REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders

Document Security Systems, Inc. and Subsidiaries

We have audited the accompanying consolidated balance sheets of Document Security Systems, Inc. and Subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended.  These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor have we been engaged to perform, an audit of its internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly we express no such opinion.  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 that 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 Document Security Systems, Inc. and Subsidiaries as of December 31, 2010 and 2009, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

/s/ FREED MAXICK & BATTAGLIA, CPAs, PC

Buffalo, New York

March 31, 2011

 

F-1

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DOCUMENT SECURITY SYSTEMS, INC.  AND SUBSIDIARIES

Consolidated Balance Sheets

As of December 31,

		2010				2009
ASSETS
Current assets:
Cash and cash equivalents		$	4,086,574			$	448,895
Accounts receivable, net of allowance
of  $66,000 ($66,000- 2009)			2,227,877				1,143,939
Inventory			601,359				184,174
Prepaid expenses and other current assets			231,190				91,310
Total current assets			7,147,000				1,868,318
Equipment and leasehold improvements, net			2,543,494				1,286,226
Other assets			325,953				305,507
Goodwill			1,943,081				1,315,721
Other intangible assets, net			1,847,859				1,588,969
Investment			-				350,000
Total assets		$	13,807,387			$	6,714,741
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable		$	1,828,138			$	1,673,901
Accrued expenses and other current liabilities			1,312,363				934,595
Revolving line of credit			614,833				-
Current portion of long-term debt			300,000				-
Current portion of capital lease obligations			88,776				78,167
Total current liabilities			4,144,110				2,686,663
Revolving notes from related party			583,000				583,000
Long-term debt, net of unamortized discount of $0 in 2010 ($420,000 -2009)			1,578,242				954,616
Capital lease obligations			98,532				182,424
Deferred tax liability			89,779				70,830
Derivative liabilities			3,866,836				-
Commitments and contingencies (see Note 13)
Stockholders' equity
Common stock, $.02 par value;  200,000,000 shares authorized,
19,391,319 shares issued and outstanding (16,397,887 in 2009)			387,825				327,957
Additional paid-in capital			44,178,569				38,399,033
Accumulated other comprehensive loss			(25,834	)			-
Accumulated deficit			(41,093,672	)			(36,489,782	)
Total stockholders' equity			3,446,888				2,237,208
Total liabilities and stockholders' equity		$	13,807,387			$	6,714,741

DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

For the Years Ended December 31,

 

		2010				2009
Revenue
Security and commercial printing		$	6,987,930			$	8,773,131
Packaging			5,752,601				-
Technology license royalties and digital solutions			641,050				783,453
Legal products			-				355,107
Total Revenue			13,381,581				9,911,691
Costs of revenue
Security and commercial printing			5,303,952				6,063,479
Packaging			4,386,829				-
Technology license royalties and digital solutions			5,476				14,028
Legal products			-				178,892
Total costs of revenue			9,696,257				6,256,399
Gross profit			3,685,324				3,655,292
Operating expenses:
Selling, general and administrative			6,136,152				5,733,908
Research and development			265,360				291,538
Impairment of intangible assets			376,481				-
Amortization of intangibles			803,468				1,342,105
Operating expenses			7,581,461				7,367,551
Operating loss			(3,896,137	)			(3,712,259	)
Other income (expense):
Interest income			-				18,140
Loss on equity investment			(121,393	)			-
Interest expense			(290,087	)			(258,918	)
Amortizaton of note discount			(420,385	)			(250,102	)
Gain on deconsolidation of Legalstore.com division			-				25,755
Litigation settlements			-				(115,101	)
Registration rights penalties			-				(109,464	)
Gain on foreign currency transactions			-				15,050
Other income			143,061				415,838
Loss before income taxes			(4,584,941	)			(3,971,061	)
Income tax expense			18,949				18,952
Net loss		$	(4,603,890	)		$	(3,990,013	)
Other comprehensive loss:
Interest rate swap loss			(25,834	)			-
Comprehensive Loss		$	(4,629,724	)		$	(3,990,013	)
Divedend per share		$	0.01			$	-
Net loss per share -basic and diluted:		$	(0.26	)		$	(0.27	)
Weighted average common shares outstanding, basic and diluted			17,755,141				14,700,453

 

Consolidated Statements of Changes in Stockholders' Equity

For the Years Ended December 31, 2010 and 2009

 

		Common Stock																Accumulated
		Shares				Amount				Additional Paid-in Capital				Subscriptions Receivable				Other Comprehensive Income				Accumulated Deficit				Total
Balance, December 31, 2008			14,369,764			$	287,395			$	35,538,695			$	(1,300,000	)		$	-			$	(32,499,769	)		$	2,026,321
Issuance of common stock, net			1,010,000				20,200				1,354,702				-				-				-				1,374,902
Conversion of debt to equity			1,250,000				25,000				1,975,000				-				-				-				2,000,000
Discount on debt			-				-				72,126				-				-				-				72,126
Fair value of beneficial conversion features			-				-				350,871				-				-				-				350,871
Stock based payments, net of tax effect			93,123				1,862				401,139				-				-				-				403,001
Cancellation of subscribed shares			(325,000	)			(6,500	)			(1,293,500	)			1,300,000				-				-				-
Net Loss															-				-				(3,990,013	)			(3,990,013	)
Balance, December 31, 2009			16,397,887			$	327,957			$	38,399,033			$	-			$	-			$	(36,489,782	)		$	2,237,208
Issuance of common stock, net			1,729,129				34,583				5,977,113				-				-				-				6,011,696
Acquisition of Premier Packaging			735,437				14,709				2,551,966				-				-				-				2,566,675
Stock based payments, net of tax effect			50,000				1,000				555,476				-				-				-				556,476
Property dividend											(228,607	)			-				-				-				(228,607	)
Conversion of debt			478,866				9,576				790,424				-				-				-				800,000
Other comprehensive loss			-				-								-				(25,834	)			-				(25,834	)
Derivative liabilities			-				-				(3,866,836	)			-				-				-				(3,866,836	)
Net Loss			-				-								-				-				(4,603,890	)			(4,603,890	)
Balance, December 31, 2010			19,391,319			$	387,825			$	44,178,569			$	-			$	(25,834	)		$	(41,093,672	)		$	3,446,888

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1. - DESCRIPTION OF BUSINESS

The Company develops, markets, manufactures and sells paper and plastic products designed to protect valuable information from unauthorized scanning, copying, and digital imaging.  We have developed security technologies that are applied during the normal printing process and by all printing methods including traditional offset, gravure, flexo, digital or via the internet on paper, plastic, or packaging.  Our technologies and products are used by federal, state and local governments, law enforcement agencies and are also applied to a broad variety of industries as well, including financial institutions, high technology and consumer goods, entertainment and gaming, healthcare/pharmaceutical, defense and genuine parts industries.   Our customers use our technologies where there is a need for enhanced security for protection and verification of critical financial instruments and vital records, or where there are concerns of counterfeiting, fraud, identity theft, brand protection and liability.

NOTE 2. - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation - The consolidated financial statements include the accounts of Document Security System and its subsidiaries.  All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates - The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the accounts receivable, fair values of intangible assets and goodwill, useful lives of intangible assets and property and equipment, fair values of options and warrants to purchase our common stock, valuation of derivative liabilities arising from issuances of common stock and associated warrants and other rights to acquire common stock in the future, deferred revenue and income taxes, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We engage third-party valuation consultants to assist management in the allocation of the purchase price of significant acquisitions and the determination of the fair value of derivative liabilities.

Reclassifications - Certain prior year amounts have been reclassified to conform to the current year presentation.

Cash and Cash Equivalents – The Company maintains its cash in bank deposit accounts and, from time to time, short term Certificates of Deposits with original maturities of three months or less.  For financial statement presentation purposes, the Company considers those short-term, highly liquid investments with original maturities of three months or less to be cash or cash equivalents.

Accounts Receivable - The Company carries its trade accounts receivable at invoice amount less an allowance for doubtful accounts.  On a periodic basis, the Company evaluates its accounts receivable and establishes an allowance for doubtful accounts based upon management’s estimates that include a review of the history of past write-offs and collections and an analysis of current credit conditions.  At December 31, 2010, the Company established a reserve for doubtful accounts of approximately $66,000 ($66,000 – 2009). The Company does not accrue interest on past due accounts receivable.

Inventory - Inventories consist primarily of paper, plastic materials and cards, pre-printed security paper, paperboard and fully-prepared packaging which and are stated at the lower of cost or market on the first-in, first-out (“FIFO”) method.   Packaging Work-in-process and finished goods included the cost of materials, direct labor and overhead.

Equipment and Leasehold Improvements - Equipment and leasehold improvements   are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives or lease period of the assets whichever is shorter. Expenditures for renewals and betterments are capitalized. Expenditures for minor items, repairs and maintenance are charged to operations as incurred.  Any gain or loss upon sale or retirement due to obsolescence is reflected in the operating results in the period the event takes place. Depreciation expense in 2010 was approximately $458,000 ($319,000- 2009).

 

F-6

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Investment   - On October 8, 2009, the Company entered into an Asset Purchase Agreement with Internet Media Services whereby the Company sold the assets and liabilities of Legalstore, a division of the Company, in exchange for 7,500,000 shares of common stock of the Internet Media Services.  The Company recorded its investment in Internet Media Services as an equity method investment at the fair market value of the business sold.   Management determined that the transaction qualified as a derecognition of a subsidiary under FASB ASC 810-10-40.  Therefore, the Company accounted for the deconsolidation of a subsidiary (“the business”) by recording the consideration received at fair market value and recognizing a gain in net income measured as the difference between: the fair value of the consideration received (7,500,000 shares of common stock of Internet Media Services or a 37% interest) and the carrying value of the assets and liabilities sold.  Given that the consideration received is not readily measurable because of the lack of activity in Internet Media Services shares prior to the transaction, the Company determined that the value of the “business transferred” is more readily measurable by determining the fair market value of the business transferred based on a discounted cash flow model.   The Company recorded the equity method investment at fair value.  Under the equity method investment the Company is required to account for the difference between the cost of an investment and the amount of the underlying equity in net assets of an investee as if the investee were a consolidated subsidiary.  If the investor is unable to relate the difference to specific accounts of the investee ( e.g. , property and equipment), the difference should be considered to be the same as goodwill.  Investors shall not amortize goodwill associated with equity method investments after the date FASB ASC 350 is initially applied by the entity in its entirety.  The Company determined that given the lack of activity in Internet Media Services shares prior to the transaction, the difference between the cost of the investment (fair market value) and the underlying equity interest is attributable to goodwill which difference amounted to approximately $243,000 at December 31, 2009.   For the period from October 9, 2009 through December 31, 2009, the Company’s equity in the earnings of Internet Media Services was di minimus and not recorded by the Company.  The total assets and liabilities of Internet Media Services as of December 31, 2009 amounted to approximately $350,000 and $60,000, respectively.

The Company recognized gains or losses on its investment under the equity method of accounting for investments.   During 2010, the Company recorded a cumulative loss on its investment of approximately $121,000.   On September 23, 2010, the Company’s Board of Directors declared a dividend whereas the Company distributed to its stockholders of record on October 8, 2010 on a pro-rata basis its 7,500,000 shares of stock of Internet Media Services.  As a result, the Company has recorded a dividend of approximately $229,000 which was the book value of the investment as of September 23, 2010.

Business Combinations - The Company adopted   new FASB guidance on business combinations and non-controlling interests. The new guidance on business combinations retains the underlying concepts of the previously issued standard in that the acquirer of a business is required to account for the business combination at fair value. As under previous guidance, the assets and liabilities of the acquired business are recorded at their fair values at the date of acquisition. The excess of the purchase price over the estimated fair values is recorded as goodwill. The new pronouncement results in some changes to the method of applying the acquisition method of accounting for business combinations in a number of significant aspects. Under the new guidance, all acquisition costs are expensed as incurred and in-process research and development costs are recorded at fair value as an indefinite-lived intangible asset. The application of business combination and impairment accounting requires the use of significant estimates and assumptions.

Goodwill - Goodwill is the excess of cost of an acquired entity over the fair value of amounts assigned to assets acquired and liabilities assumed in a business combination.  Goodwill is not amortized, rather it is tested for impairment annually, and will be tested for impairment between annual tests if an event occurs or circumstances change that would indicate the carrying amount may be impaired. Impairment testing for goodwill is done at a reporting unit level. Reporting units are one level below the business segment level, but are combined when reporting units within the same segment have similar economic characteristics.  The Company has three reporting units based on the current structure.  An impairment loss generally would be recognized when the carrying amount of the reporting unit’s net assets exceeds the estimated fair value of the reporting unit.  The Company performs annual assessments and has determined that no impairment is necessary during the years ended December 31, 2010 and 2009.

Other Intangible Assets, Patent Defense Costs and   Patent Application Costs – Other intangible assets consists of costs associated with the application, acquisition and defense of the Company’s patents, contractual rights to patents and trade secrets associated with the Company’s technologies and a customer list obtained as a result of acquisitions. The Company’s patents and trade secrets are for document anti-counterfeiting and anti-scanning technologies and processes that form the basis of the Company’s document security business.  Patent application costs are capitalized and amortized over the estimated useful life of the patent, which generally approximates its legal life.  External legal costs incurred to defend the Company’s patents are capitalized to the extent of an evident increase in the value of the patents and an expected successful outcome. Patent defense costs are expensed at the point when it is determined that the outcome is expected to be unsuccessful.   The Company capitalizes the cost of an appeal until it is determined that the appeal will be unsuccessful.     The Company’s capitalized patent defense costs expenses are analyzed for impairment based on the expected eventual outcome of the legal action and recoverability of proceeds or added economic value of the patent in excess of the costs.    Legal actions related to the same patent defense case are unified into one asset group for the purposes on the impairment analysis.  Intangible asset amortization expense is classified as an operating expense.  The Company believes that the decision to incur patent costs is discretionary as the associated products or services can be sold prior to or during the application process.   The Company accounts for other intangible amortization as an operating expense, unless the underlying asset is directly associated with the production or delivery of a product.  Costs incurred to renew or extend the term of recognized intangible assets, including patent annuities and fees, are expensed as incurred. To date, the amount of related amortization expense for other intangible assets directly attributable to revenue recognized is not material.

 

F-7

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Impairment of Long-Lived Assets -   The Company accounts for long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.  Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset including its ultimate disposition.  If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.  Fair value is determined based on discounted cash flows or appraised values, depending on the nature of the assets.

Fair Value of Financial Instruments - Effective January 1, 2008, the Company adopted the new accounting guidance relating to fair value measurements as required by the Fair Value Measurement Topic of the FASB ASC for financial instruments measured at fair value on a recurring basis and effective January 1, 2009 on a non-recurring basis. The new accounting guidance defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP and expands disclosures about fair value measurements.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Fair Value Measurement Topic of the FASB ASC establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers include:

·	Level 1, defined as observable inputs such as quoted prices for identical instruments in active markets;

·	Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and

·	Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

 

The carrying amounts reported in the balance sheet of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximate fair value because of the immediate or short-term maturity of these financial instruments. The fair value of revolving credit lines, notes payable and long-term debt approximates their carrying value as the stated or discounted rates of the debt reflect recent market conditions. Derivative instruments are recorded as assets and liabilities at estimated fair value based on available market information. One of the Company's derivative instruments is an interest rate swap that changes a variable rate into a fixed rate on the term loan and qualifies as a cash flow hedge and is included in accrued expenses on the accompanying Consolidated Balance Sheet as of December 31, 2010.   Gains and losses on these instruments are recorded in other comprehensive income (loss) until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive income (loss) (AOCI) to the Consolidated Statement of Operations on the same line item as the underlying transaction.   The cumulative net loss attributable to this cash flow hedge recorded in AOCl at December 31, 2010, was approximately $26,000.

The Company accounts for warrants and other rights to acquire capital stock with exercise price reset features, or “down-round” provisions, as derivative liabilities. Similarly, down-round provisions for issuances of common stock are also accounted for as derivative liabilities. These derivative liabilities are measured at fair value with the changes in fair value at the end of each period reflected in current period income or loss. The fair value of derivative liabilities is estimated using a binomial model or Monte Carlo simulation to model the financial characteristics, depending on the complexity of the derivative being measured.  A Monte Carlo simulation provides a more accurate valuation than standard option valuation methodologies such as the Black-Scholes or binomial option models when derivatives include changing exercise prices or different alternatives depending on average future price targets. In computing the fair value of the derivatives, the Company uses significant judgments, which, if incorrect, could have a significant negative impact to the Company’s consolidated financial statements.  The input values for determining the fair value of the derivatives include observable market indices such as interest rates, and equity indices as well as unobservable model-specific input values such as certain volatility parameters.  Future changes in the fair value of the derivatives liabilities, if any, will be recorded in the statement of operations as gains or losses from derivative liabilities.

 

F-8

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Conventional Convertible Debt - When the convertible feature of the conventional convertible debt provides for a rate of conversion that is below market value, this feature is characterized as a beneficial conversion feature (“BCF"). Prior to the determination of the BCF, the proceeds from the debt instrument were first allocated between the convertible debt and any detachable free standing instruments that are included, such as common stock warrants.  We record a BCF as a debt discount pursuant to FASB ASC Topic 470-20. In those circumstances, the convertible debt will be recorded net of the discount related to the BCF. We amortize the discount to interest expense over the life of the debt using the effective interest method. During 2010, the holders of both of the Company’s convertible notes totaling $800,000 exercised the conversion features of the respective convertible notes for an aggregate of 478,866 shares of the Company’s common stock, which retired the debt in full.  In conjunction with the conversions, the Company recognized approximately $263,000 of unamortized note discount expense.

Share-Based Payments - Compensation cost for stock awards are measured at fair value and recognize compensation expense over the service period for which awards are expected to vest. The Company uses the Black-Scholes option pricing model for determining the estimated fair value for stock-based awards. The Black-Scholes model requires the use of subjective assumptions which determine the fair value of stock-based awards, including the option’s expected term and the price volatility of the underlying stock.  For equity instruments issued to consultants and vendors in exchange for goods and services follows the Company determines the measurement date for the fair value of the equity instruments issued at the earlier of (i) the date at which a commitment for performance by the consultant or vendor is reached or (ii) the date at which the consultant or vendor’s performance is complete. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement.

Revenue Recognition   - Sales of security and commercial printing products, and legal products are recognized when a product or service is delivered, shipped or provided to the customer and all material conditions relating to the sale have been substantially performed.

 

For digital solutions sales, revenue is recognized in accordance with FASB ASC 985-605.   Accordingly, revenue is recognized when all of the following conditions are satisfied:   (1) there is persuasive evidence of an arrangement; (2) the service or product has been provided to the customer; (3) the amount of fees to be paid by the customer is fixed or determinable (4) the collection of our fees is reasonably assured.

 

For technology licenses revenue is recognized once all the following criteria for revenue recognition have been met: (1) persuasive evidence of an agreement exists; (2) the right and ability to use the product or technology has been rendered; (3) the fee is fixed and determinable and not subject to refund or adjustment; and (4) collection of the amounts due is reasonably assured.

Advertising Costs – Generally consist of online, keyword advertising with Google with additional amounts spent on certain print media in targeted industry publications .    Advertising costs were $32,000 in 2010 ($23,000 – 2009).

Research and Development – Research and development costs are expensed as incurred.

 

Foreign Currency- Net gains and losses resulting from transactions denominated in foreign currency are recorded as other income or loss.

Income Taxes - The Company recognizes estimated income taxes payable or refundable on income tax returns for the current year and for the estimated future tax effect attributable to temporary differences and carry-forwards. Measurement of deferred income items is based on enacted tax laws including tax rates, with the measurement of deferred income tax assets being reduced by available tax benefits not expected to be realized.  We recognize penalties and accrued interest related to unrecognized tax benefits in income tax expense.

Earnings Per Common Share - The Company presents basic and diluted earnings per share.  Basic earnings per share reflect the actual weighted average of shares issued and outstanding during the period. Diluted earnings per share are computed including the number of additional shares that would have been outstanding if dilutive potential shares had been issued. In a loss year, the calculation for basic and diluted earnings per share is considered to be the same, as the impact of potential common shares is anti-dilutive.

 

F-9

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For the years ended December 31, 2010 and 2009, there were up to 2,767,131 and 2,652,886, respectively, of shares potentially issuable under convertible debt agreements, options, warrants and restricted stock agreements that could potentially dilute basic earnings per share in the future were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive to the Company’s losses in the respective years.   This amount includes the warrants issued to Fletcher on December 31, 2010 (as amended on February18, 2011 and March 14, 2011).  These amounts do not include potentially issuable shares under Fletcher’s Later Investment rights which provide Fletcher the right to acquire up to 756,387 shares of the Company’s common stock at a price per share of $5.38 anytime prior to July 2, 2011. For each share purchased by Fletcher pursuant to the Later Investment, Fletcher would receive a warrant to purchase an additional share of the Company’s commons stock at $5.38 for up to nine years.   If Fletcher exercises all of its Later Investment Rights, then an additional 756,387 warrants would be issued.  (See Note 7).

Concentration of Credit Risk - The Company maintains its cash and cash equivalents in bank deposit accounts, which at times may exceed federally insured limits.  The Company believes it is not exposed to any significant credit risk as a result of any non-performance by the financial institutions.

During 2010, two customers accounted for 25% and 10% of the Company’s total revenue from continuing operations, respectively.   As of December 31, 2010, these customers accounted for 37% and 7% of the Company’s trade accounts receivable balance, respectively.  During 2009, two customers accounted for 19% and 12% of the Company’s total revenue from continuing operations, respectively.  As of December 31, 2009, two customers’ account receivable balance accounted for 21% and 17% of the Company’s trade accounts receivable balance, respectively.  The risk with respect to trade receivables is mitigated by credit evaluations we perform on our customers, the short duration of our payment terms for the significant majority of our customer contracts and by the diversification of our customer base.

 

Recent Accounting Pronouncements

  In January 2010, the FASB issued ASU 2010-6, “ Improving Disclosures About Fair Value Measurements” (“ASU 2010-6”), which requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair- value measurements. ASU 2010-6 is effective for interim and annual reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for interim and annual periods beginning after December 15, 2010. The Company partially adopted the requirements within ASU 2010-6 as of January 1, 2010. The adoption did not have an impact on our financial statements.

 

In December 2010, the FASB issued ASU 2010-29,  Business Combinations (Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations.   This ASU specifies that when comparative financial statements are presented, the revenue and earnings of the combined entity should be disclosed as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 is effective for business combinations with acquisition dates on or after the beginning of the first annual reporting period beginning on or after December 15, 2010; early adoption is permitted.  Management is currently evaluating the impact that the adoption of ASU 2010-29 will have and does not believe the adoption will have a material impact on our consolidated financial statements.

 

F-10

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NOTE 3. – INVENTORY

Inventory consisted of the following at December 31,:

		2010				2009
Finished Goods		$	193,346			$	38,093
Work in process			86,776				58,493
Raw Materials			321,237				87,588
		$	601,359			$	184,174

 

NOTE 4. - EQUIPMENT AND LEASEHOLD IMPROVEMENTS

Equipment and leasehold improvements consisted of the following at December 31:

 

			2010								2009
	Estimated Useful Life		Purchased				Under Capital Leases				Purchased				Under Capital Leases
Machinery & equipment	5-7 years		$	2,514,045			$	369,114			$	752,387			$	547,936
Leasehold improvements	up to 13 years (1)			741,919				-				735,434				-
Furniture & fixtures	7 years			104,709				-				70,209				-
Software & websites	3 years			356,125				-				270,725				-
Total cost			$	3,716,798			$	369,114			$	1,828,755			$	547,936
Less accumulated depreciation				1,391,693				150,725				809,082				281,383
Net			$	2,325,105			$	218,389			$	1,019,673			$	266,553

 

(1) Expiration of lease term

NOTE 5. - INTANGIBLE ASSETS

Goodwill - The Company performs an annual fair value test of its recorded goodwill for its reporting units using a discounted cash flow and capitalization of earnings approach.   As of December 31, 2010, the Company had goodwill of approximately $1,943,000 ($1,316,000- December 31, 2009) attributable to the commercial and security printing segment ($1,316,000) and the packaging segment ($627,000) which was recorded in 2010 as a result of our acquisition of Premier Packaging (See Note 9).   In October 2009, we sold the assets and liabilities associated with Legalstore in exchange for common stock of  Internet Media Services.  The sale included goodwill with a net book value of approximately $81,000.

Other Intangible Assets - Other intangible assets are comprised of the following at December 31:

			2010												2009
	Useful Life		Gross Carrying A mount				Accumulated Amortizaton				Net Carrying Amount				Gross Carrying Amount				Accumulated Amortizaton				Net Carrying Amount
Acquired intangibles	5 -10 years			2,038,300				815,177				1,223,123				666,300				532,285				134,015
Patent acquisition and defense costs	Varied			4,729,889				4,729,889				-				4,729,889				3,879,341				850,548
Patent application costs	Varied (1)			843,693				218,957				624,736				776,159				171,753				604,406
			$	7,611,882			$	5,764,023			$	1,847,859			$	6,172,348			$	4,583,379			$	1,588,969
(1)- patent rights are amortized over their expected useful life which is generally the legal life of the patent. As of December 31, 2010 the weighted average remaining useful life of these assets in service was 14.8 years.

 

 

F-11

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Actual amortization for 2010 and 2009 and expected amortization for each of the next five years is as follows:

2009 Actual			$	1,342,000
2010 Actual			$	803,000
Expected	2011		$	242,253
	2012			232,365
	2013			232,365
	2014			232,365
	2015			147,198
	Thereafter			761,313
			$	1,847,859

 

Acquired Intangible Assets - In February 2010, the Company acquired intangible assets associated with its acquisition of Premier Packaging  as described in Note 9.  These intangible assets were valued at $1,372,000 by an independent valuation firm and consist of customer lists, amortized over the expected life of 10 years, and a non-compete agreement, amortized over the expected life of 5 years.

In February 2006, the Company acquired intangible assets associated with its acquisition of the assets of P3.  These intangible assets were valued at $625,300 by an independent valuation firm and consist of customer lists, trade name and brand, and a non-compete agreement, which will be fully amortized as of February 2011.

Patent Acquisition and Defense Costs -   Included in the Company’s capitalized patent defense costs are costs associated with the acquisition of certain rights associated with patents that the Company is defending.  In December 2004, the Company entered into an agreement with the Wicker Family in which Document Security Systems obtained the legal ownership of technology (including patent ownership rights) previously held by the Wicker Family.  At that time, the agreement with the Wicker Family provided that the Company would retain 70% of the future economic benefit derived from settlements, licenses or subsequent business arrangements from any infringer of the Wicker patents that Document Security Systems chooses to pursue.  The Wicker Family was to receive the remaining 30% of such economic benefit.  In February 2005, the Company further consolidated its ownership of the Wicker Family based patents and its rights to the economic benefit of infringement settlements when the Company purchased economic interests and legal ownership from approximately 45 persons and entities that had purchased various rights in Wicker Family technologies over several decades.   The Company issued an aggregate of 541,460 shares of its common stock for the rights of the interest holders and secured 100% ownership of a US Patent and approximately 16% of additional economic rights to settlements with infringers of the Wicker Family’s foreign patents.  The value of the shares of common stock was determined based upon the closing price of the shares of the Company’s common stock on the American Stock Exchange on February 15, 2005 of $7.25 per share was, $ 3,905,672 net of expenses.   The Company amortized these costs over the weighted average expected life of the patents underlying the acquired rights, which was 6.75 years as of the date of acquisition.   As of December 31, 2010, the net unamortized balance of acquired patent assets was $377,000, which was recorded in the corporate segment. As a result of the losses in the appeal of two court decisions in the fourth quarter of 2010 related to the Company’s infringement case against the ECB (as described in Note 13- Legal Proceedings), the Company’s management determined that an impairment of this asset occurred as it is more likely than not that the Company would not receive proceeds from infringement litigation in these non-European jurisdictions, and the remaining balance was considered impaired.

Patent defense costs are comprised of legal cost associated with our patent infringement suit against the ECB which the Company commenced in 2005.  The Company bases it decision to defer the costs associated with this case on the principal that successful patent defense costs are capitalizable.  First, the Company’s infringement case is based on the relationship of the inventor of the Company’s patent with various representatives of European currency printers, consultants, and other participants during the late 1990’s in regard to the industry’s attempts to defeat new advanced levels of copier and scanning technologies that were then emerging in the marketplace.  The inventor of the  patent had a proven history of success in anti-counterfeiting technology, and was seen as a source by these industry participants for help solve these challenges.  The Company believed that it could establish a direct link between these communications and the use of the technology by these industry participants in the design and production of the Euro, which was designed in the late 1990’s and was initially released for circulation in 2002.  In addition, prior to filing the ECB litigation, the Company consulted extensively with legal counsel and performed extensive due diligence with our legal counsel for approximately one year to analyze the merits of our patent infringement case, and only after these efforts did we take our legal counsel’s recommendation to proceed with the ECB litigation.   Based on the cumulative evidence available to the Company at the time of filing the suit, the Company believed from the outset of the case that it will be able to prove in court that the ECB infringed the Company’s patent on its Euro notes by using the Company’s technology in the design of the notes for the specific purpose of making the notes difficult to copy, and therefore the Company’s infringement case would be successful.

 

F-12

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During the course of the ECB litigation, the most significant events in the case were challenges of patent validity by the ECB in nine jurisdictions in Europe as a core component of its defense.  The Company believed that the ECB’s challenge of patent validity represented the biggest hurdle to a successful outcome of the overall infringement case.  During the course of the ECB litigation, the Company spent approximately $4,247,000 on legal and related court cost associated with defending the patent in these jurisdictions.   The Company amortized these costs over the expected life of the patent which expired as of January 2010.   During the course of the ECB litigation, the Company analyzed the recoverability of its capitalized patent defense costs.  The Company used the potential proceeds from its ECB Litigation as the primary source of future cash flows.  Specifically, the Company used assumptions of banknote production volumes during the alleged infringement period and estimated banknote production costs from third party sources to determine the estimated total costs of the production of the Euro banknotes in each year of infringement.  The Company then applied a royalty rate that the Company generally charges international licensees and that the Company believes is consistent with industry standards to determine the amount that would be due to the Company if the ECB had licensed the technology from the Company on the Company’s standard licensing terms.   The Company uses this amount as an estimate of the gross proceeds it could receive from a successful outcome of the litigation in all jurisdictions.  The Company then allocated these potential proceeds by the percent of circulation of each jurisdiction in which the Company has ongoing litigation to determine the potential proceeds of a successful outcome in the jurisdictions where the patent has been held as valid or where the patent validity has not yet been determined.  Finally, the Company uses a probability factor in its analysis that discounts these potential future proceeds that takes into account the different status levels of each jurisdiction.   Thus, the Company determined a probability based cash flow which is compared to the net patent defense costs balance to determine whether an impairment of these costs has occurred.    In 2008, as a result of an adverse decision regarding patent validity in one of the jurisdictions, the United Kingdom, the Company recognized an impairment of approximately $281,000.  All other patent defense costs were amortized over the expected life of the patent and were fully amortized as of January 2010.   As of December 31, 2010, there were no longer any unamortized patent defense costs or patent acquisition costs reflected on the Company’s balance sheet.

In August 2008, the Company entered into an agreement with Trebuchet under which Trebuchet agreed to pay substantially all of the litigation costs associated with pending validity proceedings and infringement suits, if any, subsequent to that point.  Under the terms of the Agreement, and in consideration for Trebuchet’s funding obligations, the Company assigned and transferred a 49% interest of the Company’s rights, title and interest in the patent to Trebuchet.  Trebuchet will receive 50% of all proceeds from any judgments, settlements, licenses or other forms of payment received as a result of any litigation.   Pursuant to this transaction, the Company recognized a loss on the sale of patent assets for its assignment and transfer of 49% of its ownership rights in the patent, which had a net book value of approximately $1,670,000, for proceeds of $500,000.

Patent Application Costs - On an ongoing basis, the Company submits formal and provisional patent applications with the United States, Canada and countries included in the Patent Cooperation Treaty (PCT).   The Company capitalizes these costs and amortizes them over the patents’ estimated useful life.

NOTE 6. – SHORT TERM AND LONG TERM DEBT

Revolving Note - Related Party- On January 4, 2008, the Company entered into a Credit Facility Agreement with Fagenson and Co., Inc., as agent, a related party to Robert B. Fagenson, the Chairman of the Company's Board of Directors (the “Fagenson Credit Agreement” or “Credit Facility”). Under the Fagenson Credit Agreement, the Company could borrow up to a maximum of $3,000,000 from time to time up to and until January 4, 2010.  Any amount borrowed by the Company pursuant to the Fagenson Credit Agreement has annual interest rate of 2% above LIBOR and is secured by the Common Stock of P3, the Company's wholly owned subsidiary.  Interest is payable quarterly in arrears and the principal is payable in full at the end of the term under the Fagenson Credit Agreement.  On December 11, 2009, the Company entered into a Letter Agreement with the lender for the conversion of $2,000,000 of debt owed under the Credit Facility into 1,250,000 shares of Document Security Systems common stock.   In addition, the parties amended the Credit Facility to allow for a maximum borrowing of up to $1,000,000 and extended the due date to January 4, 2012.   As of December 31, 2010, the Company had outstanding $583,000 ($583,000 – December 31, 2009) under the Fagenson Credit Agreement.    Under the terms of the Credit Facility the Company is required to comply with various covenants, in which the Company was in violation of one covenant for the lack of payment of interest.  While the Company had not received a notice of default from the lender, the Company did receive a waiver from the lender for the violation as of December 31, 2010.

 

F-13

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Interest expense for revolving notes from related parties for the year ended December 31, 2010 was approximately $20,000 ($108,000 – 2009) of which approximately $172,000 is included in accrued expenses as of December 31, 2010 ($152,000 –December 31, 2009).

Notes Payable and Revolving Credit Line - On December 9, 2009, the Company used the proceeds from a $350,000 Convertible Note and a $575,000 Promissory Note (collectively, the “Notes”), respectively, to pay in full a $900,000 Term Note.   The $350,000 Convertible Note was set to mature on November 24, 2012, accrued interest at 10% and was convertible into up to 218,750 shares of Document Security Systems common stock.  The $575,000 Promissory Note matures on November 24, 2012 accrues interest at 10%, payable quarterly.   Both Notes are secured with equal rights by the assets of the Company’s wholly owned subsidiary, DPI. In conjunction with the convertible note, the Company determined a beneficial conversion feature existed amounting to approximately $94,000 which was recorded as discount on debt and was being amortized over the term of the Note.  On November 29, 2010, the holder exercised the conversion feature of the $350,000 Convertible Note for 218,750 shares of Document Security Systems common stock, par value $0.02 which retired the debt in full.  In conjunction with the conversion, the Company recognized approximately $63,000 of note discount expense.

On December 30, 2009, the Company used the proceeds from a $450,000 Convertible Note (“Note”) to pay in full $450,000 due under a previous Credit Facility due to the Company’s CEO.   The $450,000 Note was set to mature on June 23, 2012, accrued interest at 8%, and was convertible into up to 260,116 shares of Document Security Systems common stock, and was secured by the accounts receivable of the Company, excluding the accounts receivable of the Company’s wholly owned subsidiaries, P3 and DPI.   In conjunction with the Note, the Company issued to the holders of the Note warrants to purchase up to 65,000 shares of the Company’s common stock within five years at $2.00 per share.  The estimated fair market value of these warrants was determined using the Black Scholes option pricing model at approximately $72,000, which was recorded as discount on debt and is being amortized over the term of the Note.  Furthermore, in conjunction with this Note, the Company determined a beneficial conversion feature existed amounting to approximately $257,000, which was recorded as discount on debt and is being amortized over the term of the Note.   In addition, the Company recorded expense of approximately $110,000 for the fair value of 40,000 warrants to purchase the shares of the Company’s common stock at $2.00 issuable under the terms of the  Note as a result of the Company’s failure to timely file a registration statement for the shares issuable upon conversion of the Note and underlying the warrants, respectively,   On December 24, 2010, the holder of the Note exercised the conversion feature of the Note for 260,116 shares of Document Security Systems common stock, par value $0.02 which retired the debt in full.  In conjunction with the conversion, the Company recognized approximately $200,000 of note discount expense.

On February 12, 2010, the Company acquired all of the outstanding common stock of Premier Packaging.  In conjunction with the transaction, the Company entered into a Credit Facility Agreement with RBS Citizens, N.A. (“Citizens Bank”) pursuant to which Citizens Bank provided Premier Packaging with a term loan of $1,500,000, and a revolving credit line of up to $1,000,000, which provides for the ability to get letters of credits based on available revolving credit balances.  The Citizens Bank Credit Facility Agreement contains customary representations and warranties, affirmative and negative covenants, including financial covenants (minimum coverage ratio, debt to EBITDA ratio, and current ratio requirements) and events of default and is secured by all of the assets of Premier Packaging.   The $1,500,000 term loan matures March 1, 2013 and is payable in 35 monthly payments of $25,000 plus interest commencing March 1, 2010 and a payment of $625,000 on the 36th month.  Interest accrues at LIBOR plus 3.75%.   The proceeds of the term loan were used as partial payment of the purchase of all of the outstanding common stock of Premier Packaging. The revolving line of credit up to $1,000,000 is accessible by the Premier Packaging division subject to certain terms matures on May 13, 2011, as amended, and is payable in monthly installments of interest only beginning on March 1, 2010. Interest accrues at 1 Month LIBOR plus 3.75%.   The Company subsequently entered into an interest rate swap agreement to lock into a 5.6% effective interest over the life of the term loan.  The amount of the swap liability was $26,000 at December 31, 2010 and is included in accrued expenses in the accompanying balance sheet.  As of December 31, 2010, the remaining principal balance due on the Note was $1,250,000 and there was approximately $615,000 outstanding on the revolving credit line.

Standby Term Loan Note - On   October 8, 2010, the Company amended the Credit Facility Agreement to add a Standby Term Loan Note pursuant to which Citizens Bank will provide Premier Packaging with up to $450,000 towards the funding of eligible equipment purchases.   The Company has 12 months to draw upon this line of credit, after which the balance of funds advanced from the line is converted into a 5 year term loan.  Interest accrues at LIBOR plus 3.00%.   As of December 31, 2010, the Company has drawn approximately $53,000 from the Standby line for the purchase of equipment.

 

F-14

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All of the Citizen’s credit facilities are secured by all of the assets of Premier Packaging and are also secured through cross guarantees by Document Security Systems and the Company’s other wholly owned subsidiaries, P3 and DPI.

A summary of scheduled principal payments of revolving notes related party and notes payable at December 31, 2010 are as follows:

 

2011		$	300,000
2012			1,458,000
2013			650,000
		$	2,408,000

NOTE 7. - STOCKHOLDERS’ EQUITY

Stock Issued in Private Placements   -Between May 29, 2009 and June 22, 2009, the Company sold 56 investment units in a private placement at a price of $10,000 per unit for aggregate proceeds of $560,000 less $44,000 in expenses, consisting of 400,000 shares of common stock and warrants to purchase an aggregate of 80,000 shares of common stock.  The estimated fair market value of these warrants was determined using the Black Scholes option pricing model at approximately $80,000.  On July 15, 2009, the Company sold 24.5 investment units for $10,000 per unit for gross cash proceeds of $245,000, consisting of 175,000 shares of common stock and warrants to purchase an aggregate of 35,000 shares of common stock. The estimated fair market value of these warrants was determined using the Black Scholes option pricing model at approximately $34,000.  On August 24, 2009, the Company completed the sale of 7 investment units in a private placement pursuant to subscription agreements with one accredited investor dated the same date.  In the transaction, the Company sold 7 investment units for $10,000 per unit for gross cash proceeds of $70,000, consisting of 50,000 shares of common stock and warrants to purchase an aggregate of 10,000 shares of common stock.  The estimated fair market value of these warrants was determined using the Black Scholes option pricing model at approximately $10,000.  Each investment unit consisted of 7,142 shares of its common stock and five-year warrants to purchase up to an aggregate of 1,427 shares of its common stock at an exercise price of $2.00 per share.

On September 4, 2009, the Company completed the sale of 44 investment units in a private placement pursuant to subscription agreements with three accredited investors dated the same date. Each investment unit is comprised of 6,250 shares of the Company’s common stock and five year warrants to purchase 1,250 shares of common stock at an exercise price of $2.00 per share. In the transaction, the Company sold 44 investment units for $10,000 per unit for gross cash proceeds of $440,000, less expenses of $52,000, consisting of 275,000 shares of common stock and warrants to purchase an aggregate of 55,000 shares of common stock. The estimated fair market value of these warrants was determined using the Black Scholes option pricing model at approximately $54,000.

On October 19, 2009, the Company completed the sale of 17.6 investment units in a private placement pursuant to subscription agreements with three accredited investors dated the same date. Each investment unit is comprised of 6,250 shares of the Company’s common stock and five year warrants to purchase 1,250 shares of common stock at an exercise price of $2.00 per share. In the transaction, the Company sold 17.6 investment units for $10,000 per unit for gross cash proceeds of $176,000, less expenses of $17,600, consisting of 110,000 shares of common stock and warrants to purchase an aggregate of 22,000 shares of common stock. The estimated fair market value of these warrants was determined using the Black Scholes option pricing model at approximately $38,000.

On February 12, 2010, the Company acquired all of the outstanding common stock of Premier Packaging from Robert B. and Joan T. Bzdick for $2,000,000 in cash and 735,437 shares of the Company's common stock which was valued at $2,566,675.

               On February 17, 2010, the Company completed the sale of 20 investment units in a private placement pursuant to subscription agreements with six accredited investors.  Each investment unit was comprised of 5,000 shares of the Company’s common stock and five year warrants to purchase 1,000 shares of common stock at an exercise price of $3.50 per share. In the transaction, the Company sold 20 investment units for $15,000 per unit for gross cash proceeds of $300,000, consisting of 100,000 shares of common stock and warrants to purchase an aggregate of 20,000 shares of common stock.  In connection with these sales EKN Financial Services Inc., a registered broker-dealer, acted as non-exclusive placement agent.  EKN Financial Services, Inc. received a cash fee in the aggregate of $30,000 as commission for these sales. On February 17, 2010, the Company also sold 20 investment units for gross cash proceeds of $270,000, consisting of an aggregate of 100,000 shares of common stock and warrants to purchase an aggregate of 20,000 shares of common stock.   No placement agent fees were paid on these sales. On February 23, 2010, the Company issued 304,000 shares of common stock pursuant to the exercise of warrants in which the Company received proceeds of $608,000.

 

F-15

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On July 21, 2010 and July 22, 2010, Document Security Systems entered into subscription agreements with twenty two accredited investors.   Under these subscription agreements the Company issued an aggregate of 413,787 shares of common stock and five-year warrants to purchase up to 82,753 shares of common stock, in consideration of an aggregate of $1,200,000.  The warrants are exercisable at $3.75 per share.    The Company paid Aegis Capital Corp., for its services as placement agent, a 7% commission, and a 3% non-accountable expense allowance, in the aggregate amount of $120,000.  In addition, we issued the placement agent five year warrants to purchase 41,379 shares of common stock, exercisable at $3.75 per share.

On February 18, 2011, the Company entered into an Amended and Restated Agreement (“Amended Agreement”) with Fletcher  for the purpose of modifying the terms of an agreement (“Original Agreement”) previously entered into between the Company and Fletcher on December 31, 2010.

Under the Original Agreement, Fletcher purchased $4,000,000 of the Company’s Common Stock (756,287 shares) at a price of approximately $5.29 per share on December 31, 2010 (the “Initial Investment”). In conjunction with the Initial Investment, Fletcher received a warrant (the “Initial Warrant”) to purchase up to $4,000,000 of the Company’s Common Stock at a price of approximately $5.29 per share at any time until December 31, 2019, subject to adjustment as set forth in the Initial Warrant.  Under the Original Agreement, Fletcher also received the right to make additional equity investments of up to $4,000,000 in total (the “Later Investments”) by May 2, 2011 at the average of the daily volume-weighted price of the Company’s Common Stock in the calendar month preceding each Later Investment notice date at prices no lower than approximately $4.76 per share and no greater than approximately $6.35 per share, subject to adjustment as set forth in the Original Agreement.    The warrants issued to Fletcher have down-round and anti-dilution provisions as of December 31, 2010, and are considered derivative liabilities recorded at fair value. The down-round provisions result in the number of shares to be issued determined on a variable that is not an input to the fair value of a “fixed-for-fixed” option.  Under the Original Agreement, Fletcher also received a second warrant (the “Second Warrant”) to purchase shares of the Company’s Common Stock with an aggregate purchase price of up to the total dollar amount of the Later Investments at a per-share exercise price of 120% of the per-share price paid in the final Later Investment to occur, subject to adjustment as set forth in the Second Warrant.   The Initial Warrant and the Second Warrant each also have a cashless exercise provision.

Under the Amended Agreement, the purchase price for the Initial Investment made on December 31, 2010 was increased to $5.38 per share, increasing the aggregate purchase price paid by Fletcher for the Initial Investment from $4,000,000 to $4,068,825. The Initial Warrant received by Fletcher was amended and reissued (the “Amended Initial Warrant”) entitling Fletcher to purchase newly-issued shares of Common Stock at $5.38 per share (the “Warrant Price”) at any time until February 18, 2020 (the “Warrant Term”), up to an aggregate purchase price of $4,300,000 (the “Warrant Amount”). Under the Amended Agreement, Fletcher also received the right to make additional equity investments (“Later Investments”) of up to $4,068,000 (the “Aggregate Later Investment Amount”) provided notice is given to the Company prior to July 2, 2011 of Fletcher’s intention to make Later Investments. The Second Warrant received by Fletcher was amended (the “Amended Second Warrant”, and together with the Amended Initial Warrant, the “Warrants”) to fix the Warrant Price at $5.38 per share. The Second Warrant entitles Fletcher to purchase newly-issued shares of Common Stock up to the aggregate purchase price of the Later Investments. The Amended Initial Warrant and the Amended Second Warrant each have a cashless exercise provision.

In connection with the Amended Agreement, the Company was required to file a registration statement with the SEC covering the Initial Investment of 756,287 shares and 799,256 shares underlying the Initial Warrant, and to have such registration statement declared effective no later than April 15, 2011. The Company filed Amendment No. 1 to S-3 Registration Statement with the SEC on March 7, 2011 in accordance with the requirements of the Amended Agreement. If Fletcher makes any Later Investment purchases of the Company’s Common Stock, the Company would have similar registration requirements. In the event that any registration statement is not timely filed or declared effective, or is not kept effective and available in accordance with the Amended Agreement, the Company will be obligated to pay certain amounts to Fletcher as set forth in the Amended Agreement.

 

  On March 14, 2011, the Company and Fletcher executed further amendments to the Amended and Restated Agreement and Warrants addressing stockholder approval and pricing provisions relating to Change of Control (as defined therein). The March 14, 2011 amendments were executed by the Company and Fletcher in response to an NYSE Amex inquiry, and were required to solidify NYSE Amex approval of the Company’s additional listing applications, which approval was received from NYSE Amex on March 15, 201 1. The Company filed Amendment No. 2 to S-3 Registration Statement with the SEC on March 25, 2011.

 

 

F-16

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Certain events, such as dividends, stock splits, and other events specified in the Amended Agreement and in the Warrants may result in additional shares of Common Stock being issued to Fletcher, adjustments being made to the terms of the Later Investments, the Initial Warrant or the Second Warrant, or other results, in each case as set forth in the Amended Agreement, the Amended Initial Warrant and the Amended Second Warrant.   The terms of the Amended Agreement granted Fletcher certain participation rights in certain later equity issuances by the Company  (except for certain exclusions) and certain other rights upon a change of control, in each case as set forth in the Amended Agreement, the Amended Initial Warrant and the Amended Second Warrant.

 

Proceeds from the transaction will be used primarily for sales and marketing, product development, and working capital. The Company will pay WM Smith & Co., as placement agent, a cash placement fee of 6% of all cash investments received under the Amended Agreement, or in the case of the cashless exercise of the Warrants, common stock equal to 6% of the shares issued to Fletcher in conjunction with the cashless exercise.   As of December 31, 2010, the Company accrued $240,000 for placement agent fees paid in January 2011.

             Derivative Liabilities

The warrants issued to Fletcher have down-round and anti-dilution provisions as of December 31, 2010, and are considered derivative liabilities recorded at fair value. The down-round provisions result in the number of shares to be issued determined on a variable that is not an input to the fair value of a “fixed-for-fixed” option. The Company recognizes the derivative liabilities at their respective fair values at inception and on each reporting date.  The derivative liabilities are considered Level 3 liabilities on the fair value hierarchy as the determination of fair value includes various assumptions about our future activities and the Company’s stock prices and historical volatility as inputs. To determine the fair value of the various components of the Fletcher investments, the Company selected the binomial option model and the Monte Carlo Simulation to model the financial characteristics of the various components.   The derivative liabilities were initially recorded in the consolidated balance sheet upon issuance as of December 31, 2010 at a fair value of $3,866,836.   Future changes in the fair value of the derivatives liabilities, if any, will be recorded in the statement of operations as gains or losses from derivative liabilities.

The components of the derivative liability, measured at fair value, are summarized as follows at December 31:

 

		2010
Initial Warrant		$	3,482,486
Later Investment Rights			384,350
		$	3,866,836

The table below provides a reconciliation of the beginning and ending balances for the liabilities measured at fair value using significant unobservable inputs (Level 3). There were no assets as of or during the year ended December 31, 2010 measured using significant unobservable inputs.

Fair Value Measurements Using Significant Unobservable Inputs (Level 3):

 

		Derivative Liabilities
Balance, January 1, 2010		$	-
Fair Value upon issuance:
Expensed at issuance			-
Allocated to net proceeds			3,866,836
Balance, December 31, 2010		$	3,866,836

 

 

F-17

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Stock Warrants - During 2010, in conjunction with the private placements described above, the Company issued an aggregate of 922,009 warrants to purchase the Company’s shares of common stock at exercise prices ranging from $3.50 to $5.38, as described above.  In addition, in connection with the Fletcher Investment (as described above), the Company issued a contingent warrant  for the purchase of up to the amount of the Later Investment of the Company’s common stock at a price contingent on the purchse price of the Later Investment, but not less than $5.71 per share.  In addition, during 2010, the Company issued to the holders of a Convertible Note warrants to purchase up to 40,000 shares of the Company’s common stock within five years at $2.00 per share as compensation for a registration rights penalty.

During 2009, in conjunction with the private placements described above, the Company issued an aggregate of 202,000 warrants to purchase the Company’s shares of common stock at an exercise price of $2.00, as described above.  In addition, during 2009, the Company issued to the holders of a Convertible Note warrants to purchase up to 65,000 shares of the Company’s common stock within five years at $2.00 per share.  On October 21, 2009, the Company entered into a consulting agreement with Vertical Innovations and agreed to issue the consultant five year warrants to purchase 50,000 shares of the Company's common stock at $3.00, 100,000 shares of common stock at $3.50 and 50,000 shares of common stock at $4.00.  The Company estimated the value of these warrants at approximately $258,000 as of December 31, 2009 using the Black-Scholes option pricing model which the Company expects to record the measurement date fair value as expense over a two year period.  On November 19, 2009, the Company entered into an agreement with Baum Capital for which Baum Capital would execute up to an aggregate amount of $275,000 of Letters of Credit on behalf of the Company’s subsidiary, DPI, for the extension of credit from certain of DPI’s paper vendors. In exchange, the Company issued to Baum Capital warrants to purchase 50,000 shares of the Company's common stock at $2.00.  The Company valued these warrants at approximately $56,000 using the Black-Scholes option pricing model which the Company expects to record as expense over a one year period.  On December 7, 2009, the Company reached an agreement to issue 40,000 shares of common stock and 50,000 of common stock warrants for the purchase of common shares at $3.00 per share for a period of three years from November 23, 2009, in connection with the settlement of certain litigation between the Company and the recipients.  The value of the stock amounted to $85,000 based on the closing price the day the agreement was reached.  The fair value of the warrants of approximately $29,500 was determined utilizing the Black Scholes pricing model.  The aggregate cost of approximately $115,000 is recognized in the statement of operations under Litigation Settlements.  During 200 9,  the Company recorded expense of approximately $110,000 for the fair value of 40,000 warrants to purchase the shares of the Company’s common stock at $2.00 issuable to Printer’s LLC as a result of the Company’s failure to file a registration statement under the terms of the $450,000 Convertible Note the Company entered into in December 2009.

The following is a summary with respect to warrants outstanding and exercisable at December 31, 2010 and 2009 and activity during the years then ended:

 

			2010								2009
			Warrants				Weighted Average Exercise Price				Warrants				Weighted Average Exercise Price
Outstanding January 1			1,318,020			$	6.15				761,032			$	8.73
Granted during the year			962,009				5.02				556,988				2.63
Exercised			(363,398	)			(2.16	)			-				-
Lapsed			(25,000	)			(12.59	)			-				-
Outstanding at December 31			1,891,631			$	6.26				1,318,020			$	6.15
Exercisable  at December 31			1,891,631			$	6.26				1,118,020			$	6.63
Weighted average months remaining
							44.2								43.0

 

 

F-18

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Stock Options - The Company has two stock-based compensation plans.  The 2004 Employees’ Stock Option Plan (the “2004 Plan”) provides for the issuance of up to a total of 1,700,000 shares of common stock authorized to be issued for grants of options, restricted stock and other forms of equity to employees and consultants.  Under the terms of the 2004 Plan, options granted thereunder may be designated as options which qualify for incentive stock option treatment (“ISOs”) under Section 422A of the Internal Revenue Code, or options which do not qualify (“NQSOs”).  The exercise price for options granted under the Director Plan is 100% of the fair market value of the Common Stock on the date of grant. The Non-Executive Director Stock Option Plan (the “Director Plan”) provides for the issuance of up to a total of 200,000 shares of common stock authorized to be issued for options grants for non-executive directors and advisors.  Under the terms of the Director Plan, an option to purchase (a) 5,000 shares of our common stock shall be granted to each non-executive director upon joining the Board of Directors and (b) 5,000 shares of our common stock plus an additional 1,000 shares of our common stock for each year that the applicable director has served on the Board of Directors, up to a maximum of 10,000 shares per year shall be granted to each non-executive director thereafter on January 2nd of each year; provided that any non-executive director who has not served as a director for the entire year immediately prior to January 2nd shall receive a pro rata number of options based on the time the director has served in such capacity during the previous year.  Both Plans were adopted by the Company’s shareholders.

The following is a summary with respect to options outstanding at December 31, 2010 and 2009 and activity during the years then ended:

 

		2004 Employee Plan												Non-Executive Director Plan
		Number of Options				Weighted Average Exercise Price				Weighted Average Life Remaining				Number of Options				Weighted Average Exercise Price				Weighted Average Life Remaining
										(in years)												(in years)
Outstanding at December 31, 2008			663,500				7.27								115,750			$	7.99
Granted			274,000				4.00								40,000				1.86
Exercised			-				-								-				-
Forfeited			(298,500	)			(6.37	)							(23,750	)			(4.59	)
Outstanding at December 31, 2009:			639,000				6.29								132,000				6.74
Granted			185,000				3.40								40,000				2.45
Exercised			-				-								-				-
Forfeited			(150,500	)			5.54								(15,000	)			(7.14	)
Outstanding at December 31, 2010:			673,500				5.66				2.6				157,000				5.61				2.4
Exercisable at December 31, 2010:			329,850				7.64				1.4				117,000				6.69				1.8
Aggregate Intrinsic Value of outstanding options at December 31, 2010		$	631,225											$	258,800
Aggregate Intrinsic Value of exercisable options at December 31, 2010		$	116,969											$	141,200

 

The weighted-average grant date fair value of options granted during the year ended December 31, 2010 was $1.38 ($0.53 -2009). The aggregate grant date fair value of options that vested during the year was approximately $128,000.  There were no options exercised during the year ended December 31, 2010 or 2009.

The fair value of each option award is estimated on the date of grant utilizing the Black Scholes Option Pricing Model that uses the assumptions noted in the following table.

 

 

F-19

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	2010		2009
Volatility	54.3	%	54.7	%
Expected option term	3.8	years	3.9	years
Risk-free interest rate	2.5	%	2.3	%
Expected forfeiture rate	0.0	%	0.0	%
Expected dividend yield	0.0	%	0.0	%

Restricted Stock Issued to Employees – Restricted common stock is issued under the 2004 Plan for services to be rendered and may not be sold, transferred or pledged for such period as determined by our Compensation Committee.  Restricted stock compensation cost is measured as the stock’s fair value based on the quoted market price at the date of grant.   The restricted shares issued reduce the amount available under the employee stock option plans.   Compensation cost is recognized only on restricted shares that will ultimately vest.  The Company estimates the number of shares that will ultimately vest at each grant date based on historical experience and adjust compensation cost and the carrying amount of unearned compensation based on changes in those estimates over time.   Restricted stock compensation cost is recognized ratably over the requisite service period which approximates the vesting period.  An employee may not sell or otherwise transfer unvested shares and, in the event that employment is terminated prior to the end of the vesting period, any unvested shares are surrendered to us.  We have no obligation to repurchase any restricted stock.

The following is a summary of activity of restricted stock during the years ended at December 31, 2010 and 2009:

 

			Shares				Weighted- average Grant Date Fair Value
Restricted shares outstanding, December 31, 2008			327,781			$	9.05
Restricted shares granted			-				-
Restricted shares vested			(30,281	)			(6.77	)
Restricted shares forfeited			(212,500	)			(10.05	)
Restricted shares outstanding, December 31, 2009			85,000			$	7.61
Restricted shares granted			-				-
Restricted shares vested			-				-
Restricted shares forfeited			(40,000	)			(2.10	)
Restricted shares outstanding, December 31, 2010			45,000			$	12.50

As of December 31, 2010, there are 45,000 restricted shares that will vest only upon the occurrence of certain through May 2012 which include, among other things a change of control of the Company or other merger or acquisition of the Company, the achievement of certain financial goals, including among other things a successful result of the Company’s patent infringement lawsuit against the European Central Bank.   These 45,000 shares, if vested, would result in the recording of stock based compensation expense of approximately $562,500, the grant date fair value, over the period beginning when any of the contingent vesting events is deemed to be probable over the expected requisite service period.  As of December 31, 2010, vesting is not considered probable and no compensation expense has been recognized related to the performance grants.

Stock-Based Compensation   – Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards.   During the year ended December 31, 2010, the Company had stock compensation expense of approximately $423,000 or $0.02 per share ($292,000- 2009; $0.02 per share).     As of December 31, 2010, there was approximately $368,000 of total unrecognized compensation costs (excluding the $562,500 that vest upon the occurrence of certain events) related to non-vested options and restricted stock granted under the Company’s stock option plans which the Company expects to vest over a period of not to exceed five years.

 

 

F-20

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NOTE 8.  –DECONSOLIDATION OF LEGALSTORE DIVISION

On October 8, 2009, the Company entered into an Asset Purchase Agreement with Internet Media Services whereby the Company sold the assets and liabilities of Legalstore, a division of the Company with assets of approximately $252,000 and liabilities of $13,000, in exchange for 7,500,000 shares of common stock of Internet Media Services.  The Company recorded its investment in Internet Media Services as an equity method investment at the fair market value of the business sold.   Management determined that the transaction did not qualify as a non-monetary exchange due to the exception noted in FASB ASC 845-10 ( [ A transfer of assets to an entity in exchange for an equity interest in that entity).  Management determined that the transaction qualified as a derecoginition of a subsidiary under FASB ASC 810-10-40.  Therefore, the Company accounted for the deconsolidation of a subsidiary (“the business”) by recording the consideration received at fair market value and recognizing a gain in net income measured as the difference between: the fair value of the consideration received (7,500,000 shares of common stock of Internet Media Services or a 37% interest) and the carrying value of the assets and liabilities sold.  Given that the consideration received is not readily measurable because of the lack of activity in Internet Media Services shares prior to the transaction, the Company determined that the value of the “business transferred” is more readily measurable by determining the fair market value of the business transferred based on a discounted cash flow model amounted to $350,000, which resulted in a gain of approximately $26,000 which is included in the consolidated statement of operations.   The Company recorded the equity method investment at fair value.  Under the equity method investment the Company was required to account for the difference between the cost of an investment and the amount of the underlying equity in net assets of an investee as if the investee were a consolidated subsidiary.  If the investor is unable to relate the difference to specific accounts of the investee ( e.g. , property and equipment), the difference should be considered to be the same as goodwill.  Investors shall not amortize goodwill associated with equity method investments after the date FASB ASC 350 is initially applied by the entity in its entirety.  The Company determined that given the lack of activity in Internet Media Services shares prior to the transaction, the difference between the cost of the investment (fair market value) and the underlying equity interest is attributable to goodwill.  The Company is continuing to report the activity in operating loss and not breaking out and reporting it as discontinued operations because the operations and cash flows of the component have not been eliminated from the ongoing operations of the entity as a result of the equity method investment and because the Company had significant continuing involvement in the operations of Internet Media Services after the disposal transaction because of the ownership percentage and board representation.    The Company recognized gains or losses on its investment under the equity method of accounting for investments.   During 2010, the Company recorded a cumulative loss in its investment of $121,000.   On September 23, 2010, the Company’s Board of Directors declared a dividend whereas the Company would distribute to its stockholders of record on October 8, 2010 on a pro-rata basis its shares of stock in Internet Media Services.  As a result, the Company has recorded a dividend of approximately $229,000 which was the book value of the investment as of September 23, 2010.

NOTE 9.  –BUSINESS COMBINATIONS

On February 12, 2010, the Company acquired all of the outstanding common stock of Premier Packaging from Robert B. and Joan T. Bzdick for $2,000,000 in cash and 735,437 shares of the Company's common stock with a value of $2,566,675 at February 12, 2010.  In addition, the purchase price was subject to increase if the capital gains tax rate that was in effect as of February 12, 2010 is retroactively increased by legislation or otherwise whereas the seller’s tax on its gain increases, which did not occur.   In addition, the seller had registration rights for its shares to which the Company was subject to registration penalties of up to $5,000 per month after 120 days, which the sellers waived

The acquisition has been accounted for as a business combination, whereby the Company measured the identifiable assets acquired and liabilities assumed based on the acquisition date fair value.  The Company incurred approximately $30,000 of acquisition related legal and professional fees that were expensed in the period in which they were incurred.   The Company is required to recognize and measure any related goodwill acquired in the business combination or a gain from a bargain purchase.  Management determined that the fair value of the assets acquired and liabilities assumed was less than the purchase price resulting in the recording of goodwill.   Goodwill totaling approximately $627,000 represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired, which included $861,000 for customer relationships and $511,000 for non-compete agreement, and is due primarily to expected increased market penetration from future products in the secure packaging market s and synergies expected from combining packaging capabilities of Premier Packaging with the printing capabilities of the Company’s DPI division.   The goodwill recorded with the transaction is not deductible for income taxes.

 

F-21

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The Company engaged a valuation expert, The Financial Valuation Group, to assist management in determining the fair value of the assets acquired.  The allocation of the purchase price and the estimated useful lives associated with the acquired assets and liabilities is as follows:

 

Fair value of the consideration transferred		$	4,566,675		Estimated Useful Lives
Fair value of assets acquired and liabilities assumed:
Cash		$	5,290
Accounts receivable			1,284,227
Inventories			504,162
Machinery and equipment			1,557,500		3 to 7 years
Other intangible assets			1,372,000		5 to 10 years
Goodwill			627,360
Total Assets		$	5,350,539
Liabilities assumed:
Accounts payable		$	448,128
Revolving credit lines			277,645
Accrued Liabilities			58,091
Total Liabilities		$	783,864
Total prelimary purchase price		$	4,566,675

Set forth below is the unaudited proforma revenue, operating loss, net loss and loss per share of the Company as if Premier Packaging had been acquired by the Company as of January 1, 2009.

 

		Year Ended December 31,
(unaudited)		2010				2009
Revenue			14,265,949				17,011,427
Operating Loss			(3,961,963	)			(3,170,288	)
Net Loss			(4,671,527	)			(3,526,173	)
Basic and diluted loss per share			(0.26	)			(0.24	)

 

Since the acquisition, Premier Packaging had sales of $5,753,000 and profit of $54,000.

 

NOTE 10. – OTHER INCOME

The Company received $143,000 during 2010 and $416,000 during 2009 for New York State Qualified Emerging Technology Company (“QETC”) refundable tax credits for the tax years ended 2008, 2007, 2006, and 2005.

 

 

F-22

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NOTE 11. - INCOME TAXES

Following is a summary of the components giving rise to the income tax provision (benefit) for the years ended December 31:

The provision (benefit) for income taxes consists of the following:
		2010				2009
Currently payable:
Federal		$	-			$	-
State			-				-
Total currently payable			-				-
Deferred:
Federal			(1,150,645	)			(1,113,695	)
State			(274,396	)			(265,310	)
Total deferred			(1,425,041	)			(1,379,005	)
Less increase in allowance			1,443,990				1,397,957
Net deferred			18,949				18,952
Total income tax provision (benefit)		$	18,949			$	18,952

 

Individual components of deferred taxes are as follows:
Deferred tax assets:			2010				2009
Net operating loss carry forwards		$	11,909,891			$	10,330,310
Equity issued for services			801,204				1,006,186
Other			138,291				425,619
Total			12,849,386				11,762,115
Less valuation allowance			(11,903,718	)			(11,600,983	)
Gross deferred tax assets		$	945,668			$	161,132
Deferred tax liabilities:
Goodwill		$	87,452			$	69,665
Depreciation and amortization			947,995				162,297
Gross deferred tax liabilities		$	1,035,447			$	231,962
Net deferred tax liabilities		$	(89,779	)		$	(70,830	)

 

During 2010, the Company acquired the stock of Premier Packaging.  As part of the business combination, various intangible assets and equipment with fair market values of $1, 372,000 and $1,557,500, respectively, were recorded along with  a deferred tax liability of approximately $1,141,000.

The Company has approximately $32,114,000 in net operating loss carryforwards (“NOL’s”) available to reduce future taxable income, of which approximately $1,412,000 is subject to change of control limitations that generally restricts the utilization of the NOL per year and $1,855,000 of the NOL will be allocated to contributed capital when subsequently realized.  Due to the uncertainty as to the Company’s ability to generate sufficient taxable income in the future and utilize the NOL’s before they expire, the Company has recorded a valuation allowance accordingly.  The excess tax benefits associated with stock option exercises are recorded directly to stockholders’ equity only when realized.  As a result, the excess tax benefits included in net operating loss carryforwards but not reflected in deferred tax assets was approximately $1,019,000. .These carryforwards expire at various dates from 2022 through 2030.   In addition, a portion of the valuation allowance amounting to approximately $318,000 will be recorded as a reduction to additional paid in capital in the event that it is determined that a valuation allowance is no longer considered necessary.

 

F-23

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The differences between the United States statutory federal income tax rate and the effective income tax rate in the accompanying consolidated statements of operations are as follows:

 

			2010				2009
Statutory United States federal rate			34	%			34	%
State income taxes net of federal benefit			4.0				4.4
Permanent differences			(6.5	)			(3.8	)
Change in valuation reserves			(31.9	)			(35.1	)
Effective tax rate			(0.4	) %			(0.5	) %

 

At December 31, 2010 and 2009, the total unrecognized tax benefits of $446,000 have been netted against the related deferred tax assets.

 

The Company recognizes interest accrued and penalties related to unrecognized tax benefits in tax expense. During the years ended December 31, 2010 and 2009 the Company recognized no interest and penalties.

 

The Company files income tax returns in the U.S. federal jurisdiction and various states. The tax years 2007-2010 generally remain open to examination by major taxing jurisdictions to which the Company is subject.

 

NOTE 12. - DEFINED CONTRIBUTION PENSION PLAN

The Company has an Employee savings plan (the “401(k) Plan”) which qualifies as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code which covers its employees at its Document Security Systems, P3 and DPI subsidiaries.  Employees become eligible to participate in the Plan at the beginning of the following quarter after the employee’s hire date.  Employees may contribute up to 20% of their pay to the Plan, subject to the limitations of the Internal Revenue Code.   Company matching contributions are discretionary. Pursuant to the 401(k) Plan, employees may elect to defer a portion of their salary on a pre-tax basis.  During the years ended December 31, 2010 and 2009, the Company did not make any matching contributions.   In addition, the Company’s subsidiary, Premier Packaging, which the Company acquired in February 2010, has a 401(k) Plan which allows for employee salary deferrals with Premier Packaging matching benefits of up to 3% of the employee’s salary.  The matching contribution for 2010 was approximately $25,000.

NOTE 13. – COMMITMENTS AND CONTINGENCIES

Facilities - The Company leases a total of approximately 95,000 square feet of office space for its administrative offices and its printing facilities at a monthly rental aggregating approximately $49,000. The leases expire at various dates through February 2020, although renewal options exist to extend lease agreements for up to an additional 60 months.  The Company’s lease for its Premier Packaging facility is with the Company’s COO Bob Bzdick, a related party.   The total rent expense for the facility lease with Mr. Bzdick during the year ended December 31, 2010 amounted to approximately $147,000.  Future minimum lease commitments under the facility lease with Mr. Bzdick subsequent to December 31, 2010 are approximately $160,000 per year for the next five years and $735,000 thereafter.

Equipment Leases  - The Company leases digital and offset presses, laminating and finishing equipment for its various printing operations. The leases may be capital leases or operating leases and are generally for a term of 36 to 60 months.   The leases expire through March 2016.

 

F-24

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A summary of lease commitments, including related party lease to Mr. Bzdick, at December 31, 2010 are as follows:

						Operating Leases
		Capital Leases				Equipment				Facilities				Total
Payments made in 2010		$	107,052			$	662,701			$	568,115			$	1,230,816
Future minimum lease commitments:
2011			107,052				625,218				627,639				1,252,857
2012			94,453				439,912				515,540				955,452
2013			5,665				296,284				525,366				821,650
2014			-				245,100				313,898				558,998
2015			-				228,300				178,333				406,633
Thereafter			-				54,450				735,000				789,450
Total future minimum lease commitments		$	207,170			$	1,889,264			$	2,895,776			$	4,785,040
Less amount representing interest			(19,862	)
Present value of future minimum lease
commitments			187,308
Less current portion			(88,776	)
Long term portion		$	98,532

 

Employment agreements - The Company has employment agreements with four members of its management team with terms ranging from one to 10 years through February 2020. The agreements provide for severance payments in the event of termination for certain causes. As of December 31, 2010, the minimum annual severance payments under these employment agreements are, in aggregate, approximately $1,098,000.

 

In May 2008, the Company entered into a Separation Agreement with its former President that, among other things, accelerated the vesting of 33,333 shares of restricted common stock of the Company that were previously awarded to the former President pursuant to the Company’s 2004 Employee Stock Option Plan so that such shares vested in equal monthly installments during the immediately following ten months.  The Separation Agreement further provided that if the former President did not realize at least $212,000 in gross proceeds from the sale of such 33,333 shares of restricted stock upon their vesting, then the Company would pay the former President the amount that such proceeds is less than $212,000 in cash or additional shares of common stock of the Company.  As of December 31, 2010, there is no remaining amount due under the agreement. ($74,000 -2009)

 

Contingent Litigation Payment – In May 2005, the Company made an agreement with its legal counsel in charge of the Company’s litigation with the European Central Bank which capped the fees for all matters associated with that litigation at $500,000 plus expenses, and a $150,000 contingent payment upon a successful ruling or settlement on the Company’s behalf in that litigation.  The Company will record the $150,000 in the period in which the Company has determined that a successful ruling or settlement is probable.

 

In addition, pursuant to an agreement made in December 2004, the Company is required to share the economic benefit derived from settlements, licenses or subsequent business arrangements that the Company obtains from any infringer of patents formerly owned by the Wicker Family.  For infringement matters involving certain U.S. patents, the Company will be required to disburse 30% of the settlement proceeds.  For infringement matters involving certain foreign patents, the Company will be required to disburse 14% of the settlement proceeds.  These payments do not apply to licenses or royalties to patents that the Company has developed or obtained from persons other than the Wicker Family.  As of December 31, 2010, there have been no settlement amounts related to these agreements.

 

Legal Proceedings -On August 1, 2005, the Company commenced a suit against the ECB alleging patent infringement by the ECB and claimed unspecified damages. We brought the suit in the European Court of First Instance in Luxembourg.  We alleged that all Euro banknotes in circulation infringe the Company European Patent 0 455 750B1 (the “Patent”), which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices.  The Court of First Instance ruled on September 5, 2007 that it does not have jurisdiction to rule on the patent infringement claim, and also ruled that we will be required to pay attorneys and court fees of the ECB.  The ECB formally requested the Company to pay attorneys and court fees in the amount of Euro 93,752 which, unless the amount is settled will be subject to an assessment procedure that has not been initiated, the Company will accrue as soon as the assessed amount, if any, is reasonably estimable.

 

F-25

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 In 2006, the Company received notices that the ECB had filed separate claims in each of the United Kingdom, The Netherlands, Belgium, Italy, France, Spain, Germany, Austria and Luxembourg courts seeking the invalidation of the Patent.  Proceedings were commenced before the national courts seeking revocation and declarations of invalidity of the Patent.  On March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in London, England  ruled that the Patent was deemed invalid in the United Kingdom, and on March 19, 2008 this decision was upheld on appeal.   As a result of these decisions, the Company was notified of the final assessment of the reimbursable ECB costs for both court cases was ₤356,490, of which all was paid as of December 31, 2010.

On March 27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that the German part of the Patent was valid, having considered the English Court’s decision.  On July 6, 2010, the Company was notified that the German Court has ruled that the Patent, that was awarded to the Company by the European Patent Office and upheld as valid in a previous hearing in the German Court of First Instance, has now been deemed invalid in Germany due to added matter.  On January 9, 2008 the French Court held that the Patent was invalid in France for the same reasons given by the English Court.  The Company filed an appeal against the French decision on May 7, 2008. On March 20, 2010, the Company was informed that the decision was upheld in the French appeal.  On March 12, 2008 the Dutch Court  ruled that the Patent is valid in the Netherlands.  The ECB filed an appeal against the Dutch decision on March 27, 2008.  The Dutch appeal was heard in June 2010, and the Company was notified on December 21, 2010 that the patent was deemed invalid upon appeal.  On November 3, 2009, the Belgium Court held that the Patent was invalid in Belgium for the same reasons given by the English and French courts as were similarly informed by the Austrian court on November 17, 2009.   Cost reimbursement, if any, associated with the Belgium, Austrian, and French validity cases as well as the appeals in Germany and France are covered under the Trebuchet agreement described below.  On March 24, 2010 the Spanish Court ruled that the Patent was valid.  In Italy the validity case is to be heard again by a newly appointed judge expected during 2011 and a hearing in Luxembourg thereafter.

On August 20, 2008, the Company entered into an agreement with Trebuchet under which Trebuchet agreed to pay substantially all of the litigation costs associated validity proceedings in eight European countries relating to the Patent.  Trebuchet also agreed to pay substantially all of the litigation costs associated with any future validity challenges filed by the ECB or other parties, provided that Trebuchet elects to assume the defense of any such challenges, in its sole discretion, and patent infringement suits filed against the ECB and certain other alleged infringers of the Patent, all of which suits may be brought at the sole discretion of Trebuchet and may be in the name of the Company, Trebuchet or both. The Company provided Trebuchet with the sole and exclusive right to manage infringement litigation relating to the Patent in Europe, including the right to initiate litigation in the name of the Company, Trebuchet or both and to choose whom and where to sue, subject to certain limitations set forth in the agreement under the terms of the Agreement, and in consideration for Trebuchet's funding obligations, the Company assigned and transferred a 49% interest of the Company's rights, title and interest in the Patent to Trebuchet which allows Trebuchet to have a separate and distinct interest in and share of the Patent, along with the right to sue and recover in litigation, settlement or otherwise to collect royalties or other payments under or on account of the Patent. In addition, the Company and Trebuchet have agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. Trebuchet is also entitled to recoup any litigation expenses specifically awarded to the Company in such actions.

The Patent has thus been confirmed to be valid and enforceable in one jurisdiction (Spain) that uses the Euro as its national currency allowing the Company or Trebuchet, on the Company’s behalf, to proceed with infringement cases in this country if we choose to do so.   On February 18, 2010, Trebuchet, on behalf of the Company, filed an infringement suit in the Netherlands.  The suit was being lodged against the ECB and two security printing entities with manufacturing operations in the Netherlands, Joh. Enschede Banknotes B.V.; and Koninklijke Joh. Enschede B.V.  and was cancelled upon determination on Dcember 21, 2010, that the patent was invalid in the Netherlands.

On January 31, 2003, the Company commenced an action, unrelated to the above ECB litigation, entitled New Sky Communications, Inc., As Successor-In-Interest To Thomas M. Wicker, Thomas M.Wicker Enterprises, Inc. and Document Security Consultants V. Adler Technologies, Inc. N/K/A Adlertech International, Inc. and Andrew McTaggert (United States District Court, Western District Of New York Case No.03-Cv-6044t(F)) regarding certain intellectual property in which the Company has an interest.  On December 7, 2009, the Company reached an agreement to terminate all litigation in association with this suit.  In conjunction with that agreement, the Company issued to the opposing parties an aggregate of 40,000 shares of common stock valued at approximately $85,000 and 50,000 of common stock warrants for the purchase of common shares at $3.00 per share valued at approximately $30,000 utilizing the Black Scholes pricing model.  The Company recorded an expense related to the estimated grant date fair value of the shares and warrants issued of approximately $115,000.   In addition, both parties agreed not to compete with certain of the other party’s customers for 7 years.  The Company does not believe that the competition agreement will have a material impact on its business.

 

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In addition to the foregoing, we are subject to other legal proceedings that have arisen in the ordinary course of business and have not been finally adjudicated. Although there can be no assurance in this regard, in the opinion of management, none of the legal proceedings to which we are a party, whether discussed herein or otherwise, will have a material adverse effect on our results of operations, cash flows or our financial condition.

 

NOTE 14. - SUPPLEMENTAL CASH FLOW INFORMATION

 

		2010				2009
Cash paid for interest		$	302,000			$	157,000
Non-cash investing and financing activities:
Conversion of debt to equity			800,000				2,000,000
Equity issued for severance agreements			74,000				55,000
Non-monetary dividend			229,000				-
Equity issued for acqusition			2,567,000				-
Equity issued for prepaid services			115,000				56,000
Accrued placement agent fees			240,000				-
Issuance of derivative liability instruments			3,867,000				-
Interest rate swap loss			26,000				-
Equipment purchased via capital lease			-				63,000
Warrants issued with debt			-				72,000
Beneficial conversion features of convertible debt			-				351,000
Equity method investment received in exchange for the assets and liabilities of Legalstore.com			-				350,000

 

NOTE 15. - SEGMENT INFORMATION

The Company's businesses are organized, managed and internally reported as four operating segments.  Three of these operating segments, Document Security Systems, P3 and DPI, are engaged in various aspects of developing and applying printing technologies and procedures to produce, or allow others to produce, documents with a wide range of features, including the Company’s patented technologies and trade secrets, along with traditional commercial printing on paper and plastic.    For the purposes of providing segment information, these three operating segments have been aggregated into one reportable segment in accordance with FASB ASC 280.  The fourth operating segment is engaged in the production of packaging products and is classified as a separate segment.    A summary of the three segments follows:

 

Security and Commercial Printing		License, manufacture and sale of patented document security technologies, including digital security print solutions, and general commercial printing, primarily on paper and plastic,comprises the operations of Document Security Systems, P3 and DPI.
Packaging		The Company acquired Premier Packaging in February 12, 2010 which produces packaging products such as boxes, mailers, and point of sale displays for various end-users.
Legal Supplies		Sale of specialty legal supplies, primarily to lawyers and law firms located throughout the United States as Legalstore. During the fourth quarter of 2009, the Company sold its legal products business to Internet Media Services in exchange for Internet Media Services common stock.

 

 

 

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Approximate information concerning the Company’s operations by reportable segment as of and for the years ended December 31, 2010 and 2009 is as follows.  The Company relies on intersegment cooperation and management does not represent that these segments, if operated independently, would report the results contained herein:

 

2010		Legal Supplies				Security and Commercial Printing				Packaging Division				Corporate				Total
Revenues from external customers		$	-			$	7,629,000			$	5,753,000			$	-			$	13,382,000
Interest Expense and amortization of note discount			-				34,000				78,000				598,000				710,000
Stock based payments			-				-				-				115,000				115,000
Impairment of patent acquisition costs and other intangible assets			-				377,000				-				-				377,000
Depreciation and amortization			-				955,000				299,000				7,000				1,261,000
Net (loss) profit			-				(2,633,000	)			54,000				(2,025,000	)			(4,604,000	)
Capital Expenditures			-				59,000				98,000				-				157,000
Identifiable assets			-				4,357,000				5,324,000				4,126,000				13,807,000
Revenues from transactions with other operating segments of the Company.			-				326,000				110,000				-				436,000
Other income, net			-				-				-				143,000				143,000
Loss on equity investment			-				-				-				(121,000	)			(121,000	)
Income tax expense or benefit.			-				-				-				19,000				19,000
Stock based compensation			-				224,000				18,000				181,000				423,000
2009
Revenues from external customers		$	355,000			$	9,556,000			$	-			$	-			$	9,911,000
Interest Expense and amortization of note discount			-				363,000				-				146,000				509,000
Stock based payments			-				-				-				292,000				292,000
Depreciation and amortization			16,000				1,644,000				-				2,000				1,662,000
Net (loss) profit			40,000				(2,353,000	)			-				(1,400,000	)			(3,713,000	)
Capital Expenditures			-				302,000				-				-				302,000
Identifiable assets			-				6,276,000				-				439,000				6,715,000
Other income, net			-				-				-				232,000				232,000
Income tax expense or benefit.			-				-				-				19,000				19,000
Stock based compensation			-				73,000				-				(5,000	)			68,000

 

International revenue, which consists of sales to customers with operations in Western Europe, Latin America, Africa, Mddle East and Asia comprised 2% of total revenue for 2010, (3%- 2009).  Revenue is allocated to individual countries by customer based on where the product is shipped to, location of services performed or the location of equipment that is under an annual maintenance agreement.  The Company had no long-lived assets in any country other than the United States for any period presented.

 

Major Customers –

During 2010, two customers accounted for 25% and 10% of the Company’s total revenue from continuing operations, respectively.   As of December 31, 2010, these customers accounted for 37% and 7% of the Company’s trade accounts receivable balance, respectively.  During 2009, two customers accounted for 19% and 12% of the Company’s total revenue from continuing operations, respectively.  As of December 31, 2009, two customers’ account receivable balance accounted for 21% and 17% of the Company’s trade accounts receivable balance, respectively.  The risk with respect to trade receivables is mitigated by credit evaluations we perform on our customers, the short duration of our payment terms for the significant majority of our customer contracts and by the diversification of our customer base.

 

 

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NOTE 16. – SUBSEQUENT EVENTS

 

As discussed in Note 7, on February 18, 2011, and subsequently on March 14, 2011, the Company entered into certain amendments with Fletcher for the purpose of modifying the terms of an agreement previously entered into between the Company and Fletcher on December 31, 2010.  As a result of the amendments, the down-round and anti-dilution provisions were eliminated, therefore, the Company determined that the derivative liabilities that existed under the terms of the original agreement no longer exist.  As a result, the Company will revalue these derivative liability instruments as of the modification date with the change in fair value reported in the statement of operations.  The Company will then reclass the derivative liability to equity.    Furthermore, the March 14, 2011 amendments were executed by the Company and Fletcher in response to an NYSE Amex inquiry, and were required to solidify NYSE Amex approval of the Company’s additional listing applications, which approval was received from NYSE Amex on March 15, 2011.

 

 

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