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Crossroads Systems Inc – ‘10-Q’ for 7/31/15

On:  Monday, 9/14/15, at 2:29pm ET   ·   For:  7/31/15   ·   Accession #:  1144204-15-54806   ·   File #:  1-15331

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  As Of               Filer                 Filing    For·On·As Docs:Size             Issuer                      Filing Agent

 9/14/15  Crossroads Systems Inc            10-Q        7/31/15   63:5.5M                                   Toppan Merrill/FA

Quarterly Report   —   Form 10-Q   —   Sect. 13 / 15(d) – SEA’34
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: 10-Q        Quarterly Report                                    HTML    298K 
 2: EX-31.1     Certification -- §302 - SOA'02                      HTML     22K 
 3: EX-31.2     Certification -- §302 - SOA'02                      HTML     22K 
 4: EX-32.1     Certification -- §906 - SOA'02                      HTML     18K 
 5: EX-32.2     Certification -- §906 - SOA'02                      HTML     18K 
12: R1          Document And Entity Information                     HTML     34K 
13: R2          Consolidated Balance Sheets                         HTML     62K 
14: R3          Consolidated Balance Sheets [Parenthetical]         HTML     30K 
15: R4          Consolidated Statements of Operations               HTML     61K 
16: R5          Consolidated Statements of Comprehensive Loss       HTML     23K 
17: R6          Consolidated Statements of Cash Flows               HTML     77K 
18: R7          Organization and Basis of Presentation              HTML     38K 
19: R8          Fair Value Measurement                              HTML     23K 
20: R9          Inventory                                           HTML     30K 
21: R10         Property and Equipment                              HTML     37K 
22: R11         Accrued Expenses and Deferred Revenue               HTML     66K 
23: R12         Line of Credit and Long Term Liabilities            HTML     42K 
24: R13         Commitments and Contingencies                       HTML     48K 
25: R14         Stockholders' Equity                                HTML     61K 
26: R15         Stock Options and Stock Based Compensation          HTML    135K 
27: R16         Employee Benefits                                   HTML     21K 
28: R17         Related Party Transactions                          HTML     28K 
29: R18         Preferred Stock Rights                              HTML     24K 
30: R19         Subsequent Events                                   HTML     21K 
31: R20         Organization and Basis of Presentation (Policies)   HTML     45K 
32: R21         Inventory (Tables)                                  HTML     30K 
33: R22         Property and Equipment (Tables)                     HTML     36K 
34: R23         Accrued Expenses and Deferred Revenue (Tables)      HTML     68K 
35: R24         Line of Credit and Long Term Liabilities (Tables)   HTML     32K 
36: R25         Stockholders' Equity (Tables)                       HTML     31K 
37: R26         Stock Options and Stock Based Compensation          HTML    129K 
                (Tables)                                                         
38: R27         Organization and Basis of Presentation (Details     HTML     30K 
                Textual)                                                         
39: R28         Inventory (Details)                                 HTML     22K 
40: R29         Property and Equipment (Details)                    HTML     38K 
41: R30         Property and Equipment (Details Textual)            HTML     19K 
42: R31         Accrued Expenses and Deferred Revenue (Details)     HTML     28K 
43: R32         Accrued Expenses and Deferred Revenue (Details 1)   HTML     23K 
44: R33         Accrued Expenses and Deferred Revenue (Details 2)   HTML     24K 
45: R34         Accrued Expenses and Deferred Revenue (Details      HTML     23K 
                Textual)                                                         
46: R35         Line of Credit and Long Term Liabilities (Details)  HTML     28K 
47: R36         Line of Credit and Long Term Liabilities (Details   HTML     48K 
                Textual)                                                         
48: R37         Commitments and Contingencies (Details Textual)     HTML     28K 
49: R38         Stockholders' Equity (Details)                      HTML     34K 
50: R39         Stockholders' Equity (Details Textual)              HTML    152K 
51: R40         Stock Options and Stock Based Compensation          HTML     29K 
                (Details)                                                        
52: R41         Stock Options and Stock Based Compensation          HTML     33K 
                (Details 1)                                                      
53: R42         Stock Options and Stock Based Compensation          HTML     45K 
                (Details 2)                                                      
54: R43         Stock Options and Stock Based Compensation          HTML     69K 
                (Details 3)                                                      
55: R44         Stock Options and Stock Based Compensation          HTML     69K 
                (Details Textual)                                                
56: R45         Employee Benefits (Details Textual)                 HTML     21K 
57: R46         Related Party Transactions (Details Textual)        HTML     47K 
58: R47         Preferred Stock Rights (Details Textual)            HTML     29K 
59: R48         Subsequent Events (Details Textual)                 HTML     20K 
61: XML         IDEA XML File -- Filing Summary                      XML    137K 
60: EXCEL       IDEA Workbook of Financial Reports                  XLSX     60K 
62: EXCEL     ˛ IDEA Workbook of Financial Reports                  XLSX     60K 
 6: EX-101.INS  XBRL Instance -- crds-20150731                       XML   1.14M 
 8: EX-101.CAL  XBRL Calculations -- crds-20150731_cal               XML    114K 
 9: EX-101.DEF  XBRL Definitions -- crds-20150731_def                XML    617K 
10: EX-101.LAB  XBRL Labels -- crds-20150731_lab                     XML    829K 
11: EX-101.PRE  XBRL Presentations -- crds-20150731_pre              XML    700K 
 7: EX-101.SCH  XBRL Schema -- crds-20150731                         XSD    129K 
63: ZIP         XBRL Zipped Folder -- 0001144204-15-054806-xbrl      Zip    116K 


‘10-Q’   —   Quarterly Report
Document Table of Contents

Page (sequential)   (alphabetic) Top
 
11st Page  –  Filing Submission
"Part I Financial Information
"Financial Statements
"Management's Discussion and Analysis of Financial Condition and Results of Operations
"Quantitative and Qualitative Disclosures About Market Risk
"Controls and Procedures
"Part Ii Other Information
"Legal Proceedings
"Risk Factors
"Unregistered Sales of Equity Securities and Use of Proceeds
"Defaults Upon Senior Securities
"Mine Safety Disclosures
"Other Information
"Exhibits

This is an HTML Document rendered as filed.  [ Alternative Formats ]



 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(MARK ONE)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTERLY PERIOD ENDED July 31, 2015

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE TRANSITION PERIOD FROM TO

 

COMMISSION FILE NUMBER: 001-15331

 

CROSSROADS SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

DELAWARE 74-2846643
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)  
   
11000 NORTH MOPAC EXPRESSWAY  
SUITE 150  
AUSTIN, TEXAS 78759
(Address of principal executive offices) (Zip code)

 

(512) 349-0300

(Registrant's telephone number, including area code)

 

Indicate by check mark whether registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x   Yes  ¨  No

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  x  Yes  ¨  No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

¨  Large Accelerated Filer ¨  Accelerated Filer  ¨  Non-Accelerated Filer x   Smaller Reporting Company 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)   ¨  Yes     x  No

 

As of September 14, 2015, Registrant had outstanding 23,471,576 shares of common stock, par value $0.001 per share. 

 

 C: 

 

 

 

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

 

FORM 10-Q

QUARTER ENDED July 31, 2015

 

TABLE OF CONTENTS

 

  PAGE
PART I   FINANCIAL INFORMATION
   
Item 1. Financial Statements 3
     
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 20
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk 28
     
Item 4. Controls and Procedures 28
     
PART II   OTHER INFORMATION
     
Item 1. Legal Proceedings 29
     
Item 1A. Risk Factors 31
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 31
     
Item 3. Defaults Upon Senior Securities 31
     
Item 4. Mine Safety Disclosures 31
     
Item 5. Other Information 31
     
Item 6. Exhibits 32

 

 C: 
  C: 2 

 

  

PART I -         FINANCIAL INFORMATION

 

ITEM 1.         FINANCIAL STATEMENTS –

 

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

 

   July 31,   October 31, 
   2015   2014 
   (unaudited)     
ASSETS          
           
Current assets:          
Cash and cash equivalents  $7,041   $4,676 
Restricted cash   270    270 
           
Total cash, cash equivalents and restricted cash   7,311    4,946 
           
Accounts receivable, net of allowance for doubtful accounts of $3 and $151, respectively   1,896    2,252 
Inventory   480    357 
Prepaid expenses and other current assets   445    798 
           
Total current assets   10,132    8,353 
           
Property and equipment, net   553    440 
Other assets   62    63 
           
Total assets  $10,747   $8,856 
           
LIABILITIES AND STOCKHOLDERS' EQUITY          
           
Current liabilities:          
Accounts payable  $2,777   $1,443 
Accrued expenses   1,601    1,397 
Deferred revenue, current portion   953    1,032 
Current portion of long term debt, net of debt discount   2,650    3,160 
           
Total current liabilities   7,981    7,032 
           
           
Long term debt, net of current portion and debt discount   -    1,651 
Long term portion of deferred revenue, net of current portion   593    423 
           
Commitments and contingencies (See Note 7)   -    - 
           
Total liabilities   8,574    9,106 
           
Stockholders' equity (deficit):          
Convertible preferred stock, $0.001 par value, 25,000,000 shares authorized, 3,041,257 and 3,318,197 shares issued and outstanding, respectively   3    3 
Common stock, $0.001 par value, 75,000,000 shares authorized, 23,418,989 and 15,831,810 shares issued and outstanding, respectively   23    16 
Additional paid-in capital   238,027    226,208 
Accumulated other comprehensive loss   (86)   (60)
Accumulated deficit   (235,794)   (226,417)
           
Total stockholders' equity (deficit)   2,173    (250)
           
Total liabilities and stockholders' equity  $10,747   $8,856 

 

See accompanying notes to the condensed consolidated financial statements.

 

 C: 
 3 

 

  

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(In thousands, except share and per share data)

 

   Three Months Ended   Nine Months Ended 
   July 31,   July 31, 
   2015   2014   2015   2014 
                 
Revenue:                    
Product  $516   $600   $1,962   $2,925 
IP license, royalty and other   1,628    1,487    4,074    5,581 
                     
Total revenue   2,144    2,087    6,036    8,506 
                     
Cost of revenue:                    
Product   150    138    652    578 
IP license, royalty and other   417    296    934    934 
                     
Total cost of revenue   567    434    1,586    1,512 
                     
Gross profit   1,577    1,653    4,450    6,994 
                     
Operating expenses:                    
Sales and marketing   715    872    2,373    2,842 
Research and development   1,091    1,351    3,641    4,399 
General and administrative   2,826    1,146    6,706    3,664 
                     
Total operating expenses   4,632    3,369    12,720    10,905 
                     
Loss from operations   (3,055)   (1,716)   (8,270)   (3,911)
                     
Gain on settlement   -    -    -    1,050 
                     
Loss before other expenses   (3,055)   (1,716)   (8,270)   (2,861)
                     
Other expense:                    
Interest expense   (89)   (184)   (316)   (662)
Amortization of debt discount and issuance costs   (112)   (301)   (512)   (967)
Change in value of derivative liability   -    -    -    (2,765)
Other income   (1)   -    19    (17)
                     
Net loss  $(3,257)  $(2,201)  $(9,079)  $(7,272)
                     
Dividends attributable to preferred stock  $(43)  $(152)  $(228)  $(400)
Net loss available to common stockholders, basic and diluted  $(3,300)  $(2,353)  $(9,307)  $(7,672)
Net loss per share available to common stockholders, basic and diluted  $(0.17)  $(0.16)  $(0.51)  $(0.56)
                     
Weighted average number of common shares outstanding, basic and diluted   19,428,070    15,165,629    18,206,002    13,705,434 

 

See accompanying notes to the condensed consolidated financial statements.

 

 C: 
 4 

 

 

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(unaudited)

(In thousands)

 

   Three Months Ended   Nine Months Ended 
   July 31,   July 31, 
   2015   2014   2015   2014 
                 
Net loss  $(3,257)  $(2,201)  $(9,079)  $(7,272)
                     
Other comprehensive income:                    
Foreign currency translation adjustments   (7)   (7)   (26)   (4)
                     
Comprehensive loss  $(3,264)  $(2,208)  $(9,105)  $(7,276)

 

See accompanying notes to the condensed consolidated financial statements.

 

 C: 
 5 

 

  

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(In thousands)

 

   Nine Months Ended 
   July 31, 
   2015   2014 
         
Cash flows from operating activities:          
Net loss  $(9,079)  $(7,272)
Adjustments to reconcile net loss to net cash used in operating activities:          
Depreciation   300    517 
Loss on change in value of derivative liability   -    2,765 
Amortization of debt discount   512    967 
Gain on disposal of property and equipment   -    (15)
Stock-based compensation   743    1,312 
Provision for doubtful accounts receivable   61    10 
Changes in assets and liabilities:          
Accounts receivable   260    286 
Inventory   (123)   17 
Prepaid expenses and other assets   209    96 
Accounts payable   1,337    (252)
Accrued expenses   211    (950)
Deferred revenue   154    37 
Net cash used in operating activities   (5,415)   (2,482)
Cash flows from investing activities:          
Purchase of property and equipment   (180)   (71)
Proceeds from sale of property and equipment   -    18 
Net cash used in investing activities   (180)   (53)
Cash flows from financing activities:          
Proceeds from issuance of common stock, net of expenses   10,549    5,461 
Repayment of debt   (2,534)   (3,633)
Net cash provided by financing activities   8,015    1,828 
           
Effect of foreign exchange rate on cash and cash equivalents   (55)   (8)
Change in cash and cash equivalents   2,365    (715)
Cash and cash equivalents, beginning of period   4,946    7,795 
Cash, cash equivalents, and restricted cash end of period  $7,311   $7,080 
           
Supplemental disclosure of cash flow information:          
           
Cash paid for interest  $309   $676 
Cash paid for income taxes  $1   $2 
           
Supplemental disclosure of non cash financing activities:          
Conversion of preferred stock to common stock  $418   $729 
Common stock dividends issued to preferred shareholders  $298   $612 
Warrants issued with private placement stock  $1,893   $- 
Conversion of derivative liability to equity  $-   $3,537 
Lease incentive received, non-cash addition to fixed assets  $243   $- 

 

See accompanying notes to the consolidated financial statements.

 

 C: 
 6 

 

 

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1. ORGANIZATION AND BASIS OF PRESENTATION

 

The accompanying consolidated financial statements include the accounts of Crossroads Systems, Inc. and its wholly-owned subsidiaries (“Crossroads” or the “Company”). Crossroads, a Delaware corporation, is a global provider of data storage solutions. Founded in 1996 and based in Austin, Texas, Crossroads develops technology and products that address specific IT challenges, such as cost-effectively storing and protecting business-critical data.

 

Principles of Consolidation and Presentation

 

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation.

 

The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has accumulated significant losses as it has been developing its current and next generation products. The Company believes that cash flow from operations, customer reimbursed expenses, debt, and proceeds from the sale of common and preferred stock will be sufficient to fund the anticipated operations for the next 12 months.  These financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern for a reasonable period of time.

 

The investment in KIP CR P1 LP (which we refer to as the “partnership” (see Note 6)), of which the Company is a limited partner and of which an affiliate of Fortress (as defined in Note 6) is the general partner, is accounted for using the equity method. The current investment balance is nominal at July 31, 2015.

 

Use of Estimates

 

The preparation of the consolidated financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates, and such differences may be material to the consolidated financial statements.

      

Derivative Liabilities

 

The Company, in accordance with Financial Accounting Standards Boards (“FASB”) Accounting Standards Codification (“ASC”) 815-40-25 and ASC 815-10-15 Derivatives and Hedging and ASC 480-10-25 Liabilities-Distinguishing Liabilities from Equity, accounted for the Series F warrants (as defined in Note 8), as liabilities at their fair value during periods where the full ratchet anti-dilution provision was in effect.

 

The Series F warrants full ratchet anti-dilution provision was eliminated on January 2014, and the fair value of the warrants were reclassified to shareholders’ equity.

 

Contracts to Modify or Customize Products

 

The Company periodically enters into contracts with certain customers to significantly modify or customize products. In accounting for such arrangements, the Company first looks to the guidance in FASB ASC Subtopic 985-605, Software - Revenue Recognition (“ASC 985-605”), and then ASC Subtopic 605-25, Revenue Recognition – Multiple-Element Arrangements, to determine the appropriate accounting elements in the arrangement.  The Company then considers the appropriate recognition model for each accounting element based on the nature of the element and applies the guidance in ASC Subtopic 605-35, Revenue Recognition – Construction-Type and Production-Type Contracts, ASC Subtopic 985-60, ASC Subtopic 605-15, Revenue Recognition – Products, or ASC Subtopic 605-20, Revenue Recognition – Services, as applicable.  Amounts allocated to the modification/customization service element are evaluated for classification in the consolidated statement of operations as either revenue or reduction of research and development expense based on the following considerations: whether and in what circumstances the consideration received is refundable, ownership of the final product and intellectual property rights to develop the product, and exclusivity of the final product. 

   

Computation of Net Loss Per Share

 

Basic loss per share is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share is computed by giving effect to all dilutive potential common shares that were outstanding during the period. Basic earnings per share excludes the dilutive effect of common stock equivalents such as stock options and warrants, while earnings per share, assuming dilution, includes such dilutive effects. Future weighted-average shares outstanding calculations will be impacted by the following factors, among others: (i) the ongoing issuance of common stock associated with stock option and warrant exercises; (ii) any fluctuations in the Company’s stock price, which could cause changes in the number of common stock equivalents included in the earnings per share, assuming dilution computation; and (iii) the issuance of common stock to effect business combinations should the Company enter into such transactions.

 

 C: 
 7 

 

 

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

The Company has excluded all outstanding common stock equivalents from the calculation of diluted net loss per share because all such common stock equivalents are antidilutive for all periods presented. The total number of common stock equivalents excluded from the diluted net loss per common share calculation was 13,449,135 and 12,266,695 for the nine months ended July 31, 2015 and 2014, respectively. The dilutive common stock equivalents for the nine months ended July 31, 2015 include warrants to purchase 7,085,426 shares of common stock, 3,041,257 shares of preferred stock, which are excluded until converted to common shares (Note 8), and stock options to purchase 3,322,452 shares of common stock.

 

Net loss available to common stockholders is calculated by deducting from loss, preferred dividends paid and accrued of $43,000 and $0.2 million for the three and nine months ended July 31, 2015, respectively.

 

Recently Issued Accounting Pronouncements

 

During November 2014, the FASB issued ASU 2014-16 Derivatives and Hedging (Topic 815) Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity (“ASU 2014-16”).  ASU 2014-16 does not change the current criteria in GAAP for determining when separation of certain embedded derivative features in a hybrid financial instrument is required. That is, an entity will continue to evaluate whether the economic characteristics and risks of the embedded derivative feature are clearly and closely related to those of the host contract, among other relevant criteria. The amendments clarify how current GAAP should be interpreted in evaluating the economic characteristics and risks of a host contract in a hybrid financial instrument that is issued in the form of a share. Specifically, the amendments clarify that an entity should consider all relevant terms and features—including the embedded derivative feature being evaluated for bifurcation—in evaluating the nature of the host contract.  This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015.  These changes are not expected to have a material impact on the consolidated financial statements.  This could impact the accounting for future hybrid financial instruments issued by the Company.

 

The Company has implemented all new accounting pronouncements that are in effect and that may impact its consolidated financial statements. The Company does not believe that there are any new accounting pronouncements that have been issued that might have a material impact on its consolidated financial position or results of operations.

 

2. FAIR VALUE MEASUREMENT

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. To increase the comparability of fair value measurements, a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies, is applied as follows:

 

Level 1 – Valuations based on quoted prices for identical assets and liabilities in active markets.

 

Level 2 –  Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.

 

Level 3 – Valuations based on unobservable inputs reflecting management’s assumptions, consistent with reasonably available assumptions made by other market participants. These valuations require significant judgment.

 

As of July 31, 2015, the fair value of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, approximates book value due to the short maturity of these instruments. Based upon borrowing rates currently available to the Company for loans with similar terms, the carrying value of its debt obligations approximates fair value. As of July 31, 2015 and October 31, 2014, the Company held no investments.

 

 C: 
 8 

 

 

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

3.  INVENTORY

 

Inventory, net consists of the following (in thousands):

 

   July 31,   October 31, 
   2015   2014 
         
         
Raw materials  $229   $186 
Finished goods   251    171 
   $480   $357 

 

4.  PROPERTY AND EQUIPMENT 

 

Property and equipment, net consist of the following (in thousands, except number of years):

 

      July 31,   October 31, 
      2015   2014 
   Life (years)        
Equipment  1-3  $16,691   $16,635 
Furniture and fixtures  5   633    634 
Leasehold improvements  5   934    576 
       18,258    17,845 
Less: Accumulated depreciation      (17,705)   (17,405)
      $553   $440 

 

Depreciation expense was approximately $300,000 and $517,000 for the nine months ended July 31, 2015 and 2014, respectively.

 

5.  ACCRUED EXPENSES AND DEFERRED REVENUE

 

Accrued expenses consist of the following (in thousands):

 

   July 31,   October 31, 
   2015   2014 
         
Professional services  $799   $394 
Payroll related   404    846 
Deferred rent   191    - 
Warranty reserve   17    48 
Other   190    109 
   $1,601   $1,397 

 

Included in payroll related accrued expenses as of October 31, 2014 was $451,000 related to bonus compensation, $301,000 of which was settled with 117,577 shares of common stock in the first quarter of 2015.  

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Warranty reserve activity, included in accrued expenses, during the year ended October 31, 2014 and nine months ended July 31, 2015 was as follows (in thousands):

 

   Balance at   Charged to       Balance at 
   Beginning   Costs and   Reserve   End of 
   of Period   Expenses   Usage   Period 
                 
Year ended October 31, 2014                    
Warranty reserve  $41   $31   $(24)  $48 
                     
Nine months ended July 31, 2015                    
Warranty reserve  $48   $36   $(67)  $17 

 

Deferred revenue, current portion, consists of the following (in thousands):

 

   July 31,   October 31, 
   2015   2014 
         
Product  $151   $- 
Services   802    1,032 
   $953   $1,032 

 

6.  LINE OF CREDIT AND LONG TERM LIABILITIES

 

Effective July 22, 2013, the Company entered into a credit agreement (the “Credit Agreement”) with Fortress Credit Co. LLC, an affiliate of Fortress Investment Group LLC (collectively referred to as “Fortress”) that provided for aggregate term loan commitments of up to $10.0 million. The Credit Agreement consisted of a Term Loan A in the principal amount of $5.0 million, maturing on July 22, 2016 and bearing no interest for the first 12 months, and a Term Loan B in the principal amount of $5.0 million, maturing on February 1, 2016 and bearing no interest for the first six months. The Company drew down the full $10.0 on Term Loan A and Term Loan B (collectively referred to as the “Fortress Term Loans”) on July 24, 2013. The Fortress Term Loans accrue interest at 10% annually after the interest free period and interest is due monthly in arrears. The Company began making principal payments on Term Loan A in July 2014. The proceeds from the Fortress Term Loans were used to pay off the Company’s outstanding revolving credit and term loan with Silicon Valley Bank.

 

Debt issuance costs associated with the Fortress Term Loans totaling $1.7 million were recorded as a deferred charge and are being amortized over the term of the debt using the effective interest rate method with an effective interest rate of 16.39% as opposed to the statutory rate of 10%. The effective interest rate is higher due to the use of the effective interest method to calculate the monthly expense, which includes debt discount and loan origination fee amortization.

 

In connection with the Credit Agreement, the Company issued warrants to Fortress to purchase 1,454,545 shares of the Company’s common stock at an exercise price of $2.0625 per share (the “Fortress Warrants”). See Note 8 for discussion of the Fortress Warrants.

 

In addition, the Company also transferred substantially all of its patents, other than its ’972 patent family, to a limited partnership KIP CR P1 LP of which the Company is a limited partner and of which an affiliate of Fortress is the general partner. The partnership now controls 132 pending or granted non-’972 patents. There was no licensing activity associated with these patents. The general partner cannot be removed without the consent of Fortress. The Company accounts for the investment in the partnership on a consolidated basis using the equity method of accounting.

 

In conjunction with the Credit Agreement, the Company agreed to certain financial covenants. The Company is required to maintain a minimum of $1.5 million of unrestricted cash at each month end and the Company is restricted from making certain cash distributions to equity security holders or from incurring additional indebtedness without prior written consent from Fortress. The Company has also agreed to certain reporting covenants and must supply monthly financial statements to Fortress within 30 days of the end of each month.  

 

The Fortress Warrants also previously contained what is commonly known as a “full-ratchet” anti-dilution provision, which provided that if the Company issued or were deemed to have issued additional shares of common stock without consideration or for a consideration per share less than the applicable exercise price of the Fortress Warrants, which is initially $2.0625 per share, then the exercise price of the Fortress Warrants will be reduced on a “full ratchet” basis, concurrently with the new issue, to the consideration per share the Company received for the new issue or deemed issue of the additional shares of common stock. In January 2014, the Company and the warrant holder agreed to amend the Fortress Warrant to remove this full-ratchet anti-dilution provision.

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

On June 23, 2015, the Company entered into an amendment to the Credit Agreement (the “Agreement”), with CF DB EZ LLC, as assignee of Fortress Credit Co LLC, to amend certain payment terms of the Credit Agreement as it relates to Term Loan B to effectuate a 12-month deferral of approximately $1.5 million in principal payments. Interest at the applicable rate (10%) will continue to be paid monthly, in arrears, and in addition, commencing on July 1, 2015, the unpaid principal amount shall bear additional interest equal to four percent (4%) per annum, which amount shall be paid in kind by adding to the principal balance of the Term Loan B. 

 

As of July 31, 2015, the outstanding principal of the Credit Agreement was $2.8 million.

 

The principal balance and carrying value to Fortress is as follows (in thousands):

 

   July 31,   October 31, 
   2015   2014 
         
Principal balance Fortress Term Loans  $2,795   $5,327 
Unaccreted debt discount   (145)   (516)
Net carrying value due Fortress   2,650    4,811 
Less current portion   (2,650)   (3,160)
Long term portion  $-   $1,651 

 

7.  COMMITMENTS AND CONTINGENCIES

 

Leases

 

The Company leases office space and equipment under long-term operating lease agreements that expire on various dates through March 31, 2020. Rental expense under these agreements was approximately $80,000 and $81,000 the three months ended July 31, 2015 and 2014, respectively, and $260,000 and $327,000 for the nine months ended July 31, 2015 and 2014, respectively. Crossroads leases approximately 37,800 square feet of general office, laboratory, data center and administrative space at its headquarters in Austin, Texas. The original lease was effective October 31, 2005 and was extended in accordance with an extension agreement through February 28, 2015. On May 2, 2014, the lease was amended, extending the lease through March 31, 2020, and reducing the space leased to 16,200 square feet. The minimum lease commitments represent approximately $244,000 per year through the lease term.  

 

Legal Proceedings

 

Legal Proceedings

 

Intellectual Property Litigation

 

The Company has a number of ongoing lawsuits and related proceedings as described below. In discussing these patent litigation proceedings, the following terms will be used:

 

A “Markman hearing” in a patent infringement case is a pre-trial hearing in U.S. District Court, in which the court hears arguments regarding the meanings of key words used in a disputed patent claim. The outcome of a Markman hearing can play a significant role in whether findings of infringement and validity are made by the Court or by the jury at trial. The earliest the Company expects a ruling on any Markman hearing is approximately five months after the hearing.

 

An Inter Partes Review” or “IPR”, is a post-grant review of an issued patent in which the petitioner attempts to challenge the validity of a patent on certain grounds (e.g. novelty and obviousness). If successful during inter partes Review, a petitioner could potentially invalidate some or all of the claims in the patents asserted against that petitioner in related litigation, and an adverse ruling in any of these proceedings would result in invalidation or other limitations on the Company’s patent rights. Inter partes review, if granted, is typically a twelve- to eighteen-month process. 

 

Crossroads v. Dot Hill  

 

The Company filed a lawsuit on September 11, 2013 against Dot Hill Systems Corp. ("Dot Hill") styled Crossroads Systems, Inc. v. Dot Hill Systems Corp., Civil Action No. 1:13-CV-800-SS alleging patent infringement of U.S. Patent No. 6,425,035 and breach of the Amended Settlement and License Agreement dated June 27, 2006 between Crossroads and Dot Hill. The action is pending. The Markman hearing was conducted October 6-7, 2014. Dot Hill moved to join two existing IPR proceedings previously filed against Crossroads by other defendants (one filed by NetApp/Oracle/Huawei and one filed by Cisco/Quantum, each as defined below) and to stay the pending litigation based on those IPR proceedings. On June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads and issued an order staying the case pending resolution of the IPR proceedings. If the patents are found partially or entirely invalid during the IPR proceedings, Crossroads might be adversely impacted in the litigation proceeding against Dot Hill, including potentially losing the ability to continue with its claims of infringement.

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Crossroads v. Oracle, Huawei, Cisco, NetApp and Quantum

 

These related cases were filed on October 7, 2013, November 26, 2013, and February 18, 2014 in the United States District Court for the Western District of Texas alleging infringement by these parties of one or more patents in the ‘972 patent family. The asserted patents (6,425,035, 7,934,041, 7,987,311 and 7,051,147) were subject to a re-examination of the patents conducted in 2005-2006 by the United States Patent and Trademark Office (the “U.S. Patent Office”) or were issued after the re-examination. On May 7, 2014, these cases and the Dot Hill case were consolidated for purposes of discovery and a Markman hearing occurred on October 6 and 7, 2014. On June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads and entered an order staying these actions in light of various pending IPR proceedings.

 

During the time Crossroads was pursuing the potential infringers of the ‘972 patent family, the Company put companies with potentially infringing products on notice and gave them the opportunity to license the Company’s proprietary technology. For example, NetApp was first given notice of potential infringement in 2004. Cisco was first given notice of potential infringement in 2002. Quantum has been on notice of its potential infringement since 2006. Oracle acquired several companies that were given notice of potential infringement at least as early as 2009 and Oracle itself has been on notice since then. Despite repeated attempts by Crossroads throughout the years to negotiate licenses to the ‘972 patent family, these companies refused and left Crossroads with no alternatives to litigation. Crossroads believes these companies (and companies they have acquired) have been illegally using Crossroads’ proprietary technology for years and that the potential compensatory damages could be in excess of $200 million, which does not include enhanced damages or attorney fees. While the uncertainties and expense of litigation are great and the Company can provide no guarantees of success, the Company believes the infringement by most of these companies has been prolonged and potentially willful.

 

In response to the lawsuits brought by Crossroads, these parties have sought inter partes review of the patents asserted in these lawsuits in a total of nineteen petitions before the U.S. Patent Office challenging the validity of the patents asserted by the Company in the lawsuits (despite the prior re-examination). The U.S. Patent Office has instituted review of seven petitions, denied review of two petitions, with decisions on ten petitions still pending. Oracle is a party in ten petitions; Huawei is a party in three petitions; NetApp is a party in eight petitions; Cisco and Quantum are parties to three petitions; and Dot Hill is a party to two petitions. The first of the petitions were filed only months after Crossroads filed lawsuits against these parties and years after they were made aware of their potential infringement. If the patents are found partially or entirely invalid during these inter partes review proceedings, Crossroads might be adversely impacted in the litigation proceedings against these companies, including potentially losing the ability to continue with its claims of infringement. Crossroads believes it has meritorious factual and legal defenses to the challenges presented in these petitions and will vigorously defend the validity of the patents. Based on the current schedule set by the U.S. Patent Office, Crossroads expects a final decision in the six instituted proceedings by March 17, 2016.

 

The Company filed a lawsuit on November 26, 2013 against Huawei Technologies Co. Ltd., Huawei Enterprise USA, Inc. & Huawei Technologies USA, Inc. (collectively, “Huawei”) alleging infringement of U.S. Patent Nos. 6,425,035, 7,051,147 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Huawei Technologies Co., Ltd. et al; Civil Action No. 1:13-cv-01025-SS (W.D. Tex., Austin Division)). On July 17, 2015, the parties settled the case.

 

The Company filed a lawsuit on October 7, 2013 against Oracle Corporation (“Oracle”) alleging infringement of U.S. Patent Nos. 6,425,035, 7,051,147 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Oracle Corporation; Civil Action No. 1:13-cv-0895-SS (W.D. Tex., Austin Division)). The action is pending. The Markman hearing was conducted October 6-7, 2014 and on June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads. Oracle is a party to nine petitions for IPR filed at the U.S. Patent Office, which collectively challenge the validity of each of the patents Crossroads asserted in the lawsuit against Oracle. The U.S. Patent Office has granted four of those petitions and Crossroads filed its Patent Owner’s Responses laying out the arguments regarding the validity of the patents in those granted proceedings. The Oral Hearing is scheduled for October 30, 2015.  The remaining five petitions were filed relatively recently and Crossroads has filed its Preliminary Owner’s Responses to those five petitions. Based on the IPRs, Oracle filed a motion to stay the litigation pending the IPR proceedings, which was granted by the court. If the patents are found partially or entirely invalid during the IPR proceedings, Crossroads might be adversely impacted in the litigation proceeding against Oracle, including potentially losing the ability to continue with its claims of infringement.

 

The Company filed a lawsuit on February 18, 2014 against Cisco Systems, Inc. (“Cisco”) alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Cisco Systems, Inc.; Civil Action No. 1:14-cv-00148-SS (W.D. Tex., Austin Division)). The action is pending. The Markman hearing was conducted October 6-7, 2014 and on June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads. Cisco is a party to three petitions for IPR filed at the U.S. Patent Office, which collectively challenge the validity of each of the patents Crossroads asserted in the lawsuit against Cisco. The U.S. Patent Office has granted those petitions and Crossroads filed its Patent Owner’s Responses laying out the arguments regarding the validity of the patents in those granted proceedings. The Oral Hearing is scheduled for October 30, 2015. Based on the IPRs, Cisco filed a motion to stay the litigation pending the IPR proceedings, which was granted by the court. If the patents are found partially or entirely invalid during the IPR proceedings, Crossroads might be adversely impacted in the litigation proceeding against Cisco, including potentially losing the ability to continue with its claims of infringement.

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

The Company filed a lawsuit on February 18, 2014 against NetApp, Inc. (“NetApp”) alleging infringement of U.S. Patent Nos. 6,425,035, 7,934,041, 7,987,311 and 7,051,147 (the case is styled Crossroads Systems, Inc. v. Net App, Inc.; Civil Action No. 1:14-cv-00149-SS (W.D. Tex., Austin Division)). The action is pending. The Markman hearing was conducted October 6-7, 2014 and on June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads. NetApp is a party to seven petitions for IPR filed at the U.S. Patent Office, which collectively challenge the validity of each of the patents Crossroads asserted in the lawsuit against NetApp. The U.S. Patent Office has granted three of those petitions and Crossroads filed its Patent Owner’s Responses laying out the arguments regarding the validity of the patents in those granted proceedings. The Oral Hearing is scheduled for October 30, 2015. The remaining four petitions were filed relatively recently and Crossroads has filed its Preliminary Owner’s Response to those four petitions. Based on the IPRs, NetApp filed a motion to stay the litigation pending the IPR proceedings, which was granted by the court. If the patents are found partially or entirely invalid during the IPR proceedings, Crossroads might be adversely impacted in the litigation proceeding against NetApp, including potentially losing the ability to continue with its claims of infringement.

 

The Company filed a lawsuit on February 18, 2014 against Quantum Corporation (“Quantum”) alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Quantum Corporation; Civil Action No. 1:14-cv-00150-SS (W.D. Tex., Austin Division)). The action is pending. The Markman hearing was conducted October 6-7, 2014 and on June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads. Quantum is a party to three petitions for IPR filed at the U.S. Patent Office, which collectively challenge the validity of each of the patents Crossroads asserted in the lawsuit against Quantum. The U.S. Patent Office has granted those petitions and Crossroads filed its Patent Owner’s Responses laying out the arguments regarding the validity of the patents in those granted proceedings. The Oral Hearing is scheduled for October 30, 2015. Based on the IPRs, Quantum filed a motion to stay the litigation pending the IPR proceedings, which was granted by the court. If the patents are found partially or entirely invalid during the IPR proceedings, Crossroads might be adversely impacted in the litigation proceeding against Quantum, including potentially losing the ability to continue with its claims of infringement.

 

Quantum v. Crossroads  

 

On September 23, 2014, Quantum filed a lawsuit in the U.S. District Court for the Northern District of California alleging that the Company’s StrongBox product infringes a patent owned by Quantum. This lawsuit was filed only months after Crossroads filed its lawsuit against Quantum claiming infringement of Crossroads’ patents. The Company believes it has meritorious legal positions and will represent its interest vigorously in this matter. If Quantum is successful in this lawsuit, it could result in the Company not having all of the patent rights necessary to conduct the Company’s business. A scheduling order has been entered in this case and trial is scheduled in February 2016. In addition, Quantum has threatened to file additional inter partes review proceedings against other, as yet unidentified, non-‘972 patents. If Quantum files any such proceedings, and Quantum is successful in any of those proceedings, it could adversely affect the Company’s patent rights and result in the Company not having all of the patent rights necessary to conduct the Company’s business.

 

Dot Hill v. Crossroads  

 

On June 29, 2015, Dot Hill filed a lawsuit in the U.S. District Court for the District of Colorado alleging that the Company’s StrongBox product infringes a patent owned by Dot Hill. The Company believes it has meritorious legal positions and will defend its interest vigorously in this matter. If Dot Hill is successful in this lawsuit, it could result in the Company not having all of the patent rights necessary to conduct the Company’s business. Crossroads has filed a response to the complaint and a scheduling conference is set for September 2015.

 

NetApp v. Crossroads  

 

NetApp has threatened to file three lawsuits against the Company alleging that the Company’s SPHiNX virtual tape library, StrongBox, and RVA products infringe three NetApp patents. If NetApp files any of these three lawsuits, and if NetApp is successful in any of those lawsuits, it could adversely affect the Company’s patent rights and result in us not having all of the patent rights necessary to conduct the Company’s business.

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

8. STOCKHOLDERS’ EQUITY

 

2010 Private Placement

 

On October 23, 2010, the Company sold 3,125,000 shares of its common stock at $3.20 per share for gross proceeds to the Company of $10.0 million.  In conjunction with this private placement, the Company also issued warrants to purchase an additional 1,074,212 shares of common stock with an exercise price of $3.20 per share.   Fees in the amount of $0.8 million relating to the stock placement were netted against proceeds.  The warrants were valued at $1.3 million using the Black-Scholes model.  The Black-Scholes inputs used were:  expected dividend rate of 0%, expected volatility of 63%, risk free interest rate of 1.47%, and expected term of 5 years.  The warrants were exercisable immediately upon issue, and expire October 22, 2015. As of July 31, 2015, there were 949,034 warrants outstanding.

 

2013 Private Placement

 

On March 22, 2013, the Company entered into a securities purchase agreement with certain accredited investors for the issuance and sale in a private placement of 4,231,154 units at a purchase price of $2.0625 per unit, valued at $8.6 million, for net proceeds of approximately $7.9 million after related expenses. Each unit consists of one share of cumulative 5.0% Series F convertible preferred stock (“Series F Preferred Stock”), par value $0.001 per share and a warrant to purchase one-half of a share of common stock per share of Series F Preferred Stock purchased (the “Series F warrant”), at an exercise price of $2.00 per whole share, subject to certain adjustments, resulting in the issuance of warrants to purchase an additional 2,282,754 shares of common stock with an exercise price of $2.00 per share. The Series F Preferred Stock ranks senior to the common stock and each other class or series of the Company’s capital stock, whether common, preferred or otherwise, with respect to distributions of dividends and distributions upon liquidation, dissolution or winding up of the Company. The Series F warrants were initially valued using the Black-Scholes pricing model at approximately $2,284,000.  The relative fair value of these warrants totaling $1,543,000 was initially allocated to additional paid in capital.  The Black-Scholes inputs used were: expected dividend rate of 0 %, expected volatility of 63%, risk free interest rate of 0.82%, and expected term of 5 years.  This valuation resulted in a beneficial conversion feature on the Series F Preferred Stock of approximately $1,090,000, of which was recorded as a deemed dividend.  Fees in the amount of $0.7 million relating to the stock placement were netted against proceeds. The Series F warrants were exercisable immediately upon issue, and expire March 22, 2018.  During the nine months ended July 31, 2015, the Company issued 152,046 dividend common shares valued at approximately $298,000. During the nine months ended July 31, 2014, the Company issued 224,099 dividend common shares valued at approximately $612,000. Accrued and unpaid dividends were valued at approximately $43,000 as of July 31, 2015.

 

The Series F Preferred Stock has the rights, qualifications, limitations and restrictions set forth in the Certificate of Designation (the “Certificate of Designation”) filed with the Secretary of State of the State of Delaware on March 28, 2013. The Certificate of Designation authorizes issuance of up to 4,500,000 shares of Series F Preferred Stock, with 3,750,000 shares designated as “Sub-Series F-1” and 750,000 shares designated as “Sub-Series F-2.” The right of holders of Series F Preferred Stock to convert the Series F Preferred Stock is subject to a 9.99% beneficial ownership limitation for holders of Sub-Series F-1 and a 4.99% beneficial ownership limitation for holders of Sub-Series F-2. Such beneficial ownership limitations may be increased or decreased by a holder of Sub-Series F-1 to any percentage not in excess of 19.99% after providing notice of such increase or decrease to the Company. For as long as at least 90% of the aggregate number of shares of Sub-Series F-1 issued on the original issue date are outstanding, the holders of such Sub-Series F-1, voting as a single class, will be entitled to elect two directors of the Company. If less than 90%, but at least 20%, of such shares of Sub-Series F-1 are outstanding, such holders, voting as a single class, will be entitled to elect one director of the Company. As of the date hereof, less than 78% of the aggregate number of shares of Sub-Series F-1 are outstanding, as the remainder have been voluntarily converted into common stock at the option of the holders. Therefore, the holders of the Sub-Series F-1 shares are entitled to elect one director to the Board of Directors. The holders of Sub-Series F-2 will not be entitled to vote on the directors elected by the holders of Sub-Series F-1. The holders of shares of the Series F Preferred Stock are entitled to a liquidation preference equal to the original issuance price plus any unpaid dividends.

 

The Certificate of Designation contains customary anti-dilution protection for proportional adjustments (e.g. stock splits). The Series F Preferred Stock previously included an anti-dilution provision that would adjust the conversion price of the Series F Preferred Stock to the issue price of any equity securities the Company issued at a price less than $2.0625 per share, subject to certain exceptions. This type of provision is commonly referred to as a “full-ratchet” anti-dilution provision.    

 

Upon approval of the full ratchet anti-dilution provisions on June 21, 2013, the Series F warrants were reclassified as a derivative liability and recorded at fair value. This created a scenario for which the shares of Series F Preferred Stock were potentially convertible into more shares of common stock than authorized. Therefore, the Series F Preferred Stock was classified in temporary equity. Upon the expiration of the full ratchet anti-dilution provisions in March 2014, the Company reclassified the Series F Preferred Stock and Series F warrants to permanent stockholders' equity following the stockholders vote.

  

During the nine months ended July 31, 2015, there were 276,940 shares of Series F Preferred Stock converted to common shares.

  

Dividends on the Series F Preferred Stock accrue at an annual rate of 5.0% of the original issue price and are payable on a semi-annual basis. The Series F Preferred Stock ranks senior to the common stock and each other class or series of the Company’s capital stock, whether common, preferred or otherwise, with respect to distributions of dividends and distributions upon liquidation, dissolution or winding up of the Company. The Company may elect to satisfy the obligation to pay semi-annual dividends in cash, by distribution of common stock or a combination thereof, in the Company’s discretion.

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

2013 Fortress Credit Agreement

 

On July 22, 2013 the Company issued warrants to purchase 1,454,545 shares of its common stock to Fortress at $2.0625 per share (the “Fortress Warrants”). To derive an estimate of the fair value of these warrants, the Company utilized a dynamic Black Scholes formula that computes the impact of share dilution upon the exercise of the warrant shares. This process relies upon inputs such as shares outstanding, estimated stock prices, strike price and volatility assumptions to dynamically adjust the payoff of the warrants in the presence of the dilution effect.   The Fortress Warrants were recorded at a fair value of $1,374,000 or $1.0625 per underlying warrant share.

 

The Fortress Warrants will expire on the seventh anniversary of the effective date of the Fortress transactions, on July 22, 2020.

 

2014 Private Placement

 

On March 31, 2014, the Company sold 1,986,622 units at $2.2565 per unit for gross proceeds to the Company of $4.5 million. Each unit consists of one share of common stock and a warrant to purchase one-half of a share of common stock.  The warrants to purchase 993,311 shares of common stock have a weighted average exercise price of $2.45 per share.   Fees in the amount of $0.2 million relating to the stock placement were netted against proceeds.  The warrants were valued at $1.1 million using the Black-Scholes model.  The Black-Scholes inputs used were:  expected dividend rate of 0%, expected volatility of 74%, risk free interest rate of 1.64%, and expected term of 2.5 years.  The warrants were exercisable upon the six-month anniversary of issue, and expire March 31, 2019. As of July 31, 2015, there were 993,311 warrants outstanding. 

 

2015 Common Stock Offering

 

On January 28, 2015, the Company sold 3,071,739 units at $2.30 per unit for gross proceeds to the Company of $7.1 million. Each unit consists of one share of common stock and a warrant to purchase one-half of a share of common stock.  The warrants to purchase 1,658,760 shares of common stock have an exercise price of $2.76 per share.   Fees in the amount of $1.1 million relating to the stock placement were netted against proceeds.  The warrants were valued at $1.9 million using the Black-Scholes model.  The Black-Scholes inputs used were:  expected dividend rate of 0%, expected volatility of 75%, risk free interest rate of 1.55%, and expected term of 4.0 years.  The warrants were exercisable upon the six-month anniversary of issue, and expire January 31, 2020. As of July 31, 2015, there were 1,658,760 warrants outstanding. 

 

2015 Common Stock Rights Offering

 

On July 28, 2015, the Company completed a subscription rights offering for shares of the Company’s common stock (the “Rights Offering”). Under the terms of the Rights Offering, the Company distributed to its common and preferred stock holders one subscription right for each share of the Company’s common or preferred stock owned as of the record date, which entitled the holder to purchase 0.50 shares of common stock, at the subscription price of $1.25 per share, subject to certain protection mechanics in place to preserve the Company's ability to utilize its net operating loss carryforwards ("NOLs").

 

The Company accepted subscriptions for 3,933,879 shares, resulting in aggregate gross proceeds of approximately $4.9 million. Expenses incurred to complete the Rights Offering amounted to approximately $0.4 million.

 

Warrant Summary List

 

The Company has the following common stock warrants outstanding at July 31, 2015:

 

Warrant Transaction  Warrants
Outstanding
   Weighted
Average Exercise
Price
 
2010 Private Placement   949,034   $3.20 
2013 Private Placement   2,029,776   $2.00 
2013 Fortress Credit Agreement   1,454,545   $2.06 
2014 Private Placement   993,311   $2.45 
2015 Common Stock Offering   1,658,760   $2.76 
Total Warrants   7,085,426      

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

9. STOCK OPTIONS AND STOCK BASED COMPENSATION

 

The Company has a stock-based compensation plan available to grant incentive stock options, non-qualified stock options and restricted stock to employees and non-employee members of the Board of Directors and advisors.

 

The Company’s 2010 Stock Incentive Plan (the “2010 Plan”), succeeded the 1999 Stock Option/Stock Issuance Plan (the “1999 Plan”).  As of July 31, 2015, options to purchase 368,563 shares of common stock were outstanding under the 1999 Plan, and no further grants can be made under the 1999 Plan.

 

The 2010 Plan was approved by the Board of Directors on May 26, 2010 and became effective on August 13, 2010, upon approval by shareholders.  A maximum of 5,250,000 shares of Crossroads common stock may be awarded.  As of July 31, 2015, options to purchase 4,138,936 shares of common stock were granted from the 2010 Plan, of which 2,953,889 were outstanding. During the nine months ended July 31, 2015 and 2014, common stock share grants of 117,577 and 66,081, respectively, were granted from the 2010 Plan.

 

As of July 31, 2015, options to purchase an aggregate of 3,322,452 shares of common stock were outstanding under the 1999 Plan and the 2010 Plan, of which 2,719,200 were vested. Under the 2010 Plan, 1,518,723 shares of common stock were available for future grants as of July 31, 2015.  The shares of common stock reserved for future grant are reduced by 363,216 options previously exercised under the 2010 Plan, and 414,172 shares of stock granted under the 2010 Plan.  The Compensation Committee of the Board of Directors determines the exercise price, term and other conditions applicable to each stock option granted under the 2010 Plan. The exercise price of stock options is set on the grant date and may not be less than the fair market value per share of the Company’s stock on that date (at market close). The 2010 Plan options generally become exercisable over a four-year period (vesting 25% after one year, the remaining 75% vesting quarterly thereafter) and expire after ten years. During 2015, the majority of the employee incentive stock option grants vest on a schedule of 25% at the end of six months and 12.5% thereafter until fully vested. Stock option exercises are fulfilled with new shares of common stock.

 

The Company realized stock-based compensation expense for all awards issued under the Company’s stock plans in the following line items in the consolidated statements of operations:

 

   Nine months ended July 31, 
   2015   2014 
         
Cost of revenue  $9   $28 
Sales and marketing   98    305 
Research and development   135    444 
General and administrative   501    535 
Total stock-based compensation  $743   $1,312 

 

During the year ended October 31, 2014, share based compensation expense of approximately $301,000 was accrued for 67% of the total estimated management bonus for the fiscal year ended October 31, 2014. Accordingly, 117,577 shares of common stock were granted in January 2015 to satisfy this liability.

 

The fair value of each option award is estimated on the date of grant using the Black-Scholes option-pricing model. Expected volatility is based on historical volatility of the Company’s stock. The expected term represents an estimate of the time options are expected to remain outstanding based upon historical analysis. The risk-free rate for periods within the contractual life of the option is based on the U.S. treasury yield curve in effect at the time of grant. The variables used in the Black-Scholes calculation are listed below for the respective periods:

 

   Nine months ended July 31, 
   2015   2014 
         
Expected dividend yield   0%   0%
Expected volatility   74 - 76%   73 - 79%
Risk-free interest rate   1.4 - 1.6%   1.4 - 1.7%
Expected term (years)   4 - 5    4 - 5 

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

The following table summarizes information about stock option activity for the nine months ended July 31, 2015:  

 

   Number of
Shares
   Weighted
Average
Exercise Price
   Weighted Average
Remaining
Contractual Term
(years)
   Aggregate
Intrinsic
Value ($M)
 
                 
Outstanding and expected to vest at October 31, 2014   3,104,067   $2.32    7.54   $2.4 
                     
Granted   331,513   $2.35           
Forfeited   (78,130)  $3.25           
Exercised   (34,998)  $1.50           
                     
Outstanding and expected to vest at July 31, 2015   3,322,452   $2.31    7.12   $0.1 
                     
Exercisable at July 31, 2015   2,719,200   $2.30    6.7   $0.1 

 

The weighted average fair value per option granted during the nine months ended July 31, 2015 and 2014 was $1.56 and $1.18, respectively. The total intrinsic value of options (which is the amount by which the stock price exceeded the exercise price of the options on the date of exercise) exercised during the nine months ended July 31, 2015 and 2014 was $36,000 and $310,000, respectively. During the nine months ended July 31, 2015 and 2014, the amount of cash received from the exercise of stock options was $52,000 and $515,000, respectively.

 

The Company granted no options to non-employees during the nine months ended July 31, 2015, and 10,000 options to non-employees with a fair value of approximately $14,000 during the nine months ended July 31, 2014.

 

At July 31, 2015, there was approximately $0.5 million of total unrecognized compensation cost related to non-vested stock option awards which is expected to be recognized over a weighted-average period of 0.9 years. There were 955,800 and 1,016,820 options that became vested during the nine months ended July 31, 2015 and 2014, respectively, with the total fair value of these awards of approximately $1.3 million and $1.3 million, respectively.

 

The following table shows information about outstanding stock options at July 31, 2015:

 

        Options Outstanding   Options Exercisable 
            Weighted             
            Average   Weighted       Weighted 
Range of   Shares   Remaining   Average       Average 
Exercise Prices   Outstanding   Contractual Term   Exercise Price   Shares   Exercise Price 
$-   $1.21    426,512    7.23   $1.12    389,637   $1.11 
$1.24   $1.48    118,540    8.74   $1.28    71,506   $1.25 
$1.54   $1.54    450,000    8.31   $1.54    393,750   $1.54 
$1.56   $2.04    321,720    4.90   $1.64    315,258   $1.63 
$2.10   $2.10    819,888    7.84   $2.10    819,888   $2.10 
$2.12   $2.56    416,227    8.85   $2.47    130,214   $2.41 
$2.74   $3.98    332,828    6.57   $3.04    172,962   $3.29 
$4.00   $7.20    436,737    3.93   $4.74    425,985   $4.73 
                                 
$-   $7.20    3,322,452    7.06   $2.31    2,719,200   $2.30 

 

10. EMPLOYEE BENEFITS

 

In 1996, the Company established the Crossroads Systems, Inc. 401(k) Savings Plan (the “Savings Plan”), which is a qualified plan under section 401(k) of the Internal Revenue Code.  All employees who have attained 18 years of age are eligible to enroll in the Savings Plan.   The Company may make matching contributions to those employees participating in the Savings Plan based upon Company productivity and profitability. Company contributions vest over a period of six years.   In October 2000, the Company adopted a new 401(k) Savings Plan that meets all of the criteria set forth above in the Savings Plan.   The Company made matching contributions of $143,000 and $136,000 during the nine months ended July 31, 2015 and 2014, respectively.

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

11.  RELATED PARTY TRANSACTIONS

 

Iron Mountain

 

On December 19, 2013, the Company and Iron Mountain (“IRM”) mutually agreed to end their contract involving the development of a co-branded product.   The Company received $1.6 million in connection with the terminated contract in the first quarter of fiscal year 2014.   The Company bifurcated the payment between amounts received for work performed on the development of the product of $550,000, and a gain from settlement of $1,050,000. The Company recorded the amounts attributable to development as services revenue, and the gain on settlement was reflected as a reduction in operating expenses. IRM also agreed that it would not transfer the shares without the Company's prior written consent until the two-year anniversary date of the settlement, and that it would vote the shares consistent with the recommendation of Crossroads’ Board of Directors.

 

2014 Private Placement

 

On March 31, 2014 and April 4, 2014, the Company entered into Securities Purchase Agreements with certain accredited investors for the issuance and sale in a private placement (the “2014 Private Placement”) of an aggregate of 1,986,622 units, at a purchase price of $2.2565 per unit for net aggregate proceeds of approximately $4.5 million before expenses. Each unit consisted of one share of common stock and warrants to purchase one-half of a share of common stock at an exercise price of $2.46 per whole share. The lead investor of the 2014 Private Placement was Lone Star Value Investors, LP (“Lone Star Value, LP”). Lone Star Value LP is controlled by Jeffrey E. Eberwein, Crossroads’ Chairman of the Board of Directors. Lone Star Value LP acquired 1,288,352 units in the 2014 Private Placement for approximately $2.9 million.

 

2015 Private Placement

 

On January 27, 2015, the Company entered into placement agency agreements with certain accredited investors for the issuance and sale in a private placement (the “2015 Private Placement”) of an aggregate of 3,071,739 units, at a purchase price of $2.30 per unit for net aggregate proceeds of approximately $7.1 million before expenses. Each unit consisted of one share of common stock and warrants to purchase one-half of a share of common stock at an exercise price of $2.76 per whole share. Lone Star Value LP, controlled by Jeffrey E. Eberwein, Crossroads’ Chairman of the Board of Directors, acquired 350,000 units in the 2015 Private Placement for approximately $0.8 million.

 

2015 Common Stock Rights Offering

 

On July 28, 2015, the Company completed its Rights Offering and accepted subscriptions for 3,933,879 shares of common stock at the subscription price of $1.25 per share, resulting in aggregate gross proceeds of approximately $4.9 million. Lone Star Value LP, controlled by Jeffrey E. Eberwein, Crossroads’ Chairman of the Board of Directors, acquired 1,537,907 shares in the offering for approximately $1.9 million.

 

12.  PREFERRED STOCK RIGHTS

 

On May 23, 2014, the Company's Board of Directors adopted a tax benefit preservation plan (the “Plan”). The Plan is intended to diminish the risk that the Company’s ability to use net operating loss carryforwards to reduce future federal income tax obligations may become substantially limited due to an “ownership change,” as defined in Section 382 of the Internal Revenue Code. The Board of Directors authorized and declared a dividend distribution of one right for each outstanding share of common stock, par value $0.001 per share, and Series F Preferred Stock, par value $0.001 per share, of the Company to stockholders of record as of the close of business on June 4, 2014. Each right entitles the registered holder to purchase from the Company one one-thousandth of a share of Series G Participating Preferred Stock, par value $0.001 per share, of the Company at an exercise price of $14.00 per one one-thousandth of a share of Series G Participating Preferred Stock, subject to adjustment.

 

The rights will become exercisable following (i) the 10th business day (or such later date as may be determined by the Board of Directors) after the public announcement that an acquiring person has acquired beneficial ownership of 4.99% or more of the common stock (calculated pursuant to the Plan) or (ii) the 10th business day (or such later date as may be determined by the board) after a person or group announces a tender or exchange offer that would result in ownership by a person or group of 4.99% or more of the common stock (calculated pursuant to the Plan).

 

In addition, upon the occurrence of certain events, the exercise price of the rights would be adjusted and holders of the rights (other than rights owned by an acquiring person or group) would be entitled to purchase common stock at approximately half of market value. Given the potential adjustment of the exercise price of the rights, the rights could cause substantial dilution to a person or group that acquires 4.99% or more of the Company's common stock on terms not approved by the Company's Board of Directors.

 

No rights were exercisable at July 31, 2015. There is no impact to the Company's financial results as a result of the adoption of the Plan for the nine months ended July 31, 2015 or 2014. 

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

13.  SUBSEQUENT EVENTS

 

In connection with the Rights Offering and the resulting increase in the number of shares of common stock outstanding, the Board of Directors of the Company determined to make an equitable adjustment to all warrants and options. Warrants will be increased by a rate of 20.19%, with the strike price remaining the same and all of the outstanding options under the 1999 Plan and the 2010 Plan are effectively split 1.2019:1, with the strike prices being proportionately adjusted. These adjustments were effective as of August 31, 2015

 

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ITEM 2.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and analysis of the financial condition and results of our operations should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended October 31, 2014. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section entitled “Risk Factors” included elsewhere in our filings with the Securities and Exchange Commission.

 

Forward-Looking Statements

 

Various statements contained in or incorporated by reference into this quarterly report that express a belief, expectation, or intention, or that are not statements of historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). These forward-looking statements may include projections and estimates concerning capital expenditures, our liquidity and capital resources, the timing and success of specific projects, outcomes and effects of litigation, claims and disputes, elements of our business strategy and other statements concerning our operations, economic performance and financial condition. When used in this quarterly report, the words “could,” “believe,” “anticipate,” “intend,” “estimate,” “expect,” “may,” “continue,” “predict,” “potential,” “project” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. In particular, the factors discussed below and detailed in our Form 10-K for the year ended October 31, 2014, as well as those discussed in the section entitled “Risk Factors” included elsewhere in our filings with the Securities and Exchange Commission, could affect our actual results and cause our actual results to differ materially from expectations, estimates, or assumptions expressed in, forecasted in, or implied in such forward-looking statements.

 

Forward-looking statements may include statements about our:

 

  · ability to implement our business strategy, including the transition from a hardware storage company to a software solutions and services provider;
  · anticipated trends and challenges in our business and the markets in which we operate;
  · expected future financial performance;
  · expectations regarding our operating expenses;
  · ability to generate revenues from patent licensing and enforcement activity through our arrangement with Fortress;
  · future adjustments to the conversion price of our Series F Preferred Stock and to the exercise price of the warrants issued in our March 2013 private placement;
  · ability to anticipate market needs or develop new or enhanced products to meet those needs;
  · ability to expand into other sectors of the storage market, beyond protection storage;
  · expectations regarding market acceptance of our products;
  · ability to compete in our industry and innovation by our competitors;
  · ability to protect our confidential information and intellectual property rights;
  · ability to successfully identify and manage any potential acquisitions;
  · ability to manage expansion into international markets;
  · ability to remediate any material weakness in our internal controls identified by our independent registered public accounting firm;
  · ability to maintain or broaden our business relationships and develop new relationships with strategic alliances, suppliers, customers, distributors or otherwise;
  · ability to recruit and retain qualified sales, technical and other key personnel;
  · ability to obtain additional financing; and
  · ability to manage growth.

 

All forward-looking statements involve risks, assumptions and uncertainties. The occurrence of the events described, and the achievement of the expected results depends on many events, some or all of which are not predictable or within our control. Actual results may differ materially from expected results. These risks, assumptions and uncertainties are not necessarily all of the important factors that could cause actual results to differ materially from those expressed in any of our forward-looking statements. Other unknown or unpredictable factors also could harm our results. In light of these risks, uncertainties and assumptions, the forward-looking events might not occur.

 

Readers are cautioned not to place undue reliance on forward-looking statements, as there can be no assurance that the plans, intentions or expectations upon which they are based will occur. By their nature, forward-looking statements involve numerous assumptions, known and unknown risks and uncertainties, both general and specific, that contribute to the possibility that the predictions, forecasts, projections and other things contemplated by the forward-looking statements will not occur. Forward-looking statements in this quarterly report are based on management’s beliefs and opinions at the time the statements are made. The forward-looking statements contained in this quarterly report are expressly qualified in their entirety by this cautionary statement. The forward-looking statements included in this quarterly report are made as of the date of this quarterly report and we undertake no obligation to publicly update or revise any forward-looking statements to reflect new information, future events or otherwise, except as required by applicable securities laws.

 

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Overview

 

The following discussion and analysis of the financial condition and results of our operations should be read in conjunction with consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q.

 

IP Licensing Campaign Focus

 

We generate revenue when companies using our technology agree to pay us either an upfront licensing fee, or a combination of upfront fees and on-going licensing fees for use of our intellectual property. Our licensing and litigation settlements sometimes include provisions to cross-license patents from other companies, further enhancing our intellectual property assets and product capabilities. We have developed intellectual property assets in two distinct categories. The first category, known as the ’972 patent family, is wholly owned by Crossroads and consists of 31 patents and a pending patent application that are primarily concentrated around access controls. The second category, known as the non-’972 patents, consists of 132 patents and pending patent applications held in a limited partnership controlled by an affiliate of Fortress (defined below). The patents, described more fully below, are primarily directed to five product families: optimizing command processing, enabling interoperability, managing networks, enhancing tape libraries, and improving data systems.

 

In July 2013, we entered into a loan transaction with Fortress Credit Co LLC that was later assigned to CF DB EZ LLC, each an affiliate of Fortress, which included the formation of a partnership controlled by Fortress to which we assigned all of our existing and issued patents and applications other than our patents in the ’972 family. This partnership may seek to generate revenues through patent licensing and enforcement activity with respect to these patents, but we are unable to predict at this time when or if such efforts may commence or, if they do, whether they will be profitable. We also have the right, in connection with the repayment of the amounts due under the Credit Agreement (defined below) and upon the payment of a pre-determined premium of $2 million (20% of the amount Fortress loaned to us), to buy out the Fortress partnership interest and return all of the assigned non-’972 patent rights to the Company. We intend to periodically monitor and assess the viability and the value to the Company of such a buyout.

 

We continue to look for different ways to extract value from our patents outside the ‘972 family, which may include commercial, financial and strategic initiatives. We believe our IP has value beyond its quantifiable monetary value. For example, we believe that the proprietary nature of our products is appealing to both end-users and strategic partners who view our products as not being easily replaceable. Additionally, IP may be a significant barrier to entry for potential competitors. Therefore, we will continue to assess the value of our current portfolio and attempt to expand and take advantage of our IP portfolio.

 

Product Focus

 

We are a global provider of data storage solutions. Through the innovative use of new technologies, we deliver customer-driven solutions that enable proactive data protection, advanced data preservation, optimized performance and significant cost-savings over current solutions.

 

Crossroads’ StrongBox® is an enterprise-level network attached storage (“NAS”) solution built to simplify data access and provide the most cost-effective storage for unstructured data. With its intelligent storage management, StrongBox delivers embedded data protection for online, nearline, and archive storage needs

 

We deliver our current offerings to the market as software and hardware appliances. This strategy allows us to use off-the-shelf hardware platforms, which can easily be customized to support specific original equipment manufacturer (“OEM”) or system integrator (“SI”) specifications. We believe this strategy provides us with low-cost, high performance options that can be quickly deployed with minimal disruption to customers while minimizing inventory and associated excess and obsolete costs.

 

Substantially all of our current products have been sold in combination with support and services contracts. Our support and services contracts are typically offered for periods of one to three years. We mainly sell these products through a network of OEMs, SIs, value-added resellers (“VARs”), and other strategic partners.

 

Key Financial Definitions

 

Revenue. Revenue consists of sales of hardware, software and services, as well as royalties we earn for products and the license of certain intellectual property. Our “product revenue” is composed of sales of our hardware products and software products sold to our network of strategic partners, including value added resellers, and original equipment manufacturers, as well as directly to end users. Our “IP license, royalty and other revenue” is derived from the licensing of intellectual property, royalty payments, and sales of service contracts.

 

Cost of Revenue. Cost of revenue is composed of cost of product revenue and IP license, royalty and other revenue. “Cost of product revenue” consists primarily of the cost charged by our previous contract manufacturer to manufacture our products, shipping charges and warranty obligations. “Cost of IP license, royalty and other revenue” consists of professional fees and services, overhead allocations, and obsolete inventory adjustments.

 

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Operating Expenses. Operating expenses consist of sales and marketing, research and development, general and administrative expenses and amortization of intangible assets. Personnel-related costs, which include stock-based compensation expense, are the most significant component of each of these expense categories. We had 47 employees as of both July 31, 2015, and 2014. In any particular period, the timing of additional hires could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue.

 

Sales and Marketing Expenses. Sales and marketing expenses include personnel costs, employee sales commissions and marketing programs. We have sales and marketing personnel throughout the United States and in our sales office in Germany.

 

Research and Development Expenses. Research and development expenses primarily include personnel costs, depreciation on lab equipment, costs of prototype equipment, other related costs of quality assurance and overhead allocations. We expense research and development costs as incurred. Though we incur software development costs, the costs of software development that we incur after a product has reached marketability are considered immaterial, and to date, we have not capitalized any such costs.

 

General and Administrative Expenses. General and administrative expenses consist primarily of compensation and related costs for personnel and facilities related to our executive, finance, human resource, information technology and legal organizations, and fees for professional services. Professional services, excluding those for IP (which are included in cost of revenue), consists of outside legal, tax and audit costs.

 

Interest Expense. Interest expense consists of amounts charged by lenders related to interest on our line of credit and term loans, both paid and accrued.

 

Amortization of Debt Discount and Issuance Costs Expense. Amortization of debt discount and issuance costs expense consists of the effective interest amortization of debt, which includes the amortization of financing costs, and the fair value of the Fortress warrants. It is separated from interest paid due to the material nature of both.

 

Critical Accounting Policies and Estimates

 

Contracts to Modify or Customize Products

 

We have entered into contracts with certain customers to significantly modify or customize products. In accounting for such arrangements, we first look to the guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Subtopic 985-605, Software - Revenue Recognition (“ASC 985-605”), and then ASC Subtopic 605-25, Revenue Recognition – Multiple-Element Arrangements, to determine the appropriate accounting elements in the arrangement.  We then consider the appropriate recognition model for each accounting element based on the nature of the element and apply the guidance in ASC Subtopic 605-35, Revenue Recognition – Construction-Type and Production-Type Contracts, ASC Subtopic 985-60, ASC Subtopic 605-15, Revenue Recognition – Products, or ASC Subtopic 605-20, Revenue Recognition – Services, as applicable.  Amounts allocated to the modification/customization service element are evaluated for classification in the consolidated statement of operations as either revenue or reduction of research and development expense based on the following considerations: whether and in what circumstances the consideration received is refundable, ownership of the final product and intellectual property rights to develop the product, and exclusivity of the final product. 

 

There have been no other material updates to our critical accounting policies and estimates set forth in “Part II—Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates” in the Company’s Annual report on Form 10-K for the fiscal year ended October 31, 2014.

 

Results of Operations

 

Three and Nine Months Ended July 31, 2015 Compared to the Three and Nine Months Ended July 31, 2014

 

Revenue.   Total revenue remained consistent at $2.1 million for the three months ended July 31, 2015 and 2014. Total revenue decreased $2.5 million, or 29.1%, to $6.0 million for the nine months ended July 31, 2015 from $8.5 million for the nine months ended July 31, 2014.

 

Product revenues for the three months ended July 31, 2015 decreased $0.1 million, or 14.0%, to $0.5 million compared with $0.6 million for the three months ended July 31, 2014 due primarily to a decrease in revenue from SPHiNX of $0.2 million, due to reduced royalties received from an OEM partner, offset by an increase in revenue from our StrongBox product of $0.1 million.

 

Product revenues for the nine months ended July 31, 2015 decreased $0.9 million, or 32.9%, to $2.0 million compared with $2.9 million for the nine months ended July 31, 2014 due primarily to a decrease in revenue from our SPHiNX product of $0.7 million, and by an decrease in revenue from our StrongBox product of $0.2 million, as a result of less volume from SPHiNX and less one-time StongBox revenue in 2015.

 

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IP license, royalty and other revenue consists of the following for the three and nine months ended July 31, 2015 and 2014:

 

   Three months ended July 31,   Nine months ended July 31, 
   2015   2014   2015   2014 
   (unaudited)   (unaudited) 
IP license revenue  $439   $356   $776   $1,612 
HP royalty and post contract service revenue   725    862    2,085    2,573 
Post contract service and other service revenue (non-HP)   464    269    1,213    1,396 
IP license, royalty and other revenue  $1,628   $1,487   $4,074   $5,581 

 

IP license, royalty and other revenues for the three months ended July 31, 2015 increased $0.1 million, or 9.5%, to $1.6 million compared with $1.5 million for the three months ended July 31, 2014.

 

IP license revenue remained consistent at approximately $0.4 million for the three months ended July 31, 2015 and 2014. HP royalty and post contract support (PCS) service revenue decreased $0.1 million for the three months ended July 31, 2015, due to decreasing royalties for legacy router shipments, and reduced support for our SPHiNX product which HP is actively moving to their new platform. PCS and other service revenue (non-HP) increased $0.2 million primarily due to revenue recognized from fulfilling our obligations on an existing maintenance contract.

 

IP license, royalty and other revenues for the nine months ended July 31, 2015 decreased $1.5 million, or 26.8%, to $4.1 million compared with $5.6 million for the nine months ended July 31, 2014.

 

IP license revenue decreased $0.8 million for the nine months ended July 31, 2015, primarily as a result of the decreased royalties received from IBM, and a decrease in royalty received from Dot Hill Systems, offset partially by a new license agreement, partially recognized during the third quarter. HP royalty and PCS service revenue decreased $0.5 for the nine months ended July 31, 2015 due to decreasing royalties for legacy router shipments, and reduced support for our SPHiNX product which HP is actively moving to their new platform. PCS and other service revenue (non-HP) decreased $0.2 million primarily due to revenue recognized from the Iron Mountain research and development services agreement of approximately $0.6 million recognized in 2014, partially offset by revenue recognized from fulfilling our obligations on an existing maintenance contract.

 

Cost of Revenue.   Cost of revenue increased $0.2 million, or 30.6%, to $0.6 million for the three months ended July 31, 2015 from $0.4 million for the three months ended July 31, 2014. Product costs for the three months ended July 31, 2015 remained consistent, increasing $12,000 from the three months ended July 31, 2014. IP license, royalty and other costs increased $0.1 million for the three months ended July 31, 2015 to $0.4 million from $0.3 million for the three months ended July 31, 2014, due to increased cost of sales relating to a new license agreement during the quarter.

 

Cost of revenue increased $0.1 million, or 4.9%, to $1.6 million, for the nine months ended July 31, 2015 from $1.5 million for the nine months ended July 31, 2014. Product costs for the nine months ended July 31, 2015 increased $0.1 million to $0.7 million from $0.6 million for the nine months ended July 31, 2014, primarily due to higher costs associated with Strongbox bundles sold with third party hardware components included. IP license, royalty and other costs remained consistent at $0.9 million for the nine months ended July 31, 2015 and 2014.

 

Sales and Marketing.   Sales and marketing expenses decreased $0.2 million, or 18.0%, to $0.7 million for the three months ended July 31, 2015 from $0.9 million for the three months ended July 31, 2014. This decrease was primarily due to decreased payroll and benefits, including stock based compensation, of approximately $0.2 million.

 

Sales and marketing expenses decreased $0.4 million, or 16.5%, to $2.4 million for the nine months ended July 31, 2015 from $2.8 million for the nine months ended July 31, 2014. This decrease was primarily due to decreased payroll and benefits, including stock based compensation, of approximately $0.3 million, reduced commissions of approximately $0.2 million, partially offset by an increase in tradeshow and travel related expenses of approximately $0.1 million.

 

Research and Development.    Research and development expenses decreased $0.3 million, or 19.2%, to $1.1 million for the three months ended July 31, 2015 from $1.4 million for the three months ended July 31, 2014. This decrease was due to decreased payroll and benefits expenses, including stock based compensation, of approximately $0.1 million, professional fees of approximately $0.1 million, and depreciation of approximately $0.1 million.

 

Research and development expenses decreased $0.8 million, or 17.2%, to $3.6 million for the nine months ended July 31, 2015 from $4.4 million for the nine months ended July 31, 2014. This decrease was due to decreases in payroll and benefits, including stock based compensation, of approximately $0.5 million, decreased depreciation expense of approximately $0.2 million, and decreased consulting and outside services of $0.1 million.

 

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General and Administrative.  General and administrative expenses increased $1.7 million, or 146.6%, to $2.8 million for the three months ended July 31, 2015 from $1.1 million for the three months ended July 31, 2014. The increase was due to increases in professional and legal services of approximately $1.6 million, and consulting and outside services of approximately $0.1 million. The professional fees are in connection with the increased activity in ongoing patent and IP litigation.

 

General and administrative expenses increased $3.0 million for the nine months ended July 31, 2015, or 83.0%, to $6.7 million for the nine months ended July 31, 2015 from $3.7 million for the nine months ended July 31, 2014. The increase was due to increases in professional and legal services of approximately $3.1 million, offset partially by a decrease in payroll and benefits expenses, including stock based compensation, of approximately $0.1 million. The professional fees are in connection with the increased activity in ongoing patent and IP litigation.

 

Gain on settlement.  No gain on settlement occurred during the three months ended July 31, 2015 or 2014. Gain on settlement decreased $1.0 million, or 100.0%, for the nine months ended July 31, 2015 from $1.0 million for the nine months ended July 31, 2014. The increase was due to the bifurcation of the payment received from IRM, between amounts received for work performed on the development of the product, and a gain from settlement. We recorded the amounts attributable to development as services revenue, and the gain on settlement was reflected as a reduction in operating expenses.

 

Interest expense.  Interest expense decreased $0.1 million, or 51.6%, to $0.1 million for the three months ended July 31, 2015 from $0.2 million for the three months ended July 31, 2014. The decrease was due to lower average outstanding borrowings during the fiscal quarter compared to 2014.

 

Interest expense decreased $0.4 million, or 52.2%, to $0.3 million for the nine months ended July 31, 2015 from $0.7 million for the nine months ended July 31, 2014. The decrease was due to lower average outstanding borrowings during the fiscal quarter compared to 2014.

 

Amortization of debt discount and issuance costs.  Amortization of debt discount and issuance costs expense decreased $0.2 million, or 59.5%, to $0.1 million for the three months ended July 31, 2015 from $0.3 million for the three months ended July 31, 2014.

 

Amortization of debt discount and issuance costs expense decreased $0.5 million, or 46.0%, to $0.5 million for the nine months ended July 31, 2015 from $1.0 million for the nine months ended July 31, 2014. The amortization relates to the borrowings drawn from Fortress during 2013, and the decrease is due to the reduced calculated amortization based on lower average outstanding balances of Fortress debt.

 

Change in value of derivative liability.  The change in value of derivative liability was $0 for the three months ended July 31, 2014, and expense of $2.8 million for the nine months ended July 31, 2014. The change is the periodic revaluation of the warrants issued in connection with the Series F Preferred Stock sold during fiscal year 2013. Upon the expiration of the full ratchet anti-dilution provisions on the one-year anniversary of the March 2013 private placement, the Company expects the preferred stock and warrants to be reclassified back to permanent stockholders' equity. At this time, the derivative liability associated with the warrants will be removed and recorded as a positive change in derivative liability in the statement of operations. No activity occurred in fiscal year 2015.

 

Liquidity and Capital Resources

 

Cash Flows

 

Our principal liquidity requirements are to meet our lease obligations, our working capital needs, and the repayment of our line of credit from Fortress. Subject to our operating performance, which, if significantly adversely affected, would adversely affect the availability of funds, we expect to finance our operations through cash and cash equivalents provided by operations (including IP licensing) and customer reimbursed expenses, proceeds from the sale of our common stock or preferred stock, debt instruments, and exercises of options or warrants. Expected revenue from our StrongBox product has been slower to materialize than expected, due in part to its longer selling cycle and in part to the time required to establish and train an effective network of sales partners. We may require additional capital from equity or debt financings to fund our operations or respond to strategic opportunities. The Company recently completed its Rights Offering and raised aggregate gross proceeds of approximately $4.9 million, however we are also continuing to consider additional opportunities to raise additional capital, whether through the issuance of equity or debt financings, or a combination thereof, to fund our operations, respond to competitive pressures and strategic opportunities, and to pursue our intellectual property monetization strategy.

 

The following table summarizes our primary sources and uses of cash in the periods presented:

 

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   Nine Months Ended July 31, 
   2015   2014 
         
Net cash used in operating activities  $(5,415)  $(2,482)
Net cash used in investing activities   (180)   (53)
Net cash provided by financing activities   8,015    1,828 
Change in cash and cash equivalents   2,365    (715)
Cash, cash equivalents, and restricted cash, end of period   7,311    7,080 

 

Net cash used in operating activities increased $2.9 million from approximately $2.5 million in the nine months ended July 31, 2014 to approximately $5.4 million in the nine months ended July 31, 2015. Net loss for the nine months ended July 31, 2015 increased approximately $1.8 million from $7.3 million for the nine months ended July 31, 2014 to $9.1 million for the nine months ended July 31, 2015, due to lower sales volumes and higher professional expenses. Included in the 2015 net loss were non cash adjustments for stock based compensation for $0.7 million, amortization of debt discount for $0.5 million, and depreciation for $0.3 million. Cash used in operating activities was also affected by an increase in accounts payable and accrued expenses by $1.5 million, a decrease in accounts receivable of $0.3 million, increased deferred revenue by $0.2 million, and a decrease in prepaid expenses of $0.2 million. Included in the July 31, 2014 net loss were non-cash adjustments for the loss on derivative liability of $2.8 million, which was $0 for the nine months ended July 31, 2015.

 

Cash flows from investing activities primarily relate to capital expenditures to support our employees and our capital needs in our research and development efforts. Net cash used by investing activities was $0.2 million in the nine months ended July 31, 2015 compared to $53,000 in cash used by investing activities during the nine months ended July 31, 2014. In the nine months ended July 31, 2015 and 2014, the entire use of cash related to the purchase of property and equipment, net of sales of surplus property, which increased in the nine months ended July 31, 2015.

 

Cash flows provided by financing activities for the nine months ended July 31, 2015 was $8.0 million. Proceeds from the sale of common stock and exercise of options amounted to approximately $10.5 million, offset by the repayment of debt of $2.5 million. Cash provided by financing activities for the nine months ended July 31, 2014 was $1.8 million, primarily from the sale of common stock, and exercise of options of $5.5 million, offset by the repayment of debt of $3.6 million.

 

Financing Arrangements

 

Fortress Loan Transaction and Related Warrants. Effective July 22, 2013, we entered into a Credit Agreement (the “Credit Agreement”) with Fortress Credit Co LLC, an affiliate of Fortress Investment Group LLC (such affiliates collectively, “Fortress”) that provides for aggregate term loan commitments of up to $10.0 million, consisting of a term loan A (“Term Loan A”) in the principal amount of $5.0 million and a term loan B (“Term Loan B” and, together with Term Loan A, the “Term Loans”) in the principal amount of $5.0 million. We drew down the full $10.0 million of both Term Loans on July 24, 2013. The obligations under the Credit Agreement are secured by, among other things, substantially all of our assets. In connection with our entry into this loan transaction with Fortress, we transferred 109 pending or granted non-’972 patents, which constitute substantially all of our patents other than those relating to our ’972 patent family, to a limited partnership of which we are a limited partner and of which an affiliate of Fortress is the general partner. The limited partnership concurrently provided us with a non-exclusive license to the assigned non-’972 patent rights for the life of such patents, subject to earlier termination if we undergo an insolvency event.

 

Term Loan A will mature on July 22, 2016 and Term Loan B will mature on February 1, 2016. The outstanding principal balance of the Term Loans bear interest at 10.0% per annum. Term Loan A required payments of interest only until August 1, 2014, with the principal to be repaid in 24 equal monthly payments beginning on that date together with accrued interest. Term Loan B required payments of interest only for the first six months after it was initially drawn, with the principal to be repaid in 24 equal monthly payments beginning on the first day of the month that is seven months after the date Term Loan B was initially drawn, together with accrued interest. The Company may prepay all or any part of the Term Loans at any time but would need to pay 2.8% of the original amount loaned upon repayment in entirety of the loans.

 

Under the Credit Agreement, we are subject to certain customary affirmative covenants, including, but not limited to, our obligations to deliver financial statements to Fortress, provide certain information and notices to Fortress, discharge all taxes, maintain good standing and governmental authorizations, maintain its properties and maintain insurance. Crossroads Systems (Texas), Inc., our wholly owned subsidiary (“Crossroads Texas”), and the limited partnership described above are also subject to certain customary negative covenants, including, but not limited to, limitations on dispositions, changes in the nature of business, mergers or acquisitions, distributions, investments and transactions with affiliates.

 

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The Credit Agreement also contains certain covenants that generally protect the collateral granted to Fortress and the patents and patent rights of Crossroads, Crossroads Texas and the limited partnership. We are also subject to certain financial covenants, including (i) a requirement to maintain a minimum of $1,500,000 of unrestricted cash at each month end; (ii) a prohibition on making any cash dividend payments or distributions to any of its equity security holders other than dividends payable with respect to our presently issued and outstanding 5.0% Series F Convertible Preferred Stock (the “Series F Preferred Stock” described below) and any additional shares of preferred stock issued pursuant to the transaction documents currently in effect pursuant to which the presently issued and outstanding shares of Series F Preferred Stock were issued; and (iii) a prohibition on incurring other indebtedness without Fortress’s prior written consent or as provided in the Credit Agreement.

 

Events of Default are defined under the Credit Agreement to include, but are not limited to, actions by any of the Company, Crossroads Texas or the limited partnership that result in a payment default, breach of representations and warranties, failure to comply with specific covenants, other defaults under or invalidity of any loan documents, insolvency proceedings, inability to pay debts, change of control and certain events relating to the intellectual property of the Company.

 

The Credit Agreement also contains customary representations and warranties by Crossroads to Fortress and customary indemnification provisions.

 

As a condition to and in connection with the Credit Agreement, we issued a warrant (the “Fortress Warrant”), pursuant to which Fortress is entitled to purchase 1,454,545 shares of our common stock. The Fortress Warrant is exercisable and will expire on the seventh anniversary of the effective date of the Fortress transactions. These warrants also previously contained what is commonly known as a “full-ratchet” anti-dilution provision, which provided that if we issued or were deemed to have issued additional shares of common stock without consideration or for a consideration per share less than the applicable exercise price of the Fortress Warrants, which is initially $2.0625 per share, then the exercise price of the warrants will be reduced on a “full ratchet” basis, concurrently with the new issue, to the consideration per share we received for the new issue or deemed issue of the additional shares of common stock. In January 2014, we and the warrantholder agreed to amend the warrant to remove this full-ratchet anti-dilution provision.

 

On June 23, 2015, we entered into an amendment to the Credit Agreement, with CF DB EZ LLC, as assignee of Fortress Credit Co LLC, to amend certain payment terms of the Credit Agreement as it relates to Term Loan B to effectuate a 12-month deferral of approximately $1.5 million in principal payments. Interest at the Applicable Rate (10%) will continue to be paid monthly, in arrears, and in addition, commencing on July 1, 2015, the unpaid principal amount shall bear additional interest equal to four percent (4%) per annum, which amount shall be paid in kind by being added to the principal balance of the Term Loan B.

 

Private Placements

 

On March 22, 2013, we entered into a securities purchase agreement with certain accredited investors for the issuance and sale in a private placement of 4,231,154 units at a purchase price of $2.0625 per unit, valued at $8.6 million, for net proceeds of approximately $7.9 million after related expenses.

 

Each unit consists of one share of Series F Preferred Stock, par value $0.001 per share and a warrant to purchase one-half of a share of common stock per share of Series F Preferred Stock purchased, at an exercise price of $2.00 per whole share, subject to certain adjustments, resulting in the issuance of warrants to purchase an additional 2,282,754 shares of common stock with an exercise price of $2.00 per share. The warrants were valued using the Black-Scholes pricing model at approximately $2,284,000 which resulted in a beneficial conversion feature on the Series F Preferred Stock of approximately $1,090,000. This amount was recorded as a deemed dividend.

 

The Series F Preferred Stock has the rights, qualifications, limitations and restrictions set forth in the Certificate of Designation (the “Certificate of Designation”) filed with the Secretary of State of the State of Delaware on March 28, 2013. The Certificate of Designation authorizes for issuance up to 4,500,000 shares of Series F Preferred Stock, with 3,750,000 shares designated as “Sub-Series F-1” and 750,000 shares designated as “Sub-Series F-2.” The right of holders of Series F Preferred Stock to convert the Series F Preferred Stock is subject to a 9.99% beneficial ownership limitation for holders of Sub-Series F-1 and a 4.99% beneficial ownership limitation for holders of Sub-Series F-2. Such beneficial ownership limitations may be increased or decreased by a holder of Sub-Series F-1 to any percentage not in excess of 19.99% after providing notice of such increase or decrease to us. For as long as at least 90% of the aggregate number of shares of Sub-Series F-1 issued on the Original Issue Date are outstanding, the holders of such Sub-Series F-1, voting as a single class, will be entitled to elect two directors of the Company. If less than 90%, but at least 20%, of such shares of Sub-Series F-1 are outstanding, such holders, voting as a single class, will be entitled to elect one director. As of the date hereof, 78% of the aggregate number of shares of Sub-Series F-1 are outstanding, as a remainder have been voluntarily converted into common stock at the option of the holders. Therefore, the holders of Sub-Series F-1 shares are entitled to elect one director to our Board of Directors. The holders of Sub-Series F-2 will not be entitled to vote on the directors elected by the holders of Sub-Series F-1. The holders of shares of the Series F Preferred Stock are entitled to a liquidation preference equal to the original issuance price plus accrued and unpaid dividends.

 

The Certificate of Designation contains customary anti-dilution protection for proportional adjustments (e.g. stock splits). The Series F Preferred Stock previously included an anti-dilution provision that would adjust the conversion price of the Series F Preferred Stock to the issue price of any equity securities we issued at a price less than $2.0625 per share, subject to certain exceptions. This type of provision is commonly referred to as a “full-ratchet” anti-dilution provision. This “full-ratchet” provision is no longer in effect as it was removed from the Certificate of Designation on March 14, 2014 by the requisite approval of the holders of shares of our common stock and Series F Preferred Stock. In accordance with ASC 815-40-25 and ASC 815-10-15 Derivatives and Hedging and ASC 480-10-25 Liabilities-Distinguishing Liabilities from Equity, the Series F Preferred Stock shares are accounted for net, outside of stockholder’s equity and warrants may be accounted for as liabilities at their fair value during periods where the full ratchet anti-dilution provision is in effect, which could have a significant impact on our financial statements. Upon the expiration of the full ratchet anti-dilution provisions in March 2014, we reclassified the Series F Preferred Stock and warrants to permanent stockholders' equity.

 

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The Series F warrants are accounted for as a liability at their fair value of $0.8 million as of October 31, 2013. The value of the derivative warrant liability was re-measured at each reporting period with changes in fair value recorded as earnings. We engaged an independent company to value its derivative liability and perform re-measurements. To derive an estimate of the fair value of these warrants, a dynamic Black Scholes formula is utilized that computes the impact of share dilution upon the exercise of the warrant shares. This process relied upon inputs such as shares outstanding, estimated stock prices, strike price and volatility assumptions to dynamically adjust the payoff of the warrants in the presence of the dilution effect. In the event the Series F Preferred Stock shares were redeemed, any redemption price in excess of the carrying amount of the Series F Preferred Stock would be treated as a dividend.

 

The warrants are exercisable six months after the closing date of the issuance, and expire March 22, 2018.

 

Dividends on the Series F Preferred Stock accrue at an annual rate of 5.0% of the original issue price and are payable on a semi-annual basis. The Series F Preferred Stock ranks senior to the common stock and each other class or our capital stock, whether common, preferred or otherwise, with respect to distributions of dividends and distributions upon liquidation, dissolution or winding up of the Company. Pursuant to a registration rights agreement entered into with the purchasers of the Series F Preferred Stock, in the event that a registration statement for the resale of the common stock underlying the Series F Preferred Stock and March 2013 warrants is not declared effective prior to July 26, 2013 (120 days from the closing of the March 2013 private placement), then the rate at which dividends accrue on our Series F Preferred Stock will be increased to an annual rate of 12.0% from that date until such time as a registration statement is declared effective, at which time the dividend rate will revert to an annual rate of 5.0%. Our registration statement was not declared effective by July 26, 2013, and as a result the dividend rate on the Series F Preferred Stock at present increased to an annual rate of 12.0% until September 19, 2013, when that registration statement was declared effective. We may elect to satisfy our obligation to pay semi-annual dividends in cash, by distribution of common stock or a combination thereof, in our discretion.

 

On March 31, 2014, we entered into a securities purchase agreement with certain accredited investors for the issuance and sale in a private placement of 1,986,622 units, at a purchase price of $2.2565 per unit for net proceeds of approximately $4.5 million before expenses. Affiliates of Lone Star Value Management, LLC, of which our Chairman of the Board of Directors, Jeffrey E. Eberwein, serves as a managing member, purchased approximately $2.9 million of Units. Roth Capital Partners acted as our financial advisor in the transaction, which was negotiated and approved by a special committee of the Board of Directors. We did not engage a placement agent in connection with the Private Placement, and therefore paid no commissions.

 

Each unit consists of one share of our common stock, par value $0.001 per share, and warrants to purchase one-half of a share of common stock, at a weighted average exercise price of $2.45 per whole share.

 

2015 Common Stock Offering

 

On January 27, 2015 we sold 3,071,739 units at $2.30 per unit for gross proceeds of $7.1 million. Each unit consists of one share of common stock and a warrant to purchase one-half of a share of common stock.  The warrants to purchase 1,658,760 shares of common stock have an exercise price of $2.76 per share.   Fees in the amount of $1.1 million relating to the stock placement were netted against proceeds.  The warrants were valued at $1.5 million using the Black-Scholes model.  The Black-Scholes inputs used were:  expected dividend rate of 0%, expected volatility of 75%, risk free interest rate of 1.55%, and expected term of 2.5 years.  The warrants are exercisable upon the six-month anniversary of issue, and expire January 31, 2020. As of July 31, 2015, there were 1,658,760 warrants outstanding. We will use the net proceeds of this offering for general working capital purposes.

 

2015 Common Stock Rights Offering

 

On July 28, 2015, the Company completed its Rights Offering. Under the terms of the Rights Offering, the Company distributed to its common and preferred stock holders one subscription right for each share of the Company’s common or preferred stock owned as of the record date, which entitled the holder to purchase 0.50 shares of common stock at the subscription price of $1.25 per share, subject to certain protection mechanics in place to preserve the Company’s ability to utilize its net operating loss carryforwards (“NOLs”).

 

The Company accepted subscriptions for 3,933,879 shares, resulting in aggregate gross proceeds of approximately $4.9 million. Expenses incurred to complete the Rights Offering amounted to approximately $0.4 million.

 

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Recent Accounting Pronouncements

 

During November 2014, the FASB issued ASU 2014-16 Derivatives and Hedging (Topic 815) Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity (“ASU 2014-16”).  ASU 2014-16 does not change the current criteria in GAAP for determining when separation of certain embedded derivative features in a hybrid financial instrument is required. That is, an entity will continue to evaluate whether the economic characteristics and risks of the embedded derivative feature are clearly and closely related to those of the host contract, among other relevant criteria. The amendments clarify how current GAAP should be interpreted in evaluating the economic characteristics and risks of a host contract in a hybrid financial instrument that is issued in the form of a share. Specifically, the amendments clarify that an entity should consider all relevant terms and features—including the embedded derivative feature being evaluated for bifurcation—in evaluating the nature of the host contract.  This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015.  These changes are not expected to have a material impact on the its consolidated financial statements.  This could impact the accounting for future hybrid financial instruments issued by the Company.

 

ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Not applicable.

 

ITEM 4.CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

Under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, our management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective (i) to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms; and (ii) to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

 

Changes in Internal Controls

 

During the last fiscal quarter, there were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II - OTHER INFORMATION

 

ITEM 1.LEGAL PROCEEDINGS

 

Patent Litigation Proceedings

 

We have a number of ongoing lawsuits and related proceedings as described below. In discussing these patent litigation proceedings, the following terms will be used:

 

  · A “Markman hearing ” in a patent infringement case is a pre-trial hearing in U.S. District Court, in which the court hears arguments regarding the meanings of key words used in a disputed patent claim. The outcome of a Markman hearing can play a significant role in whether a finding of infringement and validity are made by the Court or by the jury at trial.

 

  · An “ Inter Partes Review ” (“IPR”) is a post-grant review of an issued patent in which the petitioner attempts to challenge the validity of a patent on certain grounds (e.g. novelty and obviousness). If successful during Inter Partes Review, a petitioner could potentially invalidate some or all of the claims in the patents asserted against that petitioner in related litigation, and an adverse ruling in any of these proceedings would result in invalidation or other limitations on our patent rights. An IPR, if granted, is typically a twelve-to eighteen-month process.

 

Crossroads v. Dot Hill

 

We filed a lawsuit on September 11, 2013 against Dot Hill Systems Corp. ("Dot Hill") styled Crossroads Systems, Inc. v. Dot Hill Systems Corp., Civil Action No. 1:13-CV-800-SS alleging patent infringement of U.S. Patent No. 6,425,035 and breach of the Amended Settlement and License Agreement dated June 27, 2006 between us and Dot Hill. The action is pending. The Markman hearing was conducted October 6-7, 2014. Dot Hill moved to join two existing IPR proceedings previously filed against us by other defendants (one filed by NetApp/Oracle/Huawei and one filed by Cisco/Quantum, each as defined below) and to stay the pending litigation based on those IPR proceedings. On June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads and issued an order staying the case pending resolution of the IPR proceedings. If the patents are found partially or entirely invalid during the IPR proceedings, Crossroads might be adversely impacted in the litigation proceeding against Dot Hill, including potentially losing the ability to continue with its claims of infringement.

 

Crossroads v. Oracle, Huawei, Cisco, NetApp and Quantum

 

These related cases were filed on October 7, 2013, November 26, 2013, and February 18, 2014 in the United States District Court for the Western District of Texas alleging infringement by these parties of one or more patents in the ‘972 patent family. The asserted patents (6,425,035, 7,934,041, 7,987,311 and 7,051,147) were subject to a re-examination of the patents conducted in 2005-2006 by the United States Patent and Trademark Office (the “U.S. Patent Office”) or were issued after the re-examination. On May 7, 2014, these cases and the Dot Hill case were consolidated for purposes of discovery and a Markman hearing occurred on October 6 and 7, 2014. On June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads and entered an order staying these actions in light of various pending IPR proceedings.

 

During the time we were pursing the potential infringers of the ‘972 patent family, we also undertook efforts to put companies with potentially infringing products on notice and gave them the opportunity to license our proprietary technology. For example, NetApp was first given notice of potential infringement in 2004. Cisco was first given notice of potential infringement in 2002. Quantum has been on notice of its potential infringement since 2006. Oracle acquired several companies that were given notice of potential infringement at least as early as 2009 and Oracle itself has been on notice since then. Despite repeated attempts by us throughout the years to negotiate licenses to the ‘972 patent family, these companies refused and left us with no alternatives to litigation. We believe these companies (and companies they have acquired) have been illegally using our proprietary technology for years and that the potential compensatory damages could be in excess of $200 million which does not include enhanced damages or attorney fees. While the uncertainties and expense of litigation are great and we can provide no guarantees of success, we believe the infringement by most of these companies has been prolonged and potentially willful.

 

In response to the lawsuits brought by Crossroads, these parties have sought inter partes review of the patents asserted in these lawsuits in a total of nineteen petitions before the U.S. Patent Office challenging the validity of the patents asserted by the Company in the lawsuits (despite the prior re-examination). The U.S. Patent Office has instituted review of seven petitions, denied review of two petitions, with decisions on ten petitions still pending. Oracle is a party in ten petitions; Huawei is a party in three petitions; NetApp is a party in eight petitions; Cisco and Quantum are parties to three petitions; and Dot Hill is a party to two petitions. The first of the petitions were filed only months after Crossroads filed lawsuits against these parties and years after they were made aware of their potential infringement. If the patents are found partially or entirely invalid during these inter partes review proceedings, Crossroads might be adversely impacted in the litigation proceedings against these companies, including potentially losing the ability to continue with its claims of infringement. We believe we have meritorious factual and legal defenses to the challenges presented in these petitions and will vigorously defend the validity of the patents. Based on the current schedule set by the U.S. Patent Office, We expect a final decision in the six instituted proceedings by March 17, 2016.

 

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We filed a lawsuit on November 26, 2013 against Huawei Technologies Co. Ltd., Huawei Enterprise USA, Inc. & Huawei Technologies USA, Inc. (collectively, “Huawei”) alleging infringement of U.S. Patent Nos. 6,425,035, 7,051,147 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Huawei Technologies Co., Ltd. et al; Civil Action No. 1:13-cv-01025-SS (W.D. Tex., Austin Division)). On July 17, 2015, the parties settled the case.

 

We filed a lawsuit on October 7, 2013 against Oracle Corporation (“Oracle”) alleging infringement of U.S. Patent Nos. 6,425,035, 7,051,147 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Oracle Corporation; Civil Action No. 1:13-cv-0895-SS (W.D. Tex., Austin Division)). The action is pending. The Markman hearing was conducted October 6-7, 2014 and on June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads. Oracle is a party to nine petitions for IPR filed at the U.S. Patent Office, which collectively challenge the validity of each of the patents Crossroads asserted in the lawsuit against Oracle. The U.S. Patent Office has granted four of those petitions and Crossroads filed its Patent Owner’s Responses laying out the arguments regarding the validity of the patents in those granted proceedings. The Oral Hearing is scheduled for October 30, 2015. The remaining five petitions were filed relatively recently and Crossroads has filed its Preliminary Owner’s Responses to those five petitions. Based on the IPRs, Oracle filed a motion to stay the litigation pending the IPR proceedings, which was granted by the court. If the patents are found partially or entirely invalid during the IPR proceedings, Crossroads might be adversely impacted in the litigation proceeding against Oracle, including potentially losing the ability to continue with its claims of infringement.

 

We filed a lawsuit on February 18, 2014 against Cisco Systems, Inc. (“Cisco”) alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Cisco Systems, Inc.; Civil Action No. 1:14-cv-00148-SS (W.D. Tex., Austin Division)). The action is pending. The Markman hearing was conducted October 6-7, 2014 and on June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads. Cisco is a party to three petitions for IPR filed at the U.S. Patent Office, which collectively challenge the validity of each of the patents Crossroads asserted in the lawsuit against Cisco. The U.S. Patent Office has granted those petitions and Crossroads filed its Patent Owner’s Responses laying out the arguments regarding the validity of the patents in those granted proceedings. The Oral Hearing is scheduled for October 30, 2015. Based on the IPRs, Cisco filed a motion to stay the litigation pending the IPR proceedings, which was granted by the court. If the patents are found partially or entirely invalid during the IPR proceedings, Crossroads might be adversely impacted in the litigation proceeding against Cisco, including potentially losing the ability to continue with its claims of infringement.

 

We filed a lawsuit on February 18, 2014 against NetApp, Inc. (“NetApp”) alleging infringement of U.S. Patent Nos. 6,425,035, 7,934,041, 7,987,311 and 7,051,147 (the case is styled Crossroads Systems, Inc. v. Net App, Inc.; Civil Action No. 1:14-cv-00149-SS (W.D. Tex., Austin Division)). The action is pending. The Markman hearing was conducted October 6-7, 2014 and on June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads. NetApp is a party to seven petitions for IPR filed at the U.S. Patent Office, which collectively challenge the validity of each of the patents Crossroads asserted in the lawsuit against NetApp. The U.S. Patent Office has granted three of those petitions and Crossroads filed its Patent Owner’s Responses laying out the arguments regarding the validity of the patents in those granted proceedings. The Oral Hearing is scheduled for October 30, 2015. The remaining four petitions were filed relatively recently and Crossroads has filed its Preliminary Owner’s Response to those four petitions. Based on the IPRs, NetApp filed a motion to stay the litigation pending the IPR proceedings, which was granted by the court. If the patents are found partially or entirely invalid during the IPR proceedings, Crossroads might be adversely impacted in the litigation proceeding against NetApp, including potentially losing the ability to continue with its claims of infringement.

 

We filed a lawsuit on February 18, 2014 against Quantum Corporation (“Quantum”) alleging infringement of U.S. Patent Nos. 6,425,035 and 7,934,041 (the case is styled Crossroads Systems, Inc. v. Quantum Corporation; Civil Action No. 1:14-cv-00150-SS (W.D. Tex., Austin Division)). The action is pending. The Markman hearing was conducted October 6-7, 2014 and on June 16, 2015, Judge Sparks entered the Markman Order construing the claims in a manner favorable to Crossroads. Quantum is a party to three petitions for IPR filed at the U.S. Patent Office, which collectively challenge the validity of each of the patents we asserted in the lawsuit against Quantum. The U.S. Patent Office has granted those petitions and we filed our Patent Owner’s Responses laying out the arguments regarding the validity of the patents in those granted proceedings. The Oral Hearing is scheduled for October 30, 2015. Based on the IPRs, Quantum filed a motion to stay the litigation pending the IPR proceedings, which was granted by the court. If the patents are found partially or entirely invalid during the IPR proceedings, we may be adversely impacted in the litigation proceeding against Quantum, including potentially losing the ability to continue with its claims of infringement.

 

Quantum v. Crossroads

 

On September 23, 2014, Quantum filed a lawsuit in the U.S. District Court for the Northern District of California alleging that our StrongBox product infringes a patent owned by Quantum. This lawsuit was filed only months after we filed our lawsuit against Quantum claiming infringement of our patents. We believe we have meritorious legal positions and will represent our interest vigorously in this matter. If Quantum is successful in this lawsuit, it could result in us not having all of the patent rights necessary to conduct our business. A scheduling order has been entered in this case and trial is scheduled in February 2016. In addition, Quantum has threatened to file additional inter partes review proceedings against other, as yet unidentified, non-‘972 patents. If Quantum files any such proceedings, and Quantum is successful in any of those proceedings, it could adversely affect our patent rights and result in us not having all of the patent rights necessary to conduct our business.

 

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Dot Hill v. Crossroads

 

On June 29, 2015, Dot Hill filed a lawsuit in the U.S. District Court for the District of Colorado alleging that our StrongBox product infringes a patent owned by Dot Hill. We believe we have meritorious legal positions and will defend our interests vigorously in this matter. If Dot Hill is successful in this lawsuit, it could result in the Company not having all of the patent rights necessary to conduct the Company’s business. We have filed a response to the complaint and a scheduling conference is set for September 2015.

 

NetApp v. Crossroads

 

NetApp has threatened to file three lawsuits against us alleging that our SPHiNX virtual tape library, StrongBox, and RVA products infringe three NetApp patents. If NetApp files any of these three lawsuits, and if NetApp is successful in any of those lawsuits, it could adversely affect our patent rights and result in us not having all of the patent rights necessary to conduct our business.

 

ITEM 1A.RISK FACTORS

 

In evaluating us and our common stock, we urge you to carefully consider the risks and other information in this Quarterly Report on Form 10-Q, as well as the risk factors disclosed in Item 1A to Part I of our Annual Report on Form 10-K for the fiscal year ended October 31, 2014, which we filed with the SEC on January 14, 2015. The risks and uncertainties described in “Item 1A – Risk Factors” of our Annual Report on Form 10-K have not materially changed. Any of the risks discussed in this Quarterly Report on Form 10-Q or any of the risks disclosed in Item 1A to Part I of our Annual Report on Form 10-K for the fiscal year ended October 31, 2014, as well as additional risks and uncertainties not currently known to us or that we currently deem immaterial, could materially and adversely affect our results of operations or financial condition.

 

ITEM 2.UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

In January 2015, the Company issued an aggregate of 67,781 shares of common stock as a dividend to the holders of its Series F Preferred Stock.

 

In July 2015, the Company issued an aggregate of 84,265 shares of common stock as a dividend to the holders of its Series F Preferred Stock.

 

The issuance of these securities was exempt from the registration requirements of the Securities Act as under applicable Securities and Exchange Commission guidance, the issuance did not constitute a “sale” within the meaning of Section 2(a)(3) of the Securities Act.

 

ITEM 3.DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM 4.MINE SAFETY DISCLOSURES

 

Not applicable.

 

ITEM 5.OTHER INFORMATION

 

None.

   

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ITEM 6.EXHIBITS

 

Exhibit No.   Description
31.1   Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended
     
31.2   Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended
     
32.1   Certification of Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. §1350
     
32.2   Certification of Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. §1350
     
101.INS   XBRL Instance Document
101.SCH   XBRL Taxonomy Schema Linkbase Document
101.CAL   XBRL Taxonomy Calculation Linkbase Document
101.DEF   XBRL Taxonomy Definition Linkbase Document
101.LAB   XBRL Taxonomy Labels Linkbase Document
101.PRE   XBRL Taxonomy Presentation Linkbase Document

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

  CROSSROADS SYSTEMS, INC.  
     
September 14, 2015 /s/ Richard K. Coleman, Jr.  
(Date) Richard K. Coleman, Jr.  
  President and Chief Executive Officer  
  (Principal Executive Officer)  
     
September 14, 2015 /s/ Jennifer Crane  
(Date) Jennifer Crane  
  Chief Financial Officer  
  (Principal Accounting Officer)  

 

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Dates Referenced Herein   and   Documents Incorporated by Reference

This ‘10-Q’ Filing    Date    Other Filings
7/22/20
3/31/20
1/31/20
3/31/19
3/22/18
7/22/16
3/17/168-K
2/1/16
12/15/15
10/31/1510-K
10/30/154
10/22/154
Filed on:9/14/15SC 13D/A
8/31/15
For Period end:7/31/154
7/28/154
7/17/15
7/1/15EFFECT
6/29/158-K,  CORRESP,  S-1/A
6/23/158-K
6/16/15
2/28/15
1/28/15
1/27/154,  424B5,  8-K
1/14/1510-K,  4
10/31/1410-K,  4
9/23/144,  4/A
8/1/144
7/31/1410-Q,  4,  CORRESP,  UPLOAD
6/4/14
5/23/148-A12B,  8-K
5/7/14
5/2/143
4/4/143,  8-K,  SC 13D/A
3/31/143,  4,  8-K
3/14/148-K,  8-K/A,  DEF 14A
2/18/144,  8-K
12/19/13
11/26/134,  424B3,  8-K
10/31/1310-K,  4
10/7/138-K
9/19/13EFFECT
9/11/13
7/26/13S-1/A
7/24/133,  424B3,  8-K
7/22/13
6/21/133,  8-K,  8-K/A
3/28/13
3/22/1310-Q/A,  4,  8-K,  8-K/A
10/23/10
8/13/10
5/26/10
6/27/06
10/31/05
 List all Filings 
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