10-Q/A 1 v218173_10qa.htm Unassociated Document

United States
Securities and Exchange Commission
Washington, D. C. 20549

FORM 10-Q/A
Amendment No. 1

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010 or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from __________ to ___________

1-32589

(Commission File No.)

ZANETT, INC.

(Exact Name of Registrant as specified in its charter)

Delaware
 
56-4389547
(State or other jurisdiction of
 
(IRS Employer
incorporation or organization)
 
Identification No.)

635 Madison Avenue, 15th Floor, New York, NY 10022

(Address of principal executive offices)

(212) 583-0300

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act during the preceding 12 months (or for such shorter 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 x  No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes ¨    No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  Large accelerated filer ¨  Accelerated filer ¨  Non-accelerated filer ¨  (Do not check if smaller reporting company) Smaller reporting company x

Indicate by a check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ¨  No x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:

CLASS
 
Outstanding at November 11, 2010
Common stock $.001 Par Value
  
9,265,224
 
 
 

 
 
Zanett, Inc.
Form 10-Q/A
Explanatory Note

Restatement of Financial Statements based on a conversion feature in a Convertible Debt Instrument
 
This Amendment No. 1 to the quarterly report of Zanett, Inc. (the “Company”) on Form 10-Q/A amends our quarterly report on Form 10-Q for the period ended September 30, 2010, which was originally filed on November 15, 2010. This amendment is being filed for the purpose of restating certain amounts in Item 1, Financial Statements, Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and to provide currently dated certifications from the Company’s chief executive officer and chief financial officer as required by Section 302 and 906 of the Sarbanes Oxley Act of 2002. The certifications of the Company’s chief executive officer and chief financial officer are attached to this Form 10-Q/A as Exhibits 31.1, 31.2, 32.1, and 32.2.

The Company re-evaluated its accounting with respect to the conversion feature in the Company’s convertible note issued to Rockport Investments Ltd. (“Rockport”) on March 31, 2010 (“inception”). The Company did not initially bifurcate the conversion feature and account for it separately as a derivative liability at inception in accordance with ASC 815-15, “Derivatives and Hedging- Embedded Derivatives”. The fair value of this derivative liability was not material at inception and the changes in fair value during the year were also not material. On September 17, 2010, the Company incorrectly recognized a Beneficial Conversion Feature (“BCF”) upon the reset of the conversion rate on that date. In accordance with ASC 470-20, “Debt-Debt with Conversion and Other Options, a BCF should not have been recognized upon this reset.
  
As of September 17, 2010, the Company initially recorded a BCF of $1,369,054 as a reduction in debt (via a debt discount) and an offsetting increase in additional paid-in capital. The Company recorded an increase to interest expense of $8,435 and a reduction of the debt discount for the amortization of the debt discount for the period from September 17, 2010 through September 30, 2010.
 
The revised accounting treatment described above with respect to the BCF, as reflected in this restatement, resulted in an increase in net income for the three months ended September 30, 2010 and a decrease in the net loss for the nine months ended September 30, 2010 by $8,435 in each case, and a reduction in total stockholders’ equity and an increase in total liabilities by $1,360,619 at September 30, 2010.

The restatement is more fully described in Note 1 to the Notes to Condensed Consolidated Financial Statements.

This Form 10-Q/A does not reflect events occurring after the filing of the Form 10-Q on November 15, 2010, other than the restatement for the matter discussed above. Such events include, among other things, the events described in the Company’s current reports on Form 8-K after the date of filing of the Form 10-Q on November 15, 2010.
 
 
 

 

TABLE OF CONTENTS
 
   
Page
PART I   FINANCIAL INFORMATION
   
     
Item 1 – Condensed Consolidated Financial Statements.
 
4
     
Condensed Consolidated Balance Sheets as of
   
September 30, 2010 (unaudited) and December 31, 2009
 
4
     
Condensed Consolidated Statements of Operations for the three
   
and nine months ended September 30, 2010 and 2009
   
(unaudited)
 
5
     
Condensed Consolidated Statements of Cash Flows for the nine
   
months ended September 30, 2010 and 2009 (unaudited)
 
6
     
Notes to Condensed Consolidated Financial Statements
 
7
(unaudited)
   
     
Item 2 – Management’s Discussion and Analysis of Financial Condition
   
and Results of Operations
 
18
     
Item 4 - Controls and Procedures.
 
24
     
PART II    OTHER INFORMATION
 
24
     
Item 6 – Exhibits.
 
24
     
Signatures
  
25
 
 
 

 

Part I - FINANCIAL INFORMATION

Item 1 - Financial Statements
Zanett, Inc.
Condensed Consolidated Balance Sheets

   
September 30,
   
December 31,
 
   
2010
   
2009
 
   
(unaudited)
       
   
(Restated)
       
Assets
 
  
       
Current assets:
           
Cash and cash equivalents
  $ 78,270     $ 180,598  
Accounts receivable, net of allowance for doubtful accounts of $308,297 and $432,490, respectively
    8,949,666       6,536,874  
Income tax receivable
    34,358       51,863  
Unbilled revenue
    311,977       206,681  
Prepaid expenses
    297,503       250,335  
Customer deposits
    35,000       535,000  
Other current assets
    226,558       174,306  
Total current assets
    9,933,332       7,935,657  
Property and equipment, net
    1,254,357       1,304,522  
Goodwill
    17,321,972       16,479,746  
Other intangibles, net
    416,619       615,088  
Other assets
    177,342       165,349  
Total assets
  $ 29,103,622     $ 26,500,362  
Liabilities and stockholders' equity
               
Current liabilities:
               
Accounts payable
  $ 1,888,709     $ 1,235,640  
Accrued expenses
    2,970,489       2,836,387  
Short-term debt
    5,117,484       4,350,090  
Short-term debt-related party
    -       6,652,322  
Short-term renewable unsecured subordinated debt
    1,309,873       1,123,048  
Other current liabilities
    1,238,731       1,032,620  
Income taxes payable
    -       14,591  
Deferred revenue
    1,979,915       1,228,802  
Deferred income taxes
    30,645       30,645  
Capital lease obligations
    35,988       35,988  
Total current liabilities
    14,571,834       18,540,133  
Convertible subordinated note
    7,131,983       -  
Long term renewable unsecured subordinated debt
    692,919       1,131,104  
Capital lease obligations
    20,988       47,980  
Deferred rent expense
    83,654       76,535  
Deferred income taxes
    25,053       25,053  
Total liabilities
    22,526,431       19,820,805  
Commitments and contingencies
    -       -  
                 
Stockholders' equity
               
Preferred stock, $0.001 par value; 10,000,000 shares authorized; none issued and outstanding
    -       -  
Common stock, $0.001 par value; 200,000,000 shares authorized; 9,249,040 and 8,738,833 shares issued and outstanding, respectively
    32,953       32,443  
Additional paid-in capital
    33,064,435       32,482,502  
Treasury stock, at cost; 14,915 shares
    (179,015 )     (179,015 )
Accumulated deficit
    (26,341,182 )     (25,656,373 )
Total stockholders' equity
    6,577,191       6,679,557  
Total liabilities and stockholders' equity
  $ 29,103,622     $ 26,500,362  

The accompanying notes are an integral part of these condensed consolidated financial statements.
 
 
4

 

ZANETT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
   
Restated
         
Restated
       
                         
Revenues
  $ 12,697,163     $ 9,903,120     $ 35,155,185     $ 31,795,705  
Operating expenses:
                               
Costs of revenues
    8,995,130       7,402,212       25,588,080       22,558,819  
Selling and marketing
    1,584,944       1,213,919       4,405,101       4,269,631  
General and administrative
    1,734,351       1,812,285       4,877,705       5,620,186  
Total operating expenses
    12,314,425       10,428,416       34,870,886       32,448,636  
Operating income(loss)
    382,738       (525,296 )     284,299       (652,931 )
                                 
Other income (expense):
                               
Interest expense
    (302,806 )     (317,312 )     (952,984 )     (959,914 )
Total other expense
    (302,806 )     (317,312 )     (952,984 )     (959,914 )
Income/(loss) from continuing operations before
                               
income taxes
    79,932       (842,608 )     (668,685 )     (1,612,845 )
                                 
Income tax benefit/(expense)
    23,163       24,536       (16,124 )     (9,600 )
Income/(loss)from continuing operations after taxes
    103,095       (818,072 )     (684,809 )     (1,622,445 )
Gain on sale of discontinued operations,
                               
net of taxes
    -       -       -       887,500  
                                 
Net income (loss)
  $ 103,095     $ (818,072 )   $ (684,809 )     $ (734,945 )
Basic income (loss) per share:
                               
                                 
Continuing operations
  $ 0.01     $ (0.09 )   $ (0.08 )     $ (0.19 )
Discontinued operations
  $ 0.00     $ 0.00     $ 0.00     $ 0.10  
Net income (loss) per common share to common stockholders - basic
  $ 0.01     $ (0.09 )   $ (0.08   $ 0.09  
Weighted average shares outstanding – basic
    9,249,040       8,738,833       9,005,235       8,590,696  
Diluted income (loss) per share:
                               
Continuing operations
  $ 0.01     $ (0.09 )   $ (0.08   $ (0.19 )
Discontinued operations
  $ 0.00     $ 0.00     $ 0.00     $ 0.10  
Net income (loss) per common share to common stockholders – diluted
  $ 0.01     $ (0.09 )   $ (0.08 )     $ 0.09  
Weighted average shares outstanding – diluted
    9,283,414       8,738,833       9,005,235       8,590,696  

The accompanying notes are an integral part of these condensed consolidated financial statements.
 
 
5

 

Zanett, Inc.
Condensed Consolidated Statements of Cash Flows
(Unaudited)

   
Nine Months Ended
 
   
September 30,
 
   
2010
   
2009
 
  
 
Restated
       
Cash flows from operating activities:
           
Net loss
  $ (684,809 )   $ (734,945 )
Adjustments to reconcile net loss to net cash
               
provided by (used in) operating activities:
               
Depreciation and amortization
    631,749       662,162  
Stock based compensation and services
    -       481,775  
Gain on sale of discounted operations
    -       (887,500 )
Provision (recoveries) for doubtful accounts
    (124,193 )     471,809  
Income tax payable
    (14,591 )     (11,502 )
Changes in:
               
Accounts receivable
    (2,288,598 )     (184,424 )
Unbilled revenue
    (105,295 )     (123,059 )
Prepaid expenses and other current assets
    414,664       51,336  
Other assets
    (11,994 )     (30,956 )
Accrued expenses
    134,097       (862,034 )
Accounts payable
    653,070       984,199  
Other current liabilities
    490,989       (14,384 )
Deferred revenue
    751,114       (343,182 )
Deferred rent expense
    7,119       (5,550 )
Income taxes receivable
    17,505       (28,567 )
Net cash used in operating activities
    (129,173 )     (574,822 )
Cash flows from investing activities:
               
Cash received from sale of discontinued operation, net
    -       720,833  
Cash paid for contingent consideration related
               
to acquisitions
    (65,000 )     (317,657 )
Additions to property and equipment
    (383,115 )     (242,829 )
Net cash (used in) provided by investing activities
    (448,115 )     160,347  
Cash flows from financing activities:
               
Payments for debt issuance costs
    (14,083 )     -  
Repayments of short term debt
    267,394       (287,285 )
Proceeds of notes payable to related party
    -       300,000  
Borrowings of short term debt
    500,000       -  
Repayments for redemptions of unsecured notes
    (251,360 )     -  
Issuance of unsecured notes
    -       54,058  
Capital lease payments
    (26,991 )     (15,000 )
Net cash provided by financing activities
    474,960       51,773  
Net decrease in cash and cash equivalents
    (102,328 )     (362,703 )
Cash and cash equivalents, beginning of period
    180,598       450,305  
Cash and cash equivalents, end of period
  $ 78,270     $ 87,602  
Supplemental cash flow information:
               
Income taxes paid
  $ 65,337     $ 66,368  
Interest paid
  $ 494,081     $ 777,556  
Non-cash financing activity:
               
Value of Shares issued for contingent consideration
  $ 582,443     $ 243,372  
Capital lease obligations
  $ 56,976     $ 92,964  
Exchange of related party debt for convertible subordinated debt
  $ 7,131,983     $ -  

The accompanying notes are an integral part of these condensed consolidated financial statements.
 
 
6

 

Zanett, Inc.
Notes to Condensed Consolidated Financial Statements

Note 1. Restatement of Financial Statements based on a conversion feature in a Convertible Debt Instrument
 
Zanett, Inc. (“Zanett” or the “Company”) has re-evaluated its accounting with respect to the conversion feature in the Company’s convertible note issued to Rockport Investments Ltd. (“Rockport”) on March 31, 2010 (“inception”). The Company did not initially bifurcate the conversion feature and account for it separately as a derivative liability at inception in accordance with ASC 815-15, “Derivatives and Hedging- Embedded Derivatives”. As discussed further in Note 8, Rockport may, at its option, reset the conversion price once per calendar year to the greater of (a) the average of the closing price of the Company’s common stock during the preceding 20 consecutive trading day period and (b) $0.10. Based on these specific terms, the conversion reset feature is not indexed to its own stock as the variables that could affect the settlement amount are not inputs to the fair value of a fixed-for-fixedinstrument. Therefore this feature is an embedded derivative that should have been recorded as a liability with an offsetting debt discount at inception and then have been adjusted to fair value each reporting period. The Company, using a probability weighted expected return lattice model calculated a fair value of the derivative liability at March 31, 2010 of approximately $160,000. The key variables included a 5 year life, 88.225% volatility and potential reset prices ranging from $1.99 per share to $1.15 per share. The Company calculated the impact of the amortization of the debt discount to be approximately $16,000 and the decrease in fair value of the derivative liability to be approximately $20,000 from inception to September 30, 2010. Both the qualitative and quantitative impact to each of the quarterly consolidated financial statements during 2010 was immaterial.

On September 17, 2010, the Company incorrectly recognized a Beneficial Conversion Feature (“BCF”) upon the reset of the conversion rate on that date. In accordance with ASC 470-20, “Debt-Debt with Conversion and Other Options”, a BCF should not have been recognized upon this reset.
 
As of September 17, 2010, the Company initially recorded a BCF of $1,369,054 as a reduction in debt (via a debt discount) and an offsetting increase in additional paid-in capital. The Company recorded an increase to interest expense of $8,435 and a reduction of the debt discount for the amortization of the debt discount for the period from September 17, 2010 through September 30, 2010.
 
The revised accounting treatment described above with respect to the BCF, as reflected in this restatement, resulted in an increase in net income for the three months ended September 30, 2010 and a decrease in the net loss for the nine months ended September 30, 2010 by $8,435 in each case, and a reduction in total stockholders’ equity and an increase in total liabilities by $1,360,619 at September 30, 2010.

A summary of all adjustments included in this Quarterly Report on Form 10-Q/A is detailed below.

The following table represents the impact of the restatement on the September 30, 2010 consolidated statement of operations:

   
Three Months ended September 30, 2010
   
Nine Months Ended September 30, 2010
 
   
As Previously
         
As Previously
       
   
Reported
   
As Restated
   
Reported
   
As Restated
 
                         
Selected Statement of Operations Data:
                       
Interest Expense
  $ (311,241 )   $ (302,806 )   $ (961,419 )   $ (952,984 )
Net income/(loss)
    94,660       103,095       (693,244 )     (684,809 )
 
The following table represents the impact of the restatement on the September 30, 2010 consolidated balance sheet:

   
September 30, 2010
 
   
As Previously
       
   
Reported
   
As Restated
 
             
Selected Balance Sheet Data:
           
Convertible Subordinated Note
  $ 5,771,364     $ 7,131,983  
Total Liabilities
    21,165,812       22,526,431  
Additional Paid-in Capital
    34,433,489       33,064,435  
Accumulated Deficit
    (26,349,617 )     (26,341,182 )
Total Stockholders' Equity
    7,937,810       6,577,191  
 
 
7

 

The following table represents the impact of the restatement on the statement of cash flows for the nine months ended September 30, 2010:

   
Nine Months ended September 30, 2010
 
   
As Previously
       
   
Reported
   
As Restated
 
             
Selected Cash Flow Data:
           
Net loss
  $ (693,244 )   $ (684,809 )
Non-cash interest expense
    8,435       -  

Note 2.     Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. In the opinion of management, such statements include all adjustments consisting only of normal, recurring adjustments necessary for a fair presentation of the financial position, results of operations and cash flows at the dates and for the periods indicated for the Company.  Pursuant to accounting requirements of the Securities and Exchange Commission (the "SEC") applicable to Quarterly Reports on Form 10-Q, the accompanying condensed consolidated financial statements do not include all disclosures required by accounting principles generally accepted in the United States of America for audited financial statements.  While the Company believes that the disclosures presented are adequate to make the information not misleading, these condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes  for the year ended December 31, 2009 which are contained in the Company's Annual Report on Form 10-K, as amended.  The results for the nine-month period ended September 30, 2010 are not necessarily indicative of the results to be expected for the full fiscal year.

As of September 30, 2010, there have been no material changes to any of the significant accounting policies, described in our Annual Report on Form 10-K, as amended, for the fiscal year ended December 31, 2009.

Note 3.     Organization and Business

Zanett is an information technology ("IT") company that provides customized IT solutions to Fortune 500 corporations and mid-market companies.  Until the disposition of Paragon Dynamics, Inc. ("PDI") discussed below, the Company also provided such solutions to classified government agencies.  The Company's overarching mission is to provide custom solutions that exceed client expectations, are delivered on time and within budget, and achieve superior results.
 
 
8

 

The Company historically provided commercial solutions through its wholly-owned subsidiaries: Back Bay Technologies, Inc., (“BBT”), based in Burlington, Massachusetts, INRANGE Consulting Corporation (“ICC”), based in West Chester, Ohio, and Whitbread Technology Partners, Inc. (“WTP”), also based in Burlington, Massachusetts.  On December 30, 2005, BBT, ICC and WTP merged with and into another of the Company’s wholly-owned subsidiaries, Zanett Commercial Solutions, Inc. (“ZCS”).  In May 2006, ZCS acquired Data Road, based in Jacksonville, Florida. In March 2007, ZCS acquired DBA Group, Inc. (“DBA”), based in Alpharetta, Georgia, and DBA was merged into ZCS in connection with that acquisition. In December 2008, ZCS acquired PS GoLive, LLC (“PS GoLive”), based in North Palm Beach, Florida.

The Company provides full lifecycle, end-to-end business solutions. These include services to initiate, develop and implement e-business systems, application development, project management, business analysis, architecture design, package customization, testing and quality assurance and implementation management, implementation of ERP, supply chain management (“SCM”) and customer relationship management (“CRM”) systems, and voice and data communications network integration solutions that include the provision of hardware, peripheral equipment and telecommunications lines for voice and data communications networks as well as related security and design services.

On March 14, 2008, the Company entered into a Stock Purchase Agreement (the "Agreement") with KOR Electronics ("KOR") and PDI.  The Agreement provided for the sale by the Company to KOR of all the issued and outstanding stock of PDI which the company had acquired on January 31, 2003.  The transaction closed on March 18, 2008 (the "Closing Date").

The Agreement provided for a purchase price of $8,875,000 in cash, plus certain working capital adjustments. The initial working capital adjustment was $715,175, which was adjusted to $566,691 for a total aggregate purchase consideration of $9,441,691, including the working capital adjustment.  Of that amount, $887,500 (the "Holdback Amount") was held back by KOR to secure the Company's indemnification obligations. On the Closing Date, KOR paid the Company $8,554,191, adjusted for the working capital adjustment.  Total proceeds net of transaction expense were $8,092,758. The Holdback Amount of $887,500, was paid in full to the Company on the one year anniversary of the Closing Date.  The proceeds of the sale of PDI were used to pay down the Company’s then existing debt, as described under the heading “Liquidity and Capital Resources” in this Quarterly Report on Form 10-Q.

Liquidity

During the nine months ended September 30, 2010, the Company incurred a loss from continuing operations of $684,809 and had net cash used in operations of approximately $129,173. As of September 30, 2010, the Company had an excess of current liabilities compared to current assets of $4,638,403.  As of September 30, 2010, the Company’s revolving line of credit with Bank of America, N.A. (“Bank of America”), as successor-by-merger to LaSalle Bank National Association (“LaSalle”) had a balance of $4,617,484 with available borrowings of $324,295 which matured on June 21, 2010.  On June 21, 2010 the Company entered into a forbearance agreement extending the expiration of the respective obligations of Bank of America and the Company to July 21, 2010.  On July 21, 2010 the Company entered into an amended forbearance agreement which extended the term of forbearance to August 21, 2010.  On September 28, 2010, the Company entered into a forbearance agreement extending the expiration of the respective obligations of Bank of America and the Company to October 31, 2010.  To date, the respective obligations of the Company and Bank of America remain in forbearance pursuant to the forbearance agreement, as amended, as described above.
 
 
9

 

Bruno Guazzoni, the uncle of Zanett’s Chief Executive Officer and a principal shareholder and related party of the Company, sold a line of credit and promissory notes issued to Mr. Guazzoni by ZCS in the amounts of $4,575,000 and $750,000, respectively, to Rockport in a private transaction on February 28, 2010.  On March 31, 2010 the Company exchanged the debt held by Rockport for a new note convertible into shares of the Company’s common stock at any time following stockholder approval of the transaction at the option of the noteholder, which stockholder approval was received at the Company’s annual meeting of stockholders on May 20, 2010.  The note is in the principal amount of $7,131,983, bears interest at a rate of 7.95% per annum, payable quarterly in arrears, and matures on March 31, 2015.  The initial conversion price of the convertible note is $1.99, which was the closing bid price of Zanett’s common stock as listed on Nasdaq immediately preceding the date of the convertible note. Rockport may, at its option, reset the conversion price once per calendar year to the greater of (a) the average of the closing sales price of the Company’s common stock during the preceding 20 consecutive trading day period and (b) $0.10. On September 17, 2010, Rockport elected to reset the conversion price to $1.608 per share.  The conversion price is also subject to adjustment in the event of dilutive issuances by the Company or the Company’s issuance of options, warrants or other rights to purchase the Company’s common stock or convertible securities (subject to certain exceptions, including the grant of options to purchase common stock to employees, officers, directors or consultants of the Company).  The Company may prepay the convertible note at any time, subject to a prepayment premium.  The Company may request that Rockport accept any prepayments of principal and/or any scheduled payments of interest in shares of the Company’s common stock, but Rockport is not required to accomodate the Company’s request.

In May 2010 the Company issued a promissory note payable to Rockport in the principal amount of $500,000.  This note bears interest at 1.5% per month and was payable on July 27, 2010.  On August 13, 2010, the Company and Rockport entered into an amendment to this note extending the maturity date to October 10, 2010 at the same interest rate.  To date, this promissory note remains outstanding and payable to Rockport.

The loss from continuing operations, working capital deficit, current maturity dates of the Company’s outstanding debt and limited available borrowings raise substantial doubt about the Company’s ability to continue as a going concern.  The Company is currently negotiating the replacement or refinancing of its line of credit arrangements and is otherwise looking to secure additional funding, though there can be no assurances that such financing will be obtained.  The accompanying condensed consolidated financial statements do not include any adjustments relating to the recoverability of the carrying amount of recorded assets or the amount of liabilities that might result should the Company be unable to continue as a going concern.
 
 
10

 

Fair Value Measurements

The Company adopted ASC topic 820, "Fair Value Measurements and Disclosures" (“Topic 820”) on July 1, 2008 for all financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Topic 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. Topic 820 defines fair value as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities should include consideration of non-performance risk including the Company’s own credit risk. In addition to defining fair value, Topic 820 expands the disclosure requirements around fair value and establishes a fair value hierarchy for valuation inputs. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market. Each fair value measurement is reported in one of the three levels which is determined by the lowest level input that is significant to the fair value measurement in its entirety. These levels are: Level 1 - inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Level 2 - inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 - inputs are generally unobservable and typically reflect management's estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques that include option pricing models, discounted cash flow models, and similar techniques.

Earnings Per Share

Basic income/(loss) per share is calculated based on the weighted average number of common shares outstanding during the period.  Diluted income/(loss) per share gives effect to all dilutive potentially issuable common shares outstanding during the period.  The computation of diluted earnings per share does not assume conversion, exercise or contingent exercise of securities that would have an anti-dilutive effect on earnings.  At September 30, 2010 and 2009, respectively, options to acquire 1,337,398 and 1,626,148 shares of Common Stock, and convertible debt convertible into 3,583,911 shares of Common Stock, were excluded from the calculation of diluted net income/(loss) per share, as their effect would be anti-dilutive. 

Note 4.     Stock Based Compensation

The Company’s Stock Option Plan is designed to provide incentives that will attract and retain individuals key to the success of the Company through direct or indirect ownership of the Company’s common stock. The plan provides for the granting of stock options, stock appreciation rights, restricted stock, stock awards, performance awards and bonus stock purchase awards. The terms and conditions of each award are determined by the Company’s Executive Committee, which is comprised of certain directors and officers of the Company. Under the plan, the Executive Committee may grant either qualified or nonqualified stock options with a term not to exceed ten years from the grant date and at an exercise price per share that the Executive Committee may determine (which in the case of incentive stock options may not be less than the fair market value of a share of the Company’s common stock on the date of the grant). The options generally vest over a four year period. The Company’s policy for attributing the value of graded vesting share based payments is on a straight line basis over the requisite service period for the entire award.
 
 
11

 

As of September 30, 2010, the Company had 519,875 options issued and outstanding, which vest only when the Company files an annual report on Form 10-K showing annual revenue amount for the fiscal year of $250,000,000, and expire November 6, 2011, five years following issuance of these options. Currently, the Company has incurred no expense for these options because the occurrence of the vesting event is not probable. If the occurrence of this event becomes probable an expense will be recorded.

A summary of the status of the Company’s Stock Option Plan as of September 30, 2010 is presented below:

   
Number of
Options
   
Weighted
Avg.
Exercise
Price
 
Outstanding at January 1, 2010
    1,617,773     $ 6.99  
Granted
    -       -  
Exercised
    (147,500 )     0.70  
Forfeited
    (17,875 )   $ 6.89  
                 
Outstanding at September 30, 2010
    1,452,398     $ 7.63  
                 
Exercisable at September 30, 2010
    932,523     $ 9.03  
 
There were no options granted during the nine months ended September 30, 2010.

The options outstanding and exercisable at September 30, 2010 were in the following exercise price ranges:

   
Options Outstanding
   
Options Exercisable
 
Range of
Exercise
Prices
 
Number
Outstanding
   
Weighted
Average
Remaining
Contractual
Life-Years
   
Weighted
Average
Exercise
Price
   
Number
Vested and
Exercisable
   
Weighted
Average
Exercise
Price
 
                               
$0.70 to $0.85
    115,000       8.1     $ 0.70       115,000     $ 0.70  
$1.92 to $10.00
    1,060,085       1.7     $ 6.58       540,210     $ 8.00  
$10.04 to $20.32
    277,313       4.6     $ 14.50       277,313     $ 14.50  
      1,452,398       3.2     $ 7.63       932,523     $ 9.03  
 
All outstanding and executable options at September 30, 2010 had an aggregate intrinsic value of $103,500.

The activity with respect to non-vested options under the Company’s Stock Option Plan was as follows:
 
 
12

 

   
Number of
Options
   
Weighted
Avg. Grant
Date Fair
Value
 
Non-vested at January 1, 2010
    550,750     $ 5.34  
Granted
    -       -  
Vested
    (15,000 )   $ 12.92  
Forfeited
    (15,875 )   $ 5.71  
                 
Non-vested at September 30, 2010
    519,875     $ 5.11  

At September 30, 2010, there was zero total unrecognized compensation cost related to non-vested, non-qualified stock option awards. The total fair value of options vested in the quarter ended September 30, 2010 was zero.

Note 5.       Other Intangibles and Goodwill

Intangibles and long-lived assets consisted of the following at September 30, 2010 and December 31, 2009:

          
September 30, 2010 (unaudited)
   
December 31, 2009
 
   
Average
Remaining
Useful
Life (in
years)
   
Gross
Carrying
Value
   
Accumulated
Amortization
Amount
   
Net
Carrying
Value
   
Gross
Carrying
Value
   
Accumulated
Amortization
Amount
   
Net
Carrying
Value
 
                                           
Customer
                                         
Relationships
    1.25       1,577,000       (1,315,631 )     261,369       1,577,000       (1,149,474 )     427,526  
                                                         
Non-compete
                                                       
Agreement
    0.50       193,000       (181,750 )     11,250       193,000       (161,440 )     31,560  
                                                         
Trade
                                                       
Names
    1.50       288,000       (264,000 )     24,000       288,000       (251,998 )     36,002  
                                                         
Trade
                                                       
Names
 
Infinite
      120,000       -       120,000       120,000       -       120,000  
                                                         
Total
          $ 2,178,000     $ (1,761,381 )   $ 416,619     $ 2,178,000     $ (1,562,912 )   $ 615,088  

Amortization expense was $62,074 and $86,005 for the three months ended September 30, 2010 and 2009, respectively. Amortization expense was $198,469 and $192,503 for the nine months ended September 30, 2010 and 2009, respectively. Based on the Company’s amortizable intangible assets as of September 30, 2010, the Company expects related amortization expense for the remainder of 2010 and the two succeeding fiscal years to approximate $62,075, $194,092 and $40,452, respectively.
 
Goodwill during the third quarter of 2010 was $17,321,972, an increase from goodwill of $16,479,746 for the period ended December 31, 2009. Recorded goodwill is not amortized and no impairment losses have been recognized during the nine month period ended September 30, 2010. The Company performs its annual testing for impairment of goodwill as of October 1, after its annual forecasting process is completed.
 
 
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Balance at January 1, 2010
  $ 16,479,746  
Contingent consideration - DBA
    582,443  
PSGoLive consideration
    259,783  
         
Balance at September 30, 2010
  $ 17,321,972  

Under the original DBA agreement there was a provision for stock protection at the third anniversary of the closing date. The stock protection was calculated using the difference between the average closing price of a share of Zanett common stock as reported on NASDAQ for the three (3) consecutive trading days prior to the third anniversary of the closing date (which was $1.45) and the average closing price for a share of Zanett common stock as reported on NASDAQ for the three (3) consecutive trading days prior to the closing date (which was $6.51).  To the extent the closing bid price calculated at the time of the third anniversary was less than the closing bid price calculated at the time of the closing, then an additional number of shares of Zanett common stock would be issued to the DBA equity holders equaling the price per share difference multiplied by the number of shares issued as the initial stock payment.  In May 2010, the Company issued 401,024 shares to the DBA equity holders.

Note 6.    Related Party Transactions

On March 15, 2009, ZCS replaced two promissory notes, one for $1,500,000 and the other for $3,075,000, both entered into on December 30, 2005 with Bruno Guazzoni, the uncle of Zanett’s Chief Executive Officer, Claudio Guazzoni, and the owner of approximately 22.8% of Zanett’s outstanding common stock calculated as of November 11, 2010, with a combined promissory note for $4,575,000 having a maturity date of March 15, 2010.  Also on March 15, 2009, ZCS replaced an existing promissory note issued to Bruno Guazzoni in the aggregate principal amount of $750,000 with a new note with identical terms, except the maturity date which was extended from March 15, 2009 to March 15, 2010.  These two new notes required quarterly payments of interest at the rate of eleven percent (11%) per annum.

In March 2009, the Company extended the maturity date on a line of credit agreement with Bruno Guazzoni from March 15, 2009 to March 15, 2010.  The maximum borrowings under this line of credit were $3,000,000 and the interest rate was prime plus two percent (2%).  Interest expense attributed to this line of credit for the nine months ended September 30, 2010 and 2009 was $17,421 and $40,944, respectively. The Company paid Mr. Guazzoni $39,767 and $41,372 of interest under this line of credit for the nine months ended September 30, 2010 and 2009, respectively. Mr. Guazzoni sold the line of credit and promissory notes to Rockport in a private transaction on February 28, 2010 (see Note 8).

In respect of all of the promissory notes described above, interest expense was $168,859 and $80,256 for the nine months ended September 30, 2010 and 2009, respectively.  In 2010 and 2009, the Company paid $0 and $320,464 to Mr. Guazzoni in respect of these promissory notes, respectively.
 
 
14

 

Note 7.    Concentration of Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk primarily consist of cash and cash equivalents and trade accounts receivable.  The Company places its excess cash and cash equivalents primarily in commercial checking accounts and in money-market instruments with institutions of high credit quality.  All of the Company's accounts receivable are unsecured.  The Company believes that any credit risk associated with its receivables is minimal due to the size and creditworthiness of its customers, which principally are large domestic corporations.  Receivables are stated at estimated net realizable value, which approximates fair value.

For the nine months ended September 30, 2010, the Company had one customer that accounted for 7.41% of total revenue. For the nine months ended September 30, 2009, the Company had a different customer that accounted for 8.1% of total revenue.

In May 2009, two customers of the Company filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code.  For the quarter ended March 31, 2009, these customers accounted for $98,038 of total revenue, and did not account for any revenue in the three or nine months ended September 30, 2010. As of the end of the third quarter of 2010, one of these customers accounted for approximately 3.4% of accounts receivable, which is fully reserved as of September 30, 2010 (the other customer has no balance).

Note 8.
Notes Payable, Revolving Credit Facility and Subordinated Debt Arrangements

Notes payable, a revolving credit facility, a line of credit and subordinated debt arrangements comprise all of the Company’s outstanding debt at September 30, 2010 and are as follows:

Convertible Subordinated Note

On March 31, 2010, the Company exchanged the line of credit and promissory notes previously held by Bruno Guazzoni and sold to Rockport in a private transaction on February 28, 2010 for a new note convertible into shares of the Company’s common stock at the option of the noteholder and at any time following stockholder approval of the transaction, which was received on May 20, 2010.  The note has a principal amount of $7,131,983 and bears interest at a rate of 7.95% per annum, payable quarterly in arrears through March 31, 2015.  The conversion rate is initially equal to the closing bid price immediately preceding the closing date ($1.99).  Rockport may, at its option, reset the conversion price once per calendar year to the greater of (a) the average of the closing price of the Company’s common stock during the preceding 20 consecutive trading day period and (b) $0.10. As described below, Rockport elected to reset the conversion price to $1.608 per share.   The conversion price is also subject to adjustment in the event of dilutive issuances by the Company or the Company’s issuance of options, warrants or other rights to purchase the Company’s common stock or convertible securities subject to certain exceptions, including the grant of options to purchase common stock to employees, officers, directors or consultants of the Company.  In addition, the noteholder has the right to vote on all matters to which holders of the Company’s common stock are entitled to vote, on an as-converted basis using the closing bid price immediately preceding the closing date as the conversion rate.  Pursuant to the terms of the convertible subordinated note, effective upon such stockholder approval, Rockport would have the right to vote approximately 32% of the Company’s common stock; however, Rockport has entered into a voting agreement with the Company’s Chief Executive Officer, Claudio Guazzoni, pursuant to which it has appointed Mr. Guazzoni as its proxy to vote on Rockport’s behalf in all matters to which stockholders are entitled to vote beginning upon such stockholder approval and continuing for the term of the note.  On September 17, 2010, Rockport elected to reset the conversion price to $1.608 per share.
 
 
15

 
 
The Company may prepay the convertible note at any time, subject to a prepayment premium.  The Company may request that Rockport accept any prepayments of principal and/or any scheduled payments of interest in shares of the Company’s common stock, but Rockport is not required to accomodate the Company’s request.

In May 2010 the Company issued a promissory note payable to Rockport in the principal amount of $500,000.  This note bears interest at 1.5% per month and was payable on July 27, 2010.  On August 13, 2010, the Company and Rockport entered into an amendment to this note extending the maturity date to October 10, 2010 at the same interest rate.  To date, this promissory note remains outstanding and payable to Rockport.

Revolving Credit Facility

On December 31, 2006 the Company entered into a revolving credit facility with LaSalle, which facility is now with Bank of America, as successor-by-merger to LaSalle.  The agreement was amended on May 31, 2007, November 14, 2007, March 18, 2008, January 22, 2009 and December 21, 2009.  As amended, the available line of credit was based on 80% of eligible accounts receivable up to a maximum of $6,000,000, which has since been decreased as described below.  Loans under the revolving credit facility bear interest at a rate per annum equal to the greatest of (a) the prime rate, (b) the federal funds rate plus 0.5% or (c) the 30-day LIBOR rate plus 1.0%, in each case plus 3.0% per annum, which has since been increased as described below.  In addition to the credit facility, Bank of America provides the Company with treasury and cash management services.  The facility is secured by a first priority lien on all of the Company’s assets. In addition to the interest charges there is an unused line fee of 1/2% per annum, payable monthly. At September 30, 2010, fees paid to the bank and attorneys were $178,825.  These fees were classified as other assets in our balance sheet and amortized over the life of the loan. The credit facility terms require the Company to meet certain financial covenants, including a fixed charge coverage ratio of 1.25 to 1.0, a maximum senior debt ratio of 2.5 to 1.0, maintenance of minimum net availability of $500,000 at all times, and excess cash flow of not less than $0 at all times, tested quarterly.  The Company was not in compliance with these covenants as of September 30, 2010. As amended, the credit facility matured on June 21, 2010.  The Company’s line of credit is subject to a forbearance agreement, entered into between the Company and Bank of America on June 21, 2010, amended on July 21, 2010, following expiration of the previous forbearance term, and amended again on September 28, 2010, following expiration of the previous forbearance term, with a forbearance term expiring on October 31, 2010.   Under the forbearance agreement, as amended, the advance rate was reduced from 80% of the face amount of eligible accounts receivable to 62.5% of the face amount of eligible accounts receivable, and the maximum revolving loan limit was reduced to $5,000,000.  Under the forbearance agreement, as amended, interest on loans under the line of credit was increased by 2.0% to 5.0% per annum over the base rate of the revolving credit facility.  To date, the respective obligations of Bank of America and the Company remain in forbearance pursuant to the forbearance agreement, as amended.

 
16

 

The Company had borrowings under its revolving line of credit with Bank of America of $4,617,484 as of September 30, 2010, which is reflected as a current liability on the balance sheet.  Available borrowings under the revolving line of credit were $324,295 as of September 30, 2010.

The Company is currently in discussion to replace its revolving credit facility.

Renewable Unsecured Subordinated Debt

In December 2004, the Company filed a public offering of up to $50,000,000 of Renewable Unsecured Subordinated Notes that was declared effective in February 2005. Through September 30, 2010, the Company has issued $2,002,792 in renewable unsecured subordinated notes net of redemptions. The Company had no gains or losses or redemptions during the nine months ended September 30, 2010 and 2009. The table below presents the Company’s outstanding notes payable as of September 30, 2010:

       
(Unaudited)
             
   
Original
Term
 
Principal
Amount
   
Percentage
   
Weighted
Average
Interest Rate
 
Renewable unsecured
 
3 months
  $ 45,781       2.29 %     7.71 %
subordinated notes
 
6 months
    26,500       1.32 %     8.66 %
   
1 year
    565,705       28.25 %     12.51 %
   
2 years
    522,729       26.10 %     12.96 %
   
3 years
    692,981       34.60 %     13.76 %
   
4 years
    43,500       2.17 %     14.92 %
   
5 years
    28,096       1.40 %     12.22 %
   
10 years
    77,500       3.87 %     8.77 %
Total
      $ 2,002,792       100.00 %     12.80 %
Less current portion of notes payable
        (1,309,873 )                
Long-term portion
        692,919                  

The Company recognized interest expense on the above mentioned unsecured subordinated notes during the nine months ended September 30, 2010 and 2009 in the amounts of $175,331 and $165,482, respectively.
 
Note 9.    Recent Accounting Pronouncements

In September 2009, the FASB issued ASU 2009-14, “Certain Revenue Arrangements That Include Software Elements” (“ASU 2009-14”), which excludes tangible products containing software components and non-software components that function together to deliver the product’s essential functionality from the scope of Subtopic 985-605, “Revenue Recognition.” ASU 2009-14 is effective for periods beginning after December 15, 2009 with earlier adoption permitted. The adoption of ASU 2009-14 did not have a material impact on our consolidated financial statements.
 
 
17

 
 
October 2009, the FASB issued ASU 2009-13 which supersedes certain guidance in ASC 605-25, “Revenue Recognition – Multiple Elements Arrangements”.  This topic requires and entity to allocate arrangements consideration at the inception of an arrangement to all of its deliverable based on their relative selling prices.  This topic is effective for annual reporting periods beginning after June 15, 2010.  The Company is currently evaluating the impact that this topic will have on its consolidated financial statements.
  
Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations
  
This report contains certain forward-looking statements and information relating to Zanett and its wholly-owned subsidiaries that are based on assumptions made by management and on information currently available.  When used in this report, the words "anticipate,” "believe,” "estimate,” "expect,” "intend,” "plan," and similar expressions, as they relate to the Company or its management, are intended to identify forward-looking statements. These statements reflect management's current view of the Company concerning future events and are subject to certain risks, uncertainties and assumptions, including among many others: a further or prolonged general economic downturn; a further or prolonged downturn in the securities or credit markets; federal or state laws or regulations having an adverse effect on the Company; and other risks and uncertainties. Please see Item 1A of the Company’s Form 10-K, as amended, for the year ended December 31, 2009 for a discussion of important risk factors that relate to the forward looking statements in this report.  Should any of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described in this report as anticipated, estimated or expected.

The following discussion should be read in conjunction with Zanett's audited Consolidated Financial Statements and related Notes thereto included in its Annual Report on Form 10-K, as amended, for the year ended December 31, 2009 as filed with the SEC.
 
Overview
 
Zanett is an information technology ("IT") company that provides customized, mission-critical IT solutions to Fortune 500 corporations and mid-market companies. Our overarching mission is to provide custom solutions that exceed client expectations, are delivered on time and within budget, and achieve superior results.
 
Results of Operations
 
Three months ended September 30, 2010 versus three months ended September 30, 2009
 
In the three months ended September 30, 2010, we generated revenues of $12,697,163, an increase of $2,794,043, or 28.2%, from revenues of $9,903,120 generated in the third quarter of 2009. This increase in revenue was attributable to the commencement of services pursuant to several contracts which were signed late in 2009 and early 2010 under which we began to perform our services late in the first quarter of 2010 and continued to perform services in the three months ended September 30, 2010.
 
 
18

 

Cost of revenue increased in the three months ended September 30, 2010 compared to the same period in 2009, primarily as a result of the start of projects which began in 2010.  This resulted in a $1,592,918 increase in cost of revenue in the quarter ended September 30, 2010 as compared to the third quarter of 2009.

Our selling and marketing expense was $1,584,944 for the quarter ended September 30, 2010, as compared with $1,213,919 during the quarter ended September 30, 2009.  This increase resulted from our continued investment in our marketing activities in the third quarter of 2010 compared to the third quarter of 2009.

General and administrative expenses for the third quarter of 2010 were $1,734,351 as compared to $1,812,285 in the third quarter of 2009, representing a decrease of $77,939 or 4.3%. In the third quarter of 2010 there was no expense for stock based compensation for employees and contractors as compared to an expense of $162,987 for the comparable period in 2009.  In addition, reduced expenses in several other office related areas such as rent and IT infrastructure also contributed to the overall reduction in general and administrative expenses during the third quarter of 2010.

Due to the increase in revenues, offset by the cost of revenues and selling and marketing expenses, our operating income in the third quarter of 2010 was $382,738, compared to our operating loss of $525,296 in the comparable prior year period.

Net interest expense decreased $14,506, or 4.6%, to $302,806 in the quarter ended September 30, 2010 from $317,312 in the quarter ended September 30, 2009. This resulted from a decrease in working capital borrowings, along with a lower interest rate on the Rockport convertible note as compared to the interest rate on the Company’s debt with a related party in the third quarter of 2009.

On a consolidated basis, the effect of the increases in revenue, cost of revenue, and in selling and marketing expense, and the decrease in general and administrative expense as discussed above resulted in operating income of $382,738 for the quarter ended September 30, 2010 compared to an operating  loss of $525,296 for the comparable period last year.

Based upon the accounting principles described in the paragraph below, in the three months ended September 30, 2010 we recorded an income tax benefit of $23,163 compared to an income tax provision of $24,536 for the same three month period in 2009.

Deferred income tax assets and liabilities are recognized based on the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as measured by tax rates that are expected to be in effect in the periods when the deferred tax assets and liabilities are expected to be realized or settled. We also assess the likelihood of the realization of deferred tax assets and adjust the carrying amount of these deferred tax assets by a valuation allowance to the extent we believe it is more likely than not that all or a portion of the deferred tax assets will not be realized. Many factors are considered when assessing the likelihood of future realization of deferred tax assets, including recent earnings results, expectations of future taxable income, the carryforward periods available and other relevant factors. Changes in the required valuation allowance are recorded in income in the period such determination is made. Changes in estimates may create volatility in our effective tax rate in future periods for various reasons including changes in tax laws or rates, changes in forecasted amounts and mix of pretax income (loss), settlements with various tax authorities, either favorable or unfavorable, the expiration of the statute of limitations on some tax positions and obtaining new information about particular tax positions that may cause management to change its estimates. It is our policy to recognize the impact of an uncertain income tax position on our income tax return at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50.0% likelihood of being sustained. The tax provisions are analyzed periodically (at least quarterly) and adjustments are made as events occur that warrant adjustments to those provisions. We record interest expense and penalties payable to relevant tax authorities as income tax expense.

 
19

 
 
As a result of the above, for the quarter ended September 30, 2010, we reported net income of $103,095 compared to a net loss of $818,072 for the quarter ended September 30, 2009.

Nine months ended September 30, 2010 versus nine months ended September 30, 2009

Our revenues were $35,155,185 for the nine months ended September 30, 2010 versus revenues of $31,795,705 for the nine months ended September 30, 2009, an increase of $3,359,480 or 10.6%. This increase in revenue can be attributed primarily to the continued focus and success of our sales, delivery and marketing teams.  As a result, primarily, of this increase in revenues, costs of revenues also increased by 13.4%. Selling and marketing expenses increased 3.2%, from $4,269,631 in the nine months ended September 30, 2009 to $4,405,101 for the first nine months of 2010.

General and administrative expenses for the first nine months of 2010 were $4,877,705 as compared to $5,620,186 in the first nine months of 2009, representing a decrease of $742,481, or 13.2%. This decrease is a result of stock based compensation of $481,775 expensed in 2009 as compared to no expense in 2010.  In addition, reduced expenses in several other office related areas such as rent and IT infrastructure also contributed to the overall reduction in general and administrative expenses during the nine months ended September 30, 2010.

For the reasons discussed above, our operating income in the first nine months of 2010 was $284,299 compared to our operating loss of $652,931 in the comparable prior year period.

Net interest expense decreased slightly by $6,930, or .01%, to $952,984 for the nine months ended September 30, 2010 from $959,914 for the same period in 2009. This decrease in interest expense was a result of the repayment of debt with a portion of the proceeds from the PDI transaction and cash flow from continuing operations in 2009, but no corresponding repayments were made in 2010.  In addition, the interest rate on the Rockport convertible note was less than the interest rate on the related party debt in the corresponding prior period.

In the first nine months of 2010, we recorded an income tax provision of $16,124 versus an income tax benefit of $9,600 in the same period last year.

In addition, we recorded an $887,500 gain on the sale of PDI in the nine months ended September 30, 2009, and no similar gain was recorded in the nine months ended September 30, 2010.

 
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As a result of the above, for the nine months ended September 30, 2010, we reported a net loss of $684,809 compared to a net loss of $734,945 for the nine months ended September 30, 2009.

Summary of Critical Accounting Policies; Significant Judgments and Estimates

There were no changes to our critical accounting policies, which are described in our Annual Report on Form 10-K, as amended, for the year ended December 31, 2009 during the first nine months of 2010.  Items incorporated in the Company's financial statements that required the significant use of management estimates include the allowance for doubtful accounts, revenue recognition, stock based compensation, purchase accounting and the evaluation of the carrying value of goodwill.

Liquidity and Capital Resources

At September 30, 2010 we had cash and cash equivalents of $78,270, representing a decrease of $102,328 from the December 31, 2009 year-end balance of $180,598.

Cash used in operating activities was $129,173 for the nine months ended September 30, 2010 compared to cash used in operating activities of $574,822 for the same period in 2009.  The cash used in operating activities of $129,173 for the nine months ended September 30, 2010 was primarily due to an increase in accounts payable, other liabilities, customer deposits and deferred revenue, which was partially offset by an increase in accounts receivable and accrued expenses.

Cash used in investing activities was $448,115 for the nine months ended September 30, 2010 compared to cash provided by investing activities of $160,347 for the corresponding period in 2009. The 2009 inflow primarily reflected proceeds of $720,833 from the PDI disposition. In 2010 we had additions to property and equipment of $383,115 as well as $65,000 of contingent consideration payments in the third quarter of 2010, as compared to $317,657 and $242,829, respectively, paid in the third quarter of 2009.

Cash provided by financing activities for the nine months ended September 30, 2010 was $474,960 as compared to cash provided of $51,773 for the same period in 2009. This difference resulted from the borrowings of $500,000 in short term debt in the second quarter of 2010.

In March 2008 the Company sold all of the issued and outstanding common stock of PDI for cash to KOR Electronics. This transaction resulted in a cash payment of $8.7 million with a holdback amount of $875,000 that was paid to the Company on March 17, 2009. With the proceeds from this transaction, the Company repaid in full promissory notes in an aggregate principal amount of $3,000,000 owing to Bruno Guazzoni and approximately $5,000,000 of short term debt.

On December 31, 2006 we entered into a revolving credit facility with LaSalle Bank National Association (“LaSalle”). The agreement was amended on May 31, 2007 and November 14, 2007. As amended, the available line of credit was based on 80% of eligible accounts receivable up to a maximum of $8 million. The line of credit with LaSalle was further amended on March 18, 2008 at the time of the sale of PDI. The Company paid down $5,700,000 of the outstanding balance on the line of credit at the time of the amendment.

 
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On January 22, 2009, the Company and ZCS entered into a Fifth Amendment and Modification to Loan and Security Agreement and Other Loan Documents with Bank of America, N.A. (“Bank of America”), as successor-by-merger to LaSalle. The amendment increased the maximum revolving loan limit to $6 million from $5 million and modified the fixed charge coverage ratio test required by the loan agreement. As amended, the loan agreement requires the borrowers to maintain a fixed charge coverage ratio of not less than 1.25 to 1.0 for the twelve month period ended on December 31, 2008 and each twelve month period ending on the last day of each fiscal quarter thereafter. In addition, the loan agreement also waived the EBITDA covenant for the November 2008 calendar month and terminated the EBITDA covenant as of the date of the amendment. Further, the amendment raised the face amount of the borrowers’ eligible accounts receivable from 60% to 80%. At September 30, 2010, the outstanding loan balance was $4,617,784 with available borrowings of $324,295. The credit facility matured on June 21, 2010 and the Company entered into a forbearance agreement with Bank of America on June 21, 2010 and amended the forbearance agreement on July 21, 2010, following expiration of the first forbearance term.  Under the first forbearance agreement, the advance rate was reduced from 80% of the face amount of eligible accounts receivable by 2.5% each Tuesday commencing on July 6, 2010, and continuing until the expiration of the forbearance term on August 21, 2010.  On September 28, 2010, the Company extended the forbearance agreement to October 31, 2010.  Under the forbearance agreement, as amended, the advance rate was reduced from 80% of the face amount of eligible accounts receivable to 62.5% of the face amount of eligible accounts receivable, the maximum revolving loan limit was reduced from $6,000,000 to $5,000,000, and interest on loans under the line of credit was increased by 2.0% to 5.0% per annum over the base rate of the revolving credit facility.  To date, the respective obligations of Bank of America and the Company remain in forbearance pursuant to the forbearance agreement, as amended.

The Company is currently in discussions to replace or refinance the Bank of America credit facility.

The Company had a line of credit agreement with Bruno Guazzoni in the amount of $3,000,000.  The interest rate on the line of credit was prime plus two percent 2%.  This line was available for working capital requirements and was unrestricted.  The line had a maturity date of March 15, 2010. The line of credit was sold by Bruno Guazzoni to Rockport Investments Ltd. (“Rockport”) on February 28, 2010 in a private transaction and later exchanged for a convertible note, in each case as described below.

On February 21, 2007, ZCS entered into a new, unsecured promissory note in an aggregate principal amount of $750,000, with Bruno Guazzoni. This note had a maturity date of March 15, 2010 (extended from February 21, 2009) and required quarterly payments of interest at the rate of eleven percent (11%) per annum. Principal was repayable at maturity. The note could be pre-paid without penalty. The proceeds of this note were used to fund the cash portion of consideration paid at closing for the acquisition of DBA. This was sold February 28, 2010 in connection with the Rockport transaction discussed below.

On March 15, 2009, ZCS replaced two promissory notes, one for $1,500,000 and the other for $3,075,000, both entered into on December 30, 2005 with Bruno Guazzoni, with a combined promissory note for $4,575,000 having a maturity date of March 15, 2010. This new note required quarterly payments of interest at the rate of eleven percent (11%) per annum. Principal was repayable at maturity. The note could be prepaid without penalty. This was sold February 28, 2010 in connection with the Rockport transaction discussed below.

 
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On February 28, 2010, Mr. Guazzoni sold the line of credit and the promissory notes issued by ZCS to Rockport in a private transaction.  On March 31, 2010 we exchanged the debt held by Rockport for a new note convertible into shares of our common stock at any time following stockholder approval of the transaction at the option of the noteholder, which our stockholders approved at our May 20, 2010 annual meeting of stockholders.  The note has a principal amount of $7,131,983 and bears interest at a rate of 7.95% per annum, payable quarterly in arrears.

Because of our net loss from continuing operations, our working capital deficit, the current maturity date of our revolving credit facility, and our limited access to additional borrowings under these financing arrangements, there is substantial doubt about our ability to continue as a going concern.  The accompanying condensed consolidated financial statements do not include any adjustments relating to the recoverability of the carrying amount of recorded assets or the amount of liabilities that might result should the Company be unable to continue as a going concern.

Management will continue to monitor the Company’s cash position carefully and evaluate its future operating cash requirements with respect to its strategy, business objectives and performance.  However, due to the scheduled debt maturities discussed above, the Company will require additional capital or other sources of financing in order to meet its commitments. If necessary we will explore other opportunities that may be available to maximize the Company’s value for its stock holders, including strategic transactions. As a result of tightening of the credit markets and volatility in the equity markets, it may be difficult for us to secure such additional liquidity sources on favorable terms or at all.  If we cannot secure additional funding, we will be unable to finance our acquisition strategy and/or continue our organic growth, and we may need to reduce the scope of our existing operations and/or curtail some of our present operations.

To minimize cash outlays, we have compensated employees with equity incentives where possible. We believe this strategy provides us with the ability to increase stockholder value as well as utilize cash resources more effectively. The issuance of equity securities under the stock plan may, however, result in dilution to existing stockholders.

Our Board of Directors also reauthorized a stock repurchase plan effective March 21, 2008 that allows us to repurchase up to 4,000,000 shares of our common stock from time to time in open market transactions.  As a result of the plan, through September 30, 2010, we have repurchased a total of 14,915 shares of common stock.  These shares are reflected as treasury stock on the balance sheet. In the quarters ended September 30, 2010 and 2009, no shares were repurchased.
 
Recent Accounting Pronouncements

See Note 9 to the Condensed Consolidated Financial Statements included elsewhere in this report for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on our consolidated financial statements, which is incorporated herein by reference.
 
 
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Item 4 - Controls and Procedures
 
The Company carried out, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Securities Exchange Act”) as of the end of the quarter covered by this quarterly report. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act is accumulated and communicated to management, including its Chief Executive Officer and Chief Financial Officer as appropriate to allow timely decisions regarding required disclosure. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2010, the design and operation of the Company’s disclosure controls and procedures were effective.

During the fiscal quarter covered by this quarterly report, there have been no changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
 
PART II 
OTHER INFORMATION
 
Item 6 – 
Exhibits

3.1(2)
Certificate of Incorporation, as amended
3.2(1)
Bylaws
31.1(4)
Certification of the Chief Executive Officer pursuant to Rule 13a 14(a)/15d-14(a)
31.2(4)
Certification of the Chief Financial Officer pursuant to Rule 13a 14(a)/15d(a)
32.1(3)
Certification by the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002
32.2(3)
Certification by the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002

(1)
Incorporated by reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.
(2)
Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010.
(3)
Furnished herewith.
(4)
Filed herewith.

 
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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
 
ZANETT, INC.
   
Dated: April 15, 2011
/s/ Claudio M. Guazzoni
 
Claudio M. Guazzoni, Chairman and Chief
 
Executive Officer (Principal Executive Officer)

Dated: April 15, 2011
/s/ Dennis J. Harkins
 
Dennis J. Harkins, President and Chief
 
Financial Officer (Principal Accounting and
 
Financial Officer)
 
 
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