Dolphin Entertainment, Inc. annual report, FY2011

Business context and reporting period

Issuer: Dolphin Digital Media, Inc. (the filing issuer; not Dolphin Entertainment, Inc.). This Form 10-K covers the fiscal year ended December 31, 2011, with 2010 as the comparable year. The company focused primarily on Dolphin Digital Studios, producing online series for tween, teen/young-adult, and general audiences. It also operated the Dolphin Secure child-safety product and began developing branded Kids Clubs.

Key financial metrics

2011 revenue comprised $275,000 for German software licensing rights, $97,824 for post-production services, and $100,000 for production services to related party Dolphin Entertainment. The reported gross margin reflects low reported cost of revenue against this revenue base; it does not represent the profitability of the company’s developing production slate.

At December 31, 2011, total assets were $1,608,690, including $1,538,251 of capitalized production costs. Current liabilities were $5,957,050, versus current assets of $52,986. Liabilities included $995,000 of revenue-participation financing classified as debt, $540,000 of notes payable, and a $2,120,623 demand loan from the CEO. Stockholders’ deficit was $4,348,360; accumulated deficit was $34,400,074. The filing reports no off-balance-sheet arrangements.

Material changes versus 2010

• Revenue rose from zero to $472,824, primarily from licensing and production services; the company recognized no revenue from the web series financed under its equity finance agreements in 2011.
• Net loss narrowed by about $4.4 million. The company attributes the improvement mainly to lower G&A costs, no 2010 warrant-repricing finance charge, lower interest expense, and $208,593 of other income from litigation and vendor settlements. The 2010 comparison included $2,166,143 of website impairment and $170,500 of impairment of advances.
• Despite the lower net loss, operating cash use increased by about $841,000, largely amid production spending and working-capital movements. Financing activities provided $2,276,021 in 2011, including $995,000 from revenue-participation agreements, $794,521 in CEO advances, and $450,000 from a note payable.
• Capitalized production costs rose to $1,538,251; the principal project, “Hiding,” was incomplete at year-end, so no related revenue or amortization was recognized.

Outlook, risks, contingencies and unusual items

• Going concern: The independent auditor’s report raises substantial doubt about the company’s ability to continue as a going concern, citing losses, accumulated deficit, and insufficient working capital. Management planned to seek loans and equity financing; success was not assured.
• Management expectations: The company expected 2012 revenue from completed “Hiding” and another series in production. The filing describes a $250,000 production fee for “Hiding” and a $750,000 non-refundable advance on future licensing royalties, expected after delivery. Timing references differ within the filing: one discussion anticipates the production fee in Q1 2012, while MD&A refers to expected revenue in Q2. These are expectations, not reported results. Management also expected to produce 6–8 web series annually; no formal financial guidance is provided.
• Financing and dilution: Two additional unsecured, demand notes totaling $600,000 were signed after year-end, both at 10% interest. The CEO’s $2,120,623 note is unsecured, bears 10% interest, and is payable on ten days’ demand. Existing preferred-stock provisions and warrants, including 10,614,007 potential warrant shares, may constrain financing or dilute common shareholders.
• Revenue-sharing obligations: Investors in web-series agreements contributed $895,000 and receive a share of future series revenues. The filing says investors receive distributions until their investment is recouped and then a lower share; it also describes a production cycle ending December 31, 2012, after which gross receipts are distributed under the agreements. The company’s production fee is capped at $250,000 per production.
• Controls and reporting: Management concluded disclosure controls and internal control over financial reporting were ineffective at year-end due to material weaknesses, including weak governance and risk oversight, inadequate documented review of reconciliations and journal entries, and insufficient segregation of accounting duties. The company restated its Q1 2011 filing to recognize an additional $261,250 of software-license revenue and identified a separate revenue-recognition error involving a related-party production agreement. Remediation was planned for 2012.
• Legal and subsidiary matters: A Canadian lease-related third-party claim could result in a loss from $0 to $325,000; the company recorded no accrual, believing loss was not probable. A court notice said the case could be dismissed for delay if action was not taken within 90 days. The Canadian subsidiary filed for bankruptcy in March 2012 and had approximately $300,000 of unsecured payables; the company said the bankruptcy would not protect it from the claim. The company also began dissolving two inactive foreign subsidiaries.
• Governance and market risks: The company had no board committees and only one of its two directors was independent. Common shares traded on the OTC Bulletin Board in a limited-liquidity market. The COO resigned in March 2012. The company said it did not anticipate paying common-stock dividends.

Most important facts for investors to verify

1. Whether the company obtained sufficient capital to fund operations and meet near-term obligations, including demand notes and the CEO loan.
2. Actual cash receipts and recognized revenue from “Hiding” and other series, including timing and terms of the $750,000 licensing advance and $250,000 production fee.
3. The value and recoverability of $1,538,251 in capitalized production costs, and the remaining production obligations and investor revenue-sharing claims.
4. Progress in remediating the disclosed material weaknesses and whether subsequent filings avoid further revenue-recognition errors or restatements.
5. Developments in the Canadian claim, potential exposure up to $325,000, and the effect of the subsidiary bankruptcy.
6. Potential dilution from preferred stock, warrants, financing terms, and related anti-dilution or ownership provisions.