**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-QSB**

 

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

 

**For Period Ended March 31, 2002**

 

| **o** |   | **Transition Report Pursuant to  Section 13 or 15 (d) of the Securities Exchange Act of 1934** |
|-------|--------|------------------------------------------------------------------------------------------------|

 

**For the transition periodfrom                         to**

 

**Commission FileNumber        00-23527**

 

**eSoft, Inc.**

(Exact name of small business issuer asspecified in its charter)

 

| **DELAWARE**                                                                        |   | **84-0938960**           |
|-------------------------------------------------------------------------------------|--------|--------------------------|
| (State or other jurisdiction                                                        |   | (IRS Employer ID Number) |
| of incorporation or organization)                                                   |   |                     |
|                                                                                |
| **295 Interlocken Boulevard, #500**                                                 |
| **Broomfield, CO 80021**                                                            |
| (Address of Principal Executive Offices)                                            |
|                                                                                |   |                     |
| **(303) 444-1600**                                                                  |
| (Issuer’s Telephone Number, Including Area Code)                               |
|                                                                                |
| (Former name, former address and former fiscal year, if changed since  last report) |

 

Indicate by check mark whether the Registrant(1) has filed all reports required to be filed by Section 13 or 15 (d) of theSecurities 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 theRegistrant’s $0.01 par value common stock on May 8, 2002 was 15,916,235.

 

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**eSoft Inc.**

** **

**Table of Contents**

** **
|                                    |                                                                                        |   |
|-----------------------------------------|---------------------------------------------------------------------------------------------|--------|
| **PART I.  FINANCIAL INFORMATION** |                                                                                        | 3      |
|                                    |                                                                                        |   |
| ITEM 1.                                 | CONDENSED FINANCIAL STATEMENTS                                                              |   | 3 |
| ITEM 2                                  | MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL  CONDITIONAND RESULTS OF OPERATIONS |   |   |
|                                    | 12                                                                                          |
|                                    |                                                                                        |   |
| **PART II - OTHER INFORMATION**         |                                                                                        | 19     |
|                                    |                                                                                        |   |
| ITEM 1.                                 | LEGAL PROCEEDINGS                                                                           |   | 19 |
| ITEM 6.                                 | EXHIBITS AND REPORTS ON FORM 8-K                                                            |   | 19 |

 

 

2

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**eSoft, Inc.**

**Balance Sheet**

**(Unaudited)**

# **PART I.  FINANCIAL INFORMATION**

 

## **Item1.    CondensedFinancial Statements.**

 
|                                                                                                   |   | **March 31,  2002** |      |
|--------------------------------------------------------------------------------------------------------|--------|---------------------|-----------|
| **Assets**                                                                                             |   |                |      |
| **Current assets:**                                                                                    |   |                |      |
| Cash and cash equivalents                                                                              |   | $                   | 406,441   |   |
| Available-for-sale securities                                                                          |   | 5,068,064           |      |
| Accounts receivable trade, net of allowance  of $930,069                                               |   | 670,749             |      |
| Inventories, net of allowance of $34,786                                                               |   | 578,817             |      |
| Prepaid expenses and other                                                                             |   | 736,957             |      |
| Total current assets                                                                                   |   | 7,461,028           |      |
|                                                                                                   |   |                |      |
| **Property and equipment:**                                                                            |   |                |      |
| Computer equipment                                                                                     |   | 1,628,135           |      |
| Furniture and equipment                                                                                |   | 351,046             |      |
| Other                                                                                                  |   | 62,358              |      |
|                                                                                                   |   | 2,041,539           |      |
| Less: accumulated depreciation                                                                         |   | (1,243,142          | )         |
| Net property and equipment                                                                             |   | 798,397             |      |
| Other                                                                                                  |   | 582,615             |      |
|                                                                                                   |   | $                   | 8,842,040 |   |
| **Liabilities & Stockholders’ Deficit**                                                       |   |                |      |
| **Current liabilities:**                                                                               |   |                |      |
| Accounts payable                                                                                       |   | $                   | 925,863   |   |
| Accrued expenses                                                                                       |   | 583,614             |      |
| Deferred revenue                                                                                       |   | 1,344,797           |      |
| Total current liabilities                                                                              |   | 2,854,274           |      |
|                                                                                                   |   |                |      |
| **Long-term liabilities:**                                                                             |   |                |      |
| Convertible debt                                                                                       |   | 6,110,683           |      |
| Total liabilities                                                                                      |   | 8,964,957           |      |
|                                                                                                   |   |                |      |
| **Stockholders’ deficit:**                                                                        |   |                |      |
| Preferred stock, $.01 par value, 5,000,000  shares authorized                                          |   | —              |      |
| Common stock, $.01 par value, 100,000,000  shares authorized, 15,916,235 shares issued and outstanding |   | 159,162             |      |
| Additional paid-in capital                                                                             |   | 41,129,784          |      |
| Treasury stock, at cost; 457,803 shares                                                                |   | (444,993            | )         |
| Notes receivable from stockholders                                                                     |   | (358,860            | )         |
| Accumulated other comprehensive loss                                                                   |   | (9,387              | )         |
| Accumulated deficit                                                                                    |   | (40,598,623         | )         |
| Total stockholders’ deficit                                                                       |   | (122,917            | )         |
|                                                                                                   |   | $                   | 8,842,040 |   |

* *

*The accompanying notes to financialstatements are an integral part of these statements.*

 

3

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**eSoft, Inc.**

**Statements of Operations and ComprehensiveLoss**

**(Unaudited)**

 
|                                                                     |   | **For the  Three Months Ended  March 31,** |       |
|--------------------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                                     |   | **2002**                                   |       | **2001** |   |
| **Revenue:**                                                             |   |                                       |       |   |   |
| Product sales                                                            |   | $                                          | 771,713    |   | $ | 1,495,614 |   |
| Subscriptions, maintenance and other                                     |   | 990,812                                    |       | 485,644 |   |
| Product development and license fees                                     |   | 300,000                                    |       | 32,000 |   |
|                                                                     |   |                                       |       |   |   |
| Total revenue                                                            |   | 2,062,525                                  |       | 2,013,258 |   |
|                                                                     |   |                                       |       |   |   |
| **Cost of revenue:**                                                     |   |                                       |       |   |   |
|                                                                     |   |                                       |       |   |   |
| Product sales                                                            |   | 597,438                                    |       | 1,247,245 |   |
| Subscriptions, maintenance and other                                     |   | 450,442                                    |       | 171,146 |   |
|                                                                     |   |                                       |       |   |   |
| Total costs of revenue                                                   |   | 1,047,880                                  |       | 1,418,391 |   |
|                                                                     |   |                                       |       |   |   |
| **Gross profit**                                                         |   | 1,014,645                                  |       | 594,867 |   |
|                                                                     |   |                                       |       |   |   |
| **Operating expenses:**                                                  |   |                                       |       |   |   |
| Sales and marketing                                                      |   | 688,502                                    |       | 1,145,359 |   |
| General and administrative                                               |   | 926,537                                    |       | 1,117,085 |   |
| Research and development                                                 |   | 653,614                                    |       | 831,838 |   |
| Total operating expenses                                                 |   | 2,268,653                                  |       | 3,094,282 |   |
|                                                                     |   |                                       |       |   |   |
| Loss from operations                                                     |   | (1,254,008                                 | )          | (2,499,415 | ) |
|                                                                     |   |                                       |       |   |   |
| **Other income (expense):**                                              |   |                                       |       |   |   |
| Interest income                                                          |   | 65,459                                     |       | 284,644 |   |
| Interest expense                                                         |   | (296,260                                   | )          | (430,194 | ) |
| Write-down on available-for-sale securities                              |   | —                                     |       | (1,276,200 | ) |
| Total other (expense)                                                    |   | (230,801                                   | )          | (1,421,750 | ) |
|                                                                     |   |                                       |       |   |   |
| **Net loss**                                                             |   | $                                          | (1,484,809 | ) | $ | (3,921,165 | ) |
|                                                                     |   |                                       |       |   |   |
| Basic and diluted loss per common share                                  |   | (0.10                                      | )          | (0.25 | ) |
|                                                                     |   |                                       |       |   |   |
| Weighted-average number of common shares outstanding, basic and  diluted |   | 15,415,521                                 |       | 15,566,227 |   |
|                                                                     |   |                                       |       |   |   |
| **Comprehensive  loss**                                                  |   |                                       |       |   |   |
| Net Loss                                                                 |   |                                       |       |   |   |
| Other comprehensive loss                                                 |   | $                                          | (1,484,809 | ) | $ | (3,921,165 | ) |
| Net unrealized loss on available for sale securities                     |   | (100,159                                   | )          | (35,400 | ) |
| Reclassification for unrealized loss included in net loss                |   | —                                     |       | 1,276,200 |   |
| Comprehensive Loss                                                       |   | $                                          | (1,584,968 | ) | $ | (2,680,365 | ) |

 

*The accompanying notes to financialstatements are an integral part of these statements.*

 

4

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**eSoft, Inc.**

**Statements of Stockholders' Equity**

**For the Three Months Ended March 31, 2002**

**(Unaudited)**

** **
|                                                            |   | **Common Stock** |       |       |       |                      |       |                                   |       |                          |       |                                  |       |                     |       |
|-----------------------------------------------------------------|--------|------------------|------------|------------|------------|---------------------------|------------|----------------------------------------|------------|-------------------------------|------------|---------------------------------------|------------|--------------------------|------------|
|                                                            |   | **Shares**       |       | **Amount** |       | **Treasury********Stock** |       | **Additional****P****aid-In  Capital** |       | **Subscriptions  Receivable** |       | **Other  Comprehensive  Gain/(Loss)** |       | **Accumulated  Deficit** |       | **Total  Stockholders’  Deficit** |   |
|                                                            |   |             | ** ** |       | ** ** |                      | ** ** |                                   | ** ** |                          | ** ** |                                  | ** ** |                     | ** ** |   | ** ** |
| Balances, December 31,  2001                               |   | 15,748,397       |       | $          | 157,484    |                      | $          | (444,993                               | )          | $                             | 41,066,097 |                                  | $          | (358,860                 | )          | $ | 90,772 |   | $ | (39,113,814 | ) | $ | 1,396,686 |   |
| Issuance of common stock upon  exercise of warrants and options |   | 84,156           |       | 841        |       | —                    |       | 6,909                                  |       | —                        |       | —                                |       | —                   |       | 7,750 |   |
| Employee stock purchase plan                                    |   | 83,682           |       | 837        |       | —                    |       | 56,778                                 |       | —                        |       | —                                |       | —                   |       | 57,615 |   |
| Net unrealized loss on  available-for-sale securities           |   | —           |       | —     |       | —                    |       | —                                 |       | —                        |       | (100,159                              | )          | —                   |       | (100,159 | ) |
| Net loss for the year                                           |   | —           |       | —     |       | —                    |       | —                                 |       | —                        |       | —                                |       | (1,484,809               | )          | (1,484,809 | ) |
| Balances, March 31, 2002                                        |   | 15,916,235       |       | $          | 159,162    |                      | $          | (444,993                               | )          | $                             | 41,129,784 |                                  | $          | (358,860                 | )          | $ | (9,387 | ) | $ | (40,598,623 | ) | $ | (122,917 | ) |

 

*The accompanying  notes tofinancial statements are an integral part of these statements.*

* *

*5*

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***eSoft,Inc.***

***Statementsof Cash Flows***

***(Unaudited)***

*** ***
|                                                                         |   | **For the Three Months Ended  March 31,** |       |
|------------------------------------------------------------------------------|--------|-------------------------------------------|------------|
|                                                                         |   | **2002**                                  |       | **2001** |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES**                                     |   |                                      |       |   |   |
| Net loss from operations                                                     |   | $                                         | (1,484,809 | ) | $ | (3,921,165 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |   |                                      |       |   |   |
| Depreciation and software amortization                                       |   | 139,368                                   |       | 180,748 |   |
| Provision for losses on accounts receivable                                  |   | 94,000                                    |       | 72,230 |   |
| Provision for obsolete inventory                                             |   | 45,000                                    |       | 45,000 |   |
| Amortization of debt discounts and  financing costs                          |   | 177,979                                   |       | 186,447 |   |
| Accrued interest on available-for-sale  securities                           |   | (63,374                                   | )          |   |   |
| Write-down on available-for-sale securities                                  |   | —                                    |       | 1,276,200 |   |
| Changes in operating assets and  liabilities:                                |   |                                      |       |   |   |
| Accounts receivable                                                          |   | 962,262                                   |       | (173,000 | ) |
| Inventories                                                                  |   | (94,214                                   | )          | (304,548 | ) |
| Prepaid expenses                                                             |   | (11,181                                   | )          | (53,262 | ) |
| Other assets                                                                 |   | (41,105                                   | )          | (13,701 | ) |
| Accounts payable                                                             |   | (393,900                                  | )          | 288,876 |   |
| Accrued expenses                                                             |   | (58,675                                   | )          | (5,966 | ) |
| Deferred revenue                                                             |   | (510,154                                  | )          | 32,060 |   |
| Net cash used in operating activities                                        |   | (1,238,803                                | )          | (2,390,081 | ) |
|                                                                         |   |                                      |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES**                                     |   |                                      |       |   |   |
| Proceeds from sale of available-for-sale  securities                         |   | 1,103,051                                 |       | — |   |
| Purchase of property and equipment                                           |   | (10,136                                   | )          | (73,515 | ) |
| Net cash provided (used) in investing  activities                            |   | 1,092,915                                 |       | (73,515 | ) |
|                                                                         |   |                                      |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES**                                     |   |                                      |       |   |   |
| Proceeds from issuance of common stock                                       |   | 65,365                                    |       | 5,000 |   |
| Payment of convertible debentures                                            |   | (2,000,000                                | )          | — |   |
|                                                                         |   |                                      |       |   |   |
| Net cash (used) provided by financing  activities                            |   | (1,934,635                                | )          | 5,000 |   |
|                                                                         |   |                                      |       |   |   |
| **DECREASE IN CASH**                                                         |   | (2,080,523                                | )          | (2,458,596 | ) |
|                                                                         |   |                                      |       |   |   |
| **CASH,**beginning of period                                                 |   | 2,486,964                                 |       | 20,128,119 |   |
|                                                                         |   |                                      |       |   |   |
| **CASH,**end of period                                                       |   | $                                         | 406,441    |   | $ | 17,669,523 |   |
|                                                                         |   |                                      |       |   |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOWS AND  NON-CASH FINANCING ACTIVITIES** |   |                                      |       |   |   |
|                                                                         |   |                                      |       |   |   |
| CASH PAID DURING THE PERIOD FOR:                                             |   |                                      |       |   |   |
| Interest                                                                     |   | $                                         | 139,117    |   | $ | 157,948 |   |

** **

6

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**eSoft, Inc.**

**Notes to Financial Statements**

**For the Three Months Ended March 31, 2002**

 

**1.**              Summary of AccountingPolicies

 

**Basisof Presentation**

 

The unaudited condensed financial statements of eSoft, Inc. (the“Company”) included herein reflect all adjustments, consisting only of normalrecurring adjustments which, in the opinion of management, are necessary tofairly present our financial position, results of operations, and cash flowsfor the periods presented.  Certaininformation and footnote disclosures normally included in audited financialinformation prepared in accordance with generally accepted accountingprinciples have been condensed or omitted pursuant to the Securities andExchange Commission’s (“SEC”) rules and regulations.  The results of operations for the period ended March 31, 2002 arenot necessarily indicative of the results to be expected for any subsequentquarter or for the entire fiscal year. The information included in this Form 10-QSB should be read inconjunction with the financial statements and notes thereto, together withManagement’s Discussion and Analysis of Financial Statements and notes thereto,included in the Company’s Form 10-KSB for the year ended December 31, 2001.

 

To date, the Company’s cash flow fromoperations has been insufficient to cover the Company’s expenses and capitalneeds.  The Company has financed itsoperations primarily through debt and equity financing.  The Company’s estimated funding requirementsdo not reflect any contingency amounts and may increase, perhaps substantially,if the Company is unable to generate revenue in the amount and within the timeframe it expects or if it has unexpected cost increases.  If the Company is unable to obtain capital oris required to obtain it on terms less satisfactory than what it desires, theCompany may need to delay the development and marketing of its products or takeother actions that could adversely affect its revenue growth and net income.

 

The Company’s cash on hand at March 31, 2002was $406,000, a decrease of $2,081,000 from year end, primarily due to thepayment of the Brown Simpson Convertible Debentures.  The Company’s working capital at March 31, 2002 was $4,607,000, adecrease of $1,253,000 from December 31, 2001. Management anticipates continuing losses in support of its growthinitiatives and, thus expects continued negative cash flow in 2002.  However, we continue to improve our cashmanagement efforts and attempt to reduce our operating costs where possible. Webelieve that our current cash and investment position and the anticipated cashreceipts from receivables will be sufficient to meet our working capital needsthrough December 31, 2002.

** **

**Available-for-SaleSecurities**

 

Available-for-sale securities are carried at their estimated marketvalue, with unrealized holding gains and losses, net of tax, reported as aseparate component of stockholders’ equity until realized.  The Company reviews securities with unrealizedlosses for permanent impairment when the facts and circumstances may indicatethat the unrealized losses may be other than temporary.  Permanent impairments of available-for-salesecurities are reflected as permanent impairment losses in the statement ofoperations.  Realized gains and losseson securities sold are determined based on the specific identification of thesecurities sold.

 

**Revenue Recognition**

 

The Company generates revenue from sales ofhardware products, software licenses and professional servicearrangements.  The Companyaccounts for software license and related revenue under Statement of Position97-2 “Software Revenue Recognition,” and related amendments, interpretations,and Technical Practice Aids issued from time to time by the American Institute of Certified Public Accountants(collectively referred to as “SOP 97-2”). Sales of hardware products are also accounted for in accordance with SOP97-2 as the Company has determined that certain software imbedded in suchproducts is essential to the functionality of the hardware.

 

SOP 97-2 generally requires revenue earned on software arrangementsinvolving multiple elements to be allocated to each element based on therelative 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, the Company utilizes the residualmethod of accounting, whereby revenue may be recognized for delivered elementsof a contract provided:  a) VSOE existsfor all undelivered elements; b) none of the undelivered elements are essentialto the functionality of the delivered elements; and c) revenue is deferredequal to the fair value of all such undelivered elements until they aredelivered.

 

The Company generates revenue from the following elements:

 

**Productsales**– eSoft markets, licenses and sells Internet security appliances.  In addition, the Company sells perpetuallicenses to certain software applications in connection with the sale of itshardware products. Revenue from the sale of the Company’s Internet securityappliance products and perpetual software licenses is recognized upon deliveryto the customer, which is generally at the time the products are shipped, andwhen the fee is fixed, determinable and deemed collectible.  In general, 

 

7

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there are noacceptance criteria and the Company has no further obligation to thecustomer.  Provision is made currentlyfor estimated product returns that may occur. For sales made to distributors under terms allowing certain rights ofreturn and price protection on unsold product, revenue is deferred andrecognized only upon sell-through to the end user.

 

**Subscriptions,maintenance and other services —** eSoft sells licenses foradditional software products for its Internet security products on asubscription basis, whereby customers have a right to use the products for aspecified period of time.  The Companyrecognizes revenue from such subscriptions ratably over the subscription period,commencing upon delivery.  In addition,the Company provides maintenance and other services under separateagreements.  Revenue from suchagreements is deferred and recognized ratably over the service period,generally one year.

** **

**Productdevelopment and license fees** — From time to time, the Company enters intomultiple-element arrangements to develop and license its proprietary softwareproducts.  The Company recognizesrevenue from such arrangements based upon progress to completion.  Such arrangements may include customeracceptance criteria, in which case revenue recognition is deferred untilcustomer acceptance is obtained.

 

The Company believes its current revenue recognition policies andpractices 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 the Company’s current revenue recognitionpolicies.  Such changes could affect thetiming of the Company’s future revenue and results of operations.

 

**Net Loss Per Share**

 

Basic earnings or loss per share is computed by dividing the netearnings or loss by the weighted-average number of shares of common stockoutstanding.  Diluted earnings or lossper share is determined by dividing the net earnings or loss by the sum of (1)the weighted-average number of common shares outstanding, (2) if notanti-dilutive, the number of shares of convertible debt as if converted uponissuance, and (3) if not anti-dilutive, the effect of outstanding stock optionsand warrants determined utilizing the treasury stock method.  Basic and diluted earnings per share are thesame for all periods presented.

 

**Use of Estimates**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosures of contingent assets and liabilities at the date ofthe financial statements and revenues and expenses during the reportingperiod.  Actual results could differfrom those estimates and assumptions.

 

**New AccountingPronouncements**

 

The Company adopted the provisions of SFAS No. 142, “Goodwill and OtherIntangible Assets.”  This statementaddresses financial accounting and reporting for intangible assets (excludinggoodwill) acquired individually or with a group of assets at the time of theiracquisition.  It also addressesfinancial accounting and reporting for goodwill and other intangible assets subsequentto their acquisition.  Intangible assets(excluding goodwill) acquired outside of a business combination will beinitially recorded at their estimated value. If the intangible asset has a finite useful life, it will be amortizedover that life.  Intangible assets withan indefinite life are not amortized. Both types of intangible assets will be reviewed annually for impairmentand a loss recorded when the asset’s carrying value exceeds its estimated fairvalue.  Goodwill will be treated similarto an intangible asset with an indefinite life and will be reviewed annuallyfor impairment.  The adoption of SFASNo. 142 did not have a material effect on the Company’s financial position,results of operations or cash flows.

 

8

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The Company adopted the provisions of SFAS No. 144, “Accounting for theImpairment 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”, but retains therequirements of SFAS No. 121 to (a) recognize an impairment loss only if thecarrying amount of the 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 removes goodwill from its scopeas the impairment of goodwill is addressed prospectively pursuant to SFAS No.142.  The adoption of SFAS 144 did nothave a material effect on the Company’s financial position, results ofoperations or cash flows.

 

**2.   **Available-for-Sale Securities

 

As of March 31, 2002, the Company held 30,000 shares of Gateway, Inc.common stock, which were acquired in connection with the debt financing inSeptember 2000.  At March 31, 2002, thisinvestment had a fair market value of $189,600.  In addition, as of March 31, 2002, the Company had investmentswith a cost basis of $4,916,113 and a fair market value of $4,878,464 in lowduration fixed income funds.

 

At March 31, and September 30 2001, management analyzed the investmentin Gateway, noting a continued downturn in the capital markets, the generaleconomic slowdown and developments at Gateway, and determined that the declinein value was other than temporary and accordingly, a permanent impairment wasrecognized in the same period. Permanent impairments of $1,276,200 and $340,800 were recognized as ofMarch 31 and September 30, 2002, respectively. The impairments were determinedbased upon the fair market value of the securities and the historical cost ofthe investment of $1,780,500.  TheCompany continues to evaluate the investment for further permanent impairment.

 

**3.     Concentrations**

 

For the three months ended 2002, the Company had one customer thatrepresented 15% of the Company’s total revenue.  This customer generated 100% of product development and licensefee revenue for the three months ending March 31, 2002 and 10% of accountsreceivable at March 31, 2002. International sales represented 14% of sales and represents 42% ofoutstanding gross accounts receivable at March 31, 2002.

 

**4.     ConvertibleDebt**

 

In September 2000, the Company enteredinto an Amendment of the Stock and Warrant Purchase and Investor RightsAgreement (the “Amendment”), dated April 26, 2000, with Gateway wherebyeSoft issued a Convertible Subordinated Promissory Note with an aggregateprincipal amount of $12,500,000 and an interest rate of seven percent per annumwhich is due September 15, 2004 (“September 2000 Note”) and stockpurchase warrants (“September 2000 Warrants”) with a right to purchase anaggregate of 600,000 shares of eSoft common stock, par value $.01 per share, atan exercise price of $11.00 per share. In connection with the issuance of theSeptember 2000 Note, the Company purchased 30,000 shares ofGateway, Inc. common stock for $3,000,000, which reflected a premium ofapproximately $1,200,000. This premium was recorded as an original issuediscount on the September 2000 Note, and is being amortized over the termof the note as interest expense. The principal amount of theSeptember 2000 Note is convertible at any time at the investor’s optioninto a fixed number of shares of common stock at the then current fair marketvalue, but not less than $11.00 or more than $19.507 per share.

 

9

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In November 2001, the Company entered into a Note Prepayment andAmendment agreement (the “Second Amendment”) that amends theSeptember 2000 Note. Under the terms of the Second Amendment the Companymade a prepayment of $3,300,000, while the principal amount of the loan wasreduced by $6,000,000. At the time of the prepayment, the carrying amount ofthe retired principal was $5,587,000, net of an unamortized discount of$413,000. The prepayment resulted in an extraordinary gain of $2,287,000.

 

At March 31, 2002, the balance of the AmendedNote was $6,110,683, which reflects principal of $6,500,000, less unamortizeddiscount of $389,317.

 

*Warrants*

 

In connection with the Amendment, the Companyissued warrants for up to 600,000 shares of its common stock at an exerciseprice of $11.00 per share. The September 2000 Warrants vest and becomeexercisable based upon certain performance criteria. Accordingly, the Companymeasures the fair value of the September 2000 Warrants at the date ofissuance, and will continue to re-measure the fair value at each reporting dateuntil such time that the warrants become vested. Changes in the estimated fairvalue of the warrants will be recognized as Additional Paid-in Capital and acharge against our results of operations. Since the date of issuance throughMarch 31, 2002, due to the uncertainty surrounding the ability of Gatewayto achieve the performance milestones, the Company determined that the fairvalue of the warrants is nominal. The September 2000 Warrants expireApril 2005.

** **

**5.     Net Lossper Share**

 

Basic loss per share is calculated by dividing the net loss by theweighted average common shares outstanding during the period.  Options and warrants to purchase 3,687,293and 2,623,976 shares of common stock and notes convertible into 1,647,546shares and 590,909 shares were not included in the computation of dilutedearnings per share because their effect was anti-dilutive for the periods endedMarch 31*,*****2001and 2002, respectively.

 

In December 2001, the Company’s Board of Directors approved a stockoption exchange offer pursuant to which all employees, officers and directorswith stock option grants having an exercise price of $2.50 or above couldexchange such options for the right to receive new stock options (the“Replacement Options”) to be granted at least six months and one day from thecancellation date of the old options. On January 8, 2002, the Company accepted for exchange options topurchase an aggregate of 1,696,182 shares of its common stock.  Replacement Options equal to the number ofoptions exchanged will be issued on or after July 9, 2002 with an exerciseprice equal to the fair market value on that date.

 

**6.     BusinessSegments**

 

During 2002 and 2001, eSoft’s operating structure included thefollowing operating segments:  Internetappliances, redphishtm, and corporate operations.  eSoft’s operating segments derivesubstantially all revenue from the sale and licensing of Internet securityproducts and associated software, development and licensing of proprietarysoftware products, and related support, training and consultation services.Management evaluates the performance of its operating segments separately toindividually monitor the different factors affecting financialperformance.  Segment profit or lossincludes 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.

 

10

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Information about the Company’s reportable segments is as follows (inthousands):

 
|                                  |   | **Quarter ended March 31 2002** |   | **Quarter ended March 31 2001** |   |
|---------------------------------------|--------|---------------------------------|--------|---------------------------------|--------|
|                                  |   | **Internet  appliances**        |   | **redphish**                    |   | **Total** |   | **Internet  appliances** |   | **redphish** |   | **Total** |   |
|                                  |   |                            |   |                            |   |   |   |   |   |   |   |   |   |
| Revenue:                              |   |                            |   |                            |   |   |   |   |   |   |   |   |   |
| Product sales                         |   | $                               | 772    |                            | $      | — |   | $ | 772 |   | $ | 1,092 |   | $ | 403 |   | $ | 1,495 |   |
| Subscriptions, maintenance and other  |   | 991                             |   | —                          |   | 991 |   | 486 |   | — |   | 486 |   |
| Software development and license fees |   | —                          |   | 300                             |   | 300 |   | — |   | 32 |   | 32 |   |
|                                  |   | 1,763                           |   | 300                             |   | 2,063 |   | 1,578 |   | 435 |   | 2,013 |   |
|                                  |   |                            |   |                            |   |   |   |   |   |   |   |   |   |
| Cost of revenue:                      |   |                            |   |                            |   |   |   |   |   |   |   |   |   |
| Product sales                         |   | 598                             |   | —                          |   | 598 |   | 847 |   | 400 |   | 1,247 |   |
| Subscriptions, maintenance and other  |   | 450                             |   | —                          |   | 450 |   | 171 |   | — |   | 171 |   |
| Software development and license fees |   | —                          |   | —                          |   | — |   | — |   | — |   | — |   |
|                                  |   | 1,048                           |   | —                          |   | 1,048 |   | 1,018 |   | 400 |   | 1,418 |   |
|                                  |   |                            |   |                            |   |   |   |   |   |   |   |   |   |
| Gross profit                          |   | $                               | 715    |                            | $      | 300 |   | $ | 1,015 |   | $ | 560 |   | $ | 35 |   | $ | 595 |   |

 

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FORWARD-LOOKING STATEMENTS

 

Statements made in this Form 10-QSB that are not historical or currentfacts are “forward-looking statements” made pursuant to the safe harborprovisions of Section 27A of the Securities Act of 1933, as amended and Section21E of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”).  These statements often can beidentified by the use of terms such as “may,” “will,” “expect,” “believes,”“anticipate,” “estimate,” “approximate” or “continue,” or the negativethereof.  The Company intends that suchforward-looking statements be subject to the safe harbors for suchstatements.  The Company wishes tocaution readers 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 the control of the Company that could cause actualresults and events to differ materially from historical results of operationsand events and those presently anticipated or projected.  These factors include adverse economicconditions, entry of new and stronger competitors, inadequate capital,unexpected costs, failure to gain product approval in foreign countries and failureto capitalize upon access to new markets. Additional risks and uncertainties which may affect forward-lookingstatements about the Company’s business and prospects include the possibilitythat a competitor will develop a more comprehensive or less expensive solution,delays in market awareness of eSoft and its products, possible delays ineSoft’s marketing strategy, and failure of our strategic partners tosuccessfully implement their marketing strategies, each of which could have animmediate and material adverse effect by placing eSoft behind itscompetitors.  For a fuller descriptionof certain of these important factors that could cause actual results to differmaterially from those currently anticipated or projected, please see theCompany’s most recently filed Annual Report on Form 10-KSB for the fiscal yearended December 31, 2001.  The Companydisclaims any obligation subsequently to revise any forward-looking statementsto reflect events or circumstances after the date of such statement or to reflectthe occurrence of anticipated or unanticipated events.

 

The Company uses market data and industry forecasts throughout thisreport, which it has obtained from internal surveys, market research, publiclyavailable information and industry publications.  Industry publications generally state that the information theyprovide has been obtained from sources believed to be reliable, but that theaccuracy and completeness of such information is not guaranteed.  Similarly, the Company believes that thesurveys and market research the Company or others have performed are reliable,but the Company has not independently verified this information.

 

## **Item 2 -  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*SiteFilter (with design)is a registered trademark owned by eSoft, Inc. eSoft, InstaGate EX, InstaGate EX2, InstaRak HP, SoftPak, SoftPakDirector, and redphish are all service marks and/or trademarks owned by eSoft,Inc.*

 

Thefollowing discussion and analysis should be read together with our financialstatements and accompanying notes included elsewhere in this report on Form10-QSB.  This discussion containscertain forward-looking statements that involve risks and uncertainties.  Our actual results and the timing of certainevents could differ materially from those discussed in these forward-looking statements as a result of certain factors, including, but notlimited to, those set forth herein andelsewhere in this report.  In addition,we are considering several strategic alternatives including businesscombinations, repurchases of our common stock, terminating the registration ofour common stock under the Securities Exchange Act of 1934, joint ventures andother strategic alliances.

 

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**Overview**

 

We design, develop and market secure Internetappliance products to address the Internet security needs of small, medium, anddistributed enterprises (SMEs) under the InstaGate EX2 brand names, and thehosting needs of Internet service providers (Service Providers) under theInstaRak and InstaRak HP brand names. Our current family of products providesbusinesses with Internet security, firewall, distributed virtual private network (VPN)technology, Internet and Web hosting services, and security and IT relatedofferings, whose demand is driven by the deployment of broadband Internetconnections and the growing demand for secure Website and email hostingservices. Our products offer a plug-and-play solution that we believe virtuallyeliminates traditional costs of hardware upgrades, box swaps and site visitswith quick, hassle-free installation and a revolutionary approach to ongoingautomatic security updates and management. New applications and upgrades,called SoftPak applications, are available through software downloads asbusinesses grow and new security and IT applications are developed. SoftPakapplications have been developed by eSoft or in combination with third parties.Our current SoftPak offerings include applications and services such asanti-virus, Website filtering, intrusion detection, webmail, reporting, and avariety of communications options. In addition, we continue to evaluate theneeds of our customers and develop new SoftPaks, which we believe address thoseneeds. SoftPaks are most commonly licensed to the end user on an annualsubscription basis and form a recurring revenue stream for us and ourchannel partners, which we believe provides better visibility andpredictability to our revenue growth. SoftPak applications, as well as softwareupdates and enhancements, are distributed through our patent-pending SoftPakDirector. The SoftPak Director allows an end user to utilize a browser-basedinterface to evaluate and select SoftPak applications. As SoftPaks can be addedwithout requiring new boxes, we believe the need for hardware swaps andassociated downtime is eliminated. Through our offerings, we believe that wehave been able to simplify the delivery and use of complex technologies toenable SMEs to compete effectively in their respective markets.

 

With the deployment of broadband and theincreasing popularity of telecommuting, which we believe has created a moreimmediate need for products such as firewalls, VPNs, and domain hosting, wehave continued our focus on providing flexible, customizable, secure Internetappliances. International Data Corporation (IDC) estimated total revenue forthe firewall and VPN appliance market to grow from $1.0 billion in 2000 to$4.0 billion by the end of 2005. We believe this growth can be attributedto the convergence of VPN and firewall technologies, the growing number ofcompanies linking their networks to the Internet, increases in the numbers ofremote office locations, increased remote access connectivity utilized by branchoffices and mobile users, cost savings of implementing an Internet-based VPN,and growing concern over network security. Not only have companies increaseddeployment of firewalls, but according to the marketing consulting firm ofFrost and Sullivan, Internet Protocol VPN has emerged as a requirement forsecure, cost efficient communication between employees and global offices.Frost and Sullivan indicates that the U.S. gateway VPN industry generatedrevenue of $575 million in 2000 and projects such revenue to increase tonearly $3 billion by 2007. Furthermore, TeleChoice, Inc., atelecommunications industry consulting firm, estimates that the use of VPNs cancut telecommunications costs by as much as 90% over private leased linenetworks. In October 2000, we introduced the InstaGate EX integratedInternet security appliance, which is capable of SoftPak applications, inaddition to the firewall or VPN capabilities. In January 2001, we introducedthe InstaGate EX2 integrated Internet security appliance which has firewall andVPN capabilities. The InstaGate EX2 Internet security appliance is a slimprofile, reliable unit based on an Intel reference design motherboard and isthe end result of over a year of collaboration with Intel on the design andfabrication of the appliance.

 

In early 2001, we recognized that ServiceProviders were experiencing increased security and hacking concerns from theircustomers, which in turn created the need for secure servers designed to hostweb, email and Domain Name Service (“DNS”) services for multiple Internetdomains. In July 2001, we announced the introduction of the InstaRaksecure server appliance, which uses the same hardware platform as the InstaGateEX2 Internet security appliance and allows us to leverage our investments insecurity software and SoftPak applications. Subsequently, inNovember 2001, we announced the InstaRak HP, which is a high performancemodel and provides a faster CPU, additional RAM and a larger hard drive. Oursecure server appliances integrate server features with security protection,and are designed to protect against hackers and individuals attempting to 

 

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exploit or gain control of the operatingsystem. These secure server appliances are also designed to protect multiplecustomers hosted on the same appliance from each other. According to IDC, theworldwide appliance server market will grow from $3.8 billion in 2000 to$31.4 billion in 2005, representing a compound annual growth rate of56 percent.

 

Our InstaGate EX2 Internet security appliancetargets SMEs and branch offices that typically have between ten and 250 desktopcomputers connected to a local area network, or LAN. We market this productprimarily through value added resellers (VARs), distributors and ServiceProviders. In addition, we market our InstaRak HP secure server appliancedirectly to Service Providers, as well as through VARs and distributors. Inearly 2002, we signed a distribution agreement with Ingram Micro Inc., thelargest global wholesale provider of technology products and supply chainmanagement services. Under the terms of the agreement, Ingram Micro U.S. willdistribute our InstaGate EX2 Internet security appliance and InstaRak HP secureserver appliance to its global network of resellers.

 

We believe SMEs comprise the largest portionof installed LANs and increasingly recognize the importance of the Internet togrow their business and improve productivity. IDC estimated that approximately65%, or approximately 5 million of U.S. SMEs would be connected to theInternet by 2001. We believe the availability of low-cost, high-speedbandwidth, through technologies such as cable modems and digital subscriberlines, or DSL, is driving SMEs’ demand for full-time Internet access, which inturn creates the need to effectively protect corporate assets and data throughthe implementation of integrated VPN/firewall appliances. According to IDC, thenumber of small businesses in the United States using high-speed access isexpected to expand from 380,000 in 1998 to 3.3 million in 2003. We believethat the integrated VPN/firewall market will increasingly shift its focus toserving the needs of SMEs because that market segment has the largestpotential.

 

IDC projects by the year 2003 that theVPN/firewall security appliance market will be $1.3 billion for the UnitedStates, $780 million for Western Europe and $320 million for AsiaPacific. In order to expand our international market presence, we havelocalized our products for the following key markets: Japanese, TraditionalChinese, Korean, German, French and Spanish. By localizing our product, userinterface, documentation and web presence, we believe that our productofferings will provide even more value for our partners and will continue tomake Internet usage and our products simpler and easier for end users in keyinternational markets.

 

**Resultsof Operations for Three Months Ended March 31, 2002 Compared To The ThreeMonths Ended March 31, 2001**

 

In the first quarter of 2002, revenues totaled $2,063,000 versusrevenue of $2,013,000 for the first quarter of 2001, an increase of $50,000 or2%.  Product revenue for the firstquarter of 2002 was $772,000, a decrease of $724,000, or 48%, from $1,496,000 in the first quarter of 2001.  The decrease is related primarily to thecompletion of contract related to an OEM partner in 2001. Also contributing tothe decrease is the discontinuance of legacy products and lower sales in oneinternational market. International sales accounted for 26% of product revenuein the first quarter of 2002 compared to 44% for the same period of 2001.  The revenue from subscriptions, maintenanceand other services totaled $991,000 in the first quarter of 2002 compared to $485,000for the same period of 2001, an increase of $506,000 or 104%.  Over the past year, the Company continued tofocus on building a recurring revenue stream through the sales of SoftPaks andhas increased the number of SoftPaks offered to fourteen compared to four inthe same quarter 2001.  Approximatelyhalf of the increase is due to a subscription bundle offered to customers inconnection with the agreement signed with IBM in the second half of 2001.Revenue from product development and license fees totaled $300,000 in the firstquarter of 2002 versus revenue of $32,000 for the same period of 2001, anincrease of $268,000 or 838%.  Thisrepresents contractual licensing revenue from Gateway in both periods thatexpire in the second quarter of 2002.

 

Gross profit margin in the current quarter was $1,015,000, which is 49%of revenues for the three months ended March 31, 2002, compared to $595,000,which is 30% of revenues for the three months ended 

 

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March 31, 2001.  Gross margin onproduct was 23% and 17% for the three months ending March 31, 2002 and 2001,respectively. The improvement is attributed to the decreased emphasis on theInstaGate EX with the launch of the InstaGate EX2 in January 2001, which hashigher margins than the InstaGate EX. Gross profit margin on subscription, maintenance and other was 54% and65% in the first quarter of 2002 and 2001, respectively.  This decrease relates to higher royalty costsassociated with SoftPaks released subsequent to the first quarter of 2001.  Also contributing to this decrease is theoutsourcing of technical support in the first quarter of 2002.  Gross profit margin on product developmentand license fees was 100% the first quarters of 2002 and 2001.

 

Operating expenses decreased $826,000, or 27%, from $3,095,000 for thequarter ending March 31, 2001 to $2,269,000 for the quarter ending March 31,2002.  Sales and marketing expensesdecreased $457,000, or 40%, from $1,146,000 in the first quarter of 2001 to$689,000 in the same period of 2002.  Thedecrease is mainly associated with a decrease in salary expense due to areduction in force and a reduction in other salary related expenses.  In the first quarter of 2002, eSoft electedto consolidate its international sales operations back to its corporateheadquarters, which contributed to the reduction in force and resulted in areduction of travel expenses. Advertising and product launch expenses alsocontributed to the decrease due to a branding campaign and product launch thattook place in the first quarter of 2001. Careful management of other expensessuch as public relations and training, added to the decrease.  General and administrative expensesdecreased $190,000 or 17% from $1,117,000 in the first quarter of 2001 comparedto $927,000 for the same period of 2002. This can be attributed to a reduction in salary related expenses,careful management of operating expenses such as outside services includingservices for investor relations, telephone expenses due to the negotiation ofmore favorable fees charged and consolidation of telecommunication services anda reduction in board fees.  Theseincreases were offset by an increase in legal fees and bad debt expense.  Research and development expenses decreased$179,000, or 22%, from $832,000 for the quarter ending March 31, 2001 to$653,000 for the same period of 2002. This is attributed to decreases in salaries due to the outsourcing ofsome technical support functions, which resulted in a reduction in headcountand a reduction of salary related items. Also contributing to the decrease is the reduction in servicesoutsourced for the translation of the product into several foreign languagesdue to completion of the project during the quarter.  The Company will continue to closely monitor operating expenses.

 

Interest expense decreased $134,000, or 31%, in the three months endedMarch 31, 2002 from $430,000 in the first quarter of 2001 to $296,000 for thesame period of 2002.  The decrease isdue to the reduction of debt compared to 2001 and is comprised of interest onthat debt and discount amortization on the convertible debentures andamortization of deferred offering costs. Interest income decreased $220,000 in the quarter as a result of lowercash on hand.

 

The Company recorded an unrealized loss at March 31, 2001 for thepermanent impairment of equity securities due to the continued downturn of thecapital markets and the developments at Gateway.

 

Net loss was $1,485,000 for the three months ended March 31, 2002,compared to $3,921,000 for the same period in 2001, a decrease in the loss of$2,436,000 over the same period. The decrease in the loss is due primarily tothe unrealized loss recorded for the permanent impairment of equity securitiesin 2001 as well as improved gross margins on revenue and a decrease in ouroperating expenses.  Losses areanticipated to continue through the current fiscal year.  However, we expect our net losses tocontinue to decrease.

 

**Critical Accounting Policies**

 

Management’sDiscussion and Analysis of Financial Condition and Results of Operationsdiscusses our financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America. Thepreparation of these financial statements requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenue and expenses duringthe reporting period.

 

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Onan on-going basis, management evaluates its estimates and judgments, includingthose related to income taxes, inventory, property and equipment, accountsreceivable, intangible assets and other assets. Management bases its estimatesand judgments on historical experience and on various other factors that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.Management believes the following critical accounting policies, among others,affect its more significant judgments and estimates used in the preparation ofits financial statements.

* *

*Revenue Recognition*—the Company generates revenue from sales ofhardware products, software licenses and professional service arrangements. TheCompany accounts for hardware products, software licenses and related revenueunder Statement of Position 97-2 “Software Revenue Recognition,” and relatedamendments, interpretations, and Technical Practice Aids issued from time totime by the American Institute of Certified Public Accountants (collectivelyreferred to as “SOP 97-2”). Sales of hardware products are also accounted forin accordance with SOP 97-2 as the Company has determined that certain softwareimbedded in such products is essential to the functionality of the hardware.

 

SOP97-2 generally requires revenue earned on software arrangements involvingmultiple elements to be allocated to each element based on the relative fairvalues of the elements. The fair value of an element must be based onvendor-specific objective evidence (“VSOE”). If VSOE does not exist for allelements of the arrangement the Company utilizes the residual method ofaccounting, whereby revenue may be recognized for delivered elements of acontract, provided: a) VSOE exists for all undelivered elements;b) none of the undelivered elements are essential to the functionality ofthe delivered elements; and c) revenue is deferred equal to the fair valueof all such undelivered elements until they are delivered.

 

TheCompany generates revenue from the following elements:

 

**Product sales**—The Company markets, licenses and sells Internet security appliances.In addition, the Company sells perpetual licenses to certain softwareapplications in connection with the sale of its hardware products. Revenue fromthe sale of the Company’s Internet security appliance products and perpetualsoftware licenses is recognized upon delivery to the customer, which isgenerally at the time the products are shipped, and when the fee is fixed,determinable and deemed collectible. In general, there are no acceptancecriteria and the Company has no further obligation to the customer. Provisionis made currently for estimated product returns that may occur. For sales madeto distributors under terms allowing certain rights of return and priceprotection on unsold product, revenue is deferred and recognized only uponsell-through to the end user.

 

**Subscriptions, maintenance and other services**—The Company sells licenses for additionalsoftware products for its Internet security products on a subscription basis,whereby customers have a right to use the products for a specified period oftime. The Company recognizes revenue from such subscriptions ratably over thesubscription period, commencing upon delivery. In addition, the Companyprovides maintenance and other services under separate agreements. Revenue fromsuch agreements is deferred and recognized ratably over the service period,generally one year.

** **

**Product development and license fees**—From time to time, the Company enters intomultiple-element arrangements to develop and license its proprietary softwareproducts. The Company recognizes revenue from such arrangements based uponprogress to completion. Such arrangements may include customer acceptancecriteria, in which case revenue recognition is deferred until customeracceptance is obtained.

 

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*Investments*—Investment securities are classified as either held-to-maturity,available-for-sale or trading. Investment securities classified asheld-to-maturity are stated at cost, adjusted for amortization of premiums andaccretion of discounts. Investment securities classified as available-for-saleare carried at their estimated market value with unrealized holding gains andlosses, net of tax, reported as a separate component of stockholders’ equityuntil realized. The Company reviews available-for-sale securities withunrealized losses for impairment when the facts and circumstances may indicatethat the unrealized losses may be other than temporary. Permanent impairmentsof available-for-sale securities are reflected as permanent losses in thestatement of operations. Realized gains and losses on securities sold aredetermined based on the specific identification of the securities sold.

* *

*Software Development Costs*—Software development costs for new softwareproducts to be sold or marketed externally for resale are expensed untiltechnological feasibility has been established upon completion of a detailprogram design. Thereafter, all software development costs are capitalizeduntil the point that the product is ready for sale and are subsequentlyreported at the lower of amortized cost or net realizable value. The Companyrecognizes the greater amount of annual amortization of capitalized softwarecosts under 1) the ratio of current year revenues by product to theproduct’s total estimated revenues method or 2) over the productsestimated economic useful life by the straight-line method.

** **

**Liquidity and Capital Resources**

 

To date, the Company’s cash flow from operations has been insufficientto cover the Company’s expenses and capital needs.  The Company has financed its operations primarily through debtand equity financing.  The Company’sestimated funding requirements do not reflect any contingency amounts and mayincrease, perhaps substantially, if the Company is unable to generate revenuein the amount and within the time frame it expects or if it has unexpected costincreases.  If the Company is unable toobtain capital or is required to obtain it on terms less satisfactory than whatit desires, the Company may need to delay the development and marketing of itsproducts or take other actions that could adversely affect its revenue growthand net income.

 

The Company’s cash on hand at March 31, 2002 was $406,000, a decreaseof $2,081,000 from year end, primarily due to the payment of the Brown SimpsonConvertible Debentures.  The Company’sworking capital at March 31, 2002 was $4,607,000, a decrease of $1,253,000 fromDecember 31, 2001.  Managementanticipates continuing losses in support of its growth initiatives and, thusexpects continued negative cash flow in 2002. However, we continue to improve our cash management efforts and attemptto reduce our operating costs where possible. We believe that our current cashand investment position and the anticipated cash receipts from receivables willbe sufficient to meet our working capital needs through December 31, 2002.

 

**Cash Flow**

 

Net cash used in operating activities for the three months ended March31, 2002 was $1,239,000 compared with $2,390,000 for the three months endedMarch 31, 2001, a decrease of $1,151,000. The Company’s net loss at March 31, 2002 was $1,485,000, a decrease of$2,436,000 compared with March 31, 2001. The decrease in the loss is due primarily to the recognition of a$1,276,000 unrealized loss relating to the other-than-temporary impairment ofequity securities in 2001.  Otherfactors include improved gross margins and reductions in operatingexpenses.  Other items impacting thecash used in operating activities during the three months ended March 31, 2002were decreases in accounts receivable of $962,000, accounts payable of $394,000and deferred revenue of $510,000.

 

Net cash provided by investing activities for the three months endingMarch 31, 2002 was $1,093,000 compared with $74,000 used in investingactivities for the three months ending March 31, 2001.  The increase in cash of $1,167,000 for the2002 period compared to the 2001 period was due to the liquidation of lowduration fixed income funds to support our current operating activities.

 

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Net cash used in financing activities for the three months ending March31, 2002 was $1,935,0000 compared with $5,000 provided for the three monthsending March 31, 2001.  The decrease incash of $1,940,000 for the 2002 period compared to the 2001 period wasprimarily due to the payment of the Brown Simpson Convertible Debentures.

** **

**Income Taxes**

 

At March 31, 2002, a valuation allowance of 100% of the deferred taxasset has been recorded, as management of the Company is not able to determinethat it is more likely than not that its deferred tax assets will berealized.  In addition, the Company’soperating loss carryforwards may be limited under Section 382 of the InternalRevenue Code.

 

**Other Matters**

 

The Company adopted the provisions of SFAS No. 142, “Goodwill and OtherIntangible Assets.”  This statementaddresses financial accounting and reporting for intangible assets (excludinggoodwill) acquired individually or with a group of assets at the time of theiracquisition.  It also addressesfinancial accounting and reporting for goodwill and other intangible assetssubsequent to their acquisition. Intangible assets (excluding goodwill) acquired outside of a businesscombination will be initially recorded at their estimated value.  If the intangible asset has a finite usefullife, it will be amortized over that life. Intangible assets with an indefinite life are not amortized.  Both types of intangible assets will bereviewed annually for impairment and a loss recorded when the asset’s carryingvalue exceeds its estimated fair value. Goodwill will be treated similar to an intangible asset with anindefinite life and will be reviewed annually for impairment.  The adoption of SFAS No. 142 is not expectedto have a material effect on the Company’s financial position, results ofoperations or cash flows.

 

The Company adopted the provisions of SFAS No. 144, “Accounting for theImpairment 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”, but retains therequirements of SFAS No. 121 to (a) recognize an impairment loss only if thecarrying amount of the 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. 133 removes goodwill from its scopeas the impairment of goodwill is addressed prospectively pursuant to SFAS No.142.  The adoption of SFAS 144 did nothave a material effect on the Company’s financial position, results ofoperations or cash flows.

 

The Company has reviewed all other recently issued, but not yetadopted, accounting standards in order to determine their effects, if any, onthe results of operations or financial position of the Company.  Based on that review, the Company believesthat none of these pronouncements will have a significant effect on current orfuture earnings or operations.

 

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# **PARTII - OTHER INFORMATION**

 

## **Item 1.          Legal Proceedings**

 

From time to time, the Company may becomeinvolved in or subject to various litigation and legal proceedings incidentalto the normal conduct of its business. On March 1, 2002, the Company filed a complaint against NERA(Philippines) Inc. (“NERA”) in the United States District Court for theDistrict of Colorado in connection with the Company’s delivery of certainhardware products and related warranties and software products.  The Company and NERA had previously enteredinto an International Value-Added Reseller Agreement.  After execution of the agreement, NERA submitted various purchaseorders, which the Company fulfilled. The Company is seeking relief for damages incurred as a result of NERA’srefusal to pay for certain of the shipped products.  The Company has reserved approximately $485,000 against suchreceivable.

 

## **Item 6.          Exhibits and Reports on Form 8-K**

 

(b)     Reportson Form 8-K.

 

On January 8, 2002 the Company filed a Current Report on Form 8-K thatreported that we had received a delisting notice from the NASDAQ SmallCapMarket.

 

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SIGNATURES

 

In accordance with the requirements of the Exchange Act, the Registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
| Date:  May 15, 2002 | eSoft, Inc.                                     |
|--------------------------|-------------------------------------------------|
|                     |                                            |
|                     |                                            |
|                     | /s/ Jeffrey Finn                                |   |
|                     | Jeffrey Finn                                    |
|                     | President and Chief Executive Officer           |
|                     | *(Principal  Executive Officer)*                |
|                     |                                            |
|                     |                                            |
| Date:  May 15, 2002 | /s/ Amy Beth Bennett                            |   |
|                     | Amy Beth Bennett                                |
|                     | Vice President of Finance                       |
|                     | *(Principal  Financial and Accounting Officer)* |
|                          |                                                 |  |  |

 

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