U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10QSB QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the period ended September 30, 2002 Commission file number 333-47986 TELKONET, INC. (Name of Small Business Issuer in Its Charter) Utah 87-0627421 (State of Incorporation) (IRS Employer Identification No.) 902 A Commerce Road Annapolis, Maryland 21401 (Address of Principal Executive Offices) (410) 897-5900 Issuer's Telephone Number Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 --- --- State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 17,326,531 shares of Common Stock ($.001 par value) as of November 7, 2002. Transitional small business disclosure format: Yes No x --- --- TELKONET, INC. Quarterly Report on Form 10-QSB for the Quarterly Period Ending September 30, 2002 Table of Contents PART I. FINANCIAL INFORMATION Item 1. Financial Statements (Unaudited) Condensed Consolidated Balance Sheets: 3 September 30, 2002 and December 31, 2001 Condensed Consolidated Statements of Losses: 4 Three Months Ended September 30, 2002 and 2001 Nine Months Ended September 30, 2002 and 2001 November 3, 1999 (Date of Inception) through September 30, 2002 Consolidated Statement of Deficiency in Stockholders' 5-7 Equity November 3, 1999 (Date of Inception) through September 30, 2002 Condensed Consolidated Statements of Cash Flows: 8 Nine Months Ended September 30, 2002 and 2001 November 3, 1999 (Date of Inception) through September 30, 2002 Notes to Condensed Consolidated Financial Information: 9 September 30, 2002 Item 2. Plan of Operation 10 Item 3. Controls and Procedures 13 PART II. OTHER INFORMATION Item 1. Legal Proceedings 13 Item 2. Changes in Securities 13 Item 3. Defaults Upon Senior Securities 13 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 2 Item 1. Financial Statements (Unaudited) TELKONET, INC. (A DEVELOPMENT STAGE COMPANY) CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited) September 30, December 31, 2002 2001 ------------ ------------ ASSETS CURRENT ASSETS: Cash and equivalents $ 4,880 $ 21,885 Accounts receivable 1,194 -- Inventory 43,997 -- Prepaid and deposit 9,625 4,625 ------------ ------------ Total current assets 59,696 26,510 PROPERTY AND EQUIPMENT: Furniture, equipment, and leasehold improvements, at cost 70,588 54,950 Less: Accumulated depreciation 41,522 28,108 ------------ ------------ 29,066 26,842 OTHER ASSETS Financing costs, less amortization costs of $499,442 and $415,742 at September 30, 2002 and December 31, 2001, respectively 600,625 684,325 ------------ ------------ 600,625 684,325 $ 689,387 $ 737,677 ============ ============ LIABILITIES AND DEFICIENCY IN STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable and accrued expenses $ 456,502 $ 116,741 Notes payable 533,000 400,000 Due to related parties 33,474 7,500 Total current liabilities 1,022,976 524,241 Convertible Debentures 1,677,200 940,000 COMMITMENTS AND CONTINGENCIES -- -- DEFICIENCY IN STOCKHOLDER'S EQUITY Common stock, par value $.001 per share; 100,000,000 shares authorized; 17,049,483 shares issued at September 30, 2002 and 22,115,371 shares issued at December 31, 2001 17,049 22,115 Common stock subscription (1,805,400) -- Additional paid-in-capital 4,791,838 2,221,154 Deficiency accumulated during development stage (5,014,276) (2,969,833) Deficiency in stockholder's equity (2,010,789) (726,564) $ 689,387 $ 737,677 See accompanying footnotes to the unaudited condensed consolidated financial information 3
TELKONET, INC. (A DEVELOPMENT STAGE COMPANY) CONDENSED CONSOLIDATED STATEMENTS OF LOSSES (UNAUDITED)
For the period from November 3, 1999 (date of inception) Three Months ended Nine Months ended through September 30, September 30, September 30, 2002 2001 2002 2001 2002 ------------- ------------- ------------- ------------- ------------- Net Revenues $ 2,856 $ -- $ 2,856 $ -- $ 2,856 Cost of Sales 1,860 -- 1,860 -- 1,860 ------------- ------------- ------------- ------------- ------------- Gross Profit 996 -- 996 -- 996 Costs and Expenses: Research & Development 91,334 208,321 242,764 300,636 $ 521,879 Selling, General and Administrative 585,547 205,931 1,595,461 691,921 3,788,720 Interest Expense (Income) 92,884 6,444 110,100 22,154 543,179 Depreciation and Amortization 32,370 7,882 97,114 23,609 162,751 ------------- ------------- ------------- ------------- ------------- Operating expense 802,135 428,578 2,045,439 1,038,320 5,016,529 Loss from Operations (801,139) (428,578) (2,044,443) (1,038,320) (5,015,533) Other Income (Expense) -- -- -- -- 1,257 Provision for Income Tax -- -- -- -- -- ------------- ------------- ------------- ------------- ------------- -- -- -- -- 1,257 Net income $ (801,139) $ (428,578) $ (2,044,443) $ (1,038,320) $ (5,014,276) ============= ============= ============= ============= ============= Loss per common share (basic and assuming dilution) $ (0.05) $ (0.02) $ (0.12) $ (0.05) $ (0.32) ============= ============= ============= ============= ============= Weighted average common shares outstanding 16,692,841 21,841,593 17,005,847 21,925,075 15,915,997 See accompanying footnotes to the unaudited condensed consolidated financial information 4
TELKONET, INC. (A DEVELOPMENT STAGE COMPANY) CONDENSED CONSOLIDATED STATEMENT OF DEFICIENCY IN STOCKHOLDERS' EQUITY FOR THE PERIOD NOVEMBER 3, 1999 (DATE OF INCEPTION) TO SEPTEMBER 30, 2002
Deficit Accumulated Additional Common During Common Paid in Stock Development Shares Stock Amount Capital Subscription Stage Total ------------ ------------ ------------ ------------ ------------ ------------ Net Loss -- $ -- $ -- $ -- $ (33,973) $ (33,973) ------------ ------------ ------------ ------------ ------------ ------------ BALANCE AT DECEMBER 31, 1999 -- -- -- -- (33,973) (33,973) ============ ============ ============ ============ ============ ============ Shares issued to founders January 2000, in exchange for services and costs valued at $ 0.60 per share 19,300 193 11,387 -- -- 11,580 Shares issued in June 2000, for cash in connection with private placement at $375 per share, net of costs 1,735 17 644,219 -- -- 644,236 Shares issued in July 2000, for warrants exercised at a price of $375 per share 190 -- 71,250 -- -- 71,250 Shares issued in August 2000, in connection with the merger of Comstock Coal and Telkonet Communications, Inc 21,775,335 21,775 -- -- -- 21,775 August 2000, retirement of Telkonet Communications, Inc shares (21,225) (210) -- -- -- (210) Shares issued in October 2000, in exchange for warrants exercised at a price of $1 per share 29,145 29 29,115 -- -- 29,144 Shares issued in October 2000, in exchange for warrants exercised at a price of $0.40 per share 10,891 11 4,345 -- -- 4,356 Net loss -- -- -- -- (929,720) (929,720) ------------ ------------ ------------ ------------ ------------ ------------ BALANCE AT DECEMBER 31, 2000 21,815,371 $ 21,815 $ 760,316 $ -- $ (963,693) $ (181,562) ============ ============ ============ ============ ============ ============ See accompanying footnotes to the unaudited condensed consolidated financial information 5
TELKONET, INC. (A DEVELOPMENT STAGE COMPANY) CONDENSED CONSOLIDATED STATEMENT OF DEFICIENCY IN STOCKHOLDERS' EQUITY FOR THE PERIOD NOVEMBER 3, 1999 (DATE OF INCEPTION) TO SEPTEMBER 30, 2002
Deficit Accumulated Additional Common During Common Paid in Stock Development Shares Stock Amount Capital Subscription Stage Total ------------ ------------ ------------ ------------ ------------ ------------ BALANCE FORWARD 21,815,371 $ 21,815 $ 760,316 $ -- $ (963,693) $ (181,562) Shares issued in June 2001, for cash in connection with a private placement, shares issued at $.50 a share, net of costs 260,000 260 129,740 -- -- 130,000 1,839,378 warrants issued in June 2001, valued at $0.13 per warrant, in exchange for services -- -- 237,036 -- -- 237,036 72,668 stock options issued in June 2001, valued at $0.09 per stock option, in exchange for services -- -- 6,375 -- -- 6,375 245,287 warrants issued in July 2001, valued at $0.08 per warrant, in exchange for services -- -- 18,568 -- -- 18,568 36,917 stock options issued in July 2001, valued at $0.08 per warrant, in exchange for services -- -- 2,795 -- -- 2,795 Shares issued in August 2001, for cash in connection with a private placement, shares issued at $.50 a share, net of costs 40,000 40 19,960 -- -- 20,000 241,000 warrants issued in August 2001, valued at $0.39 per warrant in exchange for financing costs -- -- 94,687 -- -- 94,687 114,000 warrants issued in August 2001, valued at $0.43 per warrant, in exchange for interest -- -- 49,020 -- -- 49,020 150,000 warrants issued in August 2001, valued at $0.16 per warrant, in exchange for services -- -- 23,340 -- -- 23,340 36,917 stock options issued in August 2001, valued at $0.06 per stock option, in exchange for services -- -- 2,422 -- -- 2,422 818,000 warrants issued in September 2001, valued at $0.14 per warrant, in exchange for financing costs -- -- 112,230 -- -- 112,230 1,636,000 warrants issued in September 2001, valued at $0.40 per warrant, in exchange for interest -- -- 654,400 -- -- 654,400 25,000 warrants issued in September 2001, valued at $0.30 per warrant in exchange for services -- -- 7,380 -- -- 7,380 60,000 warrants issued in October 2001, valued at $0.16 per warrant, in exchange for financing costs -- -- 9,720 -- -- 9,720 120,000 warrants issued in October 2001, valued at $0.44 per warrant, in exchange for interest -- -- 52,800 -- -- 52,800 95,000 warrants issued in October 2001, valued at $0.21 per warrant, in exchange for services -- -- 19,558 -- -- 19,558 5,000 warrants issued in November 2001, valued at $0.16 per warrant, in exchange for financing costs -- -- 810 -- -- 810 10,000 warrants issued in November 2001, valued at $0.44 per warrant, in exchange for interest -- -- 4,400 -- -- 4,400 25,000 warrants issued in November 2001, valued at $0.33 per warrant, in exchange for services -- -- 8,218 -- -- 8,218 25,000 warrants issued in December 2001, valued at $0.30 per warrant, in exchange for services -- -- 7,380 -- -- 7,380 Net loss -- -- -- -- (2,006,140) (2,006,140) ------------ ------------ ------------ ------------ ------------ ------------ BALANCE AT DECEMBER 31, 2001 22,115,371 $ 22,115 $ 2,221,155 $ -- $(2,969,833) $ (726,563) ============ ============ ============ ============ ============ ============ See accompanying footnotes to the unaudited condensed consolidated financial information 6
TELKONET, INC. (A DEVELOPMENT STAGE COMPANY) CONDENSED CONSOLIDATED STATEMENT OF DEFICIENCY IN STOCKHOLDERS' EQUITY FOR THE PERIOD NOVEMBER 3, 1999 (DATE OF INCEPTION) TO SEPTEMBER 30, 2002
Deficit Accumulated Additional Common During Common Paid in Stock Development Shares Stock Amount Capital Subscription Stage Total ------------- ------------- ------------- ------------- ------------- ------------- BALANCE FORWARD 22,115,371 $ 22,115 $ 2,221,155 $ -- $ (2,969,833) $ (726,563) Shares issued in February 2002, in exchange for convertible debentures interest, at $.50 per share 43,586 44 21,749 -- -- 21,793 Shares issued in March 2002, to a founder in exchange for shares canceled (Note B) 5,250,000 5,250 (5,250) -- -- -- Shares canceled in March 2002 due to capital restructure (Note B) (13,480,961) (13,481) 13,481 -- -- -- Shares issued in June 2002, for warrants exercised at $1.00 per share for services rendered 47,906 48 47,858 -- -- 47,906 Shares issued in June 2002, for warrants exercised at $.40 per share for services rendered 26,443 26 10,551 -- -- 10,577 Shares issued in June 2002 to founders, for options exercised at $1.00 per share (Note B) 1,000,000 1,000 999,000 -- -- 1,000,000 Shares issued in June 2002, for warrants exercised at $1.0025 per share, for services rendered 80,039 80 80,159 -- -- 80,239 Shares issued in June 2002, for warrants exercised at $.402, in connection with original private placement 189,327 189 77,720 -- -- 77,909 Shares issued in July 2002, for warrants exercised at $.402, in connection with original private placement 41,970 42 16,830 -- -- 16,872 Shares issued in July 2002 to founders, for options exercised at $1.00 per share (Note B) 1,000,000 1,000 999,000 -- -- 1,000,000 Shares issued in August 2002, for warrants exercised at $.402, in connection with original private placement 542,500 543 232,458 -- -- 233,001 Shares issued in August 2002, for warrants exercised at $.403, in connection with original private placement 193,302 193 77,127 -- -- 77,320 Common stock subscription (Note C) -- -- -- (1,805,400) -- (1,805,400) Net Loss -- -- -- -- (2,044,443) (2,044,443) ------------- ------------- ------------- ------------- ------------- ------------- BALANCE AT SEPTEMBER 30, 2002 17,049,483 $ 17,049 $ 4,791,838 $ (1,805,400) $ (5,014,276) $ (2,010,789) ============= ============= ============= ============= ============= ============= See accompanying footnotes to the unaudited condensed consolidated financial information 7
TELKONET, INC. (A DEVELOPMENT STAGE COMPANY) CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
For the period from November 3, 1999 (date of inception) Nine Months Ended through September 30, September 30, 2002 2001 2002 ------------ ------------ ------------ INCREASE (DECREASE) IN CASH AND EQUIVALENTS CASH FLOWS FROM OPERATING ACTIVITIES: Net loss from development stage operations $(2,044,443) $(1,038,320) $(5,014,276) Adjustments to reconcile net loss from development stage operations to cash used for operating activities Warrants issued in exchange for financing and interest -- -- 378,213 Warrants issued in exchange for services -- -- 333,072 Common stock issued in exchange for services rendered 138,722 -- 150,302 Depreciation and amortization 97,114 23,609 162,751 Increase / decrease in: Accounts receivable (1,194) -- (1,194) Other receivable -- -- -- Inventory (43,997) -- (43,997) Deposits (5,000) -- (9,625) Accounts payable and accrued expenses, net 339,762 (107,694) 456,502 ------------ ------------ ------------ NET CASH USED BY OPERATING ACTIVITIES (1,519,036) (1,122,405) (3,588,252) CASH FLOWS USED IN INVESTING ACTIVITIES: Capital expenditures, net of disposals (15,638) (4,629) (70,588) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from sale of common stock, net of costs 621,495 150,000 1,420,046 Advances from stockholders, net of repayments 25,974 87,500 33,474 Proceeds from issuance of convertible debentures, net of costs 737,200 903,000 1,677,200 Proceeds from loans 133,000 400,000 533,000 ------------ ------------ ------------ NET CASH PROVIDED BY FINANCING ACTIVITIES 1,517,669 1,540,500 3,663,720 NET (DECREASE) INCREASE IN CASH AND EQUIVALENTS (17,005) 413,466 4,880 Cash and cash equivalents at the beginning of the period 21,885 10,450 -- ------------ ------------ ------------ Cash and cash equivalents at the end of the period $ 4,880 $ 423,916 $ 4,880 ============ ============ ============ Supplemental Disclosures of Cash Flow Information Cash paid during the period for interest $ 25,011 $ -- $ 24,965 Income taxes paid -- -- -- Issuance of warrants for financing and interest -- -- 1,278,983 Issuance of warrants and options for services -- -- 333,072 Common stock issued for services 138,722 -- 150,302 Acquisition: Assets Acquired -- -- 1 Accumulated Deficit -- -- 2,643 Liabilities Assumed -- -- (2,642) ------------ ------------ ------------ $ -- $ -- $ 1 ------------ ------------ ------------ See accompanying footnotes to the unaudited condensed consolidated financial information 8
TELKONET, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION SEPTEMBER 30, 2002 (UNAUDITED) NOTE A - SUMMARY OF ACCOUNTING POLICIES - --------------------------------------- General - ------- The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-QSB, and therefore, do not include all the information necessary for a fair presentation of financial position, results of operations and cash flows in conformity with generally accepted accounting principles. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results from developmental stage operations for the nine-month period ended September 30, 2002 are not necessarily indicative of the results that may be expected for the year ended December 31, 2002. The unaudited consolidated financial statements should be read in conjunction with the consolidated December 31, 2001 financial statements and footnotes thereto included in the Company's SEC Form 10-KSB dated February 14, 2002. Basis of Presentation - --------------------- Telkonet, Inc. (the "Company"), formerly Comstock Coal Company, Inc., was formed on November 3, 1999 under the laws of the state of Utah. The Company is a development stage enterprise, as defined by Statement of Financial Accounting Standards No. 7 ("SFAS No. 7") and is seeking to develop, produce and market proprietary equipment enabling the transmission of voice and data over electric utility lines. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Telkonet Communications, Inc. Significant inter-company transactions have been eliminated in consolidation. Reclassification - ---------------- Certain reclassifications have been made to conform to prior periods' data to the current presentation. These reclassifications had no effect on reported losses. NOTE B - CAPITAL RESTRUCTURE In January 2002, the Company re-organized its capital structure, whereby the Company agreed to purchase 8,936,244 shares of the Company's common stock held by the Founders and cancel certain vested options held by the Founders to purchase the Company's common stock, in exchange for the issuance of newly issued options to purchase 3,500,000 of the Company's common stock. The new stock options expire in January 2012, and have an exercise price of $1.00 per share.
RETURNED ADJUSTED RETURNED VESTED FOUNDERS PRIOR SHARES SHARES SHARES OPTIONS OPTIONS Dave Grimes 4,971,918 3,721,918 1,250,000 160,000 1,000,000 Peter Larson 1,455,285 705,285 750,000 200,000 1,000,000 Don Erat 2,861,348 2,361,348 500,000 - 500,000 Steve Sadle 5,647,695 2,147,695 3,500,000 200,000 1,000,000 ------------ ------------ ------------ ------------ ------------ 14,936,246 8,936,246 6,000,000 560,000 3,500,000
In connection with this transaction, the Company cancelled 13,480,961 shares of previously issued common stock. 9 TELKONET, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONDENSED CONSOLIDATED FINANCIAL INFORMATION SEPTEMBER 30, 2002 (UNAUDITED) NOTE C - COMMON STOCK SUBSCRIPTION - ---------------------------------- In connection with the stock options described in Note B, 2,000,000 shares of common stock were issued to two of the Company's Founders in June and July 2002. The Company also entered into four promissory notes with principal amounts of $250,000 each and two promissory notes with principal amounts of $500,000 each with the Founders to ensure payments for issued stock. The notes are due one year from date of issuance. Interests will begin to accrue from and after the maturity dates on any unpaid balances at an interest rate of 6%. As of September 30, 2002, the Company received $194,600 proceeds from the stock subscription. Item 2. Management's Plan of Operation The following discussion should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto, included elsewhere within this Report. Description of the Company - -------------------------- Telkonet is a high technology systems application developer with a primary focus on high speed Internet distribution over the electrical power lines for the commercial and the multi-dwelling residential markets. Telkonet believes that through extensive research and development, it has refined a business model that will provide marketable Internet services across a wide spectrum of commercial and business end users. Telkonet has designed and constructed its third generation of power line communication products to provide high speed Internet access to office buildings, hotels, schools, shopping malls, commercial buildings, and multi-dwelling units. These products provide connectivity over the existing electrical wiring and do not require the addition of costly wiring, or major disruption to business activity. In many situations the Telkonet system can be implemented more quickly and less expensively than adding dedicated wiring or installing wireless systems. Telkonet believes that utilizing the power line to deliver Internet and telephone connectivity for the commercial and the multi-dwelling residential markets creates a significant and definitive niche market opportunity for Telkonet. Telkonet's solutions overcome many of the difficulties associated with power-line communications that historically have prevented the achievement of high data transmission rates. Telkonet is now at a point in its business development cycle at which the system requirements and hardware have been developed, and the Company is ready to bring to market its suite of PlugFast products for high-speed Internet access. As Internet access becomes a more critical tool, the demand for higher access speeds has triggered the growth of broadband solutions, and as these roll out, the desire for access to these emerging broadband networks provides opportunities for Telkonet. The built-in dial-up modems that have become a part of most new PCs are not suitable for higher speed connections. Hardwired network connections with high construction costs and disruption of the workplace, or complex wireless networks which have coverage and security issues are the only solutions available today. The Telkonet PlugFast family of Internet access products provides a viable and cost effective alternative to the challenges of hard-wired and wireless local area networks (LANs). This solution set is comprised of two products, the PLUGFAST GATEWAY and the PLUGFAST TERMINAL. The Telkonet PlugFast Gateway and Terminal are aimed at multi-user applications such as residential apartment complexes, hotels and motels, and a variety of small and medium sized businesses. High-speed Internet connections are becoming widely available and providers are anxious to sell these connections to their new and existing customers. Several companies now specialize in providing T1 access and most telephone companies now offer DSL products. 10 Providers are also offering connectivity through Microwave networks, 2-way Satellite, Fiber and Cable connections. However, these products share in the same problem: getting the access to where the customers want it. The Telkonet solution interfaces to the backbone of the Internet by taking the signal from any of these broadband sources and, through the Telkonet PlugFast Gateway, distributing access to the Internet to the ultimate user over the existing electrical wiring in the building. With the Telkonet PlugFast Gateway in place, access is provided by simply plugging the user's Telkonet PlugFast Terminal into the nearest standard electrical outlet. Any existing electrical outlet in the structure can provide immediate access to the Internet via a Telkonet PlugFast Terminal. Moving the location of a PC, server, or printer is accomplished by simply moving the PlugFast Terminal to another electrical outlet. No additional wiring is required and changes can be made quickly and easily. The Telkonet PlugFast Gateway provides the connection to the incoming broadband signal (DSL, TL, Satellite, Cable Modem) and the Telkonet PlugFast Terminal connects to a user device. Many PCs, each equipped with one Telkonet PlugFast Terminal, can communicate amongst themselves and can share a single broadband resource via the Telkonet PlugFast Gateway. Telkonet has applied for patents that cover its unique technology, and intends to utilize recently announced advancements in transmission speeds to build next generation devices for field tests and marketing demonstrations. Telkonet will continue to identify, design and develop enhancements to its core technologies that will provide additional functionality, diversification of application and desirability for current and future users. Forward Looking Statements - -------------------------- CERTAIN STATEMENTS INCLUDED HEREIN OR INCORPORATED BY REFERENCE CONSTITUTE "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 (THE "REFORM ACT"). TELKONET DESIRES TO TAKE ADVANTAGE OF CERTAIN "SAFE HARBOR" PROVISIONS OF THE REFORM ACT AND IS INCLUDING THIS SPECIAL NOTE TO ENABLE THE COMPANY TO DO SO. FORWARD-LOOKING STATEMENTS INCLUDED OR INCORPORATED BY REFERENCE IN THIS PART INVOLVE KNOWN AND UNKNOWN RISKS, UNCERTAINTIES AND OTHER FACTORS WHICH COULD CAUSE THE COMPANY'S ACTUAL RESULTS, PERFORMANCE (FINANCIAL OR OPERATING) OR ACHIEVEMENTS TO DIFFER MATERIALLY FROM THE FUTURE RESULTS, PERFORMANCE (FINANCIAL OR OPERATING) OR ACHIEVEMENTS EXPRESSED OR IMPLIED BY SUCH FORWARD LOOKING STATEMENTS. Management's Discussion and Analysis of Financial Condition and Results of - -------------------------------------------------------------------------- Operations - ---------- Telkonet, transitioning from a development stage company to an active growth and acquisition stage company has generated initial revenues from operations. Telkonet may experience fluctuations in operating results in future periods due to a variety of factors including, but not limited to, market acceptance of the Internet and power line communication technologies as a medium for customers to purchase the Telkonet's products, Telkonet's ability to acquire and deliver high quality products at a price lower than currently available to consumers, Telkonet's ability to obtain additional financing in a timely manner and on terms favorable to the Telkonet, Telkonet's ability to successfully attract customers at a steady rate and maintain customer satisfaction, Telkonet promotions, branding and sales programs, the amount and timing of operating costs and capital expenditures relating to the expansion of the Telkonet's business, operations and infrastructure and the implementation of marketing programs, key agreements and strategic alliances, the number of products offered by the Telkonet, the number of returns experienced by the Telkonet, and general economic conditions specific to the Internet, power-line communications, and the communications industry. Revenues - -------- Telkonet generated revenues of $2,856 from operations from its inception. Telkonet believes it will begin earning revenues from operations within the next twelve months as it transitions from a development stage company to that of an active growth and acquisition stage company. 11 Costs and expenses - ------------------ >From its inception on November 3, 1999 through September 30, 2002, Telkonet has incurred operating expenses of $5,016,529. These expenses were associated principally with compensation to employees, product development costs and professional services. During the third quarter of 2002, Telkonet transitioned it's focus on bringing their initial offering of powerline communication products to the commercial and residential market, expenses increased by 87% over the third quarter of 2001 due to an increase in manpower expense from the further expansion of the core technical team, initial production costs for the PlugFast powerline products, and the ramp-up and increase in sales and marketing activities. Liquidity and Capital Resources - ------------------------------- To date the Company has generated minimum sales revenues, has incurred expenses, and has sustained losses. As a result of the Telkonet's operating losses from its inception through September 30, 2002, Telkonet generated a cash flow deficit of $3,588,252 from operating activities. The Company's current liabilities exceeded its current assets by $963,280 as of September 30, 2002. For the period from inception through September 30, 2002, the Company has accumulated losses of $5,014,276. Consequently, its operations are subject to all risks inherent in the establishment of a new business enterprise. While Telkonet has raised capital to meet its working capital and financing needs in the past, additional financing is required in order to meet the Telkonet's current and projected cash flow deficits from operations and development. Telkonet is seeking financing in the form of equity investment in order to provide the necessary working capital. Telkonet currently has no commitments for financing. There are no assurances Telkonet will be successful in raising the funds required. The Company's independent certified public accountants have stated in their report included in the Company's December 31, 2001 Form 10-KSB, that the Company has incurred operating losses in the last two years, and that the Company is dependent upon management's ability to develop profitable operations. These factors among others may raise substantial doubt about the Company's ability to continue as a going concern. Product Research and Development - -------------------------------- Company-sponsored research and development costs related to both present and future products are expended in the period incurred. Total expenditures on research and product development for the third quarter of 2002 were $91,334 compared to $208,321 for the third quarter of 2001. Acquisition or Disposition of Plant and Equipment - ------------------------------------------------- Telkonet does not anticipate the sale of any significant property, plant or equipment during the next twelve months. Telkonet does not anticipate the acquisition of any significant property, plant or equipment during the next 12 months, other than computer equipment and peripherals used in the Telkonet's day-to-day operations. Number of Employees - ------------------- During the period ended September 30, 2002, the Company had 12 employees. In order for the Company to attract and retain quality personnel, the Company anticipates it will continue to offer competitive salaries to current and future employees. As the Company continues to expand, the Company will incur additional costs for personnel. This projected increase in personnel is dependent upon the Company generating revenues and obtaining sources of financing. There are no assurances the Company will be successful in raising the funds required or generating revenues sufficient to fund the projected increase in the number of employees. Trends, Risks and Uncertainties - ------------------------------- Telkonet has sought to identify what it believes to be the most significant risks to its business, but cannot predict whether or to what extent any of such risks may be realized nor can there be any assurances that Telkonet has identified all possible risks that might arise. Investors should carefully consider all of such risk factors before making an investment decision with respect to the Company's stock. Telkonet's prospects must be evaluated with a view to the risks encountered by a company in an early stage of development, particularly in light of the uncertainties relating to the new and evolving power line modulation and transmission technologies. Telkonet will be incurring costs to develop, introduce and enhance its products, to establish marketing relationships, to acquire and develop products that will compliment each other and to build an administrative organization. To the extent that such expenses are not subsequently followed by commensurate revenues, Telkonet's business, results of operations and financial condition will be materially adversely 12 affected. There can be no assurance that Telkonet will be able to generate sufficient revenues from the sale of their first product and other product candidates. Telkonet expects negative cash flow from operations to continue for the next 6 months as it continues to develop and market its business. Telkonet will be required to sell additional equity or debt securities. The sale of additional equity or convertible debt securities will result in additional dilution to Telkonet's stockholders. Potential fluctuations in quarterly operating results - ----------------------------------------------------- Telkonet's quarterly operating results may fluctuate significantly in the future as a result of a variety of factors, most of which are outside Telkonet's control, including: the level of use of the Internet; the demand for high-tech goods; trends in broadband service provisioning, the amount and timing of capital expenditures and other costs relating to the expansion of the Telkonet's operations; price competition or pricing changes in the industry; technical difficulties; general economic conditions, and economic conditions specific to the Internet and communications industry. Limited public market, possible volatility of share price - --------------------------------------------------------- Telkonet's common stock is currently quoted on the NASD OTC Bulletin Board under the ticker symbol TLKO.OB. As of September 30, 2002, there were approximately 17,049,483 shares of common stock outstanding. There can be no assurance that a trading market will be sustained in the future. Factors such as, but not limited to, technological innovations, new products, acquisitions or strategic alliances entered into by Telkonet or its competitors, failure to meet securities analysts' expectations, government regulatory action, patent or proprietary rights developments, and market conditions for technology stocks in general could have a material effect on the volatility of the Telkonet's stock price. Item 3. Controls and Procedures. (a) On September 30, 2002, we made an evaluation of our disclosure controls and procedures. In our opinion, the disclosure controls and procedures are adequate because the systems of controls and procedures are designed to assure, among other items, that 1) recorded transactions are valid; 2) valid transactions are recorded; and 3) transactions are recorded in the proper period in a timely manner to produce financial statements which present fairly the financial condition, results of operations and cash flows for the respective periods being presented. Moreover, the evaluation did not reveal any significant deficiencies or material weaknesses in our disclosure controls and procedures. (b) There have been no significant changes in our internal controls or in other factors that could significantly affect these controls since the last evaluation. PART II. OTHER INFORMATION Item 1. Legal Proceedings None Item 2. Changes in Securities and Use of Proceeds (a) None (b) None (c) In July 2002, the Company issued an aggregate of 1,000,000 shares of registered common stock in exchange for previously issued options with an exercise price of $1.00 per share to two Company officers in exchange for a $1,000,000 note receivable. The options were issued pursuant to an employee stock option plan filed on SEC Form S-8 on April 17, 2002. In the third quarter 2002, the Company issued 777,772 shares of its restricted common stock in exchange for previously issued warrants with an exercise price from $.402-$.403 per share to accredited investors in exchange for $327,193. These issuances were considered exempt by reason of Section 4(2) of the Securities Act of 1933. Item 3. Defaults Upon Senior Securities None 13 Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits No. Description --- ----------- 99.1 Certification of J. Gregory Fowler Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith). 99.2 Certification of Stephen Sadle Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith). (b) Reports on Form 8-K filed during the three months ended September 30, 2002. None SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Telkonet, Inc. Registrant November 14, 2002 By: /s/ J. Gregory Fowler - ----------------- ------------------------------------- Date J. Gregory Fowler President and Chief Executive Officer 14 CERTIFICATIONS I, J. Gregory Fowler, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of Telkonet, Inc. 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations, and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14 for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions); a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize, and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions, with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 /s/ J. Gregory Fowler ------------------------------------- J. Gregory Fowler President and Chief Executive Officer 15 CERTIFICATIONS I, STEPHEN SADLE, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of Telkonet, Inc. 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations, and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14 for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions); a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize, and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions, with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 /s/ STEPHEN SADLE ------------------------ STEPHEN SADLE Chief Operating Officer 16