As filed with the Securities and Exchange Commission on October 20, 2006
Registration No. 333- 130900
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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PRE-EFFECTIVE AMENDMENT NO. 5 TO
FORM SB-2
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
ELECTRONIC SENSOR TECHNOLOGY, INC.
(Name of Small Business Issuer in Its Charter)
Nevada 3679 98-0372780
(State or Other (Primary Standard Industrial (I.R.S. Employer
Jurisdiction of Classification Code Number) Identification Number)
Incorporation or
Organization)
1077 Business Center Circle
Newbury Park, California 91320
(805) 480-1994
(Address and Telephone Number of Principal Executive Offices and
Principal Place of Business)
Francis Chang
Secretary, Treasurer and Vice President of Finance and Administration
1077 Business Center Circle
Newbury Park, California 91320
(805) 480-1994
(Name, Address and Telephone Number of Agent For Service)
With a copy to:
Neil W. Rust, Esq.
White & Case LLP
633 West Fifth Street
Los Angeles, California 90071
(213) 620-7700
Approximate Date of Proposed Sale to the Public: As soon as practicable
after this registration statement becomes effective.
If this form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, check the following box and
list the Securities Act registration statement number of the earlier effective
registration statement for the same offering. [ ] ______________________________
If this form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ] _____________________________________________________
If this form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ] _____________________________________________________
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [ ]
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CALCULATION OF REGISTRATION FEE
PROPOSED PROPOSED
AMOUNT MAXIMUM MAXIMUM AMOUNT OF
TITLE OF SECURITIES TO BE OFFERING PRICE AGGREGATE REGISTRATION
TO BE REGISTERED REGISTERED PER UNIT OFFERING PRICE FEE
-------------------------- ---------------- ---------------- ---------------- -----------------
Common stock, par
value $.001 per share 1,925,000(1) $ 1.0000 $ 1,925,000 $ 205.98
-------------------------- ---------------- ---------------- ---------------- -----------------
Common stock, par
value $.001 per share 1,500,000(2) $ 1.0000 $ 1,500,000 $ 160.50
-------------------------- ---------------- ---------------- ---------------- -----------------
Common stock, par
value $.001 per share 130,000(3) $ .8145 $ 105,882 $ 11.33
-------------------------- ---------------- ---------------- ---------------- -----------------
Common stock, par
value $.001 per share 350,000(4) $ 2.4000 $ 840,000 $ 90.00
-------------------------- ---------------- ---------------- ---------------- -----------------
Common stock, par
value $.001 per share 23,148,482(5) $ .4000 $ 9,259,393 $ 990.76
-------------------------- ---------------- ---------------- ---------------- -----------------
Common stock, par
value $.001 per share 485,213(6) $ .4761 $ 231,010 $ 24.72
-------------------------- ---------------- ---------------- ---------------- -----------------
Total 27,538,695 $ 13,861,285 $ 1,483.29*
-------------------------- ---------------- ---------------- ---------------- -----------------
(1) 1,925,000 shares of common stock of Electronic Sensor Technology, Inc., par
value $.001 per share issued on February 1, 2005 at a price of
approximately $1.00 per share (unit price of $1.00, such units including
one share of common stock and a warrant to purchase one share of common
stock at an exercise price of $1.00 per share).
(2) 1,500,000 shares of common stock underlying three-year warrants issued on
February 1, 2005 with an exercise price of $1.00 per share.
(3) 130,000 shares of common stock issued on December 5, 2005 in exchange for
services, the value of which totaled $105,882.
(4) 350,000 shares of common stock underlying a five-year warrant issued on
December 5, 2005 with an exercise price of $2.40 per share.
(5) 27,357,297 shares of common stock underlying 110% of an aggregate principal
amount of $7,000,000 of 8% unsecured convertible debentures due December 7,
2009 issued on December 7, 2005 with a conversion price of $.4544 per
share, as amended on September 7, 2006 to reduce the conversion price to
$.4000 per share, plus interest on the debentures that may be paid in
common stock.
(6) 485,213 shares of common stock underlying a five-year warrant issued on
December 7, 2005 with an exercise price of $.4761 per share.
* Previously paid $1,516.42.
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES
AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE
A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT
SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF THE
SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A),
MAY DETERMINE.
PROSPECTUS
[LOGO OF ELECTRONIC SENSOR TECHNOLOGY]
ELECTRONIC SENSOR TECHNOLOGY, INC.
27,538,695 SHARES OF COMMON STOCK
This prospectus is part of a registration statement on Form SB-2 that we
filed with the Securities and Exchange Commission. Under this registration
statement, the holders of common stock named in this registration statement may,
and the holders of the warrants and the debentures described below may upon
exercise of such warrants and upon conversion of such debentures, offer for
resale up to a total of 27,538,695 shares of common stock at any time at market
prices prevailing at the time of the sale or at privately negotiated prices. The
selling security holders may sell the common stock directly to purchasers or
through underwriters, broker-dealers or agents, who may receive compensation in
the form of discounts, concessions or commissions.
The 27,538,695 shares of common stock that may be sold by selling security
holders pursuant to this registration statement consist of:
o 1,925,000 shares of common stock of Electronic Sensor Technology, Inc.
(formerly Bluestone Ventures Inc.), par value $.001 per share, which
were issued in a private offering on February 1, 2005;
o 1,500,000 shares of common stock underlying three-year warrants to
purchase such common stock at an exercise price of $1.00 per share,
which were issued in the same private offering on February 1, 2005;
o 130,000 shares of common stock, which were issued in a private
offering on December 5, 2005;
o 350,000 shares of common stock underlying a five-year warrant to
purchase such common stock at an exercise price of $2.40 per share,
which was issued in a private offering on December 5, 2005;
o 23,148,482 shares of common stock, which include 110% of shares
underlying 8% unsecured convertible debentures due December 7, 2009,
which were issued in a private offering on December 7, 2005 and shares
that, at our option, may be used to pay interest on the debentures;
and
o 485,213 shares of common stock underlying a five-year warrant to
purchase such common stock at an exercise price of $0.4761 per share,
which was issued in a private offering on December 7, 2005.
We have agreed to register the foregoing shares of common stock in order to
facilitate secondary trading by the holders of the aforementioned common stock,
debentures and warrants.
Our common stock is quoted on the OTC bulletin board under the symbol
"ESNR.OB".
INVESTING IN OUR COMMON STOCK INVOLVES RISK. SEE "RISK FACTORS" BEGINNING
ON PAGE 2 FOR A DISCUSSION OF CERTAIN RISKS THAT YOU SHOULD CONSIDER BEFORE
INVESTING IN OUR COMMON STOCK.
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR PASSED UPON THE
ADEQUACY OR ACCURACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
This prospectus is dated [___________], 2006
In making your investment decision, you should rely only on the information
contained in this prospectus and in each prospectus supplement, if any. We have
not authorized anyone to provide you with any other information. If you receive
any unauthorized information, you must not rely on it. This prospectus is not an
offer to sell these securities and is not soliciting an offer to buy these
securities in any state or jurisdiction where the offer or sale of these
securities is not permitted. You should assume that the information appearing in
this prospectus and any prospectus supplement is accurate only as of the
respective dates thereof. Our business, financial condition, results of
operations and prospects may have changed since those dates.
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TABLE OF CONTENTS
Page
Prospectus Summary.............................................................1
Risk Factors...................................................................2
Use of Proceeds................................................................8
Determination of Offering Price................................................8
Selling Security Holders.......................................................8
Plan of Distribution..........................................................12
Legal Proceedings.............................................................13
Directors, Executive Officers and Control Persons.............................13
Security Ownership of Certain Beneficial Owners and Management................16
Description of Securities.....................................................18
Interest of Named Experts and Counsel.........................................19
Disclosure of Commission Position on Indemnification for Securities Act
Liabilities..................................................................19
Description of Business.......................................................19
Management's Discussion and Analysis of Financial Condition and Results of
Operations...................................................................27
Description of Property.......................................................35
Certain Relationships and Related Transactions................................35
Market for Common Equity and Related Stockholder Matters......................36
Executive Compensation........................................................39
Financial Statements..........................................................44
Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure...................................................................45
Where You Can Find More Information...........................................45
Special Note of Caution Regarding Forward-Looking Statements..................46
Legal Matters.................................................................46
Experts.......................................................................46
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(i)
PROSPECTUS SUMMARY
This summary highlights information described more fully elsewhere in this
prospectus. This summary does not contain all of the information that you should
consider before investing in our common stock. You should read the entire
prospectus carefully, including "Risk Factors" and our audited and unaudited
financial statements and the notes to those financial statements, which are
included in this prospectus.
OVERVIEW OF THE COMPANY
Electronic Sensor Technology is engaged in the development, manufacture,
and sale of a patented product called zNose(R), a device designed to detect and
analyze chemical odors and vapors, or, in other words, an electronic "nose." The
zNose(R) identifies the chemical makeup of any fragrance, vapor or odor. The
zNose(R) does this by creating a visual image of the fragrance, vapor or odor
that it detects, so that the user of the zNose(R) may easily identify the
fragrance, vapor or odor. We are involved in ongoing product research and
development efforts in the homeland security and laboratory instrumentation
markets.
Electronic Sensor Technology was originally incorporated under the name
"Bluestone Ventures Inc.", on July 12, 2000. From inception until February 1,
2005, we were engaged in the business of acquiring, exploring and developing
certain mining properties in Canada. On January 26, 2005, a transaction closed
whereby:
(i) Amerasia Acquisition Corp., a wholly-owned subsidiary of Bluestone,
merged with and into Amerasia Technology, Inc., holder of
approximately 55% of the partnership interests of Electronic Sensor
Technology, L.P. (the predecessor business of Electronic Sensor
Technology, Inc.), such that Amerasia Technology became a wholly-owned
subsidiary of Bluestone;
(ii) L&G Acquisition Corp., a wholly owned subsidiary of Bluestone, merged
with and into L&G Sensor Technology, L.P., holder of approximately 45%
of the partnership interests of Electronic Sensor Technology, L.P.,
such that L&G Sensor Technology became a wholly-owned subsidiary of
Bluestone;
(iii) as a result of the merger of (i) and (ii), Bluestone indirectly
acquired all of the partnership interests of Electronic Sensor
Technology, L.P.; and
(iv) Bluestone issued 20,000,000 shares of its common stock to the
shareholders of Amerasia Technology and L&G Sensor Technology.
Upon the acquisition of Electronic Sensor Technology, L.P., we abandoned
our mining business and adopted Electronic Sensor Technology, L.P.'s business of
developing, manufacturing and selling the vapor analysis device. Prior to the
closing of the aforementioned mergers, we changed our name to "Electronic Sensor
Technology, Inc."
Electronic Sensor Technology's executive offices are located at 1077
Business Center Circle, Newbury Park, California 91320, telephone: (805)
480-1994.
THE OFFERING
Issuer..................... Electronic Sensor Technology, Inc.
Securities Offered......... 27,538,695 shares of common stock, par value $.001.
Use of Proceeds............ We will not receive any proceeds from the resale by
the selling security holders of the common stock
registered pursuant to this registration statement.
-1-
SUMMARY FINANCIAL DATA
The financial data set forth below under the captions "Results of
Operations Data" and "Balance Sheet Data" for the years ended December 31, 2005
and December 31, 2004 and as of December 31, 2005, respectively, are derived
from our financial statements, included elsewhere in this prospectus, audited by
Sherb & Co., LLP, independent public accountants. The financial data set forth
below should be read in conjunction with the financial statements and notes
thereto included elsewhere in this prospectus and "Management's Discussion and
Analysis of Financial Condition and Results of Operations." All statistical data
set forth herein is unaudited.
RESULTS OF OPERATIONS DATA
Year Ended December 31, Six Months Ended June 30,
---------------------------- ----------------------------
2005 2004 2006 2005
------------ ------------ ------------ ------------
(Restated) (Restated)
(Restated) (Restated) (unaudited) (unaudited)
Revenues ......................................... $ 2,122,349 $ 1,076,749 $ 1,154,224 $ 651,652
Cost of sales .................................... 1,302,602 1,039,280 592,714 375,086
Gross profit ..................................... 819,747 37,469 561,510 276,566
Operating expenses ............................... 2,902,089 468,509 1,853,105 1,434,315
Net operating loss ............................... (2,082,342) (431,040) (1,291,595) (1,157,749)
Other income and (expense) ....................... 4,861,318 (171,843) 266,840 2,033,324
Net income (loss) ................................ 2,778,976 (602,883) (1,024,755) 875,576
Earning (loss) per common share, basic ........... 0.05 (0.01) (0.02) 0.02
Weighted average number of common shares, basic .. 53,636,560 53,525,865 54,159,945 53,304,475
Loss per common share, diluted ................... (0.04) (0.01) (0.02) (0.02)
Weighted average number of common shares, diluted 53,636,560 53,525,865 54,159,945 53,304,475
BALANCE SHEET DATA
December 31, 2005 June 30, 2006
------------------ ---------------
(Restated) (Restated)
(unaudited)
Working capital ................. $ 220,388 $ 436,679
Total assets .................... 7,450,360 6,249,079
Total liabilities ............... 6,587,989 6,390,463
Stockholders' equity (deficit) .. 862,371 (141,384)
RISK FACTORS
You should carefully consider each of the following risk factors, as well
as the other information contained elsewhere in this prospectus before deciding
to purchase any of our common stock. We face risks other than those listed here,
but at present consider such risks immaterial. We may also face additional risks
which are unknown to us at this time. Because of the following factors, as well
as other variables affecting our operating results, past financial performance
may not be a reliable indicator of future performance, and historical trends
should not be used to anticipate results or trends in future periods.
RISKS RELATED TO OUR COMPANY
WE HAVE A SIGNIFICANT ACCUMULATED DEFICIT AND WE MAY NEVER ACHIEVE
PROFITABILITY.
We have incurred significant net losses every year since our inception,
including net losses in 2005 and 2004. These losses have resulted principally
from expenses incurred in our research and development programs and general and
administrative expenses. We have also incurred non-cash expenses related to the
recognition of derivative liabilities. To date, we have not generated
significant recurring revenues. Our limited revenues that derive from sales of
the zNose(R) product have not been and
-2-
may not be sufficient to sustain our operations. We anticipate that we will
continue to incur substantial operating losses based on projected sales revenues
less manufacturing, general and administrative and other operating costs for the
next twelve months. We expect that our revenues will not be sufficient to
sustain our operations for the near term, notwithstanding any anticipated
revenues we may receive when our vapor detection products obtain increased
visibility in our markets, due to the significant costs associated with the
development and marketing of our products. No assurances can be given when we
will ever be profitable.
We expect to continue to experience losses until the time, if ever, when we
are able to sell products sufficient to generate revenues adequate to support
our operations. If we fail to become profitable, we may be forced to cease
operations.
OUR LIMITED MANUFACTURING EXPERIENCE AND CAPACITY MAY LIMIT OUR ABILITY TO GROW
OUR REVENUES.
To be successful, we must manufacture our products in compliance with
industry standards and on a timely basis, while maintaining product quality and
acceptable manufacturing costs. We also currently use a limited number of
sources for most of the supplies and services that we use in the manufacturing
of our vapor detection and analysis technology. We do not have agreements with
our suppliers. Our manufacturing strategy presents the following risks:
o delays in the quantities needed for product development could delay
commercialization of our products in development;
o if market demand for our products increases suddenly, our current
suppliers might not be able to fulfill our commercial needs, which
would require us to seek new supply arrangements and may result in
substantial delays in meeting market demand; and
o we may not have intellectual property rights, or may have to share
intellectual property rights, to any improvements in the manufacturing
processes or new manufacturing processes for our products.
Any of these factors could delay commercialization of our products under
development, entail higher costs and result in our being unable to effectively
sell our products.
WE FACE SIGNIFICANT COMPETITION AND OUR BUSINESS AND FINANCIAL RESULTS COULD
SUFFER FROM COMPETITION.
While we are unaware of any competitor that has created a vapor analysis
device similar to the zNose(R), there are companies that offer products and
services that compete with the zNose(R) in our markets. We believe that
manufacturers of X-Rays, Ion Mobility Spectrometers, and other electronic noses
compete with us in the security-related markets. In the markets for instruments
that analyze chemicals, we compete with many manufacturers including
Perkin-Elmer (NYSE: PKI) and Agilent Technologies (NYSE: A). Many of our
existing and potential competitors have longer operating histories, greater
experience, greater name recognition, larger customer bases and significantly
greater financial, technical and marketing resources than we do. Because of
their greater resources, our competitors are able to undertake more extensive
marketing campaigns for their products and services, and make more attractive
offers to potential employees, strategic partners, and others. We may not be
able to compete successfully against our current or future competitors and our
business and financial results could suffer from such competition.
IF OUR PRODUCTS DO NOT ACHIEVE A SIGNIFICANT LEVEL OF MARKET ACCEPTANCE, IT IS
HIGHLY UNLIKELY THAT WE EVER WILL BECOME PROFITABLE.
To our knowledge, electronic nose technology, and our zNose(R) product, has
yet to receive widespread market acceptance in the markets we are focused on.
The commercial success of our current and future products will depend upon the
adoption of our zNose(R) technology by our customers. In order to be successful,
our future products must meet the technical and cost requirements for the
markets we intend to penetrate. Market acceptance will depend on many factors,
including:
o our ability to convince potential customers to adopt our products;
o the willingness and ability of potential customers to adopt our
products;
-3-
o our ability to sell and service sufficient quantities of our products;
and
o new, advanced technology offered by other companies which compete with
our products.
Because of these and other factors, our products may not achieve market
acceptance. If our products do not achieve a significant level of market
acceptance, demand for our future products will not develop as expected and it
is highly unlikely that we ever will become profitable.
OTHER COMPANIES COULD CREATE A TECHNOLOGY WHICH COMPETES EFFECTIVELY WITH OUR
ZNOSE(R) TECHNOLOGY, AND WE MAY BE UNABLE TO MAINTAIN OUR EXISTING, OR CAPTURE
ADDITIONAL, MARKET SHARE IN OUR MARKETS.
Based upon our review of the industry, we are unaware of any company today
that markets a technology which is similar to our zNose(R) technology.
Nonetheless, our intended markets generally are dominated by very large
corporations (or their subsidiaries), which have greater access to capital,
manpower, technical expertise, distribution channels and other elements which
would give them a competitive advantage over us were they to begin to compete
directly against us. It is possible that these and other competitors may
implement new, advanced technologies before we are able to, allowing them to
provide more effective products at more competitive prices. Any number of future
technological developments could:
o adversely impact our competitive position;
o require write-downs of obsolete technology;
o require us to discontinue production of obsolete products before we
can recover any or all of our related research, development and
commercialization expenses; or
o require significant capital expenditures beyond those currently
contemplated.
We cannot assure investors that we will be able to achieve the
technological advances to remain competitive and profitable, that new products
and services will be developed and manufactured on schedule or on a
cost-effective basis, that anticipated markets will exist or develop for new
products or services, or that any marketed product will not become
technologically obsolete.
WE DEPEND ON KEY PERSONNEL IN A COMPETITIVE MARKET FOR SKILLED EMPLOYEES, AND
FAILURE TO RETAIN AND ATTRACT QUALIFIED PERSONNEL COULD SUBSTANTIALLY HARM OUR
BUSINESS.
We believe that our future success will depend in large part on our ability
to attract and retain highly skilled engineering, sales and marketing and
management personnel. If we are unable to hire the necessary personnel, the
development of our business will likely be delayed or prevented. Competition for
these highly skilled employees is intense. As a result, we cannot assure you
that we will be successful in retaining our key personnel or in attracting and
retaining the personnel we require for expansion.
WE ARE DEPENDENT UPON A MAJOR CUSTOMER FOR A LARGE PERCENTAGE OF OUR SALES AND
ANY CHANGES TO THAT CUSTOMER'S BUSINESS OR OUR RELATIONSHIP WITH THAT CUSTOMER
COULD HAVE A SUBSTANTIAL EFFECT ON OUR SALES AND REVENUE.
Our largest customer is Beijing R&D Technology Co., Ltd., which is our
exclusive distributor in China. During the fiscal year ending December 31, 2005,
purchases by Beijing R&D Technology accounted for $601,000, or approximately 29%
of our total sales. We expect that in the upcoming fiscal year, Beijing R&D
Technology will continue to account for a large percentage of our total sales.
If Beijing R&D Technology experiences any changes in its business that affect
its level of purchases from Electronic Sensor Technology, or if there is any
change in the business relationship between Beijing R&D Technology and
Electronic Sensor Technology leading to a decrease in its level of purchases
from Electronic Sensor Technology, our sales and revenues could substantially
decrease.
-4-
WE MAY NOT BE ABLE TO PROTECT OUR INTELLECTUAL PROPERTY AND MAY INFRINGE ON THE
INTELLECTUAL PROPERTY RIGHTS OF OTHERS.
The protection of our intellectual property, including our patents and
other proprietary rights, is important to our success and our competitive
position. Accordingly, we devote substantial resources to the maintenance and
protection of intellectual property through various methods such as patents and
patent applications, trademarks, copyrights, confidentiality and non-disclosure
agreements. We also rely on trade secrets, proprietary methodologies and
continuing technological innovation to remain competitive. We have taken
measures to protect our trade secrets and know-how, including the use of
confidentiality agreements with our employees. However, it is possible that
these agreements may be breached and that the available remedies for any breach
will not be sufficient to compensate us for damages incurred.
We currently have four patents in the United States and patents in various
foreign countries. There can be no assurance that the patents that we hold will
protect us from competition from third parties with similar technologies or
products, as it is possible that third parties may be able to develop similar
technologies or products without necessarily infringing on the patents that we
currently hold. Moreover, we cannot assure you that others will not assert
rights in, or ownership of, patents and other proprietary rights we may
establish or acquire or that we will be able to successfully resolve such
conflicts. We do not have reason to believe that our current patents are at
great risk of being challenged, however, due to the nature and complexity of our
technology, we cannot assure you that any patents issued to us will not be
challenged, invalidated or circumvented or that the rights granted under these
patents will provide a competitive advantage to us. Moreover, the laws of some
foreign countries do not protect intellectual property rights to the same extent
as the laws of the United States, and we could experience various obstacles and
high costs in protecting our intellectual property rights in foreign countries.
If we are unable to obtain or maintain these protections, we may not be able to
prevent third parties from using our intellectual property.
RISKS RELATED TO OWNERSHIP OF OUR COMMON STOCK
OUR STOCK PRICE IS SUBJECT TO EXTREME VOLATILITY.
The trading price of our common stock has been, and is likely to continue
to be, highly volatile and could be subject to wide fluctuations in response to
factors such as actual or anticipated variations in our quarterly operating
results, announcements of technological innovations, announcements of
significant new orders or cancellation of significant orders, or new products by
Electronic Sensor Technology or its competitors, changes in financial estimates
by securities analysts, conditions or trends in the analytic instrumentation
markets, changes in the market valuations of other security-detection oriented
companies, announcements by Electronic Sensor Technology or its competitors of
significant acquisitions, strategic partnerships, joint ventures or capital
commitments, additions or departures of key personnel, sales of common stock or
other securities of Electronic Sensor Technology in the open market and other
events or factors, many of which are beyond our control.
THERE IS NO ESTABLISHED TRADING MARKET FOR OUR SHARES OF COMMON STOCK.
THE LIQUIDITY OF OUR COMMON STOCK WILL BE AFFECTED BY ITS LIMITED TRADING
MARKET.
Bid and ask prices for our common stock are quoted on the Over-the-Counter
Bulletin Board under the symbol "ESNR.OB." There is currently no broadly
followed, established trading market for our common stock. An established
trading market for our shares may never develop or be maintained. Active trading
markets generally result in lower price volatility and more efficient execution
of buy and sell orders. The absence of an active trading market reduces the
liquidity of our shares. Prior to the consummation of the merger in February
2005, we had no reported trading volume in our common stock. Since then, we have
had sporadic reported trading in our shares. As a result of this sporadic
trading activity, the quoted price for our common stock on the Over-the-Counter
Bulletin Board is not necessarily a reliable indicator of its fair market value.
Further, if we cease to be quoted, holders would find it more difficult to
dispose of, or to obtain accurate quotations as to the market value of, our
common stock, and the market value of our common stock would likely decline.
IF AND WHEN A TRADING MARKET FOR OUR COMMON STOCK DEVELOPS, BECAUSE WE ARE A
TECHNOLOGY COMPANY, WE EXPECT THAT THE TRADING PRICES WILL BE EXTREMELY
VOLATILE.
The trading prices of technology company stocks in general tend to
experience extreme price fluctuations. The valuations of many technology
companies without consistent product revenues or earnings, if any, are not based
on conventional valuation standards such as price to earnings and price to sales
ratios. Any negative change in the public's perception of the prospects of
-5-
technology companies could depress our stock price regardless of our results of
operations if a trading market for our stock develops. In addition, our stock
price could be subject to wide fluctuations in response to factors including,
but not limited to, the following:
o announcements of new technological innovations or new products by us
or our competitors;
o conditions or trends in the sensor technology industry;
o changes in the market valuations of other technology companies;
o developments in domestic and international governmental policy or
regulations that affect the technology utilized in our products;
o announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
o developments in patent or other proprietary rights held by us or by
others; or
o loss or expiration of our intellectual property rights.
WE MAY RAISE ADDITIONAL CAPITAL THROUGH A SECURITIES OFFERING THAT COULD DILUTE
THE OWNERSHIP INTERESTS OF OUR SHAREHOLDERS.
We require substantial working capital to fund our business. If we raise
additional funds through the issuance of equity, equity-related or convertible
debt securities, these securities may have rights, preferences or privileges
senior to those of the holders of our common stock. The issuance of additional
common stock or securities convertible into common stock by our management will
also have the effect of further diluting the proportionate equity interest and
voting power of holders of our common stock.
In addition, under our articles of incorporation, our Board of Directors is
authorized to issue, without obtaining shareholder approval, shares of preferred
stock having the rights, privileges and designations as determined by the Board
of Directors. Therefore, the Board of Directors could issue shares of preferred
stock that would have preferential liquidation, distribution, voting, dividend
or other rights, which would be superior to the rights of common stockholders.
A SIGNIFICANT NUMBER OF OUR SHARES ARE ELIGIBLE FOR SALE, AND THEIR SALE COULD
DEPRESS THE MARKET PRICE OF OUR COMMON STOCK.
Sales of a significant number of shares of our common stock in the open
market could harm the market price of our common stock. A reduced market price
for our shares could make it more difficult to raise funds through future
offerings of common stock. Approximately 27 million shares are presently
eligible for trading in the open market. As additional shares become available
for resale in the open market, including new shares issued upon conversion of
our debentures issued on December 7, 2005, the exercise of our outstanding
options, warrants, and contractual obligations to issue shares, the number of
our publicly tradable shares will increase, which could decrease their trading
price. In addition, some of our shares may be offered from time to time in the
open market pursuant to Rule 144, and these sales may have a depressive effect
on the market for our shares. In general, a person who has held restricted
shares for a period of one year may, upon satisfying certain conditions to the
application of Rule 144, sell into the market shares up to an amount equal to 1%
of the outstanding shares (and potentially more) of our common stock. These
sales may be repeated once each three months. In addition, an unlimited amount
of restricted shares may be sold by a non-affiliate after they have been held
for two years pursuant to Rule 144(k).
WE ARE NOT REQUIRED TO FILE REPORTS WITH THE SEC ON A CONTINUOUS BASIS BECAUSE
OUR STOCK IS NOT CURRENTLY REGISTERED UNDER THE EXCHANGE ACT.
Our registered common stock is registered under the Securities Act and
is not currently registered under the Exchange Act. As long as we do not have
any class of stock registered under the Exchange Act, continue to have less than
300 record holders of our shares (we presently have substantially below 300
record holders), and until this registration statement is declared
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effective, we are under no legal obligation to file reports with the SEC. Once
this registration statement is declared effective, we will be required to file
annual, quarterly and periodic reports with the SEC during the fiscal year in
which this registration statement is declared effective. We currently plan to
register our common stock under the Exchange Act prior to the end of the fiscal
year in which this registration statement is declared effective, which will
cause us to be subject to the requirements of the Exchange Act, including the
requirements to file various reports with the SEC and to comply with the SEC's
proxy rules. However, if we do not register our stock under the Exchange Act, we
will not be required to comply with the SEC's proxy rules or the additional
reporting requirements of the Exchange Act. In addition, if we continue to have
less than 300 record holders of our shares, we will not be required to file any
reports with the SEC for any fiscal year in which we have not had a Securities
Act registration statement declared effective.
WE ARE SUBJECT TO THE SEC'S PENNY STOCK RULES.
Broker-dealer practices in connection with transactions in "penny stocks"
are regulated by certain rules adopted by the SEC. Penny stocks generally are
equity securities with a price of less than $5.00, other than securities
registered on certain national securities exchanges or quoted on the NASDAQ
Stock Market if current price and volume information with respect to
transactions in such securities is provided by the exchange or system. The rules
require that a broker-dealer, prior to a transaction in a penny stock not
otherwise exempt from the rules, deliver a standardized risk disclosure document
that provides information about penny stocks and the risks in the penny stock
market. The broker-dealer also must provide the customer with current bid and
offer quotations for the penny stock, the compensation of the broker-dealer and
its salesperson in connection with the transaction and monthly account
statements showing the market value of each penny stock held in the customer's
account. In addition, the rules generally require that prior to a transaction in
a penny stock, the broker-dealer must make a special written determination that
the penny stock is a suitable investment for the purchaser and receive the
purchaser's written agreement to the transaction. These disclosure requirements
may have the effect of reducing the liquidity of penny stocks. Our securities
are subject to the penny stock rules. As such, holders of our shares of common
stock may find it more difficult to sell their securities.
WE HAVE NOT PAID DIVIDENDS IN THE PAST AND DO NOT EXPECT TO PAY DIVIDENDS IN THE
FUTURE. ANY RETURN ON INVESTMENT MAY BE LIMITED TO POTENTIAL FUTURE APPRECIATION
IN THE VALUE OF OUR STOCK.
We have never paid cash dividends on our stock and do not anticipate paying
cash dividends on our stock in the foreseeable future. The payment of dividends
on our shares, if ever, will depend on our earnings, financial condition and
other business and economic factors affecting us at such time as the Board of
Directors may consider relevant. If we do not pay dividends, our stock may be
less valuable because a return on investment will only occur if and to the
extent that our stock price appreciates, and if the price of our stock does not
appreciate, then there will be no return on investment.
OUR ANTI-TAKEOVER DEFENSE PROVISIONS MAY DETER POTENTIAL ACQUIRERS AND DEPRESS
OUR STOCK PRICE.
Certain provisions of our articles of incorporation, bylaws and Nevada law
could be used by our incumbent management to make it substantially more
difficult for a third party to acquire control of us. These provisions include
the following:
o we may issue preferred stock with rights senior to those of our common
stock; and
o the Board of Directors may fill casual vacancies occurring in the
Board of Directors and may appoint one or more additional directors
between annual meetings of shareholders to hold office until the next
annual meeting of shareholders.
These provisions may discourage certain types of transactions involving an
actual or potential change in control. These provisions may also limit our
shareholders' ability to approve transactions that they may deem to be in their
best interests and discourage transactions in which our shareholders might
otherwise receive a premium for their shares over the then current market price.
-7-
SOME OF OUR EXISTING SHAREHOLDERS CAN EXERT CONTROL OVER US, AND MAY NOT MAKE
DECISIONS THAT ARE IN THE BEST INTERESTS OF ALL SHAREHOLDERS.
Our officers and directors currently own or control approximately 40.11% of
our outstanding common stock, and may acquire an additional 3.23% of our
outstanding common stock upon the exercise of warrants and options. Land &
General Berhad through its wholly owned subsidiary, L&G Resources (1994), Inc.,
owns approximately 17.78% of our outstanding common stock, and may acquire an
additional 0.48% of our outstanding common stock upon the exercise of warrants
and options. As a result, these shareholders may exert a significant degree of
influence over our management and affairs and/or over matters requiring
shareholder approval, including the election of directors and approval of
significant corporate transactions. In addition, this concentration of ownership
may delay or prevent a change in control of Electronic Sensor Technology and
might affect the market price of our shares, even when a change may be in the
best interests of all shareholders. Moreover, the interests of this
concentration of ownership may not always coincide with our interests or the
interests of other shareholders, and, accordingly, they could cause us to enter
into transactions or agreements which we would not otherwise consider.
PAST ACTIVITIES OF THE COMPANY AND ITS AFFILIATES MAY LEAD TO FUTURE LIABILITY
FOR US.
Prior to the acquisition of Electronic Sensor Technology, L.P., we engaged
in the exploitation of mining claims, a business unrelated to Electronic Sensor
Technology's current operations. Although we are unaware of any at this time,
liabilities, if any, of the prior business may have a material adverse effect on
us. These liabilities potentially may include liabilities relating to
Bluestone's operations of its mining business, individuals that Bluestone
employed, contracts to which Bluestone was a party, any personal injury claims
against Bluestone and any other liabilities that may arise as a result of
operating a publicly-traded mining business.
USE OF PROCEEDS
We will not receive any proceeds from the resale by the selling security
holders of the common stock registered pursuant to this registration statement.
DETERMINATION OF OFFERING PRICE
There is currently no broadly followed, established trading market for our
common stock. Each selling security holder and any of their pledgees, assignees
and successors-in-interest may, from time to time, sell any or all of their
shares of common stock on through the OTC Bulletin Board or any stock exchange,
market or trading facility on which the shares are traded (if we ever become
eligible for trading on any stock exchange, market or trading facility and seek
a listing or quotation thereon) or in private transactions. These sales may be
at fixed prices or negotiated prices, as determined by the selling security
holder.
SELLING SECURITY HOLDERS
Each of the selling security holders obtained beneficial ownership of the
common stock being registered for resale pursuant to this registration statement
in one of the following transactions, as set forth below.
o On February 1, 2005, in a private offering, Electronic Sensor
Technology issued 3,985,000 shares of common stock of Electronic
Sensor Technology and three-year warrants to purchase 3,985,000 shares
of our common stock at an exercise price of $1.00 per share (units
consisting of one share of common stock and one warrant were sold for
$1.00 per unit). The following selling security holders obtained
beneficial ownership of our common stock through this private
offering: Mark S. Barbara, Bixbie Financial Corp., John J. and Alicia
C. Caufield, Chase Investments, Inc., Crown Capital Partners SA,
Richard Forte, Jeffrey R. Haines, Highgate House Funds, Ltd.,
Nathaniel Kramer, Memphis Group, Inc., Jeremy Shaffer Roenick, Gene
Salkind, M.D., Brian Patrick Shanahan and Paul Tompkins.
o Electronic Sensor Technology issued 130,000 shares of common stock to
CEOcast, Inc. on December 5, 2005, in a private offering, in exchange
for investor relations services valued at approximately $105,882.
CEOcast provides us with investor relations services valued at
approximately $17,500 per month. We have entered into three short-term
consulting agreements with CEOcast on each of January 17, 2005, July
17, 2005 and October 17, 2005, pursuant to which we agreed to
compensate CEOcast with $7,500 per month, paid in cash, and
-8-
CEOcast is compensated for the remainder of the value of its
services with our common stock. The 130,000 shares of common stock
issued to CEOcast represented the compensation in our shares due to
CEOcast under the three consulting agreements. The number of shares
issued to CEOcast was calculated by determining for each of the nine
months of the contract between us and CEOcast that number of shares
that could be purchased per month at a 15% discount with $10,000.
o On December 5, 2005, in a private offering, Electronic Sensor
Technology issued to HomelandSecurityStocks, a division of
Protect-A-Life, Inc., a warrant to purchase 350,000 shares of common
stock at an exercise price of $2.40 per share. HomelandSecurityStocks
formerly provided us with investor relations services. The warrant was
issued pursuant to a Settlement Agreement entered into on October 11,
2005 among HomelandSecurityStocks, Protect-A-Life and Electronic
Sensor Technology. The Settlement Agreement settled a dispute between
HomelandSecurityStocks and Electronic Sensor Technology resulting from
the termination by Electronic Sensor Technology of a consulting
agreement dated February 7, 2005, between HomelandSecurityStocks and
Electronic Sensor Technology. Pursuant to the consulting agreement, we
had engaged HomelandSecurityStocks to provide us with investor
relations and public relations services from February 9, 2005 through
February 9, 2006 for a fee of $12,000 per month and warrants to
purchase 500,000 shares of common stock at an exercise price of $2.40
per share, to vest as follows: (i) warrants to purchase 200,000 shares
on February 9, 2005, (ii) warrants to purchase 75,000 shares on May 9,
2005, (iii) warrants to purchase 75,000 shares on August 9, 2005, (iv)
warrants to purchase 75,000 shares on November 9, 2005 and (v)
warrants to purchase 75,000 shares on February 8, 2006. Electronic
Sensor Technology terminated the consulting agreement in July 2005.
o In a private offering on December 7, 2005, we issued to Islandia, L.P.
and Midsummer Investment Ltd. an aggregate principal amount of
$7,000,000 of 8% unsecured convertible debentures due December 7, 2009
that were convertible into 15,404,930 shares of our common stock. At
issuance, the debentures were convertible into common stock at a
conversion price of $0.4544 per share. This price was calculated based
upon 105% of the volume weighted average price over the 20 trading
days preceding the date of issuance of the debentures. Such conversion
price was subsequently reduced to $0.4000, pursuant to the Forbearance
and Amendment Agreement entered into among Electronic Sensor
Technology, Midsummer and Islandia on September 7, 2006, which
consequently increased the shares of common stock issuable upon
conversion of the debentures to 17,500,000. Under certain
circumstances, we have the right, at our option to pay interest on the
debentures with shares of common stock. In connection with the private
offering, we agreed to register 130% of the common stock into which
the debentures are convertible plus 130% of the common stock that we
may use to pay interest on the debentures. On this registration
statement, we are registering 110% of such shares, or 23,148,482
shares, to facilitate secondary trading by the holders of the
debentures.
o In a private offering on December 7, 2005, we issued to Montgomery &
Co., LLC a five-year warrant to purchase 485,213 shares of common
stock at an exercise price of $0.4761 per share. This price was
calculated based upon 110% of the volume weighted average price over
the 20 trading days preceding the date of issuance of the warrant.
Montgomery provided us with financial advisory services in connection
with the issuance of the 8% unsecured convertible debentures issued on
December 7, 2005 and various other securities, for which it received
$490,000 in addition to the warrant.
The table below sets forth the following information, as of the date that
we received such information from the selling security holder (this information
was received by Electronic Sensor Technology between December 6, 2005 and the
date of this prospectus):
o the name of each beneficial owner of the common stock registered
pursuant to this registration statement;
o the number of shares of common stock that each selling security holder
beneficially owns as of such date;
o the number of shares of common stock that may, assuming the exercise
in full of all of the warrants described above and the conversion in
full of all of the debentures described above, be offered for sale by
each selling security holder from time to time pursuant to this
prospectus;
-9-
o the number of shares of common stock to be beneficially owned by each
selling security holder assuming the exercise in full of all of the
warrants described above and the conversion in full of all of the
debentures described above, and the sale of all of the shares of
common stock offered hereby;
o the percentage of common stock to be beneficially owned by each
selling security holder after completion of the offering, based upon
the number of shares of common stock to be beneficially owned by such
selling security holder (taking into account the assumptions set forth
above), divided by 54,173,745, which represents the total number of
shares of common stock issued and outstanding as of September 7, 2006,
plus, for such selling security holder, the number of shares of common
stock to be beneficially owned by such selling security holder; and
o by footnote, any position or office held or other material
relationship with Electronic Sensor Technology or any of its
predecessors or affiliates within the past three years, other than
that of being a shareholder, and details regarding the transaction in
which each selling security holder acquired beneficial ownership of
its common stock.
Of the selling security holders, we understand that Montgomery & Co. LLC is
registered as a broker-dealer with the NASD, California, Connecticut, Florida,
Massachusetts, Nevada, New York and Washington. Otherwise, to our knowledge,
none of the selling security holders is a broker-dealer or an affiliate of a
broker-dealer.
NUMBER OF SHARES
SHARES OF OF COMMON STOCK SHARES OF COMMON STOCK
COMMON STOCK TO BE OFFERED FOR BENEFICIALLY OWNED AFTER
BENEFICIALLY THE SELLING COMPLETION OF THE OFFERING
OWNED PRIOR TO SECURITY HOLDER'S --------------------------
NAME OF SELLING SECURITY HOLDER THE OFFERING ACCOUNT NUMBER PERCENTAGE
----------------------------------------- ----------------- ------------------ ---------- -------------
Mark S. Barbara (1) 50,000 50,000 0 *
Bixbie Financial Corp. (2) 250,000 250,000 0 *
John J. and Alicia C. Caufield (3) 130,000 100,000 30,000 *
CEOcast, Inc. (4) 130,000 130,000 0 *
Chase Investments, Inc. (5) 50,000 50,000 0 *
Crown Capital Partners SA (6) 1,000,000 1,000,000 0 *
Richard Forte (7) 50,000 50,000 0 *
Jeffrey R. Haines 50,000 50,000 0 *
Highgate House Funds, Ltd. (8) 1,000,000 1,000,000 0 *
HomelandSecurityStocks.com, a division
of Protect-A-Life, Inc. (9) 350,000 350,000 0 *
Islandia, L.P. (10) 10,582,255 8,267,315 2,314,940 4.10
Nathaniel Kramer (11) 50,000 50,000 0 *
Memphis Group Inc. (12) 500,000 500,000 0 *
Midsummer Investment Ltd. (13) 19,048,059 14,881,167 4,166,892 7.14
Montgomery & Co., LLC (14) 485,213 485,213 0 *
Jeremy Shaffer Roenick (15) 50,000 50,000 0 *
Gene Salkind, M.D. (16) 200,000 200,000 0 *
Brian Patrick Shanahan 212,500 50,000 162,500 *
Paul Tompkins 25,000 25,000 0 *
(*) Less than 1%.
(1) Mr. Barbara's shares include 25,000 shares of common stock underlying a
warrant exercisable within 60 days of the date of this prospectus.
(2) Alan Meiteen is a beneficial owner of Bixbie Financial Corp.'s shares by
virtue of his position as sole control person of Bixbie Financial Corp.
(3) The Caufields' shares include 50,000 shares of common stock underlying a
warrant exercisable within 60 days of the date of this prospectus.
(4) Rachel Glicksman and Kenneth D. Sgro are beneficial owners of CEOcast's
shares by virtue of their positions as principal shareholders of CEOcast,
Inc.
-10-
(5) Richard Chase is a beneficial owner of Chase Investment, Inc.'s shares by
virtue of his position as sole control person of Chase Investments, Inc.
(6) Crown Capital Partners SA's shares include 500,000 shares of common stock
underlying a warrant exercisable within 60 days of the date of this
prospectus. John Graham Douglas is a beneficial owner of Crown Capital
Partners' shares by virtue of his position as sole control person of Crown
Capital Partners SA.
(7) Mr. Forte's shares include 25,000 shares of common stock underlying a
warrant exercisable within 60 days of the date of this prospectus.
(8) Highgate House Funds, Ltd.'s shares include 500,000 shares of common stock
underlying a warrant exercisable within 60 days of the date of this
prospectus. Mark Angelo is a beneficial owner of Highgate House Funds'
shares by virtue of his position as Portfolio Manager of Highgate House
Funds, Ltd.
(9) HomelandSecurityStocks.com's shares include 350,000 shares of common stock
underlying a warrant exercisable within 60 days of the date of this
prospectus. Leon Hamerling and J. Robert Paul are both beneficial owners of
HomelandSecurityStocks' shares by virtue of their collective ownership of
100% of the outstanding shares of Protect-A-Life.
(10) Islandia, L.P.'s shares include 110% of 6,250,000 shares of common stock
underlying a debenture convertible within 60 days of the date of this
prospectus and of 1,265,741 shares of common stock that may be used to pay
interest on the debenture. The general partner of Islandia is John Lang,
Inc., a New York Sub-S corporation formed to manage investments. John Lang,
Inc. has sole dispositive power and sole voting power over all matters not
related to director elections. The individuals that exercise shared
dispositive and voting power for John Lang, Inc. are Richard Berner,
President of John Lang, Inc. and Edgar Berner and Thomas Berner, both
Vice-Presidents of John Lang, Inc. By virtue of these relationships John
Lang, Inc., Richard Berner, Edgar Berner and Thomas Berner may be deemed to
have indirect beneficial ownership of the shares of common stock
beneficially owned by Islandia; however, John Lang, Inc. Richard Berner,
Edgar Berner and Thomas Berner disclaim beneficial ownership of the shares
of common stock beneficially owned by Islandia.
(11) Mr. Kramer's shares include 25,000 shares of common stock underlying a
warrant exercisable within 60 days of the date of this prospectus.
(12) Memphis Group, Inc.'s shares include 250,000 shares of common stock
underlying a warrant exercisable within 60 days of the date of this
prospectus. Jeffrey Shear is a beneficial owner of Memphis Group's shares
by virtue of his position as sole control person of Memphis Group, Inc.
(13) Midsummer Investment Ltd.'s shares include 110% of 11,250,000 shares of
common stock underlying a debenture convertible within 60 days of the date
of this prospectus and of 2,278,334 shares of common stock that may be used
to pay interest on the debenture. Midsummer Capital, LLC, a New York
limited liability company, serves as investment advisor to Midsummer
Investment Ltd., a Bermuda company. By reason of such relationships,
Midsummer Capital may be deemed to share dispositive power over the shares
of common stock beneficially owned by Midsummer Investment. Midsummer
Capital disclaims beneficial ownership of such shares of common stock.
Michel A. Amsalem and Scott D. Kaufman are members of Midsummer Capital. By
reason of such relationships, Mr. Amsalem and Mr. Kaufman may be deemed to
share dispositive power over the shares of common stock stated as
beneficially owned by Midsummer Investment. Mr. Amsalem and Mr. Kaufman
disclaim beneficial ownership of such shares of common stock.
(14) Montgomery & Co., LLC's shares include 485,213 shares of common stock
underlying a warrant exercisable within 60 days of the date of this
prospectus. Montgomery & Associates is a beneficial owner of Montgomery &
Co., LLC's shares by virtue of its position as a controlling entity of
Montgomery & Co., LLC. George Montgomery, Michael Montgomery and Brian Bean
are beneficial owners of Montgomery & Co.'s shares by virtue of their
positions as control persons of Montgomery & Co. Jamie Montgomery is a
beneficial owner of Montgomery & Co.'s shares by virtue of his positions as
both a control person of Montgomery & Co. and sole control person of
Montgomery & Associates.
-11-
(15) Mr. Roenick's shares include 25,000 shares of common stock underlying a
warrant exercisable within 60 days of the date of this prospectus.
(16) Dr. Salkind's shares include 100,000 shares of common stock underlying a
warrant exercisable within 60 days of the date of this prospectus.
PLAN OF DISTRIBUTION
Each selling security holder and any of their pledgees, assignees and
successors-in-interest may, from time to time, sell any or all of their shares
of common stock on through the OTC Bulletin Board or any other stock exchange,
market or trading facility on which the shares are traded or in private
transactions. These sales may be at fixed or negotiated prices. A selling
security holder may use any one or more of the following methods when selling
shares:
o ordinary brokerage transactions and transactions in which the
broker-dealer solicits purchasers;
o block trades in which the broker-dealer will attempt to sell the
shares as agent but may position and resell a portion of the block as
principal to facilitate the transaction;
o purchases by a broker-dealer as principal and resale by the
broker-dealer for its account;
o an exchange distribution in accordance with the rules of the
applicable exchange;
o privately negotiated transactions;
o settlement of short sales entered into after the effective date of the
registration statement of which this prospectus is a part;
o broker-dealers may agree with the selling security holders to sell a
specified number of such shares at a stipulated price per share;
o a combination of any such methods of sale;
o through the writing or settlement of options or other hedging
transactions, whether through an options exchange or otherwise; or
o any other method permitted pursuant to applicable law.
The selling security holders may also sell shares under Rule 144 under the
Securities Act of 1933, as amended, if available, rather than under this
prospectus.
Broker-dealers engaged by the selling security holders may arrange for
other brokers-dealers to participate in sales. Broker-dealers may receive
commissions or discounts from the selling security holders (or, if any
broker-dealer acts as agent for the purchaser of shares, from the purchaser) in
amounts to be negotiated, but, except as set forth in a supplement to this
prospectus, in the case of an agency transaction not in excess of a customary
brokerage commission in compliance with NASDR Rule 2440; and in the case of a
principal transaction a markup or markdown in compliance with NASDR IM-2440.
In connection with the sale of the common stock or interests therein, the
selling security holders may enter into hedging transactions with broker-dealers
or other financial institutions, which may in turn engage in short sales of the
common stock in the course of hedging the positions they assume. The selling
security holders may also sell shares of the common stock short and deliver
these securities to close out their short positions, or loan or pledge the
common stock to broker-dealers that in turn may sell these securities. The
selling security holders may also enter into option or other transactions with
broker-dealers or other financial institutions or the creation of one or more
derivative securities which require the delivery to such broker-dealer or other
financial institution of shares offered by this prospectus, which shares such
broker-dealer or other financial institution may resell pursuant to this
prospectus (as supplemented or amended to reflect such transaction).
-12-
The selling security holders and any broker-dealers or agents that are
involved in selling the shares may be deemed to be "underwriters" within the
meaning of the Securities Act in connection with such sales. In such event, any
commissions received by such broker-dealers or agents and any profit on the
resale of the shares purchased by them may be deemed to be underwriting
commissions or discounts under the Securities Act. Each selling security holder
has informed us that it does not have any written or oral agreement or
understanding, directly or indirectly, with any person to distribute the common
stock. In no event shall any broker-dealer receive fees, commissions and markups
which, in the aggregate, would exceed eight percent (8%).
Electronic Sensor Technology is required to pay certain fees and expenses
incurred by Electronic Sensor Technology incident to the registration of the
shares. Electronic Sensor Technology has agreed to indemnify the selling
security holders against certain losses, claims, damages and liabilities,
including liabilities under the Securities Act.
Because selling security holders may be deemed to be "underwriters" within
the meaning of the Securities Act, they will be subject to the prospectus
delivery requirements of the Securities Act. In addition, any securities covered
by this prospectus which qualify for sale pursuant to Rule 144 under the
Securities Act may be sold under Rule 144 rather than under this prospectus.
Each selling security holder has advised us that they have not entered into any
written or oral agreements, understandings or arrangements with any underwriter
or broker-dealer regarding the sale of the resale shares. There is no
underwriter or coordinating broker acting in connection with the proposed sale
of the resale shares by the selling security holders.
We agreed to keep this prospectus effective until the earlier of (i) the
date on which the shares may be resold by the selling security holders without
registration and without regard to any volume limitations by reason of Rule
144(e) under the Securities Act or any other rule of similar effect or (ii) all
of the shares have been sold pursuant to the prospectus or Rule 144 under the
Securities Act or any other rule of similar effect. The resale shares will be
sold only through registered or licensed brokers or dealers if required under
applicable state securities laws. In addition, in certain states, the resale
shares may not be sold unless they have been registered or qualified for sale in
the applicable state or an exemption from the registration or qualification
requirement is available and is complied with.
Under applicable rules and regulations under the Exchange Act, any person
engaged in the distribution of the resale shares may not simultaneously engage
in market making activities with respect to the common stock for the applicable
restricted period, as defined in Regulation M, prior to the commencement of the
distribution. In addition, the selling security holders will be subject to
applicable provisions of the Exchange Act and the rules and regulations
thereunder, including Regulation M, which may limit the timing of purchases and
sales of shares of the common stock by the selling security holders or any other
person. We will make copies of this prospectus available to the selling security
holders and have informed them of the need to deliver a copy of this prospectus
to each purchaser at or prior to the time of the sale.
We will not receive any part of the proceeds from the resale by the selling
security holders of any common stock under this prospectus. We will bear all
expenses other than selling discounts and commissions and fees and expenses of
the selling security holders in connection with the registration of the shares
being reoffered by the selling security holders.
LEGAL PROCEEDINGS
We are not a party to any pending legal proceeding, other than routine
litigation that is incidental to our business, and are not aware of any
proceeding contemplated by a governmental authority against us.
DIRECTORS, EXECUTIVE OFFICERS AND CONTROL PERSONS
TEONG C. LIM
Teong C. Lim, age 66, currently serves as interim President and Chief
Executive Officer and a director of Electronic Sensor Technology. Dr. Lim has
served as a director of Electronic Sensor Technology since January 31, 2005 and
served as Vice President of Corporate Development from February 1, 2005 through
January 25, 2006. Dr. Lim was the director of corporate development of
Electronic Sensor Technology, L.P. from March 1995 through August 2000 and was
the Manager of Corporate Development of Electronic Sensor Technology, L.P. from
August 2000 through February 2005. Dr. Lim has been the President of Amerasia
Technology, Inc., a subsidiary of Electronic Sensor Technology, since 1984.
Since 1997, Dr. Lim has been a director of Crystal Clear Technology, Sdn. Bhd.,
a privately-owned Malaysian company that manufactures and markets a
high-contrast liquid
-13-
crystal display (LCD) product line. Dr. Lim received a Ph.D. in Electrical
Engineering from McGill University in 1968 and an M.B.A. from Pepperdine
University in 1982. Dr. Lim does not serve as a director of any other publicly
reporting company.
FRANCIS H. CHANG
Francis H. Chang, age 71, currently serves as Secretary, Treasurer and Vice
President of Finance and Administration and a director of Electronic Sensor
Technology. Mr. Chang has served as a director of Electronic Sensor Technology
since January 31, 2005 and has served as Secretary and Vice President of Finance
and Administration since February 1, 2005. Mr. Chang was the Vice President of
Finance and Operations of Electronic Sensor Technology, L.P. from March 1995
through February 2005. Mr. Chang received a B.A. in Economics from National
Taiwan University in Taiwan in 1956 and an M.B.A. from Pepperdine University in
1978. Mr. Chang does not serve as a director of any other publicly reporting
company.
JAMES H. FREY
James H. Frey, age 68, currently serves as Chairman of the Board of
Directors of Electronic Sensor Technology. Mr. Frey has served as Chairman since
February 21, 2005. From June 1999 to March 2003, Mr. Frey served as Chief
Executive Officer of TASC Inc., a subsidiary of Litton/Northrup Grumman. He also
served as the Vice President of Information Technology at Litton from March 2001
to March 2002. Mr. Frey is currently a director of SSG Precision Optronics, a
privately-held optical component manufacturing company. Mr. Frey received a B.S.
in Electrical Engineering from Duke University in 1960. Mr. Frey does not serve
as a director of any other publicly reporting company.
MIKE KRISHNAN
Mike Krishnan, age 66, currently serves as a director of Electronic Sensor
Technology. Mr. Krishnan has served as a director of Electronic Sensor
Technology since February 21, 2005. Mr. Krishnan serves on our audit committee
and compensation committee. Mr. Krishnan has been President of L&G Resources
(1994) Inc. since August 2003. He has served as Managing Director of Land &
General Berhad since September 2001. Land & General Berhad is an investment
holding company with subsidiaries engaging in property development, property
management and education services in Malaysia and Australia. Mr. Krishnan also
served as the executive director of Antah Holdings Berhad from April 1990 to
October 2000. Mr. Krishnan received an A.M.P from Harvard Business School in
1987. Mr. Krishnan does not serve as a director of any other publicly reporting
company in the United States. Mr. Krishnan is a director of Land & General
Berhad, which is listed on the Kuala Lumpur Stock Exchange.
EDWARD J. STAPLES
Edward J. Staples, age 62, currently serves as Chief Scientific Officer and
a director of Electronic Sensor Technology. Dr. Staples has served as a director
of Electronic Sensor Technology since January 31, 2005 and has served as Chief
Scientific Officer of Electronic Sensor Technology since May 26, 2005. From
February 1, 2005 through May 26, 2005, Dr. Staples served as President and Chief
Executive Officer of Electronic Sensor Technology. Dr. Staples was a co-founder
of Electronic Sensor Technology, L.P. and was its managing director from
February 1995 through February 2005. Dr. Staples received a B.S. in Electrical
Engineering from Loyola University in 1966, an M.S. in Electrical Engineering in
1969 and a Ph.D. in Solid State Electronics in 1971 from Southern Methodist
University. Dr. Staples does not serve as a director of any other publicly
reporting company.
JAMES WILBURN
James Wilburn, age 73, currently serves as a director of Electronic Sensor
Technology. Dr. Wilburn has served as a director of Electronic Sensor Technology
since September 8, 2005. Dr. Wilburn serves on our audit committee and
compensation committee. Dr. Wilburn has served as dean of Pepperdine
University's School of Public Policy since September 1996. Dr. Wilburn has also
served Pepperdine as Vice President of University Affairs, and as provost and
Chief Operating Officer. He is also a member of the European Parliament
Industrial Council. Dr. Wilburn has served as a director of several companies in
the United States and Europe, including Signet Scientific, George Fisher
(Switzerland), The Olsen Company, Flowline, Brentwood Square Savings Bank and
First Fidelity Thrift and Loan. Dr. Wilburn received his Ph.D. in economic
history from the University of California at Los Angeles, a masters degree from
Midwestern State University and an MBA from Pepperdine's Presidential/Key
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Executive program. He received his bachelors degree from Abilene Christian
University. Dr. Wilburn currently serves as a director of Virco Manufacturing,
which is a publicly reporting company.
GARY WATSON
Gary Watson, age 56, currently serves as Vice President of Engineering of
Electronic Sensor Technology. Mr. Watson has served as Vice President of
Engineering since September 8, 2005. Mr. Watson is the co-inventor of the
zNose(R). Mr. Watson has over twenty years experience in gas chromatography. Mr.
Watson joined Amerasia Technology in 1988 and directed Amerasia Technology's
research in adapting gas chromatographic techniques with surface acoustic wave
(SAW) detectors. He received his B.S. degree from the University of Southern
California in 1972.
MICHEL A. AMSALEM
Michel A. Amsalem, age 59, currently serves as a director of Electronic
Sensor Technology. Mr. Amsalem has served as a director of Electronic Sensor
Technology since September 7, 2006. Mr. Amsalem is the founder and, since July
2001, President of Midsummer Capital, the investment manager of the Midsummer
Group of Funds, as well as a director of Midsummer Investment Ltd. Prior to his
involvement with hedge funds and the creation of Midsummer Capital, Mr. Amsalem,
from May 1999 through June 2001, was a Principal and Managing Partner of Omicron
Capital, an investment advisor to a group of funds with a strategy similar to
that of Midsummer. Mr. Amsalem was also founder and head of the Structured
Finance Department of Citibank, and of similar activities for Banque Indosuez'
Investment Bank for Latin America and Eastern Europe and Patricof & Co. Mr.
Amsalem holds a Doctoral degree in Business Administration from Harvard
University, an MBA from Columbia University and is a graduate of Ecole des
Hautes Etudes Commerciales in France. He is a professor of Business and
Investment Strategy at Columbia University Graduate School of Business. Mr.
Amsalem currently serves as a director of Hartville Group, Inc., which is a
publicly reporting company.
LEWIS E. LARSON
Lewis E. Larson, age 60, currently serves as a director of Electronic
Sensor Technology. Mr. Larson has served as a director of Electronic Sensor
Technology since September 7, 2006. Mr. Larson is the founder and President of
The Lion Group which has provided consulting and system engineering services to
the Federal Government and supporting industries since 1994. He has 15 years of
Federal service with the National Security Agency (NSA) and the Central
Intelligence Agency (CIA). Mr. Larson holds professional certifications from NSA
and the Department of Defense in Collection Management; Traffic Analysis and
Special Research; Education and Training; and Arabic language. After leaving the
Federal Government as a senior executive in 1984, Mr. Larson co-founded
Analytical Decisions Inc. which was acquired by the Ball Corporation. Mr. Larson
received his BSEE from the University of Minnesota and has conducted post-
graduate studies at the University of Maryland; New Mexico; California;
Georgetown; Naval Post Graduate School; and John Hopkins. He also completed the
Senior Executive Education business program at Stanford University and also the
John F. Kennedy School of Government at Harvard University. Mr. Larson currently
serves as a director of Digital Media Broadcasting Corporation, Global Wireless
Networks, Fortress Technologies and Universal Scientific Technologies Ltd in
England.
FAMILY RELATIONSHIPS AND INVOLVEMENT IN CERTAIN LEGAL PROCEEDINGS
Each of our directors holds office until the next annual meeting of our
shareholders, or until his prior death, resignation or removal. There are no
family relationships among our directors or executive officers. Within the past
five years, there has not been any bankruptcy petition filed by or against any
business of which any of our officers, directors or control persons were a
general partner or executive officer either at the time of the bankruptcy or
within two years prior to that time. None of our officers, directors or control
persons has been convicted in a criminal proceeding in the past five years or is
subject to a pending criminal proceeding (excluding traffic violations and other
minor offenses). None of our officers, directors or control persons is subject
to any order, judgment, or decree, not subsequently reversed, suspended or
vacated, of any court of competent jurisdiction, permanently or temporarily
enjoining, barring, suspending or otherwise limiting his involvement in any type
of business, securities or banking activities. None of our officers, directors
or control persons has been found by a court of competent jurisdiction (in a
civil action), the Securities and Exchange Commission or the Commodity Futures
Trading Commission to have violated a federal or state securities or commodities
law, where the judgment has not been reversed, suspended, or vacated.
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AUDIT COMMITTEE FINANCIAL EXPERT
While we believe that certain members of our Board of Directors have some
of the attributes of an audit committee financial expert, no single individual
possesses all of the attributes; therefore, no one on our Board of Directors can
be deemed to be an audit committee financial expert. In forming our Board of
Directors, we sought out individuals who would be able to guide our operations
based on their business experience, both past and present, or their education.
Our business model is not complex and our accounting issues are straightforward.
Responsibility for our operations is centralized within our executive
management, which is comprised of four persons. We recognize that having a
person who possesses all of the attributes of an audit committee financial
expert would be a valuable addition to our Board of Directors, however, we are
not, at this time, able to compensate such a person therefore, we may find it
difficult to attract such a candidate.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth information, as of September 7, 2006,
concerning our issued and outstanding stock beneficially owned (i) by each
director and each named executive officer of Electronic Sensor Technology, (ii)
by all directors and executive officers of Electronic Sensor Technology as a
group and (iii) by each shareholder known by Electronic Sensor Technology to be
the beneficial owner of more than 5% of the outstanding common stock.
AMOUNT AND NATURE OF
NAME AND ADDRESS (1) BENEFICIAL OWNERSHIP PERCENTAGE OF
TITLE OF CLASS OF BENEFICIAL OWNER (SHARES OF STOCK) CLASS (2)
------------------ ----------------------------------- --------------------- ---------------
Common stock Francis Chang*+++ 3,933,160(3) 7.22%
Common stock Teong Lim*+++ 5,247,908(4) 9.60%
Common stock James Frey* 125,000(5) 0.23%
Common stock Mike Krishnan*++ 9,948,801(6) 18.26%
Common stock Edward Staples*+++ 4,212,544(7) 7.71%
Common stock James Wilburn* 0 0.00%
Common stock Michel Amsalem* 0(8) 0.00%
Common stock Lewis Larson* 0 0.00%
Common stock Gary Watson+ 175,000(9) 0.32%
Common stock Land & General Berhad++ 9,948,801(10) 18.26%
Common stock L&G Resources (1994), Inc.++ 9,948,801(11) 18.26%
Common stock 3 Springs, LLC++ 3,595,913 6.64%
Common stock TC Lim, LLC++ 4,729,112 8.73%
Common stock Midsummer Investment Ltd.++ 19,048,059(12) 26.01%
Common stock Islandia L.P.++ 10,582,255(13) 16.34%
All directors and named executive
Common stock officers as a group 23,579,913(14) 43.34%
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(*) Director
(+) Named executive officer
(++)5% or more beneficial owner
(1) The address of each director, named executive officer, Land & General
Berhad, L&G Resources (1994), Inc., 3 Springs, LLC and TC Lim, LLC is c/o
Electronic Sensor Technology, Inc., 1077 Business Center Circle, Newbury Park,
California 91320. The address of Midsummer Investment Ltd. and Islandia L.P. is
485 Madison Avenue, 23rd Floor, New York, New York 10022.
(2) These percentages are calculated based upon the total amount of outstanding
shares of common stock beneficially owned by each person or group, including
shares of common stock that person or group has the right to acquire within 60
days pursuant to options, warrants, conversion privileges or other rights,
divided by 54,173,745, which represents the total number of shares of common
stock issued and outstanding as of September 7, 2006, plus, for each person or
group, any shares of common stock that person or group has the right to acquire
within 60 days pursuant to options, warrants, conversion privileges or other
rights.
(3) Includes 80,000 shares of common stock underlying options exercisable
within 60 days of the date of this prospectus and 257,247 shares of common stock
underlying a warrant exercisable within 60 days of the date of this prospectus
and 3,595,913 shares of common stock held by 3 Springs, LLC and beneficially
owned by Mr. Chang by virtue of his position as sole member of 3 Springs.
(4) Includes 80,000 shares of common stock underlying options exercisable
within 60 days of the date of this prospectus and 438,796 shares of common stock
underlying a warrant exercisable within 60 days of the date of this prospectus
and 4,729,112 shares of common stock held by TC Lim, LLC and beneficially owned
by Dr. Lim by virtue of his position as sole member of TC Lim.
(5) Includes 125,000 shares of common stock underlying options exercisable
within 60 days of the date of this prospectus.
(6) Includes 9,632,534 shares of common stock and 316,267 shares of common
stock underlying a warrant exercisable within 60 days of the date of this
prospectus held by L&G Resources (1994), Inc., of which Mr. Krishnan is a
beneficial owner by virtue of being President of L&G Resources (1994), Inc. and
Managing Director of Land & General Berhad, the parent company of L&G Resources
(1994), Inc.
(7) Includes 100,000 shares of common stock underlying options exercisable
within 60 days of the date of this prospectus and 343,708 shares of common stock
underlying a warrant exercisable within 60 days of the date of this prospectus.
(8) Mr. Amsalem is a member of Midsummer Capital, LLC, a New York limited
liability company, which serves as investment advisor to Midsummer Investment
Ltd., a Bermuda company. By virtue of his position, Mr. Amsalem may be deemed to
share dispositive power over the 19,048,059 shares of common stock beneficially
owned by Midsummer Investment Ltd. Midsummer Capital disclaims beneficial
ownership of such shares of common stock and Mr. Amsalem disclaims beneficial
ownership of such shares of common stock.
(9) Includes 175,000 shares of common stock underlying options exercisable
within 60 days of the date of this prospectus.
(10) Includes 9,632,534 shares of common stock and 316,267 shares of common
stock underlying a warrant exercisable within 60 days of the date of this
prospectus held by its wholly-owned subsidiary, L&G Resources (1994), Inc., of
which Land & General Berhad is a beneficial owner.
(11) Includes 316,267 shares of common stock underlying a warrant exercisable
within 60 days of the date of this prospectus.
(12) Includes 11,250,000 shares of common stock underlying a debenture
convertible within 60 days of the date of this prospectus and 7,798,059 shares
of common stock underlying a warrant exercisable within 60 days of the date of
this prospectus. The conversion of the debenture and exercise of the warrant is
contractually capped such that such conversion or exercise, as applicable, shall
not cause Midsummer's beneficial ownership to exceed 4.99%, unless waived by
Midsummer, and in no event to exceed 9.99% (without giving effect to shares of
common stock underlying any unconverted portion of the debenture or
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unexercised portion of the warrant). Midsummer Capital, LLC, a New York limited
liability company, serves as investment advisor to Midsummer Investment Ltd., a
Bermuda company. By reason of such relationships, Midsummer Capital may be
deemed to share dispositive power over the shares of common stock beneficially
owned by Midsummer Investment. Midsummer Capital disclaims beneficial ownership
of such shares of common stock. Michel A. Amsalem and Scott D. Kaufman are
members of Midsummer Capital. By reason of such relationships, Mr. Amsalem and
Mr. Kaufman may be deemed to share dispositive power over the shares of common
stock stated as beneficially owned by Midsummer Investment. Mr. Amsalem and Mr.
Kaufman disclaim beneficial ownership of such shares of common stock.
(13) Includes 6,250,000 shares of common stock underlying a debenture
convertible within 60 days of the date of this prospectus and 4,332,255 shares
of common stock underlying a warrant exercisable within 60 days of the date of
this prospectus. The conversion of the debenture and exercise of the warrant is
contractually capped such that such conversion or exercise, as applicable, shall
not cause Islandia's beneficial ownership to exceed 4.99%, unless waived by
Islandia, and in no event to exceed 9.99% (without giving effect to shares of
common stock underlying any unconverted portion of the debenture or unexercised
portion of the warrant). The general partner of Islandia is John Lang, Inc., a
New York Sub-S corporation formed to manage investments. John Lang, Inc. has
sole dispositive power and sole voting power over all matters not related to
director elections. The individuals that exercise shared dispositive and voting
power for John Lang, Inc. are Richard Berner, President of John Lang, Inc. and
Edgar Berner and Thomas Berner, both Vice-Presidents of John Lang, Inc. By
virtue of these relationships John Lang, Inc., Richard Berner, Edgar Berner and
Thomas Berner may be deemed to have indirect beneficial ownership of the shares
of common stock beneficially owned by Islandia; however, John Lang, Inc. Richard
Berner, Edgar Berner and Thomas Berner disclaim beneficial ownership of the
shares of common stock beneficially owned by Islandia.
(14) Includes 497,500 shares of common stock underlying options exercisable
within 60 days of the date of this prospectus and 1,356,018 shares of common
stock underlying warrants exercisable within 60 days of the date of this
prospectus, as well as 9,632,534 shares of common stock held by L&G Resources
(1994), Inc., 3,595,913 shares of common stock held by 3 Springs, LLC and
4,729,112 shares of common stock held by TC Lim, LLC.
DESCRIPTION OF SECURITIES
As of September 7, 2006, Electronic Sensor Technology has 54,173,745 shares
of common stock issued and outstanding and no shares of preferred stock issued
and outstanding. Electronic Sensor Technology is authorized to issue 200,000,000
shares of common stock in the aggregate and 50,000,000 shares of preferred stock
in the aggregate. Each of our shareholders is entitled to one vote for each
share of common stock on all matters submitted to a shareholder vote. Holders of
our common stock do not have cumulative voting rights. Directors must be elected
by a plurality of the votes cast in an election of directors. Those candidates
for directors receiving the highest number of votes, up to the number of
directors to be elected are elected directors. A quorum is required for any
annual or special meeting of our shareholders in order to transact any business
at the meeting. The presence of the holders of a majority of the issued and
outstanding shares of each class of stock entitled to vote at a meeting
constitutes a quorum.
Dividends on our common stock may be declared and paid at such times as the
Board of Directors may determine. Holders of common stock are entitled to share
in all dividends that the Board of Directors, in its discretion, declares from
legally available funds. However, we have never paid cash dividends on our
common stock and do not anticipate paying cash dividends on our common stock in
the foreseeable future.
In the event of a liquidation, dissolution or winding up, each outstanding
share of common stock entitles its holder to participate pro rata in all assets
that remain after payment of liabilities and after providing for each class of
stock, if any, having preference over the common stock. Holders of our common
stock have no pre-emptive rights, no conversion rights and there are no
redemption provisions applicable to our common stock.
Certain provisions of our articles of incorporation, bylaws and Nevada law,
as well as certain agreements we have with our executives, could be used by our
incumbent management to make it substantially more difficult for a third party
to acquire control of us. These provisions include the following:
o we may issue preferred stock with rights senior to those of our common
stock; and
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o the Board may fill casual vacancies occurring in the Board and may
appoint one or more additional directors between annual meetings of
shareholders to hold office until the next annual meeting of
shareholders.
These provisions may discourage certain types of transactions involving an
actual or potential change in control. These provisions may also limit our
shareholders' ability to approve transactions that they may deem to be in their
best interests and discourage transactions in which our shareholders might
otherwise receive a premium for their shares over the then current market price.
INTEREST OF NAMED EXPERTS AND COUNSEL
No expert preparing or certifying all or part of this registration
statement or a report or valuation for use in connection with the registration
statement or counsel named in this prospectus as having given an opinion on the
validity of the securities being registered or upon other legal matters
concerning the registration or offering of the securities was hired on a
contingent basis, will receive a direct or indirect interest in Electronic
Sensor Technology, or was a promoter, underwriter, voting trustee, director,
officer, or employee of Electronic Sensor Technology.
DISCLOSURE OF COMMISSION POSITION ON INDEMNIFICATION
FOR SECURITIES ACT LIABILITIES
Under our bylaws, directors and officers are generally indemnified to the
fullest extent permitted by law. Nevada Revised Statute 78.7502 provides that
Electronic Sensor Technology may indemnify directors, officers, employees and
agents of Electronic Sensor Technology for expenses reasonably incurred in
connection with and to the extent that such director, officer, employee or agent
of Electronic Sensor Technology has been successful on the merits or otherwise
in defense of any action, suit or proceeding or any claim, issue or matter
wherein such person "acted in good faith and in a manner which he reasonably
believed to be in or not opposed to the best interests of the corporation, and,
with respect to any criminal action or proceeding, had no reasonable cause to
believe his conduct was unlawful," subject to certain limitations.
Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers and controlling persons of Electronic
Sensor Technology pursuant to the foregoing provisions, or otherwise, Electronic
Sensor Technology has been advised that in the opinion of the Securities and
Exchange Commission such indemnification is against public policy as expressed
in the Securities Act and is, therefore, unenforceable.
DESCRIPTION OF BUSINESS
We are engaged in the development, manufacture, and sale of a patented
product we call zNose(R), a device designed to detect and analyze chemical odors
and vapors, or, in another words, an electronic "nose". We believe the zNose(R)
is superior to other electronic "noses" because of its speed, specificity and
sensitivity. The zNose(R) identifies the chemical makeup of any fragrance, vapor
or odor. The zNose(R) does this by creating a visual image of the fragrance,
vapor or odor that it detects, so that the user of the zNose(R) may easily
identify the fragrance, vapor or odor.
We believe that our products will have broad applications in the homeland
security, environmental monitoring and detection and laboratory instrument
markets. We are involved in ongoing product research and development efforts in
that regard. We have also concentrated our efforts on further product
development, testing and proving, and assembling our sales and support
organization.
Our executive offices are located at 1077 Business Center Circle, Newbury
Park, California 91320 and our telephone number is (805) 480-1994.
HISTORY AND BACKGROUND
We were incorporated under the laws of the state of Nevada as Bluestone
Ventures Inc. on July 12, 2000. From the date of our incorporation until
February 1, 2005, we were in the business of acquiring and exploring potential
mineral properties in Ontario, Canada. We changed our name to Electronic Sensor
Technology, Inc. on January 26, 2005 in connection with the acquisition of two
corporations that had together owned Electronic Sensor Technology, L.P. Since
the acquisition of Electronic
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Sensor Technology, L.P., our business has been the development, manufacture and
sale of instruments that detect and analyze vapors and odors. We have abandoned
our mining exploration business.
ELECTRONIC SENSOR TECHNOLOGY, L.P. ACQUISITION
On February 1, 2005, pursuant to the terms of an Agreement and Plan of
Merger by and among Electronic Sensor Technology, Amerasia Technology, holder of
approximately 55% of the partnership interests of Electronic Sensor Technology,
L.P., L&G Sensor Technology, holder of approximately 45% of the partnership
interests of Electronic Sensor Technology, L.P., Amerasia Acquisition, a
wholly-owned subsidiary of Electronic Sensor Technology, and L&G Acquisition, a
wholly-owned subsidiary of Electronic Sensor Technology, Electronic Sensor
Technology acquired 100% of the outstanding equity partnership interest of
Electronic Sensor Technology, L.P. Under the Agreement and Plan of Merger:
(i) Amerasia Technology merged with and into Amerasia Acquisition such
that it became a wholly-owned subsidiary of Electronic Sensor
Technology;
(ii) L&G Sensor Technology merged with and into L&G Acquisition such that
L&G Sensor Technology became a wholly-owned subsidiary of Electronic
Sensor Technology;
(iii) as a result of the mergers of (i) and (ii), Electronic Sensor
Technology indirectly acquired the partnership interests of
Electronic Sensor Technology, L.P.; and
(iv) Electronic Sensor Technology issued 20,000,000 shares of its common
stock to the shareholders of Amerasia Technology and L&G Sensor
Technology.
In November 2004, Electronic Sensor Technology, L.P. sold $200,000 in
limited partnership interests to certain bridge investors. Concurrent with the
mergers, these limited partnership interests were directly exchanged into
200,000 shares of common stock of Electronic Sensor Technology and warrants to
purchase 200,000 shares of common stock of Electronic Sensor Technology at $1.00
per share to certain investors.
In connection with the mergers, Electronic Sensor Technology entered into
Subscription Agreements with certain investors on January 31, 2005. Under these
Subscription Agreements, Electronic Sensor Technology issued and sold in a
private placement 3,985,000 shares of its common stock and warrants to purchase
3,985,000 shares of common stock at $1.00 per share to certain investors for
gross proceeds of $3,985,000. Electronic Sensor Technology received the gross
proceeds of the sale of these shares on February 1, 2005. Electronic Sensor
Technology received net proceeds of approximately $3,821,000 less fees,
including counsel fees for the investors and Electronic Sensor Technology, L.P.
of approximately $164,000.
Immediately following the mergers and the private placement, on February 1,
2005 there were 53,968,471 shares of Electronic Sensor Technology common stock
outstanding, of which (i) shareholders of Bluestone prior to the mergers and the
private placement held 26,988,279 shares (approximately 50.0% of our common
stock), (ii) the shareholders of Amerasia Technology and L&G Sensor Technology
prior to the mergers and the private placement held 22,783,471 shares
(approximately 42.2% of our common stock) and (iii) investors in the private
placement occurring on February 1, 2005 as a group held 4,185,000 shares
(approximately 7.8% of our common stock). The total outstanding interests of
Electronic Sensor Technology, L.P. were exchanged for 20,000,000 shares of
Electronic Sensor Technology, Inc. In addition, 2,783,279 shares of Electronic
Sensor Technology, Inc. were distributed to pre-merger shareholders of Amerasia
Technology and L&G Sensor Technology in exchange for the cancellation of debt
owed to such shareholders, at a conversion rate of $1.00 per share. The
conversion rate of $1.00 per share was established immediately preceding the
merger through the private placement of 3,985,000 shares of common stock at
$1.00 per share and the conversion of a $200,000 equity advance to Electronic
Sensor Technology, L.P. for 200,000 shares of Electronic Sensor Technology
stock. The transaction price of $1.00 per share was established by arms length
negotiation between the former management of Bluestone Ventures and Electronic
Sensor Technology, L.P. (now management of Electronic Sensor Technology, Inc.)
in December 2004. As a condition to the merger transactions, Bluestone Ventures
agreed to raise not less than $3,000,000 of new equity capital in a private
placement offering. In determining to proceed with the merger transactions,
management of Electronic Sensor Technology, L.P. (now management of Electronic
Sensor Technology, Inc.) weighed the expected cash balance of Bluestone Ventures
after giving effect to the private placement offering discussed above and the
mergers against the overall equity ownership of Electronic Sensor Technology,
Inc. post-merger that would be held by the former owners of Electronic Sensor
Technology, L.P. (i.e., the former owners of Electronic Sensor Technology, L.P.
were willing to give up
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57.8% of Electronic Sensor Technology, L.P. for not less than $3,000,000 in
cash). While management of Electronic Sensor Technology, L.P. (now management of
Electronic Sensor Technology, Inc.) was not privy to the valuation methodology
used by management of Bluestone Ventures in establishing a transaction price of
$1.00 per share, management of Electronic Sensor Technology, L.P. (now
management of Electronic Sensor Technology, Inc.) assumes that management of
Bluestone Ventures and its advisors used one or more traditional valuation
methodologies.
In conjunction with the mergers, all of the officers and directors of
Bluestone resigned and Dr. Edward Staples was appointed President of Bluestone.
Dr. Staples, along with Mr. Francis Chang and Dr. Teong Lim were named directors
of Bluestone and the prior operations of Bluestone were terminated.
Following the mergers we assumed as our principal operations, the
operations of Electronic Sensor Technology, L.P. and we appointed additional
officers. In May 2005, we expanded our Board of Directors from 5 to 7 directors
and appointed additional directors to fill the new directorships.
OVERVIEW OF PAST OPERATIONS OF ELECTRONIC SENSOR TECHNOLOGY, L.P.
Following the mergers, our operations are a continuation of operations
originally conducted by Electronic Sensor Technology, L.P. Electronic Sensor
Technology, L.P. was formed in 1995 to develop and manufacture, the zNose(R), an
advanced technology in chemical vapor detection and analysis. The zNose(R) has
been developed with over $10 million in funding, primarily from equity funding
from existing equity holders. In 1999, Electronic Sensor Technology, L.P.
completed beta testing of its products and commenced commercial sales to the
analytical instrumentation/quality control market as well as the homeland
security market.
In order to finance its operations, Electronic Sensor Technology, L.P.
obtained a 4% loan of $1.975 million from East West Bank in September 2003. This
loan was guaranteed by three officers of Electronic Sensor Technology, L.P. In
connection with the mergers, we assumed the then outstanding balance of $1.8
million on the East West Bank loan from Electronic Sensor Technology, L.P., and
the guarantees were released. In addition, we agreed to pledge a $900,000
certificate of deposit as collateral for repayment under the loan.
INDUSTRY OVERVIEW
Although there are a vast number of applications for the zNose(R) product,
we believe that the most significant demands for our product will be in three
general market categories - homeland security, analytical
instrumentation/quality control and environmental monitoring and detection.
Homeland Security. According to published sources, the overall homeland
security market was projected to be $98-114 billion in 2004. We believe that
detection and analysis of chemical compounds will aid greatly in various
homeland security efforts including:
o Cargo Containers. Over seven million sea cargo containers arrive in
the U.S. every year and only 4% of them are being inspected by the
U.S. Customs Department. Cargo container security is a top priority
with the U.S. government.
o Airports. Our zNose(R) products may be used to complement existing
X-Ray and bomb detection technologies.
o Drug Interdiction. The zNose(R)has been used to detect contrabands,
including illicit controlled substances along U.S. borders.
o Building Security. zNose(R) technology can be applied for continuous
and real-time chemical detection and to monitor the air in buildings
and in confined spaces. Detecting hazardous gases and poisonous
chemical agents such as sarin, VX explosives, and contrabands for
security and environmental safety purposes are the main concerns for
various government and commercial buildings, as well as military
facilities.
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Analytical Instrumentation/Quality Control. The zNose(R) has been serving
the chemical vapor analysis needs in various manufacturing industries. We
estimate that the market for products such as zNose(R) may reach as much as $50
million during the next few years. The zNose(R) has been used for a host of
applications relating to analysis and quality control such as:
o screening incoming raw materials;
o checking ingredients in processed food and pharmaceutical products;
o inspecting packaging materials and finished goods; and
o detecting hazardous gas leaks in chemical plants.
Environmental Monitoring and Detection. The zNose(R) has been serving rapid
on-location needs in detection and monitoring of toxic chemicals in the water
for environmental protection purposes. In a recent toxic chemical spill caused
by a chemical plant explosion in northeastern China which contaminated major
water sources, the zNose(R) was deployed by local authorities to detect and
monitor toxic flows in a river and to determine the safety of the water on a
near real-time basis.
CONVENTIONAL ELECTRONIC NOSE TECHNOLOGY
Conventional electronic noses are unable to meet the needs of the market
because of their fundamental construction. They are not able to identify
fragrances, vapors and odors with an acceptable degree of specificity and
preciseness. In addition, conventional electronic noses require sophisticated
computer software in order for its chemical analyses to be recognized. This type
of electronic nose is therefore not acceptable for use in scientific
measurement.
THE ZNOSE(R) SOLUTION
Speed, precision and versatility are the key characteristics of the
zNose(R) product. The zNose(R) has been developed to replace the conventional
electronic nose. The zNose(R) operates as quickly as a conventional electronic
nose while delivering the precision and accuracy of a much more expensive
instrument. The zNose(R) has advanced chemical analysis technology by performing
vapor analysis within 10 seconds. Early models of the zNose(R) have been tested
by the U.S. Environmental Protection Agency under Environmental Technology
Verification program and by the Office of National Drug Control Policy for drug
interdiction. Tests have also been performed at the Midwest Research Institute's
Surety Laboratory in Kansas City and at the U.S. Army Dugway Proving Ground in
Utah with respect to the effectiveness of the zNose(R) in detecting chemical
agents such as sarin gases. We believe that the zNose(R) is currently the only
electronic nose approved for purchase through the General Services
Administration pre-approved procurement program.
Our VaporPrint(TM) imaging ability is another major advantage of the
zNose(R) product. VaporPrint(TM) allows the user of the zNose(R) to see a visual
image of the makeup of a particular fragrance, vapor or odor within 10 seconds.
In addition, VaporPrint(TM) can produce high-resolution visual images of odor
intensity. VaporPrint(TM) images are displayed on a laptop computer screen and
are recorded on the hard drive of the laptop computer.
OUR PRODUCTS
ZNOSE(R)
The zNose(R) is essentially a vapor detector that uses a sensor based on
Surface Acoustic Wave technology. Basically, the zNose(R) "inhales" a particular
fragrance, vapor or odor. The fragrance, vapor or odor is carried up through a
column and the chemicals making up the fragrance, vapor or odor condense on the
crystal surface of the sensor in the zNose(R). This condensation on the sensor
causes a change in what is called the "fundamental acoustic frequency" of the
crystal surface. It is this change in fundamental acoustic frequency that allows
the zNose(R) to determine the chemical makeup of the fragrance, vapor or odor.
This change is measured by a microprocessor that calculates the change in
frequency which is related to the amount of fragrance, vapor or odor sampled by
the zNose(R). The microprocessor also measures the arrival time (called the
retention time) of the change in the fundamental frequency. Different chemicals
arrive at different times and so, once the microprocessor has determined the
retention time of the unidentified fragrance, vapor or odor, it compares it to
retention times that are stored in a computer library. This allows the zNose(R)
to identify the particular fragrance, vapor or odor.
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The zNose(R) analyzes and identifies vapor specimens in a two-step process.
In the first step, typically lasting 10 seconds, the instrument collects a small
sample of the vapor to be analyzed. The sample is then injected in to the gas
chromatography column where the individual chemicals present are separated and
measured. The chemical analysis requires as little as 10 seconds to produce the
vapor's chemical signature, or chromatogram. The vapor's chemical signature can
also be visually displayed in a graphic form called a "VaporPrint". This
chemical signature is then compared against the reference database of chemical
odor profiles. If the chemical compound of the specimen is not in the reference
database, it will not be identified by name; however, the makeup of the
unidentified specimen can be stored in the reference database for future
identification. The reference database of chemical odor profiles that is stored
on the hard drive of the laptop computer is composed of standards of various
chemicals that are available through the National Institute of Standards and
Technology (NIST). The database can be updated when standards of new chemicals
are encountered and input by way of simple software selection, or by way of
sampling unknown chemical compounds and storing the measurements of such
chemical compounds in the database. If the zNose(R) samples a non-specimen
vapor, such as clear ambient air, no signal is generated on the laptop computer
screen and no VaporPrint(TM) is created. If the zNose(R) samples a complex
mixture of chemical compounds, each compound and the concentration of such
compound is measured independently of the other compounds contained in the
mixture. Due to the independent measurement of each compound in a complex
mixture, each measurement is free from the influence of the other compounds, and
the accuracy of the zNose(R) is therefore not affected by complex mixtures.
We currently manufacture and sell two zNose(R) models designated as Model
4200 (Handheld Unit) and Model 7100 (Bench Top Unit). Model 4200 is designed for
portability and for applications requiring quick and accurate vapor screening in
the field. Model 7100 is designed for laboratory testing and is ideal for
testing water and product quality control samples. Both Model 4200 and Model
7100 weigh approximately 27 pounds, not including a laptop computer that must be
used with each zNose(R). The Model 4200 has two housings (the case and the
detector head) and a laptop computer. The case of the Model 4200 is 10" x 12" x
6" and weighs 20 pounds and the detector head of the Model 4200 is 4 1/4" x 12"
x 7" and weighs 7 pounds. The Model 7100 is packaged in a single housing and
also requires a laptop computer. The dimensions of the Model 7100 packaging are
14.3" x 14.3" x 7.5". Both the Model 4200 and Model 7100 are powered by a
standard AC electrical outlet, and both models adapt to standard outlets in
North America, Asia and Europe (i.e., the zNose(R) may be operated by a 110 volt
or 220 volt power source). In addition, both the Model 4200 and 7100 may be
powered by connecting the unit to a car battery with an appropriate adaptor.
Either model can be produced in one of two basic vapor sensing configurations:
volatile and semi-volatile. The volatile configuration can detect volatile
organic compounds, such as benzene. The semi-volatile configuration can detect
heavier vapors such as those found in explosives and drugs.
We are also developing Models 7100B and 7100C. Model 7100B is designed as a
fixed installation unit for both indoor and outdoor ambient air monitoring
instrument. It can be used for building security as well as outdoor
environmental monitoring applications. It is designed to be operated remotely
from a central control station via a radio frequency (RF) control link. Model
7100C is designed to be used for shipping containers and truck monitoring for
both commercial and homeland security applications. It is designed to be used
with a remote sampling kit which enables multiple samples to be collected then
taken to the zNose(R) to be analyzed.
We have designs to produce a hand-held zNose(R) that is smaller than the
Model 4200 for commercial market. This model is designed to meet the needs of
law enforcement, manufacturing process monitoring, and environmental monitoring.
We plan to develop a separate version of the mini-zNose(R) to be used as a
personal nerve agents detector for the military and security markets.
ACCESSORIES
We offer several lines of accessory products such as calibration devices,
sample desorbers, MicroSense Software(C), and GPS receivers. An example is our
Model 3100 which provides a calibrated vapor source as well as a tool for
extracting vapors from solid and liquid samples.
TECHNICAL SUPPORT
All zNose(R) instruments sold are equipped with a software package called
PCAnywhere. PCAnywhere allows a technical support person at EST to operate an
instrument anywhere in the world through the internet. This better enables an
EST technician to be available to address any customer problem.
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SALES AND DISTRIBUTION
We sell our zNose(R) product through distribution channels including
equipment distributors and sales representatives in over 20 foreign countries,
e-commerce and customer referrals. We entered into an agreement with
TechMondial, Ltd. to be our exclusive distributor for a seven-year period in the
countries of the European Community, Romania, Bulgaria, Turkey, Croatia and
Switzerland on October 21, 2005. We entered into an agreement with eScreen
Sensor Solutions to be our exclusive distributor for a five-year period in
Israel, the Caribbean, the State of Florida, and Central and South America on
October 16, 2003. As part of this latter agreement, eScreen paid us an up-front
fee of $250,000 in 2004.
All sales representatives and distributors are required to attend a
three-day training course conducted at our headquarters in Newbury Park,
California. We advertise in selected industry trade journals and trade
conventions. In the future, we intend to build a dedicated marketing and sales
team. We have historically generated sales from both U.S. and international
customers, each of which have accounted for approximately 50% of our sales in
the past. However, in the fiscal year ending December 31, 2005, international
customers accounted for approximately two-thirds of our total sales. We expect a
similar split among U.S. and international sales to continue. All of our
customers pay us in U.S. dollars. Major domestic customers include the U.S.
Armed Forces, Lockheed Corporation and NASA. Major international customers
include Beijing R&D Technology Company Ltd. in China, TechMondial Limited of
England, Hitachi Corporation in Japan and Max Planck Institute in Germany.
COMPETITION
We are unaware of any direct competitor to the zNose(R) product on the
market today. In the homeland security markets, we face competition from
manufacturers of X-Ray machines, Ion-Mobility Spectrometers and chemical coated
sensors. X-Ray machines have been widely used for security purposes in detecting
metal objects but not for chemical compounds. Ion-Mobility Spectrometer
equipment is a vapor detector and is designed to detect certain compounds but is
blind to other compounds. Hence, it can only see a small dot in a space but
cannot see the total picture. It employs a different sample collection technique
by wiping the surfaces of the object placed for screening. Ion-Mobility
Spectrometer also uses materials in its construction which may be offensive to
users in certain countries.
Chemical coated sensors are the conventional electronic noses. They use an
array of chemical sensors each reacting to certain specific compounds. As
mentioned earlier, electronic noses cannot be calibrated with chemical standards
and therefore cannot be used for scientific measurement.
We have another set of competitors manufacturing portable vapor and odor
analysis products for the instrumentation market from major corporations such as
Agilent Technologies, Inc. (NYSE: A), Perkin-Elmer, Inc. (NYSE: PKI) and Varian,
Inc. (NASDAQ: VARI). We believe that our zNose(R)product is competitive with
these companies' products based on speed and cost.
Many of our current and potential competitors have larger customer bases,
including the previously listed competitors, greater brand recognition and
significantly greater financial, marketing and other resources than we do and
may enter into strategic or commercial relationships with larger, more
established companies. Some of our competitors may be able to secure alliances
with customers and affiliates on more favorable terms, devote greater resources
to marketing, advertising and promotional campaigns and devote substantially
more resources to research and development than we do. In addition, new
technologies and the expansion of existing technologies may increase the
competitive pressures on us.
We cannot assure you that we will be able to compete successfully against
current or future competitors, and competitive pressures faced by us could harm
our business, operating results and financial condition. We do not currently
represent a significant competitive presence in the homeland security or
analytic instrumentation markets.
MANUFACTURING AND RAW MATERIALS
We design, prototype and manufacture our products at our headquarters.
Our manufacturing facilities adhere to ISO9000 manufacturing methods (quality
standards developed by the International Organization for Standardization, which
have been adopted by many countries around the world). We contract out the
manufacturing and assembling of certain components to subcontractors. Our
current annual manufacturing capacity is approximately 1,000 zNose(R) units. The
principal components to our products are computer chips, circuit boards,
transformers and sensory devices. The prices for these components are subject to
market forces largely beyond our control, including energy costs, market demand,
and freight costs. The prices for these
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components have varied significantly in the past and may vary significantly in
the future. Our principal suppliers of components and raw materials include:
Sigma Co. of Bellefonte, Pennsylvania, Ventura Fluid System Technologies of
Camarillo, California and Valco Instruments Co., Inc. of Houston, Texas.
CUSTOMERS
In 2005, we had approximately 35 customers. Our largest customer in 2005,
Beijing R&D Technology Company Ltd., purchased 15 of the total 56 zNose(R) units
sold by us in 2005, constituting approximately 27% of the zNose(R) units sold in
2005. In 2005, we selected Beijing R&D Technology Co., Ltd. to be our exclusive
distributor in China and TechMondial, Ltd. to be our exclusive distributor in
the countries of the European Community, Romania, Bulgaria, Turkey, Croatia and
Switzerland for a seven-year term. Our largest customers are (1) Beijing R&D
Technology Company Ltd. of China, (2) TechMondial Limited of England and (3)
Agency for Defense Development of the Republic of South Korea.
PATENTS, TRADEMARKS AND OTHER PROPRIETARY RIGHTS
We regard our patents, trademarks, trade names and similar intellectual
property as critical to our success. We rely on patent and trademark laws, trade
secret protection and confidentiality agreements with employees, distributors,
customers, partners and others to protect our proprietary rights.
We own four United States patents covering our zNose(R) product, including:
o No. 5,289,715, "Vapor Detection Apparatus and Method Using an Acoustic
Interferometer" issued March 1, 1994;
o No. 5,970,803, "Method and Apparatus for Identifying and Analyzing
Vapor Elements", issued October 26, 1999;
o No. 6,212,938, "Method of Detecting Smell of a Vapor and Producing a
Unique Visual Representation thereof," issued April 10, 2001;
o No. 6,354,160, "Method and Apparatus for Identifying and Analyzing
Vapor Elements," issued December 3, 2002.
We may not be able to obtain patent protection for any derivative uses of
zNose(R), or for any other products we may later acquire or develop. We also
cannot assure you that we will be able to obtain other foreign patents to
protect our products.
We have copyrighted our MicroSense Windows software and Xilinx gate array
firmware, which controls the operation of the zNose(R) and produces visual
images. These images, trademarked as VaporPrints(TM), make it possible to
display vapor analysis data from any vapor analysis system, as unique visual
images and facilitate pattern recognition of complex odors and fragrances.
We currently hold registered trademarks for zNose(R) and VaporPrints(TM).
We intend to evaluate the possible application for new patents and trademarks as
needed to cover current and future applications of our technology and product
developments. We intend to undertake all steps necessary to preserve and protect
our patents, trademarks and intellectual property generally.
We are not aware that our products, trademarks or other proprietary rights
infringe the rights of third parties, nor are we aware of any infringements of
our proprietary rights. We continually evaluate potential infringements of our
proprietary rights and intend to take such legal and other actions as may be
necessary to protect those rights. However, there can be no assurance that
third parties will not assert infringement claims against us in the future with
respect to current or future products or that any such assertion may not require
us to enter into royalty arrangements or result in costly litigation.
GOVERNMENT REGULATION
Government agencies, in particular, the Department of Defense, are
principal customers for our products. We are required to comply with the Federal
Acquisition Regulations, a comprehensive set of regulations governing how
vendors do business with the U.S. federal government, to the extent we contract
with departments or agencies of the U.S. government, as well
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as similar regulations to the extent we contract with state or local
governments. Sales to or grants from foreign governments or organizations will
have their own regulatory framework, which may or may not be similar to present
U.S. standards or requirements.
RESEARCH AND DEVELOPMENT
Our research and development program consists of developing technologies
related to enhancing our electronic nose product and making it more portable.
Fees related to research and development, include consulting fees, technical
fees, and research, development and testing of our zNose(R) product. We spent
approximately $600,000 in each of 2005 and 2004 on research and development
activities, none of which was borne directly by customers.
EMPLOYEES
As of December 31, 2005 we had a total of 23 staff persons, including 21
full time staff and 2 consultants. In addition to management, we employ sales
people, administrative staff, and development and technical personnel. From time
to time, we may employ independent consultants or contractors to support our
research and development, marketing, sales and support, and administrative
organizations. No collective bargaining units represent our employees and
Electronic Sensor Technology is not party to any labor contracts.
REPORTS TO SECURITY HOLDERS
Electronic Sensor Technology is not currently required to deliver annual
reports to security holders. We are not currently required to deliver an annual
report to security holders because our registered common stock is registered
under the Securities Act and is not currently registered under the Exchange Act.
As long as we do not have any class of stock registered under the Exchange Act,
we are not required to deliver an annual report to security holders. We
currently plan to register our common stock under the Exchange Act prior to the
end of the fiscal year in which this registration statement is declared
effective. Once we do so, we will be subject to the requirements of the Exchange
Act, and intend to comply with all additional rules and regulations, including
but not limited to the additional reporting requirements, proxy rules and the
requirement to deliver an annual report to security holders when we deliver
proxy solicitation materials to security holders in connection with an annual
meeting. However, unless and until we register our stock under the Exchange Act,
we are not subject to the proxy rules and are under no obligation to deliver an
annual report to security holders.
Electronic Sensor Technology is a voluntary reporting company and files
with the Securities and Exchange Commission annual reports on Form 10-KSB,
quarterly reports on Form 10-QSB and current reports on Form 8-K. The public may
read and copy any materials that Electronic Sensor Technology files with the SEC
at the SEC's Public Reference Room at 450 Fifth Street, N.W., Washington, D.C.
20549. The public may 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 issuers that file electronically with the SEC at:
http://www.sec.gov. More information regarding Electronic Sensor Technology is
available at our website: http://www.znose.com. The information on or that can
be accessed through our website is not part of this prospectus.
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CAPITALIZATION
The following table sets forth our capitalization as of June 30, 2006. The
figures in the table are derived from our unaudited financial statements and
should be read in conjunction with our consolidated financial statements and
related notes included elsewhere in this prospectus.
June 30, 2006
(unaudited)
Long-term debt.......................................... $ 1,361,111
Stockholders' deficit:
Common stock; $0.001 par value; 200,000,000
Shares authorized; 54,173,745 shares issued
and outstanding..................................... $ 54,174
Additional paid-in capital............................ $ 8,516,354
Accumulated deficit................................... ($8,711,912)
Total Stockholders' deficit............................. ($141,384)
Total capitalization.................................... $ 1,219,727
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion and analysis of our financial
condition and results of operations together with the financial statements and
the related notes appearing at the end of this prospectus. The following
discussion and other parts of this prospectus contain forward-looking statements
that involve risks and uncertainties. Forward-looking statements can be
identified by words such as "anticipates," "expects," "believes," "plans," and
similar terms. Risks and uncertainties exist that may cause results to differ
materially from those set forth in these forward-looking statements. Factors
that could cause the anticipated results to differ from those described in the
forward-looking statements include: changes in the market for security
technology, general volatility in the capital markets, changes in the businesses
of our significant customers and other factors, including those discussed in
"Risk Factors" beginning on page 2 and elsewhere in this prospectus. The
forward-looking statements speak only as of the date they are made. We do not
undertake to update forward-looking statements to reflect circumstances or
events that occur after the date the forward-looking statements are made.
Service marks, trademarks and trade names referred to in this prospectus are the
property of their respective owners.
As a result of the mergers whereby Electronic Sensor Technology, L.P.
became a wholly-owned indirect subsidiary of Electronic Sensor Technology and
the subsequent termination of Bluestone's prior operations, our business plan
has been altered to focus on the product operations previously conducted by
Electronic Sensor Technology, L.P. Following the mergers, our revenues were
expected to be, and have been, derived principally from the sale of the zNose(R)
products.
CRITICAL ACCOUNTING POLICIES
We record revenue from direct sales of products to end-users when the
products are shipped, collection of the purchase price is probable and we have
no significant further obligations to the customer. Costs of remaining
insignificant company obligations, if any, are accrued as costs of revenue at
the time of revenue recognition. Cash payments received in advance of product or
service revenue are recorded as deferred revenue.
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the recorded amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
The company reviews long-lived assets, such as property and equipment, to
be held and used or disposed of, for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. If the sum of the expected cash flows, undiscounted and without
interest, is less than the carrying amount of the asset, an impairment
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loss is recognized as the amount by which the carrying amount of the asset
exceeds its fair value. At June 30, 2006 no assets were impaired.
We account for liquidated damages pursuant to Emerging Issue Task Force
("EITF") 05-04, View C, "The Effect of a Liquidated Damages Clause on a
Freestanding Financial Instrument", subject to EITF Issue No. 00-19, "Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock". Pursuant to EITF 05-04, View C, liquidated damages payable
in cash or stock are accounted for as a separate derivative, which requires a
periodical valuation of its fair value and a corresponding recognition of
liabilities associated with such derivative. We also account for our embedded
conversion features and freestanding warrants pursuant to SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities", which requires a
periodic valuation of their fair value and a corresponding recognition of
liabilities associated with such derivatives. The recognition of derivative
liabilities related to the issuance of shares of common stock is applied first
to the proceeds of such issuance, at the date of issuance, and the excess of
derivative liabilities over the proceeds is recognized as other expense in the
accompanying consolidated financial statements. The recognition of derivative
liabilities related to the issuance of convertible debt is applied first to the
proceeds of such issuance as a debt discount, at the date of issuance, and the
excess of derivative liabilities over the proceeds is recognized as other
expense in the accompanying consolidated financial statements. Any subsequent
increase or decrease in the fair value of the derivative liabilities is
recognized as other expense or other income, respectively. The valuation of such
derivatives requires significant judgment. We exercise our judgment in
determining the maximum liabilities associated with such derivatives as well as
the expected volatility related to their fair value. We base our estimate of the
maximum liabilities on our interpretation of the agreements related the
derivatives.
Accounts receivable are reported at net realizable value. We have
established an allowance for doubtful accounts based upon factors pertaining to
the credit risk of specific customers, historical trends, and other information.
Delinquent accounts are written-off when it is determined that the amounts are
uncollectible.
Inventories are stated at the lower of cost or market, cost determined by
the first-in, first-out (FIFO) method. The Company writes down its inventory for
estimated obsolescence or unmarketable inventory using the difference between
the cost of inventory and the estimated market value based upon assumptions
about future demand and market conditions.
We are required to estimate our income taxes in each of the jurisdictions
in which we operate as part of the process of preparing our consolidated
financial statements. SFAS No. 109, "Accounting for Income Taxes", requires a
valuation allowance to reduce the deferred tax assets reported if, based on the
weight of the evidence, it is not more likely than not that some portion or all
of the deferred tax assets will be realized. Management reviews deferred tax
assets periodically for recoverability and makes estimates and judgments
regarding the expected geographic sources of taxable income, gains from
investments, as well as tax planning strategies in assessing the need for a
valuation allowance. We determined that a valuation allowance of approximately
$900,000 relating to net operating loss carryovers was necessary to reduce our
deferred tax assets to the amount that will more likely than not be realized. As
a result, at December 31, 2005, the Company has no net deferred tax assets. If
the estimates and assumptions used in our determination change in the future, we
could be required to revise our estimates of the valuation allowances against
our deferred tax assets and adjust our provisions for additional income taxes.
In the ordinary course of global business, there are transactions for which the
ultimate tax outcome is uncertain, thus judgment is required in determining the
worldwide provision for income taxes. We provide for income taxes on
transactions based on our estimate of the probable liability. We adjust our
provision as appropriate for changes that impact our underlying judgments.
Changes that impact provision estimates include such items as jurisdictional
interpretations on tax filing positions based on the results of tax audits and
general tax authority rulings.
PLAN OF OPERATIONS
Over the course of the next 12 months, we intend to execute our business
plan and focus our business development efforts in the following key areas:
o By diversifying our product offerings to enhance the usefulness of our
solutions for customers who will have already adopted one or more
products;
o By enhancing our product lines and developing new products to attract
new customers; and
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o By developing partnering relationships with wide-ranging sales and
distribution channel leaders already serving our vertical market space
in a way that assists them in developing new revenue streams and
opportunities through improved technical and sales support and
customer services.
The terms of the convertible debentures and warrants that we issued in a
private placement on December 7, 2005 to Midsummer Investment, Ltd. and
Islandia, L.P. required that we register the shares of our common stock
underlying such debentures and warrants within 180 days of the date of issuance
of the debentures and warrants. The failure to do so is an event of default
under the debentures, giving the debenture holders the right to accelerate the
debentures and receive a premium of approximately 30% of the outstanding amounts
due under the debentures upon acceleration. The failure to do so also reduces
the exercise price of the warrants by $0.03 per month until such shares are
registered. In addition, the failure to register such shares within 150 days of
the date of issuance of the debentures and warrants gives the holders the right
to receive liquidated damages in the amount of 2% per month of the purchase
price of the debentures and warrants, pursuant to a registration rights
agreement, and the failure to pay such liquidated damages relating to the
debentures is an event of default under the debentures. Although we have been
working diligently to obtain effectiveness of our registration statement and
continue to do so, we have thus far been unable to have such registration
statement declared effective by the Securities and Exchange Commission. As such,
the aforementioned penalties have been triggered. At this time, the declaration
of an acceleration would cause approximately $9.1 million to be due and payable
immediately upon such a declaration. Under the terms of the warrants, the
exercise prices of the warrants would have fallen from $0.4761 per share to
approximately $0.3461 per share. Pursuant to the registration rights agreement,
we would also owe the holders of the debentures and warrants approximately
$746,666, plus interest thereon at a rate of 18% per annum.
As described further under "Certain Relationships and Related
Transactions", on September 7, 2006, Electronic Sensor Technology entered into a
Forbearance and Amendment Agreement with Midsummer and Islandia. Pursuant to the
Forbearance and Amendment Agreement, Midsummer and Islandia have agreed to
abstain from exercising the aforementioned rights and remedies arising out of
the existing defaults under the debentures and warrants until February 28, 2007.
In exchange for such forbearance, we have agreed to reduce the conversion price
of the debentures issued to Midsummer and Islandia on December 7, 2005 from
$0.4544 per share to $0.4000 per share and to reduce the exercise price of the
warrants issued to Midsummer and Islandia on such date from $0.4761 per share to
$0.4300 per share. In addition, we have agreed to appoint (and have appointed) a
director and an independent director nominated by Midsummer to our Board of
Directors, and has agreed to commence a search for a chief operating officer
with the potential to become a chief executive officer. If we do not have the
shares of common stock underlying the debentures and the warrants issued to
Midsummer and Islandia fully registered by February 28, 2007 or if we default
prior to such date under any other provision of the debentures, the warrants or
the related agreements, the Forbearance and Amendment Agreement provides that
all penalties incurred before and after entry to the Forbearance and Amendment
Agreement will again apply, and Midsummer and Islandia will have the ability to
collect all of the aforementioned penalties, as well as any that accrue over the
term of the Forbearance and Amendment Agreement.
RESULTS OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 2006 COMPARED TO SIX MONTHS ENDED JUNE 30, 2005
The following tables sets forth, in $ and as a percentage of revenues,
certain items included in our Income Statements (see Financial Statements and
Notes) for the periods indicated:
SIX MONTHS ENDED JUNE 30
-----------------------------
2006 2005
------------ ------------
STATEMENT OF OPERATIONS DATA: (Restated)
Revenues ....................... 100% 100%
Cost of Sales .................. 51% 58%
Gross Profit ................... 49% 42%
Operating Expenses ............. 161% 220%
(Loss) From Operations ......... (112)% (178)%
Other Income ................... 23% 312%
Net Income (loss) .............. (89)% 134%
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Revenues are derived from product sales and product support services. For
the six months ended June 30, 2006 revenues were $1,154,224, compared to
$651,652 in 2005. The 77% increase in revenues results mainly from an increase
in the number of zNose(R) units shipped from 19 units in 2005 to 32 units in
2006 for the six-month period. Also contributing to the increase in revenues was
a slight increase in sales from product support services.
Cost of Sales consist of product costs and expenses associated with product
support services. For the six-month period, cost of sales was $592,714 for 2006
as compared to $375,086 in 2005. The increase in cost of sales was due to a
greater volume of products shipped in the current year as compared to last year.
The improvement in cost of sales as a percent of revenues, from 58% of 2005
revenues to 51% of 2006 revenues, is attributed to production efficiencies and
production economies of scales resulting in overhead being spread over a greater
volume of production - all of which contributed to a lower manufacture cost per
unit.
Gross profit was $561,510 for the six months ending June 30, 2006, compared
to $276,566 for the same period in 2005. The increase in gross profit was due to
greater sales volume, and an increase in high-margin support services revenues
over 2005. The improvement in 2006 gross profit from 42% in 2005 to 49% of
revenues is attributed to greater labor utilization, which improved labor
productivity and lowered the direct labor cost per manufactured unit.
Research and Development costs for the first six months of 2006 were
$416,144 versus $331,285 for 2005. The increase of $84,859 in current year
expenditures over 2005 were mainly for greater personnel related expenses
incurred for enhancement of existing products and development of the Model 4300,
the company's newest zNose(R) product that was introduced to market in June
2006.
Selling, General and Administrative expenses for the six months ending June
30, 2006 were $1,436,961, compared to $1,103,030 for 2005. The $333,931 increase
was due to increased staffing required to support the growth of the company,
incurrence of necessary expenses associated with being a public company,
expansion of marketing activities including increased personnel staffing and
participation in a greater number of industry trade shows and conferences.
Interest expense for the first six months of 2006 was $1,416,279, as
compared to $34,271 in 2005. The increase in interest expense is primarily due
to the amortization of debt discount and stated interest associated with our
$7,000,000 convertible debentures, which were issued in December 2005.
Other income-derivatives primarily consist of the decrease in the fair
value of derivative liabilities between the measurement dates. The increase in
other income during the six-month period ending June 30, 2006 when compared to
prior period is primarily attributable to a decrease in the quoted price of our
common stock. Please refer to Note 5 of our accompanying financial statements
for further explanation of the origin and nature of such income. We are unable
to determine whether we will record further decreases in the fair value of
derivative liabilities in the foreseeable future, which would be recorded as
other income-derivatives. Such decreases would be generally triggered by a
decrease in the fair value of our stock price, upon satisfaction of liquidated
damages pursuant to registration rights, or, possibly, upon satisfaction of our
convertible debentures.
Other expense-derivatives primarily consist of the recognition of
derivative liabilities we issued during the three-month period ended March 31,
2005. No derivatives were issued during the three-month period ended June 30,
2005 nor were any derivatives issued in 2006. Please refer to Notes 5 of our
accompanying financial statements for further explanation of the origin and
nature of such expenses.
-30-
FISCAL YEAR ENDED DECEMBER 31, 2005 COMPARED TO FISCAL YEAR ENDED DECEMBER
31, 2004
The following table sets forth certain items included in our Income
Statements (see Financial Statements and Notes) for the periods indicated:
Year Ended
December 31, Variation $ Variation %
-------------------------- 2005 vs 2005 vs
2005 2004 2004 2004(*)
----------- ----------- ----------- ------------
(Restated) (Restated) (Restated) (Restated)
In $
REVENUES $ 2,122,349 $ 1,076,749 1,045,600 0.97
COST OF SALES 1,302,602 1,039,280 263,322 0.25
----------- ----------- ----------- ------------
GROSS PROFIT 819,747 37,469 782,278 20.88
OPERATING EXPENSES:
Research and development 260,125 0 260,125 NM(**)
Compensation 466,421 81,734 384,687 4.71
Selling 653,092 161,546 491,546 3.04
General and administrative 1,522,451 225,229 1,297,222 5.76
----------- ----------- ----------- ------------
TOTAL OPERATING EXPENSES 2,902,089 468,509 2,433,580 5.19
LOSS FROM OPERATIONS (2,082,342) (431,040) (1,651,302) (3.83)
OTHER INCOME AND EXPENSE:
Other income - derivative liabilities 7,577,929 0 7,577,929 NM
Other expense - derivative liabilities (2,401,358) 0 (2,401,358) NM
Gain (loss) on sale of property and equipment 9,287 (7,710) 16,997 2.20
Interest expense (324,540) (164,133) (160,407) (0.98)
----------- ----------- -----------
TOTAL OTHER INCOME AND (EXPENSE) 4,861,318 (171,843) 5,033,161 29.29
NET (LOSS) INCOME $ 2,778,976 $ (602,883) 3,381,859 5.61
=========== =========== =========== ============
----------
(*) Expressed as a decimal.
(**) NM = not meaningful.
-31-
The following table sets forth, as a percentage of revenues, certain items
included in our Income Statements (see Financial Statements and Notes) for the
periods indicated:
Year Ended
December 31,
---------------------------
2005 2004
----------- -----------
As a % of revenues (Restated) (Restated)
REVENUES 100% 100%
COST OF SALES 61% 97%
GROSS PROFIT 39% 3%
OPERATING EXPENSES 137% 44%
(LOSS) FROM OPERATIONS (98%) (41%)
OTHER INCOME AND (EXPENSE) 229% (16%)
NET (LOSS) INCOME 131% (57%)
Revenues primarily consists of the sale of our zNose products. Our increase
in revenues during 2005, when compared to 2004, is primarily attributable to an
increase of volume of shipments of zNose units from 28 units during 2004 to 56
units during 2005.
Cost of Sales primarily consists of manufacturing costs. The increase in
cost of sales during 2005 when compared to 2004 is primarily attributable to an
increase in our number of units shipped, offset by a decrease in idle labor
hours during 2005 when compared to 2004. We believe that our per unit
manufacturing costs will continue to decline as we increase the number of units
sold per quarter, due to economies of scale.
Research and development expenses primarily consists of salaries and
related benefits, material and supplies associated with our efforts in
developing and enhancing our products. The increase in our research and
development expenses during 2005 is primarily attributable to an increase in
salaries and related benefits resulting from the hiring of personnel whose time
is devoted to the development and enhancement of our products.
Compensation expenses primarily consists of salaries and related benefits
of our general and administrative personnel. The increase in compensation
expenses during 2005 when compared to 2004 is primarily attributable to an
increase in personnel to support the growth of our operations.
Selling expenses primarily consists of salaries, commissions and related
benefits associated with our selling and marketing efforts The increase in
selling expenses during 2005 when compared to 2004 is primarily attributable to
an increase in employees associated with sales efforts as well expanded sales
activities.
General and administrative expenses primarily consists of costs incurred in
connection with the reverse merger as well professional fees associated with
being a publicly-traded company. Our increase in general and administrative
expenses during 2005 when compared to 2004 results from professional fees
associated with the reverse merger, which occurred during 2005, as well as an
increase of professional fees related to being publicly-traded, which also began
in 2005. The costs incurred in connection with the reverse merger totaled
approximately $635,000, which consisted of approximately $310,000 in legal fees,
$143,000 in investment banking and consultant fees and $182,000 in public
relations firm fees.
Other income-derivative liabilities primarily consists of the decrease in
the fair value of derivative liabilities between the date of issuance of such
derivatives and our year-end. The increase in other income during 2005 when
compared to 2004 is primarily attributable to a decrease in the fair value of
derivative liabilities, between measurement dates, recognized during 2005. No
such derivatives were issued during 2004.
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Other expense-derivative liabilities primarily consists of the recognition
of derivative liabilities we issued during 2005. No such derivatives were issued
during 2004.
Interest expense primarily consists of debt discount amortization and
interest on certain debt. The increase in interest discount during 2005 when
compared to 2004 is primarily attributable to the recognition of debt discount
associated with the issuance of convertible debentures in December 2005, offset
by a decrease on certain loans payable which were satisfied in February 2005.
LIQUIDITY AND CAPITAL RESOURCES
Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005
For the six-month period, net cash used by the company for operating
activities were $1,454,193 and $1,364,616 for 2006 and 2005 respectively. Cash
used in the first six months of 2006 was comprised of the net loss for the
period of $1,024,755, less net non-cash items (including depreciation and
amortization expenses of $18,865, issuance of common shares for services of
$21,000, amortization of debt discount of $1,166,667, amortization of deferred
financing costs of $103,782, less decrease in fair value of derivative liability
of $1,683,119) of $372,805 minus the net change in operating assets and
liabilities of $56,633. Cash used in operations during the same six months of
2005 was comprised of the net income for the period of $875,576, less net
non-cash expenses of $2,052,703 (including depreciation and amortization
expenses of $5,605, recognition of derivative liabilities of $2,205,642, less
decrease in fair value of derivative liability of $4,263,950), less the net
change in operating assets and liabilities of $187,488.
Investing activities provided cash of $599,413 in the first six months of
2006 and used $47,500 during the same period in 2005. Cash of $69,265 in 2006
and $77,780 in 2005 were used to purchase of capital equipment. In 2005, $30,280
was received from the sales of property and equipment. Whereas in 2006, $668,678
was provided due to a reduction in the amount of collateral required for the
company's line of credit.
Cash provided from financing activities for the first six months of 2006
consisted of $370,000 drawn from the line of credit the company has in place
with its bank. The funds from the credit line were used for operating expenses.
In 2005, financing activities provided cash of $3,501,708 primarily from the
issuance of common stock in February.
On June 30, 2006 the company's cash (including cash equivalents) was
$3,735,141, compared to $1,209,424 on June 30, 2005. The company had working
capital on June 30, 2006 of $436,679. Working capital includes $4,087,959 for
derivative liabilities - excluding this amount from current liabilities, the
company's working capital would be $4,524,638. The company's working deficit at
June 30, 2005 was $1,220,398 - excluding derivative liabilities of $1,753,400,
working capital would be $533,011.
The company has a line of credit facility in place with East West Bank for
$500,000. The line of credit had borrowings of $370,000 against it at June 30,
2006. The funds from the line of credit were used for operating expenses. The
line of credit expires on March 31, 2007.
Although the company possesses a bank operating line of credit, there can
be no assurance that these proceeds will be adequate for our future capital
needs. There can be no assurance that any required or desired financing will be
available through any other bank borrowings, debt, or equity offerings, or
otherwise, on acceptable terms. If future financing requirements are satisfied
through the issuance of equity securities, investors may experience significant
dilution in the net book value per share of common stock and there is no
guarantee that a market will exist for the sale of the company's shares.
The company's primary capital needs are to fund its growth strategy, which
includes a sales and marketing staff to support the marketing, advertising and
selling of the zNose(R) family of chemical detection products, increasing
distribution channels both in the domestic and foreign markets, introducing new
products, improving existing product lines and development of a strong corporate
infrastructure.
FISCAL YEAR ENDED DECEMBER 31, 2005 COMPARED TO FISCAL YEAR ENDED
DECEMBER 31, 2004
Our cash and cash equivalents amounted to approximately $4.2 million at
December 31, 2005.
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During 2005, we used approximately $3.0 million in our operating activities
which is the result of the following:
o A net income of approximately $2.8 million adjusted for:
o the recognition of derivative liabilities of $2.4 million
resulting from the issuance of such derivatives (convertible
debentures and warrants) and a decrease in the fair value of the
derivative liabilities of approximately $7.6 million.
o An increase in accounts receivables, inventories, and accounts payable
and accrued expenses of approximately $435,000, $459,000, and
$266,000, respectively, resulting from increased revenues, increased
production to meet increased demand for our products and a general
increase in our expenses associated with our growth.
During 2005, we used approximately $1.0 million in investing activities by
purchasing a certificate of deposit of approximately $919,000 to satisfy the
collateral requirement of our line of credit and by incurring capital
expenditures of approximately $127,000.
During 2005, we generated approximately $8.1 million in financing
activities by generating proceeds of approximately $7,000,000 and $3.8 million
from the issuance of our convertible debentures and our shares of common stock,
respectively, offset by the repayment of our line of credit of approximately
$2.0 million and by paying financing costs of approximately $593,000.
As a result of the mergers, as of February 1, 2005, we assumed certain
liabilities and obligations of Electronic Sensor Technology, L.P. Total
liabilities assumed pursuant to the mergers were approximately $2.2 million,
including approximately (1) $1.8 million owed under a revolving line of credit
with East West Bank, (2) $212,000 of accounts payable and accrued expenses and
(3) $35,000 of other current liabilities. The outstanding loan for $1.8 million
with East West Bank accrued interest at the prime rate as reported in the Wall
Street Journal plus one-half point (0.5%) and was paid off on December 9, 2005.
The original maturity date of the East West Bank line of credit was December 31,
2005, which was extended to February 28, 2006 in order to provide additional
time for processing a pending renewal of the line of credit. East West Bank has
extended a reduced line of credit of $500,000 (based on projected cash flow
requirements for the coming year) with a maturity date of March 31, 2007 and
with an annual interest rate of 7.75%. The loan will be collateralized by all
assets of Electronic Sensor Technology. As part of such collateral, we will also
pledge a certificate of deposit of $250,000 to East West Bank. The loan
documents are currently being processed and we expect to execute them as soon as
they are approved by our Board of Directors.
During 2004, we used approximately $167,000 in our operating activities
which is the result of the following:
Our net loss of approximately $603,000 adjusted for:
o a decrease in our accounts receivable and accounts payable amounting
to approximately $363,000 and $66,000, respectively, resulting from a
shorter average collection time on accounts receivable and more timely
payments on accounts payable as well as an increase in inventories and
deferred revenues of approximately $88,000 and $192,000, respectively,
to meet the increased demand of our products and receipt of a one-time
license fee from a customer to be amortized to revenues in equal
installments over the terms of the license agreement.
During 2004, we incurred capital expenditures of approximately $35,000.
During 2004, we financed our operations and capital expenditures by issuing
shares of our common stock generating proceeds of $200,000 and repaying
partners' loan of $120,000.
As of December 31, 2005, our cash balance and working capital, adjusted for
derivative liabilities were $4,219,921 and $5,991,467, respectively. Our current
monthly cash burn rate is approximately $250,000 and we do not anticipate any
extraordinary cash payments that we will have to make in the near future until
the first principal payment of approximately $780,000 is due on the convertible
debentures that we issued on December 7, 2005, which such payment is to be made
on January 1, 2008. Based on our current monthly cash burn rate, we believe that
we will not require any financing until the second half of 2007, at the
earliest. Accordingly, we believe that we will be able to continue as a going
concern for at least the next twelve months.
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SEASONALITY AND QUARTERLY RESULTS
We do not foresee any seasonality to our revenues or our results of
operations.
INFLATION
Although we currently use a limited number of sources for most of the
supplies and services that we use in the manufacturing of our vapor detection
and analysis technology, our raw materials and finished products are sourced
from cost-competitive industries. While prices for our raw materials may vary
significantly based on market trends, we do not foresee any material
inflationary trends for our product sources.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements.
DESCRIPTION OF PROPERTY
We lease approximately 13,500 square feet of office space at 1077 Business
Center Circle, Newbury Park, California. Our current lease expires on September
30, 2006. The lease payments are $15,826 per month. The facility serves as our
headquarters and R&D and manufacturing facility.
INVESTMENT POLICIES
We do not invest, nor do we plan to invest in the foreseeable future in
real estate, interests in real estate, real estate mortgages, securities of or
interests in persons primarily engaged in real estate activities.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
On September 7, 2006, Electronic Sensor Technology entered into a
Forbearance and Amendment Agreement with Midsummer Investment, Ltd. and
Islandia, L.P., each of which beneficially owns more than 5% of our outstanding
shares of common stock, by virtue of ownership of convertible debentures and
warrants. The terms of the convertible debentures and warrants that we issued to
Midsummer and Islandia in a private placement on December 7, 2005 required that
we register the shares of our common stock underlying such debentures and
warrants within 180 days of the date of issuance of the debentures and warrants.
The failure to do so is an event of default under the debentures, giving
Midsummer and Islandia the right to accelerate the debentures and receive a
premium of approximately 30% of the outstanding amounts due under the debentures
upon acceleration. The failure to do so also reduces the exercise price of the
warrants by $0.03 per month until such shares are registered. In addition, the
failure to register such shares within 150 days of the date of issuance of the
debentures and warrants gives the holders the right to receive liquidated
damages in the amount of 2% per month of the purchase price of the debentures
and warrants, pursuant to a registration rights agreement, and the failure to
pay such liquidated damages relating to the debentures is an event of default
under the debentures. Although we have been working diligently to obtain
effectiveness of our current registration statement and continue to do so, we
have thus far been unable to have such initial registration statement declared
effective by the Securities and Exchange Commission.
Pursuant to the Forbearance and Amendment Agreement, Midsummer and Islandia
have agreed to abstain from exercising the aforementioned rights and remedies
arising out of the existing defaults under the debentures and warrants until
February 28, 2007. In exchange for such forbearance, we have agreed to reduce
the conversion price of the debentures issued to Midsummer and Islandia on
December 7, 2005 from $0.4544 per share to $0.4000 per share and to reduce the
exercise price of the warrants issued to Midsummer and Islandia on such date
from $0.4761 per share to $0.4300 per share. In addition, we have agreed to
appoint (and have appointed) a director nominated by Midsummer to Electronic
Sensor Technology's Board of Directors within 14 days of the date of the
Forbearance and Amendment Agreement. In addition, within 14 days of the date of
the Forbearance and Amendment Agreement, Midsummer may nominate (and has so
noninated) an independent director to Electronic Sensor Technology's Board of
Directors, subject to the approval of a majority of the Board, which such
nominee may only be rejected in good faith and with cause. Electronic Sensor
Technology has also agreed not to increase its Board of Directors to more than 9
members without the consent of Midsummer. Pursuant to the Forbearance and
Amendment Agreement, as soon as practicable, a special committee of 3 Board
members comprised of one director chosen by Midsummer, one independent director
and one
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appointee of the founding shareholders of Electronic Sensor Technology, shall
begin a search for a candidate for chief operating officer of Electronic Sensor
Technology with the potential to become chief executive officer. If the Board
approves of a candidate appointed by the special committee, the company has
agreed to hire such candidate for an interim and trial basis for up to 3 months,
at which time the Board will meet to determine whether such chief operating
officer shall be promoted to chief executive officer or be released. If such
chief operating officer is released, a new search by the special committee will
begin.
If we do not have the shares of common stock underlying the debentures
and the warrants issued to Midsummer and Islandia fully registered by February
28, 2007 or if we default prior to such date under any other provision of the
debentures, the warrants or the related agreements, the Forbearance and
Amendment Agreement provides that all penalties incurred before and after entry
to the Forbearance and Amendment Agreement will again apply, and Midsummer and
Islandia will have the ability to collect all of the aforementioned penalties,
as well as any that accrue over the term of the Forbearance and Amendment
Agreement.
Electronic Sensor Technology, L.P., prior to becoming an indirect
subsidiary of Electronic Sensor Technology, Inc., was a party to the following
transactions with the following then executive officers and directors of
Electronic Sensor Technology, L.P. during the past two years:
o On January 22, 2005, Electronic Sensor Technology, L.P. converted
$399,643 in debt of Electronic Sensor Technology, L.P. held by Edward
Staples, then Managing Director of Electronic Sensor Technology, L.P.,
into the right to receive, upon completion of the acquisition of
Electronic Sensor Technology, L.P. by Bluestone Ventures Inc.
(predecessor to Electronic Sensor Technology, Inc.), 399,643 shares of
common stock of Bluestone and warrants to purchase 199,821.5 shares of
common stock of Bluestone at $1.00 per share, exercisable only if the
trading price of such stock is at least $1.50 per share. In addition,
Electronic Sensor Technology, L.P. converted $952,577 in debt owed to
Amerasia Technology into the right to receive shares of common stock
of Bluestone and warrants to purchase shares of common stock of
Bluestone. By virtue of his 30.21% ownership of Amerasia Technology,
Dr. Staples obtained the right to receive, upon the acquisition of
Electronic Sensor Technology, L.P. by Bluestone, 287,773 shares of
Bluestone common stock and warrants to purchase 143,866.5 shares of
Bluestone common stock at $1.00 per share, exercisable only if the
trading price of such stock is at least $1.50 per share.
o On January 22, 2005, on the same terms as those described above,
Electronic Sensor Technology, L.P. converted $226,720 in debt of
Electronic Sensor Technology, L.P. held by 3 Springs, LLC (of which
Francis Chang, then Chief Financial Officer of Electronic Sensor
Technology, L.P. is the sole member), into the right to receive,
226,720 shares of Bluestone common stock and warrants to purchase
113,360 shares of Bluestone common stock. In addition, 3 Springs, LLC
obtained the right to receive 287,773 shares of Bluestone common stock
and warrants to purchase 143,886.5 shares of Bluestone common stock by
virtue of its 30.21% ownership of Amerasia Technology.
o On January 22, 2005, on the same terms as those described above,
Electronic Sensor Technology, L.P. converted $517,899 in debt of
Electronic Sensor Technology, L.P. held by TC Lim, LLC (of which Teong
Lim, then Manager of Corporate Development of Electronic Sensor
Technology, L.P. is the sole member), into the right to receive,
517,899 shares of Bluestone common stock and warrants to purchase
258,949.5 shares of Bluestone common stock. In addition, TC Lim, LLC
obtained the right to receive 359,693 shares of Bluestone common stock
and warrants to purchase 179,846.5 shares of Bluestone common stock by
virtue of its 37.76% ownership of Amerasia Technology.
MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock has been quoted on the Over-the-Counter Bulletin Board
since February 1, 2005 under the symbol "ESNR.OB". Prior to February 1, 2005 our
common stock was quoted on the Over-the-Counter Bulletin Board under the symbol
"BLUV.OB". There is currently no broadly followed, established public trading
market for our common stock. The quarterly range of high and low
Over-the-Counter Bulletin Board quotation information for our common stock for
the last two fiscal years is set forth below. These quotations reflect
inter-dealer prices, without retail mark-up, mark-down or commission, and may
not represent actual transactions.
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QUARTERLY COMMON STOCK PRICE RANGES
QUARTER ENDED 2006
------------------- ----------------
HIGH LOW
------ ------
June 30 $ .29 $ .17
March 31 .41 .19
QUARTER ENDED 2005
------------------- ----------------
HIGH LOW
------ ------
December 31 $ .62 $ .27
September 30 1.19 .42
June 30 2.50 1.07
February 1-March 31 2.51 1.90
QUARTER ENDED 2004
------------------- ----------------
HIGH LOW
------ ------
December 31 $ .01 $ .01
September 30 .01 .01
June 30 .01 .01
March 31 .01 .01
As of the date of this prospectus, 37,074,398 of our shares of common stock
are subject to outstanding options or warrants to purchase, or securities
convertible into common stock.
As of September 7, 2006, approximately 26,968,741 shares of our common
stock may be sold pursuant to Rule 144 under the Securities Act, provided that
all of the requirements of Rule 144 have been met.
There were 59 record holders of our common stock as of September 7, 2006.
This number does not include an indeterminate number of shareholders whose
shares are held by brokers in street name.
We have not paid dividends on our common stock since our inception. The
decision to pay dividends on common stock is within the discretion of the Board
of Directors. It is our current policy to retain any future earnings to finance
the operations and growth of our business. Accordingly, we do not anticipate
paying any dividends on common stock in the foreseeable future.
-37-
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following table illustrates, as of December 31, 2005, information
relating to all of our equity compensation plans:
EQUITY COMPENSATION PLAN INFORMATION
NUMBER OF SECURITIES
NUMBER OF SECURITIES TO BE WEIGHTED AVERAGE REMAINING AVAILABLE
ISSUED UPON EXERCISE OF EXERCISE PRICE OF FOR FUTURE ISSUANCE
OUTSTANDING OPTIONS, OUTSTANDING OPTIONS UNDER THE EQUITY
WARRANTS AND RIGHTS WARRANTS AND RIGHTS COMPENSATION PLAN
-------------------------- ------------------- ----------------------
Equity Compensation Plans
approved by security holders 0 N/A 0
Equity compensation plans not
approved by security holders 1,794,500 $.89 3,205,500
Total 1,794,500 $.89 3,205,500
ELECTRONIC SENSOR TECHNOLOGY, INC. 2005 STOCK INCENTIVE PLAN
In 2005, the Board of Directors adopted the Electronic Sensor Technology,
Inc. 2005 Stock Incentive Plan. The purpose of the Stock Incentive Plan is to
attract and retain the services of experienced and knowledgeable individuals to
serve as our employees, consultants and directors. On the date the Stock
Incentive Plan was adopted, the total number of shares of common stock subject
to it was 5,000,000. The Stock Incentive Plan is currently administered by the
Board of Directors, and may be administered by any Committee authorized by the
Board of Directors, so long as any such Committee is made up of Non-Employee
Directors, as that term is defined in Rule 16(b)-3(b) of the Securities Exchange
Act of 1934.
The Stock Incentive Plan is divided into two separate equity programs: the
Discretionary Option Grant Program and the Stock Issuance Program. Under the
Discretionary Option Grant Program, eligible persons may, at the discretion of
the administrator, be granted options to purchase shares of common stock and
stock appreciation rights. Under the Stock Issuance Program, eligible persons
may, at the discretion of the administrator, be issued shares of common stock
directly, either through the immediate purchase of such shares or as a bonus for
services rendered for Electronic Sensor Technology (or a parent or subsidiary of
Electronic Sensor Technology).
Pursuant to the terms of the Discretionary Option Grant Program, the
exercise price per share is fixed by the administrator, but may not be less than
85% of the fair market value of the common stock on the date of grant, unless
the recipient of a grant owns 10% or more of Electronic Sensor Technology's
common stock, in which case the exercise price of the option must not be less
than 110% of the fair market value. An option grant may be subject to vesting
conditions. Options may be exercised in cash, with shares of the common stock of
Electronic Sensor Technology already owned by the person or through a special
sale and remittance procedure, provided that all applicable laws relating to the
regulation and sale of securities have been complied with. This special sale and
remittance procedure involves the optionee concurrently providing irrevocable
written instructions to: (i) a designated brokerage firm to effect the immediate
sale of the purchased shares and remit to Electronic Sensor Technology, out of
the sale proceeds available on the settlement date, sufficient funds to cover
the aggregate exercise price payable for the purchased shares plus all
applicable federal, state and local income and employment taxes required to be
withheld by Electronic Sensor Technology by reason of such exercise and (ii)
Electronic Sensor Technology to deliver the certificates for the purchased
shares directly to such brokerage firm in order to complete the sale. The term
of an option granted pursuant to the Discretionary Option Grant Program may not
be more than 10 years.
The Discretionary Option Grant Program also allows for the granting of
Incentive Options to purchase common stock, which may only be granted to
employees, and are subject to certain dollar limitations. Any options granted
under the Discretionary Option Grant Program that are not Incentive Options are
considered Non-Statutory Options and are governed by the aforementioned terms.
The exercise price of an Incentive Option must be no less than 100% of the fair
market value of the
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common stock on the date of grant, unless the recipient of an award owns 10% or
more of Electronic Sensor Technology's common stock, in which case the exercise
price of an incentive stock option must not be less than 110% of the fair market
value. The term of an Incentive Option granted may not be more than five years
if the option is granted to a recipient who owns 10% or more of Electronic
Sensor Technology's common stock, or 10 years for all other recipients of
Incentive Options. Incentive Options are otherwise governed by the general terms
of the Discretionary Option Grant Program.
Pursuant to the terms of the Stock Issuance Program, the purchase price per
share of common stock issued is fixed by the administrator, but may not be less
than 85% of the fair market value of the common stock on the issuance date,
unless the recipient of a such common stock owns 10% or more of Electronic
Sensor Technology's common stock, in which case the purchase price must not be
less than 100% of the fair market value. Common stock may be issued in exchange
for cash or past services rendered to Electronic Sensor Technology (or any
parent or subsidiary of Electronic Sensor Technology). Common stock issued may
be fully and immediately vested upon issuance or may vest in one or more
installments, at the discretion of the administrator.
EXECUTIVE COMPENSATION
For the fiscal years ended December 31, 2003 and December 31, 2004 and for
the period from January 1, 2005 through January 31, 2005, no salary or any other
compensation was paid to any named executive officer of Bluestone for services
provided to us. The table below outlines the compensation of the named executive
officers of Electronic Sensor Technology for the fiscal year ended December 31,
2005, beginning on February 1, 2005, the date upon which Electronic Sensor
Technology, Inc. acquired Electronic Sensor Technology, L.P.:
SUMMARY COMPENSATION TABLE
LONG-TERM COMPENSATION
AWARDS
SECURITIES
RESTRICTED STOCK UNDERLYING
NAME AND SALARY AWARD(S) OPTIONS/SARS
PRINCIPAL POSITION YEAR ($) ($)(6) (#)
---------------------------------------- ------------ ------- ---------------- --------------
Matthew Collier, President and Chief
Executive Officer (May 26, 2005-January
25, 2006) 2005 135,384 24,750(1) 500,000
Edward Staples, President and Chief
Executive Officer (February 1, 2005-May
26, 2005), Chief Scientific Officer (May
26, 2005-present) 2005 132,411 0 100,000(2)
Francis Chang, Secretary and Vice
President of Finance and Administration 2005 123,888 0 80,000(3)
Teong Lim, Vice President of Corporate
Development 2005 111,316 0 80,000(4)
Gary Watson, Vice President of
Engineering 2005 120,898 0 175,000(5)
(1) Matthew Collier was granted, on May 26, 2005, the right to receive 75,000
shares of restricted common stock, subject to approval by the Board of
Directors, pursuant to a letter agreement of employment entered into with
Electronic Sensor Technology. On January 25, 2006, Mr. Collier was granted
75,000 shares of restricted common stock, subject to a right of first refusal on
the part of Electronic Sensor Technology in the event Mr. Collier decides to
sell such shares. Such shares have been valued, for purposes of the Summary
Compensation Table, at $0.33 per share, the closing quotation on the
Over-the-Counter Bulletin Board on January 25, 2006.
-39-
(2) Edward Staples was granted options to purchase 100,000 limited partnership
interests of Electronic Sensor Technology, L.P. at $1.00 per limited partnership
interest on December 31, 2003. Such options were terminated in connection with
the merger whereby Electronic Sensor Technology, L.P. became an indirect
subsidiary of Electronic Sensor Technology, Inc., and were replaced with options
to purchase 100,000 shares of common stock at $1.00 per share.
(3) Francis Chang was granted options to purchase 80,000 limited partnership
interests of Electronic Sensor Technology, L.P. at $1.00 per limited partnership
interest on December 31, 2003. Such options were terminated in connection with
the merger whereby Electronic Sensor Technology, L.P. became an indirect
subsidiary of Electronic Sensor Technology, Inc., and were replaced with options
to purchase 80,000 shares of common stock at $1.00 per share.
(4) Teong Lim was granted options to purchase 80,000 limited partnership
interests of Electronic Sensor Technology, L.P. at $1.00 per limited partnership
interest on December 31, 2003. Such options were terminated in connection with
the merger whereby Electronic Sensor Technology, L.P. became an indirect
subsidiary of Electronic Sensor Technology, Inc., and were replaced with options
to purchase 80,000 shares of common stock at $1.00 per share.
(5) Gary Watson was granted options to purchase (i) 50,000 limited partnership
interests of Electronic Sensor Technology, L.P. at $1.00 per limited partnership
interest on March 15, 1999, (ii) 50,000 limited partnership interests of
Electronic Sensor Technology, L.P. at $1.05 per limited partnership interest on
July 1, 2000, (iii) 50,000 limited partnership interests of Electronic Sensor
Technology, L.P. at $1.05 per limited partnership interest on May 15, 2001 and
(iv) 25,000 limited partnership interests of Electronic Sensor Technology, L.P.
at $1.05 per limited partnership interest on September 15, 2002. Such options
were terminated in connection with the merger whereby Electronic Sensor
Technology, L.P. became an indirect subsidiary of Electronic Sensor Technology,
Inc., and were replaced with options to purchase 50,000 shares of common stock
at $1.00 per share and options to purchase 125,000 shares of common stock at
$1.05 per share.
(6) As of December 31, 2005, there were no shares of restricted common stock of
Electronic Sensor Technology outstanding. Only a right to receive 75,000 shares
of restricted common stock, subject to approval by the Board of Directors, was
held by Matthew Collier as of December 31, 2005. On January 25, 2006, the 75,000
shares of restricted common stock were issued to Mr. Collier, valued at $24,750,
in the aggregate, for purposes of the Summary Compensation Table. Such shares of
restricted common stock have been valued, for purposes of the Summary
Compensation Table, at $0.33 per share, the closing quotation on the
Over-the-Counter Bulletin Board on January 25, 2006, the date of the grant of
restricted common stock. The 75,000 shares were all fully vested on the date of
the grant, but are restricted by a right of first refusal on the part of
Electronic Sensor Technology in the event Mr. Collier decides to sell such
shares. Aside from the right of first refusal on our part, the shares of
restricted common stock carry the same rights and privileges as our unrestricted
shares of common stock, including the right to receive dividends, if any.
Individual grants of stock options (whether or not in tandem with stock
appreciation rights (SARs)), and freestanding SARs made during the fiscal year
ended December 31, 2005 to each of the named executed officers are outlined in
the table below:
OPTION/SAR GRANTS IN LAST FISCAL YEAR
(INDIVIDUAL GRANTS)
PERCENT OF
NUMBER OF TOTAL
SECURITIES OPTIONS/SARS
UNDERLYING GRANTED TO EXERCISE OF
OPTIONS/SARS EMPLOYEES IN BASE PRICE
NAME GRANTED (#) FISCAL YEAR ($/SH) EXPIRATION DATE
--------------- --------------- --------------- --------------- ---------------
Matthew Collier 500,000 100% .64 May 26, 2015
Edward Staples (1)
Francis Chang (2)
Teong Lim (3)
Gary Watson (4)
-40-
(1) Edward Staples was granted options to purchase 100,000 limited partnership
interests of Electronic Sensor Technology, L.P. at $1.00 per limited partnership
interest on December 31, 2003. Such options were terminated in connection with
the merger whereby Electronic Sensor Technology, L.P. became an indirect
subsidiary of Electronic Sensor Technology, Inc., and were replaced with options
to purchase 100,000 shares of common stock at $1.00 per share. In connection
with such merger, Dr. Staples also received a warrant to purchase 343,708 shares
of common stock at $1.00 per share in exchange for the cancellation of debt owed
by Electronic Sensor Technology, L.P. The warrant was issued to Dr. Staples
solely in exchange for the cancellation of such debt, and not as compensation.
(2) Francis Chang was granted options to purchase 80,000 limited partnership
interests of Electronic Sensor Technology, L.P. at $1.00 per limited partnership
interest on December 31, 2003. Such options were terminated in connection with
the merger whereby Electronic Sensor Technology, L.P. became an indirect
subsidiary of Electronic Sensor Technology, Inc., and were replaced with options
to purchase 80,000 shares of common stock at $1.00 per share. In connection with
such merger, Mr. Chang also received a warrant to purchase 257,247 shares of
common stock at $1.00 per share in exchange for the cancellation of debt owed by
Electronic Sensor Technology, L.P. The warrant was issued to Mr. Chang solely in
exchange for the cancellation of such debt, and not as compensation.
(3) Teong Lim was granted options to purchase 80,000 limited partnership
interests of Electronic Sensor Technology, L.P. at $1.00 per limited partnership
interest on December 31, 2003. Such options were terminated in connection with
the merger whereby Electronic Sensor Technology, L.P. became an indirect
subsidiary of Electronic Sensor Technology, Inc., and were replaced with options
to purchase 80,000 shares of common stock at $1.00 per share. In connection with
such merger, Dr. Lim also received a warrant to purchase 438,796 shares of
common stock at $1.00 per share in exchange for the cancellation of debt owed by
Electronic Sensor Technology, L.P. The warrant was issued to Dr. Lim solely in
exchange for the cancellation of such debt, and not as compensation.
(4) Gary Watson was granted options to purchase (i) 50,000 limited partnership
interests of Electronic Sensor Technology, L.P. at $1.00 per limited partnership
interest on March 15, 1999, (ii) 50,000 limited partnership interests of
Electronic Sensor Technology, L.P. at $1.05 per limited partnership interest on
July 1, 2000, (iii) 50,000 limited partnership interests of Electronic Sensor
Technology, L.P. at $1.05 per limited partnership interest on May 15, 2001 and
(iv) 25,000 limited partnership interests of Electronic Sensor Technology, L.P.
at $1.05 per limited partnership interest on September 15, 2002. Such options
were terminated in connection with the merger whereby Electronic Sensor
Technology, L.P. became an indirect subsidiary of Electronic Sensor Technology,
Inc., and were replaced with options to purchase 50,000 shares of common stock
at $1.00 per share and options to purchase 125,000 shares of common stock at
$1.05 per share.
AGGREGATED OPTION/SAR EXERCISES IN THE LAST FISCAL YEAR AND FY-END
OPTION/SAR VALUES
NUMBER OF
SECURITIES VALUE OF
UNDERLYING UNEXERCISED
SHARES UNEXERCISED IN-THE-MONEY
ACQUIRED OPTIONS/SARS OPTIONS/SARS
ON VALUE AT FY-END (#) AT FY-END ($)
EXERCISE REALIZED EXERCISABLE/ EXERCISABLE/
NAME (#) ($) UNEXERCISABLE UNEXERCISABLE
--------------- --------------- --------------- --------------- ---------------
Matthew Collier N/A N/A 0/500,000 N/A
Edward Staples N/A N/A 100,000/0 N/A
Francis Chang N/A N/A 80,000/0 N/A
Teong Lim N/A N/A 80,000/0 N/A
Gary Watson N/A N/A 175,000/0 N/A
-41-
COMPENSATION OF DIRECTORS
Commencing April 2005, each director who is not an employee is paid $2,500
per meeting. Mr. Frey, as the Chairman of the Board of Directors, is also
provided with a business class airline ticket for meetings requiring more than
two hours travel, and out-of-pocket expenses. On October 7, 2005, Mr. Frey was
granted 250,000 non-qualified stock options to acquire common stock at an
exercise price of $0.64 per share, under our 2005 Stock Incentive Plan. Mr.
Frey's stock options will vest as follows: one quarter of the options will vest
on March 8, 2006, one quarter on September 8, 2006, one quarter on March 8, 2007
and one quarter on September 8, 2007, provided he is still participating as a
member of our Board of Directors at the end of each such six-month period.
EMPLOYMENT CONTRACTS
On May 16, 2005, Electronic Sensor Technology entered into a letter
agreement with Matthew Collier, who was appointed President and Chief Executive
Officer on May 26, 2005. Pursuant to the letter agreement, Mr. Collier agreed to
serve as President and Chief Executive Officer of Electronic Sensor Technology
for at an annual salary of $220,000 per year and a potential target bonus of 25%
of such annual salary, to be paid at the discretion of the Board of Directors.
The letter agreement also provides for a grant of 75,000 shares of restricted
common stock that may be traded one year from Mr. Collier's date of employment
and an additional 75,000 shares of restricted common stock to be granted one
year from Mr. Collier's date of employment, if Mr. Collier remains an employee
of Electronic Sensor Technology, tradable on the first anniversary of such
grant. The letter agreement also provides for a grant of 500,000 options to
purchase common stock, 33% of which will vest on each of the first and second
anniversaries of Mr. Collier's date of employment and the remaining 34% of which
will vest on the third anniversary of Mr. Collier's date of employment. On
January 25, 2006, the letter agreement with Mr. Collier was mutually terminated
by Mr. Collier and Electronic Sensor Technology (other than that portion of the
letter agreement relating to indemnification of Mr. Collier for liability
incurred within the scope of his employment with the Registrant, embodied in
Section 7 of the letter agreement), by way of a Settlement Agreement, Mutual
Release and Amendment of Option Agreement entered into between Mr. Collier and
Electronic Sensor Technology in connection with the resignation of Mr. Collier
as President and Chief Executive Officer and a director of Electronic Sensor
Technology, effective January 25, 2006.
The terms of the Settlement Agreement, Mutual Release and Amendment of
Option Agreement in large part carried out the terms of the letter agreement
dated May 16, 2005 with Mr. Collier. Specifically, the Settlement Agreement,
Mutual Release and Amendment of Option Agreement provided for (i) the payment of
six months' base salary to Mr. Collier, totaling $110,000, over the course of 13
biweekly payroll periods, (ii) the payment of a bonus in the sum of $18,334
earned through the date of Mr. Collier's resignation, (iii) the acceleration by
six months of the vesting schedule of Mr. Collier's options to purchase 500,000
shares of common stock, each of (i) through (iii) as provided for in the letter
agreement in the event of a termination without cause and (iv) the issuance of
75,000 shares of restricted common stock, as contemplated in the letter
agreement. The Settlement Agreement, Mutual Release and Amendment of Option
Agreement also provided for the vesting of options to purchase 200,000 shares of
common stock in the first vesting period of the vesting schedule of Mr.
Collier's options to purchase 500,000 shares of common stock, described above.
As a result of the six-month acceleration of the vesting schedule, such vesting
of options to purchase 200,000 shares of common stock was deemed to occur on
November 26, 2005. In accordance with the terms of Mr. Collier's Option
Agreement, Mr. Collier's resignation will result in the forfeiture of the
remaining unvested options to
-42-
purchase 300,000 shares of common stock, and Mr. Collier will have three months
from January 25, 2006 in which to exercise the vested options to purchase
200,000 shares of common stock.
Other than the terminated letter agreement with Mr. Collier, we have no
employment agreements with any of our named executive officers, nor do we have
any compensatory plans or arrangements with respect to any named executive
officers that results or will result from the resignation, retirement or any
other termination of such executive officer's employment with Electronic Sensor
Technology or from a change-in-control of Electronic Sensor Technology or a
change in the named executive officer's responsibilities following a
change-in-control wherein the amount involved, including all periodic payments
or installments, exceeds $100,000.
REPORT ON REPRICING OF OPTIONS/SARs
On May 26, 2005, Matthew Collier, former President and Chief Executive
Officer of Electronic Sensor Technology, entered into a letter agreement of
employment with Electronic Sensor Technology pursuant to which we agreed to
grant Mr. Collier options to purchase 500,000 shares of common stock at an
exercise price of $1.50 per share, subject to approval by the Board of
Directors. On September 8, 2005, the Board of Directors approved the granting of
such options and also approved a repricing of the options from the $1.50 per
share exercise price stated in the May 26, 2005 letter agreement to $0.64 per
share, the closing price of the common stock on September 8, 2005. On October 7,
2005, Electronic Sensor Technology entered into an Option Agreement with Mr.
Collier, substantially in the form attached as Exhibit 10.2 to our annual report
on Form 10-KSB for the fiscal year ended December 31, 2004 filed with the
Commission on April 15, 2005 for the granting of options to purchase 500,000
shares of common stock at an exercise price of $0.64 per share.
-43-
FINANCIAL STATEMENTS
INDEX TO FINANCIAL STATEMENTS
AUDITED FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2005
Report of Independent Registered Public Accounting Firm F-1
Consolidated Balance Sheet as of December 31, 2005 F-2
Consolidated Statements of Operations for the Year Ended
December 31, 2005 F-3
Consolidated Statement of Changes in Stockholders' Deficit
for the Period from January 1, 2004 to December 31, 2005 F-4
Consolidated Statements of Cash Flows for the Year Ended December 31, 2005 F-5
Notes to Consolidated Financial Statements F-6
UNAUDITED FINANCIAL STATEMENTS FOR THE SIX MONTHS ENDED JUNE, 2006
Consolidated Balance Sheet (Unaudited) as of June 30, 2006 F-28
Consolidated Statements of Operations (Unaudited) for the Three
and Six Months Ended June 30, 2006 and 2005 F-29
Consolidated Statements of Cash Flows (Unaudited) for the Six Months
Ended June 30, 2006 and 2005 F-30
Notes to Consolidated Financial Statements F-31
-44-
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Electronic Sensor Technology, Inc.
We have audited the accompanying balance sheet of Electronic Sensor
Technology, Inc. as of December 31, 2005 and the related consolidated statements
of operations, changes in stockholders' deficit and cash flows for the years
ended December 31, 2005 and 2004. 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 the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. 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,
the consolidated financial position of Electronic Sensor Technology, Inc., as of
December 31, 2005 and the consolidated results of its operations and its cash
flows for the years ended December 31, 2005 and 2004 in conformity with
accounting principles generally accepted in the United States of America.
As discussed in Note 14 to the accompanying financial statements, the
Company has restated its financial statements as of and for the year ended
December 31, 2005 to reflect additional non-operating gains and losses, the
classification of embedded conversion features, warrants and liquidated damages
as derivative liabilities and to adjust revenues related to a one-time licensing
fee.
/s/ Sherb & Co., LLP
Sherb & Co., LLP
Certified Public Accountants
New York, New York
February 20, 2006
With respect to Note 14, the date is July 12, 2006
F-1
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEET
DECEMBER 31, 2005
ASSETS
(Restated)
CURRENT ASSETS:
Cash and cash equivalents $ 4,219,921
Certificate of deposit-restricted 918,678
Accounts receivable, net of allowance for
doubtful accounts of $20,577 465,776
Prepaid expenses 69,936
Inventories 939,622
--------------
TOTAL CURRENT ASSETS 6,613,933
--------------
DEFERRED FINANCING COSTS, net of amortization of $17,297 711,062
PROPERTY AND EQUIPMENT, net of accumulated
depreciation of $917,010 112,548
SECURITY DEPOSITS 12,817
--------------
$ 7,450,360
==============
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES:
Accounts payable and accrued expenses 480,799
Deferred revenues 141,667
Derivative liabilities 5,771,079
--------------
TOTAL CURRENT LIABILITIES 6,393,545
--------------
CONVERTIBLE DEBENTURES, net of unamortized discount
of $6,805,556 194,444
--------------
TOTAL LIABILITIES 6,587,989
--------------
STOCKHOLDERS' DEFICIT:
Preferred stock, $.001 par value 50,000,000
shares authorized, none issued and outstanding -
Common stock, $.001 par value, 200,000,000
shares authorized, 54,098,745 issued and outstanding 54,099
Additional paid-in capital 8,495,429
Accumulated deficit (7,687,157)
--------------
TOTAL STOCKHOLDERS' DEFICIT 862,371
--------------
$ 7,450,360
==============
See notes to consolidated financial statements
F-2
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended
December 31,
----------------------------------
2005 2004
--------------- ---------------
(Restated) (Restated)
REVENUES $ 2,122,349 $ 1,076,749
COST OF SALES 1,302,602 1,039,280
--------------- ---------------
GROSS PROFIT 819,747 37,469
--------------- ---------------
OPERATING EXPENSES:
Research and development 260,125 -
Compensation 466,421 81,734
Selling 653,092 161,546
General and administrative 1,522,451 225,229
--------------- ---------------
TOTAL OPERATING EXPENSES 2,902,089 468,509
--------------- ---------------
LOSS FROM OPERATIONS (2,082,342) (431,040)
--------------- ---------------
OTHER INCOME AND EXPENSE:
Other income - derivative liabilites 7,577,929 -
Other expense - derivative liabilites (2,401,358) -
Gain (loss) on sale of property and equipment 9,287 (7,710)
Interest expense (324,540) (164,133)
--------------- ---------------
TOTAL OTHER INCOME AND (EXPENSE) 4,861,318 (171,843)
--------------- ---------------
NET (LOSS)INCOME $ 2,778,976 $ (602,883)
=============== ===============
Earnings (loss) per share, basic $ 0.05 $ (0.01)
=============== ===============
Weighted average number of shares, basic 53,636,560 53,525,865
=============== ===============
Earnings (loss) per share, diluted $ (.04) $ (0.01)
=============== ===============
Weighted average number of shares, diluted 53,636,560 53,525,865
=============== ===============
See notes to consolidated financial statements
F-3
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' DEFICIT
(Restated)
Common Stock Preferred Stock Additional
-------------------------------- ------------------- Paid-In
Shares Amount Shares Amount Capital
-------------- -------------- -------- -------- --------------
BALANCE - January 1, 2004 81,279,000 $ 81,279 - $ - $ 4,500,000
Sale of Partnership interest -
Class C - - - - 200,000
Note payable related party -
interest waived - - - - 63,774
Net loss - - - - -
-------------- -------------- -------- -------- --------------
BALANCE - December 31, 2004 81,279,000 81,279 - - 4,763,774
Cancellation of common stock (54,279,147) (54,279) - - 54,279
Notes payable converted to
common stock 1,272,000 1,272 - - 1,270,728
Reverse acquisition - - - - (89,325)
Sale of common stock 3,985,000 3,985 - - (3,985)
Deferred compensation
contributed to capital - - - - 934,957
Officers loans converted to
common stock 1,198,630 1,199 - - 1,197,431
Issuance of shares for
services 130,000 130 - - 74,820
Accrued interest converted
to common stock 313,262 313 - - 312,950
Common stock issued for
acquisition of EST 20,200,000 20,200 - - (20,200)
Net income - - - - -
-------------- -------------- -------- -------- --------------
BALANCE - December 31, 2005 54,098,745 $ 54,099 - $ - $ 8,495,429
============== ============== ======== ======== ==============
Total
Accumulated Stockholders'
Deficit Deficit
-------------- --------------
BALANCE - January 1, 2004 $ (9,863,250) $ (5,281,971)
Sale of Partnership interest -
Class C - 200,000
Note payable related party -
interest waived - 63,774
Net loss (602,883) (602,883)
-------------- --------------
BALANCE - December 31, 2004 (10,466,133) (5,621,080)
Cancellation of common stock - -
Notes payable converted to
common stock - 1,272,000
Reverse acquisition - (89,325)
Sale of common stock - -
Deferred compensation
contributed to capital - 934,957
Officers loans converted to
common stock - 1,198,630
Issuance of shares for
services - 74,950
Accrued interest converted
to common stock - 313,263
Common stock issued for
acquisition of EST - -
Net loss 2,778,976 2,778,976
-------------- --------------
BALANCE - December 31, 2005 $ (7,687,157) $ 862,371
============== ==============
See notes to consolidated financial statements.
F-4
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended
December 31,
--------------------------------
2005 2004
-------------- --------------
(Restated) (Restated)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 2,778,976 $ (602,883)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization 21,300 11,223
Issuance of shares for services 74,950 -
Recognition of derivative liabilities 2,401,358 -
Amortization of debt discount 194,444 -
Amortization of deferred financing costs 17,297 -
Notes payable related party - interest waived - 63,774
Decrease in fair value of derivative liability (7,577,929) -
Changes in assets and liabilities:
Accounts receivable (435,089) 363,042
Inventories (458,974) (87,544)
Prepaid expenses (55,679) 2,312
Security deposits 140 -
Accounts payable and accrued expenses 266,578 (66,120)
Deferred revenues (50,000) 191,667
Due to related party (60,000) (40,910)
Interest payable (26,961) 4,364
Other current liabilities (35,665) (6,773)
-------------- --------------
Net cash provided by (used in) operating activities (2,945,254) (167,848)
-------------- --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of property and equipment 43,933 12,198
Purchase of certificate deposit (918,678)
Purchase of property and equipment (126,582) (35,113)
-------------- --------------
Net cash (used in) investing activities (1,001,327) (22,915)
-------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Increase (decrease) in line of credit (1,969,137) 17,000
Repayment of partners' loans payable (110,000) (120,000)
Proceeds from issuance of common stock 3,811,708 200,000
Proceeds from convertible debenture 7,000,000 -
Payment of deferred financing costs (592,500) -
-------------- --------------
Net cash provided by financing activities 8,140,071 97,000
-------------- --------------
NET INCREASE (DECREASE) IN CASH 4,193,491 (93,763)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 26,430 119,968
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 4,219,921 $ 26,205
============== ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest $ 102,928 $ 87,284
============== ==============
Taxes $ - $ -
============== ==============
NON-CASH INVESTING AND FINANCING ACTIVITIES
Notes payable, loans payable and accrued expenses converted into
Common stock and additional paid-in capital $ 3,718,849 $ -
============== ==============
Fair value of derivative liability recorded as debt discount on
convertible debentures $ 7,000,000 $ -
============== ==============
Fair value of derivative liability recorded as deferred financing costs $ 135,859 -
============== ==============
See notes to consolidated financial statements.
F-5
ELECTRONIC SENSOR TECHNOLOGY, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2005
(1) NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF BUSINESS
Electronic Sensor Technology, Inc. (the "Company") (formerly Bluestone
Ventures, Inc.) develops and manufactures electronic devices used for vapor
analysis. It markets its products through distribution channels in over 20
countries.
BASIS OF CONSOLIDATION
The accompanying financial statements include the accounts of the Company
and its wholly owned subsidiaries. All intercompany balances and transactions
have been eliminated in consolidation. Bluestone Ventures, Inc. ("Bluestone")
executed an Agreement and Plan of Merger ("Merger Agreement") by and among
Bluestone, Amerasia Technology, Inc., ("Amerasia"), holder of approximately 55%
of the partnership interests of Electronic Sensor Technology, L.P., ("EST"), L &
G Sensor Technology, L.P., ("L&G"), holder of approximately 45% of the
partnership interests of EST, Amerasia Acquisition Corp., ("AAC") a wholly-owned
subsidiary of Bluestone, and L & G Acquisition Corp., ("LAC") a wholly owned
subsidiary of Bluestone on January 31, 2005. Under the Merger Agreement (i) AAC
merged with and into Amerasia such that Amerasia became a wholly-owned
subsidiary of Bluestone, (ii) LAC merged with and into L&G such that L&G became
a wholly-owned subsidiary of Bluestone, (iii) as a result of the merger of (i)
and (ii), Bluestone indirectly acquired all of the partnership interests of EST
and (iv) Bluestone issued 20,000,000 shares of its common stock to the
shareholders of Amerasia and L&G. This merger has been treated as a purchase
only of the partnership interests of Electronic Sensor Technology L.P.
For accounting purposes, the transaction was treated as a recapitalization
of EST and accounted for as a reverse acquisition. Prior to the merger,
Bluestone was a non-operating public shell and EST was a privately-held
operating limited partnership. Accordingly, the accompanying financial
statements include the accounts of EST for the period from January 1, 2004 to
December 31, 2005 and the accounts of Bluestone from February 1, 2005 to
December 31, 2005.
CASH AND CASH EQUIVALENTS
The Company considers highly liquid financial instruments with maturities
of three months or less at the time of purchase to be cash equivalents. The
Company did not have any cash equivalents at December 31, 2005.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying value of cash and cash equivalents, certificate of deposit,
accounts receivables, accounts payable and accrued expenses approximate their
fair value due to their short-term maturities. The fair value of the convertible
debentures amounts to $7,000,000, based on the Company's incremental borrowing
rate. The carrying value of the derivative liability associated with the
convertible debentures represents its fair value.
CONCENTRATION OF CREDIT RISKS
The Company is subject to concentrations of credit risk primarily from cash
and cash equivalents and accounts receivable. The Company maintains accounts
with financial institutions, which at times exceeds the insured limit of
approximately $100,000. The Company minimizes its credit risks associated with
cash by periodically evaluating the credit quality of its primary financial
institutions. The Company's accounts receivables are due from distributors in
all other countries in which it markets its products. The Company does not
require collateral to secure its accounts receivables. Three of the Company's
customers accounted for approximately 36%, 16% and 16%, respectively, of its net
accounts receivable at December 31, 2005. No other customers accounted for more
than 10% of its net accounts receivables.
PRODUCT CONCENTRATION RISK
Substantially all of the Company's revenues derive from the sale of
electronic devices used for vapor analysis.
F-6
CUSTOMER CONCENTRATION RISK
One of the Company's customers accounted for 29% of its revenues during
2005 and two of the Company's customers accounted for 20% and 10%, respectively
of its revenues during 2004. No other customers accounted for more than 10% of
its revenues.
INVENTORIES
Inventories are stated at the lower of cost or market, cost determined by
the first-in, first-out (FIFO) method. The Company writes down its inventory for
estimated obsolescence or unmarketable inventory using the difference between
the cost of inventory and the estimated market value based upon assumptions
about future demand and market conditions. The Company writes down inventory
during the period in which such products are no longer marketable in any of
their markets due to governmental regulations as well as inventory which matures
within the next three months.
PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and are depreciated on a
straight-line basis over their estimated useful lives of five years. Maintenance
and repairs are charged to expense as incurred. Significant renewals and
betterments are capitalized.
Property and equipment consist of the following as of December 31, 2005:
Machinery and equipment $ 777,017
Leasehold improvements 39,500
Office furniture and equipment 213,041
---------
1,029,558
Accumulated depreciation (917,010)
---------
$ 112,548
=========
Depreciation expense amounted to approximately $21,000 and $11,000 during
2005 and 2004, respectively.
DEFERRED FINANCING COSTS
Deferred financing costs consists of direct costs incurred by the Company
in connection with the issuance of its convertible debentures. The direct costs
include cash payments and fair value of warrants issued to the placement agent
which secured the financing. Deferred financing costs are amortized over the
term of the related convertible debentures using the effective interest rate
method.
INCOME TAXES
Income taxes are accounted for in accordance with SFAS No. 109, Accounting
for Income Taxes. SFAS No. 109 requires the recognition of deferred tax assets
and liabilities to reflect the future tax consequences of events that have been
recognized in the Company's financial statements or tax returns. Measurement of
the deferred items is based on enacted tax laws. In the event the future
consequences of differences between financial reporting bases and tax bases of
the Company's assets and liabilities result in a deferred tax asset, SFAS No.
109 requires an evaluation of the probability of being able to realize the
future benefits indicated by such assets. A valuation allowance related to a
deferred tax asset is recorded when it is more likely than not that some or the
entire deferred tax asset will not be realized.
USE OF ESTIMATES
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting periods. Significant estimates made by management include,
but are not limited to, the realization of receivables and the valuation of the
derivative liability. Actual results may differ from these estimates.
F-7
BASIC AND DILUTED EARNINGS PER SHARE
Basic earnings per share is calculated by dividing income available to
stockholders by the weighted-average number of common shares outstanding during
each period. Diluted earnings per share is computed using the weighted-average
number of common and dilutive common share equivalents outstanding during the
period. Dilutive common share equivalents consist of shares issuable upon the
exercise of stock options and warrants embedded conversion features (calculated
using the reverse treasury stock method). The outstanding options, warrants and
shares equivalent issuable pursuant to embedded conversion features amounted to
45,612,115 and 0 at December 31, 2005 and 2004, respectively. The outstanding
options, warrants and shares equivalent issuable pursuant to embedded conversion
features and warrants at December 31, 2004 are excluded from the loss per share
computation for that period due to their antidilutive effect. The Company
adjusted the numerator for any changes in income or loss that would result if
the contract had been reported as an equity instrument for accounting purposes
during 2005. However, the Company did not adjust the numerator for interest
charges during 2005 on the convertible debentures because it would have been
anti-dilutive.
The following sets forth the computation of basic and diluted earnings per share
for the year ended December 31:
2005 2004
-------------- --------------
(Restated) (Restated)
Numerator:
Net (loss) income $ 2,778,976 $ (602,883)
Net other income (expense) associated with derivative contracts (5,176,571) -
-------------- --------------
Net loss for diluted earnings per share purposes ($ 2,397,595) ($ 602,883)
============== ==============
Denominator:
Denominator for basic earnings per share - Weighted average shares outstanding 53,636,560 53,525,865
Effect of dilutive warrants, embedded conversion features and liquidated damages - -
-------------- --------------
Denominator for diluted earnings per share - Weighted average shares outstanding 53,636,560 53,525,865
============== ==============
Basic earnings (loss) per share $ 0.05 $ (0.01)
============== ==============
Diluted earnings (loss) per share $ (0.04) $ (0.01)
============== ==============
STOCK-BASED COMPENSATION
The Company accounts for stock options issued to employees in accordance
with the provisions of Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations. As
such, compensation cost is measured on the date of grant as the excess of the
current market price of the underlying stock over the exercise price. Such
compensation amounts, if any, are amortized over the respective vesting periods
of the option grant. The Company adopted the disclosure provisions of SFAS No.
123, "Accounting for Stock-Based Compensation" and SFAS 148, "Accounting for
Stock-Based Compensation -Transition and Disclosure", which permits entities to
provide pro forma net income and pro forma earnings per share disclosures for
employee stock option grants as if the fair-valued based method defined in SFAS
No. 123 had been applied. The Company accounts for stock options and stock
issued to non-employees for goods or services in accordance with the fair value
method of SFAS 123.
ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses at December 31, 2005 consist
primarily of vendor payables.
DEFERRED REVENUES
Deferred revenues at December 31, 2005 amounted to $141,667. The deferred
revenues consist of a one-time licensing fee received by the Company during 2004
and is recognized over the term of the agreement which is five years. The
Company recognized revenues of $50,000 and $58,333 pursuant to this agreement
during 2005 and 2004, respectively.
F-8
DERIVATIVE LIABILITIES
The Company accounts for its liquidated damages granted pursuant to a
separate registration rights agreement pursuant to Emerging Issue Task Force
("EITF") 05-04, View C, "The Effect of a Liquidated Damages Clause on a
Freestanding Financial Instrument", subject to EITF Issue No. 00-19, "Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock". Pursuant to EITF 05-04, View C, liquidated damages payable
in cash or stock are accounted for as a separate derivative, which requires a
periodical valuation of its fair value and a corresponding recognition of
liabilities associated with such derivative.
The Company accounts for liquidated damages granted pursuant to
registration rights which are not included in a separate registration right
agreement as a combined unit with the warrants which are contemporaneously
issued with the registration rights pursuant to SFAS 133 "Accounting for
Derivative and Hedging Activities" and EITF 00-19.
The Company accounts for its embedded conversion features and freestanding
warrants pursuant to SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities", which requires a periodic valuation of their fair value, at
issuance and at each subsequent balance sheet date, and a corresponding
recognition of liabilities associated with such derivatives. The recognition of
derivative liabilities related to the issuance of shares of common stock is
applied first to the proceeds of such issuance, at the date of issuance, and the
excess of derivative liabilities over the proceeds is recognized as other
expense in the accompanying consolidated financial statements. The recognition
of derivative liabilities related to the issuance of convertible debt is applied
first to the proceeds of such issuance as a debt discount, at the date of
issuance, and the excess of derivative liabilities over the proceeds is
recognized as other expense in the accompanying consolidated financial
statements. Any subsequent increase or decrease in the fair value of the
derivative liabilities, which are measured at the balance sheet date, are
recognized as other expense or other income, respectively.
Embedded conversion features represent embedded derivatives which are
separated from their host and accounted for as derivatives. An embedded
derivative instrument may consist of:
1) The underlying is an interest rate that alters net interest payments
such that they could at least double the investor's initial rate of
return on the host contract, such as an interest bearing debenture,
and that is at least twice what would otherwise be the market return
for a contract that has the same terms as the host contract and that
involves a debtor with similar credit quality;
2) The underlying is a an debt instrument which provides for non-standard
anti-dilution provisions upon conversion of a debt instrument into
equity, such as anti-dilution provisions which reset to a lower
conversion price than initially stated in the debt instrument in the
event of a subsequent financing with a lower effective price which
classify the debt instrument as non-conventional debt;
3) The underlying is a debt instrument which provides for variable number
of shares upon conversion of a debt instrument into equity;
4) The underlying is an instrument which provides for acceleration of the
repayment of a principal on a debt instrument that requires principal
repayments if the debt involves a substantial premium and the
acceleration is only contingently exercisable and is not indexed to
interest rates or credit risk.
Freestanding warrants may be recorded as derivative liabilities if they
allow for net-cash settlement or if they give the counterparty a choice of
net-cash or physical settlement or would not qualify for the following
conditions for equity classification, among others:
1) The Company does not have sufficient authorized and unissued shares
available to settle the contract after considering all other
commitments that may require the issuance of stock during the maximum
period the derivative contract could remain outstanding;
2) The contract does not contain an explicit limit on the number of
shares to be delivered in a share settlement;
F-9
3) The contract provides for cash payments to the counterparty in the
event the Company fails to make timely filings with the SEC.
In June 2005, the Financial Accounting Standard Board issued EITF 05-04.
EITF 05-04 addresses the question as to whether liquidated damages pursuant to a
registration rights agreement should be combined as a unit with the underlying
financial instruments and be evaluated as a single instrument. EITF 05-04 does
not reach a consensus on this matter and allows for the treatment as a combined
unit (Views A and B) as well as separate freestanding financial instruments
(View C). On September 15, 2005, the FASB staff postponed further discussion of
EITF 05-04. As of May 31, 2006, the FASB still has not rescheduled EITF 05-04
for further discussion.
In connection with the issuance of a convertible debentures and related
warrants, we granted liquidated damages pursuant to a separate registration
right agreement. The Company adopted View C of EITF 05-04. Accordingly, the
liquidated damages pursuant to this registration right agreement were evaluated
as a stand alone financial instrument. This treatment did not have a significant
different effect than if the Company would have adopted View A or B, because the
classification of the warrants and certain embedded features of the convertible
debentures were classified as derivative liabilities. The Company believes that
should the FASB staff reach a consensus on EITF 05-04 and select combined
treatment (View A or B), the embedded conversion features and the warrants will
have to be evaluated as a combined unit with the liquidated damages pursuant to
the registration rights agreement, and accordingly, be evaluated as derivative
liabilities. The Company does not believe that its measurement of the derivative
liabilities under View A or View B would significantly differ from its
measurement of the derivative liabilities under View C in these circumstances.
The classification of each contract (e.g., embedded conversion feature,
liquidated damage, freestanding warrant) is reassessed at each balance sheet
date. If the classification required under EITF 00-19 changes as a result of
events during the period (if, for example, as a result of issuing an instrument
which is convertible into an undeterminable amount of shares we cannot ascertain
that we have a sufficient amount of authorized but unissued shares to satisfy
the maximum number of shares that could be required to net-share settle the
contract), the contract is reclassified as of the date of the event that caused
the reclassification. If a contract is reclassified from permanent or temporary
equity to an asset or liability, the change in fair value of the contract during
the period the contract was classified as equity is accounted for as an
adjustment to stockholders' equity. The contract is subsequently marked to fair
value through earnings. If a contract is reclassified from an asset or a
liability to equity, gains or losses recorded to account for the contract at
fair value during the period that the contract was classified as asset or
liability is not reversed.
Additionally, because there is no explicit number of shares that are to be
delivered upon satisfaction of the liquidated damages, the Company is unable to
assert that it had sufficient authorized and unissued shares to settle the
liquidated damages. Accordingly, all of the Company's previously issued and
outstanding instruments, such as warrants and options as well as those issued in
the future, would be classified as liabilities as well, effective with the
granting of the registration rights
RESEARCH AND DEVELOPMENT
Research and development costs are charged to operations as incurred and
consists primarily of salaries and related benefits, raw materials and supplies.
SEGMENT REPORTING
The Company operates in one segment, manufacturing of electronic devices
used for vapor analysis. The Company's chief operating decision-maker evaluates
the performance of the Company based upon revenues and expenses by functional
areas as disclosed in the Company's statements of operations.
RECENT PRONOUNCEMENTS
In December 2004, the FASB issued SFAS 123 (revised 2004) "Share-Based
Payment". This Statement requires that the cost resulting from all share-based
transactions be recorded in the financial statements. The Statement establishes
fair value as the measurement objective in accounting for share-based payment
arrangements and requires all entities to apply a fair-value-based measurement
in accounting for share-based payment
F-10
transactions with employees. The Statement also establishes fair value as the
measurement objective for transactions in which an entity acquires goods or
services from non-employees in share-based payment transactions. The Statement
replaces SFAS 123 "Accounting for Stock-Based Compensation" and supersedes APB
Opinion No. 25 "Accounting for Stock Issued to Employees". The provisions of
this Statement will be effective for the Company beginning in the first quarter
of 2006. The Company is currently evaluating the impact this new Standard will
have on its financial position, results of operations or cash flows.
REVENUE RECOGNITION
The Company records revenue from direct sales of products to end-users when
the products are shipped, collection of the purchase price is probable and the
Company has no significant further obligations to the customer. Costs of
remaining insignificant Company obligations, if any, are accrued as costs of
revenue at the time of revenue recognition. Cash payments received in advance of
product or service revenue are recorded as deferred revenue.
SHIPPING AND HANDLING
The Company accounts for shipping and handling costs as a component of
"Cost of Sales".
INVENTORIES
Inventories are comprised of raw materials, work in process, and finished
goods. Inventories are stated at the lower of cost or market and are determined
using the first-in, first-out method.
USE OF ESTIMATES
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the recorded amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of certain financial instruments, including accounts
receivable, accounts payable and accrued liabilities, approximates their
carrying value due to the short maturity of these instruments.
LONG-LIVED ASSETS
The Company reviews long-lived assets, such as property and equipment, to
be held and used or disposed of, for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. If the sum of the expected cash flows, undiscounted and without
interest, is less than the carrying amount of the asset, an impairment loss is
recognized as the amount by which the carrying amount of the asset exceeds its
fair value. At December 31, 2005 no assets were impaired.
EXTINGUISHMENT OF DEBT
During 2004, the Company recognized a gain on extinguishment of debt which
lapsed pursuant to statute of limitations. The debt was associated with general
and administrative expenses previously provided by a vendor. The gain amounted
to approximately $57,000. The gain was classified as an operating activity.
(2) INVENTORY
Inventory at December 31, 2005 consist of the following:
Finished goods $ 260,517
Work-in-process 464,610
Raw materials 214,495
-----------
$ 939,622
===========
F-11
(3) CONVERTIBLE DEBENTURES
During December 2005, we issued in a private offering $7,000,000 aggregate
principal amount of convertible debentures due December 7, 2009. The convertible
debentures are convertible at a variable conversion price, which is the lesser
of $0.4544 or 90% of the average of the volume weighted average price for the 20
consecutive trading days immediately prior to the conversion date. The
convertible debentures are convertible at any time on or prior to the maturity
date at the option of the debenture holder. We received $7,000,000 in cash as
consideration. The convertible debentures bear interest at 8%, payable in cash
or stock, at the Company's options, and are required to be redeemed in 9 equal
quarterly payments commencing January 1, 2008.
In connection with the issuance of the convertible debentures, the Company
issued five-year warrants to purchase 12,130,314 shares of common stock at an
exercise price of $0.4761 per share. Furthermore, the Company granted liquidated
damages pursuant to a registration rights agreement.
The convertible debentures and related agreements provide, among other
things, for:
1) Liquidated damages amounting to 2% per month of the outstanding
principal amount, payable in cash or stock, to the debenture holders
in the event that a registration statement covering the shares
underlying the convertible debentures is not declared effective within
150 days of the date the debentures were issued. The liquidated
damages are payable in cash monthly or in unpaid, bear interest at 18%
per annum. If unpaid by January 1, 2008 and thereafter, they may be
converted in shares of common stock at the same prevailing rate as the
remaining principal amount of the convertible debentures;
2) Default interest rate of 18% and a default premium of 30% of the
principal amount of the debentures, payable in cash or stock. Events
of default include, among other things, if a payment, whether cash or
stock is not paid on time and cured within three days, if the
Company's common stock is not quoted for trading for at least five
trading days, if a registration is not effective within 180 days after
December 5, 2005. The default interest rate and the default premium
may be converted in shares of common stock at the same prevailing rate
as the remaining principal amount of the convertible debentures;
3) A reset feature of the conversion price in the event of a subsequent
equity or convertible financing with an effective price lower than the
debenture conversion price, whereby the aforementioned variable
conversion price of the convertible debentures is adjusted to the new
lower effective price of the subsequent equity or convertible
financing;
4) A prepayment premium amounting to 30% of the principal balance of the
convertible debentures in the event that the Company, at its sole
option, prepays the convertible debentures before its due date. The
prepayment is payable in cash only; and
5) The warrants require that the Company reimburse any holder of a
warrant in respect of any trading loss resulting from the failure of
the Company to timely deliver shares issued pursuant to the exercise
of warrants. This compensation may be paid in shares of common stock
or cash. The exercise price of the warrants, which is $0.4761 per
share at the date of the agreement, may be reduced to $0.001 per
share, at a monthly rate $0.03 per share if the registration statement
we are required to file at the request of the warrant holders with
respect to the common stock underlying the warrants is not declared
effective within six months of the date of issuance of the warrants.
In connection with the issuance of the convertible debentures, we issued
485,213 warrants to a company in partial consideration for financial advisory
services, as well as paid $490,000 to this company. The warrants have the same
terms as those granted to the debenture holders. The fair value of the warrants
at the date of issuance amounted to approximately $136,000. We also incurred
approximately $102,500 in additional professional fees relating to the issuance
of the convertible debentures and warrants. The payments of professional fees
and the fair value of the warrants, aggregating approximately $729,000 have been
recorded as deferred financing costs. The deferred financing costs are amortized
over the term of the convertible debentures. The amortization of deferred
financing costs amounted to $17,000 during 2005.
See Note 4- Derivative Liabilities for further information on the
accounting and measurement of the derivative liabilities associated with the
issuance of the convertible debentures and related agreements.
F-12
We recognized a debt discount of $7,000,000 at the date of issuance of the
convertible debentures and the excess amount has been recorded as liability and
a corresponding increase to other expense. The debt discount is recognized over
the term of the convertible debentures.
The interest expense, including the amortization of debt discount but
excluding charges related to the recognition of derivative liability amounted to
approximately $238,000 during 2005.
(4) DERIVATIVE LIABILITIES
FEBRUARY 2005 TRANSACTION
During February 2005, we recognized derivative liabilities of approximately
$6.0 million pursuant to the issuance of 3,985,000 freestanding warrants and
granting certain registration rights which provided for liquidated damages in
the event of failure to timely register the shares in connection with the
issuance of shares of common stock and the related warrants.
There are no liquidated damages provided for untimely effectiveness of
shares pursuant to piggy-back registration rights. The Company intends to
register all shares and warrants pursuant to the subscriber piggy-back
registration rights.
The agreement under which the warrants were issued and the registration
rights were granted provided for liquidated damages pursuant to demand
registration rights in the event of failure to timely register the shares in
connection with the issuance of shares of common stock and the related warrants.
The demand registration rights of these investors are such that if the Company
fails to register the investors shares, including the shares underlying the
warrants, the Company will pay a cash penalty amounting to 1% of the amount
invested per month, $39,850, if the registration statement is not filed within
60 days of demand or is not declared effective within 150 days from the date of
initial filing. The maximum liability associated with the liquidated damages
amount to 49% of the gross proceeds associated with the issuance of shares of
common stock, which amounts to $1,952,650. The percentage of liquidated damages
amounts to the difference between 60 months, which is the inherent time
limitation under which the underlying shares would be free-trading (three year
term and two year holding period) and 11 months, which is the grace period for
registering the shares (no demand permitted for four months, two-month period to
file and five-month period to become effective), times the penalty percentage,
which is 1%. The Company believes that the likelihood that it will incur any
liabilities resulting from the liquidated damages pursuant to the demand
registration rights is remote considering that it will register the shares and
the shares underlying the warrants pursuant to piggy-back registration rights,
which do not contain liquidated damages.
Because the registration rights were not granted under a separate
registration rights agreements, we considered those features in evaluating
whether the associated warrants should be classified as derivative liabilities.
Considering that the amount of the maximum penalty is 49%, the Company cannot
conclude that that this discount represents a reasonable approximation of the
difference between registered and unregistered shares under paragraph 16 of EITF
00-19. Accordingly, the warrants issued in connection with the February 2005
transaction are considered derivative liabilities.
The fair value of the warrants issued in connection with the February 2005
transaction at the date of issuance of the warrants and the granting of
registration rights and at December 31, 2005 is as follows:
At issuance At December 31, 2005
------------- --------------------
Freestanding warrants $ 6,017,350 $ -
The Company used the following assumptions, using the Black Scholes Model
to measure the identified derivatives as follows:
F-13
Freestanding warrants
At Issuance At December 31, 2005
------------- --------------------
Market price: $ 2.40 $ 0.34
Exercise price: $ 1.00 $ 1.00
Term: 3 years 2.08 years
Volatility: 39% 39%
Risk-free interest rate: 2.78% 4.39%
Number of warrants: 3,985,000 3,985,000
DECEMBER 2005 TRANSACTION
During December 2005, in connection with the issuance of the convertible
debentures, the Company determined that the conversion feature of the
convertible debentures represents an embedded derivative since the debentures
are convertible into a variable number of shares upon conversion. Because there
is no explicit number of shares that are to be delivered upon satisfaction of
the convertible debentures and that there is no cap on the number of shares to
be delivered upon expiration of the contract to a fixed number, the Company is
unable to assert that it had sufficient authorized and unissued shares to settle
its obligations under the convertible debentures and therefore, net-share
settlement is not within the control of the Company. Accordingly, the
convertible debentures are not considered to be conventional debt under EITF
00-19 and the embedded conversion feature must be bifurcated from the debt host
and accounted for as a derivative liability.
The embedded conversion features are as follows:
Default Interest Rate and Premium: The default interest rate is 18% while
the stated rate of the convertible debentures is 8%. Additionally, the Company
is liable to pay for a premium amounting to 30% of the principal amount of the
convertible debentures in the event of default. This embedded derivative could
at least double the investor's initial rate of return on the host contract and
could also result in a rate of return that is at least twice what otherwise
would be the market return for a contract that has the same terms as the host
contract and that involves a debtor with a similar credit quality. Furthermore,
the default interest rate may be triggered by certain events of defaults which
are not related to credit-risk-related covenants or the Company's
creditworthiness (e.g., if a registration statement is not effective within 180
days after December 5, 2005). The default provisions are effective upon the
event of default and at the holders' option. The holders have not notified the
Company of an event of default.
Reset Feature Following Subsequent Financing: the debenture provides for a
reset feature of the conversion price in the event of a subsequent equity or
convertible financing with an effective price lower than the debenture
conversion price, whereby the aforementioned variable conversion price of the
convertible debentures is adjusted to the new lower effective price of the
subsequent equity or convertible financing , which amounts to 10% of the shares
issuable pursuant to the convertible debentures, which is the effective discount
to market value we would offer in the event we provide for a subsequent private
placement financing. This reset does not constitute a standard anti-dilution
provision and is indexed to an underlying other than an interest rate or credit
risk.
Conversion Rate: The convertible debentures are convertible at a variable
conversion price, which is the lesser of $0.4544 or 90% of the average of the
volume weighted average price for the 20 consecutive trading days immediately
prior to the conversion date. The convertible debentures are convertible at any
time on or prior to the maturity date at the option of the debenture holder. The
implied conversion embedded feature amounts to a conversion discount of 10% to
market.
The Company believes that the aforementioned embedded derivatives meet the
criteria of SFAS 133, including Implementation issue No. B16 and EITF 00-19,
when appropriate, and should be accounted for as derivatives with a
corresponding value recorded as a liability.
In connection with the issuance of the convertible debentures, the Company
issued warrants to the debenture holders. The related warrants require that the
Company reimburse any holder of a warrant in respect of any trading loss
resulting from the failure of the Company to timely deliver shares issued
pursuant to the exercise of warrants. This compensation may be paid in shares of
common stock or cash. Accordingly, we have accounted for such warrants as
derivatives.
F-14
In connection with the issuance of the convertible debentures, the Company
granted liquidated damages pursuant to registration rights. The liquidated
damages amount to 2% per month of the outstanding principal amount, payable in
cash or stock, to the debenture holders in the event that a registration
statement covering the shares underlying the convertible debentures is not
declared effective within 150 days of the date the debentures were issued. The
liquidated damages are payable in cash monthly or if unpaid, bear interest at
18% per annum. If unpaid by January 1, 2008 and thereafter, they may be
converted in shares of common stock at the same prevailing rate as the remaining
principal amount of the convertible debentures. Pursuant to View C of EITF 05-04
the liquidated damages are accounted for as a separate derivative. While the
liquidated damages may be settled in stock if unpaid by January 1, 2008, the
Company determined that it was more likely that they would be paid in cash
shortly after their occurrence and has used such assumption in measuring the
fair value of the derivative liability associated with the liquidated damages.
The maximum liability associated with the liquidated damages amount to 38% of
the gross proceeds associated with the issuance of the convertible debentures,
which amounts to $2,660,000.
Additionally, because there is no explicit number of shares that are to be
delivered upon satisfaction of the convertible debentures, the Company is unable
to assert that it had sufficient amount of authorized and unissued shares to
settle its obligations under the convertible debentures. Accordingly, all of the
Company's previously issued and outstanding instruments, such as warrants, as
well as those issued in the future, would be classified as liabilities as well,
effective with the issuance of the convertible debentures and until the Company
is able to assert that it has a sufficient amount of authorized and unissued
shares to settle its obligations under all outstanding instruments. At the date
of the issuance of the convertible debentures, the Company had 1,941,871
warrants outstanding which were classified as derivatives.
The fair value of the derivative liabilities at the date of issuance of the
convertible debentures and at December 31, 2005 are as follows:
At Issuance At December 31, 2005
------------- --------------------
(Restated) (Restated)
Freestanding warrants $3,532,348 $1,892,329
Embedded conversion features 3,463,542 3,654,412
Liquidated damages 192,500 192,500
Other outstanding warrants 143,268 31,838
The Company used the following methodology to value the embedded conversion
features and liquidated damages:
It estimated the discounted cash flows payable by the Company, using
probabilities and likely scenarios, for event of defaults triggering the 30%
penalty premium and 18% interest accrual, subsequent financing reset, and
liquidated damages, such as the untimely effectiveness of a registration
statement. If the additional cash consideration was payable in cash or stock, it
determined the amount of additional shares would be issuable pursuant to its
assumptions. The Company will revisit the weight of probabilities and the
likelihood of scenarios at each measurement dates of the derivative liabilities,
which are the balance sheet dates.
The Company used the following assumptions to measure the identified
derivatives, using the Lattice valuation model, as follows:
Embedded conversion features
At issuance At December 31, 2005
------------- --------------------
(Restated) (Restated)
Market price: $0.4880 $0.340
Conversion price: $0.4544 $0.306
Term: 4 years 3.92 years
Volatility: 39% 39%
Risk-free interest rate: 4.39% 4.39%
F-15
Freestanding warrants
The derivative liability amounts to the fair value of the warrants issuable
upon exercise, assuming that the underlying shares will not be timely
registered. We computed the fair value of this embedded derivative using the
Black Scholes valuation model with the following assumptions:
At issuance At December 31, 2005
------------- --------------------
(Restated) (Restated)
Market price: $0.488 $0.34
Exercise price: $0.300 $0.30
Term: 5 years 4.92 years
Volatility: 39% 39%
Risk-free interest rate: 4.39% 4.39%
We adjusted the effective exercise price to reflect the contractual
adjustment assuming that the warrants will most likely be registered during the
fourth quarter of 2006.
Liquidated damages
The liquidated damages, payable in cash, are valued using the weighting
probabilities and likely scenarios to estimate the amount of liquidated damages
and were valued at approximately $193,000 at the date of the grant of the
registration rights and at December 31, 2005.
The aggregate fair value of the derivative liabilities associated with the
warrants, embedded conversion features, and liquidated damages in connection
with the issuance of the convertible debentures and related agreements amounted
to approximately $7.05 million at the date of issuance which exceeded the
principal amount of the convertible debentures by approximately $50,000. The
Company recognized $7,000,000 as debt discount and the excess amount has been
recorded as other expenses. Additionally, approximately $136,000 of the fair
value of the warrants was recorded as deferred financing costs.
The aggregate fair value of all derivative liabilities upon issuance of the
various debt and equity instruments amounted to $13.3 million, of which $10.7
million was allocated to the net proceeds of the issuance of common stock and
convertible debentures, $2.4 million was allocated to other expenses and
approximately $136,000 was allocated to deferred financing costs.
The decrease in fair value of the derivative liabilities between
measurement dates, which are the date of issuance of the various debt and equity
instruments and the balance sheet date, which is December 31, 2005 amounted to
approximately $7.6 million and has been recorded as other income.
(5) LINE OF CREDIT
In September 2004, the Company's subsidiary renewed its revolving line of
credit agreement for borrowings up to $1,800,000. The line of credit was assumed
and renewed by the Company. The line of credit matured in February 2006.
Borrowings under this agreement bear interest at prime, are guaranteed by
certain related parties and are collateralized with the assets of the Company
and by the certificate of deposit. No amounts were due under this line of credit
at December 31, 2005.
(6) NOTES PAYABLE - RELATED PARTIES
On September 12, 1999, the Company's subsidiary issued convertible
promissory notes to its general and limited partners' in consideration of
$1,000,000. The convertible promissory notes were due September 12, 2005 and
were convertible at the election of the holder into Class A Units or Class A
Equivalents at a conversion price of $2, on or after the maturity date. The
notes bore interest at a rate of 5% per annum. At December 31, 2004 interest due
under these notes was $265,000.
During 2004, the Company's subsidiary entered into notes payable to the
general partner amounting to $272,000. The notes bore interest at 5% per annum.
F-16
In January 2005 the notes payable to related parties of $1,272,000 plus
accrued interest of $313,262 were converted into 1,585,262 shares of common
stock of the Company.
(7) PARTNERS' LOANS PAYABLE
The Company entered into short-term loans with three partners' of its
subsidiary prior to the merger. The notes were non-interest bearing and due on
demand. The loans were due upon successful closure of a private placement of new
ownership interests. In January 2005 the loans payable to three partners of
Electronic Sensor Technology L.P., totaling $1,198,630 were converted into
1,198,630 shares of common stock of the Company.
In September 2004, three partners' of its subsidiary lent additional funds
to the Partnership. The agreements were for borrowings up to $100,000, from each
partner, payable on March 31, 2005. Borrowings under these agreements bore
interest at prime and were guaranteed by the officers. At December 31, 2004 the
total amount outstanding for these loans was $110,000. The loans were paid off
in March 2005.
(8) DUE TO RELATED PARTY
The Company's subsidiary received funds from Amerasia Technology, Inc., a
related party, for various purposes during the normal course of business. The
amount due to Amerasia as of December 31, 2004 was $60,000 and was fully repaid
during 2005. The due to related party was non-interest bearing and payable on
demand.
(9) ACCRUED COMPENSATION DUE TO OFFICERS
Three officers employed by the Company's subsidiary agreed to defer a
portion of their salaries until such time as it is financially able to meet
these financial obligations. During January 2005 the officers forfeited their
accrued compensation amounting to $934,957 which was recorded as additional
paid-in capital.
(10) STOCKHOLDERS' DEFICIT
COMMON STOCK
Shares issued pursuant to private placement
The Company entered into various Subscription Agreements with certain
investors on January 31, 2005. Under these Subscription Agreements, the Company
issued 3,985,000 shares of its common stock ("shares") and warrants to purchase
3,985,000 shares at $1.00 per share to certain investors for gross proceeds of
$3,985,000. The Company received the gross proceeds of the sale of these shares
on February 1, 2005. The Company received proceeds, net of financing costs, of
approximately $3,822,000.
Shares issued pursuant to the Mergers
By virtue of the Mergers, all shares of common stock of Amerasia were
converted into the right to receive shares of common stock of Bluestone at an
exchange ratio of 4.6223537 shares of Bluestone common stock for each share of
Amerasia common stock and all shares of common stock L&G were converted into the
right to receive shares of common stock of Bluestone at an exchange ratio of 90
shares of Bluestone common stock for each share of L&G common stock. In
addition, all 200,000 Class C limited partnership units of Electronic Sensor
Technology L.P. were automatically converted into 200,000 shares of Bluestone
common stock. The combined effect of the adjustment of the shares pursuant to
the Mergers was to cancel 54,279,147 shares of common stock held by certain of
the pre-merger stockholders of the Company and the issuance of 20,200,000 shares
of common stock to the pre-merger partners of EST.
Conversion of shares for pre-merger liabilities
In connection with the Mergers, the Company issued, in aggregate, 2,783,892
shares of common stock in satisfaction of liabilities incurred pursuant to notes
payable, loan payable, and related accrued interest to related parties.
F-17
Shares issued pursuant to services
During December 2005, the Company issued 130,000 shares of common stock to
a consultant for services rendered. The fair value of such shares amounted to
approximately $75,000 based on the quoted price of the Company's shares at the
date of issuance.
OPTIONS
In 2005, the Board of Directors adopted the Electronic Sensor Technology,
Inc. 2005 Stock Incentive Plan. The purpose of the Stock Incentive Plan is to
attract and retain the services of experienced and knowledgeable individuals to
serve as our employees, consultants and directors. On the date the Stock
Incentive Plan was adopted, the total number of shares of common stock subject
to it was 5,000,000. The Stock Incentive Plan is currently administered by the
Board of Directors, and may be administered by any Committee authorized by the
Board of Directors, so long as any such Committee is made up of Non-Employee
Directors, as that term is defined in Rule 16(b)-3(b) of the Securities Exchange
Act of 1934.
The Stock Incentive Plan is divided into two separate equity programs: the
Discretionary Option Grant Program and the Stock Issuance Program. Under the
Discretionary Option Grant Program, eligible persons may, at the discretion of
the administrator, be granted options to purchase shares of common stock and
stock appreciation rights. Under the Stock Issuance Program, eligible persons
may, at the discretion of the administrator, be issued shares of common stock
directly, either through the immediate purchase of such shares or as a bonus for
services rendered for Electronic Sensor Technology (or a parent or subsidiary of
Electronic Sensor Technology).
Pursuant to the terms of the Discretionary Option Grant Program, the
exercise price per share is fixed by the administrator, but may not be less than
85% of the fair market value of the common stock on the date of grant, unless
the recipient of a grant owns 10% or more of Electronic Sensor Technology's
common stock, in which case the exercise price of the option must not be less
than 110% of the fair market value. An option grant may be subject to vesting
conditions. Options may be exercised in cash, with shares of the common stock of
Electronic Sensor Technology already owned by the person or through a special
sale and remittance procedure, provided that all applicable laws relating to the
regulation and sale of securities have been complied with. This special sale and
remittance procedure involves the optionee concurrently providing irrevocable
written instructions to: (i) a designated brokerage firm to effect the immediate
sale of the purchased shares and remit to Electronic Sensor Technology, out of
the sale proceeds available on the settlement date, sufficient funds to cover
the aggregate exercise price payable for the purchased shares plus all
applicable federal, state and local income and employment taxes required to be
withheld by Electronic Sensor Technology by reason of such exercise and (ii)
Electronic Sensor Technology to deliver the certificates for the purchased
shares directly to such brokerage firm in order to complete the sale. The term
of an option granted pursuant to the Discretionary Option Grant Program may not
be more than 10 years.
The Discretionary Option Grant Program also allows for the granting of
Incentive Options to purchase common stock, which may only be granted to
employees, and are subject to certain dollar limitations. Any options granted
under the Discretionary Option Grant Program that are not Incentive Options are
considered Non-Statutory Options and are governed by the aforementioned terms.
The exercise price of an Incentive Option must be no less than 100% of the fair
market value of the common stock on the date of grant, unless the recipient of
an award owns 10% or more of Electronic Sensor Technology's common stock, in
which case the exercise price of an incentive stock option must not be less than
110% of the fair market value. The term of an Incentive Option granted may not
be more than five years if the option is granted to a recipient who owns 10% or
more of Electronic Sensor Technology's common stock, or 10 years for all other
recipients of Incentive Options. Incentive Options are otherwise governed by the
general terms of the Discretionary Option Grant Program.
Pursuant to the terms of the Stock Issuance Program, the purchase price per
share of common stock issued is fixed by the administrator, but may not be less
than 85% of the fair market value of the common stock on the issuance date,
unless the recipient of a such common stock owns 10% or more of Electronic
Sensor Technology's common stock, in which case the purchase price must not be
less than 100% of the fair market value. Common stock may be issued in exchange
for cash or past services rendered to Electronic Sensor Technology (or any
parent or subsidiary of Electronic Sensor Technology). Common stock issued may
be fully and immediately vested upon issuance or may vest in one or more
installments, at the discretion of the administrator.
The following pro forma information regarding stock-based compensation has
been determined as if the Company had accounted for its employee stock options
under the fair value method pursuant to SFAS 123. For purposes of the proforma
calculations, the fair value of each option granted in 2005 and 2004 was
estimated at the date of grant using the Black-Scholes
F-18
model with the following assumptions used: risk-free interest rate: 4.39%,
respectively; dividend yield: none; volatility: 39% (at the date of grant);
expected lives: 3 years.
No stock-based employee compensation cost is reflected in net income, as
all options granted under the Company's plans had an exercise price equal to or
above market value of the underlying common stock on the date of grant. Had
compensation cost for the Company's stock-based compensation plans been
determined based on the fair value at the grant dates for grants under those
plans consistent with the method of SFAS No. 123, the Company's cash flows would
have remained unchanged; however net loss and loss per share would have been
reduced to the pro forma amounts indicated below:
2005 2004
--------------- ---------------
(Restated) (Restated)
Net income loss as reported: $ 2,778,976 $ (602,883)
Deduct: Total stock-based employee compensation expense determined
under fair value based method for all awards, net of related tax
effects (12,500) (-)
--------------- ---------------
Net income (loss) pro forma $ 2,776,476 $ (602,883)
=============== ===============
A summary of the activity during 2005 and 2004 of the Company's stock
option plan and options and rights granted prior to the adoption, or otherwise
outside, of the 2005 Stock Incentive Plan is presented below:
Options
and Weighted Average
Rights Exercise Price
--------- ----------------
Outstanding at January 1, 2004 - $ -
Granted - -
Exercised - -
Expired or cancelled - -
--------- ----------------
Outstanding at December 31, 2004 - -
Granted 1,794,500 0.89
Exercised - -
Expired or cancelled - -
--------- ----------------
Outstanding at December 31, 2005 1,794,500 $ 0.89
========= ================
Exercisable at December 31, 2004 - $ -
========= ================
Exercisable at December 31, 2005 969,500 $ 1.03
========= ================
The weighted average remaining contractual life and weighted average
exercise price of options and rights outstanding at December 31, 2005, for
selected exercise price ranges, is as follows:
Options outstanding:
Weighted average remaining Weighted average
Range of exercise prices Number of options contractual life exercise price
------------------------ ----------------- -------------------------- ----------------
$0.64 750,000 9.5 $0.64
1.00-1.05 969,500 9.91 1.03
1.57 75,000 9.91 1.57
WARRANTS
During February 2005, the Company issued 3,985,000 warrants in connection
with the Subscription Agreements. These warrants have an exercise price of $1.00
per share. These warrants expire in 2008. The Subscription Agreement provided
for certain registration rights: piggy-back registration rights and demand
registration rights.
There are no liquidated damages provided for untimely effectiveness of
shares pursuant to piggy-back registration rights. The Company intends to
register all shares and warrants pursuant to the subscriber piggy-back
registration rights.
F-19
The Subscription Agreement provided for liquidated damages pursuant to
demand registration rights in the event of failure to timely register the shares
in connection with the issuance of shares of common stock and the related
warrants. The demand registration rights of these investors are such that if the
Company fails to register the investors shares, including the shares underlying
the warrants, the Company will pay a cash penalty amounting to 1% of the amount
invested per month, $39,850, if the registration statement is not filed within
60 days of demand or is not declared effective within 150 days from the date of
initial filing. The maximum liability associated with the liquidated damages
amount to 49% of the gross proceeds associated with the issuance of shares of
common stock, which amounts to $1,952,650. The percentage of liquidated damages
amounts to the difference between 60 months, which is the inherent time
limitation under which the underlying shares would be free-trading (three year
term and two year holding period) and 11 months, which is the grace period for
registering the shares (no demand permitted for four months, two-month period to
file and five-month period to become effective), times the penalty percentage,
which is 1%. The Company believes that the likelihood that it will incur any
liabilities resulting from the liquidated damages pursuant to the demand
registration rights is remote considering that it will register the shares and
the shares underlying the warrants pursuant to piggy-back registration rights.
Please refer to Note 4 - Derivative Liabilities - February 2005 Transaction
for further discussion on the accounting and valuation of the derivative
liabilities associated with freestanding warrants.
During February 2005, the Company issued 1,591,871 warrants in connection
with its merger. These warrants have an exercise price of $1.00 per share. These
warrants expire in 2010. The fair value of the warrants has been accounted as a
derivative liability at the date of issuance and at December 31, 2005.
During December 2005, the Company issued 12,615,527 warrants in connection
with the issuance of its convertible debentures. These warrants have an initial
exercise price of $0.4761 per share. The exercise price per share may be reduced
to $0.001 per share in the event the Company fails to timely register the
underlying shares. Furthermore, the warrants could be converted in cash if
certain events occur, such as a provision which require compensation for buy-in
on failure to timely deliver shares issued pursuant to the exercise of warrants,
whereas we reimburse the warrant holders for shares they purchase on the market
at the market price for shares issued pursuant to the exercise of warrants we
fail to issue in a timely manner. This compensation may be paid in shares of
common stock or cash. These warrants expire in 2010. The fair value of the
warrants has been accounted as a derivative liability at the date of issuance
and at December 31, 2005.
Please refer to Note 4 - Derivative Liabilities - December 2005 Transaction
for further discussion on the accounting and valuation of the derivative
liabilities associated with freestanding warrants.
During December 2005, the Company issued 350,000 warrants to an investor
relations firm in partial satisfaction of amounts due to the firm. The warrants
have an exercise price of $2.40 and expire in 2010. No value was attributed to
the issuance of such warrants based on the Black Scholes model using the
following assumptions: volatility: 39%; dividend rate: 0%, term: 5 years,
risk-free interest rate: 4.39%.
A summary of the activity during 2005 and 2004 of the Company's warrants is
presented below:
Weighted Average
Warrants Exercise Price
---------- ----------------
Outstanding at January 1, 2004 - $ -
Granted - -
Exercised - -
Expired or cancelled - -
Outstanding at December 31, 2004 - -
Granted 18,542,398 0.67
Exercised - -
Expired or cancelled - -
---------- ------------------
Outstanding at December 31, 2005 18,542,398 $ 0.67
========== ==================
Exercisable at December 31, 2004 - $ -
========== ==================
Exercisable at December 31, 2005 18,542,398 $ 0.67
========== ==================
F-20
The weighted average remaining contractual life and weighted average
exercise price of warrants outstanding at December 31, 2005, for selected
exercise price ranges, is as follows:
Weighted average remaining Weighted average
Range of exercise prices Number of warrants contractual life exercise price
------------------------ ------------------ -------------------------- ----------------
$0.48 12,615,527 4.91 years $ 0.48
1.00 5,576,871 4.09 years 1.00
2.40 350,000 4.91 years 2.40
(11) COMMITMENTS AND CONTINGENCIES
LEASES
The Company rents office space in Newbury Park, California. The lease
expires in September 2006 with an optional extension through September 2007.
Rental expense associated with this lease amounted to $155,581 and $155,581
during 2005 and 2004, respectively.
(12) RETIREMENT SAVINGS PLAN
The Company sponsors a 401(k) retirement savings plan (the plan) which
covers most of its full-time employees. Eligible employees may elect to
contribute a percentage of their compensation to the Plan. Matching
contributions by the Company equal 50% of the eligible participant's
tax-deferred contribution percentage for each payroll period of up to a maximum
election of 3% and 6% per payroll period, during 2005 and 2004, respectively.
During 2005 and 2004, the Company contributed approximately $27,000 and $10,000,
respectively, to the Plan.
(13) INCOME TAXES
Deferred income taxes reflect the net tax effect 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 net deferred taxes, as of December 31, 2005, are as follows:
Deferred tax assets:
Net operating loss carryforward $ 900,000
Less valuation allowance (900,000)
----------
Total net deferred tax assets: $ -
==========
The Company's net operating losses amounts to approximately $2.1 million at
December 31, 2005 and expire in 2025.
SFAS No. 109 requires a valuation allowance to reduce the deferred tax
assets reported, if any, based on the weight of the evidence, it is more likely
than not that some portion or all of the deferred tax assets will not be
realized. Management has determined that a valuation allowance of $ 900,000 at
December 31, 2005 is necessary to reduce the deferred tax assets to the amount
that will more likely than not be realized. The change in the valuation
allowance during 2005 and 2004 was a decrease of approximately $900,000 and $0,
respectively.
The federal statutory tax rate reconciled to the effective tax rate during
2005 and 2004, respectively, is as follows:
2005 2004
---------- ----------
Tax at U.S. Statutory Rate: 35.0% 35.0%
State tax rate, net of federal benefits 5.7 5.7
Change in valuation allowance (40.7) (40.7)
---------- ----------
Effective tax rate 0.0% 0.0%
========== ==========
F-21
(14) RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS
As a result of inquiries from the Securities and Exchange Commission in
connection with this registration statement, the Company is restating its 2004
and 2005 financial statements as follows:
REVENUE RECOGNITION
The Company had previously recognized a one-time license fee of $250,000 as
revenues in its 2004 financial statements. The substance of the transaction
indicated that the client was paying for certain services to be performed over
time. Accordingly, the Company believes that it should have recognized this
one-time license fee over the terms of the license agreement. The Company
adjusted its financial statements to recognized revenues of $58,333 in its 2004
statement of operations. The effect on the 2004 financial statements is as
follows:
Balance sheet as of December 31, 2004:
Increase in deferred revenues and current liabilities of $191,667 to $191,667
and $6,318,313, respectively. Increase in accumulated deficit of $191,667 to
$10,466,133
2004 statement of operations:
Decrease in revenues of $191,667 to $1,076,749
Increase in loss from operations and net loss of $191,667 to $431,040 and
$602,883, respectively.
There is no impact on the loss per share and the cash flows from operating,
investing, and financing activities for 2004.
Consistent with its revised revenue recognition of the one-time license fee, the
Company recognized an additional amount of $49,999 in revenue during 2005.
Please see the effect on the 2005 financials statement below (Adjustment a).
DERIVATIVE LIABILITIES
February 2005 Transaction
The Company had previously recognized derivative liabilities in connection with
the granting of liquidated damages pursuant to registration rights in a February
2005 private placement. Such liquidated damages were not granted pursuant to a
separate registration rights agreement and are payable in cash. The Company had
valued such liquidated damages at approximately $580,000 and $630,000 at their
issuance and at December 31, 2006, respectively. The fair value of such
liquidated damages at issuance were recorded as other expenses and the increase
in fair value of approximately $54,000 at December 31, 2005 was recognized as an
offset to other income. The Company believes it has incorrectly valued such
liquidated damages and that it will not incur any corresponding liabilities.
Accordingly it has reversed the entries resulting from the revised treatment
(Adjustment b).
The Company incorrectly assumed that such liquidated damages would be settled in
shares and that it could not ascertain that it had a sufficient amount of
authorized and unissued shares to satisfy its obligations under the liquidated
damages and any other outstanding warrants at the time of the issuance of the
liquidated damages. Based on that assumption, it believed that all other
outstanding warrants at the date of issuance of the liquidated damages would be
also classified as derivative liabilities. The Company valued such outstanding
warrants at approximately $2.5 million and $32,000 at the date of issuance of
the liquidated damages and at December 31, 2005, respectively. The fair value of
such outstanding warrants were recorded as other expenses and the decrease in
fair value of $2.5 million at December 31, 2005 was recognized as other income.
The Company has reversed the entries resulting from the revised treatment
(Adjustment c).
The Company incorrectly assumed that the options outstanding and issued to
employees would be reclassified as derivative contracts. The Company valued such
outstanding options at approximately $1.5 million and $0 at the date of issuance
of the liquidated damages and at December 31, 2005, respectively. The fair value
of such outstanding options at the date of the February 2005
F-22
transaction were recorded as other expenses and the decrease in fair value of
$1.5 million at December 31, 2005 was recognized as other income. The Company
has reversed the entries resulting from the revised treatment (Adjustment d).
December 2005 Transaction
The Company also initially recognized an aggregate $13.4 million and $13.3
million in derivative liabilities associated with the issuance of the
convertible debentures and the related warrants and registration rights in
December 2005 and at December 31, 2005, respectively. We have revised the fair
value of such derivatives at the time of issuance and at December 31, 2005 to
weight probabilities and likely scenarios which have reduced the fair value of
such liabilities to $7.05 at the date of the December 2005 transaction. The
revised measurement and accounting of these instruments resulted in a decrease
of approximately $6.3 million in other expenses and $100,000 in deferred
financing costs for the fair value of warrants issued to the placement agent
which had similar terms that the warrants issued in connection with the December
2005 transaction. Additionally, the Company revised the fair value of the
derivatives associated with December 2005 Transaction at December 31, 2005 to
weight probabilities and likely scenarios which have reduced the fair value of
such derivative liabilities by approximately $7.0 million to approximately $5.7
million at December 31, 2005. The revised valuation has also resulted in an
adjustment in the decrease in the fair value of the derivative liabilities
associated with the December 2005 transaction, which was recorded as other
income, of approximately $9,000 (Adjustment e).
In connection with the issuance of the convertible debentures, the Company could
no longer ascertain that it had sufficient authorized but unissued shares to
satisfy its obligations under the convertible debentures and any other
outstanding warrants at the time of the December 2005 transaction. Accordingly,
the Company reclassified its outstanding warrants, other than those issued
pursuant to the December 2005 transaction, as derivative liabilities. The
Company valued the derivative liabilities associated with such warrants at
approximately $140,000 and $30,000 at the date of the December 2005 transaction
and at December 31, 2005, respectively. Pursuant to the reclassification of
these warrants from equity to derivative liabilities, the Company recognized
approximately $140,000 as other expense during 2005 and recorded the decrease in
fair value of the derivative liabilities of approximately $110,000 as other
income (Adjustment f).
EARNINGS PER SHARE
The Company has also revised its diluted earnings per share to reflect an
adjustment to the numerator for any changes in income or loss that would result
if the derivative contracts had been reported as an equity instrument for
accounting purposes during that period to the extent that they are not
antidilutive. The Company decreased the numerator by approximately $5.2 million,
which is the aggregate of the other income and other expenses associated with
the derivative liabilities during 2005. (Adjustment g).
RECLASSIFICATION OF ACCUMULATED DEFICIT
The Company had initially reclassed to additional paid-in capital its
accumulated deficit incurred while it was a pass-through entity for tax purposes
during 2005. The Company's accumulated deficit incurred while it was a pass
through entity for tax purposes amounted to approximately $10.3 million.
However, this reclassification did not meet the criteria for quasi
reorganization provided by Financial Reporting Release 210. Accordingly, the
Company reversed this reclassification (Adjustment h).
The effect on the 2005 financial statements is as follows:
F-23
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEET
DECEMBER 31, 2005
As Previously
Reported Adjustments Restated
-------------- -------------- -------------
CURRENT ASSETS:
Cash and cash equivalents $ 4,219,921 $ 4,219,921
Certificate of deposit-restricted 918,678 918,678
Accounts receivable, net of allowance for
doubtful accounts of $20,577 465,776 465,776
Prepaid expenses 69,936 69,936
Inventories 939,622 939,622
-------------- -------------- -------------
TOTAL CURRENT ASSETS 6,613,933 6,613,933
DEFERRED FINANCING COSTS, net of amortization of $17,297 812,957 (101,895)(e) 711,062
PROPERTY AND EQUIPMENT, net of accumulated
depreciation of $917,010 112,548 112,548
SECURITY DEPOSITS 12,817 12,817
-------------- -------------- -------------
$ 7,552,255 (101,895) $ 7,450,360
============== ============== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses 480,799 - 480,799
Deferred revenues - 141,667 (a) 141,667
Derivative liabilities 12,780,439 (631,740)(b) 5,771,079
(31,837)(d)
(6,377,620)(e)
31,837 (f)
-------------- -------------- -------------
TOTAL CURRENT LIABILITIES 13,261,238 (6,867,693) 6,393,545
-------------- -------------- -------------
CONVERTIBLE DEBENTURES, net of unamortized discount
of $6,805,556 194,444 194,444
-------------- -------------- -------------
TOTAL LIABILITIES 13,455,682 (6,867,693) 6,587,989
-------------- -------------- -------------
STOCKHOLDERS' EQUITY:
Preferred stock, $.001 par value 50,000,000
shares authorized, none issued and outstanding - - -
Common stock, $.001 par value, 200,000,000
shares authorized, 54,098,745 issued and outstanding, 54,099 - 54,099
Additional paid-in capital (1,779,037) 10,274,466 (h) 8,495,429
Accumulated deficit (4,178,489) 6,957,464 (7,687,157)
(10,274,466)(h)
(191,666)(a)
-------------- -------------- -------------
TOTAL STOCKHOLDERS' EQUITY (5,903,427) 6,765,798 862,371
-------------- -------------- -------------
$ 7,552,255 (101,895) $ 7,450,360
============== ============== =============
F-24
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
For The Year Ended December 31, 2005
As Previously
Reported Adjustments Restated
-------------- -------------- -------------
REVENUES $ 2,072,350 $ 49,999(a)$ 2,122,349
COST OF SALES 1,302,602 - 1,302,602
-------------- -------------- -------------
GROSS PROFIT 769,748 49,999 819,747
-------------- -------------- -------------
OPERATING EXPENSES:
Research and development 260,125 - 260,125
Compensation 466,421 - 466,421
Selling 653,092 - 653,092
General and administrativ 1,522,451 - 1,522,451
-------------- -------------- -------------
TOTAL OPERATING EXPENSES 2,902,089 - 2,902,089
-------------- -------------- -------------
LOSS FROM OPERATIONS (2,132,341) 49,999 (2,082,342)
-------------- -------------- -------------
OTHER INCOME AND EXPENSE:
Other income- derivative liabilities 11,404,106 53,999 (b) 7,577,929
(2,475,157)(c)
(1,524,970)(d)
8,520 (e)
111,431 (f)
Other expense- derivative liabilities (13,135,000) 577,741 (b) (2,401,358)
2,506,994 (c)
1,524,970 (d)
6,267,205 (e)
(143,268)(f)
Gain (loss) on sale of property and equipment 9,287 - 9,287
Interest expense (324,540) - (324,540)
-------------- -------------- -------------
TOTAL OTHER INCOME AND EXPENSE (2,046,147) 6,907,465 4,861,318
-------------- -------------- -------------
NET (LOSS) INCOME $ (4,178,488) 6,957,464 2,778,976
============== ============== =============
Earnings (loss) per share, basic $ (0.08) 0.13 $ 0.05
============== ============== =============
Weighted average number of shares, basic 53,636,560 53,636,560
============== ============== =============
Earnings (loss) per share, diluted $ (0.08) -(g)$ (0.04)
============== ============== =============
Weighted average number of shares, diluted 53,636,560 7,446,419(g) 53,636,560
============== ============== =============
F-25
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For The Year Ended December 31, 2005
As Previously
Reported Adjustments Restated
-------------- -------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (4,178,488) $ 6,957,464 $ 2,778,976
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization 21,300 - 21,300
Issuance of shares for services 74,950 - 74,950
Recognition of derivative liabilities 13,135,000 (10,733,642)(b,c,d,e,f) 2,401,358
Amortization of debt discount 194,444 - 194,444
Amortization of deferred financing costs 17,297 - 17,297
Notes payable related party - interest waived - - 0
Decrease in fair value of derivative liability (11,404,023) 3,826,094 (b,c,d,e,f) (7,577,929)
Changes in assets and liabilities: 0
Accounts receivable (435,089) - (435,089)
Inventories (458,974) - (458,974)
Prepaid expenses (55,679) - (55,679)
Security deposits 140 - 140
Accounts payable and accrued expenses 266,494 83 266,577
Due to related party (60,000) - (60,000)
Interest payable (26,961) - (26,961)
Deferred revenues 0 (49,999)(a) (49,999)
Other current liabilities (35,665) - (35,665)
-------------- -------------- --------------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES (2,945,254) - (2,945,254)
-------------- -------------- --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of property and equipment 43,933 - 43,933
Purchase of certificate deposit (918,678) - (918,678)
Purchase of property and equipment (126,582) - (126,582)
-------------- -------------- --------------
NET CASH (USED IN) INVESTING ACTIVITIES (1,001,327) - (1,001,327)
-------------- -------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Increase (decrease) in line of credit (1,969,137) - (1,969,137)
Repayment of partners' loans payable (110,000) - (110,000)
Proceeds from issuance of common stock 3,811,708 - 3,811,708
Proceeds from convertible debenture 7,000,000 - 7,000,000
Payment of deferred financing costs (592,500) - (592,500)
-------------- -------------- --------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 8,140,071 - 8,140,071
-------------- -------------- --------------
NET INCREASE (DECREASE) IN CASH 4,193,491 - 4,193,491
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 26,430 - 26,430
-------------- -------------- --------------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 4,219,921 - 4,219,921
============== ============== ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest $ 102,928 - $ 102,928
============== ============== ==============
Taxes $ - - $ -
============== ============== ==============
NON-CASH INVESTING AND FINANCING ACTIVITIES
Notes payable, loans payable and accrued expenses
converted into Common stock and additional paid-in capital $ 3,718,849 - $ 3,718,849
============== ============== ==============
Fair value of derivative liability recorded as debt
discount on convertible debentures $ 7,000,000 - $ 7,000,000
============== ============== ==============
Fair value of derivative liability recorded as a deferred
financing costs $ 237,754 $ (101,895) $ 135,859
============== ============== ==============
F-26
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)
Common Stock Preferred Stock Additional
-------------------------------- ------------------- Paid-In
Shares Amount Shares Amount Capital
-------------- -------------- -------- -------- --------------
BALANCE - December 31, 2003 81,279,000 $ 81,279 - $ - $ 4,500,000
Sale of Partnership interest
- Class C - - - - 200,000
Note payable related party
interest waived - - - - 63,774
Net loss - - - - -
-------------- -------------- -------- -------- --------------
BALANCE - December 31, 2004 81,279,000 81,279 - - 4,763,774
Cancellation of common stock (54,279,147) (54,279) - - 54,279
Notes payable converted to
common stock 1,272,000 1,272 - - 1,270,728
Reverse Acquisition - - - - (89,325)
Sale of common stock 3,985,000 3,985 - - (3,985)
Deferred compensation
contributed to capital - - - - 934,957
Officers loans converted to
common stock 1,198,630 1,199 - - 1,197,431
Issuance of shares for
services 130,000 130 - - 74,820
Accrued interest converted
to common stock 313,262 313 - - 312,950
Common stock issued for
acquisition of EST 20,200,000 20,200 - - (20,200)
Net income - - - - -
-------------- -------------- -------- -------- --------------
54,098,745 $ 54,099 $ - $ - $ 8,495,429
============== ============== ======== ======== ==============
Total
Accumulated Stockholders'
Deficit Deficit
-------------- --------------
BALANCE - December 31, 2003 $ (9,863,250) $ (5,281,971)
Sale of Partnership interest
- Class C - 200,000
Note payable related party -
interest waived - 63,774
Net loss (602,883) (602,883)
-------------- --------------
BALANCE - December 31, 2004 (10,466,133) (5,621,080)
Cancellation of common stock - -
Notes payable converted to
common stock - 1,272,000
Reverse Acquisition - (89,325)
Sale of common stock - -
Deferred compensation
contributed to capital - 934,957
Officers loans converted to
common stock - 1,198,630
Issuance of shares for
services - 74,950
Accrued interest converted
to common stock - 313,263
Common stock issued for
acquisition of EST - -
Net income 2,778,976 2,778,976
-------------- --------------
$ (7,687,157) $ 862,371
=============== ===============
F-27
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEET
JUNE 30, 2006
(Restated)
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 3,735,141
Certificate of deposit-restricted 250,000
Accounts receivable, net of allowance for doubtful accounts of $17,700 280,149
Prepaid expenses 36,721
Inventories 1,164,020
---------------
TOTAL CURRENT ASSETS 5,466,031
---------------
DEFERRED FINANCING COSTS, net of amortization of $121,079 607,282
PROPERTY AND EQUIPMENT, net of accumulated depreciation of $935,874 162,950
SECURITY DEPOSITS 12,817
---------------
$ 6,249,079
---------------
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES:
Accounts payable and accured expenses $ 454,726
Credit line borrowings 370,000
Deferred revenues 116,667
Derivative liabiities 4,087,959
---------------
TOTAL CURRENT LIABILITIES 5,029,352
---------------
CONVERTIBLE DEBENTURES, net of unamortized discount of $5,638,889 1,361,111
---------------
TOTAL LIABIILTIES 6,390,463
---------------
STOCKHOLDERS' DEFICIT:
Preferred stock, $.001 par value 50,000,000 shares authorized,
none issued and outstanding -
Common stock, $.001 par value, 200,000,000 shares authorized,
54,173,745 issued and outstanding 54,174
Additinal paid-in capital 8,516,354
Accumulated deficit (8,711,912)
---------------
TOTAL STOCKHOLDERS' DEFICIT (141,384)
---------------
$ 6,429,079
===============
See notes to consolidated financial statements
F-28
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Six Months Ended Three Months Ended
June 30, June 30,
------------------------------- -------------------------------
2006 2005 2006 2005
-------------- -------------- -------------- --------------
(Restated)
REVENUES $ 1,154,224 $ 651,652 $ 621,407 $ 432,141
COST OF SALES 592,714 375,086 291,122 224,800
-------------- -------------- -------------- --------------
GROSS PROFIT 561,510 276,566 330,285 207,341
OPERATING EXPENSES:
Research and development 416,144 331,285 204,345 191,113
Selling, general and administrative
1,436,961 1,103,030 656,651 535,163
-------------- -------------- -------------- --------------
TOTAL OPERATING EXPENSES 1,853,105 1,434,315 860,996 726,276
-------------- -------------- -------------- --------------
LOSS FROM OPERATIONS (1,291,595) (1,157,749) (530,711) (518,935)
-------------- -------------- -------------- --------------
OTHER INCOME AND EXPENSE:
Other income - derivative 1,683,119 4,263,950 462,922 4,144,400
Other expense - derivative - (2,205,642) - -
Gain (loss) on sale of property and equipment - 9,287 - (3,970)
Interest expense (1,416,279) (34,271) (685,887) (13,706)
-------------- -------------- -------------- --------------
TOTAL OTHER INCOME AND EXPENSE 266,840 2,033,324 (222,965) 4,126,724
-------------- -------------- -------------- --------------
NET INCOME (LOSS) $ (1,024,755) $ 875,576 $ (753,676) $ 3,607,789
============== ============== ============== ==============
Earnings (loss) per share, basic $ (0.02) $ 0.02 $ (0.01) $ 0.07
============== ============== ============== ==============
Weighted average number of shares, basic 54,159,945 53,304,475 54,173,745 53,968,643
============== ============== ============== ==============
Earnings (loss) per share, diluted $ (0.02) $ (0.02) $ (0.01) $ 0.07
============== ============== ============== ==============
Weighted average number of shares, diluted 54,159,945 53,304,475 54,173,745 53,968,643
============== ============== ============== ==============
See notes to consolidated financial statements
F-29
ELECTRONIC SENSOR TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended
June 30,
-------------------------------
2006 2005
-------------- --------------
(Restated)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (1,024,755) $ 875,576
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization 18,865 5,605
Issuance of shares for services 21,000 -
Amortization of debt discount 1,166,667 -
Amortization of deferred financing costs 103,782 -
Recognition of derivative liabilities - 2,205,642
Decrease in fair value of derivative liability (1,683,119) (4,263,950)
Changes in assets and liabilities:
Accounts receivable 185,625 (98,020)
Inventories (224,400) (12,502)
Prepaid expenses 33,214 (9,361)
Security deposits - 140
Accounts payable and accrued expenses (26,072) 46,842
Deferred revenues (25,000) (25,000)
Due to related party - (60,000)
Interest payable - (26,961)
Other current liabilities - (2,626)
-------------- --------------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES (1,454,193) (1,364,616)
-------------- --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Decrease (increase) in restricted security deposit 668,678 -
Proceeds from sale of property and equipment - 30,280
Purchase of property and equipment (69,265) (77,780)
-------------- --------------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 599,413 (47,500)
-------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Increase (decrease) in line of credit 370,000 (200,000)
Repayment of partners' loans payable - (110,000)
Proceeds from issuance of common stock - 3,811,708
-------------- ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 370,000 3,501,708
-------------- ------------
NET INCREASE (DECREASE) IN CASH (484,780) 2,089,592
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 4,219,921 26,430
-------------- --------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 3,735,141 $ 2,116,022
============== ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest $ 282,236 $ 40,870
============== ==============
NON-CASH FINANCING ACTIVITIES
Fair Value of derivative liabilities issued in
connection with issuance of shares of common stock $ - $ -
============== ==============
See notes to consolidated financial statements.
F-30
ELECTRONIC SENSOR TECHNOLOGY, INC.
NOTES TO FINANCIAL STATEMENTS
(Unaudited)
JUNE 30, 2006
1) Basis of Presentation
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial statements and with the instructions to Form 10-QSB and
Article 10 of Regulation S-B. Accordingly, they do not include all the
information and disclosures required for annual financial statements. These
financial statements should be read in conjunction with the consolidated
financial statements and related footnotes for the year ended December 31,
2005, included in the Annual Report filed on Form 10-KSB/A for the year
then ended.
In the opinion of the management of Electronic Sensor Technology, Inc. (the
"Company"), all adjustments (consisting of normal recurring accruals)
necessary to present fairly the Company's financial position as of June 30,
2006, and the results of operations and cash flows for the six month period
ending June 30, 2006 have been included. The results of operations for the
six-month period ended June 30, 2006 are not necessarily indicative of the
results to be expected for the full year. For further information, refer to
the consolidated financial statements and footnotes thereto included in the
Company's Annual Report filed on Form 10-KSB/A as filed with the Securities
and Exchange Commission for the year ended December 31, 2005.
2) Basis of Consolidation
The accompanying financial statements include the accounts of the Company
and its wholly owned subsidiaries. All intercompany balances and
transactions have been eliminated in consolidation.
3) Nature of Business and Summary of Significant Accounting Policies
a) Nature of Business
The Company develops and manufactures electronic devices used for
vapor analysis. It markets its products through distribution channels
in over 20 countries.
b) Cash and Cash Equivalents
The Company considers highly liquid financial instruments with
maturities of three months or less at the time of purchase to be cash
equivalents. The Company did not have any cash equivalents at June 30,
2006.
c) Line of Credit
The Company has a revolving line of credit agreement for borrowings up
to $500,000. The line of credit is secured and collateralized with a
certificate of deposit in the amount of $250,000. The line of credit
had borrowings of $370,000 against it at June 30, 2006. The line of
credit expires on March 31, 2007.
d) Revenue Recognition
The Company records revenue from direct sales of products to end-users
when the products are shipped, collection of the purchase price is
probable and the Company has no significant further obligations to the
customer. Costs of remaining insignificant Company obligations, if
any, are accrued as costs of revenue at the time of revenue
recognition. Cash payments received in advance of product shipment or
service revenue are recorded as deferred revenue.
F-31
e) Shipping and Handling
The Company accounts for shipping and handling costs as a component of
"Cost of Sales".
f) Inventories
Inventories are comprised of raw materials, work in process, and
finished goods. Inventories are stated at the lower of cost or market
and are determined using the first-in, first-out method.
g) Deferred Financing Costs
Deferred financing costs consist of direct costs incurred by the
Company in connection with the issuance of its convertible debentures.
The direct costs include cash payments and fair value of warrants
issued to the placement agent, which secured the financing. Deferred
financing costs are amortized over 48 months using the effective
interest rate method.
h) Property and Equipment
Property and equipment are stated at cost, net of accumulated
depreciation. Depreciation is computed using the straight-line method
over the estimated useful lives of five years.
i) Research and Development
Research and development costs are charged to operations as incurred
and consists primarily of salaries and related benefits, raw materials
and supplies.
j) Use of Estimates
The preparation of the financial statements in conformity with
generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosures of contingent assets and liabilities
at the date of the financial statements and the recorded amounts of
revenues and expenses during the reporting period. Actual results
could differ from those estimates.
k) Fair Value of Financial Instruments
The fair value of certain financial instruments, including accounts
receivable, accounts payable and accrued liabilities, approximate
their carrying values due to the short maturity of these instruments.
l) Long-lived Assets
The Company reviews long-lived assets, such as property and equipment,
to be held and used or disposed of, for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. If the sum of the expected cash flows,
undiscounted and without interest, is less than the carrying amount of
the asset, an impairment loss is recognized as the amount by which the
carrying amount of the asset exceeds its fair value. At June 30, 2006
no assets were impaired.
m) Derivative Liabilities
In June 2005, the Financial Accounting Standard Board issued EITF
05-04. EITF 05-04 addresses the question as to whether liquidated
damages pursuant to a registration rights agreement should be combined
as a unit with the underlying financial instruments and be evaluated
as a single instrument. EITF 05-04 does not reach a consensus on this
matter and allows for the treatment as
F-32
a combined unit (Views A and B) as well as separate freestanding
financial instruments (View C). On September 15, 2005, the FASB staff
postponed further discussion of EITF 05-04. As of May 31, 2006, the
FASB still has not rescheduled EITF 05-04 for further discussion.
In connection with the issuance of a convertible debentures and
related warrants, we granted liquidated damages pursuant to a separate
registration right agreement. The Company adopted View C of EITF
05-04. Accordingly, the liquidated damages pursuant to this
registration right agreement were evaluated as a stand alone financial
instrument. This treatment did not have a significant different effect
than if the Company would have adopted View A or B, because the
classification of the warrants and certain embedded features of the
convertible debentures were classified as derivative liabilities. The
Company believes that should the FASB staff reach a consensus on EITF
05-04 and select combined treatment (View A or B), the embedded
conversion features and the warrants will have to be evaluated as a
combined unit with the liquidated damages pursuant to the registration
rights agreement, and accordingly, be evaluated as derivative
liabilities. The Company does not believe that its measurement of the
derivative liabilities under View A or View B would significantly
differ from its measurement of the derivative liabilities under View C
in these circumstances.
The Company accounts for liquidated damages granted pursuant to
registration rights which are not included in a separate registration
right agreement as a combined unit with the warrants which are
contemporaneously issued with the registration rights pursuant to SFAS
133 "Accounting for Derivative and Hedging Activities" and EITF 00-19.
The Company accounts for its embedded conversion features and
freestanding warrants pursuant to SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities", which requires a
periodic valuation of their fair value and a corresponding recognition
of liabilities associated with such derivatives. The recognition of
derivative liabilities related to the issuance of shares of common
stock is applied first to the proceeds of such issuance, at the date
of issuance, and the excess of derivative liabilities over the
proceeds is recognized as other expense in the accompanying
consolidated financial statements. The recognition of derivative
liabilities related to the issuance of convertible debt is applied
first to the proceeds of such issuance as a debt discount, at the date
of issuance, and the excess of derivative liabilities over the
proceeds is recognized as other expense in the accompanying
consolidated financial statements. Any subsequent increase or decrease
in the fair value of the derivative liabilities, which are measured at
the balance sheet date, are recognized as other expense or other
income, respectively.
n) Basic and Diluted Earnings Per Share
Basic earnings per share are calculated by dividing income available
to stockholders by the weighted-average number of common shares
outstanding during each period. Diluted earnings per share are
computed using the weighted average number of common and dilutive
common share equivalents outstanding during the period. Dilutive
common share equivalents consist of shares issuable upon the exercise
of stock options and warrants embedded conversion features (calculated
using the reverse treasury stock method). The outstanding options,
warrants and shares equivalent issuable pursuant to embedded
conversion features amounted to 66,982,944 and 5,576,871 at June 30,
2006 and 2005, respectively. The outstanding options, warrants and
shares equivalent issuable pursuant to embedded conversion features
and warrants at June 30, 2006 and 2005, respectively, are excluded
from the loss per share computation for that period due to their
antidilutive effect. The Company adjusted the numerator for any
changes in income or loss that would result if the contract had been
recorded as an equity instrument for accounting purposes during the
period. However, the Company did not adjust the numerator for interest
charges during the period on the convertible debentures because it
would have been anti-dilutive.
F-33
The following sets forth the computation of basic and diluted earnings
per share at June 30:
2006 2005
------------ ------------
(Restated)
Numerator:
Net income (loss) $ (1,024,755) $ 875,576
Net other income (expense) associated with
derivative contracts 1,683,119 2,058,308
------------ ------------
Net income (loss) for diluted earnings per share
purposes $ (2,707,874) $ (1,182,732)
============ ============
Denominator:
Denominator for basic earnings per share-
Weighted average shares outstanding 54,159,945 53,304,475
Effect of dilutive warrants, embedded
conversion features and liquidated damages - -
------------ ------------
Denominator for diluted earnings per share-
Weighted average shares outstanding 54,159,945 53,304,475
============ ============
Basic earnings (loss) per share $ (0.02) $ 0.02
============ ============
Diluted earnings (loss) per share $ (0.02) $ (0.02)
============ ============
4) CONVERTIBLE DEBENTURES
During December 2005, we issued in a private offering, $7,000,000 aggregate
principal amount of convertible debentures due December 7, 2009. The
convertible debentures are convertible at any time on or prior to the
maturity date at the option of the debenture holder at a conversion price
of $0.4544 and can be redeemed at the lesser of $0.4544 or 90% of the
average of the volume weighted average price for the 20 consecutive trading
days immediately prior to the conversion date. The Company received
$7,000,000 in cash as consideration. The convertible debentures bear
interest at 8%, payable in cash or stock, at the Company's option, and are
required to be redeemed in 9 equal quarterly payments commencing January 1,
2008, in cash or stock, at the Company's option. If the Company chooses to
pay interest on or redeem the debentures in shares of the Company's common
stock, rather than in cash, the conversion rate for such stock payment is
the lesser of $0.4544 and 90% of the average of the volume weighted average
price for the 20 consecutive trading days immediately prior to the interest
payment or redemption date, as applicable.
In connection with the issuance of the convertible debentures, the Company
issued five-year warrants to purchase 12,130,314 shares of common stock at
an exercise price of $0.4761 per share. Furthermore, the Company granted
liquidated damages pursuant to a registration rights agreement.
The convertible debentures and related agreements provide, among other
things, for:
1) Liquidated damages amounting to 2% per month of the outstanding
principal amount, payable in cash or stock, to the debenture holders
in the event that a registration statement covering the shares
underlying the convertible debentures is not declared effective within
150 days of the date the debentures were issued (although a
registration statement covering the shares underlying the convertible
debentures has not been declared effective as of June 30, 2006, no
claims for liquidated damages have been received from the debenture
holders). The liquidated damages are payable in cash monthly or if
unpaid, bear interest at 18% per annum. If unpaid by January 1, 2008
and thereafter, they may be converted in shares of common stock at the
same prevailing rate as the remaining principal amount of the
convertible debentures;
2) Default interest rate of 18% and a default premium of 30% of the
principal amount of the debentures, payable in cash or stock. Events
of default include, among other things, if a payment, whether cash or
stock is not paid on time and cured within three days, if the
Company's common
F-34
stock is not quoted for trading for at least five trading days, if a
registration is not effective within 180 days after December 7, 2005
(although a registration statement covering the shares underlying the
convertible debentures has not been declared effective as of June 30,
2006, no claims for liquidated damages have been received from the
debenture holders). The default interest rate and the default premium
may be converted in shares of common stock at the same prevailing rate
as the remaining principal amount of the convertible debentures;
3) A reset feature of the conversion price in the event of a subsequent
equity or convertible financing with an effective price lower than the
debenture conversion price, whereby the aforementioned variable
conversion price of the convertible debentures is adjusted to the new
lower effective price of the subsequent equity or convertible
financing;
4) A prepayment premium amounting to 30% of the principal balance of the
convertible debentures in the event that the Company, at its sole
option, prepays the convertible debentures before its due date. The
prepayment is payable in cash only; and
5) The warrants require that the Company reimburse any holder of a
warrant in respect of any trading loss resulting from the failure of
the Company to timely deliver shares issued pursuant to the exercise
of warrants. This compensation may be paid in shares of common stock
or cash. The exercise price of the warrants, which is $0.4761 per
share at the date of the agreement, may be reduced to $0.001 per
share, at a monthly rate $0.03 per share if the registration statement
we are required to file at the request of the warrant holders with
respect to the common stock underlying the warrants is not declared
effective within six months of the date of issuance of the warrants.
In connection with the issuance of the convertible debentures, we issued
485,213 warrants to a company in partial consideration for financial
advisory services. The warrants have the same terms as those granted to the
debenture holders. The fair value of the warrants (at the time of their
issuance) and related professional fees pertaining to the issuance of the
convertible debentures have been recorded as deferred financing costs. The
deferred financing costs are amortized over the term of the convertible
debentures. See Note 5 - Derivative Liabilities for further information on
the accounting and measurement of the derivative liabilities associated
with the issuance of the convertible debentures and related agreements.
5) DERIVATIVE LIABILITIES
FEBRUARY 2005 TRANSACTION
During February 2005, we recognized derivative liabilities of approximately
$6.0 million pursuant to the issuance of 3,985,000 freestanding warrants
and granting certain registration rights which provided for liquidated
damages in the event of failure to timely register the shares in connection
with the issuance of shares of common stock and the related warrants.
There are no liquidated damages provided for untimely effectiveness of the
registration of shares pursuant to piggy-back registration rights. The
Company intends to register all shares and warrants pursuant to the
subscriber piggy-back registration rights.
The agreement pursuant to which the warrants were issued and the
registration rights were granted provided for liquidated damages pursuant
to demand registration rights in the event of a failure to timely register
the shares after demand is made by the holders of a majority of the
warrants and shares of common stock issued pursuant to such agreement. The
demand registration rights of these investors are such that if the Company
fails to register the investors shares, including the shares underlying the
warrants, the Company will pay a cash penalty amounting to 1% of the amount
invested per month, $39,850, if the registration statement is not filed
within 60 days of demand or is not declared effective within 150 days from
the date of initial filing. The maximum liability associated with the
liquidated damages amounts to 49% of the gross proceeds associated with the
issuance of shares of common stock, which amounts to $1,952,650. The
percentage of liquidated damages amounts to the difference between 60
months, which is
F-35
the inherent time limitation under which the underlying shares would be
free-trading (three year term and two year holding period) and 11 months,
which is the grace period for registering the shares (no demand permitted
for four months, two-month period to file and five-month period to become
effective), times the penalty percentage, which is 1%. The Company believes
that the likelihood that it will incur any liabilities resulting from the
liquidated damages pursuant to the demand registration rights is remote
considering that it will register the shares and the shares underlying the
warrants pursuant to piggy-back registration rights, which do not contain
liquidated damages.
Because the registration rights were not granted under a separate
registration rights agreement, we considered those features in evaluating
whether the associated warrants should be classified as derivative
liabilities. Considering that the amount of the maximum penalty is 49%, the
Company cannot conclude that that this discount represents a reasonable
approximation of the difference between registered and unregistered shares
under paragraph 16 of EITF 00-19. Accordingly, the warrants issued in
connection with the February 2005 transaction are considered derivative
liabilities.
The fair value of the warrants issued in connection with the February 2005
transaction at the date of issuance of the warrants and the granting of
registration rights and at June 30, 2006 is as follows:
At issuance At June 30, 2006
------------- --------------------
Freestanding warrants $ 6,017,350 $ 0
The Company used the following assumptions, using the Black Scholes Model
to measure the identified derivatives as follows:
Freestanding warrants
At Issuance At June 30, 2006
------------- --------------------
Market price: $ 2.40 $ 0.19
Exercise price: $ 1.00 $ 1.00
Term: 3 years 1.58 years
Volatility: 39% 39%
Risk-free interest rate: 2.78% 5.13%
Number of warrants: 3,985,000 3,985,000
December 2005 Transaction
During December 2005, in connection with the issuance of the convertible
debentures, the Company determined that the conversion feature of the
convertible debentures represents an embedded derivative since the
debentures are convertible into a variable number of shares upon
conversion. Because there is no explicit number of shares that are to be
delivered upon satisfaction of the convertible debentures and that there is
no cap on the number of shares to be delivered upon expiration of the
contract to a fixed number, the Company is unable to assert that it had
sufficient authorized and unissued shares to settle its obligations under
the convertible debentures and therefore, net-share settlement is not
within the control of the Company. Accordingly, the convertible debentures
are not considered to be conventional debt under EITF 00-19 and the
embedded conversion feature must be bifurcated from the debt host and
accounted for as a derivative liability.
The embedded conversion features are as follows:
Default Interest Rate and Premium: The default interest rate is 18% while
the stated rate of the convertible debentures is 8%. Additionally, the
Company is liable to pay for a premium amounting to 30% of the principal
amount of the convertible debentures in the event of default. This embedded
derivative could at
F-36
least double the investor's initial rate of return on the host contract and
could also result in a rate of return that is at least twice what otherwise
would be the market return for a contract that has the same terms as the
host contract and that involves a debtor with similar credit quality.
Furthermore, the default interest rate may be triggered by certain events
of defaults which are not related to credit-risk-related covenants or the
Company's creditworthiness (e.g., if a registration statement is not
effective within 180 days after December 7, 2005). The default provisions
are effective, at the holders' option, upon an event of default. Although a
registration statement covering the shares underlying the convertible
debentures has not been declared effective as of June 30, 2006, the
debenture holders have not notified the Company of an election to
accelerate the debentures, nor have any claims for liquidated damages been
received.
Reset Feature Following Subsequent Financing: The debenture provides for a
reset feature of the conversion price in the event of a subsequent equity
or convertible financing with an effective price lower than the debenture
conversion price, whereby the aforementioned variable conversion price of
the convertible debentures is adjusted to the new lower effective price of
the subsequent equity or convertible financing , which amounts to 10% of
the shares issuable pursuant to the convertible debentures, which is the
effective discount to market value we would offer in the event we provide
for a subsequent private placement financing. This reset does not
constitute a standard anti-dilution provision and is indexed to an
underlying other than an interest rate or credit risk.
Conversion Rate: The convertible debentures are convertible at a variable
conversion price, which is the lesser of $0.4544 or 90% of the average of
the volume weighted average price for the 20 consecutive trading days
immediately prior to the conversion date. The convertible debentures are
convertible at any time on or prior to the maturity date at the option of
the debenture holder. The implied conversion embedded feature amounts to a
conversion discount of 10% to market.
The Company believes that the aforementioned embedded derivatives meet the
criteria of SFAS 133, including Implementation issue No. B16 and EITF
00-19, when appropriate, and should be accounted for as derivatives with a
corresponding value recorded as a liability.
In connection with the issuance of the convertible debentures, the Company
issued warrants to the debenture holders. The related warrants require that
the Company reimburse any holder of a warrant in respect of any trading
loss resulting from the failure of the Company to timely deliver shares
issued pursuant to the exercise of warrants. This compensation may be paid
in shares of common stock or cash. Accordingly, we have accounted for such
warrants as derivatives.
In connection with the issuance of the convertible debentures, the Company
granted liquidated damages pursuant to a registration rights agreement. The
liquidated damages amount to 2% per month of the outstanding principal
amount, payable in cash or stock, to the debenture holders in the event
that a registration statement covering the shares underlying the
convertible debentures is not declared effective within 150 days of the
date the debentures were issued (although a registration statement covering
the shares underlying the convertible debentures has not been declared
effective as of June 30, 2006, no claims for liquidated damages have been
received from the debenture holders). The liquidated damages are payable in
cash monthly or if unpaid, bear interest at 18% per annum. If unpaid by
January 1, 2008 and thereafter, they may be converted in shares of common
stock at the same prevailing rate as the remaining principal amount of the
convertible debentures. Pursuant to View C of EITF 05-04 the liquidated
damages are accounted for as a separate derivative. While the liquidated
damages may be settled in stock if unpaid by January 1, 2008, the Company
determined that it was more likely that they would be paid in cash shortly
after their occurrence and has used such assumption in measuring the fair
value of the derivative liability associated with the liquidated damages.
The maximum liability associated with the liquidated damages amount to 38%
of the gross proceeds associated with the issuance of the convertible
debentures, which amounts to $2,660,000.
Additionally, because there is no explicit number of shares that are to be
delivered upon satisfaction of the convertible debentures, the Company is
unable to assert that it had sufficient amount of authorized and unissued
shares to settle its obligations under the convertible debentures.
Accordingly, all of the Company's previously issued and outstanding
instruments, such as warrants, as well as those issued in the
F-37
future, would be classified as liabilities as well, effective with the
issuance of the convertible debentures and until the Company is able to
assert that it has a sufficient amount of authorized and unissued shares to
settle its obligations under all outstanding instruments. At the date of
the issuance of the convertible debentures, the Company had 1,941,871
warrants outstanding which were classified as derivatives.
The fair value of the derivative liabilities at the date of issuance of the
convertible debentures and at June 30, 2006 are as follows:
At Issuance At June 30, 2006
------------- --------------------
Freestanding warrants $3,532,348 $ 504,621
Embedded conversion features 3,463,542 3,390,838
Liquidated damages 192,500 192,500
Other outstanding warrants 143,268 0
The Company used the following methodology to value the embedded conversion
features and liquidated damages:
It estimated the discounted cash flows payable by the Company, using
probabilities and likely scenarios, for event of defaults triggering the
30% penalty premium and 18% interest accrual, subsequent financing reset,
and liquidated damages, such as the untimely effectiveness of a
registration statement. If the additional cash consideration was payable in
cash or stock, it determined the amount of additional shares that would be
issuable pursuant to its assumptions. The Company will revisit the weight
of probabilities and the likelihood of scenarios at each of the measurement
dates of the derivative liabilities, which are the balance sheet dates.
The Company used the following assumptions to measure the identified
derivatives, using the Lattice valuation model, as follows:
Embedded conversion features
At issuance At June 30, 2006
------------- --------------------
Market price: $0.4880 $ 0.19
Conversion price: $0.4544 $ 0.17
Term: 4 years 3.42 years
Volatility: 39% 39%
Risk-free interest rate: 4.39% 5.13%
Freestanding warrants
The derivative liability amounts to the fair value of the warrants issuable
upon exercise, assuming that the underlying shares will not be timely
registered. We computed the fair value of this embedded derivative using
the Black Scholes valuation model with the following assumptions:
At issuance At June 30, 2006
------------- --------------------
Market price: $0.488 $0.19
Exercise price: $0.4761 $0.34
Term: 5 years 4.42 years
Volatility: 39% 39%
Risk-free interest rate: 4.39% 5.13%
We adjusted the effective exercise price to reflect the contractual
adjustment assuming that the warrants will most likely be registered during
the fourth quarter of 2006.
F-38
Liquidated damages
The liquidated damages, payable in cash, are valued using the weighting
probabilities and likely scenarios to estimate the amount of liquidated
damages and were valued at approximately $192,500 at the date of the grant
of the registration rights and at June 30, 2006.
The aggregate fair value of the derivative liabilities associated with the
warrants, embedded conversion features, and liquidated damages in
connection with the issuance of the convertible debentures and related
agreements amounted to approximately $7.05 million at the date of issuance
which exceeded the principal amount of the convertible debentures by
approximately $50,000. The Company recognized $7,000,000 as debt discount
and the excess amount has been recorded as other expenses. Additionally,
approximately $136,000 of the fair value of the warrants was recorded as
deferred financing costs.
The aggregate fair value of all derivative liabilities upon issuance of the
various debt and equity instruments amounted to $13.3 million, of which
$10.7 million was allocated to the net proceeds of the issuance of common
stock and convertible debentures, $2.4 million was allocated to other
expenses and approximately $136,000 was allocated to deferred financing
costs.
The decrease in fair value of the derivative liabilities between
measurement dates, which are the date of issuance of the various debt and
equity instruments and the balance sheet date, which is June 30, 2006
amounted to approximately $8.7 million and has been recorded as other
income.
6) RESTATEMENT OF INTERIM FINANCIAL STATEMENTS
After amending our financial statements for the interim periods ended March
31, 2005, June 30, 2005, September 30, 2005 and March 31, 2006; and for the
year ended December 31, 2005 to properly account for certain liquidated
damages associated with the $3.985 million private placement of warrants
and shares of our common stock, and the $7,000,000 private offering of
convertible debentures and warrants, management determined that the carry
forward impact of some of the restatements were not properly reflected in
the financial statements for the interim period ended June 30, 2006. Proper
carry forward of the restated amounts would affect following figures in our
quarterly financial statements:
Balance sheet: decrease in deferred financing costs ($101,894), accumulated
deficit ($10,568,028); and an increase in additional paid-in capital
($10,466,134).
Statement of income for the six-month period ended June 30, 2005: decrease
in other expense-derivatives ($92,860), earnings per share-diluted ($0.03);
and an increase in net income ($92,860), earnings per share-basic ($0.01).
Statement of cash flows for the six-month period ended June 30, 2005:
decrease in recognition of derivative liabilities ($92,860); and an
increase in net income ($92,860).
7) SUBSEQUENT EVENT
On September 7, 2006, the Company entered into a Forbearance and Amendment
Agreement with the holders of the convertible debentures and warrants that
we issued in a private placement on December 7, 2005. The terms of the
convertible debentures and warrants required that we register the shares of
our common stock underlying such debentures and warrants within 180 days of
the date of issuance of the debentures and warrants. The failure to do so
is an event of default under the debentures, giving the holders the right
to accelerate the debentures and receive a premium of approximately 30% of
the outstanding amounts due under the debentures upon acceleration. The
failure to do so also reduces the exercise price of the warrants by $0.03
per month until such shares are registered. In addition, the failure to
register such shares within 150 days of the date of issuance of the
debentures and warrants gives the holders the right to receive liquidated
damages in the amount of 2% per month of the purchase price of the
debentures and warrants, pursuant to a registration rights agreement, and
the failure to pay such liquidated damages relating to the debentures is an
event of default under the debentures.
F-39
Pursuant to the Forbearance and Amendment Agreement, the holders have
agreed, among other things, to abstain from exercising the aforementioned
rights and remedies arising out of the existing defaults under the
debentures and warrants unless we are unable to register the shares
underlying the convertible debentures and the warrants by February 28,
2007. In exchange for such forbearance, the Company agreed to reduce the
conversion price of the debentures issued on December 7, 2005 from $0.4544
per share to $0.4000 per share and to reduce the exercise price of the
warrants issued to the holders of the convertible debentures on such date
from $0.4761 per share to $0.4300 per share.
The Forbearance and Amendment Agreement constitutes a temporary
modification of terms of the convertible debentures and associated
agreements. The temporary modification of terms impacts the probabilities
and likely scenarios in our valuation of freestanding warrants, derivatives
and liquidated damages associated with the convertible debentures and
related financial instruments used at issuance and at each subsequent
balance sheet date. Based on the terms of the Forbearance and Amendment
Agreement and management's analysis of the status of its current
registration statement, notwithstanding any unforeseen circumstances, the
Company believes that it will be able to register all of the shares of its
common stock underlying such debentures and warrants by February 28, 2007.
Accordingly, the Forbearance and Amendment Agreement provides for revised
probabilities and likely outcomes that the Company will use in its
valuation of the embedded conversion features, the freestanding warrants
and the liquidated damages associated with the issuance of the convertible
debentures, as required by SFAS 133, paragraph 17. Such valuation is
performed at each balance sheet date.
The terms of the Forbearance and Amendment Agreement were finalized on
September 7, 2006 and its impact will be reflected in the valuation of the
derivatives related to the convertible debentures, associated freestanding
warrants, and liquidated damages as of September 30, 2006, which is the
next balance sheet date following entry into the Forbearance and Amendment
Agreement. The resulting changes in the fair value between balance sheet
dates of such derivatives will be recorded through earnings.
F-40
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
On April 18, 2005, Electronic Sensor Technology engaged Sherb & Co. LLP as
our independent registered public accounting firm.
Manning Elliott Chartered Accountants resigned as Electronic Sensor
Technology's auditors effective from April 18, 2005. Manning Elliott served as
Bluestone's (now Electronic Sensor Technology) independent auditors for fiscal
years ended December 31, 2004 and December 31, 2003. Manning Elliott's report on
Bluestone's (now Electronic Sensor Technology) consolidated financial statements
for the audit reports fiscal years ended December 31, 2004 and December 31, 2003
did not contain any adverse opinion or disclaimer of opinion and were not
qualified or modified as to uncertainty, audit scope or accounting principles
except as follows: In Manning Elliott's audit reports dated April 7, 2005 and
March 25, 2004 for Bluestone's (now Electronic Sensor Technology) fiscal years
ended December 31, 2004 and December 31, 2003, respectively, Manning Elliott
indicated that: "The accompanying financial statements have been prepared
assuming the Company will continue as a going concern. As discussed in Note 1 to
the financial statements, the Company has not generated any revenue since
inception and will need additional financing to sustain operations. These
factors raise substantial doubt about the Company's ability to continue as a
going concern. Management's plans in regard to these matters are also discussed
in Note 1. The financial statements do not include any adjustments that might
result from the outcome of this uncertainty."
The decision to change accountants was approved and recommended by the
Board of Directors.
During the fiscal years ended December 31, 2004 and December 30, 2003 and
until Manning Elliott's resignation, there were no disagreements with Manning
Elliott within the meaning of item 304 of regulation S-B or any matter of
accounting principles or practices, financial disclosure, or auditing scope or
procedure, which disagreements if not resolved to Manning Elliott's
satisfaction, would have caused Manning Elliott to make reference to the subject
matter of the disagreements in connection with its reports. During the fiscal
years ended December 31, 2004 and December 31, 2003, until Manning Elliott's
resignation, there were no "reportable events" (as such term is defined in item
304(a)(1)(v) of regulation S-K).
During Electronic Sensor Technology's two most recent fiscal years and any
subsequent interim period prior to the engagement of Sherb & Co. LLP, neither
Electronic Sensor Technology nor anyone on Electronic Sensor Technology's behalf
consulted with Sherb & Co. LLP, regarding either (i) the application of
accounting principles to a specified transaction, either contemplated or
proposed, or the type of audit opinion that might be rendered on Electronic
Sensor Technology's financial statements or (ii) any matter that was either the
subject of a "disagreement" or a "reportable event."
Electronic Sensor Technology requested that Manning Elliott review the
disclosure contained in Electronic Sensor Technology's current report filed on
Form 8-K on April 19, 2005, which is reproduced herein, and Manning Elliott
furnished Electronic Sensor Technology with a letter addressed to the Commission
containing any new information, clarification of Electronic Sensor Technology's
expression of Manning Elliott's views, or the respects in which Manning Elliott
did not agree with the statements contained in Electronic Sensor Technology's
current report filed on Form 8-K on April 19, 2005. A copy of Manning Elliott's
letter is included as an Exhibit to this prospectus.
WHERE YOU CAN FIND MORE INFORMATION
We file annual reports on Form 10-KSB, quarterly reports on Form 10-QSB and
current reports on Form 8-K with the SEC. You may read and copy any materials
that Electronic Sensor Technology files with the SEC at the SEC's Public
Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. You may 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 issuers that file
electronically with the SEC at: http://www.sec.gov. More information regarding
Electronic Sensor Technology is available at our website: http://www.znose.com.
The information on or that can be accessed through our website is not part of
this prospectus.
-45-
This prospectus is part of a registration statement on Form SB-2 that we
filed with the SEC. As allowed by SEC rules, this prospectus does not contain
all of the information that is in the registration statement and the exhibits to
the registration statement. For further information about Electronic Sensor
Technology, investors should refer to the registration statement and its
exhibits. A copy of the registration statement and its exhibits may be
inspected, without charge, at the SEC's Public Reference Room or on the SEC's
web site.
It is important for you to analyze the information in this prospectus, the
registration statement and the exhibits to the registration statement before you
make your investment decision.
SPECIAL NOTE OF CAUTION REGARDING FORWARD-LOOKING STATEMENTS
This prospectus and the documents incorporated by reference herein contain
"forward-looking statements" within the meaning of the federal securities laws.
These forward-looking statements are based on our management's estimates and
assumptions and take into account only the information available at the time the
forward-looking statements are made. Although we believe these estimates and
assumptions are and will be reasonable, forward-looking statements involve
risks, uncertainties and other factors that could cause our actual results to
differ materially from those suggested in the forward-looking statements.
Forward-looking statements include the information concerning future financial
performance, business strategy, projected plans and objectives of Electronic
Sensor Technology set forth in this prospectus. The words "anticipates,"
"estimates," "projects," "forecasts," "goals," "believes," "expects," "intends,"
and similar expressions are intended to identify such forward-looking
statements.
Risks and uncertainties exist that may cause results to differ materially
from those set forth in these forward-looking statements. Factors that could
cause the anticipated results to differ from those described in the
forward-looking statements include: changes in the market for security
technology, general volatility in the capital markets, changes in the businesses
of our significant customers and other factors, including those discussed in
"Risk Factors" beginning on page 2 and elsewhere in this prospectus. The
forward-looking statements speak only as of the date they are made. We do not
undertake to update forward-looking statements to reflect circumstances or
events that occur after the date the forward-looking statements are made.
LEGAL MATTERS
The validity of the common stock offered hereunder will be passed upon by
Snell & Wilmer LLP.
EXPERTS
The financial statements of Electronic Sensor Technology for the fiscal
years ended December 31, 2005 and 2004 included in this prospectus have been so
included in reliance on the report of Sherb & Co., LLP, an independent
registered public accounting firm, given on the authority of said firm as
experts in auditing and accounting.
* * *
-46-
[LOGO OF ELECTRONIC SENSOR TECHNOLOGY]
ELECTRONIC SENSOR TECHNOLOGY, INC.
27,538,695 SHARES OF COMMON STOCK
----------
PROSPECTUS
----------
We have not authorized anyone to give you any information that differs from
the information in this prospectus. If you receive any different information,
you should not rely on it.
The delivery of this prospectus shall not, under any circumstances, create
an implication that Electronic Sensor Technology, Inc. is operating under the
same conditions that it was operating under on the date of this prospectus. Do
not assume that the information contained in this prospectus is correct at any
time past the date indicated.
This prospectus does not constitute an offer to sell, or the solicitation
of an offer to buy, any securities other than the securities to which it
relates.
This prospectus does not constitute an offer to sell, or the solicitation
of an offer to buy, the securities to which it relates in any circumstances in
which such offer or solicitation is unlawful.
Dated [________], 2006
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 24. INDEMNIFICATION OF DIRECTORS AND OFFICERS.
Subject to certain limitations, Nevada Revised Statute 78.7502 provides
that "[a] corporation may indemnify any person who was or is a party or is
threatened to be made a party to any threatened, pending or completed action,
suit or proceeding, whether civil, criminal, administrative or investigative,
except an action by or in the right of the corporation, by reason of the fact
that he is or was a director, officer, employee or agent of the corporation, or
is or was serving at the request of the corporation as a director, officer,
employee or agent of another corporation, partnership, joint venture, trust or
other enterprise, against expenses, including attorneys' fees, judgments, fines
and amounts paid in settlement actually and reasonably incurred by him in
connection with the action, suit or proceeding if he . . . [a]cted in good faith
and in a manner which he reasonably believed to be in or not opposed to the best
interests of the corporation, and, with respect to any criminal action or
proceeding, had no reasonable cause to believe his conduct was unlawful."
Our bylaws provide, in pertinent part, that "[t]he Corporation shall
indemnify its officers and directors to the fullest extent permitted by law . .
.. ."
Our bylaws also allow our directors to cause Electronic Sensor Technology
to "purchase and maintain insurance or make other financial arrangements on
behalf of any person who is or was a director, officer, employee or agent of the
Corporation . . . for any liability asserted against such person and liability
and expenses incurred by such person in his capacity as a director, officer,
employee or agent, or arising out of his status as such . . . ." We maintain a
policy of liability insurance that insures our directors and officers against
the cost of defense, settlement or payment of a judgment under certain
circumstances.
Anyone serving on a committee appointed by the Board of Directors to
administer Electronic Sensor Technology's 2005 Stock Incentive Plan is entitled
to the full indemnification and reimbursement to which members of the Board of
Directors are entitled under the Stock Incentive Plan. Under the terms of the
Stock Incentive Plan, no member of the Board of Directors is liable for any act
or omission made in good faith with respect to the Stock Incentive Plan or any
option grants or stock issuances under the Stock Incentive Plan.
ITEM 25. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.
The expenses in connection with the issuance and distribution of the
securities being registered, other than underwriting discounts and commissions,
are estimated to be as follows:
SEC registration fee .................. $ 1,483.29
Printing fees* ........................ $ 0.00
Legal fees and expenses* .............. $ 90,000.00
Accounting fees and expenses*.......... $ 20,000.00
Miscellaneous* ........................ $ 1,500.00
Total ............................ $ 112,983.29
----------
* Estimated
ITEM 26. RECENT SALES OF UNREGISTERED SECURITIES.
We relied upon Section 4(2) of the Securities Act in claiming exemption
from registration of the securities described below due to the knowledge and
experience in financial and business matters of the investors involved, there
was no public offering of such securities, there was no general solicitation or
advertising involved in the offers or sales of the securities and the issuances
otherwise met the requirements for exemption from registration pursuant to
Section 4(2). We have provided below the facts relied upon in order to make the
Section 4(2) exemption available for each transaction.
II-1
On January 25, 2006, we issued 75,000 shares of common stock to our former
President and Chief Executive Officer, Matthew Collier. Such shares were granted
to Mr. Collier as compensation for his service as President and Chief Executive
Officer. Mr. Collier was the only investor in this transaction, and this
transaction qualified for exemption from registration by virtue of Mr. Collier's
position as President and Chief Executive Officer of Electronic Sensor
Technology and Mr. Collier's representation to us that he was acquiring such
securities for his own account and not with a view toward distribution.
On December 7, 2005, we issued to Midsummer and Islandia, in a private
offering, (i) $7,000,000 aggregate principal amount of convertible debentures
due December 7, 2009, convertible into 15,404,930 shares of common stock, with a
conversion price of $0.4544 per share and (ii) five-year warrants to purchase
12,130,314 shares of common stock at an exercise price of $0.4761 per share. We
received $4,500,000 in cash from Midsummer and $2,500,000 in cash from Islandia
in exchange for the debentures and warrants. There were a total of 2 investors
in this transaction (Midsummer and Islandia), and each investor represented and
warranted to us, among other things, the following:
(i) that the debentures and warrants were being acquired for its own
account and not with a view to distribute such debentures and
warrants;
(ii) that such investor is an "accredited investor" as defined in Rule
501(a)(1), (a)(2), (a)(3), (a)(7) or (a)(8) under the Securities act
or a "qualified institutional buyer" as defined in Rule 144A(a) under
the Securities Act;
(iii)that such investor has such knowledge, sophistication and experience
in business and financial matters so as to be capable of evaluating
the merits and risks of such investment; and
(iv) that such investor was not purchasing the debentures and warrants as a
result of any advertisement, article, notice or other communication
regarding the securities.
On December 7, 2005, we also issued, in a private offering, a five-year
warrant to purchase 485,213 shares of common stock at an exercise price of
$0.4761 per share to Montgomery in partial consideration for financial advisory
services performed by Montgomery in connection with the foregoing private
offering. Montgomery was the only investor in this transaction, and Montgomery
provided us with similar representations and warranties as those given by
Midsummer and Islandia, described above.
On December 5, 2005, we issued to CEOcast, in a private offering, 130,000
shares of common stock in partial consideration of investor relations services
provided to Electronic Sensor Technology by CEOcast. CEOcast was the only
investor in this transaction, and CEOcast provided us with similar
representations and warranties as those given by Midsummer and Islandia,
described above.
On December 5, 2005, we issued to HomelandSecurityStocks, in a separate
private offering, a five-year warrant to purchase 350,000 shares of common stock
at an exercise price of $2.40 per share in partial settlement of litigation
between Electronic Sensor Technology and HomelandSecurityStocks.
HomelandSecurityStocks was the only investor in this transaction, and
HomelandSecurityStocks provided us with similar representations and warranties
as those given by Midsummer and Islandia, described above.
On October 7, 2005, we granted to James Frey, Chairman of the Board of
Directors, non-qualified options to purchase 250,000 shares of common stock at
an exercise price of $0.64 per share under our 2005 Stock Incentive Plan. Mr.
Frey's stock options will vest as follows: one quarter of the options will vest
on March 8, 2006, one quarter on September 8, 2006, one quarter on March 8, 2007
and one quarter on September 8, 2007, provided Mr. Frey is still participating
as a member of our Board of Directors at the end of each such six-month period.
Such options were granted to Mr. Frey as compensation for his service as
Chairman of the Board of Directors. Mr. Frey was the only investor in this
transaction, and this transaction qualified for exemption from registration by
virtue of Mr. Frey's position as Chairman of the Board of Electronic Sensor
Technology and Mr. Frey's representation to us that he was acquiring such
securities for his own account and not with a view toward distribution.
II-2
On October 7, 2005, we granted to Matthew Collier, former President and
Chief Executive Officer of Electronic Sensor Technology, non-qualified options
to purchase 500,000 shares of common stock at an exercise price of $0.64 per
share. Mr. Collier's options would have vested, 33% annually (and 34% in the
third year), provided Mr. Collier was still employed by Electronic Sensor
Technology at the end of each such annual period. On January 25, 2006, Mr.
Collier resigned from his position as President and Chief Executive Officer of
Electronic Sensor Technology, and is no longer employed by Electronic Sensor
Technology. Pursuant to the terms of Mr. Collier's employment agreement, upon
Mr. Collier's resignation, the vesting schedule of his options was accelerated
by six months. In addition, pursuant to the terms of the Settlement Agreement,
Mutual Release and Amendment of Option Agreement entered into between Electronic
Sensor Technology and Mr. Collier on January 25, 2006, options to purchase
200,000 shares of common stock at an exercise price of $0.64 per share will vest
in the first vesting period, which, as a result of the six-month acceleration of
the vesting of the options, was deemed to occur on November 26, 2005. In
accordance with the terms of the Option Agreement, Mr. Collier's resignation
will result in the forfeiture of the unvested options to purchase 300,000 shares
of common stock, and Mr. Collier will have three months from January 25, 2006 in
which to exercise the vested options to purchase 200,000 shares of common stock.
Mr. Collier also was granted 75,000 shares of restricted common stock on January
25, 2006, subject to a right of first refusal by Electronic Sensor Technology in
the event Mr. Collier wishes to sell such shares. Such shares and options were
granted to Mr. Collier as compensation for his service as President and Chief
Executive Officer. Mr. Collier was the only investor in these transactions, and
these transactions qualified for exemption from registration by virtue of Mr.
Collier's position as Chairman of the Board of Electronic Sensor Technology and
Mr. Collier's representation to us that he was acquiring such securities for his
own account and not with a view toward distribution.
On February 1, 2005, in connection with various mergers whereby Electronic
Sensor Technology, Inc. acquired Electronic Sensor Technology, L.P., we issued,
in a private offering, 3,985,000 shares of common stock and three-year warrants
to purchase 3,985,000 shares of common stock at an exercise price of $1.00 per
share. In exchange for such common stock and warrants, we received $3,985,000 in
cash from investors. There were 38 investors in this transaction, and each
investor provided us with similar representations and warranties as those given
by Midsummer and Islandia, described above.
On the same date, certain bridge investors of Electronic Sensor Technology,
L.P. exchanged Class C Partnership Interests in Electronic Sensor Technology,
L.P. for 200,000 shares of common stock and warrants to purchase 200,000 shares
of common stock at $1.00 per share. There were 7 investors in this transaction,
and each investor provided us with similar representations and warranties as
those given by Midsummer and Islandia, described above.
On the same date, we issued 20,000,000 shares of common stock to
shareholders of Amerasia Technology, Inc. and L&G Sensor Technology, L.P.,
holders of the partnership interests of Electronic Sensor Technology, L.P. On
the same date, we also issued 2,783,741 shares of common stock and warrants to
purchase 1,391,871 shares of common stock at an exercise price of $1.00 per
share, so long as the trading price of the common stock is at least $1.50 per
share, in exchange for the cancellation of certain debt by Electronic Sensor
Technology, L.P. debtholders. On the same date, in connection with the mergers,
options to purchase 969,500 limited partnership interests of Electronic Sensor
Technology, L.P. were terminated and replaced by options to purchase 969,500
shares of common stock of Electronic Sensor Technology, Inc. The replacement
options of Electronic Sensor Technology, Inc. carried over the same exercise
prices and vesting provisions as the options to purchase limited partnership
interests of Electronic Sensor Technology, L.P. There were 20 investors, in the
aggregate, in the foregoing 3 related transactions, and each investor provided
us with similar representations and warranties as those given by Midsummer and
Islandia, described above.
On March 1, 2004, Bluestone issued, in a private offering, 260,000 shares
of common stock at $0.25 per share. In exchange for such common stock, Bluestone
received $65,000 in cash from investors. We are not aware of the factual
circumstances surrounding Bluestone's reliance on an exemption from registration
of such securities.
II-3
ITEM 27. EXHIBITS.
EXHIBIT
NUMBER DESCRIPTION
------- ----------------------------------------------------------------------
See Exhibit Index.
ITEM 28. UNDERTAKINGS.
(a) Electronic Sensor Technology hereby undertakes and will:
(1) File, during any period in which it offers or sells securities, a
post-effective amendment to this registration statement to:
(i) Include any prospectus required by Section 10(a)(3) of the
Securities Act;
(ii) Reflect in the prospectus any facts or events which, individually
or together, represent a fundamental change in the information in the
registration statement. Notwithstanding the foregoing, any increase or
decrease in volume of securities offered (if the total dollar value of
securities offered would not exceed that which was registered) and any
deviation from the low or high end of the estimated maximum offering range
may be reflected in the form of prospectus filed with the Commission
pursuant to Rule 424(b) if, in the aggregate, the changes in volume and
price represent no more than a 20 percent change in the maximum aggregate
offering price set forth in the "Calculation of Registration Fee" table in
the effective registration statement; and
(iii) Include any additional or changed material information on the
plan of distribution.
(2) For determining liability under the Securities Act, treat each
post-effective amendment as a new registration statement of the securities
offered, and the offering of the securities at that time to be the initial bona
fide offering.
(3) File a post-effective amendment to remove from registration any
of the securities that remain unsold at the end of the offering.
(4) For determining liability of the undersigned company under the
Securities Act to any purchaser in the initial distribution of the securities,
the undersigned company undertakes that in a primary offering of securities of
the undersigned company pursuant to this registration statement, regardless of
the underwriting method used to sell the securities to the purchaser, if the
securities are offered or sold to such purchaser by means of any of the
following communications, the undersigned company will be a seller to the
purchaser and will be considered to offer or sell such securities to such
purchaser:
(i) Any preliminary prospectus or prospectus of the undersigned
company relating to the offering required to be filed pursuant to Rule 424
(Section 230.424 of this chapter);
(ii) Any free writing prospectus relating to the offering prepared by
or on behalf of the undersigned company or used or referred to by the
undersigned company;
(iii) The portion of any other free writing prospectus relating to the
offering containing material information about the undersigned company or
its securities provided by or on behalf of the undersigned company; and
(iv) Any other communication that is an offer in the offering made by
the undersigned company to the purchaser.
II-4
(b) Insofar as indemnification for liabilities arising under the Securities
Act of 1933 may be permitted to directors, officers and controlling persons of
Electronic Sensor Technology pursuant to the foregoing provisions, or otherwise,
Electronic Sensor Technology has been advised that in the opinion of the
Securities and Exchange Commission such indemnification is against public policy
as expressed in the Securities Act and is, therefore, unenforceable. In the
event that a claim for indemnification against such liabilities (other than the
payment by Electronic Sensor Technology of expenses incurred or paid by a
director, officer or controlling person of Electronic Sensor Technology in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities being
registered, Electronic Sensor Technology will, unless in the opinion of its
counsel the matter has been settled by controlling precedent, submit to a court
of appropriate jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Securities Act and will be governed by
the final adjudication of such issue.
* * *
II-5
SIGNATURES
In accordance with the requirements of the Securities Act of 1933, the
registrant certifies that it has reasonable grounds to believe that it meets all
of the requirements for filing on Form SB-2 and authorized this Pre-Effective
Amendment No. 5 to registration statement on Form SB-2 to be signed on its
behalf by the undersigned, in the city of Newbury Park, state of California on
October 20, 2006.
ELECTRONIC SENSOR TECHNOLOGY, INC.
By: /s/ Teong C. Lim
-------------------------------------
Teong C. Lim
President and Chief Executive Officer
(Principal Executive Officer)
In accordance with the requirements of the Securities Act of 1933, this
Pre-Effective Amendment No.5 to registration statement on Form SB-2 has been
signed by the following persons in the capacities and on the dates stated.
Date: October 20, 2006 By: /s/ Teong C. Lim
-------------------------------------
Teong C. Lim
President and Chief Executive Officer
(Principal Executive Officer)
Date: October 20, 2006 By: /s/ Francis Chang
-------------------------------------
Francis Chang
Secretary, Treasurer and
Vice President of Finance
and Administration
(Principal Financial Officer and
Principal Accounting Officer)
Pursuant to the requirement the requirements of the Securities Act of 1933,
this Pre-Effective Amendment No.5 to registration statement on Form SB-2 has
been signed by the following persons in the capacities and on the dates
indicated.
Date: October 20, 2006 By: *
-------------------------------------
James Frey, Chairman
Date: October 20, 2006 By: *
-------------------------------------
Francis Chang, Director
Date: October 20, 2006 By: *
-------------------------------------
Teong C. Lim, Director
Date: October 20, 2006 By: *
-------------------------------------
Edward Staples, Director
Date: October 20, 2006 By: *
-------------------------------------
Mike Krishnan, Director
Date: October 20, 2006 By: *
-------------------------------------
James Wilburn, Director
Date: October 20, 2006 By: *
-------------------------------------
Michel Amsalem, Director
By:
-------------------------------------
Lewis Larson, Director
*By: /s/ Francis Chang
------------------
Francis Chang
Attorney-in-Fact
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
------- ----------------------------------------------------------------------
3.1 Articles of Incorporation of Electronic Sensor Technology, as
amended.*
4.1 Description of our common stock in Article Fourth of the Amendment to
Electronic Sensor Technology's Articles of Incorporation dated
January 25, 2005 (incorporated by reference from Exhibit 3.1 hereto).
4.2 Description of rights of shareholders of Electronic Sensor Technology
in Article I and Article IX of Electronic Sensor Technology's Amended
and Restated Bylaws (incorporated by reference from Exhibit 3.1 of the
quarterly report on Form 10-QSB filed on August 16, 2006).
5.1 Opinion of Snell & Wilmer LLP regarding validity of the common stock.*
10.1 Term Sheet dated December 2, 2004 between Bluestone Ventures Inc. and
Electronic Sensor Technology, L.P. (incorporated by reference from
Exhibit 10.1 of the current report on Form 8-K filed on January 10,
2005).
10.2 Agreement and Plan of Merger dated as of January 31, 2005, by and
among Bluestone Ventures Inc., Amerasia Technology, Inc., L&G Sensor
Technology, Inc., Amerasia Acquisition Corp. and L&G Acquisition Corp.
(incorporated by reference from Exhibit 10.1 of the current report on
Form 8-K filed on February 7, 2005).
10.3 Form of Subscription Agreement between Bluestone Ventures Inc. and
each investor on the signature page thereto (incorporated by reference
from Exhibit 10.2 of the current report on Form 8-K filed on February
7, 2005).
10.4 Electronic Sensor Technology, Inc. 2005 Stock Incentive Plan
(incorporated by reference from Exhibit 10.1 of the annual report on
Form 10-KSB filed on April 15, 2005).
10.5 Form of Stock Option Agreement (incorporated by reference from Exhibit
10.2 of the annual report on Form 10-KSB filed on April 15, 2005).
10.6 Business Loan Agreement dated March 11, 2005, between Electronic
Sensor Technology, Inc. and East West Bank (incorporated by reference
from Exhibit 10.4 of the annual report on Form 10-KSB filed on April
15, 2005).
10.7 Commercial Security Agreement dated March 11, 2005, between Electronic
Sensor Technology, Inc. and East West Bank (incorporated by reference
from Exhibit 10.5 of the annual report on Form 10-KSB filed on April
15, 2005).
10.8 Letter agreement dated as of May 16, 2005, by and between Electronic
Sensor Technology, Inc. and Matthew Collier (incorporated by reference
from Exhibit 10.1 of the current report on Form 8-K/A filed on October
6, 2005).
10.9 Letter agreement dated as of October 3, 2005, between Electronic
Sensor Technology, Inc. and James Frey (incorporated by reference from
Exhibit 10.1 of the current report on Form 8-K filed on October 7,
2005).
10.10 Letter agreement dated as of February 21, 2005, between Electronic
Sensor Technology, Inc. and James Frey (incorporated by reference from
Exhibit 10.2 of the current report on Form 8-K filed on October 7,
2005).
10.11 Addendum dated as of April 1, 2005 to the letter agreement dated
February 21, 2005, between Electronic Sensor Technology, Inc. and
James Frey (incorporated by reference from Exhibit 10.3 of the current
report on Form 8-K filed on October 7, 2005).
10.12 International Distributorship Agreement dated August 2005, between
Electronic Sensor Technology, Inc. and Beijing R&D Technology Co.,
Ltd.*
10.13 International Distributorship Agreement dated October 21, 2005,
between Electronic Sensor Technology, Inc. and TechMondial, Ltd.*
10.14 Form of Securities Purchase Agreement dated as of December 7, 2005,
among Electronic Sensor Technology, Inc., Midsummer Investment, Ltd.
and Islandia, L.P. (incorporated by reference from Exhibit 10.1 of the
current report on Form 8-K filed on December 8, 2005).
10.15 Form of Registration Rights Agreement dated as of December 7, 2005,
among Electronic Sensor Technology, Inc., Midsummer Investment, Ltd.
and Islandia, L.P. (incorporated by reference from Exhibit 10.2 of the
current report on Form 8-K filed on December 8, 2005).
10.16 Settlement Agreement, Mutual Release and Amendment of Option
Agreement, effective as of January 25, 2006, between Electronic Sensor
Technology, Inc. and Matthew S. Collier (incorporated by reference
from Exhibit 10.1 of the current report on Form 8-K filed on January
31, 2006).
10.17 Forbearance and Amendment Agreement dated as of September 7, 2006,
among Electronic Sensor Technology, Inc., Midsummer Investment, Ltd.
and Islandia L.P. (incorporated by reference from Exhibit 10.1 of the
current report on Form 8-K filed on September 8, 2006).
16.1 Letter from Manning Elliott Chartered Accountants (incorporated by
reference from Exhibit 16.1 of the current report on Form 8-K filed on
April 19, 2005).
21.1 Subsidiaries of Electronic Sensor Technology.*
23.1 Consent of Sherb & Co., LLP, Certified Public Accountants.
23.3 Consent of Snell & Wilmer LLP (contained in Exhibit 5.1).*
24.1 Power of Attorney.*
24.2 Power of Attorney.*
----------
(*) Previously filed.