<DOCUMENT>
<TYPE>S-2/A
<SEQUENCE>1
<FILENAME>h13383a2sv2za.txt
<DESCRIPTION>I-SECTOR CORPORATION - AMEND. #2 TO 333-113575
<TEXT>
<PAGE>
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON MAY 3, 2004
REGISTRATION NO. 333-113575
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------------
AMENDMENT NO. 2
TO
FORM S-2
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933
I-SECTOR CORPORATION
(Exact name of registrant as specified in its charter)
<Table>
<S> <C>
DELAWARE 76-0515249
(State or Other Jurisdiction of Incorporation or (I.R.S. Employer Identification No.)
Organization)
</Table>
6401 SOUTHWEST FREEWAY
HOUSTON, TEXAS 77074
(713) 795-2000
(Address, including zip code, and telephone number, including area code, of
registrant's principal executive offices)
JAMES H. LONG
CHIEF EXECUTIVE OFFICER
I-SECTOR CORPORATION
6401 SOUTHWEST FREEWAY
HOUSTON, TEXAS 77074
(713) 795-2000
(Name, address, including zip code, and telephone number, including area code,
of agent for service)
COPIES TO:
<Table>
<S> <C>
NICK D. NICHOLAS JOHN J. HALLE
PORTER & HEDGES, L.L.P. STOEL RIVES LLP
700 LOUISIANA, SUITE 3500 900 SW 5TH AVENUE, SUITE 2600
HOUSTON, TEXAS 77002 PORTLAND, OREGON 97204
(713) 226-0600 (503) 224-3380
(713) 226-0237 FACSIMILE (503) 220-2480 FACSIMILE
</Table>
APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: as soon as
practicable after this registration statement becomes effective.
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, as amended (the "Securities Act"), check the following box. [X]
If the registrant elects to deliver its annual report to security holders,
or a complete and legible facsimile thereof, pursuant to item 11(a)(1) of this
form, check the following box. [ ]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, check the following box and
list the Securities Act registration statement number of the earlier effective
registration statement for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [ ]
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF
THE SECURITIES ACT OF 1933 OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A),
MAY DETERMINE.
<PAGE>
THE INFORMATION IN THIS PROSPECTUS IS NOT COMPLETE AND MAY BE CHANGED. WE MAY
NOT SELL THESE SECURITIES UNTIL THE REGISTRATION STATEMENT FILED WITH THE SEC IS
EFFECTIVE. THIS PROSPECTUS IS NOT AN OFFER TO SELL THESE SECURITIES AND IT IS
NOT SOLICITING AN OFFER TO BUY THESE SECURITIES IN ANY STATE WHERE THE OFFER OR
SALE IS NOT PERMITTED.
Filed pursuant to Rule 424(a)
Registration No. 333-113575
SUBJECT TO COMPLETION, DATED MAY 3, 2004
PROSPECTUS
(I-SECTOR LOGO)
--------------------------------------------------------------------------------
500,000 Units
each unit consisting of two shares of common stock and one redeemable warrant to
purchase one share of common stock
--------------------------------------------------------------------------------
We are offering 500,000 units with each unit consisting of two shares of
common stock and one warrant. Each warrant entitles its holder to purchase one
share of common stock at an exercise price of $ [75% of the unit offering
price]. The warrants are exercisable at any time after they become separately
tradable until their expiration date, which is five years after the date of this
prospectus. Beginning six months from the date of this prospectus, we may redeem
some or all of the warrants at a price of $0.25 per warrant at any time after
the closing price for our stock on the principal exchange on which the stock
trades, equals or exceeds $ [100% of the unit offering price] for any five
consecutive trading days by giving not less than 30 days notice to the holders
of the warrants. The warrants will trade only as part of a unit for 30 days
following the date of this prospectus unless Paulson Investment Company, Inc.,
as the representative of the underwriters, determines that separate trading of
the warrants should occur earlier.
Our common stock is currently traded on the American Stock Exchange under
the symbol "ISR." On April 30, 2004, the last reported sale price of our common
stock on the American Stock Exchange was $8.55 per share. We are applying to the
American Stock Exchange to list the units and warrants.
INVESTING IN THESE UNITS INVOLVES SIGNIFICANT RISKS. SEE "RISK FACTORS"
BEGINNING ON PAGE 5 TO READ ABOUT RISKS YOU SHOULD CONSIDER BEFORE BUYING THESE
UNITS.
NEITHER THE SEC NOR ANY OTHER REGULATORY BODY HAS APPROVED OR DISAPPROVED
OF THESE SECURITIES OR PASSED UPON THE ADEQUACY OR ACCURACY OF THIS PROSPECTUS.
ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
<Table>
<Caption>
PER UNIT TOTAL
-------- -------
<S> <C> <C>
Public offering price(1).................................... $ $
Underwriting discount....................................... $ $
Proceeds to us, before expenses............................. $ $
</Table>
---------------
(1) The public offering price of the units will be determined by I-Sector
Corporation and Paulson Investment Company, Inc. and will be approximately
twice the closing market price of I-Sector's common stock on the American
Stock Exchange at the time of pricing. As an illustration, assuming the
offering priced on April 30, 2004, the public offering price would be
approximately $17.10, which was the closing price of I-Sector's common stock
on April 30, 2004 of $8.55 multiplied by two.
The expenses for this offering will include a non-accountable expense
allowance of % of the gross proceeds of this offering payable to Paulson
Investment Company, Inc., the representative of the underwriters of this
offering. Additionally, we have granted the representative a 45-day option to
purchase up to an additional 75,000 units to cover over-allotments and have
agreed to issue the representative a warrant to purchase 50,000 units.
PAULSON INVESTMENT COMPANY, INC.
S.W. BACH & COMPANY
PALI CAPITAL, INC.
The date of this prospectus is May , 2004
<PAGE>
PROSPECTUS SUMMARY
Please read the following summary together with the more detailed
information concerning our company, the units being sold in this offering and
our financial statements appearing in this prospectus and in the documents
incorporated by reference in this prospectus. Because this is only a summary, we
urge you to read the rest of this prospectus, including the documents
incorporated by reference in this prospectus, and "Risk Factors," before you
invest in the units. In this prospectus "we," "us" and "our" refer to I-Sector
Corporation and its subsidiaries.
I-SECTOR CORPORATION
COMPANY OVERVIEW
We design, implement and support both IP telephony solutions and the
network routing and switching infrastructure technology that IP telephony
solutions are dependent upon. IP ("Internet Protocol") telephony is the use of
switched data networks using IP, rather than traditional circuit-switched
telephone systems, to perform telephony and video communications.
We design, sell and install IP telephony solutions and network routing and
switching equipment from Cisco Systems, Inc. ("Cisco") and provide both
implementation services and post-implementation support services related to
those solutions. Our customers for Cisco-centric network infrastructure and IP
telephony solutions include large enterprises such as corporations, public
schools and federal, state and local governmental agencies. We develop and
market our own computer-telephony software. Customers for our computer-telephony
software have traditionally been professional contact centers. As the market for
enterprise Cisco-centric IP telephony solutions becomes more established, we
intend to apply our experience with developing computer-telephony software
applications to take advantage of what we believe is an opportunity to develop
and market computer-telephony applications that enhance and augment Cisco-
centric IP telephony solutions for enterprises.
Because we have significant experience implementing and supporting the
critical infrastructure of IP telephony solutions, we believe we are well
positioned to take advantage of the growing trend towards the use of IP
telephony.
INDUSTRY OVERVIEW
IP telephony is the use of local area network ("LAN") and wide area network
("WAN") infrastructure using packet-based Internet Protocol to provide telephony
functions that were traditionally provided by a circuit switched private branch
exchange ("PBX") phone system. IP telephony includes the ability to integrate
voice, video and data into a single digital communications system. This
combination of voice, video and data into a single system is commonly called
"convergence." Primary reasons enterprises are adopting IP telephony are
long-term cost savings on systems support, telephone cabling systems and long
distance charges as well as improved productivity.
We believe the transition from traditional PBX phone technology to IP
telephony technology has begun, and IP telephony is poised for significant
growth over the next five to ten years. We also believe Cisco is well positioned
to capture a significant portion of what will be a large market for enterprise
IP telephony solutions. Various independent industry research reports indicate
that the market for IP telephony solutions could grow at compound annual growth
rates of 20% to as high as over 50% over the next several years.
Since the implementation of IP telephony within an enterprise requires a
state-of-the-art network infrastructure, the transition by enterprises to IP
telephony technology will create demand for upgraded network infrastructure. The
majority of the installed network infrastructure is based upon Cisco routing and
switching equipment, so we believe there will be increased demand for
Cisco-centric network infrastructure integration and upgrading services, with a
particularly strong demand for expertise in the area of IP telephony
integration.
1
<PAGE>
As the adoption of IP telephony technology accelerates over the next
several years, we believe there will be an opportunity to provide increasing
levels of support services to maintain and support the growing installed base of
complex IP network-based IP telephony solutions. We believe this requires a
somewhat different type of support than has been provided historically by
suppliers of traditional telephony systems.
We believe that as the use of IP telephony technology by enterprises grows
and the installed base of IP telephony solutions becomes larger, there will be
an opportunity to develop and market new software applications for IP telephony,
including many computer-telephony convergence applications that have never
existed before.
BUSINESS STRATEGY
Our goal is to become one of the leading national Cisco-centric IP
telephony solution and integration companies. While we had operating losses over
the past several years, we expect to be profitable in 2004. An important part of
our strategy includes improving gross and operating margins to achieve
profitability. There are five primary components to our business strategy:
- Continue to align ourselves with Cisco and its products, which we believe
will encourage Cisco to continue to work closely with us and give us the
opportunity to take advantage of Cisco's incentive programs;
- Offer superior implementation services for IP telephony solutions, which
we believe will allow us to gain market share in the rapidly growing
market for Cisco IP telephony solutions;
- Actively promote our recently created Netsurant branded support services
to take advantage of what we believe will be a significant growth in
demand for higher margin post-implementation support services;
- Develop and market our own computer-telephony software that augments or
enhances Cisco-centric IP telephony solutions; and
- Expand our Cisco-centric network infrastructure and IP telephony
solutions business beyond our historical markets in Texas by acquiring
complementary businesses and opening offices in new regions in order to
both increase revenues and improve operating profitability.
We know of no single entity that is currently considered to be a national
leader in the area of Cisco-centric IP telephony solutions, and we believe that
because of our focus and expertise we are well positioned to take advantage of
this opportunity. We believe that our strategy will allow us to effectively
compete and continue to gain market share.
2
<PAGE>
THE OFFERING
Securities offered............ 500,000 units, each unit consisting of two
shares of common stock and one warrant to
purchase one share of common stock. The
warrants will trade only as part of a unit for
30 days following the date of this prospectus
unless the representative of the underwriters
determines that separate trading of the
warrants should occur earlier.
Shares of common stock to be
outstanding after this
offering...................... 4,998,554(1)
Warrants:
Number to be outstanding
after this offering......... 500,000
Exercise terms.............. The warrants are exercisable at any time after
they become separately tradable, until the
expiration date. Each warrant entitles its
holder to purchase one share of common stock at
an exercise price of $ [75% of the
unit offering price].
Expiration date............. May , 2009
Redemption.................. Beginning six months from the date of this
prospectus, we may redeem some or all of the
warrants, at a price of $0.25 per warrant, on
30 days notice to the holders. However, we may
only redeem the warrants if the closing price
for our stock, as reported on the principal
exchange on which our stock trades, for any
five consecutive trading days has equaled or
exceeded 100% of the unit offering price.
<Table>
<S> <C> <C>
AMEX symbols:................. Common Stock................... ISR
Units.......................... ISR.U
Warrants....................... ISR.WS
</Table>
Risk Factors.................. Please refer to "Risk Factors" for a
description of the risk factors you should
consider.
---------------
(1) Based on 3,998,554 shares of our common stock issued and outstanding as of
April 29, 2004. Unless the context indicates otherwise, all share and per
share information in this prospectus assumes no exercise of the
underwriters' over-allotment option, the warrants, the representative's
warrants or other options, warrants or other rights to acquire our common
stock outstanding as of April 29, 2004, or issued thereafter. At April 29,
2004, we had outstanding options exercisable to purchase 482,507 shares of
our common stock at a weighted average exercise price of $2.05 per share.
3
<PAGE>
SUMMARY CONSOLIDATED FINANCIAL DATA
In the table below, we provide you with summary consolidated financial data
for the three years ended December 31, 2001, 2002 and 2003, derived from our
audited consolidated financial statements included elsewhere in this prospectus.
Historical results are not necessarily indicative of the results that may be
expected for any future period. You should read the summary consolidated
financial data set forth below in conjunction with "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and our consolidated
financial statements and related notes included elsewhere in this prospectus.
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
---------------------------------------------
2001 2002 2003
------------- ------------- -------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
OPERATING DATA:
Revenue................................................ $ 23,620 $ 42,021 $ 62,152
Gross profit........................................... 6,295 8,269 12,727
Operating loss......................................... (4,278) (2,356) (2,334)
Other income, net...................................... 316 115 107
Loss from continuing operations before benefit for
income taxes........................................ (3,962) (2,241) (2,227)
Tax benefit............................................ 87 1,595 181
Net loss from continuing operations.................... (3,875) (646) (2,046)
Net loss from discontinued operations, net of taxes.... (167) -- --
Gain on disposal of discontinued operations, net of
taxes............................................... 337 262 210
Net loss............................................... $ (3,705) $ (384) $ (1,836)
Net income per share from discontinued operations and
disposals........................................... $ 0.04 $ 0.07 $ 0.06
Net loss per share -- basic............................ $ (0.95) $ (0.10) (0.49)
-- diluted......................... $ (0.95) $ (0.10) $ (0.50)
Shares used in computing net loss per share:
Basic.................................................. 3,911,019 3,709,689 3,691,052
Diluted................................................ 3,911,019 3,709,689 3,691,052
</Table>
The table below sets forth summary consolidated balance sheet data as of
December 31, 2003, derived from our audited consolidated financial statements
included elsewhere in this prospectus on an actual basis and on an as adjusted
basis. As adjusted data reflects the issuance of the units at an assumed
offering price of $17.00 per unit, the receipt of the net proceeds from this
offering and the repayment of $1,688,000 of outstanding indebtedness with the
net proceeds from this offering.
<Table>
<Caption>
AS OF DECEMBER 31, 2003
-----------------------
ACTUAL AS ADJUSTED
-------- ------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents................................. $ 2,172 $ 7,182
Working capital........................................... $ 3,724 $10,422
Total assets.............................................. $19,207 $24,217
Notes payable and current portion of long-term debt....... $ 1,784 $ 96
Long-term debt, net of current portion.................... $ 229 $ 229
Total stockholders' equity................................ $ 6,619 $13,317
</Table>
4
<PAGE>
RISK FACTORS
RISKS RELATED TO OUR BUSINESS
WE HAVE A HISTORY OF LOSSES AND MAY CONTINUE TO INCUR LOSSES.
We have incurred a net loss in each fiscal year since 1998. As of December
31, 2003, our accumulated deficit was $3.2 million. Our loss in 2003 was $1.8
million, and we cannot assure you when we will be profitable, if at all. In
order to achieve profitability, we will have to improve operating margins. Those
improvements could result from increases in revenue without comparable increases
in expense, from changes in the mix of product and services we sell favoring
higher margin services, or from other factors. Although our revenues from 2003
increased by approximately 47.9% from 2002, our operating margins did not
improve significantly in 2003, and we cannot assure you that they will do so in
the future. Whether we are able to be profitable in the future will depend on
many factors, but primarily upon the commercial acceptance of IP telephony
products and services, specifically those developed and marketed by Cisco.
OUR SUCCESS DEPENDS LARGELY ON THE MAINTENANCE OF OUR RELATIONSHIP WITH CISCO.
Approximately 80.4% of our revenue for the year ended December 31, 2003 was
derived from the sale of Cisco products, network products and related services.
We anticipate that these products and related services will account for a
significant portion of our revenue for the foreseeable future. We have a
contract with Cisco to purchase the products that we resell, and we purchase
substantially all of our Cisco products directly from Cisco. Cisco can terminate
this agreement on relatively short notice. Cisco has designated us an authorized
reseller, and we receive certain benefits from this designation, including
special pricing and payment terms. We have in the past, and may in the future,
purchase Cisco-centric products from other sources. When we purchase
Cisco-centric products from sources other than Cisco, the prices are typically
higher and the payment terms are not as favorable. Accordingly, if we are unable
to purchase directly from Cisco, maintain our status as an authorized reseller
of Cisco network products and expand our relationship with Cisco, our business
could be significantly harmed. If we are unable to purchase Cisco products from
other sources on terms that we feel are commercially reasonable, our business
would be harmed and our operating results and financial condition would be
materially and adversely affected.
OUR SUCCESS DEPENDS ON BROAD MARKET ACCEPTANCE OF IP TELEPHONY.
The market for IP telephony products and services has begun to develop only
recently and is characterized by rapid technological change, evolving industry
standards and strong customer demand for new products, applications and
services. As is typical of a new and rapidly evolving industry, the demand for,
and market acceptance of, recently introduced IP telephony products and services
are highly uncertain. We cannot assure you that the use of IP telephony will
become widespread. The commercial acceptance of IP telephony products, including
Cisco-centric products, may be affected by a number of factors including:
- quality of infrastructure;
- security concerns;
- equipment, software or other technology failures;
- government regulation;
- inconsistent quality of service;
- poor voice quality over IP networks; and
- lack of availability of cost-effective, high-speed network capacity.
If the market for IP telephony fails to develop, develops more slowly than
we anticipate, or if IP telephony products fail to achieve market acceptance,
our business could be adversely affected.
5
<PAGE>
ALTHOUGH OUR SUCCESS IS GENERALLY DEPENDENT ON THE MARKET ACCEPTANCE OF IP
TELEPHONY, OUR SUCCESS ALSO DEPENDS UPON A BROAD MARKET ACCEPTANCE OF
CISCO-CENTRIC IP TELEPHONY.
We cannot assure you that the Cisco-centric IP telephony products we offer
will obtain market acceptance. Competition, technological advances and other
factors could reduce demand for, or market acceptance of, the Cisco-centric IP
telephony products and services we offer. In addition, new products,
applications or services may be developed that are better adapted to changing
technology or customer demands and that could render our Cisco-centric products
and services unmarketable or obsolete. To compete successfully, the
Cisco-centric IP telephony products we offer must achieve broad market
acceptance and we must continually enhance our related software and customer
services in a timely and cost-effective manner. If the Cisco-centric IP
telephony products we offer fail to achieve broad market acceptance, or if we do
not adapt our existing services to customer demands or evolving industry
standards, our business, financial condition and results of operation could be
significantly harmed.
OUR BUSINESS DEPENDS ON THE LEVEL OF CAPITAL SPENDING BY ENTERPRISES FOR
COMMUNICATIONS PRODUCTS AND SERVICES.
As a supplier of IP telephony products, applications and services for
enterprises, our business depends on the level of capital spending for
communications products and services by enterprises in our markets. We believe
that an enterprise's investment in communications systems and related products
and services depends largely on general economic conditions that can vary
significantly as a result of changing conditions in the economy as a whole. The
market for communications products and services may continue to grow at a modest
rate or not at all. If the level of spending by our customers on communications
systems and related products and services decreases, our revenue and operating
results may be adversely affected.
A MAJORITY OF OUR CUSTOMERS ARE BASED IN TEXAS.
We offer our IP telephony products and services primarily to businesses in
Texas. Because a majority of the enterprises that we offer our IP telephony
products to are geographically concentrated in Texas, our customers' level of
spending on communication products may be affected by economic conditions in
Texas, in addition to general economic conditions in the United States. If
demand for IP telephony products by enterprises decreases, our business,
financial condition and results of operations could be significantly harmed.
OUR STRATEGY CONTEMPLATES RAPID GEOGRAPHIC EXPANSION, WHICH WE MAY BE UNABLE
TO ACHIEVE, AND WHICH IS SUBJECT TO NUMEROUS UNCERTAINTIES.
A component of our strategy is to become one of the leading national
providers of Cisco-centric IP telephony products. To achieve this objective, we
must either acquire existing businesses or hire qualified personnel in various
locations throughout the country, fund a rapid increase in operations and
implement corporate governance and management systems that will enable us to
function efficiently on a national scale. Identifying and acquiring existing
businesses is a time-consuming process and is subject to numerous risks.
Qualified personnel are in demand, and we expect the demand to increase as the
market for IP telephony grows. We will also likely face competition from our
existing competitors and from local and regional competitors in the markets we
attempt to enter. A rapid expansion in the size and geographical scope of our
business is likely to introduce management challenges that may be difficult to
overcome. We cannot assure you that we will be successful in expanding our
operations beyond Texas or achieving our goal of becoming a national provider.
An unsuccessful expansion effort would consume capital and human resources
without achieving the desired benefit and would have an adverse affect on our
business.
6
<PAGE>
WE MAY REQUIRE ADDITIONAL FINANCING TO ACHIEVE EXPANSION OF OUR BUSINESS
OPERATIONS, AND FAILURE TO OBTAIN FINANCING MAY PREVENT US FROM CARRYING OUT
OUR BUSINESS PLAN.
We may need additional capital to grow our business. Our business plan
calls for the expansion of sales of our IP telephony products to enterprises in
geographical markets where we currently do not operate. If we do not have
adequate capital or are not able to raise the capital to fund our business
objectives, we may have to delay the implementation of our business plan. We can
provide no assurance that we will be able to find financing if required. Our
ability to obtain additional financing would be subject to a number of factors,
including general market conditions, investor acceptance of our business plan
and investor sentiment. These factors may affect the timing, amount, terms or
conditions of additional financing available to us.
WE MAY BE UNABLE TO ACHIEVE OR MANAGE OUR GROWTH EFFECTIVELY, WHICH MAY HARM
OUR BUSINESS.
The ability to operate our business in a rapidly evolving market requires
effective planning and management. Our efforts to grow have placed, and are
expected to continue to place, a significant strain on our personnel, management
systems, infrastructure and other resources. Our ability to manage future growth
effectively will require us to successfully attract, train, motivate and manage
new employees, integrate new employees into our operations and continue to
improve our operational, financial and management controls and procedures. If we
are unable to implement adequate controls or integrate new employees into our
business in an efficient and timely manner, our operations could be adversely
affected and our growth could be impaired.
OUR OPERATING RESULTS HAVE HISTORICALLY BEEN VOLATILE, AND MAY CONTINUE TO BE
VOLATILE, PARTICULARLY FROM QUARTER TO QUARTER.
Our revenue for the third quarter of 2003 increased by approximately 32%
from the second quarter, and it increased over 81% from the third quarter of
2002. Our revenue for the fourth quarter of 2003 decreased by approximately 27%
from the third quarter of 2003, but increased over 39% from the fourth quarter
of 2002. Our quarterly operating results have historically depended on, and may
fluctuate in the future as a result of, many factors including:
- volume and timing of orders received during the quarter;
- amount and timing of supplier incentives received in any particular
quarter, which can vary substantially;
- gross margin fluctuations associated with the mix of products sold;
- general economic conditions;
- patterns of capital spending by enterprises for communications products;
- the timing of new product announcements and releases;
- pricing pressures;
- the cost and effect of acquisitions;
- the amount and timing of sales incentives we may receive from our
suppliers, particularly Cisco; and
- the availability and cost of products and components from our suppliers.
As a result of these and other factors, we have historically experienced,
and may continue to experience, fluctuations in sales and operating results. In
addition, it is possible that in the future our operating results may fall below
the expectations of analysts and investors, and as a result, the price of our
securities may fall.
7
<PAGE>
ANTICIPATED ADDITIONAL ISSUANCES OF INX COMMON STOCK TO EMPLOYEES WILL
MATERIALLY REDUCE OUR INTEREST IN INX AND WILL MATERIALLY AFFECT OUR FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.
In April of 2004, our subsidiary, Internetwork Experts, Inc., which we
refer to as "INX," ceased being a wholly owned subsidiary and became a
majority-owned subsidiary. I-Sector now owns 92.4% of INX's outstanding common
stock. The minority ownership interest in INX resulted from the issuance of INX
common stock in connection with its acquisition in 2003 of Digital Precision,
Inc., which we refer to as "Digital Precision." In addition, we have granted to
certain employees options, which are subject to vesting, to acquire INX common
stock. In addition to vesting, approximately 66% of these options may not be
exercised unless certain significant corporate events occur. Among these events
include a change in control of I-Sector, sale of substantially all of INX's
assets or James H. Long ceases to be Chairman of our board of directors. We
refer to these options as the "INX" options." We expect that many of the INX
options may be considered to be in the money, based on the relatively low
exercise price of the options. We also expect that the other outstanding INX
options may become in the money assuming that our expectations for INX's
business growth are met. It is not a certainty, however, that all of the INX
Options will be exercised because the stock of INX is not publicly traded and is
therefore relatively illiquid and because vesting of some of the options may not
occur. If, however, all currently outstanding INX options become exercisable and
are exercised, I-Sector's ownership interest in INX will be reduced to 68.4%,
assuming no other changes in INX's equity occur. Accordingly, exercise of the
INX options could materially reduce our ownership interest in INX which would
materially reduce our participation in any earnings that INX may produce. The
possible effect of these issuances on our financial condition and results of
operations is more fully discussed in "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Existing and Future Minority
Interest in INX."
THE EXISTENCE OF A MINORITY INTEREST IN INX MAY LIMIT OUR MANAGEMENT
FLEXIBILITY, SUBJECT US TO LITIGATION AND OTHERWISE INCREASE OUR COSTS.
The existence of a minority interest in INX creates potential conflict of
interest issues between I-Sector and the INX minority stockholders. Such
conflicts of interest may arise in connection with intercompany financing or
other transactions, INX dividend payments, allocation of business or combined
company resources among the various subsidiaries, or other reasons. The need to
respond appropriately to actual and potential conflict of interest situations
can be expected to reduce management flexibility and increase the time and cost
required to engage in transactions in which such conflicts arise. If the INX
minority stockholders disagree with I-Sector's resolution of any conflict issue,
they could bring a lawsuit against I-Sector that could be costly and
time-consuming and could further limit management's flexibility. Any such events
could materially and adversely affect I-Sector's financial condition and results
of operations.
WE MAY, IN THE FUTURE, ELECT TO EXCHANGE MINORITY SHARES IN INX OR INX OPTIONS
FOR I-SECTOR STOCK OR OPTIONS, WHICH MAY RESULT IN MATERIAL DILUTION TO
I-SECTOR STOCKHOLDERS.
To resolve the conflict of interest issues described above and to provide
liquidity to the INX minority stockholders, I-Sector and the INX minority
stockholders may, in the future, agree to exchange the minority INX stock or
options for I-Sector stock, stock options, cash or any combination of those.
I-Sector management has discussed the possibility of such an exchange with Mark
Hilz, who is the President and Chief Operating Officer of I-Sector, the
President of INX, and the largest holder of INX options. No specific proposal
has been made or agreed to with respect to any such future exchange.
If a future exchange transaction does occur, the value of the consideration
for the INX minority stock and stock options would be determined by negotiations
between a committee of I-Sector's board of directors (the "Board"), composed of
disinterested, independent members of the Board and the principal INX minority
stockholders and option holders. We cannot predict the outcome of those future
negotiations, if any, and thus cannot predict the financial impact on us or our
stockholders of any future exchange transaction. We expect, however, that any
such negotiations would involve negotiating the value of INX at the time of the
exchange, and, in the case of consideration in the form of I-Sector equity, the
8
<PAGE>
negotiated value of I-Sector equity securities at the time of the exchange.
Because INX's financial significance to us is currently high and we expect it to
remain so, any future exchange transaction could result in significant dilution
to existing I-Sector stockholders.
IF IN THE FUTURE WE EXCHANGE OR CONVERT INX STOCK OR INX OPTIONS FOR I-SECTOR
STOCK OR STOCK OPTIONS, WE COULD BE REQUIRED TO RECORD SUBSTANTIAL NON-CASH
EXPENSES IN CONNECTION WITH THE TRANSACTION, THE AMOUNT OF WHICH WE CANNOT
QUANTIFY.
If we choose to exchange or convert INX stock or INX options into I-Sector
stock or stock options, we may be required by generally accepted accounting
principles to record substantial non-cash expenses. We are not now able to
determine the amount or timing of any such charges. This is because those
charges would largely depend upon the timing and terms on which any future
exchange or conversion would occur, particularly the exchange or conversion
ratio used. Based on the presently high financial significance to us of INX
relative to our other business segments and our expectation that its
significance to us will remain high, we believe that any resulting non-cash
expense charges could be substantial. Any such future non-cash expenses charges
could materially and adversely affect our financial results of operations.
WE HAVE MANY COMPETITORS AND EXPECT NEW COMPETITORS TO ENTER OUR MARKET, WHICH
COULD INCREASE PRICE COMPETITION AND MAY AFFECT THE AMOUNT OF BUSINESS
AVAILABLE TO US AND THE PRICES THAT WE CAN CHARGE FOR OUR PRODUCTS AND
SERVICES.
The markets for our IP telephony products and services are extremely
competitive and subject to rapid change. Substantial growth in demand for IP
telephony solutions has been predicted, and we expect competition to increase as
existing competitors enhance and expand their products and services and as new
participants enter the IP telephony market. IP telephony involves the
application of traditional computer-based technology to voice communication, and
the hardware component of the solution is readily available. Accordingly, there
are relatively few barriers to entry to companies with computer and network
experience. A rapid increase in competition could negatively affect the amount
of business that we get and the prices that we can charge.
Additionally, many of our competitors and potential competitors have
substantially greater financial resources, customer support, technical and
marketing resources, larger customer bases, longer operating histories, greater
name recognition and more established relationships than we do. We cannot be
sure that we will have the resources or expertise to compete successfully.
Compared to us, our competitors may be able to:
- develop and expand their products and services more quickly;
- adapt faster to new or emerging technologies and changing customer needs;
- take advantage of acquisitions and other opportunities more readily;
- negotiate more favorable agreements with vendors;
- devote greater resources to marketing and selling their products; and
- address customer service issues more effectively.
Some of our competitors may also be able to increase their market share by
providing customers with additional benefits or by reducing their prices. We
cannot be sure that we will be able to match price reductions by our
competitors. In addition, our competitors may form strategic relationships with
each other to better compete with us. These relationships may take the form of
strategic investments, joint-marketing agreements, licenses or other contractual
arrangements that could increase our competitors' ability to serve customers.
9
<PAGE>
BUSINESS ACQUISITIONS, DISPOSITIONS OR JOINT VENTURES ENTAIL NUMEROUS RISKS
AND MAY DISRUPT OUR BUSINESS, DILUTE SHAREHOLDER VALUE OR DISTRACT MANAGEMENT
ATTENTION.
As part of our business strategy, we plan to consider acquisitions of, or
significant investments in, businesses that offer products, services and
technologies complementary to ours. Any acquisition could materially adversely
affect our operating results and/or the price of our securities. Acquisitions
involve numerous risks, some of which we have experienced and may continue to
experience, including:
- unanticipated costs and liabilities;
- difficulty in integrating the operations, products and personnel of the
acquired business;
- difficulties in managing the financial and strategic position of acquired
or developed products, services and technologies;
- difficulties in maintaining customer relationships, in particular when a
substantial portion of the target's sales were derived from products that
compete with products that we currently offer;
- the diversion of management's attention from the core business;
- inability to maintain uniform standards, controls, policies and
procedures; and
- damage to relationships with acquired employees and customers as a result
of integration of the acquired business.
Finally, to the extent that shares of our common stock or rights to
purchase our common stock are issued in connection with any future acquisitions,
dilution to our existing stockholders will result and our earnings per share may
suffer. Any future acquisitions may not generate additional revenue or provide
any benefit to our business, and we may not achieve a satisfactory return on our
investment in any acquired businesses.
OUR INTERNATIONAL OPERATIONS, WHICH WE PLAN TO EXPAND, WILL SUBJECT US TO
ADDITIONAL RISKS THAT MAY ADVERSELY AFFECT OUR OPERATING RESULTS DUE TO
INCREASED COSTS.
Our revenue generated outside the United States, as a percentage of our
total revenue, was 4.4% and 5.1% for the years ended December 31, 2002 and 2003,
respectively. We intend to continue to pursue international opportunities.
Pursuit of international opportunities may require us to make significant
investments for an extended period before returns on such investments, if any,
are realized. International operations are subject to a number of risks and
potential costs, including:
- unexpected changes in regulatory requirements and telecommunication
standards;
- tariffs and other trade barriers;
- exchange controls or other currency restrictions;
- difficulty in collecting receivables;
- difficulty in staffing and managing foreign operations;
- the need to customize marketing and products;
- inadequate protection of intellectual property in countries outside the
United States;
- adverse tax consequences; and
- political and economic instability.
Any of these factors could prevent us from increasing our revenue and
otherwise adversely affect our operating results. We may not be able to overcome
some of these barriers and may incur significant costs in addressing others.
10
<PAGE>
IF WE LOSE KEY PERSONNEL WE MAY NOT BE ABLE TO ACHIEVE OUR OBJECTIVES.
We are dependent on the continued efforts of our senior management team,
including our Chairman and Chief Executive Officer, James H. Long, and our
President and Chief Operating Officer, Mark T. Hilz. If, for any reason, our
senior executives do not continue to be active in management, our business,
financial condition or results of operations could be adversely affected. We
cannot assure you that we will be able to continue to retain our senior
executives or other personnel necessary for the development of our business.
WE MAY NOT BE ABLE TO HIRE AND RETAIN HIGHLY SKILLED TECHNICAL EMPLOYEES,
WHICH COULD AFFECT OUR ABILITY TO COMPETE EFFECTIVELY AND COULD ADVERSELY
AFFECT OUR OPERATING RESULTS.
We depend on highly skilled technical personnel to research and develop and
to market and service our products. To succeed, we must hire and retain
employees who are highly skilled in rapidly changing communications
technologies. In particular, as we implement our strategy of focusing on IP
telephony, we will need to:
- hire more employees with experience in developing and providing advanced
communications products and services;
- retrain our current personnel to sell IP telephony products and services;
and
- retain personnel to service our products.
Individuals who can perform the services we need to provide our products
and services are scarce. Because the competition for qualified employees in our
industry is intense, hiring and retaining qualified employees is both
time-consuming and expensive. We may not be able to hire enough qualified
personnel to meet our needs as our business grows or to retain the employees we
currently have. Our inability to hire and retain the individuals we need could
hinder our ability to sell our existing products, systems, software or services
or to develop and sell new ones. If we are not able to attract and retain
qualified employees, we will not be able to successfully implement our business
plan and our business will be harmed.
IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, OUR BUSINESS MAY
BE HARMED.
Although we attempt to protect our intellectual property through patents,
trademarks, trade secrets, copyrights, confidentiality and non-disclosure
agreements and other measures, intellectual property is difficult to protect and
these measures may not provide adequate protection. Patent filings by third
parties, whether made before or after the date of our patent filings, could
render our intellectual property less valuable. Competitors may misappropriate
our intellectual property, disputes as to ownership of intellectual property may
arise and our intellectual property may otherwise become known or independently
developed by competitors. The failure to protect our intellectual property could
seriously harm our business because we believe that developing new products and
technology that are unique to us is important to our success. If we do not
obtain sufficient international protection for our intellectual property, our
competitiveness in international markets could be significantly impaired, which
would limit our growth and future revenue.
WE MAY BE FOUND TO INFRINGE ON THIRD-PARTY INTELLECTUAL PROPERTY RIGHTS.
Third parties have in the past and may in the future assert claims or
initiate litigation related to their patent, copyright, trademark and other
intellectual property rights in technology that is important to us. The asserted
claims and/or litigation could include claims against us or our suppliers
alleging infringement of intellectual property rights with respect to our
products or components of those products. Regardless of the merit of the claims,
they could be time consuming, result in costly litigation and diversion of
technical and management personnel, or require us to develop a non-infringing
technology or enter into license agreements. There can be no assurance that
licenses will be available on acceptable terms, if at all. Furthermore, because
of the potential for high court awards, which are not necessarily predictable,
it is not unusual to find even arguably unmeritorious claims resulting in large
settlements. If any infringement or other intellectual property claim made
against us by any third party is successful, or if we fail to develop
11
<PAGE>
non-infringing technology or license the proprietary rights on commercially
reasonable terms and conditions, our business, operating results and financial
condition could be materially adversely affected.
COSTS OF COMPLIANCE WITH THE SARBANES-OXLEY ACT OF 2002 AND THE RELATED SEC
REGULATIONS MAY HARM OUR RESULTS OF OPERATIONS.
The Sarbanes-Oxley Act of 2002 requires heightened financial disclosure and
corporate governance for all publicly traded companies. Although costs of
compliance with the Sarbanes-Oxley Act are uncertain due to several factors, we
expect that our general and administrative expenses will increase. Furthermore,
the American Stock Exchange has adopted amendments to its listing standards that
will impose additional corporate governance requirements. We are currently a
"controlled company" and are only required to comply with certain of the
American Stock Exchange's recently adopted corporate governance requirements.
Upon completion of this offering, we will cease to qualify as a controlled
company and we will have to comply with all of the American Stock Exchange's
corporate governance requirements. This may cause us to incur additional
expense. Although we expect to comply with these corporate governance listing
requirements, if we are unable to comply in a timely manner our securities may
be delisted from the American Stock Exchange, which could limit our ability to
access the capital markets, having a negative impact on our financial condition
and results of operations.
RISKS RELATED TO THIS OFFERING
WE ARE CONTROLLED BY OUR CHIEF EXECUTIVE OFFICER.
Immediately after this offering, our chief executive officer, James H.
Long, will own 40.0% of the issued and outstanding shares of our common stock
(38.8% if the over-allotment option is exercised in full). As a result, he will
have the ability to exercise substantial control over our affairs and corporate
actions, including electing directors, selling all or substantially all of our
assets, merging with another entity or amending our certificate of
incorporation. This could delay, deter or prevent a change in control and could
adversely affect the price that investors might be willing to pay for our
securities.
WE HAVE PROVISIONS IN OUR CERTIFICATE OF INCORPORATION AND BYLAWS THAT MAY
DELAY, DETER OR PREVENT A CHANGE IN CONTROL.
Our certificate of incorporation and bylaws contain provisions that may
delay, deter or prevent a change in our control. Among other things, these
provisions authorize our board of directors to issue shares of preferred stock
on terms and with rights, preferences and designations as our board of directors
may determine without further stockholder action and limit the ability of
stockholders to call special meetings or amend our certificate of incorporation
or bylaws. Each of these provisions, as well as the Delaware business
combination statute, could, among other things, restrict the ability of certain
stockholders to effect a merger or business combination or obtain control of the
company.
IF WE DO NOT MAINTAIN AN EFFECTIVE REGISTRATION STATEMENT COVERING THE WARRANTS
OR COMPLY WITH APPLICABLE STATE SECURITIES LAWS, YOU MAY NOT BE ABLE TO EXERCISE
THE WARRANTS.
In order for you to be able to exercise the warrants, the warrants must be
covered by an effective registration statement. We cannot assure you that we
will continue to maintain a current registration statement relating to the offer
and sale of the warrants and the common stock underlying these warrants. This
may have an adverse effect on the demand for the warrants and the prices that
can be obtained from reselling them.
THE WARRANTS MAY BE REDEEMED ON SHORT NOTICE. THIS MAY HAVE AN ADVERSE IMPACT ON
THEIR PRICE.
Beginning six months after the effective date of the offering, we may
redeem the warrants for $0.25 per warrant on 30-days notice at any time after
the closing price for our stock, as reported on its principal trading market,
has, for any five consecutive trading days, equaled or exceeded 100% of the unit
offering price. If we give notice of redemption, you will be forced to sell or
exercise your warrants or accept the
12
<PAGE>
redemption price. The notice of redemption could come at a time when, under your
personal circumstances, it is not advisable or possible for you to exercise the
warrants or a current prospectus or exemption does not exist.
FUTURE SALES OR THE POTENTIAL FOR SALE OF A SUBSTANTIAL NUMBER OF SHARES OF OUR
COMMON STOCK COULD CAUSE THE TRADING PRICE OF OUR COMMON STOCK AND WARRANTS TO
DECLINE AND COULD IMPAIR OUR ABILITY TO RAISE CAPITAL THROUGH FUTURE EQUITY
OFFERINGS.
Sales of a substantial number of shares of our common stock, or the
perception that these sales may occur, could cause the market price of our stock
to decline and could materially impair our ability to raise capital through the
sale of additional equity securities. Once this offering is completed, in
addition to the 4,998,554 shares of common stock that we expect will then be
actually issued and outstanding, there will be an additional 875,000 shares of
our common stock available for future issuance upon exercise of the warrants,
the underwriters' over-allotment option and the representative's warrant, and
482,507 shares available for future issuance upon exercise of currently
exercisable stock options as of April 29, 2004.
The common stock included in the units as well as the common stock
underlying the warrants will be freely tradable without restriction. Before this
offering, we had 3,998,554 shares of common stock outstanding, of which
approximately 1,872,000 are freely tradable. The remaining 2,126,000 shares are
either held by "affiliates," as defined by the rules and regulations promulgated
under the Securities Act of 1933, or are "restricted securities" as defined in
Rule 144 promulgated under the Securities Act of 1933. Of this amount, 2,125,000
restricted or non-restricted shares are held by "affiliates" and can be sold
only in compliance with the timing and volume limitations of Rule 144
promulgated under the Securities Act of 1933. The other 1,200 restricted shares
may be sold without limitation under Rule 144(k). Other than certain shares sold
under 10b5-1 plans that were put in place prior to this offering, we, our
executive officers and directors have agreed not to sell any shares of stock for
a period of 90 days after this offering without the consent of the
representative of the underwriters. The representative may waive that
restriction at its sole discretion.
MANAGEMENT HAS BROAD DISCRETION OVER THE USE OF PROCEEDS FROM THIS OFFERING. WE
MAY USE THE PROCEEDS OF THIS OFFERING IN WAYS THAT DO NOT IMPROVE OUR OPERATING
RESULTS OR THE MARKET VALUE OF OUR SECURITIES.
While we have general expectations as to the use of the net proceeds of
this offering, that intended use may change in response to a variety of
unanticipated events, such as differences between our expected and actual
revenues from operations or availability of commercial financing opportunities,
unexpected expenses or unanticipated opportunities requiring cash expenditures.
We have significant flexibility as to the timing and the use of the proceeds.
You will rely on the judgment of our management with only limited information
about their specific intentions regarding the use of proceeds. We may spend most
of the proceeds of this offering in ways with which you may not agree. If we
fail to apply these funds effectively, our business, results of operations and
financial condition may be materially and adversely affected.
THE ABSENCE OF DIVIDENDS MEANS STOCKHOLDER RETURNS ARE DEPENDENT ON THE PRICE
APPRECIATION OF OUR COMMON STOCK.
We have never declared cash dividends on our common stock and do not
anticipate paying cash dividends on our common stock for the foreseeable future.
We expect to retain future earnings, if any, to develop or expand our business.
Any future decision to pay cash dividends will be at the discretion of the board
of directors and will be dependent upon our financial condition, results of
operations, capital requirements, and such other factors as the board of
directors deems relevant. As a result, investors will only achieve a return on
their investment if the price of our common stock increases.
13
<PAGE>
FORWARD-LOOKING STATEMENTS
This prospectus contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934 that involve risks and uncertainties. In some cases, you
can identify forward-looking statements by words like "may," "will," "should,"
"could," "believes," "intends," "expects," "anticipates," "plans," "estimates,"
"predicts," "potential," "continue" and similar expressions. You should not rely
on these forward-looking statements. These forward-looking statements are
subject to substantial risks, uncertainties and assumptions. Some of the factors
that could cause actual results to differ materially from the forward-looking
statements we make or incorporate by reference in this prospectus are described
under "Risk Factors" in this prospectus and in the documents incorporated or
deemed to be incorporated by reference in this prospectus. These factors
include, but are not limited to:
- market and economic conditions;
- risks associated with entry into new markets;
- our ability to attract and retain key management, sales and technical
staff;
- our ability to identify suitable acquisition candidates and successfully
integrate acquired companies;
- the estimated needs of customers and the nature and volume of products
and services anticipated to be delivered;
- our ability to obtain sufficient volumes of products for resale;
- our ability to finance continued growth;
- unforeseen costs and results related to acquiring and integrating new
businesses;
- catastrophic events;
- uncertainties related to rapid changes in the information technology
industry; and
- other risks and uncertainties set forth in the "Risk Factors" section of
this prospectus.
If one or more of these risks or uncertainties materialize, or if any of
these underlying assumptions proves incorrect, our actual results, performance
or achievements may vary materially from future results, performance or
achievements expressed or implied by these forward-looking statements. All
forward-looking statements attributable to us or persons acting on our behalf
are expressly qualified in their entirety by the cautionary statements in this
section. We undertake no obligation to update or revise any forward-looking
statements to reflect future events or developments.
USE OF PROCEEDS
We expect to receive approximately $6.7 million from the sale of units by
us in this offering, or $7.8 million if the underwriters exercise their
over-allotment option in full, assuming an offering price of $17.00 per unit and
after deducting the underwriting discounts and commissions and estimated
offering expenses that we are to pay.
We intend to use the net proceeds of the offering to repay the interest
bearing portion of our indebtedness outstanding, if any, under our credit
facility with Textron Financial Corporation, which we refer to as the "Textron
Facility," after completion of the offering. We use our Textron Facility to
finance the purchase of products we resell. Accordingly, the interest bearing
portion of our Textron Facility varies widely from month to month, depending
primarily on the cost of goods we order through INX. At April 29, 2004, the
balance of our interest bearing indebtedness under the Textron Facility was
$1,206,000. The Textron Facility accrues interest at the prime rate plus 2.5%.
We plan to use the remainder of the net proceeds of the offering for general
corporate purposes, which may include working capital and acquisitions of
companies, products, or technology, although there are no current agreements
with respect to any acquisitions. If we acquire companies, products, rights or
technology in order to execute our business
14
<PAGE>
strategy, we may need to raise additional capital. Pending these uses, we intend
to invest the net proceeds of the offering in short-term, interest-bearing,
investment grade securities.
PRICE RANGES OF OUR COMMON STOCK
On Monday, December 29, 2003, we listed our common stock on the American
Stock Exchange under the ticker symbol ISR. Prior to December 29, 2003, and
since the change of the corporate name on July 11, 2000, our common stock was
traded on the NASDAQ Small Cap Market under the symbol "ISEC." Prior to July 11,
2000, our shares traded under the symbol "ALLS." Below are the price ranges of
our common stock:
<Table>
<Caption>
HIGH LOW
------ -----
<S> <C> <C>
2002
First Quarter............................................. $ 0.97 $0.67
Second Quarter............................................ $ 2.50 $0.61
Third Quarter............................................. $ 2.30 $1.10
Fourth Quarter............................................ $ 2.00 $1.05
2003
First Quarter............................................. $ 2.21 $1.25
Second Quarter............................................ $ 2.50 $1.75
Third Quarter............................................. $ 4.49 $2.39
Fourth Quarter............................................ $16.82 $4.14
2004
First Quarter............................................. $15.87 $6.25
Second Quarter (through April 30)......................... $ 9.90 $8.00
</Table>
The last reported sale price of our common stock on the American Stock
Exchange on April 30, 2004 was $8.55 per share. According to the records of our
transfer agent, there were approximately 40 holders of record of our common
stock as of April 30, 2004.
We have applied to the American Stock Exchange to list the units offered by
this prospectus, as well as the warrants and common stock underlying those
units.
DIVIDEND POLICY
We have not declared or paid any dividends and do not intend to pay any
dividends in the foreseeable future. We intend to retain any future earnings for
use in the operation and expansion of our business. Any future decision to pay
dividends on common stock will be at the discretion of our board of directors
and will be dependent upon our financial condition, results of operations,
capital requirements and other factors our board of directors may deem relevant.
15
<PAGE>
CAPITALIZATION
The following table sets forth our cash and cash equivalents and our actual
capitalization as of December 31, 2003 on a historical basis and as adjusted to
give effect to the issuance and sale by us of 500,000 units in this offering at
an assumed public offering price of $17.00, resulting in net proceeds of
approximately $5.0 million after deducting underwriting discounts and
commissions, estimated offering expenses payable by us and the repayment of
approximately $1.7 million of notes payable representing the interest bearing
portion of our indebtedness under our Textron Facility. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources -- Sources of Liquidity -- Textron
Facility."
This capitalization table should be read in conjunction with "Selected
Consolidated Financial Data" and our consolidated financial statements and
related notes beginning on page F-1.
<Table>
<Caption>
AS OF DECEMBER 31, 2003
-----------------------
ACTUAL AS ADJUSTED
-------- ------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Cash and cash equivalents................................... $ 2,172 $ 7,182
======= =======
Notes payable and current portion of long-term debt(1)...... $ 1,784 $ 96
------- -------
Long-term debt, net of current portion...................... 229 229
Stockholders' equity:
Preferred Stock; $.01 par value; 5,000,000 shares
authorized; no shares issued........................... -- --
Common Stock; $.01 par value; 15,000,000 shares
authorized, 4,762,809 shares issued, 5,762,809 shares
as adjusted(2)......................................... 48 58
Additional paid-in capital.................................. 10,853 17,541
Additional paid-in capital -- other......................... 337 337
Treasury stock, 811,800 shares, at cost..................... (1,373) (1,373)
Retained deficit............................................ (3,246) (3,246)
------- -------
Total stockholders' equity................................ 6,619 13,317
------- -------
Total capitalization................................... $ 8,632 $13,642
======= =======
</Table>
---------------
(1) See Note 7 to our Consolidated Financial Statements as of December 31, 2003.
Notes payable and current portion of long-term debt does not include
non-interest bearing floor plan finance borrowings that are included in
accounts payable.
(2) Excludes (a) 689,498 shares of common stock reserved for issuance upon
exercise of outstanding options, (b) 500,000 shares of common stock issuable
upon exercise of the warrants included in the units, and (c) 100,000 shares
of common stock and 50,000 shares of common stock issuable upon exercise of
the warrants included in the units issuable upon exercise of the
representative's warrant.
16
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data as of December 31, 1999,
2000 and 2001 and for the years ended December 31, 1999 and 2000 are derived
from our audited consolidated financial statements, which are not included in
this prospectus. The selected consolidated financial data as of December 31,
2002 and 2003 and for the years ended December 31, 2001, 2002 and 2003 are
derived from our audited consolidated financial statements, which are included
elsewhere in this prospectus. Our historical results are not necessarily
indicative of the results of operations for future periods. The following data
is qualified in its entirety by and should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," and our financial statements and related notes beginning on Page
F-1.
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
-----------------------------------------------
1999 2000 2001 2002 2003
------- ------- ------- ------- -------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
OPERATING DATA:
Revenue:
Products................................... $ 780 $ 1,670 $ 9,925 $29,805 $46,900
Services................................... 13,137 8,757 6,477 5,647 7,725
Custom projects............................ 4,067 6,660 7,218 6,569 7,527
------- ------- ------- ------- -------
Total revenue........................... 17,984 17,087 23,620 42,021 62,152
Cost of sales and services:
Products................................... 1,235 2,104 8,685 26,437 41,060
Services................................... 8,445 7,291 5,322 4,395 5,383
Custom projects............................ 2,126 3,573 3,318 2,920 2,982
------- ------- ------- ------- -------
Total cost of sales and services........ 11,806 12,968 17,325 33,752 49,425
Gross profit:
Products................................... (455) (434) 1,240 3,368 5,840
Services................................... 4,692 1,466 1,155 1,252 2,342
Custom projects............................ 1,941 3,087 3,900 3,649 4,545
------- ------- ------- ------- -------
Total gross profit...................... 6,178 4,119 6,295 8,269 12,727
Selling, general and administrative
expenses................................... 6,207 9,479 10,573 10,625 15,061
------- ------- ------- ------- -------
Operating loss.......................... (29) (5,360) (4,278) (2,356) (2,334)
Interest and other income, net............... 23 239 316 115 107
------- ------- ------- ------- -------
Loss from continuing operations before income
taxes...................................... (6) (5,121) (3,962) (2,241) (2,227)
Tax benefit (expense)........................ (20) 1,493 87 1,595 181
------- ------- ------- ------- -------
Net loss from continuing operations.......... (26) (3,628) (3,875) (646) (2,046)
Discontinued operations:
Net income (loss) from discontinued
operations, net of taxes................... 319 195 (167) -- --
Gain (loss) on disposal, net of taxes........ (1,138) 3,390 337 262 210
------- ------- ------- ------- -------
Net loss................................ $ (845) $ (43) $(3,705) $ (384) $(1,836)
======= ======= ======= ======= =======
(continued on following page)
</Table>
17
<PAGE>
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
-----------------------------------------------
1999 2000 2001 2002 2003
------- ------- ------- ------- -------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
Net loss per share:
Basic:
Net loss from continuing operations..... $ (0.01) $ (0.90) $ (0.99) $ (0.17) $ (0.55)
Net gain (loss) from discontinued
operations............................ 0.08 0.05 (0.04) -- --
Gain (loss) on disposal................. (0.27) 0.84 0.08 0.07 0.06
------- ------- ------- ------- -------
Net loss per share...................... $ (0.20) $ (0.01) $ (0.95) $ (0.10) $ (0.49)
======= ======= ======= ======= =======
Diluted:
Net loss from continuing operations..... $ (0.01) $ (0.90) $ (0.99) $ (0.17) $ (0.56)
Net gain (loss) from discontinued
operations............................ 0.08 0.05 (0.04) -- --
Gain (loss) on disposal................. (0.27) 0.84 0.08 0.07 0.06
------- ------- ------- ------- -------
Net loss per share...................... $ (0.20) $ (0.01) $ (0.95) $ (0.10) $ (0.50)
======= ======= ======= ======= =======
BALANCE SHEET DATA:
Working capital.............................. $ 9,567 $10,098 $ 5,983 $ 5,540 $ 3,724
Total assets................................. 54,531 17,142 13,548 15,751 19,207
Current portion of long-term debt............ 15,869 -- 213 157 1,784
Long-term debt............................... -- -- 410 247 229
Stockholders' equity......................... $11,830 $11,912 $ 8,015 $ 7,640 $ 6,619
</Table>
18
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Please read the following discussion of our financial condition and results
of operations together with "Selected Consolidated Financial Data" and our
consolidated financial statements and the notes to those statements included
elsewhere in this report. The following discussion and analysis contains
forward-looking statements that involve risks and uncertainties. Our actual
results may differ materially from those anticipated in these forward-looking
statements as a result of certain factors, including, but not limited to, those
set forth under "Risk Factors -- Risks Related to Our Business" and elsewhere in
this prospectus.
GENERAL
We are a leading regional provider of network infrastructure and IP
telephony solutions including related implementation and support services. The
IP telephony industry is characterized by rapidly evolving and competing
technologies. Our three principal offices are located in Texas, and we primarily
market to potential customers headquartered in, or making purchasing decisions
from, Texas. Our long-term goal, however, is to become one of the leading
national providers of Cisco-centric network and IP telephony solutions to
enterprises.
We begin Management's Discussion and Analysis of Financial Condition and
Results of Operations with an overview of our strategies for achieving this goal
and becoming profitable. From a financial perspective, these operating
strategies have a number of important implications for our results of operations
and financial condition.
STRATEGY
We plan to become profitable in 2004 by implementing the strategies
discussed below. We believe that our strategies will allow us to continue to
increase total revenues in 2004. Importantly, we also believe our strategies
will enable us to improve our gross profit in 2004 by improving our gross
margins on INX revenue. At the same time, we will seek to contain the relatively
fixed components of our selling, general and administrative expenses so that
those components become a relatively smaller percentage of total revenues.
Although selling expenses can generally be expected to increase as our revenues
increase, we believe that if we are successful in implementing our strategies,
many general and administrative expenses (such as management salaries,
administrative wages and professional expenses) will decrease as a percentage of
our total revenues.
Our key operating strategies are as follows:
- seeking larger, full-scale IP telephony implementation projects, as
opposed to smaller pilot projects;
- increasing the gross revenues from our higher gross margin operations,
such as INX services and Stratasoft custom projects, as opposed to
product sales, which typically produce lower gross margins;
- aligning ourselves with Cisco as our exclusive supplier for the network
and IP telephony equipment and technology that we offer;
- expanding geographically by acquiring complementary businesses and by
opening our own offices; and
- developing and marketing our own computer telephony software that
operates with and augments Cisco-centric IP telephony products.
If we are successful in obtaining larger, full-scale IP telephony
implementation projects, we expect that our gross revenues from both products
and services will increase because these projects, by their nature, typically
require a substantially higher level of our services and more products than do
smaller projects. Larger projects, however, can strain our financial resources.
For example, a potential customer for a major IP telephony project may require
that we post a bid bond or performance bond in order for us to
19
<PAGE>
be awarded the project. This often occurs on competitive bids. Because of our
financial condition, bonding companies typically require that we provide
security to collateralize the issuance of its bond. We have been financially
unable to provide sufficient collateral in some instances, and as a result have
not been able to obtain the bond. We believe we have occasionally lost business
that we might have otherwise been awarded because we were unable to obtain the
bond required by the potential customer. We compete with larger and better
financed entities that do not face the same difficulties obtaining bonds.
Increases in the size and volume of IP telephony projects we undertake can
also challenge our cash management. For example, larger projects can reduce our
available cash by causing us to carry higher levels of inventory. Larger
projects can also require us to invest our available cash in labor costs. This
is because, in some cases, we do not receive payments from our customers for
extended periods of time. Until they pay us, all the cash we previously invested
in labor and products on the project remains tied up. We expect that greater
amounts of our cash will become invested in accounts receivable in the future if
we are successful in growing our business as we intend.
To meet our cash requirements to support this growth, we expect to rely on
capital provided from our operations and our credit facility, which is
collateralized by our accounts receivable and substantially all of our assets.
We also expect to raise capital through a public offering of our equity
securities.
Although over 75% of our revenue in 2003 was attributable to product sales,
the gross profit margins on sales of our services have been substantially higher
than those for sales of products, with the exception of sales of our proprietary
software products through our wholly owned subsidiary Stratasoft, Inc., which we
refer to as "Stratasoft." In 2003, for example, the gross profit margin on sales
of products by INX was 12.4%, while the gross profit margin on sales of services
by INX for that year was 29.6%. We therefore plan to increase revenue from
services, particularly our post-implementation services for IP telephony. The
success of this aspect of our strategy largely depends on our ability to attract
and retain highly skilled and experienced employees.
For the last three years, the largest component of our total cost of sales
and service has been purchases of Cisco-centric IP telephony products by INX.
The majority of those purchases were directly from Cisco. We typically purchase
from various wholesale distributors only when we cannot timely purchase products
directly from Cisco. Our reliance on Cisco as the primary supplier for the
network and IP telephony equipment and technology we offer means that our
results of operations from period to period depend substantially on the terms
under which we are able to purchase these products from Cisco and, to a much
lesser extent, from wholesale distributors of Cisco's products. Therefore, our
ability to manage the largest component of our cost of sales and service is very
limited and depends to a large degree on maintaining and growing our
relationship with Cisco. Our cost of products purchased from Cisco can be
substantially influenced by whether Cisco sponsors sales incentive programs and
whether we qualify for the incentives that Cisco offers.
We plan to also grow our business in other geographic areas through
strategic acquisition of similar businesses or by opening our own offices. This
aspect of our strategy can affect our financial condition and results of
operations in many ways. The purchase price for business acquisitions and the
costs of opening offices may require substantial cash and may require us to
incur long-term debt. The expenses of a geographic expansion in an area may well
exceed the revenues attributable to a new business or office for some time, even
if it performs as we expect. Additionally, it is possible that our acquisition
activities may require that we record substantial amounts of goodwill if the
purchase consideration paid for an acquisition exceeds the estimated fair value
of the net identified tangible and intangible assets acquired. To the extent an
acquisition results in goodwill, we will reevaluate the realizability of that
goodwill at least annually and adjust it as appropriate. The resulting
adjustment could result in significant charges to earnings in future periods.
Developing new or substantially improved computer telephony software
products will likely require us to expend cash and record software development
expenses. Software development costs will likely be expensed as incurred because
we expect to incur substantially all costs prior to achieving technological
feasibility in developing a new or substantially improved software product.
20
<PAGE>
EXISTING AND FUTURE MINORITY INTEREST IN INX
In April 2004, INX ceased to be a wholly-owned subsidiary as the result of
the issuance of INX common stock to Digital Precision, which INX acquired in
April 2003. In connection with that acquisition, we agreed to issue to the
seller 1.8 million shares of INX common stock as additional purchase
consideration for its business if certain employees remain employed through
April 4, 2004, the first anniversary of the acquisition. Those conditions were
met and the INX stock was issued in April 2004. Our ownership percentage of
INX's common stock is now approximately 92.4%.
INX has also granted stock options to employees of INX to acquire INX
common stock pursuant to a stock option plan for INX employees to purchase
8,274,288 shares of common stock. The exercise prices for the INX options range
from $0.01 to $0.25 with a weighted average of $0.16. Additionally, I-Sector
holds a warrant to acquire an additional 1.2 million shares of INX common stock,
which we refer to as the "I-Sector Warrant," at an exercise price of $0.25 per
share. We estimate that I-Sector's ownership in INX could be reduced to 69.6%,
assuming that all of the INX options are exercised, we exercise the I-Sector
Warrant and there are no other changes in INX's equity. If the I-Sector Warrant
is not exercised, we estimate that our ownership in INX would be reduced to
68.4% assuming all INX options are exercised. The terms of the INX options and
the I-Sector Warrant are discussed further in Note 14 to the Consolidated
Financial Statements and in "Executive Compensation."
Because I-Sector will own less than all of INX's stock, its interest in
INX's future profits and losses will be reduced. Under U.S. generally accepted
accounting principles, we expect that I-Sector's consolidated financial
statements will reflect a minority interest adjustment of the otherwise
reportable profits and losses of INX by the percentage of minority ownership in
INX during the period covered by the financial statements. I-Sector's percentage
share of any cash dividends or other distributions paid by INX to its
stockholders will likewise be reduced by the percentage of minority ownership in
INX. Additionally, if the percentage of minority ownership of INX's stock grows
as a result of future exercises of INX options, that increase will cause a
corresponding decrease in the reportable share of INX's profits and losses
included in our consolidated financial statements, and our share of cash
dividends and other distributions from INX.
The following table summarizes the pro forma effect on our consolidated net
loss for 2003 if, as of January 1, 2003: we exercised the I-Sector Warrant; all
INX options outstanding at December 31, 2003 were exercised; and all the INX
shares we issued in connection with the Digital Precision acquisition were
issued on January 1, 2003:
<Table>
<Caption>
DECEMBER 31, 2003
-----------------
(IN THOUSANDS)
<S> <C>
Net loss as reported........................................ $(1,836)
Assumed minority interest in INX income..................... (189)
Adjusted pro forma net loss................................. $(2,025)
</Table>
As a result of the adjustment to net income, our pro forma consolidated balance
sheet would include a liability entitled "Minority Interest" of $559,000 and our
stockholders' equity would be reduced by $559,000.
Unlike the boards of directors of our wholly-owned subsidiaries, the board
of directors of INX will be required to be mindful of the interests of INX's
minority stockholders, in addition to our interests, when considering whether to
approve business and financing transactions involving INX. For example, we may
be unable to cause the assets of INX to be pledged as collateral security for
indebtedness if the proceeds of that indebtedness disproportionately benefit
I-Sector or our wholly-owned subsidiaries in relation to INX. Conflicts of
interest may reduce our flexibility in structuring business and financing
transactions beneficial to us and our wholly-owned subsidiaries.
Contributions of capital to INX by us, in the form of stock purchases,
which may be necessary to fund INX's growth, could increase our percentage
ownership of INX but would use capital. Because of the
21
<PAGE>
potential minority interest in INX, we will be required to make capital
contributions to INX on a basis that is, in the good-faith judgment of our board
of directors, fair to us and the holders of the minority interest.
Minority stock ownership in INX could also subject us to lawsuits from its
minority stockholders complaining of our actions with respect to INX and its
minority stockholders, even if the actions complained of are ultimately
determined to have been proper. For example, if we choose to cause INX to merge
with, or sell all or substantially all of its assets to, another entity, the
minority stockholders of INX may bring lawsuits seeking to block the transaction
or seeking to exercise statutory dissenters' rights with respect to the
transaction. Whether or not successful, any such actions would cause us to incur
litigation costs and potentially reduce the benefit of any such transaction to
us.
The stock of INX is not publicly traded. Accordingly, any shares of INX
stock issued, including those issued to the former owners of Digital Precision
upon exercise of INX options, are, and will be for the foreseeable future,
relatively illiquid. For this reason, and to eliminate the other consequences of
having a minority interest in a subsidiary, we believe that in the future we
will offer to exchange INX stock and stock options for I-Sector common stock or
stock options to acquire I-Sector common stock. If we conclude such a
transaction, the aggregate ownership percentage of our common stock by our
stockholders immediately before the conversion or exchange transaction will be
reduced by the percentage of post-transaction ownership acquired by the former
minority stockholders of INX. Their post-transaction ownership may be further
reduced by subsequent exercises of I-Sector stock options that we may choose to
exchange for INX stock options.
We cannot predict the percentage of ownership reduction to our stockholders
that may result from any future exchange or conversion of INX stock and INX
options. The ownership reduction resulting from any such transaction may,
however, be significant. We believe this may be the case principally because:
- we expect that the total number of shares of our common stock that we
would be required to issue in any such transaction would be approximately
equivalent in value, as determined at a future date, to the value of the
INX stock and INX options to be exchanged at the same future date;
- the historical financial effect of INX on our business is significant, as
compared with our other subsidiaries; and
- we expect INX will continue to generate most of our revenue for the
foreseeable future.
If in the future we propose to exchange INX stock and INX options for
I-Sector common stock or options, we intend to appoint a special committee of
our independent directors to negotiate any exchange ratio for the transaction
with the principal INX minority stockholders and option holders. The facts and
circumstances that the special committee may choose to consider and the relative
weights to be accorded them in negotiating the relative values of our common
stock and INX stock and in negotiating the exchange ratio for any future
transaction are matters that we intend to delegate to the discretion of the
special committee. Accordingly, presently we cannot quantify the amount of any
future ownership reduction that our stockholders may experience in an exchange
transaction with INX stockholders and option holders.
Under some circumstances, we may be required by generally accepted
accounting principles to record substantial non-cash expenses if we choose to
exchange INX stock or INX options for our common stock or options. We are not
now able to determine the amount or timing of any such charges. This is because
those matters will largely depend upon the timing and terms on which any future
exchange would occur, particularly the exchange ratio negotiated at the time.
Because most of our revenues in 2003 were generated by INX and we expect that
this situation will continue for the foreseeable future, we believe that any
resulting non-cash charges could be substantial. Any such future non-cash
charges could materially and adversely affect our financial results.
If we determine to undertake a transaction to exchange INX stock or INX
options into our common stock or stock options, we also plan to submit any such
transaction to our stockholders for their approval,
22
<PAGE>
even if not required by Delaware law or the rules of the American Stock
Exchange. Even if we believe that such transaction is in our best interest, our
stockholders may refuse to approve it. If that were to occur, it could
disappoint the expectations of those INX minority stockholders and INX option
holders in favor of the transaction, some of who are currently, and are expected
to remain, key employees. This could cause employee morale and retention
problems for us.
RESULTS OF OPERATIONS
OVERVIEW
Sources of Revenue. Our revenue is derived from three segments represented
by our three operating subsidiaries, which are INX, Stratasoft and Valerent,
Inc., which we refer to as "Valerent." During the year ended December 31, 2003,
INX, Stratasoft and Valerent accounted for 80.4%, 12.1% and 8.2%, respectively,
of total consolidated revenue, and (0.7)% of subsidiary revenue was eliminated
in consolidation due to intercompany transactions.
INX revenue consists of product and service revenue. Product revenue
consists of reselling Cisco products and limited amounts of complementary
products by other manufacturers. Service revenue is generated by fees from a
variety of implementation and support services. Product prices for INX are set
by the market for Cisco products, and provide our lowest gross margins. Service
revenue for INX has recently provided a higher gross margin that has generally
improved over the past several years as the cost of INX's technical resources,
which are reflected as a cost of service, has decreased as a percentage of
service revenue. Also, certain fixed and flat fee service contracts that extend
over three months or more are accounted for using the percentage of completion
method of accounting.
Historically, the majority of INX's service revenue has been generated from
implementation services, which is project oriented and tends to be volatile as
projects are completed and new projects commence. As the number, frequency and
size of INX projects has grown, INX has achieved better utilization of its
engineering resources resulting in improved services gross margins. The normal
sales cycles for corporate customers typically ranges from three to six months
depending on the nature, scope and size of the deal involved. But our direct
experience with school districts involved in the e-Rate program (a governmental
funding program for schools) indicates that the sales lead time is generally
about six to 12 months. In mid-2003, INX introduced Netsurant, its branded
support service that consists primarily of customer service personnel and a
support center that we believe could further improve overall services gross
margins. Through 2003, Netsurant service revenue was not significant.
Stratasoft revenue consists primarily of custom project revenue from the
sale of proprietary computer-telephony software. Our Stratasoft revenue is
reported as custom project revenue in our financial statements, because it
consists of product and services which cannot be accounted for separately.
Stratasoft has traditionally provided our highest gross margin since it is
primarily sales of our proprietary computer-telephony software. Our cost of
goods sold for Stratasoft's custom project revenue includes the cost of
developing our computer-telephony software products, installation costs, and the
cost of hardware and other equipment bundled with our software applications and
included in a sale to a customer. Stratasoft revenue also includes sales to
resellers. The sales to resellers are recorded when the sale becomes fixed or
determinable; otherwise revenue from resellers is recorded when payments become
due.
Valerent revenue consists of both product revenue and service revenue.
Product revenue consists of reselling primarily software products and, to a
lesser degree, hardware products that facilitate Valerent's managed services,
including remote management software products from Altiris, Inc., and security
software products from Network Associates, Inc. Product sales prices for
Valerent are set by the market for these products, and Valerent's product sales
have typically provided lower gross profit margins than its service revenue.
Valerent's service revenue consists of remote and onsite technical assistance to
its customers. Valerent's gross margin on service revenue, much like INX's
implementation service revenue, is subject to variability based upon the
utilization of Valerent's billable technical resources. Recurring service
agreements exist with some customers, but usually with varying terms and
conditions that conform to their year-over-year business changes and specific
needs. Although these agreements provide predictable and
23
<PAGE>
stable sources of revenue, the loss of a recurring agreement could disrupt the
stability of that revenue stream for Valerent.
Gross Profit and Gross Profit Margin. The mix of our various revenue
components, each of which has a substantially different gross margin, materially
influences our overall gross profit and gross margin in any particular quarter.
In periods in which service revenue or Stratasoft custom project revenue is
high, as compared to INX and Valerent product sales, our gross margin generally
improves as compared to periods in which we have higher levels of product sales.
Our gross margin for product sales also varies depending on the type of product
sold and the mix of large revenue product contracts, which typically have lower
gross margin, as compared to smaller revenue product contracts, which typically
have a higher gross margin.
In addition, our quarterly gross profit and gross margin can be materially
affected by vendor incentives received in certain quarterly periods, most of
which are Cisco incentives received by INX. The incentive programs sponsored by
Cisco currently enable us to qualify for cash rebates or product pricing
discounts. These incentives are generally earned based on sales volume, sales
growth and, in some cases, customer satisfaction levels. The amounts earned
under these programs are recorded as a reduction of cost of goods and can vary
significantly between periods. Currently, incentives by Cisco are paid
semiannually, and are typically paid in the first and third quarters of each
calendar year. Incentives are recognized when we receive payment from the
supplier or when we have earned and can reasonably estimate the amount due from
the supplier.
Expenses. A significant portion of our cost of services for each of our
service businesses is composed of labor. Labor cost related to permanent
employees is generally fixed in the short-term so that higher levels of service
revenue produce higher gross margins while lower levels of service revenue
produce lower gross margins. Our gross margin on service revenue fluctuates from
period to period depending not only upon the prices charged to customers for our
services, but also upon the level of utilization of our technical staff.
Management of labor cost is therefore important in order to prevent erosion of
gross margin. Our gross margin is also impacted by such factors as contract
size, time and material pricing versus fixed fee pricing, discounting, vendor
incentives and other business and marketing factors normally incurred during the
conduct of business.
Selling, General and Administrative Expenses. Our selling, general and
administrative expenses include both fixed and variable expenses. Relatively
fixed expenses in selling, general and administrative expenses include rent,
utilities, promotion and advertising, and administrative wages. Variable
expenses in selling, general and administrative expenses include sales
commissions and travel, which will usually vary based on our sales and gross
profit. Selling, general and administrative expenses also include expenses which
vary significantly from period to period but not in proportion to sales or gross
profit. These include legal expenses and bad-debt expense both of which vary
based on factors that are difficult to predict.
A significant portion of our selling, general and administrative expenses
relate to personnel costs, some of which are variable and others that are
relatively fixed. Our variable personnel costs consist primarily of sales
commissions. Sales commissions are typically calculated based upon our gross
profit on a particular sale transaction and, thus, generally fluctuate based on
the dollar amount of the sale and the gross profit margin produced by the mix of
products and services included in the sale. Bad debt expense generally
fluctuates somewhat in proportion to increases or decreases in revenue levels,
although not always in the same periods as increases or decreases in revenue.
Legal expense varies based on legal issue activity, which can vary substantially
from period to period. The remainder of selling, general and administrative
expenses are relatively fixed and do not vary in direct proportion to increases
or decreases in revenue.
Acquisition and Disposition. In the second quarter of 2003, INX acquired
the fixed assets, inventory, intellectual property, customer lists, trademarks,
trade names, service marks, contract rights and other intangibles of Digital
Precision. In connection with that acquisition we also assumed leases for
equipment and office space. Our results of operations include those attributable
to Digital Precision on and after April 4, 2003. The purchase price for Digital
Precision was $540,000 in cash and 1.8 million shares of
24
<PAGE>
INX common stock. In April 2004, we issued 1.8 million shares of INX stock for
contingent consideration resulting in additional intangible assets of
approximately $300,000.
The sale of our computer reselling and PBX telephone systems reselling
business in early 2000 and the sale of our IT Staffing business in 2001 resulted
in a gain on disposal. Since the sale of these businesses, we have realized, in
various periods, income and expense from discontinued operations that have been
primarily a result of litigation expenses and settlement of litigation related
to our discontinued operations. We expect the income and expense from
discontinued operations to decrease over time and to eventually be eliminated
after these matters are fully resolved.
Tax Loss Carryforward. Because of our operating losses in 2003, we have
accumulated a net operating loss carryforward for federal income tax purposes
that, as of December 31, 2003, was approximately $2.4 million and is available
to offset future federal and state taxable income. This carryforward expires in
2023. In addition to potential expiration, there are several factors that could
limit or eliminate our ability to use these carryforwards. For example, under
Section 382 of the Internal Revenue Code of 1986, as amended, use of prior net
operating loss carryforwards is limited after an ownership change. This type of
change could result from this offering, either alone or in combination with
other prior or subsequent offerings of equity securities. If we achieve
sustained profitability, which may not happen, the use of net operating loss
carryforwards would reduce our tax liability and increase our net income and
available cash resources. When all operating loss carryforwards have been used
or have expired, we would again be subject to increased tax expense and reduced
earnings due to such tax expense.
Period Comparisons. The following table sets forth, for the periods
indicated, certain financial data derived from our consolidated statements of
operations. Percentages shown in the table below are percentages of total
revenue, except for each individual segment's cost of sales and services, gross
profit, selling, general and administrative expenses, and operating income,
which are percentages of the respective segment's revenue, and the product and
service components of the INX and Valerent segments' cost of goods sold and
gross profit, which are percentages of such segment's respective product and
service revenue.
<Table>
YEAR ENDED DECEMBER 31,
----------------------------------------------------
2001 2002 2003
---------------- --------------- ---------------
AMOUNT % AMOUNT % AMOUNT %
------- ------ ------- ----- ------- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Revenue:
INX product.................................. $ 8,853 37.5 $28,990 69.0 $45,749 73.6
INX service.................................. 1,922 8.1 1,748 4.1 4,226 6.8
------- ------ ------- ----- ------- -----
Total INX revenue....................... 10,775 45.6 30,738 73.1 49,975 80.4
------- ------ ------- ----- ------- -----
Stratasoft -- custom projects................ 7,257 30.7 6,569 15.6 7,527 12.1
Valerent product............................. 1,113 4.7 1,092 2.6 1,573 2.5
Valerent service............................. 4,555 19.3 3,900 9.3 3,503 5.6
------- ------ ------- ----- ------- -----
Total Valerent revenue.................. 5,668 24.0 4,992 11.9 5,076 8.2
Corporate revenue............................ (6) 0.0 -- 0.0 -- 0.0
Eliminations revenue...................... (74) (0.3) (278) (0.6) (426) (0.7)
------- ------ ------- ----- ------- -----
Total revenue........................ 23,620 100.0 42,021 100.0 62,152 100.0
</Table>
(continued on following page)
25
<PAGE>
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
----------------------------------------------------
2001 2002 2003
---------------- --------------- ---------------
AMOUNT % AMOUNT % AMOUNT %
------- ------ ------- ----- ------- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Cost of sales and service:
INX product.................................. 7,707 87.1 25,659 88.5 40,060 87.6
INX service.................................. 1,956 101.8 1,658 94.9 2,976 70.4
------- ------ ------- ----- ------- -----
Total INX cost of sales and service..... 9,663 89.7 27,317 88.9 43,036 86.1
Stratasoft -- custom projects................ 3,318 45.7 2,920 44.5 2,982 39.6
Valerent product............................. 1,026 92.2 1,055 96.6 1,421 90.3
Valerent service............................. 3,377 74.1 2,738 70.2 2,412 68.9
------- ------ ------- ----- ------- -----
Total Valerent cost of sales and
service.............................. 4,403 77.7 3,793 76.0 3,833 75.5
Corporate of cost of sales and service.... (13) 216.7 -- 0.0 -- 0.0
Eliminations of cost of sales and
service................................. (46) (62.2) (278) 100.0 (426) 100.0
------- ------ ------- ----- ------- -----
Total cost of sales and service...... 17,325 73.5 33,752 80.3 49,425 79.5
Gross profit:
INX product............................... 1,146 12.9 3,331 11.5 5,689 12.4
INX service............................... (34) (1.8) 90 5.1 1,250 29.6
------- ------ ------- ----- ------- -----
Total INX gross profit.................. 1,112 10.3 3,421 11.1 6,939 13.9
Stratasoft -- custom projects................ 3,939 54.3 3,649 55.5 4,545 60.4
Valerent product............................. 87 7.8 37 3.4 152 9.7
Valerent service............................. 1,178 25.9 1,162 29.8 1,091 31.1
------- ------ ------- ----- ------- -----
Total Valerent gross profit............. 1,265 22.3 1,199 24.0 1,243 24.5
Corporate gross profit.................... 7 (116.7) -- 0.0 -- 0.0
Eliminations gross profit................. (28) 37.8 -- 0.0 -- 0.0
------- ------ ------- ----- ------- -----
Total gross profit................... 6,295 26.7 8,269 19.7 12,727 20.5
Selling, general and administrative expenses:
INX.......................................... 3,103 28.8 3,545 11.5 6,045 12.1
Stratasoft................................... 3,021 41.6 3,922 59.7 5,888 78.2
Valerent..................................... 3,077 54.3 2,236 44.8 1,963 38.7
Corporate.................................... 1,400 (NA) 922 (NA) 1,165 (NA)
Eliminations................................. (28) 37.8 -- 0.0 -- 0.0
------- ------ ------- ----- ------- -----
Total selling, general and administrative
expenses..................................... 10,573 44.8 10,625 25.3 15,061 24.2
Operating loss:
INX.......................................... (1,991) (18.5) (124) (0.4) 894 1.8
Stratasoft................................... 918 12.6 (273) (4.2) (1,343) (17.8)
Valerent..................................... (1,812) (32.0) (1,037) (20.8) (720) (14.2)
Corporate.................................... (1,393) (NA) (922) (NA) (1,165) (NA)
Eliminations................................. -- (NA) -- (NA) -- 0.0
------- ------ ------- ----- ------- -----
Total operating loss.................... (4,278) (18.1) (2,356) (5.6) (2,334) (3.8)
Interest and other income (expense), net....... 316 1.3 115 0.3 107 0.2
------- ------ ------- ----- ------- -----
Loss from continuing operations before benefit
for income taxes............................. (3,962) (16.8) (2,241) (5.3) (2,227) (3.6)
Benefit for income taxes....................... 87 0.4 1,595 3.8 181 0.3
------- ------ ------- ----- ------- -----
Net loss from continuing operations............ (3,875) (16.4) (646) (1.5) (2,046) (3.3)
Discontinued operations:
Loss from discontinued operations, net of
taxes........................................ (167) (0.7) -- 0.0 -- 0.0
Gain on disposal, net of taxes................. 337 1.4 262 0.6 210 0.3
------- ------ ------- ----- ------- -----
Net loss....................................... $(3,705) (15.7) $ (384) (0.9) $(1,836) (3.0)
======= ====== ======= ===== ======= =====
</Table>
(continued on following page)
26
<PAGE>
YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2003
Revenue. Our total revenue, net of intercompany eliminations, increased by
$20.1 million, or 47.9%, from $42.0 million to $62.2 million.
INX revenue increased by $19.2 million, or 62.6%, from $30.7 million to
$50.0 million. As a percentage of total revenue, INX revenue increased from
73.1% to 80.4%. Of the increase, $10.8 million was attributed to the Houston
office, $4.6 million was attributed to a new office in Austin, $1.1 million was
attributed to government sector sales and $2.8 million was attributed to the
Dallas office. The increase in revenue attributable to the Digital Precision
acquisition, including the $4.6 million of revenue of the acquired Austin
office, was $8.5 million. INX's revenue grew rapidly primarily due to large
sales to four school districts totaling $14.3 million and due to synergy of $8.5
million resulting from its acquisition of Digital Precision. The sales to the
school districts are one-time competitive bid events fostered by the e-Rate
program that provides schools with 90% of their funding for Internet-related
expenditures, and there can be no assurance as to the level of revenue provided,
if any, in future periods from school districts.
Stratasoft revenue increased by $958,000, or 14.6%, from $6.6 million to
$7.5 million. As a percentage of total revenue, Stratasoft revenue decreased
from 15.6% to 12.1%. Stratasoft's increased revenue was primarily the result of
two large international custom projects in 2003, as compared to no individually
large custom projects initiated during 2002. This was slightly offset by
deferred revenue for certain custom projects that included fees that were
determined to not be fixed and determinable in 2003. Stratasoft's international
sales accounted for 42.2% of Stratasoft's revenue as compared to 28.2% in 2002.
Stratasoft has it own internally managed sales force, but it also utilizes
dealer agreements from time to time with certain established resellers in
domestic and international markets that do not require the continued involvement
of our personnel. Stratasoft derived $929,000 or 12.3% of its revenue from sales
to resellers in 2003 which compares with $614,000 or 9.3% of revenue in 2002.
Sales to resellers are included in revenue when the fees are fixed and
determinable; otherwise revenue from resellers is deferred and recognized when
the payment becomes due.
Valerent revenue increased by $84,000, or 1.7%, from $5.0 million to $5.1
million. As a percentage of total revenue, Valerent revenue decreased from 11.9%
to 8.2%. The increase in Valerent revenue was primarily attributable to
decreased service revenue of $397,000 offset by increased product sales of
$481,000. The decrease in service revenue is primarily attributable to the loss
of revenue from certain customers of $355,000, which was primarily related to
Valerent making changes to its business model so that it no longer pursued
certain non-strategic sources of service revenue. Valerent's business model now
focuses on identifying and developing markets with enterprise customers and we
expect that the redirection will provide generally improved margins in the
future.
Gross Profit. Our total gross profit increased by $4.4 million, or 53.9%,
from $8.3 million to $12.7 million. Gross margin increased from 19.7% to 20.5%,
primarily because of the increase in gross margin in our INX and Stratasoft
subsidiaries as discussed below.
INX gross profit increased $3.5 million, or 102.8%, from $3.4 million to
$6.9 million. INX's gross margin increased from 11.1% to 13.9%. INX's gross
profit on its product sales component increased $2.4 million or 70.8%, from $3.3
million to $5.7 million due to increased product sales revenue and a vendor
rebate of $313,000. INX's gross profit on its service component increased $1.2
million, from $90,000 to $1.3 million, and service gross margin improved from
5.1% to 29.6%, as a result of significantly increased service revenue of $2.5
million with a somewhat fixed cost of service component due to improved
utilization of technical personnel.
Stratasoft gross profit increased by $896,000, or 24.6%, from $3.6 million
to $4.5 million. Stratasoft's gross margin increased from 55.5% to 60.4%.
Stratasoft gross profit was impacted by the mix of sales between "systems
sales," which include a hardware component, as compared to "software only"
sales, which do not have a hardware component. Stratasoft's increased gross
profit is primarily due to an increased "software only" component relative to
the "systems sales" component of total Stratasoft sales.
27
<PAGE>
"Software only" sales primarily relate to reseller customers and do not require
the continuing involvement of our personnel.
Valerent gross profit increased by $44,000, or 3.7%. Valerent's gross
margin increased from 24.0% to 24.5%. Valerent's cost of service consists
primarily of fixed labor cost that does not fluctuate directly with changes in
revenue. Valerent improved its utilization of its labor pool by reducing the
number of technicians employed and lowering its fixed cost, which contributed to
improved gross profits.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by $4.4 million, or 41.8% from $10.6 million
to $15.1 million. As a percentage of total revenue, these expenses decreased
1.1%, from 25.3% to 24.2%. Sales compensation increased $919,000 due to
corresponding increase in sales. Legal and professional fees increased $629,000
due to an Equal Employment Opportunity Commission claim, collection efforts, and
commercial disputes in the ordinary course of business. Administrative
compensation expense increased $580,000 due to hiring additional INX and
Stratasoft personnel in Houston, Dallas, Canada and India. Payroll tax expense
increased $109,000 correspondingly with compensation expenses. Contract labor
expense increased $147,000 to supplement technical service labor need to fulfill
contractual obligations. Travel expense increased $312,000 primarily due to
Stratasoft international travel and INX travel for technical staff and
management. General office expenses increased $354,000 due to printing and
general growth. Insurance expense increased $64,000 because of rate increases
and volume increases. Stockholder relations expense increased $209,000, due to
employing a shareholder relations firm, attending investor conferences and
visiting investor groups. Depreciation expense increased $163,000 due to asset
additions and the Digital Precision acquisition in April 2003. Rents increased
$172,000 due to additional office space in Austin and Dallas. Other corporate
expenses increased $198,000 due to our overall growth.
Operating Loss. Operating loss decreased $22,000, or 0.9%, from $2.4
million to $2.3 million, primarily due to the $4.5 million increase in gross
profit being offset by the $4.4 million increase in selling, general and
administrative expenses. INX's operating profit increased $1.0 million, or
821.0%, from a loss of $124,000 to a profit of $894,000. Stratasoft's operating
loss increased $1.1 million, or 391.9%, from a loss of $273,000 to a loss of
$1.3 million. Valerent's operating loss decreased $317,000, or 30.6%, from $1.0
million to $720,000. The operating loss for the Corporate Segment increased
$243,000, or 26.4%, from a loss of $922,000 to an operating loss of $1.2
million.
Interest and Other Income, Net. Interest and other income, net, decreased
by $8,000, or 7.0%, from $115,000 to $107,000, primarily due to a decrease in
interest income of $102,000, or 57.6%, from $177,000 to $75,000 which is
attributable to interest on the settlement of a past-due customer account in
2002. The decrease in interest income was also affected by an increase in
interest expense of $41,000, or 136.6%, from $30,000 to $71,000 due to increased
borrowings used to finance inventory purchases to supply the increased business
activity. Our borrowings under the Textron Facility increased from $3.2 million
to $7.6 million while the interest-bearing portion of our borrowings increased
from $0 at December 31, 2002 to $1.7 million at December 31, 2003. Foreign
exchange loss increased $13,000 from $0 to a loss of $13,000. Other income
increased $148,000, or 461.0%, from a loss of $32,000 to $116,000.
Net Loss. The net loss increased $1.5 million, or 378.1%, from $384,000 to
$1.8 million. The benefit for income taxes decreased $1.4 million, or 88.7%,
from $1.6 million to $181,000. Because the Job Creation and Worker Assistance
Act of 2002 provided for the carryback of net operating losses for any taxable
year ending during 2001 or 2002 to each of the five tax years preceding the loss
year, we were able to use our net operating loss carryback. The benefit in 2003
includes amounts related to additional carryback benefits for 2002 not
previously recorded.
Discontinued Operations. During 1999, we discontinued our Telecom Systems
business. On March 16, 2000 we entered into an agreement to sell certain assets
of, and the ongoing operation of, our Computer Products Division. The sale
transaction closed on May 19, 2000. On December 31, 2000, we sold our IT
Staffing business. As a consequence of these events, the operations of these
businesses are reported as discontinued operations. For the year ended December
31, 2002, the gain on disposal related to these three businesses was $171,000,
$104,000 and $(13,000), net of taxes of $88,000, $53,000 and
28
<PAGE>
$(7,000), for a net total of $262,000. For the year ended December 31, 2003 the
gain on disposal related to these three businesses was $80,000, $104,000 and
$26,000, net of taxes of $41,000, $53,000 and $14,000, for a total gain of
$210,000. The gains and/or losses on disposal related to these discontinued
operations are primarily related to collections of accounts receivables retained
when these businesses were sold.
YEAR ENDED DECEMBER 31, 2001 COMPARED TO THE YEAR ENDED DECEMBER 31, 2002
Revenue. Total revenue increased $18.4 million, or 77.9%, from $23.6
million to $42.0 million. International sales accounted for $1.9 million, or
4.4%, of consolidated revenue as compared to 13.2%, and were primarily derived
from the Stratasoft segment.
INX revenue increased $20.0 million, or 185.3%, from $11.0 million to $31.0
million. As a percentage of total revenue, INX revenue increased from 45.6% to
73.1%. INX's growth in revenue related to products primarily in the Houston
market, where its revenue increased by $13.5 million, and in the Dallas market,
where its revenue expanded by $6.5 million. During November 2001, INX achieved
gold status with Cisco, its primary product line manufacturer, which allows INX
to purchase directly from Cisco at lower pricing levels and enhances INX's
relationship with Cisco in the areas of lead generation, joint marketing and
technical support.
Stratasoft revenue decreased $688,000, or 9.5%, from $7.3 million to $6.6
million. As a percentage of total revenue, Stratasoft revenue decreased from
30.7% to 15.6%. A large portion of orders in the fourth quarter of 2002 were
booked late in the quarter, resulting in less progress toward completion and
lower recognized revenue in that quarter in the current year. Additionally, 2001
included eight large international projects that were substantially completed
during 2001 and were not replicated. Stratasoft's international revenue
decreased $1.2 million, or 38.7% from $3.1 million (42.9% of its total revenue)
to $1.9 million (28.2% of its total revenue).
Valerent revenue decreased $676,000, or 11.9%, from $5.7 million to $5.0
million. As a percentage of total revenue, revenue decreased from 24.0% to
11.9%. The decrease in revenue is attributable to the loss of service revenue
from certain customers of $666,000 and a decision not to participate in the
National Service Network, a network of information technology organizations that
provide service and support for regional and national customers through the
certified services professionals employed by its participants, resulting in
decreased revenue of $63,000.
Gross Profit. Gross profit increased $2.0 million, or 31.4%, from $6.3
million to $8.3 million. Gross margin decreased from 26.7% to 19.7%. The primary
reason for the decrease in gross margin is the rapid growth in the INX segment
that experiences lower gross margin because of a high proportion of its revenue
being derived from product sales.
INX gross profit increased $2.3 million, or 207.6%, from $1.1 million to
$3.4 million. INX's gross margin increased from 10.3% to 11.1%. INX's product
gross profit increased $2.2 million from $1.1 million to $3.3 million due to the
sales volume increase offset by gross margin decreases from 12.9% to 11.5%.
INX's gross profit on its service component improved $124,000, or 364.7%, from
$(34,000) to $90,000 due to better utilization of technical personnel. The
overall increase in gross profit is consistent with an increase in revenue of
$20.0 million, and with better pricing from Cisco after achieving Cisco Gold
levels, along with higher levels of service revenue.
Stratasoft gross profit decreased $290,000, or 7.4%, from $3.9 million to
$3.6 million. Stratasoft's gross margin increased from 54.3% to 55.5%. The
decreased gross profit is consistent with a decrease in revenue of $688,000. As
discussed above, Stratasoft's revenue, and consequently its gross profit,
suffered from a large portion of its orders for the fourth quarter being booked
late in the quarter, resulting in lower recognized revenue and gross profit for
both the fourth quarter and the current year. Stratasoft's gross margin is
impacted by the mix of sales between "systems sales," which include a hardware
component, as compared to "software only" sales, which do not have a hardware
cost of goods component.
Valerent gross profit decreased $66,000, or 5.2%, from $1.3 million to $1.2
million. Valerent's gross margin increased from 22.3% to 24.0%. Valerent's cost
of service consists primarily of labor cost, which
29
<PAGE>
has a more fixed nature. In periods when service revenue decreases, it becomes
more important to manage labor cost in order to prevent erosion of gross margin.
Valerent discontinued its relationship with the National Service Network in the
first quarter of 2002 because it could not realize high enough margin on the
work directed its way by that network.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased $52,000, or 0.1% to $10.6 million. As a
percentage of total revenue, selling, general and administrative expenses for
continuing operations decreased 19.5% from 44.8% to 25.3%.
INX selling, general and administrative expenses increased $442,000, or
14.2% from $3.1 million to $3.5 million primarily due to increased sales
compensation that is consistent with increased revenue of $20.0 million.
Stratasoft's selling, general and administrative expenses increased $901,000, or
30% from $3.0 million to $3.9 million primarily due to increased bad-debt
expense and to Stratasoft's lower legal expense due to settlement of the eshare
lawsuit resulting in an insurance reimbursement of legal fees incurred in the
defense and recorded prior to 2001. Other factors contributing to Stratasoft's
increase include increases in rent, promotion and advertising and insurance.
Corporate selling, general and administrative expenses decreased by $478,000, or
34.1% from $1.4 million to $932,000, primarily due to administrative staff
reductions. Valerent selling, general and administrative expenses decreased
$841,000, or 27.3%, from $3.1 million to $2.2 million, primarily due to sales
and administrative staff reductions, as well as reduced bad-debt expense. Other
contributing factors in the corporate decrease are decreases in legal expense,
bad-debt expense, general office expenses and utilities.
Operating Loss. Operating loss decreased $1.9 million, or 44.2%, from $4.3
million to $2.4 million, primarily due to the increase in gross profit of $2.0
million and the increase in selling, general and administrative expenses of
$52,000. INX's operating loss decreased $1.9 million, or 93.7%, from $2.0
million to a loss of $124,000. Stratasoft's operating loss increased $1.2
million, or 129.7%, from income of $918,000 to a loss of $273,000. Valerent's
operating loss decreased $775,000, or 42.8%, from $1.8 million to $1.0 million.
The operating loss for the corporate segment decreased $471,000, or 33.8%, from
a loss of $1.4 million to an operating loss of $922,000.
Interest and Other Income, Net. Interest and other income, net decreased
$201,000, or 63.6%, from $316,000 to $115,000. During 2001 and continuing
through 2002, interest rates decreased steadily due to attempts by the national
government to stimulate the economy. In addition to the decrease in interest
rates, while the cash balances at year end are comparable, average cash balances
encompassing the entire year were higher. Interest income was also increased by
the recognition of other income of $65,000 relating to an insurance
reimbursement in September 2001.
Net Loss. Net loss from continuing operations decreased $3.3 million, or
84.6%, from $3.9 million to $646,000. A valuation allowance against deferred tax
assets eliminated the income tax benefit. In March 2002, President Bush signed
into law the Job Creation and Worker Assistance Act of 2002. Under the new law,
which provided for the carryback of net operating losses for any taxable year
ending during 2001 or 2002 to each of the five tax years preceding the loss
year, we were able to record $1.6 million in tax benefit. A valuation allowance
has been recorded against remaining income tax benefits generated.
Discontinued Operations. In connection with the sale of IT Staffing, we
recognized a loss from discontinued operations of $167,000 (net of taxes of
$85,000) on the operations before the measurement date of November 7, 2001 and
we recognized a loss on disposal of $9,000 and $13,000 (net of taxes of $5,000
and $7,000). During 2001 we recognized additional gain on the sale of the
Computer Products Division of $346,000 (net of taxes of $179,000) and we
recognized additional gain on the sale of the Computer Products Division of
$104,000 (net of taxes of $53,000). We recognized additional gain related to the
disposal of the Telecom Division of $171,000 (net of taxes of $88,000).
30
<PAGE>
QUARTERLY RESULTS
The following table sets forth certain unaudited quarterly financial
information for each of our last eight quarters and, in the opinion of
management, includes all adjustments (consisting of only normal recurring
adjustments) that we consider necessary for a fair presentation of the
information set forth therein. Our quarterly results may vary significantly
depending on factors such as the timing of large customer orders, timing of new
product introductions, adequacy of product supply, variations in our product
costs, variations in our product mix, promotions, seasonal influences and
fluctuations in competitive pricing pressures. The results of any particular
quarter may not be indicative of results for the full year or any future period.
<Table>
2002 2003
------------------------------------------------- -------------------------------------------------
FIRST SECOND THIRD FOURTH FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Revenue
INX product.............. $ 5,336 $ 7,177 $ 8,034 $ 8,443 $ 6,661 $ 12,253 $ 15,954 $ 10,881
INX service.............. 377 253 550 568 477 782 1,392 1,575
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total INX revenue.......... 5,713 7,430 8,584 9,011 7,138 13,035 17,346 12,456
Stratasoft custom
project.................. 2,171 1,657 1,743 998 2,069 1,511 2,415 1,532
Valerent product......... 371 265 303 153 193 509 515 356
Valerent service......... 1.094 962 988 856 812 874 877 940
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total Valerent revenue..... 1,465 1,227 1,291 1,009 1,005 1,383 1,392 1,296
Eliminations............... (141) (54) (11) (72) (132) (59) (172) (63)
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total revenue.............. 9,208 10,260 11,607 10,946 10,080 15,870 20,981 15,221
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Cost of sales and services:
INX product.............. 4,647 6,472 7,150 7,390 5,844 10,846 13,758 9,612
INX service.............. 481 350 377 450 516 757 795 908
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total INX cost of sales and
service.................. 5,128 6,822 7,527 7,840 6,360 11,603 14,553 10,520
Stratasoft custom
project.................. 837 871 781 431 801 574 728 879
Valerent product......... 377 227 296 155 192 424 474 331
Valerent service......... 773 687 687 591 584 599 606 623
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total Valerent cost of
sales and service........ 1,150 914 983 746 776 1,023 1,080 954
Eliminations............. (141) (54) (11) (72) (132) (59) (171) (64)
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total cost of sales and
services................. 6,974 8,553 9,280 8,945 7,805 13,141 16,190 12,289
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Gross profit:
INX product.............. 689 705 884 1,053 817 1,407 2,196 1,269
INX service.............. (104) (97) 173 118 (39) 25 597 667
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total INX gross profit..... 585 608 1,057 1,171 778 1,432 2,793 1,936
Stratasoft custom
project.................. 1,334 786 962 567 1,268 937 1,687 653
Valerent product......... (6) 38 7 (2) 1 85 41 25
Valerent service......... 321 275 301 265 228 275 271 317
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total Valerent gross
profit................... 315 313 308 263 229 360 312 342
Eliminations............. -- -- -- -- -- -- (1) 1
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total gross profit......... 2,234 1,707 2,327 2,001 2,275 2,729 4,791 2,932
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
</Table>
(continued on following page)
31
<PAGE>
<Table>
<Caption>
2002 2003
------------------------------------------------- -------------------------------------------------
FIRST SECOND THIRD FOURTH FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Selling, general and
administrative expenses:
INX..................... 789 691 966 1,099 945 1,448 2,126 1,526
Stratasoft.............. 1,011 675 914 1,322 1,596 1,344 1,754 1,194
Valerent................ 653 501 569 513 560 536 455 412
Corporate............... 169 147 170 436 275 234 287 369
Eliminations............ -- -- -- -- -- -- (1) 1
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total selling, general and
administrative
expenses................ 2,622 2,014 2,619 3,370 3,376 3,562 4,621 3,502
Operating income (loss)
INX..................... (204) (83) 91 72 (167) (16) 667 410
Stratasoft.............. 323 111 48 (755) (328) (407) (67) (541)
Valerent................ (338) (188) (261) (250) (331) (176) (143) (70)
Corporate............... (169) (147) (170) (436) (275) (234) (287) (369)
Eliminations............ -- -- -- -- -- -- -- --
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total operating income
(loss)................ (388) (307) (292) (1,369) (1,101) (833) 170 (570)
Interest (income) and
other income, net....... (5) 7 (3) (114) (10) (96) 11 (12)
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Income (loss) before
benefit for income
taxes................... (383) (314) (289) (1,255) (1,091) (737) 159 (558)
Benefit for income
taxes................... 1,182 7 -- 406 -- 81 12 88
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net income (loss) from
continuing operations... 799 (307) (289) (849) (1,091) (656) 171 (470)
Discontinued operations
gain (loss) on
disposal................ 6 12 (1) 245 -- 16 23 171
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net income (loss)......... $ 805 $ (295) $ (290) $ (604) $ (1,091) $ (640) $ 194 $ (299)
========== ========== ========== ========== ========== ========== ========== ==========
Net income (loss) per
share:
Basic:
Continuing operations..... $ 0.21 $ (0.08) $ (0.08) $ (0.23) $ (0.30) $ (0.19) $ 0.04 $ (0.12)
Gain on disposal.......... -- -- -- 0.06 -- 0.01 0.01 0.04
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net income (loss) per
share................... $ 0.21 $ (0.08) $ (0.08) $ (0.17) $ (0.30) $ (0.18) $ 0.05 $ (0.08)
========== ========== ========== ========== ========== ========== ========== ==========
Diluted:
Continuing operations..... $ 0.21 $ (0.08) $ (0.08) $ (0.23) $ (0.30) $ (0.19) $ 0.03 $ (0.12)
Gain on disposal.......... -- -- -- 0.06 -- 0.01 0.01 0.04
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net income (loss) per
share................... $ 0.21 $ (0.08) $ (0.08) $ (0.17) $ (0.30) $ (0.18) $ 0.04 $ (0.08)
========== ========== ========== ========== ========== ========== ========== ==========
Weighted average number of
shares outstanding:
Basic................... 3,849,525 3,733,481 3,629,525 3,629,525 3,630,285 3,636,441 3,703,206 3,874,730
Diluted................. 3,849,525 3,733,481 3,629,525 3,629,525 3,630,285 3,636,441 3,974,298 3,874,730
</Table>
For the quarter ended September 30, 2003, we saw unusually strong revenue,
partially due to larger contracts, which we believe was partially attributable
to a rebound in the economy and consumer confidence following the Iraq war, and
partially attributable to customers moving forward with projects that they had
put on hold pending the outcome of the Iraq war. For the fourth quarter ended
December 31, 2003, our revenue, as expected, decreased as compared to the
exceptionally strong third quarter, but increased 39% as compared to the fourth
quarter of 2002.
Our gross profit has fluctuated between quarters primarily due to changes
in our revenue mix between service revenues in INX and Valerent and our
Stratasoft custom project revenue, which have generally generated higher
margins, and the lower margin components of our business including product sales
in INX and Stratasoft. While INX service gross margin increased significantly
and Valerent service gross margin increased by a small amount for the fiscal
year ended December 31, 2003 as compared to the fiscal year ended December 31,
2002, quarter-to-quarter gross margin levels have varied primarily based on the
level of utilization of billable technical staff and the type of service
revenues generated, which can vary
32
<PAGE>
from period to period and result in varying levels of gross margin. While
product gross profit also increased for both INX and Valerent for the fiscal
year ended December 31, 2003, as compared to the fiscal year ended December 31,
2002, the levels of gross margin have also varied, although to a lesser extent,
between quarters based on the type of product sold and the mix of large revenue
product contracts, which typically have a lower gross margin, as compared with
smaller revenue product contracts, which typically have a higher gross margin.
Our third quarter 2003 gross margin improved in comparison to both the
prior quarter and the third quarter of 2002. The improved gross margin was the
result of higher service revenue from INX, INX vendor incentives and revenue
growth in Stratasoft, which produces our highest gross margin. Our fourth
quarter 2003 gross margin declined in comparison to the third quarter but
improved in comparison to the fourth quarter of 2002. The decline in gross
profit in comparison to the third quarter resulted from smaller vendor
incentives and lower revenue in Stratasoft offset by an increase in the
percentage of revenue from higher profit margin services.
In the third quarter of 2003 our selling, general and administrative
expenses increased as compared to previous quarters due to increases in sales
commissions resulting from higher revenue and gross profit and unanticipated
increases in bad-debt and settlement of litigation. Our selling, general and
administrative expenses decreased substantially as compared to the third quarter
primarily because of decreased expenses from lower sales commissions related to
the decreased level of sales and gross profits during the quarter, lower
bad-debt expense and lower legal expense as compared to the third quarter 2003.
CRITICAL ACCOUNTING POLICIES
REVENUE RECOGNITION
We have a number of different revenue sources, which vary among our three
reportable segments. Each reportable segment has more than one revenue source,
and revenue is recognized differently for each component (or "stream") of
revenue earned by a segment. The material revenue streams earned by us, some of
which are earned by more than one segment, and some by only one segment, are:
Products Revenue. All three of our operating segments earn revenue
from product shipments. Product shipment revenue occurs when products
manufactured by other parties are purchased and resold to a customer and
such products are contracted for independently of material services. We
recognize revenue from product shipments when there are binding contracts
or purchase orders, the price is fixed or determinable, the product is
shipped or delivered to the customer and collectibility is reasonably
assured.
Services Revenue. All of our operating segments earn revenue from
providing stand-alone service revenue. This revenue consists of billings
for engineering and technician time, programming services, which are
provided on either an hourly basis or a flat-fee basis, and the service
component of maintenance and repair service ticket transactions. These
services are contracted for separately from any product sale, and are
recognized when the service is performed and when collection is reasonably
assured. Two of our segments sometimes earn agency fee revenue from various
sources, the primary source of which is referring customers to other
organizations for which an agency fee is received. Revenue is recognized at
the earlier of when payment is received or when notification of amounts
being due is received from the entity paying such agency fee and
collectibility is reasonably assured.
Certain fixed and flat fee contracts that extend over three months or
more are accounted for on the percentage of completion method of
accounting. The percentage of revenue recognized in any particular period
is determined on the basis of the relationship of the actual hours worked
to estimated total hours to complete the contract. Revisions of the
estimated hours to complete are reflected in the period in which the facts
necessitating the revisions become known. When a contract indicates a loss,
a provision is made for the total anticipated loss.
Custom Project Revenue. Stratasoft earns revenue from projects that
are recognized using the percentage of completion method of accounting for
such revenue. The majority of Stratasoft's revenue
33
<PAGE>
consists of systems sales in which it bundles its proprietary software,
along with third-party hardware products and related software customization
services, installation, training services, warranty services and incidental
post contract services ("PCS") together under a single contract with the
customer. PCS is insignificant on such contracts for one year or less, and
therefore, we have determined that the value of such PCS should not be
unbundled from the project revenue as set forth in paragraph 59 of SOP
97-2. Accordingly, PCS revenue is recognized together with the project
revenue, and the estimated cost to provide the PCS is accrued. The software
customization, together with the hardware customization and integration,
represent a significant modification, customization and/or production of
the product and therefore the entire arrangement is required to be
accounted for using the percentage-of-completion method of accounting
pursuant to SOP 81-1. The percentage of revenue recognized in any
particular period is determined principally on the basis of the
relationship of the cost of work performed on the contract to estimated
total costs. The percentage-of-completion method relies on estimates of
total expected contract revenue and costs. We follow this method since
reasonably dependable estimates of the revenue and costs applicable to
various stages of a contract can be made. Revisions of estimates are
reflected in the period in which the facts necessitating the revisions
become known. When a contract indicates a loss, a provision is made for the
total anticipated loss.
We have risk to the extent that this group of customers has not paid
or issued contractual letters of credit up to the level of cost and
earnings recognized. On our projects in South Asia we typically require a
cash payment or letter of credit from the customer prior to shipping the
product. Additionally, Stratasoft has had revenue derived from Africa, the
United Kingdom, and Canada.
We maintain allowances for doubtful accounts and notes receivable for
estimated losses resulting from the inability of our customers to make required
payments. If the financial condition of our customers were to deteriorate,
resulting in an impairment of their ability to make payments, additional
allowances may be required.
CREDIT AND COLLECTIONS POLICY
Inherent in our revenue recognition policy is the determination of the
collectibility of amounts due from our customers, which requires us to use
estimates and exercise judgment. We routinely monitor our customer's payment
history and current credit worthiness to determine that collectibility is
reasonably assured and, then in some instances, require letters of credit in
support of contracted amounts. This requires us to make frequent judgments and
estimates in order to determine the appropriate period to recognize a sale to a
customer and the amount of valuation allowances required for doubtful accounts.
We record provisions for doubtful accounts when it becomes evident that the
customer will not be able to make the required payments either at contractual
due dates or in the future. Changes in the financial condition of our customers,
either adverse or positive, could impact the amount and timing of any additional
provision for doubtful accounts that may be required.
LIQUIDITY AND CAPITAL RESOURCES
SOURCES OF LIQUIDITY
Our principal sources of liquidity are collections from our accounts and
notes receivable, and our Textron Facility. We use the Textron Facility to
finance the majority of our purchases of inventory. In 2003, we experienced
negative cash flow from operating activities of $2.5 million. Our working
capital was $5.5 million and $3.7 million at December 31, 2002 and 2003,
respectively.
Accounts and Notes Receivable. The timing of our collection of accounts
and notes receivable and payments of our accounts payable is one of the
principal influences on our cash flow from operations. We typically sell our
products and services on short-term credit terms. We try to minimize our credit
risk by performing credit checks, obtaining letters of credit in certain
instances, and conducting our own collection efforts.
34
<PAGE>
We had accounts receivable, net of allowance for doubtful accounts, of $6.5
million and $9.8 million at December 31, 2002 and 2003, respectively.
Our Stratasoft subsidiary has accepted customer notes receivable as part of
its consideration for certain of its custom projects sales. At December 31, 2002
and December 31, 2003, Stratasoft had net notes receivable of $962,000 and
$928,000, respectively. The current portion of those notes receivable is
reflected on our balance sheets as current portion of notes receivable, net, and
the long-term portion of the notes receivable is reflected on our balance sheets
as Other assets. The following table shows the breakdown of the total notes
receivable:
<Table>
<Caption>
DECEMBER 31,
---------------
2002 2003
------ ------
(DOLLARS IN
THOUSANDS)
<S> <C> <C>
Current portion of notes receivable, gross.................. $1,236 $1,049
Allowance for doubtful notes................................ (338) (373)
------ ------
Current portion of notes receivable, net.................... 898 676
------ ------
Long term portion of notes receivable, gross................ 87 502
Allowance for doubtful notes................................ (23) (250)
------ ------
Long-term portion of notes receivable, net.................. 64 252
------ ------
Total notes receivable, net................................. $ 962 $ 928
====== ======
</Table>
Alternatively, our Stratasoft subsidiary also has other sales that require
payment to occur more than 90 days but less than 12 months from the date of the
sale. Those outstanding balances are classified as accounts receivable on the
accompanying balance sheets.
Inventory. We had inventory of $781,000 and $1.0 million at December 31,
2002 and 2003, respectively. We try to minimize the amount of inventory on hand
to reduce the risk that the inventory will become obsolete or decline in value.
We are able to do this by relying on the ready availability of products from our
principal suppliers. As noted above, we rely principally on our Textron Facility
to finance our inventory purchases.
Textron Facility. On January 31, 2002, we entered into the Textron
Facility to provide financing for our inventory purchases. As of December 31,
2003, we owed $7.6 million under the Textron Facility and had an additional $2.4
million available. The Textron Facility is collateralized by substantially all
of our assets other than our patent licenses.
In November 2003, Textron agreed to increase the Textron Facility from $7.5
million to $10.0 million. Textron also agreed to increase the facility to $15.0
million subject to the execution of syndication loan documents and an activation
of syndication for $5.0 million with Silicon Valley Bank. In February 2004, the
syndication loan documents were executed and the credit line was increased in
March 2004, to the lesser of $15.0 million or the amount of our borrowing base
under the Textron Facility. The borrowing base amount under the Textron Facility
is generally the sum of 80% of eligible accounts receivable (the "Accounts
Advance Amount") plus the lesser of: (a) 90% of eligible inventory purchased by
us from manufacturers with whom Textron has acceptable repurchase agreements,
plus 40% of other eligible inventory; (b) $4,000,000; or (c) 30% of the Accounts
Advance Amount. An account receivable will not qualify as an eligible accounts
receivable if, among other things, it is not paid within 90 days after our
invoice date, the customer has failed to pay more than 25% of all accounts
receivable owed by the customer to us within 90 days after our invoice date, or
to the extent that the customer's total accounts receivable exceed 15% of all
our eligible accounts receivable.
We use the Textron Facility to finance purchases of Cisco products from
Cisco and from certain wholesale distributors. Cisco provides 60-day terms, and
other wholesale distributors typically provide 30-day terms. Balances under the
Textron Facility that are within those respective 60-day and 30-day
35
<PAGE>
periods (the "Free Finance Period") do not accrue interest and are classified as
accounts payable in our balance sheet. We refer to non-interest bearing balances
as "inventory floor plan borrowings."
To the extent that we can borrow under the Textron Facility, it gives us
the ability to extend the payment terms past the Free Finance Period. Amounts
extended past the Free Finance Period accrue interest and are classified as
notes payable on our balance sheet. These extended payment balances under the
Textron Facility accrue interest at the prime rate (4.0% at December 31, 2003)
plus 2.5% per annum for the first 60 days after the applicable Free Finance
Period, and at the prime rate plus 6.0% per annum thereafter, which is the
default interest rate under the Textron Facility. Because payment cycles of
sales to school districts under the e-Rate program extend beyond 60 days, we
expect we will continue to carry extended payment balances under the Textron
Facility during 2004. The total outstanding balance under the Textron Facility
at December 31, 2003 was $7.6 million. Approximately $5.9 million of that was
within the Free Finance Period and therefore is reflected as accounts payable on
our balance sheet at December 31, 2003 and approximately $1.7 million consisted
of extended payment balances and therefore is reflected as notes payable on our
balance sheet at December 31, 2003.
The Textron Facility contains restrictive covenants that are measured at
each quarter end. These covenants require us to:
- maintain Minimum Tangible Capital Funds of $2.2 million, which is defined
to be the sum of cash, trade accounts receivable, inventory and fixed net
assets, minus subordinated liabilities minus total liabilities, with
total liabilities being defined as accounts payable, accrued expenses and
short- and long-term notes payable; and
- maintain a maximum Debt to Tangible Capital Funds ratio of 6.0 to 1.
Additionally, effective at March 31, 2004, we must be able to achieve a
fixed charge coverage ratio of no less than 1.1 to 1.0, the fixed charge
coverage ratio being defined as (a) quarterly net income plus interest expense,
taxes, and lease and rental expense divided by (b) the sum of (1) quarterly
interest expense and lease and rental expense, and (2) quarterly current
maturities of long-term debt divided by 1 minus the current tax rate.
At December 31, 2003, we were in compliance with these loan covenants.
During previous quarters we have not always been able to comply with the
quarterly loan covenants and have had to seek, and have obtained, waivers from
Textron. We may violate the loan covenants in future quarters, and may be
required to seek waivers from Textron and Silicon Valley Bank for those
non-compliance events. There can be no assurance that we will be able to obtain
waivers from Textron and Silicon Valley Bank. If Textron or Silicon Valley Bank
refused to give us waivers, the amount due under the Textron Facility could be
accelerated and we could be required to seek other sources of financing.
36
<PAGE>
CONTRACTUAL OBLIGATIONS
The following table summarizes certain of our contractual cash obligations
and related payments due as of December 31, 2003:
<Table>
<Caption>
PAYMENTS DUE BY PERIOD
----------------------------------------------------
LESS THAN AFTER
CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS 5 YEARS
----------------------- ------ --------- --------- --------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Lease obligations(1).................. $1,865 $ 641 $1,224 $ -- $ --
Textron, interest bearing debt........ 1,688 1,688 -- -- --
Other debt obligations................ 325 96 229 -- --
------ ------ ------ ----- -----
Total contractual cash obligations.... $3,878 $2,425 $1,453 $ -- $ --
====== ====== ====== ===== =====
</Table>
---------------
(1) Subsequent to December 31, 2003, we entered into a lease agreement for new
office facilities in the Dallas, Texas area. Had this new lease been
included in the lease obligations above, our lease obligations would have
been $3,098, $641, $1,586, $496, and $375, respectively.
We do not have any material contractual purchase obligations. We purchase
inventory to fulfill in-hand orders from customers and we try to minimize the
amount of inventory on hand to reduce risk that the inventory will become
obsolete or decline in value. We are able to do this by relying on the ready
availability of products from our principal suppliers.
We expect to be able to meet our contractual cash payment obligations by
their due dates through cash generated from operations, augmented, if needed, by
borrowings under the Textron Facility, and through the proceeds from this
offering.
Cash Flows. During 2003, our cash decreased by $1.3 million. Operating
activities used $2.5 million, investing activities used $885,000 and financing
activities provided $2.0 million.
Operating Activities. Operating activities used $2.5 million in 2003 as
compared to providing cash of $809,000 in 2002 and using cash of $4.5 million in
2001. The use of cash in 2003 was primarily related to the net loss of $1.8
million. Adjustments to the net loss for non-cash-related items for 2003
included $764,000 for depreciation and amortization and a $210,000 gain on
disposal of discontinued operations, net of tax, due to collection of
discontinued receivables previously reserved against as uncollectable.
Adjustments to the net loss for non-cash expenses in 2003 included bad-debt
expense of $769,000, which is attributable to allowances for uncollectable
receivables.
Changes in asset and liability accounts used $1.7 million. The most
significant use related to an increase in accounts receivable of $3.7 million,
which was related primarily to increased revenue. Days sales outstanding stayed
consistent at 57 days for both years. Net working capital used for contracts in
progress increased $556,000 due to an increase in cost and estimated earnings in
excess of billings of $743,000, which was primarily related to an increase in
the Stratasoft custom projects in process at year-end. In addition, notes
receivable increased $287,000 due to more notes receivables being accepted from
Stratasoft customers, particularly in the first half of 2003. These uses of cash
were partially offset by an increase in accounts payable of $1.7 million, which
related primarily to increased purchases of Cisco products for sales by our INX
subsidiary, an increase in accrued expenses of $556,000, primarily due to
increases in sales commissions and other payroll costs of $560,000 due to
increased levels of revenue, a decrease in income tax receivable of $488,000
related to collection of an income tax refund in 2003, and an increase of
$475,000 in deferred revenue related to a sale of software to resellers.
Investing Activities. Investing activities used $885,000 in 2003 compared
to a use of $347,000 for 2002 and a use of $206,000 for 2001. Our investing
activities related to capital expenditures in all three years were primarily
related to purchases of computer equipment and software, and to a lesser degree,
leasehold improvements. Investing activities related to cash paid for
acquisitions increased in 2003 due to the acquisition of Digital Precision by
INX. During the next 12 months, we do not expect to incur
37
<PAGE>
significant capital expenditures requiring cash, except possibly for
acquisitions, of which we cannot predict the certainty or magnitude.
Financing Activities. Financing activities provided $2.0 million in 2003
as compared to using $405,000 and $253,000, respectively, in 2002 and 2001. In
2003, our stock price increased substantially, resulting in stock option holders
exercising stock options, which provided $478,000. No options were exercised
during the previous two years. During December 2003, $1.7 million of debt under
the Textron Facility became interest-bearing debt and was classified as notes
payable rather than accounts payable.
FUTURE TRENDS
We expect revenue to continue to increase through 2004 for our three
subsidiaries. We expect INX will grow the most, but that INX's growth rate for
2004 will be less than its growth rate for 2003. We expect Cisco-centric systems
will continue to gain market share, and we expect our revenue growth in 2004
will be primarily the result of prior investments in increased sales and
marketing programs. If we are successful at raising additional equity capital
early in 2004, we also anticipate making one or more acquisitions in the latter
half of 2004, which we expect would add revenue growth.
For 2004 we expect our business to be positively impacted by a slight
improvement in the somewhat depressed general market conditions that we
experienced in 2003, particularly during the first half of 2003, which we expect
will result from an upswing in the cyclical buying patterns of customers for
technology products as well as the situation in Iraq, which we believe depressed
activity in the first half of 2003.
If we are successful in increasing our revenues, we expect that the rate of
growth in selling, general and administrative expenses will generally be less
than that of revenues. This is because, as discussed above, our selling, general
and administrative expenses include some categories of expenses that are
relatively fixed in nature and we therefore expect that those types of expenses
will not grow at the same rate as revenues.
We have experienced no material impact of inflation and changing prices on
net sales and income from continuing operations in the last three years.
RELATED PARTY TRANSACTIONS
We lease office space from Allstar Equities, Inc., a Texas corporation
("Equities"), a company wholly owned by James H. Long, our Chairman and Chief
Executive Officer. On December 1, 1999 Equities purchased our corporate office
building and executed a direct lease with us with an expiration date of December
31, 2004. In conjunction with Equities obtaining new financing on the building,
a new lease was executed with us on February 1, 2002 with an expiration date of
January 31, 2007. The new lease has a rental rate of $37,192 per month.
From time to time, we make short-term loans and travel advances to our
non-executive employees. The balance of approximately $16,000 relating to these
loans and advances is included on our balance sheet and reported as part of
Accounts receivable -- affiliates at December 31, 2003.
OFF-BALANCE SHEET ARRANGEMENTS
We had no off-balance sheet arrangements at December 31, 2003.
ACCOUNTING PRONOUNCEMENTS
In April 2002, the Financial Accounting Standards Board, which we refer to
as "FASB," issued Statement of Financial Accounting Standards ("SFAS") No. 145,
"Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections." SFAS No. 145, among other things, amends
SFAS No. 4 and SFAS No. 64 to require that gains and losses from the
extinguishments of debt generally be classified within continuing operations.
The provisions of SFAS No. 145 are effective for fiscal years beginning after
May 15, 2002 and early application is
38
<PAGE>
encouraged. We adopted SFAS No. 145 on January 1, 2003. The adoption of this
statement had no impact on our financial statements.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 replaces Emerging
Issues Task Force ("EITF") Issue 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity." This
standard requires companies to recognize costs associated with exit or disposal
activities when they are incurred rather than at the date of a commitment to an
exit or disposal plan. We adopted SFAS No. 146 on January 1, 2003. The adoption
of this statement had no impact on our financial statements.
In February 2003, the FASB issued SFAS No. 148, "Accounting for Stock Based
Compensation: Transition and Disclosure -- An Amendment of FASB Statement No.
123." SFAS No. 148 amends SFAS No. 123 to provide alternative methods of
transition for an entity that voluntarily changes to the fair-value-based method
of accounting for stock-based employee compensation. It also amends the
disclosure provisions of that statement to require prominent disclosure about
the effects on reported net income of an entity's accounting policy decisions
with respect to stock-based compensation. The statement also amends APB Opinion
No. 28, "Interim Financial Reporting," to require disclosure about those effects
in interim financial information. We have chosen not to voluntarily change to
the fair value based methods of accounting for stock-based employee
compensation, but we have adopted the disclosure rules of SFAS No. 148.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies when a derivative contains a financing component that warrants special
reporting in the statement of cash flows and amends certain other existing
pronouncements, resulting in more consistent reporting of contracts that are
derivatives in their entirety or that contain embedded derivatives that warrant
separate accounting. SFAS No. 149 is effective for contracts entered into or
modified after June 30, 2003. We do not believe that the adoption of SFAS No.
149 will have a material impact on our financial statements.
In January 2003, the FASB issued FASB Interpretation 46 ("FIN 46"),
"Consolidation of Variable Interest Entities -- An Interpretation of ARB No.
51." FIN 46 addresses consolidation by business enterprises of variable interest
entities. This interpretation applies immediately to variable interest entities
created after January 31, 2003, and to variable interest entities in which an
enterprise obtains an interest after that date. It applies in the first fiscal
year or interim period beginning after June 15, 2003, to variable interest
entities in which an enterprise holds a variable interest that it acquired
before February 1, 2003. On December 17, 2003, the FASB issued FIN 46R,
providing a deferral of the application of FIN 46 for interests held by public
entities in a variable interest entity or potential variable interest entity
until fiscal periods ending after March 15, 2004. We have not fully assessed the
impact of FIN 46 on our financial statements, particularly our relationship with
Allstar Equities, Inc., but the adoption of this statement is not expected to
have a material impact on our financial statements.
In November 2002, the EITF reached a consensus on EITF Issue 00-21,
"Revenue Arrangements with Multiple Deliverables." EITF 00-21 addresses certain
aspects of the accounting by a vendor for arrangements under which it will
perform multiple revenue-generating activities. EITF Issue 00-21 is effective
for revenue arrangements entered into in fiscal periods beginning after June 15,
2003. The adoption of EITF 00-21 did not have a material impact on our financial
statements.
In August 2003, the EITF reached a consensus on EITF 03-05, "Applicability
of AICPA Statement of Position 97-2 to Non-Software Deliverables in an
Arrangement Containing More-Than-Incidental Software." EITF 03-05 requires
revenue recognition under SOP 97-2 for all arrangements in which the software
sold is essential to the functionality of the hardware. The adoption of the EITF
03-05 had no impact on our financial statements.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We attempt to manage our borrowings under the Textron Facility to minimize
interest expense. The non-default interest rate of the Textron Facility is the
prime rate plus 2.5% (see "-- Liquidity and Capital
39
<PAGE>
Resources"). During the year ended December 31, 2003, the interest rates of
borrowings under the Textron Facility ranged from 6.5% to 10.3%. A 1% change in
variable interest rates will not have a material impact on our financial
condition.
CONTROLS AND PROCEDURES
Grant Thornton LLP ("Grant Thornton"), our independent accountants, has
identified and reported to the audit committee of our board of directors certain
internal control deficiencies that Grant Thornton considers to be significant
deficiencies under the standards established by the American Institute of
Certified Public Accountants and the SEC. The identified internal control
deficiencies relate to:
- a material weakness involving contemporaneous documentation of all terms
related to revenue transactions and conclusions regarding customer
creditworthiness; and
- a significant deficiency with respect to the review of significant
agreements by our accounting personnel in order to monitor compliance
with their terms.
We have initiated corrective actions to address these internal control
deficiencies, by implementing the following measures:
- established improved procedures for the review of revenue recognition
policies and contract management policies and procedures;
- held formalized training of finance and sales staff; and
- hired an additional person in our accounting department.
We will consider further actions and continue to evaluate the effectiveness
of our disclosure controls and internal controls and procedures on an ongoing
basis, taking corrective action as appropriate. Our management does not expect
that disclosure controls and procedures or internal controls can prevent all
error and all fraud. A control system, no matter how well conceived and
operated, can provide only reasonable and not absolute assurance that the
objectives of the control system are met. Further, the design of a control
system must reflect the fact that there are resource constraints, and the
benefits of controls must be considered relative to their costs. While our
management believes that its disclosure controls and procedures provide
reasonable assurance that fraud can be detected and prevented, because of the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, have been detected.
40
<PAGE>
BUSINESS
GENERAL
We are a leading regional provider of network infrastructure and IP
telephony solutions including related implementation and support services for
enterprises. The network and IP telephony solutions we offer are
"Cisco-centric," meaning they are based on the products and technology of Cisco
Systems, Inc. These solutions include design, implementation and support of IP
telephony, LAN/WAN routing and switching, virtual private networks, voice over
IP, network security, and wireless networks. Because of our substantial
experience and technical expertise in the design, implementation and support of
IP telephony solutions, we believe we are well-positioned to take advantage of
what we believe to be the growing trend of implementation by enterprises of IP
telephony in general and, in particular, the pure, packet-switched IP telephony
solutions of Cisco. We also develop and market our own computer telephony
integration software and provide remote information technology services. Our
operations are managed from offices in Houston, Dallas and Austin, Texas. Our
long term goal is to become one of the leading national providers of
Cisco-centric networks and IP telephony solutions for enterprises.
I-Sector Corporation is a holding company, and we operate each of our three
business segments through separate subsidiaries. We sometimes refer to our
business segments by referring to the name of the subsidiary that operates that
business segment. We operate our IP telephony and network infrastructure
business through INX. Our computer telephony business is conducted through
Stratasoft. Our remote information technology management business is operated by
Valerent.
Each of our three business segments derives revenues from sales of both
products and services. As a percentage of revenue, our largest business segment
is INX, our IP telephony and network infrastructure business. INX provided
approximately 80% of our revenues in 2003. Computer telephony software provided
by Stratasoft accounted for approximately 12% of our revenues in 2003. The third
and smallest business segment is our remote information technology management
business of Valerent, which provided approximately 8% of our revenues in 2003.
EXISTING AND FUTURE MINORITY INTEREST IN INX
Each of Stratasoft and Valerent is a wholly-owned subsidiary of I-Sector.
In April of 2004, however, INX ceased to be a wholly-owned subsidiary of
I-Sector. This occurred as a result of the acquisition in April 2003 by INX of
the business of Digital Precision. In connection with that acquisition, we
agreed to issue to Digital Precision 1.8 million shares of INX common stock as
additional purchase price for its business if certain employees remained
employed by INX through April 4, 2004, the first anniversary of the acquisition.
That condition was met and we issued the shares of INX common stock in April
2004. Our ownership percentage of INX's common stock is now 92.4%.
We have also granted 8,274,288 stock options to employees of INX to acquire
INX common stock pursuant to a stock option plan for INX employees. The exercise
prices for the INX options range from $0.01 to $0.25 with a weighted average of
$0.16. Additionally, the I-Sector Warrant entitles us to acquire 1.2 million
additional shares of INX common stock, at an exercise price of $0.25 per share.
We estimate that our ownership in INX would be reduced to 69.6%, assuming that
all INX options become exercisable and are exercised, and the I-Sector Warrant
is exercised. If the I-Sector Warrant is not exercised, we estimate that our
ownership in INX would be reduced to 68.4% assuming that all INX options become
exercisable and are exercised.
We do not intend to issue any additional shares of INX common stock to
persons other than I-Sector, except to the holders of presently outstanding INX
options if those options become exercisable and are exercised. We also do not
intend to grant any additional INX options and have amended the INX stock option
plan to so provide. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Existing and Future Minority Interest in
INX."
41
<PAGE>
IP TELEPHONY INDUSTRY BACKGROUND
TERMINOLOGY
IP telephony is a general term for an existing and rapidly expanding
technology that uses Internet Protocol, or "IP," for exchanging voice
communications, faxes, and other types of information that have traditionally
been carried by conventional private, branch exchange ("PBX") telephone systems
used by enterprises and by the public switched telephone network ("PSTN"). The
term IP telephony generally encompasses a narrower term frequently used in our
industry called "VoIP," or voice over Internet Protocol. We refer to VoIP as
including only the exchange of voice communication by means of IP technology,
while we refer to IP telephony as including not only VoIP but also the broader
range of voice and other communications over IP-based networks, and the systems
that enable those communications.
Internet Protocol, or IP, is a set of industry standard procedures that are
used to:
- format large volumes of data into smaller, discrete units or "packets";
- give each packet both the sender's and the recipient's network address;
and
- send those packets over the Internet or through the enterprise's own
network to the recipient's address.
Sometimes the packets are sent by different routes and arrive out of proper
sequence. At their destination, the multiple packets are reassembled into their
correct order by another protocol known as Transmission Control Protocol, or
TCP, to produce a coherent communication.
IP telephony uses "packet-switched" connections, instead of using the
conventional "circuit-switched" connections traditionally employed by PBXs and
PSTNs. Because IP telephony uses packet-switching, multiple users can share the
same path for voice, data and other communications. In contrast, conventional
circuit-switched telephony is carried over a circuit dedicated only to the use
of the specific senders and recipients that are a part of the communication then
in progress.
IP telephony uses network infrastructure, such as a local area network (a
"LAN") or a wide area network (a "WAN"), employing IP technology to either
enhance the telephony functions performed by the enterprise's existing PBX
telephone system or to replace the existing PBX entirely. We refer to IP
telephony systems that incorporate and augment an enterprise's existing PBX as a
"hybrid" system, and to the PBX retained by the enterprise as a "legacy PBX." We
refer to a "pure" or "packet-switched" IP telephony system as one in which
network infrastructure totally supplants the enterprise's existing PBX with a
packet-switched solution.
In addition to offering potential long-term cost savings, implementation of
IP telephony allows enterprises to reap the benefits of participating in a
growing trend in communications technology called "convergence."
CONVERGENCE TREND
We believe the market for enterprise communications is moving from the
"traditional model" to what industry observers sometimes term the "converged
model." IP telephony is expected to be an important part of the trend toward
convergence.
In the traditional enterprise communications model, different types of
communication are conducted by different means:
- data communication is performed using LAN/WAN network infrastructure,
including the Internet;
- telephone/voice communication is carried over traditional
circuit-switched PBX systems and PSTNs; and
- video communications are often accomplished using stand-alone video
conferencing systems using either multiple circuit-switched telephone
lines or network communications.
42
<PAGE>
In contrast, the converged communications model will enable voice, video
and data to be carried by a single, unified IP-based network. IP telephony and
data communication over IP-based network infrastructures is already being used
by many enterprises. We believe that technology to enable video teleconferencing
over IP-based networks is rapidly developing, and that it will become available
for commercial implementation in the near future.
Today, implementation of converged IP telephony and data communications
networks can offer both significant long-term cost savings and increased
productivity to enterprises. Among the potential long-term savings that an
enterprise might experience are:
- elimination of redundant traditional telephone line circuits and cabling
systems as internal voice communications move to the enterprise's
IP-based network cabling system;
- reduced cost resulting from consolidation of PSTN circuits to a central
location so that all external communications to and from the enterprise
occur through fewer or only one point of interface to the PSTN;
- more efficient support of telephone and data functions by a single
support organization rather than multiple service providers and in-house
support departments;
- simplified administration and lower costs for moves, adds and changes of
the telephone system because an IP telephony handset can be moved or
changed within an enterprise without rewiring the PBX or re-programming
the telephone number as is required in a conventional PBX system; and
- elimination or reduction of long distance toll charges as enterprises
operating a converged solution move their internal voice communications
to the fixed-cost data network that often already exists between the
enterprise's remote facilities.
Later, as convergence progresses, we expect it to further improve the
productivity and cost savings of enterprises. We believe that much of these
long-term productivity enhancements and cost savings will come from yet-to-be
created applications designed to take full advantage of convergence technology.
COMPETING IP TELEPHONY SOLUTIONS
We believe there are two primary technologies competing for enterprise IP
telephony market share. One is offered primarily by Cisco, the leading
manufacturer of network routing and switching equipment. Cisco promotes the use
of a network server running its call management software, also called a "soft
switch," which enables its system to perform IP telephony functions without the
use of a PBX. This approach is often referred to as a "packet-switched"
solution. While other manufacturers are moving toward this technology, we
believe that Cisco has established an early competitive advantage in the market
for packet-switched telephony solutions.
The competing technology is promoted by manufacturers of conventional
circuit-switched PBX systems, such as Avaya Inc. and Nortel Networks Corp. These
manufacturers have many customers with traditional circuit-switched PBX
telephone systems. Consequently, their current products generally feature hybrid
IP telephony solutions that promote retaining and upgrading their customers'
legacy PBXs to make them "IP enabled," thus avoiding the immediate obsolescence
of their older PBX telephone systems.
IP telephony is a comparatively new communication technology that we
believe is rapidly gaining acceptance by enterprises. There are, however,
barriers to its immediate acceptance by many enterprises. We believe one of the
most common barriers is the cash expense to an enterprise of upgrading or
replacing existing network infrastructure and legacy PBX systems. A related
concern of some enterprises is the non-cash expense associated with writing off
the undepreciated cost of their legacy PBX system, particularly when substantial
undepreciated costs of that system remain on an enterprise's balance sheet.
Additionally, doubts about the perceived quality of service offered by an
IP-based telephony system are a barrier to some enterprises. In our experience,
these concerns generally focus on features such as audio quality, reliability,
privacy and security.
43
<PAGE>
IP telephony as implemented by most enterprises typically requires upgraded
or new network infrastructure, regardless of whether the enterprise chooses a
hybrid or pure IP telephony solution. Most networks designed solely for data
communications are inadequate to accommodate IP telephony functions featuring
the quality of telephony service demanded by most customers. For example, most
customers demand that voice communications be given priority over data
communication in the allocation of their network's available resources. To do
this, the enterprise's network infrastructure must be able to distinguish
between data communication and voice communication. It must also be capable of
prioritizing and allocating the use of system resources between voice and data
to achieve the enterprise's quality-of-service expectations.
We believe that the many complexities associated with IP telephony networks
require specialized knowledge and skills not generally available to service
providers experienced only in data networks or traditional telephone systems.
The optimal design, implementation and support of IP telephony requires a
service provider that is experienced and proficient in many different
technologies, including data networking, telephony, and various industry
protocols, as well as the software and hardware needed to integrate those
technologies.
OUR IP TELEPHONY AND NETWORK INFRASTRUCTURE BUSINESS
We offer a complete range of products and services for Cisco-centric IP
telephony solutions through our INX subsidiary. Until recently, most IP
telephony solutions work we did involved our customer testing the technology
rather than full-scale implementation of IP telephony. As the market for IP
telephony solutions for enterprises matures from testing to full-scale
deployment, we believe that offering a comprehensive range of products and
services to our customers will be critical in differentiating us from our
competitors. Because services typically provide higher margins than the sale of
products, we plan to emphasize recurring support services in our marketing
strategy.
NETWORK INFRASTRUCTURE PRODUCTS
Our products consist principally of network infrastructure components
manufactured by Cisco, including switching and routing equipment, and related
Cisco software, including Cisco Call Manager IP Telephony Software. We also
offer software products to augment Cisco technology that are available from
vendors other than Cisco, including our own software products.
DESIGN AND IMPLEMENTATION SERVICES
We design and implement Cisco-centric IP telephony solutions. To provide
these services, we employ highly trained network engineering staff, who are
trained and experienced in both large, complex network infrastructure technology
and Cisco IP telephony technology. Our technical and engineering staffs are also
experienced in essential related technology such as network security. We have
developed not only expertise in the area of enterprise IP telephony solutions
and converged communications, but also methodologies for designing and
implementing large, complex, converged communications infrastructures for
enterprises.
During 2001 and 2002, as the move toward IP telephony technology by
enterprises began to develop, the majority of our customer engagements were
limited to the installation of pilot projects in which our customers tested the
technology. These types of projects required long selling cycles, substantial
pre-sale involvement by skilled engineers and significant IP network design and
upgrade services. Our IP telephony implementation services were a comparatively
small component of the total services we provided in these pilot projects
because our customers were implementing only relatively small "test" sites.
These projects were characterized by sporadic service revenue and generally
depressed gross margins for our services. Additionally, our engineering staff
was often not fully utilized between projects. We expect to be able to more
fully employ our engineering staff if we begin to perform more large-scale
implementations as IP telephony gains greater acceptance by enterprises. This
increased demand should improve our service revenue and service margin if we
properly manage these larger installations.
44
<PAGE>
We have installed many trial IP telephony solutions for enterprises, and we
believe that many of these enterprise customers will eventually choose to adopt
a Cisco-centric IP telephony solution for their entire organization. If they do,
we believe we will have a competitive advantage when those customers select a
provider to design and implement their new system.
POST-IMPLEMENTATION SUPPORT SERVICES
In our view, there are two main support models for IP telephony: the
current model used to support traditional PBX systems and the model used to
support computer networks. We believe that neither the traditional PBX telephone
support model nor the existing computer network support model best suits the
needs of customers operating a converged communications infrastructure. We have
created a specialized support model for supporting Cisco-centric converged
communications systems, which we have branded under the Netsurant name. These
services include remote monitoring and management of the customer's IP telephony
and related IP network infrastructure, using specialized toolsets and a network
support center with technical staff who are specifically trained and experienced
in the area of Cisco IP telephony and complex, state-of-the-art IP network
infrastructure. Customers are notified of system problems and we solve the
detected problems either remotely or onsite.
Until recently, when most customers were interested only in testing IP
telephony technology, post-implementation support services were not a high
priority for those customers. But as customers make the decision to fully
implement this relatively new technology, we believe that post-implementation
support will become a higher priority. Additionally, we believe that the quality
of support services is likely to become among the more substantial concerns of
enterprises when they are choosing a service provider. We believe we will be
positioned to provide support services that the customers require.
WHY WE OFFER CISCO-CENTRIC IP TELEPHONY SOLUTIONS EXCLUSIVELY
We offer only Cisco-centric network infrastructure solutions and
Cisco-centric IP telephony solutions. We do this because we believe it enables
us to compete more effectively for large Cisco-centric IP telephony projects.
Our sales force works closely with Cisco's sales organization to identify and
close IP telephony projects. By deliberately refraining from selling products
that are competitive with Cisco's products, we believe our relationship with
Cisco is enhanced, and our sales staff and sales management are more focused and
knowledgeable about the products that we sell.
We believe that most sales of Cisco IP telephony systems are market share
gains by Cisco and the packet-switched IP telephony technology it promotes over
PBX manufacturers and their hybrid solution. This is because Cisco recently
entered the voice communications market and does not have a large traditional
PBX telephone systems customer base to protect against encroachment by
competitors. Because IP telephony systems sold to enterprises will be largely
systems replacing existing traditional PBX telephone systems, the traditional
PBX manufacturers will be seeking to retain their existing customers while each
system sold by Cisco will be a new customer for Cisco at the expense of a
competitor, resulting in market share gains by Cisco.
The majority of the IP-based routing and switching equipment installed
today is manufactured by Cisco. For that reason, we believe Cisco has a
competitive advantage with respect to implementing pure, packet-switched IP
telephony solutions. According to Infotech's April 2003 report on enterprise IP
telephony titled "Enterprise Convergence -- The Race for IP Telephony
Supremacy," Cisco had over a 50% share of the installed IP telephony handsets,
but less than a 2% market share of all enterprise handsets installed, including
traditional circuit-switched systems. Because of this, we believe Cisco has the
potential to gain market share from its competitors as the move toward full
adoption of IP telephony technology by enterprises accelerates. If we are able
to grow to become a national rather than a regional provider of Cisco-centric
network infrastructure, and if, as we expect, Cisco gains market share, we
believe that we will be able to substantially increase our revenues and our
significance to Cisco.
Because the IP telephony and network infrastructure solutions we offer are
based on the IP telephony products and technology of Cisco, it is critical to
our business that we maintain a good working
45
<PAGE>
relationship with Cisco. We believe that because of our focus on Cisco's
products, and our commitment to their strategy, our relationship with Cisco is
excellent. Cisco awarded us its Regional Direct Value Added Reseller for its
Southern Region for 2002, and its Regional Direct Value Added Reseller for the
entire United States for 2003.
We are an authorized reseller of Cisco products and have been awarded its
"Gold" level status, which enables us to obtain the best published pricing
discounts on the Cisco products that we sell, which in turn enables us to be
competitive with other large Cisco product resellers.
GEOGRAPHIC EXPANSION AND ACQUISITIONS
We have grown to be what we believe is the leading regional Cisco-centric
IP telephony solutions provider for Texas, with offices in Houston, Dallas and
Austin, Texas. With full adoption of IP telephony technology by enterprises just
now beginning to occur, we intend to expand nationally, establishing offices in
other major U.S. markets in order to rapidly create a national presence. We
intend to do this, when feasible, by acquiring select Cisco-centric network
infrastructure solutions companies in major markets, and adjusting the focus of
those companies toward the opportunities created by the trend toward full
adoption of IP telephony technology.
OUR COMPUTER TELEPHONY SOFTWARE BUSINESS
EXISTING PRODUCTS
We develop and market computer telephony software through our Stratasoft
subsidiary. This software is used by professional contact centers and other
complex, high volume telephony environments and is marketed under the trade name
"Stratasoft." Our current complete contact center product offering allows our
customers to rapidly customize our software to their business applications. Our
Stratasoft products provide telephony functionality essential to contact center
operations including:
- outbound predictive dialing;
- inbound automatic call distribution;
- call blending between inbound and outbound activity;
- voice mail and auto attendant applications;
- text-to-speech capabilities;
- Web-based text chatting;
- fax on demand;
- interactive voice response; and
- rapid application development.
The open architecture design of our Stratasoft products allows for
integration with the customer's existing systems and software applications, thus
minimizing implementation expenses. Stratasoft's products have been awarded
numerous awards by industry trade journals, including Call Centers Editors
Choice Award for 1998, Call Center Solutions Product of the Year Award for 1998,
Customer Interaction Solutions Product of the Year Award for both 2001 and for
2002, and Communications Solutions Product of the Year Award for 2002. Recently,
Technology Marketing Corporation's TMC Labs presented Stratasoft its Innovation
Award for 2003.
Stratasoft's products are currently being used primarily to operate call
centers internationally, including centers in the United States, Canada, the
United Kingdom, Germany, Greece, India, Egypt, the Philippines and Grenada.
46
<PAGE>
CONVERGENCE SOFTWARE RESEARCH AND DEVELOPMENT
We intend to use our computer telephony software development expertise to
create and market new software products that augment and enhance Cisco-centric
IP telephony solutions. We believe that IP telephony and convergence will create
an environment where there will be an opportunity to create new software
applications to integrate voice, video and data into a customer's business
process and traditional business applications in ways that could not have been
possible before. These software applications are often called "convergence
applications." We believe our extensive experience in developing and marketing
complex computer telephony software applications positions us to take advantage
of this opportunity.
REMOTE INFORMATION TECHNOLOGY MANAGEMENT
Through Valerent we offer a variety of services related to cost reduction
and performance improvement of information technology through Internet-based
remote service and support of that technology. These services include the
following:
- remote end-user and server management;
- data and network management; and
- security and internet services.
CUSTOMERS
We had no single customer that represented 10% or more of our total
continuing revenue during the years ended December 31, 2001, 2002 or 2003. In
2001, however, end-user customers that purchased our Stratasoft software through
a single reseller of our computer telephony software products collectively
represented 10% of our total consolidated revenue in 2001.
IP TELEPHONY AND NETWORK INFRASTRUCTURE
Customers for our Cisco-centric IP telephony and other network solutions
are typically large corporate organizations, schools and governmental agencies
that use large network infrastructures, a majority of which are located in
Texas, or make significant network infrastructure decisions in Texas. They
include private enterprises in various industries such as healthcare, legal,
banking, energy and utilities, hospitality, transportation, manufacturing and
entertainment. In addition to its direct sales model, INX also provides
technical consulting and project management services as a subcontractor for
companies such as EDS, IBM and Sprint. Although our customers are generally
based in Texas, we have performed work at their locations in other parts of the
United States and, on occasion, internationally.
During 2003, we performed an increasing amount of business with educational
and governmental customers, including schools that receive funding for network
infrastructure under a federal program, commonly referred to as the "e-Rate"
program. These customers typically pay more slowly than our commercial
customers, and to the extent a greater portion of our revenue is derived from
these customers, our business cycle and collections cycle are extended and our
working capital requirements are increased, relative to revenue.
COMPUTER TELEPHONY SOFTWARE
Customers for our computer telephony software are typically contact centers
or companies or organizations that operate contact centers, including political
and non-profit organizations. Most of our customers have historically been
located in the United States, but we have increasingly sold and installed call
center systems internationally. In 2001, 2002 and 2003, approximately 42.9%,
28.2% and 42.2%, respectively, of Stratasoft's revenue and 13.2%, 4.4% and 5.1%,
respectively, of our consolidated revenue, were with customers outside the
United States, including customers in India, Egypt, the United Kingdom, Canada,
Japan, Germany, Greece and the Philippines.
47
<PAGE>
We believe that Stratasoft's typical customers may change in the future due
to changes in the contact industry that are occurring as a result of the
"National Do Not Call" legislation. This may occur because the new legislation
created unintended incentives for large companies or organizations that have
large numbers of customers to enter the contact center industry. We believe the
new legislation created these incentives because the new legislation permits
companies to contact their own customers for the purpose of marketing. If this
trend develops as we expect, our typical customer could become a larger
enterprise rather than a smaller contact center business.
REMOTE INFORMATION TECHNOLOGY MANAGEMENT
Customers for our remote information technology management consist
primarily of commercial businesses as well as state and local governmental
organizations, primarily in Houston and Dallas.
SALES AND MARKETING
We market our products and services primarily through sales personnel,
including account managers and customer service representatives. These sales
personnel are partially compensated, and in some cases are solely compensated,
on either the revenue or the profitability of sales that they participate in
developing. In addition, Stratasoft markets its computer telephony software
applications through a network of value added resellers, which often integrate
their products and services with Stratasoft's software products. We also promote
our products and services through general and trade advertising and
participation in trade shows. INX's sales organization works closely with the
Cisco sales organization to identify opportunities for IP telephony and network
infrastructure solutions.
Potential customers for our IP telephony and network infrastructure
business, particularly governmental and educational customers, sometimes specify
that bid and performance bonds must be provided in order to be considered for
the award of their projects, particularly in the case of larger projects. We
have been unable to obtain bid bonds or performance bonds requested by potential
customers in connection with some large potential transactions. In some cases,
we have lost business because of this. In other cases, we were able to obtain
only a smaller portion of the overall project by acting as a subcontractor to a
larger, better financed organization that was able to obtain the necessary
bonding.
Our difficulty in obtaining bonds is caused principally by two factors. The
first is that we have not been financially capable of providing a bonding
company with the necessary collateral to issue bonds on larger projects. We
believe that the proceeds of this offering will partially alleviate, but not
eliminate entirely, this problem, provided that our financial condition does not
deteriorate.
We have also had difficulty establishing a relationship with bonding
companies because we believe there are fewer bonding companies today than there
were in the past and that the current bonding companies prefer to bond only
their larger, existing customers.
SUPPLY AND DISTRIBUTION
We purchase equipment that is sold in conjunction with Stratasoft's
software products and by INX as part of network infrastructure and/or IP
telephony solutions. INX purchases the majority of the Cisco products that it
resells directly from Cisco. We also purchase some of our products through
various distribution channels when product is not available directly from Cisco.
In addition, Valerent and INX purchase or exchange service parts typically with
the product manufacturer or its authorized parts distributor. Also, Stratasoft
sometimes uses resellers to distribute its software products. We attempt to keep
minimal inventory on hand and attempt to purchase inventory only as needed to
fulfill orders.
COMPETITION
The market for communications systems, including network infrastructure, IP
telephony solutions and computer telephony software for contact centers, is
evolving rapidly, highly competitive and subject to rapid technological change.
Many of our competitors are substantially larger than we are and have
48
<PAGE>
significantly greater financial, sales, marketing, technical and other
resources. We expect to face increasing competitive pressures from both current
and future competitors in the markets we serve. Our competition varies by
business segment.
For Cisco-centric IP telephony solutions and network infrastructure
solutions, we compete with large, well established Cisco equipment integrators
and solution providers, including most of the major national and international
solution providers such as EDS, IBM, SBC and others. Our competition for IP
telephony and network infrastructure solutions is highly fragmented, and we
compete with numerous large and small competitors.
With regard to our computer telephony software applications for contact
centers, we compete primarily with manufacturers of specialized contact center
systems, such as Avaya Inc., Concerto Software, Inc., Interactive Intelligence,
Inc., and others. If we are successful in developing other software applications
to augment and enhance Cisco-centric IP telephony solutions, we expect to face
competition from numerous early stage companies focused in this area as well as
many large, well-established software companies and telephone systems
manufacturers.
For our remote managed services business, we compete with numerous large,
well established IT services and support organizations, large IT equipment
manufacturers, and numerous smaller IT services and support organizations.
We believe that the principal competitive factor in all segments of our
business is price. Other important factors include technical competence, the
perception of the customer regarding our financial and operational ability to
manage a project, and the quality of our relationship with Cisco. In our
computer telephony software business, the array of features offered by our
software products as compared to those of our competitors is also an important
competitive factor. Additionally, the IP telephony products we offer compete
with hybrid systems.
MANAGEMENT INFORMATION SYSTEMS
We use an internally developed, highly customized management information
system ("MIS") to manage most aspects of our business. All of our subsidiaries
use our MIS, which is customized to their specific needs. We use our MIS to
manage accounts payable, accounts receivable and collections, general ledger,
sales order processing, purchasing, service contracts, service calls and work
orders, engineer and technician scheduling and time tracking, service parts
acquisition and manufacturer warranties, and project management. Reporting can
be generated for project profitability, contract and customer analysis, parts
and inventory tracking and employee time tracking. The system provides for
separate company accounting and also for consolidation of all subsidiary company
financial information.
EMPLOYEES
At April 29, 2004 we employed approximately 196 people. Of these,
approximately 55 were employed in sales, marketing and customer service; 92 were
employed in engineering and technical positions; and 49 were employed in
administration, finance and MIS. Our management, sales management and sales
staff work closely with Cisco representatives to plan and execute sales and
marketing strategies. We believe that our ability to recruit and retain highly
skilled and experienced technical, sales and management personnel has been, and
will continue to be, critical to our ability to execute our business plans. None
of our employees are represented by a labor union nor are any subject to a
collective bargaining agreement. We believe that our relations with our
employees are good.
HISTORY
We started business as a computer reseller and service provider in 1983. We
added a traditional PBX telephone systems business unit in 1994 and founded
Stratasoft in 1995. We conducted an initial public offering and became a public
company in 1997. By 1999, we had grown to over $200 million in revenue,
operating from five offices in Texas, with over 500 employees.
49
<PAGE>
In 2000, we sold both our computer products reselling business and our
traditional PBX telephone systems business, which together accounted for
approximately 90% of our total revenue at that time, and repositioned our
company to take advantage of what we then believed would become a significant
opportunity in the area of converged communications using network
infrastructure. We closed the sale of these two business units by mid-2000 and
started the process of building our current Cisco-centric network infrastructure
solutions organization with a significant focus on IP telephony technology in
the enterprise market.
GENERAL INFORMATION
Our corporate headquarters are located at 6401 Southwest Freeway, Houston,
Texas 77074, and our telephone number is (713) 795-2000. Our annual report on
Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K and
all amendments to those reports are available without charge from us on our
website at http://www.I-Sector.com, as soon as reasonably practicable following
the time they are filed with or furnished to the SEC. Information on our website
is not part of this prospectus.
MANAGEMENT
The following table sets forth the names and ages, as of April 29, 2004, of
directors and executive officers:
<Table>
<Caption>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
James H. Long......... 45 Chairman of the Board, Chief Executive Officer and
Chief Financial Officer
John B. Cartwright.... 57 Director
Donald R. Chadwick.... 60 Director
Kevin M. Klausmeyer... 45 Director
Mark T. Hilz.......... 45 President and Chief Operating Officer, and President
of Internetwork Experts, Inc.
William R. Hennessy... 45 President, Stratasoft, Inc.
Frank Cano............ 40 President, Valerent, Inc.
Paul Klotz............ 42 Vice President, Internetwork Experts, Inc.
Jeffrey A. 49 Controller and Secretary
Sylvester...........
Timothy J. Grothues... 55 Treasurer
</Table>
DIRECTORS
James H. Long is our founder and has served as a member of our board of
directors, our Chairman of the Board and Chief Executive Officer since our
inception in 1983. Mr. Long also served as our president through December of
2003. Prior to founding I-Sector, Mr. Long served with the United States Navy in
a technical position and was then employed by IBM in a technical position.
Donald R. Chadwick has served as a member of our board of directors since
September 1996. He served as Secretary from February 1992 to August 2002 and
served as our Chief Financial Officer from February 1992 until December 1999. As
Chief Financial Officer, his duties included supervision of finance, accounting
and controller functions.
Kevin M. Klausmeyer has served as a member of our board of directors since
August 2001. He is currently the Chief Financial Officer of RLX Technologies, a
company that invented and manufactured the blade server and has evolved into a
full modular computing company. Mr. Klausmeyer is also currently on the board of
Quest Software, Inc., an independent software vendor. Mr. Klausmeyer was
previously the Chief Financial Officer of PentaSafe Security Technologies, Inc.,
a security software company and provider of complete security policy and
infrastructure solutions, from December 1, 1999 through 2002. From 1993 to
November 1999, Mr. Klausmeyer was Vice President and Chief Accounting Officer of
BMC
50
<PAGE>
Software, Inc., a publicly-held distributor of computer software. Mr. Klausmeyer
is one of three software finance executives, who, together with representatives
from the big four accounting firms, serve on the AICPA's Software Revenue
Recognition Task Force, which interprets and provides guidance to the software
industry on U.S. authoritative software revenue accounting rules. Mr. Klausmeyer
spent 13 years at Arthur Andersen LLP in the audit and business consulting
practice, with a primary focus in assisting high technology companies.
John B. Cartwright has served as a member of our board of directors since
August 2001. He has been the owner of John B. Cartwright & Associates, a
Certified Public Accounting firm, since 1990. From 1973 to 1990, Mr. Cartwright
was the managing partner or managing shareholder of Cartwright, Matthews,
Gonsoulin & Bradley, PC, and its predecessors. From 1969 to 1973 Mr. Cartwright
was an Audit Supervisor at Touche Ross & Co., (now Deloitte & Touche LLP) in
Houston. Mr. Cartwright is a member of the American Institute of Certified
Public Accountants, Texas Society of Certified Public Accountants, Houston
Chapter of the Texas Society of Certified Public Accountants, and the past
President of the Houston Chapter of the Community Associations Institute.
COMMITTEES OF THE BOARD OF DIRECTORS
The Board has no nominating committee or any committee performing similar
functions. All of the members of the Board participate in the consideration of
nominations for the election of directors. The Board has two standing
committees, which are an audit committee and a compensation committee.
Audit Committee. The audit committee is currently composed of Messrs.
Chadwick, Cartwright and Klausmeyer. The Board has determined that Mr.
Klausmeyer is qualified as an audit committee financial expert within the
meaning of SEC regulations and has accounting and related financial management
expertise within the meaning of the listing standards of the American Stock
Exchange. The functions of the audit committee are set forth in a written
charter adopted by the Board and include:
1. reviewing the accounting principles and practices we employ;
2. meeting with our independent accountants to review their report on their
annual examination of our accounts, their comments on our internal
controls and the actions taken by management in response to such
comments; and
3. recommending annually to the Board the appointment of our independent
accountants.
Compensation Committee. The compensation committee is currently composed
of Messrs. Chadwick, Klausmeyer and Cartwright. The functions of the
compensation committee include:
1. reviewing and making recommendations regarding the compensation of our
executive officers; and
2. administrating and making awards under our compensation plans.
EXECUTIVE OFFICERS
Our executive officers serve until resignation or removal by the board of
directors. Set forth below is certain information about our executive officers
other than Mr. Long.
Mark T. Hilz was appointed as our President and Chief Operating Officer in
December 2003. Mr. Hilz' responsibilities include management of our operations
and the operations of our subsidiaries, INX, Stratasoft and Valerent. Mr. Hilz
has also served as the President of INX since its founding in July 2000. Mr.
Hilz served as a director of our company from April 1999 until June 2001. From
January 1999 to June 2000, Mr. Hilz was Vice President of Project Development at
Mathews Southwest, LLC, Inc., a real estate investment and development firm
headquartered in Dallas. From 1998 to July 2000, Mr. Hilz was one of our
directors and the Chief Executive Officer of Nichecast, Inc., a privately held
Internet services company.
William R. Hennessy has served as the President of Stratasoft since January
1996. Mr. Hennessy's responsibilities include the general management of the
operations of Stratasoft.
51
<PAGE>
Frank Cano has served as the President of Valerent since November 2002. Mr.
Cano's responsibilities include the general management of the operations of
Valerent. From May 2000 to May 2002, Mr. Cano served as a Division President of
Amherst Southwest, LLP. Prior to that, Mr. Cano held various positions in our
company including serving as the President of our former computer products
division, as our Senior Vice President, Branch Operations and as our Branch
Manager for the Dallas-Fort Worth office. Mr. Cano is the brother-in-law of Mr.
Long.
Jeffrey A. Sylvester was appointed as our Controller in December 2003 and
has responsibility for supervision of our accounting and reporting functions. In
April 2004, he became our Corporate Secretary. From March 2001 until September
2003, Mr. Sylvester was with Balli Klockner, Inc., headquartered in Houston,
Texas, where he served as Chief Financial Officer for the North American
operations. From September 2000 to March 2001, Mr. Sylvester was the Corporate
Controller of Henley Healthcare, Inc., headquartered in Sugar Land, Texas. From
1995 to 2001 Mr. Sylvester served in various accounting and management
positions, including Controller, Regional Controller and Division President for
Master Graphics, Inc. headquartered in Memphis, and its Houston division
Technigrafiks. Mr. Sylvester is a Certified Public Accountant.
Timothy J. Grothues has been our Treasurer since November 2003. From
November 2001 to November 2003, he was our Assistant Controller. His
responsibilities include the treasury and risk management functions. From
January 1998 to November 2001, Mr. Grothues was a private investor. For the
eighteen years prior to that, Mr. Grothues was the Chief Financial Officer of
Blackburn Group, Inc., a privately held industrial construction company
specializing in the petroleum and petrochemical industries.
Paul Klotz has served as the Vice President and Chief Operating Officer of
Internetwork Experts since August 2000. Mr. Klotz' responsibilities include the
operations management of INX. From 1997 to July 2000, Mr. Klotz was the Vice
President of Marketing of PC Service Source.
LIMITATION OF DIRECTORS' LIABILITY AND INDEMNIFICATION
Our certificate of incorporation provides that a director will not be
personally liable to us or to our stockholders for monetary damages for breach
of the fiduciary duty of care as a director, including breaches which constitute
gross negligence. This provision does not eliminate or limit the liability of a
director:
- for breach of his or her duty of loyalty to us or to our stockholders;
- for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
- under Section 174 of the Delaware General Corporation Law (relating to
unlawful payments or dividends or unlawful stock repurchases or
redemptions);
- for any improper benefit; or
- for breaches of a director's responsibilities under the federal
securities laws.
52
<PAGE>
Our certificate of incorporation also provides that we indemnify and hold
harmless each of our directors and officers to the fullest extent authorized by
the Delaware General Corporation Law, against all expense, liability and loss
(including attorney's fees, judgments, fines, ERISA excise taxes or penalties
and amounts paid or to be paid in settlement) reasonably incurred or suffered by
such person in connection therewith.
Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers and controlling persons pursuant to our
certificate of incorporation, bylaws and the Delaware General Corporation Law,
we have been advised that in the opinion of the SEC such indemnification is
against public policy and is, therefore, unenforceable.
EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following table sets forth information about compensation we paid or
awarded for services rendered during the fiscal years ended December 31, 2003,
2002 and 2001 to our (i) Chief Executive Officer and (ii) the three most highly
compensated executive officers who were serving as executive officers at the end
of 2003 and whose total annual salary and bonus exceeded $100,000 (the "Named
Executive Officers").
<Table>
<Caption>
LONG-TERM
COMPENSATION
---------------------
ANNUAL COMPENSATION AWARDS
--------------------------------------------- ---------------------
OTHER ANNUAL SECURITIES UNDERLYING
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS COMPENSATION($)(1) OPTIONS(2)
--------------------------- ---- -------- ------ ------------------ ---------------------
<S> <C> <C> <C> <C> <C>
James H. Long.................. 2003 $121,125 -- -- --
Chairman, Chief Executive 2002 127,690 -- -- --
Officer and Chief Financial 2001 133,315 -- -- --
Officer
Mark T. Hilz................... 2003 200,000 55,120 -- 32,000
President and Chief Operating 2002 185,190 -- -- --
Officer 2001 185,190 -- -- --
William R. Hennessy............ 2003 125,000 19,063 -- 80,000
President, Stratasoft, Inc. 2002 133,167 59,028 -- --
2001 91,162 60,966 -- --
Paul Klotz..................... 2003 150,000 41,370 -- 25,000
Vice President, 2002 144,252 7,500 -- --
Internetwork Experts, Inc. 2001 144,854 -- -- --
</Table>
---------------
(1) Amounts exclude the value of perquisites and personal benefits because the
aggregate amount thereof did not exceed the lesser of $50,000 or 10% of the
Named Executive Officer's total annual salary and bonus.
(2) See "-- INX Stock Options" for information regarding grants of INX options
to the Named Executive Officers.
I-SECTOR STOCK OPTIONS
We have issued stock options to purchase our common stock to our officers,
directors and employees. We have also issued stock options to purchase the
common stock of our subsidiary INX to officers, directors and employees of INX.
The INX stock option plan and the options issued under are discussed below under
the caption "-- INX Stock Options."
Options to purchase shares of our common stock may be granted to executive
officers and other employees under our 1996 Incentive Stock Option Plan (the
"1996 Incentive Plan") and the I-Sector Corp. Incentive Stock Plan (the
"I-Sector Incentive Plan"). As of December 31, 2003, 114,448 shares
53
<PAGE>
were reserved for issuance upon exercise of outstanding options under the 1996
Incentive Plan and 4,170 were reserved and remained available for future grants
pursuant to the I-Sector Incentive Plan. No options under the plans were granted
to officers or other employees during 2001 and 2002. During 2003, options to
purchase 456,760 shares were granted to officers, consultants and other
employees under the Incentive Stock Plan.
Options Granted in Last Fiscal Year. The following table sets forth
information regarding stock options we granted to our Named Executive Officers
during the fiscal year ended December 31, 2003. We did not grant any stock
appreciation rights in the fiscal year ended December 31, 2003.
<Table>
<Caption>
POTENTIAL POTENTIAL
REALIZABLE REALIZABLE
NUMBER OF VALUE AT VALUE AT
SHARES OF PERCENT OF ASSUMED ANNUAL ASSUMED ANNUAL
COMMON TOTAL RATE OF STOCK RATE OF STOCK
STOCK OPTIONS EXERCISE PRICE PRICE
UNDERLYING GRANTED TO OR BASE APPRECIATIONS APPRECIATIONS
OPTIONS EMPLOYEES IN PRICE EXPIRATION FOR OPTION FOR OPTION
NAME GRANTED FISCAL YEAR ($/SHARE) DATE TERM 5%(3) TERM 10%(3)
---- ---------- ------------ --------- ---------- -------------- --------------
<S> <C> <C> <C> <C> <C> <C>
William R. Hennessy(1)........ 50,000 15.4% $2.70 09/08/2013 $219,901 $350,155
William R. Hennessy(1)........ 30,000 9.3% 4.14 10/03/2013 202,309 322,143
Mark T. Hilz(2)............... 32,000 9.9% 4.14 10/03/2013 215,796 343,619
Paul Klotz(2)................. 25,000 7.7% 4.14 10/03/2013 168,591 268,452
</Table>
---------------
(1) 100% of the options vested as of January 1, 2004, but may not be exercised
until six months from the date of grant. The options expire ten years from
the date of grant. Vesting was contingent upon continued employment with us.
The option is not assignable or transferable otherwise than by will or by
the laws of descent and distribution.
(2) Options shall vest cumulatively as follows: 50% of the shares shall vest on
April 3, 2004 and 50% of the shares shall vest on October 3, 2004. Vesting
is contingent upon continued employment with us, or one of our subsidiaries.
The options are exercisable at any time after six months from the date of
grant, but expire ten years from such date. The option is not assignable or
transferable otherwise than by will or by the laws of descent and
distribution.
(3) The dollar amounts under these columns are the result of calculations at the
5% and 10% compounded annual rates set by the Securities and Exchange
Commission, and therefore are not intended to forecast future appreciation,
if any, in the price of the common stock. The potential realizable values
illustrated at the 5% and 10% compounded annual rates of appreciation assume
that the price of the common stock increases $5.89 and $9.37 per share,
respectively, over the 10-year term of the options.
Aggregated Option Exercises and Year-End Option Values. The following
table sets forth information regarding option exercises during the fiscal year
ended December 31, 2003, as well as the number and total of in-the-money options
at December 31, 2003 for each of the Named Executive Officers:
<Table>
<Caption>
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED
OPTIONS AT IN-THE MONEY OPTIONS AT
SHARES DECEMBER 31, 2003 DECEMBER 31, 2003
ACQUIRED ON VALUE --------------------------- ---------------------------
NAME EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ----------- -------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
James H. Long............... -- $ -- 2,400 -- $ 37,632 $ --
William R. Hennessy......... -- -- 68,000 30,000 1,066,240 470,400
Mark T. Hilz................ 15,000 109,050 -- 32,000 -- 501,760
Paul Klotz.................. -- -- -- 25,000 -- 392,000
</Table>
54
<PAGE>
INX STOCK OPTIONS
The Internetwork Experts Incentive Plan (the "INX Plan") was adopted
effective July 1, 2000, when INX was formed. The INX Plan was amended, effective
December 31, 2003, so that no further grants may be made under this plan in the
future. We have determined that because INX is a large portion of our total
business, all future stock-based compensation for INX officers and employees
will be made under I-Sector option plans rather than under the INX Plan.
Under the INX Plan and related option grant agreements, options typically
vest ratably over three to five years. In December 2003, we amended option
agreements with INX's two most senior executives, Mark Hilz and Paul Klotz, to
change the vesting under their INX options to a fixed five-year vesting schedule
from one that was determined based on the percentage of attainment of predefined
financial goals by INX. Liquidity events include: (a) a sale of substantially
all of INX's common stock to a non-related party; (b) a sale of substantially
all of INX's assets; or (c) a sale of all of INX's stock to the general public
in which the general public owns at least 20% of the total outstanding INX
common stock. Any unvested INX stock options may vest immediately upon the
occurrence of a liquidity event. The INX options expire ten years after the
grant date if they are not exercised. The INX stock option grants are subject to
dilution if, and when, we purchase additional shares of INX stock.
As of December 31, 2001, 2002 and 2003 options for 1,388,500, 5,444,499 and
9,490,692 shares, respectively, of INX stock were granted and outstanding under
the INX Plan. The number of shares of INX stock underlying vested INX options
was 3,777,666 shares as of December 31, 2003. On the date of grant, the INX
options had an exercise price equal to or greater than the fair market value of
the underlying INX stock. The exercise price of the INX options ranges from $.01
per share to $0.25 per share. For 2000, 2001, 2002 and 2003, the weighted
average exercise price of the outstanding INX options was $0.07, $0.07, $0.13
and $0.17, respectively. A portion of the options granted under the INX Plan
will become exercisable only upon a liquidity event involving INX, or during a
thirty-day period prior to expiration of the option.
During 2000, 2002 and 2003, options under the INX Plan were granted for
900,000, 4,100,000 and 1,675,000 shares of INX stock, respectively, to Named
Executive Officers. The following table sets forth for each of those years
certain information with respect to the INX options issued to the Named
Executive Officers. INX has not granted any restricted stock or stock
appreciation rights under the INX Plan.
<Table>
<Caption>
POTENTIAL POTENTIAL
NUMBER OF REALIZABLE VALUE REALIZABLE VALUE
SHARES OF PERCENT OF AT ASSUMED AT ASSUMED
COMMON STOCK TOTAL ANNUAL RATE OF ANNUAL RATE OF
UNDERLYING OPTIONS EXERCISE PRICE PRICE
OPTIONS GRANTED TO OR BASE APPRECIATIONS APPRECIATIONS
NAME AND GRANTED IN EMPLOYEES IN PRICE EXPIRATION FOR OPTION FOR OPTION
PRINCIPAL POSITION YEAR YEAR(2) FISCAL YEAR ($/SHARE) DATE TERM 5%(1) TERM 10%(1)
------------------ ---- ------------ ------------ --------- ---------- ---------------- ----------------
<S> <C> <C> <C> <C> <C> <C> <C>
James H. Long,........... 2003 1,200,000 29.7% $0.25 09/01/2013 $488,688 $ 778,123
Chairman, Chief 2002 -- -- -- -- -- --
Executive Officer 2001 -- -- -- -- -- --
and Chief Financial 2000 -- -- -- -- -- --
Office
Mark T. Hilz,............ 2003 300,000 7.4% 0.25 09/01/2013 122,167 194,531
President and Chief 2002 3,400,000 82.5% 0.15 03/01/2012 872,273 1,455,090
Operating Officer 2001 -- -- -- -- -- --
2000 700,000 54.9% 0.01 07/01/2010 11,402 18,156
Paul Klotz,.............. 2003 175,000 4.3% 0.25 11/10/2013 57,011 90,781
Vice President, 2002 700,000 17.0% 0.15 03/01/2012 171,034 272,343
Internetwork 2001 -- -- -- -- -- --
Exports, Inc. 2000 200,000 15.7% 0.01 08/14/2010 3,592 5,992
All Other Employees...... 2003 2,365,192 58.6% 0.20 11/10/2013 770,530 1,226,940
2002 23,000 0.5% 0.20 12/09/2012 7,493 11,931
2001 52,500 100.0% 0.20 11/05/2011 17,103 27,234
2000 375,000 29.4% 0.20 10/30/2010 122,167 194,531
</Table>
(See notes on following page)
55
<PAGE>
---------------
(1) During the quarter ended September 30, 2003, INX granted options to purchase
1,200,000 shares to Mr. Long and 300,000 shares to Mr. Hilz for their
personal limited guarantee of our credit facility. In February 2004, Mr.
Long voluntarily cancelled his 1,200,000 share option in exchange for the
issuance by INX to I-Sector of the I-Sector Warrant for the same number of
shares, at the same exercise price. Mr. Hilz's option grant for 300,000
shares related to the personal limited guarantee is fully vested and may be
exercised at any time after six months from the grant date until expiration.
(2) There is currently no trading market for the common stock of INX. The dollar
amounts under these columns are the result of calculations at the 5% and 10%
compounded annual rates and are not intended to forecast future
appreciation, if any, in the value of the INX common stock. The potential
realizable values illustrated at the 5% and 10% compounded annual rates of
appreciation are based on the exercise price of INX options on their
respective dates of grant, over the 10-year term of the options.
EMPLOYMENT AGREEMENTS
We have entered into employment agreements with each of the Named Executive
Officers (collectively, the "Executive Employment Agreements"). Under the terms
of the respective agreements, Messrs. Long, Hennessy, Hilz and Klotz are
entitled to an annual base salary of $150,000, $125,000, $200,000 and $150,000
respectively, plus other bonuses, the amounts and payment of which are within
the discretion of our compensation committee. Beginning in the quarter ended
June 30, 2001, Messrs. Long, Hilz and Klotz took voluntarily pay reductions as
compared to the base salary set in their respective employment agreements. The
voluntary pay reductions were terminated for Messrs. Hilz and Klotz after
certain financial performance goals were attained. Mr. Long has extended his
voluntary pay reduction through the current pay period. The agreements with
Messrs. Hilz, Cano, Hennessy and Klotz also include special bonus plan
provisions that may be changed or eliminated at our sole discretion. These four
executives each currently have an opportunity to receive two bonuses on a
quarterly basis, which two bonuses are tied to each of gross profits per share
compared to plan and earnings per share compared to plan for the pertinent
subsidiary. The bonus amounts that may be earned range from zero to as much as
70% of their quarterly salary based upon performance attained. These bonus
arrangements may be modified at any time at the sole discretion of our
compensation committee. All Executive Employment Agreements may be terminated by
us or by the officer named therein at any time by giving proper notice. The
Executive Employment Agreements generally provide that the executive officer
will not, for the term of his employment and for a period of either twelve or
eighteen months, whichever the case may be, following the end of such executive
officer's employment with us, compete with us, disclose any of our confidential
information, solicit any of our employees or customers or otherwise interfere
with the our business relations. The non-compete provision with Mr. Long does
not apply if we elect to terminate Mr. Long's employment without cause; except
that, we may elect to continue the non-compete restrictions in that event by
paying Mr. Long a severance amount during the restricted period. The severance
amount payable to Mr. Long is based upon the greater of 75% of his salary at the
time of termination or 75% of his average monthly salary and bonus, calculated
based on his compensation during the 12 months period prior to his termination.
DIRECTORS' COMPENSATION
Our directors who are also officers or employees do not receive any
additional compensation for their services as a director. We pay each
independent director $1,000 for each board meeting attended and $500, except for
the Chairperson of the audit committee who is paid $1,000, for audit committee
meetings attended, along with reasonable out-of-pocket expenses incurred by
independent directors to attend board and committee meetings. Independent
directors are also entitled to receive options pursuant to the Director Plan.
56
<PAGE>
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
SECURITY OWNERSHIP OF CERTAIN MANAGEMENT OF I-SECTOR COMMON STOCK
The following table sets forth, as of April 29, 2004 the number of shares
of common stock owned by each Director, each Named Executive Officer, as defined
in "Executive Compensation," and all directors and executive officers as a
group.
<Table>
<Caption>
NAME OF AMOUNT AND NATURE OF PERCENT
BENEFICIAL OWNER BENEFICIAL OWNERSHIP(1) OF CLASS
---------------- ----------------------- --------
<S> <C> <C>
James H. Long........................................... 1,997,430(2) 49.9%
Donald R. Chadwick...................................... 44,486(3) 1.1%
Kevin Klausmeyer........................................ 11,250(4) *
William R. Hennessy..................................... 85,000(5) 2.1%
John B. Cartwright...................................... 15,200(6) *
All executive officers and directors as a group......... 2,305,290(7) 55.2%
</Table>
---------------
(1) Beneficially owned shares include shares over which the named person
exercises either sole or shared voting power or sole or shared investment
power. It also includes shares the named person has the right to acquire
within 60 days by the exercise of any right or option. Unless otherwise
noted, all shares are owned of record and beneficially by the name person.
(2) Includes 2,400 shares that may be acquired upon exercise of currently
exercisable options.
(3) Includes 12,686 shares which may be acquired upon exercise of currently
exercisable options and 300 shares owned by his minor children for which Mr.
Chadwick disclaims beneficial ownership.
(4) Includes 11,250 shares that may be acquired upon exercise of currently
exercisable options.
(5) Includes 68,000 shares that may be acquired upon exercise of currently
exercisable options and 2,000 shares owned by his children, of which one is
a minor, for which Mr. Hennessy disclaims beneficial ownership.
(6) Includes 15,000 shares which may be acquired upon exercise of currently
exercisable options.
(7) Includes 180,270 shares which may be acquired upon exercise of currently
exercisable options.
SECURITY OWNERSHIP OF CERTAIN MANAGEMENT OF INX COMMON STOCK
Currently, I-Sector owns 92.4% of the issued and outstanding shares of
common stock of INX. The following table sets forth information regarding the
beneficial ownership of the common stock of INX, as of April 29, 2004, by each
Named Executive Officer, as defined in "Executive Compensation," all directors
and executive officers of INX as a group. No officer or director of I-Sector
beneficially owns INX common stock except Mr. Hilz who is an officer of both
I-Sector and INX. Except as otherwise indicated, the persons listed below have
sole voting and investment power with respect to all of shares of common stock
of INX owned by them.
<Table>
<Caption>
NAME OF AMOUNT AND NATURE OF PERCENT
BENEFICIAL OWNER BENEFICIAL OWNERSHIP(1) OF CLASS
---------------- ----------------------- --------
<S> <C> <C>
Mark T. Hilz............................................ 2,080,000(2)(3) 8.1%
Paul Klotz.............................................. 400,000(3)(4) 1.7%
All officers and directors of INX....................... 3,428,000(5) 12.7%
</Table>
---------------
(1) Beneficially owned shares include shares over which the named person
exercises either sole or shared voting power or sole or shared investment
power. Beneficially owned shares also include shares underlying INX options
that have vested at April 29, 2004, and shares underlying INX options that
will become vested within 60 days after April 29, 2004. As described below,
beneficially owned shares also include shares underlying INX options that
are also subject to further conditions on their exercise in addition to
vesting.
57
<PAGE>
(2) Includes 1,400,000 shares that may be acquired upon exercise of currently
vested options. This amount does not include an additional 3,000,000 shares
underlying options which may vest in the future. All such options, except
300,000 vested options, are also subject to the further condition to
exercise described in note (3) below.
(3) In addition to vesting conditions, all such options, whether currently
vested or unvested, may not be exercised unless at least one of the
following events has occurred: (a) the ownership percentage of the
outstanding common stock of I-Sector held by our chairman, James H. Long,
falls below 10%; (b) Mr. Long ceases to be Chairman of the board of
directors of I-Sector; (c) a sale of substantially all of INX's common
stock by its owners to an unrelated person; (d) substantially all of the
assets of INX are sold; (e) a public offering by INX resulting in public
ownership of at least 20% of INX's common stock outstanding after the
offering; or (f) none of the events in (c), (d) or (e) has occurred and
there remains only 30 days or less of the 10-year term of the option.
(4) Includes 260,000 shares that may be acquired upon exercise of currently
vested options. This amount does not include an additional 640,000 shares
underlying options which may vest in the future. All such options, except
58,333 vested options and 116,667 unvested options, are also subject to the
further condition to exercise described in note (3) above.
(5) Includes 2,985,000 shares which may be acquired upon exercise of currently
vested options, assuming the other conditions to the exercise of Mr. Hilz's
and Mr. Klotz's options have been met. This amount does not include an
additional 3,640,000 shares underlying options which may vest in the
future.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The table presented below contains certain information about our equity
compensation plans, as of December 31, 2003, which consists of the 1996
Incentive Plan, the Director Plan and the 2000 I-Sector Incentive Plan. All of
our equity compensation plans have been previously approved by its stockholders.
<Table>
<Caption>
NUMBER OF SECURITIES
REMAINING AVAILABLE
FOR FUTURE ISSUANCE
NUMBER OF SECURITIES WEIGHTED AVERAGE UNDER EQUITY
TO BE ISSUED UPON EXERCISE PRICE OF COMPENSATION PLANS
EXERCISE OF OUTSTANDING (EXCLUDING SECURITIES
OUTSTANDING OPTIONS, OPTIONS, WARRANTS REFLECTED IN
WARRANTS AND RIGHTS AND RIGHTS COLUMN(A))
PLAN CATEGORY(1) (A) (B) (C)
---------------- -------------------- ----------------- ---------------------
<S> <C> <C> <C>
Equity compensation plans approved by
security holders......................... 501,966 $2.85 128,658
Equity compensation plans not approved by
security holders......................... None None None
</Table>
---------------
(1) Does not include the INX Incentive Plan. See "Executive Compensation," and
Notes to Consolidated Financial Statements -- Note 14.
CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
We lease office space from Allstar Equities, Inc. a Texas corporation
("Equities"), which is wholly-owned by James H. Long, our Chairman and Chief
Executive Officer. On December 1, 1999, Equities purchased the building where
our principal office is located and we executed a direct lease with Equities
with an expiration date of December 31, 2004. In conjunction with Equities
obtaining new financing on the building, we executed a new lease with Equities
on February 1, 2002 with an expiration date of January 31, 2007. Under the new
lease, our rental rate was reduced from $37,692 per month to $37,192 per month.
58
<PAGE>
DESCRIPTION OF SECURITIES
GENERAL
I-Sector Corporation is a Delaware corporation. Our authorized capital
stock consists of 20,000,000 shares, consisting of 15,000,000 shares of common
stock, par value $0.01 per share, and 5,000,000 shares of preferred stock, par
value $0.01 per share. We have 3,998,554 shares of common stock outstanding.
After this offering, we will have 4,998,554 shares of common stock outstanding,
or 5,148,554 shares if the over-allotment option is exercised in full.
UNITS
Each unit consists of two shares of common stock and one warrant to
purchase one share of common stock. The warrants will trade only as part of a
unit for 30 days following the date of this prospectus unless the representative
of the underwriters determines that separate trading of the warrants should
occur earlier. At the closing of the offering, we will deliver only certificates
representing the units to the representatives of the underwriters through the
facilities of the Depository Trust Company. Thereafter, investors may request
physical delivery of unit certificates at any time before the warrants begin
trading separately from the common stock included in the units. An investor may
also request delivery of separate physical certificates for the warrants and the
common stock comprising the units, but we will not be obligated to make delivery
of the separate certificates until after the warrants begin trading separately
from the common stock. Until the warrants begin trading separately, investors
will be unable to make separate delivery of certificates for the warrants and
common stock comprising a unit and will be unable to settle trades in those
securities.
COMMON STOCK
The holders of outstanding shares of common stock are entitled to receive
dividends out of legally available assets when and to the extent determined by
our board of directors from time to time. Each stockholder is entitled to one
vote for each share held by him on each matter submitted to a vote of
stockholders. At an election of directors, each director is elected by a
plurality of the voting shares of common stock. The shares of common stock are
not entitled to preemptive rights and are not convertible or redeemable. In the
case of a liquidation, dissolution or other termination of our business, the
holders of common stock are entitled to share ratably in the distribution of all
of our assets remaining available for distribution after all of our liabilities
have been satisfied. Each outstanding share of common stock is, and all shares
of common stock to be outstanding after this offering is completed will be,
fully paid and nonassessable.
PREFERRED STOCK
Our certificate of incorporation provides for the issuance of up to
5,000,000 shares of preferred stock. Our board of directors will have the
authority, without further action by the stockholders, to issue up to 5,000,000
shares of preferred stock in one or more series and to designate the rights,
preferences, privileges and restrictions of each such series. The issuance of
preferred stock could have the effect of restricting dividends on the common
stock, diluting the voting power of the common stock, impairing the liquidation
rights of the common stock or delaying or preventing a change in control without
further action by the stockholders. At present, we have no plans to issue any
shares of preferred stock.
WARRANTS
General. The warrants issued in this offering may be exercised after they
become separately tradable until the expiration date. Each warrant entitles the
holder to purchase one share of common stock at an exercise price of $ per
share [75% of the unit offering price]. This exercise price will be adjusted if
specific events, summarized below, occur. A holder of warrants will not be
deemed a holder of the underlying stock for any purpose until the warrant is
exercised.
59
<PAGE>
Redemption. Beginning six months from the date of this prospectus, we will
have the right to redeem the warrants at a price of $0.25 per warrant, after
providing 30 days prior written notice to the warrantholders, at any time after
the closing price for our common stock, as reported on the principal exchange on
which our stock trades, has been at or above 100% of the unit offering price for
any five consecutive trading days. We will send a written notice of redemption
by first class mail to holders of the warrants at their last known addresses
appearing on the registration records maintained by the transfer agent. No other
form of notice or publication will be required. If we call the warrants for
redemption, the holders of the warrants will then have to decide whether to sell
warrants, exercise them before the close of business on the business day
preceding the specified redemption date or hold them for redemption.
Exercise. The holders of the warrants may exercise them only if an
appropriate registration statement is then in effect. To exercise a warrant, the
holder must deliver to our transfer agent the warrant certificate on or before
the expiration date or the redemption date, as applicable, with the form on the
reverse side of the certificate executed as indicated, accompanied by payment of
the full exercise price for the number of warrants being exercised. Fractional
shares of common stock will not be issued upon exercise of the warrants.
Adjustments of exercise price. The exercise price of the warrants will be
adjusted if we declare stock dividends to stockholders or effect any split or
share combination with regard to our common stock. If we effect a stock split or
stock combination, the exercise price in effect immediately before the stock
split or combination will be proportionately reduced or increased, as the case
may be. Any adjustment of the exercise price will also result in an adjustment
of the number of shares underlying a warrant or, if we elect, an adjustment of
the number of warrants outstanding.
AUTHORIZED BUT UNISSUED SHARES
The authorized but unissued shares of common and preferred stock are
available for future issuance without stockholder approval. These additional
shares may be used for a variety of corporate purposes, including future public
offerings to raise additional capital, corporate acquisitions and employee
benefit plans. The existence of authorized but unissued shares could hinder or
discourage an attempt to obtain control of us by means of a proxy contest,
tender offer, merger or otherwise.
The Delaware General Corporation Law provides generally that the
affirmative vote of a majority of the shares entitled to vote on any matter is
required to amend a corporation's certificate of incorporation or bylaws, unless
the corporation's certificate of incorporation or bylaws, as the case may be,
requires a greater percentage.
CERTAIN ANTI-TAKEOVER PROVISIONS
Our certificate of incorporation and bylaws contain a number of provisions
that could make our acquisition by means of a tender or exchange offer, a proxy
contest or otherwise more difficult. These provisions are summarized below.
Removal of Directors. Our certificate of incorporation provides that our
directors may only be removed for cause and only by the affirmative vote of the
holders of two-thirds or more of the voting power of all of the then outstanding
shares of capital stock entitled to vote generally in the election of directors,
voting together as a single class. For purposes of director removal, cause means
conviction of a felony involving moral turpitude, proof beyond a reasonable
doubt that a director has committed grossly negligent or willful misconduct
resulting in a material detriment or commission of a material breach of
fiduciary duty to the company resulting in a material detriment.
Advance Notice Provisions for Certain Stockholder Actions. Our bylaws
establish an advance notice procedure with regard to the nomination, other than
by or at the direction of the Board or a committee thereof, of candidates for
election as directors and with regard to certain matters to be brought before an
annual meeting of stockholders. The advance notice procedures generally require
that a stockholder give prior written notice, in proper form, to our Secretary,
the requirements as to the form and timing of those
60
<PAGE>
notices are specified in the bylaws. If it is determined that those advance
notice procedures were not complied with, a nomination could be precluded or
certain business may not be conducted at the meeting.
Although our bylaws do not give the Board the power to approve or
disapprove stockholder nominations for the election of directors or of any other
business stockholders desire to conduct at an annual or any other meeting, the
bylaws may have the effect of precluding a nomination for the election of
directors or precluding the conduct of business at a particular annual meeting
if the proper procedures are not followed, or discouraging or deterring a third
party from conducting a solicitation of proxies to elect its own slate of
directors or otherwise attempting to obtain control, even if the conduct of that
solicitation or attempt might be beneficial to our stockholders.
No Stockholder Action by Written Consent; Special Meetings. Our
certificate of incorporation provides that stockholder action can be taken only
at an annual or special meeting of stockholders and prohibits stockholder action
by written consent in lieu of a meeting. Our certificate of incorporation and
bylaws provide that special meetings of stockholders can be called only by the
Chairman of the Board, the Chief Executive Officer, the President, the Board by
the written order of a majority of directors or upon a written request of
stockholders owning two-thirds or more of our issued and outstanding capital
stock and entitled to vote. The written request of stockholders must state the
purpose of the meeting and be delivered to the Chairman of the Board, Chief
Executive Officer, the President or the Secretary. Accordingly, holders of a
significant percentage of our outstanding capital stock may not be able to
compel a special meeting of stockholders.
Amendment of Certain Provisions of the Certificate of Incorporation and
Bylaws. Under the Delaware General Corporation Law, the stockholders have the
right to adopt, amend or repeal our bylaws and with the approval of the board,
the certificate of incorporation. Our certificate of incorporation provides that
the affirmative vote of at least two-thirds of the voting power of the then
outstanding shares of voting stock, voting together as a single class and in
addition to any other vote required by our certificate of incorporation or
bylaws, is required to amend provisions of the certificate of incorporation or
bylaws relating to:
- the prohibition of stockholder action without a meeting;
- the restriction of stockholders calling a special meeting;
- the number, election and term of directors; or
- the removal of directors.
The vote of a majority of the voting power of the then outstanding shares
of voting stock is required to amend all other provisions of our certificate of
incorporation. Our certificate of incorporation further provides that our bylaws
may otherwise be amended by the board or by the affirmative vote of at least a
majority of the voting power of the then outstanding shares of our voting stock,
voting together as a single class. These supermajority voting requirements will
have the effect of making it more difficult for stockholders to amend the bylaws
or the certificate of incorporation.
Anti-Takeover Legislation. As a Delaware corporation, we are subject to
Section 203 of the Delaware General Corporation Law, which is an anti-takeover
law. In general, Section 203 prohibits a publicly held corporation from engaging
in a "business combination" with an "interested stockholder" for a period of
three years following the time in which the person became an interested
stockholder unless:
- before that person became an interested stockholder, the board of
directors of the corporation approved either the transaction in which the
stockholder became an interested stockholder or the business combination;
- upon consummation of the transaction that resulted in the stockholder
becoming an interested stockholder, the interested stockholder owns at
least 85% of the voting stock of the corporation outstanding at the time
the transaction commenced, excluding stock held by (1) directors who are
also officers of the corporation and (2) employee stock plans that do not
provide employees with
61
<PAGE>
the rights to determine confidentially whether shares held subject to the
plan will be tendered in a tender or exchange offer; or
- following the transaction in which that person became an interested
stockholder, the business combination is approved by the board of
directors of the corporation and authorized at a meeting of the
stockholders by the affirmative vote of the holders of two-thirds of the
outstanding voting stock of the corporation not owned by the interested
stockholder.
Generally, a business combination includes a merger, asset or stock sale,
or other transaction resulting in a financial benefit to the interested
stockholder. An interested stockholder is a person who, together with affiliates
and associates, owns or, within three years prior to the determination of
interested stockholder status did own, 15% or more of a corporation's
outstanding voting securities. We expect this provision to have an anti-takeover
effect with respect to transactions our board of directors does not approve in
advance. Section 203 may also discourage takeover attempts that might result in
a premium over the market price for the shares of common stock.
TRANSFER AGENT, WARRANT AGENT AND REGISTRAR
The transfer agent and registrar for our common stock and the warrant agent
for the warrants is American Stock Transfer & Trust Company located in New York,
New York.
SHARES ELIGIBLE FOR FUTURE SALE
Future sales of substantial amounts of common stock or our other securities
in the public market or the prospect of sales could adversely affect prevailing
market prices.
Upon completion of this offering, 4,998,554 shares of common stock will be
outstanding, which includes 3,998,554 shares of common stock outstanding as of
April 29, 2004 and the 1,000,000 shares of our common stock comprising a part of
the units to be sold pursuant to this prospectus. Of these shares, the 1,000,000
shares comprising a part of the units will be freely tradable without
restriction under the Securities Act of 1933, unless purchased by an "affiliate"
of ours, as that term is defined in Rule 144 under the Securities Act. Of the
remaining 3,998,554 shares, (a) as of April 29, 2004, approximately 2,305,290
shares, including 180,270 shares which may be acquired upon exercise of
currently exercisable options, will be subject to contractual lock-up agreements
with Paulson Investment Company, Inc. pursuant to which shares may not be sold
for a period of 90 days from the effective date of this offering, except for
shares sold by our officers and directors under Rule 10b5-1 plans and (b) as of
that date, most of the remaining 1,872,000 shares will be freely tradable.
An additional 875,000 shares of our common stock may become available for
resale upon exercise of the warrants, the underwriters' over-allotment option
and the representative's warrant; and 482,507 shares may become available for
resale upon exercise of currently exercisable stock options outstanding as of
April 29, 2004.
As a result of the foregoing, 2,175,771 of the shares outstanding
immediately prior to the offering (or obtainable on exercise or conversion of
securities outstanding immediately prior to the offering) can be resold in the
public market immediately following the offering without restriction or subject
to limitations other than the passage of additional time. Approximately
2,305,290 additional shares will be eligible for resale upon expiration of, or
release from, the lock-up agreements applicable to them. Many of the holders of
these securities have held them for a considerable period of time and may wish
to dispose of some or all of their investment. The sale of a substantial number
of shares in the public market, or the possibility of sales, could have a
depressive effect on our stock price.
62
<PAGE>
UNDERWRITING
Paulson Investment Company, Inc. is acting as the representative of the
underwriters. We and the underwriters named below have entered into an
underwriting agreement with respect to the units being offered. In connection
with this offering and subject to certain conditions, each of the underwriters
named below has severally agreed to purchase, and we have agreed to sell, the
number of units set forth opposite the name of each underwriter.
<Table>
<Caption>
UNDERWRITERS NUMBER OF UNITS
------------ ---------------
<S> <C>
Paulson Investment Company, Inc.............................
S.W. Bach & Company.........................................
Pali Capital, Inc. .........................................
--------
Total..................................................... 500,000
========
</Table>
The underwriting agreement provides that the underwriters are obligated to
purchase all of the units offered by this prospectus, other than those covered
by the over-allotment option, if any units are purchased. The underwriting
agreement also provides that the obligations of the several underwriters to pay
for and accept delivery of the units is subject to the approval of certain legal
matters by counsel and certain other conditions. These conditions include, among
other things, the requirements that no stop order suspending the effectiveness
of the registration statement be in effect and that no proceedings for this
purpose have been instituted or threatened by the SEC.
The representative has advised us that the underwriters propose to offer
our units to the public initially at the offering price set forth on the cover
page of this prospectus and to selected dealers at that price less a concession
of not more than $ per unit. The underwriters and selected dealers may re-
allow a concession to other dealers, including the underwriters, of not more
than $ per unit. After completion of the initial public offering of the
units, the offering price, the concessions to selected dealers and the
reallowance to their dealers may be changed by the underwriters.
The underwriters have informed us that they do not expect to confirm sales
of our units offered by this prospectus on a discretionary basis.
OVER-ALLOTMENT OPTION
Pursuant to the underwriting agreement, we have granted the underwriters an
option, exercisable for 45 days from the date of this prospectus, to purchase up
to an additional 75,000 units on the same terms as the other units being
purchased by the underwriters from us. The underwriters may exercise the option
solely to cover over-allotments, if any, in the sale of the units that the
underwriters have agreed to purchase. If the over-allotment option is exercised
in full, the total public offering price, underwriting discounts and
commissions, and proceeds to us before offering expenses will be $ , $
and $ , respectively.
STABILIZATION
Until the distribution of the units offered by this prospectus is
completed, rules of the SEC may limit the ability of the underwriters to bid for
and to purchase units or their component securities. As an exception to these
rules, the underwriters may engage in transactions that stabilize the price of
the units. Paulson Investment Company, Inc., on behalf of the underwriters, may
engage in over-allotment sales, stabilizing transactions, syndicate covering
transactions and penalty bids in accordance with Regulation M under the
Securities Exchange Act of 1934.
- Over-allotment involves syndicate sales in excess of the offering size,
which creates a syndicate short position.
- Stabilizing transactions permit bids to purchase the underlying security
so long as the stabilizing bids do not exceed a specified maximum.
63
<PAGE>
- Syndicate covering transactions involve purchases of the common stock and
public warrants in the open market after the distribution has been
completed in order to cover syndicate short positions. The underwriters
may also elect to reduce any short position by exercising all or part of
the over-allotment option to purchase additional units as described
above.
- Penalty bids permit the representative to reclaim a selling concession
from a syndicate member when the units originally sold by the syndicate
member are purchased in a syndicate covering transaction to cover
syndicate short positions.
Short sales involve the sale by the underwriters of a greater number of
shares than they are required to purchase in this offering. Covered short sales
are sales made in an amount not greater than the representative's over-allotment
option to purchase additional shares in this offering. In determining the source
of shares to close out the covered short position, the underwriters will
consider, among other things, the price of shares available for purchase in the
open market as compared with the price at which they may purchase shares through
the over-allotment option. Naked short sales are sales in excess of the over-
allotment option. A naked short position is more likely to be created if the
underwriters are concerned that there may be downward pressure on the price of
the shares in the open market after pricing that could adversely affect
investors who purchase in this offering.
In general, the purchase of a security to stabilize or to reduce a short
position could cause the price of the security to be higher than it might be
otherwise. These transactions may be effected on the American Stock Exchange or
otherwise. Neither we nor the underwriters can predict the direction or
magnitude of any effect that the transactions described above may have on the
price of the units. In addition, neither we nor the underwriters can represent
that the underwriters will engage in these types of transactions or that these
types of transactions, once commenced, will not be discontinued without notice.
INDEMNIFICATION
The underwriting agreement provides for indemnification between us and the
underwriters against specified liabilities, including liabilities under the
Securities Act, and for contribution by us and the underwriters to payments that
may be required to be made with respect to those liabilities. We have been
advised that, in the opinion of the SEC, indemnification for liabilities under
the Securities Act is against public policy as expressed in the Securities Act
and is therefore unenforceable.
UNDERWRITERS' COMPENSATION
We have agreed to sell the units to the underwriters at the initial
offering price of $ , which represents the initial public offering price of
the units set forth on the cover page of this prospectus less the %
underwriting discount. The underwriting agreement also provides that Paulson
Investment Company, Inc. will be paid a nonaccountable expense allowance equal
to % of the gross proceeds from the sale of the units offered by this
prospectus, including any units purchased on exercise of the over-allotment
option.
We have also agreed to issue warrants to the representative to purchase
from us up to 50,000 units at an exercise price per unit equal to $ per unit
[120% of the unit offering price]. These warrants are exercisable during the
four-year period beginning one year from the date of this prospectus. Pursuant
to NASD Rule 2710(g), these warrants cannot be sold, transferred, assigned,
pledged or hypothecated by any person for a period of one year following the
effective date of the offering, except to any NASD member participating in the
offering, to our bona fide officers, by operation of law or if we are
reorganized, so long as the securities so transferred remain subject to the same
transfer restriction for the remainder of the one-year period.
The holder of the representative's warrant will have, in that capacity, no
voting, dividend or other stockholder rights. Any profit realized by the
representative on the sale of the securities issuable upon exercise of the
representative's warrant may be deemed to be additional underwriting
compensation. The securities underlying the representative's warrant are being
registered on the registration statement. During
64
<PAGE>
the term of the representative's warrant, the holder thereof is given the
opportunity to profit from a rise in the market price of our common stock. We
may find it more difficult to raise additional equity capital while the
representative's warrant is outstanding. At any time at which the
representative's warrant is likely to be exercised, we may be able to obtain
additional equity capital on more favorable terms.
The following table summarizes the underwriting discounts and commissions
we will pay to the underwriters. These amounts are shown assuming both no
exercise and full exercise of the underwriters' over-allotment option.
<Table>
<Caption>
TOTAL
-------------------------------
WITHOUT WITH
OVER-ALLOTMENT OVER-ALLOTMENT
-------------- --------------
<S> <C> <C>
Underwriting discounts and commissions...................... $ $
Non-accountable expense allowance........................... $ $
</Table>
LOCK-UP AGREEMENTS
Our officers, directors and certain of our stockholders have agreed that
for a period of 90 days from the date this registration statement becomes
effective they will not sell, contract to sell, grant any option for the sale or
otherwise dispose of any of our equity securities, or any securities convertible
into or exercisable or exchangeable for our equity securities, other than
through existing Rule 10b5-1 trading plans, intra-family transfers or transfers
to trusts for estate planning purposes, without the consent of Paulson
Investment Company, Inc., as the representative of the underwriters, which
consent will not be unreasonably withheld. Paulson Investment Company, Inc. may
consent to an early release from the 90-day lock-up period if in its opinion the
market for the common stock would not be adversely impacted by sales and in
cases of an officer, director or other stockholder's financial emergency. We are
unaware of any officer, director or current stockholder who intends to ask for
consent to dispose of any of our equity securities during the lock-up period.
DETERMINATION OF OFFERING PRICE
The initial public offering price of the units offered by this prospectus
and the exercise price of the public warrants were determined by negotiation
between us and the underwriters. Among the factors considered in determining the
initial public offering price of the units and the exercise price of the
warrants were:
- the market price of the common stock;
- our history and our prospects;
- the industry in which we operate;
- the status and development prospects for our proposed products and
services;
- our past and present operating results;
- the previous experience of our executive officers; and
- the general condition of the securities markets at the time of this
offering.
The offering price stated on the cover page of this prospectus should not
be considered an indication of the actual value of the units. That price is
subject to change as a result of market conditions and other factors, and we
cannot assure you that the units, or the common stock and warrants contained in
the units, can be resold at or above the initial public offering price.
65
<PAGE>
LEGAL MATTERS
The validity of the common stock offered by this prospectus will be passed
upon for us by Porter & Hedges, LLP, Houston, Texas. Stoel Rives LLP, Portland,
Oregon, will pass upon certain matters for the underwriters named in this
prospectus in connection with this offering.
EXPERTS
The consolidated financial statements as of and for the year ended December
31, 2003 included in this prospectus and elsewhere in the registration statement
have been audited by Grant Thornton LLP, independent certified public
accountants, as indicated in their report with respect thereto, and are included
herein in reliance upon the authority of said firm as experts in accounting and
auditing in giving said report.
The consolidated financial statements and the related financial statement
schedule of I-Sector Corporation as of December 31, 2002, and for each of the
two years in the period ended December 31, 2002, included and incorporated by
reference in this prospectus have been audited by Deloitte & Touche LLP,
independent auditors, as stated in their reports, which are included and
incorporated by reference herein, and have been so included and incorporated in
reliance upon the reports of such firm given upon their authority as experts in
accounting and auditing.
CHANGES IN CERTIFYING ACCOUNTANT
On June 5, 2003, we dismissed Deloitte & Touche LLP as our principal
accountant. We engaged Grant Thornton effective June 5, 2003. Our audit
committee approved the decision to change accountants.
In connection with the audits of our financial statements for the fiscal
years ended December 31, 2002 and 2001, there were no disagreements with
Deloitte on any matter of accounting principles or practices, financial
statement disclosure, or auditing scope or procedures, which disagreements if
not resolved to their satisfaction would have caused them to make reference in
connection with their opinion to the subject matter of the disagreement. In the
unaudited interim period ended March 31, 2003 and through June 5, 2003, the date
of dismissal, there were no disagreements with Deloitte on any matter of
accounting principles or practices or financial statement disclosure. The audit
report of Deloitte on our consolidated financial statements as of and for the
years ended December 31, 2002 and 2001 did not contain any adverse opinion or
disclaimer of opinion, nor was it qualified or modified as to uncertainty, audit
scope, or accounting principles. During the fiscal years ended December 31, 2002
and 2001 and the subsequent interim period, there were no reportable events as
defined in Item 304(a)(1)(v) of Regulation S-K.
During the fiscal years ended December 31, 2002 and 2001 and the subsequent
interim period ended March 31, 2003 and through June 5, 2003, the date of
dismissal, prior to engaging Grant Thornton, neither we nor anyone on our behalf
consulted with Grant Thornton regarding the application of accounting principles
to a specified transaction, either completed or proposed; or the type of audit
opinion that might be rendered on our financial statements, and neither a
written report nor oral advice was provided to us by Grant Thornton that was an
important factor considered in reaching a decision as to any accounting,
auditing or financial reporting issue.
In connection with the audits of our financial statements for the fiscal
year ended December 31, 2003, there were no disagreements with Grant Thornton on
any matter of accounting principles or practices, financial statement
disclosure, or auditing scope or procedures, which disagreements if not resolved
to their satisfaction would have caused them to make reference in connection
with their opinion to the subject matter of the disagreement. In the unaudited
interim periods ended June 30, 2003 and September 30, 2003 and through December
31, 2003, there were no disagreements with Grant Thornton on any matter of
accounting principles or practices or financial statement disclosure. The audit
report of Grant Thornton on our consolidated financial statements as of and for
the year ended December 31, 2003 did not contain any adverse opinion or
disclaimer of opinion, nor was it qualified or modified as to uncertainty, audit
scope, or accounting principles. During the fiscal years ended December 31, 2003
and the subsequent interim period, there were no reportable events as defined in
Item 304(a)(1)(v) of Regulation S-K.
66
<PAGE>
WHERE YOU CAN FIND MORE INFORMATION
In connection with the units offered by this prospectus, we have filed a
registration statement on Form S-2 under the Securities Act with the SEC. This
prospectus, filed as part of the registration statement, does not contain all of
the information included in the registration statement and the accompanying
exhibits and schedules. For further information with respect to our units,
common stock and warrants, and us you should refer to the registration statement
and the accompanying exhibits and schedules. Statements contained in this
prospectus regarding the contents of any contract or any other document are not
necessarily complete, and you should refer to the copy of the contract or other
document filed as an exhibit to the registration statement, each statement being
qualified in all respects by the actual contents of the contract or other
document referred to.
We also file annual, quarterly and special reports, proxy statements and
other information with the SEC. You can read our SEC filings, including the
registration statement, over the Internet at the SEC's web site at
http://www.sec.gov. You may also read and copy any document we file with the SEC
at its public reference facilities at 450 Fifth Street, N.W. Washington, DC
20549. You can also obtain copies of the documents at prescribed rates by
writing to the Public Reference Section of the SEC at 450 Fifth Street, NW,
Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for further
information on the operations of the public reference facilities.
INCORPORATION BY REFERENCE
The SEC allows us to "incorporate by reference" the information we file
with them, which means that we can disclose important information to you by
referring you to those documents. The information incorporated by reference is
considered to be part of this prospectus, except for information superseded by
information in this prospectus. We incorporate by reference our annual report on
Form 10-K for the fiscal year ended December 31, 2003.
Any statement contained in a document that is incorporated by reference
will be modified or superceded for all purposes to the extent that a statement
contained in this prospectus (or in any other document that is subsequently
filed with the SEC and incorporated by reference) modifies or is contrary to
that previous statement. Any statement so modified or superseded will not be
deemed a part of this prospectus except as so modified or superceded.
We will furnish without charge to you, on written or oral request, a copy
of any or all of the documents incorporated by reference, other than exhibits to
those documents. To obtain a copy of these filings at no cost, you may write or
telephone us at the following address:
I-Sector Corporation
6401 Southwest Freeway
Houston, Texas 77074
(713) 795-2000
67
<PAGE>
I-SECTOR CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<Table>
<Caption>
PAGE
----
<S> <C>
Report of Independent Certified Public Accountants for the
year ended December 31, 2003.............................. F-2
Independent Auditors' Report for the years ended December
31, 2001 and 2002......................................... F-3
Consolidated Balance Sheets at December 31, 2002 and 2003... F-4
Consolidated Statements of Operations for the years ended
December 31, 2001, 2002 and 2003.......................... F-5
Consolidated Statements of Stockholders' Equity the years
ended December 31, 2001, 2002 and 2003.................... F-6
Consolidated Statements of Cash Flows for the years ended
December 31, 2001, 2002 and 2003.......................... F-7
Notes to Consolidated Financial Statements.................. F-8
</Table>
F-1
<PAGE>
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Stockholders of I-Sector Corporation:
We have audited the accompanying consolidated balance sheet of I-Sector
Corporation (a Delaware corporation) and subsidiaries as of December 31, 2003,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for the year ended December 31, 2003. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of I-Sector Corporation
and subsidiaries as of December 31, 2003, and the results of their operations
and their cash flows for the year ended December 31, 2003, in conformity with
accounting principles generally accepted in the United States of America.
/s/ GRANT THORNTON LLP
Houston, Texas
February 6, 2004
F-2
<PAGE>
INDEPENDENT AUDITORS' REPORT
To the Stockholders of I-Sector Corporation:
We have audited the accompanying consolidated balance sheet of I-Sector
Corporation and subsidiaries ("I-Sector") as of December 31, 2002, and the
related statements of operations, stockholders' equity and cash flows for each
of the two years in the period ended December 31, 2002. These financial
statements are the responsibility of I-Sector's management. Our responsibility
is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of I-Sector as of December 31, 2002,
and the results of its operations and its cash flows for each of the two years
in the period ended December 31, 2002 in conformity with accounting principles
generally accepted in the United States of America.
/s/ DELOITTE & TOUCHE LLP
Houston, Texas
March 21, 2003
F-3
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<Table>
<Caption>
DECEMBER 31,
---------------------
2002 2003
--------- ---------
(IN THOUSANDS, EXCEPT
SHARE AND PAR VALUE
AMOUNTS)
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents................................. $ 3,491 $ 2,172
Accounts receivable -- trade, net of allowance of $928 and
$612................................................... 6,525 9,757
Accounts receivable -- affiliates......................... 99 16
Accounts receivable -- other.............................. 57 29
Notes receivable, net of allowance of $338 and $373....... 898 676
Inventory................................................. 781 1,038
Cost and estimated earnings in excess of billings......... 709 1,452
Income taxes receivable................................... 488 --
Other current assets...................................... 356 943
------- -------
Total current assets.............................. 13,404 16,083
Property and equipment, net of accumulated depreciation of
$1,988 and $1,887......................................... 1,115 1,271
Notes receivable, long-term, net of allowance of $23 and
$250...................................................... 64 252
Patent license rights, net of accumulated amortization of
$148 and $265............................................. 955 849
Deferred offering costs..................................... -- 317
Other intangible assets, net of accumulated amortization of
$160 and $335............................................. 207 435
Other assets................................................ 6 --
------- -------
Total Assets...................................... $15,751 $19,207
======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Notes payable and current portion of long-term debt....... $ 157 $ 1,784
Accounts payable.......................................... 4,844 6,524
Billings in excess of cost and estimated earnings......... 75 262
Accrued expenses.......................................... 1,803 2,676
Liabilities related to discontinued operations............ 904 557
Deferred revenue.......................................... 81 556
------- -------
Total current liabilities......................... 7,864 12,359
------- -------
Long-term debt.............................................. 247 229
Commitments and Contingencies
Stockholders' Equity:
Preferred stock, $.01 par value, 5,000,000 shares
authorized, no shares issued........................... -- --
Common stock, $.01 par value, 15,000,000 shares
authorized, 4,441,325 and 4,762,809 issued............. 44 48
Additional paid in capital................................ 10,379 10,853
Additional paid in capital -- other....................... -- 337
Treasury stock, at cost 811,800 and 811,800 shares........ (1,373) (1,373)
Retained deficit.......................................... (1,410) (3,246)
------- -------
Total stockholders' equity........................ 7,640 6,619
------- -------
Total Liabilities and Stockholders' Equity........ $15,751 $19,207
======= =======
</Table>
The accompanying notes are an integral part of these consolidated financial
statements
F-4
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
------------------------------------
2001 2002 2003
---------- ---------- ----------
(IN THOUSANDS, EXCEPT SHARE AND
PER SHARE AMOUNTS)
<S> <C> <C> <C>
Revenue:
Products............................................... $ 9,925 $ 29,805 $ 46,900
Services............................................... 6,477 5,647 7,725
Custom projects........................................ 7,218 6,569 7,527
---------- ---------- ----------
Total revenue.......................................... 23,620 42,021 62,152
---------- ---------- ----------
Cost of goods and services:
Products............................................... 8,685 26,437 41,060
Services............................................... 5,322 4,395 5,383
Custom projects........................................ 3,318 2,920 2,982
---------- ---------- ----------
Total cost of goods and services....................... 17,325 33,752 49,425
---------- ---------- ----------
Gross profit........................................ 6,295 8,269 12,727
Selling, general and administrative expenses............. 10,573 10,625 15,061
---------- ---------- ----------
Operating loss........................................... (4,278) (2,356) (2,334)
Interest and other income, net........................... 316 115 107
---------- ---------- ----------
Loss from continuing operations before benefit for income
taxes.................................................. (3,962) (2,241) (2,227)
Benefit for income taxes................................. 87 1,595 181
---------- ---------- ----------
Net loss from continuing operations...................... (3,875) (646) (2,046)
Discontinued operations:
Net loss from discontinued operations, net of taxes...... (167) -- --
Gain on disposal of discontinued operations, net of
taxes.................................................. 337 262 210
---------- ---------- ----------
Net loss................................................. $ (3,705) $ (384) $ (1,836)
========== ========== ==========
Net loss per share:
Basic:
Net loss from continuing operations...................... $ (0.99) $ (0.17) $ (0.55)
Net loss from discontinued operations, net of taxes...... (0.04) -- --
Gain on disposal of discontinued operations net of
taxes.................................................. 0.08 0.07 0.06
---------- ---------- ----------
Net loss per share....................................... $ (0.95) $ (0.10) $ (0.49)
========== ========== ==========
Diluted:
Net loss from continuing operations...................... $ (0.99) $ (0.17) $ (0.56)
Net loss from discontinued operations, net of taxes...... (0.04) -- --
Gain on disposal of discontinued operations, net of
taxes.................................................. 0.08 0.07 0.06
---------- ---------- ----------
Net loss per share....................................... $ (0.95) $ (0.10) $ (0.50)
========== ========== ==========
Shares used in computing net loss per share:
Basic and diluted........................................ 3,911,019 3,709,689 3,691,052
========== ========== ==========
</Table>
The accompanying notes are an integral part of these consolidated financial
statements
F-5
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<Table>
<Caption>
$.01 PAR VALUE
COMMON STOCK ADDITIONAL ADDITIONAL
------------------ PAID-IN PAID-IN TREASURY RETAINED
SHARES AMOUNT CAPITAL CAPITAL -- OTHER STOCK EARNINGS TOTAL
--------- ------ ---------- ---------------- -------- -------- -------
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at beginning of January
1, 2001...................... 4,441,325 $44 $10,182 $ (1) $ (992) $ 2,679 $11,912
Purchase of treasury stock..... -- -- -- -- (195) -- (195)
Satisfaction of restricted
stock........................ -- -- -- 1 -- -- 1
Issuance of restricted stock... -- -- 2 -- -- -- 2
Net loss....................... -- -- -- -- -- (3,705) (3,705)
--------- --- ------- ---- ------- ------- -------
Balance at December 31, 2001... 4,441,325 44 10,184 -- (1,187) (1,026) 8,015
Purchase of treasury stock..... -- -- -- -- (186) -- (186)
Stock warrants expired......... -- -- 195 -- -- -- 195
Net loss....................... -- -- -- -- -- (384) (384)
--------- --- ------- ---- ------- ------- -------
Balance at December 31, 2002... 4,441,325 44 10,379 -- (1,373) (1,410) 7,640
Issuance of options to
consultants.................. -- -- -- 337 -- -- 337
Exercise of common stock
options...................... 321,484 4 474 -- -- -- 478
Net loss....................... -- -- -- -- -- (1,836) (1,836)
--------- --- ------- ---- ------- ------- -------
Balance at December 31, 2003... 4,762,809 $48 $10,853 $337 $(1,373) $(3,246) $ 6,619
========= === ======= ==== ======= ======= =======
</Table>
The accompanying notes are an integral part of these consolidated financial
statements
F-6
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
---------------------------
2001 2002 2003
------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
CASH FLOW FROM OPERATING ACTIVITIES:
Net loss.................................................. $(3,705) $ (384) $(1,836)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Net loss from discontinued operations..................... 167 -- --
Gain on disposal of discontinued operations............... (337) (262) (210)
Depreciation and amortization............................. 666 596 764
Current income tax benefit attributable to discontinued
operations.............................................. (87) (136) (108)
Satisfaction of restricted stock.......................... 1 -- --
Loss (gain) on retirement of assets....................... 10 34 (88)
Bad debt expense.......................................... 1,052 1,271 769
Changes in assets and liabilities that provided (used)
cash:
Accounts receivable..................................... (881) (3,133) (3,680)
Accounts receivable, affiliates and other............... 173 115 111
Inventory............................................... 187 (147) (257)
Income taxes receivable................................. 712 (337) 488
Notes receivable........................................ (117) (1,154) (287)
Other current assets.................................... (69) (58) (250)
Other assets............................................ (13) -- --
Accounts payable........................................ (119) 3,072 1,676
Cost and estimated earnings in excess of billings....... (1,695) 986 (743)
Billings in excess of cost and estimated earnings....... (431) 3 187
Accrued expenses........................................ 456 (288) 556
Deferred revenue........................................ (10) (45) 475
------- ------- -------
Net cash provided by (used in) continuing
operations.......................................... (4,040) 133 (2,433)
Net operating activities from discontinued operations..... (413) 676 (29)
------- ------- -------
Net cash provided by (used in) operating
activities.......................................... (4,453) 809 (2,462)
------- ------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures...................................... (688) (347) (399)
Proceeds on sale of assets................................ 6 -- 80
Cash paid for acquisitions................................ (50) -- (566)
Proceeds on sale of discontinued operations............... 526 -- --
------- ------- -------
Net cash used in investing activities............... (206) (347) (885)
------- ------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Exercise of stock options................................. -- -- 478
Purchase of treasury stock................................ (195) (186) --
Net decrease in notes payable............................. (58) (219) (138)
Notes payable -- interest bearing borrowings on credit
line.................................................... -- -- 1,688
------- ------- -------
Net cash provided by (used in) financing
activities.......................................... (253) (405) 2,028
------- ------- -------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS........ (4,912) 57 (1,319)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD............ 8,346 3,434 3,491
------- ------- -------
CASH AND CASH EQUIVALENTS AT END OF PERIOD.................. $ 3,434 $ 3,491 $ 2,172
======= ======= =======
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest.................................... $ 9 $ -- $ 29
======= ======= =======
Cash received for income taxes............................ $ (712) $(1,123) $ (73)
======= ======= =======
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING
ACTIVITIES:
Intangible assets acquired through note payable........... $ 646 $ -- $ --
Fixed assets acquired through note payable................ 35 -- --
Fixed assets acquired through capital lease............... -- -- 63
Options granted to consultants............................ -- -- 337
Offering costs accrued.................................... -- -- 317
</Table>
The accompanying notes are an integral part of these consolidated financial
statements
F-7
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2001, 2002 AND 2003
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
I-Sector Corporation and subsidiaries ("I-Sector" or the "Company") are
engaged in the business of providing computer services and of selling associated
hardware and telephony software products in the United States and abroad.
I-Sector operates through three wholly-owned subsidiaries:
- Internetwork Experts, Inc. ("INX") is a network professional services and
integration organization with areas of practice that include large-scale
enterprise network engineering consulting, network security, network
management, wireless networking and IP telephony.
- Stratasoft, Inc. ("Stratasoft") creates and markets software related to
the integration of computer and telephone technologies.
- Valerent, Inc. ("Valerent") provides information technology solutions
that lowers its client's expense by utilizing centralized, remote enabled
computing management tools which predict, announce and manage service
interruptions. Additionally Valerent provides customers with traditional
computer services such as on-site and carry-in computer repair,
application support, operating system and network migration services,
turn-key outsourced IT helpdesk solutions, technical staff augmentation
for IT helpdesk operations, helpdesk solutions consulting services.
I-Sector's significant accounting policies are as follows:
Principles of Consolidation -- The accompanying consolidated financial
statements include the accounts of I-Sector and its subsidiaries. All
significant intercompany balances and transactions have been eliminated.
Inventory -- Inventory consists primarily of Cisco network equipment,
Stratasoft dialers, computer equipment and components and is valued at the lower
of cost or market with cost determined on the first-in first-out method.
Substantially all of I-Sector's inventory is finished goods. The Company records
write downs of its inventory to net realizable value as appropriate.
Property and Equipment -- Property and equipment are recorded at cost.
Expenditures for repairs and maintenance are charged to expense when incurred,
while expenditures for betterments are capitalized. Disposals are removed at
cost less accumulated depreciation with the resulting gain or loss reflected in
operations in the year of disposal.
Intangible Assets -- Intangible assets are being amortized over their
estimated useful lives of five to sixteen years (see Note 12).
Impairment of Long-Lived Assets -- I-Sector records impairment losses on
long-lived assets used in operations when events and circumstances indicate that
the assets might be impaired and the undiscounted cash flows estimated to be
generated by those assets are less than the carrying amounts of those assets.
Income Taxes -- I-Sector accounts for income taxes under the liability
method, which requires, among other things, recognition of deferred income tax
liabilities and assets for the expected future tax consequences of events that
have been recognized in I-Sector's consolidated financial statements or tax
returns. Under this method, deferred income tax liabilities and assets are
determined based on the temporary differences between the financial statement
carrying amounts and the tax bases of existing assets and liabilities and the
recognition of available tax carryforwards.
Reclassifications -- Certain prior period amounts in the consolidated
financial statements presented herein have been reclassified to conform to
current period presentation.
Use of Estimates -- The preparation of the financial statements in
conformity with accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions
F-8
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amount of revenue and expense during the reporting period. Actual
results could differ from these estimates.
Revenue Recognition -- I-Sector has a number of different revenue
components, which vary between its reportable operating segments. Each
reportable operating segment has more than one revenue component, and revenue is
recognized differently for each component (or "stream") of revenue earned by
operating segment. The material revenue streams earned by I-Sector, some of
which are earned by more than one operating segment, and some by only one
operating segment, are:
Products Revenue. Three of I-Sector's operating segments earn revenue
from product shipments. Product shipment revenue occurs when products
manufactured by other parties are purchased and resold to a customer and
such products are contracted for independently of material services.
I-Sector recognizes revenue from product shipments when the product is
shipped or delivered to the customer. In all three segments, the four
criteria for revenue recognition have been met because: (1) there are
written, executed contracts, or in the case of INX and Valerent, in some
situations there are binding purchase orders; (2) delivery has occurred or
services have been rendered. Stratasoft, however, recognizes revenue on the
percentage of completion method, as described below; (3) the price is fixed
or determinable, and (4) collectibility is reasonably assured. Each of
I-Sector's business segments perform credit research prior to extending
credit. In Stratasoft's business segment, a substantial portion of the
total contract price is received in cash or letter of credit when the unit
is installed.
Services Revenue. All of I-Sector's operating segments earn revenue
from providing stand-alone service revenue. This revenue consists of
billings for engineering and technician time, programming services, which
are provided on either a hourly basis or a flat-fee basis, support
contracts and the service component of maintenance and repair service
ticket transactions. These services are contracted for separately from any
product sale, and generally for contracts of short duration are recognized
when the service is performed and when collection is reasonably assured.
Two of I-Sector's segments sometimes earn agency fee revenue from various
sources, the primary source of which is referring customers to other
organizations for which an agency fee is received. This revenue is
recognized at the earlier of when payment is received or when notification
of amounts being due is received from the entity paying such agency fee and
collectibility is reasonably assured.
INX has certain fixed and flat fee contracts that extend over three
months or more, and are accounted for on the percentage of completion
method of accounting. The percentage of revenue recognized in any
particular period is determined on the basis of the relationship of the
actual hours worked to estimated total hours to complete the contract.
Revisions of the estimated hours to complete are reflected in the period in
which the facts necessitating the revisions become known. When a contract
indicates a loss, a provision is made for the total anticipated loss.
Custom Project Revenue. Stratasoft earns revenue from projects that
are recognized using the percentage of completion method of accounting for
such revenue. The majority of Stratasoft's revenue consists of system sales
in which it bundles its proprietary software, along with third-party
hardware products and related software customization services,
installation, training services, warranty services and incidental post
contract support ("PCS") together under a single contract with the
customer. PCS is insignificant on such contracts for one year or less, and
therefore, we have determined that the value of such PCS should not be
unbundled from the project revenue as set forth in paragraph 59 of SOP
97-2. Accordingly, such PCS revenue is recognized together with the project
revenue, and the estimated cost to provide the PCS is accrued. The value of
the PCS is determinable within the contract, which defines the period that
the PCS is granted and offers renewals at stated amounts, thereby defining
the value of the PCS. The software customization, together with the
hardware customization and integration, represent a significant
modification, customization and/or production of the product and,
therefore, the entire
F-9
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
arrangement is required to be accounted for using the percentage of
completion method of accounting pursuant to SOP 81-1. The percentage of
revenue recognized in any particular period is determined principally on
the basis of the relationship of the cost of work performed on the contract
to estimated total costs. The percentage-of-completion method relies on
estimates of total expected contract revenue and costs. We follow this
method since reasonably dependable estimates of the revenue and costs
applicable to various stages of a contract can be made. Revisions of
estimates are reflected in the period in which the facts necessitating the
revisions become known. When a contract indicates a loss, a provision is
made for the total anticipated loss. The following reflects the amounts
relating to uncompleted contracts at:
<Table>
<Caption>
DECEMBER 31, DECEMBER 31,
2002 2003
------------ ------------
<S> <C> <C>
Costs incurred on uncompleted contracts..................... $ 429 $1,019
Estimated earnings.......................................... 1,478 3,117
------ ------
1,907 4,136
Less: Billings to date...................................... 1,273 2,946
------ ------
Total....................................................... $ 634 $1,190
====== ======
Included in accompanying balance sheets under the following
captions:
Cost and estimated earnings in excess of billings........... $ 709 $1,452
Billings in excess of cost and estimated earnings........... (75) (262)
------ ------
Total....................................................... $ 634 $1,190
====== ======
</Table>
During the quarter ended June 30, 2003, the Company recorded
adjustments to defer revenue for certain custom projects that had more than
one year of free PCS and certain renewals of PCS paid in advance. The
adjustment includes approximately $152 related to years prior to 2003.
Management determined that the effect of these adjustments was not material
to the previously reported results or to the results expected for 2003.
During December 2003 I-Sector's operating segment Stratasoft sold $408
of software products to a reseller for which the related revenue was
deferred at December 31, 2003. Revenue from this sale will be recognized in
the accounting periods that payments from the reseller become due, or in
the accounting period when it has been firmly established that the software
has been re-sold to an end-user of the software and that collection is
reasonably assured by the Company.
During 2001, 2002 and 2003, I-Sector has recognized revenue of $2,251,
$614 and $502, respectively, on the percentage-of-completion basis for
several projects associated with one reseller in South Asia. For these
projects, Stratasoft entered into a three-party contract between
Stratasoft, the South Asia reseller and the end-user customers. Stratasoft
was responsible for performing the substantial majority of the project for
the end-user customer, from whom Stratasoft was directly obligated to be
paid for such project by the end-user customer.
Credit Risk -- The Company extends credit to its customers in the normal
course of business and generally does not require collateral or other security.
The Company performs ongoing credit evaluations of its customers' financial
condition and, in some instances, requires letters of credit or additional
guarantees in support of contracted amounts. Earnings are charged with a
provision for doubtful accounts based on a current review of the collectibility
of the accounts and using a systematic approach based on historical collections
and age of the amounts due. Accounts deemed uncollectible are applied against
the allowance for doubtful accounts.
F-10
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Vendor Incentives -- From time to time, the Company participates in
programs provided by suppliers that enable it to earn incentives. These
incentives are generally earned by sales volume, sales growth and customer
satisfaction levels. The amounts earned under these programs are recorded as a
reduction of cost of goods when earned and determinable. The amount of vendor
incentives recognized can vary significantly between quarterly and annual
periods.
Advertising Costs -- Advertising costs consist of print advertising and
trade show materials and are expensed as incurred. Advertising costs for the
year ended December 31, 2001, 2002 and 2003 were $334, $370 and $323,
respectively.
Research and Development Costs -- Expenditures relating to the development
of new products and processes, including significant improvements and
refinements to existing products, are expensed as incurred.
Warranty Reserve -- I-Sector records a warranty reserve related to certain
software products sold by its Stratasoft subsidiary. That reserve is classified
in accrued expenses and is amortized over the life of the warranty, which is
generally twelve months, against actual warranty expenditures. This warranty
reserve relates to the estimate of warranty obligations from sales of
Stratasoft's call center telephony systems, which consist of Stratasoft's
software, configured hardware components as well as telephone support relating
to Stratasoft's software products. This liability amount has been consistently
recorded within each period as a charge to cost of goods based upon five percent
of period revenue. This percentage was based upon a review of the costs of
providing the warranty work, which was initially performed in connection with
the acquisition of the Stratasoft technology. Stratasoft incurs numerous types
of costs related to the warranty work, which includes labor cost of technicians
and programmers, hardware cost, the cost of developing and uploading software
patches related to "bug fixes", telephone support, and hardware parts cost
related to defective hardware sold as a part of a complete Stratasoft system.
The majority of these costs are individually insignificant amounts for which the
cost/benefit relationship does not warrant tracking, but which we periodically
assess and continue to estimate at approximately five percent of Stratasoft
sales. As the actual costs are not tracked, Stratasoft amortizes the recorded
amounts to cost of goods over the average life of the contractual warranty
period as costs are believed to be incurred ratably over the warranty period.
The difference between the actual warranty costs incurred and the amount of
amortization is not considered to be materially different. The following table
depicts the activity in the warranty reserve:
<Table>
<Caption>
DECEMBER 31,
-------------
2002 2003
----- -----
<S> <C> <C>
Balance, beginning of the period............................ $ 263 $ 305
Additions to reserve........................................ 373 348
Expenses offset against reserve............................. (331) (351)
----- -----
Balance, end of period...................................... $ 305 $ 302
===== =====
</Table>
Stock-Based Compensation -- The Company has elected to account for employee
stock-based compensation using the intrinsic value method of accounting in
accordance with Accounting Principles Bulletin ("APB") No. 25 "Accounting for
Stock Issued to Employees". Under this method no compensation expense is
recognized when the number of shares granted is known and the exercise price of
the stock option is equal to or greater than the fair value of the common stock
on the grant date. The Company has recorded no stock-based compensation
associated with stock options granted to employees and directors in its
consolidated statement of operations. I-Sector and its subsidiaries apply the
fair value method as prescribed by SFAS No. 123, as interpreted and amended, for
stock and stock options issued to non-employees and during the year ended
December 31, 2003, recorded $337 of other additional paid in capital related to
compensation to the non-employees. If compensation cost for all option issuances
had been determined consistent with the
F-11
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
fair value method, I-Sector's net loss and net loss per share would have
increased to the pro-forma amounts indicated below.
For purposes of estimating the fair value disclosures below, the fair value
of each stock option has been estimated on the grant date with a Black-Scholes
option pricing model using the following weighted-average assumptions for the
2001, 2002 and 2003 periods; dividend yield of 0% for all periods; expected
volatility of 59%, 82.1% and 85.7%, respectively; risk-free interest rate of
5.5%, 3.63% and 3.63%, respectively; and expected lives of 8.0, 7.57 and 8.4
years, respectively, from the original date of the stock option grants.
<Table>
<Caption>
DECEMBER 31,
--------------------------
2001 2002 2003
------- ------ -------
<S> <C> <C> <C>
Net loss as reported........................................ $(3,705) $ (384) $(1,836)
Deduct: Total stock-based employee compensation determined
under fair value based method for all awards, net of
related tax effects....................................... (256) (184) (233)
------- ------ -------
Pro forma net loss -- basic................................. (3,961) (568) (2,069)
Deduct: INX income attributable to potential minority
interest related to INX options..................... -- -- (29)
------- ------ -------
Pro forma net loss -- diluted............................... $(3,961) $ (568) $(2,098)
======= ====== =======
Basic earnings per share:
As reported............................................... $ (0.95) $(0.10) $ (0.49)
Pro forma................................................. $ (1.01) $(0.15) $ (0.56)
Diluted earnings per share:
As reported............................................... $ (0.95) $(0.10) $ (0.50)
Pro forma................................................. $ (1.01) $(0.15) $ (0.57)
</Table>
Earnings Per Share -- Basic net income per share is computed on the basis
of the weighted-average number of common shares outstanding during the periods.
Diluted net income per share is computed based upon the weighted-average number
of common shares plus the assumed issuance of common shares for all potentially
dilutive securities using the treasury stock method (See Note 6).
Fair Value of Financial Instruments -- I-Sector's financial instruments
consist of cash and cash equivalents, accounts receivable and accounts payable
for which the carrying values approximate fair values given the short-term
maturity of the instruments. The carrying value of the Company's debt
instruments approximate their fair value based on estimates of rates offered to
the Company for instruments with the same maturity dates and security
structures.
Cash and Cash Equivalents -- Cash and cash equivalents include any highly
liquid securities with an original maturity of three months or less when
purchased.
ACCOUNTING PRONOUNCEMENTS
In April 2002, the FASB issued Statement of Financial Accounting Standards
No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections." SFAS No. 145, among other things,
amends SFAS No. 4 and SFAS No. 64, to require that gains and losses from the
extinguishments of debt generally be classified within continuing operations.
The provisions of SFAS No. 145 are effective for fiscal years beginning after
May 15, 2002 and early application is encouraged. The Company adopted SFAS No.
145 on January 1, 2003. The adoption of this statement had no impact on the
financial statements.
F-12
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 replaces Emerging
Issues Task Force (EITF Issue 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity"). This standard
requires companies to recognize costs associated with exit or disposal
activities when they are incurred rather than at the date of a commitment to an
exit or disposal plan. The Company adopted SFAS No. 146 on January 1, 2003. The
adoption of this statement had no impact on the financial statements.
In February 2003, the FASB issued SFAS No. 148, "Accounting for Stock Based
Compensation: Transition and Disclosure -- An Amendment of FASB Statement No.
123." SFAS No. 148 amends SFAS 123 to provide alternative methods of transition
for an entity that voluntarily changes to the fair value based method of
accounting for stock-based employee compensation. It also amends the disclosure
provisions of that Statement to require prominent disclosure about the effects
on reported net income of an entity's accounting policy decisions with respect
to stock-based compensation. The statement also amends APB Opinion No. 28,
"Interim Financial Reporting", to require disclosure about those effects in
interim financial information. The Company has chosen not to voluntarily change
to the fair value based methods of accounting for stock-based employee
compensation but has adopted the disclosure rules of SFAS 148.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies when a derivative contains a financing component that warrants special
reporting in the statement of cash flows and amends certain other existing
pronouncements, resulting in more consistent reporting of contracts that are
derivatives in their entirety or that contain embedded derivatives that warrant
separate accounting. SFAS No. 149 is effective for contracts entered into or
modified after June 30, 2003. The Company does not believe that the adoption of
SFAS No. 149 will have a material impact on its financial statements.
In January 2003, the FASB issued FASB Interpretation 46 ("FIN 46"),
"Consolidation of Variable Interest Entities -- An Interpretation of ARB No.
51". FIN 46 addresses consolidation by business enterprises of variable interest
entities. This Interpretation applies immediately to variable interest entities
created after January 31, 2003, and to variable interest entities in which an
enterprise obtains an interest after that date. It applies in the first fiscal
year or interim period beginning after June 15, 2003, to variable interest
entities in which an enterprise holds a variable interest that it acquired
before February 1, 2003. On December 17, 2003, the FASB issued FIN 46R,
providing a deferral of the application of FIN 46 for interests held by public
entities in a variable interest entity or potential variable interest entity
until fiscal periods ending after March 15, 2004. The Company has not fully
assessed the impact of FIN 46 on its financial statements, particularly its
relationship with Allstar Equities, Inc., but the adoption of this statement is
not expected to have a material impact on the Company's financial statements.
In November 2002, the Emerging Issues Task Force ("EITF") reached a
consensus on EITF Issue 00-21, "Revenue Arrangements with Multiple
Deliverables." EITF 00-21 addresses certain aspects of the accounting by a
vendor for arrangements under which it will perform multiple revenue-generating
activities. Issue 00-21 is effective for revenue arrangements entered into in
fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not
have a material impact on the Company's financial statements.
In August 2003, the EITF reached a consensus on EITF 03-05, "Applicability
of AICPA Statement of Position 97-2 to Non-Software Deliverables in an
Arrangement Containing More-Than-Incidental Software". EITF 03-05 requires
revenue recognition under SOP 97-2 for all arrangements in which the software
sold is essential to the functionality of the hardware. The adoption of the EITF
03-05 had no impact on the Company's financial statements.
F-13
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2. DISCONTINUED OPERATIONS
On November 6, 2001, I-Sector approved a plan to sell or close its IT
Staffing business. This is the measurement date. A sale was finalized effective
December 31, 2001. Under the terms of the sale, I-Sector received a note
receivable for $52, $50 for the ongoing operations of IT Staffing, Inc. and $2
for certain fixed assets of I-Sector. The note receivable bears interest at 5%
per annum and is collectible in installments based on the total monthly revenue
of the buyer over 24 months beginning in April 2002. A disposal loss, including
an estimate of the operating results from the measurement date, November 6, 2001
to the closing date of the sale of $17, and estimates for impairment of assets
caused by the disposal decision of $43, totaling $9 (net of tax of $5) was
recognized in 2001. Additional loss on disposal of $13 (net of tax of $7) was
recognized in 2002. Net loss from discontinued operations was $167 and $0 (net
of tax of $85 and $0) in 2001 and 2002, respectively. I-Sector retained accounts
receivable of approximately $82 and $0, net of reserves at December 31, 2001 and
2002, fixed assets of $52 and liabilities related to the IT Staffing business at
December 31, 2001. Fixed assets were redeployed in the continuing operations.
The balance sheet caption "Liabilities related to discontinued operations"
contains $36 and $0 of estimated future expenses relating to the wind-up of the
IT Staffing business at December 31, 2002 and 2003, respectively. Revenue for
the IT Staffing business for the year ended December 31, 2001 was $967; there
was no revenue subsequent to 2001.
Prior to 2001, I-Sector sold two other businesses that have contributed to
discontinued operations in subsequent periods. In 1999, I-Sector decided to sell
both its computer products reselling business and its PBX telephone systems
dealer business, which together accounted for approximately 90% of total revenue
at the time. I-Sector closed the sale of its PBX telephone systems dealer
business, its Telecom Systems division, on March 16, 2000 and closed the sale of
its computer products reselling business, its Computer Products division, on May
19, 2000.
During the periods specified below, I-Sector recognized a gain on disposal,
net of income tax provision, of these three businesses as follows:
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
------------------------
2001 2002 2003
------ ------ ------
<S> <C> <C> <C>
IT Staffing, Inc. (net of taxes of $(5), $(7) and $14,
respectively)............................................. $ (9) $(13) $ 26
Computer Products Division (net of taxes of $179, $53 and
$53, respectively)........................................ 346 104 104
Telecom Division (net of taxes of $0, $88 and $41,
respectively)............................................. -- 171 80
---- ---- ----
Net gain on disposal........................................ $337 $262 $210
==== ==== ====
</Table>
The balance sheet caption "Liabilities related to discontinued operations"
contains $904 and $557 at December 31, 2002 and 2003, respectively, of estimated
future expenses related to the winding up of the IT Staffing business, the
Telecom Division and the Computer Products Division, and includes amounts
related to settlement of pending litigation and to Telecom warranties. In 2003
the Company settled liabilities of $285 and revised estimates of liabilities
related to discontinued operations by $62. The liability at December 31, 2003,
relates primarily to the estimated cost to settle pending litigation.
F-14
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
3. ACCOUNTS AND NOTES RECEIVABLE
Accounts receivable consisted of the following:
<Table>
<Caption>
DECEMBER 31,
----------------
2002 2003
------ -------
<S> <C> <C>
Accounts receivable......................................... $7,021 $10,276
Accounts receivable retained -- discontinued operations..... 432 93
Allowances for doubtful accounts............................ (928) (612)
------ -------
Total.................................................. $6,525 $ 9,757
====== =======
</Table>
Notes receivable short-term consisted of the following:
<Table>
<Caption>
DECEMBER 31,
---------------
2002 2003
------ ------
<S> <C> <C>
Notes receivable, short-term................................ $1,236 $1,049
Allowances for doubtful accounts, short-term................ (338) (373)
------ ------
Total.................................................. $ 898 $ 676
====== ======
</Table>
Notes receivable long-term consisted of the following:
<Table>
<Caption>
DECEMBER 31,
------------
2002 2003
---- -----
<S> <C> <C>
Notes receivable, long-term................................. $ 87 $ 502
Allowances for doubtful accounts, long-term................. (23) (250)
---- -----
Total.................................................. $ 64 $ 252
==== =====
</Table>
4. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following:
<Table>
<Caption>
DECEMBER 31,
-----------------
2002 2003
------- -------
<S> <C> <C>
Equipment................................................... $ 248 $ 270
Computer equipment.......................................... 1,942 1,888
Furniture and fixtures...................................... 278 330
Leasehold improvements...................................... 588 623
Vehicles.................................................... 47 47
------- -------
3,103 3,158
Accumulated depreciation and amortization................... (1,988) (1,887)
------- -------
Total.................................................. $ 1,115 $ 1,271
======= =======
</Table>
Property and equipment are depreciated over their estimated useful lives
ranging from three to ten years using the straight-line method. Depreciation
expense totaled $475, $356 and $466 for 2001, 2002 and 2003, respectively.
Assets under capital leases at December 31, 2002 and 2003 totaled $0 and $63
with $0 and $1 of recorded depreciation for 2002 and 2003, respectively.
F-15
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. SEGMENT INFORMATION
I-Sector has four reportable segments: INX, Stratasoft, Valerent and
Corporate. Corporate is not an operating segment. The accounting policies of the
business segments are the same as those for I-Sector. I-Sector evaluates
performance of each segment based on operating income. Management views accounts
receivable and inventory and not total assets in their decision-making.
Inter-segment sales and transfers are not significant and are shown in the
Eliminations column in the following table. The tables below show the results of
the four reportable segments:
For the year ended December 31, 2003:
<Table>
<Caption>
INX STRATASOFT VALERENT CORPORATE ELIMINATIONS CONSOLIDATED
------- ---------- -------- --------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Revenue:
Products..................... $45,749 $ -- $1,573 $ -- $(422) $46,900
Services..................... 4,226 -- 3,503 -- (4) 7,725
Custom projects.............. -- 7,527 -- -- -- 7,527
------- ------- ------ ------- ----- -------
Total revenue.................. 49,975 7,527 5,076 -- (426) 62,152
------- ------- ------ ------- ----- -------
Cost of goods and services:
Products..................... 40,060 -- 1,421 -- (421) 41,060
Services..................... 2,976 -- 2,412 -- (5) 5,383
Custom projects.............. -- 2,982 -- -- -- 2,982
------- ------- ------ ------- ----- -------
Cost of goods and services... 43,036 2,982 3,833 -- (426) 49,425
------- ------- ------ ------- ----- -------
Gross profit................... 6,939 4,545 1,243 -- -- 12,727
Selling, general and
administrative expenses...... 6,045 5,888 1,963 1,165 -- 15,061
------- ------- ------ ------- ----- -------
Operating income (loss)........ $ 894 $(1,343) $ (720) $(1,165) $ -- (2,334)
======= ======= ====== ======= =====
Interest and other income,
net.......................... 107
-------
Loss from continuing operations
before benefit for income
taxes........................ (2,227)
Benefit for income taxes....... 181
-------
Net loss from continuing
operations................... (2,046)
Net gain on disposal of
discontinued operations, net
of taxes..................... 210
-------
Net loss....................... $(1,836)
=======
Accounts receivable, net....... $ 7,898 $ 978 $ 788 $ -- $ -- $ 9,664
======= ======= ====== ======= =====
Accounts receivable retained
from discontinued operations,
net.......................... 93
-------
Total accounts receivable,
net.......................... $ 9,757
=======
Inventory...................... $ 365 $ 657 $ 16 $ -- $ -- $ 1,038
======= ======= ====== ======= ===== =======
</Table>
F-16
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
For the year ended December 31, 2002:
<Table>
<Caption>
INX STRATASOFT VALERENT CORPORATE ELIMINATIONS CONSOLIDATED
------- ---------- -------- --------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Revenue:
Products.................... $28,990 $ -- $ 1,092 $ -- $(277) $29,805
Services.................... 1,748 -- 3,900 (1) 5,647
Custom projects............. -- 6,569 -- -- 6,569
------- ------ ------- ----- ----- -------
Total revenue................. 30,738 6,569 4,992 -- (278) 42,021
------- ------ ------- ----- ----- -------
Cost of goods and services:
Products.................... 25,659 -- 1,055 -- (277) 26,437
Services.................... 1,658 -- 2,738 -- (1) 4,395
Custom projects............. -- 2,920 -- -- -- 2,920
------- ------ ------- ----- ----- -------
Cost of goods and
services................. 27,317 2,920 3,793 -- (278) 33,752
------- ------ ------- ----- ----- -------
Gross profit.................. 3,421 3,649 1,199 -- -- 8,269
Selling, general and
administrative expenses..... 3,545 3,922 2,236 922 -- 10,625
------- ------ ------- ----- ----- -------
Operating loss................ $ (124) $ (273) $(1,037) $(922) $ -- (2,356)
======= ====== ======= ===== =====
Interest and other income,
net......................... 115
-------
Loss from continuing
operations before benefit
for income taxes............ (2,241)
Benefit for income taxes...... 1,595
-------
Net loss from continuing
operations.................. (646)
Net gain on disposal of
discontinued operations, net
of taxes.................... 262
-------
Net loss...................... $ (384)
=======
Accounts receivable, net...... $ 4,454 $1,124 $ 400 $ 115 $ -- $ 6,093
======= ====== ======= ===== =====
Accounts receivable retained
from discontinued
operations, net............. 432
-------
Total accounts receivable,
net......................... $ 6,525
=======
Inventory..................... $ 348 $ 409 $ 24 $ -- $ -- $ 781
======= ====== ======= ===== ===== =======
</Table>
F-17
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
For the year ended December 31, 2001:
<Table>
<Caption>
INX STRATASOFT VALERENT CORPORATE ELIMINATIONS CONSOLIDATED
------- ---------- -------- --------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Revenue:
Products.................... $ 8,853 $ -- $ 1,113 $ (6) $(35) $ 9,925
Services.................... 1,922 -- 4,555 -- -- 6,477
Custom projects............. -- 7,257 -- -- (39) 7,218
------- ------ ------- ------- ---- -------
Total revenue................. 10,775 7,257 5,668 (6) (74) 23,620
Cost of goods and services:
Products.................... 7,707 -- 1,026 (13) (35) 8,685
Services.................... 1,956 -- 3,377 -- (11) 5,322
Custom projects............. -- 3,318 -- -- -- 3,318
------- ------ ------- ------- ---- -------
Cost of goods and
services............... 9,663 3,318 4,403 (13) (46) 17,325
------- ------ ------- ------- ---- -------
Gross profit (loss)........... 1,112 3,939 1,265 7 (28) 6,295
Selling, general and
administrative expenses..... 3,103 3,021 3,077 1,400 (28) 10,573
------- ------ ------- ------- ---- -------
Operating income (loss)....... $(1,991) $ 918 $(1,812) $(1,393) $ -- (4,278)
======= ====== ======= ======= ====
Interest and other income,
net......................... 316
-------
Loss from continuing
operations before benefit
for income taxes............ (3,962)
Benefit for income taxes...... 87
-------
Net loss from continuing
operations.................. (3,875)
-------
Loss from discontinued
operations, net of taxes.... (167)
Net gain on disposal of
discontinued operations, net
of taxes.................... 337
-------
Net loss...................... $(3,705)
=======
</Table>
International sales accounted for $3,111, $1,851 and $3,179 or 13.2%, 4.4%
and 5.1% of consolidated revenue in 2001, 2002 and 2003, respectively, and were
primarily in the Stratasoft segment. International sales accounted for 42.2% of
the Stratasoft segment revenue in the year ended December 31, 2003.
International sales are derived primarily from United States, Canada, the United
Kingdom, Germany, Greece, India, Egypt, the Philippines and Grenada.
6. EARNINGS PER SHARE
Basic EPS is computed by dividing net income (loss) by the weighted-average
number of common shares outstanding for the period. Diluted EPS is based on the
weighted-average number of shares outstanding during each period and the assumed
exercise of dilutive stock options and warrants less the number of treasury
shares assumed to be purchased from the proceeds using the average market price
of the Company's common stock for each of the periods presented.
F-18
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The potentially dilutive options of 0; 101,318 and 215,395 for the years
ended December 31, 2001, 2002 and 2003, respectively, were not used in the
calculation of diluted earnings since the effect of potentially dilutive
securities in computing a loss per share is antidilutive.
The potentially dilutive options of the Company's wholly-owned subsidiary,
Internetwork Experts, Inc., (see Note 14) did not impact the calculation of
I-Sector's earnings per share for 2001 and 2002 since the effect would have been
antidilutive. In 2003, net loss from continuing operations for purposes of
computing the diluted loss per share increased $29 for the assumed exercise of
INX options under the treasury method.
<Table>
<Caption>
DECEMBER 31,
------------------------------------
2001 2002 2003
---------- ---------- ----------
<S> <C> <C> <C>
Numerator for basic earnings per share:
Net loss from continuing operations.............. $ (3,875) $ (646) $ (2,046)
Net loss from discontinued operations, net of
taxes.......................................... (167) -- --
Gain on disposal of discontinued operations, net
of taxes....................................... 337 262 210
---------- ---------- ----------
Net loss......................................... $ (3,705) $ (384) $ (1,836)
========== ========== ==========
Numerator for diluted earnings per share:
Net loss from continuing operations.............. $ (3,875) $ (646) $ (2,046)
INX income attributable to potential minority
interest....................................... -- -- (29)
---------- ---------- ----------
Net loss from continuing operations used in
computing loss per share....................... (3,875) (646) (2,075)
Net loss from discontinued operations, net of
taxes.......................................... (167) -- --
Gain on disposal of discontinued operations, net
of taxes....................................... 337 262 210
---------- ---------- ----------
Net diluted loss................................. $ (3,705) $ (384) $ (1,865)
========== ========== ==========
Denominator for basic and diluted earnings per
share -- weighted-average shares outstanding... 3,911,019 3,709,689 3,691,052
</Table>
There were warrants to purchase 176,750 shares of common stock for 2001 and
2002 which were not included in computing diluted earnings per share because the
inclusion would have been anti-dilutive. During the three months ended September
30, 2002 such warrants expired and the carrying value of the warrants was
recognized as additional paid in capital.
7. DEBT
On September 27, 2001, Stratasoft, a subsidiary of I-Sector, signed a note
payable to a third party for $725, payable in monthly installments through
February 2007. The note does not bear interest and I-Sector has imputed interest
at 5.5% to record the debt and related patent license asset and has recorded
interest of $9, $30 and $17 in 2001, 2002 and 2003, respectively. This note is
collateralized by Stratasoft's patent license assets and Stratasoft has granted
a security interest in its pending patent application and the next two patent
applications filed by Stratasoft. In connection with this note payable, I-Sector
has short-term debt maturing within one year of $68 and long-term debt of $184
at December 31, 2003.
In October 2001, I-Sector signed a non-interest bearing note payable for
$39 payable in monthly installments through October 2004. In connection with
this note payable, I-Sector has short-term debt maturing within one year of $10
at December 31, 2003.
In December 2003, I-Sector signed a 36 month non-cancelable capital lease
for the purchase of equipment. I-Sector imputed interest at 10% to record the
debt on which I-Sector has recorded $0 interest in
F-19
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2003. In connection with this capital lease, I-Sector has recorded short-term
debt maturing within one year of $18 and long-term debt of $45 at December 31,
2003.
In connection with its credit agreement for the purchase of inventory
discussed immediately below, $1,688 of the outstanding balance on such credit
line was interest bearing at December 31, 2003 and is reflected as short-term
debt in the accompanying balance sheet.
On January 31, 2002, I-Sector entered into a credit agreement with Textron
Financial Corporation ("Textron") for a revolving line of credit (the "Textron
Facility"). The total credit available under the Textron facility, as amended,
was $7,500 subject to borrowing base limitations that are generally computed as
80% of eligible accounts receivable, and 90% of identifiable inventory purchased
under this agreement and 40% of all other inventory. The borrowing base
limitations restrict the eligibility of accounts receivable for
collateralization by disallowing as eligible any customer's receivables in their
entirety that have balances over 90 days old and that exceed 25% of their total
balance. In November 2003 Textron agreed to increase the credit facility from
$7,500 to $10,000. The facility would increase to $15,000 upon the execution of
syndication loan documents and an activation of syndication for $5,000 with
Silicon Valley Bank. In February 2004, the syndication loan documents were
executed and the credit line increase to $15,000 became effective in March 2004.
Inventory floor plan borrowings are reflected in accounts payable in the
accompanying balance sheets, except for $1,688 that is interest bearing and is
reflected in short term debt in the accompanying balance sheet at December 31,
2003. Borrowings accrue interest at the prime rate (4.0% at December 31, 2003)
plus 2.5% on outstanding balances that extend beyond the vendor approved free
interest period. This agreement is collateralized by substantially all of
I-Sector's assets except its patent license assets. The loan documents contain
restrictive covenants measured at each quarter end and effective at December 31,
2003, which requires us to maintain minimum tangible capital funds, maintain
minimum debt to tangible capital funds ratio, and effective at March 31, 2004,
to achieve a fixed charge coverage ratio. At December 31, 2003 I-Sector was in
compliance with those loan covenants effective at that date and anticipates that
it will be able to comply with its loan covenants prospectively. In the event
I-Sector does not maintain compliance, it would be required to seek waivers from
Textron and Silicon Valley Bank for those events, which, if not obtained, could
accelerate repayment and require I-Sector to seek other sources of finance. At
December 31, 2003, I-Sector had $7,608 outstanding on inventory floor plan
finance borrowings, and the remaining credit availability was $2,392.
The weighted-average interest rate for borrowings under all credit line
arrangements in effect during, 2001, 2002 and 2003 was 0%, 0% and 6.73%,
respectively. Interest expense on all credit lines was $0, $0 and $29 for the
years ended December 31, 2001, 2002 and 2003, respectively.
The aggregate amounts of installments due by calendar year on long-term
debt at December 31, 2003 are as follows:
<Table>
<S> <C>
2004........................................................ $1,784
2005........................................................ 106
2006........................................................ 117
2007........................................................ 6
------
Total....................................................... $2,013
======
</Table>
F-20
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
8. INCOME TAXES
The provision for income taxes consisted of the following:
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
-------------------------
2001 2002 2003
----- -------- ------
<S> <C> <C> <C>
Current provision (benefit):
Federal..................................................... $(87) $(1,595) $(181)
State....................................................... -- -- --
---- ------- -----
Total current provision (benefit)........................... (87) (1,595) (181)
Deferred provision (benefit)................................ -- -- --
---- ------- -----
Total benefit from continuing operations.................... (87) (1,595) (181)
Total benefit from discontinued operations.................. (85) -- --
Total provision for gain on disposal........................ 172 136 108
---- ------- -----
Total..................................................... $ -- $(1,459) $ (73)
==== ======= =====
</Table>
The total provision for income taxes for continuing operations during the
years ended December 31, 2001, 2002 and 2003 varied from the U.S. federal
statutory rate due to the following:
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
-------------------------
2001 2002 2003
------- ------- -----
<S> <C> <C> <C>
Federal income tax at statutory rate...................... $(1,347) $ (762) $(757)
Nondeductible expenses.................................... 52 18 20
Other..................................................... -- -- (2)
Valuation allowance....................................... 1,208 (851) 558
------- ------- -----
Total benefit from continuing operations................ $ (87) $(1,595) $(181)
======= ======= =====
</Table>
Net deferred tax assets computed at the statutory rate related to temporary
differences were as follows:
<Table>
<Caption>
DECEMBER 31,
---------------
2002 2003
----- -------
<S> <C> <C>
Net deferred tax assets (liabilities):
Accounts and notes receivable............................. $ 486 $ 458
Closing and severance costs............................... 307 189
Deferred service revenue.................................. 27 (35)
Inventory................................................. -- 13
Amortization of intangibles............................... (27) (17)
Depreciation.............................................. -- (63)
Net operating loss carryforward........................... -- 806
----- -------
Total.................................................. 793 1,351
Less Valuation allowance.................................... (793) (1,351)
----- -------
Total..................................................... $ -- $ --
===== =======
</Table>
Due to the company's recurring losses, a valuation allowance was
established to fully offset the net deferred tax assets at December 31, 2001,
2002 and 2003.
F-21
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
At December 31, 2003, I-Sector has a net operating loss (NOL) carryforward
for federal income tax reporting purposes of approximately $2,372. Since United
States tax laws limit the time during which an NOL may be applied against future
taxable income and tax liabilities, I-Sector may not be able to take full
advantage of its NOL carryforward for federal income tax purposes. The
carryforward will expire in 2023 if not otherwise used. A change in ownership,
as defined by federal income tax regulations, could significantly limit
I-Sector's ability to utilize its carryforward.
During 2003, a significant number of non-qualified options were exercised
creating an excess income tax benefit for I-Sector. This benefit will be
utilized to the extent that I-Sector has tax basis income that was not offset by
net operating loss (NOL) carryforwards. At December 31, 2003, approximately $243
of the valuation allowance has been attributed to "excess benefit due to
options." The company will use this portion only when the valuation allowance
has been reduced by $564. Any tax benefit that is realized in subsequent years
from the reduction of the valuation allowance established related to these
options will be recorded as an expense and additional paid-in capital.
On March 9, 2002, President Bush signed into law the Job Creation and
Worker Assistance Act of 2002. The law provides for the carryback of net
operating losses for any taxable year ending during 2001 and 2002 to each of the
5 tax years preceding the loss year. Previously, a net operating loss was only
eligible to be carried back to the 2 years preceding the year of loss. As a
result of the change in the carryback period, I-Sector recognized a tax benefit
of $1,459 and $73 in the years ended December 31, 2002 and 2003, respectively.
On July 26, 2002 the Company received $1,123 in tax refunds. Additionally, on
July 24, 2003 the Company received $561 in tax refunds.
9. ACCRUED EXPENSES
Accrued expenses consisted of the following:
<Table>
<Caption>
DECEMBER 31,
---------------
2002 2003
------ ------
<S> <C> <C>
Sales tax payable........................................... $ 386 $ 374
Accrued employee benefits, payroll and other related
costs..................................................... 799 1,359
Accrued property taxes...................................... 6 4
Accrued offering costs...................................... -- 317
Accrued warranty costs...................................... 305 302
Other....................................................... 307 320
------ ------
Total..................................................... $1,803 $2,676
====== ======
</Table>
10. COMMITMENTS AND CONTINGENCIES
Litigation -- In August 2002, Inacom Corp. ("Inacom") filed a lawsuit in
the District Court of Douglas County, Nebraska styled Inacom Corp v. I-Sector
Corporation, f/k/a Allstar Systems, Inc., claiming that I-Sector owed the sum of
approximately $570 to Inacom as a result of Inacom's termination of a Vendor
Purchase Agreement between Inacom and I-Sector. I-Sector believes that the claim
is without merit and intends to vigorously contest the demand.
I-Sector had filed a claim to collect on a note receivable from E Z Talk
Communications ("E Z Talk") and had entered into arbitration discussions with E
Z Talk. In July 2002, E Z Talk filed a lawsuit to set aside the arbitration and
claiming damages of $250. On March 7, 2003, the parties settled with E Z Talk
paying $25 over 5 months from April 2003 through August 2003 and agreeing to
release all equipment back to I-Sector
F-22
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
90 days after the final payment. All payments have been made with the last
payment occurring on August 22, 2003.
The Equal Employment Opportunity Commission ("EEOC") filed a Charge of
Discrimination against Stratasoft on behalf of a former employee on August 1,
2002 in the EEOC Minneapolis, Minnesota office. Stratasoft reached agreement to
settle this claim, without admitting or denying, in September 2003 for $130, and
general and administrative expense of $130 was recognized in the year ended
December 31, 2003.
In March 2003, I-Sector and other parties were notified of a demand for
return of payments relating to the business activities of a call center
customer. In March 2004, I-Sector was informed by the claimant that claims will
not be pursued at this time. I-Sector believes that the claims against it, if
re-initiated, are without merit and intends to vigorously contest any demands
related to this matter.
I-Sector is also party to other litigation and claims which management
believes are normal in the course of its operations. While the results of such
litigation and claims cannot be predicted with certainty, I-Sector believes the
final outcome of such matters will not have a materially adverse effect on its
results of operations or financial position.
Leases -- I-Sector leases office space from Allstar Equities, Inc. In 1999,
I-Sector renewed its office lease for a five year period with monthly rental
payments of $38 plus certain operating expenses through December 1, 2004. The
lease was renewed February 1, 2002 for a five year period with monthly rental
payments of $37 plus certain operating expenses through January 31, 2007. Rental
expense under this agreement amounted to approximately $452, $446, and $446
during years ended December 31, 2001, 2002 and 2003, respectively. Additionally,
future minimum rentals on other operating leases amount to approximately $185 in
2004, $159 in 2005, $112 in 2006 and $3 in 2007. Amounts paid during the years
ended December 31, 2001, 2002 and 2003, under such agreements totaled
approximately $197, $131 and $295, respectively.
401(k) plan -- I-Sector maintains a 401(k) savings plan wherein I-Sector
matches a portion of the employee contribution. In addition, I-Sector has a
discretionary matching fund based on the net profitability of I-Sector. All
full-time employees who have completed 90 days of service with I-Sector are
eligible to participate in the plan. Declaration of the discretionary portion of
the matching fund is the decision of the Board. I-Sector has made no additional
contributions to the plan for the years ended December 31, 2001, 2002 or 2003.
Under the standard I-Sector matching program, I-Sector's match was $32, $27, and
$31 for the years ended December 31, 2001, 2002 and 2003, respectively.
Related Party Transactions
The Company leases office space from Allstar Equities, Inc., a Texas
corporation ("Equities"), a company wholly owned by the CEO. On December 1, 1999
Equities purchased the Company's corporate office building and executed a direct
lease with us with an expiration date of December 31, 2004. In conjunction with
Equities obtaining new financing on the building, a new lease was executed with
the Company on February 1, 2002 with an expiration date of January 31, 2007. The
new lease has rental rates of $37 per month.
From time to time, I-Sector makes short-term loans and travel advances to
its non-executive employees. The balance of approximately $16 relating to these
loans and advances is included in the Company's balance sheet and reported as
part of Accounts receivable -- other at December 31, 2003.
F-23
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
12. INTANGIBLE ASSETS
<Table>
<Caption>
DECEMBER 31, 2002 DECEMBER 31, 2003
----------------------- -----------------------
GROSS GROSS WEIGHTED
CARRYING ACCUMULATED CARRYING ACCUMULATED AMORTIZATION
AMOUNT AMORTIZATION AMOUNT AMORTIZATION YEARS
-------- ------------ -------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Amortized intangible assets
Patent license rights................ $1,046 $148 $1,114 $265 7.50
Customer list........................ 200 90 602 231 2.14
Other................................ 224 70 168 104 1.90
------ ---- ------ ----
Total.................................. $1,470 $308 $1,884 $600
====== ==== ====== ====
</Table>
The estimated aggregate amortization expense for each of the next five
years and thereafter is as follows:
<Table>
<S> <C>
2004........................................................ $ 318
2005........................................................ 295
2006........................................................ 140
2007........................................................ 103
2008........................................................ 63
Thereafter.................................................. 365
------
Total..................................................... $1,284
======
</Table>
In October 2000, I-Sector's wholly owned subsidiary INX acquired certain
assets and liabilities of Internetwork Experts, Inc., a professional services
firm focused on the architecture, design, implementation and support of high-end
network infrastructure. The purchase price was $225 in cash and assumed
liabilities of $116. The acquisition was accounted for using the purchase method
of accounting, and accordingly, the purchase price has been allocated to the
assets and liabilities acquired based on fair values at the date of acquisition.
The excess of the purchase price over the fair market value of the net assets
acquired was approximately $341, $200 of which has been allocated to a customer
list and service agreements. The remaining has been allocated to other
intangibles. INX was contingently liable for future payments to the former owner
based on the level of service revenue generated within a specified period of
time and within certain ranges for the customers included on the customer list.
That contingent liability was settled in 2001 for $50. The customer list and
other intangibles are being amortized over their estimated useful lives of 5
years.
On April 7, 2003, I-Sector's subsidiary, INX, acquired certain assets and
liabilities of one of its competitors, Digital Precision, Inc. ("Digital").
Under the terms of the purchase, INX acquired fixed assets valued at $63,
inventory valued at $101 and intellectual property, customer lists, trademarks,
trade names and service marks, contract rights and other intangibles of Digital
valued at $376, as well as assumed certain operating leases of equipment and
office space with a net future obligation of $548. The office space in Dallas,
Texas was subleased with future rentals of $234. The intangibles are subject to
amortization and have a three year expected life. The purchase price was $540 in
cash and, contingent upon the retention of certain key employees, the obligation
to issue 1,800,000 shares of INX common stock in April 2004. If that contingency
is resolved in April 2004, I-Sector will recognize a minority interest related
to the issuance of INX's common stock (see Note 14). No goodwill was recognized
in the acquisition. The results of operations subsequent to April 7, 2003 are
included in I-Sector's consolidated statement of operations.
F-24
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
13. STOCKHOLDERS' EQUITY
STOCK OPTION PLANS
Under the 1996 Incentive Stock Plan (the "1996 Incentive Plan") and the
1996 Non-Employee Director Stock Option Plan (the "Director Plan") as approved
by the shareholders, I-Sector's Compensation Committee may grant up to 442,500
shares of common stock, which have been reserved for issuance to certain
employees of I-Sector. At December 31, 2003, 114,488 shares were available for
future grant under the 1996 Incentive Plan. The 1996 Incentive Plan provides for
the granting of incentive awards in the form of stock options, restricted stock,
phantom stock, stock bonuses and cash bonuses in accordance with the provisions
of the plan. Additionally, no shares may be granted after the tenth anniversary
of the 1996 Incentive Plan's adoption. I-Sector has reserved for issuance, under
the Director Plan, 100,000 shares of common stock, subject to certain
anti-dilution adjustments, of which 10,000 shares were available for future
grants at December 31, 2003. The Director Plan provides for a one-time option by
newly elected directors to purchase up to 5,000 common shares, after which each
director is entitled to receive an option to purchase up to 5,000 common shares
upon each date of re-election to I-Sector's Board of Directors. Options granted
under the Director Plan and the 1996 Incentive Plan have an exercise price equal
to the fair market value on the date of grant and generally expire ten years
after the grant date.
In May 2000, I-Sector adopted the 2000 Stock Incentive Plan (the "2000
Incentive Plan") as approved at the annual shareholder's meeting. At the August
20, 2003 shareholder's meeting, the 2000 Incentive Plan was amended and
restated, including a change in the name of the plan to I-Sector Corporation
Incentive Plan ("I-Sector Incentive Plan") and amendments to make it compliant
with both the Sarbanes-Oxley Act of 2002 and with Section 162(m) and other
sections of the Internal Revenue Code. Additionally, the plan was amended to
increase the number of shares of common stock available for granting stock
options to 600,000 in 2003. The I-Sector Incentive Plan provides for the
granting of incentive awards in the form of stock-based awards and cash bonuses
in accordance with the provisions of the plan. All employees, including
officers, and consultants and non-employee directors are eligible to participate
in the I-Sector Incentive Plan. Generally, the Compensation Committee has the
discretion to determine the exercise price of each stock option under the
I-Sector Incentive Plan, and they must be exercised within ten years of the
grant date, except those classified as Incentive Stock Option ("ISO") grants to
a 10% or greater stockholder. ISO options grants to a 10% or greater stockholder
must be exercised within five years of the grant date. The exercise price of
each ISO option grant may not be less than 100% of the fair market value of a
share of common stock on the date of grant (110% in the case of a 10% or greater
stockholder). At December 31, 2003, 4,170 shares were available for future grant
under the I-Sector Incentive Plan.
F-25
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The activity of employees in all plans is summarized below:
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
---------------------------------------------------------------
2001 2002 2003
------------------- ------------------- -------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
-------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Options outstanding at beginning
of the period.................. 383,112 $1.72 399,812 $1.48 396,042 $1.47
Granted during the period........ 25,000 1.00 25,000 1.20 338,760 3.58
Exercised during the period...... -- -- -- -- (222,736) 1.44
Transfers to non-employees....... -- -- (11,330) .99 -- --
Canceled during the period....... (8,300) 1.64 (17,440) 1.66 (10,100) 1.36
-------- -------- --------
Options outstanding at end of
period......................... 399,812 $1.48 396,042 $1.47 501,966 $2.85
======== ======== ========
Options exercisable at end of
period......................... 317,722 $1.58 369,312 $1.46 259,406 $1.81
======== ======== ========
Options outstanding price
range.......................... $1.06 $0.82 $0.82
to $7.62 to $7.62 to $8.06
Weighted average fair value of
options granted during the
period......................... $1.00 $1.20 $2.55
Options weighted average
remaining life................. 6.88 6.29 8.39
Years Years Years
</Table>
<Table>
<Caption>
EMPLOYEE AND DIRECTOR
-------------------------------------------------------------
OUTSTANDING EXERCISABLE
------------------------------------ ----------------------
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
OUTSTANDING CONTRACTUAL EXERCISE EXERCISABLE EXERCISE
SHARES LIFE PRICE SHARES PRICE
----------- ----------- -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$0.82 to $1.99.......................... 201,766 6.03 $1.39 163,686 $1.33
$2.00 to $2.99.......................... 88,200 9.53 2.66 95,720 2.63
$3.00 to $3.99.......................... -- -- -- -- --
$4.00 to $4.99.......................... 202,000 9.76 4.14 -- --
$5.00 to $8.06.......................... 10,000 -- 8.06 -- --
----------- -----------
Total.............................. 501,966 8.22 $2.85 259,406 $1.81
=========== ===========
</Table>
Employees affected by the sale of the Telecom Division on March 16, 2000
and of the Computer Products Division on May 19, 2000 (See Note 2) retained
their respective stock option grants received prior to I-Sector's disposal of
these divisions. In addition, certain affected employees were eligible and
received stock options awards subsequent to their termination dates. The
affected employees' awards will vest or continue to vest according to the
periods specified in their respective stock option agreements, generally five
years, contingent upon the employment with the respective division's acquirer.
F-26
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The activity of options to the non-employee group is summarized below:
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
---------------------------------------------------------------
2001 2002 2003
------------------- ------------------- -------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
-------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Options outstanding at beginning
of the period.................. 183,771 $2.18 181,483 $1.45 168,280 $1.43
Transferred from employee plan... -- -- 10,200 0.99 -- --
Exercised during the period...... -- -- -- -- (98,748) 1.56
Grants during the period......... -- -- -- -- 118,000 2.32
Canceled during the period....... (2,288) 1.64 (23,403) 1.72 -- --
-------- -------- --------
Options outstanding at end of
period......................... 181,483 $1.45 168,280 $1.43 187,532 $1.92
======== ======== ========
Options exercisable at end of
period......................... 83,304 $1.37 151,859 $1.42 165,492 $1.62
======== ======== ========
Options outstanding price
range.......................... $1.06 $1.06 $1.06
to $2.31 to $2.31 to $4.14
Options weighted average
remaining life................. 3.13 3.13 5.33
Years Years Years
</Table>
<Table>
<Caption>
NON-EMPLOYEE
-------------------------------------------------------------
OUTSTANDING EXERCISABLE
------------------------------------ ----------------------
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
OUTSTANDING CONTRACTUAL EXERCISE EXERCISABLE EXERCISE
SHARES LIFE PRICE SHARES PRICE
----------- ----------- -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$0.82 to $1.99.................. 155,780 7.47 $1.70 155,740 $1.70
$2.00 to $2.99.................. 9,752 6.35 2.25 9,752 2.25
$3.00 to $3.99.................. -- -- -- -- --
$4.00 to $4.99.................. 22,000 9.88 4.14 -- --
$5.00 to $6.00.................. -- -- -- -- --
----------- -----------
Total......................... 187,532 7.69 $1.92 165,492 $1.62
=========== ===========
</Table>
Capital Stock -- Holders of I-Sector's common stock are entitled to one
vote per share on all matters to be voted on by shareholders and are entitled to
receive dividends, if any, as may be declared from time to time by the Board of
Directors of I-Sector (the "Board"). Upon any liquidation or dissolution of
I-Sector, the holders of common stock are entitled, subject to any preferential
rights of the holders of preferred stock, to receive a pro rata share of all of
the assets remaining available for distribution to shareholders after payment of
all liabilities. There are no shares of preferred stock issued or outstanding.
Restricted Stock -- At December 31, 2002, I-Sector had 1,200 shares of
restricted stock with a par value of $0.01 per share outstanding. The 1,200
shares, valued at $1.563 per share, vested ratably at the end of each one year
period over a five year period from the date of issuance. At December 31, 2003,
all restrictions on these shares have lapsed.
Warrants -- I-Sector issued warrants to purchase 176,750 common shares at
$9.60 per share to underwriters in connection with its public offering of common
stock. The warrants expired on July 7, 2002.
F-27
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. SUBSIDIARY STOCK OPTION PLAN
Each of I-Sector's three primary subsidiaries had an incentive stock option
plan in place, but all of the subsidiary plans except for INX were terminated in
December 2003. The INX plan has not been presented to the shareholders of
I-Sector for approval. INX has granted incentive awards under its incentive
plan, and such awards have been granted to certain employees and to management
of INX. Under INX's plan such options vest typically ratably over three to five
years. In December 2003, the Company amended option agreements with INX's two
most senior executives to convert to a fixed 5-year vesting schedule from one
that was determined based on the percentage of attainment of predefined
financial goals by INX. No stock-based compensation was recorded as the exercise
price equaled or exceeded management's estimated fair value of the INX common
stock. Any unvested INX stock options may vest immediately upon the occurrence
of a liquidity event for that subsidiary. 5,435,000 of the options contain an
exercise restriction which only allows vested options to be exercised upon the
occurrence of a liquidity event or one month prior to the option's expiration
date. The INX options expire ten years after the grant date if they are not
exercised. The INX stock option grants are subject to dilution when I-Sector
purchases additional shares of the subsidiary stock in order to keep the
subsidiary sufficiently capitalized. INX has 9,490,692 options granted and
outstanding, of which 3,777,666 are vested and 500,000 are exercisable at
December 31, 2003. The outstanding options have exercise prices ranging from
$0.01 to $0.25 per share with a weighted average of $0.17 per share. There are
no shares in INX's plan available to be issued at December 31, 2003 and INX's
plan has been amended, effective December 31, 2003 so that no further options
may be granted under the plan. The tables below reflect the ownership of INX at
December 31, 2003 and summarize the potential dilutive effect on I-Sector's
ownership in INX if all options granted at December 31, 2003 were fully vested
and option grants were exercised, and include the effects of the issuance of
stock in 2004 relating to INX's acquisition of certain assets and liabilities of
Digital Precision, Inc. The table does not assume any repurchase of shares with
proceeds from option exercises.
<Table>
<Caption>
INX PERCENT OF
COMMON STOCK TOTAL
------------ ----------
<S> <C> <C>
Ownership of INX shares at December 31, 2003:
Common Stock owned by I-Sector............................ 21,834,333 100.0%
---------- ------
Total Common Stock Outstanding............................ 21,834,333 100.0%
========== ======
Potential Future I-Sector Dilution of Ownership:
Common Stock owned by I-Sector at December 31, 2003....... 21,834,333 65.9%
Options granted and outstanding at December 31,
2003(1)(2)(3)(4)....................................... 9,490,692 28.7%
Contingent obligation to issue Common Stock related to
acquisition(5)......................................... 1,800,000 5.4%
---------- ------
Total at December 31, 2003................................ 33,125,025 100.0%
========== ======
</Table>
---------------
(1) Options granted and outstanding at December 31, 2003 include option grants
for 4,100,000 shares of INX granted to the two senior executives of INX and
vesting of these option grants was performance-based relating to the
percentage of predefined financial goals attained by INX while these two
senior executives remain employed. In December 2003, these option agreements
were amended to convert to a fixed 5-year vesting schedule.
(2) Included in the option grants outstanding at December 31, 2003 are grants
for 1,881,692 shares granted to key employees related to the acquisition
Digital Precision, Inc. Grants for 500,000 of these shares vested April
2003. The balance of the grants for 1,381,692 shares, which were granted in
November 2003, vest over three years, starting in April 2004
F-28
<PAGE>
I-SECTOR CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(3) During the year ended December 31, 2003, INX granted fully vested options to
purchase 1,200,000 shares of INX at an exercise price of $0.25 per share to
the CEO and Chairman of the Board of I-Sector Corporation. Such option grant
was voluntarily canceled by the CEO and Chairman of the Board of I-Sector
Corporation in February 2004 concurrent with the issuance of a warrant for
1.2 million Shares to I-Sector on similar terms. During the year ended
December 31, 2003, INX granted fully vested options to purchase 300,000
shares at an exercise price of $0.25 per share to the President and CEO of
INX. In addition, INX granted options vesting over three years to various
other employees during the year ended December 31, 2003.
(4) The remainder of the shares included in INX option grants outstanding at
December 31, 2003 vest over either three or five years based upon continued
employment by INX of the individuals to whom such grants have been made. All
options granted by INX expire in ten years if unexercised.
(5) In connection with the acquisition of certain assets and liabilities of
Digital Precision, Inc. (see Note 12), a portion of the consideration given
by INX was the contingent obligation to issue 1,800,000 shares of INX Common
Stock to Digital Precision, Inc. when and if three key employees complete
one year of employment with INX. If any of such key employees terminates
employment without cause before completion of one year of employment, the
number of shares of Common Stock to be issued to all of the former
stockholders of Digital Precision is decreased by scheduled and agreed upon
percentages.
F-29
<PAGE>
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
YOU MAY RELY ON THE INFORMATION CONTAINED IN THIS PROSPECTUS. WE HAVE NOT
AUTHORIZED ANYONE TO PROVIDE INFORMATION DIFFERENT FROM THAT CONTAINED IN THIS
PROSPECTUS. WE ARE OFFERING TO SELL SECURITIES AND SEEKING OFFERS TO BUY
SECURITIES ONLY IN JURISDICTIONS WHERE OFFERS AND SALES ARE PERMITTED. THE
INFORMATION CONTAINED IN THIS PROSPECTUS IS ACCURATE ONLY AS TO THE DATE OF THIS
PROSPECTUS, REGARDLESS OF THE TIME OF DELIVERY OF THIS PROSPECTUS OR OF ANY SALE
OF SECURITIES.
---------------------
TABLE OF CONTENTS
<Table>
<Caption>
PAGE
----
<S> <C>
Prospectus Summary.................... 1
Risk Factors.......................... 5
Forward-Looking Statements............ 14
Use of Proceeds....................... 14
Price Ranges of Our Common Stock...... 15
Dividend Policy....................... 15
Capitalization........................ 16
Selected Consolidated Financial
Data................................ 17
Management's Discussion and Analysis
of Financial Condition and Results
of Operations....................... 19
Business.............................. 41
Management............................ 50
Security Ownership of Certain
Beneficial Owners and Management.... 57
Certain Relationships and Related
Party Transactions.................. 58
Description of Securities............. 59
Shares Eligible for Future Sale....... 62
Underwriting.......................... 63
Legal Matters......................... 66
Experts............................... 66
Changes In Certifying Accountant...... 66
Where You Can Find More Information... 67
Incorporation By Reference............ 67
Index to Consolidated Financial
Statements.......................... F-1
</Table>
---------------------
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
500,000 UNITS
(I-SECTOR CORPORATION LOGO)
-------------------------
PROSPECTUS
-------------------------
May , 2004
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
<PAGE>
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 14. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.
The following are the expenses of the issuance and distribution of the
securities being registered, other than underwriting commissions and expenses,
all of which will be paid by the Company. Other than the SEC registration fee,
the American Stock Exchange listing fee and the NASD filing fees, all of such
expenses are estimated.
<Table>
<S> <C>
Registration fee............................................ $ 4,911
NASD fee.................................................... $ 15,000
American Stock Exchange listing fee......................... $ 70,000
Printing expenses........................................... $ 190,000
Accounting fees and expenses................................ $ 250,000
Legal fees and expenses..................................... $ 450,000
Transfer/Warrant agent and registrar fees and expenses...... $ 7,500
Miscellaneous............................................... $ 85,000
----------
Total....................................................... $1,072,411
==========
</Table>
ITEM 15. INDEMNIFICATION OF DIRECTORS AND OFFICERS.
Our certificate of incorporation provides that a director will not be
personally liable to us or to our stockholders for monetary damages for breach
of the fiduciary duty of care as a director, including breaches which constitute
gross negligence. This provision does not eliminate or limit the liability of a
director:
- for breach of his or her duty of loyalty to us or to our stockholders;
- for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
- under Section 174 of the Delaware General Corporation Law (relating to
unlawful payments or dividends or unlawful stock repurchases or
redemptions);
- for any improper benefit; or
- for breaches of a director's responsibilities under the federal
securities laws.
Our certificate of incorporation also provides that we indemnify and hold
harmless each of our directors and officers to the fullest extent authorized by
the Delaware General Corporation Law, against all expense, liability and loss
(including attorney's fees, judgments, fines, ERISA excise taxes or penalties
and amounts paid or to be paid in settlement) reasonably incurred or suffered by
such person in connection therewith.
Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers and controlling persons pursuant to our
certificate of incorporation, bylaws and the Delaware General Corporation Law,
we have been advised that in the opinion of the SEC such indemnification is
against public policy and is, therefore, unenforceable.
The Underwriting Agreement provides for reciprocal indemnification between
us and our controlling persons, on the one hand, and the underwriters and their
respective controlling persons, on the other hand, against certain liabilities
in connection with this offering, including liabilities under the Securities Act
of 1933, as amended.
II-1
<PAGE>
ITEM 16. EXHIBITS
<Table>
<Caption>
EXHIBIT EXCEPT AS OTHERWISE INDICATED, PREVIOUSLY FILED OR
NO. DESCRIPTION INCORPORATED BY REFERENCE FROM:
------- ----------- --------------------------------------------------
<C> <S> <C>
1.1 Form of Underwriting Agreement. Filed herewith
3.1 Bylaws of the Company. Exhibit 3.1 to Form S-1, Registration No.
333-09789, filed August 8, 1996
3.2 Certificate of Incorporation of the Exhibit 3.2 to Amendment 1 to Form S-1,
Company. Registration No. 333-09789, filed August 8, 1996
3.3 Certificate of Amendment to Certificate Exhibit 3.4 to Amendment 5 to Form S-1,
of Incorporation of Allstar Systems, Registration No. 333-09789, filed August 8, 1996
Inc., dated June 24, 1997.
3.4 Certificate of Amendment to Certificate Exhibit 3.3 to Form 8-A filed December 29, 2003
of Incorporation of Allstar Systems,
Inc., dated March 5, 1999.
3.5 Certificate of Amendment to Certificate Exhibit 3.4 to Form 8-A filed December 29, 2003
of Incorporation of Allstar Systems, Inc.
dated July 10, 2000.
4.1 Specimen Common Stock Certificate. Filed herewith
4.2 Form of Unit Certificate. Filed herewith
4.3 Form of Warrant Agreement, including Form Filed herewith
of Warrant.
4.4 Form of Representative's Warrant. Filed herewith
5.1 Opinion of Porter & Hedges, L.L.P. Previously filed
10.1 Form of Employment Agreement by and Exhibit 10.5 to Amendment 1 to Form S-1,
between the Company and certain members Registration No. 333-09789, filed August 8, 1996
of management.
10.2 Employment Agreement by and between Exhibit 10.6 to Form S-1, Registration No.
Stratasoft, Inc. and William R. Hennessy, 333-09789, filed August 8, 1996
dated September 7, 1995.
10.3 Employment Agreement by and between Exhibit 10.3 to the Form 10-K filed March 12, 2004
Allstar Systems, Inc. and James H. Long,
dated August 15, 1996.
10.4 Systems Integrator Agreement by and Exhibit 10.4 to the Form 10-K filed March 12, 2004
between Cisco Systems, Inc. and
Internetwork Experts, Inc., dated
November 13, 2000.
10.5 Amendment One, dated January 28, 2002, to Exhibit 10.5 to the Form 10-K filed March 12, 2004
Systems Integrator Agreement by and
between Cisco Systems, Inc. and
Internetwork Experts, Inc., dated
November 13, 2000.
10.6 Amendment Two, dated November 21, 2002, Exhibit 10.6 to the Form 10-K filed March 12, 2004
to Systems Integrator Agreement by and
between Cisco Systems, Inc. and
Internetwork Experts, Inc., dated
November 13, 2000.
10.7 Amendment Three, dated January 20, 2003, Exhibit 10.7 to the Form 10-K filed March 12, 2004
to Systems Integrator Agreement by and
between Cisco Systems, Inc. and
Internetwork Experts, Inc., dated
November 13, 2000.
10.8 Amendment Four, dated January 16, 2004, Exhibit 10.8 to the Form 10-K filed March 12, 2004
to Systems Integrator Agreement by and
between Cisco Systems, Inc. and
Internetwork Experts, Inc., dated
November 13, 2000.
</Table>
II-2
<PAGE>
<Table>
<Caption>
EXHIBIT EXCEPT AS OTHERWISE INDICATED, PREVIOUSLY FILED OR
NO. DESCRIPTION INCORPORATED BY REFERENCE FROM:
------- ----------- --------------------------------------------------
<C> <S> <C>
10.9 Amended & Restated Allstar Systems, Inc. Exhibit 10.9 to the Form 10-K filed March 12, 2004
1996 Incentive Stock Plan, dated
effective July 1, 1997.
10.10 Amended & Restated I-Sector Corp. Stock Exhibit 10.10 to the Form 10-K filed March 12,
Incentive Plan, dated effective July 28, 2004
2003.
10.11 Amended & Restated Internetwork Experts, Exhibit 10.11 to the Form 10-K filed March 12,
Inc., Stock Incentive Plan dated 2004
effective August 1, 2003.
10.12 Lease Agreement by and between Allstar Exhibit 10.32 to the Form 10-K filed March 28,
Equities, Inc. and I-Sector Corporation, 2002
dated February 1, 2002.
10.13 Asset Purchase Agreement between Amherst Exhibit 2.1 to the Form 10-K filed March 22, 2000
Computer Products Southwest, L.P.,
Amherst Technologies, L.L.C. and Allstar
Systems, Inc., dated March 16, 2000.
10.14 Asset Purchase Agreement, by and between Exhibit 10.14 to the Form 10-K filed March 12,
Digital Precision, Inc. and Internetwork 2004
Experts, Inc., dated April 4, 2003.
10.15 First Refusal and Transfer Restriction Filed herewith
Agreement by and between Internetwork
Experts, Inc., I-Sector Corporation,
Digital Precision Inc., and David
Peoples, Don Smith, David DeYoung, et
al., dated April 3, 2003
10.16 Asset Purchase Agreement by and between Exhibit 10.36 to the Form 10-K filed March 24,
Internetworking Sciences Corporation and 2001
Internetwork Experts, Inc. dated October
27, 2000.
10.17 Lease Agreement by and between Whitehall- Exhibit 10.37 to the Form 10-K filed March 24,
Midway Park North, Ltd. and Allstar 2001
Systems, Inc. dated July 31, 2000.
10.18 Dealer Loan and Security Agreement by and Exhibit 10.38 to the Form 10-K filed March 28,
between Textron Financial Corporation and 2002
I-Sector Corporation, dated January 31,
2002.
10.19 Limited Fraud Guarantee, by and between Exhibit 10.18 to the Form 10-K filed March 12,
James H. Long and Textron Financial 2004
Corporation, dated September 3, 2003.
10.20 Loan and Security Agreement by and Exhibit 10.19 to the Form 10-K filed March 12,
between Textron Financial Corporation and 2004
Valerent, Inc., Internetwork Experts,
Inc., I-Sector Corporation, ISECOLDSUB,
Inc., and Stratasoft, Inc., dated
February 14, 2004.
10.21 Schedule to Loan and Security Agreement Exhibit 10.20 to the Form 10-K filed March 12,
by and between Textron Financial 2004
Corporation and Valerent, Inc.,
Internetwork Experts, Inc., I-Sector
Corporation, ISECOLDSUB, Inc., and
Stratasoft, Inc., dated February 14,
2004.
10.22 Reaffirmation of Limited Fraud Guaranty Exhibit 10.21 to the Form 10-K filed March 12,
by and between Textron Financial 2004
Corporation and James H. Long, dated
February 14, 2004.
</Table>
II-3
<PAGE>
<Table>
<Caption>
EXHIBIT EXCEPT AS OTHERWISE INDICATED, PREVIOUSLY FILED OR
NO. DESCRIPTION INCORPORATED BY REFERENCE FROM:
------- ----------- --------------------------------------------------
<C> <S> <C>
10.23 Warrant to Purchase 1,200,000 shares of Exhibit 10.22 to the Form 10-K filed March 12,
common stock of Internetwork Experts, 2004
Inc., by and between Internetwork
Experts, Inc. and I-Sector Corporation,
dated February 26, 2004.
10.24 Lease Agreement by and between Vantage Filed herewith
Development #21, Inc. and I-Sector
Corporation dated April 9, 2004
16.1 Letter from Deloitte & Touche LLP dated Exhibit 16.1 to Form 8-K filed June 5, 2003
June 17, 2003.
21.1 List of Subsidiaries of the Company. Exhibit 21.1 to Form 10-K, Registration No.
000-21479, filed March 31, 2003
23.1 Consent of Grant Thornton LLP. Filed herewith
23.2 Consent of Deloitte & Touche LLP. Filed herewith
23.3 Consent of Porter & Hedges, LLP. Previously filed
24.1 Power of Attorney. Previously filed
</Table>
ITEM 17. UNDERTAKINGS.
A. The undersigned Registrant hereby undertakes:
(1) To file, during any period in which offers or sales are being
made, a post-effective amendment to this registration statement to:
(i) Include any prospectus required by Section 10(a)(3) of the
Securities Act of 1933, as amended (the "Securities Act");
(ii) Reflect in the prospectus any facts or events arising after
the effective date of the registration statement (or the most recent
post-effective amendment thereof) which, individually or in the
aggregate, represent a fundamental change in the information set forth
in the registration statement. Notwithstanding the foregoing, any
increase or decrease in volume of securities offered (if the total
dollar value of securities offered would not exceed that which was
registered) and any deviation from the low or high end of the estimated
maximum offering range may be reflected in the form of prospectus filed
with the Commission pursuant to Rule 424(b) if, in the aggregate, the
changes in volume and price represent no more than a 20% change in the
maximum aggregate offering price set forth in the "Calculation of
Registration Fee" table in the effective registration statement; and
(iii) Include any material information with respect to the plan of
distribution not previously disclosed in the registration statement or
any material change to such information in the registration statement.
(2) That, for the purpose of determining any liability under the
Securities Act, each such post-effective amendment shall be deemed to be a
new registration statement relating to the securities offered therein, and
the offering of such securities at that time shall be deemed to be the
initial bona fide offering thereof.
(3) To remove from registration by means of a post-effective amendment
any of the securities being registered which remain unsold at the
termination of the offering.
II-4
<PAGE>
(4) For purposes of determining any liability under the Securities
Act, the information omitted from the form of prospectus filed as part of a
registration statement in reliance upon Rule 430A and contained in the form
of prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or
497(h) under the Securities Act shall be deemed to be part of the
registration statement as of the time it was declared effective.
(5) For the purpose of determining any liability under the Securities
Act, each post-effective amendment that contains a form of prospectus shall
be deemed to be a new registration statement relating to the securities
offered therein, and the offering of such securities at that time shall be
deemed to be the initial bona fide offering thereof.
B. Insofar as indemnification for liabilities arising under the Securities
Act may be permitted to directors, officers and controlling persons of the
Registrant pursuant to the foregoing provisions, or otherwise, the Registrant
has been advised that in the opinion of the SEC such indemnification is against
public policy as expressed in the Securities Act and is, therefore,
unenforceable. In the event that a claim for indemnification against such
liabilities (other than the payment by the Registrant of expenses incurred or
paid by a director, officer or controlling person of the Registrant in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities being
registered, the Registrant will, unless in the opinion of its counsel the matter
has been settled by controlling precedent, submit to a court of appropriate
jurisdiction the question whether such indemnification by it is against public
policy as expressed in the Securities Act and will be governed by the final
adjudication of such issue.
II-5
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, as amended, the
registrant certifies that it has reasonable grounds to believe that it meets all
of the requirements for filing on Form S-2 and authorized this Registration
Statement to be signed on its behalf by the undersigned, in the City of Houston,
State of Texas on April 30, 2004.
I-SECTOR CORPORATION
By: /s/ JAMES H. LONG
------------------------------------
James H. Long
Chief Executive Officer
Pursuant to the requirements of the Securities Act of 1933, as amended,
this Registration Statement has been signed by the following persons in the
capacities indicated on April 30, 2004.
<Table>
<Caption>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C> <C>
/s/ JAMES H. LONG Chief Executive Officer, Chairman April 30, 2004
-------------------------------------- of the Board and Chief Financial
James H. Long Officer
*/s/ JEFFREY A. SYLVESTER Controller and Chief Accounting April 30, 2004
-------------------------------------- Officer
Jeffrey A. Sylvester
*/s/ DONALD R. CHADWICK Director April 30, 2004
--------------------------------------
Donald R. Chadwick
*/s/ KEVIN M. KLAUSMEYER Director April 30, 2004
--------------------------------------
Kevin M. Klausmeyer
*/s/ JOHN B. CARTWRIGHT Director April 30, 2004
--------------------------------------
John B. Cartwright
*By: /s/ JAMES H. LONG
--------------------------------------
James H. Long, Attorney-in-Fact
</Table>
<PAGE>
EXHIBIT TABLE
<Table>
<Caption>
EXHIBIT EXCEPT AS OTHERWISE INDICATED, PREVIOUSLY FILED OR
NO. DESCRIPTION INCORPORATED BY REFERENCE FROM:
------- ----------- --------------------------------------------------
<C> <S> <C>
1.1 Form of Underwriting Agreement. Filed herewith
3.1 Bylaws of the Company. Exhibit 3.1 to Form S-1, Registration No.
333-09789, filed August 8, 1996
3.2 Certificate of Incorporation of the Exhibit 3.2 to Amendment 1 to Form S-1,
Company. Registration No. 333-09789, filed August 8, 1996
3.3 Certificate of Amendment to Certificate Exhibit 3.4 to Amendment 5 to Form S-1,
of Incorporation of Allstar Systems, Registration No. 333-09789, filed August 8, 1996
Inc., dated June 24, 1997.
3.4 Certificate of Amendment to Certificate Exhibit 3.3 to Form 8-A filed December 29, 2003
of Incorporation of Allstar Systems,
Inc., dated March 5, 1999.
3.5 Certificate of Amendment to Certificate Exhibit 3.4 to Form 8-A filed December 29, 2003
of Incorporation of Allstar Systems, Inc.
dated July 10, 2000.
4.1 Specimen Common Stock Certificate. Filed herewith
4.2 Form of Unit Certificate. Filed herewith
4.3 Form of Warrant Agreement, including Form Filed herewith
of Warrant.
4.4 Form of Representative's Warrant. Filed herewith
5.1 Opinion of Porter & Hedges, L.L.P. Previously filed
10.1 Form of Employment Agreement by and Exhibit 10.5 to Amendment 1 to Form S-1,
between the Company and certain members Registration No. 333-09789, filed August 8, 1996
of management.
10.2 Employment Agreement by and between Exhibit 10.6 to Form S-1, Registration No.
Stratasoft, Inc. and William R. Hennessy, 333-09789, filed August 8, 1996
dated September 7, 1995.
10.3 Employment Agreement by and between Exhibit 10.3 to the Form 10-K filed March 12, 2004
Allstar Systems, Inc. and James H. Long,
dated August 15, 1996.
10.4 Systems Integrator Agreement by and Exhibit 10.4 to the Form 10-K filed March 12, 2004
between Cisco Systems, Inc. and
Internetwork Experts, Inc., dated
November 13, 2000.
10.5 Amendment One, dated January 28, 2002, to Exhibit 10.5 to the Form 10-K filed March 12, 2004
Systems Integrator Agreement by and
between Cisco Systems, Inc. and
Internetwork Experts, Inc., dated
November 13, 2000.
10.6 Amendment Two, dated November 21, 2002, Exhibit 10.6 to the Form 10-K filed March 12, 2004
to Systems Integrator Agreement by and
between Cisco Systems, Inc. and
Internetwork Experts, Inc., dated
November 13, 2000.
10.7 Amendment Three, dated January 20, 2003, Exhibit 10.7 to the Form 10-K filed March 12, 2004
to Systems Integrator Agreement by and
between Cisco Systems, Inc. and
Internetwork Experts, Inc., dated
November 13, 2000.
10.8 Amendment Four, dated January 16, 2004, Exhibit 10.8 to the Form 10-K filed March 12, 2004
to Systems Integrator Agreement by and
between Cisco Systems, Inc. and
Internetwork Experts, Inc., dated
November 13, 2000.
</Table>
<PAGE>
<Table>
<Caption>
EXHIBIT EXCEPT AS OTHERWISE INDICATED, PREVIOUSLY FILED OR
NO. DESCRIPTION INCORPORATED BY REFERENCE FROM:
------- ----------- --------------------------------------------------
<C> <S> <C>
10.9 Amended & Restated Allstar Systems, Inc. Exhibit 10.9 to the Form 10-K filed March 12, 2004
1996 Incentive Stock Plan, dated
effective July 1, 1997.
10.10 Amended & Restated I-Sector Corp. Stock Exhibit 10.10 to the Form 10-K filed March 12,
Incentive Plan, dated effective July 28, 2004
2003.
10.11 Amended & Restated Internetwork Experts, Exhibit 10.11 to the Form 10-K filed March 12,
Inc., Stock Incentive Plan dated 2004
effective August 1, 2003.
10.12 Lease Agreement by and between Allstar Exhibit 10.32 to the Form 10-K filed March 28,
Equities, Inc. and I-Sector Corporation, 2002
dated February 1, 2002.
10.13 Asset Purchase Agreement between Amherst Exhibit 2.1 to the Form 10-K filed March 22, 2000
Computer Products Southwest, L.P.,
Amherst Technologies, L.L.C. and Allstar
Systems, Inc., dated March 16, 2000.
10.14 Asset Purchase Agreement, by and between Exhibit 10.14 to the Form 10-K filed March 12,
Digital Precision, Inc. and Internetwork 2004
Experts, Inc., dated April 4, 2003.
10.15 First Refusal and Transfer Restriction Filed herewith
Agreement by and between Internetwork
Experts, Inc., I-Sector Corporation,
Digital Precision, Inc., and David
Peoples, Don Smith, David DeYoung, et
al., dated April 3, 2003
10.16 Asset Purchase Agreement by and between Exhibit 10.36 to the Form 10-K filed March 24,
Internetworking Sciences Corporation and 2001
Internetwork Experts, Inc. dated October
27, 2000.
10.17 Lease Agreement by and between Whitehall- Exhibit 10.37 to the Form 10-K filed March 24,
Midway Park North, Ltd. and Allstar 2001
Systems, Inc. dated July 31, 2000.
10.18 Dealer Loan and Security Agreement by and Exhibit 10.38 to the Form 10-K filed March 28,
between Textron Financial Corporation and 2002
I-Sector Corporation, dated January 31,
2002.
10.19 Limited Fraud Guarantee, by and between Exhibit 10.18 to the Form 10-K filed March 12,
James H. Long and Textron Financial 2004
Corporation, dated September 3, 2003.
10.20 Loan and Security Agreement by and Exhibit 10.19 to the Form 10-K filed March 12,
between Textron Financial Corporation and 2004
Valerent, Inc., Internetwork Experts,
Inc., I-Sector Corporation, ISECOLDSUB,
Inc., and Stratasoft, Inc., dated
February 14, 2004.
10.21 Schedule to Loan and Security Agreement Exhibit 10.20 to the Form 10-K filed March 12,
by and between Textron Financial 2004
Corporation and Valerent, Inc.,
Internetwork Experts, Inc., I-Sector
Corporation, ISECOLDSUB, Inc., and
Stratasoft, Inc., dated February 14,
2004.
10.22 Reaffirmation of Limited Fraud Guaranty Exhibit 10.21 to the Form 10-K filed March 12,
by and between Textron Financial 2004
Corporation and James H. Long, dated
February 14, 2004.
10.23 Warrant to Purchase 1,200,000 shares of Exhibit 10.22 to the Form 10-K filed March 12,
common stock of Internetwork Experts, 2004
Inc., by and between Internetwork
Experts, Inc. and I-Sector Corporation,
dated February 26, 2004.
</Table>
<PAGE>
<Table>
<Caption>
EXHIBIT EXCEPT AS OTHERWISE INDICATED, PREVIOUSLY FILED OR
NO. DESCRIPTION INCORPORATED BY REFERENCE FROM:
------- ----------- --------------------------------------------------
<C> <S> <C>
10.24 Lease Agreement by and between Vantage Filed herewith
Development #21, Inc. and I -Sector
Corporation dated April 9, 2004
16.1 Letter from Deloitte & Touche LLP dated Exhibit 16.1 to Form 8-K filed June 5, 2003
June 17, 2003.
21.1 List of Subsidiaries of the Company. Exhibit 21.1 to Form 10-K, Registration No.
000-21479, filed March 31, 2003
23.1 Consent of Grant Thornton LLP. Filed herewith
23.2 Consent of Deloitte & Touche LLP. Filed herewith
23.3 Consent of Porter & Hedges, LLP. Previously filed
24.1 Power of Attorney. Previously filed
</Table>
</TEXT>
</DOCUMENT>