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
For the fiscal year ended December 31, 2007
Commission file number: 001-31972
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. __Yes X No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(b) of the Act. __Yes X No
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 __ No
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.
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.
___ Large Accelerated Filer
X Accelerated Filer
___ Non-Accelerated Filer
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) ___ Yes X No
Aggregate market value of the voting stock held by non-affiliates of the registrant as of March 1, 2008: $51,800,422.
Number of outstanding shares of the registrant’s par value $0.001 common stock as of March 1, 2008: 72,039,455.
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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ITEM 1.
DESCRIPTION OF BUSINESS.
Business
PART I
GENERAL
Telkonet, Inc., formed in 1999 and incorporated under the laws of the State of Utah, is a leading provider of innovative, centrally managed
solutions for integrated energy management, networking, building automation and proactive support services.
Through the revolutionary Telkonet iWire System™ and newly released Series 5 platform, Telkonet utilizes proven PLC technology to deliver
commercial high-speed Broadband access from an IP “platform” that is easy to deploy, reliable and cost-effective by leveraging a building’s
existing electrical infrastructure. The building’s existing electrical wiring becomes the backbone of a local area network (LAN), which
converts virtually every electrical outlet into a high-speed data port without the costly installation of additional wiring or major disruption of
business activity.
Through the Company’s majority-owned subsidiary MSTI Holdings, Inc. (MSTI), the Company is able to offer quadruple play (“Quad-Play”)
services to multi-tenant unit (“MTU”) and multi-dwelling unit (“MDU”) residential, hospitality and commercial properties. These Quad- Play
services include video, voice, high-speed internet and wireless fidelity (“Wi-Fi”) access.
The Company’s acquisition of EthoStream, LLC, a leading high-speed wireless internet technology and services provider for the
hospitality industry (as described in greater detail below under “Segment Reporting”), has enabled Telkonet to provide installation and support
for PLC and HSIA products and third party applications to customers across North America. The Company’s new operating division
represented by the assets acquired from Smart Systems International, a leading provider of energy management products and solutions (as
described in greater detail below under “Segment Reporting”), permits the Company to offer new energy management products and solutions
to its customers in the United States and Canada.
As a result of Telkonet's acquisition of Smart Systems International and EthoStream, the Company can now provide hospitality owners with a
greater return on investment on technology investments. Hotel owners can leverage the Telkonet platform to support wired and wireless
Internet access, digital video surveillance, digital displays and the forthcoming networked energy management system. With the synergy of
EthoStream’s centralized remote monitoring and management platform extending over HSIA, digital video surveillance and energy
management, hospitality owners will have a complete technology offering based on Telkonet’s core PLC system as the infrastructure
backbone, demonstrating true technology convergence.
The Company’s headquarters are located at 20374 Seneca Meadows Parkway, Germantown, Maryland 20876. The reports that the Company
files pursuant to the Securities Exchange Act of 1934 can be found at the Company’s web site at www.telkonet.com.
The highlights and business developments for the twelve months ended December 31, 2007 include the following:
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Consolidated revenue growth of 173% driven by acquisitions, as well as an increase in sales of the Telkonet iWire System™
The acquisition of 1,800 hotel customers through the addition of EthoStream to the Telkonet segment in March 2007. As of March
1, 2008, the Company has over 2,300 hotels under management.
The acquisition of exclusive and patented technology from Smart Systems International
The raising of $10 million through a private placement of 4 million shares of common stock
Completion of a merger by 90%-owned Microwave Satellite Technologies, Inc. (MST) with a wholly-owned subsidiary of a
public shell corporation and a subsequent raise by the public shell corporation of $9.1 million through sales of convertible
debentures and a private placement of common stock of the newly formed corporation.
The acquisition of approximately 1,900 internet and telephone subscribers from Newport Telecommunications Co. by the MST
segment in July 2007.
A strategic investment in Geeks on Call America, Inc., the nation's premier provider of on-site computer services
The sale of the Company’s investment in BPL Global for $2,000,000, yielding a gross profit of $1,868,956
The award of a $3.8M Contract with InTown Suites for the installation of the Telkonet SmartEnergy™ (TSE) energy management
system in 125 properties across the U.S.
1
We classify our operations in two reportable segments: the Telkonet Segment and the MST Segment.
Telkonet Segment (“Telkonet”)
Segment Reporting
The Telkonet Segment consists of the Telkonet iWire System™ and Series 5 platform, energy management products, and centrally managed
high-speed internet network platforms integrated to form a complete SAAS technology platform. This segment employs both direct and
indirect sales models to distribute and support its products on a worldwide basis and serves five major markets: hospitality, commercial,
industrial, government (including defense and education) and retail.
The Telkonet iWire System™ and Series 5 platform offer a viable and cost-effective alternative to the challenges of hardwiring and wireless
local area networks (LANs). Telkonet’s products are designed for use in residential, commercial and industrial applications, including multi-
dwelling hospitality, government and utility markets. Applications supported by the Telkonet “platform” include, but are not limited to, VoIP
telephones, internet connectivity, local area networking, video conferencing, closed circuit security surveillance, point of sale, digital signage
and a host of other information services.
Telkonet has been shipping PLC products since 2003, initially targeting the hospitality market followed by the multi-dwelling unit (MDU)
market as well as the government and other commercial markets.
The Company released its Series 5 product on March 1, 2008. The Series 5 product provides enhancements to the Telkonet iWire System™
which include, but are not limited to, the following:
· more than 14 times faster than the legacy product,
· more robust security and data encryption,
· enhanced quality of service, or QOS,
· uses both alternating current and direct current which makes it highly compatible within utility and industrial space,
· increased survivability in harsh environments, and
· additional physical interfaces.
On March 9, 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy
management products and solutions to customers in the United States and Canada for cash and Company common stock having an aggregate
value of $7,000,000. The purchase price was comprised of $875,000 in cash and 2,227,273 shares of the Company’s common stock. 1,090,909
of these shares were held in an escrow account for a period of one year following the closing from which certain potential indemnification
obligations under the purchase agreement could be satisfied. The aggregate number of shares held in escrow was subject to adjustment
upward or downward depending upon the trading price of the Company’s common stock during the one year period following the closing
date. On March 12, 2008, the Company released these shares from escrow and plans to issue an additional 1,909,091 shares pursuant to the
adjustment provision in the SSI asset purchase agreement.
Many of the largest initiatives within Telkonet center on the sale of energy management products and services. The Telkonet SmartEnergy
system uses a combination of occupancy sensors along with intelligent programmable thermostats or controllers to adjust and maintain room
temperature according to occupancy, time of day, and environmental factors, for a preset configuration eliminating wasteful heating and
cooling of unoccupied rooms, and limiting the damaging impact of improper temperature fluctuations. On average, the installation of these
devices can save 30% or more per year on heating and cooling energy consumption.
Thus far the hospitality, MDU, educational, and government industries have been highly interested in energy management devices and
Telkonet has increased sales in these markets consistently during the past three quarters. In addition, Telkonet continues to recognize
increased interest and significant wins internationally with its SmartEnergy offering. Telkonet intends to expand these efforts to facilitate
growth acceleration in the installation of our Telkonet SmartEnergy product line. This effort is supported by the enforcement of new energy
conservation legislation such as the Energy Independence and Security Act signed into law by President Bush on December 19, 2007 which
contains provisions to improve energy efficiency in appliances and commercial products and reduce federal government energy
usage. Telkonet continues to support these initiatives and will remain at the forefront of green technology solutions throughout 2008 with
upcoming introductions such as our networked Telkonet SmartEnergy product line.
2
Additionally, the integration of the Series Five product line with the energy management products will allow Telkonet to use the electrical
grid of commercial buildings as a backbone for the networked Telkonet SmartEnergy solution making it easier, quicker, less intrusive, and
less expensive to install and operate the system within a commercial environment. The benefits of this are twofold. First, reduced costs
provide the possibility of increased margins on Telkonet’s sales. Second, Telkonet has increased price flexibility in order to respond to
competitive market pressures.
On March 15, 2007, the Company acquired 100% of the outstanding membership units of EthoStream, LLC, a network solutions integration
company that offers installation, sales and service to the hospitality industry. The EthoStream, LLC acquisition enables Telkonet to provide
installation and support for PLC products and third party applications to customers across North America. The purchase price of $11,756,097
was comprised of $2.0 million in cash and 3,459,609 shares of the Company’s common stock. The entire stock portion of the purchase price is
being held in escrow to satisfy certain potential indemnification obligations of the sellers under the purchase agreement. The shares held in
escrow are distributable over the three years following the closing.
One of Telkonet’s largest recurring revenue streams is the Milwaukee-based technical support center that was acquired in the EthoStream
acquisition. This support center is one of the only internally-operated hospitality HSIA support centers and the key driver in the quality and
customer satisfaction that EthoStream is credited with. Telkonet’s support center is a fully operating 24/7, 365 day full-service customer
support center that provides e-mail, phone, and technical support not only to hospitality internet access customers but to the third party vendors
as well.
This has been a growth market for the past several years due to business travel demand for high quality internet access in a hotel
room. Additionally, over the past year, the demands for high speed wireless internet access have extended beyond the traditional business
traveler with a significant number of leisure travelers also demanding that the service be available. Over the past few quarters, we partnered
with several large hotel chains allowing us to service more than 2,300 total properties and providing connectivity to more than a million
travelers monthly. We continue these efforts and Telkonet’s hospitality market expansion through working with additional franchisors through
approved or preferred affiliations and franchise upgrades or rollouts.
Competition
Telkonet 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 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. With the exception
of Motorola, which recently introduced a commercial product, these companies do not presently represent a direct competitive threat to
Telkonet since they only market and sell their products in the residential sector.
There can be no assurance that other companies will not develop PLC products that compete with Telkonet’s products in the future. Many
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 and industrial sector, which includes office buildings,
hotels, schools, shopping malls, commercial buildings, multi-dwelling units, government facilities, utilities, substations, and any other
commercial facilities that have a need for Internet access and network connectivity. Telkonet 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 Telkonet’s offerings.
3
Raw Materials
Telkonet has not experienced any significant or unusual problems in the purchase of raw materials or commodities. While Telkonet 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. Telkonet obtains the majority of its raw materials from
the following suppliers: Arrow Electronics, Avnet Electronics Marketing, Digi-Key Corporation, Intellon Corporation, and Versa Technology.
In addition, Superior Manufacturing Services, a U.S. based company, provides substantially all the manufacturing and assembly requirements
for Telkonet iWire System™ and ATR Manufacturing, a Chinese based company, provides substantially all the manufacturing requirements
for the Telkonet SmartEnergy products.
Customers
Telkonet is neither limited to, nor reliant upon, a single or narrowly segmented consumer base from which it derives its revenues. Presently,
Telkonet is not dependent on any particular customer under contract. Telkonet’s primary focus is in the hospitality, commercial, industrial and
government markets.
Revenue from one (1) major customer approximated $1,436,838 or 10% of total revenues for the year ending December 31, 2007. Total sales
of rental contract agreements (Note F) and the related capitalized equipment to Hospitality Leasing Corporation approximated $705,000 and
$252,000 in the year ending December 31, 2006, and $439,000 and $0 in the year ending 2005, which constituted approximately 18% and
approximately 18% of total revenue, respectively, and represented the only major customer for years then ended.
Intellectual Property
Telkonet has applied for patents that cover the unique technology integrated into the Telkonet iWire System TM and Series 5 product suite.
Telkonet also 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 of the Telkonet iWire SystemTM and Series 5 product suite.
In December 2005, the United States Patent and Trademark Office issued Patent No: 6,975,212 titled “Method and Apparatus for Attaching
Power Line Communications to Customer Premises”. The patent covers the method and apparatus for modifying a three-phase power
distribution network in a building in order to provide data communications by using a PLC signal to an electrical central location point of the
power distribution system. Telkonet’s Coupler technology enables the conversion of electrical outlets into high-speed data ports without costly
installation, additional wiring, or significant disruption of business activity. The Coupler is an integral component of the Telkonet iWire
SystemTM and Series 5 product suites.
In August 2006, the United States Patent and Trademark Office issued Patent No: 7,091,831, titled "Method and Apparatus for Attaching
Power Line Communications to Customer Premises". The patented technology incorporates a safety disconnect circuit breaker into the
Telkonet Coupler, creating a single streamlined unit. In doing so, installation of the Telkonet iWire System(TM) is faster, more efficient, and
more economical than with separate disconnect switches, delivering optimal signal quality. The Telkonet Integrated Coupler Breaker patent
covers the unique technique used for interfacing and coupling its communication devices onto the three-phase electrical systems that are
predominant in commercial buildings.
In January 2007, the United States Patent and Trademark Office issued Patent No: 7,170,395 titled “Methods and Apparatus for Attaching
Power Line Communications to Customer Premises” for Delta phase power distribution system applications, which are prevalent in the
maritime industry, shipboard systems, along with that of heavy industrial plants and facilities.
The Company acquired certain intellectual property in the SSI acquisition, including Patent No: 5,395,042, titled “Apparatus and Method for
automatic climate control,” which was issued by the United States Patent Trademark Office in March 1995. This invention calculates and
records the amount of time needed for the thermostat to return the room temperature to the occupant’s set point once a person re-enters the
room
In addition to the foregoing, Telkonet currently has multiple patent applications under examination, and intends to file additional patent
applications covering a wide range of technologies including that of improved network topologies and techniques for imposing LANs over
existing wired infrastructure.
4
Telkonet has also filed multiple Patent Cooperation Treaty (PCT) patent applications, which have been used to file national patent applications
in foreign countries including the European Union, Japan, China, Russia, India and others.
Notwithstanding the issuance of these patents, there can be no assurance that any of Telkonet’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.
In January 2003, Telkonet received Federal Communications Commission (FCC) approval to market the Telkonet iWire System TM product
suite. 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. An
independent, FCC-certified testing lab has verified the Company’s Gateway complies with the FCC technical requirements for Class A digital
devices. No further testing of this device is required and the device may be manufactured and marketed for commercial use.
In December 2003, Telkonet received approval from the U.S. Patent and Trademark Office for its “Method and Apparatus for Providing
Telephonic Communication Services” Patent No.: 6,668,058. This invention covers the utilization of an electrical power grid, for a
concentration of electrical power consumers, and use of existing consumer power lines to provide for a worldwide voice and data telephony
exchange
In March 2005, Telkonet received final certification of its Telkonet iWire System TM product suite from European Union (EU) authorities,
which certification was required before Telkonet could sell and permanently install the Telkonet iWire System TM in EU countries. As a result
of the certification, the Telkonet iWire SystemTM that will be sold and installed in EU countries will bear the Conformite Europeene (CE)
mark, a symbol that demonstrates that the product has met the EU’s regulatory standards and is approved for sale within the EU. Telkonet
now has satisfied the governmental requirements for product safety and certification in the EU and is free to sell and install the Telkonet iWire
SystemTM product suite in the EU.
In June 2005, Telkonet received the National Institute of Standards and Technology (NIST) Federal Information Processing Standard
(FIPS) 140-2 validation for the Gateway. In July 2005, Telkonet received FIPS 140-2 validation for the eXtender and iBridge. The U.S.
federal government requires, as a condition to purchasing certain information processing applications, that such applications receive FIPS 140-
2 validation. U.S. federal agencies use FIPS 140-2 compliant products for the protection of sensitive information. As a result of the foregoing
validations, as of July 2005, all of Telkonet’s powerline carrier products have satisfied all governmental requirements for security certification
and are eligible for purchase by the U.S. federal government. In addition to the foregoing, Canadian provincial authorities use FIPS 140-2
compliant products for the protection of sensitive designate information. The Communications-Electronics Security Group (CESG) also has
stated that FIPS 140-2 compliant products meet its security criteria for use in data traffic categorized as “Private.” CESG is part of the United
Kingdom’s National Technical Authority for Information Assurance, which is a government agency responsible for validating the security of
information processing applications for the government of the United Kingdom, financial institutions, healthcare organizations, and
international governments, among others.
In November 2005, Telkonet received the Norma Official Mexicana (NOM) certification, enabling Telkonet to sell the iWire System TM
product suite in Mexico. NOM certification is required for Telkonet’s products to be sold in Mexico, and no further certifications are required
to sell the Telkonet iWire SystemTM product suite in Mexico.
Future products designed by the Company will require testing for compliance with FCC and CE regulations. Moreover, if in the future, the
FCC or EU changes its technical requirements, further testing and/or modifications may be necessary.
Research and Development
During the years ended December 31, 2007, 2006 and 2005, Telkonet spent $2,349,690, $1,925,746 and $2,096,104, respectively, on research
and development activities. In 2007 and 2006, research and development activities were focused on the development of Telkonet’s next
generation product. In 2005, research and development activities included (a) QoS for VoIP service for both commercial and FIPS 140-2
product applications, (b) design of the next generation high-speed development platform, (c) design, prototype & release of the Integrated
Coupler Breaker product line, (d) design & development of the second generation automated test equipment for manufacturing, (e) automated
SQA regression testing.
5
Long Term Investments
Amperion, Inc.
On November 30, 2004, Telkonet 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%. Telkonet 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 Telkonet to regularly review the assumptions underlying the operating performance and cash flow forecasts in assessing the
carrying values of the investment. Telkonet 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. Telkonet determined that its investment
in Amperion was impaired based upon forecasted discounted cash flow. Accordingly, Telkonet wrote-off $92,000 and $400,000 of the
carrying value of its investment through a charge to operations during the year-ended December 31, 2006 and 2005, respectively. The
remaining value of Telkonet’s investment in Amperion is $8,000 at December 31, 2007 and 2006 and the amount at December 31, 2007,
represents the current fair value.
BPL Global, Ltd.
On February 4, 2005, the Company’s Board of Directors approved an investment in BPL Global, Ltd. (“BPL Global”), a privately held
company. The Company funded an aggregate of $131,000 as of December 31, 2005 and additional $44 during the year of 2006.. 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 did 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. amounted $131,044 as of December 31, 2006. On November 7, 2007, the Company completed the sale of its investment in BPL
Global, Ltd for $2,000,000 in cash to certain existing stockholders of BPL Global.
Geeks on Call America, Inc.
On October 19, 2007, the Company completed the acquisition of approximately 30.0% of the issued and outstanding shares of common stock
of Geeks on Call America, Inc. (“GOCA”), the nation's premier provider of on-site computer services. Under the terms of the stock purchase
agreement, the Company acquired approximately 1,160,043 shares of GOCA common stock from several GOCA stockholders in exchange for
2,940,200 shares of the Company’s common stock for total consideration valued at approximately $4.5 million. The number of shares issued
in connection with this transaction was determined using a per share price equal to the average closing price of the Company’s common stock
on the American Stock Exchange (AMEX) during the ten trading days immediately preceding the closing date. The number of shares is
subject to adjustment on the date the Company files a registration statement for the shares issued in this transaction, which must occur no later
than the 180th day following the closing date. The increase or decrease to the number of shares issued will be determined using a per share
price equal to the average closing price of the Company’s common stock on the AMEX during the ten trading days immediately preceding the
date the registration statement is filed. 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.
On February 8 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned subsidiary of Geeks On Call Holdings, Inc., (formerly
Lightview, Inc.) merged with Geeks on Call America, Inc (“GOCA”). As a result of the merger, the Company’s common stock in GOCA was
exchanged for shares of common stock of Geeks on Call Holdings Inc. Immediately following the merger, Geeks on Call Holdings Inc.
completed a private placement of its common stock for aggregate gross proceeds of $3,000,000. As a result of this transaction, the Company’s
30% interest in GOCA became an 18% interest in Geeks on Call Holdings Inc.
6
Multiband Corporation
In connection with a payment of $75,000 of accounts receivable, the company received 30,000 shares of common stock of Multiband
Corporation, a Minnesota-based communication services provider to multiple dwelling units. 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, and the shares are not eligible for sale by the Company under Rule 144 of the Securities Act of 1933. The value of this investment
amounted to $75,000 as of December 31, 2007.
Backlog
The Telkonet Segment maintains contracts and monthly services for more than 2,300 hotels which are expected to generate approximately
$3,600,000 annual recurring support and internet advertising revenue.
The Telkonet Segment has maintained certain purchase orders relating to a major utilities energy management initiative provided through the
two selected providers. The current order backlog amounts to approximately $1,100,000 and the estimated remaining program value amounts
to $4,500,000 for products and services to be provided through March 2010. In addition, the Company recently contracted a similar energy
efficiency program in Wisconsin estimated to achieve 5,000 rooms and establish offerings within utility programs nationally.
The Company has contracted with a national hotel operator to install energy management devices in approximately 16,000 rooms for an
approximate value of $3,800,000. The implementation is anticipated to be completed by the third quarter of 2008.
MST Segment (“MSTI”)
MSTI is a communications service provider offering quadruple play (“Quad-Play”) services to multi-tenant unit (“MTU”) and multi-dwelling
unit (“MDU”) residential, hospitality and commercial properties. These Quad-Play services include video, voice, high-speed internet and
wireless fidelity (“Wi-Fi”) access. In addition, MSTI currently offers or plans to offer a variety of next-generation telecommunications
solutions and services including satellite installation, video conferencing, surveillance/security and energy management, and other
complementary professional services.
NuVisions™
MSTI currently offers digital television service through DISH Network, a national satellite television provider, under its private label
NuVisions™ brand of services. The NuVisions TV offering currently includes over 500 channels of video and audio programming, with a
large high definition (more than 40 channels) and ethnic offering (over 100 channels from 17 countries) available in the market today. MSTI
also offers its NuVisions Broadband high speed internet service and NuVisions Digital Voice telephone service to multi-family residences and
commercial properties. MSTI delivers its broadband based services using terrestrial fiber optic links and in February 2005, began deployment
in New York City of a proprietary wireless gigabit network that connects properties served in a redundant gigabit ring - a virtual fiber optic
network in the air.
Wi-Fi Network
MSTI has constructed a large NuVisions Wi-Fi footprint in New York City intended to create a ubiquitous citywide Wi-Fi network.
NuVisions Wi-Fi offers Internet access in the southern-half of Central Park, Riverside Park from 60th to 79th Streets, Dag Hammarskjold
Plaza, and the United Nations Plaza. In addition, MSTI provides NuVisions Wi-Fi service in and around Trump Tower on Fifth Avenue,
Trump World Tower on First Avenue, the Trump Place properties located on Riverside Boulevard, Trump Palace, Trump Parc, Trump Parc
East as well as portions of Roosevelt Island surrounding the Octagon residential community. MSTI currently has plans to deploy additional
Wi-Fi “Hot Zones” throughout New York City and continue to enlarge its Wi-Fi footprint as new properties are served.
Internet Protocol Television (“IPTV”)
In fourth quarter of 2006, MSTI invested in an IPTV platform to deploy in 2008. IPTV is a method of distributing television content over IP
that enables a more user-defined, on-demand and interactive experience than traditional cable or satellite television. The IPTV service delivers
traditional cable TV programming and enables subscribers to surf the Internet, receive on-demand content, and perform a host of Internet-
based functions via their TV sets.
7
Competition
The home entertainment and video programming industry is competitive, and MSTI expects competition to intensify in the future. MSTI faces
its most significant competition from the franchised cable operators. In addition, MSTI’s competition includes other satellite providers,
telecom providers and off-air broadcasters.
Hardwired Franchised Cable System
Cable companies currently dominate the market in terms of subscriber penetration, the number of programming services available, audience
ratings and expenditures on programming. However, satellite services are gaining market share which MSTI believes will provide it with the
opportunity to acquire and consolidate a subscriber base by providing a high quality signal at a comparable or reduced price to many cable
operators' current service.
Other Operators
MSTI’s next largest competitors are other operators who build and operate communications systems such as satellite master antenna television
systems, commonly known as SMATV, or private cable headend systems, which generally serve condominiums, apartment and office
complexes and residential developments. MSTI also competes with other national DBS operators such as EchoStar.
Off-Air Broadcasters
A majority of U.S. households that are not serviced by cable operators are serviced only by broadcast networks and local television stations
(“off-air broadcasters”). Off-air broadcasters send signals through the air, which are received by traditional television antennas. Signals are
accessible to anyone with an antenna and programming is funded by advertisers. Audio and video quality is limited and service can be
adversely affected by weather or by buildings blocking a signal.
Traditional Telephone Companies
Traditional telephone companies such as Verizon and AT&T have recently diversified their service offerings to compete with traditional
franchised cable companies in a triple-play market. Although their subscriber growth is currently smaller than franchise cable companies, these
traditional phone companies are developing video offerings such as Verizon's FIOS product. These phone companies have in the past also
been resellers of DIRECTV and EchoStar video programming, however, rarely in the multi-dwelling unit market. In the future, video
offerings from traditional phone companies may become a significant competitor in the MDU market.
Customers/Strategy
MSTI’s customer base and strategy is to target and cultivate a subscriber base that will demand high margin products, including, video, IPTV,
VoIP, high-speed Internet and Wi-Fi services.
MSTI currently maintains service agreements with approximately 22 MDU and MTU properties. Generally, under the terms of a service
agreement, MSTI provides either (i) “bulk services,” which may include one or all of a bundle of products and services, at a fixed price per
month to the owner of the MDU or MTU property, and contract with individual residents for enhanced services, such as premium cable
channels, for a monthly fee or (ii) contract with individual residents of the MDU property for one or more basic or enhanced services for a
monthly fee. These agreements typically include a revenue sharing arrangement with property owners, whereby the property owner is entitled
to a share of the revenues derived from subscribers who reside at the MDU/MTU property. These revenue sharing arrangements are either
based upon a fix amount per subscriber or based on a percentage, typically between 7-10%, of the monthly fees MSTI charges residents for its
services. MSTI believes that its complementary products and services allows for future growth and as such are designed and integrated with
scalability in mind.
8
Governmental Regulation
Federal Regulation
MSTI’s systems do not use or traverse public rights-of-way and thus are exempt from the comprehensive regulation of cable systems under the
Federal Communications Act of 1934, as amended (the “Communications Act”). Because its systems are subject to minimal federal
regulation, MSTI has greater pricing freedom and is not required to serve any customer whom it does not choose to serve, and management
believes that MSTI has significantly more competitive flexibility than do the franchised cable systems. Management believes that these
regulatory advantages help to make MSTIs’ private systems competitive with larger franchised cable systems.
On October 5, 1992, Congress enacted the Cable Consumer Protection and Competition Act of 1992 (the “1992 Cable Act”), which imposed
additional regulation on traditional franchised cable operators and permits regulation of rates in markets in which there is no “effective
competition”, as defined in the 1992 Cable Act, and directed the FCC to adopt comprehensive new federal standards for local regulation of
certain rates charged by traditional franchised cable operators. Conversely, the legislation also provides for deregulation of traditional
hardwire cable in a given market where effective competition is shown to exist. Rates charged by private cable operators, typically already
lower than traditional franchise cable rates, are not subject to regulation under the 1992 Cable Act.
In February 1996, Congress passed the Telecommunications Act of 1996 (the “1996 Act”), which substantially amended the Communications
Act. The 1996 Act contains provisions intended to increase competition in the telephone, radio, broadcast television, and hardwire and
wireless cable television businesses. This legislation has altered, and management believes will continue to alter, federal, state, and local laws
and regulations affecting the communications industry, including certain of the services MSTI provides.
Under the federal copyright laws, permission from the copyright holder generally must be secured before a video program may be
retransmitted. Section 111 of the Copyright Act establishes the cable compulsory license pursuant to which certain “cable systems” are
entitled to engage in the secondary transmission of broadcast programming without the prior permission of the holders of copyrights in the
programming. In order to do so, a cable system must secure a compulsory copyright license. Such a license may be obtained upon the filing of
certain reports with and the payment of certain licensing fees to the U.S. Copyright Office. Private cable operators, such as MSTI, may rely on
the cable compulsory license with respect to the secondary transmission of broadcast programming. Management does not expect the licensing
fees to have a material adverse effect on MSTI’s business.
Under the retransmission consent provisions of the 1992 Cable Act, multichannel video programming distributors, including, but not limited
to, franchised and private cable operators, seeking to retransmit certain commercial television broadcast signals, notwithstanding the cable
compulsory license, must first obtain the permission of the broadcast station in order to retransmit the station’s signal. However, private cable
systems, unlike franchised cable systems, are not required under the FCC’s “must carry” rules to retransmit local television signals. Although
there can be no assurances that MSTI will be able to obtain requisite broadcaster consents, management believes, in most cases, MSTI will be
able to do so for little or no additional cost.
On November 29, 1999, Congress enacted the Satellite Home Viewer Improvement Act of 1999 (“SHVIA”), which amended the Satellite
Home Viewer Act. SHVIA permits DBS operators to transmit local television signals into local markets. SHVIA generally seeks to place
satellite operators on an equal footing with cable television operators in regards to the availability of television broadcast programming.
SHVIA amends the Copyright Act and other applicable laws and regulations in order to clarify the terms and conditions under which a DBS
operator may retransmit local and distant broadcast television stations to subscribers. The law was intended to promote the ability of satellite
services to compete with cable television systems and to resolve disputes that had arisen between broadcasters and satellite carriers regarding
the delivery of broadcast television station programming to satellite service subscribers. As a result of SHVIA, television stations are
generally entitled to seek carriage on any DBS operator's system providing local service in their respective markets. SHVIA creates a statutory
copyright license applicable to the retransmission of broadcast television stations to DBS subscribers located in their markets. Although there
is no royalty payment obligation associated with this license, eligibility for the license is conditioned on the satellite carrier's compliance with
applicable laws, regulations and FCC rules governing the retransmission of such “local” broadcast television stations to satellite service
subscribers. Noncompliance with such laws, regulations and/or FCC requirements could subject a satellite carrier to liability for copyright
infringement. SHVIA was extended and re-enacted by the Satellite Home Viewer Extension and Reauthorization Act (“SHVERA”) in
December of 2004.
MSTI is not directly subject to rate regulation or certification requirements by the FCC or state public utility commissions because its
equipment installation and sales agent activities do not constitute the provision of common carrier or cable television services. As a private
cable operator, MSTI is not subject to regulation as a DBS provider, but primarily relies upon its third-party programming aggregators to
procure all necessary re-transmission consents and other programming rights under the Communications Act and the Copyright Act.
9
State and Local Cable System Regulation
MSTI does not anticipate that its deployment of video programming services will be subject to state or local franchise laws primarily due to
the fact that its facilities do not use or traverse public rights-of-way. Although MSTI may be required to comply with state and local property
tax, environmental laws and local zoning laws, management does not anticipate that compliance with these laws will have any material
adverse impact on MSTI’s business.
State Mandatory Access Laws
A number of states have enacted mandatory access laws that generally require, in exchange for just compensation, the owners of rental
apartments (and, in some instances, the owners of condominiums) to allow the local franchise cable television operator to have access to
the property to install its equipment and provide cable service to residents of the MDU. Such state mandatory access laws effectively
eliminate the ability of the property owner to enter into an exclusive right of entry with a provider of cable or other broadcast services. In
addition, some states have anti-compensation statutes forbidding an owner of an MDU from accepting compensation from whomever the
owner permits to provide cable or other broadcast services to the property. These statutes have been and are being challenged on
constitutional grounds in various states. These state access laws may provide both benefits and detriments to our business plan should we
expand significantly in any of these states.
Preferential Access Right
MSTI generally negotiates exclusive rights to provide satellite services singularly or in competition with competing cable providers, and also
negotiates, where possible, “rights-of-first-refusal” to match price and terms of third-party offers to provide other communication services in
buildings where it has negotiated broadcast access rights. Management believes that these preferential rights of entry are generally
enforceable under applicable law. However, current trends at the state and federal level suggest that the future enforceability of these
provisions may be uncertain. In 2001, the FCC issued an order prohibiting telecommunications service providers from negotiating exclusive
contracts with owners of commercial MDU properties. The FCC recently extended this prior action to prohibit carriers from entering into
contracts with residential MDU owners that grant carriers exclusive access for the provision of telecommunications services to residents in
those MDUs. The ban applies retrospectively to existing contracts as well as to any future agreements. The FCC has also banned
agreements that provide exclusive access for video services to MDUs. The ban applies retrospectively to existing contracts as well as to any
future agreements. The ban on exclusive video agreements does not currently apply to non-franchised entities such as MSTI however the
FCC is currently considering extending the ban to such entities. While limitations on exclusivity may undermine the exclusivity provisions
of MSTI’s rights of entry on the one hand, they may also open up many other properties to which MSTI may provide a competing service.
There can be no assurance that future state or federal laws or regulations will not restrict MSTI’s ability to offer access payments, limit MDU
owners' ability to receive access payments or e enter into exclusive agreements, any of which could have a material adverse effect on MSTI’s
business.
Regulation of the High-Speed lnternet and Wi-Fi Business
ISPs, including Internet access providers, are largely unregulated by the FCC or state public utility commissions at this time (apart from
federal, state and local laws and regulations applicable to business in general). However, there can be no assurance that this business will not
become subject to regulatory restraints. Also, although the FCC has rejected proposals to impose additional costs and regulations on ISPs to
the extent they use local exchange telephone network facilities, such change may affect demand for Internet related services. No assurance can
be given that changes in current or future regulations adopted by the FCC or state regulators or other legislative or judicial initiatives relating
to Internet services would not have a material adverse effect on MSTI’s business.
Regulation of the VoIP Business
IP-based voice services are currently exempt from the reporting and pricing restrictions placed on common carriers by the FCC. However,
there are several state and federal regulatory proceedings further defining what specific service offerings qualify for this exemption. Due to the
growing acceptance and deployment of VoIP services, the FCC and a number of state public service commissions are conducting regulatory
proceedings that could affect the regulatory duties and rights of entities that provide IP-based voice applications. There is regulatory
uncertainty as to the imposition of traditional retail, common carrier regulation on VoIP products and services.
Long Term Investments
MSTI maintains an investment in Interactivewifi.com, LLC a privately held company. This investment represents an equity interest of
approximately 50% at December 31, 2007. Interactivewifi.com is engaged in providing internet and related services to customers throughout
metropolitan New York, including the Nuvision's internet services. MSTI accounted for this investment under the cost method, as MSTI does
not have the ability to exercise significant influence over operating and financial policies of the investee. Telkonet reviewed the assumptions
underlying the operating performance and cash flow forecasts in assessing the carrying values of the investment. The fair value of MSTI’s
investment in Interactivewifi.com amounted to approximately $55,000 as of December 31, 2007.
10
Backlog
The MSTI subscriber portfolio includes approximately 22 MDU properties with bulk service agreements and/or access licenses to service the
individual subscribers in metropolitan New York. The remaining terms of the access agreements provide MSTI access rights from 7 to 15
years with the final agreement expiring in 2016 and the revenues to be recognized under non-cancelable bulk agreements provide a minimum
of $2,100,000 in revenue through 2013.
Other information
Employees
As of March 1, 2008, the Company had 172 full time employees comprised of 141 full time employees of Telkonet and 31 employees of
MSTI. The Company intends to hire additional personnel to meet future operating requirements. The Company anticipates that it may need to
hire additional staff in the areas of customer support, engineering, sales and marketing, and administration.
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.
Financial Information About Geographic Areas
To date, the majority of the Company’s revenue has been derived in the United States, although the Company continues to derive a growing
portion of our revenue from international sales. International sales as a percentage of total revenue represented 2%, 19% and 25% in 2007,
2006 and 2005, respectively. Our international sales are concentrated in Canada, Latin America and Western Europe and we continue to
expand into other markets worldwide. The table below sets forth our net revenue by major geographic region.
United States
Worldwide
Total
ITEM 1A.
RISK FACTORS.
Year Ended December 31,
2007
13,851,021
301,712
14,152,733
$
$
Percentage
Change
207% $
-55%
173% $
2006
4,508,478
672,850
5,181,328
Percentage
Change
141% $
9%
108% $
2005
1,871,241
617,082
2,488,323
The Company’s results of operations, financial condition and cash flows can be adversely affected by various risks. These risks include, but
are not limited to, the principal factors listed below and the other matters set forth in this annual report on Form 10-K. You should carefully
consider all of these risks.
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, 2007, the Company has incurred cumulative losses of $90,815,779 and has never generated enough
funds through operations to support its business. Additional capital may be required in order to provide working capital requirements for the
next twelve months. 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.
11
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. If 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.
Our independent auditors have added an explanatory paragraph to their report of our financial statements for the year ended December 31,
2007 stating that our net losses, lack of revenues and dependence on our ability to raise additional capital to continue our existence, raise
substantial doubt about our ability to continue as a going concern. If we are not successful in raising sufficient additional capital, we may we
may not be able to continue as a going concern, our stockholders may lose their entire investment in us.
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;
· 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, 2008, the Company’s officers and directors owned 11.2% 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 that were 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.
12
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, 2007, the Company had outstanding employee options to purchase a total of 8,105,429 shares of common stock at
exercise prices ranging from $1.00 to $5.97 per share, with a weighted average exercise price of $1.98. As of December 31, 2007, the
Company had outstanding non-employee options to purchase a total of 1,815,937 shares of common stock at an exercise price of $1.00 per
share. As of December 31, 2007, the Company had warrants outstanding to purchase a total of 7,673,627 shares of common stock at exercise
prices ranging from $2.59 to $4.70 per share, with a weighted average exercise price of $4.15. 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.
The communication industry is intensely competitive and rapidly evolving.
The Company operates in a highly competitive, quickly changing environment, and our future success will depend on our ability to develop
and introduce new services and service enhancements that achieve broad market acceptance in MDU and commercial sectors. The Company
will also need to respond effectively to new product announcements by our 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 our reputation and brand; and
decline in the selling price of our products and services.
Additionally, new companies are constantly entering the market, thus increasing the competition. This could also have a negative impact on
our ability to obtain additional capital from investors. Larger companies who have been engaged in our business for substantially longer
periods of time may have access to greater resources. These companies may have greater success in the recruitment and retention of qualified
employees, as well as in conducting their operations, which may give them a competitive advantage. In addition, actual or potential
competitors may be strengthened through the acquisition of additional assets and interests. If the Company is unable to compete effectively or
adequately respond to competitive pressures, this may materially adversely affect our results of operation and financial condition. Large
companies including Direct TV, EchoStar, Time Warner, Cablevision and Verizon are active in our markets in the provision and distribution
of communications services and we will have to compete with such companies.
13
The Company is not large enough to negotiate cable television programming contracts as favorable as some of our larger competitors.
Programming costs are generally directly related to the number of subscribers to which the programming is provided, with discounts available
to large traditional cable operators and direct broadcast satellite (DBS) providers based on their high subscriber levels. As a result, larger cable
and DBS systems generally pay lower per subscriber programming costs. The Company has attempted to obtain volume discounts from our
suppliers. Despite these efforts, we believe that our per subscriber programming costs are significantly higher than large cable operators and
DBS providers with which we compete in some of our markets. This may put us at a competitive disadvantage in terms of maintaining our
operating results while remaining competitive with prices offered by these providers. In addition, as programming agreements come up for
renewal, the Company cannot assure you that we will be able to renew these agreements on comparable or favorable terms. To the extent that
we are unable to reach agreement with a programmer on terms that we believe are reasonable, we may be forced to remove programming from
our line-up, which could result in a loss of customers.
Programming costs have risen in past years and are expected to continue to rise, which may adversely affect our financial results.
The cost of acquiring programming is a significant portion of the operating costs for our cable television business. These costs have increased
each year and we expect them to continue to increase, especially the costs associated with sports programming. Many of our programming
contracts cover multiple years and provide for future increases in the fees we must pay. Historically, we have absorbed increased programming
costs in large part through increased prices to our customers. However, competitive and other marketplace factors may not permit us to
continue to pass these costs through to customers. In order to minimize the negative impact that increased programming costs may have on our
margins, we may pursue a variety of strategies, including offering some programming at premium prices or moving some programming from
our analog service to our premium digital services. Despite our efforts to manage programming expenses and pricing, the rising cost of
programming may adversely affect our results of operations.
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 the Company’s iWire System TM 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. Additional devices designed by the Company for commercial
and residential use will be subject to the FCC rules for unlicensed digital devices. Moreover, if in the future, the FCC changes its technical
requirements for unlicensed digital devices, further testing and/or modifications of devices may be necessary. Failure to comply with any FCC
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.
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 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. With the exception of Motorola, who recently introduced a commercial product,
these companies do not presently represent a direct competitive threat to the Company since they only market and sell their products in the
residential sector. There can be no assurance that other companies 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, 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.
14
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. If 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 System TM 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 of substantially equivalent technology by the Company’s competitors could negatively impact its business.
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.
15
Any acquisitions we make could result in difficulties in successfully managing our business and consequently harm our financial condition.
We may seek to expand by acquiring competing businesses in our current or other geographic markets, including as a means to acquire
spectrum. We cannot accurately predict the timing, size and success of our acquisition efforts and the associated capital commitments that
might be required. We expect to face competition for acquisition candidates, which may limit the number of acquisition opportunities
available to us and may lead to higher acquisition prices. There can be no assurance that we will be able to identify, acquire or profitably
manage additional businesses or successfully integrate acquired businesses, if any, without substantial costs, delays or other operational or
financial difficulties. In addition, acquisitions involve a number of other risks, including:
·
·
·
·
·
failure of the acquired businesses to achieve expected results;
diversion of management’s attention and resources to acquisitions;
failure to retain key customers or personnel of the acquired businesses;
disappointing quality or functionality of acquired equipment and people: and
risks associated with unanticipated events, liabilities or contingencies.
Client dissatisfaction or performance problems at a single acquired business could negatively affect our reputation. The inability to acquire
businesses on reasonable terms or successfully integrate and manage acquired companies, or the occurrence of performance problems at
acquired companies, could result in dilution, unfavorable accounting treatment or one-time charges and difficulties in successfully managing
our business.
Our inability to obtain capital, use internally generated cash or debt, or use shares of our common stock to finance future acquisitions could
impair the growth and expansion of our business.
Reliance on internally generated cash or debt to finance our operations or complete acquisitions could substantially limit our operational and
financial flexibility. The extent to which we will be able or willing to use shares of our common stock to consummate acquisitions will depend
on our market value which will vary, and liquidity. Using shares of our common stock for this purpose also may result in significant dilution to
our then existing stockholders. To the extent that we are unable to use our common stock to make future acquisitions, our ability to grow
through acquisitions may be limited by the extent to which we are able to raise capital through debt or additional equity financings. No
assurance can be given that we will be able to obtain the necessary capital to finance any acquisitions or our other cash needs. If we are unable
to obtain additional capital on acceptable terms, we may be required to reduce the scope of any expansion or redirect resources committed to
internal purposes. In addition to requiring funding for acquisitions, we may need additional funds to implement our internal growth and
operating strategies or to finance other aspects of our operations. Our failure to: (i) obtain additional capital on acceptable terms; (ii) use
internally generated cash or debt to complete acquisitions because it significantly limits our operational or financial flexibility; or (iii) use
shares of our common stock to make future acquisitions, may hinder our ability to actively pursue our acquisition program.
We rely on a limited number of third party suppliers. If these companies fail to perform or experience delays, shortages, or increased demand
for their products or services, we may face shortages, increased costs, and may be required to suspend deployment of our products and
services.
We depend on a limited number of third party suppliers to provide the components and the equipment required to deliver our solutions. If
these providers fail to perform their obligations under our agreements with them or we are unable to renew these agreements, we may be
forced to suspend the sale and deployment of our products and services and enrollment of new customers, which would have an adverse effect
on our business, prospects, financial condition and operating results.
Our management and operational systems might be inadequate to handle our potential growth.
We may experience growth that could place a significant strain upon our management and operational systems and resources. Failure to
manage our growth effectively could have a material adverse effect upon our business, results of operations and financial condition. Our
ability to compete effectively as a provider of PLC technology and a provider of digital satellite television and high-speed Internet products
and services and to manage future growth will require us to continue to improve our operational systems, organization and financial and
management controls, reporting systems and procedures. We may fail to make these improvements effectively. Additionally, our efforts to
make these improvements may divert the focus of our personnel. We must integrate our key executives into a cohesive management team to
expand our business. If new hires perform poorly, or if we are unsuccessful in hiring, training and integrating these new employees, or if we
are not successful in retaining our existing employees, our business may be harmed. To manage the growth we will need to increase our
operational and financial systems, procedures and controls. Our current and planned personnel, systems, procedures and controls may not be
adequate to support our future operations. We may not be able to effectively manage such growth, and failure to do so could have a material
adverse effect on our business, financial condition and results of operations.
16
We may be affected if the United States participates in wars or military or other action or by international terrorism.
Involvement in a war or other military action or acts of terrorism may cause significant disruption to commerce throughout the world. To the
extent that such disruptions result in (i) delays or cancellations of customer orders, (ii) a general decrease in consumer spending on
information technology, (iii) our inability to effectively market and distribute our services or products or (iv) our inability to access capital
markets, our business and results of operations could be materially and adversely affected. We are unable to predict whether the involvement
in a war or other military action will result in any long-term commercial disruptions or if such involvement or responses will have any long-
term material adverse effect on our business, results of operations, or financial condition.
A significant portion of our total assets consists of goodwill, which is subject to a periodic impairment analysis and a significant impairment
determination in any future period could have an adverse effect on our results of operations even without a significant loss of revenue or
increase in cash expenses attributable to such period.
We have goodwill totaling approximately $14.7 million at December 31, 2007 resulting from recent and past acquisitions. We evaluate this
goodwill for impairment based on the fair value of the operating business units to which this goodwill relates at least once a year. This
estimated fair value could change if we are unable to achieve operating results at the levels that have been forecasted, the market valuation of
those business units decreases based on transactions involving similar companies, or there is a permanent, negative change in the market
demand for the services offered by the business units. These changes could result in an impairment of the existing goodwill balance that could
require a material non-cash charge to our results of operations.
At December 31, 2007, the Company performed an impairment test on the goodwill and intangibles acquired, it was determined that there
were no changes in the carrying value of the intangibles acquired. However, based upon managements assessment of operating results and
forecasted discounted cash flow the carrying value of MSTI goodwill was determined to be impaired and therefore the entire value of
$1,977,768 was written off during the year ended December 31, 2007.
MSTI may be unable to register for resale all of the common stock included within the units sold in its Private Placement, which would cause
a default under the Registration Rights Agreement executed in connection with such Private Placement.
MSTI is obligated to file a “resale” registration statement with the SEC that covers all of the common stock included within the units sold in
the private placement and issuable upon conversion of its debentures and the exercise of the warrants thereto and to use its best efforts to have
such “resale” registration statement declared effective by the SEC as set forth therein. Nevertheless, it is possible that the SEC may not permit
MSTI to register all of such shares of common stock for resale. In certain circumstances, the SEC may take the view that the private
placement requires MSTI to register the issuance of the securities as a primary offering. Without sufficient disclosure of this risk, rescission of
the private placement could be sought by investors or an offer of rescission may be mandated by the SEC, which would result in a material
adverse affect to MSTI and us since we consolidate the financial statements of MSTI.
MSTI has agreed to file a registration statement with the SEC within 60 days of the final closing of the Private Placement and the issuance of
the Debentures and to use its best efforts to have the registration statement declared effective by the SEC within 120 days after the final
closing of the private placement and the original issuance of the debentures. There are many reasons, including those over which MSTI has no
control, which could delay the filing or effectiveness of the registration statement, including delays resulting from the SEC review process and
comments raised by the SEC during that process. Failure to file or cause a registration statement to become effective in a timely manner or
maintain its effectiveness could materially adversely affect MSTI and require MSTI to pay substantial penalties to the holders of those
securities pursuant to the terms of the registration rights agreement. Since we consolidate the financial statements of MSTI, the incurrence of
a significant penalty by MSTI under the Registration Rights Agreement could materially adversely affect our results of operations.
17
Obligations to the holders of MSTI’s debentures are secured by all of MSTI’s assets, so if we default on those obligations, the debenture
holders could foreclose on MSTI’s assets.
The holders of MSTI’s debentures have a security interest in all of MSTI’s assets and those of its subsidiary. As a result, if we default under
our obligations to the debenture holders, the debenture holders could foreclose their security interests and liquidate some or all of these assets,
which may cause MSTI to cease operations.
MSTI’s indebtedness and restrictive debt covenants could limit MSTI’s financing options and liquidity position, which would limit MSTI’s
ability to grow our business.
The terms of MSTI’s outstanding debentures could have negative consequences, such as:
· MSTI may be unable to obtain additional financing to fund working capital, operating losses, capital expenditures or
acquisitions on terms acceptable to MSTI, or at all;
· MSTI may be unable to refinance its indebtedness on terms acceptable to MSTI, or at all; and
· MSTI may be more vulnerable to economic downturns and limit MSTI’s ability to withstand competitive pressures.
Additionally, covenants in the securities purchase agreement governing the debentures impose operating and financial restrictions on MSTI.
These restrictions prohibit or limit MSTI’s ability, and the ability of our subsidiaries, to, among other things:
· pay cash dividends to our stockholders;
· incur additional indebtedness;
· permit liens on assets or conduct sales of assets; and
· engage in transactions with affiliates.
These restrictions may limit MSTI’s ability to obtain additional financing, withstand downturns in MSTI’s business or take advantage of
business opportunities. Moreover, additional debt financing MSTI may seek may contain terms that include more restrictive covenants, may
require repayment on an accelerated schedule or may impose other obligations that limit the ability to grow MSTI’s business, acquire needed
assets, or take other actions MSTI might otherwise consider appropriate or desirable.
MSTI's restrictive debt covenant requires Frank Matarazzo, Chief Executive Officer of MSTI, to be in his current position through term of
the Debenture agreement.
On January 31, 2008, the Company amended the Convertible Debenture agreement requiring indicating that if Frank T. Matarazzo shall
cease to serve as Chief Executive Officer of the MSTI it may constitute an event of default.
Our independent auditors have expressed substantial doubt about our ability to continue as a going concern, which may hinder our ability to
obtain future financing.
In their report dated March 31, 2008, our independent auditors stated that our financial statements for the year ended December 31, 2007
were prepared assuming that we would continue as a going concern, and that they have substantial doubt about our ability to continue as a
going concern. Our auditors’ doubts are based on our incurring net losses and deficits in cash flows from operations. We continue to
experience net operating losses. Our ability to continue as a going concern is subject to our ability to generate a profit and/or obtain
necessary funding from outside sources, including by the sale of our securities, or obtaining loans from financial institutions, where
possible. Our continued net operating losses and our auditors’ doubts increase the difficulty of our meeting such goals and our efforts to
continue as a going concern may not prove successful.
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 spent approximately $61,000 in buildout costs to increase the office space of its
Germantown headquarters by approximately 6,000 square feet in April 2007. The lease on the additional office space expires in December
2015.
In March 2005, the Company entered into a lease agreement for 6,742 square feet of commercial office space in Crystal City, Virginia. The
Crystal City lease expires in March 2008. In February 2007, the Company executed a sublease for this space commencing in April 2007
through the expiration of the lease in March 2008.
The Company 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 with an option to extend the lease an additional five years.
Following the acquisitions of SSI and Ethostream the Company assumed leases on 9,000 square feet of office space in Las Vegas, NV for the
SSI office and warehouse space on a month to month basis and 8,200 square feet of office space in Milwaukee, WI for Ethostream. The
Milwaukee lease expires in May 2011. The Las Vegas, NV office lease will terminate effective April 30, 2008.
18
ITEM 3.
LEGAL PROCEEDINGS.
None.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On December 21, 2007, the Company held its annual meeting of stockholders at which the Company’s stockholders elected seven (7)
directors to serve on the Company’s Board of Directors and ratified the appointment of the Company’s independent accountants for 2006. 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
Ronald W. Pickett
Thomas C. Lynch
James L. Peeler
Thomas M. Hall
Anthony J. Paoni
48,456,921
44,644,974
50,274,675
50,114,855
50,188,670
50,253,005
Seth D. Blumenfeld
49,285,144
0
0
0
0
0
0
0
5,154,563
8,966,510
3,336,809
3,496,629
3,422,814
3,358,479
4,326,340
The other matters presented at the meeting were approved by the Company’s stockholders as follows:
0
0
0
0
0
0
0
Matter Voted Upon
For
Against
Abstain
Broker Non-votes
Ratification of Independent
Accountants
51,337,882
1,111,186
1,162,414
0
PART II
ITEM 5.
PURCHASES OF EQUITY SECURITIES.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
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, 2008, the Company had 241 stockholders of record and 72,039,455 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 1, 2006 through December 31, 2007. The information provided for the periods listed below was obtained from the Yahoo! Finance
web site.
Year Ended December 31, 2007
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
Year Ended December 31, 2006
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
19
High
Low
$
$
$
$
$
$
$
$
4.00
2.77
2.01
1.84
4.51
4.49
3.50
3.27
$
$
$
$
$
$
$
$
2.50
1.60
1.20
0.75
3.35
2.46
1.65
2.32
The Company has never paid dividends on its common stock and does not anticipate paying dividends in the foreseeable future.
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 December 31, 2002 and each fiscal year ending December
31 thereafter through the fiscal year ended December 31, 2007. The total returns assume $100 invested on December 31, 2002 with
reinvestment of dividends.
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.
(in thousands, except per share amounts)
Total revenues
2007
Year Ended December 31,
2005
2006
2004
2003
$
14,153
$
5,181
$
2,488
$
698
$
94
Operating loss
Net loss
Loss per share - basic
Loss per share - diluted
(23,458)
(17,563)
(15,307)
(13,112)
(6,564)
(20,391)
(27,437)
(15,778)
(13,093)
(7,657)
(0.31)
(0.54)
(0.35)
(0.32)
(0.37)
(0.31)
(0.54)
(0.35)
(0.32)
(0.37)
Basic and diluted weighted average common shares
outstanding
65,415
50,824
44,743
41,384
20,702
Working capital
Total assets
(2,991)
(531)
12,061
12,672
38,741
12,517
23,291
15,493
Short-term borrowings and current portion of long-term
debt
Long-term debt, net of current portion
1,471
4,432
—
—
Stockholders’ equity (deficiency)
21,268
8,135
6,350
9,617
5,315
—
588
13,646
5,296
6,176
15
3,132
2,388
20
ITEM 7.
OPERATIONS.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
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.
The Company reports financial results for the following operating business segments:
Telkonet Segment
Through the revolutionary Telkonet iWire System™ , Telkonet utilizes proven PLC technology to deliver commercial high-speed Broadband
access from an IP “platform” that is easy to deploy, reliable and cost-effective by leveraging a building’s existing electrical infrastructure. The
building’s existing electrical wiring becomes the backbone of the local area network, which converts virtually every electrical outlet into a
high-speed data port, without the costly installation of additional wiring or major disruption of business activity. The segment’s net sales in
2007 were $11,476,983, representing 81% of the Company’s consolidated net sales.
MST Segment
MSTI is a communications service provider offering Quad-Play services to MTU and MDU residential, hospitality and commercial properties.
These Quad-Play services include video, voice, high-speed internet and Wi-Fi access. In addition, MST currently offers or plans to offer a
variety of next-generation telecommunications solutions and services, including satellite installation, video conferencing, surveillance/security
and energy management, and other complementary professional services. The segments’ net sales in 2007 were $2,675,750, representing 19%
of the Company’s consolidated net sales.
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.
Revenue Recognition
For revenue from product sales, the Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition
(“SAB104”), which superseded 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.
21
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.
Revenue from sales-type leases for Ethostream products is recognized at the time of lessee acceptance, which follows installation. The
Company recognizes revenue from sales-type leases at the net present value of future lease payments. Revenue from operating leases is
recognized ratably over the lease period
MSTI accounts for the revenue, costs and expense related to residential cable services as the related services are performed in accordance with
SFAS No. 51, Financial Reporting by Cable Television Companies. Installation revenue for residential cable services is recognized to the
extent of direct selling costs incurred. Direct selling costs have exceeded installation revenue in all reported periods. Generally, credit risk is
managed by disconnecting services to customers who are delinquent.
Management identifies a delinquent customer based upon the delinquent payment status of an outstanding invoice, generally greater than 30
days past due date. The delinquent account designation does not trigger an accounting transaction until such time the account is deemed
uncollectible. Accounts are deemed uncollectible on a case-by-case basis, at management’s discretion based upon an examination of the
communication with the delinquent customer and payment history. Typically, accounts are only escalated to “uncollectible” status after
multiple attempts have been made to communicate with the customer.
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, 2007 and 2006 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, 2007, the Company experienced approximately 3% percent of units
returned. Using this experience factor a reserve of $102,534 was accrued.
Stock Based Compensation
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,”
(“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to
employees and directors including employee stock options based on estimated fair values. SFAS 123(R) supersedes the Company’s previous
accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods
beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”)
relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
22
The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting
standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s Consolidated Financial Statements as of and
for the year ended December 31, 2007 and 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition
method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of
SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for the year ended December 31, 2007 and 2006, was
$1,534,260 and $1,080,895, respectively, net of tax effect.
SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model.
The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the
Company’s Consolidated Statement of Operations. Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards to
employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting
Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the intrinsic value method, no stock-based
compensation expense had been recognized in the Company’s Consolidated Statement of Operations because the exercise price of the
Company’s stock options granted to employees and directors approximated or exceeded the fair market value of the underlying stock at the
date of grant.
Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is
ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s Consolidated Statement of
Operations for the year ended December 31, 2006 included compensation expense for share-based payment awards granted prior to, but not
yet vested as of prior to January 1, 2006 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123
and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value
estimated in accordance with the provisions of SFAS 123(R). SFAS 123(R) requires forfeitures to be estimated at the time of grant and
revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Company’s pro forma information required
under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred.
Upon adoption of SFAS 123(R), the Company is using the Black-Scholes option-pricing model as its method of valuation for share-based
awards granted beginning in fiscal 2006, which was also previously used for the Company’s pro forma information required under SFAS 123.
The Company’s determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by
the Company’s stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but
are not limited to the Company’s expected stock price volatility over the term of the awards, and certain other market variables such as the risk
free interest rate.
Goodwill and Other Intangibles
Goodwill represents the excess of the cost of businesses acquired over fair value or net identifiable assets at the date of acquisition. Goodwill
is subject to a periodic impairment assessment by applying a fair value test based upon a two-step method. The first step of the process
compares the fair value of the reporting unit with the carrying value of the reporting unit, including any goodwill. The Company utilizes a
discounted cash flow valuation methodology to determine the fair value of the reporting unit. If the fair value of the reporting unit exceeds
the carrying amount of the reporting unit, goodwill is deemed not to be impaired in which case the second step in the process is unnecessary.
If the carrying amount exceeds fair value, the Company performs the second step to measure the amount of impairment loss. Any
impairment loss is measured by comparing the implied fair value of goodwill, calculated per SFAS No. 142, with the carrying amount of
goodwill at the reporting unit, with the excess of the carrying amount over the fair value recognized as an impairment loss.
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 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.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
The Company’s revenue consists of product sales and a recurring (lease) model in the commercial, government and international markets of
the Telkonet Segment including activity for SSI and Ethostream from the date of acquisition through December 31, 2007. The MST Segment
revenue consists of Quad-Play services provided to a subscriber portfolio of MDU properties with bulk service agreements and/or access
licenses to service the individual subscribers in metropolitan New York. The MST Segment is included in revenue since the acquisition of
MST on January 31, 2006.
The table below outlines product versus recurring (lease) revenues for comparable periods:
Revenue:
2007
Year ended December 31,
2006
Variance
Product
Rental (lease)
Total
$
9,168,077
4,984,656
14,152,733
65% $
35%
100% $
3,092,967
2,088,361
5,181,328
60% $
40%
100%
6,075,110
2,896,295
8,971,405
196%
139%
173%
23
Product revenue
The Telkonet Segment product revenue principally arises from the sale and installation of broadband networking and energy management
equipment, including the Telkonet iWire System™ to commercial resellers, and directly to customers in the hospitality, government and
international markets. The Telkonet iWire SystemTM consists of the Telkonet Gateway, the Telkonet Extender, the patented Telkonet
Coupler, and the Telkonet iBridge, which “bridges” the connection from a computer to the data port. The Telkonet SmartEnergy energy
management solution consists of thermostats, sensors and controllers. Product revenue in the Telkonet Segment increased by approximately
$5,961,000 for the year ended December 31, 2007, including approximately $3,316,000 attributed to the sale of energy management
products since the acquisition of SSI in March 2007 , and approximately $1,905,000 of additional products and services to the hospitality
market from the acquisition of Ethostream in March 2007. Additionally, revenues generated in the government market were approximately
$1,540,000 for the year ended December 31, 2007, and were related to site evaluations and deployments of certain government installations.
We anticipate a continued upward trend of quarterly growth in the hospitality, energy management utility and government markets of the
Telkonet segment.
The MST Segment product revenue consists of equipment, installations and ancillary services provided to customers independent of the
subscriber model. Product revenue in this segment for the year ended December 31, 2007 was approximately $279,000.
Recurring (lease) Revenue
The increase in recurring revenue in the Telkonet Segment for the year ended December 31, 2007, reflects the addition of Ethostream’s
hospitality portfolio in March 2007. During the year ended December 31, 2007, we added approximately 2,100 hotels to our broadband
network portfolio, and currently support over 190,000 HSIA rooms, resulting in additional recurring revenue of $2,090,000 for the year ended
December 31, 2007. The Telkonet Segment monthly recurring revenue is approximately $300,000 and we anticipate growth to our subscriber
base as we deploy additional sites upon installation of Telkonet products.
The recurring revenue for the MST Segment subscriber base increased by approximately $806,000 for the year ended December 31, 2007.
The MST Segment subscriber portfolio includes approximately 22 MDU properties with bulk service agreements and/or access licenses to
service the individual subscribers in metropolitan New York. Additionally, the MST Segment added approximately 1,900 internet and
telephone subscribers through the acquisition of Newport Telecommunications Co. in July 2007.
Cost of Sales
Cost of Sales:
Product
Rental (lease)
Total
Product Costs
2007
Year ended December 31,
2006
Variance
$
7,165,120
4,505,476
11,670,596
78% $
90%
82% $
2,062,399
2,418,260
4,480,659
67% $
116%
86%
5,102,721
2,087,216
7,189,937
247%
86%
160%
The Telkonet Segment product costs include equipment and installation labor related to the Telkonet iWire System TM product suite, as well as
wireless networking and energy management products. During the year ended December 31, 2007, product costs increased by approximately
$5,103,000 in conjunction with the increased sales to the hospitality, energy management and government markets.
The MST Segment product costs primarily consist of equipment and installation labor for installation and ancillary services provided to
customers. For the year ended December 31, 2007, product costs amounted to approximately $299,000.
Recurring (lease) Costs
The Telkonet Segment recurring costs increased by approximately $822,000 for the year ended December 31, 2007, when compared to the
prior year. This increase is primarily due to the addition of Ethostream’s customer service and support infrastructure, including an internal call
center, to support the Telkonet Segment recurring revenue from its customer portfolio.
The MST Segment’s recurring costs increased by $1,265,000 for the year ended December 31, 2007. These costs consist of customer support,
programming and amortization of the capitalized costs to support the subscriber revenue. Although MSTI's programming fees are a
significant portion of the cost, MSTI continues to pursue competitive agreements and volume discounts in conjunction with the anticipated
growth of the subscriber base. The customer support costs include build-out of the support services necessary to develop and support the
build-out of the Quad-Play subscriber base in metropolitan New York. The capitalized costs are amortized over the lease term and include
equipment and installation labor. Additionally, MSTI’s recurring costs increased due to the addition of the Newport subscribers in July 2007.
24
Gross Profit
Gross Profit:
Product
Rental (lease)
Total
Product Gross Profit
2007
Year ended December 31,
2006
Variance
$
2,002,957
479,180
2,482,137
22% $
10%
18%
1,030,568
(329,899)
700,669
33% $
-16%
14%
972,389
809,079
1,781,468
94%
-245%
254%
The gross profit percentage for the year ended December 31, 2007 decreased compared to the prior year. The primary result of the decrease is
attributable to increased costs in shipping and travel in the fourth quarter of 2007. Additionally, the Company committed significant resources
to achieve a year end commitment with InTown Suites which resulted in the $3.8 million commitment for 2008. We anticipate an increase in
our gross profit trend for product sales as energy management and hospitality opportunities expand as well as the focus on opportunities in the
government and utility markets. Additionally, the integration of acquired companies has resulted in opportunities to increase operating
efficiency by eliminating redundant processes.
Recurring (lease) Gross Profit
The Telkonet Segment’s gross profit associated with recurring (lease) revenue increased for the year ended December 31, 2007 by
approximately $1,268,000. Gross profit represented approximately 48% of recurring (lease) revenue for the year ended December 31,
2007. Ethostream’s centralized remote monitoring and management platform and customer support center has provided the platform to
increase the gross profit on the Telkonet Segment recurring revenue.
The MST Segment’s gross profit decreased by approximately $458,000 for the year ended December 31, 2007, compared to the prior year,
primarily due to increased programming costs and expenses related to the addition of the IPTV platform to the existing infrastructure. MSTI
anticipates that it will increase its gross profit through expanding its subscriber base and reduce programming costs through the IPTV
platform. Gross profit represented approximately -36% of recurring (lease) revenue for the year ended December 31, 2007.
Operating Expenses
Year ended December 31,
2007
2006
Variance
Total
$ 25,939,690
$ 18,263,255
$
7,676,435
42%
Overall expenses increased for the year ended December 31, 2007, when compared to the prior year, by approximately $7,676,435, or 42%.
The principal reasons for this increase were the additional operating costs assumed through the acquisitions of SSI and Ethostream, which
accounted for approximately $3,275,000 of the total increase. There was a one time, non-cash charge to operations for the impairment write
down of MSTI’s goodwill and fixed assets in the amount of approximately $2,471,000 for the year ended December 31, 2007. Additionally,
we increased research and development costs (see discussion below), as well as our non-cash stock compensation by $984,000, which is
related to stock options and shares earned by employees and consultants of Telkonet and MSTI, and additional non-cash depreciation expense
of $342,000, for the year ended December 31, 2007. Also, there was an increase in selling and administrative expenses for the Telkonet
Segment and MST Segment during the year ended December 31, 2007. We expect our operating expenses to decrease in 2008, when
compared to year ended December 31, 2007, as we continue the consolidation of the operations within the Telkonet Segment including the
closure of the Las Vegas operations and increase in our overall operating efficiency.
25
Research and Development
Year ended December 31,
2007
2006
Variance
Total
$
2,349,690
$
1,925,746
$
423,944
22%
The Telkonet Segment research and development costs related to both existing and development-stage products are expensed in the period
that they are incurred. Total expenses for the year ended December 31, 2007 increased by $423,944, or 22%, when compared to the prior year.
This increase was primarily related to the development of the next generation (Series Five) product suite and the integration of new
applications to the Telkonet iWire System, as well as additional development of energy management products pursuant to the acquisition of
SSI.
Selling, General and Administrative Expenses
Year ended December 31,
2007
2006
Variance
Total
$ 17,897,974
$ 14,346,364
$
3,551,610
25%
increase
is primarily attributed
Selling, general and administrative expenses increased for the year ended December 31, 2007 over the comparable prior year by $3,551,610 or
25%. This
the acquired businesses of approximately
$2,755,000. Additionally, sales and marketing costs increased following the launch of our new integrated product offerings, and professional
fees increased due to the equity financing in February 2007, the acquisitions of SSI and Ethostream, and the investment in Geeks on Call
America, Inc. Prior year expenses related to the amortization and write-off of financing fees $535,000 partially offset the overall increase. We
expect selling, general and administrative expenses to decrease in 2008, when compared to the year ended December 31, 2007 as we continue
the consolidation of the operations within the Telkonet Segment including the closure of the Las Vegas facility and increase in overall
operating efficiency.
the administrative expenses of
to
MSTI selling, general, and administrative expenses which consist of commissions, salaries, advertising, professional service fees, investor
relations services and overhead expenses, totaled approximately $4,100,000 during 2007 as compared to $2,900,000 for 2006. This increase is
primarily attributable to an overall increase in administrative and investors relations services costs compared to the prior period in conjunction
with the acquisition of Newport Telecommunications and the merger of MST with a public shell corporation.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Revenues
The Company’s revenue consists of direct product sales and a recurring (lease) model in the commercial, government and international
markets of the Telkonet Segment. Additionally, the MST Segment consists of eleven months of revenue from date of acquisition through
December 31, 2006 providing certain Quad-Play services. The table below outlines product versus recurring (lease) revenues for comparable
periods:
Revenue:
Product
Rental (lease)
Total
2006
Year ended December 31,
2005
Variance
$
3,092,967
2,088,361
5,181,328
60% $
40%
100% $
1,769,727
718,596
2,488,323
71% $
29%
100%
1,323,240
1,369,765
2,693,005
75%
191%
108%
26
Product Revenue
Product revenue in the Telkonet Segment increased approximately $800,000, excluding the sale of certain rental contract agreements to
Hospitality Leasing Corporation, for the year ended December 31, 2006, and the MST Segment revenue amounted to approximately
$280,000 in installation and ancillary services provided to customers for the eleven months ended December 31, 2006. The Telkonet
Segment product revenue principally arises from the sale of the Telkonet iWire System TM to commercial resellers as well as directly to
customers. The Telkonet iWire System™ utilizes a building’s electrical wires as the backbone for a local area network, converting electrical
outlets into data ports. The Telkonet iWire SystemTM consists of the Telkonet Gateway, the Telkonet Extender, the patented Telkonet
Coupler, and the Telkonet iBridge, which “bridges” the connection from a computer to the data port. Customers can purchase Telkonet
iBridges on an as-needed basis, allowing vendors to supply equipment to meet their occupancy demands. Telkonet’s customers to date have
been principally located in the Commercial (Hospitality and Multi-Dwelling) and International markets. Revenues to date have been
principally derived from the Commercial (Hospitality and Multi-Dwelling) and International business units. The Telkonet Segment
anticipates continued growth in Commercial and International product revenue in the Value Added Reseller (VAR) purchase programs. The
Telkonet Segment expanded its international sales and marketing efforts upon receiving its European certification (CE). The Company has
received the FIPS 140-2 certification and continues to pursue opportunities within the government sector. The Company has extended its
iWire SystemTM to included energy information, management and control solutions for residential and commercial buildings.
In the year ended December 31, 2006 and 2005, Telkonet 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 $1,209,000 and $732,000 including the customer support component of
approximately $370,000 and $205,000 which Telkonet will retain and continue to receive monthly customer support payments over the
remaining average unexpired lease term of 36 and 26 months, respectively. In the years ending December 31, 2006 and 2005, the Company
recognized revenue of approximately $683,000 and $439,000, respectively, 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 $340,000 and $267,000,
respectively, and expensed associated taxes of approximately $64,000 and $40,000, respectively.
Rental (lease) Revenue
A significant increase in the overall recurring revenue was attributable to the addition of the MST Segment subscriber base in February 2006
and amounted to approximately $1,476,000 for the eleven months ended December 31, 2006. The MST Segment subscriber portfolio includes
approximately 22 MDU properties with service bulk service agreements and/or access licenses to service the individual subscribers in
metropolitan New York. The Telkonet Segment rental (lease) revenue decreased by $95,000 in the year ended December 31, 2006 compared
to the prior year primarily due to the sale of rental contracts to Hospitality Leasing Corporation and the VAR purchase program sales effort.
Cost of Sales
Cost of Sales:
Product
Rental (lease)
Total
Product Costs
2006
Year ended December 31,
2005
Variance
$
2,062,399
2,418,260
4,480,659
67% $
116%
86% $
1,183,574
533,605
1,717,179
67% $
74%
69%
878,825
1,884,655
2,763,480
74%
353%
161%
The Telkonet Segment product cost for the Telkonet iWire System TM product suite primarily includes equipment costs and installation labor.
The related product cost in connection with the non-recourse sale of approximately $1,209,000 of rental contract agreements amounted to
approximately $347,000 of previously capitalized equipment cost and other related cost.
The MST product costs primarily consist of equipment and installation labor for installation and ancillary services provided to customers.
Rental (lease) Costs
MST Segment recurring costs primarily represent customer support, programming and amortization of the capitalized costs to support the
subscriber revenue. Although MST’s programming fees are a significant portion of the cost, MST continues to pursue competitive
agreements and volume discounts in conjunction with the growth of the subscriber base. The customer support costs for the year ended
December 31, 2006 include build-out of the support services necessary for the anticipated increase in subscribers in metropolitan New York.
The capitalized costs are amortized over the lease term and include equipment and installation labor. The Telkonet Segment recurring costs
increased for the year ended December 31, 2006 compared to the prior year due to an increase in the number of iBridges supported and
through the utilization of an out-sourced Tier I call center which was initiated in July 2005.
27
Gross Profit
Gross Profit:
Product
Rental (lease)
Total
Product Gross Profit
2006
Year ended December 31,
2005
Variance
$
1,030,568
(329,899)
700,669
33% $
-16%
14%
586,153
184,991
771,144
33% $
26%
31%
444,415
(514,890)
(70,475)
76%
-278%
-9%
The increase of Telkonet gross profit for the year 2006 associated with product revenues over the prior year offsets by ancillary services
provided by MST.
Rental (lease) Gross Profit
Telkonet gross profit associated with recurring (lease) revenue decreased as a result of the sale of rental contracts to Hospitality Leasing
Corporation resulting in a decrease in recurring (lease) revenue which was more than offset by increased customer support services related to
the increased number of iBridges supported. As MST developed the infrastructure and continued to build-out the subscriber base, the gross
margins were $417,664 or -28% for the 11 months end December 31, 2006, primarily due to programming costs and the support infrastructure.
MST anticipates increased margins in 2008 as the projected new subscriber base absorbs the current infrastructure.
Operating Expenses
Year ended December 31,
2006
2005
Variance
Total
18,263,255 $
16,077,912
2,185,343
14%
Overall expenses increased for the year ended December 31, 2006 over the comparable period in 2005 by $2,185,343 or 14%. Of this increase,
operating expenses related to the acquisition of MST represented $2,632,449 and were principally due to salary and other operating costs
related to the build-out of the “Quad Play” subscriber infrastructure, including managerial and back-office support personnel, professional fees
and the amortization of MST’s intangible assets. Additionally, the Telkonet operating expenses decreased for the year ended December 31,
2006 due to a reduction in research and development costs as well as a cost incurred in 2005 for the impairment of Telkonet’s investment in
Amperion.
Product Research and Development
Year ended December 31,
2006
2005
Variance
Total
$
1,925,746
$
2,096,104
$
(170,358)
-8%
Telkonet’s 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, 2006 decreased over the comparable prior year by $170,358 or -8%. This decrease was primarily related to costs
associated to CE, FIPS 140-2 and other required certifications of the Company’s product that were incurred in 2005.
Selling, General and Administrative
Year ended December 31,
2006
2005
Variance
Total
$ 14,346,364
$ 12,041,661
$
2,304,703
19%
28
Selling, general and administrative expenses increased for the year ended December 31, 2006 over the comparable prior year by $2,304,703 or
19%. This increase is attributed to the administrative expenses associated with the acquisition of MST such as payroll costs, advertising, trade
shows, facility costs and professional fees. Also, the selling, general and administrative expenses for Telkonet have remained approximately
the same as the prior year.
Liquidity and Capital Resources
Our working capital decreased by $2,460,030 during the twelve months ended December 31, 2007 from a working capital deficit of
$(530,634) at December 31, 2006 to a working capital deficit of $(2,990,664) at December 31, 2007. The decrease in working capital for the
twelve months ended December 31, 2007, is due to a combination of factors, of which the significant factors are set out below:
·
Cash had a net decrease from working capital by $14,454 for the twelve months ended December 31, 2007. The most significant
uses and proceeds of cash are as follows:
o Approximately $13,989,000 of cash consumed directly in operating activities
o A cash payment of $900,000 representing the second installment of the cash portion of the purchase price for the
acquisition of MST
o
o
T h e cash payment in the acquisition of Ethostream amounted to approximately $2,000,000, and as part of the
acquisition the debt payoff amounted to approximately $200,000—see discussion of acquisition below;
The cash payments in the acquisition of SSI amounted to approximately $875,000—see discussion of acquisition
below;
o A private placement from the sale of 4,000,000 shares of common stock at $2.50 per share provided proceeds of
$9,610,000.
o A private placement and sale of debentures by MSTI Holdings Inc. for proceeds, net of placement fees, of $2,694,000
and $5,303,000, respectively.
o A bridge loan in the amount of $1,500,000 issued as a Senior Note payable to GRQ Consultants, Inc.
o A sale of Telkonet’s investment in BPL Global for gross proceeds of $2,000,000
o A cash payment of $1,118,000 for the acquisition of the assets of Newport Telecommunications Co. by MSTI Holdings,
Inc.
Of the total $7,004,168 current assets as of December 31, 2007, cash represented $1,629,584. Of the total $3,766,079 current assets as of
December 31, 2006, cash represented $1,644,037.
Senior Notes
In 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 remaining outstanding senior note of $100,000 matured and was repaid in June 2006.
Convertible Senior Notes
In October 2005, the Company completed an offering of convertible senior notes (the “Notes”) in the aggregate principal amount of $20
million. The capital raised in the Note offering was used for general working capital purposes. The Notes bore interest at a rate of 7.25%,
payable in cash, and called for monthly principal installments beginning March 1, 2006. The maturity date was 3 years from the date of
issuance of the Notes. The Noteholders were entitled, at any time, to convert any portion of the outstanding and unpaid Conversion Amount
into shares of Company common stock. At the option of the Company, the principal payments could be paid either in cash or in common
stock. Upon conversion into common stock, the value of the stock was determined by the lower of $5 or 92.5% of the average recent market
price. The Company also issued one million warrants to the Noteholders exercisable for five years at $5 per share. At any time after six
months, should the stock trade at or above $8.75 for 20 of 30 consecutive trading days, the Company could cause a mandatory redemption and
conversion to shares at $5 per share. At any time, the Company was entitled to pre-pay the notes with cash or common stock. If the Company
elected to use common stock to pre-pay the Notes, the price of the common stock would be deemed to be the lower of $5 or 92.5% of the
average recent market price. If the Company prepaid the Notes other than by mandatory conversion, the Company was obligated to 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 agreed to maintain a letter of credit in favor of the Noteholders equal to $10 million. Once the principal amount
outstanding on the notes declined below $15 million, the balance on the letter of credit was reduced by $.50 for every $1 amortized.
29
These notes were repaid on August 14, 2006 as discussed in greater detail below under “Early Extinguishment of Debt.”
Principal Payments of Debt
For the period of January 1, 2006 through August 14, 2006, the Company paid down principal of $1,250,000 in cash and issued an aggregate
of 4,226,246 shares of common stock in connection with the conversion of $10,821,686 aggregate principal amount of the Senior Convertible
Notes. Pursuant to the note agreement, the Company issued an additional 1,081,820 warrants to the Noteholders covering 65% of the
$8,321,686 accelerated principal at a strike price of $5 per share.
For the period of January 1, 2006 through August 14, 2006, the Company amortized the debt discount to the beneficial conversion feature and
value of the attached warrants, and recorded non-cash interest expense in the amount of $251,759 and $500,353, respectively. The Company
also wrote-off the unamortized debt discount attributed to the beneficial conversion feature and the value of the attached warrants in the
amount of $708,338 and $1,397,857, respectively, in connection with paydown and conversion of the note.
Early Extinguishment of Debt
On August 14, 2006, the Company executed separate settlement agreements with the lenders of its Convertible Senior Notes. Pursuant to the
settlement agreements the Company paid to the lenders in the aggregate $9,910,392 plus accrued but unpaid interest of $23,951 and certain
premiums specified in the Notes in satisfaction of the amounts then outstanding under the Notes. Of the amount paid to the lenders under the
Notes, $6,500,000 was paid in cash through a drawdown on a letter of credit previously pledged as collateral for the Company’s obligations
under the Notes. The remaining note balance of $1,428,314 and a Redemption Premium of $1,982,078, calculated as 25% of remaining
principal, was paid to the lenders in shares of Company’s common stock valued at the lower of $5.00 per share and 92.5% of the arithmetic
average of the weighted average price of the Company’s common stock on the American Stock Exchange for the twenty trading days
beginning on August 16, 2006. The Company also issued 862,452 warrants to purchase shares of the Company’s common stock at the
exercise price of the lower of $2.58 per share and 92.5% of the average trading price as described above. The Company accounted for the
Redemption Premium and the warrants as non-cash early extinguishment of debt expense during the year ended December 31, 2006.
As a result of the execution of the settlement agreements and the payments required thereby, the Company fully repaid and believes it
satisfied all of its obligations under the Notes. The Company also agreed to pay the expenses of the lenders incurred in connection with the
negotiation and execution of the settlement agreements. The settlement agreements were negotiated following the allegation by one of the
lenders that the Company’s failure to meet the minimum revenue test for the period ending June 30, 2006 as specified on the Notes may have
constituted an event of default under the Notes, which allegation the Company disputed.
In conjunction with the settlement agreement, the Company recorded $4,626,679 of loss from early extinguishment of debt, which consists of
$1,982,078 redemption premium paid with the Company’s common stock, $1,014,934 of additional warrants issued to the lenders, write-off of
the remaining unamortized debt discount attributed to the beneficial conversion feature and the value of the attached warrants in the amount of
$430,040 and $845,143, respectively, and write-off of the remaining unamortized financing costs of $354,484.
The settlement agreements provide that the number of shares issued to the noteholders shall be adjusted based upon the arithmetic average of
the weighted average price of the Company’s common stock on the American Stock Exchange for the twenty trading days immediately
following the settlement date. The Company has concluded that, based upon the weighted average of the Company's common stock between
August 16, 2006 and September 13, 2006, the Company is entitled to a refund from the two noteholders. One of the noteholders has
informed the Company that it does not believe such a refund is required. As a result, the Company has declined to deliver to the noteholders
certain stock purchase warrants issued to them pursuant to the settlement agreements pending resolution of this disagreement. One of the
noteholders has alleged that the Company has failed to satisfy its obligations under the settlement agreement by failing to deliver the
warrants. In addition, the noteholder maintains that the Company has breached certain provisions of the registration rights agreement and, as
a result of such breach, such noteholder claims that it is entitled to receive liquidated damages from the Company. As of March 28, 2008, no
legal claim has been filed by the noteholder.
MSTI Holdings, Inc. Convertible Debentures
In May 2007, MSTI Holdings Inc., a majority owned subsidiary of the Company, issued senior convertible debentures having a principal
value of $6,576,350 to investors, including an original issue discount of $526,350, in exchange for $6,050,000 from investors, exclusive of
placement fees. The original issue discount to the Debentures is amortized over 12 months. The Debentures accrue interest at 8% per
annum commencing on the first anniversary of the original issue date of the Debentures, payable quarterly in cash or common stock, at
MSTI Holdings Inc.'s option, and mature on April 30, 2010. The Debentures are not callable and are convertible at a conversion price of
$0.65 per share into 10,117,462 shares of MSTI Holdings Inc. common stock.
30
Acquisition of Microwave Satellite Technologies, Inc.
On January 31, 2006, the Company acquired a 90% interest in MST from Frank Matarazzo, the sole stockholder of MST in exchange for $1.8
million in cash and 1.6 million unregistered shares of the Company’s common stock for an aggregate purchase price of $9,000,000. The cash
portion of the purchase price was paid in two installments, $900,000 at closing and $900,000 in February 2007. The stock portion is payable
from shares held in escrow, 400,000 shares of which were paid at closing and the remaining 1,200,000 shares of which shall be issued based
on the achievement of 3,300 “Triple Play” subscribers over a three year period. During the year ended December 31, 2006, the Company
issued 200,000 shares of the purchase price contingency valued at $900,000 as an adjustment to goodwill. In the event the Company’s
common stock price is below $4.50 per share upon issuance of the shares from escrow, a pro rata adjustment in the number of shares will be
required to support the aggregate consideration of $5.4 million. As of December 31, 2006, the Company’s common stock price was below
$4.50. To the extent that the market price of Company’s common stock is below $4.50 per share upon issuance of the shares from escrow, the
number of shares issuable on conversion is ratably increased, which could result in further dilution of the Company’s stockholders.
Acquisition of Smart Systems International (SSI)
On March 9, 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy
management products and solutions to customers in the United States and Canada for cash and Company common stock having an aggregate
value of $7,000,000. The purchase price was comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. 1,090,909 shares were held in escrow for a period of one year following the closing for the purpose of satisfying certain potential
indemnification obligations under the purchase agreement could be satisfied. The aggregate number of shares held in escrow was subject to
adjustment upward or downward depending upon the trading price of the Company’s common stock during the one year period following the
closing date. On March 12, 2008, the Company released these shares from escrow and plans to issue an additional 1,909,091 shares pursuant
to the adjustment provisions of the SSI asset purchase agreement.
Acquisition of Ethostream, LLC
On March 15, 2007, the Company acquired 100% of the outstanding membership units of Ethostream, LLC, a network solutions integration
company that offers installation, sales and service to the hospitality industry. The Ethostream acquisition enables Telkonet to provide
installation and support for PLC products and third party applications to customers across North America. The purchase price of $11,756,097
was comprised of $2.0 million in cash and 3,459,609 shares of the Company’s common stock. The entire stock portion of the purchase price is
being held in escrow to satisfy certain potential indemnification obligations of the sellers under the purchase agreement. The shares held in
escrow are distributable over the three years following the closing.
Proceeds from the issuance of common stock
During the twelve months ended December 31, 2007, the Company received $124,460 from the exercise of employee stock options. No non-
employee options or warrants were exercised during the year ended December 31, 2007.
In February 2007, the Company issued 4,000,000 shares of common stock valued at $2.50 per share for an aggregate purchase price of
$10,000,000. The Company also issued to this investor warrants to purchase 2.6 million shares of its common stock at an exercise price of
$4.17 per share.
Additionally, during the twelve months ended December 31, 2007, MSTI Holdings Inc. completed a private placement resulting in proceeds of
approximately $2,694,000.
31
Cash flow analysis
Cash utilized in operating activities was $13,989,434 during the year ended December 31, 2007 compared to $13,971,529 and during the year
ended December 31, 2006, respectively. The primary use of cash during the twelve months ended December 31, 2007 was net operating
expenses of the Company.
The Company utilized and was provided cash for investing activities $5,048,217 and $6,717,442 during the twelve months ended December
31, 2007 and 2006, respectively. These expenditures were primarily the result of the payment of the cash portion of the MST purchase price
of $900,000 in February 2007, and cash payments of $875,000 and $2,000,000, for the acquisition of SSI and Ethostream, respectively, in
March 2007 and $1,020,000 for the acquisition of Newport Telecommunications in July 2007. The proceeds of the sale of the investment in
BPL Global provided $2,000,000 in November 2007. Additionally, cost of equipment under operating leases, and cable and related
equipment, amounted to $1,568,651 and $1,939,759 for the twelve months ended December 31, 2007 and 2006. Equipment costs were net of
$350,571 in proceeds from the sale of certain equipment under operating leases during the twelve months ended December 31,
2006. Purchases of property and equipment amounted to $310,715 and $734,888 for the twelve months ended December 31, 2007 and 2006,
respectively. During the period ended December 31, 2006, the proceeds from the release of funds from the Restricted Certificate of Deposit
provided $10,000,000 in conjunction with the conversion and settlement agreement with the lenders under the Company’s Convertible Senior
Notes. The expenditures were primarily the result of the acquisition of MST in January 2006 of $958,438, net of acquired cash. Additionally,
cost of equipment under operating leases amounted to $1,589,188, net of proceeds from the sale of certain equipment under operating leases
of $350,571, and $458,271 for the December 31, 2006 and 2005, respectively. Furthermore, purchases of property and equipment amounted to
$734,888 and $336,448 for the year ended December 31, 2006 and 2005, respectively.
The Company was provided cash from financing activities of $19,023,197 and $476,045 during the twelve months ended December 31, 2007
and 2006, respectively. The financing activities involved the sale of 4.0 million shares of common stock at $2.50 per share for a total of
$9,610,000, net of placement fees, in February 2007. Additionally, proceeds from the exercise of stock options and warrants were $124,460
and $2,684,663 during the twelve months ended December 31, 2007 and 2006, respectively. In July 2007, the Company issued a senior note
payable in the principal amount of $1,500,000. Through its majority-owned subsidiary MSTI Holdings, Inc., the Company raised $5,303,238
through the sale of debentures, and $2,694,020 through the sale of common stock, during the twelve months ended December 31, 2007. In
2006, the proceeds of the financing activities were offset by repayment of debt principal of $8,162,119, including $7,750,000 of principal
payments in conjunction with the conversion and settlement agreement with the lenders of its Convertible Senior Notes and approximately
$410,000 in conjunction with the acquisition of MST.
We are reducing cash required for operations by reducing operating costs and reducing staff levels. In addition, we are working to manage
our current liabilities while we continue to make changes in operations to improve our cash flow and liquidity position.
Our registered independent certified public accountants have stated in their report dated March 31, 2008, that we have incurred operating
losses in the past years, and that we are dependent upon management's ability to develop profitable operations. These factors among others
may raise substantial doubt about our ability to continue as a going concern.
While we have raised capital in the First Quarter of 2008 to meet our working capital and financing needs, additional financing is required in
order to meet our current and projected cashflow requirements from operations and development . Additional investments are being sought,
but we cannot guarantee that we will be able to obtain such investments. Financing transactions may include the issuance of equity or debt
securities, obtaining credit facilities, or other financing mechanisms. However, the trading price of our common stock and the downturn in
the U.S. stock and debt markets could make it more difficult to obtain financing through the issuance of equity or debt securities. Even if we
are able to raise the funds required, it is possible that we could incur unexpected costs and expenses, fail to collect significant amounts owed
to us, or experience unexpected cash requirements that would force us to seek alternative financing. Further, if we issue additional equity or
debt securities, stockholders may experience additional dilution or the new equity securities may have rights, preferences or privileges senior
to those of existing holders of our common stock. If additional financing is not available or is not available on acceptable terms, we will have
to curtail our operations.
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
We do not maintain off-balance sheet arrangements nor do we participate in any non-exchange traded contracts requiring fair value
accounting treatment.
Acquisition or Disposition of Plant and Equipment
During the year ended December 31, 2007, fixed assets increased approximately $2,341,000, including $2,323,000 for the MST Segment
primarily from the addition of the Newport assets acquired in July 2007 and equipment purchased for the MST build-out. The remainder is
related to computer equipment and peripherals used in day-to-day operations. The Company anticipates significant expenditures in the MST
Segment to continue the build-out the head-end equipment, IPTV and other related projects. The Telkonet Segment 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.
32
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. This lease terminates in March
2008.
MSTI 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.
Following the acquisitions of SSI and Ethostream, the Company assumed leases on 9,000 square feet of office space in Las Vegas, NV for the
SSI office and warehouse space on a month to month basis and 4,100 square feet of office space in Milwaukee, WI for Ethostream. The
Milwaukee lease expires in May 2011. The Las Vegas, NV office lease will terminate effective April 30, 2008.
New Accounting Pronouncements
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits
entities to choose to measure many financial instruments, and certain other items, at fair value. SFAS 159 applies to reporting periods
beginning after November 15, 2007. The adoption of SFAS 159 is not expected to have a material impact on the Company’s financial
condition or results of operations.
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141(R), “Business Combinations” (“Statement
141(R)”) and Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“Statement 160”).
Statements 141(R) and 160 require most identifiable assets, liabilities, noncontrolling interests and goodwill acquired in a business
combination to be recorded at “full fair value” and require noncontrolling interests (previously referred to as minority interests) to be reported
as a component of equity. Both statements are effective for fiscal years beginning after December 15, 2008. Statement 141(R) will be applied
to business combinations occurring after the effective date. Statement 160 will be applied prospectively to all noncontrolling interests,
including any that arose before the effective date. The Company has not determined the effect, if any, the adoption of Statements 141(R) and
160 will have on the Company’s financial position or results of operations.
Disclosure of Contractual Obligations
Contractual obligations
Payment Due by Period
Total
Less than
1 year
1-3 years
3-5 years
More than 5
years
Long-Term Debt Obligations
Current Debt Obligations
Capital Lease Obligations
Operating Lease Obligations
Purchase Obligations (1)(2)
O t h e r Long-Term
Liabilities Reflected
Registrant’s Balance Sheet Under GAAP
Total
$
$
$
$
$
6,576,350
1,500,000
-
2,082,799
2,386,564
$
-
$ 12,545,713
-
1,500,000
-
539,681
2,576,442
-
4,616,123
on the
6,576,350
-
-
852,142
-
-
-
348,232
-
7,428,492
-
348,232
-
-
-
342,744
-
-
342,744
(1) Purchase commitment for the IPTV build-out of MSTI subscriber base in the second half of 2007 in the amount of $476,776.
(2) Purchase commitment of $1,909,788 for inventory orders of energy management products through April 2008. The Company has
prepaid approximately $380,000 as of December 31, 2007.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Short Term Investments
We held no marketable securities as of December 31, 2007. 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 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.
33
Investments in Privately Held Companies
We 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, 2008 was $8,000 in Amperion and at December 31, 2007 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 92%, or $92,000, of the carrying value of its investment through a charge to operations during the
year ended December 31, 2006. The Company sold its investment in BPL Global for $2,000,000 during the year ended December 31,
2007. The fair value of the Company’s investment in BPL Global was $131,044 at the time of the sale.
On October 19, 2007, the Company completed the acquisition of approximately 30.0% of the issued and outstanding shares of common stock
of Geeks on Call America, Inc. (“GOCA”), the nation's premier provider of on-site computer services. Under the terms of the stock purchase
agreement, the Company acquired approximately 1,160,043 shares of GOCA common stock from several GOCA stockholders in exchange for
2,940,202 shares of the Company’s common stock for total consideration valued at approximately $4.5 million.
ITEM 8.
FINANCIAL STATEMENTS.
See the Financial Statements and Notes thereto commencing on Page F-1.
ITEM 9.
DISCLOSURE.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
None.
ITEM 9A.
CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures . Under the supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, the Company evaluated the effectiveness of the design and operation of its disclosure controls
and procedures (as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).
The Company's conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of the
acquisitions in 2006 of Smart Systems International, Ethostream, LLC, and Newport Telecommunications Co. (the "acquisitions") which are
included in the 2007 consolidated financial statements of the Company.
Disclosure controls and procedures are the controls and other procedures that the Company designed to ensure that it records, processes,
summarizes and reports in a timely manner the information it must disclose in reports that it files with or submits to the Securities and
Exchange Commission under the Exchange Act. Based on this evaluation, the Chief Executive Officer and the Chief Financial Officer
concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.
Changes in Internal Control over Financial Reporting. During the fourth quarter of 2007, there was no change in the Company’s internal
control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is
reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management Report On Internal Control over Financial Reporting. The Company’s management is responsible for establishing and
maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) under the
Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and
effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally
accepted in the United States of America and includes those policies and procedures that:
34
·
·
·
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of
the Company’s assets;
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in
accordance with accounting principles generally accepted in the United States of America, and that the Company’s receipts and
expenditures are being made only in accordance with authorization of management and directors; and
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.
We have excluded from this assessment the operations of Smart Systems International, Ethostream, LLC, and Newport Telecommunications
Co. These businesses were acquired during 2007 and constituted $22.4 million total assets, respectively, as of December 31, 2007 and $7.9
million of net sales for the year then ended.
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.
Under the supervision and with the participation of the Company’s management, including its principal executive and principal financial
officers, the Company assessed, as of December 31, 2007, the effectiveness of its internal control over financial reporting. This assessment
was based on criteria established in the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Based on the Company’s assessment, management concluded that the Company’s internal
control over financial reporting was effective as of December 31, 2007.
The Company’s assessment of the effectiveness of its internal control over financial reporting as of December 31, 2007 has been audited by
RBSM LLP, an independent registered public accounting firm, as stated in their report which is included in this Annual Report on Form 10-K.
35
RBSM LLP
CERTIFIED PUBLIC ACCOUNTANTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors
Telkonet, Inc.
Germantown, MD
We have audited Telkonet, Inc. and its subsidiaries (the "Company") internal control over financial reporting as of December 31,
2007, based on criteria established inInternal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying
Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the effectiveness of the
Company's internal control over financial reporting based on our audit.
We conducted our audit 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,
assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on
assessed risk. Our audit also included 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 to 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.
As indicated in the accompanying Management's Report on Internal Control Over Financial Reporting, management's assessment of
and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Smart Systems
International, Ethostream, LLC and Newport Telecommunications Co. (the "acquisitions") which are included in the 2007 consolidated
financial statements of Telkonet, Inc. and its subsidiaries and constituted $22.4 million total assets, as of December 31, 2007 and $7.9 million
of net sales for the year then ended. Our audit of internal control over financial reporting of Telkonet, Inc. and its subsidiaries also did not
include an evaluation of the internal controls over financial reporting of the acquisitions.
In our opinion, Telkonet, Inc. and its subsidiaries maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2007, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balances sheets of Telkonet, Inc. and its subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements
of losses, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2007 and our report dated March
31, 2008 expressed an unqualified opinion thereon and included an explanatory paragraph related to the Company's ability to continue as a
going concern.
McLean, Virginia
March 31, 2008
/s/ RBSM LLP
Certified Public Accountants
36
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 for the fiscal year ended December 31, 2007.
The directors of the Company are elected every year and serve until their successors are duly elected and qualified.
Name
Jason Tienor
Dorothy E. Cleal
Richard J. Leimbach
Jeffrey Sobieski
James Landry
Warren V. Musser
Ronald W. Pickett
Thomas C. Lynch
Dr. Thomas M. Hall
James L. “Lou” Peeler
Seth Blumenfeld
Anthony J. Paoni
_________________________
(1) Member of the Audit Committee
(2) Member of the Compensation Committee
Age
Title
33
58
39
31
52
81
60
65
56
74
67
63
President & Chief Executive Officer
Chief Operating Officer
Chief Financial Officer of Telkonet, Vice President Finance, MSTI
Holdings, Inc.
Executive Vice President, Energy Management
Chief Technology Officer
Chairman of the Board
Vice Chairman of the Board, President, MSTI Holdings, Inc
Director (1), (2)
Director (1), (2)
Director (1)
Director
Director (2)
Jason Tienor—President and Chief Executive Officer
Mr. Tienor has served as the Company’s President and Chief Executive Officer since December 2007 and, from August 2007 until December
2007, he served as the Company’s Chief Operating Officer. Mr. Tienor has also served as Chief Executive Officer of EthoStream, LLC, a
wholly-owned subsidiary of the Company, since March 2007. From 2002 until his employment with the Company, Mr. Tienor served as
Chief Executive Officer of Ethostream, LLC, the company that he co-founded. Mr. Tienor received a bachelor of business administration in
management information systems and marketing from the University of Wisconsin – Oshkosh and a masters of business administration from
Marquette University.
Dorothy E. Cleal—Chief Operating Officer
Ms. Cleal has served as the Company’s Chief Operating Officer since December 2007 and, from August 2007 until December 2007, she
served as the Company’s Executive Vice President. Prior to joining Telkonet, Ms. Cleal served, since 2005, as the Company’s Vice President
and Director, Navy and Marine Corps Business Program of SRA International, a billion dollar leading provider of consulting services to
clients in the national security, civil government, health care and public health industries. From 2000 through 2005 she served as the Navy
account manager as well as the Navy and Marine Corps account manager with SRA. Prior to joining SRA, Ms. Cleal was the acting Chief
Information Officer and Associate Director for Information Systems and Technology at the White House.
37
Richard J. Leimbach—Chief Financial Officer
Mr. Leimbach has served as the Company’s Chief Financial Officer since December 2007 and, from June 2006 until December 2007, he
served as the Vice President of Finance. He also served as the Company’s Controller from January 2004 until June 2006. Mr. Leimbach is a
certified public accountant with over fifteen years of public accounting and private industry experience. Prior to joining Telkonet, Mr.
Leimbach was the Controller with Ultrabridge, Inc., an applications solution provider. Mr. Leimbach also served as Corporate Accounting
Manager for Snyder Communications, Inc., a global provider of integrated marketing solutions.
Jeffrey Sobieski—Executive Vice President, Energy Management
Mr. Sobieski has served as the Company’s Executive Vice President, Energy Management since December 2007 and from March 2007 until
December 2007, he served as Chief Information Officer of Ethostream, LLC, wholly-owned subsidiary of the Company. From 2002 until his
employment with the Company, Mr. Sobieski served as Chief Information Officer of Ethostream, LLC, the company he co-founded. Mr.
Sobieski is also the co-founder of Interactive Solutions, a consulting firm providing support to the Insurance and Telecommunications
Industries.
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.
Warren V. Musser—Chairman of the Board of Directors
Warren V. “Pete” Musser joined the Board of Telkonet in January, 2003. Mr. Musser is the President and Chief Executive Officer of The
Musser Group LLC, a strategy consulting firm based in Wayne, Pennsylvania which he started in 2001. Mr. Musser is the founder and
former Chief Executive Officer and Chairman and current Chairman Emeritus of Safeguard Scientifics, Inc., a company that builds value in
high-growth, revenue-stage information technology and life sciences businesses. He was a founding investor of QVC, Novell, Compucom
Systems and Cambridge Technology Partners, among other companies. Mr. Musser currently serves as Chairman of InfoLogix, Inc. and
Epitome Systems, Inc. and is on the Board of Directors of NutriSystem, Inc., Internet Capital Group, Inc., Health Benefits Direct
Corporation and Health Advocate. Mr. Musser serves on a variety of civic and charitable boards, including as Co-Chairman of the Eastern
Technology Council, Chairman of Economics PA and Vice Chairman of the National Center for the American Revolution.
Ronald W. Pickett—Vice Chairman of the Board of Directors
Mr. Pickett was appointed as Vice Chairman of the Board of Directors subsequent to his resignation as the Company’s Chief Executive
Officer in December 2007, a position which he held since January 2003. In addition, he has fostered the development of Telkonet since 1999
as the Company’s principal 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.
38
Thomas C. Lynch—Director
Mr. Lynch is Senior Vice President 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 Chairman of Sprinturf, a synthetic turf company, and also as a Director of
Epitome Systems, Infologix Systems, Mikros Systems Corp., Economics Pennsylvania, Armed Forces Benefit Association, Catholic
Leadership Institute, National Center for the American Revolution at Valley Forge, USO Board of Governors and is currently a trustee of the
US Naval Academy Foundation. Mr. Lynch has served as the President of Valley Forge Historical Society, and Chairman of the Cradle of
Liberty Council, Boy Scouts of America. Mr. Lynch graduated from the US Naval Academy with his Bachelor of Science degree in 1964 and
received his Master of Science degree from the George Washington University. Mr. Lynch has been a director of the Company since October
2003.
Dr. Thomas M. Hall—Director
Dr. Hall is the Managing Director of Marrell Enterprises, LLC (a company that specializes in international business development). 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.
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 was 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.
Anthony J. Paoni - Director
Professor Paoni has been a faculty member at Northwestern University’s Kellogg School of Management since 1996. Previously, he spent 28
years in the information technology industry with market leading organizations that provided computer hardware, software and consulting
services. For the first 15 years of his career Professor Paoni managed sales and marketing organizations and in the later stages of his career he
moved into general management positions starting with PANSOPHIC Systems Incorporated. This Lisle, Illinois based firm was the world’s
fifth largest international software company prior to its acquisition by Computer Associates, Incorporated. Subsequently, he became chief
operating officer of Cross Access, a venture capital funded software firm that provided industry-leading solutions to the heterogeneous
database connectivity market segment. In addition, he has been president of two wholly-owned U.S. subsidiaries of Ricardo Consulting, a
U.K.-based international engineering consulting firm focused on computer based automotive powertrain design. Prior to joining the Kellogg
faculty, Professor Paoni was chief executive officer of Eolas, an Internet software company with patent pending Web technology - one of the
key technology drivers responsible for the rapid adoption of the Internet platform.
39
Audit Committee
The Company maintains an Audit Committee of the Board of Directors. For the year ended December 31, 2007, Messrs. Hall, Lynch and
Peeler served on the Audit Committee. The Company’s Board of Directors has determined that each of Messrs. Hall, Lynch and Peeler 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 Section 121(A) of the AMEX Rules and Rule 10A-3 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 at the 2004 Annual Meeting of
Stockholders.
Compensation Committee
The Company maintains a Compensation Committee of the Board of Directors. For the year ended December 31, 2007, Dr. Hall and Messrs.
Lynch and Paoni served on the Compensation Committee. The committee held 2 meetings during 2007. During the year ended December 31,
2007, Mr. Musser served on the Compensation Committee until November 21, 2007, at which time Mr. Paoni was elected to replace him.
Code of Ethics
The Board has approved, and Telkonet has adopted, a Code of Ethics that applies to all directors, officers and employees of Telkonet. 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.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 requires our directors and certain of our officers to file reports of holdings and
transactions in shares of Telkonet common stock with the Securities and Exchange Commission. Based on our records and other information,
we believe that in 2007 our directors and our officers who are subject to Section 16 met all applicable filing requirements.
ITEM 11.
EXECUTIVE COMPENSATION.
COMPENSATION COMMITTEE REPORT
The Compensation Committee of the Board of Directors has reviewed and discussed the section of this Form 10-K entitled “Compensation
Discussion and Analysis” with management. Based on this review and discussion, the Committee has recommended to the Board that the
section entitled “Compensation Discussion and Analysis,” be included in this Form 10-K for the fiscal year ended December 31, 2007.
Thomas M. Hall
Thomas C. Lynch
Anthony J. Paoni
Oversight of Executive Compensation Program
COMPENSATION DISCUSSION AND ANALYSIS
The Compensation Committee of the Board of Directors oversees the Company’s compensation programs, which are designed specifically for
the Company’s most senior executive officers, including the Chief Executive Officer, Chief Financial Officer and the other executive officers
named in the Summary Compensation Table (collectively, the “named executive officers”). Additionally, the Compensation Committee is
charged with the review and approval of all annual compensation decisions relating to named executive officers.
40
The Compensation Committee is composed of 3 independent, non-management members of the Board of Directors. Each year the Company
reviews any and all relationships that each director has with the Company and the Board of Directors subsequently reviews these findings.
The responsibilities of the Compensation Committee, as stated in its charter, include the following:
·
·
·
·
·
·
·
·
annually review and approve for the CEO and the executive officers of the Company the annual base salary, the annual
incentive bonus, including the specific goals and amount, equity compensation, employment agreements, severance
arrangements, and change in control agreements/provisions, and any other benefits, compensation or arrangements.
make recommendations to the Board with respect to incentive compensation plans, including reservation of shares for
issuance under employee benefit plans.
annually review and recommend to the Board of Directors for its approval the compensation, including cash, equity or
other compensation, for members of the Board of Directors for their service as a member of the Board of Directors, a
member of any committee of the Board of Directors, a Chair of any committee of the Board of Directors, and the
Chairman of the Board of Directors.
annually review the performance of the Company’s Chief Executive Officer.
make recommendations to the Board of Directors on the Company’s executive compensation practices and policies,
including the evaluation of performance by the Company’s executive officers and issues of management succession.
review the Company’s compliance with employee benefit plans.
make regular reports to the Board.
annually review and reassess the adequacy of the Compensation Committee charter and recommend any proposed
changes to the Board for approval.
The Compensation Committee is also responsible for completing an annual report on executive compensation for inclusion in the Company's
proxy statement. In addition to such annual report, the Compensation Committee maintains written minutes of its meetings, which minutes are
filed with the minutes of the meetings of the Board.
Overview of Compensation Program
In order to recruit and retain the most qualified and competent individuals as senior executives, the Company strives to maintain a
compensation program that is competitive in the global labor market. The purpose of the Company’s compensation program is to reward
exceptional organizational and individual performance.
The following compensation objectives are considered in setting the compensation programs for our named executive officers:
·
·
·
·
drive and reward performance which supports the Company’s core values;
provide a percentage of total compensation that is “at-risk,” or variable, based on predetermined performance criteria;
design competitive total compensation and rewards programs to enhance the Company’s ability to attract and retain knowledgeable
and experienced senior executives; and
set compensation and incentive levels that reflect competitive market practices.
41
Compensation Elements and Rationale
Compensation for Named Executive Officers Other than the CEO
Compensation for the named executive officers, other than the CEO, is made in the CEO’s sole and exclusive discretion. While the
Compensation Committee provides its recommendations with respect to compensation for the named executive officers (other than the CEO)
as described in greater detail below, the CEO is only required to consider the Compensation Committee’s recommendations, but is not bound
by its findings.
Compensation for the Company’s CEO
To reward both short and long-term performance in the compensation program and in furtherance of the Company’s compensation objectives
noted above, the Company’s compensation program for the CEO is based on the following objectives:
(i)
Performance Goals
The Compensation Committee believes that a significant portion of the CEO’s compensation should be tied not only to individual
performance, but also to the Company’s performance as a whole measured against both financial and non-financial goals and objectives.
During periods when performance meets or exceeds these established objectives, the CEO should be paid at or more than expected levels.
When the Company’s performance does not meet key objectives, incentive award payments, if any, should be less than such levels.
(ii)
Incentive Compensation
A large portion of compensation should be paid in the form of short-term and long-term incentives, which are calculated and paid based
primarily on financial measures of profitability and stockholder value creation. The CEO has the incentive of increasing Company
profitability and stockholder return in order to earn a major portion of his compensation package.
(iii)
Competitive Compensation Program
The Compensation Committee reviews the compensation of chief executive officers at peer companies to ensure that the compensation
program for the CEO is competitive. The Company believes that a competitive compensation program will enhance its ability to retain a
capable CEO.
Financial Metrics Used in Compensation Programs
Several financial metrics are commonly referenced in defining Company performance for the CEO’s executive compensation. These metrics
include quarterly metrics to target cash flow break even and specific revenue goals to define Company performance for purposes of setting the
CEO’s compensation.
Compensation Benchmarking Relative to Market
The Company sets the CEO’s compensation by evaluating peer group companies. Peer group companies are chosen based on size, industry,
annual revenue and whether they are publicly or privately held. Based on these criteria, the Compensation Committee has identified 29
companies in the Company’s peer group. These peer group companies include Catapult Communications Corp., Endwave Corp., Carrier
Access Corp., Crystal Technology, Echelon Corp. and FiberTower Corp. The Compensation Committee has concluded that the CEO’s
compensation falls within the 50th percentile of compensation for chief executive officers within the peer group companies.
Review of Senior Executive Performance
The Compensation Committee reviews, on an annual basis, each compensation package for the named executive officers. In each case, the
Compensation Committee takes into account the scope of responsibilities and experience and balances these against competitive salary levels.
The Compensation Committee has the opportunity to meet with the named executive officers at least once per year, which allows the
Compensation Committee to form its own assessment of each individual’s performance. As indicated above, with the exception of the CEO,
recommendations with respect to compensation packages for the named executive officers must be considered by the CEO in connection with
establishing compensation for those named executive officers. However, the recommendations of the Compensation Committee with respect
to the compensation paid to the named executive officers (other than the CEO) will not be binding on the CEO.
42
Components of the Executive Compensation Program
The Compensation Committee believes the total compensation and benefits program for named executive officers should consist of the
following:
·
·
·
·
·
base salary;
stock incentive plan;
retirement, health and welfare benefits;
perquisites and perquisite allowance payments; and
termination benefits.
Base Salaries
With the exception of the CEO, whose compensation is set by the Compensation Committee and approved by the Board of Directors, base
salaries and merit increases for the named executive officers are determined by the CEO in his discretion after consideration of a competitive
analysis recommendation provided by the Compensation Committee. The Compensation Committee’s recommendation is formulated through
the evaluation of the compensation of similar executives employed by companies in the Company’s peer group.
Stock Incentive Plan
Under the Company’s Stock Incentive Plan (the “Plan”) incentive stock options and non-qualified options to purchase shares of the
Company’s common stock may be granted to key employees. An important objective of the long-term incentive program is to strengthen the
relationship between the long-term value of the Company’s stock price and the potential financial gain for employees as well as the retention
of senior management and key personnel. Stock options provide named executive officers with the opportunity to purchase the Company’s
common stock at a price fixed on the grant date regardless of future market price. Stock options generally vest ratably on a quarterly basis and
become exercisable over a five-year vesting period. A stock option becomes valuable only if the Company’s common stock price increases
above the option exercise price (at which point the option will be deemed “in-the-money”) and the holder of the option remains employed
during the period required for the option to “vest” thus, providing an incentive for an option holder to remain employed by the Company. In
addition, stock options link a portion of an employee’s compensation to stockholders’ interests by providing an incentive to increase the
market price of the Company stock.
The Company practice is that the exercise price for each stock option is equal to the fair market value on the date of grant. Under the terms of
the Plan, the option price will not be less than the fair market value of the shares on the date of grant or, in the case of a beneficial owner of
more than 5.0% of the Company’s outstanding common stock on the date of grant, the option price will not be less than 110% of the fair
market value of the shares on the date of grant.
There is a limited term in which Plan participants can exercise stock options, known as the “option term.” The option term is generally ten
years from the date of grant. At the end of the option term, the right to exercise any unexercised options expires. Option holders generally
forfeit any unvested options if their employment with the Company terminates.
Certain key executives may be a party to option agreements containing clauses that cause their options to become immediately and fully
vested and exercisable upon a Change of Control, as defined in the Plan. Additionally, death or disability of the executive during his or her
employment period may cause certain stock options to immediately vest and become exercisable per the terms outlined in the stock option
award agreement.
The Compensation Committee awards options to named executive officers upon commencement of their employment with the Company, and
for successfully achieving or exceeding predetermined individual and Company performance goals. In determining whether to award stock
options and the number of stock options granted to a named executive officer, the Compensation Committee reviews the compensation of
executives at peer group companies to ensure that the compensation program is competitive.
43
Retirement, Health and Welfare Benefits
The Company offers a variety of health and welfare and retirement programs to all eligible employees. The named executive officers generally
are eligible for the same benefit programs on the same basis as the rest of the broad-based employees. The Company’s health and welfare
programs include medical, dental, vision, life, accidental death and disability, and short and long-term disability insurance. In addition to the
foregoing, the named executive officers are eligible to participate in the Company’s 401(k) Profit Sharing Plan.
401(k) Profit Sharing Plan
Telkonet maintains a defined contribution profit sharing plan for employees (the “Telkonet 401(k)”) that is administered by a committee of
trustees appointed by the Company. All Company employees are eligible to participate upon the completion of six months of employment,
subject to minimum age requirements. Contributions by employees under the Telkonet 401(k) are immediately vested and each employee is
eligible for distributions upon retirement, death or disability or termination of employment. Depending upon the circumstances, these
payments may be made in installments or in a single lump sum.
MSTI maintains a defined contribution profit sharing plan for employees (the “MSTI 401(k)”) that is administered by a committee of trustees
appointed by the Company. All Company employees are eligible to participate upon the completion of three months of employment, subject to
minimum age requirements. Each year the Company makes a contribution to the MSTI 401(k) without regard to current or accumulated net
profits of the Company. These contributions are allocated to participants in amounts of 100% of the participants’ contributions up to 1% of
each participant’s gross pay, then 10% of the next 5% of each participant’s gross pay (a higher contribution percentage may be determined at
the Company’s discretion). In addition, the Company makes a one-time, annual contribution of 3% of each participant’s gross pay to each
participant’s contribution account in the MSTI 401(k) plan. Participants become vested in equal portions of their Company contribution
account for each year of service until full vesting occurs upon the completion of six years of service. Distributions are made upon retirement,
death or disability in a lump sum or in installments.
Perquisites
The Company leases a vehicle for the use of Telkonet's CEO. The lease will expire in September 2008. Additionally, in the first quarter of
2007 the Company began providing monthly car allowance stipends to certain executives of Telkonet, MSTI and Ethostream.
EXECUTIVE COMPENSATION
The following table sets forth certain information with respect to compensation for services in all capacities for the years ended December 31,
2007, 2006 and 2005 paid to our Chief Executive Officer (principal executive officer), Chief Financial Officer (principal financial officer) and
the three other most highly compensated executive officers who were serving as such as of December 31, 2007.
44
Name and Principal
Position
Year
Salary
($)
Bonus
($)
Summary Compensation Table
Stock
Awards
($)
Option
Awards
($)
(6)(7)(8)
Non-Equity
Incentive Plan
Compensation
($)
Jason Tienor
President and Chief
Executive Officer (1)
2007 $133,022
2006
2005
$0
$0
$0
$0
$0
Richard J. Leimbach
Chief Financial
Officer
2007 $133,491 $25,000
$5,000
2006 $111,231
$3,936
2005 $102,340
$0
$0
$0
$0
$0
$0
Ronald W. Pickett
President and Chief
Executive Officer (2)
Dorothy E. Cleal
Chief Operating
Officer (4)
Jeff Sobieski
Executive Vice
President (5)
2007 $424,075 $150,000
2006 $245,423
2005 $102,340 $200,000 $163,319 (3)
$0
$0
$0
2007
2006
2005
$70,154
$0
$0
2007 $122,003
2006
2005
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$111,230
$0
$0
$0
$0
$156,300
$0
$0
$0
$55,615
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
Change in
Pension Value
and
Nonqualified
Deferred
Compensation
Earnings
($)
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
Total
($)
All Other
Compen-
sation
($)
$6,139
$0
$0
$250,391
$0
$0
$0
$0
$0
$158,491 (9)
$116,231
$262,576
$2,296
$4,593
$0
$576,371 (10)
$250,016
$465,659
$0
$0
$0
$6,139
$0
$0
$125,769
$0
$0
$128,142
$0
$0
$0
2007 $175,698
2006 $174,886
$6,789
2005 $176,508 $15,000
James F. Landry
Chief Technology
Officer
____________________
(1) Mr. Tienor was appointed as President and Chief Executive Officer of Telkonet, Inc. on December 11, 2007. Prior to this appointment,
Mr. Tienor served as Chief Executive Officer of Ethostream, the Company’s wholly-owned subsidiary since March 2007, and Chief
Operating Officer of Telkonet, Inc. since August 20, 2007.
$175,698
$181,675
$191,508
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
$0
(2) Mr. Pickett resigned as President and Chief Executive Officer on December 11, 2007.
(3) In the year ending December 31, 2005, 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.
(4) Ms. Cleal was appointed as Chief Operating Officer of Telkonet, Inc. on December 11, 2007. Prior to this appointment, Ms. Cleal
served as Executive Vice President since August 20, 2007.
(5) Mr. Sobieski was appointed as Executive Vice President of Telkonet, Inc. on December 11, 2007. Prior to this appointment, Mr.
Sobieski served as Chief Information Officer of Ethostream, the Company’s wholly-owned subsidiary, since March 2007.
(6) In 2005 the following assumptions were used to determine the fair value of stock option awards granted: historical volatility of 71%
expected option life of 5.0 years and a risk-free interest rate of 4.5%.
(7) In 2006 the following assumptions were used to determine the fair value of stock option awards granted: historical volatility of 65%
expected option life of 5.0 years and a risk-free interest rate of 5.0%.
(8) In 2007 the following assumptions were used to determine the fair value of stock option awards granted: historical volatility of 70%
expected option life of 5.0 years and a risk-free interest rate of 4.8%.
(9) Mr. Leimbach received $8,750 in salary for his services as Vice President Finance of MSTI, a position which he has held since July
2007.
(10) Mr. Pickett received $34,615 in salary for his services as President of MSTI, a position which he has held since May 2007.
45
Employment Agreements
Jason Tienor, President and Chief Executive Officer, is employed pursuant to an employment agreement dated March 15, 2007. Mr. Tienor’s
employment agreement has a term of three years, which may be extended by mutual agreement of the parties thereto, and provides for an
annual base salary of $148,000 per year and bonuses and benefits based on Telkonet’s internal policies. On August 20, 2007, Mr. Tienor’s
annual salary was increased to $200,000 and he remains eligible to participate in the incentive and benefit plans pursuant to his existing
employment agreement and Telkonet’s internal policies.
Dorothy (Dottie) Cleal, Chief Operating Officer, has been employed since August 20, 2007 with an annual salary of $190,000 and bonuses
and benefits based upon Telkonet’s internal policies. Ms. Cleal does not have a written employment agreement.
Richard J. Leimbach, Chief Financial Officer, has been employed by the Company since January 26, 2004. Mr. Leimbach’s annual salary
was increased from $130,000 to $190,000 in December 2007 in connection with his appointment as Chief Financial Officer. He is also
eligible to receive bonuses and benefits based upon Telkonet’s internal policies. Mr. Leimbach does not have a written employment
agreement. In addition, Mr. Leimbach receives an annual salary of $25,000 for his services as Vice President Finance of MSTI.
James F. Landry, Chief Technology Officer, has been employed with the Company since September 24, 2001. Mr. Landry’s annual salary in
2007 was $176,508 and he is entitled to receive bonuses and benefits based upon Telkonet’s internal policies. Mr. Landry does not have a
written employment agreement.
Jeff Sobieski, Executive Vice President, Energy Management, is employed pursuant to an employment agreement, dated March 15, 2007. Mr.
Sobieski’s employment agreement has a term of three years, which may be extended by mutual agreement of the parties thereto, and provides
for a base salary of $148,000 per year and bonuses and benefits based upon Telkonet’s internal policies. On December 11, 2007, Mr.
Sobieski’s salary was increased to $190,000 and he remains eligible to participate in the incentive and benefit plans pursuant to his existing
employment agreement and Telkonet’s internal policies.
Ronald W. Pickett, President and Chief Executive Officer, was employed pursuant to an employment agreement for an unspecified term that
commenced January 30, 2003. As of January 1, 2007, Mr. Pickett’s annual salary was $250,000 and he was entitled to receive bonuses
and benefits based upon Telkonet’s internal policies. On March 19, 2007, Mr. Pickett’s annual base salary was increased to $425,000,
including compensation in the annual amount of $75,000 for his service as President of MSTI, and he was awarded an incentive bonus of
$150,000 for his performance as Chief Executive Officer during the year ended December 31, 2006. On December 11, 2007, Mr. Pickett
resigned as President and Chief Executive Officer and on February 13, 2008, the Board of Directors approved a severance compensation
package of $350,000 plus benefits paid through 2008. In addition, Mr. Pickett agreed to provide services as Vice Chairman of the Board of
Directors in 2008 for no additional compensation.
In addition, to the foregoing, stock options are periodically granted to employees under the Company’s Plan at the discretion of the
Compensation Committee of the Board of Directors. Executives of Telkonet are eligible to receive stock option grants, based upon individual
performance and the performance of Telkonet as a whole.
GRANT OF PLAN BASED AWARDS
The following table sets forth information concerning stock options granted in the fiscal year ended December 31, 2007, to the persons listed
on the Summary Compensation Table.
Name
Jason Tienor
Richard J. Leimbach
Dorothy E. Cleal
Jeffrey Sobieski
James Landry
All Other
Option Awards:
Number of
Securities Underlying
Options Granted
(#)
100,000
0
50,000
0
0
Exercise Price or
Base Price of
Option Awards
($/sh)
$1.80
n/a
$1.80
n/a
n/a
Grant Date
Fair Value of
Stock
and Option
Awards
$111,230
n/a
$55,615
n/a
n/a
Grant Date
8/10/2007
n/a
8/10/2007
n/a
n/a
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END TABLE
The following table shows outstanding stock option awards classified as exercisable and unexercisable as of December 31, 2007 for the named
executive officers. The table also shows unvested and unearned stock awards (both time-based awards and performance-contingent) assuming
a market value of $0.75 a share (the closing market price of the Company’s stock on December 31, 2007).
46
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END
Name
Number of
Securities
Underlying
Unexercised
Options
(#)
Exerciseable
Number of
Securities
Underlying
Unexercised
Options
(#)
Unexerciseable
Option Awards
Equity
Incentive
Plan
Awards:
Number of
Securities
Underlying
Unexercised
Unearned
Options
(#)
Stock Awards
Option
Exercise
Price
($)
Option
Expiration
Date
Number of
Shares or
Units of
Stock
That Have
Not Vested
(#)
Market
Value of
Shares or
Units of
Stock That
Have Not
Vested
($)
Equity
Incentive
Plan
Awards:
Number of
Unearned
Shares,
Units
or Other
Rights That
Have Not
Vested
(#)
Jason Tienor
Dorothy Cleal
5,000
2,500
95,000
47,500
Richard J. Leimbach
60,000
27,500
James F. Landry
450,000
50,000
Jeffrey Sobieski
Ronald W. Pickett
_________________
-
-
-
-
-
-
-
-
-
-
$1.80
$1.80
(1)
(2)
N/A
N/A
4/23/2012
(3)
4/23/2012
(3)
4/23/2012
(3)
4/23/2012
(3)
N/A
N/A
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
Equity
Incentive
Plan
Awards:
Market or
Payout
Value of
Unearned
Shares,
Units
or Other
Rights That
Have Not
Vested
($)
-
-
-
-
-
-
(1)
Includes 27,500 and 10,000 vested and unvested options, respectively, exerciseable at $2.59, and 32,500 and 17,500 vested and
unvested options, respectively, exerciseable at $5.08 per share.
Includes 250,000 fully vested options, exerciseable at $1.00 per share with expiration dates ranging from 12/3/2011 to 7/1/2013 and
200,000 and 50,000 vested and unvested options, respectively, exerciseable at $3.45 per share with an expiration dates of 5/1/2014.
(3) All options granted in accordance with the Telkonet Amended and Restated Stock Incentive Plan (the “Plan”) have an outstanding term
(2)
equal to the shorter of ten years, or the expiration of the Plan. The Plan expires on April 24, 2012.
OPTION EXERCISES AND STOCK VESTED
There were no options exercised by, or stock awards vested for the account of, the named executive officers during 2007.
POTENTIAL PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL
Each of Mr. Tienor’s and Mr. Sobieski’s Employment Agreement obligate the Company to continue to pay each executive’s base salary and
provide continued participation in employee benefit plans for the duration of the term of their employment agreements in the event such
executive is terminated without “cause” by the Company or if the executive terminates his employment for “good reason.” “Cause” is defined
as the occurrence of any of the following: (i) theft, fraud, embezzlement, or any other act of dishonesty by the executive; (ii) any material
breach by the executive of any provision of the employment agreement which breach is not cured within a reasonable time (but not to exceed
thirty (30) days after written notification thereof to the executive by Telkonet; (iii) any habitual neglect of duty or misconduct of the executive
in discharging any of his duties and responsibilities under the employment agreement after a written demand for performance was delivered to
the executive that specifically identified the manner in which the board believed the executive had failed to discharge his duties and
responsibilities, and the executive failed to resume substantial performance of such duties and responsibilities on a continuous basis
immediately following such demand; (iv) commission by the executive of a felony or any offense involving moral turpitude; or (v) any default
of the executive’s obligations under the employment agreement, or any failure or refusal of the executive to comply with the policies, rules
and regulations of Telkonet generally applicable to Telkonet employees, which default, failure or refusal is not cured within a reasonable time
(but not to exceed thirty (30) days) after written notification thereof to the executive by Telkonet. If cause exists for termination, the executive
shall be entitled to no further compensation, except for accrued leave and vacation and except as may be required by applicable law. “Good
reason” is defined as the occurrence of any of the following: (i) any material adverse reduction in the scope of the executive’s authority or
responsibilities; (ii) any reduction in the amount of the executive’s compensation or participation in any employee benefits; or (iii) the
executive’s principal place of employment is actually or constructively moved to any office or other location 50 miles or more outside of
Milwaukee, Wisconsin.
47
In the event Telkonet fails to renew the employment agreements upon expiration of the term, then Telkonet shall continue to pay the
executive's base salary and provide the executive with continued participation in each employee benefit plan in which the executive
participated immediately prior to expiration of the term for a period of three months following expiration of the term. Each of Messrs. Tienor
and Sobieski have agreed to not to compete with the Company or solicit any Company employees for a period of one year following
expiration or earlier termination of the employment agreements.
Director Compensation
Telkonet reimburses non-management directors for costs and expenses in connection with 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 $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.
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 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 are made to The Musser Group pursuant to a consulting agreement described
below under the heading “Certain Relationships and Related Transactions.”
On July 1, 2005, the Company executed a consulting agreement with Mr. Blumenfeld pursuant to which Mr. Blumenfeld was issued 10,000
shares of Company common stock upon execution of the agreement, 10,000 shares of Company common 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. Under the terms of the consulting
agreement Mr. Blumenfeld was also entitled to receive a commission equal to 5% on all international sales generated by him having gross
margins of 50% or more. This commission was payable in cash or common stock, at Mr. Blumenfeld’s option. The agreement had a one year
term, and was renewable annually upon both parties’ agreement. The consulting agreement expired on June 20, 2006 and was not renewed. On
March 16, 2007, the Board of Directors authorized a payment to Mr. Blumenfeld of $24,000 for Board service between July 1, 2006, and
December 31, 2006, which payments were commensurate with the payments made to the other directors for Board service during that time
period. Effective January 1, 2007, Mr. Blumenfeld began receiving compensation in accordance with the non-management director
compensation plan.
The following table summarizes all compensation paid to the Company’s directors in the year ended December 31, 2007.
Fees
Earned or
Paid in
Cash
($)
Name
Stock
Awards
($)
Option
Awards
($)
Non-Equity
Incentive Plan
Compensation
($)
Change in
Pension Value
and
Nonqualified
Deferred
Compensation
Earnings
All Other
Compensation
($)
Total
($)
$
$
- $
-
-
-
48,000
56,000
56,000
52,000
$
-
60,217(2)
60,217(2)
60,217(2)
Warren V.
Musser
Thomas M. Hall
Thomas C. Lynch
James L. Peeler
Seth D.
Blumenfeld
Ronald W. Pickett
Anthony J. Paoni
_________________
(1) fees for director services performed by Mr. Musser and paid to the Musser Group pursuant to a September 2003 consulting agreement.
(2) Stock options granted pursuant to the 2007 non-management director compensation plan.
(3) Includes a payment of $24,000 to Mr. Blumenfeld for his services as a director in 2006.
52,000(1) $
-
-
-
60,217(2)
-
37,367(2)
67,950(3)
-
37,000
- $
-
-
-
- $
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
100,000
116,217
116,217
112,217
128,167
-
74,367
48
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
During the year ended December 31, 2007, Messrs, Hall, Lynch and Paoni served as members of the Company’s Compensation Committee.
None of the members of the Compensation Committee was an employee of the Company during the year ended December 31, 2007 nor has
any of them been an officer of the Company. No executive officer of the Company served during the year ended December 31, 2007 as a
member of a compensation committee or as a director of any entity of which any of the Company’s directors served as an executive officer.
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, 2007.
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)
9,421,366
-
9,421,366
(b)
$1.84
-
$1.84
Number of securities
remaining available for
future issuance under equity
compensation plans
(excluding securities
reflected in column (a))
(c)
2,170,423
-
2,170,423
The following table sets forth, as of March 1, 2008, 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, 2008, there were no issued and outstanding
shares of any other class of the Company’s equity securities.
Name and Address of Beneficial Owner
Amount and Nature of Beneficial
Ownership
Percentage of Class
5% Shareholders
Stephen L. Sadle
20374 Seneca Meadows Parkway
Germantown, MD 20876
Officers and Directors
Jason Tienor, President and Chief Executive Officer
20374 Seneca Meadows Parkway
Germantown, MD 20876
Dorothy Cleal, Chief Operating Officer
20374 Seneca Meadows Parkway
Germantown, MD 20876
4,254,514(1)
5.8%
886,803(2)(3)
10,000(4)
49
1.2%
*
Richard Leimbach, Chief Financial Officer
20374 Seneca Meadows Parkway
Germantown, MD 20876
James Landry, Chief Technology Officer
20374 Seneca Meadows Parkway
Germantown, MD 20876
Jeffrey Sobieski, Executive Vice President
20374 Seneca Meadows Parkway
Germantown, MD 20876
Warren V. Musser, Chairman
20374 Seneca Meadows Parkway
Germantown, MD 20876
Ronald W. Pickett, Vice Chairman
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 L. Peeler, Director
20374 Seneca Meadows Parkway
Germantown, MD 20876
Seth D. Blumenfeld, Director
20374 Seneca Meadows Parkway
Germantown, MD 20876
Anthony J. Paoni, Director
20374 Seneca Meadows Parkway
Germantown, MD 20876
61,000(5)
484,200(6)
876,803(7)
2,000,000(8)
2,537,699
170,000(9)
707,790(10)
154,400(11)
90,000(12)
40,000(13)
All Directors and Executive Officers as a Group
_____________________
* Represents less than 0.1% beneficial ownership of Telkonet common stock as of reporting date
8,538,695
0.1%
0.7%
1.2%
2.7%
3.5%
0.2%
1.0%
0.2%
0.1%
0.1%
11.2%
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
(13)
Includes options exercisable within 60 days to purchase 900,000 shares of the Company’s common stock at $1.00 per share.
Includes 876,803 shares of the Company’s common stock issued to Mr. Tienor in conjunction with the Company’s March 2007
acquisition of Ethostream, LLC.
Includes options exercisable within 60 days to purchase 10,000 shares of the Company’s common stock at $1.80 per share.
Includes options exercisable within 60 days to purchase 5,000 shares of the Company’s common stock at $1.80 per share.
Includes options exercisable within 60 days to purchase 27,500 and 32,500 shares of the Company’s common stock at $2.59 and $5.08
per share, respectively.
Includes options exercisable within 60 days to purchase 250,000 and 200,000 shares of the Company’s common stock at $1.00 and
$3.45 per share, respectively.
Includes 876,803 shares of the Company’s common stock issued to Mr. Sobieski in conjunction with the Company’s March 2007
acquisition of Ethostream, LLC.
Includes options exercisable within 60 days to purchase 2,000,000 shares of the Company’s common stock at $1.00 per share.
Includes options exercisable within 60 days to purchase 20,000, 70,000 and 80,000 shares of the Company’s common stock at $2.00,
$2.66 and $3.45 per share, respectively.
Includes options exercisable within 60 days to purchase 70,000 and 80,000 shares of the Company’s common stock at $2.66 and $3.45
per share, respectively.
Includes options exercisable within 60 days to purchase 70,000 and 80,000 shares of the Company’s common stock at $2.66 and $3.45
per share, respectively.
Includes options exercisable within 60 days to purchase 40,000 shares of the Company’s common stock at $2.66 per share.
Includes options exercisable within 60 days to purchase 40,000 shares of the Company’s common stock at $2.30 per share.
50
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
Description of Related Party 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 and owner of The Musser Group. For the years ended December 31, 2007, 2006, and 2005, the Company paid and
expensed $100,000, $100,000 and $100,000, respectively.
In February 2007, the Company entered into a one-year professional services agreement with Global Transport Logistics, Inc. (“GTI”), for the
provision of consulting services for which GTI is paid a fee of $10,000 per month. GTI is 50% owned by Anthony Matarazzo, the brother of
MSTI’s Chief Executive Officer.
The Chief Administrative Officer at MSTI, Laura Matarazzo, is the sister of the Chief Executive Officer of MSTI and receives an annual base
salary of approximately $134,000 with bonuses and benefits based upon the Company’s internal policies.
Company’s Policies on Related Party Transactions
Under the Company’s policies and procedures, related-party transactions that must be publicly disclosed under the federal securities laws
require prior approval of the Company’s independent directors without the participation of any director who may have a direct or indirect
interest in the transaction in question. Related parties include directors, nominees for director, principal shareholders, executive officers and
members of their immediate families. For these purposes, a “transaction” includes all financial transactions, arrangements or relationships,
ranging from extending credit to the provision of goods and services for value and includes any transaction with a company in which a
director, executive officer immediate family member of a director or executive officer, or principal shareholder (that is, any person who
beneficially owns five percent or more of any class of the Company’s voting securities) has an interest by virtue of a 10-percent-or-greater
equity interest. The Company’s policies and procedures regarding related-party transactions are not a part of a formal written policy, but
rather, represent the Company’s historical course of practice with respect to approval of related-party transactions.
Director Independence
The Board of Directors has determined that the following Directors are “independent” under the listing standards of the American Stock
Exchange (AMEX): Dr. Hall, Mr. Lynch, Mr. Peeler and Mr. Paoni. Each of Dr. Hall, Mr. Peeler and Mr. Lynch serve on, and are the only
members of, the Company’s Audit Committee. Each of Dr. Hall, Mr. Lynch and Mr. Paoni serve on, and are the only members of, the
Company’s Compensation Committee. Although Telkonet does not maintain a standing Nominating Committee, nominees for election as
directors are considered and nominated by a majority of Telkonet’s independent directors in accordance with the AMEX listing standards.
“Independence” for these purposes is determined in accordance with Section 121(A) of the AMEX Rules and Rule 10A-3 under the Securities
Exchange Act of 1934.
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, 2007 and 2006.
51
1. Audit Fees
2. Audit Related Fees
3. Tax Fees
4. All Other Fees
Total Fees
$
$
December
31,
2007
379,828 $
136,525
--
--
516,353 $
December 31,
2006
229,552
52,600
--
--
282,152
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 RBSM 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 consist 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, 2007, 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, 2007 and 2006.
QUARTERLY FINANCIAL DATA
(unaudited)
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
March 31,
2007
1,246,269
$
(70,192) $
$
-
(0.09) $
(0.09) $
$
$
$
$
$
June 30,
2007
$
3,666,607
$
670,718
-
$
(0.07) $
(0.07) $
September
30,
2007
$
4,588,777
$
1,219,758
-
$
(0.07) $
(0.07) $
December
31,
2007
4,651,081
661,854
-
(0.08)
(0.08)
March 31,
2006
$
1,943,912
$
648,342
$
-
(0.09) $
(0.09) $
$
$
$
$
$
June 30,
2006
$
1,152,470
$
139,628
-
$
(0.16) $
(0.16) $
September
30,
2006
$
1,143,097
$
83,049
-
$
(0.20) $
(0.20) $
December
31,
2006
941,848
(170,350)
-
(0.08)
(0.08)
52
The following table sets forth selected unaudited valuation and qualifying account information for the Company’s year-ended December 31,
2007, 2006 and 2005.
SCHEDULE II- VALUATION AND QUALIFYING ACCOUNTS
(unaudited)
DESCRIPTION
Allowance for doubtful accounts:
Year ended December 31,
2007
2006
2005
Reserve for product returns:
Year ended December 31,
2007
2006
2005
BALANCE
BEGINNING
CHARGED
TO COSTS
AND
OF YEAR
EXPENSES DEDUCTIONS
BALANCE,
END OF
YEAR
$
60,000
30,000
13,000
$
366,495
36,659
39,710
(314,538) $
(6,659)
(22,710)
111,957
60,000
30,000
$
47,300
24,000
—
$
83,901
23,300
—
(28,667) $
—
—
102,534
47,300
—
$
$
53
The following exhibits are included herein or incorporated by reference:
Exhibit
Number
Description Of Document
2.1
2.2
2.3
3.1
3.2
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.11
4.12
4.13
4.14
4.15
10.1
10.2
10.3
10.4
10.5
10.6
MST Stock Purchase Agreement and Amendment (incorporated by reference to our 8-K filed on February 2, 2006)
Asset Purchase Agreement by and between Telkonet, Inc. and Smart Systems International, dated as of February 23, 2007
(incorporated by reference to our Form 8-K filed on March 2, 2007)
Unit Purchase Agreement by and among Telkonet, Inc., Ethostream, LLC and the members of Ethostream, LLC dated as of
March 15, 2007 (incorporated by reference to our Form 8-K filed on March 16, 2007)
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)
Senior Convertible Note by Telkonet, Inc. in favor of Portside Growth & Opportunity Fund (incorporated by reference to
our Form 8-K (No. 001-31972), filed on October 31, 2005)
Senior Convertible Note by Telkonet, Inc. in favor of Kings Road Investments Ltd. (incorporated by reference to our Form
8-K (No. 001-31972), filed on October 31, 2005)
Warrant to Purchase Common Stock by Telkonet, Inc. in favor of Portside Growth & Opportunity Fund (incorporated by
reference to our Form 8-K (No. 001-31972), filed on October 31, 2005)
Warrant to Purchase Common Stock by Telkonet, Inc. in favor of Kings Road Investments Ltd. (incorporated by reference
to our Form 8-K (No. 001-31972), filed on October 31, 2005)
Form of Warrant to Purchase Common Stock (incorporated by reference to our Current Report on Form 8-K (No. 001-
31972), filed on September 6, 2006)
Form of Accelerated Payment Option Warrant to Purchase Common Stock (incorporated by reference to our Registration
Statement on Form S-3 (No. 333-137703), filed on September 29, 2006.
Form of Warrant to Purchase Common Stock (incorporated by reference to our Current Report on Form 8-K filed on
February 5, 2007)
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)
Registration Rights Agreement by and among Telkonet, Inc., Kings Road Investments Ltd. and Portside Growth &
Opportunity Fund, dated October 27, 2005 (incorporated by reference to our Form 8-K (No. 001-31972), filed on October
31, 2005)
Professional Services Agreement by and between Telkonet, Inc. and Seth D. Blumenfeld, dated July 1, 2005 (incorporated
by reference to our Form 10-Q (No. 000-27305), filed on November 9, 2005.
54
10.7
10.9
10.10
10.11
10.12
10.13
10.14
10.15
10.16
10.17
10.18
14
21
23
24
31.1
31.2
32.1
32.2
Employment Agreement by and between Telkonet, Inc. and Frank T. Matarazzo, dated as of February 1, 2006 (incorporated
by reference to our Form 10-K (No. 001-31972), filed March 16, 2006)
Settlement Agreement by and among Telkonet, Inc. and Kings Road Investments Ltd., dated as of August 14, 2006
(incorporated by reference to our Form 8-K (No. 001-31972), filed on August 16, 2006)
Settlement Agreement by and among Telkonet, Inc. and Portside Growth & Opportunity Fund, dated as of August 14, 2006
(incorporated by reference to our Form 8-K (No. 001-31972), filed on August 16, 2006)
Securities Purchase Agreement, dated August 31, 2006, by and among Telkonet, Inc., Enable Growth Partners LP, Enable
Opportunity Partners LP and Pierce Diversified Strategy Master Fund LLC, Ena (incorporated by reference to our Form 8-
K (No. 001-31972), filed on September 6, 2006)
Registration Rights Agreement, dated August 31, 2006, by and among Telkonet, Inc., Enable Growth Partners LP, Enable
Opportunity Partners LP and Pierce Diversified Strategy Master Fund LLC, Ena (incorporated by reference to our Form 8-
K (No. 001-31972), filed on September 6, 2006)
Securities Purchase Agreement, dated February 1, 2007, by and among Telkonet, Inc., Enable Growth Partners LP, Enable
Opportunity Partners LP, Pierce Diversified Strategy Master Fund LLC, Ena, Hudson Bay Fund LP and Hudson Bay
Overseas Fund, Ltd. (incorporated by reference to our Current Report on Form 8-K filed on February 5, 2007)
Registration Rights Agreement, dated February 1, 2007, by and among Telkonet, Inc., Enable Growth Partners LP, Enable
Opportunity Partners LP and Pierce Diversified Strategy Master Fund LLC, Ena, Hudson Bay Fund LP and Hudson Bay
Overseas Fund, Ltd. (incorporated by reference to our Current Report on Form 8-K filed on February 5, 2007)
Employment Agreement by and between Telkonet, Inc. and William Dukes, dated as of March 9, 2007 (incorporated by
reference to our Form 10-K (No. 001-31972), filed March 16, 2007)
Employment Agreement by and between Telkonet, Inc. and Robert Zirpoli, dated as of March 9, 2007 (incorporated by
reference to our Form 10-K (No. 001-31972), filed March 16, 2007)
Employment Agreement by and between Telkonet, Inc. and Jason Tienor, dated as of March 15, 2007 (incorporated by
reference to our Form 10-K (No. 001-31972), filed March 16, 2007)
Employment Agreement by and between Telkonet, Inc. and Jeff Sobieski, dated as of March 15, 2007 (incorporated by
reference to our Form 10-K (No. 001-31972), filed March 16, 2007)
Code of Ethics (incorporated by reference to our Form 10-KSB (No. 001-31972), filed on March 30, 2004).
Telkonet, Inc. Subsidiaries
Consent of RBSM LLP , Independent Registered Certified Public Accounting Firm, filed herewith
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 Jason Tienor
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Richard J. Leimbach
Certification of Jason Tienor pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
Certification of Richard J. Leimbach pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
55
Pursuant to the requirements of 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.
SIGNATURES
TELKONET, INC.
/s/ Jason Tienor
Jason Tienor
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
/s/ Jason Tienor
Jason Tienor
/s/ Richard J. Leimbach
Richard J. Leimbach
/s/ Warren V. Musser
Warren V. Musser
/s/ Ronald W. Pickett
Ronald W. Pickett
/s/ Anthony J. Paoni
Anthony J. Paoni
/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
Position
Chief Executive Officer
(principal executive officer)
Chief Financial Officer
(principal financial officer)
(principal accounting officer)
Date
April 1, 2008
April 1, 2008
Chairman of the Board
April 1, 2008
Vice Chairman of the Board
April 1, 2008
Director
Director
Director
Director
Director
56
April 1, 2008
April 1, 2008
April 1, 2008
April 1, 2008
April 1, 2008
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FINANCIAL STATEMENTS AND SCHEDULES
DECEMBER 31, 2007 AND 2006
FORMING A PART OF ANNUAL REPORT
PURSUANT TO THE SECURITIES EXCHANGE ACT OF 1934
TELKONET, INC.
F-1
TELKONET, INC.
Index to Financial Statements
Report of Independent Registered Certified Public Accounting Firm
Consolidated Balance Sheets at December 31, 2007 and 2006
Consolidated Statements of Losses for the Years ended December 31, 2007, 2006 and 2005
Consolidated Statements of Stockholders’ Equity for the Years ended December 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows for the Years ended December 31, 2007, 2006 and 2005
Notes to Consolidated Financial Statements
F-2
F-3
F-4
F-5
F-6
F-9
F-11
RBSM 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 subsidiaries (the "Company") as of
December 31, 2007 and 2006 and the related consolidated statements of losses, stockholders' equity, and cash flows for each of the three
years in the period ended December 31, 2007. 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 subsidiaries as of December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of
America.
As discussed in Note 1 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial
Accounting Standards No. 123(R), "Share-Based Payment", effective January 1, 2006.
The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern.
As discussed in the Note A to the accompanying financial statements, the Company has incurred significant operating losses in current year
and also in the past. These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern. The
financial statements do not include any adjustments that might result from the outcome of this uncertainty.
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, 2007, 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 March 31, 2008 express an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
McLean, Virginia
March 31, 2008
F-3
/s/ RBSM LLP
Certified Public Accountants
TELKONET, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2007 AND 2006
ASSETS
Current assets:
Cash and cash equivalents
Accounts receivable, net of allowance for doubtful accounts of $111,957 and $60,000 at December 31,
2007 and 2006, respectively
Investment in Sales Type Leases (Note T)
Income tax receivable (Note L)
Inventories (Note D)
Prepaid expenses and deposits
Total current assets
Property and equipment, at cost (Note E):
Furniture and equipment
Less: accumulated depreciation
Total property and equipment, net
Equipment under operating leases, at cost (Note F):
Telecommunications and related equipment, at cost
Less: accumulated depreciation
Total equipment under operating leases, net
Cable and related equipment (Note G):
Telecommunications and related equipment, at cost
Less: accumulated depreciation
Total equipment under operating leases, net
Other assets:
Long-term investments (Note H)
Intangible assets, net of accumulated amortization of $895,085 and $282,325 at December 31, 2007 and
December 31, 2006, respectively (Note B and C)
Financing Costs, net of accumulated amortization and write-off of $168,353 and $1,219,410
at December 31, 2007 and 2006, respectively (Note I)
Investment in Sales Type Leases (Note T)
Goodwill (Note B and C)
Deposits
Total other assets
Total Assets
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued liabilities (Note P)
Note Payable - officer (Note L)
Income tax refund due to officer (Note L)
Note payable in connection with subsidiary acquisition (Note B)
Senior note payable, net of debt discounts (Note I)
Registration Rights Liability (Note I)
Deferred revenue
Customer deposits and other
Total current liabilities
Long-term liabilities:
Convertible debentures, net of debt discounts (Note I)
Deferred revenue
Deferred lease liability and other
Total long-term liabilities
Commitments and contingencies (Note Q)
Minority interest (Note R)
Stockholders’ equity (Note J)
Preferred stock, par value $.001 per share; 15,000,000 shares authorized;
none issued and outstanding at December 31, 2007 and 2006
2007
2006
$
1,629,583
$
1,644,037
2,134,978
16,501
-
2,578,084
645,022
7,004,168
295,116
-
291,000
1,306,593
229,333
3,766,079
1,660,493
809,915
850,578
1,370,780
577,759
793,021
313,941
243,894
70,047
471,207
225,346
245,861
5,764,645
1,537,862
4,226,783
3,555,049
343,376
3,211,673
4,603,970
193,847
6,449,029
2,181,602
697,461
11,169
14,670,455
157,685
26,589,769
-
-
1,977,768
146,665
4,499,882
$ 38,741,345
$ 12,516,516
$
$
7,354,177
-
291,000
-
1,470,820
500,000
250,613
128,222
9,994,832
4,432,342
8,436
58,676
4,499,454
-
2,978,918
-
2,865,144
80,444
291,000
900,000
-
-
160,125
-
4,296,713
-
42,019
42,561
84,580
-
-
-
Common stock, par value $.001 per share; 100,000,000 shares authorized; 70,826,544 and
56,992,301 shares issued and outstanding at December 31, 2007 and 2006, respectively
Additional paid-in-capital
Accumulated deficit
Stockholders’ equity
Total Liabilities and Stockholders’ Equity
70,827
112,013,093
56,992
78,502,900
(90,815,779) (70,424,669)
8,135,223
21,268,141
$ 38,741,345
$ 12,516,516
See accompanying notes to consolidated financial statements
F-4
TELKONET, INC.
CONSOLIDATED STATEMENTS OF LOSSES
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
Revenues, net:
Product
Rental
Total Revenue
Cost of Sales:
Product
Rental
Total Cost of Sales
Gross Profit
Operating Expenses:
Research and Development (Note A)
Selling, General and Administrative
Impairment Write-Down in Goodwill of Subsidiary (Note C)
Impairment Write-Down in Long Lived Assets of Subsidiary (Note G)
Impairment Write-Down in Investment in Affiliate (Note H)
Non-Employee Stock Based Compensation
Non-Employee Stock Based Compensation of Subsidiary
Employee Stock Based Compensation (Note K)
Employee Stock Based Compensation of Subsidiary
Depreciation and Amortization
Total Operating Expenses
2007
2006
2005
$
$
9,168,077
4,984,656
14,152,733
$
3,092,967
2,088,361
5,181,328
1,769,727
718,596
2,488,323
7,165,120
4,505,476
11,670,596
2,062,399
2,418,260
4,480,659
1,183,574
533,605
1,717,179
2,482,137
700,669
771,144
2,349,690
17,897,974
1,977,768
493,512
-
470,220
337,500
1,225,626
308,634
878,766
25,939,690
1,925,746
14,346,364
-
-
92,000
277,344
-
1,080,895
-
540,906
18,263,255
2,096,104
12,041,661
-
-
400,000
1,354,219
-
-
-
185,928
16,077,912
Loss from Operations
(23,457,553)
(17,562,586)
(15,306,768)
Other Income (Expenses):
Gain on Sale of Investment in Affiliate (Note H)
Registration Rights Liquidated Damages of Subsidiary (Note I)
Loss on Early Extinguishment of Debt (Note I)
Other Income (Note I)
Interest Income
Interest Expense
Total Other Income (Expenses)
1,868,956
(500,000)
-
-
116,043
(1,328,624)
156,375
-
-
(4,626,679)
-
327,184
(5,594,604)
(9,894,099)
-
-
-
8,600
166,070
( 646,183)
(471,513)
Loss Before Provision for Income Taxes
(23,301,178)
(27,456,685)
(15,778,281)
Minority interest (Note R)
Provision for Income Tax (Note N)
Net (Loss)
Loss per common share (basic and assuming dilution) (Note O)
2,910,068
-
19,569
-
-
-
(20,391,110) $
(27,437,116) $
(15,778,281)
(0.31) $
(0.54) $
(0.35)
$
$
Weighted average common shares outstanding
65,414,875
50,823,652
44,743,223
See accompanying notes to consolidated financial statements
F-5
TELKONET, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
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
Shares issued in exchange for interest
expense on convertible debentures
Beneficial conversion feature of
convertible debentures (Note I)
Value of warrants attached to
convertible debentures
(Note I)
Stock options and warrants granted to
consultants in exchange for services
rendered
Net loss
Balance at December 31, 2005
Preferred
Stock
Amount
Preferred
Shares
- $
Common
Shares
- 44,335,989 $
Common
Stock
Amount
Additional
Paid in
Capital
Accumulated
Deficit
Total
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
-
321,900
36,150
36
(36)
-
-
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
-
-
-
-
- 45,765,171 $
- 1,354,219
-
1,354,219
-
- (15,778,281) (15,778,281)
45,765 $48,256,784 $(42,987,553) $ 5,314,996
See accompanying footnotes to consolidated financial statements
F-6
TELKONET, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
Preferred
Shares
Preferred
Stock
Amount
Balance at January 1, 2006
Shares issued for employee stock options
exercised at approximately $1.36 per
share
Shares issued in exchange for non-
employee options exercised at $1.00
per share
Shares issued in exchange for warrants
exercised at $1.15 per share
Issuance of shares for purchase of
subsidiary (Note B)
Shares issued in exchange for services
rendered at approximately $3.87 per
share
Shares issued in exchange for convertible
debentures, interest expense and
penalty at approximately $2.36 per
share (Note I)
Shares issued for cash in connection with
a private placement, shares issued at
$2.50 per share
Value of additional warrants issued in
conjunction with exchange of
convertible debentures (Note I)
Stock-based compensation expense
related to employee stock options
(Note K)
Stock options and warrants granted to
consultants in exchange for services
rendered (Note K)
Net Loss
Balance at December 31, 2006
-
-
-
-
-
-
-
-
-
-
-
-
-
Common
Shares
- 45,765,171
Common
Stock
Amount
Additional
Paid in
Capital
Accumulated
Deficit
45,765 48,256,784 (42,987,553)
Total
5,314,996
- 2,051,399
2,051 2,656,774
-
2,658,825
-
25,837
26
25,811
-
25,837
-
47,750
48
55,090
-
55,138
-
600,000
600 2,699,400
-
2,700,000
-
52,420
52
202,974
-
203,026
- 6,049,724
6,050 14,249,979
- 14,256,029
- 2,400,000
2,400 5,997,600
-
6,000,000
-
-
-
-
-
-
-
-
- 3,000,249
-
3,000,249
- 1,080,895
-
1,080,895
-
-
277,344
-
277,344
- (27,437,116) (27,437,116)
- 56,992,301 $
56,992 $78,502,900 $(70,424,669) $ 8,135,223
See accompanying footnotes to consolidated financial statements
F-7
TELKONET, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
Preferred
Shares
Preferred
Stock
Amount
Common
Shares
Common
Stock
Amount
Additional
Paid in
Capital
Accumulated
Deficit
Total
Balance at January 1,
2007
Shares issued for
employee stock options
exercised at approximately
$1.05 per share (Note K)
Shares issued in exchange
for services rendered at
approximately $2.63 per
share
Shares issued in exchange
for services at $1.36 per
share (Note J)
Issuance of shares for
purchase of subsidiary
(Note B)
Issuance of shares for
purchase of subsidiary
(Note B)
Issuance of shares for
acquisition by subsidiary
(Note B)
Shares Issued in
connection with Private
Placement
Issuance of shares for
investment in affiliate
(Note H)
Value of additional
warrants issued in
conjunction with exchange
of convertible debentures
(Note K)
Debt discount attributable
to warrants attached to
Note (Note I)
Stock-based compensation
expense related to
employee stock options
(Note K)
Stock-based compensation
related to Stock option
expenses accrued in prior
period
Net Loss
Balance at December 31,
2007
-
-
-
-
-
-
-
56,992,301
$
56,992
$ 78,502,900
$ (70,424,669) $
8,135,223
-
118,500
119
124,342
-
124,460
-
-
21,803
22
57,320
200,000
200
271,300
-
-
57,342
271,500
-
2,227,273
2,227
5,997,773
-
6,000,000
-
3,459,609
3,460
9,752,637
-
9,756,097
-
-
866,856
867
1,529,133
-
1,530,000
-
-
4,000,000
4,000
9,606,000
-
9,610,000
-
- 2,940,202
2,940
4,463,227
-
4,466,167
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
132,949
195,924
-
-
132,949
195,924
-
1,225,626
-
1,225,626
-
153,963
-
153,963
-
-
-
-
(20,391,110)
(20,391,110)
-
$
-
70,826,544
$
70,827
$ 112,013,093
$ (90,815,779)
$ 21,268,141
See accompanying footnotes to consolidated financial statements
F-8
TELKONET, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
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:
Minority interest
Amortization and write-off of debt discount - beneficial conversion feature of convertible
debentures (Note I)
Amortization and write-off of debt discount - value of warrants attached to convertible
2007
2006
2005
$ (20,391,110) $ (27,437,116) $ (15,778,281)
(2,910,068)
(19,569)
-
-
1,390,137
138,406
debentures
(Note I)
Amortization and write-off of financing costs
Impairment write-down of goodwill of subsidiary (Note C)
Impairment write-down of long lived assets of subsidiary( Note G)
Write-off of fixed assets in conjunction with loss on sublease
Registration rights liquidated damages of subsidiary
Gain on sale of investment in affiliate
Warrants issued for interest expense
Other income in connection with derivative warrant liabilities (Note I)
Warrants issued prepayment of debt
Amortization of debt discount and financing costs
Common stock issued in exchange for and penalty in connection with early
extinguishment of debt
(Note I)
Stock options and warrants issued in exchange for services (Note K)
Common stock issued in exchange for services rendered (Note J)
Common stock issued in exchange for conversion of interest
Other
Depreciation and Amortization
Impairment write-down in investment in Amperion (Note H)
Increase / decrease in:
Accounts receivable, trade and other
Inventory
Investment in sales type leases
Customer Deposits
Prepaid expenses and deposits
Deferred lease liability
Deferred rent
Deferred revenue
Other
Accounts payable, accrued expenses, net
Net Cash Used In Operating Activities
Cash Flows From Investing Activities:
Costs of equipment under operating leases and Cable and related equipment
Sale of equipment under operating lease, net
Purchase of property and equipment, net
Proceeds (Investment) in Restricted Certificate of Deposit (Note A)
Investment in Newport
Payment of note payable and investment in subsidiary (Note B)
Net cash acquired from MST (Note B)
Investment in subsidiaries
Proceeds from (Investment in) and BPL Global (Note H)
Net Cash Used In Investing Activities
Cash Flows From Financing Activities:
Proceeds from sale of common stock, net of costs and fees (Note J)
Proceeds from issuance of senior note payable
Proceeds from subsidiaries’ sale of common stock, net of costs
Proceeds from issuance of convertible debentures, net of costs and fees (Note I)
Repayment of convertible debenture (Note I)
Repayment of senior notes (Note J)
Proceeds from exercise of warrants (Note K)
-
-
1,977,768
493,512
64,608
500,000
(1,868,956)
764,279
-
-
475,391
2,743,342
1,145,911
-
-
-
-
-
-
3,000,249
-
198,805
73,499
-
-
-
-
-
(8,600)
-
-
-
1,534,260
706,842
-
(12,184)
1,721,224
-
2,006,029
1,358,239
203,026
-
-
980,470
92,000
-
1,354,219
300,117
28,131
-
430,104
400,000
(1,469,450)
251,185
27,866
20,936
(106,661)
(56,044)
397,912
-
-
(313,956)
11,406
-
59,020
-
679,230
(13,989,434) (13,971,529) (12,086,032)
(143,013)
169,213
-
-
405,952
245
-
68,801
-
64,555
-
11,401
(88,857)
30,238
4,278,342
(1,568,651)
-
(310,715)
(1,939,759)
350,571
(734,888)
-
10,000,000
-
(458,271)
-
(336,448)
(10,000,000)
-
-
-
-
(131,000)
(10,925,719)
-
-
-
18,780,590
(10,000)
(350,000)
321,900
(1,017,822)
59,384
-
(44)
6,717,442
6,000,000
-
-
-
(7,750,000)
(100,000)
55,138
(1,118,294)
(900,000)
-
(3,150,557)
2,000,000
(5,048,217)
9,610,000
1,500,000
2,694,023
5,303,238
-
-
-
Proceeds from exercise of stock options and warrants (Note K)
Repayments of loans
Net Cash Provided By Financing Activities
Net Increase (Decrease) In Cash and Equivalents
Cash and cash equivalents at the beginning of the year
Cash and cash equivalents at the end of the year
124,460
(208,524)
19,023,197
(14,454)
1,644,037
1,629,583
$
2,684,663
(413,756)
476,045
(6,778,042)
8,422,079
1,644,037
852,638
-
19,595,128
(3,416,623)
11,838,702
8,422,079
$
$
See accompanying notes to consolidated financial statements
F-9
TELKONET, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
Supplemental Disclosures of Cash Flow Information:
Cash transactions:
Cash paid during the period for interest
Income taxes paid
2007
2006
2005
$
$
4,521
-
990,846
-
$
40,645
-
Non-cash transactions:
Stock options and warrants issued in exchange for services (Note K)
Common stock issued in exchange for services rendered (Note J)
Common stock issued in exchange for interest (Note J)
Note payable under subsidiary acquisition (Note B)
Common stock issued in exchange for interest expense and penalty in connection with
early extinguishment of debt (Note I)
1,534,260
706,842
-
-
1,358,239
203,026
-
900,000
1,354,219
300,117
28,131
-
-
2,006,030
-
Registration rights liquidated damages of subsidiary
Issuance of shares for purchase of subsidiary
Issuance of shares for investment in affiliate (Note H)
Common stock issued in exchange for conversion of convertible debenture (Note I and K)
Write-off of beneficial conversion feature for conversion of debenture
Write-off of value of warrants attached to debenture in connection with conversion
Impairment write-down of goodwill (Note B)
Impairment write-down of long-lived assets (Note G)
Impairment write-down in investment in affiliate (Note H)
Beneficial conversion feature on convertible debentures (Note I)
Value of warrants attached to convertible debentures (Note I)
Value of warrants attached to senior note (Note I)
Value of common stock received for outstanding accounts receivable
500,000
17,286,097
4,466,167
-
-
-
1,977,768
493,512
-
1,457,815
931,465
359,712
75,000
2,700,000
-
12,250,000
-
-
-
-
92,000
-
-
-
-
-
-
200,000
-
-
-
-
400,000
1,479,300
2,910,700
-
-
Acquisition of Subsidiaries (Note B):
Assets acquired
Subscriber lists
Goodwill (including purchase price contingency)
Minority Interest
Liabilities assumed
Common stock issued
Notes payable issued
Purchase price contingency
Direct acquisition costs
Cash paid for acquisition
3,052,880
4,781,893
15,096,922
-
(1,356,415)
(17,286,097)
-
-
(394,183)
3,895,000
1,656,673
2,463,927
6,477,767
(19,569)
(1,460,976)
(2,700,000)
(900,000)
(4,500,000)
(117,822)
900,000
-
-
-
-
-
-
-
-
-
-
See accompanying notes to consolidated financial statements
F-10
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2007, 2006 AND 2005
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., formed in 1999 and incorporated under the laws of the State of Utah, is a leading provider of innovative, centrally managed
solutions for integrated energy management, networking, building automation and proactive support services. Prior to January 1, 2007, the
Company was primarily engaged in the business of developing, producing and marketing proprietary equipment enabling the transmission of
voice and data communications over electric utility lines.
In January 2006, following the acquisition of Microwave Satellite Technologies (MST) (Note B), the Company began offering complete
sales, installation, and service of VSAT and business television networks, and became a full-service national Internet Service Provider (ISP).
The MST solution offers a complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision Broadband Internet access
and wireless fidelity (“Wi-Fi”) access, to commercial multi-dwelling units and hotels.
In March 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy
management products and solutions to customers in the United States and Canada.
In March 2007, the Company acquired 100% of the outstanding membership units of Ethostream, LLC, a network solutions integration
company that offers installation, sales and service to the hospitality industry. The Ethostream acquisition will enable Telkonet to provide
installation and support for PLC products and third party applications to customers across North America.
In May 2007, Microwave Acquisition Corp., a newly formed, wholly-owned subsidiary of MSTI Holdings Inc. (formerly Fitness Xpress-
Software Inc.) merged with MST. As a result of the merger, the Company’s common stock in MST was exchanged for shares of common
stock of MSTI Holdings Inc. Immediately following the merger, MSTI Holdings Inc. completed a private placement of its common stock for
aggregate gross proceeds of $3,078,716 and sold senior convertible debentures in the aggregate principal amount of $6,050,000 (plus an 8%
original issue discount added to such principal amount). As a result of these transactions, the Company’s 90% interest in MST became a 63%
interest in MSTI Holdings Inc.
In July 2007, Microwave Satellite Technologies, Inc., the wholly-owned subsidiary of the Company’s majority owned subsidiary MSTI
Holdings Inc., acquired substantially all of the assets of Newport Telecommunications Co., a New Jersey general partnership. Pursuant to the
terms of the acquisition, the total consideration paid was $2,550,000, consisting of unregistered shares of the Company’s common stock,
equal to $1,530,000, and (ii) $1,020,000 in cash, subject to adjustments. The total consideration will be increased or decreased depending on
the number of subscriber accounts acquired in the acquisition that were in good standing at that time.
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Telkonet Communications,
Inc. and Ethostream, LLC and 63%-owned subsidiary MSTI Holdings Inc. (reported as the Company’s MSTI segment). Significant
intercompany transactions have been eliminated in consolidation.
Investments in entities over which the Company has significant influence, typically those entities that are 20 to 50 percent owned by the
Company, are accounted for using the equity method of accounting, whereby the investment is carried at cost of acquisition, plus the
Company’s equity in undistributed earnings or losses since acquisition.
Going Concern
The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in
the United States of America, which contemplate continuation of the Company as a going concern. However, the Company has reported a
net loss of $20,391,110 for the year ended December 31, 2007, accumulated deficit of $90,815,779 and a working capital deficit of
$2,990,664 as of December 31, 2007.
F-11
The Company believes that anticipated revenues from operations will be insufficient to satisfy its ongoing capital requirements for at least
the next 12 months. If the Company’s financial resources are insufficient, the Company will require additional financing in order to execute
its operating plan and continue as a going concern. The Company cannot predict whether this additional financing will be in the form of
equity or debt, or be in another form. The Company may not be able to obtain the necessary additional capital on a
timely basis, on acceptable terms, or at all. In any of these events, the Company may be unable to implement its current plans for expansion,
repay its debt obligations as they become due, or respond to competitive pressures, any of which circumstances would have a material
adverse effect on its business, prospects, financial condition and results of operations.
Management plans to take the following steps that it believes will be sufficient to provide the Company with ability to continue as a
going concern. Management intends to raise capital through asset-based financing and/or the sale of its stock in private
placements. Management believes that with this financing, the Company will be able to generate additional revenues that will allow the
Company to continue as a going concern. There can be no assurance that the Company will be sucessful in obtaining additional funding.
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 $111,957 and $60,000 at December 31, 2007 and
December 31, 2006, respectively.
Cash and Cash Equivalents
For purposes of the Statements of Cash Flows, the Company considers all highly liquid debt instruments purchased with an original maturity
date of three months or less to be cash equivalents.
Liquidity
As shown in the accompanying consolidated financial statements, the Company incurred net loss of $20,391,110, $27,437,116 and
$15,778,281 for the years ended December 31, 2007, 2006 and 2005, respectively. The Company's current liabilities, on a consolidated basis,
exceeded its current assets by $2,990,664 as of December 31, 2007.
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 10 years.
Goodwill and Other Intangibles
Goodwill represents the excess of the cost of businesses acquired over fair value or net identifiable assets at the date of acquisition.
Goodwill is subject to a periodic impairment assessment by applying a fair value test based upon a two-step method. The first step of the
process compares the fair value of the reporting unit with the carrying value of the reporting unit, including any goodwill. The Company
utilizes a discounted cash flow valuation methodology to determine the fair value of the reporting unit. If the fair value of the reporting unit
exceeds the carrying amount of the reporting unit, goodwill is deemed not to be impaired in which case the second step in the process is
unnecessary. If the carrying amount exceeds fair value, the Company performs the second step to measure the amount of impairment loss.
Any impairment loss is measured by comparing the implied fair value of goodwill, calculated per SFAS No. 142, with the carrying amount
of goodwill at the reporting unit, with the excess of the carrying amount over the fair value recognized as an impairment loss.
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 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.
Inventories
Inventories consist of the primary components of the Telkonet iWire System™, which are Gateways, Extenders, iBridges and Couplers, and
the primary components of the Telkonet SmartEnergy energy management solution , which are thermostats, sensors and controllers. Cost is
determined by the first-in, first-out method. (Note D).
F-12
Investments
Telkonet maintains an investment in two publicly-traded companies for the year ended December 31, 2007. These investments are
accounted for using the cost method as of the transaction date since the securities held are not eligible for sale by the Company under Rule
144 of the Securities Act of 1933, as of December 31, 2007.
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.
In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB
Statement No. 109 ("FIN 48"). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition
and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition,
classification, treatment of interest and penalties, and disclosure of such positions. Effective January 1, 2007, the Company adopted the
provisions of FIN 48, as required. As a result of implementing FIN 48, there has been no adjustment to the Company’s financial statements
and the adoption of FIN 48 did not have a material effect on the Company’s consolidated financial statements for the year ending
December 31, 2007.
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 2007, 2006 and 2005,
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 superseded 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 2006. The related equipment was charged to cost of sales
commensurate with the associated revenue recognition (Note F).
F-13
MST accounts for the revenue, costs and expense related to residential cable services as the related services are performed in accordance
with SFAS No. 51, Financial Reporting by Cable Television Companies . Installation revenue for residential cable services is recognized to
the extent of direct selling costs incurred. Direct selling costs have exceeded installation revenue in all reported periods. Generally, credit risk
is managed by disconnecting services to customers who are delinquent.
Management identifies a delinquent customer based upon the delinquent payment status of an outstanding invoice, generally greater than 30
days past due date. The delinquent account designation does not trigger an accounting transaction until such time the account is deemed
uncollectible. The allowance for doubtful accounts is determined by examining the reserve history and any outstanding invoices that are over
30 days past due as of the end of the reporting period. Accounts are deemed uncollectible on a case-by-case basis, at management’s
discretion based upon an examination of the communication with the delinquent customer and payment history. Typically, accounts are only
escalated to “uncollectible” status after multiple attempts have been made to communicate with the customer.
Revenue from sales-type leases for Ethostream products is recognized at the time of lessee acceptance, which follows installation. The
Company recognizes revenue from sales-type leases at the net present value of future lease payments. Revenue from operating leases is
recognized ratably over the lease period
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 were issued subject to the recognition and disclosure requirements of FIN 45 as of December 31, 2007 and 2006.
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, 2007 and 2006, the Company experienced approximately three percent of units
returned. As of December 31, 2007 and 2006, the Company recorded warranty liabilities in the amount of $102,534 and $47,300,
respectively, using this experience factor.
Advertising
The Company follows the policy of charging the costs of advertising to expenses incurred. The Company incurred $592,313, $663,323 and
$657,794 in advertising costs during the years ended December 31, 2007, 2006 and 2005, respectively.
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 2007, 2006 and 2005 were $2,349,690, $1,925,746 and $2,096,104,
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.
F-14
Reclassifications
Certain reclassifications have been made in prior year's financial statements to conform to classifications used in the current year.
Stock Based Compensation
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,”
(“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to
employees and directors including employee stock options based on estimated fair values. SFAS 123(R) supersedes the Company’s previous
accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods
beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”)
relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting
standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s Consolidated Financial Statements as of and
for the year ended December 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method,
the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS
123(R). Stock-based compensation expense recognized under SFAS 123(R) for the years ended December 31, 2007 and 2006 was
$1,534,260, and $1,080,895, respectively, net of tax effect.
SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing
model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in
the Company’s Consolidated Statement of Operations. Prior to the adoption of SFAS 123(R), the Company accounted for stock-based
awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial
Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the intrinsic value method, no stock-
based compensation expense had been recognized in the Company’s Consolidated Statement of Operations because the exercise price of the
Company’s stock options granted to employees and directors approximated or exceeded the fair market value of the underlying stock at the
date of grant.
Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is
ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s Consolidated Statement of
Operations for the year ended December 31, 2007 and 2006 included compensation expense for share-based payment awards granted but not
yet vested prior to January 1, 2006 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and
compensation expense for the share-based payment awards granted on or after January 1, 2006 based on the grant date fair value estimated in
accordance with the provisions of SFAS 123(R). SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if
necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Company’s pro forma information required under
SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred.
Upon adoption of SFAS 123(R), the Company is using the Black-Scholes option-pricing model as its method of valuation for share-based
awards granted beginning in fiscal 2006, which was also previously used for the Company’s pro forma information required under SFAS
123. The Company’s determination of fair value of share-based payment awards on the date of grant using an option-pricing model is
affected by the Company’s stock price as well as assumptions regarding a number of highly complex and subjective variables. These
variables include, but are not limited to the Company’s expected stock price volatility over the term of the awards, and certain other market
variables such as the risk free interest rate.
The following table shows the effect on net earnings and earnings per share had compensation cost been recognized based upon the
estimated fair value on the grant date of stock options for the year ended December 31, 2005, in accordance with SFAS 123, as amended by
SFAS No. 148 “Accounting for Stock-Based Compensation - Transition and Disclosure."
Net loss - as reported
Deduct: stock-based compensation expense, net of tax
Net loss - pro forma
Net loss per common share — basic (and assuming dilution):
As reported
Deduct: stock-based compensation expense, net of tax
Pro forma
F-15
2005
$
(15,778,281)
(2,440,097)
$
(18,218,378)
$
$
(0.35)
(0.06)
(0.41)
Disclosure for the years ended December 31, 2007 and 2006 is not presented because the amounts are recognized in the consolidated
financial statements. The fair value for stock awards was estimated at the date of grant using the Black-Scholes option valuation model with
the following weighted average assumptions for the year ended December 31, 2005:
Significant assumptions (weighted-average):
Risk-free interest rate at grant date
Expected stock price volatility
Expected dividend payout
Expected option life (in years)
2005
4.5%
71%
-
5.0
The expected term of the options represents the estimated period of time until exercise and is based on historical experience of similar
awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. For 2007 and prior
years, expected stock price volatility is based on the historical volatility of the Company’s stock for the related vesting periods. Prior to the
adoption of SFAS 123R, expected stock price volatility was estimated using only historical volatility. The risk-free interest rate is based on
the implied yield available on U.S. Treasury constant maturity securities with an equivalent remaining term. The Company has not paid
dividends in the past and does not plan to pay any dividends in the near future.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting
restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, particularly
for the expected term and expected stock price volatility. The Company’s employee stock options have characteristics significantly different
from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimate. Because
Company stock options do not trade on a secondary exchange, employees do not derive a benefit from holding stock options unless there is
an increase, above the grant price, in the market price of the Company’s stock. Such an increase in stock price would benefit all shareholders
commensurately.
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.
Registration Payment Arrangements
The Company accounts for registration payment arrangements under Financial Accounting Standards board (FASB) Staff Position EITF 00-
19-2, “Accounting for Registration Payment Arrangements” (FSP EITF 00-19-2). FSP EITF 00-19-2 specifies that the contingent obligation
to make future payments under a registration payment arrangement should be separately recognized and measured in accordance with SFAS
No. 5, Accounting for Contingencies. FSP EITF 00-19-2 was issued in December, 2006. As of December 31, 2007, the Company had
accrued an estimated penalty (see Note I).
New Accounting Pronouncements
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159
permits entities to choose to measure many financial instruments, and certain other items, at fair value. SFAS 159 applies to reporting
periods beginning after November 15, 2007. The adoption of SFAS 159 is not expected to have a material impact on the Company’s
financial condition or results of operations.
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141(R), “Business Combinations” (“Statement
141(R)”) and Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“Statement 160”).
Statements 141(R) and 160 require most identifiable assets, liabilities, noncontrolling interests and goodwill acquired in a business
combination to be recorded at “full fair value” and require noncontrolling interests (previously referred to as minority interests) to be
reported as a component of equity. Both statements are effective for fiscal years beginning after December 15, 2008. Statement 141(R) will
be applied to business combinations occurring after the effective date. Statement 160 will be applied prospectively to all noncontrolling
interests, including any that arose before the effective date. The Company has not determined the effect, if any, the adoption of Statements
141(R) and 160 will have on the Company’s financial position or results of operations.
F-16
NOTE B - ACQUISITION OF SUBSIDIARY
Acquisition of Microwave Satellite Technologies, Inc.
On January 31, 2006, the Company acquired a 90% interest in Microwave Satellite Technologies, Inc. (“MST”) from Frank Matarazzo, the
sole stockholder of MST, in exchange for $1.8 million in cash and 1.6 million unregistered shares of the Company’s common stock for an
aggregate purchase price of $9,000,000. The purchase price of $9,000,000 was increased by $117,822 for direct costs related to the
acquisition. These direct costs included legal, accounting and other professional fees. The cash portion of the purchase price was paid in two
installments, $900,000 at closing and $900,000 in February 2007. The stock portion is payable from shares held in escrow, 400,000 shares at
closing and the remaining 1,200,000 “purchase price contingency” shares issued based on the achievement of 3,300 “Triple Play”
subscribers over a three year period. In the year ended December 31, 2006, the Company issued 200,000 shares of the purchase price
contingency valued at $900,000 as an adjustment to Goodwill.
On May 24, 2007, MST completed a merger transaction pursuant to which it became a wholly-owned subsidiary of MSTI Holdings, Inc.
(formerly Fitness Xpress, Inc. ("FXS")), an inactive publicly registered shell corporation with no significant assets or operations. As a result
of the merger, there was a change in control of the public shell corporation. In accordance with SFAS No. 141, MST was the acquiring
entity. While the transaction is accounted for using the purchase method of accounting, in substance the transaction represented a
recapitalization of MST’s capital structure. For accounting purposes, the Company accounted for the transaction as a reverse acquisition and
MST is the surviving entity. MST did not recognize goodwill or any intangible assets in connection with the transaction. In connection with
the acquisition, the Company’s 90% interest in MST was converted to a 63% interest in MSTI Holdings, Inc.
The purchase price contingency shares are price protected for the benefit of the former owner of MSTI. In the event the Company’s
common stock price is below $4.50 per share upon issuance of the shares from escrow, a pro rata adjustment in the number of shares will be
required to support the aggregate consideration of $5.4 million. The price protection provision provides a cash benefit to the former owner of
MSTI if the as-defined market price of the Company’s common stock is less than $4.50 per share at the time of issuance from the escrow.
The issuance of additional shares or distribution of other consideration upon resolution of the contingency based on the Company’s common
stock prices will not affect the cost of the acquisition. When the contingency is resolved or settled, and additional consideration is
distributable, the Company will record the current fair value of the additional consideration and the amount previously recorded for the
common stock issued will be simultaneously reduced to the lower current value of the Company’s common stock.
MSTI is 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). Management believes that the MSTI
acquisition will enable Telkonet to provide a complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision Broadband
Internet access and wireless fidelity (“Wi-Fi”) access, to commercial multi-dwelling units and hotels.
The acquisition of MSTI was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” 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 and after the acquisition of MSTI. The results of operations for MST have been included in the Consolidated
Statements of Operations since the date of acquisition. The components of the purchase price were as follows:
Common stock
Cash (including note payable)
Direct acquisition costs
Purchase price
Minority interest
Total
As Reported
$
2,700,000
1,800,000
117,822
4,617,822
19,569
4,637,391
F-17
$
Including
Purchase
Price
Contingency
(*)
$
$
7,200,000
1,800,000
117,822
9,117,822
19,569
9,137,391
In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the
estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best
estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:
Cash and other current assets
Equipment and other assets
Subscriber lists
Goodwill
Subtotal
Current liabilities
Total
$
Including
Purchase
Price
Contingency
(*)
346,548
1,310,125
2,463,927
6,477,767
10,598,367
1,460,976
9,137,391
$
As Reported
$
346,548
1,310,125
2,463,927
1,977,767
6,098,367
1,460,976
4,637,391
$
(*) At the date of the acquisition, the effect of the “purchase price contingency” shares valued at approximately $5.4 million had not been
recorded in accordance with FAS 141. In the second quarter of 2006, the Company issued 200,000 shares of the purchase price contingency
valued at $900,000 as an adjustment to Goodwill. The remaining shares, when issued, will reflect an adjustment to Goodwill and Other
Intangibles.
Goodwill and other intangible assets represent the excess of the purchase price over the fair value of the net tangible assets acquired. The
Company used a discounted cash flow model to determine the value of the intangible assets and to allocate the excess purchase price to the
intangible assets and goodwill as appropriate. In this model, expected cash flows from subscribers were discounted to their present value at a
rate of return of 20% (incorporating the risk-free rate, expected inflation, and related business risks) over a period of eight years. Expected
costs such as income taxes and cost of sales were deducted from expected revenues to arrive at after tax cash flows. In accordance with
SFAS 142, goodwill is not amortized and will be tested for impairment at least annually. The subscriber list was valued at $2,463,927 with
an estimated useful life of eight years.
The acquisition of MSTI resulted in the valuation of MSTI’s subscriber lists as intangible assets. The MSTI subscriber list was determined
to have an eight-year life. This intangible was amortized using that life, and amortization from the date of the acquisition through December
31, 2007, was taken as a charge against income in the consolidated statement of operations. In accordance with SFAS 144, Accounting for
the Impairment or Disposal of Long-Lived Assets, the intangible asset subject to amortization was reviewed for impairment at December 31,
2007.
Goodwill of $1,977,768, excluding the remaining purchase price contingency, represented the excess of the purchase price over the fair
value of the net tangible and intangible assets acquired. In accordance with SFAS 142, goodwill is not amortized and will be tested for
impairment at least annually. At December 31, 2007, the Company performed an impairment test on the goodwill. Based upon
management’s assessment of operating results and forecasted discounted cash flow, the carrying value of goodwill was determined to be
impaired and therefore the entire value of $1,977,768 was written off during the year ended December 31, 2007.
Acquisition of Smart Systems International, Inc.
On March 9, 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy
management products and solutions to customers in the United States and Canada for cash and Company common stock having an aggregate
value of $6,875,000. The purchase price was comprised of $875,000 in cash and 2,227,273 shares of the Company’s common stock. The
Company is obligated to register the stock portion of the purchase price on or before May 15, 2007 and on March 14, 2008, this registration
statement was declared effective. Additionally, 1,090,909 of these shares were held in an escrow account for a period of one year following
the closing from which certain potential indemnification obligations under the purchase agreement could be satisfied. The aggregate number
of shares held in escrow was subject to adjustment upward or downward depending upon the trading price of the Company’s common stock
during the one year period following the closing date. On March 12, 2008, the Company released these shares from escrow and plans to
issue an additional 1,909,091 shares pursuant to the adjustment provision in the SSI asset purchase agreement (Note V).
F-18
The acquisition of SSI was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The value of
the Company’s common stock issued as a part of the acquisition was determined based on the most recent price of the Company's common
stock on the day immediately preceding the acquisition date. The results of operations for SSI have been included in the Consolidated
Statements of Operations since the date of acquisition. The components of the purchase price were as follows:
Common stock
Cash
Direct acquisition costs
Total Purchase Price
As
Reported
$
$
6,000,000
875,000
131,543
7,006,543
In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the
estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best
estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:
Current assets
Property, plant and equipment
Other assets
Goodwill
Total assets acquired
Accounts payable and accrued liabilities
Total liabilities assumed
Net assets acquired
$
$
1,646,054
36,020
8,237
5,874,016
7,564,327
(557,784)
(557,784)
7,006,543
Goodwill represents the excess of the purchase price over the fair value of the net tangible assets acquired. In accordance with SFAS 142,
goodwill is not amortized and will be tested for impairment at least annually. We completed our annual impairment testing during the fourth
quarter of 2007, and determined that there was no impairment to the carrying value of goodwill.
Acquisition of Ethostream LLC
On March 15, 2007, the Company acquired 100% of the outstanding membership units of Ethostream, LLC, a network solutions integration
company that offers installation, sales and service to the hospitality industry. The Ethostream acquisition will enable Telkonet to provide
installation and support for PLC products and third party applications to customers across North America. The purchase price of $11,756,097
was comprised of $2.0 million in cash and 3,459,609 shares of the Company’s common stock. The entire stock portion of the purchase price
is being held in escrow to satisfy certain potential indemnification obligations of the sellers under the purchase agreement. The shares held in
escrow are distributable over the three years following the closing. If during the twelve months following the Closing, the common stock
has a volume-weighted average trading price of at least $4.50, as reported on the American Stock Exchange, for twenty (20) consecutive
trading days, the aggregate number of shares of common stock issuable to the sellers shall be adjusted such that the number of shares of
common stock issuable as the stock consideration shall be determined assuming a per share price equal to $4.50.
The acquisition of Ethostream was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The
value of the Company’s common stock issued as a part of the acquisition was determined based on the most recent price of the Company's
common stock prior to the acquisition date. The results of operations for Ethostream have been included in the Consolidated Statements of
Operations since the date of acquisition. The components of the purchase price were as follows:
F-19
Common stock
Cash
Direct acquisition costs
Total Purchase Price
As Reported
$
$
9,756,097
2,000,000
164,346
11,920,443
In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the
estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best
estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:
Current assets
Property, plant and equipment
Other assets
Subscriber lists
Goodwill
Total assets acquired
Accounts payable and accrued liabilities
Total liabilities assumed
Net assets acquired
$
$
949,308
51,724
21,602
2,900,000
8,796,440
12,719,074
(798,631)
(798,631)
11,920,443
Goodwill and other intangible assets represent the excess of the purchase price over the fair value of the net tangible assets acquired. The
Company used a discounted cash flow model to determine the value of the intangible assets and to allocate the excess purchase price to the
intangible assets and goodwill as appropriate. In this model, expected cash flows from subscribers were discounted to their present value at a
rate of return of 20% (incorporating the risk-free rate, expected inflation, and related business risks) over a period of twelve years. Expected
costs such as income taxes and cost of sales were deducted from expected revenues to arrive at after tax cash flows. In accordance with
SFAS 142, goodwill is not amortized and will be tested for impairment at least annually.
The subscriber list was valued at $2,900,000 with an estimated useful life of twelve years. This intangible was amortized using that life, and
amortization from the date of the acquisition through December 31, 2007, was taken as a charge against income in the consolidated
statement of operations.
In accordance with SFAS 142, goodwill is not amortized and will be tested for impairment at least annually. We completed our annual
impairment testing during the fourth quarter of 2007, and determined that there was no impairment to the carrying value of goodwill.
Acquisition of Newport Telecommunications Co. by Subsidiary
On July 18, 2007, Microwave Satellite Technologies, Inc., the wholly-owned subsidiary of the Company’s majority owned subsidiary MSTI
Holdings Inc., acquired substantially all of the assets of Newport Telecommunications Co., a New Jersey general partnership (“NTC”),
relating to NTC’s business of providing broadband internet and telephone services at certain residential and commercial properties in the
development known as Newport in Jersey City, New Jersey. Pursuant to the terms of the NTC acquisition, the total consideration paid was
$2,550,000, consisting of (i) 866,856 unregistered shares of the Company’s common stock, equal to $1,530,000 (which is based on the
average closing prices for the Company common stock for the ten trading days immediately prior to the closing date), and (ii) $1,020,000 in
cash.
The acquisition of Newport was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The
value of the Company’s common stock issued as a part of the acquisition was determined based on the average closing prices for the
Company common stock for the ten trading days immediately prior to the closing date. The results of operations for Newport have been
included in the Consolidated Statements of Operations since the date of acquisition. The components of the purchase price were as follows:
F-20
Common stock
Cash
Direct acquisition costs
Total Purchase Price
As Reported
$
1,530,000
1,020,000
98,294
2,648,294
$
In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the
estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best
estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:
Current assets
Property, plant and equipment
Subscriber lists
Total assets acquired
Accounts payable and accrued liabilities
Total liabilities assumed
Net assets acquired
$
$
-
668,107
1,980,187
2,648,294
-
-
2,648,294
Goodwill and other intangible assets represent the excess of the purchase price over the fair value of the net tangible assets acquired. The
subscriber list was valued at $1,980,187 with an estimated useful life of eight years.
The following unaudited condensed combined pro forma results of operations reflect the pro forma combination of the Telkonet, MSTI, SSI,
Ethostream and Newport businesses as if the combination had occurred at the beginning of the periods presented compared with the actual
results of operations of Telkonet for the same period. The unaudited pro forma condensed combined results of operations do not purport to
represent what the companies’ combined results of operations would have been if such transaction had occurred at the beginning of the
periods presented, and are not necessarily indicative of Telkonet’s future results.
Revenues
Net profit (loss)
Net (loss) per common share outstanding - basic
Weighted average common shares outstanding - basic
Revenues
Net (loss)
Net (loss) per common share outstanding - basic
Weighted average common shares outstanding - basic
Revenues
Net (loss)
Net (loss) per common share outstanding - basic
Weighted average common shares outstanding - basic
NOTE C - INTANGIBLE ASSETS AND GOODWILL
Year Ended December 31, 2007
Pro Forma
Adjustments Pro Forma
As Reported
$ 16,576,053
$ 14,152,733
$
$ (19,879,572)
$ (20,391,110) $
$
(0.29)
(0.31) $
$
68,003,834
2,423,320
511,538
0.02
2,588,959
65,414,875
Year Ended December 31, 2006
Pro Forma
Adjustments Pro Forma
As Reported
6,865,181
$
$ 12,046,506
$
5,181,328
(269,276) $ (27,806,392)
$ (27,437,116) $
$
(0.48)
(0.54) $
$
58,377,390
0.06
7,553,738
50,823,652
Year Ended December 31, 2005
Pro Forma
Adjustments Pro Forma
As Reported
$
9,756,922
$
2,488,323
$ (15,778,281) $ (2,893,681) $ (18,681,962)
(0.36)
$
52,296,961
44,743,223
7,268,599
7,553,738
(0.01) $
(0.35) $
$
As a result of the MSTI acquisition at January 31, 2006 and the Ethostream acquisition on March 15, 2007 and MSTI Holdings, Inc.’s
acquisition of Newport on July 18, 2007, the Company had intangibles totaling $7,344,114 at December 31, 2007 (Note B).
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 has determined that the value of MSTI’s capitalized cable and related equipment has been impaired based upon
managements assessment of forecasted discounted cash flow from subscriber revenue and has written off $493,512 of its value, based on the
lower of the carrying amount or the fair value less costs to sell, for the year ended December 31, 2007 (Note G). During the year ended
December 31, 2006 and 2005, the Company determined that its investment in Amperion Inc. had been impaired based upon forecasted
discounted cash flow and wrote off $92,000 and $400,000, respectively, of its investment based on management’s assessment (Note H).
F-21
We used a discounted cash flow model to determine the value of the intangible assets and to allocate the excess purchase price to the
intangible assets and goodwill as appropriate. In this model, expected cash flows from subscribers were discounted to their present value at a
rate of return of 20% (incorporating the risk-free rate, expected inflation, and related business risks) over a determined length of life year.
Expected costs such as income taxes and cost of sales were deducted from expected revenues to arrive at after tax cash flows.
We have applied the same discounted cash flow methodology to the assessment of value of the intangible assets of Ethostream, LLC, during
the acquisition completed on March 15, 2007, for purposes of determining the purchase price.
The MSTI subscriber list was determined to have an eight-year life. This intangible was amortized using that life and amortization from the
date of the acquisition through December 31, 2007 was taken as a charge against income in the consolidated statement of operations.
Total identifiable intangible assets acquired and their carrying values at December 31, 2006 are:
Gross
Carrying
Amount
Accumulated
Amortization
Net
Residual
Value
Amortized Identifiable intangible Assets:
Subscriber lists - MSTI
$
2,463,927
$
(282,325) $
2,181,602
$
Total Amortized Identifiable Intangible Assets
Unamortized Identifiable Intangible Assets:
Total
2,463,927
None
2,463,927
$
(282,325)
2,181,602
$
$
(282,325) $
2,181,602
$
Total identifiable intangible assets acquired and their carrying values at December 31, 2007 are:
Amortized Identifiable Intangible Assets:
Subscriber lists – MSTI
Subscriber lists - Ethostream
$
4,444,114
2,900,000
$
$
(703,765)
(191,320)
3,740,349
2,708,680
$
Gross
Carrying
Amount
Accumulated
Amortization
Net
Residual
Value
Total Amortized Identifiable Intangible Assets
Unamortized Identifiable Intangible Assets:
Total
$
7,344,114
$
None
$
7,344,114
(895,085)
6,449,029
(895,085)
6,449,029
$
Weighted
Average
Amortization
Period
(Years)
8.0
8.0
8.0
Weighted
Average
Amortization
Period
(Years)
8.0
12.0
9.6
9.6
-
-
-
-
-
-
Total amortization expense charged to operations for the year ended December 31, 2007 and 2006 was $612,760 and $282,325, respectively.
Estimated amortization expense as of December 31, 2007 is as follows:
Years Ended December 31,
2008
2009
2010
2011
2012 and after
Total
F-22
797,181
797,181
797,181
797,181
3,260,305
6,449,029
$
The Company does not amortize goodwill. The Company recorded goodwill in the amount of $1,977,768 as a result of the acquisition of
MSTI during the year ended December 31, 2006, and additional $14,670,455 as a result of the acquisition of Ethostream and SSI during the
year ended December 31, 2007 (Note B). At December 31, 2007, the Company has determined that the value of MSTI’s goodwill has been
impaired based upon managements assessment of operating results and forecasted discounted cash flow and has written off the entire
$1,977,768 of its value.
NOTE D - INVENTORIES
Inventories are stated at the lower of cost or market determined by the first-in, first-out (FIFO) method. Inventories consist of the primary
components of the Telkonet iWire System™, which are Gateways, Extenders, iBridges and Couplers, and the primary components of the
Telkonet SmartEnergy energy management solution , which are thermostats, sensors and controllers.
Components of inventories as of December 31, 2007 and 2006 are as follows:
Raw Materials
Finished Goods
Total
2007
$
$
928,739 $
1,649,345
2,578,084 $
2006
516,604
789,989
1,306,593
NOTE E - PROPERTY, PLANT AND EQUIPMENT
The Company’s property and equipment at December 31, 2007 and 2006 consists of the following:
Development Test Equipment
Computer Software
Leasehold Improvements
Office Equipment
Office Fixtures and Furniture
Total
Accumulated Depreciation
2007
153,487 $
160,894
512,947
426,813
406,352
1,660,493
(809,915)
850,578 $
$
$
2006
184,575
151,986
394,871
297,686
341,662
1,370,780
(577,759)
793,021
Depreciation expense included as a charge to income was $266,006, $258,581 and $185,928 for the years ended December 31, 2007, 2006
and 2005, respectively.
NOTE F - 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 ten years. Equipment under operating leases at December 31, 2007 and 2006 consist of the
following:
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
$
2007
2006
313,941 $
(243,894)
70,047
-
70,047
471,207
(225,346)
245,861
-
245,861
In the year end December 31, 2006 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 $1,209,000 including the customer support component of approximately $370,000
which the Company will retain and continue to receive monthly customer support payments over the remaining average unexpired lease term
of 36 months. In the year ending December 31, 2006 the Company recognized revenue of approximately $683,000 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 $340,000 and expensed associated taxes of approximately $64,000.
F-23
The following is a schedule by years of minimum future rentals on non-cancellable operating leases as of December 31, 2007:
2008
2009
2010
2011
2012
Total
$
$
116,378
50,237
19,514
-
-
186,129
NOTE G - CABLE AND RELATED EQUIPMENT
MSTI currently maintains service agreements with approximately 22 MDU and MTU properties and the equipment is capitalized under
Cable and related equipment. Generally, under the terms of a service agreement, MSTI provides either (i) “bulk services,” which may
include one or all of a bundle of products and services, at a fixed price per month to the owner of the MDU or MTU property, and contract
with individual residents for enhanced services, such as premium cable channels, for a monthly fee or (ii) contract with individual residents
of the MDU property for one or more basic or enhanced services for a monthly fee.
Equipment maintained for customers under Cable and related equipment is recorded at cost and is depreciated on the straight line basis to its
estimated residual value. Estimated useful lives are three to ten years. Cable and related equipment at December 31, 2007 and December 31,
2006 consists of the following:
Cable equipment and installations
Less: accumulated depreciation
Capitalized equipment, net of accumulated depreciation
Less: estimated reserve for residual values
Capitalized Cable equipment and installations, net
$
December 31,
2007
5,764,645
$
(1,537,862)
4,226,783
-
4,226,783
$
$
December
31,
2006
3,555,049
(343,376)
3,211,673
-
3,211,673
The Company has determined that the value of MSTI’s capitalized equipment maintained at certain properties has been impaired based upon
management’s assessment of forecasted discounted cash flow from subscriber revenue and has written off $493,512 of its value, based on the
lower of the carrying amount or the fair value less costs to sell, for the year ended December 31, 2007.
The following is a schedule by years of minimum future rentals under bulk services of non-cancelable operating agreements as of December
31, 2007:
2008
2009
2010
2011
2012
2013
Total
NOTE H - LONG-TERM INVESTMENTS
Amperion, Inc.
$
$
512,813
484,914
456,972
315,934
256,925
75,305
2,102,863
On 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 0.8%. 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.
F-24
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
$92,000 and $400,000 of the carrying value of its investment through a charge to operations during the year ended December 31, 2006 and
2005, respectively. The remaining value of the Company’s investment in Amperion is $8,000 at December 31, 2007 and 2006, respectively,
and this amount represents the current fair value.
BPL Global, Ltd.
On February 4, 2005, the Company’s Board of Directors approved an investment in BPL Global, Ltd. (“BPL Global”), a privately held
company. The Company funded an aggregate of $131,000 as of December 31, 2005 and additional $44 during the year of 2006. This
investment represents an equity interest of approximately 4.67% at December 31, 2006. 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. amounted
$131,044 as of December 31, 2006. On November 7, 2007, the Company completed the sale of its investment in BPL Global, Ltd for
$2,000,000 in cash to certain existing stockholders of BPL Global. The Company recorded $1,868,956 of gain on sale of the investment.
Interactivewifi.com, LLC
MST maintains an investment in Interactivewifi.com, LLC a privately held company. This investment represents an equity interest of
approximately 50% at December 31, 2007. Interactivewifi.com is engaged in providing internet and related services to customers throughout
metropolitan New York, including the Nuvisions internet services. MST accounted for this investment under the cost method, as MST does
not have the ability to exercise significant influence over operating and financial policies of the investee. Telkonet reviewed the assumptions
underlying the operating performance and cash flow forecasts in assessing the carrying values of the investment. The fair value of MST’s
investment in Interactivewifi.com amounted to approximately $55,000 as of December 31, 2007 and 2006.
Geeks on Call America, Inc.
On October 19, 2007, the Company completed the acquisition of approximately 30.0% of the issued and outstanding shares of common
stock of Geeks on Call America, Inc. (“GOCA”), the nation's premier provider of on-site computer services. Under the terms of the stock
purchase agreement, the Company acquired approximately 1,160,043 shares of GOCA common stock from several GOCA stockholders in
exchange for 2,940,200 shares of the Company’s common stock for total consideration valued at approximately $4.5 million. The number of
shares issued in connection with this transaction was determined using a per share price equal to the average closing price of the Company’s
common stock on the American Stock Exchange (AMEX) during the ten trading days immediately preceding the closing date. The number
of shares is subject to adjustment on the date the Company files a registration statement for the shares issued in this transaction, which must
occur no later than the 180th day following the closing date. The increase or decrease to the number of shares issued will be determined using
a per share price equal to the average closing price of the Company’s common stock on the AMEX during the ten trading days immediately
preceding the date the registration statement is filed. 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.
On February 8 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned subsidiary of Geeks On Call Holdings, Inc., (formerly
Lightview, Inc.) merged with Geeks on Call America, Inc (“GOCA”). As a result of the merger, the Company’s common stock in GOCA
was exchanged for shares of common stock of Geeks on Call Holdings Inc. Immediately following the merger, Geeks on Call Holdings Inc.
completed a private placement of its common stock for aggregate gross proceeds of $3,000,000. As a result of this transaction, the
Company’s 30% interest in GOCA became an 18% interest in Geeks on Call Holdings Inc.
F-25
Multiband Corporation
In connection with a payment of $75,000 of accounts receivable, the company received 30,000 shares of common stock of Multiband
Corporation, a Minnesota-based communication services provider to multiple dwelling units. 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, and the shares are not eligible for sale by the Company under Rule 144 of the Securities Act of 1933. The value of this investment
amounted to $75,000 as of December 31, 2007.
NOTE I - SENIOR CONVERTIBLE DEBENTURES AND SENIOR NOTES PAYABLE
Senior Convertible Debentures
A summary of convertible promissory notes payable at December 31, 2007 and December 31, 2006 is as follows:
Senior Convertible Debentures, accrue interest at 8% per annum commencing on the first anniversary of
the original issue date of the debentures, payable quarterly in cash or common stock, at MSTI Holdings
Inc.’s option, and mature on April 30, 2010
Original Issue Discount - net of accumulated amortization of $307,037 and $0 at December 31, 2007 and
December 31, 2006, respectively.
Debt Discount - beneficial conversion feature, net of accumulated amortization of $283,464 and $0 at
December 31, 2007 and December 31, 2006, respectively.
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of
$181,118 and $0 at December 31, 2007 and December 31, 2006, respectively.
Total
Less: current portion
2007
2006
$
6,576,350
$
(219,312)
(1,174,351)
(750,347)
$
$
4,432,342
-
4,432,342
$
$
-
-
-
-
-
-
Aggregate maturities of long-term debt as of December 31, 2007 are as follows:
For the twelve months ended December 31
2008
2009
2010
Amount
-
-
6,576,350
6,576,350
$
During the year ended December 31, 2007, MSTI Holdings Inc., a majority owned subsidiary of Telkonet, Inc., issued senior convertible
debentures (the "Debentures") having a principal value of $6,576,350 to investors, including an original issue discount of $526,350, in
exchange for $6,050,000 from investors, exclusive of placement fees. The original issue discount to the Debentures is amortized over 12
months. The Debentures accrue interest at 8% per annum commencing on the first anniversary of the original issue date of the Debentures,
payable quarterly in cash or common stock, at MSTI Holdings Inc.’s option, and mature on April 30, 2010. The Debentures are not callable
and are convertible at a conversion price of $0.65 per share into 10,117,462 shares of MSTI Holdings Inc. common stock, subject to certain
limitations. The Company and noteholders are subject to a “Beneficial Ownership Limitation” pursuant to which the number of shares of
common stock of MSTI Holdings, Inc. held by such noteholders immediately following conversion of the Debenture shall not exceed 4.99%
of all of the issued and outstanding common stock of MSTI Holdings, Inc. The Debentures are senior indebtedness and the holders of the
Debentures have a security interest in all of MSTI assets and its subsidiaries.
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"), MSTI 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 the MSTI additional paid in capital included in
the Company’s minority interest. The Company recognized and measured an aggregate of $1,457,815 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, 2007. 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 Debentures, MSTI Holdings, Inc. has also agreed to issue to the Noteholders, five-year warrants to
purchase an aggregate of 5,058,730 shares of MSTI Holdings, Inc. common stock at an exercise price of $1.00 per share. MSTI Holdings
Inc. 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 5.00%, a dividend yield of 0%, and volatility of 54%. The $931,465 of debt discount
attributed to the value of the warrants issued is amortized over the Notes maturity period (three years) as interest expense.
F-26
In connection with the issuance of the Debentures, MSTI Holdings Inc. incurred placement fees of $423,500. Additionally, MSTI Holdings
Inc. issued such agents five-year warrants to purchase 708,222 shares of MSTI Holdings Inc. common stock at an exercise price of $1.00.
The Company amortized the original issue discount, the beneficial conversion feature and the value of the attached warrants, and recorded
non-cash interest expense in the amount of $307,037, $283,464, and $181,118, respectively, for the year ended December 31, 2007.
Registration Rights Liquidated Damages
On May 24, 2007, the Company’s majority-owned subsidiary, MSTI Holdings, Inc. completed a private placement, pursuant to which
5,597,664 shares of common stock and five-year warrants to purchase 2,798,836 shares of common stock were issued at an exercise price of
$1.00 per share, for total proceeds of $2,694,020. Additionally, MSTI Holdings, Inc. also sold senior convertible debentures for total
proceeds of $6,050,000. The debentures bear interest at a rate of 8% per annum, commencing on the first anniversary of the original issue
date of the debentures, payable quarterly in cash or common stock, at MSTI Holdings, Inc. option, and mature on April 30, 2010. The
debentures are not callable and are convertible at a price of $0.65 per share into 10,117,462 shares of common stock. In addition, holders of
the debentures received five-year warrants to purchase an aggregate of 5,058,730 shares of MSTI Holdings, Inc. common stock at an
exercise price of $1.00 per share.
MSTI Holdings, Inc. agreed to file a “resale” registration statement with the SEC within 60 days after the final closing of the private
placement and the issuance of the debentures covering all shares of common stock sold in the private placement and underlying the
debentures, as well as the warrants attached to the private placement. MSTI Holdings, Inc. has agreed to its our best efforts to have such
“resale” registration statement declared effective by the SEC as soon as possible and, in any event, within 120 days after the initial closing of
the private placement and the issuance of the debentures.
In addition, with respect to the shares of common stock sold in the private placement and underlying the warrants, MSTI Holdings, Inc.
agreed to maintain the effectiveness of the “resale” registration statement from the effective date until the earlier of (i) 18 months after the
date of the closing of the private placement or (ii) the date on which all securities registered under the registration statement (a) have been
sold, or (b) are otherwise able to be sold pursuant to Rule 144, at which time exempt sales may be permitted for purchasers of the Units,
subject to MSTI Holdings right to suspend or defer the use of the registration statement in certain events.
The registration rights agreement requires the payment of liquidated damages to the investors of approximately 1% per month of the
aggregate proceeds of $9,128,717, or the value of the unregistered shares at the time that the liquidated damages are assessed, until the
registration statement is declared effective, payable at the option of MSTI Holdings, Inc. In accordance with EITF 00-19-2, the Company
evaluated the likelihood of achieving registration statement effectiveness. Accordingly, the Company has accrued an estimate of $500,000
as of December 31, 2007, to account for these potential liquidated damages until the expected effectiveness of the registration statement is
achieved.
On February 11, 2008, the Purchasers executed a letter agreement (the “Letter Agreement”) with us containing, among other things, the
following:
(i)
(ii)
The Purchasers waived any non-compliance with clause (a) above, along with any and all related penalties, damages and
claims, in connection with our issuance of (A) $3 million of shares of common stock to Telkonet, Inc., (B) shares of
common stock in connection with acquisitions or strategic transactions approved by our directors, but not including a
transaction where the shares are being issued primarily for the purpose of raising capital or to an entity whose primary
business is investing in securities, and (C) 2,000,000 shares of common stock to employees and consultants under our
2007 Stock Incentive Plan at an exercise price of no less than $0.65 per share;
The Purchasers waived any non-compliance with clause (b) above, along with any default, breach or threatened breach,
arising under the Registration Rights Agreement, the Debentures or the Warrants, and waiving any Liquidated Damages,
in each case resulting or that could result from our failure to have the Registration Statement declared effective by the
SEC by the Effectiveness Date. In exchange for the investors waiving their rights to Liquidated Damages, we agreed to
reduce the exercise price of the Warrants from $1.00 to $0.65;
(iii)
If Frank Matarazzo ceases being our Chief Executive Officer, that would be an event of default under the Debentures;
and
F-27
(iv)
The exercise price of all of our outstanding options and warrants was set at $0.65 per share.
Senior Convertible Notes
During the year ended December 31, 2005, the Company issued convertible senior notes (the "Convertible Senior Notes") having an
aggregate principal value of $20 million to sophisticated investors in exchange for $20,000,000, exclusive of $1,219,410 in placement costs
and fees. 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 date of 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 shares of the Company’s 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 nine 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. Once the
principal amount of the note declines below $15 million, the balance is reduced by $.50 for every $1 amortized. 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 to the Noteholders one million
warrants to purchase company common stock 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 shares issuable to the Noteholders upon conversion, amortization and/or redemption of the Convertible
Senior Notes and upon exercise of 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 effectiveness of the Form S-3. The Company charged
$8,600 to Other Income 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.
Principal Payments of Debt
For the period of January 1, 2006 through August 14, 2006, the Company paid down principal of $1,250,000 in cash and issued an aggregate
of 4,226,246 shares of common stock in connection with the conversion of $10,821,686 aggregate principal amount of the Senior
Convertible Notes. Pursuant to the note agreement, the Company issued warrants to purchase 1,081,820 shares of common stock to the
Noteholders, at a strike price of $5.00 per share, which represented 65% of the $8,321,686 accelerated principal at a strike price of $5 per
share. The Company valued the warrants at $1,906,089 using the Black-Scholes pricing model and the following assumptions: contractual
terms of 5 years, an average risk free interest rate of 5.00%, a dividend yield of 0%, and volatility of 65%. The warrants are subject to anti-
dilution protection in conjunction with the issuance of certain equity securities. The Company has warrants due the Noteholders as a result of
the anti-dilution impact from a $6,000,000 private placement in September 2006 (Note K). The Company has accounted for the additional
warrants issued as interest expense during the period ended September 30, 2006.
For the period of January 1, 2006 through August 14, 2006, the Company amortized the debt discount to the beneficial conversion feature
and value of the attached warrants, and recorded non-cash interest expense in the amount of $251,759 and $500,353, respectively. The
Company also wrote-off the unamortized debt discount attributed to the beneficial conversion feature and the value of the attached warrants
in the amount of $708,338 and $1,397,857, respectively, in connection with paydown and conversion of the note.
F-28
The Company has warrants due the Noteholders as a result of the anti-dilution impact from a $10,000,000 private placement in February
2007 (Note K). The Company has accounted for the additional 76,230 warrants issued, valued at $131,009, as interest expense during the
year ended December 31, 2007. The Company valued the warrants using the Black-Scholes pricing model and the following assumptions:
contractual terms of 5 years, an average risk free interest rate of 4.75%, a dividend yield of 0%, and volatility of 70%.
Early Extinguishment of Debt
On August 14, 2006, the Company executed separate settlement agreements with the lenders of its Convertible Senior Notes. Pursuant to the
settlement agreements the Company paid to the lenders on August 15, 2006 in the aggregate $9,910,392 plus accrued but unpaid interest of
$23,951 and certain premiums specified in the Notes in satisfaction of the amounts then outstanding under the Notes. Of the amount to be
paid to the lenders under the Notes, $6,500,000 was paid in cash through a drawdown on a letter of credit previously pledged as collateral for
the Company’s obligations under the Notes. The remaining note balance of $1,428,314 and a Redemption Premium of $1,982,078,
calculated as 25% of remaining principal, was paid to the lenders in shares of the Company’s common stock valued at the lower of $5.00 per
share and 92.5% of the arithmetic average of the weighted average price of the Company’s common stock on the American Stock Exchange
for the twenty trading days beginning on August 16, 2006. The Company also issued 862,452 warrants to purchase shares of the Company’s
common stock at the exercise price of $2.58 per share (92.5% of the average trading price as described above) and a contractual term of 5
years. The warrants were issued fully exercisable, and, upon exercise, the warrants will be exchanged for shares of the Company’s common
stock. The Company valued the warrants at $1,014,934 using the Black-Scholes pricing model and the following assumptions: contractual
terms of 5 years, an average risk free interest rate of 5.00%, a dividend yield of 0%, and volatility of 65%. The Company has accounted for
the Redemption Premium and the additional warrants issued as non-cash early extinguishment of debt expense during the year ended
December 31, 2006. Registration statements covering the shares underlying the warrants, were filed with the Securities and Exchange
Commission on Form S-3 on September 29, 2006 and October 13, 2006 and were declared effective on October 16, 2006 and October 24,
2006, respectively. As of December 31, 2006, the Company included the warrant derivatives as equity since the criteria under EITF 00-19
for permanent equity was achieved in a nominal period of time subsequent to year end. The achievement of permanent equity had been
realized on October 16, 2006 and October 24, 2006 upon the declared effectiveness of the Form S-3. Upon the declared effectiveness of the
Form S-3, the registration rights agreement requirements had been satisfied and achieved; therefore the warrants were accounted for as
equity. The registrations rights agreement required liquidated damages in the event of failure to achieve the registration with the SEC.
As a result of the execution of the settlement agreements and the payments required thereby, the Company fully believes it repaid and
satisfied all of its obligations under the Notes. The Company also agreed to pay the expenses of the lenders incurred in connection with the
negotiation and execution of the settlement agreements. The settlement agreements were negotiated following the allegation by one of the
lenders that the Company’s failure to meet the minimum revenue test for the period ending June 30, 2006 as specified on the Notes
constituted an event of default under the Notes, which allegation the Company disputed.
The Settlement Agreement provides that the number of shares issued to the Noteholders shall be adjusted based upon the arithmetic average
of the weighted average price of the Company’s common stock on the American Stock Exchange for the twenty trading days immediately
following the settlement date. The Company has concluded that, based upon the weighted average of the Company's common stock between
August 16, 2006 and September 13, 2006, the Company is entitled to a refund from the two Noteholders. One of the Noteholders has
informed the Company that it does not believe such a refund is required. As a result, the Company has declined to deliver to the Noteholders
certain stock purchase warrants issued to them pursuant to the Settlement Agreement pending resolution of this disagreement. The
Noteholder has alleged that the Company has failed to satisfy its obligations under the Settlement Agreement by failing to deliver the
warrants. In addition, the Noteholder maintains that the Company has breached certain provisions of the Registration Rights Agreement and,
as a result of such breach, such Noteholder claims that it is entitled to receive liquidated damages from the Company.
Senior Note Payable
A summary of the senior notes payable at December 31, 2007 and December 31, 2006 is as follows:
Senior Note Payable, accrues interest at 6% per annum, and mature on the earlier to occur of (i) the
closing of the Company’s next financing, or (ii) January 28, 2008.
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of
$166,744 and $0 at December 31, 2007 and December 31, 2006, respectively.
Total
Less: current portion
F-29
2007
2006
$
1,500,000
$
(29,180)
$
$
1,470,820
1,470,820
-
$
$
-
-
-
-
-
Aggregate maturities of the Senior Note as of December 31, 2007 are as follows:
For the twelve months ended December 31
2008
2009
2010
Amount
1,500,000
-
-
1,500,000
$
On July 24, 2007, Telkonet entered into a Senior Note Purchase Agreement with GRQ Consultants, Inc. (“GRQ”) pursuant to which the
Company issued to GRQ a Senior Promissory Note (the “Note”) in the aggregate principal amount of $1,500,000. The Note is due and
payable on the earlier to occur of (i) the closing of the Company’s next financing, or (ii) January 28, 2008, and bears interest at a rate of six
(6%) percent per annum. The Company has incurred approximately $25,000 in fees in connection with this transaction. The net proceeds
from the issuance of the Note will be for general working capital needs.
In connection with the issuance of the Note, the Company also issued to GRQ warrants to purchase 359,712 shares of common stock at
$4.17 per share. These warrants expire five years from the date of issuance. 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 $195,924 of debt discount attributed to the value of the warrants issued is
amortized over the note maturity period (six months) as non-cash interest expense. The Company amortized the value of the attached
warrants, and recorded non-cash interest expense in the amount of $166,744, respectively, for the year ended December 31, 2007.
NOTE J - 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, 2007, 2006 and
2005, 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, 2007, 2006 and 2005, the Company has 70,826,544, 56,992,301, and 45,765,171 shares,
respectively, of common stock issued and outstanding.
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 K).
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.
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.
F-30
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.
During the year ended December 31, 2006, the Company issued an aggregate of 2,051,399 shares of common stock for an aggregate
purchase price of $2,658,826 to certain employees upon exercise of employee stock options at approximately $1.36 per share. Additionally,
the Company issued an aggregate of 25,837 shares of common stock for an aggregate purchase price of $25,837 to consultants upon exercise
of non-employee stock options at $1.00 per share (Note K).
During the year ended December 31, 2006, the Company issued an aggregate of 52,420 shares of common stock, valued at $203,026, to
consultants in exchange for services rendered, which approximated the fair value of the shares issued during the year services were
completed and rendered.
During the year ended December 31, 2006, the Company issued an aggregate of 6,049,724 shares of common stock at approximately $2.36
per share to its senior convertible debenture holders in exchange for $12,250,000 of debt, $23,951 of interest expenses, and $1,982,078 of
redemption premium (Note I).
The Company issued an aggregate of 47,750 shares of common stock to debenture holders upon the exercise of warrants at approximately
$55,138 per share (Note K).
On January 31, 2006, the Company entered into a Stock Purchase Agreement (“Agreement”) with MST, a privately held company. Pursuant
to the Agreement, the Company issued 600,000 shares of Common Stock valued at $4.50 per share (Note B).
During the year ended December 31, 2006, the Company issued 2,400,000 shares of Common Stock valued at $2.50 per share for an
aggregate purchase price of $6,000,000. The Company also has issued to this investor warrants to purchase 1.56 million shares of its
common stock at an exercise price of $4.17 per share. A registration statement covering the shares underlying the warrants was filed with the
Securities and Exchange Commission on Form S-3 on September 29, 2006 and was declared effective on October 16, 2006. As of December
31, 2006, the Company included the warrant derivatives as equity since the criteria under EITF 00-19 for permanent equity was achieved
(Note K).
During the year ended December 31, 2007, the Company issued an aggregate of 118,500 shares of common stock for an aggregate purchase
price of $124,460 to certain employees upon exercise of employee stock options at approximately $1.05 per share. (Note K).
During the year ended December 31, 2007, the Company issued an aggregate of 21,803 shares of common stock, valued at $57,342, to a
consultant and an employee in exchange for services, which approximated the fair value of the shares issued during the period services were
completed and rendered.
During the year ended December 31, 2007, the Company issued 200,000 shares of common stock pursuant to a consulting agreement. These
shares were valued at $271,500, which approximated the fair value of the shares issued during the period services were completed and
rendered (Note Q).
On March 9, 2007, the Company entered into an Asset Purchase Agreement (“Agreement”) with Smart Systems International, a privately
held company. Pursuant to the Agreement, the Company issued 2,227,273 shares of Common Stock at approximately $2.69 per share (Note
B).
On March 15, 2007, the Company entered into a Purchase Agreement (“Agreement”) with Ethostream, LLC, a privately held company.
Pursuant to the Agreement, the Company issued 3,459,609 shares of Common Stock at approximately $2.82 per share (Note B).
On July 18, 2007, Telkonet issued 866,856 unregistered shares of common stock of Telkonet, Inc. in connection with the acquisition of
substantially all of the assets of Newport Telecommunications Co. by the Telkonet majority-owned subsidiary, Microwave Satellite
Holdings, Inc. The Common Stock issued by Telkonet represented $1,530,000 of the total consideration of $2,550,000 paid in the asset
purchase (Note B).
In February 2007, the Company issued 4,000,000 shares of Common Stock valued at $2.50 per share for an aggregate purchase price of
$9,610,000, net of placement fees. The Company also issued to this investor warrants to purchase 2.6 million shares of its common stock at
an exercise price of $4.17 per share in this private placement transaction. A registration statement covering the shares underlying the
warrants was filed with the Securities and Exchange Commission on Form S-3 on March 5, 2007 and was declared effective on March 20,
2007. In accordance with EITF 00-19-02, “Accounting for Registration Payment Arrangements”, at the time of the issuance of the equity for
registration the Company deemed it probable that a registration of shares would be deemed effective therefore a loss contingency would not
be necessary and the equity was recorded at fair value on the date of issuance.
F-31
On October 19, 2007, the Company completed the acquisition of approximately 30.0% of the issued and outstanding shares of common
stock of Geeks on Call America, Inc. (“GOCA”), the nation's premier provider of on-site computer services. Under the terms of the stock
purchase agreement, the Company acquired approximately 1,160,043 shares of GOCA common stock from several GOCA stockholders in
exchange for 2,940,202 shares of the Company’s common stock for total consideration valued at approximately $4.5 million (Note H). On
February 8 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned subsidiary of Geeks On Call Holdings, Inc., (formerly
Lightview, Inc.) merged with Geeks on Call America, Inc (“GOCA”). As a result of the merger, the Company’s common stock in GOCA
was exchanged for shares of common stock of Geeks on Call Holdings Inc. Immediately following the merger, Geeks on Call Holdings Inc.
completed a private placement of its common stock for aggregate gross proceeds of $3,000,000. As a result of this transaction, the
Company’s 30% interest in GOCA became an 18% interest in Geeks on Call Holdings Inc.
NOTE K - 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
Weighted
Average
Remaining
Contractual
Life
(Years)
5.16
7.18
7.37
7.22
7.11
6.15
Number
Outstanding
4,273,429
1,875,250
1,661,750
160,000
135,000
8,105,429
Weighted
Average
Exercise
Price
$1.04
$2.54
$3.29
$4.44
$5.24
$1.98
Number
Exercisable
Weighted
Average
Exercise
Price
4,089,179 $1.00
1,389,500 $2.49
927,000 $3.37
76,000 $4.44
70,250 $5.22
6,551,929 $1.74
Exercise Prices
$1.00 - $1.99
$2.00 - $2.99
$3.00 - $3.99
$4.00 - $4.99
$5.00 - $5.99
Transactions involving stock options issued to employees are summarized as follows:
Outstanding at January 1, 2005
Granted
Exercised (Note J)
Cancelled or expired
Outstanding at December 31, 2005
Granted
Exercised (Note J)
Cancelled or expired
Outstanding at December 31, 2006
Granted
Exercised (Note J)
Cancelled or expired
Outstanding at December 31, 2007
$
Number of
Shares
9,614,267
1,325,000
(415,989)
(372,200)
$
10,151,078
1,125,000
(2,051,399)
(703,750)
$
8,520,929
935,000
(118,500)
(1,232,000)
$
8,105,429
F-32
Weighted
Average
Price
Per Share
1.61
3.97
1.18
3.74
1.85
3.01
1.30
2.67
2.06
2.55
1.05
3.00
1.98
The weighted-average fair value of stock options granted to employees during the years ended December 31, 2007, 2006 and 2005 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)
Fair value per share of options granted
2007
2006
2005
4.8%
70%
-
5.0
1.57
$
5.0%
65%
-
5.0
1.82
$
4.5%
71%
-
5.0
2.40
$
The expected life of awards granted represents the period of time that they are expected to be outstanding. We determine the expected life
based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules, exercise patterns and
pre-vesting and post-vesting forfeitures. We estimate the volatility of our common stock based on the calculated historical volatility of our
own common stock using the trailing 24 months of share price data prior to the date of the award. We base the risk-free interest rate used in
the Black-Scholes-Merton option valuation model on the implied yield currently available on U.S. Treasury zero-coupon issues with an
equivalent remaining term equal to the expected life of the award. We have not paid any cash dividends on our common stock and do not
anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-
Scholes-Merton option valuation model. We use historical data to estimate pre-vesting option forfeitures and record share-based
compensation for those awards that are expected to vest. In accordance with SFAS No. 123R, we adjust share-based compensation for
changes to the estimate of expected equity award forfeitures based on actual forfeiture experience.
The total intrinsic value of the options exercised in 2005, 2006 and 2007 is $1,235,487, $2,810,417 and $137,666, respectively. Additionally,
the total fair value of shares vested during these years is $2,440,097, $1,080,095 and $1,225,626, respectively.
Total stock-based compensation expense recognized in the consolidated statement of earnings for the year ended December 31, 2007 and
2006 was $1,534,260 and 1,080,895, respectively, net of tax effect. Additionally, the aggregate intrinsic value of options outstanding and
unvested as of December 31, 2007 is $0.
The financial statements for the year ended December 31, 2005 has not been restated. Had compensation expense for employee stock
options granted under the plan been determined based on the fair value at the grant date consistent with SFAS 123R, 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.
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 Prices
$1.00
Number
Outstanding
1,815,937
Weighted
Average
Remaining
Contractual
Life (Years)
4.34
Weighted
Average
Exercise Price
$1.00
Number
Exercisable
1,815,937
Weighted
Average
Exercise Price
$1.00
Transactions involving options issued to non-employees are summarized as follows:
F-33
Outstanding at January 1, 2005
Granted
Exercised (Note J)
Canceled or expired
Outstanding at December 31, 2005
Granted
Exercised (Note J)
Canceled or expired
Outstanding at December 31, 2006
Granted
Exercised
Canceled or expired
Outstanding at December 31, 2007
Number of
Shares
Weighted
Average Price
Per Share
$
1,999,169
15,000
(172,395)
-)
$
1,841,774
-
(25,837)
-
1,815,937
-
-
-
1,815,937
$
$
1.07
3.45
2.07
-
1.00
-
1.00
-
1.00
-
-
-
1.00
There were no non-employee stock options vested during the year ended December 31, 2007. The estimated value of the non-employee
stock options vested during the years ended December 31, 2006 and 2005 was determined using the Black-Scholes option pricing model and
the amount of the expense charged to operations in connection with granting the options was $273,499 and $1,191,767 during the years
ended December 31, 2006 and 2005, 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
Weighted
Average
Remaining
Contractual
Life (Years)
3.62
3.98
3.21
3.72
Number
Outstanding
862,452
4,596,451
2,214,724
7,673,627
Weighed
Average
Exercise Price
$2.59
$4.17
$4.70
$4.15
Number
Exercisable
862,452
4,596,451
2,214,724
7,673,627
Weighted
Average
Exercise Price
$2.59
$4.17
$4.70
$4.15
Exercise Prices
$2.59
$4.17
$4.70
Transactions involving warrants are summarized as follows:
Number of
Shares
Weighted
Average Price
Per Share
Outstanding at January 1, 2005
Granted
Exercised (Note J)
Canceled or expired
Outstanding at December 31, 2005
Granted
Exercised (Note J)
Canceled or expired
Outstanding at December 31, 2006
Granted
Exercised
Canceled or expired
Outstanding at December 31, 2007
$
575,900
1,040,000
(371,900)
(14,000)
$
1,230,000
3,657,850
(47,750)
(282,250)
4,557,850
$
3,115,777
-
-
7,673,627
$
F-34
1.12
4.85
1.00
1.00
4.31
4.03
1.15
2.64
4.20
4.18
-
-
4.15
The Company granted 79,326, 2,097,850 and 1,000,000 warrants to Convertible Senior Notes holders (Note I), 2,600,000, 1,560,000 and 0
warrants to private placement investors (Note J), and 76,739, 0 and 40,000 compensatory warrants to non-employees during the years ended
December 31, 2007, 2006 and 2005, respectively. Additionally, 359,712 warrants were granted to a Senior Note holder in July 2007. The
estimated value of compensatory warrants granted during the period ended December 31, 2007 was determined using the Black-Scholes
option pricing model and the following assumptions: contractual term of 5 years, a risk free interest rate of approximately 4.75%, a dividend
yield of 0% and volatility of 70%. Compensation expense of $139,112, $3,845 and $162,453 was charged to operations for the year ended
December 31, 2007, 2006 and 2005, respectively. The purchase price of the warrants issued to Convertible Senior Notes holders was
adjusted from $4.87 to $4.70 per share and approximately 79,000 additional warrants were issued during the year ended December 31, 2007
in accordance with the anti-dilution protection provision of the Convertible Senior Notes Payable Agreement dated October 27, 2005 (Note
I), upon the issuance of the 4,000,000 shares of common stock and 2,400,000 warrants to private placement investors (Note J) for a price per
share lower than $4.70.
NOTE L - RELATED PARTY TRANSACTIONS
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, 2006, and 2005, the Company has provided for the issuance of 36,000, and
36,000 shares, respectively, of its common stock to Mr. Pickett. During the year ended December 31, 2007, there were no shares issued to
Mr. Pickett.
In 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,
2007, 2006, and 2005, an aggregate of $100,000 of consulting fees was charged to income each year pursuant to the agreement.
On July 1, 2005, the Company and Mr. Blumenfeld executed a consulting agreement pursuant to which Mr. Blumenfeld agreed to act as a
consultant with respect to international sales. Pursuant to the terms of the agreement, Mr. Blumenfeld received 10,000 shares of Telkonet
stock upon execution of the agreement, 10,000 shares of Telkonet stock per quarter for the first year (for a total 50,000 shares in the first
year) and 5,000 shares of Telkonet stock per quarter thereafter plus a five percent (5%) commission (payable in cash or Telkonet stock at the
Consultant’s option) 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. The agreement was not renewed and therefore expired effective June 30, 2006. On March 16, 2007, the Board of Directors
approved the payment of compensation to Mr. Blumenfeld in the amount of $24,000 for his service as a director during the period of July 1,
2006 through December 31, 2006, which payment is commensurate with the payments made to the other directors for their board service. In
addition, effective January 1, 2007, Mr. Blumenfeld is being compensated according to the non-management compensation plan.
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.
In conjunction with the acquisition of MST (Note B) on January 31, 2006, the Company assumed a non-interest bearing demand promissory
note in the amount of $80,444 due to Frank Matarazzo, MST President. Additionally, an estimated $291,000 income tax receivable due to
the Company for certain carryback tax losses of MST for the period prior to the Company’s acquisition is payable to Frank Matarazzo.
In February 2007, the Company entered into a one-year professional services agreement with Global Transport Logistics, Inc. (“GTI”), for
the provision of consulting services for which GTI is paid a fee of $10,000 per month. GTI is 50% owned by Anthony Matarazzo, the
brother of MST’s Chief Executive Officer.
The Chief Administrative Officer at MST, Laura Matarazzo, is the sister of the Chief Executive Officer of MST and receives an annual base
salary of approximately $134,000 with bonuses and benefits based upon the Company’s internal policies.
The Company’s Vice President of Government Sales, John Vasilj, is the son-in-law of the Vice Chairman of the Board of Directors of the
Company and receives an annual base salary of approximately $150,000 with bonuses and benefits based upon the Company’s internal
policies. Mr. Vasilj’s employment with the Company terminated on January 18, 2008.
On August 1, 2007, the Company entered into an agreement with Barry Honig, President of GRQ Consultants, Inc. (“GRQ”). Telkonet has
agreed to pay Mr. Honig 50,000 shares of common stock per month for six (6) months, to provide the Company with transaction advisory
services. As of December 31, 2007, GRQ held a Senior Promissory Note issued by Telkonet on July 24, 2007, in the principal amount of
$1,500,000 (Note I). On February 8, 2008, this note was repaid in full including $49,750 in accrued but unpaid interest from the issuance
date through the date of repayment.
F-35
From time to time the Company may receive advances from certain of its officers to meet short term working capital needs. These advances
may not have formal repayment terms or arrangements. As of December 31, 2007, there were no amounts due to officers of the Company.
NOTE M - BUSINESS SEGMENTS AND GEOGRAPHIC INFORMATION
The Company's reportable operating segments are strategic businesses differentiated by the nature of their products, activities and customers
and are described as follows:
Telkonet (TKO) is engaged in the business of developing products for use in the powerline communications (PLC) industry. PLC products
use existing electrical wiring in commercial buildings and residences to carry high speed data communications signals, including the internet.
Microwave Satellite Technologies (MST) (Note B), offers complete sales, installation, and service of VSAT and business television
networks, and became a full-service national Internet Service Provider (ISP). The MST solution offers a complete “Quad-play” solution to
subscribers of HDTV, VoIP telephony, NuVision Broadband Internet access and wireless fidelity (“Wi-Fi”) access, to commercial multi-
dwelling units and hotels.
The measurement of losses and assets of the reportable segments is based on the same accounting principles applied in the consolidated
financial statements.
Financial data relating to reportable operating segments is as follows:
Revenues:
Telkonet
MST
Total revenue
Gross Profit
Telkonet
MST
Total gross profit
Operating (loss):
Telkonet
MST
Total operating (loss)
Interest Income
Telkonet
MST
Total interest income
Interest Expenses
Telkonet
MST
Total interest expense
2007
Year ended December 31,
2006
(In thousands of U.S. $)
2005
11,477
2,676
14,153
$
3,425
1,756
5,181
$
3,212
(730)
$
2,482
1,155
(455)
$
700
2,488
-
2,488
771
-
771
(14,996)
(8,462)
(23,458) $
(14,476)
(3,087)
(17,563) $
(15,307)
-
(15,307)
45
72
117
189
1,140
1,329
$
$
327
-
327
$
5,594
1
5,595
$
166
-
166
646
-
646
$
$
$
$
$
F-36
Assets
Telkonet
MST
Total asset
Capital Expenditures
Telkonet
MST
Total capital expenditures
Operating Expenses
Telkonet
MST
Total operating expenses
Depreciation and Amortization
Telkonet
MST
Total depreciation and amortization
2007
Year ended December 31,
2006
(In thousands of U.S. $)
2005
29,492
9,249
38,741
224
1,655
1,879
18,208
7,732
25,940
410
469
879
$
$
$
$
4,137
8,379
12,516
$
23,291
-
23,291
94
2,581
2,675
$
794
-
794
15,632
2,633
18,265
$
16,078
-
16,078
221
320
541
$
186
-
186
$
$
$
$
All of the Company’s assets as of December 31, 2007, 2006, and 2005 were attributable to U.S. operations.
The following is a summary of operations within geographic areas, classified by the Company's country of domicile and by foreign
countries:
Revenues from sales to unaffiliated
customers from continuing operations
in Telkonet and MST segments:
United States
Worldwide
2007
Year ended December 31,
2006
(In thousands of U.S. $)
2005
13,851
302
14,153
$
4,509
673
5,182
$
1,871
617
2,488
$
Sales to major customers in the Telkonet and MST segments out of total revenues are as follows:
Year ended December 31,
2006
2005
2007
Honeywell Utility Solutions
Hospitality Leasing Corporation
NOTE N - INCOME TAXES
10%
2%
-
18%
-
18%
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:
F-37
Tax provision computed at the statutory rate
Deferred state income taxes, net of federal income tax benefit
Stock-based compensation
Goodwill impairment
Book expenses not deductible for tax purposes
U.S. NOL created from stock option exercise
U.S. deferred tax liability for beneficial conversion feature
Minority Interest
Change in valuation allowance for deferred tax assets
Income tax expense
2005
2007
-
563,000
692,000
135,000
-
-
2006
$ (7,137,000) $ (9,564,000) $ (5,522,000)
(525,000)
-
-
19,000
(463,000)
518,000
-
5,973,000
--
-
333,000
-
526,000
-
-
-
9,038,000
--
(1,019,000)
6,766,000
--
$
$
$
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
Property and equipment, principally due to differences in depreciation
Warrants and non-employee stock options
Investment in Amperion
Other
Total deferred tax assets
Deferred Tax Liabilities:
Beneficial Conversion Feature of Convertible Debentures
Acquired Intangibles
Outside stock basis
Other
Total deferred tax liabilities
Valuation allowance
Net deferred tax assets
2007
2006
$ 32,231,000
259,000
1,031,000
188,000
915,000
34,624,000
$ 24,273,000
(13,000)
774,000
189,000
403,000
25,626,000
(513,000)
(984,000)
(816,000)
(19,000)
(2,332,000)
-
(1,050,000)
-
(19,000
(1,069,000)
(32,292,000) (24,557,000)
--
$
--
$
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.
At December 31, 2007 and 2006, the Company has net operating loss carryforwards of approximately $87 million and $66 million,
respectively, for federal income tax purposes which will expire at various dates from 2020 through 2027.
With the implementation of FAS123R, the amount of the NOL carryforward related to stock based compensation expense is not recognized
until the stock-based compensation tax deductions reduce taxes payable. Accordingly, the NOL's reported in the deferred tax asset that were
generated in the current year do not include the component of the NOL related to excess tax deductions over book compensation cost related
to stock based compensation.. The NOL deferred tax asset does include pre-implementation excess tax deductions over book compensation
cost related to stock based compensation. The NOL related to excess tax deductions will be recorded directly into Additional Paid-in-Capital
at the time they produce a future current tax benefit. Approximately, $5.6 million and $5.5 million of the NOLs at December 31, 2007 and
December 31, 2006, respectively, relate to stock option expense for which subsequently recognized tax benefits will be allocated to capital in
excess of par value. No tax deduction benefit from the exercise of stock options was recorded to capital in excess of par value for the years
ended December 31, 2007, 2006 and 2005, respectively.
During 2006, the Company acquired Microwave Satellite Technologies, Inc. As part of the purchase accounting for this acquisition, a
deferred tax liability in the amount of approximately $1.2 million was established. This acquired $1.2 million resulted in a release
of Telkonet's pre-acquisition valuation allowance. The release of this valuation allowance of approximately $1.2 million was recorded as a
reduction of goodwill in connection with the acquisition purchase accounting.
During 2007, the Company acquired SSI and Ethostream. As part of the purchase accounting for these acquisitions, deferred tax assets in
the amount of $3.8 million and $74,000, respectively, were established. A valuation allowance against these deferred assets was established
as part of purchase accounting and was recorded to goodwill.
SFAS 109 requires recognition of a deferred tax liability for outside basis differences arising in fiscal years beginning after December 15,
1992. An outside basis difference represents the amount by which the basis of an investment in a domestic subsidiary for financial reporting
purposes exceeds the tax basis in such asset. If under applicable tax law, the outside basis difference in a domestic subsidiary can be
recovered tax-free and the Company expects to avail itsself of such law, the outside basis difference is not a temporary difference since no
taxes are expected to result upon its reversal. Subsequent to the transaction in May 2007 discussed previously, Telkonet's ownership in
Microwave Satellite Technologies, Inc. is only 63%. As such, it can no longer recover the outside tax basis in a tax-free manner and
Telkonet does not intend to modify its ownership to avail itself of a tax-free recovery alternative. As such, a deferred liability was
established in 2007 for the outside basis difference in Telkonet's ownership of Microwave Satellite Technologies, Inc.
F-38
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.
NOTE O - 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
2007
2006
$ (20,391,110) $(27,437,116) $(15,778,281)
$
(0.35)
44,743,223
65,414,875
50,823,652
(0.31) $
(0.54) $
2005
For the years ended December 31, 2007, 2006 and 2005, 2,800,950, 4,604,414 and 7,577,208 potential shares, respectively were excluded
from shares used to calculate diluted losses per share as their inclusion would reduce net losses per share.
NOTE P - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable and accrued liabilities at December 31, 2007 and 2006 are as follows:
Accounts payable and accrued expenses
Accrued interest
Accrued payroll and payroll taxes
Accrued purchase price contingency
Warranty
Other
Total
NOTE Q - COMMITMENTS AND CONTINGENCIES
Office Leases Obligations
2007
$ 4,940,472
40,000
913,962
400,000
102,534
957,209
$ 7,354,177
2006
$ 1,625,357
-
559,411
400,000
47,300
233,076
$ 2,865,144
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 2007, the Company entered into a sub-lease agreement for an additional 4,800 square feet
of adjacent office space through December 2015.
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. In February 2007, the
Company agreed to sub-lease the Crystal City, Virginia office through the remaining term of the contract resulting in a loss of approximately
$192,000. This lease terminates in March 2008.
Additionally, the Company leases 2 corporate apartments through August 2008 in Germantown, MD.
MST, which was acquired by the Company in January 2006, 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.
In the year ended September 2006, the Company leased a vehicle for the then Chief Executive Officer and current Vice Chairman of the
Board of Directors. The operating lease will expire in September 2008.
Following the acquisitions of Smart Systems International and Ethostream, the Company assumed leases on 9,000 square feet of office space
in Las Vegas, NV for Smart Systems International on a month to month basis and 4,100 square feet of office space in Milwaukee, WI for
Ethostream. The Ethostream lease expires in May 2011. The Las Vegas, NV office lease will terminate effective April 30, 2008.
F-39
Commitments for minimum rentals under non cancelable leases at December 31, 2007 are as follows:
2008
2009
2010
2011
2012 and thereafter
Total
$
$
539,681
485,239
366,903
192,434
498,542
2,082,799
Rental expenses charged to operations for the year ended December 31, 2007, 2006 and 2005 are $825,785, $578,022 and $389,935,
respectively.
Capital Lease Obligations
Development test equipment (Note E) includes the following amounts for capitalized leases at December 31, 2007 and 2006:
Computer equipment and software
Less: accumulated depreciation and amortization
2007
2006
$
$
52,000 $
(36,600)
15,400 $
52,000
(25,000)
27,000
The Company has computer equipment and software purchased under non-cancelable leases with an original cost of $52,000. As of
December 31, 2007, the Company has paid in full the lease obligation. Depreciation expense of $11,600, $10,400, and $10,400 in
connection with the capital leased equipment was charged to operations during the year ended December 31, 2007, 2006 and 2005,
respectively.
Employment and Consulting Agreements
The 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.
The Company entered into an exclusive financial advisor and consulting agreement in January 2007. The agreement provides a minimum
consideration fee, not less than $250,000, in the event of an equity or financing transaction where the advisor is engaged. The agreement
may be terminated with sixty days notification by either party.
On August 1, 2007, the Company entered into an agreement with Barry Honig, President of GRQ Consultants, Inc. (“GRQ”). Telkonet has
agreed to pay Mr. Honig 50,000 shares of common stock per month for six (6) months, to provide the Company with transaction advisory
services. As of December 31, 2007, GRQ held a Senior Promissory Note issued by Telkonet on July 24, 2007, in the principal amount of
$1,500,000 (Note I). On February 8, 2008, this note was repaid in full including $49,750 in accrued but unpaid interest from the issuance
date through the date of repayment (Note V).
Jason Tienor, President and Chief Executive Officer, is employed pursuant to an employment agreement dated March 15, 2007. Mr.
Tienor’s employment agreement has a term of three years and provides for a base salary of $200,000 per year.
Jeff Sobieski, Executive Vice President, Energy Management, is employed pursuant to an employment agreement, dated March 15, 2007.
Mr. Sobieski’s employment agreement has a term of three years for a base salary of $190,000 per year.
Frank T. Matarazzo, Chief Executive Officer, MSTI Holdings, Inc, is employed pursuant to an employment agreement that provides for an
annual salary of $300,000 and expires December 31, 2011.
F-40
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.
Senior Convertible Noteholder Claim
The August 14, 2006 Settlement Agreement with the Senior Convertible Debenture Noteholders provided that the number of shares issued to
the Noteholders shall be adjusted based upon the arithmetic average of the weighted average price of the Company’s common stock on the
American Stock Exchange for the twenty trading days immediately following the settlement date (Note I). The Company has concluded
that, based upon the weighted average of the Company's common stock between August 16, 2006 and September 13, 2006, the Company is
entitled to a refund from the two Noteholders. One of the Noteholders has informed the Company that it does not believe such a refund is
required. As a result, the Company has declined to deliver to the Noteholders certain stock purchase warrants issued to them pursuant to the
Settlement Agreement pending resolution of this disagreement. The Noteholder has alleged that the Company has failed to satisfy its
obligations under the Settlement Agreement by failing to deliver the warrants. In addition, the Noteholder maintains that the Company has
breached certain provisions of the Registration Rights Agreement and, as a result of such breach, such Noteholder claims that it is entitled to
receive liquidated damages from the Company.
However, in the Company’s opinion, the ultimate disposition of these matters will not have a material adverse effect on the Company’s
results of operations or financial position.
Purchase Price Contingency
In conjunction with the acquisition of MST on January 31, 2006, the purchase price contingency shares are price protected for the benefit of
the former owner of MST (Note B). In the event the Company’s common stock price is below $4.50 per share upon the achievement of thirty
three hundred (3,300) subscribers a pro rata adjustment in the number of shares will be required to support the aggregate consideration of
$5.4 million. The price protection provision provides a cash benefit to the former owner of MST if the as-defined market price of the
Company’s common stock is less than $4.50 per share at the time of issuance from the escrow on or before January 31, 2009. The issuance
of additional shares or distribution of other consideration upon resolution of the contingency based on the Company’s common stock prices
will not affect the cost of the acquisition. When the contingency is resolved or settled, and additional consideration is distributable, the
Company will record the current fair value of the additional consideration and the amount previously recorded for the common stock issued
will be simultaneously reduced to the lower current value of the Company’s common stock. In addition, the Company agreed to fully fund
the MST three year business plan, established on January 31, 2006, to satisfy the benchmarks established to achieve 3,300 subscribers. In the
event, for any reason, the Company materially fails to satisfy its obligations then the former owners of MST shall be entitled to the release of
any and all consideration held in reserve.
On March 9, 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy
management products and solutions to customers in the United States and Canada for cash and Company common stock having an aggregate
value of $6,875,000. The purchase price was comprised of $875,000 in cash and 2,227,273 shares of the Company’s common stock. The
Company was obligated to register the stock portion of the purchase price on or before May 15, 2007. Pursuant to the registration rights
agreement, the registration statement was required to be effective no later than July 14, 2007. The registration rights agreement does not
expressly provide for penalties in the event this deadline is not met. This registration statement was declared effective on March 14, 2008.
Of the stock issued in the SSI acquisition, 1,090,909 shares are being held in an escrow account for a period of one year following the
closing from which certain potential indemnification obligations under the purchase agreement may be satisfied. The aggregate number of
shares held in escrow is subject to adjustment upward or downward depending upon the trading price of the Company’s common stock
during the one year period following the closing date. On March 12, 2008, the Company released these shares from escrow and plan to issue
an additional 1,909,091 shares pursuant to the adjustment provision in the SSI asset purchase agreement.
(Note V).
Senior Convertible Debentures
On February 11, 2008, the Purchasers executed a letter agreement with MSTI containing, among other things, in the event Frank Matarazzo
ceases being our Chief Executive Officer of MSTI, that would be an event of default under the Debentures.
F-41
NOTE R - MINORITY INTEREST IN SUBSIDIARY
Minority interest in results of operations of consolidated subsidiaries represents the minority shareholders' share of the income or loss of the
consolidated subsidiary MST. The minority interest in the consolidated balance sheet reflects the original investment by these minority
shareholders in the consolidated subsidiaries, along with their proportional share of the earnings or losses of the subsidiaries.
On January 31, 2006, the Company acquired a 90% interest in Microwave Satellite Technologies, Inc. (“MST”) from Frank Matarazzo, the
sole stockholder of MST in exchange for $1.8 million in cash and 1.6 million unregistered shares of the Company’s common stock for an
aggregate purchase price of $9,000,000 (See Note B). This transaction resulted in a minority interest of $19,569, which reflects the original
investment by the minority shareholder of MST.
On May 24, 2007, MST merged with a wholly-owned subsidiary of MSTI Holdings, Inc. (formerly Fitness Xpress, Inc. ("FXS")).
Immediately following the merger, MSTI Holdings Inc. completed an equity financing of approximately $3.1 million through the private
placement of common stock and warrants and a debt financing of approximately $6 million through the private placement of debentures and
warrants. These transactions resulted in additional minority interest of $4,576,740 and increased the minority interest from 10% to 37% of
MSTI Holding, Inc. outstanding common shares.
For the twelve months ended ended December 31, 2007 and 2006, the minority shareholder's share of the loss of MST was limited to
$2,910,068 and $19,569, respectively. The minority interest in MST through May 24, 2007 was a deficit and, in accordance with Accounting
Research Bulletin No. 51, subsidiary losses should not be charged against the minority interest to the extent of reducing it to a negative
amount. As such, any losses will be charged against the Company's operations, as majority owner. However, if future earnings do
materialize, the majority owner should be credited to the extent of such losses previously absorbed in the amount of $545,745.
Minority interest at December 31, 2007 and December 31, 2006 amount to $2,978,918 and $0, respectively.
NOTE S - BUSINESS CONCENTRATION
Revenue from one (1) major customer approximated $1,436,838 or 10% of total revenues for the year ending December 31, 2007. Total sales
of rental contract agreements (Note F) and the related capitalized equipment to Hospitality Leasing Corporation approximated $705,000 and
$252,000 in the year ending December 31, 2006, and $439,000 and $0 in the year ending 2005, which constituted approximately 18% and
approximately 18% of total revenue, respectively, and represented the only major customer for years then ended. Total accounts receivable of
$290,990, or 10% of total accounts receivable, was due from these customers as of December 31, 2007. Total accounts receivable of $8,774,
or 2% of total accounts receivable, was due from Hospitality Leasing Corporation as of December 31, 2006. There was no outstanding
accounts receivable from these major customers as of December 31, 2005.
Purchases from two (2) major suppliers approximated $2,126,137 or 36% of purchases, $446,038 or 61% of purchases, and $598,000 or 48%
of purchases for the years ended December 31, 2007, 2006 and 2005, respectively. Total accounts payable of approximately $761,033 or
19% of total accounts payable was due to these three suppliers as of December 31, 2007, and approximately $1,871 or 0.3% of total accounts
payable was due to these three suppliers as of December 31, 2006.
NOTE T - NET INVESTMENT IN SALES-TYPE LEASES
Ethostream, LLC’s net investment in sales-type leases as of December 31, 2007 and 2006 consists of the following:
Total Minimum Lease Payments to be Received
Less: Unearned Interest Income
Net Investment in Sales-Type Leases
Less: Current Maturities
Non-Current Portion
2007
2006
$
$
30,000
$
(2,330)
27,670
(16,501)
$
11,169
-
-
-
-
-
Aggregate future minimum lease payments to be received under the above leases are as follows as of December 31, 2007:
2008
2009
2010
2011
$
$
18,291
10,797
912
-
30,000
F-42
NOTE U - - EMPLOYEE BENEFIT PLAN
MSTI maintains a defined contribution profit sharing plan for employees (the “401(k)”), that is administered by a committee of trustees
appointed by MSTI. All MSTI employees are eligible to participate upon the completion of three months of employment, subject to
minimum age requirements. Each year MSTI makes a contribution to the 401(k) without regard to current or accumulated net profits of
MSTI. These contributions are allocated to participants in amounts of 100% of the participants’ contributions up to 1% of each participant’s
gross pay, then 10% of the next 5% of each participant’s gross pay (a higher contribution percentage may be determined at MSTI’s
discretion). In addition, MSTI makes a one-time, annual contribution of 3% of each participant’s gross pay to each participant’s contribution
account in the 401(k) plan. Participants become vested in equal portions of their MSTI contribution account for each year of service until
full vesting occurs upon the completion of six years of service. Distributions are made upon retirement, death or disability in a lump sum or
in installments. The expense for these benefits was $65,812 for the period ending December 31, 2007.
NOTE V - SUBSEQUENT EVENTS
Amendments to Stock Purchase Warrants
On February 1, 2008, the Board of Directors of Telkonet, Inc. approved an amendment to the stock purchase warrants held by Enable
Opportunity Partners, L.P., Pierce Diversified Strategy Master Fund, LLC, Ena and Enable Growth Partners, L.P. to reduce the exercise price
under such warrants from $4.17 per share to $0.6978258 per share. The warrants entitled the holders to purchase an aggregate of up to
3,380,000 shares of Telkonet’s common stock. These warrants were originally granted in connection with two private placements that were
completed in September 2006 and February 2007.
On February 7, 2008, Enable Opportunity Partners, L.P., Pierce Diversified Strategy Master Fund, LLC, Ena and Enable Growth Partners,
L.P. exercised all of their warrants on a cashless basis using the a five day volume average weighted price (VWAP) as of January 31, 2008 of
$.99 resulting in the issuance of 1,000,000 shares of Company common stock and a return of 2,380,000 to shares authorized.
As a result of this amendment to the warrants, Telkonet expects to have a one-time “non-cash” charge of approximately $1,700,000, which is
comprised of approximately $1,200,000 attributable to the amendment to the foregoing warrants and approximately $500,000 attributable to
anti-dilution provisions of certain other outstanding stock purchase warrants.
Private Placement
On February 8, 2008, Telkonet, Inc. completed a private placement of 2.5 million shares of its common stock for aggregate gross proceeds of
$1.5 million. The proceeds of this private placement were primarily used to repay the Senior Promissory Note issued by Telkonet to GRQ
Consultants, Inc. that became due on January 28, 2008.
Financing Agreement
On February 13, 2008, Telkonet, Inc. entered into a Factoring and Security Agreement (the “Agreement”) with Thermo Credit, LLC
(“Thermo”), pursuant to which Thermo has agreed to lend to Telkonet, on a revolving basis, up to $2,500,000. The Agreement has a two
year term and is secured by substantially all of the Company’s accounts receivable. The proceeds will be used for general working capital
needs.
Purchase Price Contingency
As of March 9, 2008, Telkonet owed an additional 1,909,091 shares of its common stock to the sellers of Smart Systems International to
satisfy the adjustment provision for the number of shares held in escrow to satisfy the indemnification provisions of the purchase agreement.
F-43
Exhibit 23.1
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. 333-142986, 333-148731, 333-114425, 333-
129950, 333-137703, 333-141069, 333-138001) on Form S-3 of Telkonet, Inc. and its subsidiaries of our reports dated March 31. 2008, with
respect to the consolidated balance sheets of Telkonet, Inc. and its subsidiaries as of December 31, 2007 and 2006, and the related
consolidated statements of losses, stockholders' equity, and cash flows for the three-years ended December 31, 2006, and the effectiveness of
internal control over financial reporting as of December 31, 2007, which reports appear in the December 31, 2007 annual report on Form 10-K
of Telkonet, Inc. and its subsidiaries.
/s/ RBSM LLP
RBSM LLP
Certified Public Accountants
McLean, Virginia
March 31, 2008
Exhibit 31.1
I, Jason Tienor, certify that:
Certifications
1.
I have reviewed this annual report on Form 10-K of Telkonet, Inc.;
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact
2.
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: April 1, 2008
By: /s/ Jason Tienor
Jason Tienor
Chief Executive Officer
Exhibit 31.2
I, Richard J. Leimbach, certify that:
1.
I have reviewed this annual report on Form 10-K of Telkonet, Inc.;
Certifications
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact
2.
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: April 1, 2008
By: /s/ Richard J. Leimbach
Richard J. Leimbach
Chief Financial Officer
Exhibit 32.1
CERTIFICATION PURSUANT TO SECTION 906
OF
THE SARBANES-OXLEY ACT OF 2002
I, Jason Tienor, 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, 2007 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/ Jason Tienor
Jason Tienor
Chief Executive Officer
April 1, 2008
Exhibit 32.2
CERTIFICATION PURSUANT TO SECTION 906
OF
THE SARBANES-OXLEY ACT OF 2002
I, Richard J. Leimbach, 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, 2007 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/ Richard J. Leimbach
Richard J. Leimbach
Chief Financial Officer
April 1, 2008