| FOCUS ENHANCEMENTS INC Item 1A Risk Factors You should carefully consider the following risks relating to our business and our common stock, together with the other information described herein |
| If any of the following risks actually occur, our business, results of operations and financial condition could be materially adversely affected, the trading price of our common stock could decline, and you might lose all or part of your investment in our common stock |
| Risks Related to Our Business We have a long history of operating losses |
| As of December 31, 2005, we had an accumulated deficit of dlra89dtta4 million |
| We incurred net losses of dlra15dtta4 million, dlra11dtta0 million and dlra1dtta7 million for the years ended December 31, 2005, 2004 and 2003, respectively |
| There can be no assurance that we will ever become profitable |
| Additionally, our independent registered public accounting firm has included an explanatory paragraph in its report on our consolidated financial statements for the year ended December 31, 2005 with respect to substantial doubt about our ability to continue as a going concern |
| The consolidated financial statements do not include any adjustments that might result from the outcome of that uncertainty |
| We will need to raise additional capital, which, if through equity securities placements, will result in further dilution of existing and future stockholders |
| Historically, we have met our short- and long-term cash needs through debt issuances and the sale of common stock in private placements, because cash flow from operations has been insufficient to fund our operations |
| Set forth below is information regarding net proceeds received recently through private placements of our common stock: (In thousands) Private Placements of Common Stock Exercise of Stock Options and Warrants 2005 $ 4cmam531 $ 152 2004 $ 10cmam741 $ 192 2003 $ 1cmam920 $ 3cmam437 Future capital requirements will depend on many factors, including cash flow from operations, continued progress in research and development programs, competing technological and market developments, and our ability to market our products successfully |
| We received gross proceeds of dlra10cmam000cmam000 from the issuance of secured convertible notes to a group of private investors in January 2006 |
| While we believe that these funds, along with the cash flow generated by our expanding Systems business, should be adequate to enable us to complete our UWB engineering development and launch commercialization of UWB products, depending upon the results and timing of our UWB initiative and the profitability of our Systems business, we may need to raise further capital in 2006 |
| There can be no assurance that sufficient funds will be raised |
| Furthermore, any additional debt financing will result in higher interest expense |
| 9 ______________________________________________________________________ Our common stock currently does not meet the minimum bid price requirement to remain listed on the Nasdaq Capital Market |
| If we were to be delisted, it could make trading in our stock more difficult |
| Our voting common stock is traded on the Nasdaq Capital Market |
| There are various quantitative listing requirements for a company to remain listed on the Nasdaq Capital Market, including maintaining a minimum bid price of dlra1dtta00 per share of common stock and maintaining stockholders’ equity of dlra2dtta5 million |
| On November 23, 2005, the Nasdaq Stock Market notified us that for the previous 30 consecutive business days, the bid price of our common stock had closed below the minimum dlra1dtta00 per share price requirement for continued inclusion under Nasdaq Marketplace Rules |
| We have until May 22, 2006 to regain compliance with the Nasdaq Capital Market dlra1dtta00 minimum bid price rule |
| If at any time before this date the bid price of our common stock closes at dlra1dtta00 or more per share for a minimum of ten consecutive business days, Nasdaq will notify us that we are in compliance with the Rules |
| If we do not regain compliance within the allotted compliance period, including any extensions that may be granted by Nasdaq, Nasdaq will notify us that our common stock will be delisted from The Nasdaq Capital Market, eliminating the only established trading market for our shares |
| We would then be entitled to appeal this determination to a Nasdaq Listing Qualifications Panel and request a hearing |
| In the event we are delisted from the Nasdaq Capital Market, we would be forced to list our shares on the OTC Electronic Bulletin Board or some other quotation medium, such as the pink sheets, depending on our ability to meet the specific listing requirements of those quotation systems |
| As a result, an investor might find it more difficult to trade, or to obtain accurate price quotations for, such shares |
| Delisting might also reduce the visibility, liquidity, and price of our voting common stock |
| We are dependent upon a significant shareholder to meet our financing needs and there can be no assurance that this shareholder will continue to provide financing |
| We have relied upon the ability of Carl Berg, a director and significant owner of our common stock, for interim financing needs |
| Berg has provided a personal guarantee to Samsung Semiconductor Inc, our contracted ASIC manufacturer, to secure our working capital requirements for ASIC purchase order fulfillment and a personal guarantee to Greater Bay Bank in connection with our dlra4dtta0 million accounts receivable-based line of credit facility and dlra2dtta5 million term loan |
| In connection with these guarantees, Mr |
| Berg maintains a security interest in all the company’s assets, subject to the bank’s lien on our accounts receivable |
| There can be no assurances that Mr |
| Berg will continue to provide such interim financing or personal guarantees, should we need additional funds or increased credit facilities with our vendors |
| We have a significant amount of convertible securities that will dilute existing stockholders upon conversion |
| At March 17, 2006, we had 3cmam161 shares of preferred shares issued and outstanding, and 6cmam063cmam865 warrants and 6cmam996cmam582 options outstanding, which are all exercisable into shares of common stock |
| The 3cmam161 shares of preferred stock are convertible into 3cmam161cmam000 shares of our voting common stock |
| Furthermore, at March 17, 2006, 769cmam947 additional shares of common stock were available for grant to our employees, officers, directors and consultants under our current stock option and incentive plans |
| We also may issue additional shares in acquisitions |
| Any additional grant of options under existing or future plans or issuance of shares in connection with an acquisition will further dilute existing stockholders |
| Delays in product development could adversely affect our market position or customer relationships |
| We have experienced delays in product development in the past and may experience similar delays in the future |
| Given the short product life cycles in the markets for certain products, any delay or unanticipated difficulty associated with new product introductions or product enhancements could cause us to lose customers and damage our competitive position |
| Prior delays have resulted from numerous factors, such as: • changing product specifications; • the discontinuation of certain third party components; • difficulties in hiring and retaining necessary personnel; • difficulties in reallocating engineering resources and other resource limitations; • difficulties with independent contractors; 10 ______________________________________________________________________ • changing market or competitive product requirements; • unanticipated engineering complexity; • undetected errors or failures in software and hardware; and • delays in the acceptance or shipment of products by customers |
| The development of new, technologically advanced products, including our significant investment in UWB, is a complex and uncertain process requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends |
| In order to compete, we must be able to deliver products to customers that are highly reliable, operate with the customer’s existing equipment, lower the customer’s costs of acquisition, installation and maintenance, and provide an overall cost-effective solution |
| We may not be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis |
| Further, our new products may not gain market acceptance or we may not be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards |
| Our failure to respond effectively to technological changes would significantly harm our business |
| Finally, there can be no assurances we will be successful in these efforts |
| We rely on certain vendors for a significant portion of our manufacturing |
| If these vendors experience delays in the production and shipping of our products, this would have an adverse effect on our results of operations |
| Approximately 72prca of the components for our products are manufactured on a turnkey basis by four vendors: BTW Inc, Furthertech Company Ltd, Samsung Semiconductor Inc |
| and Veris Manufacturing |
| If these vendors experience production or shipping problems for any reason, we in turn could experience delays in the production and shipping of our products, which would have an adverse effect on our results of operations |
| We are dependent on our suppliers |
| If our suppliers experience labor problems, supply shortages or product discontinuations, this would have an adverse effect on our results of operations |
| We purchase all of our parts from outside suppliers and from time-to-time experience delays in obtaining some components or peripheral devices |
| Additionally, we are dependent on sole source suppliers for certain components |
| There can be no assurance that labor problems, supply shortages or product discontinuations will not occur in the future, which could significantly increase the cost, or delay shipment, of our products, which in turn could adversely affect our results of operations |
| If we fail to meet certain covenants required by our credit facilities, we may not be able to draw down on such facilities and our ability to finance our operations could be adversely affected |
| We have a dlra4dtta0 million credit line under which we can borrow up to 90prca of our eligible outstanding accounts receivable and a dlra2dtta5 million term loan |
| The various agreements in connection with such credit line and term loan require us to maintain certain covenants |
| In the event we violate the covenants and are not able to obtain a waiver for any covenant violation, and/or remain out of compliance with a particular covenant, we will not be able to draw down on the line of credit or term loan, and any amounts outstanding under such line of credit or term loan may become immediately due and payable, either of which could have a material adverse impact on our financial condition and results of operation |
| Furthermore, the restrictions contained in the line of credit and term loan documents, as well as the terms of other indebtedness we may incur from time-to-time, could limit our ability to plan for or react to market conditions or meet capital needs or otherwise restrict our activities or business plans |
| These restrictions could also adversely affect our ability to finance our operations or other capital needs, or to engage in other business activities that would be in our interest |
| If we are unable to renew or extend our existing line of credit or term loan when they naturally expire, our ability to finance our operations could be adversely affected |
| We have a dlra2dtta5 million term loan and a dlra4dtta0 million credit line facility with the same bank |
| Both these credit facilities expire on December 24, 2006 |
| If we are unable to renew the term loan or credit line on favorable terms upon their natural expiration, we would be required to immediately pay all outstanding obligations under such term loan and credit line |
| 11 ______________________________________________________________________ Repayment of the principal amounts and interest due under these facilities could adversely affect our other capital requirements, as well as our ability to finance our operations on an ongoing basis |
| We depend on a few customers for a high percentage of our revenues and the loss or failure to pay of any one of these customers could result in a substantial decline in our revenues and profits |
| For year ended December 31, 2005, our five largest customers in aggregate provided 26prca of our total revenues and as of December 31, 2005, comprised 45prca of our accounts receivable balance |
| We do not have long-term contracts requiring any customer to purchase any minimum amount of products |
| There can be no assurance that we will continue to receive orders of the same magnitude as in the past from existing customers or will be able to market our current or proposed products to new customers |
| The loss of any major customer, the failure of any such identified customer to pay us, or to discontinue issuance of additional purchase orders, would have a material adverse effect on our revenues, results of operation, and business as a whole, absent the timely replacement of the associated revenues and profit margins associated with such business |
| Furthermore, many of our products are dependent upon the overall success of our customers’ products, over which we often have no control |
| Our quarterly financial results are subject to significant fluctuations and if actual revenues are less than projected revenues, we may be unable to reduce expenses proportionately, and our operating results, cash flows and liquidity would likely be adversely affected |
| We have been unable in the past to accurately forecast our operating expenses or revenues |
| Revenues currently depend heavily on volatile customer purchasing patterns |
| If actual revenues are less than projected revenues, we may be unable to reduce expenses proportionately, and our operating results, cash flows and liquidity would likely be adversely affected |
| Our markets are subject to rapid technological change, and to compete effectively, we must continually introduce new products, requiring significant influx of additional capital |
| Many of our markets are characterized by extensive research and development and rapid technological change resulting in short product life cycles |
| Development by others of new or improved products, processes or technologies may make our products or proposed products obsolete or less competitive |
| We must devote substantial efforts and financial resources to enhance our existing products and to develop new products, including our significant investment in UWB technology |
| To fund such ongoing research and development, we will require a significant influx of additional capital |
| Failure to effectively develop such products, notably our UWB technology, could have a material adverse effect on our financial condition and results of operations |
| We may not be able to protect our proprietary information |
| As of December 31, 2005 we held six patents and four pending applications in the United States |
| Certain of these patents have also been filed and issued in countries outside the United States |
| We treat our technical data as confidential and rely on internal non-disclosure safeguards, including confidentiality agreements with employees, and on laws protecting trade secrets, to protect our proprietary information |
| There can be no assurance that these measures will adequately protect the confidentiality of our proprietary information or prove valuable in light of future technological developments |
| There can be no assurance that third parties will not assert infringement claims against us or that such assertions will not result in costly litigation or require us to license intellectual proprietary rights from third parties |
| In addition, there can be no assurance that any such licenses would be available on terms acceptable to us, if at all |
| If we are unable to respond to rapid technological change in a timely manner, then we may lose customers to our competitors |
| To remain competitive, we must continue to enhance and improve the responsiveness, functionality and features of our products |
| Our industry is characterized by rapid technological change, changes in user and customer requirements and 12 ______________________________________________________________________ preferences and frequent new product and service introductions |
| If competitors introduce products and services embodying new technologies, or if new industry standards and practices emerge, then our existing proprietary technology and systems may become obsolete |
| Our future success will depend on our ability to do the following: • both license and internally develop leading technologies useful in our business; • enhance our existing technologies; • develop new services and technology that address the increasingly sophisticated and varied needs of our prospective customers; and • respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis |
| To develop our proprietary technology entails significant technical and business risks |
| We may use new technologies ineffectively, or we may fail to adapt our proprietary technology and transaction processing systems to customer requirements or emerging industry standards |
| If we face material delays in introducing new services, products and enhancements, then our customers may forego the use of our services and use those of our competitors |
| We typically operate without a significant amount of backlog, which could have an adverse impact on our operating results |
| Accordingly, we generally do not have a material backlog of unfilled orders, and revenues in any quarter are substantially dependent on orders booked in that quarter |
| Any significant weakening in current customer demand would therefore have, and has had in the past, an almost immediate adverse impact on our operating results |
| Our common stock price is volatile |
| The market price for our voting common stock is volatile and has fluctuated significantly to date |
| For example, between January 1, 2005 and March 17, 2006, the per share price has fluctuated between dlra0dtta62 and dlra1dtta22 per share, closing at dlra0dtta66 on March 17, 2006 |
| The trading price of our voting common stock is likely to continue to be highly volatile and subject to wide fluctuations in response to factors including the following: • actual or anticipated variations in our quarterly operating results; • announcements of technological innovations or failures, new sales formats or new products or services by us or our competitors; • cyclical nature of consumer products using our technology; • changes in financial estimates by us or securities analysts; • changes in the economic performance and/or market valuations of other multi-media, video scan companies; • announcements by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments; • additions or departures of key personnel; • additions or losses of significant customers; and • sales of common stock or issuance of other dilutive securities |
| In addition, the securities markets have experienced extreme price and volume fluctuations in recent times, and the market prices of the securities of technology companies have been especially volatile |
| These broad market and industry factors may adversely affect the market price of common stock, regardless of actual operating performance |
| In the past, following periods of volatility in the market price of stock, many companies have been the object of securities class action litigation, including us |
| If we are sued in a securities class action, then it could result in additional substantial costs and a diversion of management’s attention and resources |
| 13 ______________________________________________________________________ We are subject to various environmental laws and regulations that could impose substantial costs upon us and may adversely affect our business |
| Some of our operations are subject to state, federal, and international laws governing protection of the environment, human health and safety, and regulating the use of certain chemical substances |
| We endeavor to comply with these environmental laws, yet compliance with such laws could increase our operations and product costs |
| Any violation of these laws can subject us to significant liability, including fines and penalties, and prohibit sales of our products into one or more states or countries, and result in a material adverse effect on our financial condition |
| Recent environmental legislation within the European Union (EU) may increase our cost of doing business internationally and impact our revenues from EU countries as we comply with and implement these new requirements |
| The European Parliament has enacted the Restriction on Use of Hazardous Substances Directive, or “RoHS Directive”, which restricts the use of certain hazardous substances in electrical and electronic equipment |
| We need to redesign products containing hazardous substances regulated under the RoHS Directive to reduce or eliminate regulated hazardous substances in our products |
| As an example, certain of our products include lead, which is included in the list of restricted substances |
| Although we believe our semiconductor products now comply with the RoHS Directive, certain of our systems products do not yet comply |
| We are in the process of working towards compliance relative to these systems products but do not expect all our systems products to meet the requirements of the RoHS Directive by the required implementation date of July 1, 2006 |
| This failure to meet the requirements by the implementation date could result in our being unable to sell certain products into the EU market until such compliance is achieved and could also result in inventory write-offs if compliance is not obtained in timely fashion |
| These circumstances could have an adverse effect on our sales and results of operations |
| Any acquisitions of companies or technologies by us may result in distraction of our management and disruptions to our business |
| We may acquire or make investments in complementary businesses, technologies, services or products if appropriate opportunities arise, as was the case in February 2004 when we acquired the stock of COMO and in May 2004 when we acquired substantially all the assets of Visual Circuits |
| From time-to-time, we may engage in discussions and negotiations with companies regarding the possibility of acquiring or investing in their businesses, products, services or technologies |
| We may not be able to identify suitable acquisition or investment candidates in the future, or if we do identify suitable candidates, we may not be able to make such acquisitions or investments on commercially acceptable terms, if at all |
| If we acquire or invest in another company, we could have difficulty assimilating that company’s personnel, operations, technology or products and service offerings |
| In addition, the key personnel of the acquired company may decide not to work for us |
| These difficulties could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect the results of operations |
| Furthermore, we may incur indebtedness or issue equity securities to pay for any future acquisitions and/or pay for the legal, accounting or finders fees, typically associated with an acquisition |
| The issuance of equity securities could be dilutive to our existing stockholders |
| In addition, the accounting treatment for any acquisition transaction may result in significant goodwill and intangible assets, which, if impaired, will negatively affect our consolidated results of operations |
| The accounting treatment for any potential acquisition may also result in a charge for in-process research and development expense, as was the case with the acquisition of Visual Circuits, which will negatively affect our consolidated results of operations |
| We are exposed to potential risks from legislation requiring companies to evaluate financial controls under Section 404 of the Sarbanes-Oxley Act of 2002 |
| Section 404 of the Sarbanes-Oxley Act of 2002 requires that we evaluate and report on our system of internal controls |
| We will be required to meet the requirements of the Sarbanes-Oxley Act by December 31, 2006 if our market capitalization, adjusted for certain items, is greater than dlra75 million on June 30, 2006, otherwise we must meet the requirements by December 31, 2007 |
| Compliance with the requirements of Section 404 is expected to be expensive and time-consuming |
| If we fail to complete this evaluation in a timely manner, or if our independent registered public accounting firm cannot timely attest to our evaluation, we could be subject to regulatory scrutiny and a loss of public confidence in our internal controls |
| In addition, any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligations |
| 14 ______________________________________________________________________ Risks Related to Our Industry International sales are subject to significant risk |
| Our revenues from outside the United States are subject to inherent risks related thereto, including currency rate fluctuations, the general economic and political conditions in each country |
| There can be no assurance that an economic or currency crisis experienced in certain parts of the world will not reduce demand for our products and therefore have a material adverse effect on our revenue or operating results |
| Our businesses are very competitive |
| The computer peripheral markets are extremely competitive and are characterized by significant price erosion over the life of a product |
| We currently compete with other developers of video conversion products and with video-graphic integrated circuit developers |
| Many of our competitors have greater market recognition and greater financial, technical, marketing and human resources |
| There can be no assurance that we will be able to compete successfully against existing companies or new entrants to the marketplace |
| The video production equipment market is highly competitive and is characterized by rapid technological change, new product development and obsolescence, evolving industry standards and significant price erosion over the life of a product |
| Competition is fragmented with several hundred manufacturers supplying a variety of products to this market |
| We anticipate increased competition in the video post-production equipment market from both existing manufacturers and new market entrants |
| Increased competition could result in price reductions, reduced margins and loss of market share, any of which could materially and adversely affect our business, financial condition and results of operations |
| There can be no assurance that we will be able to compete successfully against current and future competitors in this market |
| Often our competitors have greater financial, technical, marketing, sales and customer support resources, greater name recognition and larger installed customer bases than we possess |
| In addition, some of our competitors also offer a wide variety of video equipment, including professional video tape recorders, video cameras and other related equipment |
| In some cases, these competitors may have a competitive advantage based upon their ability to bundle their equipment in certain large system sales |
| Recent corporate bankruptcies, accounting irregularities, and alleged insider wrong doings have negatively affected general confidence in the stock markets and the economy, causing the United States Congress to enact sweeping legislation, which will increase the costs of compliance |
| In an effort to address growing investor concerns, the United States Congress passed, and on July 30, 2002, President Bush signed into law, the Sarbanes-Oxley Act of 2002 |
| This sweeping legislation primarily impacts investors, the public accounting profession, public companies, including corporate duties and responsibilities, and securities analysts |
| Some highlights include establishment of a new independent oversight board for public accounting firms, enhanced disclosure and internal control requirements for public companies and their insiders, required certification by CEO’s and CFO’s of Securities and Exchange Commission financial filings, prohibitions on certain loans to offices and directors, efforts to curb potential securities analysts’ conflicts of interest, forfeiture of profits by certain insiders in the event financial statements are restated, enhanced board audit committee requirements, whistleblower protections, and enhanced civil and criminal penalties for violations of securities laws |
| Such legislation and subsequent regulations will increase the costs of securities law compliance for publicly traded companies such as us |