================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 _______________ FORM 10-QSB (Mark One) |X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004. OR |_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ___________ TO ___________. COMMISSION FILE NUMBER 000-29927 IMPROVENET, INC. (Exact name of registrant as specified in its charter) DELAWARE 77-0452868 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 10799 N. 90TH STREET, SUITE 200 SCOTTSDALE, AZ 85260 (Address of principal executive offices) (480) 346-0000 (Issuer's telephone number) _______________ 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 of 1934 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 |_| The number of shares outstanding of the registrant's common stock, $.001 par value, was 39,460,315 as of April 30, 2004. ================================================================================ ImproveNet, Inc. Form 10-QSB For the Quarter Ended March 31, 2004 Index PART I FINANCIAL INFORMATION Item 1 Financial Statements: Condensed Consolidated Balance Sheets as of March 31, 2004 (Unaudited) and December 31, 2003............................ 1 Condensed Consolidated Statements of Operations for the three months ended March 31, 2004 and 2003 (Unaudited)............ 2 Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003 (Unaudited)............ 3 Notes to Unaudited Condensed Consolidated Financial Statements........................................................ 4 Item 2 Management's Discussion and Analysis or Plan of Operation......... 7 Item 3 Controls and Procedures........................................... 13 PART II OTHER INFORMATION Item 1 Legal Proceedings................................................. 14 Item 2 Changes in Securities............................................. 14 Item 3 Defaults upon Senior Securities................................... 14 Item 4 Submission of Matters to a Vote of Security Holders............... 14 Item 5 Other Information................................................. 14 Item 6 Exhibits and Reports on Form 8-K.................................. 14 SIGNATURES................................................................. 18 Rule 13a-14(a)/15d-14(a) Certifications.................................... 19 Section 1350 Certifications................................................. 21 i PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS IMPROVENET, INC. CONDENSED CONSOLIDATED BALANCE SHEETS March 31, 2004 December 31, 2003 ------------ ------------ (unaudited) Current Assets: Cash and cash equivalents $ 161,670 $ 382,415 Accounts receivable, net 494,725 330,472 Prepaid expenses 28,635 7,833 ------------ ------------ Total Current Assets 685,030 720,720 ------------ ------------ Property and equipment, net 90,014 99,800 ------------ ------------ Total Assets $ 775,044 $ 820,520 ============ ============ Current Liabilities: Obligations under capital leases - current portion 17,824 17,824 Line of credit 63,082 65,619 Accounts payable 359,605 378,679 Accrued compensation -- 1,329 Accrued customer claims 308,502 305,588 Accrued furniture lease buyout - current portion 52,500 60,000 Deferred revenue 38,942 49,292 Other liabilities and accrued expenses 130,549 129,877 ------------ ------------ Total Current Liabilities 971,004 1,008,208 Long-Term Liabilities: Notes payable - long-term portion 400,000 400,000 Obligations under capital leases - long-term portion 6,544 10,900 Accrued furniture lease buyout - long-term portion -- 7,500 ------------ ------------ Total Liabilities 1,377,548 1,426,608 ------------ ------------ Commitments and Contingencies: -- -- Stockholders' Deficit Common Stock, $.001 par value, 100,000,000 shares authorized, 39,210,315 shares issued and outstanding at March 31, 2004 and December 31, 2003, respectively 53,124 53,124 Additional paid-in capital 539,770 539,770 Accumulated deficit (1,195,398) (1,198,982) ------------ ------------ Total Stockholders' Deficit (602,504) (606,088) ------------ ------------ Total Liabilities and Stockholders' Equity $ 775,044 $ 820,520 ============ ============ See accompanying notes to the unaudited condensed consolidated financial statements 1 IMPROVENET, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, (UNAUDITED) 2004 2003 ------------ ------------ Revenues $ 880,007 $ 807,651 Cost of Revenues 455,363 530,560 ------------ ------------ Gross Profit 424,644 277,091 Selling, General and Administrative Expenses 316,623 449,137 Research and Development Expenses 101,470 89,089 ------------ ------------ Income (Loss) from Operations 6,551 (261,135) Other Revenues (Expenses) Interest income 607 2,787 Interest expense and financing costs (13,633) (3,410) Relief of debt 103,876 Miscellaneous income 10,059 8,372 ------------ ------------ Income (Loss) from Operations before Income Taxes 3,584 (149,510) Benefit for Income Taxes -- -- ------------ ------------ Net Income (Loss) $ 3,584 $ (149,510) ============ ============ INCOME (LOSS) PER SHARE - Net income (loss) per common share - basic 0.00 (0.00) ============ ============ - Net income (loss) per common share - diluted $ 0.00 $ (0.00) ============ ============ Weighted average common shares - basic 39,210,315 40,107,991 ============ ============ Weighted average common shares - diluted 40,170,315 40,107,991 ============ ============ See accompanying notes to the unaudited condensed consolidated financial statements 2 IMPROVENET, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, (UNAUDITED) 2004 2003 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) $ 3,584 $ (149,510) Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization 21,315 19,000 Extraordinary gain -- (103,876) Treasury stock subscribed -- 1,961,941 Changes in: Accounts receivable, net (164,253) (63,110) Accounts receivable - other -- 1,000 Receivable from stock transfer agent -- 594,715 Costs and estimated earnings in excess of billings on uncompleted contracts -- (35,425) Prepaid expenses (20,802) (14,884) Accounts payable (19,074) (87,560) Accrued compensation (1,329) (120,484) Accrued customer claims 2,914 -- Accrued furniture lease buyout (15,000) -- Accrued merger and tender offer redemption liabilities -- (2,378,029) Other liabilities and accrued expenses 672 229,382 Billings and estimated earnings in excess of costs on uncompleted contracts -- (66,750) Deferred revenue (10,350) (9,625) ------------ ------------ Net cash used in continuing operations (202,323) (223,215) ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES Purchase of property, plant and equipment (11,529) (6,394) ------------ ------------ Net cash used in investing activities (11,529) (6,394) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES Repayment of debt -- (13,197) Repayment of capital leases (4,356) (2,499) Repayment on line of credit (2,537) (5,500) ------------ ------------ Net cash used in financing activities (6,893) (21,196) ------------ ------------ Net increase (decrease) in cash and cash equivalents (220,745) (250,805) Cash and cash equivalents, beginning of period 382,415 446,833 ------------ ------------ Cash and cash equivalents, end of period $ 161,670 $ 196,028 ============ ============ SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION Interest paid $ 10,506 $ 3,410 ============ ============ Income taxes paid $ -- $ -- ============ ============ See accompanying notes to the unaudited condensed consolidated financial statements 3 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE PERIOD ENDED MARCH 31, 2004 NOTE 1 - NATURE OF BUSINESS AND BASIS OF PRESENTATION ImproveNet, Inc., a Delaware corporation ("ImproveNet" or "Company"), operates in two business segments: Software - the Company licenses, installs and maintains its proprietary e-commerce software products to window and door manufacturers and distributors in the Building Materials Industry (BMI). The software segment consists primarily of products developed by eTechLogix. The Company provides a comprehensive, integrated software platform that enables manufacturers to quickly create a "Pure Internet" true eCommerce solution specifically with regard to their product order configuration packages and electronic catalogs. Information Services - under the brand ImproveNet this service provides a source for home improvement information services for homeowners, service providers and suppliers nationwide. The service provider matching service is the process by which homeowners are matched to ImproveNet's network of pre-screened ImproveNet contractors. This was the core business model upon which the Company was founded and has been the primary source of our revenue. Since its inception, we have invested quite heavily in establishing a pool of national remodeling contractors. This is considered to be the core of ImproveNet's business and the major portion of the Company's resources and efforts in the foreseeable future are anticipated to be devoted to further this service. A leading brand since 1996, ImproveNet has the breadth of industry knowledge, and the credibility within the homeowner and contractor market, software design expertise and partnerships with industry leaders, to leverage the opportunity within the $1 Trillion annual BMI. ImproveNet's mission is to automate the BMI and connect the entire Value-Chain with innovative software and outstanding services. The unaudited condensed consolidated balance sheet as of March 31, 2004 and the related unaudited condensed consolidated statements of operations for the three month periods ended March 31, 2004 and 2003, and unaudited condensed cash flows for the three months ended March 31, 2004 and 2003 presented herein have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and in accordance with the instructions to Form 10-QSB. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. In our opinion, the accompanying condensed consolidated financial statements include all adjustments necessary for a fair presentation of such condensed consolidated financial statements. Such necessary adjustments consisted of normal recurring items and the elimination of all significant intercompany balances, transactions and stock holdings. These interim condensed consolidated financial statements should be read in conjunction with the Company's December 31, 2003, Annual Report on Form 10-KSB. Interim results are not necessarily indicative of results for a full year. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statement and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. EARNINGS (LOSS) PER SHARE Basic loss per share of common stock was computed by dividing net income (loss) by the weighted average number of shares outstanding of common stock. Diluted earnings per share are computed based on the weighted average number of shares of common stock and dilutive securities outstanding during the period. Dilutive securities are options and warrants that are freely exercisable into common stock at less than the prevailing market price. Dilutive securities are not included in the weighted average number of shares when inclusion would increase the earnings per share or decrease the loss per share. NEW ACCOUNTING PRONOUNCEMENT In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" (SFAS 150). This statement affects the classification, 4 measurement and disclosure requirements of the following three types of freestanding financial instruments: 1) mandatory redeemable shares, which the issuing Company is obligated to buy back with cash or other assets; 2) instruments that do or may require the issuer to buy back some of its shares in exchange for cash or other assets, which includes put options and forward purchase contracts; and 3) obligations that can be settled with shares, the monetary value of which is fixed, tied solely or predominantly to a variable such as a market index, or varies inversely with the value of the issuers' shares. In general, SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have an impact on the Company's consolidated financial position or disclosures. NOTE 2 - STOCK OPTIONS The Company has adopted FAS No. 123, "Accounting for Stock-Based Compensation". Under FAS No. 123, companies can, but are not required to, elect to recognize compensation expense for all stock-based awards using a fair value methodology. The Company has adopted the disclosure-only provisions, as permitted by FAS No. 123. The Company applies APB Opinion No. 25 and related interpretations in accounting for its stock-based plans. Accordingly, there is no related compensation expense recorded in the Company's financial statements for the periods presented. Had compensation cost for stock-based compensation been determined based on the fair value of the options at the grant dates consistent with the method of SFAS 123, the Company's net loss and loss per share for the three months ended March 31, 2004 and 2003 would have been reduced to the pro forma amounts presented below: Three Months Ended March 31, ------------------------------ 2004 2003 ------------ ------------ Net income (loss): As reported $ 3,584 $ (149,510) ============ ============ Pro forma $ (94,416) $ (224,510) ============ ============ Income (Loss) per share: Basic - As reported $ 0.00 $ (0.00) ============ ============ Basic - Pro forma $ (0.00) $ (0.01) ============ ============ Diluted - As reported $ 0.00 $ (0.00) ============ ============ Diluted - Pro forma $ (0.00) $ (0.01) ============ ============ The fair value of the 700,000 option grants during the quarter ended March 31, 2004 is estimated as of the date of grant utilizing the Black-Scholes option-pricing model with the following weighted average assumptions for all grants, expected life of options of two (2) years, risk-free interest rates of four percent (4%), volatility at 147%, and a zero percent (0%) dividend yield. 5 NOTE 3 - INDUSTRY SEGMENT DATA Information concerning operations by industry segment follows (unaudited): Three Months Ended March 31, 2004 2003 ------------ ------------ Revenue Software (eTechLogix) $ 168,625 $ 204,900 Information Services (ImproveNet) 711,382 602,751 ------------ ------------ Total 880,007 807,651 ------------ ------------ Gross profit Software (eTechLogix) 134,900 204,900 Information Services (ImproveNet) 289,744 72,191 ------------ ------------ Total 424,644 277,091 ------------ ------------ Operating Expenses 418,093 538,226 ------------ ------------ Operating Income (Loss) 6,551 (261,135) Interest Income 607 2,787 Interest Expense (13,633) (3,410) Relief of Debt -- 103,876 Miscellaneous income 10,059 8,372 ------------ ------------ Operating Income (Loss) $ 3,584 $ (149,510) ============ ============ Depreciation and Amortization Software (eTechLogix) $ 21,315 $ 19,000 Information Services (ImproveNet) -- -- ------------ ------------ Total $ 21,315 $ 19,000 ============ ============ Identifiable assets Software (eTechLogix) $ 140,145 $ 392,268 Information Services (ImproveNet) 634,899 451,378 ------------ ------------ Total $ 775,044 $ 843,646 ============ ============ 6 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION The following discussion and analysis of our financial condition and results of operation should be read with our unaudited condensed consolidated financial statements and notes included elsewhere in this Report on Form 10-QSB. The discussion in this Report on Form 10-QSB contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements using terminology such as "can," "may," "believe," "designated to," "will," "expect," "plan," "anticipate," "estimate," "potential," or "continue," or the negative thereof or other comparable terminology regarding beliefs, plans, expectations or intentions regarding the future. Forward-looking statements involve risks and uncertainties and actual results could differ materially from those discussed in the forward-looking statements. All forward-looking statements and risk factors included in this document are made as of the date hereof, based on information available to the Company as of the date thereof, and the Company assumes no obligation to update any forward-looking statement or risk factors, unless we are required to do so by law. The cautionary statements made in this Report on Form 10-QSB should be read as applying to all related forward-looking statements wherever they appear in this Report on Form 10-QSB. Factors that cause or contribute to such differences include but are not limited to those discussed elsewhere in this Form 10-QSB, as well as those in a discussion of risk factors found in our Annual Report on Form 10-KSB beginning on page 17 in the section titled "Factors Affecting Future Performance, Results of Operation and Financial Condition." Our actual results could differ materially from those discussed here. OVERVIEW BASIS OF PRESENTATION On December 23, 2002, Etech Acquisition, Inc., (the "Merger") an Arizona corporation and wholly owned subsidiary of ImproveNet merged with and into eTechLogix, Inc. ("eTech"). Through this Merger, the former shareholders of eTech acquired a controlling interest in ImproveNet and accordingly, the Merger is accounted for as a reverse merger, with eTech being the accounting acquirer of ImproveNet. The Company has treated the Merger as being effective December 31, 2002 as ImproveNet had de minimus operations from December 23, 2002 to December 31, 2002. As such, the pre-merger financial statements present the historic financial position, operations and cash flows of eTech with the December 31, 2002 balance sheet adjusted to consolidate and reflect the fair values assigned to the acquisition balance sheet of ImproveNet. The Company's financial statements are presented on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has continued to sustain losses for the past two years and has negative working capital and negative net worth. The financial statements do not include any adjustments to reflect the possible future effects of the recoverability and classification of assets or the amounts and classifications of liabilities that may result from the uncertainty of the Company's ability to continue as a going concern. ACQUISITION On December 23, 2002, eTech Acquisition, Inc., an Arizona corporation and wholly-owned subsidiary of ImproveNet, merged with and into eTech. This Merger occurred pursuant to an Agreement and Plan of Merger (the "Merger Agreement") dated July 30, 2002. Under the terms of the Merger Agreement, eTech paid $500,000 to ImproveNet and incurred $19,000 in costs directly related to the Merger. At the time of the Merger, each outstanding share of eTech Common Stock, no par value per share, was converted into the right to receive and became exchangeable for 5,555.555556 shares of ImproveNet Common Stock, par value $.001 per share. A total of 35,417,750 shares of ImproveNet common stock were issued in the Merger to eleven (11) different shareholders of eTech. Through the Merger, the former directors, who were also shareholders, of eTech collectively received 30,310,740 shares of ImproveNet Common Stock and as a result, acquired control of the Company. Un-expired outstanding options to purchase eTech Common Stock were converted, on the same vesting schedule, into an option to purchase a number of shares of ImproveNet Common Stock equal to the number of shares of eTech Common Stock that could have been purchased under such option multiplied by 5,555.555556, at a price per share of ImproveNet Common Stock equal to the per share exercise price of $.05 per share. Options to acquire 788,889 shares of ImproveNet Common Stock were issued in the Merger as a result of these outstanding options, of which, 222,222 had vested as of the date of the Merger. Warrants to purchase 1,500,000 shares of ImproveNet were issued as a result of the Merger. These warrants were issued in conjunction with subordinated convertible notes payable, as discussed below. 7 TENDER OFFER Under the terms of the Merger Agreement, the Company agreed to present a cash tender offer ("Tender Offer") to pre-merger shareholders of ImproveNet. The price per share was based in part on ImproveNet's available cash balance at the closing of the Merger. The Tender Offer was available from the time of the Merger through January 2, 2003. Prior to the closing of the Merger, ImproveNet deposited approximately $2,557,000 with its stock transfer agent for payments to be made under the Tender Offer. In conjunction with the Tender Offer, the Company disbursed a total of approximately $1,962,000 to various pre-merger ImproveNet shareholders in January 2003 resulting in the acquisition of 13,913,975 treasury shares in January 2003. Funds in excess of disbursements of approximately $595,000 were returned to the Company from stock transfer agent in January 2003. CONVERSION OF SUBORDINATED CONVERTIBLE NOTES PAYABLE During July 2002, eTech issued an aggregate of $150,000 of subordinated convertible notes payable to two accredited investors. The notes were secured by substantially all of the Company's assets and were subordinated to the eTech's 9.00% note payable to a bank (Refer to Note 5, Notes Payable on our Form 10-KSB). In conjunction with the issuance of these subordinated convertible notes payable, eTech also issued one-year warrants to purchase an aggregate of 1,500,000 shares of ImproveNet at a purchase price of $0.15 per share. The subscription of the warrants was expressly conditioned upon the closing of the Merger. The Company expensed approximately $81,000 in connection with these warrants to recognize the fair value of the warrants. During August 2002, eTech issued an aggregate of $100,000 of subordinated convertible notes payable to accredited investors and officers of eTech (refer to Note 7, Related Party Transactions on our Form 10-KSB). The notes were secured by substantially all of eTech's assets and were subordinated to the $150,000 of aggregate subordinated notes payable discussed above and to the 9.00% note payable to a bank (Refer to Note 5, Notes Payable on our Form 10-KSB). All of the subordinated convertible notes payable described above bear interest at a rate of 10.00% per annum and are due two years after the date of issue, provided they are not converted prior to this date. The notes are convertible into common shares of eTech in whole, or in part, at the option of the lender at any time during the term of the note at a rate of one share for every $555.5555556 of debt converted. The notes will automatically be converted if there is a transfer of more than 50% of the voting control of the Company, in one transaction or a series of transactions with ImproveNet directly or by merger or consolidation in which the existing shareholders of eTech do not directly retain more than 50% of the voting control of eTech, or a sale of all or substantially all assets of eTech to ImproveNet or one of ImproveNet's subsidiaries. The shares of eTech that will be received by the note holders if automatic conversion occurs will be converted to shares of ImproveNet using the same conversion rate as all other eTech shares converted in a merger transaction. Immediately prior to the closing of the Merger, all of the subordinated convertible notes payable were converted into shares of Etech common stock and upon closing of the Merger were exchanged into shares of ImproveNet common stock. The proceeds of the subordinated notes payable of $250,000 were to be used for a portion of a $500,000 deposit by Etech with ImproveNet. This deposit was made prior to the Merger and in accordance with the Merger Agreement. SHORT TERM PROMISSORY In June 2003 following the closing of the Merger, we borrowed $75,000 for a 90-day period represented by a promissory note that we issued to an accredited investor. Warrants to purchase 200,000 shares of our common stock were also issued in that transaction. The promissory note was renewed in September 2003 for $80,000 including accrued but unpaid interest, and a warrant to purchase an additional 150,000 shares of our common stock was issued at that time. The promissory note was paid in full in December 2003. ISSUANCE OF UNSECURED CONVERTIBLE PROMISSORY NOTES In December 2003, we completed a private placement of $400,000 of 8% unsecured convertible promissory notes, each with a maturity of December 15, 2005, issued to a limited group of accredited investors. The notes will accrue 8% interest per year payable quarterly commencing March 15, 2004. The first quarterly payment was made on March 15, 2004. The principal of each note and all accrued but unpaid interest is convertible into shares of our common stock at the rate of five (5) shares for each one dollar of debt represented by each note. Proceeds received from the issuance of the notes are being used for working capital and general corporate purposes. In addition, approved finders of the participating accredited investors were collectively issued warrants to purchase 520,000 shares of our common stock. 8 ACCOUNTING FOR THE MERGER The Company accounted for this Merger in accordance with SFAS No. 141, "Business Combinations." As discussed above, the former shareholders of eTech acquired a controlling interest in the Company, and accordingly, the transaction has been accounted for as a reverse merger and the total consideration given by eTech of $519,000 has been allocated to the fair values of the pre-merger assets and liabilities of ImproveNet. At the time of the acquisition, the fair value of the net assets of ImproveNet was $361,351 in excess of the consideration given by eTech after all applicable reductions of amounts that otherwise would have been assigned to the acquired assets were considered. This excess is reported in the statement of operations as an extraordinary gain. eTechLogix, Inc. ("eTech"), a wholly-owned subsidiary of ImproveNet, licenses, installs and maintains its proprietary e-commerce software products to companies primarily operating in the building material industry. With regard to our business management and e-commerce software offerings, we have initially focused our business strategy on the window and door manufacturers and distributors niche of the BMI, which accounts for over $25 billion in industry wide annual sales. It encompasses a finite universe of prospective customers with a distinct multi-tiered distribution channel and supply chain procurement processes that can be significantly enhanced with web based Enterprise Commerce Solutions ("ECM"). We provide a comprehensive, integrated software platform that enables manufacturers to quickly create a "Pure Internet" true eCommerce solution specifically with regard to their product order configuration packages and electronic catalogs. eTech was formerly known as First Systech International, Inc. and was originally incorporated in March 1989 in the State of Texas. In July of 1994, eTech relocated to the State of Arizona and incorporated itself under the laws of the State of Arizona. ImproveNet, Inc. ("ImproveNet" or the "Company") was incorporated in California in January 1996, was reincorporated in Deleware in September 1998 and is headquartered in Scottsdale, Arizona. The Company is a source for home improvement information services for homeowners, service providers and suppliers nationwide. The following discussion should be read in conjunction with the consolidated financial statements provided under Part I, Item 1 of this Form 10-QSB. Certain statements contained herein may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve a number of risks, uncertainties and other factors that could cause actual results to differ materially. The forward-looking information set forth in this Form 10-QSB is as of May 17, 2004, and ImproveNet, Inc. undertakes no duty to update this information. Should events occur subsequent to May 17, 2004 that make it necessary to update the forward-looking information contained in this Form 10-QSB, the updated forward-looking information will be filed with the SEC in a Quarterly Report on Form 10-QSB or as an earnings release included as an exhibit to a Form 8-K, each of which will be available at the SEC's website at www.sec.gov. CRITICAL ACCOUNTING POLICIES AND ESTIMATES ImproveNet, Inc.'s discussion and analysis of its financial condition and results of operations are based upon ImproveNet, Inc. consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires ImproveNet to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, ImproveNet evaluates its estimates, including those related to customer programs, bad debts, income taxes, contingencies and litigation. ImproveNet bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. ImproveNet believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. SOFTWARE DEVELOPMENT AND SALES FOR THE BUILDING MATERIALS INDUSTRY SEGMENT The Company recognizes revenue in accordance with SOP 97-2, "Software Revenue Recognition." This SOP provides guidance on revenue recognition of software transactions. The Company recognizes revenue principally from the development and licensing of its software and from consulting and maintenance services rendered in connection with such development and licensing activities. Maintenance contract revenue is recognized on a straight-line basis over the life of the respective contract. The Company also derives revenue from the sale of third party hardware and software which is recognized based on the terms of each contract. Consulting revenue is recognized when the services are rendered. No revenue is recognized prior to obtaining a binding commitment from the customer. 9 Revenue from fixed price software development contracts, which require significant modification to meet the customer's specifications, is recognized on the percentage-of-completion method using the units-of-work-performed method to measure progress towards completion. Revisions in cost estimates and recognition of losses on these contracts are reflected in the accounting period in which the facts become known. Revenue from software package license agreements without significant vendor obligations is recognized upon delivery of the software. Contract terms may provide for billing schedules that differ from revenue recognition and give rise to costs and estimated earnings in excess of billings on uncompleted software contracts, and billings in excess of costs and estimated earnings on uncompleted software contracts. Deferred revenue represents revenue billed and collected but not yet earned. The cost of maintenance and research and development related revenues, which consist principally of staff payroll and applicable overhead, are expensed as incurred. HOME IMPROVEMENT SERVICES SEGMENT Revenues in the home improvement services segment are derived from two sources: Service revenues and marketing revenues. Service revenues: ----------------- Our service provider matching service is the process by which homeowners are matched to our network of pre-screened ImproveNet contractors. This was the core business model upon which the Company was founded and has been the primary source of our revenue. Since its inception, we have invested quite heavily in establishing a pool of national remodeling contractors. We consider this to be the core of its business and we anticipate the major portion of the Company's resources and efforts in the foreseeable future will be devoted to further this service. Service revenues include lead fees and win fees from ImproveNet's contractor matching service . Lead fees are recognized at the time a homeowner and contractor are matched by the Company and the service provider becomes obligated to pay such fee. Win fees are recognized at the time the service provider or the homeowner notifies the Company that a job has been sold and the service provider becomes obligated to pay such fee. Refunds and credits against the lead fees and win fees are recognized when actually made. Marketing revenues: ------------------- Marketing revenues include co-branding programs surrounding content and site integration. Currently marketing revenues are comprised of cash co-branding programs . CASH CO-BRANDING Cash co-branding revenues generally are derived from flat rate co-branding engagements in which all impressions delivered to our Web site in a particular home improvement category will be delivered to the co-branding participant over a specified period of time for a fixed monthly fee. Cash co-branding revenues are recognized on a monthly basis. Allowance for Uncollectible Accounts Receivable ----------------------------------------------- We follow the allowance method of recognizing uncollectible accounts receivable. The allowance method recognizes bad debt expense as a percentage of accounts receivable based on a review of the individual accounts outstanding and our prior history of uncollectible accounts receivable. In the first quarter of 2004, we began utilizing the percentage of sales method to account for bad debt in lieu of our recent practice of utilizing the aging of accounts receivable method for implementing the allowance method of recognizing uncollectible accounts receivable. Both methods are acceptable under Generally Accepted Accounting Principles, and we believe this method fairly estimates uncollectible accounts receivable. This is the first quarter in which this method has been used and has favorably impacted our results of operation for the first quarter ended March 31, 2004. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Taxes ----- Deferred income taxes are provided for on an asset and liability method, whereby deferred tax assets are recognized for deductible temporary differences and operating loss carry forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. 10 Deferred tax assets are reduced by a valuation allowance, when in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. BUSINESS SEGMENTS We follow SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information." SFAS No. 131 requires publicly held companies to report financial and other information about key revenue segments of an entity for which this information is available and is utilized by the chief operating decision maker. We operate in two segments: Software development and sales for the building materials industry through eTechLogix and home improvement information services through ImproveNet. Our consolidated statements of operations and cash flows do not reflect operations for year 2002 of the home improvement services segment as this segment was acquired effective December 31, 2002 through the Merger between ImproveNet and eTech but do reflect both segments for year 2003. RESULTS OF OPERATIONS REVENUES Our revenues increased to approximately $880,000 for the three months ended March 31, 2004 from approximately $808,000 for the three months ended March 31, 2003, an increase of approximately $72,000 or 9%. The increase is primarily due to increased revenues from the Home Improvement Services Segment. The corresponding increase in our accounts receivable (net) was primarily attributable to the increased revenue from the Home Improvement Services Segment with a smaller part of such increase related to software development and sales. In addition, prior to March 2004, our Customer Care Center and operations for the service provider matching service were performed under terms of a services agreement with a Canadian corporation in Nova Scotia, Canada which provides for termination without cause upon 180 days notice by the Canadian corporation. In January 2004, the Canadian corporation provided written notice to us of termination of the services agreement. We have staffed our Scottsdale, Arizona offices for the customer service and operations for the service provider matching service. In March 2004, the transition of our Customer Care Center and operations was made to our Scottsdale, Arizona offices. It is unclear if the transition has been implemented smoothly or if the customer service and operations will be performed adequately in the new location. There is an element of goodwill associated with the customer relationship aspect of the customer service center which could be lost if the services agreement was terminated. We could experience a disruption in customer support, collections of accounts receivable and revenues. The transition of our Customer Care Center operations from the Canadian corporation to our offices in Scottsdale, Arizona during March 2004 may have briefly slowed collection of accounts receivable. However, we anticipate that locating the Customer Care Center in our Scottsdale, Arizona offices will provide benefits over the long term by allowing management to more quickly monitor and respond to the needs of our customers. The following table and discussion highlights our approximate revenues for the three months ended March 31, 2004 and 2003: Three months ended March 31, 2004 2003 Change ---------- ---------- ---------- Revenues Software Sales (eTechLogix) $ 169,000 $ 205,000 $ (36,000) Home Improvement Services (ImproveNet) 711,000 603,000 108,000 ---------- ---------- ---------- Total $ 880,000 $ 808,000 $ 72,000 ========== ========== ========== SOFTWARE SALES (ETECHLOGIX) REVENUES eTechLogix revenue decreased to approximately $169,000 for the three months ended March 31, 2004, from approximately $205,000 for the three months ended March 31, 2003, a decrease of approximately $36,000 or 18%. The decrease in eTechLogix's revenue resulted from a decrease in sales of the Company's products and consulting services. eTechLogix relies on eight primary customers for its revenue. HOME IMPROVEMENT SERVICES (IMPROVENET) REVENUES ImproveNet revenue increased to approximately $711,000 for the three months ended March 31, 2004,from approximately $603,000 for the three months ended March 31, 2003, an increase of approximately $108,000 or 18%. The increase in ImproveNet's revenue resulted from the continued building of a network of service providers and an increased number of home 11 improvement projects which were matched to those service providers. ImproveNet revenue consists almost entirely of service revenues from its contractor matching service. OPERATING EXPENSES COST OF REVENUES Cost of revenues decreased to approximately $455,000 for the three months ended March 31, 2004 from approximately $531,000 for the three months ended March 31, 2003, a decrease of approximately $76,000. The decrease is primarily due to our improvement of website optimization, ROI analysis of home improvement leads sources, and locating new home improvement lead providers, all of which has increased efficiencies in our acquisition of home improvement leads. The following table and discussion highlights our approximate cost of revenues for the three months ended March 31, 2004 and 2003: Three months ended March 31, 2004 2003 Change ---------- ---------- ---------- Cost of revenues Software Sales (eTechLogix) $ 34,000 $ -- $ 34,000 Home Improvement Services (ImproveNet) 421,000 531,000 (110,000) ---------- ---------- ---------- Total $ 455,000 $ 531,000 $ (76,000) ========== ========== ========== SOFTWARE SALES (ETECHLOGIX) COST OF REVENUE eTechLogix cost of revenues increased to approximately $34,000 for the three months ended March 31, 2004, from zero for the three months ended March 31, 2003. After evaluating the method of accounting for cost of software sales, management has determined that variable costs associated with software sales revenue is approximately twenty percent (20%) of revenues and therefore has been applied as a cost of revenue and reallocated from selling, general, and administrative expenses. This method will be re-evaluate periodically for application as a cost of revenue. HOME IMPROVEMENT SERVICES (IMPROVENET) COST OF REVENUE ImproveNet cost of revenue decreased to approximately $421,000 for the three months ended March 31, 2004, from approximately $531,000 for the three months ended March 31, 2003, a decrease of approximately $110,000 or 21%. The decrease is primarily due to our improvement of website optimization, ROI analysis of home improvement leads sources, and locating new home improvement lead providers, all of which has increase efficiencies in our acquisition of home improvement leads. ImproveNet's cost of revenue consists primarily of the acquisition and processing costs of home improvement leads and the costs of our Customer care Center, which is responsible for management, staffing and processing of our proprietary matching services . During all of year 2003 and up to late March 2004, our Customer Care Center was outsourced. In March 2004, we staffed and transitioned our Customer Care Center operations to our principal offices in Scottsdale, Arizona. SELLING, GENERAL AND ADMINISTRATIVE Our selling, general and administrative expenses decreased to approximately $317,000 for the three months ended March 31, 2004 from approximately $449,000 for the three months ended March 31 2003, a decrease of approximately $132,000 or 29% Our selling, general and administrative expenses include payroll and related costs and travel, recruiting, professional and advisory services and other general expenses for our executive, sales, finance, legal, and human resource departments. The decrease in our general and administrative expenses is primarily the result of a decrease in payroll cost. RESEARCH AND DEVELOPMENT Our research and development expenses increased to approximately $101,000 for the three months ended March 31, 2004 from approximately $89,000 for the three months ended March 31, 2003, an increase of approximately $12,000 or 13%. Our research and development costs include the payroll and related costs of our technology staff, other costs of Web site design and new technologies required to enhance the performance of our Web site. 12 The increase in research and development expenses in 2004 was primarily attributable to increased payroll and related costs associated with improving the functionality and features of www.improvenet.com and work on the integration and improvement of the eTechLogix software products which management believes will benefit us long-term if it is able to implement its sales and marketing strategy. MARKETING Upon review management has determined separating marketing expenses out of selling, general & administrative was not appropriate. Marketing expenses are no longer being reported and discussed as a separate item as of the second quarter 2003. OTHER REVENUES (EXPENSES) Other revenue (expenses) decreased to an expense of approximately $4,000 for the three months ended March 31, 2004 from revenue of approximately $112,000 for the three months ended March 31, 2003, a decrease of approximately $116,000. The following table and discussion highlights our approximate other revenues (expenses) for the three months ended March 31, 2004 and 2003: Three months ended March 31, 2004 2003 Change ---------- ---------- ---------- Other Revenues (Expenses) Interest income $ -- $ 3,000 $ (3,000) Interest expense and financing costs (14,000) (3,000) (11,000) Relief of debt -- 104,000 (104,000) Miscellaneous income 10,000 8,000 2,000 ---------- ---------- ---------- $ (4,000) $ 112,000 $ (116,000) ========== ========== ========== The decrease in other revenues (expenses) from the prior year quarter is primarily due to a decrease in the relief of debt in the current year quarter. INCOME TAXES We have recorded a 100% valuation allowance against our net deferred tax assets, which arose primarily as a result of our aggregate operating losses. The valuation allowance will remain at this level until such time that we believe that the realization of the net deferred tax assets is more likely than not. Accordingly, our results of operations do not reflect any tax benefits for our reported losses. LIQUIDITY AND CAPITAL RESOURCES During our recent history we have funded our operations and investments in property and equipment through cash from operations, short term borrowing from private lending sources, and proceeds from private placements of convertible debt. Since inception funding sources have also included private placement and public offerings of equity. Our plan is to raise additional funds as needed to fund our operations and investments in property and equipment. Cash and cash equivalents totaled approximately $162,000 at March 31, 2004, a decrease of approximately $221,000 or 58% from approximately $383,000 at December 31, 2003. The decrease was primarily due to the $202,000 of cash used in operating activities. Cash used in operating activities for the three months ended March 31, 2004 was approximately $202,000, compared to cash used of approximately $223,000 for the three months ended March 31, 2003. Cash used in operating activities in the prior year quarter reflected the impact of the Merger and tender offer obligations as well as our net loss before depreciation, offset by changes in operating assets and liabilities. The cash used in operating activities in the current quarter reflects the changes in the operating assets and liabilities. Cash used in investing activities was approximately $12,000 for the three months ended March 31, 2004, an increase of approximately $6,000 above cash used of approximately $6,000 for the three months ended March 31, 2003. In the first three months of both 2004 and 2003 the cash was used to purchase equipment. 13 Cash used in financing activities was approximately $7,000 for the three months ended March 31, 2004, a decrease of approximately $14,000 from cash used of approximately $21,000 for the three months ended March 31, 2003. In the first three months of both 2004 and 2003 the cash was used to repay debt. We anticipate increased year-over-year sales volume of our primary software products throughout 2004 and thereafter. We also anticipate increased revenues from the expansion of the home improvement information services segment. Expansion of the home improvement services segment will require us to add additional personnel to our Customer Care Center as well as necessitate new investments in additional property and equipment. We continue to research and develop more innovative ways of pricing our services, expanding our core service offerings, and identifying more efficient ways of operating our business. It is probable that we must raise additional capital for any expansion that we may pursue, and therefore we intend to raise additional capital either through a public or private offering of securities. The additional funds from continued software sales and capital financing will be used to finance continued operations and increase the Company's sales and marketing functions. Our operating losses have limited our ability to obtain vendor credit or extended payment terms and bank financing on favorable terms; accordingly, we depend on our cash and cash equivalent balances to fund our operations. Due to the significant level of current liabilities and the history of operating losses, there is no assurance that our available cash resources will be sufficient to meet our anticipated needs for operations and capital expenditures during the next 12 months. We will strive to make ongoing realignments, if required, to achieve positive cash flow with our existing cash resources. We are additionally decreasing our marketing and other operating expenditures to assist us in maintaining our available cash resources. We may need to raise additional funds, however, if results of operations for 2004 do not meet our expectations, or in order to develop new or enhance existing services, to respond to competitive pressures or to acquire complementary businesses, services or technologies. If we raise additional funds by selling equity securities, the percentage ownership of our stockholders will be reduced. We cannot be sure that additional financing will be available on terms favorable to us, or at all. If adequate funds were not available on acceptable terms, our ability to fund expansion, react to competitive pressures, or take advantage of unanticipated opportunities would be substantially limited. If this occurred, our business would be significantly harmed. We will continue to evaluate our needs for funds based on our assessment of access to public or private capital markets and the timing of our need for funds. We may seek to raise these additional funds through private or public debt or equity financings. ITEM 3. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. Under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, we have, as of a date within 90 days before the filing date of this quarterly report (the "Evaluation Date") evaluated the effectiveness of our "disclosure controls and procedures." Based upon that evaluation, our Chief Executive Officer and Acting Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be disclosed by us in our periodic reports to the Securities and Exchange Commission. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in Company reports filed or submitted under the Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. They include, without limitation, controls and procedures designed to ensure that information required to be disclosed in such reports is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING. There were no significant changes in our internal controls or to our knowledge, in other factors that could significantly affect these controls, including any corrective actions with regard to significant deficiencies and material weaknesses, subsequent to the date of their last evaluation. 14 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS From time to time, we may be involved in routine litigation relating to claims arising out of or incidental to our operations. As of the date of this filing, we are engaged in various legal proceedings that are incidental to our business. As of the date of this filing, we are engaged in legal proceedings that could materially affect our business should an adverse judgment be entered against us. Should a third party in any of the ongoing litigation matters obtain a judgment against the Company or its subsidiary, it is unlikely the Company or its subsidiary would have sufficient working capital available to timely pay any such judgment. In addition, we have received preliminary information regarding possible erroneous cancellation of health insurance benefits for former employees under COBRA for which we may have potential liability. One arbitration matter in Phoenix, Arizona involved First Systech International, Inc., a predecessor to Etech, our wholly-owned subsidiary. This proceeding concerns the 1998 sale of an ERP software product to a client who is demanding a refund of the purchase price, and First Systech International counterclaimed for the balance due on the contract plus additional work performed and professional expenses of the litigation. The matter was before an arbitrator who recently entered an award against First Systech for $116,886 plus simple interest at 10% per year. Currently, the amount owing is approximately $182,000 including interest to date. First Systech is unable to pay the amount owed and is negotiating a payout over a several year period of the amount owing. It is not clear if a satisfactory payment arrangement can be made. In late March 2004, we initiated litigation in Nova Scotia, Canada against the Canadian corporation that had been performing our Customer Care Center and operations for the service provider matching service to enforce and protect our rights under the services agreement regarding our proprietary material. On March 26, 2004, the Canadian court entered an order prohibiting the Canadian corporation from utilizing in any way ImproveNet's proprietary materials and from soliciting or contacting any ImproveNet contractor. At a court hearing in Canada on March 31, 2004, the order entered by the court provided very specific limitations on the Canadian corporation's ability to contact contractors that are participating in our membership program for a specified period of time. The provisions of that agreement were set forth in a writing filed with the Canadian court. Although no further matters are pending before the Canadian court, we are prepared to pursue additional litigation in the Canadian court or by arbitration in Arizona, if necessary, to protect our proprietary material. ITEM 2. CHANGES IN SECURITIES There were no changes in or sales of securities during the first quarter of 2004. ITEM 3. DEFAULTS UPON SENIOR SECURITIES There were no defaults upon senior securities. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the first quarter of 2004. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits EXHIBIT NUMBER DESCRIPTION OF DOCUMENT ------ ----------------------- 31.1 Certification of Jeffrey I. Rassas, Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) 31.2 Certification of Homayoon J. Farsi, Acting Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) 32.1 Certification of Jeffrey I. Rassas, Chief Executive Officer pursuant to section 906 of the Sarbanes Oxley Act of 2002 32.2 Certification of Homayoon J. Farsi, Acting Chief Financial Officer pursuant to section 906 of the Sarbanes Oxley Act of 2002 ------------------ 15 (b) Reports on Form 8-K No Reports on Form 8-K were filed during the first quarter of 2004. 16 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed, May 17, 2004 on its behalf by the undersigned duly authorized. IMPROVENET, INC. (Registrant) By: /s/ Jeffrey I. Rassas ---------------------------------------------- Jeffrey I. Rassas Co-Chairman and CEO By: /s/ Homayoon J. Farsi ---------------------------------------------- Homayoon J. Farsi, Co-Chairman, President and Acting Chief Financial Officer Date: May 17, 2004 17