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Crossroads Systems Inc – ‘10-Q’ for 7/31/16

On:  Wednesday, 9/14/16, at 2:43pm ET   ·   For:  7/31/16   ·   Accession #:  1144204-16-123871   ·   File #:  1-15331

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

 9/14/16  Crossroads Systems Inc            10-Q        7/31/16   55:4.2M                                   Toppan Merrill/FA

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

Document/Exhibit                   Description                      Pages   Size 

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 2: EX-10.1     Material Contract                                   HTML    107K 
 3: EX-31.1     Certification -- §302 - SOA'02                      HTML     20K 
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13: R1          Document And Entity Information                     HTML     37K 
14: R2          Consolidated Balance Sheets                         HTML     96K 
15: R3          Consolidated Balance Sheets [Parenthetical]         HTML     36K 
16: R4          Consolidated Statements of Operations               HTML     75K 
17: R5          Consolidated Statements of Comprehensive Loss       HTML     27K 
18: R6          Consolidated Statements of Cash Flows               HTML    100K 
19: R7          Organization and Basis of Presentation              HTML     36K 
20: R8          Fair Value Measurement                              HTML     25K 
21: R9          Accrued Expenses and Deferred Revenue               HTML     45K 
22: R10         Commitments and Contingencies                       HTML     44K 
23: R11         Discontinued Operations                             HTML    133K 
24: R12         Stockholders' Equity                                HTML     62K 
25: R13         Stock Options and Stock Based Compensation          HTML    132K 
26: R14         Employee Benefits                                   HTML     21K 
27: R15         Related Party Transactions                          HTML     26K 
28: R16         Preferred Stock Rights                              HTML     22K 
29: R17         Organization and Basis of Presentation (Policies)   HTML     54K 
30: R18         Accrued Expenses and Deferred Revenue (Tables)      HTML     46K 
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                (Tables)                                                         
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                Textual)                                                         
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                (Details 1)                                                      
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                (Details 2)                                                      
48: R36         Stock Options and Stock Based Compensation          HTML     73K 
                (Details 3)                                                      
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                (Details Textual)                                                
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55: ZIP         XBRL Zipped Folder -- 0001144204-16-123871-xbrl      Zip    112K 


‘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

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(MARK ONE)

 

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

 

FOR THE QUARTERLY PERIOD ENDED July 31, 2016

 

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, 2016, Registrant had outstanding 1,225,472 shares of common stock, par value $0.001 per share.

 

 C: 

 

 

 

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

 

FORM 10-Q

QUARTER ENDED July 31, 2016

 

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 26
     
Item 4. Controls and Procedures 26
     
  PART II   OTHER INFORMATION  
     
Item 1. Legal Proceedings 27
     
Item 1A. Risk Factors 29
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 29
     
Item 3. Defaults Upon Senior Securities 29
     
Item 4. Mine Safety Disclosures 29
     
Item 5. Other Information 29
     
Item 6. Exhibits 30

 

 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, 
   2016   2015 
   (unaudited)     
ASSETS          
           
Current assets:          
Cash and cash equivalents  $2,718   $5,314 
Restricted cash   2,192    6,478 
Total cash, cash equivalents and restricted cash   4,910    11,792 
           
Accounts receivable, net of allowance for doubtful accounts of $0 and $5, respectively   1,049    656 
Current assets of discontinued operations   -    1,544 
Prepaid expenses and other current assets   172    218 
Total current assets   6,131    14,210 
           
Non-current assets of discontinued operations   -    562 
Other assets   186    141 
Total assets  $6,317   $14,913 
           
LIABILITIES AND STOCKHOLDERS' EQUITY          
           
Current liabilities:          
Accounts payable  $409   $1,823 
Accrued expenses   508    1,727 
Deferred revenue, current portion   2,280    6,343 
Current liabilities of discontinued operations   -    1,359 
Total current liabilities   3,197    11,252 
           
Non-current liabilities of discontinued operations   -    597 
           
Commitments and contingencies (See Note 4)   -    - 
Total liabilities   3,197    11,849 
           
Stockholders' equity:          
Convertible preferred stock, $0.001 par value, 25,000,000 shares authorized, 2,591,257 and 2,791,257 shares issued and outstanding, respectively   3    3 
Common stock, $0.001 par value, 75,000,000 shares authorized, 1,225,472 and 1,209,126 shares issued and outstanding, respectively   1    1 
Additional paid-in capital   239,708    238,905 
Accumulated other comprehensive loss   -    (90)
Accumulated deficit   (236,592)   (235,755)
Total stockholders' equity   3,120    3,064 
Total liabilities and stockholders' equity  $6,317   $14,913 

 

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, 
   2016   2015   2016   2015 
                 
Revenue:                    
IP license, royalty and other revenue  $57   $445   $477   $838 
                     
Cost of revenue:                    
IP license, royalty and other cost of revenue   23    188    122    242 
                     
Gross profit   34    257    355    596 
                     
Operating expenses:                    
General and administrative   1,186    2,809    4,891    6,876 
                     
Total operating expenses   1,186    2,809    4,891    6,876 
                     
Loss from operations   (1,152)   (2,552)   (4,536)   (6,280)
                     
Other expense:                    
Interest expense   -    (79)   -    (306)
Amortization of debt discount and issuance costs   -    (122)   -    (522)
Other income (loss)   713    (1)   4,012    18 
Loss from continuing operations   (439)   (2,754)   (524)   (7,090)
                     
Discontinued operations:                    
Loss on discontinued operations   -    (503)   (1,812)   (1,989)
Gain on disposal of discontinued operations   -    -    1,771    - 
Loss from discontinued operations   -    (503)   (41)   (1,989)
                     
Net loss  $(439)  $(3,257)  $(565)  $(9,079)
                     
Dividends attributable to preferred stock  $(42)  $(43)  $(171)  $(228)
Net loss available to common stockholders, basic and diluted  $(481)  $(3,300)  $(736)  $(9,307)
                     
Loss per share, basic and diluted:                    
Discontinued operations  $-   $(0.52)  $(0.03)  $(2.19)
Continuing operations  $(0.36)  $(2.84)  $(0.43)  $(7.79)
Available to common stockholder  $(0.39)  $(3.40)  $(0.60)  $(10.22)
                     
Weighted average number of common shares outstanding, basic and diluted   1,225,472    971,403    1,224,801    910,300 

 

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, 
   2016   2015   2016   2015 
                 
Net income (loss)  $(439)  $(3,257)  $(565)  $(9,079)
                     
Other comprehensive (loss) income:                    
Foreign currency translation adjustments   -    (7)   90    (26)
                     
Comprehensive income (loss)  $(439)  $(3,264)  $(475)  $(9,105)

 

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, 
   2016   2015 
         
Cash flows from operating activities:          
Net loss  $(565)  $(9,079)
Adjustments to reconcile net loss to net cash used in operating activities:          
Depreciation from discontinued operations   69    300 
Gain on sale of discontinued operations   (919)   - 
Amortization of debt discount   -    512 
Stock-based compensation   557    743 
Provision for doubtful accounts receivable   (4)   61 
Changes in assets and liabilities:          
Accounts receivable   641    260 
Inventory   54    (123)
Prepaid expenses and other assets   62    209 
Accounts payable   (1,310)   1,337 
Accrued expenses   (737)   211 
Deferred revenue   (5,300)   154 
Net cash used in operating activities   (7,452)   (5,415)
           
Cash flows from investing activities:          
Purchase of property and equipment from discontinued operations   (28)   (180)
Proceeds from sale of discontinued operations   852    - 
Net cash provided by (used in) investing activities   824    (180)
Cash flows from financing activities:          
Proceeds from issuance of common stock, net of expenses   -    10,549 
Preferred dividends   (133)   - 
Repayment of debt   -    (2,534)
Net cash (used in) provided by financing activities   (133)   8,015 
           
Effect of foreign exchange rate on cash and cash equivalents   (121)   (55)
Change in cash and cash equivalents   (6,882)   2,365 
Cash, cash equivalents, and restricted cash beginning of period   11,792    4,946 
Cash, cash equivalents, and restricted cash end of period  $4,910   $7,311 
           
Supplemental disclosure of cash flow information:          
           
Cash paid for interest  $-   $309 
Cash paid for income taxes  $2   $1 
           
Supplemental disclosure of non cash financing activities:          
Conversion of preferred stock to common stock  $302   $418 
Common stock dividends issued to preferred shareholders  $139   $298 
Warrants issued with private placement stock  $-   $1,893 
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”).  Headquartered in Austin, Texas, Crossroads, a Delaware corporation, is an intellectual property licensing company. Founded in 1996 as a product solutions company, Crossroads created some of the storage industry’s most fundamental patents and has licensed patents to more than 50 companies since 2000.

 

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, 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”), of which the Company is a limited partner and of which an affiliate of Fortress Investment Group LLC (“Fortress”) is the general partner, is accounted for using the equity method. The partnership holds the Company’s non’972 patent portfolio. The current investment balance is nominal at July 31, 2016.

 

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.

 

Reclassification

 

Certain prior period amounts have been reclassified to conform to the current period presentation. The reclassification includes assets, liabilities, and certain expenses in sales and marketing, research and development, and general and administrative related to discontinued operations. The amounts for the prior periods have been reclassified to be consistent with the current period presentation and have no impact on previously reported financials.

 

Cash, Cash Equivalents, and Restricted Cash

 

Cash, cash equivalents, and restricted cash consist of cash on deposit and highly liquid investments with original maturities of 90 days or less at date of purchase. While the Company’s cash and cash equivalents are on deposit with high quality FDIC and Association of German Banks insured financial institutions, at times such deposits exceed insured limits. As of July 31, 2016, total uninsured deposits were $4.7 million. The Company has not experienced any losses in such accounts.

 

Restricted cash amounted to $2.2 million. The balance consists of cash held from the sale of a portion of the Company’s IP revenue stream.

 

IP Revenue Stream Sale

 

On October 30, 2015, the Company entered into an agreement with TQ Zeta LLC, an affiliate of Techquity, and Intrepidus Holdings LLC (collectively, “Techquity”), in which Techquity will share in the revenue generated from the ’972 patent litigation. For consideration of $10.0 million received by the Company, Techquity received the rights to 52% of the first $20 million in licenses, settlements or other awards related to the ’972 patents, 40% of the amounts between $20 and $100 million, and 12% of all amounts above $100 million in aggregate licensing, settlements or other awards. Proceeds from the Techquity agreement are restricted to approved legal expenditures as defined in the agreement. During the three and nine months ended July 31, 2016, the Company recognized $0.7 and $4.0 million in other income, respectively, $2.2 million is held in deferred revenue and restricted cash. The Company will recognize other income from this transaction as the authorized expenditures are made with the unspent balance being reflected as deferred revenue.

 

 C: 
 7 

 

 

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

  

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.

 

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 3,160,161 and 3,561,652 for the nine months ended July 31, 2016 and 2015, respectively. The dilutive common stock equivalents for the nine months ended July 31, 2016 include warrants to purchase 368,765 shares of common stock, 2,591,257 shares of preferred stock, which are excluded until converted to common shares (Note 6), and stock options to purchase 200,139 shares of common stock.

 

Net loss available to common stockholders is calculated by deducting from net income, preferred dividends paid and accrued of $42,000 and $171,000 for the three and nine months ended July 31, 2016, respectively.

  

Recently Issued Accounting Pronouncements

 

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.

 

 C: 
 8 

 

 

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

  

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, 2016, 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, 2016 and October 31, 2015, the Company held no investments.

 

3. ACCRUED EXPENSES AND DEFERRED REVENUE

 

Accrued expenses consist of the following (in thousands):

 

   July 31,   October 31, 
   2016   2015 
   (unaudited)     
         
Payroll related  $147   $837 
Professional services   338    657 
Deferred rent   -    184 
Warranty reserve   -    5 
Other   23    44 
   $508   $1,727 

 

Included in payroll related accrued expenses as of July 31, 2016 and October 31, 2015 was $0.1 and $0.4 million, respectively, related to bonus compensation.  

 

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

 

   July 31,   October 31, 
   2016   2015 
   (unaudited)     
         
License  $88   $135 
Deferred revenue stream sale   2,192    6,208 
   $2,280   $6,343 

 

 C: 
 9 

 

 

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Deferred revenue stream sale consists of the remaining amount of consideration received from the sale of a portion of the Company’s IP revenue stream. The deferred revenue will be recognized upon the expenditure of approved legal costs related to the ongoing IP litigation described in Note 4.

 

4. COMMITMENTS AND CONTINGENCIES

 

Leases

 

In accordance with the terms of the March 22, 2016 sale of our product division, the Company’s office space and equipment lease obligations have been assigned to the purchaser.

 

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. Depending on the Court, a ruling could be received quickly or could take months after the Markman 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 from institution.

 

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 (the “035 patent”) 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 (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. The United States Patent and Trademark Office (the “U.S. Patent Office”) issued rulings in both of the IPR proceedings that Dot Hill had joined, ruling in one that the ’035 Patent is not unpatentable in view of the prior art raised and in the other that the ’035 Patent is unpatentable in view of different prior art. Crossroads believes the ruling of unpatentability was in error and has filed an appeal of that ruling with the Federal Circuit Court of Appeals. That appeal is on-going. If the patent asserted against Dot Hill is found partially or entirely invalid at the conclusion of the IPR proceedings, including appeal, Crossroads might be adversely impacted in the litigation proceeding against Dot Hill, including potentially losing the ability to continue with its claims of infringement. In May 2016, Crossroads filed a motion to lift the stay for limited purposes regarding Dot Hill’s failure to pay certain royalties and in July 2016 the Court denied the motion and the stay and this action remains in place.

 

Dot Hill owes the Company approximately $1.2 million at July 31, 2016 related to an agreement between the companies. The Company believes these amounts have been earned and collectability is probable at July 31, 2016. Nonetheless, Crossroads has, therefore, decided to reserve a portion of past and future Dot Hill revenue of $115,000 and Cost of Sales of $28,750.

 

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 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 the IPR proceedings.

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

During the time Crossroads was pursuing the potential infringers of the ’972 patent family, the Company gave companies with potentially infringing products 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 but litigation. Crossroads believes these companies (and companies they have acquired) have been illegally using Crossroads’ proprietary technology 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, collectively these defendants filed nineteen inter partes review petitions with the U.S. Patent Office to challenge the validity of the patents asserted by the Company in these lawsuits. The U.S. Patent Office instituted review of six of the petitions, granted joinder in four of the petitions and denied review of the remaining nine 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. Crossroads continues to believe it has meritorious factual and legal defenses to the challenges presented in these petitions and will vigorously defend the validity of the patents. The U.S. Patent Office issued rulings in the IPR proceedings, ruling in one that the ’035 Patent is not unpatentable in view of the prior art raised and ruling in the others that the ’035 Patent and Patent No. 7,051,147 (the “’147 Patent”) are unpatentable in view of different prior art. Crossroads believes the rulings of unpatentability were in error and has appealed these rulings to the Federal Circuit Court of Appeals. Those appeals are on-going. If these patents, which have been asserted against Oracle, Cisco, NetApp, and Quantum, are found partially or entirely invalid at the conclusion of these IPR proceedings, including appeal, Crossroads might be adversely impacted in the litigation proceedings against these companies, including potentially losing the ability to continue with its claims of infringement.

  

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 filed nine petitions for IPR at the U.S. Patent Office challenging the validity of each of the patents Crossroads asserted in the lawsuit against Oracle. The U.S. Patent Office granted six of those petitions. Based on the IPRs, Oracle filed a motion to stay the litigation pending the outcome of the IPR proceedings, which was granted by the Court. The U.S. Patent Office issued rulings in the IPR proceedings involving Oracle, ruling in one that the ’035 Patent is not unpatentable over the prior art and ruling in the other five that the ’035 Patent and ’147 Patent are unpatentable in view of different prior art. Crossroads believes the rulings of unpatentability were in error and has appealed these rulings to the Federal Circuit Court of Appeals. Those appeals are on-going. If the patents are found partially or entirely invalid during the IPR proceedings, including appeal, 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 challenging the validity of each of the patents Crossroads asserted in the lawsuit against Cisco. The U.S. Patent Office granted those petitions. Based on the IPRs, Cisco filed a motion to stay the litigation pending the outcome of the IPR proceedings, which was granted by the Court. The U.S. Patent Office issued rulings in the IPR proceedings involving Cisco, ruling that the ’035 Patent and ’147 Patents are unpatentable in view of the cited prior art. Crossroads believes the rulings of unpatentability were in error and has appealed these rulings to the Federal Circuit Court of Appeals. Those appeals are on-going. If the patents are found partially or entirely invalid during the IPR proceedings, including appeal, 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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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 filed seven petitions for IPR filed at the U.S. Patent Office challenging the validity of each of the patents Crossroads asserted in the lawsuit against NetApp. The U.S. Patent Office granted three of those petitions. Based on the IPRs, NetApp filed a motion to stay the litigation pending the outcome of the IPR proceedings, which was granted by the Court. The U.S. Patent Office issued rulings in the IPR proceedings involving NetApp, ruling in one that the ’035 Patent is not unpatentable over the prior art and ruling in the others that the ’147 Patent is unpatentable in view of different prior art. Crossroads believes the rulings of unpatentability were in error and has appealed these rulings to the Federal Circuit Court of Appeals. Those appeals are on-going. If the patents are found partially or entirely invalid during the IPR proceedings, including appeal, Crossroads might be adversely impacted in the litigation proceeding against NetApp, including potentially losing the ability to continue with its claims of infringement. On March 4, 2016, after its IPR on the ‘311 Patent was denied, NetApp filed a Reexamination request with the U.S. Patent and Trademark Office challenging the validity of the ‘311 Patent based on a subset of the prior art used in the IPR proceeding. The U.S. Patent and Trademark Office granted the request for Reexamination and issued an office action rejecting the claims of the ‘311 Patent. Crossroads believes this rejection of the claims of the ‘311 Patent to be in error just as we believe the rulings on the IPRs are in error. On September 3, 2016, the Company conducted an interview with the patent examiners to explain why we believe the ‘311 Patent to be valid over the cited prior art. This proceeding is ongoing and could be concluded in 2017. If the ‘311 Patent is found partially or entirely invalid during the Reexamination proceeding, the Company may be adversely impacted in the litigation proceeding against NetApp, including potentially losing the ability to continue with our 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 filed three petitions for IPR filed at the U.S. Patent Office challenging the validity of each of the patents Crossroads asserted in the lawsuit against Quantum. The U.S. Patent Office granted those petitions. Based on the IPRs, Quantum filed a motion to stay the litigation pending the outcome of the IPR proceedings, which was granted by the Court. The U.S. Patent Office issued rulings in the three IPR proceedings involving Quantum, ruling that the ’035 Patent and ’147 Patents are unpatentable in view of the cited prior art. Crossroads believes the rulings of unpatentability were in error and has appealed those rulings to the Federal Circuit Court of Appeals. Those appeals are on-going. If the patents are found partially or entirely invalid during the IPR proceedings, including appeal, Crossroads might be adversely impacted in the litigation proceeding against Quantum, including potentially losing the ability to continue with its claims of infringement.

 

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 infringed a patent owned by Dot Hill. On April 22, 2016 the parties entered into a settlement agreement resolving the action and on May 5, 2016, the case was dismissed.

 

5. DISCONTINUED OPERATIONS

 

On March 22, 2016, the Company entered into a Purchase and Assignment Agreement (the “Purchase Agreement”) with StrongBox Data Solutions, Inc. (“SDSI”), a Quebec corporation.

 

Under the Purchase Agreement, the Company sold and transferred all of the assets related to the Company’s product and support services division (the “Business”), including the Company’s StrongBox and SPHiNX storage solutions, to SDSI. SDSI also assumed certain liabilities of the Company related to the Business, and absorbed the majority of Crossroads’ employees. As consideration under the Purchase Agreement, SDSI paid the Company net proceeds equal to $1.9 million in cash on the closing date. Consideration of $1.0 million was paid to the holders of the Company’s Series F Preferred Stock in exchange for a vote for approval of the divestiture. The Board of Directors approved this payment, which has been reflected as a cost to sell the Business.

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

The assets and liabilities transferred for consideration received were (in thousands, at book value, unaudited):

 

Cash Received  $1,852 
      
Cash paid to Series F Convertible Preferred shareholders   (1,000)
Net cash received   852 
      
Fixed Assets   (499)
Inventory   (386)
Other Comprehensive Income   (110)
Expenses incurred   (79)
Deferred Revenue   1,795 
Other Assets and Liabilities   198 
Net gain on sale of discontinued operations  $1,771 

 

Certain items were reclassified as part of discontinued operations for comparative purposes. The table below presents the amounts by balance sheet classification (in thousands):

 

   July 31,   October 31, 
   2016   2015 
   (unaudited)   (unaudited) 
Assets          
Current assets:          
Accounts receivable, net  $-   $976 
Inventories   -    437 
Prepaids expenses, and other current assets   -    131 
Total current assets   -    1,544 
Property and equipment, net   -    533 
Other assets   -    30 
Total assets  $-   $2,107 
           
Liabilities          
Current liabilities:          
Accounts payable   -    400 
Accrued expenses   -    68 
Deferred revenue   -    891 
Total current liabilities   -    1,359 
           
Long term deferred revenue   -    596 
Total liabilities  $-   $1,955 

  

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

The amounts in the statement of operations that are part of the discontinued operations are summarized in the following table (in thousands):

 

   Three Months Ended   Nine Months Ended 
   July 31,   July 31, 
   2016   2015   2016   2015 
   (unaudited)   (unaudited)   (unaudited)   (unaudited) 
Revenue:                    
Product  $-   $516   $859   $1,962 
IP License, royalty and other   -    1,183    923    3,236 
                     
Total revenue   -    1,699    1,782    5,198 
                     
Cost of revenue:                    
Product   -    150    309    652 
IP License, royalty and other   -    214    275    646 
                     
Total cost of revenue   -    364    584    1,298 
                     
Gross profit   -    1,335    1,198    3,900 
                     
Operating expenses:                    
Sales and marketing   -    736    1,275    2,436 
Research and development   -    1,102    1,735    3,453 
                     
Total operating expenses   -    1,838    3,010    5,889 
                     
(Loss) income from discontinued operations  $-   $(503)  $(1,812)  $(1,989)

 

6. STOCKHOLDERS’ EQUITY

  

On May 25, 2016, the Company’s stockholders approved an amendment to the Company’s Certificate of Incorporation to effect a reverse stock split (the “Reverse Split”) of the outstanding shares of the Company’s common stock at a ratio of one-for-twenty at the Company’s annual meeting of stockholders. The reverse stock split was effective on June 20, 2016. Upon the effectiveness of the Reverse Split, every twenty (20) shares of the Company’s issued and outstanding common stock were automatically combined and reclassified into one (1) share of the Company’s common stock. Stockholders who otherwise would have been entitled to receive fractional shares as a result of the Reverse Split instead received a cash payment in lieu thereof equal to the product obtained by multiplying (a) the number of shares of pre-split common stock held by the stockholder that would otherwise have been exchanged for such fractional share interest by (b) the average of the last reported sales prices of the common stock as quoted on Nasdaq for the twenty business days ending on the trading day that is the second day immediately prior to the effective date of the Reverse Split. All share and per share data in the accompanying consolidated financial statements and notes have been adjusted for the effects of the Reverse Split.

 

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, at an exercise price of $2.00 per whole share, subject to certain adjustments, resulting in the issuance of warrants to purchase an additional 114,138 shares of common stock, split adjusted, with an exercise price of $40.00 per share, split adjusted. In connection with the 2015 Common Stock Rights Offering, defined below, an additional 0.2019 warrants were granted for every outstanding warrant on August 31, 2015. As of July 31, 2016, there were 121,979 warrants outstanding. 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 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, 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 warrants were exercisable immediately upon issue, and expire March 22, 2018.  During the nine months ended July 31, 2015, the Company issued 3,389 split adjusted dividend common shares valued at approximately $169,000. During the nine months ended July 31, 2016, the Company issued a dividend of 6,346 split adjusted common shares valued at approximately $302,000. Accrued and unpaid dividends were valued at approximately $42,000 as of July 31, 2016.

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

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 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 warrants to permanent stockholders’ equity following the stockholders vote.

  

During the nine months ended July 31, 2016, 200,000 shares of Series F Preferred Stock were 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.

 

2013 Fortress Credit Agreement

 

On July 22, 2013 the Company issued warrants to purchase 72,727 shares of its split adjusted common stock to Fortress at $41.25 per share, split adjusted (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 $18.89, split adjusted, per underlying warrant share. In connection with the Offering (as defined below), an additional 0.2019 warrants were granted for every outstanding warrant on August 31, 2015, with the strike price remaining at $41.25. As of July 31, 2016, there were 87,410 warrants outstanding.

 

The Fortress Warrants will expire on the seventh anniversary of the effective date of the Fortress transactions.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

2014 Private Placement

 

On March 31, 2014, the Company sold 99,331 units at $45.13 per unit, split adjusted, 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 49,666 shares of common stock have a weighted average exercise price of $49.00 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. In connection with the Offering, an additional 0.2019 warrants were granted for every outstanding warrant on August 31, 2015, with the strike price remaining at $49.00, split adjusted. As of July 31, 2016, there were 59,693 split adjusted warrants outstanding. 

 

2015 Common Stock Offering

 

On January 27, 2015, the Company sold 153,587 units at $46.00 per unit, split adjusted, 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 82,938 shares of common stock have an exercise price of $55.20 per share, split adjusted.   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 will be exercisable upon the six-month anniversary of issue, and expire January 31, 2020. In connection with the Offering an additional 0.2019 warrants were granted for every outstanding warrant on August 31, 2015, with the strike price remaining at $55.20. As of July 31, 2016, there were 99,683 split adjusted 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 $25.00 per share, split adjusted, 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 196,694 shares, split adjusted, resulting in aggregate gross proceeds of approximately $4.9 million. Expenses incurred to complete the Rights Offering amounted to approximately $0.4 million.

 

The Company has the following common stock warrants outstanding at July 31, 2016:

 

Warrant Transaction  Warrants
Outstanding
   Weighted
Average Exercise
Price
 
2013 Private Placement   121,979   $40.00 
2013 Fortress Credit Agreement   87,410   $41.20 
2014 Private Placement   59,693   $49.00 
2015 Common Stock Offering   99,683   $55.20 
Total Warrants   368,765      

 

7. 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.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

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, 2016, options to purchase 11,739 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 stockholders, and was subsequently amended by the Board of Directors on March 12, 2015 and approved by stockholders on April 24, 2015.  A maximum of 262,500 shares of Crossroads common stock may be awarded.  As of July 31, 2016, options to purchase 297,238 shares of common stock were granted from the 2010 Plan, of which 188,399 were outstanding. During the nine months ended July 31, 2016 and 2015, 0 and 5,879 common stock shares were granted from the 2010 Plan, respectively.

 

As of July 31, 2016, options to purchase an aggregate of 200,139 shares of common stock were outstanding under the 1999 Plan and the 2010 Plan, of which 145,083 were vested. Under the 2010 Plan, 27,048 shares of common stock were available for future grants as of July 31, 2016.  The shares of common stock reserved for future grant are reduced by 26,344 options previously exercised under the 2010 Plan, and 20,709 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. 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, 
   2016   2015 
         
General and administrative  $454   $501 
Discontinued operations   103    242 
Total stock-based compensation  $557   $743 

 

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 common 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, no options were granted during the nine months ended July 31, 2016:

 

   Nine months ended July 31, 
   2016   2015 
         
Expected dividend yield   0%   0%
Expected volatility   108%   74 - 76%
Risk-free interest rate   1.2%   1.4 - 1.6%
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, 2016:  

 

   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, 2015   205,588   $37.14    7.26   $0.2 
                     
Granted   32,000   $5.90           
Forfeited   (37,449)  $47.39           
Exercised   -   $-           
                     
Outstanding and expected to vest at July 31, 2016   200,139   $30.23    5.24   $- 
                     
Exercisable at July 31, 2016   145,083   $35.05    4.07   $- 

 

The weighted average fair value per option granted during the nine months ended July 31, 2016 and 2015 was $4.67 and $1.56, 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, 2016 and 2015 was $0 and $36,000, respectively. During the nine months ended July 31, 2016 and 2015, the amount of cash received from the exercise of stock options was $0 and $52,000, respectively.

 

The Company granted no options to non-employees during the nine months ended July 31, 2016 and 2015.

 

At July 31, 2016, there was approximately $0.2 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 22,915 and 47,790 options that became vested during the nine months ended July 31, 2016 and 2015, respectively, with the total fair value of these awards of approximately $0.4 million and $1.3 million, respectively.

 

The following table shows information about outstanding stock options at July 31, 2016:

 

    Options Outstanding   Options Exercisable 
        Weighted             
        Average   Weighted       Weighted 
Range of   Shares   Remaining   Average       Average 
Exercise Prices   Outstanding   Contractual Term   Exercise Price   Shares   Exercise Price 
$-   $5.90    32,000    9.85    $5.90    -   $- 
$11.98   $24.63    20,156    4.81    $18.80    20,156   $18.80 
$25.62   $25.62    27,045    7.31    $25.62    27,045   $25.62 
$25.96   $26.80    24,863    3.13    $26.38    12,788   $25.98 
$28.20   $33.94    4,715    3.83    $29.27    2,872   $29.95 
$34.94   $34.94    43,453    1.12    $34.94    43,453   $34.94 
$35.27   $45.59    25,913    7.30    $41.78    20,155   $41.50 
$45.76   $119.80    21,994    4.76    $63.40    18,614   $66.60 
                                 
$-   $119.80    200,139    5.24    $30.23    145,083   $35.05 

 

8. 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 $92,000 and $143,000 during the nine months ended July 31, 2016 and 2015, respectively.

 

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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

9. RELATED PARTY TRANSACTIONS

 

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 153,587 split adjusted units, at a purchase price of $46.00 per unit, split adjusted, 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 $55.20 per whole share, split adjusted. Lone Star Value Investors, LP (“Lone Star Value LP”), controlled by Jeffrey E. Eberwein, Crossroads’ Chairman of the Board of Directors at the time, acquired 17,500 units in the placement for approximately $0.8 million.

 

2015 Common Stock Rights Offering

 

On July 29, 2015, the Company completed a Rights Offering for the Company’s common stock, accepting subscriptions for 196,694 shares of common stock at $25.00 per share, split adjusted, for aggregate gross proceeds of approximately $4.9 million. Lone Star Value LP, controlled by Jeffrey E. Eberwein, Crossroads’ Chairman of the Board of Directors at the time, acquired 76,895 shares in the Rights Offering for approximately $1.9 million pursuant to the terms of the Rights Offering.

 

Discontinued operations consideration paid

 

During the three months ended April 30, 2016, the Company’s Board of Directors approved a payment to the Series F Preferred stockholders of the greater of 50% of the net proceeds from the sale of the Business or $1.0 million. The sale of the Business required a 70% approval of the Series F Preferred stockholders. The $1.0 million payment was recognized as an expense of selling the Business.

 

10. 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 NOLs 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, 2016. 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, 2016 or 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, 2015. 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 (the “SEC”).

 

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, 2015, as well as those discussed in the section entitled “Risk Factors” included elsewhere in our filings with the SEC, 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 ability to monetize intellectual property through licensing or sale;

 

·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;

 

·ability to fully utilize the company’s net operating loss tax benefit;

 

·ability to protect our confidential information and intellectual property rights;

 

·ability to successfully identify and manage any potential acquisitions;

 

·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 key personnel;

 

·ability to obtain additional financing; and

 

·ability to manage growth.

 

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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 on Form 10-Q 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.

 

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.

 

Our Direction and Strategy

 

Since its inception in 1996, Crossroads has been a prolific creator of intellectual property. As pioneers in data storage, our engineers created some of the industry’s most important breakthroughs, many of which are still utilized today by technology leaders. The patents we authored are the result of investing heavily in research and development. This strategic focus resulted in Crossroads gaining unique and extensive knowledge of data storage and data management technologies. Therefore, protecting our proprietary technology is vital to our business strategy. More than 50 companies have licensed our technology since 2000 and Crossroads has been paid more than $61 million for the right to use our inventions. We believe there are additional companies who would benefit from a license to our technology.

 

On March 22, 2016, we announced the sale of our product business and all related assets to Canadian-based StrongBox Data Solutions, Inc. (“SDSI”) for gross proceeds of $1.9 million in cash. Under the purchase agreement, the Company sold and transferred all of the assets related to the Company’s product and support services division, including its StrongBox and SPHiNX products. As part of the purchase agreement, 27 of Crossroads’ employees transitioned to SDSI, and 10 employees were terminated in a reduction in force (“RIF”). Included in the transfer were assignments of ongoing contracts. In the event SDSI failed to perform such contracts, or their other assumed obligations under the purchase agreement, parties to such contracts or obligations could seek damages from the Company under certain circumstances. Depending on the claim for damages, the Company could have a claim for indemnification against SDSI pursuant to the purchase agreement. Any such indemnification claim would be subject to the provisions of the purchase agreement, as well as SDSI’s ability to pay.

 

Technology Licensing

 

We generate revenue when companies using our technology agree to pay us either an upfront licensing fee, or a combination of upfront fees and ongoing licensing fees for the use of our intellectual property. Our licensing and litigation agreements sometimes include provisions to cross-license patents from other companies, further enhancing our intellectual property assets and product capabilities. The Company’s intellectual property assets are identified in two distinct categories. The first category, known as the ’972 patent family, consists of 31 patents and pending patents that are primarily concentrated around access controls. The second category, known as the non-’972 patents, consists of 140 patents and pending patents that are primarily directed to five product families: optimizing command processing, enabling interoperability, managing networks, enhancing tape libraries, and improving data systems. On March 22, 2016, we announced that Crossroads, in partnership with Fortress Investment Group LLC (“Fortress”), signed an agreement with AQUA Licensing to market and sell the non-’972 patent portfolio. AQUA will receive a graduated commission on any revenue realized from the non-’972 patent portfolio. The Company can provide no assurance regarding the timing or value of a transaction, or even if one will occur.

 

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Key Financial Definitions

 

Revenue. Revenue consists of royalties we earn for licenses of certain intellectual property.

 

Cost of Revenue. Cost of revenue is composed of cost of royalty and other revenue. “Cost of revenue” consists of professional fees and services.

 

Operating Expenses. Operating expenses consist of general and administrative expenses. Personnel-related costs, which include stock-based compensation expense, are the most significant component of these expense categories. We had 6 and 47 employees as of July 31, 2016 and 2015, respectively. The majority of this reduction in headcount is related to our discontinued operations.

  

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 (as defined herein). It is separated from interest paid due to the material nature of both.

 

Other Income. Other income consists of amounts not able to be categorized elsewhere. A majority of the amounts recognized are from the partial sale of the Company’s IP revenue stream.

 

Discontinued Operations. Discontinued operations consist of revenue, cost of revenue, expenses, and the amounts recognized as a gain during the sale of our discontinued product and support services division.

 

Critical Accounting Policies and Estimates

 

 There have been no 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, 2015.

 

Results of Operations

 

Three and Nine Months Ended July 31, 2016 Compared to the Three and Nine Months Ended July 31, 2015

 

Revenue.  Revenue decreased $0.3 million, or 87.2%, to $0.1 million for the three months ended July 31, 2016 from $0.4 million for the three months ended July 31, 2015. Revenue decreased $0.3 million, or 43.1%, to $0.5 million for the nine months ended July 31, 2016 from $0.8 million for the nine months ended July 31, 2015. The decrease is a result of a royalty license signed in the third quarter of 2015 with Huawei Technologies Co. Ltd. “Huawei”.

 

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Cost of Revenue.   Cost of revenue decreased $165,000, or 87.8%, to $23,000 for the three months ended July 31, 2016 from $188,000 for the three months ended July 31, 2015. Cost of revenue decreased $119,000, or 49.3%, to $123,000 for the nine months ended July 31, 2016 from $242,000 for the nine months ended July 31, 2015. The decrease is a result of a cost of sales due on the royalty license signed in the third quarter of 2015 with Huawei.

  

General and Administrative.  General and administrative expenses decreased $1.6 million, or 56.3%, to $1.2 million for the three months ended July 31, 2016 from $2.8 million for the three months ended July 31, 2015. The decrease was due to decreases in professional and legal services. The decreased professional fees are in connection with the decreased activity in patent and IP litigation ongoing throughout the year.

 

General and administrative expenses decreased $2.0 million, or 28.3%, to $4.9 million for the nine months ended July 31, 2016 from $6.9 million for the nine months ended July 31, 2015. The decrease was due to a reduction in professional fees of $1.6 million, decreased payroll and related expenses, including stock based compensation, of $0.2 million, decreased bad debt expense of $0.1 million, and decreases in consulting and outside services of approximately $0.1 million. The decreased professional fees are in connection with the decreased activity in patent and IP litigation ongoing throughout the year.

 

Interest expense.  Interest expense was $0 for the three months ended July 31, 2016 as compared to $0.1 million for the three months ended July 31, 2015. Interest expense was $0 for the nine months ended July 31, 2016 as compared to $0.3 million for the nine months ended July 31, 2015. The decrease was due to the payoff of the Fortress debt.

 

Amortization of debt discount and issuance costs.  Amortization of debt discount and issuance costs were $0 for the three months ended July 31, 2016 as compared to $0.1 million for the three months ended July 31, 2015. Amortization of debt discount and issuance costs expense were $0 for the nine months ended July 31, 2016 as compared to $0.5 million for the nine months ended July 31, 2015. The amortization relates to the borrowings drawn from Fortress during 2013, and the decrease is due to the Fortress debt being paid off in October 2015.

 

Other Income.  Other income was $0.7 million for the three months ended July 31, 2016, and a loss of $1,000 for the three months ended July 31, 2015. Other income was $4.0 million for the nine months ended July 31, 2016, and $18,000 for the nine months ended July 31, 2015. The $0.7 million recorded for the three months ended July 31, 2016, and the $4.0 million for the nine months ended July 31, 2016 was the amount recognized in connection with the partial IP revenue stream sale to Techquity (as described in the “Liquidity and Capital Resources” section below).

 

Liquidity and Capital Resources

 

Cash Flows

 

Our principal liquidity requirements are to meet our working capital needs. 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 IP licensing, proceeds from the sale of our common stock or preferred stock, debt instruments, the sale of all or part of our non-’972 patents, and exercises of options or warrants. We may require additional capital from equity or debt financings to fund our operations or respond to strategic opportunities.

 

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

 

   Nine Months Ended July 31, 
   2016   2015 
   (in thousands) 
Net cash used in operating activities  $(7,452)  $(5,415)
Net cash provided by (used in) investing activities   824    (180)
Net cash (used in) provided by financing activities   (133)   8,015 
Change in cash and cash equivalents   (6,882)   2,365 
Cash, cash equivalents, and restricted cash, end of period   4,910    7,311 

 

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Net cash used in operating activities increased $2.1 million from approximately $5.4 million during the nine months ended July 31, 2015 to approximately $7.5 million during the nine months ended July 31, 2016. Net loss for the nine months ended July 31, 2016 decreased approximately $8.5 million from $9.1 million for the nine months ended July 31, 2015 to $0.6 million for the nine months ended July 31, 2016, due primarily to the other income recognized from the partial sale of our IP revenue stream, and the sale of discontinued operations. Included in the net loss for the nine months ended July 31, 2016 were non cash adjustments for stock based compensation for $0.6 million, and gain on the sale of discontinued operations of $0.9 million. Cash used in operating activities were also affected by a decrease in deferred revenue of $5.3 million as a result of the deferred revenue recognized from the partial sale of our IP revenue stream and the relief of deferred revenue due to the sale of our product operations, a decrease in accounts payable by $1.3 million due to IP legal fees paid, a decrease in accrued expenses of $0.7 million, and offset by cash provided by a decrease in accounts receivable of $0.6 million, mostly in relation to diminished activity commencing with the sale of our product business.

 

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 provided by investing activities was $0.8 million in the nine months ended July 31, 2016 compared to $180,000 in cash used by investing activities during the nine months ended July 31, 2015. The Company received $0.9 million in cash, net, in the sale of our discontinued operations.

 

Cash flows used in financing activities for the nine months ended July 31, 2016 was $0.1 million, which were cash dividends paid to preferred stockholders. 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.

 

Financing Arrangements

 

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 5.0% Series F convertible preferred stock (the “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 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. As of the date hereof, 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 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. 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 warrants were 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 of 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 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 99,331 units, at a purchase price of $45.13 per unit, split adjusted, for net proceeds of approximately $4.5 million before expenses. Affiliates of Lone Star Value Management, LLC, of which our former Chairman of the Board of Directors 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 $49.00 per whole share, split adjusted.

 

2015 Common Stock Offering

 

On January 27, 2015, we sold 153,587 units at $46.00 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 82,938 shares of common stock have an exercise price of $55.20 per share, split adjusted.  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 are exercisable upon the six-month anniversary of issue, and expire January 31, 2020.

 

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 $25.00 per share, split adjusted, 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 196,694 shares, split adjusted, resulting in aggregate gross proceeds of approximately $4.9 million. Expenses incurred to complete the Rights Offering amounted to approximately $0.4 million.

 

IP Revenue Stream Sale

 

On October 30, 2015, we entered into an agreement with TQ Zeta LLC, an affiliate of Techquity, and Intrepidus Holdings LLC (collectively, “Techquity”), pursuant to which Techquity will share in the revenue generated from the ’972 patent litigation. For consideration of $10.0 million received by the Company, Techquity received the rights to 52% of the first $20 million, 40% of the amounts between $20 and $100 million, and 12% of all amounts above $100 million in aggregate licensing, settlements or other awards related to the ’972 patents received after the date of the sale agreement. We are restricted to only making payments of approved legal expenditures with the consideration received. During the nine months ended July 31, 2016, the Company recognized $4.0 million in other income, and $2.2 million is held in deferred revenue and restricted cash. We recognize other income from this transaction as the authorized expenditures are made with the unspent balance being reflected as deferred revenue.

  

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Recent Accounting Pronouncements

 

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.

 

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 SEC’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 Rules 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.
     
  · An “Ex Parte Reexamination” (“Reexamination”) is a different post-grant review of an issued patent in which the requestor attempts challenge the validity of a patent on certain grounds (e.g. novelty and obviousness).  In a Reexamination proceeding, a panel of three senior examiners from the U.S. Patent and Trademark Office will review the issued patent against prior art in a manner similar to original examination.  An adverse ruling in a Reexamination proceeding involving any patent asserted against any defendant in district court litigation would result in invalidation or other limitations on our patent rights.   A Reexamination is typically about an 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 (the “’035 Patent”) 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 (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. The United States Patent and Trademark Office (the “U.S. Patent Office”) issued rulings in both of the IPR proceedings that Dot Hill had joined, ruling in one that the ’035 Patent is not unpatentable in view of the prior art raised and in the other that the ’035 Patent is unpatentable in view of different prior art. We believe the ruling of unpatentability was in error and has filed an appeal of that ruling with the Federal Circuit Court of Appeals. That appeal is on-going. If the patent asserted against Dot Hill is found partially or entirely invalid at the conclusion of the IPR proceedings, including appeal, we may be adversely impacted in the litigation proceeding against Dot Hill, including potentially losing the ability to continue with its claims of infringement. In May 2016, we filed a motion to lift the stay for limited purposes regarding Dot Hill’s failure to pay certain royalties and in July 2016 the Court denied the motion and the stay and this action remains in place.

 

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 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 the IPR proceedings.

 

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During the time we were pursuing the potential infringers of the ’972 patent family, we gave companies with potentially infringing products 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 Crossroads throughout the years to negotiate licenses to the ’972 patent family, these companies refused and left us with no alternatives but litigation. We believe these companies (and companies they have acquired) have been illegally using our proprietary technology 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 us, collectively these defendants filed nineteen inter partes review petitions with the U.S. Patent Office to challenge the validity of the patents asserted by us in these lawsuits. The U.S. Patent Office instituted review of six of the petitions, granted joinder in four of the petitions and denied review of the remaining nine petitions. The first of the petitions were filed only months after we filed lawsuits against these parties and years after they were made aware of their potential infringement. We continue to believe it has meritorious factual and legal defenses to the challenges presented in these petitions and will vigorously defend the validity of the patents. The U.S. Patent Office issued rulings in the IPR proceedings, ruling in one that the ’035 Patent is not unpatentable in view of the prior art raised and ruling in the others that the ’035 Patent and Patent No. 7,051,147 (the “’147 Patent”) are unpatentable in view of different prior art. We believe the rulings of unpatentability were in error and has appealed these rulings to the Federal Circuit Court of Appeals. Those appeals are ongoing. If these patents, which have been asserted against Oracle, Cisco, NetApp, and Quantum are found partially or entirely invalid at the conclusion of these IPR proceedings, including appeal, we may be adversely impacted in the litigation proceedings against these companies, including potentially losing the ability to continue with its claims of infringement.

 

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 us. Oracle filed nine petitions for IPR at the U.S. Patent Office challenging the validity of each of the patents we asserted in the lawsuit against Oracle. The U.S. Patent Office granted six of those petitions. Based on the IPRs, Oracle filed a motion to stay the litigation pending the outcome of the IPR proceedings, which was granted by the Court. The U.S. Patent Office issued rulings in the IPR proceedings involving Oracle, ruling in one that the ’035 Patent is not unpatentable over the prior art and ruling in the other five that the ’035 Patent and ’147 Patent are unpatentable in view of different prior art. We believe the rulings of unpatentability were in error and has appealed these rulings to the Federal Circuit Court of Appeals. Those appeals are ongoing. If the patents are found partially or entirely invalid during the IPR proceedings, including appeal, we may 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 us. Cisco is a party to three petitions for IPR filed at the U.S. Patent Office challenging the validity of each of the patents we asserted in the lawsuit against Cisco. The U.S. Patent Office granted those petitions. Based on the IPRs, Cisco filed a motion to stay the litigation pending the outcome of the IPR proceedings, which was granted by the Court. The U.S. Patent Office issued rulings in the IPR proceedings involving Cisco, ruling that the ’035 Patent and ’147 Patents are unpatentable in view of the cited prior art. Crossroads believes the rulings of unpatentability were in error and has appealed these rulings to the Federal Circuit Court of Appeals. Those appeals are ongoing. If the patents are found partially or entirely invalid during the IPR proceedings, including appeal, we may 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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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 us. NetApp filed seven petitions for IPR filed at the U.S. Patent Office challenging the validity of each of the patents we asserted in the lawsuit against NetApp. The U.S. Patent Office granted three of those petitions. Based on the IPRs, NetApp filed a motion to stay the litigation pending the outcome of the IPR proceedings, which was granted by the Court. The U.S. Patent Office issued rulings in the IPR proceedings involving NetApp, ruling in one that the ’035 Patent is not unpatentable over the prior art and ruling in the others that the ’147 Patent is unpatentable in view of different prior art. We believe the rulings of unpatentability were in error and has appealed these rulings to the Federal Circuit Court of Appeals. Those appeals are ongoing. If the patents are found partially or entirely invalid during the IPR proceedings, including appeal, we may be adversely impacted in the litigation proceeding against NetApp, including potentially losing the ability to continue with its claims of infringement. On March 4, 2016, after its IPR on the ‘311 Patent was denied, NetApp filed a Reexamination request with the U.S. Patent and Trademark Office challenging the validity of the ‘311 Patent based on a subset of the prior art used in the IPR proceeding. The U.S. Patent and Trademark Office granted the request for Reexamination and issued an office action rejecting the claims of the ‘311 Patent. We believe this rejection of the claims of the ‘311 Patent to be in error just as we believe the rulings on the IPRs are in error. On September 3, 2016, we conducted an interview with the patent of Examiners to explain why we believe the ‘311 Patent to be valid over the cited prior art. This proceeding is ongoing and could be concluded in 2017. If the ‘311 Patent is found partially or entirely invalid during the Reexamination proceeding, we may be adversely impacted in the litigation proceeding against NetApp, including potentially losing the ability to continue with our 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 us. Quantum filed three petitions for IPR filed at the U.S. Patent Office challenging the validity of each of the patents we asserted in the lawsuit against Quantum. The U.S. Patent Office granted those petitions. Based on the IPRs, Quantum filed a motion to stay the litigation pending the outcome of the IPR proceedings, which was granted by the Court. The U.S. Patent Office issued rulings in the three IPR proceedings involving Quantum, ruling that the ’035 Patent and ’147 Patents are unpatentable in view of the cited prior art. We believes the rulings of unpatentability were in error and has appealed those rulings to the Federal Circuit Court of Appeals. Those appeals are ongoing. If the patents are found partially or entirely invalid during the IPR proceedings, including appeal, we may be adversely impacted in the litigation proceeding against Quantum, including potentially losing the ability to continue with its claims of infringement.

  

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. On April 22, 2016, the parties entered into a settlement agreement resolving the action and on May 5, 2016, the case was dismissed.

 

ITEM 1A. RISK FACTORS

 

In evaluating the Company 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, 2015, which we filed with the SEC on January 13, 2016. 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, 2015, 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

 

None.

 

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
10.1   Amended and Restated Employment Agreement, by and between Crossroads Systems, Inc. and Richard K. Coleman, Jr., effective as of August 1, 2016
     
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 Executive 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

 

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, 2016 /s/ Richard K. Coleman, Jr.  
(Date) Richard K. Coleman, Jr.  
  President and Chief Executive Officer  
  (Principal Executive Officer)  
     
September 14, 2016 /s/ Jennifer Crane  
(Date) Jennifer Crane  
  Chief Financial Officer  
  (Principal Financial and Accounting Officer)  

 

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Dates Referenced Herein   and   Documents Incorporated by Reference

This ‘10-Q’ Filing    Date    Other Filings
1/31/20
3/31/19
3/22/18
10/31/1610-K
Filed on:9/14/164
9/3/16
8/1/16
For Period end:7/31/16
6/20/16
5/25/163,  8-K,  DEF 14A
5/5/16
4/30/1610-Q
4/22/16
3/22/168-K
3/4/16
1/13/1610-K
10/31/1510-K
10/30/154
8/31/15
7/31/1510-Q,  4
7/29/15
7/28/154
6/29/158-K,  CORRESP,  S-1/A
6/16/15
4/24/158-K,  DEF 14A
3/12/153
1/27/154,  424B5,  8-K
6/4/14
5/23/148-A12B,  8-K
5/7/14
3/31/143,  4,  8-K
3/14/148-K,  8-K/A,  DEF 14A
2/18/144,  8-K
11/26/134,  424B3,  8-K
10/7/138-K
9/19/13EFFECT
9/11/13
7/26/13S-1/A
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
8/13/10
5/26/10
6/27/06
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