Effective internal controls are necessary for us to provide reliable financial reports and effectively minimize the possibility of fraud and its impact on our company. If we cannot provide financial reports or effectively minimize the possibility of fraud, our business reputation and operating results could be harmed. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.

In addition, we will be required to include the management and auditor reports on internal controls as part of our annual report for the fiscal year ending September 30, 2008, pursuant to SOX Section 404, which requires, among other things, that we maintain effective internal controls over financial reporting and effective disclosure controls and procedures. In particular, we must perform system and process evaluation and testing of our internal controls over financial reporting to allow management and our independent registered public accounting firm to report on the effectiveness of our internal controls over financial reporting, as required by Section 404. Our compliance with Section 404 will require that we incur substantial accounting expense and expend significant management efforts.

We cannot be certain as to the timing of the completion of our evaluation and testing, the timing of any remediation actions that may be required or the impact these may have on our operations. Furthermore, there is no precedent available by which to measure compliance adequacy. If we are not able to implement the requirements relating to internal controls and all other provisions of Section 404 in a timely fashion or achieve adequate compliance with these requirements or other SOX requirements, we might become subject to sanctions or investigation by regulatory authorities such as the Securities and Exchange Commission or any securities exchange on which we may be trading at that time, which action may be injurious to our reputation and affect our financial condition and decrease the value and liquidity of our securities, including our common stock.

 

Our auditors identified material weaknesses in our internal control over financial reporting as of September 30, 2006.

In connection with its audit of our financial statements, our external auditors, UHY LLP, advised us that they were concerned that as of and for the year ended Septmber 30, 2006, our accounting resources did not include enough people with the detailed knowledge, experience and training in the selection and application of certain accounting principles generally accepted in the United States of America (GAAP) to meet the Company’s financial reporting needs. This control deficiency contributed to material weaknesses in internal control with respect to accounting for revenue recognition, equity and acquisitions. A “material weakness” is a control deficiency or combination of control deficiencies that results in more than a remote likelihood that a material misstatement in the financial statements or related disclosures will not be prevented or detected. In preparation for this offering, we engaged a consultant experienced in accounting and financial reporting who assisted us in preparing our financial statements. We have begun the process of identifying candidates to assume newly created positions in our Company, one of which will be at the vice-president level, with specific responsibilities for external financial reporting, internal control, revenue recognition and purchase accounting. We intend to have these resources in place sometime during the third quarter of fiscal year 2007.

Risks Related to Our Industry

We face intense and growing competition, which could result in price reductions, reduced operating margins and loss of market share. 

 

We operate in a highly competitive marketplace and generally encounter intense competition to create and maintain demand for our services and to obtain service contracts. If we are unable to successfully compete for new business and license renewals, our revenue growth and operating margins may decline. The market for our products, i.e., Web development services, content management products, asset management products, e-Training products, foundations management products, and Web analytics are competitive and rapidly changing, and barriers to entry in

 

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such markets are relatively low. With the introduction of new technologies and market entrants, we expect competition to intensify in the future. Some of our principal competitors offer their products at a lower price, which may result in pricing pressures. Such pricing pressures and increased competition generally could result in reduced sales, reduced margins or the failure of our product and service offerings to achieve or maintain more widespread market acceptance.

The Web development/services market is highly fragmented with a large number of competitors and potential competitors. Our primary public company competitors are Website Pros, Filenet, aQuantive, Vignette and WebSideStory. We also face competition from customers and potential customers who develop their own applications internally. We also face competition from potential competitors that are substantially larger than we are and who have significantly greater financial, technical and marketing resources, and established direct and indirect channels of distribution. As a result, they are able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, promotion and sale of their products than we can. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or prospective customers. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share which could reduce our market share and decrease our revenues. See “Business - Competition” on page 55.

Increasing government regulation could affect our business. 

We are subject not only to regulations applicable to businesses generally, but also to laws and regulations directly applicable to electronic commerce. Although there are currently few such laws and regulations, state, federal and foreign governments may adopt laws and regulations applicable to our business. Any such legislation or regulation could dampen the growth of the Internet and decrease its acceptance. If such a decline occurs, companies may choose in the future not to use our products and services. Any new laws or regulations in the following areas could affect our business:

·	user privacy;

·	the pricing and taxation of goods and services offered over the Internet;

·	the content of Websites;

·	copyrights;

·	consumer protection, including the potential application of “do not call” registry requirements on customers and consumer backlash in general to direct marketing efforts of customers;

·	the online distribution of specific material or content over the Internet; or

·	the characteristics and quality of products and services offered over the Internet.

 

Because competition for highly qualified personnel is intense, we might not be able to attract and retain the employees we need to support our planned growth. 

We will need to increase the size and maintain the quality of our sales force, software development staff and professional services organization to execute our growth plans. To meet our objectives, we must attract and retain highly qualified personnel with specialized skill sets. Competition for qualified personnel can be intense, and we might not be successful in attracting and retaining them. Our ability to maintain and expand our sales, product development and professional services teams will depend on our ability to recruit, train and retain top quality people with advanced skills who understand sales to, and the specific needs of, our target customers. For these reasons, we have experienced, and we expect to again experience in the future, challenges in hiring and retaining highly skilled employees with appropriate qualifications for our business. In addition to hiring services personnel to meet our needs, we may also engage additional third-party consultants as contractors, which could have a negative impact on our financial results. If we are unable to hire or retain qualified personnel, or if newly hired personnel fail to develop the necessary skills or reach productivity slower than anticipated, it would be more difficult for us to sell our products and services, and we could experience a shortfall in revenue and not achieve our planned growth.

 

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Risks Related to this Offering

There is no prior public market for our common stock and our stock price could be volatile and could decline following this offering, resulting in a substantial loss in your investment.

 

Prior to this offering, there has not been a public market for our common stock. An active trading market for our common stock may never develop or if it develops it may not be sustained, which could affect your ability to sell your shares and could depress the market price of your shares. In addition, the initial public offering price of the shares has been determined through negotiations between us and the representatives of the underwriters and may bear no relationship to the price at which the shares will trade upon completion of this offering. The stock market can be highly volatile. As a result, the market price of our common stock can be similarly volatile, and investors in our common stock may experience a decrease in the value of their stock, including decreases unrelated to our operating performance or prospects. The market price of our common stock after the offering will likely vary from the initial offering price and is likely to be highly volatile and subject to wide fluctuations in response to various factors, many of which are beyond our control. These factors include:

·	variations in our operating results;

·	changes in the general economy and in the local economies in which we operate;

·	the departure of any of our key executive officers and directors;

·	the level and quality of securities analysts’ coverage for our common stock;

·	announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;

·	changes in the federal, state, and local laws and regulations to which we are subject; and

·	future sales of our common stock.

 

Future sale of a significant number of our securities could cause a substantial decline in the price of our securities, even if our business is doing well.

Sales of a substantial number of shares of our common stock or the availability of a substantial number of such shares for sale could result in a decline of prevailing market price of our common stock. In particular, we are registering the resale of up to 342,000 shares of our common stock that may be acquired upon the exercise of certain warrants. These shares may not be sold or otherwise disposed of during a lock-up period of up to six months from the date of this prospectus; thereafter, holders of those shares will be able to sell them into the public market without restriction. In addition, we could issue other series or classes of preferred stock having rights, preferences and powers senior to those of our common stock, including the right to receive dividends and preferences upon liquidation, dissolution or winding-up in excess of, or prior to, the rights of the holders of our common stock. This could reduce or eliminate the amounts that would otherwise have been available to pay dividends on the common stock. In addition, all of our directors, officers and shareholders have executed lock-up agreements with the underwriters agreeing not to sell, transfer or otherwise dispose of any of their shares for a period of one year from the date of this prospectus. The lock-up agreements are subject to customary exceptions and may be waived by the underwriters. Sales of a substantial number of these shares in the public market could depress the market price of our common stock and impair our ability to raise capital through the sale of additional equity securities.

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The results of our operations could cause our stock price to decline.

      

Our operating results in the future may be affected by a number of factors and, as a result, fall below expectations. Any of these events could negatively affect our operating results which might cause our stock price to fall:

·	Our inability to attract new customers at a steady or increasing rate;

·	Our inability to provide and maintain customer satisfaction;

·	Price competition or higher prices in the industry;

·	Higher than expected costs of operating our business;

·	The amount and timing of operating costs and capital expenditures relating to the expansion of our business, operations and infrastructure are greater and higher than expected;

·	Technical, legal and regulatory difficulties with respect to our business occur; and

·	General downturn in economic conditions that are specific to our market, such as a decline in information technology spending.

 

Purchasers in this offering will experience immediate and substantial dilution in the book value of their investment.

The initial public offering price of our common stock is substantially higher than the net tangible book value per share of our common stock immediately after this offering. If you purchase our shares in this offering, you will incur an immediate dilution of $3.83 per share of common stock ($3.61 if the over-allotment option is exercised by the underwriters) in net tangible book value per share from the price you paid, based on an assumed initial mid-point offering price between $5.00 and $6.00 per share. Upon the issuance of additional shares of our common stock to Objectware’s sole stockholder in the closing described at page 52 of this prospectus, dilution will be reduced by $0.56 per share of common stock ($0.51 if the over-allotment option is exercised by the underwriters) in net tangible book value per share from the price you paid, based on an assumed initial mid-point offering price between $5.00 and $6.00 per share.

 

We do not intend to pay dividends, which may limit the return on your investment.

 

We have never declared or paid cash dividends or distributions to our equity owners. We currently intend to retain all available funds and any future earnings for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. You should not make this investment in our securities if you require dividend income from your investment. The success of your investment will likely depend entirely upon any future appreciation of the market price of our common stock, which is uncertain and unpredictable. There is no guarantee that our common stock will appreciate in value after this offering or even maintain the price at which you purchased your shares.

We have substantial discretion as to how to use the offering proceeds.

 

While we currently intend to use the net proceeds of this offering as set forth in “Use of Proceeds” on page 18 of this prospectus, we may choose, in our sole discretion, to use the net offering proceeds for different purposes. The effect of the offering will be to increase capital resources available to our management, and our management will allocate these capital resources as necessary to enhance shareholder value. You will be relying on the judgment of our management with regard to the use of the net proceeds of this offering.

 

Provisions in our charter documents or Delaware law might discourage, delay or prevent a change of control of our company, which could negatively affect your investment.

 

Our Amended and Restated Certificate of Incorporation (which will become effective shortly before the completion of this offering) and Amended and Restated By-laws will contain provisions that could discourage, delay, or prevent a change of control of our company or changes in our management that our shareholders may deem advantageous. These provisions include:

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·	authorizing the issuance of preferred stock that can be created and issued by our Board of Directors without prior shareholder approval, commonly referred to as “blank check” preferred stock, with rights senior to those of our common stock;

·	limiting the persons who can call special shareholder meetings;

·	establishing advance notice requirements to nominate persons for election to our Board of Directors or to propose matters that can be acted on by shareholders at shareholder meetings;

·	the lack of cumulative voting in the election of directors;

·	requiring an advance notice of any shareholder business before the annual meeting of our shareholders;

·	filling vacancies on our Board of Directors by action of a majority of the directors and not by the shareholders, and

·	the division of our Board of Directors into three classes with each class of directors elected for a staggered three year term. In addition, our organizational documents will contain a supermajority voting requirement for any amendments of the staggered board provisions.

 

 

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USE OF PROCEEDS 

Our net proceeds from the sale and issuance of 3,000,000 shares are estimated to be approximately $13,740,000 (approximately $15,940,000 if the underwriters’ over-allotment option is exercised in full), based upon an estimated initial public offering price of $5.50 per share and after deducting the estimated underwriting discount, the non-accountable expense allowance and the estimated offering expenses payable by us.

We intend to use the net proceeds of this offering as follows: 

Use		Amount (in thousands)			Percent
Repayment of indebtedness		$	2,800			20.4	%
Payment of cash portion in connection with the acquisition of   Objectware, together with expenses associated with that acquisition			2,955			21.5	%
Other potential acquisitions (approximate)			2,000			14.6	%
General corporate purposes, including working capital			5,985			43.5	%
Total		$	13,740			100.0	%

     

The amounts and timing of our actual expenditures will depend on numerous factors, including the results of our sales, marketing activities, competition and the amount of cash generated or used by our operations. For example, in the event that we do not complete the acquisition of Objectware, we intend to use the remainder of our net proceeds to finance our working capital needs and for general corporate purposes. Although we currently have no agreements or commitments to complete any acquisitions or other such transactions other than Objectware acquisition and have not allocated funds for any such transactions in our business plan, we believe that the proceeds from this offering will enable us to more effectively pursue strategic opportunities, such as the acquisitions and other transactions discussed above, when and as we identify them. We may find it necessary or advisable to use the net proceeds for other purposes, and we will have broad discretion in the application of the balance of the net proceeds. Pending the uses described above, we intend to invest the net proceeds in certificates of deposit, short-term obligations of the United States government, or other money-market instruments that are rated investment grade or its equivalent.

 DIVIDEND POLICY

We have never paid cash dividends or distributions to our equity owners. We do not expect to pay cash dividends on our common stock, but, instead, intend to utilize available cash to support the development and expansion of our business. Any future determination relating to our dividend policy will be made at the discretion of our Board of Directors and will depend on a number of factors, including, but not limited to, future operating results, capital requirements, financial condition and the terms of any credit facility or other financing arrangements we may obtain or enter into, future prospects and other factors our Board of Directors may deem relevant at the time such payment is considered. There is no assurance that we will be able or will desire to pay dividends in the near future or, if dividends are paid, in what amount.

 

 

 

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CAPITALIZATION

The following table sets forth our capitalization as of September 30, 2006. You should read this table in conjunction with “Management’s Discussion and Analysis” beginning on page 26 and the financial statements and accompanying notes included elsewhere in this prospectus. Such information is set forth on the following basis:

·	“Actual” is based on our audited financial statements as of September 30, 2006.

·

“Adjustments” gives the effect of the sale of shares in this offering and the application of the net proceeds from this offering as described under “Use of Proceeds” on page 18 and assumes that the underwriters do not exercise their over-allotment option and is further adjusted for issuances of shares and options pursuant to the completion of the acquisition of Objectware.

·

“As Adjusted” gives the net effect of the adjustments to actual for the sale of shares in this offering and the application of the net proceeds from this offering as described under “Use of Proceeds” on page 18 assuming that the underwriters do not exercise their over-allotment option, and the effect for issuances of shares and options pursuant to the completion of the acquisition of Objectware.

		September 30, 2006 (Dollars in thousands)
		Actual			Adjustments (a)			As Adjusted
Long-term obligations, including current maturities		$	2,641		$	(2,497	)	$	144
Shareholders’ equity:
Common stock $.001 par value: 20,000,000 shares authorized, 4,273,833 shares issued and outstanding (actual) and 7,273,833 shares issued and outstanding (as adjusted)			4			3			7
Preferred stock, $.001 par value: 1,000,000 shares authorized, no shares issued and outstanding			—			—			—
Additional paid-in capital			9,791			16,614			26,405
Accumulated deficit			(4,163	)		(576	)(b)		(4,739	)
Total equity			5,632			16,041			21,673
Total capitalization		$	8,273		$	13,544		$	21,817

(a)  Gives effect to the sale of an aggregate 3,000,000 shares of common stock in this offering resulting in net proceeds to us of $13,740, net of underwriters discount of 11% and other expenses of the offering, assuming no exercise of the underwriters’ over-allotment option, and issuance of an additional 490,909 contingent shares of common stock upon the completion of the acquisition of Objectware at an assumed price of $5.50 per share combined with $174 representing conversion of Objectware options to Bridgeline options.

(b)  Includes expensing the unamortized debt discount of $303 and unamortized financing fees of $273.

 

 

 

 

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UNAUDITED CONDENSED PRO FORMA FINANCIAL DATA

In accordance with Article 11 of Regulation S-X under the Securities Act of 1933, as amended, a condensed pro forma balance sheet as of September 30, 2006 and a condensed pro forma statement of operations for the fiscal year ended September 30, 2006 have been prepared. These pro forma financial statements are based upon our historical financial statements and the historical financial statements of New Tilt, Inc. and Objectware, Inc. included elsewhere in this prospectus and should be read in conjunction therewith.

The following unaudited condensed pro forma financial data should be read in conjunction with the audited and unaudited historical financial statements of our company, New Tilt, Inc. and Objectware, Inc. and the unaudited pro forma combined consolidated financial information, including the notes thereto, appearing elsewhere in this prospectus. The unaudited pro forma condensed combined information is presented for illustrative purposes only and is not necessarily indicative of the results of operations or financial position that would have occurred if the transactions had been completed at the dates indicated, nor is it necessarily indicative of future results of operations or financial position of the combined company.

 

Bridgeline Software, Inc.

Unaudited Condensed Historical and Pro Forma Financial Data 

 

		Year Ended September 30, (Dollars in Thousands)
					Unaudited
		Historical			Pro Forma			Historical			Historical
		2006			2006 (a)			2005			2004
Income Statement Data:
Revenues		$	8,235		$	13,056		$	5,769		$	4,888
Cost of revenue			3,809			6,653			3,113			2,290
Gross profit		$	4,426		$	6,403		$	2,656		$	2,598
Income (loss) from operations		$	(810	)	$	54		$	(461	)	$	(132	)
Net income (loss)		$	(1,448	)	$	48		$	(517	)	$	(178	)
Net income (loss) per share:
Basic		$	(0.36	)	$	0.01		$	(0.14	)	$	(0.06	)
Diluted		$	(0.36	)	$	0.01		$	(0.14	)	$	(0.06	)
Balance Sheet Data:
Current assets		$	2,073		$	11,453		$	935		$	1,878
Total assets		$	9,824		$	23,729		$	6,739		$	4,959
Current liabilities		$	4,093		$	1,948		$	1,114		$	980
Total liabilities		$	4,192		$	2,056		$	1,147		$	1,085
Total shareholders’ equity		$	5,632		$	21,673		$	5,592		$	3,874
Total liabilities and shareholders’ equity		$	9,824		$	23,729		$	6,739		$	4,959

 

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Cash Flow Data:
Net cash used in operating activities		$	(701	)				$	(430	)	$	(378	)
Acquisitions, net of cash acquired		$	(553	)				$	(310	)	$	—
Net cash used in investing activities		$	(874	)				$	(545	)	$	(226	)
Proceeds from issuance of stock		$	—					$	—		$	1,640
Proceeds from issuance of short-term debt		$	2,434					$	—		$	—
Net increase (decrease) in cash for the period		$	453					$	(818	)	$	858

 

 

(a)  Reflects the April 24, 2006 acquisition of New Tilt, the probable acquisition of Objectware and this offering.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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DILUTION

If you invest in our common stock, the book value of your shares will be diluted to the extent of the difference between the public offering price for each share of common stock and the adjusted net tangible book value per share of our common stock immediately following the completion of this offering.

The net tangible book value of our common stock as of September 30, 2006 was $(1,709,000), or $(0.40) per share. Net tangible book value per share before this offering has been determined by dividing net tangible book value (book value of total assets less intangible assets, less total liabilities) by the number of shares of common stock outstanding as of September 30, 2006. After (i) giving effect to the sale of our shares in this offering at an estimated initial public offering of $5.50 per share and (ii) deducting underwriting discounts and commissions, the non-accountable expense allowance to the representatives of the underwriters and estimated offering expenses payable by us, our net tangible book value as of September 30, 2006 would have been $12,147,000 or $1.67 per share. This represents an immediate increase in net adjusted tangible book value of $3.24 per share to existing holders of common stock and an immediate dilution of net tangible book value of $3.83 per share to purchasers of common stock in this offering. Giving effect to the release of the closing escrow related to the acquisition of Objectware immediately after this offering, our net tangible book value as of September 30, 2006 would have been $17,277,000 or $2.23 per share. This represents an immediate additional increase in net adjusted tangible book value of $4.04 per share to existing holders of common stock and an immediate additional dilution of net tangible book value of $3.27 per share to purchasers of common stock in this offering, as illustrated in the following table:

 

		Without giving effect to the release of the closing escrow in connection with the acquisition of Objectware			After giving effect to the release of the closing escrow in connection with the acquisition of Objectware
Assumed initial public offering price per share		$	5.50		$	5.50
Net tangible book value (deficit) per share before the offering			(0.40	)		(0.40	)
Reduction in deficit in net tangible book value per share attributable to the offering			2.07			2.07
Reduction in deficit in net tangible book value per share attributable to the acquisition of Objectware			—			0.56
Pro forma net tangible book value per share after the offering			1.67			2.23
Dilution per share to new investors		$	3.83		$	3.27

 

 

Technology Development Expenses. Technology development expenses increased to $176,000, or 2% of revenues, in 2006 compared to $43,000, or 1% of revenues, in 2005. The increase resulted primarily from product enhancement activities for the netEDITOR content management product.

Interest Expense. Interest expense increased $582,000 from $56,000 in 2005 to $638,000 in 2006 and as a percentage of sales increased from 1% to 8% mainly due to the contractual interest on our Senior Notes Payable issued in April 2006 and the amortization of debt discount and deferred financing fees recorded in connection therewith.

 

Comparison of Fiscal Years Ended September 30, 2005 and 2004

The following table sets forth certain Consolidated Statements of Operations data expressed as a percentage of revenue for the periods indicated:

 

		Fiscal Years Ended September 30,
		2005			2004
Revenue			100	%		100	%
Cost of revenue			54			47
Gross profit			46			53
Operating expenses:
Sales and marketing			36			38
General and administrative			17			17
Technology development			1			1
Loss from operations			(8	)		(3	)
Interest income (expense), net			(1	)		(1	)
Net loss			(9	%)		(4	%)

Revenue, Cost of Revenue and Gross Profit

The following table presents revenue, cost of revenue and gross profit for the fiscal years ended September 30, 2005 and 2004:  

								Net change 2005 vs. 2004
Fiscal Years Ended September 30,		2005			2004			$			%
Total revenue		$	5,769,000		$	4,888,000		$	881,000			18	%
Cost of revenue			3,113,000			2,290,000			823,000			36
Gross profit		$	2,656,000		$	2,598,000		$	58,000			2	%

 

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Revenue. Our revenue is generated principally by fees paid for Web Services, Managed Services and Subscription revenue. The following table presents revenue from each of our revenue streams and their respective contribution to the increase in revenue in the fiscal years ended September 30, 2005 and 2004:

 

								Net change 2005 vs. 2004
Fiscal Years Ended September 30,		2005			2004			$			%
Web Services		$	4,182,000		$	3,820,000		$	362,000			9	%
Managed Services			1,244,000			1,068,000			176,000			16
Subscription			343,000			—			343,000			100
		$	5,769,000		$	4,888,000		$	881,000			18	%

 

Web Services revenue consists primarily of revenue generated from architecture, design and development of our customers’ Web application projects. Depending on the nature of the contract, this revenue may have been accounted for utilizing the proportionate performance model or may be recognized as delivered. Revenue from Web services increased 9% to $4,182,000 in 2005 from $3,820,000 in 2004. This growth was primarily due to the ongoing signing of new or expanded customer accounts requiring Web services.

 

Managed Services revenue consists primarily of retained maintenance services agreements and Web maintenance and hosting arrangements. Revenues from managed services increased 16% to $1,244,000 in 2005 from $1,068,000 in 2004 primarily due to increased hosting and retained services revenue with three financial services customers.

Subscription revenue consists primarily of on-demand license rentals of our Orgitecture product in the foundation and non-profit sector of our business. Subscription revenue increased $343,000 in 2005, primarily due to the acquisition of iapps in December 2004.

 

Cost of Revenue and Gross Profit. Cost of revenue increased to $3,113,000 in 2005 from $2,290,000 in 2004 primarily due to increases in staff related costs associated with the delivery of Web services. The cost of revenue also increased as a result of the iapps acquisition. Specifically, we recognized $94,000 and $30,000 in amortization of intangibles related to this acquisition for the years ended September 30, 2005 and 2004, respectively. Gross margin during 2005 of 46% of revenue decreased from 2004 gross margin of 53% driven primarily by the increased direct labor incurred and associated inefficiencies of ramping up sales resulting in lower billable utilization and increased costs compared to original estimates on certain engagements.

 

Sales and Marketing Expenses. Sales and marketing expenses increased to $2,060,000 in 2005 from $1,874,000 in 2004, but as a percentage of revenue decreased from 38% in 2004 to 36% in 2005. The increase in selling and marketing expenses was primarily due to the costs associated with the additional personnel acquired in the iapps acquisition.

 

General and Administrative Expenses. General and administrative expenses increased to $1,014,000 in 2005 compared to $830,000 in 2004 but remained unchanged as a percentage of revenue. The increase resulted primarily from an increase in headcount resulting from direct hires and acquisitions. We also had an increase in computer maintenance purchases and increased compensation levels.

Technology Development Expenses. Technology development expenses increased to $43,000, or 1% of revenue, in 2005 compared to $26,000, or 0.5% of revenue in 2004. The total increase resulted primarily from product development enhancement activities for the netEDITOR content management product.

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Liquidity and Capital Resources

 

We have historically funded our operations principally through issuances of short-term debt and private equity. In April 2006, we completed a private placement financing in the amount of $2,800,000 and received net proceeds of $2,434,000 after financing fees. In connection with this debt, we issued 280,000 warrants exercisable at $0.001 (the “Debt Warrants”) and 112,000 warrants exercisable at the initial public offering price of our shares in this offering. These warrants have been valued at $646,000 and are recorded as a debt discount and deferred financing fees, respectively. This debt carries an interest rate of 10% per annum for the first six months and 12% per annum thereafter. The effective interest rate, considering the amortization of the debt discount and other debt issuance costs, is 47%. The debt was subordinated to certain debt that was retired in July 2006. The debt carries default provisions including: (1) failure to pay principal or accrued interest when due, (2) failure to observe or perform various positive and negative covenants as set forth in the loan document, (3) failure to complete our initial public offering by the maturity date and (4) the occurrence of a bankruptcy or similar event. In the event of loan default, the interest rate will increase to 15% per annum and in case of default in payment of the principal, the interest rate would increase to 18% per annum. This debt carries a one-year term and will be retired upon the successful completion of this offering. If this offering is not completed, we expect to request an extension on the payment date of the notes. If we are unable to extend the maturity of these obligations, we may be forced to raise additional funds to pay them, through the issuance of additional debt or equity securities.

In November 2006, the terms of the Debt Warrants were amended to eliminate a certain provision, included in the Debt Warrants in error during the drafting of the Debt Warrant documents, which provision resulted in a contingent obligation of ours to redeem the Debt Warrants in the event that an initial public offering of our common stock does not occur prior to the April 2011 expiration date of the Debt Warrants. As a result of the amendment correcting this error, we have accounted for the Debt Warrants in shareholder’s equity as additional paid in capital since the date of issuance.  Had this amendment not been executed, the value of the Debt Warrants would have been recorded as a liability and such value would have been subject to adjustment based on changes in the value of our common stock.

 

Cash Flows

 

Operating Activities

 

Our net cash used in operating activities was $701,000 for the fiscal year ended September 30, 2006 compared to $430,000 for the fiscal year ended September 30, 2005. The increase in cash used in operating activities corresponds to the increase in net loss during the period as well as the increased working capital needs due to the increased volume of sales.

 

At September 30, 2006, we had a working capital deficit of $2,020,000 compared to a working capital deficit of $179,000 at September 30, 2005. This increase was primarily a result of the $2,800,000 private placement completed in April 2006 offset by cash used in the acquisition of NewTilt, expenses of our initial public offering and net operating losses.

 

At September 30, 2006, we had receivables of $1,443,000. This compares to $772,000 in receivables at September 30, 2005. The level of trade receivables at September 30, 2006 and 2005 represented approximately 36 and 38 days of revenues, respectively. We typically require 30-day terms from our customers. Our receivables can vary dramatically due to overall sales volumes, the timing of implementation of services, receipts from large customers, and other contract payments. Unbilled receivables increased $466,000 resulting from billing in arrears on services completed at month end and unbilled work in process on contractual milestones which had not been achieved as of September 30, 2006. 

 

Investing Activities

 

Net cash used in investing activities was $874,000 for the fiscal year ended September 30, 2006. This was primarily the result of the cash utilized in the purchase of New Tilt in April 2006 of $553,000. This compares to net cash used in investing activities in the fiscal year ended September 30, 2005 of $545,000 which included a cash payment of $310,000 used to acquire iapps in December 2004. We expect to incur more costs for future acquisitions and capital expenditures as well as contingent earn-out payments related to our prior acquisitions.

 

Financing Activities

 

During the fiscal years ended September 30, 2006 and 2005, we financed our working capital requirements primarily through short-term debt. In March 2005, we entered into a short term credit facility with a private commercial lender whereby we pledged certain receivables and received an 80% advance against these receivables with the additional 20% being received upon collection of the receivable. This credit facility carried 1.7% interest per month and certain fees and was terminated subsequent to the successful completion of the April 2006 private placement financing.

 

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Net cash provided by financing activities was $2,028,000 for the fiscal year ended September 30, 2006, which as stated above, was primarily provided by the private placement of short-term debt of $2,800,000 offset by $366,000 in associated fees. The net cash provided by financing activities for the year ended September 30, 2005 of $157,000 was primarily provided by the private commercial lending facility described above.

 

The short-term notes have a one-year term and are payable on April 20, 2007. If we are unsuccessful in completing this offering, and if we are unable to extend the maturity of these obligations, we may be forced to raise additional funds to pay them through the issuance of additional debt or equity securities. Particularly in light of our limited operating history and losses incurred, there can be no assurance that we will be able to obtain the necessary additional capital on a timely basis, on acceptable terms or at all. In any of such events, our business prospects, financial condition and results of operations would be materially and adversely affected. As a result of any such financing, the holders of our common stock may experience substantial dilution.

 

If we are unable to increase our revenues and decrease our expenses, we will need to raise additional funds to finance our future capital needs. We may need additional financing earlier than we anticipate.

 

We currently do not have any variable interest entities. We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We are, therefore, not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

Capital Resources and Liquidity Outlook

 

We have been dependent upon raising private capital for short and long-term cash needs. In March 2005, we obtained a $500,000 credit line under which we could borrow up to 80% of our eligible outstanding accounts receivable. In connection with this credit line, the lender obtained a first priority security interest in all of our assets. This line of credit was increased to $750,000 on September 12, 2005 and was terminated on June 30, 2006 with the proceeds of the April 2006 private placement financing described above.

 

Material Weakness

 

In response to material weaknesses and other deficiencies in our internal control and in anticipation of our obligation to comply with Section 404 of the Sarbanes-Oxley Act of 2002, we expect to create new positions to enhance our financial reporting and internal control. The estimated annual cost of these new positions is estimated to be between $250,000 and $350,000. In addition, the costs incurred to bring our internal control documentation into compliance with Section 404 will be significant.

 

Inflation

We believe that the relatively moderate rates of inflation in recent years have not had a significant impact on our operations.

 

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements, financings or other relationships with unconsolidated entities or other persons.

 

Contractual Obligations