SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-KSB
(Mark One)
[x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
For the fiscal year ended December 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
Commission file number 000-32319
ESSENTIAL REALITY, INC.
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(Name of small business issuer in its charter)
NEVADA 33-0851302
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(State or other jurisdiction of incorporation or (I.R.S. Employer Identification No.)
organization)
49 WEST 27TH STREET, SUITE 7E, NEW YORK, NEW YORK 10001
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(Address of principal executive offices, including zip code)
(212) 244-3200
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(Issuer's telephone number, including area code)
Securities registered under Section 12(b) of the Exchange Act: NONE
Securities registered under Section 12(g) of the Exchange Act:
COMMON STOCK, PAR VALUE $.001 PER SHARE
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(Title of Class)
Check whether the issuer: (1) filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12
months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes [ ] No [X ]
Check if no disclosure of delinquent filers in response to Item 405 of
Regulation S-B is contained in this form, and no disclosure will be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendments to this Form 10-KSB. [X]
State issuer's revenues for its most recent fiscal year: $112,602
Based upon the closing price of the issuer's Common Stock on June 17,
2003, the aggregate market value of the shares of Common Stock held by
non-affiliates of the issuer was $2,811,616. Solely for the purposes of this
calculation, shares held by directors and officers of the issuer have been
excluded. Such exclusion should not be deemed a determination or an admission by
the issuer that such individuals are, in fact, affiliates of the issuer.
As of March 31, 2003, there were 18,223,110 shares of the issuer's
Common Stock issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE: None
TABLE OF CONTENTS
PAGE NO.
PART I
Item 1. Description of Business................................................... 3
Item 2. Description of Property................................................... 19
Item 3. Legal Proceedings......................................................... 19
Item 4. Submission of Matters to a Vote of Security Holders....................... 20
PART II
Item 5. Market for Common Equity and Related Stockholder Matters.................. 20
Item 6. Management's Discussion and Analysis or Plan of Operation................. 21
Item 7. Financial Statements...................................................... 33
Item 8. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure....................................... 33
PART III
Item 9. Directors and Executive Officers of the Registrant........................ 34
Item 10. Executive Compensation.................................................... 39
Item 11. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters... ............................ 40
Item 12. Certain Relationships and Related Transactions............................ 42
Item 13. Exhibits, List and Reports on Form 8-K.................................... 44
Item 14. Controls and Procedures................................................... 45
Signatures.................................................................................. 46
Section 302 Certifications.................................................................. 47
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CERTAIN INFORMATION CONTAINED OR INCORPORATED BY REFERENCE IN THIS FILING WITH
THE SECURITIES AND EXCHANGE COMMISSION ON FORM 10-KSB THAT IS NOT PURELY
HISTORICAL ARE FORWARD-LOOKING STATEMENTS, WITHIN THE MEANING OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995, THAT ARE BASED ON MANAGEMENT'S
BELIEFS, CERTAIN ASSUMPTIONS AND CURRENT EXPECTATIONS. THESE STATEMENTS MAY BE
IDENTIFIED BY THEIR USE OF FORWARD-LOOKING TERMINOLOGY SUCH AS THE WORDS
"EXPECTS," "PROJECTS," "ANTICIPATES," "INTENDS" AND OTHER SIMILAR WORDS. SUCH
FORWARD-LOOKING STATEMENTS INVOLVE RISKS AND UNCERTAINTIES THAT COULD CAUSE
ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE PROJECTED. THESE RISKS AND
UNCERTAINTIES INCLUDE, BUT ARE NOT LIMITED TO, GENERAL ECONOMIC, BUSINESS AND
MARKET CONDITIONS, COMPETITIVE PRICING PRESSURES, TIMELY DEVELOPMENT AND
ACCEPTANCE OF NEW PRODUCTS, AND THE HIGHLY COMPETITIVE MARKET IN WHICH WE
OPERATE. CERTAIN OF THESE RISKS AND UNCERTAINTIES ARE DISCUSSED MORE FULLY IN
PART II, "MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION - FACTORS
AFFECTING OPERATING RESULTS" AND ELSEWHERE IN THIS REPORT. THE FORWARD-LOOKING
STATEMENTS CONTAINED HEREIN ARE MADE AS OF THE DATE HEREOF AND WE, EXCEPT AS MAY
BE REQUIRED BY LAW, DO NOT UNDERTAKE ANY OBLIGATION TO UPDATE ANY
FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF FUTURE EVENTS, NEW
INFORMATION OR OTHERWISE.
PART I
ITEM 1. DESCRIPTION OF BUSINESS.
BACKGROUND
Essential Reality, Inc., a Nevada corporation formerly known as JPAL,
Inc. was incorporated on March 31, 1999. Our original line of business was to
provide vacation rental properties and services for the Year 2000 New Year's Eve
celebration in Las Vegas. Afterwards, we continued as an Internet-based provider
of vacation rental properties and services. In August 2001, we suspended
operations and the development of our website, in order to focus our attention
on our business combination with Essential Reality, LLC.
Essential Reality, LLC was organized in 1999 as a developer of
real-time tracking and sensory technologies. From its formation through the date
of its dissolution as a result of the business combination, it was involved in
research and development, marketing, entering into strategic relationships and
hiring key employees in connection with the final production, sale and
distribution of the P5(TM). The P5(TM), a virtual controller, is a glove-like
peripheral device that enables users to control the action on a screen through
simple hand movements, rather than complicated keystroke and mouse combinations.
This product is based on patented, and several patent-pending, technologies that
address technological limitations of current devices, such as the mouse,
hand-held game controllers and joysticks. The P5(TM) is engineered to capture
five-finger bend sensitivity enabling gesture recognition, combined with an
optical tracking technology that captures the movement of the hand in 3D space,
without the use of a mouse, joystick, keyboard or the like. For example, if a
user is trying to open a door while playing an adventure game, the P5TM allows
the user to make the hand motion of opening a door and see the door open
simultaneously with the motion, as opposed to the user pressing a button and
seeing the door open immediately thereafter. To date, the P5(TM) is the only
product that we have developed and marketed.
On June 20, 2002, we consummated the business combination and began
operating Essential Reality, LLC's line of business exclusively. The purpose of
the transaction was to allow us to acquire and carry on Essential Reality's
business as a public company, thereby enhancing the business' visibility and
providing a means through the public markets to additional sources of capital.
We have focused on combining our patented and patent pending
technologies into products that enhance the interaction between human beings and
personal computers, game consoles, computer tablets and other related devices,
collectively known as computer platforms. Our first product, the P5(TM), is
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currently available for sale to retailers and is directly offered to consumers
for sale on our website as well as the website of one of the game developers for
which the P5(TM) is currently enabled. Many of our retail vendors received the
P5(TM) the week of November 4, 2002.
We believe the P5(TM) is suitable for multiple applications including:
o ELECTRONIC GAMING - games produced for play on personal computers,
game consoles and location-based entertainment sites;
o COMMERCIAL APPLICATIONS - such as animation, computer aided design
(CAD), simulation training, disability and education; and
o PERSONAL APPLICATIONS - Internet browsing and navigation, and general
computer interaction.
Since the advent of the mouse, relatively little has changed in the way
of computer input devices, despite the fact that computers and applications have
changed dramatically, growing increasingly complex and specialized.
Applications, particularly in the electronic gaming and commercial markets, have
migrated from flat two-dimensional (2D) interfaces to intuitive,
three-dimensional (3D) environments. However, input devices continue to be
dominated by 2D products including mouse controllers and gaming-specific
peripherals such as joysticks, steering wheels, proprietary console controllers
and the like.
The P5(TM) is based on our patented and several patent-pending
technologies, one of which was incorporated in the "Power Glove." The Power
Glove was introduced to the market in the late 1980s as an alternative
controller for use only with the 8-bit Nintendo Entertainment System, part of
the first generation of game consoles sold to the mass market. The product
eventually sold approximately one million units in the United States, Europe and
Japan. Subsequent to a decline in consumer demand for first-generation gaming
consoles in the early 1990s, such Nintendo system ceased sales. Therefore, the
Power Glove technology was not used nor further developed, awaiting the return
of computer platforms and applications that could benefit from its utility.
With the significant increase in sales of computer platforms and
applications in the late 1990s, Essential Reality, LLC engaged developers in
1999 to create a peripheral device based on Essential Reality, LLC's belief that
the consumer and commercial markets were ripe for a product with the
capabilities of the P5(TM). The P5(TM) has been engineered to capture
five-finger bend sensitivity enabling gesture recognition, combined with an
optical tracking technology that will capture the movement of the hand in 3D
space with six degrees of freedom (X, Y, Z, yaw, pitch and roll), without the
use of the mouse, joystick, keyboard or the like.
The P5(TM) is a lightweight and comfortable peripheral, which is a
Universal Serial Bus (USB) based product that will allow for direct "plug and
play" in personal computers as well as the Sony PlayStation2 game console. There
are approximately 27 million computer peripherals that are USB-compatible and
the growth of these products is anticipated to reach over 400 million by the
year 2003.
In bringing the P5(TM) to market, we have proven our expertise in
innovating and developing products applicable to the mass market. Due to less
than expected sales of the P5(TM), however, we have recently changed our focus
and now aim to become a leading developer and distributor of unique,
technology-based consumer electronics, gaming products and consumer youth
products targeted to youths in the mass market. We see our products being
divisible into three lines of business, aligned along broad product and
technical categories, as described below. In order to achieve sales and
distribution synergies, we expect that all lines of business will produce
youth-oriented, mass market products sold
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through the same distribution channels. However, each line of business may
employ different product development strategies to achieve market share.
P5(TM) TECHNOLOGIES. Through December 31, 2002, the P5 was the only
line of business. This line of business will continue to focus on
combining our patented and patent pending technologies into products
that enhance the interaction between human beings and personal
computers, game consoles, computer tablets and other related devices,
collectively known as computer platforms. This focus stems from our
expertise in high-tech fields of sensing and tracking. Due to the
highly innovative capabilities of these technologies, we believe there
are numerous market opportunities for products based on the P5(TM)
technologies. Our goal is to enter markets with additional products
priced from $79 to $149. We will also continue to seek distribution
channels for the P5(TM), as well as strategic partnership
opportunities, both domestically and internationally.
CONSUMER ELECTRONICS. We will search for unmet needs in mass markets
where our expertise in technology can significantly enhance the value
of unique electronic products. That is, we hope to create value for our
target market by selling innovative technologies at new price points.
We aim to sell products of sophistication and value for $19 to $79,
depending on the cost of the technology involved. The innovations that
will drive this division may be technical, functional, or cost-related.
We will opportunistically scan the market for products that could
benefit from our skills in increasing the functionality of basic
technologies, or designing complex technologies for manufacturing with
lower cost solutions.
CONSUMER YOUTH PRODUCTS. We expect that the product development
strategy for this segment of our business will be highly opportunistic.
We intend to search for unique products that can meet popular price
points (from $5.99 to $29.99 retail). In some cases, product
development may be driven by entertainment and brand licensing, where
we can add a technical innovation that will clearly distinguish the
product among the masses of other popular priced consumer youth
products and games with electronic components. As such, the success of
our strategy rests on our ability to discover low-cost methods for
applying and manufacturing innovative technologies.
BUSINESS STRATEGY
Through December 31, 2002 our strategy had been to establish ourselves
as a leading developer of real-time tracking and sensory technologies by
establishing and fostering demand for our initial product, the P5(TM), in three
distinct markets - electronic gaming, commercial markets and personal
applications both domestically and internationally. As of December 31, 2002, the
Company only sold products in the electronic gaming markets. We have promoted
content integration and development across numerous markets through various
initiatives such as providing free software development kits (SDKs), allocating
resources for content integration initiatives, and bundling product with new
content that is P5(TM)-enabled. By leveraging the unique functionality of the
P5(TM) at a mass market price point, we have attempted to differentiate
ourselves from our competitors.
Through research and development, we will attempt to determine the best
ways to maximize the scope of applications for our optical tracking, bending and
sense motion technologies and the most effective products for those
applications. We hope to work with software developers in creating programs that
can best take advantage of our proprietary technologies. We also intend to work
with hardware engineers to determine the best composition of equipment to sense
and capture the remote bending of an object. We may seek to license some or all
of our products and technologies. In addition to research and development and
consultation with developers and engineers, other ways in which we
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hope to accomplish our goals are through continuing consumer interest, public
relations and targeted marketing.
Currently we are focusing on leveraging our core competency in research
and development, and believe we will be able to distinguish our products in the
market by adding technological innovations to unique concepts at competitive,
mass market price points. We plan to expand our retail sales force around these
products to grow our reputation among retailers as a reliable source of unique,
value-added products that the youth market demands. In this way, we believe that
we can expand our retail distribution channels and increase our market share
accordingly.
Historically, our revenue streams have been generated from retail sales
and direct sales of the P5(TM). Because of the limited life of the P5tm, the
company does not expect to earn significant revenue from it but from diverse and
related products. With the expansion of our business focus we believe that any
additional revenue streams will diversify our customer base and reduce operating
risk by making us less dependent on one specific product.
INDUSTRY OVERVIEW
MARKET SIZING AND KEY DRIVERS
Electronic Gaming. We operate as part of the global video game console,
peripheral, and software industry, which is currently estimated at over $28
billion worldwide and over $9.4 billion in the U.S., based on estimates from
Global Information Inc. The global electronic gaming peripheral segment alone
generated approximately $4.2 billion in sales in 2001 and is expected to reach
$5.8 billion in 2003. Gaming software sales in the U.S., which are expected to
drive demand for gaming-related peripherals, grew to $1.42 billion in 2002 from
$1.36 billion in 2000, despite the overall decline in a variety of technology
segments. Key drivers affecting the growth of this industry have been the broad
acceptance of next generation game platforms with faster processing power,
advances in technology that make games more realistic and interactive, greater
memory, online capabilities and DVD media formats - all of which offer new
opportunities to electronic entertainment software companies and peripherals
manufacturers.
Commercial Markets. Our future sales of the P5(TM) will also be driven
by the growth and changes in the computer-aided design (CAD), engineering (CAE),
and manufacturing (CAM) as well as 3D animation software markets. According to
Penton Digital Media Research, the 3D CAD market is expected to grow by over 34%
annually to reach $2.3 billion in 2005. In the 3D content creation segment,
which includes the tools used in 3D content applications in film, game, Web and
design segments, the world-wide market is estimated to be $384 million, growing
25% annually and expected to reach over $1.17 billion by 2005. Key drivers
affecting these markets include improvements in data sharing, storage of complex
CAD files and increased design collaboration over the Internet throughout a
product's lifecycle.
Consumer Electronics. The consumer electronics segment of the toy industry
generated $23 billion in sales in 2000, according to the Toy Manufacturers
Association. With our new focus on the technology-based consumer electronics
market, we hope to capture a portion of this market share.
EVOLVING TRENDS
Current trends in the peripheral industry include:
o Increased complexity of peripheral devices, including tactile feedback
and 3D capabilities;
o Wireless communication between peripherals and devices;
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o Increased precision that is enabling more robust commercial
applications in CAD and robotics;
o Game production cycles are getting shorter, requiring 3D tool vendors
to deliver better, more integrated tools to software developers;
o Decreases in component prices and innovations in product design and
construction; and o Development of more natural interaction between
man and machine.
Moreover, we believe that the following trends may impact the development of
consumer electronics and consumer youth products. We believe that our technical
competency and market awareness could allow us to capitalize on these trends and
capture market share:
o Increasing processing power at decreasing costs;
o Taking advantage of component cost efficiencies, combined with
innovations in product design and construction;
o Increasing miniaturization components and products;
o Increasing demand for popular price point products;
o Multiple, growing populations of users dedicated to specific gaming
platforms (e.g. PlayStation2, Gameboy Advance); and
o Increasing consumer and commercial demand for wireless communication
between peripherals and devices.
PRODUCT OVERVIEW
THE P5(TM)
The P5(TM) is designed as a low-cost and intuitive man-machine
interface for both 2D and 3D software applications. The P5(TM) serves as a
peripheral to personal computers, game consoles and other USB-compatible
platforms.
FIGURE 1: THE P5(TM) GLOVE AND OPTICAL TRACKER
BEND-SENSOR CAPABILITIES
[GRAPHIC OMITTED]
[CAPTIONS FOR GRAPHIC]
ADJUSTABLE GRIPS FOR IR TRANSPARANT
DIFFERENT FINGER SIZES ANTI-REFLECTIVE, ANTI-
SCRATCH LENS
PATENTED BEND
SENSOR TECHNOLOGY SPACE TO REST GLOVE
FOR HIGH FIDELITY WHEN NOT IN USE
MOVEMENTS
MINI-DIN CONNECTOR
PATENT-PENDING FOR GLOVE
LED OPTICAL
TRACKING SYSTEM WEIGHTED WITH
BUMP FEET TO
PREVENT MOVEMENT
ON ANY SURFACE
The P5(TM) consists of a hand-worn glove-like device with embedded
electronics. The product utilizes our patented bend sensor technology to
accurately determine the bend of the user's five fingers.
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The sensing of the finger bend is accomplished via conductive inks with variable
electrical resistance, detected by position changes of the fingers from a
pre-set baseline. The P5(TM) is capable of gesture recognition based on specific
placement of thumb/finger digits and can detect whether or not your fingers are
in the same position as previously recorded.
MOTION-CAPTURE CAPABILITIES
The P5(TM) also tracks the relative position of the hand in space using
a patent-pending optical tracking technology. This "triangulation technology"
tracks a hand's starting position and movement. The term "triangulation
technology" refers to the way in which the coordinates of a specific point in a
three dimensional environment is determined. "Triangulation" is a mathematical
term that describes the use of two separate cameras which track one point and
determine its exact position in a three dimensional environment.
The P5(TM) supports X, Y, Z, "yaw" (defined as movement along a plane
parallel to the ground) , "pitch" (defined as movement along an axis that is
parallel to the top of the hand and perpendicular to the wrist, such that it
would enter the wrist below the thumb and exit below the little finger) and
"roll" (defined as rotation of the hand about an axis parallel to the ground,
entering the hand at the tip of the middle finger and running through the wrist
parallel to the forearm positioning). Refer to Figure 2 below for a graphical
depiction of the specific hand movements that the P5(TM) is able to track.
The tracking technology utilizes glove-mounted light emitting diodes
(LEDs) to enable a complete six-degrees-of-freedom positioning solution. The
P5(TM) uses passive LEDs, which means that it transmits a beam of light that
causes the optical tracker to alert the software program to take the action
specified by the user's motion. Active LEDs transmit a beam of light together
with the information that causes the program to take the action specified.
FIGURE 2: X, Y, Z, YAW, PITCH AND ROLL DIAGRAM
[GRAPHIC OMITTED]
COMPATIBILITY
The first generation P5(TM) was initially designed for compatibility
with the following personal computer operating systems: Microsoft Windows 95,
98, ME, XP and 2000, as well as the Apple Mac OS9 and OS10. In addition we have
recently completed, but not yet released, the necessary drivers to
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make the P5(TM) compatible with the Linux operating system. The P5(TM) is also
compatible with the Sony PlayStation2 game console.
INTEGRATION
Our technology allows software developers to easily integrate the
P5(TM) into new and existing applications. Although the P5(TM) emulates the
mouse and the joystick right out-of-the-box in certain computer platforms, in
order to fully penetrate our target markets, the applications must have the
appropriate technological capabilities to support the P5(TM), which is primarily
a matter of having application drivers (instructions which translate commands
into an action or movement with the P5(TM)) written for existing or new
applications.
We have utilized our content development strategy to encourage software
developers to integrate our code. Currently, we pay developers a license fee to
integrate the P5TM into their software programs. We have agreements with
multiple software developers and the P5TM is bundled with PC-based games from
these developers. The three initial games are "Hitman 2", "Tigerhunt" and
"Beachhead 2002." In addition, we have begun to make "game patches" available on
our web site that users can download free-of-charge to "P5-enable" existing
popular games they might already own. These agreements allow us to penetrate
existing populations of users through direct-marketing campaigns in partnership
with the developers, as well as provide reciprocal links to retail partner web
sites for users to purchase the underlying game for a revenue override. Two
popular game patches were launched in December 2002 and March 2003, for Serious
Sam (published by Take 2 Interactive) and Black and White (published by Lion
Head Studios), respectively. Direct e-mail campaigns commenced during the
week-ending December 13th, 2002, to over 500,000 registered players of these
games. We will continue to add to this library of "game patches" in order to
continue to provide users with more P5 TM content.
It is our hope that additional software developers will seek licenses
for the right to incorporate the P5TM into their future software offerings.
Additionally, we may seek to assist software publishers in developing games and
other programs that can best take advantage of the P5TM's capabilities.
PRICING STRATEGY
We established an initial manufacturer's suggested retail price (MSRP)
of $149 for the P5(TM), which includes the two-game electronic game bundle
(Hitman 2 and Tigerhunt) and a demonstration version of Beachhead 2002. However,
initial sales of the P5TM have been slower than anticipated due, in part, to
general retail conditions and weaker than expected sales of PC's, PC games and
the peripherals associated therewith. Accordingly, we have temporarily adjusted
our pricing strategy, offering consumers a $20 "sell-through" rebate
(automatically deducted at the point of sale) in an effort to improve slower
than expected sell-through from retailers to end users. Some retailers have
lowered the price of the P5(TM) to as low as $79. While sales of the P5(TM) have
increased, in the event that we manufacture additional P5(TM)'s we will need to
do so at a dramatically lower per unit cost in order to reduce the retail cost.
There can be no assurance that we will be able to do this.
ADDITIONAL PRODUCTS
With respect to our new lines of business, we believe we have the
ability to deliver new technologies to various segments of the consumer
electronics and gaming markets at lower than customary price points. There is a
general relationship between the amount of technology in a product and its
price. Moving forward, we believe there is an opportunity to apply our knowledge
to exploit the
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general technology-price relationship that we see in the electronics-based toy
and gaming markets. We plan to apply this strategy in an opportunistic fashion,
developing only those products where we believe our value-added technology and
popular price points will provide a clear distinction in the marketplace To date
we have signed an exclusive distribution agreement with the domestic agent of a
foreign manufacturer of various toy products that grants us the exclusive right
to market, sell and distribute certain of their products, including infra-red
and remote control mini cars in the United States, Canada, Latin America, Puerto
Rico, Australia, New Zealand and Europe. We have started to receive initial
purchase orders from certain retail outlets for the purchase of these products.
TARGET MARKETS
With respect to the P5(TM) we had pinpointed three potential broad
market opportunities: electronic gaming, commercial applications and other
computer interactions. We initially focused on the electronic gaming market and
began generating retail sales of the P5(TM) during the week of November 4, 2002.
We are currently seeking partnerships with established software and hardware
manufacturers to assist us with the commercial applications market as well as
the broader computer applications market, which include Internet navigation and
general computer interaction.
ELECTRONIC GAMING MARKET
According to NPD Group, Inc., U.S. sales of video game hardware,
software and accessories, such as hand controllers, jumped 43% to $9.4 billion
in 2001 from $6.6 billion in 2000. During the same period, sales of
computer-game software rose 4.4% to $1.42 billion from $1.36 billion. Much of
this growth is due largely to the successful launch of the Sony PlayStation2,
Microsoft Xbox and the Nintendo GameCube; and the growth in the popularity of
games produced by such leading developers as Electronic Arts, Activision,
TakeTwo Interactive and Infogames. The electronic gaming industry had prompted
the need for significant developments in the man-machine interface with computer
platforms. The desire for more realistic scenes and interaction has led to the
majority of electronic games being developed with 3D environments. Thus, this
market presents an opportunity for an improved interface device capable of
meeting the interaction and intuitive manipulation needs of today's users. Input
devices play an important role in extending the overall video game experience.
As users seek more compelling gaming experiences, they often look to peripherals
as a way to deepen the feeling of immersion in the game.
As games have evolved, peripheral devices have been developed to
accommodate the actions of the user. Games are generally categorized by the type
of action taking place. Mouse controllers, joysticks and other devices have been
developed to meet specific needs: "Simulators" such as flying or driving games
have spawned steering wheels and joysticks that emulate the real tools used by
pilots or drivers. "First-person shooter" games require `fast-twitch' response:
the ability to turn and look rapidly around a room, and the ability to fire
rapidly at a target. Mouse controllers with multiple programmable buttons have
been developed to replace the many keystrokes required to move through the game.
Similarly, roller balls in mouse controllers using different technologies to
increase the accuracy of the pointer have been developed to enable quick turns
and spins within these gaming environments. "Strategy" and "role-playing" games
put the user in the role of a character that walks through an environment to
explore areas and pick up objects. Again, mouse controllers with specific
buttons and ball designs are targeted at these game users to facilitate their
game play.
Ultimately, none of the devices designed for these game types provide
the optimal functionality that a 3D environment requires, namely, the ability to
move in a natural manner and replicate
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that movement in a character or action within the application itself.
Furthermore, traditional game controllers do not offer the control and speed
(reaction time) that gamers require. For this reason, 3D gamers have typically
settled for game pads and/or a combination of the keyboard and mouse
controllers, which remain today's most common computer input devices.
COMMERCIAL SOFTWARE APPLICATIONS
Professionals use 3D visualization tools in a wide range of CAD
applications. Architects, game designers, product designers, mechanical
designers, construction engineers and animators all use PC-based design software
to create, manipulate and animate in 3D. This market's needs are distinct from
those of the gaming market in that the users seek to create 3D objects, rather
than simply manipulate them, which traditionally requires a time-consuming,
multi-action process.
While the tasks that are enabled by certain devices (i.e., drawing with
digitizing tablets) are useful, the software in general has proven consistently
frustrating to its user base, primarily because it is so difficult to learn. The
primary need in the professional market is to enable the designers to do their
jobs without much wasted time in learning and implementing a program.
Architects, for example, want to solve architectural problems, not computer
problems. It is expected that demonstration of the effectiveness of the P5(TM)
to this market through associations with leading software manufacturers and
trade groups could lead to rapid adoption of our product.
We believe there are opportunities for us to partner with leading
software firms in this industry to provide the interface device that will
rapidly address this market's needs. Applications for this market can be
distilled into four segments based upon the software used and the functionality
requirements. These segments are the Architecture, Engineering and Construction
(AEC), Mechanical Engineering (ME, or MCAD for Mechanical Computer-Aided
Design), the Game Developer and the Film/Video markets. Software vendors
operating in these markets include AutoDesk, Dassault Systems and Agile
Software.
According to Cadence Magazine, the AEC market alone is comprised of
roughly 300,000 architects, engineers and construction professionals that
utilize CAD systems for 2D drafting and 3D modeling and visualization. It is
estimated that 60% of this market works primarily in 2D, though the leading
architects have identified a need for software to move beyond today's limited 3D
modeling to the development of `live' parametric models that would allow faster
and easier establishment of design intent and support all phases of project
development. The ME market includes designers of machinery, equipment or any
other product that requires computer schematics for production. The ME market
utilizes CAD systems and 3D design software for the creation and manipulation of
objects. This market is estimated at over 3 million users and is growing at a
rate of approximately 10% a year. This recent growth spurt is a result of the
move from expensive Unix-based platforms to PCs, making it more affordable for
users to purchase and deploy CAD systems.
Game developers use 3D animation programs in the creation of both PC
and console games. 3D design programs are used in a range of commercial video
productions, everything from high-end film creation including movies such as
"Toy Story," to much simpler 3D-logo design on the evening news. The software is
run primarily on Macintosh and Windows platforms and all use high-end,
USB-compatible systems as a matter of necessity. Other markets for 3D design
include Web design and education, geographic mapping, imaging, scientific
visualization, augmented reality and medicine.
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OTHER COMPUTER INTERACTIONS
The development of 3D Internet and user interface environments are
closely tied to the proliferation of graphics-related hardware. Graphics-related
hardware includes advanced video cards, video RAM, and 3D accelerator cards, as
well as graphics capabilities built into the main processor. Such hardware
affects the online experience in that it governs the resolution of Web graphics
and the speed at which they render. In addition, some interactive environments
outside of the browser, such as a 3D software engine, require high-end hardware
acceleration. Currently, very few Web ventures outside of the gaming world use
such environments. However, 3D graphics capabilities once limited to high-end
systems have become commonplace in consumer PCs.
The P5(TM) replicates the existing mouse or joystick commands built
into current PC applications. However, with the awareness of the enhanced
capabilities of the P5(TM), a developer will be able to create entirely new
experiences (commands, gestures, etc.) and user interfaces for existing and
future applications.
We believe that the expansion of broadband use will drive developers to
produce content for the average Internet user. This will enable web developers
to incorporate real-looking objects into e-commerce sites, create desktops and
browsers, which look like real rooms and require manipulation through a 3D
space, and ultimately change the entire Internet experience for the user. The
P5(TM) will enable all users to work intuitively within this environment.
According to a Broadband Report from eMarketer, there is expected to be
approximately 90 million broadband households world-wide by the end of 2004, a
350% increase from the 20 million recorded in 2000.
Through the use of our software development kits, software companies
develop the games and other potential applications which benefit from our
products. Currently, we do not consult with or otherwise participate in the
development of these games and other software products. We seek to maximize the
ability of users to benefit from these software titles and programs by allowing
the utilization of the P5TM in conjunction therewith.
YOUTH CONSUMER MARKETS
The youth consumer products business, which taps into both the consumer
electronics and toy industries, sells approximately $23 billion per year
according to Toy Manufacturers Association. Consumers purchase gaming
peripherals and consumer electronics on a regular basis and have shown a
willingness to buy those products with more sophisticated electronics and
technologies. We intend to develop the Consumer Electronics and Consumer Youth
Products portions of our business to attract the youth market to our
technology-price segment of the industry.
UNDERDEVELOPED MARKET NICHE
There are various underdeveloped price point segments in the gaming,
consumer electronics, and youth consumer markets, particularly for products with
sophisticated technologies. By differentiating our products with a unique
technology-price equation, we believe we can offer a variety of compelling
products in the market.
12
RESEARCH & PRODUCT DEVELOPMENT
We will continue to consider future product development that may take
the initial P5(TM) through several stages of evolution. However, due the initial
sales generated by the P5(TM), we are now seeking to develop other products that
will utilize one or more of our technologies. We believe the combination of
future generations of the P5(TM) and the creation of new products will increase
the commercial opportunities for us in both existing and new markets.
Our patent pending optical tracker offers a highly functional, low-cost
alternative to current tracking technologies, which we believe will enable us to
expand our product mix. We hope to develop additional products that would
include areas where current products are hindered by sub-optimal remote tracking
functionality and costly factors. By combining innovative sensory technologies
with these optical tracking advancements, we have the potential to quickly
diversify beyond our current offering.
For the years ended December 31, 2002 and 2001 we spent $1,037,396 and
$1579,129, respectively, on product development, none of which was borne
directly by customers.
DEVELOPMENT COMPANY
We have developed our first product, and hope to develop additional
products, partially by working with arrangement between us and a Canadian based
entity that currently employs a team of technicians who had dedicated most their
time working on our products. The development company is headed by an individual
who has extensive experience in design and development of consumer electronics
and virtual reality hardware and software.
INTELLECTUAL PROPERTY
We have been awarded one U.S. patent regarding our bend sensor
technology, which expires on August 10, 2009. We also have two patents pending
for (i) our shadow-based optical tracking technology and (ii) a wearable
electronic interface device that emits an optical signal for use in tracking six
degrees of motion, and have filed a provisional patent regarding proprietary
software that converts 8-bit analog data stream to a more precise 12-bit digital
data stream for improved motion tracking accuracy and intend on filing a patent
in a timely fashion.
The integration of these technologies into the P5(TM), combined with
proprietary software, firmware and drivers, has resulted in what we believe to
be a superior product that can be offered at a mass market price point not
previously achieved in the market.
As we develop new technologies, we expect to continue to aggressively
file new patent applications.
SALES & MARKETING
We have utilized numerous sales and marketing channels in an attempt to build a
brand and capture a mass market for the P5(TM), as well as our other planned
products. We have sold the P5(TM) into multiple channels, including but not
limited to domestic and international retail, e-commerce outlets, direct
marketing and OEM/private label partnerships. In addition to those units which
were shipped to retailers or sold directly to end users, we expected to receive
additional orders for the P5(TM), based on positive media reviews, strong word
of mouth, games being designed to be compatible with the P5(TM) and discussions
with
13
multiple software developers who had indicated an interest in making future
software offerings compatible with the P5TM. However, to date sales have been
lower than expected so we have adjusted our business model. We have offered
consumers a $20 "sell-through" rebate (deducted immediately at point of sale) in
an effort to improve slower than expected sell-through from retailers to end
users. Other contemplated adjustments to our business model include a
restructured manufacturing schedule, as well as deferral of marketing programs,
licensing contracts and product development expenditures. Additionally, due to
lower than expected sales we reserved the inventory to the lower of cost or
market at a per unit price of $10 for the year ended December 31, 2002 Included
in the statement of operations in 2002 is $1,883,207 impairment of net
realizable value related to this inventory.
We plan to sell our new products through these channels both
domestically and internationally. As we expand our product lines, we may employ
more direct marketing via the Internet to soft launch our products and test our
pricing strategies. These practices are less costly and can ultimately provide
higher-margin returns than a large-scale media campaign.
In addition to direct discussions with key retailers globally, we have
agreements with commissioned sales representatives receiving 4% commission, that
are responsible for sales into regionally-headquartered retailers throughout the
United States. These retailers include national chains such as Wal-Mart, Best
Buy, CompUSA, Gamestop, Electronics Boutique, J&R Music World, Toys `R Us, and
KoB Toys. We are also in discussion with geographically-based distributors
around the world that would be responsible for sales, distribution and
fulfillment in each of their respective markets.We continue to solicit other
retailers and/or distributors, both domestically and internationally, for P5(TM)
volume commitments and to pave the way for future product placements.
CONTENT-BUNDLING STRATEGY
In order to achieve product sell through, we have offered and intend to
offer specific electronic gaming and/or non-gaming bundles with the P5(TM).
These bundles have enhanced gesture recognition functionality made possible
through the use of the P5(TM). To date, we have bundled three games with the
initial launch of the P5TM in November 2002. We also have an agreement in place
which allows one of these game developers to sell the P5TM directly to consumers
through their own website. We expected to receive bi-weekly payments for all
such sales.
With respect to other third-party products bundled with our products,
we seek to maintain the relationship with the end customer and, as such, act as
the primary obligor. We assume responsibility for customer acceptance of all
features of the product, as well as returns. As such, we will record the gross
amount of the purchase price of the P5TM as revenue and will reflect the related
royalty to be paid to the third party vendor as a component of cost of sales.
MEDIA COVERAGE / CONSUMER AWARENESS
The P5(TM) has gained considerable media acclaim. As of the date of
this report, the P5(TM) has appeared in over 125 print/online publications and
on over 25 television, radio and online segments. The P5(TM) has been covered by
publications including THE NEW YORK TIMES, CNN, WIRED MAGAZINE, POPULAR SCIENCE,
MAC WORLD, MACADDICT, KIPLINGERS, THE HISTORY CHANNEL, KTLA'S CURT THE CYBERGUY,
DISCOVERY CHANNEL (CANADA), NEWSWEEK (JAPAN) and LIVE WITH REGIS AND KELLY.
This type of media coverage is invaluable for raising awareness and
stimulating end-user demand, particularly with new concepts. We aim to build off
the relationships we have built through
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the release of the P5(TM) to win press coverage for futuRE products. There can
be no assurance, however, that we will be successful in our efforts.
BUSINESS DEVELOPMENT
We have been working to execute a comprehensive business development
plan designed to stimulate demand for our P5(TM) produCT in electronic gaming,
commercial markets and other applications. In addition to those games which are
already P5TM enabled, we have signed letters of intent with various software
development firms to incorporate the P5(TM) into applications including
electronic gamiNG and commercial markets. These letters of intent, however, only
represent expressions of interest and are not binding commitments. There can be
no assurance that any definitive agreements with such developers will be
finalized or that we will realize any revenues from such relationships.
Additionally, we are in the process of identifying additional products for our
new lines of business as well as potential development opportunities for our
existing technologies. There can be no assurances, however, that these
additional products will be identified or that we will be able to successfully
develop and sell these products.
Prior to our business combination, Essential Reality, LLC offered
software development kits (SDKs) to the developer community, and in less than
one month received in excess of 450 SDK applications from game developers and
numerous commercial software developers, including in the areas of 3D Animation,
CAD, education and research, Internet/multimedia, military and other commercial
markets. As of December 31, 2002, we made the SDKs available on our website for
free downloading, and to date there have been over 600 downloads. However, there
can be no assurance that any developers will want to integrate or create content
that is P5(TM) compatible.
The non-gaming SDK applications have come from an array of commercial
software developers in the areas of: 3D animation/CAD, education and research,
Internet/Multimedia, Military and other vertical markets. We intend to continue
to assist developers in using the SDKs to enhance their applications.
We have entered into agreements with Eidos, Infogames, Lionhead
Studios, Croteam, Ubisoft and others to gain access to underlying source code to
enhance games for P5(TM) functionality. Two popular game patches, which enabled
games for use with the P5(TM), were launched in December 2002 and March 2003,
for Serious Sam (published by Take 2 Interactive) and Black and White (published
by Lion Head Studios) respectively. We continue to seek relationships with both
PC and console content providers to develop new games, enhance current games and
explore potential non-gaming applications. However, there can be no assurance
that our efforts will result in increased sales or development of additional
content compatible with the P5(TM).
In December 2000, Essential Reality, LLC entered into a consulting
agreement with BusinessDevelopment.com, LLC (BDC) pursuant to which BDC provides
general consulting and business development services to Essential Reality LLC,
and now to us, in return for a monthly cash retainer. See Item 12 "Certain
Relationships and Related Transactions" below. Such services consist of forming
revenue-generating opportunities, including without limitation distribution
agreements, licensing agreements, joint ventures, strategic alliances and
partnerships. The amount of the retainer originally was $6,000 per month,
increased to as much as $15,000 per month from July 2002 to September 2002 and
is currently $7,500 per month. The consulting expense for the years ended
December 31, 2002 and 2001 were $203,479 and $242,000 respectively.
15
In addition to the monthly retainer, we also are obligated to pay to
BDC a potential revenue share of up to four percent (4.0%) on transactions
facilitated by BDC. Either BDC or we may cancel this agreement with thirty (30)
days prior notice.
In March 2000, Essential Reality, LLC entered into a Settlement and
Release Agreement with Rose Ganguzza, a consultant to Essential Reality, LLC, on
behalf of herself and Hollywood Productions, Ltd., which requires Essential
Reality, LLC to pay to Rose Ganguzza, a royalty of $0.25 for each of the first
150,000 units of the P5TM sold. As partial consideration for entering into such
agreement, the other parties released Essential Reality, LLC from any and all
claims they may have against Essential Reality, LLC relating to the Power Glove,
a predecessor product developed by a third party pursuant to the patent we now
own. The royalty expense for the year ended December 31, 2002 was $153.
MANUFACTURING
We utilized V-Tech Communications Ltd. as our manufacturing partner for
the P5(TM). V-Tech is one of Southeast Asia's leadiNG manufacturers of consumer
electronics, toys and other mass market devices under its own name and on a
private label basis for some of the world's foremost electronics,
telecommunications and retail concerns. V-Tech works with us under a
"work-for-hire" agreement on, amongst other things, establishing manufacturing
schemes, developing quality control procedures, arranging (and in some cases
executing) vendor agreements with our preferred vendors, identifying
cost-reduction opportunities, and preparing for the integration of our machine
tooling for production. In addition, we have identified alternative sources of
manufacturing to complement or back-up our arrangements with V-Tech. The initial
unit cost for the P5(TM) is approximately $45. Implementation of two ASIC
designs mAY potentially yield further cost reductions. However, we are currently
evaluating the feasibility of implementing potential cost reductions for the
P5(TM). Regardless, we do not intend to produce additional P5(TM)'s until we
sell our existing inventory and we iNTend on using smaller independent
manufacturing facilities in Asia for any additional products we develop.
Certain key components used in the manufacture of the P5(TM) were
purchased directly by V-Tech from single or limited sourcES that specialize in
these components. Single-sourced components included certain of our
application-specific integrated circuits, sensors (also known as bend sensors)
and other components. Due to the precise nature of these components, there are
relatively few companies capable of manufacturing the same or similar components
at a competitive price. We have closely monitored the relationship between
V-Tech and these suppliers to ensure timely performance, payment and
satisfaction of all obligations.
PRODUCT DEVELOPERS AND SUPPLIERS
As of July 1, 2001, Essential Reality, LLC entered into an agreement
with VR Yad Development Group, Ltd.,("VR Yad") a third-party developer with
expertise in virtual reality systems, for the creation and design of all of our
products and software. Through this arrangement, VR Yad worked exclusively for
Essential Reality, LLC (and following the business combination, for us) and is
reimbursed for their services at cost. This agreement remains in force until
terminated by either party, upon not less than thirty days' notice. We had
previously reimbursed them approximately up to $40,000 per month for salaries
and benefits, plus expenses. To date, the only product that VR Yad has developed
for us is the P5(TM), however we continue to utilize their services fOR product
development in connection with new products as well as evaluating potential cost
reductions for the P5(TM) which may BE implemented in the event we manufacture
additional units. VR Yad is entitled to a royalty of 1.0% of net sales, and an
additional 0.5% royalty because it timely completed all portions of its
development work.
16
These royalties are not payable until we actually collect the associated
revenue, but are payable indefinitely. The royalty expense for the year ended
December 31, 2002 is $917. During the period of engagement by us, and for two
years after termination of the relationship, VR Yad is prohibited from
developing, manufacturing, marketing or selling any product similar to the
products it develops for us. We expect to utilize the services of VR Yad in the
development of our additional products, however, we have identified alternative
sources of development capability in the event a change of developer is
necessary.
As of July 1, 2001, Essential Reality, LLC entered into a loan
agreement with VR Yad pursuant to which Essential Reality, LLC agreed to loan VR
Yad up to $2,000,000 modified June 10, 2002 to $2,700,000. The loan is
non-interest bearing, is payable two years after the date of the loan and is
collateralized by all personal property of VR Yad. As of December 31, 2002,
approximately $452,121 of this loan remains outstanding and will be remitted
through research and development credits from the Canadian government. The
Company has recorded a reserve of $52,121 against this balance due to the
potential for reduced research and development credits from the Canadian
government.
In January 2001, Essential Reality, LLC entered into a memorandum of
understanding with Apjay Technologies for the development of certain components
of the P5TM. Pursuant to the memorandum of understanding, we are required to pay
royalties of 1% of P5TM's net sales to Apjay Technologies indefinitely. The
Company was required to pay a royalty advance of $50,000, of which $15,000 has
previously been paid and $35,000 of which is now due because we have
incorporated the component developed pursuant to the memorandum of understanding
into the P5TM. No subsequent agreement has been executed with Apjay
Technologies.
In July 2000, Essential Reality, LLC entered into a consulting
agreement with MC Squared Incorporated to help manage the relationship with
product developers. This consulting agreement replaced a previous Development
Agreement executed between Essential Reality, LLC and MC Squared in November
1999. In connection with these agreements we paid MC Squared $250,000. We are no
longer making payments to MC Squared. In September 2000 the consulting agreement
terminated and the development process was managed by us internally. MC Squared
is a company owned by a person related to certain members of our Board of
Directors. Pursuant to such agreement, we are required to pay royalties of 1.8%
on net sales of the P5TM and 9% of the license fee collected by us with respect
to P5TM, indefinitely.As of December 31, 2002 $1,098 is due MC Squared. MC
Squared has sued us in connection with these agreements. See "Risk Factors -
Current Litigation May Have an Adverse Affect on Our Financial Condition and
Results of Operations."
COMPETITION
The P5(TM) faces competition in the electronic gaming peripheral market
from high-end mouse controller and joystiCK manufacturers such as Logitech and
Microsoft. While several peripherals provide high levels of precision, user
programmability and in some cases a limited amount of tactile feedback, we are
not aware of any peripherals that offer the combination of tracking and gesture
recognition that is found in the P5(TM).
Companies such as Immersion, Gyration, Fifth Dimension Technologies and
Ascension Technologies provide various higher-priced peripherals and
motion-capture products for commercial applications. These entities produce
systems for relatively complex commercial applications. Prices of these
competing products typically run in excess of $1,000 and can exceed $10,000 for
advanced models.
17
We believe the P5(TM) possesses unique competitive advantages due in part to (i)
the functionality derived from its patented aND patent-pending technologies,
(ii) its ease of integration and (iii) its mass market price point.
Moving forward, we anticipate extensive competition in the consumer
electronics and youth consumer products markets. We plan to distinguish any
products we may have by adding innovative technologies at price points that
offer exceptional value.
EMPLOYEES
As of December 31, 2002 we had 8 full-time salaried employees and no
part-time employee. We have since decided to streamline our management team in
an effort to maximize our resources as we begin to focus on the distribution of
the P5TM beyond its limited retail presence as well as the development of
additional products. We believe that the revised structure will create a smaller
but more sharply focused management team. We currently have 2 full-time salaried
employees and 1 consultant. We believe that our relationship with our employees
is satisfactory. We plan on adding additional staff in areas of senior
management and product development.
WEBSITE DISCLOSURE
The public may read and copy any materials we file with the SEC at the
SEC's Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549.
The public may also obtain information on the operation of the Public Reference
Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site
that contains reports, proxy and information statements, and other information
regarding the Company and other issuers that file electronically with the SEC at
HTTP://WWW.SEC.GOV.
ITEM 2. DESCRIPTION OF PROPERTY.
We currently lease from a third-party landlord approximately 4,300
square feet of office space at 49 West 27th Street, New York, New York 10001, at
a price of $10,570 per month. The lease provides for annual increases in the
monthly rent to a maximum monthly rental price of $11,575 and terminates on
November 30, 2006. Due to our recent reduction in personnel, we are rethinking
our needs for space and considering some alternatives.
ITEM 3. LEGAL PROCEEDINGS.
On November 21, 2002, a complaint was filed by MC Squared in United
States District Court for the Southern District of New York against us, Humbert
Powell, Chairman of our Board of Directors, Steven Francesco, our ex-Chief
Executive Officer, David Devor, an officer and Brian Jedwab, a member of our
Board of Directors, alleging breach of a development agreement between us
(originally Essential Reality, LLC) and MC Squared. Specifically, the complaint
alleges a failure by us to provide a design credit to MC Squared on the
packaging for the P5(TM). The complaint seeks specific performance and a recall
of all P5(TM) products shipped to date withouT the design credits on the
packaging. We have submitted an answer with counterclaims and have made a motion
to dismiss this complaint. A decision on the motion is pending.
18
On January 21, 2003 a complaint was filed by RDA International, Inc. in
the Supreme Court of the State of New York against us seeking payment of
$203,264 or work, labor and services performed in connection with advertising,
marketing and multimedia programs for the P5(TM).This amount has been accrued at
December 31, 2002.
On February 28, 2003, a complaint was filed by Aaron Gavios, a former
employee of ours, in The United States District Court for the Southern District
of New York against us, Humbert Powell, Chairman of our Board of Directors and
Brian Jedwab, a member of our Board of Directors, alleging breach of a contract.
Specifically, the complaint alleges failure to provide for severance pay,
failure to provide stock options and failure to reimburse for automobile lease
totaling $120,000, plus interest and legal fees.
On April 16, 2003, a complaint was filed by Ziff Davis Media, Inc. in
the Supreme Court of the State of New York against the Company (originally, ER,
LLC) seeking payment of $27,443.17 for print advertising for the P5(TM).
We believe we have valid defenses to these claims and intend to
vigorously defend ourselves; however, there can be no assurance that we will be
successful. The costs associated with these litigations, including the time
required to defend ourselves, as well as the potential cost should there be an
adverse judgment against us, may have a material adverse effect on our financial
condition and results of operation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
MARKET INFORMATION
Our common stock has been eligible for trading on the Over-the-Counter
Bulletin Board ("Bulletin Board") since April 19, 2001. To the extent we do not
timely file our reports with the SEC our common stock may no longer be eligible
for trading on the Bulletin Board. On June 26, 2002, the ticker symbol was
changed from JPAL to ESSR. The following table sets out the high and low closing
bid prices of our common stock during the periods indicated as quoted on the
Bulletin Board. Prices reflect inter-dealer prices, without retail mark-up,
mark-down or commissions, and may not represent actual transactions.
HIGH LOW
---- ---
2001
Second Quarter * $1.00 $0.26
Third Quarter $7.00 $1.00
Fourth Quarter $6.05 $2.97
2002
First Quarter $4.30 $4.05
Second Quarter $4.05 $2.25
Third Quarter $3.22 $1.41
Fourth Quarter $1.95 $0.80
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o Restated for 5 for 1 stock split effective July 2, 2001.
CHANGE IN SECURITIES
On November 6, 2002, the Company issued 50,000 shares of common stock
valued at approximately $70,000 to a consultant for legal services.
On March 12, 2003, the Company sold 100,000 shares of Common Stock to a
private investor for $1.00 per share totaling $100,000.
HOLDERS
As of June 21, 2003, we had 101 holders of record of our common stock.
DIVIDEND POLICY
We have never declared or paid dividends on our common stock and do not
anticipate declaring or paying any cash dividends on our common stock in the
near future. We plan to retain any future earnings for the development of our
business. The payment of future dividends will be at the discretion of our board
of directors and will depend upon our, among other things, future earnings,
capital requirements, financial condition and general business conditions.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.
OVERVIEW
On June 20, 2002, Essential Reality, LLC, a Delaware Limited Liability
Company ("ER LLC"), completed a business combination with JPAL, Inc., a Nevada
corporation and an SEC registrant ("JPAL") pursuant to an Amended Contribution
Agreement between ER LLC and JPAL, whereby all of the members of ER
LLCcontributed their membership interests in ER LLC to the Company in exchange
for an aggregate of 16,874,784 shares of the Company's common stock (the
"Transaction"). Concurrent with the Transaction, the shareholders of JPAL
canceled 7,564,326 of their shares of JPAL common stock and were left with
1,080,934 shares of common stock representing 6.02% of the Company. Following
the Transaction, JPAL changed its name to Essential Reality, Inc.
".
In connection with the Transaction, (i) holders of certain bridge notes
issued by the Registrant received, as additional consideration, two-year
warrants ("Bridge Warrants") to purchase up to an aggregate of 840,000 shares of
Common Stock and 15,000 shares of Common Stock (collectively, the "Bridge
Warrant Shares"), at a purchase price of $1.90 and $1.30 per share,
respectively, (ii) holders of certain bridge notes issued by the Registrant
exchanged them for convertible promissory notes of the
20
Company ("Convertible Notes"), which were convertible for a period of six months
at a conversion price of $1.90 into an aggregate of 263,158 shares of Common
Stock (the "Convertible Note Shares"), and (iii) the Company issued warrants
("Additional Warrants") to purchase up to an aggregate of 331,211 shares of
Common Stock (the "Additional Warrant Shares") at a purchase price of $1.30 per
share.
When the offer expired, a total of $250,000 of the outstanding notes
had been tendered for conversion into 217,391 common shares. The holders of
these shares were granted the following registration rights (1) the Company
became obligated to file a registration statement covering 60% of the underlying
shares of common stock and (2) piggyback registration rights were granted for
the remaining 40% of the shares granted.
The Transaction was accounted for as a capitalization in which ER
LLC is the accounting acquirer and JPAL is the legal acquirer. The management of
ER LLC remained as the management of the Company. Since the Transaction was
accounted for as a capitalization and not a business combination, no
goodwill has been recorded in connection with the Transaction and the costs
incurred in connection with the Transaction have been accounted for as a
reduction of additional paid-in capital. As a result of the capitalization,
(i) the historical financial statements of the Company for periods prior to the
date of the Transaction are the historical financial statements of JPAL, and,
therefore, JPAL's historical financial statements are no longer presented; (ii)
all references to the financial statements of the "Company" apply to the
historical financial statements of ER LLC prior to the Transaction and to the
financial statements of the Company subsequent to the Transaction; and (iii) any
reference to the Company applies solely to ER LLC and Essential Reality, Inc.
Founded in 1999, ER LLC was a developer of real-time tracking and
sensory technologies. We are focusing on combining these technologies into
products that enhance the interaction between human beings and computer
platforms, with initial emphasis on a product called the P5(TM). The P5(TM)
enables three-dimensional movement of the cursor as well as pitch, yaw and roll.
The user movinG his hand and/or bending his fingers controls the P5(TM).
The Company began product shipments in October of 2002, and has not yet
generated significant revenue, but continues to incur significant losses from
operations. Inventory sold with the right of price protection and/or right of
return is reported as inventory on consignment in accordance with the below
stated accounting policy for revenue recognition. The attainment of profitable
operations are dependent upon future events, including obtaining adequate
financing to fulfill our future development activities, and achieving a level of
revenue adequate to support its cost structure. There can be no assurance that
such future events shall occur.
CRITICAL ACCOUNTING POLICIES
We have identified the following as critical accounting policies:
PRODUCT DEVELOPMENT - Product development costs include expenses
incurred by the Company to research and develop the P5TM product. Product
development costs are expensed until such time as it is determined that a
product is technologically feasible. Product development costs are capitalized
from such date until such time as product development is substantially complete.
Product development costs capitalized will be amortized on the straight-line
basis over the lesser of the estimated useful life of the product or three
years.
21
REVENUE RECOGNITION - The Company recognizes under SAB 101 gross
revenue when the earnings process is complete, as evidenced by an agreement with
the customer, transfer of title and the rights and risks of ownership have
passed to the customer, the product is delivered, the price is fixed and
determinable, and collection of the resulting receivable is reasonably assured.
Because the Company allows many of its distributors price protection and/or
right of return, recognition of revenue in the accompanying financial statements
has been deferred until the distributors sell the merchandise and the cash is
collected by the Company. Inventory at distributors is reported as consigned in
the balance sheet.
In cases where sales are made to certain distributors and title has
transferred, risks of ownership has passed and collection is assured, sales have
been recorded and an account receivable has been recorded. The Company records
an allowance for uncollectible accounts on a customer-by-customer basis as
appropriate.
The Company may bundle product offerings from third-party vendors along
with the P5 product or may sell the P5 independently. The software is incidental
to the product as a whole and according to FASB 86, Accounting for the Costs of
Computer Software To Be Sold, Leased or Marketed, all revenue will be allocated
to the P5. As such, the Company will record the gross amount of the purchase
price of the P5 product as revenue and will reflect the royalty to be paid to
the third-party vendor as a component of cost of sales.
INVENTORY - Inventory is valued at the lower of cost or market, with
cost being determined on the first in-first out basis. The inventory represents
high-technology parts that maybe subject to rapid technology obsolescence and
which are sold in a highly competitive industry. If the actual product demand or
selling prices are less favorable than we estimate, the company establishes an
allowance account based on net realizable values. Inventory sold with the right
of price protection and or right of return is reported as inventory on
consignment.
RESULTS OF OPERATIONS
THE YEAR ENDED DECEMBER 31, 2002 COMPARED TO THE YEAR ENDED DECEMBER 31, 2001
REVENUE. For the year ended December 31, 2002, the Company recognized
product-related revenues in the amount of $112,602 as compared to no revenues
for the year ended December 31, 2001. The increase in our revenue resulted from
the launch of our first product, the P5TM, in November 2002. Revenue will be
deferred in accordance with the above stated accounting policy for revenue
recognition until certain events have been resolved.
COST OF REVENUE. For the year ended December 31, 2002, cost revenue totaled
$304,023 compared to $ $0 for the year ended December 31, 2001.This was a
development stage company through September 30, 2002. The increase in cost of
revenue resulted from the Company transitioning from a development stage company
to an operating company effective October 1, 2002.
OPERATING EXPENSES. For the year ended December 31, 2002, operating expenses
totaled $7,507,066 compared to $3,131,444 for the year ended December 31, 2001.
The increase in operating expenses resulted from the increase in sales and
marketing, general and administrative expenses and stock based compensation
which more than offset the decrease in product development as described below.
Product development expense. For the year ended December 31, 2002 product
development expense decreased from $1,579,129 to $1,037,396 a net decrease of
$541,733 as compared to the year ended December 31, 2001. The decrease was
primarily due to a decrease of approximately $315,435 in fees paid to third
party developers, which includes materials used in the development and
manufacturing of
22
our P5(TM) product, and $260,000 in capitalized product development costs.
Included in product development costs are $33,700, aND $55,000 for years ended
December 31, 2002 and 2001, respectively, paid to Abrams Gentile Entertainment,
Inc. owned by certain of our shareholders.
Sales and marketing expense. For the year ended December 31, 2002 sales and
marketing expense increased from $716,674 to $1,711,894, a net increase of
$995,220 as compared to the year ended December 31, 2001. The increases in sales
and marketing expense is primarily due to $296,429 in marketing related
salaries, $86,235 in trade shows and related travel, $289,400 in advertising and
$308,515 in consulting.
General and administrative expenses. For the year ended December 31, 2002
general and administrative expenses increased from $823,791 to $1,924,823, a net
increase of $1,027,220 as compared to the year ended December 31, 2001. The
increase in general and administrative expenses is primarily due to an increase
of approximately $426,902 in salaries and benefits, increase in consulting fees
$173,529, increase in insurance of $115,331, increase in professional fees of
$261,115, and increase in office expense of $30,486. Included in general and
administrative expenses are costs incurred of approximately $203,479 and
$242,000 for the years ended December 31, 2002 and 2001, respectively, by
Business Development.com Inc. and Hymax Group, LLC, companies that are related
to certain members of LCG Capital Group. Such costs include consulting fees,
employee salaries, occupancy, telephone and computer leases. In the case of
employee salaries, costs were allocated to us based on the time each employee
conducted business specific to us. In the case of the other expenses, costs are
allocated based on a percentage of resources used by us. In our opinion,
allocated expenses incurred from related parties approximate fair market value.
Stock based compensation for the year ended December 31, 2002 was
$880,885 as compared to -0- for the year ended December 31, 2001. The non-cash
charge was related to amortization of deferred compensation for stock options
issued to employees, directors, advisors and consultants.
OTHER INCOME(EXPENSE) Interest income for the year ended December 31, 2002,
decreased from $20,465 to $17,025, a net decrease of $3,440 as compared to the
year ended December 31, 2001. Interest earned from the note receivable for
Essential Reality, LLC's members' capital was $2,536 for the year ended December
31, 2002 compared to $20,465 for the year ended December 31, 2001. The balance
was due to lower cash balances during 2002.
Interest expense for the year ended December 31, 2002 increased from
$20,565 to $1,173,944, a net increased of $1,153,439 as compared to the year
ended December 31, 2001. In 2002, interest expense related primarily to bridge
loans (Notes Payable) of $171,396, a non cash charge of $402,173, resulting from
the beneficial conversion feature on July 17, 2002 and $579,870, was primarily
due to the warrants and the convertible notes issued at the time of the merger
and subsequent financing during 2002, described in "Liquidity and Capital
Resources" below.
Net loss for the years ended December 31, 2002 and 2001 were $8,853,480
and $3,131,484, respectively.
23
LIQUIDITY AND CAPITAL RESOURCES
Since its inception through December 31, 2002 we had accumulated
deficit of $13,625,722 and expect to continue to incur losses for the
foreseeable future. We have financed our operations primarily through bridge
loans and private placements described in the overview.
For the year ended December 31, 2002 net cash used in operating
activities increased from $2,629,163 to $6,598,959 a net increase of $3,960,796
as compared to the year ended December 31, 2001. Net cash and cash equivalents
used in operations for the year ended December 31, 2002 consisted of net loss
from continuing operations of $8,853,480 less non cash items of $3,413,200
consisting primarily reserve for collectibility of notes 102,121, reserve for
inventory obsolescence of $1,363,361, non-cash compensation of $880,885,
amortization of deferred interest of $208,302, and decrease in deferred
financing costs of $217,755, increase in inventories of $1,667,890, increase in
notes receivable of $502,121, increase in account receivable of $38,679,
increase in other assets of $61,157 and net increase in liabilities of $893,413.
Net cash used in investing activities for the year ended December
31, 2002 increased from $30,949 to $693,495 a net increase of $662,546 as
compared to the year ended December 31, 2001. The increase primarily for the
purchase of capitalized software, website and equipment.
Net cash provided by financing activities for the year ended
December 31, 2002 increased from $2,442,070 to $7,467,449 a net increase of
$5,025,379 as compared to the year ended December 31, 2001. primarily as
follows:
The Company completed a private placement which generated cash proceeds
of $6,083,076 net of costs associated with the Offering of $988,103, of which
$217,755 was prepaid as of December 31, 2001.
We received proceeds from bridge loans of $1,825,000 for
prior to the closing of June 20, 2002. Bridge loans outstanding prior to closing
of the transaction and Offering amounted to $3,325,000. Upon closing of the
Offering, $250,000 of the bridge loans were converted to 480,000 membership
units of ER LLC and we repaid an additional $1,100,000 of the bridge loans. Upon
closing of the transaction the remaining bridge loans and accrued interest in
the amount of $2,378,431 were eliminated and the Company assumed $1,717,070 of
notes payable to third party lenders. Proceeds of notes receivable $82,971 and
repayment of advances from related companies of $5,705.
On November 20, 2002, We received $500,000 partial bridge
financing (the "Financing") from a subscription agreement for $1,000,000
consisting of a six month 8% Secured Convertible Debenture (the"Debenture") due
on May 20, 2003. The Debenture is convertible into units at a price of $1.00 per
unit, each such unit consisting of one share of Common Stock and a warrant to
purchase 0.20 shares of Common Stock at an exercise price of $0.20 per warrant,
or $1.00 for a whole warrant. The Black Scholes value of the warrants and the
beneficial conversion feature will be amortized to interest expense over the
life of the debt. The Financing is intended to assist the Company with its cash
flow as it seeks to raise additional financing through the sale of equity
securities. An additional $500,000 was received in connection with this
subscription in the first half of 2003 and the company issued additional 8%
Secured Convertible Debentures.
We anticipates that, based on its proposed plans and
assumptions relating to the implementation of its business plan, cash on hand as
of December 31, 2002 together with projected revenue, it will have a cash
shortfall of approximately $600,000 as of May 31, 2003. Should the Company not
raise additional capital and generate the projected revenue, the company expects
to adjust
24
its business plan and cash burn rate such that cash on hand as of December 31,
2002, and the cash proceeds of the bridge loans and private placement received
in the amount of $662,500 through May 1, of 2003 will be sufficient to satisfy
operations through May 31 ,2003. Thereafter, the Company will require additional
funding in order to reach the point of self-sufficiency. The Company hopes to
raise the additional cash from the exercise of certain warrants and/or through
additional offerings of its securities. The Company is unable to project cash
requirements through December 31, 2003 until it more fully determines the level
of projected revenue from the sale of future products and the ability to raise
additional funds through public offerings or private placements.
POTENTIAL PRIVATE PLACEMENT
We will require substantial funding to continue our website
development, marketing, sales, and administrative activities. We have raised
funds in the past through the sale of securities, and may raise funds in the
future through public offerings or private placements of securities,
collaborative arrangements or from other sources.
However, there can be no assurance that we will be able to raise any
additional funds. If additional funding is not available to us when needed, we
may be required to cease operations.
Because we were not able to raise the necessary capital to generate the
projected revenue by December 31, 2002, we adjusted our business plan and cash
burn rate for the first quarter of 2003 by terminating five key executives with
annual salaries totaling $1,030,000.
We have an Investment Banking/Advisory Agreement with First Securities
USA, Inc. through its SBI USA division as the exclusive financial advisor, for
six months starting March 10, 2003 in connection with the management of an
offering of "PIPE" (Private Investment In Public Equity) equity securities, on a
best efforts basis up to $5 million dollars with a minimum of $3 million
dollars. The private placement will be structured as a transaction exempt from
section 5 of the Securities Act of 1933 and shall comply with section 4(2) of
the Securities Act and Regulation D. We will pay the Investment Banker a
retainer of $25,000 in shares of our common stock. In addition, we will pay a
commission in cash equal to 10% of the aggregate gross proceeds of the
securities sold, as well as warrants to the purchase of a number of securities
equal to 10% of the number of securities sold in the private placement. The
warrants will be excercisable for five years at a price equal to 110% of the
offering price per security. We will also pay all fees of the counsel to the
Investment Banker not to exceed $5,000.
We believe that if we are be able to consummate the private placement
we should have sufficient funds to cover our operating expenses for at least the
next twelve months. We will pursue opportunities to finance our operations and
satisfy our cash requirements with a combination of debt financing, stock sales,
and, in the longer term, revenue from operations. Among the options available to
and being considered by management to ensure we have sufficient working capital
for the next twelve months are a) plans to continually reduce or delay
expenditures, b) plans to increase cash flow through acquisitions, c) plans to
borrow money using the assets and cash flow of potential acquisitions and/or
existing equity investees and d) plans to increase ownership equity through
various funding vehicles including convertible debentures, private placements
and registration of shares for sale to the public.
There can be no assurance that any of these options, if they were to
occur, would provide sufficient working capital to us.
25
During 2003 we will provide severance pay for the five executives in
the amount of $201,000. Certain payments are contingent upon us obtaining
installment financing of at least $1 million, excluding bridge loans.
In February we issued to Steven T. Francesco former CEO, a 5 year
warrant to purchase 250,000 shares of common stock at an exercise price of $0.75
per share. He may join the Company's advisory board and receive an additional 5
year warrant to purchase 50,000 shares of common stock at an exercise price of
$0.75 per share. The Black- Scholes value of the warrants feature will be
amortized to stock based compensation over the life of the warrant.
Certain executives will have one year from the date of their severance
agreements to exercise their stock options in the amount of 161,667 shares or
have them forfeited.
Commitments
Payments Due By Period
----------------------------------------
Less Than 1 to 4 to After
Total One year 3 Years 5 years 5 years
------------ ---------- ------- -------- --------
Long-term debt $ 0 $ 0 $ 0 S - S -
Employment Contract -
Mr. Devore 0 0 0 - -
Other Employment Contracts
- Non Officers 0 0 0 - -
Capital Lease Obligations - - - - -
Operating Lease 0 0 0 - -
------------ ---------- ------- -------- --------
Total Cash Commitments $ 0 $ 0 $ 0 $ - $ -
============ ========== ======= ======== ========
RECENT ISSUED ACCOUNTING PRONOUNCEMENTS
On June 29, 2001, the Financial Accounting Standards Board (FASB)
issued SFAS No. 142, "Goodwill and Intangible Assets." SFAS No. 142 eliminated
the amortization of goodwill and certain other intangibles and requires an
impairment test of their carrying value. An initial impairment test of goodwill
and certain other intangibles must be completed in the year of adoption with at
least an annual impairment test thereafter. On January 1, 2002, the Company
adopted SFAS No. 142. The Company completed the initial impairment tests in the
first quarter of 2002, which did not result in an impairment of goodwill or
other intangibles.
In June 2001, the FASB issued SFAS No. 143 "Accounting for Asset
Retirement Obligations". SFAS No. 143 addresses financial accounting and
reporting for obligations and costs associated with the retirement of tangible
long-lived assets. The Company is required to implement SFAS No. 143 on January
1, 2003, and management does not expect its adoption to have a material impact
on the Company's results of operations or financial position.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets", effective for fiscal years
beginning after December 15, 2001. Under SFAS No. 144 assets held for sale will
be included in discontinued operations if the operations and cash flows will be
or have been eliminated from the ongoing operations of the entity and the entity
will not have any significant continuing involvement in the operations of the
component.The Company adopted SFAS No. 144 on January 1, 2002. The adoption of
SFAS No.144 did not have a material impact on the Company's results of
operations or financial position.
In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections". This statement eliminates the automatic classification of gain or
loss on extinguishment of debt as an extraordinary item of income and requires
that such gain or loss be evaluated for extraordinary classification under the
criteria of Accounting Principles Board No. 30 "Reporting Results of
Operations". This statement also requires sales-leaseback accounting for certain
lease modifications that have economic effects that are similar to
sales-leaseback transactions, and makes various other technical corrections to
existing pronouncements. This statement will be effective for the Company for
the year ending December 31, 2003. The adoption of this statement will not have
a material effect on our results of operations or financial position.
26
In July 2002, the Financial Accounting Standards Board issued SFAS No.
146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS
No. 146 will supersede Emerging Issues Task Force Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a Restructuring)." SFAS No. 146
requires that costs associated with an exit or disposal plan be recognized when
incurred rather than at the date of a commitment to an exit or disposal plan.
SFAS No.146 is to be applied prospectively to exit or disposal activities
initiated after December 31, 2002.
In October 2002, the FASB issued Statement No. 147, "Acquisitions of
Certain Financial Institutions - an amendment of FASB Statements No. 72 and 144
and FASB Interpretation No. 9," which removes acquisitions of financial
institutions from the scope of both Statement 72 and Interpretation 9 and
requires that those transactions be accounted for in accordance with Statements
No. 141, "Business Combinations," and No. 142, "Goodwill and Other Intangible
Assets." In addition, this Statement amends SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," to include in its scope long-term
customer-relationship intangible assets of financial institutions such as
depositor- and borrower-relationship intangible assets and credit cardholder
intangible assets. The requirements relating to acquisitions of financial
institutions are effective for acquisitions for which the date of acquisition is
on or after October 1, 2002. The provisions related to accounting for the
impairment or disposal of certain long-term customer-relationship intangible
assets are effective on October 1, 2002. The adoption of this Statement did not
have a material impact to the Company's financial position or results of
operations as the Company has not engaged in either of these activities.
In November 2002, the FASB issued Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, an Interpretation of ASB
Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34"
("FIN No. 45"). The interpretation requires that upon issuance of a guarantee,
the entity must recognize a liability for the fair value of the obligation it
assumes under that obligation. This interpretation is intended to improve the
comparability of financial reporting by requiring identical accounting for
guarantees issued with separately identified consideration and guarantees issued
without separately identified consideration. For the company, the initial
recognition, measurement provision and disclosure requirements of FIN No. 45 are
applicable to guarantees issued or modified after December 31, 2002. The company
is currently evaluating what impact, if any, adoption of FIN No. 45 will have on
its consolidated financial position, consolidated results of operations, or
liquidity.
In December 2002, the FASB issued Statement No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure," which amends FASB Statement
No. 123, "Accounting for Stock-Based Compensation," to provide alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition, this Statement
amends the disclosure requirements of Statement 123 to require prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. The transition guidance and annual disclosure
provisions of Statement 148 are effective for fiscal years ending after December
15, 2002, with earlier application permitted in certain circumstances. The
interim disclosure provisions are effective for financial reports containing
financial statements for interim periods beginning after December 15, 2002. The
adoption of this statement did not have a material impact on the Company's
financial position or results of operations as the Company has not elected to
change to the fair value based method of accounting for stock-based employee
compensation.
27
In January 2003, the FASB issued Interpretation No. 46, "Consolidation
of Variable Interest Entities." Interpretation 46 changes the criteria by which
one company includes another entity in its consolidated financial statements.
Previously, the criteria were based on control through voting interest.
Interpretation 46 requires a variable interest entity to be consolidated by a
company if that company is subject to a majority of the risk of loss from the
variable interest entity's activities or entitled to receive a majority of the
entity's residual returns or both. A company that consolidates a variable
interest entity is called the primary beneficiary of that entity. The
consolidation requirements of Interpretation 46 apply immediately to variable
interest entities created after January 31, 2003. The consolidation requirements
apply to older entities in the first fiscal year or interim period beginning
after June 15, 2003. Certain of the disclosure requirements apply in all
financial statements issued after January 31, 2003, regardless of when the
variable interest entity was established. The Company does not expect the
adoption to have a material impact to the Company's financial position or
results of operations.
During April 2003, the FASB issued SFAS 149 - "Amendment of Statement
133 on Derivative Instruments and Hedging Activities," effective for contracts
entered into or modified after June 30, 2003, except as stated below and for
hedging relationships designated after June 30, 2003. In addition, except as
stated below, all provisions of this Statement should be applied prospectively.
The provisions of this Statement that relate to Statement 133 Implementation
Issues that have been effective for fiscal quarters that began prior to June 15,
2003, should continue to be applied in accordance with their respective
effective dates. In addition, paragraphs 7(a) and 23(a), which relate to forward
purchases or sales of when-issued securities or other securities that do not yet
exist, should be applied to both existing contracts and new contracts entered
into after June 30, 2003. The Company does not participate in such transactions,
however, is evaluating the effect of this new pronouncement, if any, and will
adopt FASB 149 within the prescribed time.
During May 2003, the FASB issued SFAS 150 - "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity,"
effective for financial instruments entered into or modified after May 31, 2003,
and otherwise is effective at the beginning of the first interim period
beginning after June 15, 2003. This Statement establishes standards for how an
issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. It requires that an issuer
classify a freestanding financial instrument that is within its scope as a
liability (or an asset in some circumstances). Many of those instruments were
previously classified as equity. Some of the provisions of this Statement are
consistent with the current definition of liabilities in FASB Concepts Statement
No. 6, Elements of Financial Statements. The Company is evaluating the effect of
this new pronouncement and will adopt FASB 150 within the prescribed time.
FACTORS THAT MAY AFFECT FUTURE RESULTS
A LIMITED OPERATING HISTORY MAKES EVALUATING OUR BUSINESS DIFFICULT.
Prior to our business combination with ER LLC, their operations
consisted primarily of organizational activities and product development. In
addition, our consumer electronics and youth product divisions are still in
their initial stages. Accordingly, there is very limited operating history upon
which an evaluation of our prospects and future performance can be based. There
can be no assurance that we will be able to develop our products as we envision,
raise additional capital to develop our business, generate revenues or become a
viable business. Our prospects must be considered in the light
28
of the risks, uncertainties, expenses and difficulties frequently encountered by
companies in their early stages of development.
DUE TO OUR OPERATING REQUIREMENTS AND LESS THAN EXPECTED REVENUES, WE REQUIRE
ADDITIONAL FINANCING OR WE WILL BE UNABLE TO CONTINUE AS A GOING CONCERN.
ER LLC had no revenues prior to its business combination with us since
its products had not yet been offered to the public. We have begun to receive
limited cash proceeds from sales of the P5(TM), but sales have been slower than
we anticipated due, in part, TO general economic conditions and weaker than
expected sales of PC's, PC games and the peripherals associated therewith. We
have not sold any other products in our other divisions. We anticipate that we
will need to raise additional capital in the immediate future to continue
business operations; however, there can be no assurance that such financing, or
any additional financing, will be available to us when needed, on commercially
reasonable terms or at all. Any inability to obtain additional financing when
needed could have a material adverse effect on us, requiring us to curtail and
possibly cease our operations.
WE EXPECT TO INCUR OPERATING LOSSES AND NEGATIVE CASH FLOW FOR THE FORESEEABLE
FUTURE.
We have incurred and expect to incur significant net losses and to
experience negative cash flow for the foreseeable future. The auditors opinion
attached hereto indicates substantial doubt about our ability to continue as a
going concern. Our success depends on the further development of our products,
establishing and strengthening our lines of business, as well as establishing
distribution channels for our products and relationships with retailers.
Accordingly, we intend to continue making significant capital expenditures to
market, promote, manufacture and develop our products and execute our business
model. As a result of such expenditures, we will need to generate significant
revenues to achieve profitability. There can be no assurance that we will ever
achieve revenues or profitable operations.
WE NEED TO HIRE ADDITIONAL PERSONNEL AND MANAGE OUR GROWTH EFFECTIVELY IN ORDER
TO BECOME A SUCCESSFUL COMPANY.
We believe that our growth through the development and implementation
of our business plan will result in an increase in responsibilities on our
management team and will place added pressures on our operating and financial
resources. We will also need to hire additional management, sales and
operational personnel. There can be no assurance that we will have the funds to
hire such personnel or that they will otherwise be available to hire to allow us
to manage our business. In addition, to manage this anticipated growth, we must
implement systems and train, manage and integrate our employees as we expand our
employee base. We cannot assure you that we have made adequate allowances for
the costs and risks associated with this growth, that our procedures or controls
will be adequate to support our operations, or that our management will be able
to successfully offer and expand our products. If we are unable to manage our
growth effectively, our business could be materially adversely affected.
3D ENVIRONMENTS, ON WHICH WE HAVE BASED OUR FIRST PRODUCT LAUNCH, MAY NOT
ACHIEVE SIGNIFICANT MARKET ACCEPTANCE.
Our sales efforts with respect to the P5(TM) have not and may not
generate sufficient revenues to recover development aND marketing costs,
especially if games using the 3D environment do not reach a significant level of
market acceptance. We have devoted significant development and marketing
29
resources on designing the P5(TM) for USB-compatible systems. If such systems do
not achieve wiDE acceptance by consumers or such manufacturers are unable to
ship a significant number of such units in a timely fashion we will experience
lower than expected sales. If we cannot develop sufficient sales for the P5(TM)
or other products we may sell, we will nOT be able to continue as a going
concern.
THE EFFECTS OF A HIGHLY COMPETITIVE PERIPHERAL INPUT DEVICE MARKET MAY HAVE A
MATERIAL ADVERSE EFFECT ON OR RESULTS OF OPERATIONS.
The market for peripheral input devices, including mice and joysticks,
is very competitive. In addition, Microsoft, Sony and Nintendo, who currently
dominate the interactive entertainment hardware and software industry, may
determine to develop their own 3D peripheral port device or limit the
functionality of input devices utilizing their USB ports, and have the financial
resources to withstand significant price competition and to implement extensive
advertising campaigns. Many of our competitors have far greater financial,
technical, personnel and other resources than we do, and many are able to carry
larger inventories and adopt more aggressive pricing policies. Prolonged price
competition or reduced operating margins could cause profits associated with the
P5(TM) TO decrease significantly.
INCREASED COMPETITION FOR LIMITED SHELF SPACE AND PROMOTIONAL SUPPORT FROM
RETAILERS COULD AFFECT THE SUCCESS OF OUR BUSINESS AND REQUIRE US TO INCUR
GREATER EXPENSES TO MARKET OUR PRODUCTS.
Retailers typically have limited shelf space and promotional resources,
and competition is intense among an increasing number of newly introduced
interactive entertainment software products and related items for adequate
levels of shelf space and promotional support. Competition for retail shelf
space is expected to increase, which may require us to increase our marketing
expenditures. Competitors with more extensive lines, popular products and
financial resources frequently have greater bargaining power with retailers.
Accordingly, we may not be able to achieve the levels of support and shelf space
that such competitors receive.
PRODUCT RETURNS THAT EXCEED OUR ACCRUALS OR PRODUCTS DELIVERED BUT NOT SOLD MAY
SIGNIFICANTLY IMPACT OUR FINANCIAL RESULTS.
As a manufacturer of consumer products, we are exposed to the risk of
product returns, either through the exercise by customers of contractual return
rights or as a result of our assistance in balancing inventories of retailers
and distributors, as well as the risk of products delivered to retailers not
being sold to consumers. A portion of our net sales may result in increased
inventory at our distributors and resellers, which could lead to reduced orders
by these customers in future periods. Overstocking by our distributors and
retailers may lead to higher than normal returns or a deduction based on the
amount of product not sold. The difficulty in predicting future sales increases
the risk that new product introductions, price reductions or other factors
affecting the electronic consumer products market would result in significant
product returns. In addition, we may introduce product upgrades, enhancements
and improved packaging, and thus may experience higher rates of return on our
older products.
WE ARE UNDER THE CONTROL OF CERTAIN SHAREHOLDERS, WHICH COULD PREVENT THE TAKING
OF CERTAIN ACTIONS WHICH MAY BE BENEFICIAL TO THE OTHER SHAREHOLDERS.
LCG Capital Group, LLC, one of the original members of Essential
Reality, LLC who received shares of our common stock pursuant to our business
combination with Essential Reality, LLC, may be deemed to beneficially own a
substantial majority of our common stock by virtue of a voting agreement with
certain other of our other shareholders. Consequently, LCG will control the
outcome of
30
substantially all matters submitted to a vote of our security holders, including
but not limited to the selection of members to our Board of Directors and the
adoption of measures that could delay or prevent a change in control or impede a
merger, takeover or other business combination we may potentially be involved
in. LCG is controlled by Winchester Capital Group, LLC, which is controlled by
Michael Alpert.
OUR COMMON STOCK IS SUBJECT TO PENNY STOCK REGULATION, WHICH MAY LIMIT THE
LIQUIDITY OF OUR COMMON STOCK AND THE ABILITY OF OUR SHAREHOLDERS TO SELL OUR
SHARES.
Our common stock is subject to regulations of the SEC relating to the
market for penny stocks. These regulations generally require that a disclosure
schedule explaining the penny stock market and the risks associated with the
penny stock market be delivered to purchasers of penny stocks and impose various
sales practice requirements on broker-dealers who sell penny stocks to persons
other than established customers and accredited investors. The regulations
applicable to penny stocks may severely limit the market liquidity for our
securities and could reduce our shareholder's ability to sell our securities in
the market.
IF WE ARE NOT CURRENT IN OUR PERIODIC FILINGS WITH THE SEC, WE COULD LOSE OUR
ELIGIBILITY TO TRADE OUR SECURITIES ON THE OTC BULLETIN BOARD, WHICH WOULD HAVE
AN ADVERSE AFFECT ON OUR ABILITY TO RAISE ADDITIONAL FUNDS.
We are required to file annual and quarterly reports with the SEC,
pursuant to the Securities Exchange Act of 1934, as amended, and the rules
promulgated there under. To the extent we do not timely file such reports, our
securities may no longer be permitted to be traded on the OTC Bulletin Board,
and would then be listed on the "pink sheets." Such action would have an adverse
affect on our ability to raise additional funds in the future since many
potential investors will not invest in companies whose securities are traded on
the "pink sheets."
ITEM 7. FINANCIAL STATEMENTS.
See our financial statements beginning on page F-1.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Effective March 13 ,2003 ("Termination Date") we terminated our
relationship with Deloitte & Touche LLP ("D&T") the Company's principal
independent accountant. On such date the Company engaged Stonefield Josephson,
Inc. ("Stonefield") to serve as the Company's new principal independent
accountant.During the two most recent years and through December 31, 2002, the
Registrant has not consulted with Stinefield Josephson, Inc. on items regarding
the application of accounting ptinciples to a specified transaction, either
completed or proposed, or the type of audit opinion which might be rendered on
the Registrant`s financial statemente. Our Audit Committee and Board of
Directors participated in and approved the decision relating to the change in
independent auditors' from D&T to Stonefield.
During the two fiscal years ended December 31, 2001 and any subsequent
interim period through March 13, 2003 there were no disagreements between us,
Essential Reality LLC and D&T on any matter of accounting principles or
practices, financial statement disclosure or auditing scope or procedure, which,
if not resolved to their satisfaction, would have caused them to make reference
to the subject matter of the disagreement in connection with their report,
except for material weaknesses in internal control.
31
PART III
ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Pursuant to the terms of our business combination with ER LLC, upon
consummation of the transaction, each of the officers and directors of ER LLC
became our officers and directors. We have since decided to streamline our
management team in an effort to maximize our resources as we begin to focus on
the distribution of the P5TM beyond its limited retail presence as well as the
development of additional products. We believe that the revised structure will
create a smaller but more sharply focused management team.
EXECUTIVE OFFICERS AND OTHER SIGNIFICANT EMPLOYEES
Set forth below for each of our executive officers and other
significant employees and consultants is his name, age, positions and offices
held with us, and his principal occupations during the past five years. We plan
on hiring additional management personnel in the future, including but not
limited to a full-time President, Chief Executive Officer and Chief Financial
Officer.
NAME AGE TITLE
---- --- -----
Humbert B. Powell, III 63 Chairman of the Board
John Gentile 45 Interim President and Chief Operating Officer
George Mellides 62 Acting Chief Financial Officer
David Devor 40 Vice President, Marketing & Sales
32
HUMBERT B. POWELL, III, CHAIRMAN OF THE BOARD
Mr. Powell had been ER LLC's acting Chief Executive Officer and had worked for
us in the same capacity following the consummation of our business combination
with ER LLC until July 1, 2002. Since July 1, 2002, he has served as Chairman of
our Board of Directors. Mr. Powell also has been a Managing Director at Sanders
Morris Harris, a regional investment-banking firm headquartered in Houston,
Texas, with a branch in New York City, where he resides, since November 1996.
Mr. Powell served as Chairman of Marleau, Lemire USA and Vice Chairman of
Marleau, Lemire Securities, Inc. between 1994 and 1996. Prior to his employment
with Marleau, Lemire he served as a Senior Managing Director in the Corporate
Finance Department of Bear Stearns & Co., from 1984 to 1994, with
responsibilities for the investment banking effort both domestically and
internationally. Prior to his employment with Bear Stearns, Mr. Powell served as
a Senior Vice President and Director of E.F. Hutton & Co., where he was employed
in various capacities for 18 years. He is also a Director of Lawman Armour
Corp., Bikers Dream Inc., World Water Corp., and a trustee of Salem-Teikyo
University.
JOHN GENTILE, INTERIM PRESIDENT AND CHIEF OPERATING OFFICER
Mr. Gentile has served as our Interim President and Chief Operating Officer
since December 31, 2002. Mr. Gentile has also served as President of Abrams
Gentile Entertainment (AG), a New York-based entertainment technology and
marketing firm since its inception in 1986. He also is a principal and board
member of T-INK Technologies, Inc.(TM), a company founded in December 2000 that
develops and markets high tech conductive inks for both interactive consumer and
industrial applications. Mr. Gentile, along with his brother Anthony, holds many
patents and trademarks for technology and toy applications, as well as technical
and process technologies they have created for joint ventures with Hasbro,
Kenner and Mattel, which collectively generated over a billion dollars of retail
sales. Prior to AG, he was a founder and Chief Executive Officer of The Instar
Group from 1973 to 1986, an entertainment design firm where he created many
successful campaigns and film design for Paramount Pictures, Universal Studios
and Columbia Pictures.
GEORGE MELLIDES, ACTING CHIEF FINANCIAL OFFICER
Mr. Mellides has served as our Acting Chief Financial Officer since March 24,
2003. Previously, from May 2000 to February 2003, Mr. Mellides served as Chief
Financial Officer of James Barclay Alan, a small-cap Investment Banking Company.
From January 1999 to April 2000 he served as Chief Financial Officer of Dreman
Value Management, Investment Advisors and from January 1996 through December
1998 he served as Chief Financial Officer of Laidlaw Global Securities.
DAVID DEVOR, VICE PRESIDENT, SALES & MARKETING
Mr. Devor had been with ER LLC since November 1999, and since November 2001 has
been our Vice President of Marketing, responsible for marketing and branding of
our products. Prior to joining ER LLC, Mr. Devor managed private equity
investments from February 1991 to October 1999 through his principal position
with Devor Capital Investments LLC, which is an investment firm specializing in
high-tech companies, with a primary focus on interactive entertainment,
electronic gaming and Internet-related opportunities. Prior to that, from
October 1983 to January 1991, Mr. Devor founded and managed a large chain of
home entertainment furnishings centers. On February 27, 1996, Mr. Devor pleaded
guilty to the crime of offering a false instrument for filing. He received a
three-year conditional discharge, paid $10,000, and was obligated to perform 40
hours of community service.
John Gentile, our interim President, Chief Operating Officer and Director, is
the brother of Anthony Gentile, another Director of ours. There are no other
family relationships among our directors and executive officers.
33
BOARD OF DIRECTORS
Set forth below for each of the five members of our Board of Directors is his
name, age, the term during which he has served as one of our directors, his
principal occupations during the past five years and any additional
directorships he has held in publicly-held companies.
MARC A. FRIES, age 34
Mr. Fries has been the President of The Raynor Group ("Raynor"), an established
national sales and marketing firm in the office furniture industry, since
February 1998. Mr. Fries is responsible for the development and implementation
of sales strategies for each of the distribution channels Raynor services. These
channels include big box retail, mail order, Internet sales, national buying
groups, regional distributors and independent dealers. Mr. Fries has headed the
licensed product division at Raynor since its inception two years ago. Currently
this division is launching its Technomesh(TM) seating and accessories product
line under license agreements with National Football League Properties and the
National Hockey League. Raynor is in the process of signing agreements with the
National Basketball Association and the NCAA Collegiate Licensing Committee. Mr.
Fries has been responsible for all product development including design, global
sourcing and manufacturing for Raynor. He has been instrumental in developing
its marketing plan and coordinating sales and distribution with key retail
partners across the country. Prior to being appointed President of Raynor, Mr.
Fries was the National Sales Manager responsible for Raynor's outside sales
force. Mr. Fries began his career in sales with Raynor in October 1990. Mr.
Fries received his Bachelor of Arts in Economics from Yeshiva University in New
York.
BRIAN D. JEDWAB, ESQ., AGE 32
Mr. Jedwab has served as general counsel to Hymax Group, LLC, a private equity
investment company with investments in numerous public and private companies,
primarily Internet and technology related, since 1997. In such capacity, he has
been responsible for the direction and management of all legal and
administrative affairs. Mr. Jedwab has practiced law in the areas of commercial
litigation and real estate, is a member of the Bar of the States of New York and
New Jersey and is a member of the New York State Bar Association. Mr. Jedwab
received his B.A. in History cum laude from Queens College and received a J.D.
from the Benjamin N. Cardozo School of Law.
ANTHONY GENTILE, AGE 45
Mr. Gentile has served as Vice-President of AG since its inception in 1986. He
also is a principal and Board member of T-INK Technologies, Inc.(TM), a company
founded in December 2000 that develops and markets high tech conductive inks for
both interactive consumer and industrial applications. Mr. Gentile, along with
his brother John, holds many patents and trademarks for technology and toy
applications, as well as technical and process technologies they have created
for joint ventures with Hasbro, Kenner, and Mattel, which collectively have
generated over a billion dollars of retail sales. Prior to AG, he was a founder
and Vice-President of The Instar Group from 1973 to 1986, an entertainment
design firm where he created many successful campaigns and film design for
Paramount Pictures, Universal Studios and Columbia Pictures.
For Humbert B. Powell, III's and John Gentile's information, see "Executive
Officers and Other Significant Employees" above.
COMMITTEES
In June 2002, our Board of Directors established an audit committee and a
compensation committee. The Board has assigned certain responsibilities to the
committees and the committees approve actions and
34
make recommendations to the Board. The audit committee works with the chief
financial officer and outside auditors, in connection with various auditing and
accounting matters, including the recommendation of auditors, the scope and
accuracy of the annual audits, fees to be paid to the auditors, the independence
of the auditors, and our internal controls and accounting practices. The members
of the audit committee currently are Humbert B. Powell, III (Chairman) and Marc
Fries. The compensation committee reviews the budget and recommends, reviews and
oversees the salaries, benefits and stock option plans for our employees,
consultants, directors and other individuals compensated by us. The members of
the compensation committee currently are Humbert B. Powell, III (Chairman),
Brian D. Jedwab and Anthony Gentile. The Board and its committees currently are
examining the impact of the Sarbanes-Oxley Act of 2002 on their structure and
operations. Our Board of Directors may from time to time establish other
committees to facilitate our management.
ADVISORY BOARD
In January 2001, ER, LLC established an advisory board for the purpose of
providing it with strategic advice. The members of the advisory board meet
periodically with and advise our employees, customers and third-party
consultants. Set forth below for each member is his or her name, age and
principal occupations during the past five years.
PAUL EIBELER, AGE 45
Mr. Eibeler is the President of Take-Two Interactive, an integrated global
developer, marketer, distributor, and publisher of interactive entertainment
software games and accessories for the Sony PlayStation2, Nintendo 64, and
Microsoft Xbox. He has been with Take-Two interactive, since July 2000.
Previously, Mr. Eibeler held various consulting positions for Microsoft's Xbox
launch team, W-Trade Inc. and Essential Reality, LLC from January 1999 to June
2000. Mr. Eibeler also served as Acclaim Entertainment's executive vice
president and General Manager from June 1996 to January 1999. Mr. Eibler
graduated from Loyola University in 1978.
JOSHUA I. SMITH, AGE 61
Mr. Smith is an internationally distinguished entrepreneur and lecturer. Since
1998, Mr. Smith has been Chairman and Managing Partner of The Coaching Group. In
that capacity he is the "coach," senior advisor/consultant, to the CEO's of the
portfolio companies and assumes active roles with these companies which includes
serving as Chairman or Vice Chairman of the Board, Board member, or Advisory
Board member. Previously he was Founder, Chairman and CEO of the MAXIMA
Corporation, a 20 year-old firm that achieved a national reputation as one of
the top African American owned firms in the United States. In addition, Mr.
Smith presently serves on the Boards of Directors for Caterpillar, Inc.
(CAT-NYSE), FedEx Corp (FDX-NYSE) and Allstate Corporation (ALL-NYSE).
GLENN WONG, AGE 45
Mr. Wong has been the principal of Catalyst Solutions Ltd., a consulting
company, since February 2001. Mr. Wong provided strategic consulting services to
Mike's Hard Lemonade(TM), the number one hard lemonade in the US and Canada.
Previously, Mr. Wong served as President & General Manager for Electronic Arts
(Canada), Inc., the world's largest video game studio, from January 1998 to
January 2001. In this capacity, he oversaw development of the full line of
interactive computer and video game entertainment software for Electronic Arts
studios in Burnaby, BC and Bellevue, WA. Prior to joining Electronic Arts, he
was President of Rogers Cable TV for British Columbia from November 1995 to
January 1998, where he concentrated his efforts on the quickly changing
environment of the cable and telecommunications industry. From 1993 to 1995, Mr.
Wong served as President and Chief Executive Officer of B.C. Hothouse, Ltd., a
Canadian produce company. Mr. Wong also served as Vice President of Marketing at
Nabob Foods from January 1984 to January 1993, where he oversaw several
successful
35
campaigns and received his first AMA "Marketer of the Year" Award and "Top
Marketer" from Strategy Magazine. He began his professional career in 1980 as a
Brand Manager at Procter and Gamble Inc. Mr. Wong has served on a number of
boards including the Insurance Corporation of B.C., Canadian Cable Labs, Mohawk
Oil Ltd., and the Dragon Boat Festival Society. Mr. Wong graduated from the
University of British Columbia in 1980 with a Bachelor of Commerce and Business
Administration.
DAVID H. STARR, AGE 51
Mr. Starr is currently the Managing Director of NRW Holdings, a voice over
implementations company. Prior to NRW, Mr. Starr served as Chief Information
Officer for 3COM Corporation for two years, where he was responsible for over
800 information technology professionals in 43 countries and was involved in
managing the Palm and U.S. Robotics spin-offs. From May 1993 to August 1999, he
served as Chief Information Officer at Knight Ridder, Reader's Digest
Association and the ITT Corporation, and also has held senior officer titles at
Mastercard International, Citicorp and Price Waterhouse. His published works
have appeared in CIO Magazine and he has been a guest lecturer at various
universities and professional networks, including MIT. Mr. Starr has and/or
currently sits on the Boards of Directors of Best Buy Corporation, BoysHope
GirlsHope, ePurpose, GenerationPix, AdvisorTeam and NRW Corporation. Mr. Starr
holds an MBA from Harvard University and received his Bachelor of Arts in
Physics in 1972 from Florida State University.
MARVIN IGELMAN, AGE 40
From 1995 through March 2002, Mr. Igelman was President and CEO of BrandEra
Inc., a publicly traded company that owned and operated a business-to-business
destination for the marketing communications industry. Since April 2002, Mr.
Igelman has been a director of National Construction Inc., a multi-trade
industrial construction and maintenance contracting services company primarily
servicing Eastern Canada and Alberta. In 1983, Mr. Igelman received his law
degree from Osgoode Hall Law School located in Toronto.
ELI LEVITIN, AGE 38
Eli Levitin is Managing Director and General Counsel of Acta Realty Corp. and
affiliated companies, which hold a substantial portfolio consisting of real
estate, various investment funds, including private equity and hedge funds, and
a variety of other investments. In addition to his management responsibilities,
Mr. Levitin is actively involved in developing Acta's financial structure
associated with its investment portfolio and entities. Prior to joining Acta in
December 1993, Mr. Levitin practiced law at the law firms of White & Case and
Stroock, Stroock & Lavan, where his primary areas of practice were corporate
reorganization and structured finance. Mr. Levitin was a contributing editor of
Collier Bankruptcy Practice Guide. Mr. Levitin graduated with a bachelor of
science from Brooklyn College in 1985 and received a JD from Columbia Law School
in 1988.
HUMBERT B. POWELL, III, AGE 63
For Humbert B. Powell, III's information, see "Executive Officers and Other
Significant Employees" above.
In addition, Steven T. Francesco, our former Chief Executive Officer and a
former member of the Board of Directors has been working with us and has agreed
to join the advisory board but has not yet signed an advisory agreement with us.
Mr. Francesco worked with us to, among other things, finalize various business
development initiatives which were started during his tenure with us.
36
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 requires our directors and
executive officers, and persons who own more than 10% of our common stock, to
file with the Securities and Exchange Commission (the "Commission") initial
reports of ownership and reports of changes in ownership of our common stock.
Such persons are required by the Commission's regulations to furnish us with
copies of all Section 16(a) forms they file. Based solely upon a review of
copies of such forms received by us, or written representation from certain
reporting persons, we believe, during the fiscal year ended December 31, 2002,
that there was compliance with all Section 16(a) filing requirements applicable
to our officers, directors and 10% shareholders.
ITEM 10. EXECUTIVE COMPENSATION.
During our fiscal year ended December 31, 2002, we had three chief executive
officers. Frank Drechsler served as our chief executive officer until our
business combination with ER LLC on June 20, 2002. Mr. Drechsler did not earn or
receive any compensation for services he rendered to us. Following the business
combination, Humbert Powell, III had acted as our chief executive officer until
July 1, 2002. Mr. Powell did not earn or receive any compensation for services
he rendered to us in such capacity. Steven T. Francesco served as our chief
executive officer from July 1, 2002 until February 5, 2003. Since the
resignation of Mr. Francesco on February 5, 2003, John Gentile, as Interim
President, has been serving as our principal executive officer.
SUMMARY COMPENSATION TABLE
LONG-TERM
ANNUAL COMPENSATION COMPENSATION
------------------- ------------
OTHER ANNUAL SECURITIES
NAME AND SALARY BONUS COMPENSATION UNDERLYING OPTIONS
PRINCIPAL POSITION YEAR ($) ($) ($) (1) (SHARES)
------------------ ---- --- --- ------- --------
Steven T. Francesco, 2002 $127,000 None None 0
Chief Executive Officer
-------------
(1) The aggregate amount of perquisites and other personal benefits paid to
each of the individuals listed on this table did not exceed the lesser of
ten percent (10%) of such officer's annual salary and bonus for each fiscal
year indicated or $50,000.
During the fiscal year ended December 31, 2002, we did not grant any
options to our named executive officers nor do any of them own any options to
purchase shares of our common stock, except for Humbert B. Powell, III who was
granted 35,000 options as a member of our Board of Directors and Advisory Board.
With respect to our current officers, the status of their employment
agreements are as follows:
DAVID DEVOR, VICE PRESIDENT, MARKETING AND SALES. On September 5, 2002, Mr.
Devor signed an employment agreement which provides for a base salary of
$150,000 per year. He was also granted the following options to purchase shares
of our common stock: (i) 200,000 shares at an exercise price of $.65 per share,
which vested immediately; (ii) 100,000 shares at an exercise price of $0.65 per
share, 25,000 of which vest on February 29,2003 and 75,000 in five equal monthly
installments commencing March 29,
37
2003; (iii) 200,000 shares at an exercise price of $1.00 per share which vest
when either of the following conditions occur: (a) our market capitalization,
based on the public float, equals or exceeds $150 million for a period of sixty
consecutive business days and the average daily volume of our common stock
traded during those sixty days is no less than 125,000 or (b) we sell all or
substantially all of our assets for a minimum of $125 million.
Neither John Gentile, Interim President and Chief Operating Officer, nor George
Mellides, our acting Chief Financial Officer, have employment agreements with
the Company.
DIRECTOR COMPENSATION
As compensation for their services as members of the Board, each member
receives annual compensation of $10,000, plus options to purchase 10,000 shares
of our common stock at an exercise price equal to the closing price of our
common stock on the date of the grant. The options vest over a one-year period
in equal quarterly amounts, so long as the director completes service for such
quarter. Non-employee directors are reimbursed for reasonable expenses in
connection with serving as a director and member of a committee.
ADVISORY BOARD COMPENSATION
As compensation for serving on the advisory board, the members have
received options to purchase an aggregate of 260,000 shares of our common stock
at exercise prices ranging from $0.75 to $1.60. All of these options were
granted in June 2002 and vest equally on the first, second and third
anniversaries of the date of grant, so long as the advisory board member
completes service for such period. The issuance of the options resulted in
deferred stock-based compensation expense of $610,448 of which 93,263 was
expensed for the year ended December 31, 2002 using the Black-Scholes pricing
model.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED
STOCKHOLDER MATTERS.
The following table sets forth information concerning ownership of our common
stock as of March 31, 2003, by (i) each person known by us to be the beneficial
owner of more than five percent of the outstanding shares of our common stock,
(ii) each director, and (iii) all of our directors and executive officers as a
group.
NUMBER OF SHARES PERCENTAGE OF OUTSTANDING
NAME AND ADDRESS OF BENEFICIAL OWNER BENEFICIALLY OWNED SHARES BENEFICIALLY OWNED (1)
------------------------------------ ------------------ -----------------------------
LCG Capital Group, LLC 9,600,000 (2) 52.7%
Hamilton Resources Group, LLC
Winchester Capital Group, LLC
Michael Alpert
c/o 335 Central Avenue, 2nd Floor
Lawrence, NY 11559
Martin Abrams 2,400,480 13.2%
c/o Abrams Gentile Entertainment, Inc.
244 West 54th Street, 9th Floor
New York, NY 10017
38
NUMBER OF SHARES PERCENTAGE OF OUTSTANDING
NAME AND ADDRESS OF BENEFICIAL OWNER BENEFICIALLY OWNED SHARES BENEFICIALLY OWNED (1)
------------------------------------ ------------------ -----------------------------
Michael B. Schwab 2,113,478 (3) 11.6%
c/o 1219 Lombard Street
San Francisco, CA 94109
Big Sky Partners 2,027,078 (4) 11.2%
c/o 1219 Lombard Street
San Francisco, CA 94109
Anthony Gentile 1,129,260 (5) 6.2%
c/o Abrams Gentile Entertainment, Inc.
244 West 54th Street, 9th Floor
New York, NY 10017
John Gentile 1,129,260 (5) 6.2%
c/o Abrams Gentile Entertainment, Inc.
244 West 54th Street, 9th Floor
New York, NY 10017
Jayvee & Co., for AGF Canadian Growth Equity 1,113,800 6.1%
c/o Jayvee & Co.
P.O. Box 9
Commerce Court West
Securities Level
Toronto, Ontario M5H 4A6
Humbert B. Powell, III 7,500 (5)(6) *
Marc A. Fries 7,500 (5) *
Brian D. Jedwab 7,500 (5) *
All executive officers and directors as a group 2,281,020 12.5%
(5 persons)
--------------
o Less than 1%
(1) Unless otherwise indicated, we believe that all persons named in the
above table have sole voting and investment power with respect to all
shares of voting stock beneficially owned by them. A person is deemed
to be the beneficial owner of securities that can be acquired by such
person within 60 days from the date hereof upon the exercise of
options, warrants or convertible securities. Each beneficial owner's
percentage ownership is determined by assuming that options, warrants
and convertible securities held by such person (but not those held by
any other person) and which are exercisable or convertible within 60
days have been exercised and converted. Assumes a base of 18,223,110
shares of common stock outstanding.
(2) Includes 4,800,000 shares of common stock held by LCG Capital Group,
LLC (LCG) and an additional 4,800,000 shares of common stock held
collectively by Martin Abrams, John Gentile, Anthony Gentile and MSH
Entertainment Corporation, who have agreed to vote their shares in the
same manner as LCG votes its shares with respect to certain matters
(including but not limited to the election of directors). LCG may be
deemed to
39
beneficially own such shares whose vote it controls but it disclaims
beneficial ownership of such shares except to the extent of its
pecuniary interest. Hamilton Resources Group, LLC currently owns a
majority of the equity in LCG and may be deemed to beneficially own the
shares held by LCG. Winchester Capital Group, LLC, as the managing
member of LCG, may be deemed to beneficially own the shares held by
LCG. Michael Alpert, as the managing member of Winchester Capital
Group, may be deemed to beneficially own the shares held by LCG.
Hamilton Resources Group, Winchester Capital Group and Michael Alpert
each disclaims beneficial ownership of the shares beneficially owned by
LCG, except to the extent of its pecuniary interest therein.
(3) Includes 86,400 shares of common stock held by Mr. Schwab, 1,920,000
shares of common stock held directly by Big Sky Partners, and 107,078
shares of common stock held indirectly by Big Sky Partners through its
ownership in LCG Capital Group. Mr. Schwab, as managing partner of Big
Sky Partners, may be deemed to beneficially own the shares held by Big
Sky Partners, but he disclaims beneficial ownership of such shares,
except to the extent of his pecuniary interest therein.
(4) Includes 1,920,000 shares of common stock held directly by Big Sky
Partners and 107,078 shares of common stock held indirectly by Big Sky
Partners through its ownership in LCG Capital Group. Big Sky Partners
disclaims beneficial ownership of the shares held by LCG Capital Group,
except to the extent of its pecuniary interest therein.
(5) Includes 7,500 shares of common stock issuable upon currently
exercisable directors options.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following table sets forth certain information regarding our equity
compensation plans at December 31, 2002:
NUMBER
OF
SECURITIES
REMAINING AVAILABLE
NUMBER OF SECURITIES TO BE WEIGHTED-AVERAGE FOR FUTURE ISSUANCE
ISSUED UPON EXERCISE OF EXERCISE PRICE OF UNDER EQUITY
PLAN CATEGORY OUTSTANDING OPTIONS OUTSTANDING OPTIONS COMPENSATION PLANS
------------- ------------------- ------------------- ------------------
Equity compensation plans approved
by security holders
1,357,000 $1.08 1,357,000
Equity compensation plans not
approved by security holders
N/A N/A N/A
--------- ------- -----------
Total 1,357,000 $1.08 1,357,000
========= ======= ==========
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
ESSENTIAL REALITY, LLC
On June 20, 2002, we consummated a business combination with ER LLC.
Pursuant to the terms of the transaction, all of the members of ER LLC
contributed their membership interests to us in exchange for an aggregate of
16,874,784 shares of our common stock. LCG Capital Group, LLC, Martin Abrams,
John Gentile and Anthony Gentile, all of whom were members of ER LLC at the
consummation of the transaction, are now significant shareholders of ours. See
"Security Ownership of Certain Beneficial Owners and Management". Following the
transaction, ER LLC, then our wholly-owned subsidiary, was merged with and into
us.We owe an aggregate of $228,492 in accrued salaries to certain affiliates of
ER LLC for services rendered to ER LLC. We currently owe $39,600 to Abrams
Gentile Entertainment Corporation, $60,000 to Anthony Gentile for unpaid salary
as a Senior Vice President of ER LLC, $9,755 to David Devor in connection with
services rendered as Vice President of Marketing, $60,000 to John Gentile in
connection with services rendered as Executive Vice President of ER LLC,
40
and $59,137 to Michael Alpert in connection with services rendered as President
and Chief Executive Officer of ER LLC.
In July 2000, Essential Reality, LLC entered into a consulting
agreement with MC Squared Incorporated to help manage the relationship with
product developers. This consulting agreement replaced a previous Development
Agreement executed between Essential Reality, LLC and MC Squared in November
1999. In connection with these agreements we paid MC Squared $250,000. We are no
longer making payments to MC Squared. In September 2000 the consulting agreement
terminated and the development process was managed by us internally. MC Squared
is a company owned by a person related to certain members of our Board of
Directors. Pursuant to such agreement, we are required to pay royalties of 1.8%
on net sales of the P5TM and 9% of the license fee collected by us with respect
to P5TM, indefinitely. No payment is due MC Squared until sales or fees are
actually received by us. MC Squared has sued us in connection with these
agreements. See "Legal Proceedings" above.
LCG CAPITAL GROUP, LLC
LCG Capital Group, LLC (LCG) is a founding member of ER LLC and, after
our business combination, beneficially owns approximately 53.5% of our
outstanding common stock. ER LLC received interest-free loans from LCG in the
aggregate amount of $70,912, which are payable on demand.
BUSINESSDEVELOPMENT.COM, LLC
BusinessDevelopment.com, LLC (BDC) is an entity controlled by Michael
Alpert, an affiliate of LCG. LCG does not directly own any interest in BDC,
although certain people are affiliated with both LCG and BDC. BDC entered into
an agreement with ER LLC on December 13, 2000, pursuant to which BDC provides
general consulting services to ER LLC, and now to us, in return for a monthly
cash retainer. Such services consist of forming revenue-generating
opportunities, including without limitation distribution agreements, licensing
agreements, joint ventures, strategic alliances and partnerships. The amount of
the retainer originally was $6,000 per month, increased to $15,000 per month
from July 1, 2002 to September 30, 2002 and is currently $7,500 per month and
can increase from time to time up to a maximum of $20,000 per month, based upon
our mutual consent with BDC, depending on the level and geographic scope of the
services. To date, together with ER LLC, we have incurred $193,000 of consulting
fees from BDC under the terms of such agreement. Included in general and
administrative expenses is $117,000 and $100,000 at December 31, 2002 and 2001
respectively.
In addition to the monthly retainer, we also are obligated to pay to
BDC a potential revenue share of up to four percent (4.0%) on transactions
facilitated by BDC. Either BDC or we may cancel this agreement with thirty (30)
days prior notice. BDC is not registered as a broker-dealer. BDC does not
participate in document preparation or marketing, nor do they perform due
diligence. In determining suitability for potential business opportunities, BDC
necessarily analyzes the parties involved, but no analyses of sophistication or
other broker-dealer type functions are performed by BDC on our behalf.
Until November 30, 2001, ER LLC shared office space with BDC. This is
no longer the case. There was an allocation of general expenses in connection
with such office space, whereby BDC paid 70% and ER LLC paid 30% of such
expenses. Certain items, such as office supplies and computer leases, were
assumed by ER LLC and taken to its new offices.
41
OTHER RELATIONSHIPS AND RELATED TRANSACTIONS
Abrams Gentile Entertainment Corporation (AGE), a company owned by
certain founding members of ER LLC, including Anthony and John Gentile, who are
directors of ours, and Martin Abrams, a shareholder of ours who owns 13.4% of
our outstanding common stock, has provided services to ER LLC and us as a
general consultant and advisor with respect to developing business
relationships. Anthony Gentile owns 24.995% of AGE, John Gentile owns 24.995%
and Martin Abrams owns 50.01%. We have incurred fees (including, but not limited
to, accrued compensation and accounts payable) to AGE and may incur additional
expenses as services are performed. Services performed to date include
assistance with the product logo design, advertising, planning, production and
other business development activities. Included in product and development
expense is $33,700 and $55,000 for the years ended December 31, 2002 and 2001.
We are allocated the costs of various computer and related equipment
leases assumed by Hymax Group, LLC, an affiliate of LCG. LCG does not own any
interest in Hymax Group, LLC, but Hymax Group, LLC is affiliated with BDC and
Michael Alpert. Such payments are due through August 20003. Hymax also made
certain of its employees available to provide operational support services to ER
LLC, and now us, and was reimbursed for a portion of such employees'
compensation, based on the percentage of time worked for us. Such reimbursement
amount aggregated approximately $4,500 per month from January 1, 2002 to June
30, 2002 and were then reduced to $2,500 per month from July 1, 2002 to December
31, 2002. Effective January 2003 such services have ceased. Included in general
and administrative expenses is $46,600 and $49,600, respectively, of payroll
allocated expenses.
Advances from affiliated companies are from entities that are
affiliated with certain shareholders of the Company. The advances are payable on
demand and bear interest at the rate of 10% per annum. Certain of these advances
were satisfied in September 2002, by granting the Company's interest in "other
assets" of $22,500 to these entities. At December 31, 2002, $1,712 remains
outstanding.
Included in general and administrative expenses is $21,700 and $26,000
at December 31, 2002 and 2001, respectively, of marketing expense payable to a
company owned by a person related to certain members of the Company who assisted
in establishing and executing its marketing programs. Included in accounts
payable-related parties is $21,700 of this expense at December 31, 2002.
Included in general and administrative expenses is $35,000 and $58,000
at December 31, 2002 and 2001, respectively, of business development expense
payable to a company that is related to certain members of LCG who assisted the
Company in executing its business development program. Included in accounts
payable-related parties is $35,000 of this expense at December 31, 2002.
We currently do not have a policy with respect to future related party
transactions. Accordingly, we have frozen all future related party transactions
until such a policy is in place, but continue to make payments pursuant to the
related party transactions set forth herein.
ITEM 13. EXHIBITS, LIST AND REPORTS ON FORM 8-K.
(a) Exhibits
See the Exhibit Index immediately following the Financial Statements.
42
(b) Reports on Form 8-K:
None.
ITEM 14. CONTROLS AND PROCEDURES.
Within the 90 day period prior to the filing date of this report, we
carried out an evaluation, under the supervision and with the participation of
our management, including our acting principal executive officer and our Acting
Chief Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures. Based upon that evaluation, our principal
executive officer and Acting Chief Financial Officer concluded that our
disclosure controls and procedures are effective in timely alerting them to
material information relating to us required to be included in our periodic
Commission filings.
There were no significant changes in our internal controls or in other
factors that could significantly affect these controls subsequent to the date of
their evaluation, including any corrective actions with regard to significant
deficiencies and material weaknesses.
[SIGNATURE PAGE FOLLOWS]
43
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act
of 1934, the registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
ESSENTIAL REALITY, INC. Date: June 2003
By:
-----------------------------------
Name: Humbert B. Powell, III
Title: Chairman of the Board
POWER OF ATTORNEY
Essential Reality, Inc. and each of the undersigned do hereby appoint
Humbert B. Powell, III and John Gentile, and each of them singly, its or his
true and lawful attorney to execute on behalf of Essential Reality, Inc. and the
undersigned any and all amendments to the Annual Report on Form 10-KSB and to
file the same with all exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission.
In accordance with the Securities Exchange Act of 1934, this report has
been signed below by the following persons on behalf of the registrant and in
the capacities and on the dates indicated.
Date: June 27, 2003
-----------------------------------------------------
John Gentile, Interim President, Chief Operating
OFFICER AND DIRECTOR (principal executive officer)
Date : June 27, 2003
-----------------------------------------------------
George Mellides, Acting Chief Financial Officer
(principal financial and accounting officer)
Date: June 27, 2003
-----------------------------------------------------
Humbert B. Powell, III, CHAIRMAN OF THE BOARD
Date: June 27, 2003
-----------------------------------------------------
Marc A. Fries, DIRECTOR
Date: June 27, 2003
-----------------------------------------------------
Brian D. Jedwab, DIRECTOR
Date: June 27, 2003
-----------------------------------------------------
Anthony Gentile, DIRECTOR
CERTIFICATION
SECTION 302 CERTIFICATION
I, John Gentile, certify that:
1. I have reviewed this annual report on Form 10-KSB of Essential
Reality, Inc., a Nevada corporation (the "Registrant");
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the Registrant as of, and for, the periods presented in
this annual report;
4. The Registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant
and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
annual report is being prepared;
b) evaluated the effectiveness of the Registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The Registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the Registrant's auditors and the
audit committee of Registrant's board of directors (or persons
performing the equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the Registrant's
ability to record, process, summarize and report financial data
and have identified for the Registrant's auditors any material
weaknesses in internal controls; and b) any fraud, whether or not
material, that involves management or other employees who have a
significant role in the Registrant's internal controls; and
6. The Registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: June __, 2003 By:
----------------------------------------
John Gentile, Interim President,
Chief Operating Officer and Director
(principal executive officer)
CERTIFICATION
SECTION 302
CERTIFICATION
I, George Mellides, certify that:
1. I have reviewed this annual report on Form 10-KSB of Essential
Reality, Inc., a Nevada corporation (the "Registrant");
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the Registrant as of, and for, the periods presented in
this annual report;
4. The Registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant
and have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the Registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the Registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing of this annual report (the "Evaluation Date");
and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures
based on our evaluation as of the Evaluation Date;
5. The Registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the Registrant's auditors and the
audit committee of Registrant's board of directors (or persons
performing the equivalent functions):
d) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
Registrant's ability to record, process, summarize and
report financial data and have identified for the
Registrant's auditors any material weaknesses in internal
controls; and
e) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
Registrant's internal controls; and
6. The Registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.xcc
Date: June __, 2003 By:
-------------------------------
George Mellides
Acting Chief Financial Officer
INDEX TO FINANCIAL STATEMENTS
PAGE
----
Reports of Independent Certified Public Accountants F-2
Financial Statements F-3
Balance Sheets as of December 31, 2002 and 2001 F-4
Statements of Operations for the Years Ended F-5
December 31, 2002 and 2001
Statements of Cash Flows for the Years Ended
December 31, 2002 and 2001 F-6
Notes to Financial Statements F-7
ESSENTIAL REALITY, INC.
FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2002 AND 2001
CONTENTS
PAGE
INDEPENDENT AUDITORS' REPORTS 1-2
FINANCIAL STATEMENTS:
Balance Sheet 3
Statement of Operations 4
Statement of Changes in Stockholders' Deficit 5
Statements of Cash Flows 6-7
Notes Financial Statements 8-33
INDEPENDENT AUDITORS' REPORT
To the Members and Board of Managers of
Essential Reality, LLC:
We have audited the accompanying statements of operations, members' deficit, and
cash flows for the year ended December 31, 2001 of Essential Reality, LLC (a
development stage enterprise) (the "Company"). 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 audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. 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 audit provides a
reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the results of the Company's operations and its cash flows for the
year ended December 31, 2001, in conformity with accounting principles generally
accepted in the United States of America.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. The Company is a development stage
enterprise engaged in the development, manufacture and marketing of a gloved
shaped device that controls the movement of objects on a computer screen. As
discussed in Note 1 to the financial statements, through December 31, 2001, the
Company has experienced cumulative net losses of $4,772,242 and cumulative
negative operating cash flows of $4,057,437, which raise substantial doubt its
ability to continue as a going concern. Management's plans concerning these
matters are also described in Note 1. The financial statements do not include
any adjustments that might result from the outcome of these uncertainties.
Deloitte & Touche LLP
New York, New York
January 21, 2002 (June 20, 2002 as to Note 1)
INDEPENDENT AUDITORS' REPORT
Board of Directors
Essential Reality, Inc.
New York, New York
We have audited the accompanying balance sheet of Essential Reality, Inc. (the
"Company") as of December 31, 2002, and the related statement of operations,
stockholders' equity (deficit), and cash flows for the year then ended. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on the financial statements based on our
audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. 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 audit provides a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Essential Reality, Inc. as of
December 31, 2002, and the results of its operations and its cash flows for the
year then ended, in conformity with accounting principles generally accepted in
the United States of America.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. At December 31, 2002 the Company`s
current liabilities exceeded its current assets $1,920,958.As discussed in Note
1 to the accompanying financial statements, the Company's significant operating
losses raise substantial doubt about its ability to continue as a going concern.
Management's plans concerning these matters are also described in Note 1. The
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.
Stonefield Josephson, Inc.
Irvine, California
May 25, 2003
F-2
ESSENTIAL REALITY, INC. (FORMERLY JPAL, INC.)
BALANCE SHEET - DECEMBER 31, 2002
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 188,858
Accounts receivable 38,679
Notes receivable, net 400,000
Inventories, net 304,529
Other current assets 117,994
------------
Total current assets 1,050,060
EQUIPMENT AND IMPROVEMENTS, net of accumulated
depreciation and amortization 378,272
INTANGIBLE ASSETS, net of accumulated amortization 260,653
OTHER ASSETS 58,050
------------
$ 1,747,035
============
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 1,559,179
Due to related parties 201,870
Accrued compensation 228,492
Secured convertible debenture 500,000
Current portion of long-term debt 481,477
------------
Total current liabilities 2,971,018
LONG-TERM DEBT, net of current portion (net of deferred
interest of $806,593) 510,477
COMMITMENTS AND CONTINGENTIES
STOCKHOLDERS' DEFICIT:
Common stock, $0.001 par value; 50,000,000 shares authorized;
18,223,110 issued and outstanding 18,223
Additional paid-in capital 13,923,869
Deferred compensation expense (2,050,830)
Accumulated deficit (13,625,722)
------------
Total stockholders' deficit (1,734,460)
------------
$ 1,747,035
============
The accompanying notes are an integral part of these financial statements.
F-3
ESSENTIAL REALITY, INC (FORMERLY JPAL, INC.)
STATEMENTS OF OPERATIONS
Year ended December 31,
----------------------------
2002 2001
------------ ------------
REVENUE $ 112,602 $ --
COST OF REVENUE 304,023 --
------------ ------------
GROSS LOSS (191,421) --
------------ ------------
OPERATING EXPENSES:
Sales and marketing 1,711,894 716,674
Product development 1,037,396 1,579,129
General and administrative expenses 1,924,823 823,791
Depreciation and amortization 68,861 11,850
Impairment on inventory realization 1,883,207 --
Stock-based compensation 880,885 --
------------ ------------
TOTAL OPERATING EXPENSES 7,507,066 3,131,444
------------ ------------
LOSS FROM OPERATIONS (7,698,487) (3,131,444)
------------ ------------
OTHER INCOME (EXPENSE):
Interest income 17,025 20,465
Interest expense (1,173,944) (20,505)
Miscellaneous 1,926 --
------------ ------------
Total other income (expense) (1,154,993) (40)
------------ ------------
LOSS BEFORE PROVISION FOR INCOME TAXES $ (8,853,480) $ (3,131,484)
PROVISION FOR INCOME TAXES -- --
------------ ------------
NET LOSS $ (8,853,480) $ (3,131,484)
============ ============
NET LOSS PER SHARE - BASIC AND DILUTED $ (0.49) $ (0.017)
============ ============
NUMBER OF WEIGHTED AVERAGE SHARES - BASIC AND DILUTED 18,056,987 17,955,718
============ ============
The accompanying notes are an integral part of these financial statements.
F-4
ESSENTIAL REALITY, INC (FORMERLY JPAL, INC.)
STATEMENTS OF STOCKHOLDERS' DEFICIT
FOR THE YEARS ENDED DECEMBER 31, 2002 AND 2001
Members Common stock Additional
----------------------------- paid-in
Capital Shares Amount capital
--------------- ----------- -----------------
Balance as of January 1, 2001 $2,5000 -- -- --
Net loss -- --
----------------- --------------- ----------- -----------------
Balance at December 31, 2001 2.500,000
Exchange of members capital to Common Stock (2,500,000) 9,600,000 9,600 2,490,400
Proceeds received from private placement, net of
offering costs of $988,103 7,011,626 7,012 6,083,076
Issuance of warrants related to private placement -- -- 813,165
Offering costs related to private placement -- -- (813,165)
Conversion of convertible note payable 263,158 263 499,737
Beneficial conversion features related to convertible notes
in June 2002 -- -- 318,747
Warrants issued related to convertible notes in June 2002 -- -- 181,253
Warrants issued to non-convertible note holders
in June 2002 -- -- 497,490
Warrants issued for service -- -- 152,962
Options issued to directors and employees in June 2002 -- -- 775,710
Options issued to consultants in June 2002 -- -- 610,448
Excess note payable assumed by Essential Reality
Partners, LLC assets in reverse merger -- -- (139,039)
Issuance of shares for JPAL 1,080,934 1,081 (1,081)
Options issued to directors and employees -- -- 1,347,595
Conversion of 8 1/2% notes payable 217,392 217 250,000
Excess of fair value of shares over the face value of
the notes payable -- -- 402,173
Beneficial conversion features related to convertible notes
in November 2002 -- -- 275,000
Warrants issued related to convertible notes in
November 2002 -- -- 109,448
Shares issued for professional services 50,000 50 69,950
Accretion of deferred compensation expense -- -- --
Net loss -- -- --
----------------- --------------- ----------- -----------------
Balance, December 31,2002 $ -- (13,625,722) $ 18,223 $ 13,923,869
================= =============== =========== =================
Deferred Total
compensation Accumulated stockholders'
expense deficit deficit
--------------- ---------------- ----------------
Balance as of January 1, 2001 $ -- $ (1,640,758) $ (1,640,758)
Net loss (3,131,484) (3,131,484)
--------------- ---------------- ----------------
Balance at December 31, 2001 -- (4,772,242) (4,772,242)
Exchange of members capital to Common Stock
Proceeds received from private placement, net of
offering costs of $988,103 -- -- 6,090,088
Issuance of warrants related to private placement -- -- 813,165
Offering costs related to private placement -- -- (813,165)
Conversion of convertible note payable -- -- 500,000
Beneficial conversion features related to convertible notes
in June 2002 -- -- 318,747
Warrants issued related to convertible notes in June 2002 -- -- 181,253
Warrants issued to non-convertible note holders
in June 2002 -- -- 497,490
Warrants issued for service -- -- 152,962
Options issued to directors and employees in June 2002 (775,710) -- --
Options issued to consultants in June 2002 (610,448) -- --
Excess note payable assumed by Essential Reality
Partners, LLC assets in reverse merger -- -- (139,039)
Issuance of shares for JPAL -- -- (0)
Options issued to directors and employees (1,347,595) -- --
Conversion of 8 1/2% notes payable -- -- 250,217
Excess of fair value of shares over the face value of
the notes payable -- -- 402,173
Beneficial conversion features related to convertible notes
in November 2002 -- -- 275,000
Warrants issued related to convertible notes in
November 2002 -- -- 109,448
Shares issued for professional services -- -- 70,000
Accretion of deferred compensation expense 682,923 -- 682,923
Net loss -- (8,853,480) (8,853,480)
--------------- ---------------- ----------------
Balance, December 31,2002 $ (2,050,830) $ (13,625,722) $ 3,037,782
=============== ================ ================
The accompanying notes are an integral part of these financial statements.
F-5
ESSENTIAL REALITY, INC. (FORMERLY JPAL, INC.)
STATEMENTS OF CASH FLOWS
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
Year ended December 31,
-------------------------------------------
2002 2001
------------------- --------------------
CASH FLOWS PROVIDED BY (USED FOR) OPERATING ACTIVITIES:
Net loss $ (8,853,480) $ (3,131,484)
------------------- -------------------
ADJUSTMENTS TO RECONCILE NET LOSS TO NET CASH PROVIDED BY
(USED FOR) OPERATING ACTIVITIES:
Depreciation and amortization 68,861 11,850
Reserve for collectability of notes receivable 102,121 -
Reserve for inventory obsolesence 1,363,361 -
Amortization of deferred interest 208,302 18,361
Non-cash compensation 880,885 -
Imputed interest on conversion of debt instrument 789,670 -
CHANGES IN ASSETS AND LIABILITIES:
(INCREASE) DECREASE IN ASSETS:
Accounts receivable (38,679) -
Inventories (1,667,890) -
Deferred financing cost 217,755 (217,755)
Notes receivable (502,121) -
Interest receivable - 48,716
Prepaid expenses, deposits, and other assets (61,157) (85,567)
INCREASE (DECREASE) IN LIABILITIES:
Accounts payable and accrued expenses 950,698 600,895
Due to affiliates (28,674) 89,985
Accrued compensation (28,611) 35,836
------------------- -------------------
Total adjustments 2,254,521 502,321
------------------ -------------------
Net cash used for operating activities (6,598,959) (2,629,163)
------------------- -------------------
CASH FLOWS USED FOR INVESTING ACTIVITIES:
Payments for capitalized product development (260,000) -
Payments for tools, dies, and molds (337,331) -
Payments for capitalized website (22,300) -
Payments for purchase of domain names - (18,000)
Payments for purchases of equipment (73,864) (12,949)
------------------- -------------------
Net cash used for investing activities (693,495) (30,949)
------------------- -------------------
CASH FLOWS PROVIDED BY FINANCING ACTIVITIES:
Proceeds from insurance notes payable 81,477 -
Net proceeds from issuance of members capital 6,083,706 -
Proceeds from Secured Convertible Debenture 500,000 -
Proceeds from bridge loans 1,825,000 1,500,000
Repayment of bridge loans (550,000) -
Repayment of notes payable (550,000) -
Proceeds from repayment of notes receivable for members' capital - 865,453
Proceeds from repayment of notes receivable from developer 82,971 -
Net advances from LCG Capital, Inc. (5,705) 76,617
------------------- -------------------
Net cash provided by financing activities 7,467,449 2,442,070
------------------- -------------------
NET INCREASE (DECREASE) IN CASH 174,995 (218,042)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 13,863 231,905
------------------- -------------------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 188,858 $ 13,863
=================== ===================
The accompanying notes are an integral part of these financial statements.
F-6
ESSENTIAL REALITY, INC. (FORMERLY JPAL, INC.)
STATEMENTS OF CASH FLOWS (CONTINUED)
Year ended December 31,
-----------------------------------------------
2002 2001
------------------- -------------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid $ 22,500 $ --
==================== ====================
Income tax paid -- $ --
==================== ====================
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Bridge loans converted to member units $ 500,000 $ --
==================== ====================
Elimination of bridge loans and accrued interest
on merger $ 2,378,431 $ --
==================== ====================
Assumption of notes on merger $ 2,517,070 $ --
==================== ====================
Imputed interest on note payable $ 208,302 $ --
==================== ====================
Imputed interest on conversion of debt instruments $ 767,169 $ --
==================== ====================
Issuance of common stock for consulting fees $ 45,000 $ --
==================== ====================
Issuance of common stock to related parties
to pay off debt $ 195,735 $ --
==================== ====================
Deferred interest expense - bridge loans $ -- $ 232,389
==================== ====================
Accrued interest expense - bridge loans $ 82,178 $ 250,750
==================== ====================
The accompanying notes are an integral part of these financial statements.
F-6 (continued)
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
BUSINESS ACTIVITY:
Essential Reality, LLC ("ER LLC" or the "Company") was formed
as Freedom Multimedia, LLC in the state of Delaware on July 9,
1998 and began active operations on June 1, 1999. The Company
changed its name to Essential Reality, LLC ("ER, LLC") on
December 29, 1999. On June 20, 2002, ER LLC completed a
business combination (recapitalization) with JPAL, Inc.
("JPAL"), a Nevada Corporation (the "Transaction"). Whereby,
all of the members of ER LLC contributed their membership
interests in ER LLC to the Company in exchange for 16,874,784
shares of the Company's common stock. The shareholders of JPAL
canceled 7,564,326 of their shares of JPAL common stock and
were left with 1,080,934 shares of common stock representing
6.02% of the Company. Upon the business combination, ER LLC
was dissolved and all of its assets and liabilities were
transferred into JPAL. Following the Transaction, JPAL changed
its name to Essential Reality, Inc.
The Company was formed to develop, manufacture, and market
computer peripheral devices, with an initial emphasis on a
product called "P5." However, due to less than expected sales
of the P5, the Company has expanded its focus and now aims to
become a leading developer and distributor of unique,
technology-based consumer electronics, gaming products, and
consumer youth products targeted to teenagers in the mass
market.
BASIS OF PRESENTATION:
The financial statements of the Company were
prepared in conformity with Statement of Financial Accounting
Standards ("SFAS") No. 7, "Accounting and Reporting by
Development State Enterprises," through December 31, 2001.
Effective October 1, 2002, the Company no longer met the
requirements of SFAS No. 7 and, accordingly, all disclosures
required under SFAS No. 7 have been discontinued in these
financial statements.
GOING CONCERN:
The accompanying financial statements have been prepared in
conformity with accounting principles generally accepted in
the United States of America that contemplate continuation of
the Company as a going concern. However, the Company has
reported a net loss of $8,853,480 for the year ended December
31, 2002, and has an accumulated deficit of $13,625,722, and
at year end the Company`s current liabilities exceeded its
current assets by $1,920,958. Without realization of
additional capital, it would be unlikely for the Company to
continue as a going concern. This factor raises substantial
doubt about the Company's ability to continue as a going
concern. The financial statements do not include any
adjustments that might result from the outcome of the
uncertainty.
Management plans to take the following steps that it believes
will be sufficient to provide the Company with the ability to
continue in existence:
F-7
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
GOING CONCERN, CONTINUED:
Management intends to raise financing through the sale of its
stock on the public market as well as from bridge loans.
Management believes that with this financing, the Company will
be able to generate additional revenues that will allow the
Company to continue as a going concern. This will be
accomplished by hiring additional personnel and focusing sales
and marketing efforts on the distribution of product through
key marketing channels currently being developed by the
Company. The financial statements do not include any
adjustments that might result from the outcome of the
uncertainty.
REVENUE RECOGNITION:
The Company recognizes under Staff Accounting Bulletin 101,
gross revenue when the earnings process is complete, as
evidenced by an agreement with the customer, transfer of title
and the rights and risks of ownership have passed to the
customer, the product is delivered, the price is fixed and
determinable, and collection of the resulting receivable is
reasonably assured. Because the Company allows many of its
distributors price protection and/or right of return,
recognition of revenue in the accompanying financial
statements has been deferred until the distributors sell the
merchandise and the cash is collected by the Company.
Inventory at distributors is reported as consigned in the
balance sheet.
In cases where sales are made to certain distributors and
title has transferred, risks of ownership has passed and
collection is assured, sales have been recorded and an account
receivable has been recorded.
The Company records an allowance for uncollectible accounts on
a customer-by-customer basis as appropriate.
The Company may bundle product offerings from third-party
vendors along with the P5 product or may sell the P5
independently. The software is incidental to the product as a
whole and according to Financial Accounting Standards Board No
86, Accounting for the Costs of Computer Software To Be Sold,
Leased or Marketed, all revenue will be allocated to the P5.
As such, the Company will record the gross amount of the
purchase price of the P5 product as revenue and will reflect
the royalty to be paid to the third-party vendor as a
component of cost of sales.
USE OF ESTIMATES:
The preparation of financial statements in conformity with
accounting principles generally accepted in the United States
of America requires management to make estimates and
assumptions that affect the reported amounts of assets and
liabilities, disclosure of contingent liabilities at the date
of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual
results could differ from those estimates.
F-8
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
CASH AND CASH EQUIVALENTS:
For purposes of the statement of cash flows, cash equivalents
include all highly liquid debt instruments with original
maturities of three months or less that are not securing any
corporate obligations. The Company had no cash equivalents at
December 31, 2002.
The Company maintains its cash in bank deposits accounts that,
at times, may exceed federally insured limits. At December 31,
2002, the Company had approximately $88,900 in excess of FDIC
insured limits. The Company has not experienced any losses in
such accounts.
ACCOUNTS RECEIVABLE:
The Company provides an allowance for doubtful accounts equal
to the estimated uncollectible amounts. The Company's estimate
is based a review of the current status of trade accounts
receivable. It is reasonably possible that the Company's
estimate of the allowance for doubtful accounts will change.
The Company has not experienced any losses in accounts
receivable and has provided no allowance at December 31, 2002.
INVENTORIES:
Inventories are valued at the lower of cost or market, with
cost being determined on the first-in first-out basis. The
inventory represents high-technology parts that may be subject
to rapid technology obsolescence or limited sales cycle and
which are sold in a highly competitive industry. If the actual
product demand or selling prices are less than cost, the
Company establishes an allowance account based on net
realizable value. Included in operating expenses as Impairment
on Inventory Realization is an allowance of $1,363,600
provided against finished goods at December 31, 2002.
Inventory sold with the right of price protection and/or right
of return is reported as inventory on consignment. Consigned
inventory amounted to $275,882 at December 31, 2002.
PRODUCT WARRANTY:
Due to effective product testing and the short time between
the product shipment and the detection and correction of
production failures, the warranty accrual and the related
expense were not significant for the year ended December 31,
2002.
F-9
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
EQUIPMENT AND IMPROVEMENTS:
Equipment and improvements are valued at cost. Depreciation
and amortization are provided using the straight-line method.
Leasehold improvements are amortized on a straight-line basis
over the shorter of the lease term or the length of the lease,
which is five years.
The estimated service lives of equipment and improvements are
as follows:
Office equipment 5 years
Testing equipment 3 years
Furniture and fixtures 5 years
Computers 3 years
Leasehold improvements 5 years
INTANGIBLE ASSETS:
Domain Names:
Domain names are valued at cost and are fully amortized at
December 31, 2002. At December 31, 2001, the domain name net
book value was $9,000.
Website Development Costs:
In March 2000 the Emerging Issues Task Force ("EITF") of the
Financial Accounting Standards Board ("FASB") reached a
consensus on Issue No. 00-2 for Web Site Development Costs.
The website development costs for the years ended December 31,
2002 and 2001 were $22,320 and $-0-, respectively.
Capitalized Development Costs:
Product development costs include costs incurred by the
Company to research and develop the P5 product. Product
development costs are expensed until such time as the Company
determines that a product is technologically feasible. Product
development costs are capitalized from such date until such
time as product development is substantially complete. Product
development costs capitalized will be amortized on the
straight-line basis over the estimated useful life of the
product, which is estimated to be three years. The Company
attained technological feasibility in 2002.
F-10
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
LONG-LIVED ASSETS:
In October 2001, the FASB issued Statement of Financial
Accounting Standards ("SFAS") No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement
supersedes SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed
of." Although retaining many of the fundamental recognition
and measurement provisions of SFAS 121, the new rules
significantly change the criteria that would have to be met to
classify an asset as held-for-sale. The statement also
supersedes certain provisions of Accounting Principles Board
Opinion No. 30, "Reporting the Results of Operations-Reporting
the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," and will require expected future operating
losses from discontinued operations to be displayed in
discontinued operations in the period or periods in which the
losses are incurred rather than as of the measurement date, as
presently required. We concluded that the effect of adopting
this statement had no material impact on our financial
position, results of operations, or cash flows.
ADVERTISING:
The Company expenses advertising costs when incurred.
Advertising expense totaled $289,400 and $10,700 for the years
ended December 31, 2002 and 2001, respectively.
RESEARCH AND DEVELOPMENT:
Research and development costs are expensed in the year
incurred. These costs totaled $1,037,400, net of loan
receivable of $400,000 (see Note 3) and $1,579,100 for the
years ended December 31, 2002 and 2001, respectively.
INCOME TAXES:
Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets
and liabilities and their respective tax bases. Deferred tax
assets, including tax loss and credit carryforwards, and
liabilities are measured using enacted tax rates expected to
apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The
effect on deferred tax assets and liabilities of a change in
tax rates is recognized in income in the period that includes
the enactment date. Deferred income tax expense represents the
change during the period in the deferred tax assets and
deferred tax liabilities. The components of the deferred tax
assets and liabilities are individually classified as current
and non-current based on their characteristics. Realization of
the deferred tax asset is dependent on generating sufficient
taxable income in future years. Deferred tax assets are
reduced by a valuation allowance when, in the opinion of
management, it is more likely than not that some portion or
all of the deferred tax assets will not be realized.
F-11
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
FAIR VALUE OF FINANCIAL INSTRUMENTS:
The carrying amount of the Company's cash and cash
equivalents, accounts receivable, inventories, accounts
payable, and accrued expenses approximates their estimated
fair values due to the short-term maturities of those
financial instruments. Also, the carrying amounts for
long-term debt approximate fair value, because the terms
offered to the Company are at current market rates.
COMPREHENSIVE INCOME:
SFAS No. 130, "Reporting Comprehensive Income," establishes
standards for the reporting and display of comprehensive
income and its components in the financial statements. As of
December 31, 2002 and 2001, the Company has no items that
represent other comprehensive income and, therefore, has not
included a schedule of comprehensive income in the financial
statements.
BASIC AND DILUTED LOSS PER SHARE:
In accordance with SFAS No. 128, "Earnings Per Share," the
basic loss per common share is computed by dividing net loss
available to common stockholders by the weighted average
number of common shares outstanding. Diluted loss per common
share is computed similarly to basic loss per common share,
except that the denominator is increased to include the number
of additional common shares that would have been outstanding
if the potential common shares had been issued and if the
additional common shares were dilutive. At December 31, 2002
and 2001, the Company did not include the effects of common
stock components because their effect would have been
anti-dilutive.
SEGMENT REPORTING:
Based on the Company's integration and management strategies,
the Company operated in a single business segment. For the
year ended December 31, 2002, all revenues have been derived
from domestic and international operations.
NEW ACCOUNTING PRONOUNCEMENTS:
In July 2001, the FASB issued SFAS No. 142, "Goodwill and
Other Intangibles." SFAS No. 142 addresses the initial
recognition, measurement, and amortization of intangible
assets acquired individually or with a group of other assets
(but not those acquired in a business combination), and
addresses the amortization provisions for excess cost over
fair value of net assets acquired or intangibles acquired in a
business combination. The statement is effective for fiscal
years beginning after December 15, 2001, and is effective July
1, 2001 for any intangibles acquired in a business combination
initiated after June 30, 2001. The adoption of this statement
did not have a material impact to the Company's financial
position or results of operations.
F-12
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
NEW ACCOUNTING PRONOUNCEMENTS, CONTINUED:
In October 2001, the FASB issued SFAS No. 143, "Accounting for
Asset Retirement Obligations," which requires companies to
record the fair value of a liability for asset retirement
obligations in the period in which they are incurred. The
statement applies to a company's legal obligations associated
with the retirement of a tangible long-lived asset that
results from the acquisition, construction, and development or
through the normal operation of a long-lived asset. When a
liability is initially recorded, the company would capitalize
the cost, thereby increasing the carrying amount of the
related asset. The capitalized asset retirement cost is
depreciated over the life of the respective asset while the
liability is accreted to its present value. Upon settlement of
the liability, the obligation is settled at its recorded
amount or the company incurs a gain or loss. The statement is
effective for fiscal years beginning after June 30, 2002. The
Company does not expect the adoption to have a material impact
to the Company's financial position or results of operations.
In October 2001, the FASB issued SFAS No. 144, "Accounting for
the Impairment or Disposal of Long-Lived Assets." Statement
144 addresses the accounting and reporting for the impairment
or disposal of long-lived assets. The statement provides a
single accounting model for long-lived assets to be disposed
of. New criteria must be met to classify the asset as an asset
held-for-sale. This statement also focuses on reporting the
effects of a disposal of a segment of a business. This
statement is effective for fiscal years beginning after
December 15, 2001. The adoption of this statement did not have
a material impact to the Company's financial position or
results of operations.
In April 2002, the FASB issued Statement No. 145, "Rescission
of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections." This statement
rescinds FASB Statement No. 4, "Reporting Gains and Losses
from Extinguishment of Debt," and an amendment of that
Statement, FASB Statement No. 64, "Extinguishments of Debt
Made to Satisfy Sinking-Fund Requirements" and FASB Statement
No. 44, "Accounting for Intangible Assets of Motor Carriers."
This Statement amends FASB Statement No. 13, "Accounting for
Leases," to eliminate an inconsistency between the required
accounting for sale-leaseback transactions and the required
accounting for certain lease modifications that have economic
effects that are similar to sale-leaseback transactions. The
Company does not expect the adoption to have a material impact
to the Company's financial position or results of operations.
In July 2002, the FASB issued SFAS No. 146 "Accounting for
Exit or Disposal Activities." The provisions of this statement
are effective for disposal activities initiated after December
31, 2002, with early application encouraged. The Company does
not expect the adoption of FASB No. 146 to have a material
impact on the Company's financial position or results of
operations.
F-13
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
NEW ACCOUNTING PRONOUNCEMENTS, CONTINUED:
In October 2002, the FASB issued Statement No. 147,
"Acquisitions of Certain Financial Institutions - an amendment
of FASB Statements No. 72 and 144 and FASB Interpretation No.
9," which removes acquisitions of financial institutions from
the scope of both Statement 72 and Interpretation 9 and
requires that those transactions be accounted for in
accordance with Statements No. 141, "Business Combinations,"
and No. 142, "Goodwill and Other Intangible Assets." In
addition, this Statement amends SFAS No. 144, "Accounting for
the Impairment or Disposal of Long-Lived Assets," to include
in its scope long-term customer-relationship intangible assets
of financial institutions such as depositor- and
borrower-relationship intangible assets and credit cardholder
intangible assets. The requirements relating to acquisitions
of financial institutions are effective for acquisitions for
which the date of acquisition is on or after October 1, 2002.
The provisions related to accounting for the impairment or
disposal of certain long-term customer-relationship intangible
assets are effective on October 1, 2002. The adoption of this
Statement did not have a material impact to the Company's
financial position or results of operations as the Company has
not engaged in either of these activities.
In December 2002, the FASB issued Statement No. 148,
"Accounting for Stock-Based Compensation-Transition and
Disclosure," which amends FASB Statement No. 123, "Accounting
for Stock-Based Compensation," to provide alternative methods
of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. In
addition, this Statement amends the disclosure requirements of
Statement 123 to require prominent disclosures in both annual
and interim financial statements about the method of
accounting for stock-based employee compensation and the
effect of the method used on reported results. The transition
guidance and annual disclosure provisions of Statement 148 are
effective for fiscal years ending after December 15, 2002,
with earlier application permitted in certain circumstances.
The interim disclosure provisions are effective for financial
reports containing financial statements for interim periods
beginning after December 15, 2002. The adoption of this
statement did not have a material impact on the Company's
financial position or results of operations as the Company has
not elected to change to the fair value based method of
accounting for stock-based employee compensation.
F-14
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
NEW ACCOUNTING PRONOUNCEMENTS, CONTINUED:
In November 2002, the FASB issued Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of
Others, an Interpretation of FASB Statements No. 5, 57, and
107 and Rescission of FASB Interpretation No. 34" ("FIN No.
45"). The interpretation requires that upon issuance of a
guarantee, the entity must recognize a liability for the fair
value of the obligation it assumes under that obligation. This
interpretation is intended to improve the comparability of
financial reporting by requiring identical accounting for
guarantees issued with separately identified consideration and
guarantees issued without separately identified consideration.
For the company, the initial recognition, measurement
provision and disclosure requirements of FIN No. 45 are
applicable to guarantees issued or modified after December 31,
2002. The company is currently evaluating what impact, if any,
adoption of FIN No. 45 will have on its consolidated financial
position, consolidated results of operations, or liquidity.
In January 2003, the FASB issued Interpretation No. 46,
"Consolidation of Variable Interest Entities." Interpretation
46 changes the criteria by which one company includes another
entity in its consolidated financial statements. Previously,
the criteria were based on control through voting interest.
Interpretation 46 requires a variable interest entity to be
consolidated by a company if that company is subject to a
majority of the risk of loss from the variable interest
entity's activities or entitled to receive a majority of the
entity's residual returns or both. A company that consolidates
a variable interest entity is called the primary beneficiary
of that entity. The consolidation requirements of
Interpretation 46 apply immediately to variable interest
entities created after January 31, 2003. The consolidation
requirements apply to older entities in the first fiscal year
or interim period beginning after June 15, 2003. Certain of
the disclosure requirements apply in all financial statements
issued after January 31, 2003, regardless of when the variable
interest entity was established. The Company does not expect
the adoption to have a material impact to the Company's
financial position or results of operations.
During April 2003, the FASB issued SFAS 149 - "Amendment of
Statement 133 on Derivative Instruments and Hedging
Activities," effective for contracts entered into or modified
after June 30, 2003, except as stated below and for hedging
relationships designated after June 30, 2003. In addition,
except as stated below, all provisions of this Statement
should be applied prospectively. The provisions of this
Statement that relate to Statement 133 Implementation Issues
that have been effective for fiscal quarters that began prior
to June 15, 2003, should continue to be applied in accordance
with their respective effective dates. In addition, paragraphs
7(a) and 23(a), which relate to forward purchases or sales of
when-issued securities or other securities that do not yet
exist, should be applied to both existing contracts and new
contracts entered into after June 30, 2003. The Company does
not participate in such transactions, however, is evaluating
the effect of this new pronouncement, if any, and will adopt
FASB 149 within the prescribed time.
F-15
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
NEW ACCOUNTING PRONOUNCEMENTS, CONTINUED:
During May 2003, the FASB issued SFAS 150 - "Accounting for
Certain Financial Instruments with Characteristics of both
Liabilities and Equity," effective for financial instruments
entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period
beginning after June 15, 2003. This Statement establishes
standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities
and equity. It requires that an issuer classify a freestanding
financial instrument that is within its scope as a liability
(or an asset in some circumstances). Many of those instruments
were previously classified as equity. Some of the provisions
of this Statement are consistent with the current definition
of liabilities in FASB Concepts Statement No. 6, Elements of
Financial Statements. The Company is evaluating the effect of
this new pronouncement and will adopt FASB 150 within the
prescribed time.
RECLASSIFICATIONS:
Certain amounts in the 2001 financial statements have been
reclassified to conform to the basis of presentation used in
2002.
(2) BUSINESS COMBINATION:
On June 20, 2002, Essential Reality, LLC, a Delaware Limited Liability
Company, completed a business combination with JPAL, Inc., a Nevada
corporation and an SEC registrant pursuant to an Amended Contribution
Agreement between ER LLC and JPAL, whereby all of the members of ER LLC
contributed their membership interests in ER LLC to the Company in
exchange for an aggregate of 16,874,784 shares of the Company's common
stock. Concurrent with the Transaction, the shareholders of JPAL
canceled 7,564,326 of their shares of JPAL common stock and were left
with 1,080,934 shares of common stock representing 6.02% of the
Company. Following the Transaction, JPAL changed its name to Essential
Reality, Inc. and ER LLC, a wholly owned subsidiary of the Company, was
merged into the Company. Subsequently, ER LLC was liquidated and the
assets became assets of Essential Reality, Inc.
The Transaction was accounted for as a recapitalization of ER LLC. The
management of ER LLC remained as the management of the Company. Since
the Transaction was accounted for as a recapitalization and not a
business combination, no goodwill has been recorded in connection with
the Transaction and the costs incurred in connection with the
Transaction have been accounted for as a reduction of additional
paid-in capital. As a result of the recapitalization: (i) the
historical financial statements of the Company for periods prior to the
date of the Transaction are no longer the historical financial
statements of JPAL, and, therefore, JPAL's historical financial
statements are no longer presented; (ii) the historical financial
statements of the Company for periods prior to the date of the
Transaction are those of ER LLC; (iii) all references to the financial
statements of the "Company" apply to the historical financial
statements of ER LLC prior to the Transaction and to the financial
statements of the Company subsequent to the Transaction; and (iv) any
reference to the Company applies solely to ER LLC and Essential
Reality, Inc.
F-16
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(3) NOTES RECEIVABLE:
Notes receivable as of December 31, 2002 consisted of the following:
Due from former employee $ 50,000
Due from product developer 452,121
------------------
502,121
Less : reserve for collectibility 102,121
------------------
$ 400,000
==================
In July 2001, the Company signed an agreement with a third party for
the development of the P5. In connection with the agreement, the
Company agreed to provide loan advances up to $2,000,000, later
increased to $2,700,000, to cover approved development costs. The loan
is non-interest bearing and is reduced by qualified development
expenses incurred by the developer, and is further reduced by tax
credits from a division of the Canadian Government for research, earned
by the developer and passed through to the Company. The Company
received a General Security Agreement that created a security interest
in the developer's equipment, inventory, accounts receivable,
intangibles, etc. The loan is payable within two years after each
advance unless on demand after the two years at the discretion of ER.
For the year ended December 31, 2002, the loan balance has been reduced
by $1,403,325 of qualified development expenses and $535,092 of
research and development credits from the Canadian Government. The
remaining receivable of $400,000 is net of an allowance for reduced tax
credits of $52,121 at December 31, 2002. As of December 31, 2001, the
notes receivable in the amount of $294,297 was fully reserved.
In July, 2002 the Company loaned the former President and COO $50,000
due in one year with interest accruing at 6%. This loan was an advance
for a potential bonus the employee may receive in connection with an
employment agreement assuming he met all the terms of the agreement.
The Company terminated the employee due to cause and accordingly has
reflected the advance as still outstanding. However, the Company is
unsure of its collectability and has reserved the loan in full at
December 31, 2002.
(4) INVENTORIES:
Inventories as of December 31, 2002 consisted of:
Finished goods $ 1,392,278
Less: inventory reserve for net realizable value 1,363,631
------------------
28,647
Inventory on consignment 275,882
------------------
$ 304,529
==================
F-17
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(4) INVENTORIES, CONTINUED:
Subsequent to year-end, the Company experienced difficulty in selling
its P5 glove at its suggested retail pricing and does not expect to
sell above its cost to manufacture. Accordingly, it has provided a
reserve for the lower of cost or market against the remaining finished
goods inventory. Included in operating expenses is Impairment of
Inventory Realization of $1,363,631 and $519,576 of finished goods and
raw materials/work-in process, respectively, at December 31, 2002.
(5) EQUIPMENT AND IMPROVEMENTS:
A summary as of December 31, 2002 is as follows:
Furniture and fixtures $ 3,257
Computers 11,875
Office equipment 10,433
Tooling, molds, dies, and equipment 392,267
------------------
417,832
Less: accumulated depreciation and amortization 39,560
------------------
$ 378,272
===================
Depreciation and amortization expense amounted to $29,194 and $2,850
for the years ended December 31, 2002 and 2001, respectively.
(6) INTANGIBLE ASSETS:
Intangible assets as of December 31, 2002 are as follows:
Domain name $ 18,000
Product development 260,000
Website 22,320
------------------
300,320
Less: accumulated amortization 39,667
------------------
Intangible, net $ 260,653
==================
Amortization expense for intangible assets amounted to $39,667
and $9,000 for the years ended December 31, 2002 and 2001,
respectively.
F-18
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(7) NOTES PAYABLE AND LONG-TERM DEBT:
A summary of long-term debt as of December 31, 2002 is as follows:
Unsecured 8 1/2% convertible note payable $ 500,000
Unsecured 8 1/2% non-convertible note payable 1,217,070
Insurance note payable 81,477
------------------
1,798,547
Less: current maturities 481,477
------------------
1,317,070
Less: deferred interest 806,593
------------------
$ 510,477
==================
The non-current portion of long-term debt at December 31, 2002 matures
in 2004.
(A) SECURED CONVERTIBLE DEBENTURE:
In November 2002, pursuant to a Subscription Agreement to
raise $1,000,000 8% Secured Convertible Debenture (the
"Debenture"), the Company received $500,000 and the balance
will be received in 2003. The debenture contains a beneficial
conversion feature for six months at a conversion price of
$1.00. The debenture also contains detachable warrants to
acquire 100,000 shares of common stock at an exercise price of
$1.00 per share expiring in five years. The Debenture is
collateralized by the Company's right, title, and interest in
and to all present and future rights to payment of goods and
services.
If the Company raises at least $3,000,000, to the extent the
Debenture has not been repaid or converted in full, the
remaining outstanding amounts shall automatically be deemed
converted at the lower of 1.00 per share or 10% below offering
per security issued for future financing debt equity capital
of Company.
The payment of principal and/or interest on the Debenture
shall be equal in right of payment to the other debentures to
be received in the first half of 2003 in the amount of
$500,000, based on the principal amount of all debentures
outstanding at the time of such prepayments. In the event the
lender receives payments in excess of its pro rata share of
borrower's prepayments of the debentures, then lender shall
hold in trust all such excess payments for the benefit of the
holders of the debentures and shall pay such amounts held in
trust to such holders upon demand by such holders.
Payments on the debentures from the sale of P5 units are as
follows:
(1) $15.00 per unit from the sale of 1 to 10,000 units;
(2) $35.00 per unit from the sale of 10,001 to 20,000 units; and
(3) $50.00 per unit from the sale of 20,001 to 30,000 units.
F-19
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(7) NOTES PAYABLE AND LONG-TERM DEBT, CONTINUED:
(A) SECURED CONVERTIBLE DEBENTURE, CONTINUED:
As of December 31, 2002, 53 P5 units have been sold, however,
no payments have been made on the Debenture. Further, the
Company expects to abandon the P5 product line in 2003 and
accordingly, does not expect to realize substantial future
revenues from the sale of P5 units.
Subsequent to year-end the notes became due and the Company
defaulted on these notes. The Company requested a 90-day
extension, until July 15, 2003.
(B) CONVERTIBLE AND NON-CONVERTIBLE NOTES:
As a result of the Transaction, bridge loans and accrued
interest thereon in the amount of $2,378,431 owed by ER LLC to
JPAL were eliminated. Concurrent with the Transaction, the
Company assumed obligation of certain notes payable of JPAL in
the amount of $2,517,070 (the "JPAL" notes).
Subsequent to the completion of the Recapitalization, the
Company repaid $550,000 of JPAL notes and issued two year
warrants to purchase 15,000 shares of common stock having an
exercise price of $1.30 per share. In July 2002, $250,000 of
these notes was converted into common stock at $1.15 per
share. The remaining balance of $1,717,070 is comprised of
$500,000 of convertible notes, which are convertible for a
period of six months ended December 20, 2002 at a conversion
price of $1.90 into an aggregate of 263,158 shares of common
stock and $1,217,070 of non-convertible notes with two years
warrants to purchase 840,000 shares of common stock at a
purchase price of $1.90 per share. These notes bear interest
at the rate of 8 1/2% per annum with $77,574 of accrued
interest as of December 31, 2002. These notes are due April
30, 2004, and contain the following prepayment provisions:
i. During fiscal 2003, quarterly principal payments of
$100,000 plus accrued interest due 15 days following
each of the four quarters. The Company has requested
90-day extension for all provisions relating to
mandatory prepayments.
ii. 50% of the proceeds received by the Company as a
result of the exercise of warrants.
iii. During fiscal 2002, 15% of the net proceeds received
from the sale of equity in the Company above
$10,000,000, subject to a maximum of $700,000;
iv. During fiscal 2003, 20% of the net proceeds received
from the sale of equity in the Company, subject to a
maximum of $700,000, provided, that in the event the
aggregate principal amount of bridge loans remaining
outstanding at the time such equity is raised shall
exceed $1,000,000, then the maximum amount due and
payable shall be $900,000; and
F-20
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(7) NOTES PAYABLE AND LONG-TERM DEBT, CONTINUED:
(B) CONVERTIBLE AND NON-CONVERTIBLE NOTES, CONTINUED:
v. Beginning October 1, 2002, 35% of any Excess Cash, as
defined, greater than $2,000,000, up to a maximum of
$200,000 (in addition to amounts received under clause
(iv) above) in any quarter.
vi. The value of the warrants issued above was priced using
the Black-Scholes pricing model. (Refer to footnote
12.)
Subsequent to year-end, the Company defaulted on these notes.
The Company requested a 90-day extension, until July 15, 2003.
(9) INCOME TAXES:
Realization of deferred tax assets is dependent on future earnings, if
any, the timing and amount of which is uncertain. Accordingly, a
valuation allowance, in an amount equal to the net deferred tax asset
as of December 31, 2002, has been established to reflect these
uncertainties. As of December 31, 2002, the deferred tax asset before
valuation allowances is approximately $2,032,700 for federal purposes.
Utilization of the net operating loss carryforwards may be subject to a
substantial annual limitation due to ownership change limitations
provided by the Internal Revenue Code of 1986. The annual limitation
may result in the expiration of net operating loss carryforwards before
utilization.
Income tax provision amounted to $-0- for the year ended December 31,
2002. For the year ended December 31, 2001 the Company was taxed as a
Limited Liability Company and accordingly no provision was recorded. A
reconciliation of the provision (benefit) for income taxes with amounts
determined by applying the statutory U.S. federal income tax rate to
income before income taxes as of December 31, 2002 is as follows:
Computed tax at federal statutory rate of 34% $ (2,908,200)
Reduction for loss from ER LLC 875,500
Change in valuation allowance 2,032,700
-------------------
$ -
===================
Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for
financial reporting purposes and the amounts used for income tax
purposes. Significant components of the Company's deferred tax assets
and liabilities as of December 31, 2002 are as follows:
F-21
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(9) INCOME TAXES, CONTINUED:
Deferred tax assets:
Allowance for doubtful accounts $ 34,700
Accrued payroll 77,170
Inventory obsolescence reserve 463,500
Net operating losses carryforwards 1,456,800
-------------------
Total deferred tax assets 2,032,700
-------------------
Net deferred assets before valuation allowance 2,032,700
Valuation allowance (2,032,700)
-------------------
Net deferred tax assets $ -
===================
At December 31, 2002, the Company has available unused net operating
losses carryforwards of $5,978,500 for purposes that may be applied
against future taxable income and that, if unused, began to expire in
2002.
(10) RETIREMENT PLAN:
The Company sponsors a 401(k) contributory plan (the "Plan") for the
benefits of employees who are at least 21 years of age. The Company's
management determines, at its discretion, the annual and contribution.
The Company elected not to contribute to the Plan for the years ended
December 31, 2002 and 2001.
(11) STOCK OPTION PLANS:
The Company has elected to follow Financial Accounting Standards Board
Statement No. 123 (Accounting for Stock-Based Compensation) and
accordingly the Company determined compensation costs based on the fair
value at the grant date for its stock options.
Effective June 20, 2002, the Company adopted the 2001 Stock Incentive
Plan. The Company issued to its directors and employees, options to
purchase an aggregate of 1,097,000 shares of its common stock at a
weighted average exercise price of $1.13 per share. Such options expire
ten years following the grant date. This included 200,000 contingent
options, as further explained in the following paragraph. The issuance
of the non-contingent options resulted in deferred stock-based
compensation of $2,123,305, of which $589,660 was expensed for the year
ended December 31, 2002. Deferred compensation expense will be charged
to earnings over the vesting period of the options, which is between
one to three years. Deferred compensation expense was computed using
the Black-Scholes pricing model using a fair market value ranging from
$2.00 to $3.10 per share, a term of three years, volatility of 44% and
a risk-free rate of 5%.
F-22
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(11) STOCK OPTION PLANS, CONTINUED:
On September 5, 2002, the Company issued options to an employee (the
"Contingent" options) to purchase 200,000 shares of its common stock at
an exercise price of $1.00 per share. The options vest when either of
the following conditions occur: (i) the market capitalization of the
Company, based on the public float, equals or exceeds $150,000,000 for
a period of 60 consecutive business days and the average daily volume
of the Company's common stock traded during these 60 days is no less
than 125,000 or (ii) the Company sells all or substantially all of its
assets for a minimum of $125,000,000. Since these options do not vest
unless a future event occurs, the options are considered variable and
will only be recorded by the Company if the contingencies are
satisfied.
Effective June 20, 2002, the Company adopted the Advisory Board
Agreement. The Company issued to its advisors and consultants, options
to purchase an aggregate of 260,000 shares of its common stock at a
weighted average exercise price of $0.83 per share. Such options expire
ten years following the grant date. The issuance of the options
resulted in deferred stock-based compensation of $610,448 of which
$93,263 was expensed for the year ended December 31, 2002. Deferred
compensation expense will be charged to earnings over the term of the
advisors' and/or consultants' agreements. Deferred compensation expense
was computed using the Black-Scholes pricing model using a fair market
value of $3.05 per share, a term of 10 years, volatility of 44% and a
risk-free rate of 5%.
Additional information with respect to these two Plans' stock option
activity is as follows:
Weighed
Number Average of
of Shares Exercise Price
------------------ ---------------
Outstanding at December 31, 2001 - $ -
Granted Directors and Employees 1,097,000 1.13
Granted Advisors and Consultants 260,000 .83
Exercised - -
Cancelled - -
------------------ ---------------
Outstanding at December 31, 2002 1,357,000 $ 1.08
================== ===============
Options exercisable at December 31, 2002 422,000 $ -
================== ===============
F-23
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(11) STOCK OPTION PLANS, CONTINUED:
The following tables summarize information about stock options
outstanding and exercisable at December 31, 2002:
Weighted Outstanding Exercisable
Average Options Options
Range of Number of Remaining in Weighted Number of Weighted
Exercise Outstanding Contractual Life Average Shares Average
Prices Options in Year Exercise Price Exercisable Exercise Price
--------------- -------------- ----------- -------------- ----------- --------------
$.65 to $1.00 1,072,600 9.36 $ .75 396,334 $ .75
$1.01 to $4.00 284,400 9.36 2.31 25,666 2.31
-------------- ----------- ---------- ----------- -----------
1,357,000 9.36 $ 1.08 422,000 $ 1.08
============== =========== ========== =========== ===========
The assumptions used in the Black-Scholes model were as follows for
stock options granted in 2002:
The valuation of the directors and employees was computed using
intrinsic value method.
Risk-free interest rate 3.91 - 4.74
Expected volatility of common stock 43 - 74%
Dividend yield 0%
Expected life of options 3 years
The Black-Scholes option valuation model was developed for estimating
the fair value of traded options that have no vesting restrictions and
are fully transferable. Because option valuation models require the use
of subjective assumptions, changes in these assumptions can materially
affect the fair value of the options. The Company's options do not have
the characteristics of traded options; therefore, the option valuation
models do not necessarily provide a reliable measure of the fair value
of its options.
(12) WARRANTS:
The warrant activities as December 31, 2002 and 2001 are as follows:
Weighed
Number Average
of Shares Exercise Price
------------------ ---------------
Outstanding at December 31, 2001 - $ -
Granted 1,286,211 1.68
Exercised - -
Cancelled - -
------------------ ---------------
Outstanding at December 31, 2002 1,286,211 $ 1.68
=================== ==============
Warrants exercisable at December 31, 2002 1,286,211 $ 1.68
================== ==============
F-24
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(12) WARRANTS, CONTINUED:
The following tables summarize information about warrants outstanding
and exercisable at December 31, 2002:
Weighted Outstanding Exercisable
Average Options Options
Range of Number of Remaining in Weighted Number of Weighted
Exercise Outstanding Contractual Life Average Shares Average
Prices Options in Year Exercise Price Exercisable Exercise Price
--------------- -------------- ----------- -------------- ----------- --------------
$1.00 - 1.90 1,286,211 2.54 $1.68 1,286,211 $1.68
1. In connection with the offering ER LLC issued to the financial
advisors warrants to purchase an aggregate of 331,211 shares
of membership units. These warrants have an exercise price of
$1.30 per membership unit and are exercisable for a period of
up to five years. As a result of the Recapitalization,
warrants to purchase membership units in ER LLC have become
warrants to purchase common shares of the Company.
The Company recognized no expense and the transaction had no
net-effect on stockholders' equity as these warrants were part
of the offering costs. The fair value of the warrants of
$813,165 was determined using the Black-Scholes option-pricing
model, with the following assumptions: (i) no expected
dividends; (ii) a risk-free interest rate of 5.00%; (iii)
expected volatility of 80%; and (iv) an expected life of two
years. The value of these warrants was computed using the
Black-Scholes pricing model.
2. In connection with the Recapitalization, the Company issued to
the current and former convertible and non-convertible note
holders two-year warrants to purchase an aggregate of 840,000
shares and 15,000 shares of common stock, respectively.
The $1,467,070 non-convertible note holders were allocated
544,382 warrants of the total of 840,000 with an exercise
price of $3.05. In accordance with EITF 00-27, the Company
first determined the value of the note and the fair value of
the detachable warrants issued in connection with this
non-convertible debenture. The estimated value of the 544,382
warrants of $497,490 was determined using the Black-Scholes
pricing model with the following assumptions: (i) no expected
dividends; (ii) a risk-free interest rate of 4.83%; (iii)
expected volatility of 44%; and (iv) an expected life of two
years. The face amount of the note payable of $1,467,070 was
proportionately allocated to the note payable and the warrants
in the amount of $497,490 and $969,580, respectively. The
amount allocated to the warrants of $497,490 was recorded as a
discount on the note payable and is being accreted into notes
payable as additional interest expense over the remaining life
of the note. Of the $497,490 discount, as of December 31,
2002, $135,679 has been amortized to expense.
F-25
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(12) WARRANTS, CONTINUED:
The $500,000 convertible note holders were allocated 205,618
warrants of the total of 840,000 with an exercise price of
$3.05. In accordance with EITF 00-27, the Company first
determined the value of the note and the fair value of the
detachable warrants issued in connection with this convertible
debenture. The estimated value of the 205,618 warrants of
$284,321 was determined using the Black-Scholes pricing model
with the following assumptions: (i) no expected dividends;
(ii) a risk-free interest rate of 4.83%; (iii) expected
volatility of 44%; and (iv) an expected life of two years. The
face amount of the note payable of $500,000 was
proportionately allocated to the note payable and the warrants
in the amount of $318,747 and $181,253, respectively. The
amount allocated to the warrants of $181,253 was recorded as a
discount on the note payable and is being accreted into notes
payable as additional interest expense over the remaining life
of the note. The value of the note payable was then allocated
between the note and the beneficial conversion feature, which
amounted to $-0- and $318,747, respectively. The beneficial
conversion feature expired prior to December 31, 2002 and
accordingly the entire discount of $318,747 was charged to
interest expense. Of the $181,253 discount, as of December 31,
2002, $49,433 has been amortized to expense. None of the note
balance under this agreement has been converted into common
stock as of December 31, 2002.
The remaining 90,000 warrants granted to others represented
consulting expense of $124,449 and was determined using the
Black-Scholes pricing model with the following assumptions:
(i) no expected dividends; (ii) a risk-free interest rate of
4.83%; (iii) expected volatility of 44%; and (iv) an expected
life of two years.
The 15,000 warrants valued at $28,513 were charged to expense
and value was determined using the Black-Scholes pricing model
with the following assumptions: (i) no expected dividends;
(ii) a risk-free interest rate of 4.83%; (iii) expected
volatility of 44%; and (iv) an expected life of two years.
3. In connection with the $500,000 raised under a Subscription
Agreement dated November 20, 2002, in accordance with EITF
00-27, the Company first determined the value of the note and
the fair value of the detachable warrants issued in connection
with this convertible debenture. The estimated value of the
100,000 warrants of $140,120 was determined using the
Black-Scholes pricing model with the following assumptions:
(i) no expected dividends; (ii) a risk-free interest rate of
4.04%; (iii) expected volatility of 83%; and (iv) an expected
life of two years. The face amount of the note payable of
$500,000, which has a conversion feature for six months, was
proportionately allocated to the note payable and the warrants
in the amount of $390,552 and $109,448, respectively. The
amount allocated to the warrants of $109,448 was recorded as a
discount on the note payable. The value of the note payable
was then allocated between the note and the preferential
conversion feature, which amounted to $115,552 and $275,000,
respectively. The combined total discount is $384,448, is
being accreted into notes payable as additional interest
expense over the remaining life of the note. Of the $500,000
discount, as of December 31, 2002, $71,486 has been amortized
to expense. None of the note balance under this agreement has
been converted into common stock as of December 31, 2002.
F-26
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(13) COMMITMENTS AND CONTINGENCIES:
a. The Company leases its office and certain equipment under
non-cancellable agreements. The following is a schedule of
future minimum rental payments required under these leases:
Year ending December 31,
2003 $ 131,388
2004 142,129
2005 145,117
2006 139,710
------------------
$ 558,344
==================
Real estate taxes, insurance, and maintenance expenses are
obligations of the Company. It is expected that in the normal
course of business, leases that expire will be renewed or
replaced. Rent expense for the years ended December 31, 2002
and 2001 totaled $114,338 and $39,000, respectively.
b. The Company is allocated certain equipment lease costs under
leases assumed by a company related to a certain member of
LCG. The Company is not obligated under the leases but is
allocated a portion the minimum payments under the leases are
as follows:
Year ending December 31,
2003 $ 25,533
2004 1,188
------------------
$ 26,721
==================
Computer lease expense for the years ended December 31, 2002
and 2001 amounted to $47,666 and $13,000, respectively.
c. The Company has an employment agreement with the vice
president of marketing and sales. The agreement provides for
an annual base salary of $150,000 per year and four months of
severance compensation.
d. LITIGATION
On November 21, 2002, a complaint was filed by MC Squared in
United States District Court for the Southern District of New
York against us, Humbert Powell, Chairman of our Board of
Directors, Steven Francesco, our ex-Chief Executive Officer,
David Devor, an officer and Brian Jedwab, a member of our
Board of Directors, alleging breach of a development agreement
between us (originally Essential Reality, LLC) and MC Squared.
Specifically, the complaint alleges a failure by us to provide
a design credit to MC Squared on the packaging for the P5(TM).
The complaint seeks specific performance and a recall of all
P5(TM) products shipped to date without the design credit on
the packaging. We have submitted an answer with counterclaims
and have made a motion to dismiss this complaint. A decision
on the motion is pending.
F-27
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(13) COMMITMENTS AND CONTINGENCIES, CONTINUED:
On January 21, 2003, a complaint was filed by RDA
International, Inc. in the Supreme Court of the State of New
York against ER LLC seeking payment of $203,265 for work,
labor, and services performed in connection with advertising,
marketing, and multimedia programs for the P5(TM).
On February 28, 2003, a complaint was filed by Aaron Gavios, a
former employee of ours, in The United States District Court
for the Southern District of New York against us, Humbert
Powell, Chairman of our Board of Directors and Brian Jedwab, a
member of our Board of Directors, alleging breach of a
contract. Specifically, the complaint alleges failure to
provide for severance pay, failure to provide stock options,
and failure to reimburse for automobile lease totaling
$120,000, plus interest and legal fees.
On April 16, 2003, a complaint was filed by Ziff Davis Media,
Inc. in the Supreme Court of the State of New York against the
Company seeking payment of $27,443 for print advertising for
the P5.
Management believes there are valid defenses to these claims
and intends to vigorously defend; however, there can be no
assurance of a successful outcome. The costs associated with
these litigations, including the time required to defend the
Company, as well as the potential cost should there be an
adverse judgment, may have a material adverse effect on the
financial condition and results of operation.
(14) RELATED-PARTY TRANSACTIONS:
The Company had the following related-party transactions for the years
ended December 31, 2002 and 2001:
a. The Company accrued compensation expense of $228,492 and
$257,103 for certain officers and shareholders for the years
ended December 31, 2002 and 2001, respectively. These amounts
are included in due to related parties at December 31, 2002.
b. Advances from affiliated companies are from entities that are
affiliated with certain shareholders of the Company. The
advances are payable on demand and bear interest at the rate
of 10% per annum. Certain of these advances were satisfied in
September 2002, by granting the Company's interest in "other
assets" of $22,500 to these entities. At December 31, 2002,
$1,712 remains outstanding.
c. Non-interest bearing advances from an affiliate of certain
shareholders, LCG Capital Group, LLC, were made in 2001 of
which $5,705 was paid in 2002 leaving a balance of $70,912
outstanding at December 31, 2002.
F-28
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(14) RELATED-PARTY TRANSACTIONS, CONTINUED:
d. Included in product and development expense is $33,700 and
$55,000 for the years ended December 31, 2002 and 2001,
respectively, to a company owned by certain shareholders of
the Company that have consulted with the Company in the areas
of product strategy, design, and development.
e. Included in general and administrative expenses are costs
incurred of $203,479 and $242,000 for the years ended December
31, 2002 and 2001, respectively, by two entities that are
related to certain members of LCG Capital Group. Such costs
were determined to be allocable costs to the Company and
include consulting fees related to business development,
employee salaries, occupancy, telephone, and computer leases.
In the case of employee salaries, costs are allocated to the
Company based on the time each employee conducts business
specific to the Company. In the case of the other expenses,
costs are allocated based on a percentage of resources used by
the Company.
f. Included in general and administrative expenses is $21,700 and
$26,000 at December 31, 2002 and 2001, respectively, of
marketing expense payable to a company owned by a person
related to certain members of the Company who assisted in
establishing and executing its marketing programs. Included in
accounts payable-related parties is $21,700 of this expense at
December 31, 2002.
g. Included in general and administrative expenses is $35,000 and
$58,000 at December 31, 2002 and 2001, respectively, of
business development expense payable to a company that is
related to certain members of LCG who assisted the Company in
executing its business development program. Included in
accounts payable-related parties is $35,000 of this expense at
December 31, 2002.
(15) STOCKHOLDERS' EQUITY:
In November 2002, the Company issued 50,000 shares in exchange for
deferral of payment of legal services valued at $70,000 based on the
market price of the Company's stock when the services had been
completed. An amount of $70,000 of expense was charged to equity-based
compensation. The law firm resigned in the first quarter of 2003 before
completing the deferred legal services and the Company paid $25,000 to
settle the outstanding amount owned. The Company may pursue the return
of the shares because the law firm did not complete the agreed-upon
services.
On June 20, 2002, ER LLC completed a private placement (the "Offering")
whereby it issued 7,274,784 membership units for gross proceeds of
$7,577,900. Included in the gross proceeds was $500,000 of bridge loans
that were converted to 480,000 membership units of the Company.
$250,000 of the bridge loans converted was owed to JPAL and $250,000
was due to a third-party lender. JPAL exchanged the membership interest
in ER LLC for the reduction of $250,000 in notes payable it owed to
third-party lenders.
F-30
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(15) STOCKHOLDERS' EQUITY, CONTINUED:
In connection with the Offering, the Company issued to its financial
advisors warrants to purchase an aggregate of 331,211 shares of common
stock (the "Additional Warrants"). Such warrants shall have an exercise
price of $1.30 per membership unit and shall be exercisable for a
period of up to five years. As a result of the Transaction, warrants to
purchase membership units in ER LLC have become warrants to purchase
common shares of the Company. The value of the warrants issued above
was priced using the Black-Scholes pricing model. (Refer to footnote
12.)
(16) CONTRACTUAL OBLIGATIONS/GAME PUBLISHERS-LICENSING AGREEMENTS:
a. In March 2000, the Company entered into a consulting
agreement, which requires the Company to pay the consultant,
$0.25 for each of the first 150,000 units of the P5 sold.
b. In July 2000, the Company entered into an agreement for
product development with a company that is owned by a person
who is related to certain shareholders of the Company.
Pursuant to the agreement, the Company is required to pay
royalties of 1.8% on net sales of P5 and 9% of the license fee
collected by the Company with respect to P5, indefinitely. The
Company is contesting certain terms of this agreement and is
currently in litigation. As of December 31, 2002, $1,098 was
included in accounts payable related to this.
c. In August 2000, the Company entered into a memorandum of
understanding, which provides for a renewable two-year lease
for a certain component of P5. Royalties are calculated as the
number of units of P5 sold multiplied by the greater of a
$0.25 and the difference between the manufacturing cost of the
license component and alternative component with a minimum
license fee of $125,000 per annum. The Company has elected not
use the licensed component therefore no royalties are due
pursuant to the memorandum of understanding.
d. In January 2001, the Company entered into memorandum of
understanding for the development of certain components of P5.
Pursuant to the memorandum of understanding, the Company is
required to pay royalties of 1% of P5's net sales to the
developer, indefinitely. A nonrefundable royalty advance of
$15,000 was paid in 2001. Included in accounts payable at
December 31, 2002 is royalty expense of $35,000 incorporating
the component technology pursuant to the memorandum of
understanding into P5.
e. In July 2001, the Company entered a development agreement for
the development of certain components of P5. The developer
accomplished the objectives set forth in the agreement to
complete development of the P5 by June 2002. Consequently, the
Company is required to pay base royalties of 1% of net sales
generated from P5, indefinitely and additional 0.5% of net
sales generated from P5, indefinitely. Included in accrued
expenses is $917 at December 31, 2002.
F-31
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(16) CONTRACTUAL OBLIGATIONS/GAME PUBLISHERS-LICENSING AGREEMENTS,
CONTINUED:
f. In May 2002, the Company placed an order for the manufacture
of approximately 35,000 P5s with a third-party manufacturer.
Under the terms of the order, the Company paid a deposit of
$100,000 upon placing the order and posted letters of credit
in the amount of $2,000,000. As of September 30, 2002, there
was $2,000,000 in restricted cash, upon which the letters of
credit could be drawn. Beginning in October 2002, the Company
began accepting receipt of these goods from the manufacturer,
and as of December 24, 2002, $1,842,234 has been drawn against
the letters of credit, as payment. The balance of $157,766 was
paid on January 30, 2003.
g. In May 2002, the Company entered into an agreement with a game
developer. Under the agreement the game developer shall
disclose to the Company the source code for two specific games
so that the P5 software can be integrated with the game and
use their best efforts to provide reasonable technical
assistance to the Company and its developer during the
integration process. In addition, the game developer will
release software updates enabling current users of the games
to use P5. The Company will be responsible for integration and
payment to the game developer of $100,000. As of March 31,
2003 the Company paid $66,665. Included in accrued liabilities
is $33,335 related to this agreement.
h. In August 2002, the Company committed to pay a game publisher
a minimum of $35,000. At December 31, 2002, $17,500 was paid
with $17,500 included in accounts payable.
i. In August 2002, the Company committed to pay royalties to a
game publisher at the rate of $5.00 per unit. A minimum
commitment of $125,000 is required. At December 31, 2002,
$62,500 was paid with $62,500 included in accrued expenses.
j. In September 2002, the Company committed to pay royalties to a
game publisher at the rate of $1.50 per unit. A minimum of
$37,500 is required. At December 31, 2002, $18,750 was paid
with $18,750 included in accrued expenses.
k. In September 2002, the Company committed to pay royalties to a
game publisher at the rate of $5.00 per unit. A minimum
commitment of $187,500 is required. At December 31, 2002,
$93,750 was paid with $93,750 included in accounts payable
(17) SUBSEQUENT EVENT:
NEW FINANCING:
On March 12, 2003, the Company sold to a private investor
100,000 shares for $1.00 per share totaling $100,000.
During the first quarter of 2003, the Company raised an
additional $500,000 pursuant to the 8% Secured Convertible
Debenture described in footnote 7.
F-32
ESSENTIAL REALITY, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2002 AND 2001
(17) SUBSEQUENT EVENT, CONTINUED:
NEW FINANCING, CONTINUED:
Also, the Company obtained an additional $25,000 short-term
unsecured financing with no interest.
SEVERANCE AGREEMENTS:
In January 2003, the Company terminated six personnel
consisting of various officers and support staff. The Company
is obligated for $291,000 of severance pay contingent upon the
Company obtaining installment financing of $1,000,000 minimum,
excluding bridge loans.
In addition, in connection with these severance agreements,
the Company is obligated to issue to one of its former
officers, five-year warrants to purchase 250,000 shares of
common stock at an exercise price of $0.75 per share.
PRIVATE PLACEMENT:
On March 10, 2003, the Company entered into an Investment
Banking/Advisory Agreement with First Securities USA, Inc.
through its SBI USA division ("SBI") engaging SBI as the
exclusive financial advisor, for six months in connection with
the management of a "PIPE" (private investment in public
equity) of equity securities, which may or may not include
common stock and warrants to purchase common stock of the
Company, on a best efforts basis up to $5,000,000 with a
minimum of $3,000,000. The private placement will be
structured as a transaction exempt from section 5 of the
Securities Act of 1933 and shall comply with section 4(2) of
the Securities Act and Regulation D and to permit the initial
closing upon the receipt and acceptance by the Company of
$3,000,000 for irrevocable subscriptions for the securities up
to $5,000,000. The Company will pay the Investment Banker a
retainer of $25,000 in common stock of the Company. In
addition, the Company will pay a commission in cash equal to
10% of the aggregate gross proceeds of the securities sold, as
well as warrants for the purchase of a number of securities
equal to 10% of the number of securities sold in the private
placement. The warrants will be exercisable for five years at
a price equal to 110% of the offering price per security.
F-33
EXHIBIT INDEX
NUMBER DESCRIPTION
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2.1 Amended Contribution Agreement, dated as of April 24, 2002, by and among Essential Reality, LLC, the Registrant
(f/k/a JPAL, Inc.), Martin Abrams, John Gentile, Anthony Gentile and LCG Capital Group, LLC. Incorporated herein by
reference from Exhibit A to the Registrant's Proxy Statement on Schedule 14A filed on May 21, 2002.
2.2 Amendment to Amended Contribution Agreement, dated as of June 14, 2002, by and among Essential Reality, LLC, the
Registrant (f/k/a JPAL, Inc.), Martin Abrams, John Gentile, Anthony Gentile and LCG Capital Group, LLC.
Incorporated herein by reference from Exhibit 2.2 to the Registrant's Current Report on Form 8-K filed on July 3,
2002.
3.1 Amended and Restated Articles of Incorporation of the Registrant. Incorporated herein by reference from Exhibit 3.1
to the Registrant's Registration Statement on Form SB-2 filed on August 18, 2000 ("2000 SB-2").
3.2 Amendment to Articles of Incorporation filed June 20, 2002 with the State of Nevada. Incorporated herein by
reference from Exhibit 3.2 to the Registrant's Registration Statement on Form SB-2 filed on July 19, 2002 ("2002
SB-2").
3.3 Amendment to Articles of Incorporation filed June 21, 2002 with the State of Nevada. I incorporated herein by
reference from Exhibit 3.3 to the 2002 SB-2.
3.4 Bylaws of the Registrant. Incorporated herein by reference from Exhibit 3.2 to the 2000 SB-2.
10.1 JPAL, Inc. 2001 Stock Incentive Plan. Incorporated herein by reference from Exhibit C to the Registrant's Proxy
Statement on Schedule 14A filed on January 18, 2002.
10.2* Manufacturing Agreement with V-Tech Communications Ltd entered into as of May 15, 2002.
10.3* Development Agreement with VR Yad dated as of July 1, 2001.
10.4 Consulting / Advisor Agreement with Abrams Gentile Entertainment, Inc. dated as of February 1, 2001.
10.5* Agreement with BusinessDevelopment.com LLC dated as of December 13, 2000. Amendment with Business Development.com
LLC dated as of December 1,2001
10.6* Investment Banking/Advisor Agreement with SBI USA, a division of First Securities USA, Inc., dated March 10, 2003.
24.1* Power of Attorney (included on signature page hereto).
99.1* Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.2* Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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o Filed herewith.