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RACK > SEC Filings for RACK > Form 10-K on 16-Apr-2013All Recent SEC Filings

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Form 10-K for RACKWISE, INC.


16-Apr-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of financial condition and results of operations should be read in conjunction with our audited consolidated financial statements and the accompanying notes included elsewhere in this Annual Report. References in this Management's Discussion and Analysis of Financial Condition and Results of Operations to "us," "we," "our," and similar terms refer to Rackwise, Inc., a Nevada corporation. This discussion includes forward-looking statements, as that term is defined in the federal securities laws, based upon current expectations that involve risks and uncertainties, such as plans, objectives, expectations and intentions. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors. Words such as "anticipate," "estimate," "plan," "continuing," "ongoing," "expect," "believe," "intend," "may," "will," "should," "could," and similar expressions are used to identify forward-looking statements.

We caution you that these statements are not guarantees of future performance or events and are subject to a number of uncertainties, risks and other influences, many of which are beyond our control, which may influence the accuracy of the statements and the projections upon which the statements are based. See "Note Regarding Forward-Looking Statements." Our actual results could differ materially from those anticipated in the forward-looking statements as a result of certain factors discussed in "Risk Factors" and elsewhere in this Annual Report. Any one or more of these uncertainties, risks and other influences could materially affect our results of operations and whether forward-looking statements made by us ultimately prove to be accurate. Our actual results, performance and achievements could differ materially from those expressed or implied in these forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether from new information, future events or otherwise.

Overview

We are a software development, sales and marketing company. We create Microsoft applications for network infrastructure administrators that provide for the modeling, planning and documentation of data centers. Our Data Center Management (DCIM) software product, RackwiseŽ, is used by over 100 companies worldwide. Our product provides a multi-layered set of solutions for reporting on the multiple aspects of a company's data center, including power consumption, power efficiency, carbon footprint, green grid and density requirements. This reporting allows customers to plan data center expansions and contractions as well as equipment usage more energy efficiently and cost effectively. Our product's advanced design and ability to tightly interface with other new technologies, like Intel's newest proprietary computer chips, enables it to collect more real-time information (real-time means instantaneous and continuous) associated with more data center equipment usage than products from our competitors. We intend to continue to take advantage of new technologies that will add to our competitive differentiators.

Our ability to execute our business plans is dependent upon our generating cash flow sufficient to fund our operations. Our business strategy may not be successful in addressing these issues. If we cannot execute our business plan, our stockholders may loss their entire investment in us.

As reflected in our financial statements for the years ended December 31, 2012 and 2011, we have generated significant losses raising substantial doubt that we will be able to continue operations as a going concern. Our independent registered public accounting firm included an explanatory paragraph in their report for these years stating that we have not achieved a sufficient level of revenues to support our business and have suffered recurring losses from operations. Our ability to execute our business plan is dependent upon our generating cash flow sufficient to fund operations. Our business strategy may not be successful in addressing these issues. If we cannot execute our business plan, our stockholders may lose their entire investment in us.

We expect that with the infusion of additional capital and with additional management we will be able to increase software and professional services sales, and to expand the breadth of our product offerings. We intend to do the following:

ˇ Continue to add interfaces to our existing product offerings, which would make us a differentiator in the market.

ˇ Establish industry partners and strategic services partners to sell our product to customers, and to perform some of the services necessary to support the installation and maintenance of our product.

ˇ Initiate specific new marketing efforts to coordinate and lead our initiatives for greater market recognition with special emphasis on contacting and educating industry analysts to spread the word of our capabilities.

ˇ Increase sales of our product by though our sales team and partners. During the first and second quarter of 2012, we hired sales personnel to cover all regions in the US and Latin America and further added sales personnel to support sales of our products through strategic partnerships.

ˇ Expand our product offerings to include monitoring and managing the balance of our customer's IT infrastructure.

Recent Developments and Trends

Financings

From September to December 2012, we had seven closings of a private placement offering that commenced on September 1, 2012, pursuant to which an aggregate of 6,942,332 PPO Units were sold at a price of $0.15 per PPO Unit for gross proceeds of $1,041,350. Each PPO Unit consisted of (i) one share of our common stock and (ii) a warrant representing the right to purchase one share of our common stock, exercisable for a period of five years, at an exercise price of $0.30 per share (the "PPO Warrants"). We used the net proceeds from the closings of the private placement offering for general working capital. As a result of the foregoing arrangement, in connection with the seven closings, the placement agent (1) was paid aggregate cash commissions of $104,135 and (2) received five-year redeemable warrants to purchase shares of common stock (the "Broker Warrants") to purchase 694,233 shares of common stock.

Subsequent to December 31, 2012, we completed two closings of a private placement offering pursuant to which we sold 1,000,000 PPO Units for gross proceeds of $150,000, at a purchase price of $0.15 per PPO Unit. We used the net proceeds from the closings of the PPO for general working capital. In connection with the two closings, the placement agent (1) was paid aggregate cash commissions of $15,000 and (2) received Broker Warrants to purchase 100,000 shares of common stock.

In addition, in January 2013, we agreed to permit the holders of our 8% convertible promissory notes, which were originally issued in June through August 2012, to convert their notes (in the aggregate principal amount of $800,000 (and accrued and unpaid interest thereon) into units at a conversion price of $0.0975 per unit. As a result of such conversion, we issued to the holders of such notes 8,546,480 shares of our common stock and 8,546,480 PPO Warrants. In addition, as part of such conversion, we agreed to fix the exercise price of 800,000 warrants issued in connection with the purchase of 8% convertible promissory notes at $0.225 per share. As a result of the note conversions, the Company issued three-year placement agent warrants to purchase an aggregate of 318,808 shares of common stock at an exercise price of $0.225 per share.

On April 12, 2013, we borrowed $112,500 via a short-term interest free loan from an affiliate. The loan is intended to convert into the securities to be sold by us in a subsequent offering.

Revenues

Revenues are generated from the licensing, subscription and maintenance of our enterprise software product and to a lesser extent professional services fees.

Direct cost of revenues

Direct cost of revenues includes the cost of server hosting, the cost of installing our software for new clients, commissions to third parties for installation of our software, the costs of support and operations dedicated to customer services and the costs of maintaining and amortizing our proprietary database.

Sales and marketing expenses

Sales expenses consist of compensation and overhead associated with our channel sales, inside sales, direct sales and product sales support functions. Marketing expenses consist primarily of compensation and overhead associated with our marketing function, trade shows and Google ads, which are used as a main source of sales leads.

Research and development expenses

Research and development expenses consist mainly of compensation and overhead of research and development personnel and professional services firms performing research and development functions, plus amortization of our proprietary database.

Transaction costs

Transaction expenses represent the costs associated with professional services utilized to support the planning and implementation of non-capital raising transactions.

General and administrative expenses

General and administrative expenses consist of the compensation and overhead of administrative personnel and professional services firms performing administrative functions, including management, accounting, finance and legal services, plus expenses associated with infrastructure, including depreciation, information technology, telecommunications, facilities and insurance.

Interest, net

Interest, net consists primarily of interest expense associated with our notes payable.

Amortization of debt discount

Amortization of debt discount represents the amortization of the debt discount over the shorter of (a) the term of the related debt, or (b) the conversion of the debt into equity instruments. Debt discount consists of the fair value of the conversion options associated with certain debt, plus the fair value of the warrants provided to certain debt holders.

Amortization of deferred financing costs

Amortization of deferred financing costs represents the amortization of the deferred financing costs over the shorter of (a) the term of the related debt, or (b) the conversion of the debt into equity instruments. Deferred financing costs represent the professional fees incurred in conjunction with our debt financing activities.

Gain on change in fair value of derivative liabilities

Gain on change in fair value of derivative liabilities represents the change in the fair value of derivative liabilities over a reporting period, since derivative liabilities are required to be revalued at each reporting date.

Results of Operations

Year ended December 31, 2012 Compared to the Year ended December 31, 2011

Overview

We reported net losses of $9,593,685 and $8,880,725 for the years ended December 31, 2012 and 2011, respectively. The increase in net loss of $712,960 is primarily due to a $1,419,698 net increase in operating expenses. The increase in operating expenses include a $2,702,759 increase in sales and marketing expense associated with additional headcount necessary to expand our direct sales efforts and a $1,350,050 increase in research and development expense to develop and release our latest versions of Rackwise DCIM. The increased operating expenses were partially offset by a $874,114 increase in gross profit due to increased revenues, a $1,264,688 decrease in transaction expenses associated with the reverse merger in 2011 and a $1,368,423 decrease in general and administrative expenses. Other expenses increased by $167,376 primarily due to a charge for loss on extinguishment resulting from conversion of bridge financing notes into equity.

Revenues

Our revenues for the year ended December 31, 2012 were $3,253,436 as compared to revenues of $2,020,048, for the year ended December 31, 2011. Revenues increased by $1,233,388 or 61%. Licensing revenues were $ 1,709,868 as compared to $587,059 in the prior year, an increase of 191%, Licensing revenues increased due to the expanded sales force. Maintenance revenues were $1,112,136 as compared to $1,037,859 in the prior year, an increase of $74,227, or 7%, due to maintenance renewals from the prior year along with new maintenance revenues from new license sales. Subscription revenues were $250,062 as compared to $339,690, a decrease of $89,628, or (26%), due to a shift from subscription sales to licensing sales. Professional service revenues were $181,370 as compared to $55,440 in the prior year, an increase of $125,930 or 227%. The increase in professional service revenues was due to increased demand as a result of new software license installations and new customer training.

Direct cost of revenues

The direct cost of revenues during the years ended December 31, 2012 and 2011 was $575,956 and $216,682, respectively, representing an increase of $359,274 or 166%. The increase in direct cost of revenues resulted from increased license and professional services revenue. In addition, we realized royalty expenses of $176,890 across the third and fourth quarter of 2012 due to the licensing of Intel DCM software. The direct cost of revenues as a percentage of revenues was approximately 18% and 11% for the periods ended December 31, 2012 and December 31, 2011, respectively. Direct cost of revenues increased as a percentage of revenues in 2012 due to the royalty expense associated with Intel DCM technology that was embedded in Rackwise DCIM software beginning in the third quarter of 2012. It is impractical for the Company to break out direct cost of revenues by the types of revenues cited in the revenue discussion above.

Sales and marketing expenses

Sales and marketing expenses increased by $2,702,759, or 140%, in 2012 to $4,639,283 from $1,936,524 in 2011. The increase in sales and marketing expenses was due to increased headcount (resulting in increased cash and stock based compensation expense) in support of our strategic plan to ramp sales during 2012 through the deployment of a regional based, inside sales team.

Research and development expenses

Research and development expenses increased by $1,350,050, or 128%, in 2012 to $2,407,818 from $1,057,768 in 2011. The increase was due primarily to increases in employee related costs of $669,737, stock compensation expense of $442,374, outside services of $77,120, and a charge related to the purchase of shapes for $69,927 (schematic of the computer systems which are referred to as "Shapes" for our database library).

Transaction expense

Transaction expenses decreased to $0 in 2012 from $1,264,688 in 2011, as the reverse merger transaction was completed in 2011. Transaction expenses represent the costs associated with professional services utilized to support the planning and implementation of our 2011 reverse merger transaction.

General and administrative expenses

General and administrative expenses were $4,285,233 in 2012 as compared to $5,653,656 in 2011, a decrease of $1,368,423 or (24%). This decrease resulted primarily from a reduction of $1,526,970 in stock based compensation expense primarily related to the 2011 vesting of our Chief Executive Officer's options in connection with the November 2011 execution of the Intel agreements and a decrease of $130,969 in outside services expenses, partially offset by a $316,228 increase in factoring fees.

Interest, net

Interest expense was $97,118 for 2012 as compared to $333,726 for 2011, representing a decrease of $236,608, or (71)%. The decrease was primarily attributable to the decrease in outstanding notes payable from 2011 to 2012 (principal balance outstanding prior to the conversion of notes payable in connection with the reverse merger on September 21, 2011 was approximately $5,800,000, as compared to the principal balance outstanding of approximately $1,500,000 on December 31, 2012).

Amortization of debt discount

During 2012, we recorded an expense of $604,605 for amortization of debt discount as compared to $632,380 in 2011, representing a decrease of $27,775, or
(4)%. The decrease was primarily due to the timing of the recognition of debt discount expense.

Amortization of deferred financing costs

During 2012, we recorded an expense of $49,662 for amortization of deferred financing costs as compared to $347,632 in 2011, a decrease of $297,970, or
(86)%. The decrease was due to the timing of the recognition of the debt offering costs, which, in 2011, wereprimarily a result of the 2011 issuance of the bridge notes.

Gain on change in fair value of derivative liabilities

During 2012, we did not record a gain on change in far value of derivative liabilities. We determined that the embedded conversion options associated with the 2012 Notes were equity instruments and should not be bifurcated and accounted for as a derivative. See Note 6 - Notes Payable of the accompanying financial statements for additional details. During 2011, we recorded a gain from the change in fair value of our derivative liabilities of $542,283. The fair value of derivative liabilities derived from the binomial lattice options pricing model fluctuates based on changes in the underlying assumptions. See Note 7 - Derivative Liabilities of the accompanying financial statements for additional details.

Liquidity and Capital Resources

We measure our liquidity a variety of ways, including the following:

                                          December 31,
                                      2012             2011

Cash                              $     16,799     $    613,443
Working Capital Deficiency        $ (7,223,933 )   $ (3,944,873 )
Notes Payable (Gross - Current)   $  1,508,945     $     50,000

Prior to the September 21, 2011 merger (see "Recent Developments" below), we relied primarily on debt financing from our directors and principal stockholders and their affiliates to fund our operations.

During the year ended December 31, 2012, we had three additional closings of the Second Private Offering pursuant to which an aggregate of 4,356,669 Second Units were sold, resulting in $1,447,114 of aggregate net proceeds ($1,633,750 of gross proceeds less $186,636 of issuance costs). In connection with the closings, an aggregate of 4,356,669 shares of common stock and Second Investor Warrants to purchase 1,089,169 shares of common stock were issued. The Second Investor Warrants are redeemable in certain circumstances, are exercisable for a period of five years at an exercise price of $1.00 per full share of common stock and are subjected to weighted average anti-dilution protection.

In April and May 2012, we completed and closed an offering of ninety day 12% convertible promissory notes (the "12% Notes") in which it sold an aggregate principal amount of $580,000 in notes to five investors. Each of the 12% Notes was scheduled to mature ninety days after issuance and was convertible, at the option of the holder, into Company units, at a price of $0.40 to $.0.45 per unit, each unit consisting of one share of our common stock and one warrant representing the right to purchase one share of our common stock for a period of five years from issuance at an exercise price of $0.80 to $1.00 per share. The warrants were exercisable on a cashless basis and contain weighted average anti-dilution price protection (see Note 6 - Notes Payable in the accompanying financial statements for more details).

In June, July and August 2012, we completed and closed on $1,050,000 of Bridge Units (as hereafter defined) which consists of a twelve month 8% convertible note (the "8% Notes") and a warrant (the "Bridge Warrant"). Bridge Units are being offered in anticipation of the Subsequent Offering (see Note 6 - Notes Payable in the accompanying financial statements for more details).

During the year ended December 31, 2012, we had seven closings of a private offering that commenced on September 1, 2012 (the "PPO"), pursuant to which an aggregate of 6,942,332 PPO Units were sold at a price of $0.15 per PPO Unit, resulting in $878,051 of aggregate net proceeds ($1,041,350 of gross proceeds less $163,299 of issuance costs). Each PPO Unit consists of one share of common stock and a PPO Warrant, such that an investors were entitled to an aggregate of 6,942,332 shares of common stock and PPO Warrants to purchase 6,942,332 shares of our common stock.

In January 2013, we completed two additional closings of the PPO pursuant to which we sold 1,000,000 PPO Units for gross proceeds of $150,000, at a purchase price of $0.15 per PPO Unit. We used the net proceeds from the closings of the PPO for general working capital. In connection with the two closings, the placement agent (1) was paid aggregate cash commissions of $15,000 and (2) received Broker Warrants to purchase 100,000 shares of common stock. (see Note
13 - Subsequent Events for details of closings subsequent to December 31, 2012)

On April 12, 2013, we borrowed $112,500 via a short-term interest free loan from an affiliate. The loan is intended to convert into the securities to be sold by us in a subsequent offering.

The proceeds from these financing activities were used to fund recurring legal and accounting expenses as a result of being a public company, our existing operating deficits while we invest in our sales, R&D and support functions, which we believe will enable us to broaden our product line(s) and enhance our marketing efforts to increase revenues and general working capital needs of the business. We do not currently anticipate any material capital expenditures.

Availability of Additional Funds

As a result of the above developments, which raised additional cash and, importantly, resulted in the conversion of most of our indebtedness into equity, our working capital situation improved. Although we do not currently anticipate any material capital expenditures, we will need to raise additional capital to meet our liquidity needs for operating expenses and product development in order to execute our business plan. If we are unable to obtain adequate funds on reasonable terms, we may be required to significantly curtail or discontinue operations.

Years Ended December 31, 2012 and 2011

Operating Activities

Net cash used in operating activities for the years ended December 31, 2012 and 2011, amounted to $4,779,046 and $4,200,583 respectively. During the year ended December 31, 2012, the net cash used in operating activities was primarily attributable to the net loss of $9,593,685, adjusted for $2,851,097 of net non-cash expenses, partially offset by a $1,190,259 increase in accounts payable and a $731,611 increase in accrued expenses. During the year ended December 31, 2011, the net cash used in operating activities was primarily attributable to the net loss of $8,880,725, adjusted for $3,162,363 of net non-cash expenses, a $377,825 decrease in deferred revenues due to a decrease in revenue, a $75,326 decrease in accounts payable, partially offset by a $832,049 increase in accounts receivable, a $327,054 increase in accrued interest and a $850,529 increase in accrued expenses.

Investing Activities

Net cash used in investing activities for the years ended December 31, 2012 and 2011 amounted to $378,788 and $201,724, respectively. The net cash used in investing activities for the year ended December 31, 2012 was primarily related to the purchase of property and equipment totaling $291,348 and the acquisition of intangible assets (schematic of the computer systems which are referred to as "Shapes" for our database library) totaling $96,341. The net cash used in investing activities for the year ended December 31, 2011 related to the purchase of property and equipment totaling $99,197 and the acquisition of intangible assets totaling $102,527.

Financing Activities

Net cash provided by financing activities for the years ended December 31, 2012 and 2011 amounted to $4,561,190 and $4,968,384, respectively. For the year ended December 31, 2012, the net cash provided by financing activities resulted primarily from new borrowings of $1,630,000 and issuance of stock and warrants for net proceeds of $2,325,164, and a $712,208 increase in amounts owed to our factor as a result of the increase in accounts receivable pledged to the factor. For the year ended December 31, 2011, the net cash provided by financing activities resulted primarily from new borrowings of $2,337,980 and issuance of stock and warrants for net proceeds of $3,750,315, partially offset by $347,632 of deferred financing costs and a $767,645 decrease in amounts owed to our factor as a result of a decline in accounts receivable pledged to the factor.

Liquidity, Going Concern and Management's Plans

The accompanying financial statements have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities and commitments in the normal course of business. As discussed in Note 2 to the accompanying financial statements, we have not achieved a sufficient level of revenues to support our business and have suffered substantial recurring losses from operations since our inception, which conditions raise substantial doubt that we will be able to continue operations as a going concern. The accompanying financial statements do not include any adjustments that might be necessary if we were unable to continue as a going concern.

In addition, we have unpaid payroll taxes relating to the third and fourth quarters of 2010, the first quarter of 2011 and the third and fourth quarters of 2012 in the aggregate amount of $1,099,807. The IRS has placed federal tax liens that aggregate to approximately $771,000 against us in connection with the unpaid payroll taxes relating to the third quarter of 2010, fourth quarter of 2010, the first quarter of 2011 and the third quarter of 2012. If we are unable to negotiate a payment plan or a reduction in the amount of any tax obligation, the IRS or state authorities, as applicable, could enforce their liens by levying against our bank accounts, accounts receivables and other assets. A levy against or foreclosure on our assets could have a material adverse effect on our financial prospects.

With the proceeds from our financing activities, plus based on forecasted sales, we believe that we have enough cash on hand to sustain our operations until May 2013. If the Company is unable to obtain additional financing on a timely basis and, notwithstanding any request the Company may make, the Company's debt holders do not agree to convert their notes into equity or extend the maturity dates of their notes, the Company may have to delay note and vendor payments and/or initiate cost reductions, which would have a material adverse effect on the Company'sbusiness, financial condition and results of operations, and ultimately the Company could be forced to discontinue its operations, liquidate and/or seek reorganization under the U.S. bankruptcy code. As a result, our auditors have issued a going concern opinion in conjunction with their audit of our December 31, 2012 consolidated financial statements.

Off-Balance Sheet Arrangements

None.

Contractual Obligations

Not applicable.

Critical Accounting Policies and Estimates

Use of Estimates

The preparation of financial statements in conformity with the generally accepted accounting principles in the United States of America ("U.S. GAAP") requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities, and reported amounts of revenues and expenses in the financial statements and the accompanying notes. Actual results could differ from those estimates. Our significant estimates and assumptions relate to stock-based compensation, the useful lives of fixed assets and intangibles, valuation allowance for income taxes, bad debts and factoring fees, and fair value of derivative liabilities and warrants.

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