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, 2008
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. o 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. o 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 o 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.
o Large Accelerated Filer
o Accelerated Filer
x Non-Accelerated Filer
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) o Yes x No
Aggregate market value of the voting stock held by non-affiliates of the registrant as of March 30, 2009: $11,790,502.
Number of outstanding shares of the registrant’s par value $0.001 common stock as of March 30, 2009: 93,058,566.
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 “clean technology” company that develops and
manufactures proprietary energy efficiency and smart grid networking technology. The Company’s patented Recovery Time™ energy
management technology and Series 5™ power grid networking technology are innovative clean technology products that have helped position
the Company as a leading clean technology provider.
The Telkonet SmartEnergy™ (TSE) and Networked Telkonet SmartEnergy™ (NTSE) platforms incorporate Recovery Time™, an energy
management technology that continuously monitors climate conditions to automatically adjust a room’s temperature to account for the
presence or absence of an occupant in an effort to save energy while at the same time ensuring occupant comfort. This technology is
particularly attractive to our customers in the hospitality area and owners of multi-dwelling units who are continually seeking ways to reduce
costs without impacting customer satisfaction. By reducing energy usage automatically when a space is not being utilized, our customers can
realize a significant cost savings without diminishing occupant comfort.
Telkonet's wholly-owned subsidiary, EthoStream, LLC, operates one of the largest hospitality high-speed Internet access (HSIA) networks in
the United States. Although this business is successful in its own right, its significant customer base in the hospitality industry (i.e. more than
2,500 properties that represent 210,000 rooms) has created an opportunity for Telkonet to market its energy efficiency solutions more
successfully. It also provides a marketing opportunity for the Company’s more traditional HSIA offerings, including the Telkonet iWire
System. The iWire System offers a fast and cost effective way to deliver commercial high-speed broadband access from an IP “platform”
using a building’s existing electrical infrastructure to convert virtually every electrical outlet into a high-speed data port without the
installation of additional wiring or major disruption of business activity. EthoStream represents a significant portion of Telkonet's hospitality
growth and market share (described in detail in the Segment Reporting section).
Telkonet's Series 5 system uses powerline communications technology (PLC) to transform a site’s existing internal electrical infrastructure
into an IP network backbone. With its powerful 200 Mbps chip, the system offers a new competitive alternative in grid communications,
enabling local area network (LAN) infrastructure for command and control, monitoring and grid management, transforming a traditional power
management system into a “smart grid” that delivers electricity in a manner that saves energy, reduces cost and increases reliability. The
company’s PLC platform provides a compelling solution for substation automation, power generation, renewable facilities, manufacturing,
and research environments, by providing a rapidly-deployed, low cost alternative to structured cable or fiber. By leveraging the existing
electrical wiring within a facility to transport data, Telkonet’s PLC solutions enable facilities to deploy sensing and control systems to
locations without the need for new network wiring, and without the security risks entailed with wireless.
The Company's subsidiary MSTI Holdings, Inc. (MSTI) offers 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 ("WiFi") access.
The Company's headquarters is located at 20374 Seneca Meadows Parkway in Germantown, Maryland 20876. Telkonet’s reports that are filed
pursuant to the Securities Exchange Act of 1934 are posted on the Company's website: www.telkonet.com.
The highlights and business developments for the twelve months ended December 31, 2008 include the following:
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Consolidated revenue growth of 45% driven by increased sales activity in the Clean Technology energy management product
segment, including Telkonet SmartEnergy™ (TSE) and Networked Telkonet SmartEnergy™ (NTSE).
Recognition as Top 25 in Deloitte's 2008 Nationwide Technology Fast 500 Program.
Shipments of more than 65,000 rooms’ worth of energy management installations throughout 2008.
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The addition of over 400 new hospitality customers throughout 2008, bringing the total number of hotel customers supported by
the EthoStream Hospitality Network to over 2,500 properties (representing 210,000 rooms).
The release of Telkonet's Series 5 AV 200 Mbps-based PLC platform, targeting utilities and grid communications.
The introduction and initial sales of Telkonet’s next-generation energy management solution, NTSE.
The award of a $1.7M contract with Red Lion hotels to provide a comprehensive wired and wireless HSIA solution and customer
support to all of the Red Lion corporate-owned properties, totaling 5,400-plus rooms in 30 hotels across the United States.
The award of a contract with New York University, the largest private university in the United States, to install the first phase of a
networked energy efficiency program in two student-occupied residence halls.
The signing of an exclusive two-year energy management contract extension with West coast-based Cool Control Plus hospitality
energy efficiency program.
Entered into a relationship with the ESCO operating Nevada’s hospitality energy efficiency program.
Transition of all former SSI activities from Las Vegas to Telkonet’s Milwaukee, WI offices.
Reduction in operating expenses of -17% on a consolidated basis in 2008.
Completion of several military base energy management installations with one of the largest ESCOs in the United States.
Completion of a franchise wide rollout of energy management products with the entire InTown Suites franchise.
We classify our operations in two reportable segments: the Telkonet Segment and the MST Segment.
Telkonet Segment (“Telkonet”)
Segment Reporting
Telkonet provides integrated, centrally-managed energy management and SmartGrid networking solutions that improve energy efficiency and
reduce the demand for new energy generation. The Company's energy management systems, aimed at the hospitality, commercial,
government, healthcare and education markets, are dynamically lowering HVAC costs in over 140,000 rooms, and are an integral part of
various utilities' green energy efficiency and rebate programs.
Primarily targeting SmartGrid and utility applications, Telkonet's patented powerline communications (PLC) platform delivers cost-effective,
robust networking, with real-time online monitoring and maintenance capabilities, increasing the reliability and energy efficiency across the
entire utility grid.
The Company employs direct and indirect sales channels in all areas of its business. With a growing value-added reseller (VAR) network,
Telkonet continues to broaden its reach throughout the industry. Direct sales efforts are focused on the hospitality industry through Telkonet's
wholly-owned subsidiary, EthoStream. With a recognized brand and strong customer loyalty, EthoStream continues to grow its Hospitality
Network and expand beyond limited and economy properties into the full-service hospitality market.
Telkonet's direct sales efforts target the utility, education, commercial and government market segments. Taking advantage of legislation,
including the Energy Independence and Security Act (EISA) of 2007 and the Energy Policy Act of 2005, Telkonet has focused its sales efforts
in areas with available public funding and incentives, such as rebate programs offered by Utilities to the hospitality industry. Telkonet has
developed a strategic growth plan to meet the needs of this emerging industry.
2
Product Strengths
Telkonet's entry into the Clean Technology space has been driven by its energy efficiency product offerings. According to the International
Energy Agency, each $1 invested in energy efficiency removes the need, on average, to spend more than $2 on creating new supply. This
knowledge alone is renewing interest in energy management and reducing the reliance on new energy generation and consumption.
Telkonet’s new NTSE system, which delivers intelligent energy management control with an integrated, networked platform, has been
developed in direct cooperation with utilities and their Demand Response (DR) program interests. For example, the Brattle Group’s recent
assessment of DR, called the Power of Five Percent, concluded that if DR could reduce peak demand by 5% it would produce a benefit stream
over twenty years with a projected present value of $66 billion. This represents a significant increase over their previous projection of $35
billion, based on increased peak energy costs and decreased technology costs.
Telkonet’s differentiated approach to energy management, with its patented Recovery Time™ technology, delivers significant benefits over
competing technologies, including the following:
· Maximum energy savings by evaluating each room’s environmental conditions, including room location, window placement, dry
vs. humid climate, weather conditions, and condition of heating, ventilation and air conditioning (HVAC) equipment,
· Longer life and reduced maintenance of HVAC units through effective equipment monitoring,
· Increased occupant comfort,
· Speed and ease of installation, and
· Wide range of HVAC system compatibility.
Based on these advanced product features and capabilities, Telkonet has won significant competitive contracts in the utility, military and
educational space, including Noresco, NYU and the Cool Control Plus Program. Forming key partnerships with utility rebate programs has
enabled Telkonet to outpace its competition in the commercial occupancy-based energy management market.
Telkonet's new NTSE system has evolved the Company’s strategic vision, moving past traditional energy efficiency and energy management
to bring SmartGrid controls to the edge of the grid. Using wired and wireless technologies to network-enable in-room energy controls provides
greater granularity of control and real-time performance monitoring. Additionally, network control maximizes energy efficiency and savings.
Finally, integrating in-room management into a Utility's DR programs has significantly enhanced the NTSE proposition. With the first year of
sales completed, Telkonet has recognized 143% growth in its energy management product segment and expects increased growth in 2009.
Given our nation's population growth and the exponential increase in the number of power-hungry digital components in our digital economy,
additional infrastructure must be built, whether it is Smart or not. According to the Brattle Group, investments of $1.5 trillion will be required
from 2010 to 2030 to pay for this infrastructure. The SmartGrid can be the most affordable alternative to building out by building less and
saving more energy. It will clearly require investments that are not typical for utilities. However, these investments will far outweigh the costs
as some utilities are already discovering.
There is growing agreement among federal and state policymakers, business leaders and other key stakeholders around the concept that a
SmartGrid is not only needed but well within reach. Short term, a smarter grid will function more efficiently, delivering the expected level of
service cost-effectively while offering considerable societal benefits such as less impact on our environment. Longer term, the SmartGrid will
spur a transformation similar to the impact of the Internet on how we live, work, play and learn.
Telkonet is positioned to play a pivotal role in SmartGrid. The development of an industrial PLC product for use within the utility space has
introduced a competitive alternative to the local area network (LAN) options. By capitalizing on the shortcomings of previously available
offerings, Telkonet has gained traction and opened up a new market segment.
3
Telkonet's Series 5 PLC platform includes the following key features:
· Multiple physical interfaces, including RS232, RS485 and Ethernet, enabling a wide range of different devices to be networked,
· Multiple Utility-centric protocols supported, including DNP3, Modbus and IP,
· Granular QOS support over traditional communications,
· Ability to withstand extended temperature ranges and harsh outdoor environments,
· Stringent security features,
· Support for both AC and DC applications,
· Significant speed performance with AV chipset, and
· Flexible connection technology that avoids interruption of service through inductive coupling.
Telkonet's EthoStream division continues to cement its market leadership in the hospitality HSIA space. With strong, established customer and
vendor relationships, including Choice Hotels International, Wyndham Hospitality, Destination Hotels and Resorts, and Worldmark by
Wyndham (formerly Trendwest Resorts), EthoStream has demonstrated the continued strength of its brand through 2008. Winning
competitive bids such as the corporate rollout of the Red Lion properties, EthoStream has expanded beyond its economy and limited service
roots to enter the more lucrative segment of full-service hospitality.
EthoStream Gateway Servers (EGS) provide industry-leading HSIA technology to the hospitality industry, with advanced features based on
in-house product design and development, including the following:
· Dual ISP bandwidth aggregation for faster overall speed,
· ISP redundancy to eliminate network downtime,
· Enhanced Quality of Service (QoS), and
· Real-time meeting room scheduling.
EthoStream's 24/7 U.S.-based Support Center employs a dedicated, in-house support team that uses integrated, web-based centralized
management tools enabling proactive support. The Support Center has continued its growth over the last year. These corporate strengths,
along with established relationships with some of the largest hospitality franchises, continue to set EthoStream apart.
Looking ahead, EthoStream's core growth will come from two key areas:
· New customer growth within the full-service hospitality market and through additional preferred vendor agreements with
franchisors, and
· Ongoing sales to current customers through integration of additional in-room technologies such as lighting, minibars, media centers
and energy management products.
Industry Outlook
The National Institute of Standards and Technology (NIST), an agency of the U.S. Department of Commerce, has been chartered under
Energy Independence and Security Act 2007 (EISA) to identify and evaluate existing standards, measurement methods, technologies and other
support toward SmartGrid adoption. The agency will also be preparing a report to Congress recommending areas where standards need to be
developed. These types of initiatives reinforce the need for Telkonet's platform and technology.
4
It is estimated that SmartGrid enhancements will ease congestion and increase utilization, sending 50% to 300% more electricity through
existing energy corridors. Telkonet is focusing on the strength of its technology to target key initiatives within the SmartGrid environment.
Through key relationships with original equipment manufacturers (OEMs) and Utilities, Telkonet has been recognized as a leading technology
provider.
Telkonet is a member of Western Electricity Coordinating Council (WECC) and the North American Electric Reliability Corporation (NERC).
These industry-leading groups are defining the standards for tomorrow's Smart Grid platforms. Comprised of U.S. electrical grid operations
and subject to oversight by the U.S. Federal Energy Regulatory Commission and governmental authorities in Canada, the technologies tested
and approved by these groups create the foundation for utility decisions.
Competition
Telkonet has greatly increased its market potential by evolving its energy management products with two significant developments:
· Increased HVAC system compatibility with the broadest range of HVAC equipment, and
· Advancing Telkonet SmartEnergy™ to a networked energy management platform.
Telkonet's products are Energy Star-certified and incorporate its patented Recovery Time™ technology. Although this technology provides
Telkonet with significant competitive advantage in the occupancy-based energy efficiency space, competing technologies are
available. These technologies would include the less automated standard available within energy management of static set point temperature,
predictive based methodologies and standard building automation systems utilizing sensor and zone time-based architectures. In addition to its
competitive benefits over these methodologies, Telkonet has added functionality and techniques of these methods to its offering as well to
provide customers with more broad capabilities.
Telkonet's Series 5 product line has targeted smart grid communications with proprietary technological advancements. Telkonet's strengths in
the grid communication space include fast implementation, existing customer relationships and proven performance. Our challenges include
the introduction of a new technology into a competitive environment, entry into a fledgling market, the significant sales cycle involved in a
highly regulated environment and the consumer education required and cultivating relationships with manufacturers and VARs to assist
Telkonet in its distribution strategy.
Management has focused its sales and marketing efforts primarily on opportunities within the clean technology space in the commercial and
industrial, government, education, healthcare and hospitality sectors, concentrating on markets with public funding from government and
utilities in the form of grants, loans, tax breaks, incentives and rebates. Telkonet devotes significant resources to establishing relationships with
both value-added resellers in these markets as well as third-party manufacturers, Utilities and energy service companies (ESCOs). These
relationships enable Telkonet to reach a larger audience, as well as to offer increased value through complete packaged solutions. These sales
and distribution channels continue to drive Telkonet's clean technology growth, generating greater product recognition.
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.
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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, education,
healthcare and government markets.
Revenue from two (2) major customer approximated $6,375,182 or 31% of total revenues for the year ending December 31, 2008. Revenue
from one (1) major customer approximated $1,436,838 or 10% of total revenues for the year ending December 31, 2007.
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 System T M and Series 5 product
suite. Following is a description of the material patents held by the Company:
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 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 ™ 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, but not limited to, 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.
Telkonet has also filed multiple Patent Cooperation Treaty (PCT) patent applications, which have been used to file national patent applications
in foreign jurisdictions 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.
6
Government Regulation
We are subject to regulation in the United States by the Federal Communications Commission (“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 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 March 2005, Telkonet received final certification of its Telkonet iWire System T M 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 SystemT M 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.
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.
Future products designed by the Company will require testing for compliance with FCC and CE compliance. Moreover, if in the future, the
FCC or EU changes its technical requirements, further testing and/or modifications may be necessary in order to achieve compliance.
Research and Development
During the years ended December 31, 2008 and 2007, Telkonet spent $2,036,129 and $2,349,690, respectively, on research and development
activities. In 2008 and 2007, research and development activities were focused on the development of Telkonet’s next generation of PLC
products, and the networked Telkonet SmartEnergy™ solution.
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 Amperion.
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, 2008 and 2007.
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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 BPL Global. The Company reviewed the assumptions underlying the operating
performance and cash flow forecasts in assessing the carrying values of the investment. The fair value of the Company's investment in BPL
Global, 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 was
subject to adjustment on the date the Company filed a registration statement for the shares issued in this transaction, which occurred on April
25, 2008. The increase or decrease to the number of shares issued was 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 was
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 GOCA. On April 30, 2008, Telkonet issued an additional 3,046,425 shares of its common
stock to the sellers of GOCA to satisfy the adjustment provision.
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 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. (“Geeks Holdings”). Immediately following the merger, Geeks Holdings 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 Holdings. The Company has determined that its investment in Geeks Holdings is impaired because
it believes that the fair market value of Geeks Holdings has permanently declined. Accordingly, the Company wrote-off $4,098,514 during
the year ended December 31 2008. The remaining value of this investment amounted to $367,643 as of December 31, 2008.
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 classifies this security as
available for sale, and it is carried at fair market value. During the year ended December 31, 2008, the Company recorded a loss of $6,500 on
the sale of 5,000 shares of its investment in Multiband. In addition, the Company recorded an unrealized loss of $32,750 due to a temporary
decline in value of this security. The remaining value of this investment amounted to $29,750 as of December 31, 2008.
Backlog
The Telkonet Segment maintains contracts and monthly services for more than 2,500 hotels which are expected to generate approximately
$3,600,000 annual recurring support and internet advertising revenue.
8
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 the 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. 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. MSTI reassessed its plans for an IPTV service and has since suspended its development of an IPTV service
until the release of a more cost-effective third party distribution service.
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.
9
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, 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 fixed 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.
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.
10
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.
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.
11
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, 2008. 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 Interactivewifi.com. Telkonet reviewed the
assumptions underlying the operating performance and cash flow forecasts in assessing the carrying values of the investment. The carrying
value of the investment in Interactivewifi.com is $55,000 at December 31, 2008 and 2007.
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 $2,000,000 in revenue through 2013.
Other information
Employees
As of March 15, 2009, the Company had 122 full time employees comprised of 100 full time employees of Telkonet and 22 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, field services, engineering, sales and marketing, and administration.
12
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 portion of
our revenue from international sales. International sales as a percentage of total revenue represented 0.5%, 2% and 19% in 2008, 2007 and
2006, 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.
2008
$ 20,410,315
120,644
$ 20,530,959
Year Ended December 31,
Percentage
Change
2007
Percentage
Change
47% $ 13,851,021
301,712
-60%
45% $ 14,152,733
207% $
-55%
173% $
2006
4,508,478
672,850
5,181,328
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.
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 April 1, 2009, our independent auditors stated that our financial statements for the year ended December 31, 2008 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 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. If we are not successful in raising sufficient additional
capital, we may not be able to continue as a going concern and our stockholders may lose their entire investment.
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, 2008, the Company has incurred cumulative losses of $114,801,318 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 SmartEnergy™ (TSE), Networked Telkonet
SmartEnergy™ (NTSE) and the Telkonet Series 5™ and the Telkonet iWire System™ product suites;
· costs and expenses associated with manufacturing, distribution and marketing of the Company’s products;
· general and administrative costs relating to the Company’s operations; and
· interest expense related to the Company’s indebtedness.
The Company is currently unprofitable and may never become profitable. Since inception, the Company has funded its research and
development activities primarily from private placements of equity and debt securities, a bank loan and short term loans from certain of its
executive officers. As a result of its substantial research and development expenditures and limited product revenues, the Company has
incurred substantial net losses. The Company’s ability to achieve profitability will depend primarily on its ability to successfully
commercialize the Telkonet SmartEnergy™ (TSE) and Networked Telkonet SmartEnergy™ (NTSE) product suites and the Telkonet Series
5™ grid networking platform. 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.
13
MSTI is currently in default under its debentures and this indebtedness is secured by all of MSTI’s assets.
As of December 15, 2008, MSTI is in material default with respect to indebtedness that is secured by substantially all of MSTI’s
assets. Although MSTI’s lenders have not yet initiated legal action in connection with MSTI’s default, the lenders have the right at any time
to pursue any and all legal remedies available to them, which remedies include, but are not limited to, foreclosure on all or a portion of MSTI’s
assets. In the event such foreclosure occurs, these assets could be liquidated by the lenders. Although the lenders and MSTI have agreed to
pursue an orderly sale of MSTI’s assets, there can be no assurance that a buyer will be identified or that the amount obtained pursuant to any
sale will be sufficient to satisfy MSTI’s outstanding indebtedness. In the event the proceeds of any such sale are less than MSTI’s
indebtedness, the value of the Company’s MSTI stock will be significantly impaired or, in all likelihood, will become valueless.
Our Agreement with Frank Matarazzo, Chief Executive Officer of MSTI, obligates us to continue to fund MSTI.
Notwithstanding that MSTI has agreed with its lenders to pursue an orderly sale of its material assets, the Company agreed pursuant to the
December 6, 2005 MST purchase agreement, as further clarified by a May 2008 letter agreement, to fund MSTI's business plan. The May
2008 letter agreement confirms that the Company has funded a majority of the business plan and provides for the final amount of the
funding obligation to be mutually agreed upon by the Company and Mr. Matarazzo. Since the Company's right to distributions from MSTI
is subordinate to the rights of MSTI's secured lenders, there can be no assurance that the Company will recognize a return on this investment
in the event a sale of MSTI's assets is consummated. The obligation to fund MSTI will deplete the Company's available cash and could
create the need to raise additional capital. There can be no assurance that, if additional cash is needed, the Company will be able to
consummate a capital raising transaction on favorable terms or at all.
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.
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.
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, 2008, the Company had outstanding employee options to purchase a total of 6,993,929 shares of common stock at
exercise prices ranging from $1.00 to $5.97 per share, with a weighted average exercise price of $1.82. As of December 31, 2008, 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, 2008, the Company had warrants outstanding to purchase a total of 8,457,767 shares of common stock at exercise
prices ranging from $0.58 to $4.17 per share, with a weighted average exercise price of $2.19. 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.
14
The industry within which we operate 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 the markets within which it competes.
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 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.
15
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 our products and services is highly competitive. Some of our competitors have longer operating histories, greater name
recognition and substantially greater financial, technical, sales, marketing and other resources. These 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 competitors and these 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 competitors will also intensify their efforts to penetrate the Company’s target markets. These competitors may have more
advanced technology, more extensive distribution channels, stronger brand names, bigger promotional budgets and larger customer bases than
the Company does. These companies could devote more capital resources to develop, manufacture and market competing products than the
Company could. If any of these companies are successful in competing against the Company, its sales could decline, its margins could be
negatively impacted, and the Company could lose market share, any of which could seriously harm the Company’s business and results of
operations.
The 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.
16
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 the market value of our common stock which will vary, and our 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 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.
We are exposed to risks relating to evaluations of controls required by section 404 of the Sarbanes-Oxley Act of 2002.
We are required to comply with Section 404 of the Sarbanes-Oxley Act of 2002. As of December 31, 2008, we have concluded that there are
material weaknesses in our internal control over financial reporting. A material weakness is a control deficiency, or a combination of control
deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of annual or
interim financial statements would not be prevented or detected. Until this deficiency in our internal control over financial reporting is
remediated, there is reasonable possibility that a material misstatement to our annual or interim consolidated financial statements could occur
and not be prevented or detected by our internal controls in a timely manner.
17
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 $12.7 million at December 31, 2008 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, 2008, 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 management’s assessment of operating results and
forecasted discounted cash flow the carrying value of Ethostream LLC goodwill was determined to be impaired and therefore $2,000,000 was
written off during the year ended December 31, 2008.
The Company's indebtedness and restrictive debt covenants limit the Company's financing options and liquidity position, which could limit the
Company's ability to grow our business.
The terms of the Company's outstanding debentures put significant restrictions on the Company's ability to:
· 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 significant restrictions could have negative consequences, such as:
· the Company's may be unable to obtain additional financing to fund working capital, operating losses, capital expenditures or
acquisitions on terms acceptable to the Company's, or at all;
· the Company's may be unable to refinance its indebtedness on terms acceptable to the Company's, or at all; and
· the Company's may be more vulnerable to economic downturns and limit the Company's ability to withstand competitive
pressures.
18
Moreover, any additional debt financing pursued by the Company may contain terms that include more restrictive covenants, require
repayment on an accelerated schedule or impose other obligations that limit the ability to grow the Company’s business, acquire needed
assets, or take other actions the Company might otherwise consider appropriate or desirable.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
ITEM 2. PROPERTIES.
The Company presently leases 16,400 square feet of commercial office space in Germantown, Maryland for its corporate headquarters. The
Germantown lease expires in December 2015. The Company spent approximately $61,000 in build out costs to increase the office space of its
Germantown headquarters by approximately 6,000 square feet in April 2007.
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 expired 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.
MSTI 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.
The Company presently leases 12,000 square feet of office space in Milwaukee, WI for EthoStream. The Milwaukee lease expires in
February 2019.
Following the acquisition of SSI, the Company assumed a lease on 9,000 square feet of office and warehouse space in Las Vegas, NV on a
month to month basis. The Las Vegas, NV office lease expired on April 30, 2008.
ITEM 3. LEGAL PROCEEDINGS.
On July 2, 2008, EthoStream was named as a defendant in Linksmart Wireless Technology, LLC v. T-Mobile USA, Inc., et al, filed in the
Eastern District of Texas. The suit names 22 defendants and claims that the defendants’ services, including those of EthoStream, infringe a
wireless network security patent held by Linksmart. Linksmart is seeking a judgment for damages (including statutory enhanced damages),
costs, expenses and prejudgment and post-judgment interest and a permanent injunction enjoining the defendants from infringing its patent. In
connection with a Vendor Direct Supplier Agreement between EthoStream and WWC Supplier Services, Inc., the Company has determined
that it owes the duty to defend and indemnify Defendant Ramada Worldwide, Inc. and it has assumed Ramada’s defense. The Company
believes the claim is without merit and intends to vigorously defend the allegations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
19
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES.
On January 24, 2004, the Company’s common stock was listed for trading on the American Stock Exchange (AMEX) under the ticker
symbol “TKO.” Prior to January 24, 2004, the Company’s common stock was quoted on the OTC Bulletin Board under the symbol
“TLKO.OB.” As of March 15, 2009, the Company had 250 stockholders of record and 91,365,545 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, 2007 through December 31, 2008. The information provided for the periods listed below was obtained from the Yahoo! Finance
web site.
Year Ended December 31, 2008
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
Year Ended December 31, 2007
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
High
Low
$
$
$
$
$
$
$
$
1.11
1.02
0.56
0.33
4.00
2.77
2.01
1.84
$
$
$
$
$
$
$
$
0.57
0.40
0.24
0.10
2.50
1.60
1.20
0.75
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.) 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, 2008. The total returns assume $100 invested on December 31, 2002 with reinvestment
of dividends.
20
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
2008
Year Ended December 31,
2006
2005
2007
2004
$
20,531
$
14,153
$
5,181
$
2,488
$
698
Operating loss
Net loss
Loss per share - basic
Loss per share - diluted
Basic and diluted weighted average common shares
outstanding
Working capital
Total assets
Short-term borrowings and current portion of long-term
debt
Long-term debt, net of current portion
Stockholders’ equity (deficiency)
(14,836)
(23,458)
(17,563)
(15,307)
(13,112)
(23,986)
(20,391)
(27,437)
(15,778)
(13,093)
(0.30)
(0.30)
(0.31)
(0.31)
(0.54)
(0.35)
(0.54)
(0.35)
79,154
65,415
50,824
44,743
(15,414)
(2,991)
(531)
12,061
26,508
38,741
12,517
23,291
7,784
1,311
3,451
1,471
4,432
—
—
21,268
8,135
6,350
9,617
5,315
(0.32)
(0.32)
41,384
12,672
15,493
—
588
13,646
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the
accompanying financial statements and related notes thereto.
The Company reports financial results for the following operating business segments:
Telkonet Segment
Telkonet provides integrated, centrally-managed energy management and SmartGrid networking solutions that improve energy efficiency and
reduce the demand for new energy generation. The Company's energy management systems, aimed at the hospitality, commercial,
government, healthcare and education markets, are dynamically lowering HVAC costs in over 140,000 rooms, and are an integral part of
various utilities' green energy efficiency and rebate programs. The segment’s net sales in 2008 were $16,559,001, 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 segment’s net sales in 2008 were $3,971,958, 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.
21
Revenue Recognition
For revenue from product sales, the Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition
(“SAB104”), which includes the provisions of 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.
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.
Revenue from sales-type leases for Ethostream products is recognized at the time of lease 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 issued subject to the recognition and disclosure requirements of FIN 45 as of December 31, 2008 and 2007 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, 2008, the Company experienced approximately 3% percent of units
returned. Using this experience factor a reserve of $146,951 was accrued.
22
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).
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. The Company is using the Black-Scholes option-pricing model as its method of valuation
for share-based awards. 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 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 2008 and prior years,
expected stock price volatility is based on the historical volatility of the Company’s stock for the related vesting periods.
Stock-based compensation expense recognized under SFAS 123(R) for the years ended December 31, 2008 and 2007 was $1,216,997 and
$1,534,260, respectively, net of tax effect.
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, 2008 Compared to Year Ended December 31, 2007
Revenues
The Company’s revenue is derived from product sales and recurring revenue in the commercial, government and international markets of the
Telkonet Segment. MST revenue is derived from 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.
23
The table below outlines product versus recurring (lease) revenues for comparable periods:
2008
Year ended December 31,
2007
Variance
$ 13,690,010
6,840,949
$ 20,530,959
67%
33%
100%
$
9,168,077
4,984,656
$ 14,152,733
65%
35%
100%
$
$
4,521,933
1,856,293
6,378,226
49%
37%
45%
Product
Recurring
Total
Product revenue
The Telkonet Segment product revenue principally arises from the sale and installation of SmartGrid and broadband networking equipment,
including Telkonet SmartEnergy™ products, Telkonet Series 5™ products and the Telkonet iWire System™. The Telkonet Segment markets
and sells to hospitality, education, healthcare and government markets. The Telkonet Series 5™ and the Telkonet iWire SystemTM consist of
the Telkonet Gateways, Telkonet Extenders, the patented Telkonet Coupler, and Telkonet iBridges. The Telkonet SmartEnergy™ product
suite consists of thermostats, sensors and controllers.
For the year ended December 31, 2008, product revenue in the Telkonet Segment was approximately $13,043,000, and increased by 49%
when compared to the prior year. Telkonet Segment product revenue for the year ended December 31, 2008 includes approximately
$8,486,000 attributed to the sale of energy management products, and approximately $4,588,000 of broadband networking products and
services to the hospitality market. The Telkonet Segment’s product revenues in the second half of 2008 have been impacted by the difficult
economic climate, in addition to the normal season sales cycle for Telkonet’s products and services . However, management believes that our
products and services, specifically energy management, will provide the Company growth opportunities despite the current US
recession. Therefore we anticipate quarter over quarter growth in the energy management and hospitality markets during the year ended
December 31, 2009. Additionally, we anticipate significant opportunities for increased PLC sales in the utility and government markets in
2009, based on the sales activities of 2008 and the typical lead times for customers in these markets.
The MST Segment product revenue arises from the sale 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, 2008 was approximately $647,000, and increased
by 65% when compared to the prior year.
Recurring Revenue
The recurring revenue in the Telkonet segment arises from over 2,500 hotels in our broadband network portfolio. We currently support over
210,000 HSIA rooms, with over 2 million monthly users. For the year ended December 31, 2008, recurring revenue was approximately
$3,516,000, and increased by 30% when compared to the year ended December 31, 2007. We anticipate growth to our subscriber base as we
deploy additional sites under contract and increase Telkonet’s strategic franchise and group alliances through the Ethostream brand.
For the year ended December 31, 2008, the recurring revenue for the MST Segment subscriber base was approximately $3,325,000, and
increased by 46% when compared to the prior year. 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.
Cost of Sales
Product
Recurring
Total
2008
Year ended December 31,
2007
Variance
$
8,511,196
5,312,427
13,823,623
62%
78%
67%
$
7,165,120
4,505,476
$ 11,670,596
78%
90%
82%
$
$
1,346,076
806,951
2,153,027
19%
18%
18%
24
Product Costs
The Telkonet Segment product costs include equipment and installation labor related to the sale of Telkonet SmartEnergy™ products,
Telkonet Series 5™ products and the Telkonet iWire System™. For the year ended December 31, 2008, product costs in the Telkonet
Segment were approximately $8,105,000, and increased by 18% when compared to the prior year. Telkonet Segment product costs have
increased in connection 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, 2008, product costs for the MST segment amounted to approximately $406,000.
Recurring Costs
For the year ended December 31, 2008, recurring costs for the Telkonet segment were approximately $1,681,000, and increased by 20% when
compared to the prior year. This increase is primarily due to the increase in EthoStream’s customer base and the related recurring revenue in
the Telkonet Segment.
The MST Segment’s recurring costs amounted to approximately $3,632,000, for the year ended December 31, 2008. These costs consist of
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
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.
Gross Profit
Product
Recurring
Total
Product Gross Profit
2008
Year ended December 31,
2007
Variance
$
$
5,178,814
1,528,522
6,707,336
38%
22%
33%
$
$
2,002,957
479,180
2,482,137
22%
10%
18%
$
$
3,175,857
1,049,342
4,225,199
159%
219%
170%
The gross profit for the year ended December 31, 2008 increased compared to the prior year period as a result of increased product sales and
installations in the Telkonet Segment and represented 38% of product revenue. We anticipate an increase in our gross profit trend for product
sales as energy management, utility and government market opportunities expand.
Recurring Gross Profit
The Telkonet Segment’s gross profit associated with recurring revenue increased for the year ended December 31, 2008, and represented
approximately 52% of recurring revenue. The centralized remote monitoring and management platform and internal call support center has
provided the platform to continue to increase the gross profit on the Telkonet Segment’s recurring revenue.
The MST Segment’s gross profit represented approximately -9% of total revenue for the year ended December 31, 2008, compared to the
prior year period, primarily due to programming costs and the support infrastructure. MST anticipates that an expanded subscriber base
utilizing the current infrastructure and reduced programming costs will facilitate increased gross profit.
25
Operating Expenses
2008
Year ended December 31,
2007
Variance
Total
$
21,543,563
$
25,939,690
$
(4,396,127)
-17%
During the year ended December 31, 2008, operating expenses for the Telkonet Segment were approximately $14,759,172, and decreased by -
19% when compared to the prior year. The operating efficiencies achieved by the Company from the acquisitions of SSI and EthoStream in
March 2007, have been offset by a $2,000,000 write down of Ethostream’s goodwill, resulting from the impact of the current recession on
EthoStream’s valuation. Telkonet will continue to monitor its operating expenses and will adjust expenses appropriately to match its
anticipated revenue opportunities.
During the year ended December 31, 2008, operating expenses for the MST Segment were approximately $6,784,000 and operating expenses
decreased by 12% when compared to the prior year. Despite reductions in operating expenses, the MST Segment was impacted by non-cash
charges of $1,582,033 for the impairment write-down of MST’s fixed assets.
Research and Development
2008
Year ended December 31,
2007
Variance
Total
$
2,036,129
$
2,349,690
$
(313,561)
-13%
Telkonet’s research and development costs related to both present and future products are expensed in the period incurred. Total expenses
decreased for the year ended December 31, 2008 by approximately $314,000, or -13%. The Research and Development costs are associated
with the development of the Telkonet Series 5™ product suite and the integration of new applications to the Telkonet iWire System™, and
the development of next generation Telkonet SmartEnergy™ (TSE) and Networked Telkonet SmartEnergy™ (NTSE) products. The
Company does not anticipate significant cost increases in 2009.
Selling, General and Administrative Expenses
2008
Year ended December 31,
2007
Variance
Total
$
12,938,957
$
17,897,974
$
(4,959,017)
-28%
Selling, general and administrative expenses decreased for the year ended December 31, 2008 over the comparable prior year by
approximately $4,959,000, or -28%. This decrease is primarily the result of the efficiencies in the organization resulting in salary and related
costs reductions as well as reduced travel costs, professional fees and rent and related costs for the Telkonet Segment, when compared to the
prior year. We do not expect to significantly increase our selling, general and administrative expenses in 2009, when compared to the year
ended December 31, 2008. However, due to the difficult ecomonic climate, and the potential impact on Telkonet’s operations, if any, these
expenses will be adjusted as necessary to match our current sales.
Liquidity and Capital Resources
Our working capital decreased by $(12,423,227) during the year ended December 31, 2008 from a working capital deficit of $(2,990,664) at
December 31, 2007 to a working capital deficit of $(15,413,891) at December 31, 2008. The decrease in working capital for the year ended
December 31, 2008, 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 $1,347,594 for the year ended December 31, 2008. The most significant uses
and proceeds of cash were:
o Approximately $4,058,000 of cash consumed directly in operating activities
26
o A private placement from the sale of 2,500,000 shares of common stock at $0.60 per share provided proceeds of
$1,500,000.
o A repayment of a Senior Note in the amount of $1,500,000 issued to GRQ Consultants, Inc.
o A sale of convertible debentures for proceeds of $1,000,000 and $2,500,000 in May and July 2008, respectively.
o
Proceeds of approximately $574,000 from a working capital line of credit
Of the total current assets of $3,445,766 as of December 31, 2008, cash represented $281,989. Of the total current assets of $7,004,168 as of
December 31, 2007, cash represented $1,629,583.
Line of Credit
In September 2008, the Company entered into a two-year line of credit facility with a third party financial institution. The line of credit has an
aggregate principal amount of $1,000,000 and is secured by the Company’s inventory. The outstanding principal balance bears interest at the
greater of (i) the Wall Street Journal Prime Rate plus nine (9%) percent per annum, adjusted on the date of any change in such prime or base
rate, or (ii) sixteen percent (16%). Interest, computed on a 365/360 simple interest basis, and fees on the credit facility are payable monthly in
arrears on the last day of each month and continuing on the last day of each month until the maturity date. The Company may prepay
amounts outstanding under the credit facility in whole or in part at any time. In the event of such prepayment, the lender will be entitled to
receive a prepayment fee of four percent (4.0%) of the highest aggregate loan commitment amount if prepayment occurs before the end of the
first year and three percent (3.0%) if prepayment occurs thereafter. The outstanding borrowing under the agreement at December 31, 2008
was $574,005. The Company has incurred interest expense of $22,374 related to the line of credit for the year ended December 31, 2008. The
Prime Rate was 3.25% at December 31, 2008.
On February 19, 2009, the Company received a notice of waiver from Thermo Credit LLC on the tangible net worth requirement, as defined
item D(10)b of the line of credit agreement. The waiver is in effect as of December 31, 2008 and for the 90 day period thereafter.
Convertible Debenture
On May 30, 2008, the Company entered into a Securities Purchase Agreement with YA Global Investments, L.P. (the “Buyer”) pursuant to
which the Company agreed to issue and sell to the Buyer up to $3,500,000 of secured convertible debentures (the “Debentures”) and warrants
to purchase (the “Warrants”) up to 2,500,000 shares of the Company’s Common Stock, par value $0.001 per share (the “Common
Stock”). The sale of the Debentures and Warrants was effectuated in three separate closings, the first of which occurred on May 30, 2008, and
the remainder of which occurred in July 2008. At the May 30, 2008 closing, the Company sold Debentures having an aggregate principal
value of $1,500,000 and Warrants to purchase 2,100,000 shares of Common Stock. In July 2008, the Company sold the remaining
Debentures having an aggregate principal value of $2,000,000 and Warrants to purchase 400,000 shares of Common Stock.
The Debentures accrue interest at a rate of 13% per annum and mature on May 29, 2011. The Debentures may be redeemed at any time, in
whole or in part, by the Company upon payment by the Company of a redemption premium equal to 15% of the principal amount of
Debentures being redeemed, provided that an Equity Conditions Failure (as defined in the Debentures) is not occurring at the time of such
redemption. The Buyer may also convert all or a portion of the Debentures at any time at a price equal to the lesser of (i) $0.58, or (ii) ninety
percent (90%) of the lowest volume weighted average price of the Company’s Common Stock during the ten (10) trading days immediately
preceding the conversion date. The Warrants expire five years from the date of issuance and entitle the Buyers to purchase shares of the
Company’s Common Stock at a price per share of $0.61.
On March 31, 2009, the Company received a notice of waiver from YA Global Investments, L.P. pursuant to which it agreed that, to the
extent MSTI is in default of the MSTI Debentures, such default shall not constitute an Event of Default as defined in Section 2(a)(iii) of the
May 30, 2008 Debentures the Company issued to YA Global. The waiver is in effect as of December 31, 2008 through June 1, 2009.
Related Party Promissory Note
On May 6, 2008, Telkonet executed a Promissory Note in the aggregate principal amount of $400,000. The Note was due and payable on the
earlier to occur of (i) the closing of the Company’s next financing, or (ii) November 6, 2008. In connection with the issuance of the Note, the
Company issued warrants to purchase 800,000 shares of Telkonet common stock at $0.60 per share. These warrants expire five years from the
date of issuance. The note was repaid in July 2008.
Senior Note Payable
On July 24, 2007, Telkonet entered into a Senior Note Purchase Agreement with GRQ Consultants, Inc. pursuant to which the Company
issued to GRQ a Senior Promissory Note in the aggregate principal amount of $1,500,000. The Note was due and payable on the earlier to
occur of (i) the closing of the Company’s next financing, or (ii) January 28, 2008, and bore interest at a rate of six (6%) percent per annum.
The Company incurred approximately $25,000 in fees in connection with this transaction. The net proceeds from the issuance of the
Note were used 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. On February 8,
2008, this note was repaid in full including $49,750 in interest from the issuance date through the date of repayment.
On March 31, 2009, the Company received a notice of waiver from YA Global Investments, L.P. pursuant to which it agreed that, to the
extent MSTI is in default of the MSTI Debentures, such default shall not constitute an Event of Default as defined in Section 2(a)(iii) of the
May 30, 2008 Debentures the Company issued to YA Global. The waiver is in effect as of December 31, 2008 through June 1, 2009.
27
Convertible Senior Debentures-MSTI
In May 2007, MSTI issued Debentures having a principal value of $6,576,350, plus 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 MSTI Debentures is amortized over 12 months. The
MSTI Debentures accrue interest at 8% per annum commencing on the first anniversary of the original issue date of the MSTI Debentures,
payable quarterly in cash or common stock, at MSTI’s option, and mature on April 30, 2010. The MSTI Debentures are not callable and are
convertible at a conversion price of $0.65 per share into 10,117,462 shares of MSTI common stock, subject to certain limitations.
In connection with the placement of the MSTI Debentures, MSTI also issued to the MSTI Debenture holders, five-year warrants to purchase
an aggregate of 5,058,730 shares of MSTI common stock at an exercise price of $1.00 per share. In connection with the issuance of the MSTI
Debentures, MSTI incurred placement fees of $423,500. Additionally, MSTI issued its placement agents’ five-year warrants to purchase
708,222 shares of MSTI common stock at an exercise price of $1.00 per share. On February 11, 2008, the MSTI Debenture holders executed
a letter agreement with MSTI waiving their rights to receive any potential liquidated damages under the registration rights agreement executed
in connection with this transaction in exchange for a reduction in their warrant exercise price from $1.00 to $0.65.
The purchase agreement executed in connection with the MSTI Debenture offering prohibits MSTI from directly or indirectly, among other
things, creating or incurring any indebtedness (other than Permitted Indebtedness, as such term is defined in the purchase agreement) without
the consent of the holders of at least 85% of the principal amount of outstanding MSTI Debentures.
Registration Rights Liquidated Damages
On May 24, 2007, MSTI 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
total proceeds of
$2,694,020. Additionally, MSTI also sold MSTI Debentures (as previously described) for total proceeds of $6,050,000. The holders of the
MSTI Debentures also received five-year warrants to purchase an aggregate of 5,058,730 shares of MSTI common stock at an exercise price
of $1.00 per share.
issued at an exercise price of $1.00 per share, for
MSTI 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 MSTI Debentures covering all shares of common stock sold in the private placement and underlying the MSTI Debentures, as
well as the warrants attached to the private placement. MSTI also agreed to use its 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 MSTI Debentures.
In addition, with respect to the shares of common stock sold in the private placement and underlying the warrants, MSTI 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 common stock in the private
placement, subject to MSTI’s right to suspend or defer the use of the registration statement in certain events.
The registration rights agreement required 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 were assessed, until the
registration statement was declared effective. In accordance with EITF 00-19-2, the Company evaluated the likelihood of achieving
registration statement effectiveness. Accordingly, the Company accrued $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 investors executed a letter agreement with MSTI waiving their rights to receive liquidated damages under the
registration rights agreement, in exchange for a reduction in their warrant exercise price from $1.00 to $0.65. As a result, the Company has
reversed the accrued expense for the potential liquidated damages during the year ended December 31, 2008.
28
Additional Debentures
As previously described, in connection with MSTI Debentures offering, MSTI entered into a purchase agreement with the purchasers of the
MSTI Debentures, which prohibited MSTI from, directly or indirectly, among other things, creating or incurring any indebtedness (other than
Permitted Indebtedness, as such term is defined in the purchase agreement) without the consent of the holders of at least 85% of the principal
amount of outstanding Debentures.
On October 16, 2008, with Alpha Capital Anstalt, Gemini Master Fund, Ltd, Whalehaven Capital Fund Limited and Brio Capital L.P. (the
“Senior Lenders”) executed a letter agreement with MSTI pursuant to which MSTI issued $352,631 of Additional Debentures, due December
15, 2008 (subject to extension to April 30, 2010 upon the satisfaction of certain specified conditions) that are convertible into an aggregate of
542,509 shares of MSTI common stock at a conversion price of $0.65 per share (subject to adjustment as provided therein). The Additional
Debentures were issued with an 8% Original Issue Discount. As a result, MSTI received $307,500 from the issuance of the Additional
Debentures. Also, in connection with the issuance of the Additional Debentures and pursuant to the letter agreement, MSTI issued 2 million
shares of common stock to the purchasers of such Additional Debentures and the same number of common stock purchase warrants at a
purchase price of at least $0.125 per share.
Triggering Events that Accelerate or Increase a Direct Financial Obligation
Unless certain conditions were satisfied the Additional Debentures were to mature on December 15, 2008. Upon satisfaction of such
conditions, the Maturity Date of the Additional Debentures would be automatically extended to April 30, 2010. As a result of MSTI’s failure
to satisfy the conditions for extension of the Maturity Date, the Additional Debentures matured on December 15, 2008. MSTI did not repay
the Additional Debentures as required on the maturity date.
As a result of MSTI’s failure to timely pay its current obligations due to the Senior Lenders under the Additional Debentures, certain events of
default have occurred and are continuing beyond any applicable cure or grace period with respect to all of MSTI’s secured obligations due to
the Senior Lenders and subordinate lenders. The aggregate amount due to these lenders is $9,448,506 ($7,010,503 in debenture principal,
$2,103,151 in default penalty and $334,852 in accrued interest) as of December 31, 2008. As a result of this default by MSTI, the secured
lenders have the right take all steps they deem necessary to protect their interests, including, but not limited to, foreclosure on some or all of
MSTI’s assets, which serve as collateral for this indebtedness.
As a result of MSTI’s default and ongoing losses, MSTI’s Board of Directors and management has determined that it is advisable and in the
best interests of the Company and its stockholders, in cooperation with MSTI’s secured lenders, to explore the sale of all or substantially all of
the assets of Microwave Satellite Technologies, Inc., a wholly owned subsidiary of MSTI which process is currently ongoing.
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 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. The purchase agreement provided for an adjustment to the number of shares owed to Mr. Matarazzo in the event the Company’s
common stock price falls below $4.50 per share upon issuance of the shares from escrow. As of December 31, 2008, the Company’s common
stock price was below $4.50.
In April 2008, the Company released from escrow 200,000 shares of the purchase price contingency. In June 2008, the Company released
from escrow an additional 400,000 shares in exchange for Mr. Matarazzo’s agreement to a debt covenant contained in the transaction
documents executed in connection with the debenture financing with YA Global Investments LP which prohibits the use of the proceeds
obtained in the debt financing to fund MST.
29
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 $6,875,000. The purchase price was comprised of $875,000 in cash and 2,227,273 shares of the Company’s common stock.
Of the stock issued in the transaction, 1,090,909 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 issued an additional
1,882,225 shares on June 12, 2008 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 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 was deposited into
escrow upon closing 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. As of March 31, 2009, 876,804 shares remain in escrow pursuant to the
purchase agreement.
Proceeds from the issuance of common stock
During the year ended December 31, 2008, the Company issued 2,500,000 shares of common stock valued at $0.60 per share for an aggregate
purchase price of $1,500,000. The proceeds of this offering were used to repay the principal of the Senior Promissory Note to GRQ.
Cash flow analysis
Cash utilized in operating activities was $4,058,385 during the year ended December 31, 2008 compared to $13,989,434 and during the year
ended December 31, 2007, respectively. The primary use of cash during the twelve months ended December 31, 2008 was for operating
expenses of the Company.
During the year ended December 31, 2009, our primary capital needs are for operating expenses, including funds to support our business
strategy, which primarily includes working capital necessary to fund inventory purchases. We anticipate funding our operations through
working capital generated by the following: (i) cash flow from sales of our products; (ii) reducing our inventory levels and managing our
operating expenses; (iii) maximizing our trade payables with our domestic and international suppliers; (iv) increasing collection efforts on
existing accounts receivables; and (v) utilizing our receivable and inventory-based agreements.
The Company utilized cash for investing activities of $1,136,629 and $5,048,217 during the years ended December 31, 2008 and 2007,
respectively. During the year ended December 31, 2008, these expenditures were primarily due to the purchase of equipment under operating
lease by MSTI. In 2007, these expenditures primarily arose from the payment of the cash portion of the MST purchase price of $900,000,
cash payments of $875,000 and $2,000,000, for the acquisitions of SSI and EthoStream, respectively, and $1,020,000 for the acquisition of
Newport Telecommunications in July 2007 by our MSTI subsidiary. The proceeds of the sale of the investment in BPL Global provided
$2,000,000 in November 2007. The cost of equipment under operating leases amounted to $1,133,629 and $1,568,651 for the year ended
December 31, 2008 and 2007, respectively. Purchases of property and equipment amounted to $9,000 and $310,715 for the year ended
December 31, 2008 and 2007, respectively.
The Company had cash from financing activities of $3,847,420 and $19,023,197 during the year ended December 31, 2008 and 2007,
respectively. The financing activities involved the sale of 2.5 million shares of common stock at $0.60 per share for a total of $1,500,000, in
February 2008, the proceeds of which were used to repay the outstanding principal amount on the GRQ Note. Additionally, the Company
sold debentures for gross proceeds of $3,500,000 in May and July 2008, and the Company received a $400,000 loan from a private investor,
which was offset by $462,511 in financing costs paid. During the year ended December 31, 2007, the financing activities represented
proceeds of $9,610,000, net of placement fees, from the sale of 4.0 million shares of common stock at $2.50 per share, the issuance of a senior
note payable in the principal amount of $1,500,000 and proceeds from the exercise of stock options and warrants of $124,460. Through its
subsidiary MSTI, the Company raised $5,303,238 through the sale of debentures, and $2,694,020 through the sale of common stock, during
the year ended December 31, 2007.
30
We have reduced 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, 2009, 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 2008 to assist in our working capital and financing needs, additional financing is likely 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, 2008, fixed assets increased approximately $1,143,000, including $1,134,000 for the MST Segment
equipment purchased for the MST build-out. The remainder is related to computer equipment and peripherals used in day-to-day operations.
The Company does not anticipate the sale or purchase of any significant property, plant or equipment during the next twelve months, other
than computer equipment and peripherals to be used in the Company’s day-to-day operations.
In April 2005, the Company entered into a three-year lease agreement for 6,742 square feet of commercial office space in Crystal City,
Virginia. Pursuant to this lease, the Company agreed to assume a portion of the build-out cost for this facility. This lease terminated 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.
The Company presently leases approximately 12,000 square feet of office space in Milwaukee, WI for EthoStream. The Milwaukee lease
expires in February 2019.
Following the acquisition of SSI, the Company assumed a lease on 9,000 square feet of office and warehouse space in Las Vegas, NV on a
month to month basis. The Las Vegas, NV office lease expired on April 30, 2008.
31
New Accounting Pronouncements
In June 2008, the FASB issued Emerging Issues Task Force No. 07-5 (EITF 07-5), Determining Whether an Instrument (or Embedded
Feature) is Indexed to an Entity’s Own Stock. EITF 07-5 requires entities to evaluate whether an equity-linked financial instrument (or
embedded feature) is indexed to its own stock by assessing the instrument’s contingent exercise provisions and settlement provisions.
Instruments not indexed to their own stock fail to meet the scope exception of Statement of Financial Accounting Standards No. 133,
Accounting for Derivative Instruments and Hedging Activities , paragraph 11(a), and should be classified as a liability and marked-to-market.
The statement is effective for fiscal years beginning after December 15, 2008 and is to be applied to outstanding instruments upon adoption
with the cumulative effect of the change in accounting principle recognized as an adjustment to the opening balance of retained earnings.
The Company is currently evaluating the provisions of EITF 07-5.
In February 2007, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159 permits entities to measure
eligible assets and liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported
in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We adopted SFAS 159 on January 1, 2008 and did
not elect the fair value option which did not have a material impact on our financial position and results of operations.
In December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141R, Business
Combinations , and Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements,
an amendment of ARB No. 51 .. These new standards significantly change the accounting for and reporting of business combination
transactions and noncontrolling interests (previously referred to as minority interests) in consolidated financial statements. Both standards
are effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. These Statements are effective for the
Company beginning on January 1, 2009. The Company is currently evaluating the provisions of FAS 141(R) and FAS 160.
In March 2008, the Financial Accounting Standards Board (FASB) issued Statement No. 161, Disclosures about Derivative Instruments and
Hedging Activities - an amendment of FASB Statement No. 133 (SFAS 161). SFAS 161 requires companies to provide enhanced disclosures
regarding derivative instruments and hedging activities and requires companies to better convey the purpose of derivative use in terms of the
risks they intend to manage. Disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and
related hedged items are accounted for under SFAS No. 133 and its related interpretations, and (c) how derivative instruments and related
hedged items affect a company’s financial position, financial performance, and cash flows are required. This Statement retains the same scope
as SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and is effective for fiscal years and interim periods
beginning after November 15, 2008. We do not expect the adoption of SFAS No. 161 to have a material impact, if any, on our consolidated
financial statements.
In February 2008, the FASB issued a FASB Staff Position (FSP) on Accounting for Transfers of Financial Assets and Repurchase Financing
Transactions (FSP FAS 140-3). This FSP addresses the issue of whether the transfer of financial assets and the repurchase financing
transactions should be viewed as two separate transactions or as one linked transaction. The FSP includes a rebuttable presumption that the
two transactions are linked unless the presumption can be overcome by meeting certain criteria. The FSP will be effective for fiscal years
beginning after November 15, 2008 and will apply only to original transfers made after that date; early adoption will not be allowed. We do
not expect the adoption of FSP FAS 140-3 to have a material impact, if any, on our consolidated financial statements.
In April 2008, the FASB issued FSP No. 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP 142-3”). FSP 142-3 amends
the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized
intangible assets under FASB Statement No. 142, “Goodwill and Other Intangible Assets”. This new guidance applies prospectively to
intangible assets that are acquired individually or with a group of other assets in business combinations and asset acquisitions. FSP 142-3 is
effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. Early adoption is prohibited.
The Company does not expect the adoption of FSP 142-3 to have a significant impact on its consolidated financial statements.
32
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”). SFAS 162
identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements
of nongovernmental entities that are presented in conformity with generally accepted accounting principles (the GAAP hierarchy). SFAS
162 will become effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” The Company does not expect
the adoption of SFAS 162 to have a material effect on its results of operations and financial condition.
In May 2008, the FASB issued FSP Accounting Principles Board (“APB”) 14-1 “Accounting for Convertible Debt instruments That May Be
Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”). FSP APB 14-1 requires the issuer of certain
convertible debt instruments that may be settled in cash (or other assets) on conversion to separately account for the liability (debt) and
equity (conversion option) components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. FSP APB
14-1 is effective for fiscal years beginning after December 15, 2008 on a retroactive basis. The Company does not expect the adoption of
FSP APB 14-1 will have significant effect on its results of operations and financial condition.
Disclosure of Contractual Obligations
Contractual obligations
Long-Term Debt Obligations
Current Debt Obligations
Capital Lease Obligations
Operating Lease Obligations
Purchase Obligations (1)
Other Long-Term Liabilities Reflected on the
Registrant’s Balance Sheet Under GAAP
Total
Payment Due by Period
Total
Less than
1 year
1-3 years
3-5 years
More than 5
years
$
$
$
$
$
2,136,650
7,584,508
204,416
2,530,955
454,400
$
-
$ 12,910,929
-
7,584,508
204,416
462,515
454,400
-
8,705,839
2,136,650
-
-
740,772
-
-
2,877,422
-
-
-
613,490
-
-
613,490
-
-
-
714,178
-
-
714,178
(1) Purchase commitment for inventory orders of energy management products. The Company has prepaid approximately $90,560 as of
March 24, 2009.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Short Term Investments
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.
Marketable Securities
Telkonet maintained investments in two publicly-traded companies for the year ended December 31, 2008. The Company has classified these
securities as available for sale. Such securities are carried at fair market value. Unrealized gains and losses on these securities, if any, are
reported as accumulated other comprehensive income (loss), which is a separate component of stockholders’ equity. Unrealized losses of
$32,750 were recorded for the year ended December 31, 2008 and there were no unrealized gains or losses for the year ended December 31,
2007. Realized gains and losses and declines in value judged to be other than temporary on securities available for sale, if any, are included in
operations. Realized losses of $4,098,514 were recorded for the year ended December 31, 2008. There were no realized gains or losses for
the year ended December 31, 2007.
33
Investments in Privately Held Companies
We have invested in a privately held company, which is in the startup or development stage. This investment is inherently risky because the
market for the products of this company is developing and may never materialize. As a result, we could lose our entire initial investment in this
company. In addition, we could also be required to hold our investment indefinitely, since there is presently no public market in the securities
of this company and none is expected to develop. This investment is carried at cost, which as of March 1, 2009 was $8,000 and recorded in
other assets in the Consolidated Balance Sheet.
ITEM 8. FINANCIAL STATEMENTS.
See the Financial Statements and Notes thereto commencing on Page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.
None.
ITEM 9A. CONTROLS AND PROCEDURES.
ITEM 9A(T). CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that material information required to be disclosed in our
periodic reports filed under the Securities Exchange Act of 1934, as amended, or 1934 Act, is recorded, processed, summarized, and reported
within the time periods specified in the SEC’s rules and forms and to ensure that such information is accumulated and communicated to our
management, including our chief executive officer and chief financial officer as appropriate, to allow timely decisions regarding required
disclosure. During the quarter ended December 31, 2008 we carried out an evaluation, under the supervision and with the participation of our
management, including the principal executive officer and the principal financial officer, of the effectiveness of the design and operation of
our disclosure controls and procedures, as defined in Rule 13(a)-15(e) under the 1934 Act. Based on that evaluation and due to the lack of
segregation of duties and failure to implement accounting controls of acquired businesses, our principal executive officer and principal
financial officer concluded that our disclosure controls and procedures were ineffective as of the end of the period covered by this report.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s
internal control over financial reporting is designed to provide reasonable assurances regarding the reliability of financial reporting and the
preparation of the financial statements of the Company in accordance with U.S. generally accepted accounting principles, or GAAP.
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 or compliance with the policies or procedures may deteriorate.
34
With the participation of our Chief Executive Officer, our management conducted an evaluation of the effectiveness of our internal
control over financial reporting as of December 31, 2008 based on the framework in Internal Control—Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Based on our evaluation and the material weaknesses
described below, management concluded that the Company did not maintain effective internal control over financial reporting as of
December 31, 2008 based on the COSO framework criteria. Management has identified control deficiencies regarding the lack of
segregation of duties and the need for a stronger internal control environment. Management of the Company believes that these material
weaknesses are due to the small size of the Company’s accounting staff and continued integration of the 2007 acquisitions of Smart Systems
International, EthoStream, LLC and Newport Telecommunications Co. The small size of the Company’s accounting staff may prevent
adequate controls in the future, such as segregation of duties, due to the cost/benefit of such remediation. We do expect to retain additional
personnel to remediate these control deficiencies in the future.
These control deficiencies could result in a misstatement of account balances that would result in a reasonable possibility that a
material misstatement to our financial statements may not be prevented or detected on a timely basis. Accordingly, we have determined that
these control deficiencies as described above together constitute a material weakness.
In light of this material weakness, we performed additional analyses and procedures in order to conclude that our financial statements
for the year ended December 31, 2008 included in this Annual Report on Form 10-K were fairly stated in accordance with US GAAP.
Accordingly, management believes that despite our material weaknesses, our financial statements for the year ended December 31, 2008 are
fairly stated, in all material respects, in accordance with US GAAP.
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over
financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules
of the Securities and Exchange Commission that permit us to provide only management’s report in this Annual Report on Form 10-K.
Changes in Internal Controls
During the fiscal quarter ended December 31, 2008, there have been no changes in our internal control over financial reporting that have
materially affected or are reasonably likely to materially affect our internal controls over financial reporting.
35
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, 2008.
The directors of the Company are elected every year and serve until their successors are duly elected and qualified.
Name
Jason Tienor
Richard J. Leimbach
Jeffrey Sobieski
Warren V. Musser
Thomas C. Lynch
Dr. Thomas M. Hall
Seth Blumenfeld
Anthony J. Paoni
_________________________
Age
Title
34
40
33
82
67
57
68
64
President & Chief Executive Officer
Chief Financial Officer
Chief Operating Officer
Chairman of the Board
Director (1), (2)
Director (1), (2)
Director
Director (1), (2)
(1) Member of the Audit Committee
(2) Member of the Compensation Committee
Jason L. 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.
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 J. Sobieski—Chief Operating Officer
Mr. Sobieski was named the Company's Chief Operating Officer in June 2008. Prior to this appoinment, Mr. Sobieski 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.
36
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.
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.
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. Mr. Blumenfeld has been a director of the
Company since 2005.
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. Professor Paoni has been a director of the Company since
2007.
37
Audit Committee
The Company maintains an Audit Committee of the Board of Directors. For the year ended December 31, 2008, Messrs. Hall, Lynch and
Paoni served on the Audit Committee. The Company’s Board of Directors has determined that each of Messrs. Hall, Lynch and Paoni 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 Paoni 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. The Audit Committee held 6 meetings in 2008.
Compensation Committee
The Company maintains a Compensation Committee of the Board of Directors. For the year ended December 31, 2008, Dr. Hall and Messrs.
Lynch and Paoni served on the Compensation Committee. The Compensation Committee held 2 meetings during 2008.
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 2008 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 year ended December 31, 2008.
Thomas M. Hall
Thomas C. Lynch
Anthony J. Paoni
38
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.
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;
39
·
·
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.
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.
40
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.
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.
41
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.
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 leased a vehicle for the use of Telkonet's former CEO, which expired in September 2008. Additionally, in the first quarter of
2007 the Company began providing monthly car allowance stipends to certain executives of Telkonet and MSTI.
42
EXECUTIVE COMPENSATION
The following table sets forth certain information with respect to compensation for services in all capacities for the years ended
December 31, 2008, 2007 and 2006 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, 2008.
Summary Compensation Table
Name and
Principal
Position
Salary
($)
Bonus
($)
Year
Stock
Awards
($)
Option
Awards
($)
(1)(2)
Non-Equity
Incentive Plan
Compensation
($)
2008 $ 194,421 $
Jason L. Tienor
President and
Chief
Executive Officer 2006 $
2007 $ 133,022 $
0 $
0 $
0 $
0 $
0 $
0 $
0 $ 111,230 $
0 $
0 $
Richard J.
Leimbach
Chief Financial
Officer
Jeffrey J.
Sobieski
Chief Operating
Officer
2008 $ 180,039 $
0 $
2007 $ 133,491 $ 25,000 $
2006 $ 111,231 $
5,000 $
0 $
0 $
0 $
0 $
0 $
0 $
2008 $ 186,421 $
2007 $ 122,003 $
2006 $
0 $
0 $
0 $
0 $
0 $ 31,180 $
0 $
0 $
0 $
0 $
Change in
Pension Value
and
Nonqualified
Deferred
Compensation
Earnings
($)
0 $
0 $
0 $
0 $
0 $
0 $
0 $
0 $
0 $
All
Other
Compen-
sation
($)
Total
($)
0 $
7,431 $ 201,852
0 $
0 $
6,139 $ 250,391
0
0 $
0 $
0 $
0 $
0 $ 180,039
0 $ 158,491
0 $ 116,231
0 $
0 $
0 $
7,431 $ 225,032
6,139 $ 128,142
0
0 $
(1) 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%.
(2) In 2008 the following assumptions were used to determine the fair value of stock option awards granted: historical volatility of 74%,
expected option life of 5.0 years and a risk-free interest rate of 3.0%.
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.
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.
Jeff Sobieski, Chief Operating Officer, 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 $190,000 and he remains eligible to participate in the incentive and benefit plans pursuant to his existing employment agreement
and Telkonet’s internal policies.
In addition, to the foregoing, stock options are periodically granted to employees under the Company’s Plan at the discretion of the
Compensation Committee of the Board of Directors. Executives of Telkonet are eligible to receive stock option grants, based upon individual
performance and the performance of Telkonet as a whole.
43
GRANT OF PLAN BASED AWARDS
The following table sets forth information concerning stock options granted in the fiscal year ended December 31, 2008, to the persons listed
on the Summary Compensation Table.
Name
Jason Tienor
Richard J. Leimbach
Jeffrey Sobieski
All Other
Option Awards:
Number of
Securities Underlying
Options Granted
(#)
n/a
n/a
50,000
Exercise Price or
Base Price of
Option Awards
($/sh)
n/a
n/a
$1.00
Grant Date
Fair Value of
Stock
and Option
Awards
n/a
n/a
$31,180
Grant Date
n/a
n/a
02/19/2008
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END TABLE
The following table shows outstanding stock option awards classified as exercisable and unexercisable as of December 31, 2008 for the named
executive officers.
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END
Option Awards
Stock Awards
Equity
Incentive
Plan
Awards:
Number of
Securities
Underlying
Unexercised
Unearned
Options
(#)
Number of
Securities
Underlying
Unexercised
Options
(#)
Unexerciseable
Option
Exercise
Price
($)
Number of
Securities
Underlying
Unexercised
Options
(#)
Exerciseable
30,000
70,000
- $
1.80
77,500
10,000
-
(1)
-
-
- $
1.00
Name
Jason L.
Tienor
Richard J.
Leimbach
Jeffrey J.
Sobieski
Equity
Incentive
Plan
Awards:
Market or
Payout
Value of
Unearned
Shares,
Units
or Other
Rights
That
Have Not
Vested
($)
Equity
Incentive
Plan
Awards:
Number of
Unearned
Shares,
Units
or Other
Rights
That
Have Not
Vested
(#)
Number
of
Shares or
Units of
Stock
That
Have
Not
Vested
(#)
Market
Value of
Shares or
Units of
Stock
That
Have Not
Vested
($)
-
-
-
-
-
-
-
-
-
-
-
-
Option
Expiration
Date
4/24/2012
(2)
4/24/2012
(2)
4/24/2012
(2)
(1)
Includes 35,000 and 2,500 vested and unvested options, respectively, exerciseable at $2.59, and 42,500 and 7,500 vested and unvested
options, respectively, exerciseable at $5.08 per share.
(2) All options granted in accordance with the Telkonet Amended and Restated Stock Incentive Plan (the “Plan”) have an outstanding term
equal to the shorter of ten years, or the expiration of the Plan. The Plan expires on April 24, 2012.
44
OPTION EXERCISES AND STOCK VESTED
There were no options exercised by, or stock awards vested for the account of, the named executive officers during 2008.
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.
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. Assuming Mr. Tienor’s and Mr. Sobieski’s employment agreements were
terminated as of December 31, 2008, the total estimated compensation that would have been paid under these agreements would be $468,000
in the aggregate.
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 $24,000 for Board service between July 1, 2006, and
December 31, 2006, which payments were commensurate with the payments made to the other directors for Board service during that time
period. Effective January 1, 2007, Mr. Blumenfeld began receiving compensation in accordance with the non-management director
compensation plan.
45
The following table summarizes all compensation paid to the Company’s directors in the year ended December 31, 2008.
Fees
Earned
or
Paid in
Cash
($)
Name
Stock
Awards
($)
Option
Awards
($)
Non-Equity
Incentive Plan
Compensation
($)
Change in
Pension Value
and
Nonqualified
Deferred
Compensation
Earnings
$ 48,000
48,000
Warren V.
Musser
Thomas M. Hall
Thomas C.
Lynch
James L. Peeler
(3)
Seth D.
Blumenfeld
48,000
Anthony J. Paoni 48,000
48,000
12,000
$
-
-
-
-
-
-
$
-
$
12,196(2)
12,196(2)
-
12,196(2)
12,196(2)
$
-
-
-
-
-
-
All Other
Compensation
($)
Total
($)
$
-
-
52,000(1) $ 100,000
60,196
-
-
-
-
-
-
-
-
-
60,196
12,000
60,196
60,196
(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 2008 non-management director compensation plan. The following assumptions were used to
determine the fair value of stock option awards: historical volatility of 81%, expected option life of 5.0 years and a risk-free interest
rate of 3.5%.
(3) Mr. Peeler resigned from the Board of Directors on April 7, 2008.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
During the year ended December 31, 2008, Messrs, Hall, Lynch and Paoni served as members of the Company’s Compensation Committee.
No member of the Compensation Committee is, or was during the fiscal year ended December 31, 2008, an officer or employee of the
Company or any of its subsidiaries, or a person having a relationship requiring disclosure by the Company pursuant to Item 404 of
Regulation S-K. During 2008, no executive officer of the Company served as a member of (i) the compensation committee of another entity
of which one of the executive officers of such entity served on the Compensation Committee or Board of Directors; or (ii) the board of
directors of another entity of which one of the executive officers of such entity served on the Company’s Compensation Committee.
46
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS.
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, 2008.
Number of
securities to be
issued
upon exercise
of outstanding
options,
warrants and
rights
(a)
8,309,866 $
-
Weighted-average
exercise price of
outstanding
options,
warrants and
rights
(b)
1.71
-
Number of
securities
remaining
available for
future issuance
under equity
compensation
plans
(excluding
securities
reflected in
column (a))
(c)
2,951,012
-
Equity compensation plans approved by security holders
Equity compensation plans not approved by security holders
Total
8,309,866 $
1.71
2,951,012
47
The following table sets forth, as of March 30, 2009, 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 30, 2009, 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
Officers and Directors
Jason Tienor, President and Chief Executive Officer
20374 Seneca Meadows Parkway
Germantown, MD 20876
Richard Leimbach, Chief Financial 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
Thomas C. Lynch, Director
20374 Seneca Meadows Parkway
Germantown, MD 20876
Dr. Thomas M. Hall, 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
All Directors and Executive Officers as a Group
736,803(1)
431,000(2)
714,303(3)
2,000,000(4)
210,000(5)
747,790(6)
130,000(7)
80,000(8)
5,049,896
0.8%
0.5%
0.8%
2.1%
0.2%
0.8%
0.1%
0.1%
5.3%
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Includes 701,803 shares of the Company’s common stock and options exercisable within 60 days to purchase 35,000 shares of the
Company’s common stock at $1.80 per share.
Includes 351,000 shares of the Company’s common stock and options exercisable within 60 days to purchase 37,500 and 42,500 shares
of the Company’s common stock at $2.59 and $5.08 per share, respectively.
Includes 701,803 shares of the Company’s common stock and options exercisable within 60 days to purchase 12,500 shares of the
Company’s common stock at $1.00 per share.
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 40,000, 20,000, 70,000 and 80,000 shares of the Company’s common stock at
$1.00, $2.00, $2.66 and $3.45 per share, respectively.
Includes 557,790 shares of the Company’s common stock and options exercisable within 60 days to purchase 40,000, 70,000 and 80,000
shares of the Company’s common stock at $1.00, $2.66 and $3.45 per share, respectively.
Includes 50,000 shares of the Company’s common stock and options exercisable within 60 days to purchase 40,000 and 40,000 shares
of the Company’s common stock at $1.00 and $2.66 per share.
Includes options exercisable within 60 days to purchase 40,000 and 40,000 shares of the Company’s common stock at $1.00 and $2.30
per share.
48
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
Description of Related Party Transactions
In February 2006, MSTI entered into a one-year professional services agreement with Global Transport Logistics, Inc. (“GTI”), for consulting
services for which GTI is paid a fee of $10,000 per month. GTI is 100% owned by Eileen Matarazzo, the sister-in-law of MSTI’s Chief
Executive Officer. The agreement has been extended through February 2009. For the years ended December 31, 2008 and 2007, MSTI paid
and expensed $6,869 and $110,000, respectively.
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 Dr. Hall and Messrs. Lynch and Paoni are “independent” under the listing standards of the
American Stock Exchange (AMEX). Each of Dr. Hall, Mr. Lynch and Mr. Paoni serve on, and are the only members of, the Company’s Audit
Committee and 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, 2008 and 2007.
1. Audit Fees
2. Audit Related Fees
3. Tax Fees
4. All Other Fees
Total Fees
$
$
December
31,
2008
309,755 $
46,262
--
--
356,017 $
December 31,
2007
379,828
136,525
--
--
516,353
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.
49
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, 2008, 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, 2008 and 2007.
Net Revenue
Gross Profit
Provision for income taxes
Net loss per share -- basic
Net loss per share -- diluted
Net Revenue
Gross Profit
Provision for income taxes
Net loss per share -- basic
Net loss per share -- diluted
QUARTERLY FINANCIAL DATA
(unaudited)
June 30,
March 31,
2008
2008
$
$ 5,624,537
$ 4,959,021
$
$ 1,887,760
$ 1,116,818
-
$
$
$
-
(0.05) $
(0.07) $
$
(0.05) $
(0.07) $
$
September
30,
2008
$
5,727,815
$
2,206,451
-
$
(0.04) $
(0.04) $
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,
2008
4,219,586
1,496,307
-
(0.14)
(0.14)
December
31,
2007
4,651,081
661,854
-
(0.08)
(0.08)
50
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
3.3
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
4.16
4.17
4.18
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)
Amendment to Articles of Incorporation (incorporated by reference to our Form 10-Q (No. 001-31972), filed August 11, 2008)
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)
Senior Note by Telkonet, Inc. in favor of GRQ Consultants, Inc. (incorporated by reference to our Form 10-Q (No. 001-31972),
filed November 9, 2007)
Warrant to Purchase Common Stock by Telkonet, Inc in favor of GRQ Consultants, Inc. (incorporated by reference to our Form
10-Q (No. 001-31972), filed November 9, 2007)
Form of Promissory Note (incorporated by reference to our Form 8-K (No. 001-31972) filed on May 12, 2008)
51
4.19
4.20
4.21
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
10.10
10.11
10.12
10.13
14
21
23.1
24
31.1
31.2
32.1
32.2
Form of Warrant to Purchase Common Stock (incorporated by reference to our Form 8-K (No. 001-31972) filed on May 12, 2008)
Form of Convertible Debenture (incorporated by reference to our Form 8-K (No. 001-31972) filed on June 5, 2008)
Form of Warrant to Purchase Common Stock (incorporated by reference to our Form 8-K (No. 001-31972) filed on June 5, 2008)
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 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 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)
Securities Purchase Agreement, dated May 30, 2008, by and between Telkonet, Inc. and YA Global Investments LP (incorporated
by reference to our Current Report on Form 8-K filed on June 5, 2008)
Registration Rights Agreement, dated May 30, 2008, by and between Telkonet, Inc. and YA Global Investments LP (incorporated
by reference to our Current Report on Form 8-K filed on June 5, 2008)
Security Agreement, dated May 30, 2008, by and between Telkonet, Inc. and YA Global Investments LP (incorporated by
reference to our Current Report on Form 8-K filed on June 5, 2008)
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 L. 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
52
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
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.
TELKONET, INC.
/s/ Jason L. Tienor
Jason L. Tienor
Chief Executive Officer
Name
Position
/s/ Jason L. Tienor
Jason Tienor
Chief Executive Officer
(principal executive officer)
/s/ Richard J. Leimbach
Richard J. Leimbach
/s/ Warren V. Musser
Warren V. Musser
/s/ Thomas C. Lynch
Thomas C. Lynch
/s/ Dr. Thomas M. Hall
Dr. Thomas M. Hall
/s/ Seth D. Blumenfeld
Seth D. Blumenfeld
/s/ Anthony J. Paoni
Anthony J. Paoni
Date
April 1, 2009
April 1, 2009
Chief Financial Officer
(principal financial officer)
(principal accounting officer)
Chairman of the Board
April 1, 2009
Director
Director
Director
Director
55
April 1, 2009
April 1, 2009
April 1, 2009
April 1, 2009
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FINANCIAL STATEMENTS AND SCHEDULES
DECEMBER 31, 2008 AND 2007
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, 2008 and 2007
Consolidated Statements of Operations and Comprehensive Losses for the Years ended December 31, 2008 and 2007
Consolidated Statements of Stockholders’ Equity for the Years ended December 31, 2008 and 2007
Consolidated Statements of Cash Flows for the Years ended December 31, 2008 and 2007
Notes to Consolidated Financial Statements
F-3
F-4
F-5
F-6
F-8
F-10
F-2
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, 2008 and 2007 and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the two
years in the period ended December 31, 2008. 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, 2008 and 2007, and the results of its operations and its cash flows for each of the two
years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.
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.
New York, New York
April 1, 2009
/s/ RBSM LLP
Certified Public Accountants
F-3
TELKONET, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2008 AND 2007
ASSETS
Current assets:
Cash and cash equivalents
Accounts receivable, net
Inventories
Other current assets
Total current assets
Property and equipment, net
Other assets:
Marketable securities
Deferred financing costs, net
Goodwill and other Intangible assets, net
Other long term assets
Total other assets
Total Assets
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued liabilities
Line of credit
Capital lease payable - current
Related party advances
Convertible debentures of subsidiary - current
Senior note payable, net of debt discounts of $29,180
Other current liabilities
Total current liabilities
Long-term liabilities:
Convertible debentures, net of debt discounts of $825,585 – non current
Convertible debentures of subsidiary, net of debt discounts of $2,144,010 – non current
Derivative liability
Deferred lease liability and other
Total long-term liabilities
Commitments and contingencies
Minority interest
Stockholders’ equity
Preferred stock, par value $.001 per share; 15,000,000 shares authorized;
none issued and outstanding at December 31, 2008 and 2007
Common stock, par value $.001 per share; 130,000,000 shares authorized; 87,525,495 and
70,826,544 shares issued and outstanding at December 31, 2008 and 2007, respectively
Additional paid-in-capital
Accumulated deficit
Accumulated comprehensive loss
Stockholders’ equity
2008
2007
$
$
281,989
1,024,909
1,733,940
404,928
3,445,766
1,629,583
2,134,978
2,578,084
661,523
7,004,168
3,744,525
5,147,408
397,403
432,136
18,322,303
166,210
19,318,052
4,541,167
697,461
21,119,484
231,657
26,589,769
$ 26,508,343
$ 38,741,345
$ 10,328,255
$
574,005
204,416
285,784
7,010,503
-
456,694
18,859,657
7,847,051
-
7,128
291,000
-
1,470,820
378,833
9,994,832
1,311,065
-
2,573,126
50,791
3,934,982
-
4,432,342
-
67,112
4,499,454
262,795
2,978,918
-
-
70,827
87,526
118,197,450
112,013,093
(114,801,318) (90,815,779)
-
21,268,141
(32,750)
3,450,908
Total Liabilities and Stockholders’ Equity
$
26,508,343
$ 38,741,345
See accompanying notes to consolidated financial statements
F-4
TELKONET, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSSES
FOR THE YEARS ENDED DECEMBER 31, 2008 AND 2007
Revenues, net:
Product
Rental
Total Revenue
Cost of Sales:
Product
Rental
Total Cost of Sales
Gross Profit
Operating Expenses:
Research and Development
Selling, General and Administrative
Impairment of Goodwill and Long Lived Assets
Stock Based Compensation
Stock Based Compensation of Subsidiary
Depreciation and Amortization
Total Operating Expenses
Loss from Operations
Other Income (Expenses):
Interest Income
Financing Expense
(Loss) on Derivative Liability
Gain (Loss) on Sale of Investments
Impairment of Investment in Marketable Securities
Other Income
Total Other Income (Expenses)
Loss Before Provision for Income Taxes
Minority interest
Provision for Income Tax
Net (Loss)
Loss per common share (basic and assuming dilution)
Weighted average common shares outstanding
Comprehensive Loss:
Net Loss
Unrealized loss on investment
Comprehensive Loss
See accompanying notes to consolidated financial statements
F-5
2008
2007
$ 13,690,010
6,840,949
20,530,959
$
9,168,077
4,984,656
14,152,733
8,511,197
5,312,427
13,823,624
7,165,120
4,505,476
11,670,596
6,707,336
2,482,137
2,036,129
12,938,957
3,962,033
699,639
923,857
982,948
21,543,563
2,349,690
17,897,974
2,471,280
1,655,346
686,634
878,766
25,939,690
(14,836,227) (23,457,553)
9,961
(9,088,561)
(1,174,121)
(6,500)
(4,098,514)
270,950
(14,086,785)
116,043
(1,828,624)
-
1,868,956
-
-
156,375
(28,923,012) (23,301,178)
4,937,473
-
2,910,068
-
$ (23,985,539) $ (20,391,110)
$
(0.30) $
(0.31)
79,153,788
65,414,875
$ (23,985,539) $ (20,391,110)
-
(32,750)
$ (24,018,289) $ (20,391,110)
TELKONET, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2008 AND 2007
Preferred
Shares
Preferred
Stock
Amount
Common
Shares
Common
Stock
Amount
Additional
Paid in
Capital
Accumulated
Deficit
Total
-
-
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
-
57,342
-
200,000
200
271,300
-
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
-
132,949
-
195,924
-
195,924
-
-
-
-
1,225,626
-
1,225,626
-
-
-
-
-
-
-
-
153,963
-
153,963
-
(20,391,110)
(20,391,110)
Balance at January 1,
2007
Shares issued for
employee stock
options exercised at
approximately $1.05
per share
Shares issued in
exchange for services
rendered at
approximately $2.63
per share
Shares issued in
exchange for services
at $1.36 per share
Issuance of shares for
purchase of subsidiary
Issuance of shares for
purchase of subsidiary
Issuance of shares for
acquisition by
subsidiary
Shares Issued in
connection with
Private Placement
Issuance of shares for
investment in affiliate
Value of additional
warrants issued in
conjunction with
exchange of
convertible debentures
Debt discount
attributable to warrants
attached to Note
Stock-based
compensation expense
related to employee
stock options
Stock-based
compensation related
to Stock option
expenses accrued in
prior period
Net Loss
Balance at December
31, 2007
- $
-
70,826,544 $
70,827 $
112,013,093 $
(90,815,779) $
21,268,141
See accompanying footnotes to consolidated financial statements
F-6
TELKONET, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)
FOR THE YEARS ENDED DECEMBER 31, 2008 AND 2007
Preferred
Shares
Preferred
Stock
Amount
Common
Shares
Common
Stock
Amount
Additional
Paid in
Capital
Accumulated
Deficit
Comprehensive
Income (Loss)
Total
Balance at
January 1, 2008
-
- 70,826,544 $
70,827 $112,013,093 $ (90,815,779)
$
- $ 21,268,141
Shares issued in
exchange for
services
rendered and
accrued at
approximately
$1.00 per share
Shares issued for
cashless warrants
exercised
Shares issued in
connection with
Private
Placement
Adjustment shares
issued for
investment in
affiliate
Adjustment shares
issued for
purchase of
subsidiary
Shares issued from
escrow
contingency in
purchase of
subsidiary
Shares issued in
exchange for
convertible
debentures
Value of additional
warrants issued
in conjunction
with anti-dilution
provision
Stock-based
compensation
expense related
to the re-pricing
of investor
warrants
Stock-based
compensation
expense related
to employee
stock options
-
-
-
-
-
-
-
-
346,244
346
345,060
-
1,000,000
1,000
(1,000)
-
2,500,000
2,500
1,497,500
-
3,046,425
3,046
(3,046)
-
1,882,225
1,882
(1,882)
-
600,000
600
379,400
-
7,324,057
7,324
1,356,026
-
-
-
-
-
-
-
-
345,407
-
-
-
1,500,000
-
-
-
-
-
380,000
-
1,363,350
-
-
-
-
200,459
-
-
200,459
-
-
-
-
1,598,203
-
-
1,598,203
-
-
-
-
559,478
-
-
559,478
Value of warrants
attached to note
payable
Holding loss on
available for sale
securities
Net Loss
Balance at
December 31,
2008
-
-
-
-
-
-
-
-
-
254,160
-
-
254,160
-
-
-
-
-
-
(32,750)
(32,750)
-
(23,985,539)
-
(23,985,539)
- 87,525,495 $
87,526 $ 118,197,450 $ (114,801,318) $
(32,750) $
3,450,908
See accompanying notes to consolidated financial statements
F-7
TELKONET, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2008, 2007 AND 2006
Increase (Decrease) In Cash and Equivalents
Cash Flows from Operating Activities:
Net loss
Adjustments to reconcile net loss from operations to cash used in operating activities:
Minority interest
Registration rights liquidated damages of subsidiary (financing expense)
Debenture default penalty of subsidiary (financing expense)
Amortization of debt discounts and financing costs
Impairment of goodwill and long-lived assets
Impairment of investment in affiliate
(Gain) loss on sale of investment
Loss on derivative liability
Stock based compensation
Fair value of issuance of warrants and re-pricing (financing expense)
Inventory Allowance
Depreciation and Amortization
Increase / decrease in:
Accounts receivable, trade and other
Inventories
Prepaid expenses and deposits
Deferred revenue
Other Assets
Accounts payable, accrued expenses, net
Cash Used In Operating Activities
Cash Flows From Investing Activities:
Purchase of cable and related equipment
Purchase of property and equipment
Investment in subsidiaries
Proceeds from sale of investment
Proceeds from BPL Global
Cash Used In Investing Activities
Cash Flows From Financing Activities:
Proceeds from sale of common stock, net of costs and fees
Proceeds from issuance of note payable
Proceeds from subsidiaries’ sale of common stock, net of costs
Proceeds from issuance of convertible debentures, net of costs
Proceeds from subsidiaries’ issuance of convertible debentures, net
Proceeds from line of credit
Financing fees for line of credit and factoring agreement
Repayment of notes payable
Proceeds from exercise of stock options and warrants
Repayment of capital lease and other
Repayments of subsidiary loans
Cash Provided By Financing Activities
Net (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
See accompanying notes to consolidated financial statements
F-8
2008
2007
$ (23,985,539) $ (20,391,110)
(4,937,473)
(500,000)
2,103,151
1,713,818
3,962,033
4,098,514
6,500
1,174,121
1,623,496
5,304,502
200,000
1,910,106
(2,910,068)
500,000
-
475,391
2,471,280
-
(1,868,956)
-
2,241,102
764,279
-
1,785,832
1,089,898
671,349
476,219
29,425
104,163
897,332
(1,466,682)
251,185
(106,661)
(88,857)
3,257
4,350,590
(4,058,385) (13,989,434)
(1,133,629)
(9,000)
-
6,000
-
(1,136,629)
(1,568,651)
(310,715)
(5,168,851)
-
2,000,000
(5,048,217)
1,500,000
409,000
-
3,037,434
382,500
574,005
(112,361)
(1,900,000)
-
(34,158)
-
3,847,420
(1,347,594)
1,629,583
281,989
9,610,000
1,500,000
2,694,023
-
5,303,238
-
-
-
124,460
-
(208,524)
19,023,197
(14,454)
1,644,037
1,629,583
$
$
TELKONET, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
FOR THE YEARS ENDED DECEMBER 31, 2008 AND 2007
Supplemental Disclosures of Cash Flow Information:
Cash transactions:
Cash paid during the period for financing expenses
Income taxes paid
Non-cash transactions:
Stock options and warrants issued in exchange for services
Common stock issued in exchange for services rendered
Value of warrant repricing and additional warrants issued
Registration rights liquidated damages
Issuance of shares for purchase of subsidiary (below)
Issuance of shares for investment in affiliate
Impairment write-down of goodwill
Impairment write-down of long-lived assets
Impairment write-down in investment in affiliate
Loss on derivative liability
Debenture default penalty of subsidiary
Beneficial conversion feature on convertible debentures
Value of warrants attached to convertible debentures
Value of warrants attached to senior note
Value of common stock received for outstanding accounts receivable
Equipment purchased under capital lease obligations
Acquisition of Subsidiaries:
Assets acquired
Subscriber lists
Goodwill (including purchase price contingency)
Liabilities assumed
Common stock issued
Direct acquisition costs
Cash paid for acquisition
See accompanying notes to consolidated financial statements
F-9
2008
2007
$
333,435
-
$
4,521
-
1,216,996
406,500
5,304,502
(500,000)
1,534,260
706,842
764,279
500,000
- 17,286,097
4,466,167
-
1,977,768
2,380,000
493,512
1,582,033
-
4,098,514
-
1,174,121
-
2,103,151
1,457,815
720,966
931,465
678,041
359,712
254,160
75,000
-
-
226,185
3,052,880
-
-
4,781,893
- 15,096,922
(1,356,415)
-
- (17,286,097)
(394,183)
-
3,895,000
-
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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, has evolved into a Clean Technology company that
develops and manufactures proprietary energy efficiency and SmartGrid networking technology. 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), 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 58%-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 $23,985,539 for the year ended December 31, 2008, accumulated deficit of $114,801,318 and a working capital deficit of $15,413,891
as of December 31, 2008.
F-10
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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 from operations 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 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 successful 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, cash
equivalents and trade recievables. 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 $186,400 and $111,957 at December 31,
2008 and December 31, 2007, respectively.
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.
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.
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 2 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.
Fair Value of Financial Instruments.
In January 2008, the Company adopted the provisions of SFAS No. 157, “Fair Value Measurements”, (“FAS 157”) which defines fair value
for accounting purposes, establishes a framework for measuring fair value and expands disclosure requirements regarding fair value
measurements. The Company’s adoption of FAS 157 did not have a material impact on its consolidated financial statements. Fair value is
defined as an exit price, which is the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly
transaction between market participants at the measurement date. The degree of judgment utilized in measuring the fair value of assets and
liabilities generally correlates to the level of pricing observability. Financial assets and liabilities with readily available, actively quoted prices
or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability and require
less judgment in measuring fair value. Conversely, financial assets and liabilities that are rarely traded or not quoted have less price
observability and are generally measured at fair value using valuation models that require more judgment. These valuation techniques involve
some level of management estimation and judgment, the degree of which is dependent on the price transparency of the asset, liability or market
and the nature of the asset or liability. The Company has categorized its financial assets and liabilities measured at fair value into a three-level
hierarchy in accordance with FAS 157.
F-11
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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 Telkonet Series 5™ products and the Telkonet iWire System™, which the primary components are Gateways,
Extenders, iBridges and Couplers, and the primary components of the Telkonet SmartEnergy™ (TSE) and the Networked Telkonet
SmartEnergy™ (NTSE) product suites, which are thermostats, sensors and controllers. Inventories are stated at the lower of cost or market
determined by the first in, first out (FIFO) method.
Investments
Telkonet maintained investments in two publicly-traded companies for the year ended December 31, 2008. The Company has classified these
securities as available for sale. Such securities are carried at fair market value. Unrealized gains and losses on these securities, if any, are
reported as accumulated other comprehensive income (loss), which is a separate component of stockholders’ equity. Unrealized losses of
$32,750 were recorded for the year ended December 31, 2008 and there were no unrealized gains or losses for the year ended December 31,
2007. Realized gains and losses and declines in value judged to be other than temporary on securities available for sale, if any, are included in
operations. Realized losses of $4,098,514 were recorded for the year ended December 31, 2008. There were no realized gains or losses for
the year ended December 31, 2007.
Deferred Financing Costs
Deferred financing costs are being amortized under the straight-line method over the terms of the related indebtedness, which approximates
the effective interest method and is included in interest expense in the accompanying consolidated statements of operations.
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, 2008.
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 2008 and 2007 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.
F-12
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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 includes the provisions of 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).
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.
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.
F-13
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
The Company’s guarantees were issued subject to the recognition and disclosure requirements of FIN 45 as of December 31, 2008 and 2007.
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, 2008 and 2007, the Company experienced approximately three percent of units
returned. As of December 31, 2008 and 2007, the Company recorded warranty liabilities in the amount of $146,951 and $102,534,
respectively, using this experience factor.
Advertising
The Company follows the policy of charging the costs of advertising to expenses incurred. The Company incurred $92,410 and $592,313 in
advertising costs during the years ended December 31, 2008 and 2007, 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 2008 and 2007 were $2,036,129 and $2,349,690, 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.
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).
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. The Company is using the Black-Scholes option-pricing model as its method of valuation
for share-based awards. 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 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 2008 and prior years,
expected stock price volatility is based on the historical volatility of the Company’s stock for the related vesting periods.
Stock-based compensation expense recognized under SFAS 123(R) for the years ended December 31, 2008 and 2007 was $1,216,997 and
$1,534,260, respectively, net of tax effect.
F-14
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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 of $500,000.
On February 11, 2008, the investors in MSTI Holdings Inc. executed a letter agreement with MSTI Holdings, Inc. waiving their rights to
receive liquidated damages under the registration rights agreement, in exchange for a reduction in their warrant exercise price from $1.00 to
$0.65. Therefore the Company has reversed the accrued expense for the potential liquidated damages during the year ended December 31,
2008.
Reclassifications
Certain reclassifications have been made in prior year's financial statements to conform to classifications used in the current year.
New Accounting Pronouncements
In June 2008, the FASB issued Emerging Issues Task Force No. 07-5 (EITF 07-5), Determining Whether an Instrument (or Embedded
Feature) is Indexed to an Entity’s Own Stock. EITF 07-5 requires entities to evaluate whether an equity-linked financial instrument (or
embedded feature) is indexed to its own stock by assessing the instrument’s contingent exercise provisions and settlement provisions.
Instruments not indexed to their own stock fail to meet the scope exception of Statement of Financial Accounting Standards No. 133,
Accounting for Derivative Instruments and Hedging Activities , paragraph 11(a), and should be classified as a liability and marked-to-market.
The statement is effective for fiscal years beginning after December 15, 2008 and is to be applied to outstanding instruments upon adoption
with the cumulative effect of the change in accounting principle recognized as an adjustment to the opening balance of retained earnings. The
Company is currently evaluating the provisions of EITF 07-5.
In February 2007, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159 permits entities to measure
eligible assets and liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported
in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We adopted SFAS 159 on January 1, 2008 and did not
elect the fair value option which did not have a material impact on our financial position and results of operations.
In December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141R, Business
Combinations , and Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements,
an amendment of ARB No. 51 .. These new standards significantly change the accounting for and reporting of business combination
transactions and noncontrolling interests (previously referred to as minority interests) in consolidated financial statements. Both standards are
effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. These Statements are effective for the
Company beginning on January 1, 2009. The Company is currently evaluating the provisions of FAS 141(R) and FAS 160.
F-15
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
In March 2008, the Financial Accounting Standards Board (FASB) issued Statement No. 161, Disclosures about Derivative Instruments and
Hedging Activities - an amendment of FASB Statement No. 133 (SFAS 161). SFAS 161 requires companies to provide enhanced disclosures
regarding derivative instruments and hedging activities and requires companies to better convey the purpose of derivative use in terms of the
risks they intend to manage. Disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and
related hedged items are accounted for under SFAS No. 133 and its related interpretations, and (c) how derivative instruments and related
hedged items affect a company’s financial position, financial performance, and cash flows are required. This Statement retains the same scope
as SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and is effective for fiscal years and interim periods
beginning after November 15, 2008. We do not expect the adoption of SFAS No. 161 to have a material impact, if any, on our consolidated
financial statements.
In February 2008, the FASB issued a FASB Staff Position (FSP) on Accounting for Transfers of Financial Assets and Repurchase Financing
Transactions (FSP FAS 140-3). This FSP addresses the issue of whether the transfer of financial assets and the repurchase financing
transactions should be viewed as two separate transactions or as one linked transaction. The FSP includes a rebuttable presumption that the
two transactions are linked unless the presumption can be overcome by meeting certain criteria. The FSP will be effective for fiscal years
beginning after November 15, 2008 and will apply only to original transfers made after that date; early adoption will not be allowed. We do
not expect the adoption of FSP FAS 140-3 to have a material impact, if any, on our consolidated financial statements.
In April 2008, the FASB issued FSP No. 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP 142-3”). FSP 142-3 amends
the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized
intangible assets under FASB Statement No. 142, “Goodwill and Other Intangible Assets”. This new guidance applies prospectively to
intangible assets that are acquired individually or with a group of other assets in business combinations and asset acquisitions. FSP 142-3 is
effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. Early adoption is prohibited.
The Company does not expect the adoption of FSP 142-3 to have a significant impact on its consolidated financial statements.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”). SFAS 162
identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements
of nongovernmental entities that are presented in conformity with generally accepted accounting principles (the GAAP hierarchy). SFAS
162 will become effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” The Company does not expect
the adoption of SFAS 162 to have a material effect on its results of operations and financial condition.
In May 2008, the FASB issued FSP Accounting Principles Board (“APB”) 14-1 “Accounting for Convertible Debt instruments That May Be
Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”). FSP APB 14-1 requires the issuer of certain
convertible debt instruments that may be settled in cash (or other assets) on conversion to separately account for the liability (debt) and
equity (conversion option) components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. FSP APB
14-1 is effective for fiscal years beginning after December 15, 2008 on a retroactive basis. The Company does not expect the adoption of
FSP APB 14-1 will have significant effect on its results of operations and financial condition.
NOTE B - ACQUISITION OF SUBSIDIARY
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 issued an
additional 1,882,225 shares on June 12, 2008 pursuant to the adjustment provision in the SSI asset purchase agreement.
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
F-16
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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 2008, 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:
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
F-17
$
$
949,308
51,724
21,603
2,900,000
8,796,439
12,719,074
(798,631)
(798,631)
11,920,443
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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, 2008, 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. At December 31, 2008, 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 $2,000,000 was written off during the year ended
December 31, 2008.
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:
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.
F-18
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
The following unaudited condensed combined pro forma results of operations reflect the pro forma combination of 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
NOTE C - INTANGIBLE ASSETS AND GOODWILL
As Reported
$
14,152,733
$
$ (20,391,110) $
(0.31) $
$
Year Ended December 31, 2007
Pro Forma
Adjustments Pro Forma
16,576,053
$
(19,879,572)
$
(0.29)
$
68,003,834
2,423,320
511,538
0.02
2,588,959
65,414,875
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, 2008 (Note B).
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, 2008 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, 2007 are:
Gross
Carrying
Amount
Accumulated
Amortization
Net
Residual
Value
Weighted
Average
Amortization
Period (Years)
Amortized Identifiable Intangible Assets:
Subscriber lists – MSTI
Subscriber lists - EthoStream
Total Amortized Identifiable Intangible Assets
Goodwill - MSTI
Goodwill - EthoStream
Goodwill - SSI
Total
$
$
4,444,114
2,900,000
7,344,114
1,997,768
8,796,440
5,874,015
$
$ 24,012,337
F-19
3,740,348
2,708,680
6,449,029
$
-
-
-
8.0
12.0
9.6
(703,766) $
(191,320)
(895,085)
(1,997,768)
-
-
-
8,796,440
5,874,015
(2,892,853) $ 21,119,484
$
-
-
-
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
Total identifiable intangible assets acquired and their carrying values at December 31, 2008 are:
Gross
Carrying
Amount
Accumulated
Amortization
Net
Residual
Value
Weighted
Average
Amortization
Period (Years)
Amortized Identifiable Intangible Assets:
Subscriber lists – MSTI
Subscriber lists - EthoStream
Total Amortized Identifiable Intangible Assets
Goodwill - MSTI
Goodwill - EthoStream
Goodwill - SSI
Total
$
$
4,444,114
2,900,000
7,344,114
2,377,768
8,796,439
5,874,016
$
$ 24,392,337
$ -
3,184,833
2,467,015
5,651,848
(1,259,281) $
(432,985)
(1,692,266)
(2,377,768)
(2,000,000)
-
-
6,796,439
5,874,016
(6,070,034) $ 18,322,303
$
-
-
-
-
-
8.0
12.0
9.6
Total amortization expense charged to operations for the year ended December 31, 2008 and 2007 was $797,179 and $612,760, respectively.
Estimated amortization expense as of December 31, 2008 is as follows:
Years Ended December 31,
2009
2010
2011
2012
2013 and after
Total
$
$
797,181
797,181
797,181
797,181
2,463,123
5,651,847
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. 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. At December 31, 2008, the Company has determined that a portion of the value of EthoStream’s goodwill has been impaired based
upon management’s assessment of operating results and forecasted discounted cash flow and has written off $2,000,000 of its value. During
the year ended December 31, 2008, the Company recorded a goodwill impairment charge of $380,000 related to the additional shares issued
upon the release of the purchase price contingency escrow with the MSTI acquisition.
NOTE D – ACCOUNTS RECEIVABLE
Components of accounts receivable as of December 31, 2008 and 2007 are as follows:
Accounts receivable (factored)
Advances from factor
Due from factor
Accounts receivable (non-factored)
Allowance for doubtful accounts
Total
2008
1,961,535 $
(1,075,879)
885,656
325,653
(186,400)
$
1,024,909
$
$
2007
-
-
-
2,246,935
(111,957)
2,134,978
In February 2008, the Company entered into a factoring agreement to sell, without recourse, certain receivables to an unrelated third party
financial institution in an effort to accelerate cash flow. Under the terms of the factoring agreement the maximum amount of outstanding
receivables at any one time is $2.5 million. Proceeds on the transfer reflect the face value of the account less a discount. The discount is
recorded as interest expense in the Consolidated Statement of Operations in the period of the sale. Net funds received reduced accounts
receivable outstanding while increasing cash. Fees paid pursuant to this arrangement are included in “Financing expense” in the Consolidated
Statement of Operations and amounted to $237,813 for the year ended December 31, 2008. The amounts borrowed are collateralized by the
outstanding accounts receivable, and are reflected as a reduction to accounts receivable in the accompanying consolidated balance sheets.
F-20
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
NOTE E - INVENTORIES
Components of inventories as of December 31, 2008 and 2007 are as follows:
Raw Materials
Finished Goods
Reserve for Obsolescence
Total
2008
$
843,978
1,089,962
(200,000)
$
1,733,940
2007
928,739
1,649,345
-
2,578,084
$
$
NOTE F – OTHER CURRENT ASSETS
Components of other current assets as of December 31, 2008 and 2007 are as follows:
Investment in sales-type lease - current
Prepaid expenses and deposits
Total
2008
2007
$
$
10,270 $
394,658
404,928 $
16,501
645,022
661,523
EthoStream, LLC’s net investment in sales-type leases, included in other assets, as of December 31, 2008 and 2007 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
2008
2007
$
$
11,709
$
(540)
11,169
(10,270)
$
899
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, 2008:
2009
2010
2011
10,797
912
-
11,709
$
NOTE G - - PROPERTY AND EQUIPMENT
The Company’s property and equipment at December 31, 2008 and 2007 consists of the following:
Cable equipment and installations of subsidiary
Telecommunications and related equipment
Development Test Equipment
Computer Software
Leasehold Improvements
Office Equipment
Office Fixtures and Furniture
Total
Accumulated Depreciation
F-21
$
2008
4,879,799
117,493
153,487
160,894
512,947
382,851
383,361
6,590,831
(2,846,306)
$
3,744,525
2007
5,764,645
313,941
153,487
160,894
512,947
426,813
406,352
7,739,079
(2,591,671)
5,147,408
$
$
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
MSTI currently maintains service agreements with approximately 22 MDU and MTU properties and the equipment is capitalized under Cable
equipment and installations. 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.
Telecommunication, cable and installations equipment maintained for customers 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. The majority of the equipment is leased to customers under
operating leases.
The following is a schedule by years of minimum future rentals under bulk services of non-cancelable operating agreements as of December
31, 2008:
2009
2010
2011
2012
2013
Total
$
$
589,372
484,914
456,972
315,934
200,446
2,047,638
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 the discounted cash flows from subscriber revenues. During the years ended December 31, 2008 and 2007, the
Company recorded an impairment of long lived assets totaling $1,582,033 and $493,512, respectively.
Depreciation expense included as a charge to income was $1,112,923 and $1,173,072 for the years ended December 31, 2008 and 2007,
respectively.
NOTE H – MARKETABLE SECURITIES
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 was
subject to adjustment on the date the Company filed a registration statement for the shares issued in this transaction, which occurred on April
25, 2008. The increase or decrease to the number of shares issued was 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 was
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 GOCA. On April 30, 2008, Telkonet issued an additional 3,046,425 shares of its common
stock to the sellers of GOCA to satisfy the adjustment provision.
F-22
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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. The Company has determined that its investment in GOCA is
impaired because it believes that the fair market value of GOCA has permanently declined. Accordingly, the Company wrote-off $4,098,514
during the year ended December 31 2008. The remaining value of this investment amounted to $367,643 as of December 31, 2008.
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 classifies this security as
available for sale, and is carried at fair market value. During the year ended December 31, 2008, the Company recorded a loss of $6,500 on
the sale of 5,000 shares of its investment in Multiband. In addition, the Company recorded an unrealized loss of $32,750 due to a temporary
decline in value of this security. The remaining value of this investment amounted to $29,750 as of December 31, 2008.
NOTE I – OTHER LONG TERM ASSETS
Components of other long term assets as of December 31, 2008 and 2007 are as follows:
Long-term investments
Investments in sales-type leases – non current
Deposits and other
Total
2008
2007
$
$
62,803 $
899
102,508
166,210 $
62,803
11,179
157,675
231,657
Long-term investments held during the years ended December 31, 2008 and 2007 included the following:
Amperion, Inc.
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. The carrying value of the Company’s
investment in Amperion is $8,000 at December 31, 2008 and 2007.
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. 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 carrying value of the
investment in Interactivewifi.com is $55,000 at December 31, 2008 and 2007.
F-23
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
NOTE J - - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable and accrued liabilities at December 31, 2008 and 2007 are as follows:
Accounts payable
Accrued expenses and liabilities
Accrued payroll and payroll taxes
Accrued interest
Accrued purchase price contingency
Registration rights liability
Warranty
Other accrued expenses
Total
NOTE K – LINE OF CREDIT
$
2008
5,169,087
$
3,654,548
832,593
525,076
-
146,951
-
$ 10,328,255
$
2007
4,240,654
692,692
913,962
40,000
400,000
500,000
102,534
957,209
7,847,051
In September 2008, the Company entered into a two-year line of credit facility with a third party financial institution. The line of credit has an
aggregate principal amount of $1,000,000 and is secured by the Company’s inventory. The outstanding principal balance bears interest at the
greater of (i) the Wall Street Journal Prime Rate plus nine (9%) percent per annum, adjusted on the date of any change in such prime or base
rate, or (ii) Sixteen percent (16%). Interest, computed on a 365/360 simple interest basis, and fees on the credit facility are payable monthly in
arrears on the last day of each month and continuing on the last day of each month until the maturity date. The Company may prepay
amounts outstanding under the credit facility in whole or in part at any time. In the event of such prepayment, the lender will be entitled to
receive a prepayment fee of four percent (4.0%) of the highest aggregate loan commitment amount if prepayment occurs before the end of the
first year and three percent (3.0%) if prepayment occurs thereafter. The outstanding borrowing under the agreement at December 31, 2008
was $574,005. The Company has incurred interest expense of $22,374 related to the line of credit for the year ended December 31, 2008. The
Prime Rate was 3.25% at December 31, 2008.
On February 19, 2009, the Company received a notice of waiver from Thermo Credit LLC on the tangible net worth requirement, as defined
item D(10)b of the line of credit agreement. The waiver is in effect as of December 31, 2008 and for the 90 day period thereafter.
NOTE L - - SENIOR CONVERTIBLE DEBENTURES AND SENIOR NOTES PAYABLE
Senior Convertible Debenture
A summary of convertible debentures payable at December 31, 2008 and December 31, 2007 is as follows:
Senior Convertible Debentures, accrue interest at 13% per annum and mature on May 29, 2011
Debt Discount - beneficial conversion feature, net of accumulated amortization of $295,508 and $0 at
December 31, 2008 and December 31, 2007, respectively.
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of
$277,913 and $0 at December 31, 2008 and December 31, 2007, respectively.
Total
Less: current portion
F-24
December
31,
2008
2,136,650 $
$
December 31,
2007
(425,458)
(400,127)
$
$
1,311,065 $
-
1,311,065 $
-
-
-
-
-
-
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
On May 30, 2008, the Company entered into a Securities Purchase Agreement with YA Global Investments, L.P. (the “Buyer”) pursuant to
which the Company agreed to issue and sell to the Buyer up to $3,500,000 of secured convertible debentures (the “Debentures”) and warrants
to purchase (the “Warrants”) up to 2,500,000 shares of the Company’s Common Stock, par value $0.001 per share (the “Common
Stock”). The sale of the Debentures and Warrants was effectuated in three separate closings, the first of which occurred on May 30, 2008, and
the remainder of which occurred in June 2008. At the May 30, 2008 closing, the Company sold Debentures having an aggregate principal
value of $1,500,000 and Warrants to purchase 2,100,000 shares of Common Stock. In July 2008, the Company sold the remaining
Debentures having an aggregate principal value of $2,000,000 and Warrants to purchase 400,000 shares of Common Stock.
During the year ended December 31, 2008, $1,363,350 of the debt has been converted to equity. Accordingly, as of December 31, 2008, the
Company has $2,136,650 outstanding in convertible debentures. During the year ended December 31, 2008, the $1,363,350 of convertible
debentures was converted into 7,324,057 shares of common stock.
The Debentures accrue interest at a rate of 13% per annum and mature on May 29, 2011. The Debentures may be redeemed at any time, in
whole or in part, by the Company upon payment by the Company of a redemption premium equal to 15% of the principal amount of
Debentures being redeemed, provided that an Equity Conditions Failure (as defined in the Debentures) is not occurring at the time of such
redemption. The Buyer may also convert all or a portion of the Debentures at any time at a price equal to the lesser of (i) $0.58, or (ii) ninety
percent (90%) of the lowest volume weighted average price of the Company’s Common Stock during the ten (10) trading days immediately
preceding the conversion date. The Warrants expire five years from the date of issuance and entitle the Buyers to purchase shares of the
Company’s Common Stock at a price per share of $0.61.
The Debenture meets the definition of a hybrid instrument, as defined in SFAS 133, Accounting for Derivative Instruments and Hedging
Activities (SFAS No. 133). The hybrid instrument is comprised of a i) a debt instrument, as the host contract and ii) an option to convert the
debentures into common stock of the Company, as an embedded derivative. The embedded derivative derives its value based on the
underlying fair value of the Company’s common stock. The Embedded Derivative is not clearly and closely related to the underlying host debt
instrument since the economic characteristics and risk associated with this derivative are based on the common stock fair value.
The embedded derivative does not qualify as a fair value or cash flow hedge under SFAS No. 133. Accordingly, changes in the fair value of
the embedded derivative are immediately recognized in earnings and classified as a gain or loss on the embedded derivative financial
instrument in the accompanying statements of operations. There was a loss of $1,174,121 recognized for the year ended December 31, 2008.
The Company determines the fair value of the embedded derivatives and records them as a discount to the debt and a derivative liability on
the date of issue. The Company recognizes an immediate financing expense for any excess in the fair value of the derivatives over the debt
amount. Upon conversion of the debt to equity, any remaining unamortized discount is charged to financing expense.
The Company amortized the beneficial conversion feature and the value of the attached warrants, and recorded non-cash interest expense in
the amount of $295,508, and $277,913, respectively, for the year ended December 31, 2008.
At December 31, 2008, the Senior Convertible Debenture had an estimated fair value of $1.9 million.
On March 31, 2009, the Company received a notice of waiver from YA Global Investments, L.P. pursuant to which it agreed that, to the
extent MSTI is in default of the MSTI Debentures, such default shall not constitute an Event of Default as defined in Section 2(a)(iii) of the
May 30, 2008 Debentures the Company issued to YA Global. The waiver is in effect as of December 31, 2008 through June 1, 2009.
Senior Convertible Debentures - MST
A summary of convertible promissory notes payable at December 31, 2008 and December 31, 2007 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
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 December 15, 2008
Original Issue Discount - net of accumulated amortization of $550,503 and $307,038 at December 31, 2008
and December 31, 2007, respectively.
Debt Discount - beneficial conversion feature, net of accumulated amortization of $1,591,697and $283,464
at December 31, 2008 and December 31, 2007, respectively.
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of
$2,124,569 and $181,118 at December 31, 2008 and December 31, 2007, respectively.
December
31,
2008
December
31,
2007
$
6,657,872 $
6,576,350
352,631
-
(219,312)
-
(1,174,351)
-
(750,347)
Total
$
7,010,503 $
4,432,342
Less: current portion
7,010,503
- $
-
4,432,342
$
F-25
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
During the year ended December 31, 2007, MSTI Holdings 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 MSTI Debentures is amortized over 12 months. The MSTI Debentures accrue interest at 8%
per annum commencing on the first anniversary of the original issue date of the MSTI Debentures, payable quarterly in cash or common stock,
at MSTI Holdings Inc.’s option, and mature on April 30, 2010. The MSTI 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 MSTI Debenture
holders are subject to a “Beneficial Ownership Limitation” pursuant to which the number of shares of common stock of MSTI Holdings, Inc.
held by such debenture holders immediately following conversion of the MSTI Debenture shall not exceed 4.99% of all of the issued and
outstanding common stock of MSTI Holdings, Inc. The MSTI Debentures are senior indebtedness and the holders of the MSTI Debentures
have a security interest in all of MSTI Holdings, Inc.’s assets.
In accordance with Emerging Issues Task Force Issue 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or
Contingently Adjustable Conversion Ratios ("EITF 98-5"), MST recognized an imbedded beneficial conversion feature present in the MSTI
Debentures. The Company allocated a portion of the proceeds equal to the intrinsic value of that feature to the MST 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 MSTI
Debentures issued during the year ended December 31, 2007. The debt discount attributed to the beneficial conversion feature is amortized
over the MSTI Debentures maturity period (three years) as interest expense. On February 11, 2008, the MSTI Debenture holders executed a
letter agreement with MSTI Holdings, Inc. waiving their rights to receive liquidated damages under the registration rights agreement, in
exchange for a reduction in their warrant exercise price from $1.00 to $0.65. In connection with this waiver, the Company has recognized an
additional $641,294 of debt discount attributed to the beneficial conversion feature for the nine months ended September 30, 2008.
In connection with the placement of the MSTI Debentures, MSTI Holdings, Inc. also issued to the MSTI Debenture holders, 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 MSTI Debentures maturity period (three years) as interest
expense. On February 11, 2008, the Debenture holders executed a letter agreement with MSTI Holdings, Inc. waiving their rights to receive
liquidated damages under the registration rights agreement, in exchange for a reduction in their warrant exercise price from $1.00 to $0.65. In
connection with this waiver, the Company has recognized an additional $641,294 of debt discount attributed to the value of the warrants
issued for the year ended December 31, 2008.
In connection with the issuance of the MSTI 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.
During the year ended December 31, 2008, MSTI Holdings Inc. issued additional convertible debentures with a principal value of $81,522 to
existing note holders with a maturity date of April 30, 2010. In connection with this debenture, the Company has recognized an additional
$6,522, $25,460 and $18,938 of debt discount attributed to the original issue discount, the beneficial conversion feature and the value of the
attached warrants for the year ended December 31, 2008.
F-26
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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 $243,465, $1,841,105, and $1,410,575, respectively, for the year ended December 31, 2008.
Registration Rights Liquidated Damages
On May 24, 2007, 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 MSTI Debentures (as previously described) for total proceeds of $6,050,000. The
MSTI Debentures bear interest at a rate of 8% per annum, commencing on the first anniversary of the original issue date of the MSTI
Debentures, payable quarterly in cash or common stock, at MSTI Holdings, Inc. option, and mature on April 30, 2010. The MSTI Debentures
are not callable and are convertible at a price of $0.65 per share into 10,117,462 shares of MSTI Holdings, Inc. common stock. In addition,
holders of the MSTI 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 MSTI Debentures covering all shares of common stock sold in the private placement and underlying the
MSTI Debentures, as well as the warrants attached to the private placement. MSTI Holdings, Inc. also agreed to use its 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 MSTI 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 common stock in the private
placement, 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. In accordance with EITF 00-19-2, the Company evaluated the likelihood of achieving registration statement
effectiveness. Accordingly, the Company accrued $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 investors executed a letter agreement with MSTI Holdings, Inc. waiving their rights to receive liquidated damages
under the registration rights agreement, in exchange for a reduction in their warrant exercise price from $1.00 to $0.65. As a result, the
Company has reversed the accrued expense for the potential liquidated damages during the year ended December 31, 2008.
Additional Debentures
In connection with MSTI Holdings, Inc. (“MSTI”) May 2007 private offering of convertible debentures (the “Debentures”) and warrants to
purchase common stock (the “Warrants”), MSTI entered into a Securities Purchase Agreement (the “Purchase Agreement”) with the
purchasers of the Debentures and Warrants (the “Purchasers”), which prohibited MSTI from, directly or indirectly, among other things,
creating or incurring any indebtedness (other than Permitted Indebtedness, as such term is defined in the Purchase Agreement) without the
consent of the holders of at least 85% of the principal amount of outstanding Debentures.
On October 16, 2008, Alpha Capital Anstalt, Gemini Master Fund, Ltd, Whalehaven Capital Fund Limited and Brio Capital L.P.(the “Senior
Lenders”) executed a letter agreement (the “Letter Agreement”) with MSTI pursuant to which MSTI issued $352,631 of Additional
Debentures, due December 15, 2008, subject to being extended to April 30, 2010 upon the satisfaction of certain specified conditions, that are
convertible into an aggregate of 542,509 shares of MSTI common stock at a conversion price of $0.65 per share (subject to adjustment as
provided therein). The Additional Debentures were issued with an 8% Original Issue Discount. As a result, MSTI received $307,500 from the
issuance of the Additional Debentures. Also, in connection with the issuance of the Additional debentures and pursuant to the letter
agreement, MSTI issued 2 million shares of common stock to the purchasers of such Additional Debentures and the same number of common
stock purchase warrants at a purchase price of at least $0.125 per share (the “Equity Raise”);.
F-27
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
In connection with these debentures, MSTI has recognized an additional $17,631 of debt discount attributed to the original issue discount for
the year ended December 31, 2008.
Triggering Events that Accelerate or Increase a Direct Financial Obligation
As previously described, MSTI entered into an October 16, 2008 letter agreement with the Senior Lenders pursuant to which each of the
Senior Lenders agreed to purchase from MSTI, and MSTI agreed to sell to such Senior lenders, additional Debentures in the aggregate
principal amount of $352,631 (the “Additional Debentures”). Unless certain conditions were satisfied the Additional Debentures were to
mature on December 15, 2008. Upon satisfaction of such conditions, the Maturity Date of the Additional Debentures would be automatically
extended to April 30, 2010. As a result of MSTI’s failure to satisfy the conditions for extension of the Maturity Date, the Additional
Debentures matured on December 15, 2008.
As a result of MSTI’s failure to timely pay its current obligations due to the Senior Lenders under the Additional Debentures in the amount of
$352,631, certain events of default have occurred and are continuing beyond any applicable cure or grace period with respect to all of MSTI’s
secured obligations due to the Senior Lenders and subordinate lenders. The total amounts due is $9,448,506 ($7,010,503 in debenture
principal, $2,103,151 in default penalty and $334,852 in accrued interest). MSTI did not make such payments, and, accordingly, the Senior
Lenders may take all steps they deem necessary to protect the Senior Lenders’ interests, including the enforcement and exercise of any and all
of its rights, remedies, liens and security interests available to them.
As discussed previously, the MSTI Debentures are senior indebtedness and the holders of the MSTI Debentures have a security interest in all
of MSTI Holdings, Inc.’s assets. As a consequence of MSTI’s default, the Senior Lenders have the right to pursue any of the remedies set
forth in the security agreements.
As a result of MSTI’s default and ongoing losses, MSTI’s Board and management has determined that it is advisable and in the best interests
of the Company and its stockholders, in cooperation with the Senior Lenders to explore the sale of all or substantially all of the assets of
Microwave Satellite Technologies, Inc., a wholly owned subsidiary of MSTI which process is currently ongoing.
At December 31, 2008, the carrying amounts of the Senior Convertible Debenture of MST approximate fair value because the entire note had
been classified to current maturity.
Senior Note Payable
A summary of the senior notes payable at December 31, 2008 and December 31, 2007 is as follows:
Senior Note Payable, accrues interest at 6% per annum, and matures 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
$195,924 and $166,744 at December 31, 2008 and December 31, 2007, respectively.
Total
Less: current portion
December 31,
2008
December
31,
2007
$
$
$
- $
1,500,000
-
(29,180)
- $
-
- $
1,470,820
1,470,820
-
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 was due and
payable on the earlier to occur of (i) the closing of the Company’s next financing, or (ii) January 28, 2008, and bore interest at a rate of nine
(6%) percent per annum. The Company incurred approximately $25,000 in fees in connection with this transaction. The net proceeds from the
issuance of the Note were for general working capital needs. 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-28
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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 $29,180, respectively, during the year ended December 31, 2008.
Aggregate maturities of long-term debt as of December 31, 2008 are as follows:
For the twelve months ended December 31,
2009
2010
2011
Amount
7,010,503
-
2,136,650
9,147,153
$
$
Note Payable
On May 6, 2008, Telkonet executed a Promissory Note (the “Note”) in favor of Ralph W. Hooper (the “Note”) in the aggregate principal
amount of Four Hundred Thousand Dollars ($400,000). The Note was due and payable on the earlier to occur of (i) the closing of the
Company’s next financing, or (ii) November 6, 2008. As of December 31, 2008, there was no outstanding liability.
In connection with the issuance of the Note, the Company also issued to Mr. Hooper warrants to purchase 800,000 shares of common stock at
$0.60 per share. These warrants expire five years from the date of issuance. 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 3.2%, a dividend yield of 0%,
and volatility of 82%. The Company recorded non-cash interest expense in the amount of $254,160 for the value of the attached warrants
during the year ended December 31, 2008.
NOTE M – CAPITAL LEASE OBLIGATIONS
Capital lease obligations consists of the following as of December 31 2008 and 2007:
December 31,
2008
December 31,
2007
Capital lease of subsidiary
Capital lease
Total
Less: Current Maturities
Balance*
$
$
$
199,702
4,714
204,416
(204,416)
$
-
-
11,842
11,842
(7,128)
4,714
*Balance includes net assets under capital leases of approximately $195,160 and $10,270 in 2008 and 2007, respectively.
The following is a schedule of future minimum lease payments under capital leases and the present value of such payments as of December
31, 2008:
2009
2010
2011
Total minimum payments
Less: amount representing interest
Present value of net minimum payments
F-29
$
$
279,993
-
-
279,993
(75,577)
204,416
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
NOTE N - - 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, 2008 and 2007,
the Company has no preferred stock issued and outstanding. The company has authorized 130,000,000 shares of common stock, with a par
value of $.001 per share. As of December 31, 2008 and 2007, the Company has 87,525,495 and 70,826,544, respectively, of shares of common
stock issued and outstanding.
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 N).
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 T).
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.
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 I). 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.
In February 2008, the Company amended certain stock purchase warrants held by private placement investors 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 common stock. Subsequently, these private placement investors exercised all of their warrants on a cashless
basis using the 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.
F-30
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
During the year ended December 31, 2008, the Company issued 346,244 shares of common stock to consultants for services performed and
services accrued in fiscal 2007. These shares were valued at $345,407, which approximated the fair value of the shares issued during the
period services were completed and rendered.
In February 2008, Telkonet completed a private placement with one investor for aggregate gross proceeds of $1.5 million. Pursuant to this
private placement, the Company issued 2,500,000 shares of common stock valued at $0.60 per share.
In April 2008, Telkonet issued an additional 3,046,425 shares of its common stock to the sellers of Geeks on Call America, Inc. to satisfy the
adjustment provision in the stock purchase agreement dated October 19, 2007 (Note T).
In June 2008, Telkonet issued an additional 1,882,225 shares of its common stock to the sellers of Smart Systems International (SSI), to satisfy
the adjustment provision in the purchase agreement dated March 9, 2007 (Note B).
During the year ended December 31, 2008, Telkonet issued an aggregate of 600,000 shares of its common stock to Frank T. Matarazzo
pursuant to the stock purchase agreement between Telkonet and MST, dated January 31, 2006. These shares were valued at $380,000, which
approximated the fair value of the shares on the date the shares were issued (Note B).
During the year ended December 31, 2008, Telkonet issued 7,324,057 shares of common stock at approximately $0.19 per shares to its senior
convertible debenture holders in exchange for $1,363,350 of debentures.
NOTE O - - STOCK OPTIONS AND WARRANTS
Employee Stock Options
The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock
issued to employees of the Company under a non-qualified employee stock option plan.
Options Outstanding
Options Exercisable
Exercise Prices
$
$
$
$
$
1.00 - $1.99
2.00 - $2.99
3.00 - $3.99
4.00 - $4.99
5.00 - $5.99
Number
Outstanding
4,263,429
1,232,500
1,272,000
100,000
126,000
6,993,929
Weighted
Average
Remaining
Contractual
Life
(Years)
Weighted
Average
Exercise
Price
4.30
5.80
6.21
6.18
6.11
4.98
$
$
$
$
$
$
Number
Exercisable
4,049,679
1,213,500
1,074,500
72,000
97,000
6,506,679
$
$
$
$
$
$
1.02
2.48
3.32
4.32
5.22
1.82
Weighted
Average
Exercise
Price
1.01
2.48
3.35
4.31
5.23
1.77
Transactions involving stock options issued to employees are summarized as follows:
Outstanding at January 1, 2007
Granted
Exercised (Note M)
Cancelled or expired
Outstanding at December 31, 2007
Granted
Exercised (Note M)
Cancelled or expired
Outstanding at December 31, 2008
F-31
Weighted
Average
Price
Per Share
2.06
2.55
1.05
3.00
1.98
1.00
-
2.71
1.82
Number of
Shares
8,520,929 $
935,000
(118,500)
(1,232,000)
8,105,429 $
185,000
-
(1,296,500)
6,993,929 $
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
The weighted-average fair value of stock options granted to employees during the years ended December 31, 2008 and 2007 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
2008
2007
2.9%
78%
-
5.0
0.55
$
4.8%
70%
-
5.0
1.57
$
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 for the year ended December 31, 2007 was $137,666. There were no options exercised during
the year ended December 31, 2008. Additionally, the total fair value of shares vested during the year ended December 31, 2008 and 2007 was
$613,139 and $1,225,626, respectively.
Total stock-based compensation expense recognized in the consolidated statement of earnings for the year ended December 31, 2008 and
2007 was $1,216,997 and $1,534,560, respectively, net of tax effect. Additionally, the aggregate intrinsic value of options outstanding and
unvested as of December 31, 2008 is $0.
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
Number
Outstanding
Weighted
Average
Remaining
Contractual
Life (Years)
Weighted
Average
Exercise Price
Number
Exercisable
Weighted
Average
Exercise Price
$
1.00
1,815,937
3.33
$
1.00
1,815,937
$
1.00
F-32
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
Transactions involving options issued to non-employees are summarized as follows:
Outstanding at January 1, 2007
Granted
Exercised
Canceled or expired
Outstanding at December 31, 2007
Granted
Exercised
Canceled or expired
Outstanding at December 31, 2008
Number of
Shares
1,815,937 $
-
-
-
1,815,937 $
-
-
-
1,815,937 $
Weighted
Average Price
Per Share
1.00
-
-
-
1.00
-
-
-
1.00
There were no non-employee stock options vested during the years ended December 31, 2008 and 2007, respectively.
Warrants
The following table summarizes the changes in warrants outstanding and the related prices for the shares of the Company’s common stock
issued to non-employees of the Company. These warrants were granted in lieu of cash compensation for services performed or financing
expenses and in connection with placement of convertible debentures.
Warrants Outstanding
Warrants Exercisable
Exercise Prices
Number
Outstanding
$
$
$
$
$
$
0.58
0.60
0.61
2.59
3.98
4.17
856,739
800,000
2,500,000
862,452
3,078,864
359,712
8,457,767
Weighted Average
Remaining
Contractual
Life (Years)
Weighed
Average
Exercise Price
Number
Exercisable
Weighted
Average
Exercise Price
3.08
4.35
4.41
2.62
3.56
2.79
3.46
$
$
$
$
$
$
$
0.58
0.60
0.61
2.59
3.98
4.17
2.19
856,739
800,000
2,500,000
862,452
3,078,864
359,712
8,457,767
$
$
$
$
$
$
$
0.58
0.60
0.61
2.59
3.98
4.17
2.19
Transactions involving warrants are summarized as follows:
Weighted
Average Price
Per Share
Outstanding at January 1, 2007
Granted
Exercised (Note M)
Canceled or expired
Outstanding at December 31, 2007
Granted
Exercised (Note M)
Canceled or expired
Outstanding at December 31, 2008
______________
*The warrants were issued to Enable Capital and originally priced at $4.17 per share. In February 2008, these warrants were re-priced to
$0.6978258 per share and the holders exercised the warrants on a cashless basis and received 1,000,000 shares
4.20
4.18
-
-
4.15
1.31
0.70*
-
2.19
Number of
Shares
4,557,850 $
3,115,777
-
-
7,673,627 $
4,164,140
(3,380,000)
-
8,457,767 $
F-33
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
The Company granted 864,140 and 79,326 warrants to Convertible Senior Notes holders, 0 and 2,600,000 warrants to private placement
investors (Note M), 2,500,000 and 0 to a Convertible Debenture holder, 800,000 and 0 to a Note holder, and 0 and 76,739 compensatory
warrants to non-employees during the year ended December 31, 2008 and 2007, respectively. There was no compensatory warrant expense
recorded for the year ended December 31, 2008. The estimated value of compensatory warrants granted during the year 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 was charged to
operations for the year ended December 31, 2007.
The purchase price of the warrants issued to Convertible Senior Note holders was adjusted from $4.70 to $3.98 per share during the year
ended December 31, 2008 in accordance with the anti-dilution protection provision of the Convertible Senior Notes Payable Agreement (“the
Agreement”) dated October 27, 2005, upon the occurrence of certain events as defined in the Agreement.
In February 2008, the Company amended certain stock purchase warrants held by private placement investors 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. Subsequently, these private placement investors exercised all of their warrants on a cashless
basis using the 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. The Company has accounted for the amended warrants issued, valued at $1,224,236, as other expense using the
Black-Scholes pricing model and the following assumptions: contractual term of 5 years, an average risk-free interest rate of 3.5% a dividend
yield of 0% and volatility of 70%. In addition, during the year ended December 31, 2008, the Company recorded non-cash expenses of
$574,426 for issuing additional warrants and the re-pricing of outstanding warrants in accordance with the anti-dilution provision of the
warrant agreements.
NOTE P - - RELATED PARTY TRANSACTIONS
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, 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 conjunction with the acquisition of MST 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 $285,784 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 2006, MST entered into a one-year professional services agreement with Global Transport Logistics, Inc. (“GTI”), for consulting
services for which GTI is paid a fee of $10,000 per month. GTI is 100% owned by Eileen Matarazzo, the sister-in-law of MST’s Chief
Executive Officer. The agreement has been extended through February 2009. For the years ended December 31, 2008 and 2007, MST paid
and expensed $6,869 and $110,000, respectively.
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.
F-34
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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, 2008, there were no amounts due to officers of the Company.
NOTE Q - - INCOME TAXES
The Company has adopted Financial Accounting Standard No. 109 which requires the recognition of deferred tax liabilities and assets for the
expected future tax consequences of events that have been included in the financial statement or tax returns. Under this method, deferred tax
liabilities and assets are determined based on the difference between financial statements and tax bases of assets and liabilities using enacted
tax rates in effect for the year in which the differences are expected to reverse.
A reconciliation of tax expense computed at the statutory federal tax rate on loss from operations before income taxes to the actual income tax
expense is as follows:
Tax provision computed at the statutory rate
Stock-based compensation
Goodwill impairment
Book expenses not deductible for tax purposes
Minority Interest
Change in valuation allowance for deferred tax assets
Income tax expense
2008
(8,677,000) $
390,000
950,000
200,000
(1,728,000)
8,865,000
-- $
$
$
2007
(7,137,000)
563,000
692,000
135,000
(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
Other
Total deferred tax liabilities
Valuation allowance
Net deferred tax assets
F-35
2008
2007
$
40,076,000 $
638,000
1,421,000
188,000
915,000
43,238,000
32,231,000
259,000
1,031,000
188,000
915,000
34,624,000
(247,000 )
(984,000 )
(850,000 )
(2,081,000 )
(41,157,000 )
-- $
(513,000)
(984,000)
(825,000)
(2,332,000)
(32,292,000)
--
$
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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, 2008 and 2007, the Company has net operating loss carryforwards of approximately $116 million and $87 million,
respectively, for federal income tax purposes which will expire at various dates from 2020 through 2028.
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.
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 58%. 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.
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 R - - 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
F-36
2008
2007
$ (23,985,539) $ (20,391,110)
(0.31)
$
65,414,875
79,153,788
(0.30) $
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
For the year ended December 31, 2008, no potential shares were excluded from shares used to calculate diluted losses per share. For the year
ended December 31, 2007, 2,800,950 potential shares were excluded from shares used to calculate diluted losses per share as their inclusion
would reduce net losses per share.
NOTE S- COMMITMENTS AND CONTINGENCIES
Office Leases Obligations
The Company presently leases 16,400 square feet of commercial office space in Germantown, Maryland for its corporate headquarters. The
Germantown lease expires in December 2015. The Company spent approximately $61,000 in build-out costs to increase the office space of its
Germantown headquarters by approximately 6,000 square feet in April 2007.
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.
The Company presently leases approximately 12,000 square feet of office space in Milwaukee, WI for EthoStream. The Milwaukee lease
expires in February 2019.
Following the acquisition of SSI, the Company assumed a lease on 9,000 square feet of office and warehouse space in Las Vegas, NV on a
month to month basis. The Las Vegas, NV office lease expired on April 30, 2008.
In September 2006, the Company leased a vehicle for the then Chief Executive Officer of Telkonet, Inc. This lease expired in September
2008.
Commitments for minimum rentals under non cancelable leases at December 31, 2008 are as follows:
2009
2010
2011
2012
2013 and thereafter
Total
$
$
462,515
469,418
292,892
294,932
1,011,198
2,530,955
Rental expenses charged to operations for the years ended December 31, 2008 and 2007 are $613,663 and $825,785, 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 J). 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-37
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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.
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. 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. 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. 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 under the acquisition agreement, then the former owners of MST shall be
entitled to the release of any and all consideration held in reserve. In May 2008, the Company executed an agreement for a minimum
commitment of $2.3 million to fund MST's business plan in accordance with Section 11.1 of the Purchase Agreement between Telkonet and
Frank T. Matarazzo. In addition, the adjustment date for the achievement of MST's 3,300 subscribers has been extended an additional six
months from January 31, 2009 to July 31, 2009. Additionally, in April 2008 the Company issued from escrow 200,000 shares of the purchase
price contingency and advanced 400,000 shares in June 2008 in exchange for Mr. Matarazzo’s agreement to a debt covenant restricting the use
of proceeds in the Company’s debenture financing with YA Global Investments LP.
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.
F-38
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
Of the stock issued in the SSI acquisition, 1,090,909 shares were 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 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 issued an
additional 1,882,225 shares on June 12, 2008 pursuant to the adjustment provision in the SSI asset purchase agreement.
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 was
subject to adjustment on the date the Company filed a registration statement for the shares issued in this transaction, which occurred on April
25, 2008. The increase or decrease to the number of shares issued was 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 was
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 GOCA. On April 30, 2008, Telkonet issued an additional 3,046,425 shares of its common
stock to the sellers of GOCA to satisfy the adjustment provision.
Senior Convertible Debentures
On February 11, 2008, purchasers of MSTI Holdings, Inc. Debentures executed a letter agreement with MSTI Holdings, Inc. providing that,
among other things, in the event Frank Matarazzo ceases being Chief Executive Officer of MSTI Holdings, Inc., MSTI Holdings, Inc. will be
in default under the Debentures.
NOTE T - - 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, 2008 and 2007, the minority shareholder's share of the loss of MST was limited to
$4,937,473 and $2,910,068, 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, 2008 and December 31, 2007 amounted to $262,795 and $2,978,918, respectively.
F-39
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
NOTE U - - BUSINESS CONCENTRATION
Revenue from two (2) major customer approximated $6,375,182 or 31% of total revenues for the year ending December 31, 2008. Revenue
from one (1) major customer approximated $1,436,838 or 10% of total revenues for the year ending December 31, 2007. Total accounts
receivable of $486,906, or 22% of total accounts receivable, was due from these customers as of December 31, 2008. Total accounts
receivable of $290,990, or 10% of total accounts receivable, was due from these customers as of December 31, 2007.
Purchases from two (2) major suppliers approximated $3,243,691 or 57% of purchases and $2,126,137 or 36% of purchases for the years
ended December 31, 2008 and 2007, respectively. Total accounts payable of approximately $309,620 or 6% was due to these suppliers as of
December 31, 2008, and $761,033 or 19% of total accounts payable was due to these suppliers as of December 31, 2007.
NOTE V - - FAIR VALUE MEASUREMENTS
The financial assets of the Company measured at fair value on a recurring basis are cash equivalents, and long-term marketable securities. The
Company’s cash equivalents and long term marketable securities are generally classified within Level 1 of the fair value hierarchy because
they are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price
transparency. The Company’s long-term investments are classified within Level 3 of the fair value hierarchy because they are valued using
unobservable inputs, due to the fact that observable inputs are not available, or situations in which there is little, if any, market activity for the
asset or liability at the measurement date. The Company’s derivative liabilities are classified within Level 2 of the fair value hierarchy
because they are valued using inputs which are not actively observable, either directly or indirectly.
•
Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or
liabilities;
•
Level 2: Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially
the full term of the asset or liability; or
•
Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and are
unobservable.
The following table sets forth the Company’s short- and long-term investments as of December 31, 2008 which are measured at fair value on a
recurring basis by level within the fair value hierarchy. As required by SFAS No. 157, these are classified based on the lowest level of input
that is significant to the fair value measurement, (in thousands):
(in thousands)
Cash and cash equivalents
Marketable securities
Long-term investments
Derivative liabilities
Long-term debt
Total
NOTE W - - EMPLOYEE BENEFIT PLAN
Level 1
Level 2
Level 3
$
$
282
397
-
-
-
679
$
$
Assets at
fair value
282
397
63
$
-
-
63
$
-
-
-
2,573
-
2,573
$
$
-
1,311
1,374
$
2,573
1,311
4,626
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 $9,076 and $65,812 for the years ended December 31, 2008 and 2007, respectively.
F-40
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
NOTE X - - SUBSEQUENT EVENTS
Senior Convertible Debenture
In 2009, the Company has issued 5,449,738 shares of its common stock for the repayment of $500,000 of additional principal value of the
outstanding convertible debentures issued to YA Global Investments LP.
Sale of MSTI Holdings, Inc. common stock
On February 26, 2009, Telkonet, Inc. (the “Company”) executed and completed a Stock Purchase Agreement (the “Agreement”) with William
Davis pursuant to which the Company sold, and Mr. Davis purchased, 2,800,000 shares of MSTI Holdings, Inc. common stock (the “MSTI
Shares”) for consideration in the aggregate principal amount of $10,000.
In a related transaction, the Company entered into a Partial Release of Lien with YA Global Investments, L.P. (“YA Global”), pursuant to
which, in consideration of YA Global’s agreement to release its lien and security interest on the MSTI Shares, the Company paid a
commitment fee to YA Global in MSTI Holdings, Inc. common stock equal to one percent (1%) of MSTI Holdings, Inc. common stock owned
by the Company following the sale of the MSTI Shares (157,000 Shares). Prior to the transaction, the Company held 18,500,000 Shares of
MSTI Holdings, Inc. common stock.
With the reduction in holdings, the Company now holds 15,543,000 of MSTI Holdings, Inc. common stock reducing its percentage holdings in
MSTI Holdings, Inc. common stock to forty nine percent (49%).
Amendment to Senior Convertible Debenture Agreement
On February 20, 2009, the Company and YA Global Investments, L.P. entered into an Agreement of Clarification pursuant to which the
parties agreed upon the following clarifications to the Securities Purchase Agreement and the Debenture Agreement, dated May 30, 2008:
· The parties agree that the term Equity Conditions shall be clarified such that if the Company’s Common Stock has not been
suspended from trading and the Company has not been notified in writing that a delisting or suspension from trading is threatened
or pending, the Company shall be deemed to have satisfied the conditions in clause (B) requiring that the Company be in
compliance with the then effective minimum listing maintenance requirements of the exchange on which the Common Stock is
listed.
· Section 1(b) of the Debenture requires, among other things, that interest shall be paid quarterly, in arrears. The Debentures do not
indicate when such quarterly interest payments begin. The parties agreed to clarify that the quarterly interest payments shall be
paid on the first Business Day of each calendar quarter beginning on April 1, 2009. The parties further agreed to clarify that
quarterly interest accrued to date shall be added to the principal amount outstanding under the Debentures and that each Debenture
be amended to reflect the applicable increase in principal amount. The parties further agreed that the Company is not in breach of
Section 2(a) of the Debentures for not making any interest payments during calendar year 2008 or the first quarter of calendar year
2009.
· The conversion provisions contained in Section 4 of the Debentures and the exercise provisions contained in Section 2 of the
Warrants do not cap such conversion or exercise provisions, as applicable, to the 19.99% Limitation. The Principal Market
requires such a cap absent stockholder approval. To date the Company has not sought, nor has YA Global requested, stockholder
approval for issuances of common stock in excess of the 19.99% Limitation. Accordingly, the parties agree that the 19.99%
Limitation is applicable for conversion of the Debentures and exercises of the Warrants, in the aggregate and that the Company
shall not be obligated to issue such shares of common stock in excess of the 19.99% Limitation unless and until the Company
obtains stockholder approval in accordance with applicable Principal Market rules and regulations. Further, the Company agreed
to seek stockholder approval to remove the 19.99% Limitation at its next annual meeting, to be held on or before May 31, 2009.
NOTE Y - - 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:
F-41
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
Telkonet is a “clean technology” company that develops and manufactures proprietary energy efficiency and smart grid networking
technology. Through the Company’s wholly owned subsidiary, EthoStream, LLC, the Company also operates one of the largest hospitality
high-speed internet access (HSIA) networks in the United States.
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:
Current assets, excluding intercompany
Property and equipment, net
Other assets
Due from MST (intercompany)
Total assets
Current liabilities, excluding intercompany
Long term liabilities
Due to TKO (intercompany)
Total liabilities
Capital expenditures
Revenues
Gross profit (loss)
Research and development
Selling, general and administrative
Impairment of goodwill and long lived assets
Depreciation and amortization
Stock based compensation
Total operating expenses
Loss from operations
Other income (expenses)
Loss before minority interest and provision for income taxes
2008
2007
TKO
MST
TKO
MST
$
2,915,859
274,403
16,065,815
2,181,793
$ 21,437,870
$
$
529,907
3,470,122
3,252,237
-
7,252,266
$
5,516,844
491,606
22,084,555
1,270,287
$ 29,363,292
$
1,487,324
4,655,802
4,505,214
-
$ 10,648,340
5,371,645
3,934,982
-
9,306,627
13,488,012
-
2,181,793
$ 15,669,805
$
7,223,514
67,112
-
7,290,656
$
2,771,318
4,432,342
1,270,287
8,473,947
9,000
$
1,133,629
$
224,175
$
1,655,191
$
$
$ 16,559,001
6,772,865
$
3,971,958
(65,529)
$ 11,476,983
3,211,989
$
2,675,750
(729,849)
2,036,129
9,252,381
2,380,000
391,023
699,639
14,759,172
-
3,686,576
1,582,033
591925
923,857
6,784,391
2,349,690
13,789,897
-
412,624
1,655,346
18,207,560
-
4,108,077
2,471,280
466,142
686,634
7,732,133
(7,986,307)
(8,093,930)
(8,461,982)
(1,568,472)
$ (16,080,237) $ (12,842,775) $ (13,270,724) $ (10,030,454)
(14,995,571)
1,724,847
(6,849,920)
(5,992,855)
All of the Company’s assets as of December 31, 2008 and 2007 were attributable to U.S. operations.
F-42
TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007
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
Revenues to major customers in the Telkonet segments out of total revenues are as follows:
In Town Suites
Honeywell Utility Solutions
For the years ended December 31, 2008 and 2007, there were no major customers in the MST Segment.
F-43
Year ended December 31,
2008
(In thousands of U.S. $)
2007
20,410
121
20,531
$
13,851
302
14,153
$
Year ended December 31,
2008
2007
20%
11%
-
10%
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
EXHIBIT 23.1
Board of Directors
Telkonet, Inc.
Germantown, MD
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, 333-152051) on Form S-3 of Telkonet, Inc. and its subsidiaries of our reports dated April 1,
2009, with respect to the consolidated balance sheets of Telkonet, Inc. and its subsidiaries as of December 31, 2008 and 2007, and the related
consolidated statements of losses, stockholders' equity, and cash flows for the two years ended December 31, 2008, which reports appear in
the December 31, 2008 annual report on Form 10-K of Telkonet, Inc. and its subsidiaries.
/s/ RBSM LLP
RBSM LLP
Certified Public Accountants
New York, New York
April 1, 2009
EXHIBIT 31.1
I, Jason L. 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;
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all
3.
material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this
report;
The registrant other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as
4.
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; and
5.
The registrant’s other certifying officer(s) 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 functions):
(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, 2009
By: /s/ Jason L. Tienor
Jason L. 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;
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all
3.
material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this
report;
The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures
4.
(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; and
5.
The registrant’s other certifying officer(s) 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 functions):
(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, 2009
By:
/s/ Richard J. Leimbach
Richard J. Leimbach
Chief Financial Officer
EXHIBIT 32.1
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Annual Report of Telkonet Inc. (the "Company") on Form 10-K for the period ending December 31, 2008 as filed
with the Securities and Exchange Commission on the date hereof (the "Report"), I, Jason L. Tienor, Chief Executive Officer of Telkonet,
certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:
(1) The Report 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 L. Tienor
Jason L. Tienor
Chief Executive Officer
April 1, 2009
EXHIBIT 32.2
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Annual Report of Telkonet Inc. (the "Company") on Form 10-K for the period ending December 31, 2008 as filed
with the Securities and Exchange Commission on the date hereof (the "Report"), I, Richard J. Leimbach, Chief Financial Officer of
Telkonet, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:
(1) The Report 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, 2009
\