NOL carryovers available may be
reduced significantly. However, since the valuation allowance fully reserves for all available carryovers, the effect of the
reduction would be offset by a reduction in the valuation allowance. Thus, the resolution of this matter would have no
effect on the reported assets, liabilities, revenues and expenses for the periods presented.
F-28
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE L - LOSSES PER COMMON SHARE
The following table presents the computations of basic and dilutive loss per share:
Net loss available to common
shareholders
Basic and fully diluted loss per share
Weighted average common shares
outstanding
$
$
2005
2004
2003
(15,778,281) $
(0.35) $
(13,092,660) $
(0.32) $
( 7,657,936)
(0.37)
44,743,223
41,384,074
20,702,482
For the years ended December 31, 2005, 2004 and 2003, 7,577,208, 9,198,646 and 10,984,201 potential shares,
respectively were excluded from shares used to calculate diluted losses per share as their inclusion would reduce net
losses per share.
NOTE M - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable and accrued liabilities at December 31, 2005 and 2004 are as follows:
Accounts payable
Accrued interest
Accrued payroll and payroll taxes
Warranty
Other
Total
2005
2004
880,802 $
263,806
594,401
24,000
58,863
1,821,872 $
812,602
21,611
348,471
-
13,240
1,195,924
$
$
NOTE N - COMMITMENTS AND CONTINGENCIES
Office Leases
The Company leases office space under a sub-lease agreement through November 2010 for office space which
occupies approximately 11,600 square feet in Germantown, MD. In April 2005, the Company entered into a three-
year lease agreement for 6,742 square feet of commercial office space in Crystal City, Virginia. Pursuant to this
lease, the Company agreed to assume a portion of the build-out cost for this facility. The Company also leases office
space of approximately 1,800 square feet in White Marsh, MD. Additionally, the Company leases two corporate
apartments through May 2006 in Germantown, MD and Crystal City, VA. Commitments for minimum rentals under
non cancelable leases at December 31, 2005 are as follows:
2006
2007
2008
2009
2010 and thereafter
$ 428,907
404,667
217,479
161,195
150,918
$1,363,166
Rental expenses charged to operations for the year ended December 31, 2005, 2004 and 2003 are $389,935,
$165,249 and $74,777, respectively.
F-29
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE N - COMMITMENTS AND CONTINGENCIES (Continued)
Capital Lease Obligations
Development test equipment (Note C) includes the following amounts for capitalized leases at December 31, 2005 and 2004:
Computer equipment and software
Less: accumulated depreciation and
amortization
2005
2004
$
52,000 $
52,000
(26,000)
26,000 $
(15,600)
36,400
$
The Company has computer equipment and software purchased under non-cancelable leases with an original cost of
$52,000. As of December 31, 2005, the Company has paid in full the lease obligation. Depreciation expense of $10,400,
$10,400 and $5,200 in connection with the capital leased equipment was charged to operations during the year ended
December 31, 2005, 2004 and 2003, respectively.
Employment and Consulting Agreements
T h e Company has employment agreements with certain of its key employees which include non-disclosure and
confidentiality provisions for protection of the Company’s proprietary information.
The Company has consulting agreements with outside contractors to provide marketing and financial advisory services.
The Agreements are generally for a term of 12 months from inception and renewable automatically from year to year
unless either the Company or Consultant terminates such engagement by written notice.
Litigation
The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. Although
occasional adverse decisions or settlements may occur, the Company believes that the final disposition of such matters
should not have a material adverse effect on its financial position, results of operations or liquidity.
NOTE O - BUSINESS CONCENTRATION
The sale of certain rental contract agreements and the related capitalized equipment to Hospitality Leasing Corporation in
December 2005 represented $439,074 or approximately 18% of the 2005 revenues (Note D). Revenue from one major
customer represented $136,166 or approximately 19% of 2004 revenues. In 2003, two customers represented $32,762 or
approximately 35% of total 2003 revenues. There were no other customers which represented more than 10% of total
revenues in the three years ended December 31, 2005. There were no outstanding accounts receivable from these major
customers as of the December 31, 2005 and 2004.
Purchases from three (3) major suppliers approximated $598,000 or 48% of purchases, $885,568 or 40% of purchases and
$354,149 or 47% of purchases for the years ended December 31, 2005, 2004 and 2003, respectively. Total accounts
payable of approximately $3,000 or 0.4% of total accounts payable was due to these three suppliers as of December 31,
2005 and approximately $105,000 or 13% of total accounts payable was due to these three suppliers as of December 31,
2004.
NOTE P - SUBSEQUENT EVENTS
Sale of Rental Contracts
In January 2006, the Company consummated a non-recourse sale of certain rental contract agreements which were
previously accounted for as operating leases and the related capitalized equipment with Hospitality Leasing Corporation.
The remaining rental income payments of the contracts were valued at approximately $918,000, excluding the customer
support component of approximately $250,000 which the Company will retain and continue to receive monthly customer
support payments over the remaining average unexpired lease term of 25 months. The Company recognized revenue of
approximately $464,000 for the sale, calculated based on the present value of total unpaid rental payments, and expensed
the associated capitalized equipment cost, net of accumulated depreciation, of approximately $210,000 and expensed
associated taxes of approximately $45,000.
F-30
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE P - SUBSEQUENT EVENTS (Continued)
Acquisition of Microwave Satellite Technologies, Inc.
I n January 2006, the Company acquired a 90% interest in Microwave Satellite Technologies (MST), a communications
technology company that offers complete sales, installation, and service of VSAT and business television networks, and is a
full-service national Internet Service Provider (ISP). The $9 million cash and stock acquisition will provide the Company a
“triple-play” solution to subscribers of HDTV, VoIP telephony and Internet access. The purchase price is payable $1.8
million in cash and 1.6 million unregistered shares of the Company’s common stock. The cash portion of the purchase price
is payable $900,000 at closing and $900,000 payable in January 2007. The stock portion is payable from shares held in
escrow 400,000 shares at closing and the remaining 1,200,000 shares issued based on the achievement of 3,300 “Triple
Play” subscribers over a three year period.
The Company plans to expand the existing operations concentrated in Manhattan throughout New York and to increase its
presence in other major metropolitan cities using the New York system as a template. This acquisition will enable the
Company to establish a subscriber base with recurring revenues. A substantial portion of the purchase price will be allocated
to intangible assets and amortized over the estimated useful life. Intangible assets consist primarily of subscriber rights,
property access rights and network infrastructure. T h e acquisition was accounted for using the purchase method of
accounting under SFAS No. 141.
The value of the Company’s common stock issued as a part of the acquisition was determined based on the average price of
the Company's common stock for several days before the acquisition of MST. The components of the purchase price were as
follows:
Cash
Common stock
Direct acquisition costs
Total purchase price
$ 1,800,000
7,200,000
62,000
$ 9,062,000
The following table presents the purchase price allocation, including professional fees and other related acquisition costs, to
the assets acquired and liabilities assumed, based on their fair values at the date of acquisition:
Current assets
Fixed and other assets
Intangible assets
Goodwill
Total liabilities assumed
Acquisition costs
Total purchase price
$
400,548
1,396,190
2,737,697
5,334,249
(868,684)
62,000
$ 9,062,000
Due to its recent date of acquisition, the purchase price allocation to Intangibles and Goodwill is based upon preliminary
data that is subject to adjustment and could change significantly pending the completion of an independent appraisal to
accurately evaluate this allocation. The Company recognizes goodwill in connection with this acquisition as a result of
MST’s historical development of its subscriber base, high profile customer acquisition, its unique “Triple Play” solution
and strategic industry position. All of the intangible assets, which consist of subscriber rights, property access rights and
network infrastructure, are subject to amortization and have a weighted-average useful life of 10 years. The results of the
acquisition will be included within the consolidated financial statements from its date of acquisition as of January 31,
2006.
F-31
Table of Contents
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE P - SUBSEQUENT EVENTS (Continued)
The following data presents unaudited pro forma revenues, net loss and basic and diluted net loss per share of common stock
for the Company as if the acquisitions discussed above, had occurred on January 1, 2004. The Company has prepared these
pro forma financial results for comparative purposes only. These pro forma financial results may not be indicative of the
results that would have occurred if the Company had completed these acquisitions at the beginning of the periods shown
below or the results that will be attained in the future. Additionally, the Pro forma results for MST does not include the
results associated with the analog subscriber base sold to Cablevision in 2004:
Revenues
Net loss
Net loss per common share outstanding - basic & diluted
Weighted average common shares outstanding - basic &
diluted
$
$
$
Acquisition of Microwave Satellite Technologies, Inc. (Continued)
As Reported
Year Ended December 31, 2005
Pro Forma
Adjustments
1,795,658
(1,132,722)
(.01)
2,488,323 $
(15,919,778) $
(.36) $
Pro Forma
4,283,981
(17,052,500)
(.37)
44,743,223
46,343,223
Year Ended December 31, 2004
Pro Forma
Adjustments
As Reported
Pro Forma
Revenues
Net loss
Net loss per common share outstanding - basic & diluted
Weighted average common shares outstanding - basic &
diluted
$
$
$
698,652 $
(13,092,660) $
(.32) $
2,766,372 $
(558,299) $
.00 $
3,465,024
(13,650,959)
(.32)
41,384,074
42,984,074
F-32
EMPLOYMENT AGREEMENT
Exhibit 10.6
THIS AGREEMENT is by and between MICROWAVE SATELLITE TECHNOLOGIES, INC., a New Jersey corporation
with corporate offices located in Hawthorne, New Jersey (“MST”) and FRANK T. MATARAZZO (“Executive”).
WHEREAS, MST is being acquired by Telkonet, Inc. (the “Acquisition”);
WHEREAS, prior to the Acquisition, MST was a corporation owned by Executive; and
WHEREAS, subject to the Acquisition being completed (the “Effective Date”), MST desires to employ Executive, and
Executive desires to be employed by MST.
NOW THEREFORE, MST hereby employs Executive, and Executive hereby accepts employment with MST on the following
terms and conditions:
1. Duties. MST hereby employs Executive in the capacity of President and Chief Executive Officer. In such capacity,
Executive shall perform the duties of a president and chief executive officer in a professional, supervisory and managerial nature solely
for the benefit of MST and pertaining to the business and affairs of MST as determined by the Board of Directors and/or the Executive
Committee of MST. Executive shall report directly to Telkonet, Inc.’s Chief Executive Officer (the “Telkonet CEO”). Executive’s duties
and responsibilities shall also include, but not be limited to, the following:
(a) Serve as the chief executive officer of MST’s operations and provide leadership for MST’s activities;
(b) Oversee all MDU and, after a transition period as determined by the Telkonet CEO, all the hotel and motel
operations of MST and Telkonet, Inc. In conjunction with the 2006 planning process, the Executive and the Telkonet CEO and/or his
designees will define the geographic boundaries and managed solution offerings to be the Executive’s responsibility;
(c) Hire, compensate, discipline and terminate MST staff within the approved budget, establish job descriptions, duties
and responsibilities of all MST staff in accordance with MST Bylaws, and the policies and procedures of MST, perform regular
evaluations of all MST staff, determine the level of compensation of such staff on the basis of such evaluations, within the approved
budget and in accordance with the policies of MST and have primary responsibility for the day-to-day operations of MST;
(d) Alert and advise the Board of Directors and/or the Executive Committee about reasonably significant matters
needing their attention and action;
(e) Serve as the representative of MST in activities related to its objectives and policies;
(f) Direct the coordination of the activities of MST committees and projects;
(g) Oversee, under the direction of the Board of Directors and with the assistance of MST’s outside certified public
accountant (the “MST Accountant”), the custody and use of all funds, securities, property and, generally, all assets of MST and the
deposit of the funds of MST;
(h) Oversee the preparation of a proposed annual budget of MST;
(i) Oversee the receipt and disbursement of MST funds in accordance with the adopted budget of MST;
(j) Supervise the sales, installation and support of all MST subscriber acquisition activities;
(k) Oversee, develop and expand all aspects of MST’s business, sales and production operations;
(l) Present an annual financial report to the Board of Directors;
(m) Present to the Board of Directors an annual report of all activities of MST;
(n) Negotiate, evaluate and execute all contracts, agreements and commitments arising in the ordinary course of MST’s
business for and on behalf of MST, consistent with the duties and responsibilities set forth above;
(o) Make expenditures consistent with the approved budget of MST; and
(p) Implement all Board directives and perform all such other duties that may be assigned from time-to-time by the
Board of Directors in its discretion.
2. Term. The term of this Agreement (the “Term”) shall commence on the Effective Date and shall expire on December 31,
2008, unless terminated as provided in Section 6 or extended by the written mutual consent of the parties.
3. Extent of Services. During the Term and any extension thereof, Executive shall devote his full time and efforts to the
performance, to the best of his abilities, of such duties and responsibilities inherent in the position of President and Chief Executive
Officer, as described in Section 1 above, and as the Board of Directors and/or the Officers of MST shall determine, consistent therewith.
2
4. Compensation.
(a) Salary. Executive shall be paid Two Hundred Fifty Thousand Dollars ($250,000.00) on an annualized basis in
accordance with MST’s normal payroll practices, and subject to all lawfully required withholding.
(b) Executive Participation in MST Staff Benefits Plans. Following the Effective Date, Executive shall be entitled to
participate in any group health programs and other benefit and incentive plans, which may be instituted from time-to-time for MST
employees, and for which Executive qualifies under the terms of such plans. All such benefits shall be provided on the same terms and
conditions as generally apply to all other MST employees under these plans and may be modified by MST from time-to-time.
(c) Expenses. Subject to approval by the Telkonet CEO, Executive shall be reimbursed by MST for all ordinary,
reasonable, customary and necessary expenses incurred by him in the performance of his duties and responsibilities as President.
Executive agrees to prepare documentation for such expenses as may be necessary for MST to comply with the applicable rules and
regulations of the Internal Revenue Service. MST will provide an auto for the Executive’s business use.
5. Vacation. At full pay and without any adverse effect to his compensation, provided all other terms and conditions of this
Agreement are satisfied, Executive shall be entitled to three (3) weeks of vacation for each full calendar year during the term of this
Agreement. Executive agrees to schedule his vacation leave in advance upon written notice to the Telkonet CEO and at a time with
minimum disruption to MST. Carryover of vacation days in excess of one week is subject to the prior approval of the CEO of Telkonet.
6. Termination. This Agreement shall terminate in accordance with Section 2 of this Agreement, or upon the first to occur of
any of the following events:
(a) The bankruptcy or dissolution of MST;
(b) The death of Executive;
(c) The mutual consent of Executive and MST;
(d) “Cause” exists for termination. For purposes of this Agreement, “cause” shall include, but not be limited to, the
following: (1) theft, fraud, embezzlement, dishonesty or other similar behavior by Executive; (2) any material breach by Executive of any
provision of this Agreement; (3) any habitual neglect of duty or misconduct of Executive in discharging any of his duties and
responsibilities under this Agreement; (4) any conduct of Executive which is detrimental to or embarrassing to MST, including, but not
limited to, Executive being indicated or convicted of a felony or any offense involving moral turpitude; or (5) any default of Executive’s
obligations hereunder, or any failure or refusal of Executive to comply with the policies, rules and regulations of MST, which default,
failure or refusal is not cured within a reasonable time (but not to exceed thirty (30) days) after written notification thereof to Executive by
MST. If cause exists for termination, Executive shall be entitled to no further compensation, except for accrued leave and vacation and
except as may be required by applicable law.
3
7. Surrender of Books and Papers. Upon termination of this Agreement (irrespective of the time, manner, or cause of
termination, be it for cause or otherwise), Executive shall immediately surrender to MST all books, records, or other written papers or
documents entrusted to him or which he has otherwise acquired pertaining to MST and all other MST property in Executive’s possession,
custody or control.
8. Inventions and Patents. Executive agrees that Executive will promptly from time-to-time fully inform and disclose to MST
any and all ideas, concepts, copyrights, copyrightable material, developments, inventions, designs, improvements and discoveries of
whatever nature that Executive may have or produce during the term of Executive’s employment under this Agreement that pertain or
relate to the then current business of MST (the “Creations”), whether conceived by Executive alone or with others and whether or not
conceived during regular working hours. All Creations shall be the exclusive property of MST and shall be “works made for hire” as
defined in 17 U.S.C. §101, and MST shall own all rights in and to the Creations throughout the world, without payment of royalty or other
consideration to Executive or anyone claiming through Executive. Executive hereby transfers and assigns to MST (or its designee) all
right, title and interest in and to every Creation. Executive shall assist MST in obtaining patents or copyrights on all such inventions,
designs, improvements and discoveries being patentable or copyrightable by Executive or MST and shall execute all documents and do all
things necessary to obtain letters of patent or copyright, vest the MST with full and exclusive title thereto, and protect the same against
infringement by others, and such assistance shall be given by Executive, if needed, after termination of this Agreement for whatever cause
or reason. Executive hereby represents and warrants that Executive has no current or future obligation with respect to the assignment or
disclosure of any or all developments, inventions, designs, improvements and discoveries of whatever nature to any previous Employer,
entity or other person and that Executive does not claim any rights or interest in or to any previous unpatented or uncopyrighted
developments, inventions, designs, improvements or discoveries.
9. Trade Secrets, Non-Competition and Non-Solicitation.
(a) Trade Secrets. Contemporaneous with the execution of this Agreement and during the term of employment under
this Agreement, MST shall deliver to Executive or permit Executive to have access to and become familiar with various confidential
information and trade secrets of MST and Telkonet, Inc., including without limitation, data, production methods, customer lists, product
format or developments, other information concerning the business of MST and Telkonet, Inc., and other unique processes, procedures,
services and products of MST and Telkonet, Inc., which are regularly used in the operation of the business of the MST and Telkonet, Inc.
(collectively, the “Confidential Information”). Executive shall not disclose any of the Confidential Information that he receives from
MST, Telkonet, Inc. or their clients and customers in the course of his employment with MST, directly or indirectly, nor use it in any way,
either during the term of this Agreement or at any time thereafter, except as required in the course of employment with MST. Executive
further acknowledges and agrees that Executive owes MST and Telkonet, Inc., a fiduciary duty to preserve and protect all Confidential
Information from unauthorized disclosure or unauthorized use. All files, records, documents, drawings, graphics, processes,
specifications, equipment and similar items relating to the business of MST and/or Telkonet, Inc., whether prepared by Executive or
otherwise coming into Executive’s possession in the course of his employment with MST, shall remain the exclusive property of MST
and Telkonet, Inc. and shall not be removed from the premises of MST and/or Telkonet, Inc. without the prior written consent of MST
and/or Telkonet, Inc. unless removed in relation to the performance of Executive’s duties under this Agreement. Any such files, records,
documents, drawings, graphics, specifications, equipment and similar items, and any and all copies of such materials which have been
removed from the premises of MST and/or Telkonet, Inc., shall be returned by Executive to MST. Executive further acknowledges that
the covenants of Executive herein are intended to include the protection of the confidential information of MST's and Telkonet, Inc.’s
customers and clients, that come into the possession of Executive as a result of his employment with MST, and that such customers and
clients of MST shall be entitled to rely on and enforce these covenants against Executive for their own benefit.
4
(b) Non-Competition. Executive acknowledges that he will be provided with and have access to the Confidential
Information, the unauthorized use or disclosure of which would cause irreparable injury to MST, that MST’s willingness to enter into this
Agreement is based in material part on Executive’s agreement to the provisions of this Section 9(b) and that Executive’s breach of the
provisions of this Section would materially and irreparably damage MST. In consideration for MST’s disclosure of Confidential
Information to Executive, Executive’s access to the Confidential Information, and the salary paid to executive by MST hereunder,
Executive agrees that during Executive’s employment with MST under this Agreement and for one (1) year after the termination of
Executive’s employment and regardless whether such termination is with or without cause, Executive shall not, directly or indirectly,
either as an executive, employee, employer, consultant, agent, principal, partner, stockholder, corporate officer, director, advisor or in any
other individual or representative capacity, engage or participate in any business that is in competition in any manner whatsoever with the
Restricted Business (as defined herein) in New York City and any Major Metropolitan areas MST has committed and deployed, or
undertaken significant development of, its managed solution. “Restricted Business” means (1) any business conducted by MST at any
time prior to, or during Executive’s employment pursuant to this Agreement, and (2) any other related or similar business conducted by
MST or Telkonet, Inc. during Executive’s employment with MST under this Agreement.
(c) Reasonableness of Restrictions. Executive acknowledges that the restrictions set forth in Section 9(b) of this
Agreement are reasonable in scope and necessary for the protection of the business and goodwill of MST. Executive agrees that should
any portion of the covenants in Section 9 be unenforceable because of the scope thereof or the period covered thereby or otherwise, the
covenant shall be deemed to be reduced and limited to enable it to be enforced to the maximum extent permissible under the laws and
public policies applied in the jurisdiction in which enforcement is sought.
(d) Soliciting Executives. Executive shall not during the term of this Agreement or for a period of one (1) year after
termination of Executive’s employment hereunder for any reason, whether by resignation, discharge or otherwise, either directly or
indirectly, employ, enter into agreement with, or solicit the employment of, Executives of MST or Telkonet, Inc. for the purpose of
causing them to leave the employment of MST or Telkonet, Inc. or take employment with any business that is in competition in any
manner whatsoever with the business of MST or Telkonet, Inc.
(e) Injunctive Relief; Extension of Restrictive Period. In the event of a breach of any of the covenants by Executive or
MST contained in this Agreement, it is understood that damages will be difficult to ascertain, and either party may petition a court of law
or equity for injunctive relief in addition to any other relief which Executive or MST may have under the law, including but not limited to
reasonable attorneys’ fees.
5
10. Miscellaneous.
(a) This Agreement shall be binding upon the parties and their respective heirs, executors, administrators, successors and assigns.
Executive shall not assign any part of his rights under this Agreement without the prior written consent of MST.
(b) This Agreement contains the entire agreement and understanding between the parties and supersedes any and all prior
understandings and agreements between the parties regarding Executive’s employment.
(c) No modification hereof shall be binding unless made in writing and signed by the party against whom enforcement is sought.
No waiver of any provisions of this Agreement shall be valid unless the same is in writing and signed by the party against whom it is
sought to be enforced, unless it can be shown through custom, usage or course of action.
(d) This Agreement is executed in, and it is the intention of the parties hereto that it shall be governed by, the laws of the State of
New Jersey.
(e) The provisions of this Agreement shall be deemed to be severable, and the invalidity or unenforceability of any provision
shall not affect the validity or enforceability of the other provisions hereof.
(f) Any notice or communication permitted or required by this Agreement shall be in writing and shall become effective upon
personal service, or service by wire transmission, which has been acknowledged by the other party as being received, or two (2) days
after its mailing by certified mail, return receipt requested, postage prepaid addressed as follows:
(1) If to MST, to the then Chair of the Board at the Chair’s last recorded address on the records of MST, with a copy to the
general counsel for MST.
(2) If to Executive, to:
Frank Matarazzo
258-263 Goffle Road
Hawthorne, New Jersey 07506
6
IN WITNESS WHEREOF, MST and Executive have executed this Agreement as of the Effective Date.
MICROWAVE SATELLITE
TECHNOLOGIES, INC.
EXECUTIVE
By:_____________________________
Name:
Title:
By:____________________________________
Frank T. Matarazzo
7
Exhibit 21
List of Subsidiaries
Name
Telkonet Communications, Inc.
Microwave Satellite Technologies, Inc. (MST)
Interactivewifi.com, LLC (MST subsidiary)
Tevue, LLC (MST subsidiary)
Ownership % State of Incorporation
100.0
90.0
50.0
37.5
Delaware
New Jersey
New Jersey
New Jersey
Exhibit 23
Board of Directors
Telkonet, Inc.
Germantown, MD
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
We consent to incorporation by reference in the Registration Statements (Registration No. 333-114425) on Form S-3 of Telkonet, Inc. and
its wholly-owned subsidiary of our reports dated February 2, 2006, with respect to the consolidated balance sheets of Telkonet, Inc. and its
wholly-owned subsidiary as of December 31, 2005 and 2004, and the related consolidated statements of losses, stockholders' equity, and
cash flows for the three-years ended December 31, 2005, management's assessment of the effectiveness of internal control over financial
reporting as of December 31, 2005 and the effectiveness of internal control over financial reporting as of December 31, 2005, which reports
appear in the December 31, 2005 annual report on Form 10-K of Telkonet, Inc. and its wholly-owned subsidiary
/s/RUSSELL BEDFORD STEFANOU MIRCHANDANI LLP
Russell Bedford Stefanou Mirchandani LLP
Certified Public Accountants
McLean, Virginia
March 16, 2006
Exhibit 31.1
I, Ronald W. Pickett, certify that:
1. I have reviewed this annual report on Form 10-K of Telkonet, Inc.;
Certifications
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period
covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) for the registrant, and have:
(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by
others within those entities, particularly during the period in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed
under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles;
(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions
about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such
evaluation; and
(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s
most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over
financial reporting.
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial
reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent
function):
(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s
internal control over financial reporting.
Date: March 16, 2006
By: /s/ Ronald W. Pickett
Ronald W. Pickett
Chief Executive Officer
Exhibit 31.2
I, E. Barry Smith, certify that:
Certifications
1. I have reviewed this annual report on Form 10-K of Telkonet, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period
covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) for the registrant, and have:
(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by
others within those entities, particularly during the period in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed
under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles;
(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions
about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such
evaluation; and
(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s
most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over
financial reporting.
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial
reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent
function):
(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s
internal control over financial reporting.
Date: March 16, 2006
By: /s/ E. Barry Smith
E. Barry Smith
Chief Financial Officer
Exhibit 32.1
CERTIFICATION PURSUANT TO SECTION 906
OF
THE SARBANES-OXLEY ACT OF 2002
I, Ronald W. Pickett, Chief Executive Officer of Telkonet, Inc. (the “Company”), certify that:
(1) The Annual Report on Form 10-K of the Company for the period ended December 31, 2005 which this certification
accompanies fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of
operations of the Company.
/s/ Ronald W. Pickett
Ronald W. Pickett
Chief Executive Officer
March 16, 2006
Exhibit 32.2
CERTIFICATION PURSUANT TO SECTION 906
OF
THE SARBANES-OXLEY ACT OF 2002
I, E. Barry Smith, Chief Financial Officer of Telkonet, Inc. (the “Company”), certify that:
(1) The Annual Report on Form 10-K of the Company for the period ended December 31, 2005 which this certification
accompanies fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of
operations of the Company.
/s/ E. Barry Smith
E. Barry Smith
Chief Financial Officer
March 16, 2006