We had remaining performance obligations of approximately $18.4 million as of September 30, 2021. Our remaining performance obligations represent the amount of transaction price for which work has not been performed and revenue has not been recognized. When applying Accounting Standards Codification (“ASC”) Topic 606, with only the non-cancelable portion of these contracts included in our performance obligations we had approximately $16.0 million as of September 30, 2021. We expect to recognize revenue on approximately 87% of the remaining non-cancelable portion of these performance obligations over the next 24 months, with the balance thereafter.
At times, cash balances held in financial institutions are in excess of federally insured limits. Management performs periodic evaluations of the relative credit standing of financial institutions and limits the amount of risk by selecting financial institutions with a strong credit standing.
Our largest customer accounted for approximately 13% and 9% of our revenues for the nine months ended September 30, 2021 and 2020, respectively. Our largest customer had accounts receivable totaling approximately $59,000 and $74,000 as of September 30, 2021, and December 31, 2020, respectively.
In 2019, we entered into a Stock Purchase Agreement (the “Backbone Purchase Agreement”) with Backbone Enterprises Inc., a Minnesota corporation (“Backbone”), and its stockholders (the “Stockholders”), pursuant to which we acquired 100% of the issued and outstanding shares of common stock (the “Shares”) of Backbone from the Stockholders. Pursuant to the Backbone Purchase Agreement, the aggregate purchase price for the Shares included an earn-out, pursuant to which the Stockholders may be entitled to an additional $4,000,000 based upon the post-closing financial performance of Backbone, to be calculated based upon revenue generated by the Backbone business during the three-year earn-out period. There was no earn-out earned for the first year of the agreement. We performed an updated valuation of the contingent earn-out as of June 30, 2021, which resulted in a full write-off of the previous estimate of $1,300,000. The Company renegotiated the terms of the earnout and as a result performed an updated valuation of the contingent earn-out as of September 30, 2021, which resulted in a recovery from the previous estimate of $250,000.
On July 26, 2021, Caleb Barlow, notified the Board of Directors (the “Board”) of his resignation as the President and Chief Executive Officer of the Company, effective immediately. Mr. Barlow also informed the Board of his resignation as a member of the Board, to be effective August 26, 2021. The Board accepted Mr. Barlow’s resignation and, on July 26, 2021, appointed Michael “Mac” McMillan as President and Chief Executive Officer of the Company, effective immediately. Mr. Barlow’s resignation included a severance payment of approximately $578,000 and issuance of 200,000 shares of common stock as a result of the accelerated vesting and settlement of 200,000 restricted stock units that was paid and settled in October 2021.
In connection with Mr. McMillan’s appointment as President and Chief Executive Officer, the Company and Mr. McMillan entered into an employment agreement (the “Employment Agreement”) to be effective as of July 26, 2021 (the “Effective Date”). Pursuant to the Employment Agreement, Mr. McMillan has the duties and responsibilities as are commensurate with the positions of President and Chief Executive Officer, as reasonably and lawfully directed by the Board. The initial term of the Employment Agreement is 12 months from the Effective Date.
Pursuant to the Employment Agreement, Mr. McMillan’s base salary will be $300,000. Except in the event that Mr. McMillan’s employment is terminated for Cause (as defined below), the base salary is guaranteed and shall, in any event, be paid through the end of the 12-month term of the Employment Agreement. The Company has the right to terminate Mr. McMillan’s employment for “Cause,” which is defined in the Employment Agreement to mean: (a) acts or omissions constituting gross negligence, recklessness or willful misconduct on the part of Mr. McMillan with respect to his obligations or otherwise relating to the business of Company; (b) Mr. McMillan’s material breach of the Employment Agreement; and (c) Mr. McMillan’s conviction or entry of a plea of nolo contendere for fraud, misappropriation or embezzlement, or any felony or crime of moral turpitude.
The preceding description of the Employment Agreement is a summary of its material terms, does not purport to be complete. The Employment Agreement was filed as Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on July 26, 2021.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Section 27A of the Securities Act, and is subject to the safe harbors created by those sections. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “may,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. We undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements.
Due to possible uncertainties and risks, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Quarterly Report, which speak only as of the date of this Quarterly Report, or to make predictions about future performance based solely on historical financial performance. We disclaim any obligation to update forward-looking statements contained in this Quarterly Report.
Readers should carefully review the risk factors described in other documents we file from time to time with the SEC, including our Form 10-K for the fiscal year ended December 31, 2020, as amended. You should interpret many of the risks identified in these reports as being heightened as a result of the ongoing and numerous adverse impacts of the COVID-19 pandemic. Our filings with the SEC, including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those filings, pursuant to Sections 13(a) and 15(d) of the Exchange Act, are available free of charge at www.CynergisTek.com, when such reports are available via the EDGAR system maintained by the SEC at www.sec.gov.
OVERVIEW
We are engaged in the business of helping U.S. based companies in highly regulated industries, including healthcare, be prepared to handle unforeseen cyber threats, comply with regulations, and gain the confidence that their efforts are strengthening their security posture and building resilience. This is achieved through our cybersecurity, privacy and compliance services.
CynergisTek was born in healthcare and is one of the few consulting and advisory companies focused on converging security and privacy with a methodology to validate the rigor and effectiveness of their programs. We believe that our years of experience of understanding our clients’ unique challenges allows us to provide our customers with services designed around industry best practices to improve security controls, policies and procedures and to protect sensitive information. Our team of subject matter experts and consultants are comprised of knowledgeable professionals who have learned their craft both in the classroom and through years of practical on-the-job experience, including as policy makers, attorneys and leaders in cybersecurity, privacy and compliance.
Our services are categorized into four service groups, which are: assess, build, manage, and validate. These services are designed to meet the client where they are in their security journey as recurring managed services under long-term contracts structured to provide a sustainable and growing program, or under shorter duration consulting or professional services engagements.
·Assess – identify, measure, and test security and privacy risk of an organization’s readiness and verify and validate their programs meet compliance and business objectives through IT audits, technical testing, and risk and program assessments.
·Build – develop policies and procedures and playbooks to help build out a fully comprehensive risk management program and provide resources to help organizations prioritize, implement and execute initiatives to strengthen their security and privacy programs.
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·Manage - provide on-going management and oversight of specific components of an organization’s security and privacy programs to address or give alerts when an issue arises and to offer our expertise that they need to accelerate the effectiveness of their programs.
·Validate – verify the processes, people, and technology are working effectively and provide insight to the ROI of an organization’s security investment through advanced services requiring highly experienced resources and/or technology to deliver.
For sophisticated organizations our Resilience Partner Program encompasses a bundle of services from the assess, build, manage, and validate categories to deliver clarity and guidance as a consistent partner helping maintain and grow their security infrastructure. This highly customizable managed service allows CynergisTek to meet the unique needs of client wanting to work with a partner over a multiyear engagement.
Impact of COVID-19 Pandemic
In December 2019, a novel strain of the coronavirus (COVID-19) surfaced, which spread globally and was declared a pandemic by the World Health Organization in March 2020. The challenges posed by the COVID-19 pandemic on the global economy increased significantly in the first several months of 2020. In response to the COVID-19 pandemic, national and local governments around the world instituted certain measures, including travel bans, prohibitions on group events and gatherings, shutdowns of certain businesses, curfews, shelter-in-place orders and recommendations to practice social distancing. Variants of the COVID-19 virus pose similar and other unknown risks to the economy and our business.
In planning for the possible disruption of our business, we took steps to reduce expenses throughout the Company. This included substantially reducing Company travel for a period of time, as well as our participation in trade shows and other business meetings and decreasing expenditures. We also implemented workforce reductions during 2020 and the beginning of 2021, decreasing employment and related expenses. Continued progression of the pandemic could result in a decline in customer orders, as our customers could shift purchases to lower-priced or other perceived value offerings or reduce their purchases of our services due to decreased budgets, reduced access to credit or various other factors, which could have a material adverse impact on our results of operations and cash flow. While the current impacts of COVID-19, including from variants thereof, are reflected in our results of operations, we cannot at this time separate the direct COVID-19 impacts from other factors that cause our performance to vary from year to year. The ultimate duration and impact of the ongoing pandemic related to COVID-19 and its variants on our business, results of operations, financial condition and cash flows is dependent on future developments, including the duration and severity of the pandemic, and the related length of its impact on the global economy, which are uncertain and, given the daily evolution of the COVID-19 pandemic and the global responses to curb its spread, cannot be predicted at this time. Even after the pandemic related to COVID-19 and its variants has subsided, we may continue to experience an adverse impact to our business as a result of its national and, to some extent, global economic impact, including any recession that has occurred or may occur in the future. Furthermore, the extent to which our mitigation efforts are successful, if at all, is not presently ascertainable. However, we anticipate that our results of operations in future periods may continue to be adversely impacted by the pandemic related to COVID-19 and its variants, and its negative effects on global economic conditions.
Our common stock currently trades on the NYSE American exchange under the stock symbol “CTEK”.
Where appropriate, references to “CynergisTek,” the “Company,” “Redspin,” “we,” “us,” or “our” include CynergisTek, Inc., a Delaware corporation and its wholly-owned subsidiaries, CTEK Solutions, Inc., a California corporation, CTEK Security, Inc., a Texas corporation, Delphiis, Inc., a California corporation and Backbone Enterprises, Inc., a Minnesota corporation.
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RESULTS OF OPERATIONS
For the Three Months Ended September 30, 2021, Compared to the Three Months Ended September 30, 2020
Revenue
Revenue decreased $0.7 million to $3.8 million for the three months ended September 30, 2021, as compared to the same period in 2020. Managed Services revenue decreased $0.5 million due to the impact of some customers canceling contracts, delaying renewals, a slowdown in net new customers due to the COVID-19 pandemic, customers holding off on purchasing or trying to reduce budgets and a number of customers delaying the start of services due to technical issues related to one of our 3rd party applications that we expect to be resolved in the next few months. Consulting and professional services decreased $0.2 million due to underperformance in our Backbone business unit. We have seen an increase in sales bookings recently along with an increase in our backlog or remaining performance obligations that we expect will result in higher revenues starting in Q4.
Cost of Revenue
Cost of revenue consists primarily of salaries and related expenses of direct labor and indirect support staff. Cost of revenue was $2.0 million for the three months ended September 30, 2021, as compared to $2.9 million for the same period in 2020. Salary and related costs were lower by $0.7 million due to the reduced headcount in response to the lower revenue and the benefit from the employee retention credit provided under the CARES Act, technology related costs were lower by $0.1 million as a result of expense reduction efforts prompted by the lower revenue and stock compensation expense was down $0.1 million as a result of the reduction in headcount.
Gross margin was 48% of revenue for the three months ended September 30, 2021. Excluding the employee retention tax credit, gross margin would have been 35% for the three months ended September 30, 2021, compared to 35% for the same period in 2020. Margins remained flat with the benefit from lower salary and related costs and the employee retention credit offsetting the impact from the decline in revenue.
Sales and Marketing
Sales and marketing expenses include salaries, commissions and expenses for sales and marketing personnel, travel and entertainment, and other selling and marketing costs. Sales and marketing expenses decreased to $1.1 million for the three months ended September 30, 2021, as compared to $1.3 million for the same period in 2020. This decrease was due to $0.1 million of payroll-related expense reduction efforts taken in reaction to the lower revenue resulting from the COVID-19 pandemic, $0.1 million of employee retention tax credits provided under the CARES Act and $0.2 million in lower stock compensation expense as a result of the reduction in headcount. Those reductions were partially offset by an increase of $0.2 million in marketing and travel spend to support our Redspin business line and we are beginning to ramp back up our sales and marketing efforts to grow sales.
General and Administrative
General and administrative expenses include personnel costs for finance, administration, information systems, general management, facilities expenses, professional fees, legal expenses and other administrative costs including those required to be a publicly traded company. General and administrative expenses increased $1.1 million to $2.6 million for the three months ended September 30, 2021, compared to $1.5 million for the three months ended September 30, 2020. The increase is due to $0.7 million in non-recurring severance costs and $0.5 million in accelerated stock-based compensation as a result of the departure of our former CEO. This increase was partially offset by $0.1 million of employee retention tax credits provided under the CARES Act.
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Change in Valuation of Contingent Earn-out
The Company renegotiated the contingent earn-out with the sellers of Backbone Enterprises, Inc. during the quarter and performed an updated valuation as of September 30, 2021, which resulted in an increase from the previous estimate of $250,000 related to the potential for payout for meeting earn-out criteria in the final two years of the annual earn-out measurement periods.
Depreciation
Depreciation expense was consistent at $48,000 for the three months ended September 30, 2021, compared to $48,000 for the same period in 2020.
Amortization of Acquisition-Related Intangibles
Amortization of acquisition-related intangibles was $0.3 million for the three months ended September 30, 2021, compared to $0.4 million for the three months ended September 30, 2020. Amortization expense decreased over the comparable periods as the remaining balance of amortizable intangible assets decreased.
Net Interest Expense
Net interest expense for the three months ended September 30, 2021, was $10,000, compared to net interest expense of $24,000 for the same period in 2020.
Other Income and Expense
The Company received notice in August 2021 from the SBA that the full principal balance and related interest of the PPP Loan was forgiven and the Company recognized income of $2,862,000
Income Tax
Income tax benefit for the three months ended September 30, 2021, was $0.9 million, compared to income tax benefit of $0.4 million for the same period in 2020. These amounts were based on estimated annual income tax rates we anticipate for the year.
For the Nine Months Ended September 30, 2021, Compared to the Nine Months Ended September 30, 2020
Revenue
Revenue decreased $2.3 million to $11.9 million for the nine months ended September 30, 2021, as compared to the same period in 2020. Managed Services revenue decreased $1.9 million due to the impact of some customers canceling contracts, delaying renewals, a slowdown in net new customers due to the COVID-19 pandemic, customers holding off on purchasing or trying to reduce budgets and a number of customers delaying the start of services due to technical issues related to one of our 3rd party applications that we expect to be resolved in the next few months. Consulting and professional services decreased $0.4 million primarily due to lower revenue from two customers who completed contract work in the first half of 2020, lower revenues from our Backbone business unit as a result of the COVID-19 pandemic, and customers holding off on delivery of previously sold professional services as they attempt to minimize spend with third-party contractors or prospects limiting their purchasing of new services as they look to reduce budgets.
Cost of Revenue
Cost of revenue was $6.1 million for the nine months ended September 30, 2021, as compared to $9.7 million for the same period in 2020. We reduced salary and related costs and stock-based compensation associated with our reduction in force by approximately $1.8 million due to the lower revenue from the COVID-19 pandemic and received a $1.6 million benefit from the employee retention credit provided under the CARES Act and $0.2 million lower technology related costs as a result of the lower revenue.
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Gross margin was 48% of revenue for the nine months ended September 30, 2021, and 32% for the same period in 2020. After adjusting for the benefit from the employee retention tax credit in 2021, gross margin was 35%. Margins improved as a result of targeted expense reductions we made over the last few quarters in reaction to the lower revenue due to COVID-19.
Sales and Marketing
Sales and marketing expenses decreased to $3.5 million for the nine months ended September 30, 2021, as compared to $4.5 million for the same period in 2020. This decrease was due to $0.6 million in lower marketing and sales support payroll and benefit costs from the headcount reductions due to the COVID-19 pandemic, $0.3 million in lower stock compensation expense as a result of the reduction in headcount and $0.3 million of employee retention tax credits provided under the CARES Act. This decrease was partially offset by $0.1 million in recruiting costs to bring on a new sales leader and additional direct sales leads and an increase of $0.1 million in marketing spend to support our Redspin business line and slowly ramping back up our sales and marketing efforts to grow sales.
General and Administrative
General and administrative expenses increased $0.4 million to $5.8 million for the nine months ended September 30, 2021, compared to $5.4 million for the same period in 2020. The increase is due to $0.6 million in severance related costs and $0.5 million in higher stock-based compensation from the acceleration of vesting of restricted stock units as a result of the departure of our former CEO, which were partially offset by $0.3 million in lower payroll and benefit related costs due to the expense reduction efforts taken in reaction to the lower revenue from the COVID-19 pandemic, $0.2 million less in recruiting costs due to 2020 being higher, and $0.2 million of employee retention tax credits provided under the CARES Act.
Change in Valuation of Contingent Earn-out
As of June 30, 2021 we performed a valuation of the contingent earn-out to the sellers of Backbone Enterprises, Inc., which resulted in a reduction of the previous estimate of $1,300,000 related to the potential for payout for not meeting earn-out criteria in the final two years of the annual earn-out measurement periods. In September of 2021 the Company renegotiated the earnout with the sellers and performed an updated valuation as of September 30, 2021, which resulted in a reduction of the previous estimate to $1,050,000.
Depreciation
Depreciation remained relatively consistent at $144,000 for the nine months ended September 30, 2021, as compared to $142,000 for the same period in 2020.
Amortization of Acquisition-Related Intangibles
Amortization of acquisition-related intangibles was $1.0 million for the nine months ended September 30, 2021, compared to $1.2 million for the nine months ended September 30, 2020. Amortization expense decreased over the comparable periods as a portion of the intangible assets are now fully amortized.
Finance Cost for Equity Commitment
In April 2020 we issued a warrant to an investor in return for an obligation by them to purchase our common stock as a stated price as described in Note 13 to the unaudited condensed consolidated financial statements. The fair value of this warrant of $390,000 was recorded as an expense at the time of issuance.
Net Interest Expense
Net interest expense for the nine months ended September 30, 2021, was $47,000, compared to $68,000 for the same period in 2020.
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Other Income and Expense
The Company received notice in August 2021 from the SBA that the full principal balance and related interest on the PPP Loan was forgiven and the Company recognized income of $2,862,000
Income Tax
Income tax benefit for the nine months ended September 30, 2021, was $1.2 million, compared to income tax benefit of $1.6 million for the same period in 2020. These amounts were based on estimated annual income tax rates we anticipate for the year.
Liquidity and Capital Resources
As of September 30, 2021, our cash balance was $5.1 million, current assets minus current liabilities was positive $6.6 million. The level of additional cash needed to fund operations and our ability to conduct business for the next twelve months will be influenced primarily by the following factors:
·our ability to manage our operating expenses and maintain gross margins while attracting, recruiting and retaining cybersecurity privacy professionals;
·demand for our services from healthcare providers; the near-term impact of the COVID-19 pandemic on our customers’ allocation of time and resources to security and privacy, and their ability to pay for existing services as well as enter into new contractual arrangements during a period of crisis;
·general economic conditions and changes in healthcare reimbursement and regulatory environment, including effects of the COVID-19 pandemic; and
·our ability to collect accounts receivable from health care customers whose operations and cash flow have been significantly impacted by the COVID-19 pandemic.
We have historically funded our operating costs, acquisition activities, working capital requirements and capital expenditures with cash from operations, proceeds from the issuances of our common stock and other financing arrangements. We are currently operating in a cash flow negative position while we seek to maintain and grow our cybersecurity business and cover our public company expenses during this uncertain time. In connection with our most recent results for the nine months ended September 30, 2021, we reported a loss from operations of $1.2 million after excluding non-cash items for depreciation, amortization of intangibles, stock-based compensation, the change in valuation of the contingent earnout and non-recurring severance related costs. Cash used in operating activities was $1.4 million for the nine months ended September 30, 2021.
In late 2019, a novel strain of coronavirus (COVID-19) was first detected in Wuhan, China. Following the outbreak of this virus, governments throughout the world, including in the United States of America, have quarantined certain affected regions, restricted travel and imposed significant limitations on other economic activities. Our customer base is heavily concentrated in the healthcare provider space. The healthcare industry has experienced significant financial losses due to the pandemic and are still contending with strained budgets but are showing signs of re-engagement. Sales cycles are longer and pricing pressure is constant. The resurgence of the virus with the Delta Variant has caused some to return to operating with caution. Our operations team is closely monitoring the impact to the Company’s business, including its cash flows, customers and employees. We are working with a number of our active customers since the outbreak began providing relief in the form of extended payment terms and other contractual restructurings. If the situation continues to impact our customers’ cash flow or resources available for cybersecurity and privacy projects, our cash flows, financial position and operating results for fiscal year 2021 and beyond will be negatively impacted.
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We did experience a negative financial impact from March 2020 through September 2021 that management anticipates will continue to impact revenue and earnings for the foreseeable future due to the pandemic related to COVID-19 and variants thereof, primarily because many of the economic effects of the early stages of the COVID-19 pandemic resulting from the various shelter-in-place and other social distancing orders. The severity and duration of the COVID-19 pandemic is uncertain, and such uncertainty will likely continue in the near term. We will continue to actively monitor the situation taking into account the impact to our employees, customers and partners.
At the end of 2019 and through the second quarter of 2021, we reduced staffing levels to reduce expenses that included permanent and temporary cost reductions, the precise extent of which will depend on the duration of the COVID-19 disruptions to our customers and our short-term financial performance. In addition, we received the PPP Loan (as defined in Note 9 to the unaudited condensed consolidated financial statements below) pursuant to the CARES Act (as defined in Note 9 to the unaudited condensed consolidated financial statements below), which was fully forgiven in August 2021 as described in Note 9 to the unaudited condensed consolidated financial statements. We also received approximately $0.7 million per quarter in employee retention tax credits in the first, second and third quarters of 2021. With the proceeds from the PPP Loan and the employee retention tax credits, we have tried to minimize staff reductions in the areas of Sales and Delivery, our primary customer facing roles, to lessen the impact to our customers during this time of heightened security risks for the healthcare industry. If necessary, we could further reduce personnel and other variable and semi-variable costs to conserve cash and operate as a going concern. However, those actions if required, could negatively impact the long-term outlook of the business.
As described in Note 12 to the unaudited condensed consolidated financial statements, on November 12, 2020, we entered into an Equity Distribution Agreement (the “Equity Distribution Agreement”) with Craig-Hallum Capital Group LLC (as “Agent”) thereunder, under which we may offer and sell, from time to time at our sole discretion, shares of our common stock having an aggregate offering price of up to $5.0 million in an “at-the-market” or ATM offering, to or through the Agent. The Company agreed to pay the Agent a commission of three percent (3.0%) of the gross sales price per share of any common stock sold through the Agent under the Equity Distribution Agreement.
During September of 2021, the Company received gross proceeds under the Equity Distribution Agreement of $1,434,000 from the issuance of 762,000 shares of our common stock and paid an aggregate of $81,000 to the Agent in commissions and other offering-related expenses, yielding net proceeds of $1,352,000.
We believe that our existing sources of liquidity, including cash and cash equivalents, the proceeds from the PPP Loan, employee retention tax credits and tax refunds from NOL carrybacks, the ability to raise equity under our effective Registration Statement on Form S-3 (File No. 333-249615), filed with the Securities and Exchange Commission on October 22, 2020 (including via the Equity Distribution Agreement) and future operating cash flows will be sufficient to meet our projected capital needs for at least the next twelve months. As we execute our plans over the next twelve months, we intend to carefully monitor the impact on our operating expenses, working capital needs and cash balances relative to the availability of cost-effective debt and equity financing. In the event that capital is not available, we may then have to scale back operations, reduce expenses, and/or curtail future plans to manage our liquidity and capital resources. However, we cannot provide assurance that we will be able to raise additional capital. The COVID-19 pandemic will likely continue to create uncertainty and volatility in the financial markets which may impact our operations and our ability to access capital and/or the terms under which we can do so.
The impact of the COVID-19 pandemic on the economy and our operations is fluid and constantly evolving; we will continue to assess a variety of measures to improve our financial performance and liquidity.
Application of Critical Accounting Policies
The SEC defines critical accounting policies as those that are, in management’s view, most important to the portrayal of our financial condition and results of operations and most demanding of our judgment. The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which were prepared in accordance with accounting principles generally accepted in the U.S., which is referred to as “GAAP.” The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On
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an on-going basis, we evaluate these estimates, including those related to stock-based compensation, customer programs and incentives, bad debts, intangible assets, income taxes, contingencies and litigation. We base our 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.
We consider the following accounting policies to be those most important to the portrayal of our financial condition and those that require the most subjective judgment:
Revenue Recognition and Deferred Revenue
We operate under a consolidated strategy and management structure, deriving revenue from the following sources:
·Managed services
·Consulting and professional services
Revenue is recognized pursuant to ASC Topic 606, “Revenue from Contracts with Customers”. Accordingly, revenue is recognized at an amount that reflects the consideration to which we expect to be entitled in exchange for transferring goods or services to a customer. This principle is applied using the following 5-step process:
1.Identify the contract with the customer - A contract with a customer exists when (i) we enter into an enforceable contract with a customer that defines each party’s rights regarding the services to be transferred and identifies the payment terms related to these services, (ii) the contract has commercial substance and the parties are committed to perform, and (iii) we determine that collection of substantially all consideration to which it will be entitled in exchange for services that will be transferred is probable based on the customer’s intent and ability to pay the promised consideration.
2.Identify the performance obligations in the contract - Performance obligations promised in a contract are identified based on the services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the service either on its own or together with other resources that are readily available from third parties or from us, and are distinct in the context of the contract, whereby the transfer of the services is separately identifiable from other promises in the contract. To the extent a contract includes multiple promised services, we apply judgment to determine whether promised services are capable of being distinct and distinct in the context of the contract. If these criteria are not met the promised services are accounted for as a combined performance obligation.
3.Determine the transaction price - The transaction price is determined based on the consideration to which we will be entitled in exchange for transferring services to the customer.
4.Allocate the transaction price to the performance obligations in the contract - If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (“SSP“) basis. Determination of SSP requires judgment. We determine standalone selling price taking into account available information such as historical selling prices of the performance obligation, overall strategic pricing objective, market conditions and internally approved pricing guidelines related to the performance obligations.
5.Recognize revenue when (or as) each performance obligation is satisfied - We satisfy performance obligations over time. Revenue is recognized over the time the related performance obligation is satisfied by transferring a promised service to a customer.
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Managed Services
Managed services contracts are typically long-term contracts lasting three years. Revenue is earned monthly during the term of the contract, as services are provided at a fixed fee and is recognized ratably over the contract term beginning on the commencement date of the contract. Revenue related to managed services provided is recognized based on the customer utilization of such resources, which management estimates to occur ratably over the customer contract term.
Consulting and Professional Services
Consulting and professional services contracts are typically short-term, project-based services rendered on either a fixed fee or a time and materials basis. These contracts are normally for a duration of less than one year. For fixed fee arrangements, revenue is normally recognized ratably over the term of the project. For time and materials arrangements, revenues are recognized as the services are rendered.
Deferred and Unbilled Revenue
We receive payments from customers based on billing schedules established in our contracts. Deferred revenue primarily consists of billings or payments received in advance of the amount of revenue recognized and such amounts are recognized as the revenue recognition criteria are met. Unbilled revenue reflects our conditional right to receive payment from customers for our completed performance under contracts.
Accounts Receivable Valuation and Related Reserves
We estimate the losses that may result from that portion of our accounts receivable that may not be collectible as a result of the inability of our customers to make required payments. Management specifically analyzes customer concentration, customer creditworthiness, current economic trends, COVID-19 developments and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. We review past due accounts on a monthly basis and record an allowance for doubtful accounts where we deem appropriate.
Impairment Review of Goodwill and Intangible Assets
We periodically evaluate our intangible assets and goodwill relating to acquisitions for impairment. Goodwill is not amortized but is evaluated at least annually at year end for any impairment in the carrying value. We review our intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors we consider important which could trigger an impairment review include, but are not limited to, the following: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and a significant negative industry or economic trend for a sustained period. Goodwill and intangible asset impairment assessments are generally determined based on fair value techniques, including determining the estimated future discounted and undiscounted cash flows over the remaining useful life of the asset. Those models require estimates of future revenue, profits, capital expenditures and working capital for each reporting unit. We estimate these amounts by evaluating historical trends, the current state of the Company’s industries and the economy, current budgets, and operating plans. Determining the fair value of reporting units and goodwill includes significant judgment by management and different judgments could yield different results. Any resulting impairment loss could have a material impact on our financial condition and results of operations.
Stock-Based Compensation
Under the fair value recognition provisions of the authoritative guidance, stock-based compensation cost granted to employees is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service or performance period, which is the vesting period. Stock options and warrants issued to consultants and other non-employees as compensation for services to be provided to us are accounted for based upon the fair value of the services provided or the estimated fair value of the option or warrant, whichever can be more clearly determined. We currently use the Black-Scholes option pricing model to determine the fair value of stock options and warrants. The determination of the fair value of stock-based payment awards on the date of grant using
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an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, the expected term of the award, the risk-free interest rate and any expected dividends. Compensation cost associated with grants of restricted stock units are also measured at fair value on the date of the grant. We evaluate the assumptions used to value restricted stock units on a quarterly basis. When factors change, including the market price of the stock, stock-based compensation expense may differ significantly from what has been recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense.
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial reporting requirements and those imposed under federal and state tax laws. Deferred taxes are provided for timing differences in the recognition of revenue and expenses for income tax and financial reporting purposes and are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred income tax expense represents the change during the period in the deferred tax assets and liabilities. Realization of the deferred tax asset is largely dependent on generating sufficient taxable income in future years. 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 the deferred tax assets will not be realized. Use of our net operating loss deferred assets may be limited by changes in our ownership.
Reference is made to our Annual Report on Form 10-K for the fiscal year ended December 31, 2020, filed with the SEC on March 25, 2021, for additional discussion of our critical accounting policies.
OFF-BALANCE SHEET ARRANGEMENTS
As of September 30, 2021, we did not have any other relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS
As of September 30, 2021, expected future cash payments related to contractual obligations and commercial commitments were as follows:
|
|
Payments Due by Period
|
|
|
Total
|
Less than
1 year
|
1-3 years
|
3-5 years
|
More than 5 years
|
|
Promissory note
|
$ 290,000
|
$ 290,000
|
$ -
|
$ -
|
$ -
|
|
Operating leases
|
86,000
|
86,000
|
-
|
-
|
-
|
|
Total
|
$ 376,000
|
$ 376,000
|
$ -
|
$ -
|
$ -
|
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