** **

**SECURITIES AND EXCHANGECOMMISSIONWashington, D.C.  20549**

** **

**FORM 10-QSB**

 

**ý**Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

 

**ForPeriod Ended                                                    September 30,2001**

 

**o**  Transition Report Pursuant to Section 13 or15 (d) of the Securities Exchange Act of 1934

 

**Forthe transition period from                                          to**

 

**CommissionFile Number                                    00-23527**

** **

 

**eSoft, Inc.**(Exact name of small business issuer as specified in itscharter)

 

**             DELAWARE                                                                                                          84-0938960          **

           (State or other jurisdiction                                                                       (IRS Employer IDNumber)

      of incorporation or organization)

 

**295Interlocken Boulevard, #500**

**Broomfield,CO 80021**

(Address ofPrincipal Executive Offices)

 

 

 

 

**(303)444-1600**

(Issuer’sTelephone Number, Including Area Code)

 

 

(Former name,former address and former fiscal year, if changed since last report)

 

Check whether theissuer: (1) filed all reports required to be filed by Section 13 or 15 (d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.

|                               |   |                               |   |   |   |   |
|------------------------------------|--------|------------------------------------|--------|--------|--------|--------|
| YES     ý |   | NO      o |
|                               |   |                               |   |   |   |   |

Transitional Small Business Disclosure format (check one):

|                          |   |                              |   |   |   |   |
|-------------------------------|--------|-----------------------------------|--------|--------|--------|--------|
| YES     o |   | NO     ý |

 

The number of shares outstanding of the issuer’s $0.01par value common stock on November 14, 2001 was 15,748,397.

 

**eSoft, Inc. and Subsidiaries**

** **

**TABLE OF CONTENTS**

** **

 

 
| PART I  | FINANCIAL INFORMATION |     |
|---------|-----------------------|----------|
|    |                  |     |   |   |
|    |                  | Item  1. | Condensed  Consolidated Financial Statements (Unaudited) |   |
|    |                  |     |   |   |
|    |                  | Item  2. | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|    |                  |     |   |   |
|    |                  |     |   |   |
| PART II | OTHER INFORMATION     |     |

 

**eSoft,Inc. and Subsidiaries**

**CONSOLIDATEDBALANCE SHEET**

**(Unaudited)**

 

**PARTI.  FINANCIAL INFORMATION**

 

**Item1.  Condensed Consolidated FinancialStatements**

 
|                                                                                         |   | **September 30,  2001** |       |
|----------------------------------------------------------------------------------------------|--------|-------------------------|------------|
| **Assets**                                                                                   |   |                    |       |
|                                                                                         |   |                    |       |
| **Current assets:**                                                                          |   |                    |       |
| Cash and cash  equivalents                                                                   |   | $                       | 7,992,137  |   |
| Available-for-sale  securities                                                               |   | 6,111,827               |       |
| Accounts  receivable trade, net of allowance of $411,074                                     |   | 2,070,544               |       |
| Inventories, net  of allowance of $91,422                                                    |   | 564,846                 |       |
| Prepaid expenses  and other                                                                  |   | 267,336                 |       |
| Total current  assets                                                                        |   | 17,006,690              |       |
|                                                                                         |   |                    |       |
| **Property and equipment:**                                                                  |   |                    |       |
| Computer  equipment                                                                          |   | 1,803,030               |       |
| Furniture and  equipment                                                                     |   | 351,046                 |       |
| Other                                                                                        |   | 62,358                  |       |
|                                                                                         |   | 2,216,434               |       |
| Less:  accumulated depreciation                                                              |   | (1,041,555              | )          |
|                                                                                         |   |                    |       |
| Net property and  equipment                                                                  |   | 1,174,879               |       |
|                                                                                         |   |                    |       |
| **Other assets:**                                                                            |   |                    |       |
| Capitalized  software development costs, net of accumulated amortization of  $1,099,932 |   | 84,243                  |       |
| Deferred  financing costs, net of accumulated amortization of $233,602                       |   | 81,123                  |       |
| Other                                                                                        |   | 81,318                  |       |
|                                                                                         |   |                    |       |
| Total other assets                                                                           |   | 246,684                 |       |
|                                                                                         |   |                    |       |
|                                                                                         |   | $                       | 18,428,253 |   |

 

*The accompanying notes to consolidated financial statements are anintegral part of these statements.*

**eSoft,Inc. and Subsidiaries**

**CONSOLIDATEDBALANCE SHEET**

**(Unaudited)**

 
|                                                                                                    |   | **September 30,  2001** |       |
|---------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|
| **Liabilities & Stockholders'  Equity**                                                        |   |                    |       |
|                                                                                                    |   |                    |       |
| **Current liabilities:**                                                                                |   |                    |       |
| Accounts payable                                                                                        |   | $                       | 1,284,048  |   |
| Accrued  expenses:                                                                                      |   |                    |       |
| Payroll and  related expenses                                                                           |   | 275,866                 |       |
| Other                                                                                                   |   | 669,727                 |       |
| Deferred revenue                                                                                        |   | 1,440,052               |       |
| Convertible  debentures                                                                                 |   | 1,769,056               |       |
| Total current  liabilities                                                                              |   | 5,438,749               |       |
|                                                                                                    |   |                    |       |
| **Long-term liabilities:**                                                                              |   |                    |       |
| Convertible  debentures                                                                                 |   | 11,598,078              |       |
|                                                                                                    |   |                    |       |
| Total  liabilities                                                                                      |   | 17,036,827              |       |
|                                                                                                    |   |                    |       |
| **Commitments & contingencies**                                                                     |   |                    |       |
|                                                                                                    |   |                    |       |
| **Stockholders' equity:**                                                                               |   |                    |       |
| Preferred stock:  $.01 par value; 5,000,000 shares authorized, no shares issued or outstanding          |   | -                       |       |
| Common stock:  $.01 par value; 100,000,000 shares authorized, 15,748,397 shares issued and  outstanding |   | 157,484                 |       |
| Additional  paid-in capital                                                                             |   | 41,066,097              |       |
| Treasury stock                                                                                          |   | (99,900                 | )          |
| Notes receivable  from stockholders                                                                     |   | (358,860                | )          |
| Accumulated  other comprehensive income                                                                 |   | 70,019                  |       |
| Accumulated  deficit                                                                                    |   | (39,443,414             | )          |
|                                                                                                    |   |                    |       |
| Total  stockholders' equity                                                                             |   | 1,391,426               |       |
|                                                                                                    |   | $                       | 18,428,253 |   |

 

*The accompanying notes to consolidated financial statements are anintegral part of these statements.*

**eSoft,Inc. and Subsidiaries**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                                     |   | **For The Three Months Ended** |       | **For The Nine Months Ended** |   |
|--------------------------------------------------------------------------|--------|--------------------------------|------------|-------------------------------|--------|
|                                                                     |   | **September 30,**              |       | **September 30,**             |   |
|                                                                     |   | **2001**                       |       | **2000**                      |   | **2001** | ** ** | **2000** |   |
| **Revenue:**                                                             |   |                           |       |                          |   |   |   |   |   |
| Product sales                                                            |   | $                              | 1,833,549  |                          | $      | 800,653 |   | $ | 5,275,222 |   | $ | 4,773,311 |   |
| Product  development and license fees                                    |   | 160,000                        |       | 90,150                        |   | 277,000 |   | 1,326,150 |   |
| Subscriptions,  maintenance and other                                    |   | 637,446                        |       | 344,019                       |   | 1,618,270 |   | 866,264 |   |
| Total revenue                                                            |   | 2,630,995                      |       | 1,234,822                     |   | 7,170,492 |   | 6,965,725 |   |
|                                                                     |   |                           |       |                          |   |   |   |   |   |
| **Cost of revenue:**                                                     |   |                           |       |                          |   |   |   |   |   |
| Product sales                                                            |   | 1,221,388                      |       | 394,919                       |   | 3,917,604 |   | 2,576,489 |   |
| Product  development and license fees                                    |   | -                              |       | 32,508                        |   | - |   | 195,406 |   |
| Subscriptions,  maintenance and other                                    |   | 215,143                        |       | 232,091                       |   | 602,833 |   | 534,261 |   |
| Total cost of  revenue                                                   |   | 1,436,531                      |       | 659,518                       |   | 4,520,437 |   | 3,306,156 |   |
|                                                                     |   |                           |       |                          |   |   |   |   |   |
| **Gross profit**                                                         |   | 1,194,464                      |       | 575,304                       |   | 2,650,055 |   | 3,659,569 |   |
|                                                                     |   |                           |       |                          |   |   |   |   |   |
| **Expenses:**                                                            |   |                           |       |                          |   |   |   |   |   |
| Sales and  marketing                                                     |   | 1,023,788                      |       | 3,846,709                     |   | 3,491,133 |   | 7,531,809 |   |
| General and  administrative                                              |   | 1,026,402                      |       | 1,637,670                     |   | 3,226,606 |   | 4,228,969 |   |
| Research and  development                                                |   | 753,747                        |       | 1,142,415                     |   | 2,386,307 |   | 2,646,897 |   |
| Total cost and  expenses                                                 |   | 2,803,937                      |       | 6,626,794                     |   | 9,104,046 |   | 14,407,675 |   |
|                                                                     |   |                           |       |                          |   |   |   |   |   |
| Loss from  operations                                                    |   | (1,609,473                     | )          | (6,051,490                    | )      | (6,453,991 | ) | (10,748,106 | ) |
|                                                                     |   |                           |       |                          |   |   |   |   |   |
| **Other (income) expense:**                                              |   |                           |       |                          |   |   |   |   |   |
| Interest income                                                          |   | (163,124                       | )          | (377,666                      | )      | (637,413 | ) | (683,310 | ) |
| Interest expense                                                         |   | 430,316                        |       | 185,141                       |   | 1,290,704 |   | 457,905 |   |
| Realized loss on  sale of assets                                         |   | (2,860                         | )          | -                             |   | 5,011 |   | - |   |
| Unrealized loss  on available-for-sale securities                        |   | 340,800                        |       | -                             |   | 1,617,000 |   | - |   |
| Total other  (income) expense                                            |   | 605,132                        |       | (192,525                      | )      | 2,275,302 |   | (225,405 | ) |
|                                                                     |   |                           |       |                          |   |   |   |   |   |
| **Net loss**                                                             |   | $                              | (2,214,605 | )                             | $      | (5,858,965 | ) | $ | (8,729,293 | ) | $ | (10,522,701 | ) |
|                                                                     |   |                           |       |                          |   |   |   |   |   |
| Basic and  diluted loss per common share                                 |   | $                              | (0.14      | )                             | $      | (0.38 | ) | $ | (0.56 | ) | $ | (0.70 | ) |
|                                                                     |   |                           |       |                          |   |   |   |   |   |
| Weighted-average  number of common shares outstanding, basic and diluted |   | 15,738,595                     |       | 15,428,747                    |   | 15,632,130 |   | 15,005,869 |   |
|                                                                     |   |                           |       |                          |   |   |   |   |   |

*The accompanying notes to consolidated financial statements are anintegral part of these statements.*

** **

**eSoft,Inc. and Subsidiaries**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**(Unaudited)**

** **
|                                                           |   | **Common  Stock** |       | **Additionalin** |       | **Subscriptions**      |       | **Accumulated  Other Comprehensive** |       | **Treasury**   |       | **Accumulated** |       | **Total  Stockholders’** |       |
|----------------------------------------------------------------|--------|-------------------|------------|------------------|------------|------------------------|------------|--------------------------------------|------------|----------------|------------|-----------------|------------|-------------------------------|------------|
|                                                           |   | **Shares**        |       | **Amount**       |       | ** Paid-Capital** |       | ** Receivable**                 |       | ** Loss** |       | ** Stock** |       | **Deficit**                   |       | ** Equity** |   |
| **Balances,**December  31, 2000                           |   | 15,564,867        |       | $                | 155,648    |                   | $          | 40,861,263                           |       | $              | (234,060   | )               | $          | (1,240,800                    | )          | $ | - |   | $ | (30,714,121 | ) | $ | 8,827,930 |   |
|                                                           |   |              |       |             |       |                   |       |                                 |       |           |       |            |       |                          |       |   |   |
| Issuance of common stock upon exercise of warrants and options |   | 5,000             |       | 50               |       | 4,950                  |       | -                                    |       | -              |       | -               |       | -                             |       | 5,000 |   |
| Issuance of common stock for cash and notes receivable         |   | 120,000           |       | 1,200            |       | 124,800                |       | (124,800                             | )          | -              |       | -               |       | -                             |       | 1,200 |   |
| Stock based compensation                                       |   | -                 |       | -                |       | 30,595                 |       | -                                    |       | -              |       | -               |       | -                             |       | 30,595 |   |
| ESPP                                                           |   | 58,530            |       | 586              |       | 44,489                 |       | -                                    |       | -              |       | -               |       | -                             |       | 45,075 |   |
| Treasury Stock                                                 |   | -                 |       | -                |       | -                      |       | -                                    |       | -              |       | (99,900         | )          | -                             |       | (99,900 | ) |
| Permanent impairment of available- for-sale securities         |   | -                 |       | -                |       | -                      |       | -                                    |       | 1,240,800      |       | -               |       | -                             |       | 1,240,800 |   |
| Unrealized gain on available-for-sale securities               |   | -                 |       | -                |       | -                      |       | -                                    |       | 70,019         |       | --              |       | -                             |       | 70,019 |   |
| Net loss for the nine months ended September 30, 2001          |   | -                 |       | -                |       | -                      |       | -                                    |       | -              |       |            |       | (8,729,293                    | )          | (8,729,293 | ) |
| **6**                                                          |   | 15,748,397        |       | $                | 157,484    |                   | $          | 41,066,097                           |       | $              | (358,860   | )               | $          | 70,019                        |       | $ | (99,900 | ) | $ | (39,443,414 | ) | $ | 1,391,426 |   |
|                                                           |   |              | ** ** |             | ** ** |                   | ** ** |                                 | ** ** |           | ** ** |            | ** ** |                          | ** ** |   | ** ** |

 

** **

**eSoft,Inc. and Subsidiaries**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
|                                                                         |   | **For the nine months ended   September 30,** |       |
|------------------------------------------------------------------------------|--------|-----------------------------------------------|------------|
|                                                                         |   | **2001**                                      |       | **2000** |   |
| **CASH FLOW FROM OPERATING ACTIVITIES**                                      |   |                                          |       |   |   |
| Net loss from  operations                                                    |   | $                                             | (8,729,293 | ) | $ | (10,522,701 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |   |                                          |       |   |   |
| Depreciation and  software amortization                                      |   | 529,973                                       |       | 825,636 |   |
| Provision for  losses on accounts receivable                                 |   | 186,730                                       |       | 555,000 |   |
| Provision for  obsolete inventory                                            |   | 140,000                                       |       | 180,000 |   |
| Amortization of  debt discounts and financing costs                          |   | 559,336                                       |       | 344,690 |   |
| Stock-based  compensation                                                    |   | 30,595                                        |       | 38,488 |   |
| Loss on sale of  assets                                                      |   | 5,011                                         |       | - |   |
| Interest from  available-for-sale securities                                 |   | (82,658                                       | )          | - |   |
| Unrealized loss  from available-for-sale securities                          |   | 1,617,000                                     |       | - |   |
| Changes in  operating assets and liabilities:                                |   |                                          |       |   |   |
| Accounts  receivable                                                         |   | (853,102                                      | )          | (930,640 | ) |
| Inventories                                                                  |   | (327,121                                      | )          | 79,178 |   |
| Prepaid expenses                                                             |   | 12,760                                        |       | (153,096 | ) |
| Other assets                                                                 |   | 11,355                                        |       | (39,355 | ) |
| Accounts payable                                                             |   | 720,161                                       |       | (71,517 | ) |
| Accrued expenses                                                             |   | (507,147                                      | )          | 1,042,949 |   |
| Deferred revenue                                                             |   | 676,234                                       |       | 506,418 |   |
| Net cash used in  operating activities                                       |   | (6,010,166                                    | )          | (8,144,950 | ) |
| **CASH FLOW FROM INVESTING ACTIVITIES**                                      |   |                                          |       |   |   |
| Purchase of available-for-sale securities                                    |   | (5,795,650                                    | )          | (1,780,500 | ) |
| Purchase of  property and equipment                                          |   | (332,840                                      | )          | (1,122,986 | ) |
| Proceeds from  sale of assets                                                |   | 68,192                                        |       | - |   |
| Investment in  intangible assets                                             |   | (16,893                                       | )          | - |   |
| Net cash used in  investing activities                                       |   | (6,077,191                                    | )          | (2,903,486 | ) |
| **CASH FLOW FROM FINANCING ACTIVITIES**                                      |   |                                          |       |   |   |
| Purchase of  common stock                                                    |   | (99,900                                       | )          | - |   |
| Proceeds from issuance  of common stock                                      |   | 51,275                                        |       | 13,207,513 |   |
| Proceeds from  issuance of convertible debt                                  |   | -                                             |       | 11,280,500 |   |
| Proceeds from  collection of stock subscription receivable                   |   | -                                             |       | 39,331 |   |
| Net cash  provided by financing activities                                   |   | (48,625                                       | )          | 24,527,344 |   |
|                                                                         |   |                                          |       |   |   |
| **(DECREASE) INCREASE  IN CASH AND CASH EQUIVALENTS**                   |   | (12,135,982                                   | )          | 13,478,908 |   |
|                                                                         |   |                                          |       |   |   |
| **CASH AND CASH EQUIVALENTS,  beginning of period**                          |   | 20,128,119                                    |       | 8,576,055 |   |
|                                                                         |   |                                          |       |   |   |
| **CASH AND CASH EQUIVALENTS, end of  period**                                |   | $                                             | 7,992,137  |   | $ | 22,054,963 |   |
|                                                                         |   |                                          |       |   |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH  FLOW INFORMATION**                        |   |                                          |       |   |   |
| CASH PAID DURING  THE PERIOD FOR INTEREST                                    |   | $                                             | 764,788    |   | $ | 75,754 |   |

 

** **

**eSoft,Inc. and Subsidiaries**

**SUMMARYOF ACCOUNTING POLICIES**

**Basis of Presentation**

 

Unaudited condensedconsolidated financial statements included herein reflect all adjustments,consisting only of normal recurring adjustments which, in the opinion ofmanagement, are necessary to fairly present our consolidated financialposition, results of operations, and cash flows for the periods presented.  Certain information and footnote disclosuresnormally included in audited financial information prepared in accordance withgenerally accepted accounting principles have been condensed or omitted pursuantto the Securities and Exchange Commission's (“SEC”) rules and regulations.  The consolidated results of operations forthe period ended September 30, 2001, are not necessarily indicative of theresults to be expected for any subsequent quarter or for the entire fiscalyear.  The information included in thisForm 10-QSB should be read in conjunction with the consolidated financialstatements and notes thereto, together with Management’s Discussion andAnalysis of Financial Statements and notes thereto, included in our Form 10-KSBfor the year ended December 31, 2000. Certain amounts in the prior year consolidated financial statements havebeen reclassified to conform to the current year presentation.

 

**Available-for-Sale Securities**

 

Available-for-sale securities are carried at theirestimated market value, with unrealized holding gains and losses, net of tax,reported as a separate component of stockholders’ equity until realized.  Realized gains and losses on securities soldare determined based on the specific identification of the securities sold.  We review securities with unrealized lossesfor impairment when the facts and circumstances may indicate that theunrealized losses may be other than temporary.

** **

**Revenue Recognition**

 

We generate revenue from sales of hardware products, software licensesand professional service arrangements.  Weaccount for revenue in accordance with Statement of Position 97-2 “SoftwareRevenue Recognition,” and related amendments, interpretations, and TechnicalPractice Aids issued from time to time bythe American Institute of Certified Public Accountants (collectivelyreferred to as “SOP 97-2”).

 

SOP 97-2 generally requires revenue earned on softwarearrangements involving multiple elements to be allocated to each element basedon the relative fair values of the elements. The fair value of an element must be based on vendor-specific objectiveevidence (“VSOE”).  If VSOE does notexist for all elements of the arrangement, we utilize the residual method ofaccounting, whereby revenue may be recognized for delivered elements of acontract provided:  a) VSOE exists forall undelivered elements; b) none of the undelivered elements are essential tothe functionality of the delivered elements; and c) revenue is deferred equalto the fair value of all such undelivered elements until they are delivered.

 

We generate revenue from the following elements:

 

Product sales – Wemarket, license and sell Internet security appliances.  Revenue from the sale of our Internetsecurity appliance products is recognized upon delivery to the customer, whichis generally at the time the products are shipped, and when the fee is fixed, determinable and deemed collectible.  In general, there are no acceptance criteriaand we have no further obligation to the customer.  Provision is made currently for estimated product returns thatmay occur.  For sales made todistributors under terms allowing certain rights of return and price protectionon unsold product, revenue is deferred and recognized only upon sell-through tothe end user.

 

Product development andlicense fees – From time to time, we enter into multiple-element arrangementsto develop and license our proprietary software products.  We recognize revenue from such arrangementsbased upon progress to completion.  Sucharrangements may include customer acceptance criteria, in which case revenuerecognition is deferred until customer acceptance is obtained.

 

Subscriptions,maintenance and other services – We sell licenses for additional softwareproducts for its Internet security products on a subscription basis, whereby wegrant customers a right to use the products for a specified period oftime.  We recognize revenue from suchsubscriptions ratably over the subscription period, commencing upon delivery.  In addition, we provide maintenance and otherservices under separate agreements. Revenue from such agreements is deferred and recognized ratably over theservice period, generally one year.

 

We believe our current revenue recognition policiesand practices are consistent with the provisions of SOP 97-2. Implementationguidelines for the current standards, as well as potential new standards, couldlead to unanticipated changes in our current revenue recognition policies.  Such changes could affect the timing of ourfuture revenue and results of operations.

** **

**Net Loss Per Share**

 

Basic earnings or loss per share is computed bydividing the net earnings or loss by the weighted-average number of shares ofcommon stock outstanding.  Dilutedearnings or loss per share is determined by dividing the net earnings or lossby the sum of (1) the weighted-average number of common shares outstanding, (2)if not anti-dilutive, the number of shares of convertible debt as if convertedupon issuance, and (3) if not anti-dilutive, the effect of outstanding stockoptions and warrants determined utilizing the treasury stock method.  Basic and diluted loss per share are thesame for all periods presented as the effect of outstanding debt, common stock,options and warrants was anti-dilutive.

 

**Use of Estimates**

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosures of contingent assets and liabilitiesat the date of the financial statements and revenue and expenses during thereporting period.  Actual results coulddiffer from those estimates and assumptions.

 

**Recent Accounting Pronouncements**

 

In June 2001, the Financial Accounting Standards Board(the “FASB”) issued SFAS No. 141, “Business Combinations.”  SFAS No. 141 addresses financial accountingand reporting for business combinations. SFAS No. 141 is effective for all business combinations initiated afterJune 30, 2001, and for all business combinations accounted for under thepurchase method initiated before but completed after June 30, 2001.  In addition, in June 2000 the FASB issuedSFAS No. 142, “Goodwill and Other Intangible Assets.”  SFAS No. 142 addresses financial accounting and reporting foracquired goodwill and other intangible assets. SFAS No. 142 is effective for fiscal years beginning after December 15,2001, and applies to all goodwill and other intangibles recognized in thefinancial statements at that date.  The adoptionof these standards is not expected to have an impact on our financial positionor results of operations.  However, anybusiness combinations initiated from this point forward will be impacted bythese two standards.

 

In August 2001, the FASB issued SFAS No. 144,"Accounting for the Impairment or Disposal of Long-Lived Assets".SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment ofLong-Lived Assets and for Long-Lived Assets to Be Disposed Of", butretains the requirements of SFAS No.121 to (a) recognize an impairment lossonly if the carrying amount of a long-lived asset is not recoverable from itsundiscounted cash flows and (b) measure an impairment loss as the differencebetween the carrying amount and fair value of the asset. SFAS No. 144 removesgoodwill from its scope as the impairment of goodwill is addressedprospectively pursuant to SFAS No. 142. SFAS No. 144 is effective for financialstatements issued for fiscal years beginning after December 15, 2001, andinterim periods within those years. The Company does not expect the adoption ofSFAS No. 144 to have a material impact on its financial position or results ofoperations.

**eSoft,Inc. and SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

1.  Available-for-Sale Securities

 

As of September30, 2001, we held 30,000 shares of Gateway, Inc. ("Gateway") commonstock, which were acquired in connection with the debt financing in September2000 (Note 3).  At March 31, andSeptember 30, 2001, management analyzed the investment, noting the continueddownturn in the capital markets, the general economic slowdown and recentdevelopments at Gateway, and determined that the decline in value was otherthan temporary and accordingly, a permanent impairment was recognized in thefirst and third quarter of 2001.  Theunrealized loss of $1,276,200 and $340,800 respectively, was determined basedupon the fair market value of the securities as of March 31, which was $504,300and September 30, 2001, which was $163,500, compared to the historical cost ofthe investment of $1,780,500. Subsequent changes in the market price of these securities compared tothe new cost basis of $163,500 will be reflected in “other comprehensiveincome,” as long as the investment continues to be held, unless any furtherimpairment charge is deemed necessary.

 

In addition, as ofSeptember 30, 2001, we have investments of $5,948,327 in low duration fixedincome funds.

 

2.   Account Receivable - Trade

 

We had one customer that represented more than 10% ofour total revenue. This customer generated sales that represented 16% of totalrevenue for the nine months ending September 30, 2001 and 1% of accountsreceivable at September 30, 2001. Accounts receivable for international sales represented 52% of outstandingaccounts receivable at September 30, 2001. One international customer represented 22% of accounts receivable atSeptember 30, 2001 and 13% of sales for the quarter.

 

We do not take therisk of foreign currency fluctuation with regard to its foreign sales. Allsales are designated as payment in US denominated funds at the time of sale.

 

3.  Convertible Debentures

 

In September 1999, we issued  $2,000,000 of unsecured 5% Convertible Debentures at a 2.5%discount, due June 10, 2002, (“Debentures”), along with stock purchase warrants(“Warrants”) with a right to purchase an aggregate of 511,182 shares of commonstock at an exercise price of $4.4994 per share. The fair value of the warrantsof approximately $850,000 was recorded as an original issuance discount, and isbeing amortized over the term of the debt as interest expense.  The principal and accrued interest amountsof the Debenture are convertible at any time at the investor’s option into afixed number of shares of our common stock at $3.9125 per share, subject tocertain anti-dilution provisions and adjustments.  We have the ability, under certain circumstances, to obligate theinvestor to convert the Debentures into common stock and to exercise the Warrants.  At September 30, 2001, the balance of theunamortized original issue discount was $230,944.  The balance of the Debentures at September 30, 2001, of$1,769,056 represents the original face value of the remaining outstandingDebentures of $2,000,000 less the balance of the unamortized discount of$230,944.

 

In September 2000, we entered into an Amendment of theStock and Warrant Purchase and Investor Rights Agreement, dated April 26, 2000,with Gateway, Inc. whereby we issued $12,500,000 of unsecured 7% ConvertibleDebentures due September 15, 2004 (“September 2000 Debentures”) and stockpurchase warrants (“September 2000 Warrants”) with a right to purchase anaggregate of 600,000 shares of our common stock, par value $.01 per share, atan exercise price of $11.00 per share. In connection with the issuance of the September 2000 Debentures, wepurchased 30,000 shares of Gateway common stock for $3 million, which reflecteda premium of approximately $1.2 million. This premium was recorded as an original issue discount on the September2000 Debentures, and is being amortized over the term of the debentures asinterest expense.  The principal amountof the September 2000 Debentures is convertible at any time at the investor’soption into a fixed number of shares of our common stock at the then currentfair market value, but not less than $11.00 or more than $19.507 pershare.  The balance of the September2000 Debentures at September 30, 2001 of $11,598,078 represents the originalface value of the outstanding September 2000 Debentures, of $12,500,000 lessthe balance of the unamortized premium of $901,922.

 

4.   Net LossPer Share

 

For the three and nine months ended September 30, 2000 and 2001, optionsand warrants to purchase 3,789,296 and 4,363,109 shares of common stock anddebentures convertible into 1,647,546 shares and 1,647,546 shares were excludedfrom the computation of diluted earnings per share because their effect wasanti-dilutive.

 

5.   Business Segments

 

During the three and nine months ended September 30,2001 and 2000, our operating structure included the following operatingsegments:  Internet appliances, redphishtmand corporate operations.  Our operatingsegments derive substantially all revenue from the sale and licensing ofInternet security products and associated software, development and licensingof proprietary software products, and related support, training andconsultation services.

 

Management evaluates the performance of its operatingsegments separately to individually monitor the different factors affectingfinancial performance.  Segment profitor loss includes substantially all of the segment’s costs of revenue.  However, management does not allocatecorporate expenses as it is not meaningful to do so.  Substantially all assets, liabilities and operating expenses aremanaged at the corporate level.

 

Information about ourreportable segments for the three- and nine-months ended September 30, 2001 and2000 is as follows:

 
|          |   | ** *Three months ended September 30, 2001*** |      | ***Three months  ended September 30, 2000*** |
|---------------|--------|---------------------------------------------------|-----------|----------------------------------------------|
|          |   | **Internet appliances**                           |      | **redphish**                                 |   | **Total** |   | **Internet appliances** |   | **redphish** |   | **Total** |   |
|          |   |                                              |      |                                         |   |   |   |   |   |   |   |   |   |
| Revenue:      |   | $                                                 | 2,367,000 |                                         | $ | 264,000 |   | $ | 2,631,000 |   | $ | 1,107,000 |   | $ | 128,000 |   | $ | 1,235,000 |   |
|          |   |                                              |      |                                         |   |   |   |   |   |   |   |   |   |
| Gross profit: |   | $                                                 | 1,020,000 |                                         | $ | 174,000 |   | $ | 1,194,000 |   | $ | 546,000 |   | $ | 29,000 |   | $ | 575,000 |   |
|          |   |                                              |      |                                         |   |   |   |   |   |   |   |   |   |

 
|          |   | ***Nine months ended September 30, 2001*** |      | ***Nine months ended September 30, 2000*** |   |
|---------------|--------|--------------------------------------------|-----------|--------------------------------------------|--------|
|          |   | **Internet appliances**                    |      | **redphish**                               |   | **Total** |   | **Internet appliances** |   | **redphish** |   | **Total** |   |
|          |   |                                       |      |                                       |   |   |   |   |   |   |   |   |   |
| Revenue:      |   | $                                          | 5,664,000 |                                       | $      | 1,506,000 |   | $ | 7,170,000 |   | $ | 5,602,000 |   | $ | 1,364,000 |   | $ | 6,966,000 |   |
|          |   |                                       |      |                                       |   |   |   |   |   |   |   |   |   |
| Gross profit: |   | $                                          | 2,268,000 |                                       | $      | 382,000 |   | $ | 2,650,000 |   | $ | 2,559,000 |   | $ | 1,101,000 |   | $ | 3,660,000 |   |

 

FORWARD-LOOKINGSTATEMENTS

 

Statements made inthis Form 10-QSB that are not historical or current facts are “forward-lookingstatements” made pursuant to the safe harbor provisions of Section 27A of theSecurities Act of 1933, as amended and Section 21E of the Securities ExchangeAct of 1934, as amended (the “Exchange Act”). These statements often can be identified by the use of terms such as“may,” “will,” “expect,” “believes,” “anticipate,” “estimate,” “approximate” or“continue,” or the negative thereof.  Weintend that such forward-looking statements be subject to the safe harbors forsuch statements.  We wish to cautionreaders not to place undue reliance on any such forward-looking statements,which speak only as of the date made. Forward-looking statements are subject to risks, uncertainties andimportant factors beyond our control that could cause actual results and eventsto differ materially from historical results of operations and events and thosepresently anticipated or projected. These factors include adverse economic conditions, entry of new andstronger competitors, inadequate capital, unexpected costs, failure to gainproduct approval in foreign countries, failure to meet continued NasdaqSmallCap Market listing criteria, and failure to capitalize upon access to newmarkets.  Additional risks and uncertaintieswhich may affect forward-looking statements about our business and prospectsinclude the possibility that a competitor will develop a more comprehensive orless expensive solution, delays in market awareness of us and our products,possible delays in our marketing strategy, and failure of our strategicpartners to successfully implement their marketing strategies, each of whichcould have an immediate and material adverse effect by placing us behind ourcompetitors.  For a fuller descriptionof certain of these important factors that could cause actual results to differmaterially from those currently anticipated or projected, please see our mostrecently filed Annual Report on Form 10-KSB for the fiscal year ended December31, 2000.  We disclaim any obligationsubsequently to revise any forward-looking statements to reflect events orcircumstances after the date of such statement or to reflect the occurrence ofanticipated or unanticipated events.

 

We use market dataand industry forecasts throughout this report, which it has obtained frominternal surveys, market research, publicly available information and industrypublications.  Industry publicationsgenerally state that the information they provide has been obtained fromsources believed to be reliable, but that the accuracy and completeness of suchinformation is not guaranteed. Similarly, we believe that the surveys and market research we or othershave performed are reliable, but we have not independently verified thisinformation.

 

 

**Item2 -    Management's Discussion andAnalysis of Financial Condition and Results of Operations**

 

*InstaGate,InstaGate EX, InstaGate EX2, InstaRak, SoftPak, SoftPak Director, and redphishare all service marks and/or trademarks owned by eSoft, Inc.  TEAM Internet and SiteFilter (with design)are registered trademarks owned by eSoft, Inc.*

**Overview**

 

We design, developand market secure Internet appliances that address the Internet security needsof small, medium and distributed enterprises (SMEs) and the hosting needs ofInternet Service Providers (ISPs).  Thedemand for our products is driven by the deployment of broadband Internetconnections and the growing demand for secure Website and email hostingservices.  Our InstaGate EX2 Internetsecurity appliance provides SMEs with Internet security, firewall, virtualprivate network (VPN) and related offerings. In addition, our InstaRak secure server appliance securely hosts web,email, and domain name service (DNS) for multiple Internet domains.

 

We believe our products offerplug-and-play solutions that virtually eliminate traditional costs of hardwareupgrades, box swaps and site visits with quick, hassle-free installation.  In addition, we are pioneering the deliveryof business and IT related applications, and security updates through thesesecure Internet appliances.  Our SoftPakapplications are available through software downloads as businesses grow andnew security and IT applications are developed.  SoftPak applications have been developed by us or in combination withthird parties, and are most commonly licensed to the end user on an annualsubscription basis.  This results in arecurring revenue stream for us and our channel partners, which we believeprovides better visibility and predictability to revenue growth.  The SoftPak applications, as well assoftware updates and firewall enhancements, are distributed through ourpatent-pending SoftPak Director technology. The SoftPak Director technology allows an end-user to utilize abrowser-based interface to evaluate and select SoftPak applications.  SoftPak applications include anti-virus,Website filtering, intrusion detection, webmail, reporting and a variety ofcommunications options, with new SoftPak applications being addedcontinually.  Since SoftPak applicationscan be added without requiring new boxes, we believe the need for hardwareswaps and associated downtime is eliminated.

 

Withthe accelerating deployment of broadband communications networks, which webelieve has created a more immediate need for products such as firewalls, VPNs,domain hosting services and network attached storage (NAS) servers, we havecontinued our focus on providing flexible, customizable, secure Internetappliances. According to International Data Corporation (IDC),Firewall/VPN security appliance revenue grew 105% from 1998 to 1999 and 152%from 1999 to 2000.  The total revenuefor this sector is projected to reach $4.0 billion by 2005.  We believe this growth can be attributed tothe convergence of VPN and firewall technologies, the growing number ofcompanies linking their networks to the Internet, remote access connectivityfor branch offices and mobile users, and growing concern over networksecurity.  IDC also estimates that inthe market for firewall appliances priced at less than $10,000, revenue willgrow at an expected compounded annual growth rate of 88% over the sameperiod.  We recognized the need tocreate a firewall or VPN product that could be distinguished from the rest ofthe market and could provide us with a sustainable competitive advantage.  In October 2000, the InstaGate EX Internetsecurity appliance was introduced, which is capable of providing SoftPakapplications in addition to the firewall or VPN capabilities.  In January of 2001, we introduced theInstaGate EX2 Internet security appliance. We developed an enhanced hardware platform for the InstaGate EX2Internet security appliance, which we believe is a slim profile, highlyreliable unit.  The hardware platform isbased on an Intel reference design motherboard and includes over a year ofcollaboration with Intel on the design and fabrication of the appliance.  In early 2001, we recognized that ISPs areseeing increased security and hacking concerns from their customers, which inturn creates the need for secure servers designed to host web, email and DNSservices for multiple Internet domains. In July 2001, we announced the introduction of the InstaRak secureserver appliance, which uses the same hardware platform as the InstaGate EX2Internet security appliance and allows us to leverage our investments insecurity software and SoftPak applications. We are pioneering the delivery of secure server appliances byintegrating server features with security protection, making the InstaRakappliance what we believe to be the most secure server appliance on the markettoday.  We have designed this product toprotect against hackers and individuals attempting to exploit or gain controlof the operating system.  The InstaRaksecure server appliance is also designed to protect multiple customers hostedon the same appliance from each other. According to IDC, the worldwide Appliance Web server market was $161.9million in 2000 and is projected to grow to $2.2 billion by 2005.

 

Our InstaGate EX2 Internet security appliance targetsSMEs that typically have between ten and 250 desktop computers connected to alocal area network, or LAN.  We marketthis product primarily through value added resellers (VARs), ISPs andinternational distributors.  Inaddition, we entered into a joint marketing program with Intel during the thirdquarter of 2001, whereby we and Intel plan to highlight the ability of thepatent-pending SoftPak Director technology to provide new services,applications and software upgrades for the 1U Intel-based InstaRak andInstaGate EX2 appliances.  As part ofthis program, Intel and eSoft will promote the Company's InstaGate EX2 Internetsecurity appliance and InstaRak secure hosting appliance to more than 15,000Intel product dealers, resellers, service providers, solution providers andother vendors of embedded components, highlighting eSoft's capabilities anddesign.  According to The Yankee Group,SMEs represent 98% of U.S. businesses, and account for approximately 50% of thegross national product.  The SME segmentcomprises the largest portion of installed LANs and increasingly recognizes theimportance of the Internet to grow their business and improve productivity.  Webelieve the availability of low-cost, high-speed bandwidth, throughtechnologies such as cable modems and digital subscriber lines, or DSL, isdriving SMEs’ demand for full-time Internet access, which in turn creates theneed to effectively protect corporate assets and data through theimplementation of a firewall.  Accordingto IDC, as of the year 2000, 15% of small businesses have installed firewalls,leaving 85% of the market virtually unprotected with respect to their corporateassets and networks.  We believe thatthe firewall market will increasingly shift to small businesses because thatmarket segment has the largest potential.  Inaddition, our InstaRak secure server appliance targets ISPs, and we market thisproduct directly to ISPs, as well as through VARs and internationaldistributors.

IDC projects by the year 2003 that the firewallappliance market will reach $1.3 billion for the United States, $836 millionfor Western Europe and $346 million for Asia Pacific.  In order to expand our international market presence, we havedeveloped local-language versions of our InstaGate EX2 Internet securityappliance for the following key languages: Japanese, Traditional and SimplifiedChinese, Korean, German, French and Spanish. By localizing our product, user interface, documentation and webpresence, we believe that our product offerings will provide even more valuefor our partners and will continue to make Internet usage and our productssimpler and easier for end users in key international markets.

 

Ourredphish OEM program, targets the licensing of our InstaGate EX2 Internetsecurity appliance technology, software and hardware, along with certaincustomization or modifications from our professional engineering services, inorder to create highly specialized or customized Internet appliance offeringsfor hardware manufacturers, networking companies and broadband serviceproviders to integrate into their own offerings. We believe our redphishprogram provides a vehicle through which major hardware manufacturers candeliver customized secure Internet appliances and connectivity solutions to theirsmall- and medium-sized customers. Delivered initially as a secure Internet appliance, this platform canlater serve as a foundation for additional products and services, such asenhanced e-mail, VPN, and business-to-business applications, as well as anySoftPak applications provided by us.  Webelieve this program allows us to leverage our research, development andproduct offerings, along with our partners’ expertise in hardware design,manufacturing and distribution. We believe the redphish program may improve ourworldwide distribution capabilities and may help to drive productrequirements.  In addition, it mayenable us to gain time to market advantages in developing new softwarefeatures.  Our program is based onroyalties or revenue sharing, which provides incentive at every point of thedistribution chain.  We have currentlyde-emphasized this program due to market conditions amongst our targeted OEMpartners.  We will continue to supportexisting OEM relationships and will analyze any future relationships based onthe value that they can bring to us.  Atthis time, we have seen increased demand for our products from channel partnersand end users.  Therefore, we believethat our current shift away from our redphish OEM program will enable us to focusresources and personnel on those areas of our business that we believecurrently represent the best opportunities for profitable growth.

 

 

**Liquidity and Capital Resources**

 

The Company's cash on hand at September 30, 2001 was$7,992,000, a decrease of $12,136,000 from year end, primarily due to theinvestment made in fixed income funds and our continued operating losses.  The Company’s working capital at September30, 2001 was $11,568,000, a decrease of $8,381,000 from December 31, 2000.  The Company has increased efforts to reduceits accounts receivable balance through more stringent collection efforts ofthe current customer base in an attempt to reduce the days sales  outstanding.  The Company has analyzed its accounts receivable and adjusted itsallowance for doubtful accounts and sales returns to $411,074 at September 30,2001.  Management anticipates continuinglosses in support of its growth initiatives and, thus expects continuednegative cash flow for the remainder of 2001. However, we are continuing to improve our cash management efforts and toreduce operating costs where possible.

 

On September 25, 2001, we transferred to the NasdaqSmallCap Market.  We are currently notin compliance with the Nasdaq SmallCap listing requirements, in particular, ournet tangible assets are $1,391,000, which is $1,191,000 less than are requiredfor continued listing on the Nasdaq SmallCap Market.  We cannot provide any assurance that we will be successful in ourefforts to increase our net tangible assets and continue our listing on theNasdaq SmallCap Market, which may cause the short term convertible debenturesdue in June 2002 to be in default.  Uponthis occurrence, the Company would be obligated to pay the holders of thesedebentures all outstanding principal, which totals $2,000,000.  We are currently in discussions with ourdebt holders regarding this possible default, however there can be no assurancethat such talks will be successful. According to the terms of the 2004 debentures, the default on $1,000,000of other debt will cause these debentures to be in default.  We intend to pay enough principal of the2002 debentures so that a cross default will not be triggered.  We believe our current cash position andinvestments, together with the anticipated cash generated from operationsshould be sufficient to meet our working capital, debt service, and capitalexpenditure requirements for at least the next twelve months and theforeseeable future.  Because we expect toincur a net loss for the year 2001, our cash and investments are expected todecrease as necessary to fund such losses.

 

**Cash Flows**

 

Net cash used inoperating activities for the nine months ending September 30, 2001 was$6,010,000 compared with $8,145,000 for the nine months ending September 30,2000, a decrease of $2,135,000.  TheCompany’s net loss for the nine months ending September 30, 2001 was$8,729,293, a decrease of $1,793,000 compared with the nine months endingSeptember 30, 2000.  The decrease in theloss is due primarily to improvements in our business operations as well as toa decrease in operating expenses from the discontinuation of SmartDSL, whichwas offset by the recognition of a $1,617,000 unrealized non-cash loss relatingto the other-than-temporary impairment of equity securities of Gateway acquiredin September 2000 in connection with our debenture financing.

 

Net cash used ininvesting activities for the nine months ending September 30, 2001 was$6,077,000, compared with $2,903,000 used in investing activities for the ninemonths ending September 30, 2000.  Theincrease in cash used of $3,174,000 for the 2001 period compared to the 2000period was due primarily to investments of $5,796,000 made in fixed incomefunds, offset by a decrease in cash invested in property and equipment..

 

Net cash provided byfinancing activities for the nine months ending September 30, 2001 was $49,000compared with $24,527,000 for the nine months ending September 30, 2000.  The decrease of $24,478,000 for the 2001 periodcompared to the 2000 period was primarily due to $12,500,000 for the proceedsfrom the equity investment by Gateway in April 2000 and $11,280,500 in netproceeds from the issuance of convertible debentures to Gateway in September2000.

 

**ResultsOf Operations For Three Months Ended September 30, 2001 Compared To The ThreeMonths Ended September 30, 2000**

** **

In the third quarter of2001, revenue totaled $2,631,000 versus revenue of $1,235,000 for the thirdquarter of 2000, an increase of $1,396,000 or 113%.  Product revenue for the third quarter of 2001 was $1,834,000 anincrease of $1,033,000 or 129%, from $801,000 in the third quarter of2000.  The increase is related to theintroduction of the InstaGate EX2 Internet security appliance in January of2001.  International sales accounted for28% of product revenue in the third quarter of 2001 compared to 25% for thesame period of 2000.  One internationalcustomer accounted for 13% of sales in the third quarter of 2001.  Revenue from software development andlicense fees totaled $160,000 in the third quarter of 2001 versus revenue of$90,000 for the same period of 2000, an increase of $70,000 or 77%.  This increase represents the timing ofsoftware development contracts from 2000, which are recognized based onprogress to completion.  In the thirdquarter of 2000, we were working on projects in connection with agreements withGateway, Inc. and 3Com Corporation.  In2001, this revenue represents license fees from Gateway.  The revenue from subscriptions, maintenanceand other services totaled $637,000 in the third quarter of 2001 compared to$344,000 for the same period of 2000, an increase of $293,000 or 85%.  Over the past year, the Company has focusedon building a recurring revenue stream through the sales of SoftPakapplications.  With the October 2000implementation of the patent pending SoftPak Director technology, which enablesus to download SoftPak applications to the end user, we have been able toincrease the number of InstaGate customers who purchase SoftPak applications.  Furthermore, we introduced three additionalSoftPak applications in the third quarter of 2001.  In addition, we entered into a service agreement with IBM, whichprovides us the opportunity to offer our Internet security products designedfor small to medium enterprises and service providers to select IBM smallbusiness customers on a subscription basis.

Gross profit in thecurrent quarter was $1,194,000, which is 45% of revenue for the three monthsended September 30, 2001, compared to $575,000, or 47% of revenue for the threemonths ended September 30, 2000.  Grossmargin on product was 33% and 51% for the three months ending September 30,2001 and 2000, respectively.  Thedecrease is attributed to new products that were launched in late 2000 andearly 2001 with more competitive pricing, resulting in lower margins.  In addition, below average margins onproduct sales to a specific OEM partner contributed to the decrease.** **Gross profit margin on productdevelopment and license fees was 100% and 63% for the third quarters of 2001and 2000, respectively.  The increase isdue to the activity in 2001 resulting from licensing arrangements that have nocosts associated with them, while in 2000 the activity resulted from direct costsincurred on software development arrangements. Gross profit margin on subscriptions, maintenance and other was 66% and32% in the third quarters of 2001 and 2000, respectively.  This increase relates to additionalmaintenance agreements being in place in 2001, which have more attractive marginsthan various other SoftPak applications.

 

Operating expensesdecreased $3,823,000, or 58%, from $6,627,000 for the quarter ending September30, 2000 to $2,804,000 for the quarter ending September 30, 2001.  Sales and marketing expenses decreased $2,823,000,or 73%, from $3,847,000 in the third quarter of 2000 to $1,024,000 in the sameperiod of 2001.  The decrease isassociated with the discontinuation of SmartDSL at the end of 2000 and therelated reduction in the sales force and marketing efforts.  In addition, headcount decreased due to theclosing of the Atlanta office in late 2000. Furthermore, travel related expenses have decreased with the eliminationof outside sales representatives and cost control measures put in place.  General and administrative expensesdecreased $612,000, or 37%, from $1,638,000 in the third quarter of 2000compared to $1,026,000 for the same period of 2001.  This can be attributed to management of outside services such asaudit fees, legal expenses, and managing accounts receivable to reduce bad debtexpense.  In addition, costs associatedwith the closing of the Atlanta office resulted in increased general andadministrative expenses in the third quarter of 2000.  Research and development expenses decreased $388,000, or 34% from$1,142,000 for the quarter ending September 30, 2000 to $754,000 for the sameperiod of 2001.  This can be attributedto the development work for the InstaGate products completed by October of2000, after which time the Company has been able to decrease its research anddevelopment activities.  The Companywill continue to monitor operating expenses in conjunction with targeting nearterm positive EBITDA.

 

Interest expenseincreased $245,000 in the three months ended September 30, 2001 from $185,000in the third quarter of 2000 to $430,000 for the same period of 2001.  The interest is due to the interest anddiscount amortization on the convertible debentures issued in September 2000and amortization of associated deferred offering costs.  Interest income decreased $214,000 in thequarter as a result of lower average cash balances.

 

We recorded anunrealized loss during the three months ended September 30, 2001 for thepermanent impairment of equity securities due to the continued downturn of thecapital markets and the recent developments at Gateway.

 

Net loss was$2,215,000 for the three months ended September 30, 2001, compared to$5,859,000 for the same period in 2000, a decrease in the loss of $3,644,000over the same period.  The decrease inthe loss is due primarily to increased gross profit and the decreases in ouroperating expenses, offset by lower gross margins, interest expense, and theunrealized losses on available-for-sale securities.  Losses are anticipated to continue through the current fiscalyear due to expenditures in support of continued growth and marketpenetration.  However, we expect netlosses to continue to decrease.

 

 

**Results of Operations For Nine Months Ended September 30,2001 Compared To The Nine Months Ended September 30, 2000**

 

Revenue for the firstnine months in 2001 totaled $7,170,000 versus revenue of $6,966,000 for thesame period in 2000, an increase of $204,000, or 3%.  Product revenue for the nine months ended September 30, 2001 was$5,275,000, an increase of $502,000, or 11%, from $4,773,000 for the first ninemonths in 2000.  The increase is mainlyattributed to increased sales associated with the introduction of our InstaGateEX2 Internet security appliance. International sales accounted for 26% of product revenue in 2001compared to 25% for the same period of 2000. One international customer accounted for 16% of sales in the nine monthsended September 30, 2001.  Revenue fromsoftware development and license fees totaled $277,000 for the nine monthsended September 2001 versus revenue of $1,326,000 for the same period in 2000,a decrease of $1,049,000, or 79%.  Thisdecrease represents the timing of software development contracts from 1999 and2000, which are recognized based on the percentage of completion method.  In the first quarter of 2000, we wereworking on a significant project in connection with an agreement with Intel,Inc.  In 2001, this revenue representslicense fees from Gateway.  The revenuefrom subscriptions, maintenance and other services totaled $1,618,000 for thenine months ended September 2001 compared to $866,000 for the same period in2000, an increase of $752,000 or 87%. Over the past year, we have focused on building a recurring revenuestream through the sales of SoftPak applications.  With the October 2000 implementation of the patent pendingSoftPak Director technology, which enables us to download SoftPak applicationsto the end user, we have been able to increase the number of InstaGate customerswho purchase SoftPak applications.  Wealso introduced eleven additional SoftPak applications during 2001.

 

Gross profit forthe nine months ended September 30, 2001 was $2,650,000, or 37%, of revenue,compared to $3,660,00, or 53%, of revenue for the nine months ended September30, 2000.  Gross profit on product saleswas 26% and 46% for the nine months ended September 30, 2001 and2000,respectively.  The decrease isattributed to new products launched in late 2000 and early 2001 with morecompetitive pricing, resulting in lower margins.  In addition, below average margins on product sales to a specificOEM partner contributed to the decrease.** **Grossprofit margin on product development and license fees was 100% and 85% for thenine months ended September 2001 and 2000, respectively.  The increase is due to the activity in 2001resulting from licensing arrangements that have no costs associated with them,while in 2000 the activity resulted from direct costs incurred on softwaredevelopment arrangements.  Gross profitmargin on subscription, maintenance and other was 63% and 38% for the firstnine months of 2001 and 2000, respectively. This increase relates to additional maintenance agreements being inplace in 2001 due to renewals, which have more attractive margins than variousother SoftPak applications.

Operating expensesdecreased $5,304,000, or 37%, from $14,408,000 for the first nine months in2000 to $9,104,000 for the same nine months in the 2001 period. Sales andmarketing expenses decreased $4,041,000 or 54 % from $7,532,000 in 2000 to$3,491,000 in 2001.  The decrease isassociated with the discontinuation of SmartDSL at the end of 2000 and therelated reduction in the sales force and marketing efforts.  In addition, headcount decreased in relationto the closing of the Atlanta office in late 2000.  Furthermore, travel related expenses have decreased with theelimination of outside sales representatives and cost control measures put inplace.  General and administrativeexpense decreased $1,002,000, or 24%, from $4,229,000 in the 2000 periodcompared to total expenses of $3,227,000 in 2001.  This decrease can be attributed to management of outside servicessuch as printing fees, audit fees and legal expenses.  In addition, we have managed accounts receivable in order toreduce bad debt expense.  Furthermore,in 2000 we also experienced greater filing fees due to initial listing fees forthe Nasdaq National Market.  Inaddition, costs associated with the closing of the Atlanta office resulted inincreased general and administrative expenses in the third quarter of2000.  Software amortization of $41,000and $103,000 is included in general and administrative expense for the ninemonths ending September 30, 2000 and 2001, respectively.  Research and development expenses decreased$261,000, or 10%, from $2,647,000 for the nine months ended September 2000 to$2,386,000 for the same period in 2001. This decrease can be attributed to the development work for theInstaGate products completed by October of 2000, after which time the Companyhas been able to decreased its research and development activities.  This was offset by costs associated with thetranslation of the product into German, Spanish, French, Chinese, Korean, andJapanese in 2001.  The Company willcontinue to monitor its operating expenses in conjunction with targeting nearterm positive EBITDA.

 

Interest expenseincreased $833,000 in 2001.  Theadditional interest is due to the interest and discount amortization on theconvertible subordinated debentures issued in September 2000 and amortizationof associated deferred offering costs. Interest income decreased $46,000 for the nine month ended September2001 in relation to additional cash on hand in the first quarter of 2001related to the convertible debentures issued to Gateway in September 2000,offset by decreasing cash balances as we use cash to fund our operating losses.

 

We recorded unrealizedlosses during the three months ended September 30, 2001 and during the threemonths ended March 31, 2001 for the permanent impairment of equity securitiesdue to the continued downturn of the capital markets and recent developments atGateway.

 

Net loss fromoperations was $8,729,000 for the nine months ended September 30, 2001,compared to a $10,523,000 loss for the same period in 2000, a decrease in theloss of $1,794,000 over the same period. The decrease in the loss is due primarily to increased gross profit andthe decreases in our operating expenses, offset by lower gross margins,interest expense, and the unrealized losses on available-for-salesecurities.  Losses are anticipated tocontinue through the current fiscal year due to expenditures in support ofcontinued growth and market penetration. However, we expect net losses to continue to decrease.

 

 

**Income Taxes**

 

At September 30,2001, a valuation allowance of 100% of the deferred tax asset has beenrecorded, as our management is unable to determine that it is more likely thannot that its deferred tax assets will be realized.  In addition, our operating loss carryforwards may be limitedunder Section 382 of the Internal Revenue Code.

 

**Other Matters**

 

We have reviewed allother recently issued, but not yet adopted, accounting standards in order todetermine their effects, if any, on the results of our operations or financialposition.  Based on that review, webelieve that none of these pronouncements will have a significant effect oncurrent or future earnings or operations.

 

**eSoft, Inc. and Subsidiaries**

 

PART II - OTHER INFORMATION

 

        Item 1.    LegalProceedings

 

We are not currentlyinvolved in any material legal proceedings. From time to time, we may become involved in or subject to variouslitigation and legal proceedings incidental to the normal conduct of itsbusiness.

 

                Item 6.  Exhibits and Reports on Form 8-K

 

(b) Reports onForm 8-K

 

On August 1, 2001,we filed a Current Report on Form 8-K that reported that we had entered into aservice agreement with International Business Machines Corporation.

 

On September 6,2001, we filed a Current Report on Form 8-K that reported that our board ofdirectors had authorized us to implement a common stock repurchase program.

 

On September 25,2001, we filed a Current Report on Form 8-K that reported that the trading ofour common stock had transferred to the Nasdaq SmallCap Market from the NasdaqNational Market.

 

**eSoft,Inc. and Subsidiaries**

 

SIGNATURES

 

 

 

In accordance withthe requirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
| Date:   November 14, 2001 |   |   |   | eSoft, Inc.                           |
|--------------------------------|--------|--------|--------|---------------------------------------|
|                           |   |   |   |                                  |   |   |   |   |   |
|                           |   |   |   |                                  |   |   |   |   |   |
|                           |   |   |   |                                  |   |   |   |   |   |
|                           |   |   |   | /s/Jeffrey Finn                       |   |
|                           |   |   |   | Jeffrey Finn                          |
|                           |   |   |   | President and Chief Executive Officer |
|                           |   |   |   | *(Principal  Executive Officer)*      |
|                                |        |        |        |                                       |  |  |  |  |  |  |

 

 
| Date:   November 14, 2001 |   |   | /s/Amy Beth Hansman              |
|--------------------------------|--------|--------|----------------------------------|
|                           |   |   | Amy Beth Hansman                 |
|                           |   |   | Vice President of Finance        |
|                           |   |   | *(Principal  Financial Officer)* |