NOTES
TO FINANCIAL STATEMENTS
FOR
THE YEARS ENDED SEPTEMBER 30, 2019 AND 2018
NOTE
1- DESCRIPTION OF BUSINESS
Cipherloc
Corporation (the “Company” or “Cipherloc”) was incorporated in Texas on June 22, 1953 as American Mortgage
Company. Effective August 27, 2014, the Company changed its name to Cipherloc Corporation.
NOTE
2 – SIGNIFICANT ACCOUNTING POLICIES
The
Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of
America (“U.S. GAAP”). Significant accounting policies are as follows:
Use
of Estimates and Assumptions
The
preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect
(i) the reported amounts of assets and liabilities, (ii) the disclosure of contingent assets and liabilities known to exist as
of the date the financial statements are published, and (iii) the reported amount of net revenues and expenses recognized during
the periods presented. Adjustments made with respect to the use of estimates often relate to improved information not previously
available. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of financial statements;
accordingly, actual results could differ from these estimates. The Company’s most significant estimate relates to the valuation
of its convertible note.
Legal
The
Company is subject to legal proceedings, claims and liabilities which arise in the ordinary course of business. The Company accrues
for losses associated with legal claims when such losses are probable and can be reasonably estimated. These accruals are adjusted
as additional information becomes available or circumstances change. Legal fees are charged to expense as they are incurred.
Cash
and Cash Equivalents and Concentration of Credit Risk
The
Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. The
Company did not have any cash equivalents as of September 30, 2019 and 2018. At September 30, 2019 and 2018, cash includes cash
on hand and cash in the bank. The Company maintains its cash in accounts held by large, globally recognized banks which, at times,
may exceed federally insured limits as guaranteed by the Federal Deposit Insurance Corporation (FDIC). The FDIC insures these
deposits up to $250,000. As of September 30, 2019, $7,339,472 of the Company’s cash balance was uninsured. The Company has
not experienced any losses on cash.
Fixed
Assets
Fixed
assets are recorded at cost and depreciation is provided over the estimated useful lives of the related assets using the straight-line
method for financial statement purposes. Equipment and furniture are depreciated over an estimated useful life of three (3) to
five (5) years. Leasehold improvements are depreciated over the lesser of the related lease term or a useful life of ten (10)
years. Software is depreciated over an estimated useful life of three (3) years.
Long-Lived
Assets
Long-lived
assets are evaluated for impairment whenever events or changes in business circumstances indicate that the carrying amount of
the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. Each impairment test
is based on a comparison of the undiscounted future cash flows to the recorded value of the asset. If impairment is indicated,
the asset is written down to its estimated fair value. There was no impairment recorded during the years ended September 30, 2019
and 2018.
Fair
Value of Financial Instruments
The
Company’s financial instruments consisted primarily of cash, accounts payable and accrued expenses, deferred revenue, convertible
note payable, as well as embedded conversion features. The carrying amounts of such financial instruments approximate their respective
estimated fair value due to the short-term maturities and approximate market interest rates of these instruments.
Fair
value is focused on an exit price that would be received upon sale of an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date. Within the measurement of fair value, the use of market-based information
is prioritized over entity specific information and a three-level hierarchy for fair value measurements is used based on the nature
of inputs used in the valuation of an asset or liability as of the measurement date.
The
three-level hierarchy for fair value measurements is defined as follows:
|
●
|
Level
1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active
markets;
|
|
|
|
|
●
|
Level
2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets,
and inputs that are observable for the asset or liability other than quoted prices, either directly or indirectly, including
inputs in markets that are not considered to be active;
|
|
|
|
|
●
|
Level
3 – inputs to the valuation methodology are unobservable and significant to the fair value measurement.
|
The
fair values of the embedded conversion features in the Company’s convertible notes and of the warrants issued by the Company
were determined using level 2 measurements and are discussed in further detail in Notes 5 and 8, respectively.
Convertible
Debt
Convertible
debt is accounted for under the guidelines established by ASC 470-20, Debt with Conversion and Other Options. ASC 470-20
governs the calculation of an embedded beneficial conversion, a derivative instrument, which is treated as an additional discount
to the instruments where derivative accounting does not apply. This applies during the period for which embedded conversion features
are either fixed or not yet available to the holder. The amount of the beneficial conversion feature may reduce the carrying value
of the instrument. The discounts relating to the initial recording of the derivatives or beneficial conversion features are accreted
over the term of the debt.
When
equity instruments, such as common stock and/or warrants, are issued with convertible debt, the net proceeds from the transaction
are allocated to the convertible debt and equity instruments based on their relative fair values. The proceeds allocated to the
equity instruments may reduce the carrying value of the convertible debt, and such discount is amortized to interest expense over
the term of the debt.
In
the event a convertible note has an embedded conversion feature which, among other features, allows an unlimited number of common
shares to be issued upon conversion since the conversion price is based on the quoted market price of the Company’s common
stock, the Company records a derivative liability, which is marked to market at each reporting period and charged to the statement
of operations in accordance with ASC 815, Accounting for Derivative Financial Instruments and Hedging Activities.
Customer
Concentration
During
the years ended September 30, 2019 and 2018, one customer accounted for 100% of revenues. The loss of this customer would not
have a significant impact on operations.
Revenue
Recognition
The
Company derives its revenue from sales of its products, support and services. Product revenue consists of the Company’s
software sold as complete turn-key integrated solutions, as stand-alone software applications or sold on a subscription or consumption
basis. Depending on the nature of the arrangement revenue, related to turn-key solutions and stand-alone software applications
are generally recognized upon shipment and delivery of license keys. For certain arrangements revenue is recognized based on usage
or ratably over the term of the arrangement. Support and services revenue consist of both maintenance revenues and professional
services revenues. Revenue is recorded net of applicable sales taxes.
In
accordance with the authoritative guidance issued by the FASB on revenue recognition, the Company recognizes revenue when persuasive
evidence of an arrangement exists, the fee is fixed or determinable, delivery has occurred, and collection of the resulting receivable
is deemed probable. Products delivered to a customer on a trial basis are not recognized as revenue until the trial period has
ended and acceptance has occurred by the customer. Reseller and distributor customers typically send the Company a purchase order
when they have an end user identified.
Nature
of Products and Services
Licenses
for on-premises software provide the customer with a right to use the software as it exists when made available to the customer.
Customers may purchase perpetual licenses or subscribe to licenses, which provide customers with the same functionality and differ
mainly in the duration over which the customer benefits from the software. Revenue from distinct on-premises licenses is recognized
upfront at the point in time when the software is made available to the customer. In cases where the license is being modified
at the direction of the customer the revenue is being recognized ratably over the term of the arrangement. Revenue allocated to
software maintenance and support services is recognized ratably over the contractual support period.
Professional
services are primarily related to software implementation services and associated revenue is recognized upon customer acceptance.
Contract
Balances
Timing
of revenue recognition may differ from the timing of invoicing to customers. The Company records a contract asset or receivable
when revenue is recognized prior to invoicing, or unearned revenue when revenue is recognized subsequent to invoicing. For perpetual
licenses with multi-year product maintenance agreements, the Company generally invoices customers at the beginning of the coverage
period. For multi-year subscription licenses, the Company generally invoices customers annually at the beginning of each annual
coverage period. The Company records a contract asset related to revenue recognized for multi-year on-premises licenses as its
right to payment is conditioned upon providing product support and services in future years.
There
were no accounts receivable balances at September 30, 2019 and 2018. There was no adjustment needed to accounts receivable
for the cumulative effect of applying ASC 606 under the modified retrospective method. There was no impact on the opening balance
contract assets and liabilities, for the cumulative effect of applying ASC 606 under the modified retrospective method as of October
1, 2018.
Deferred
revenue is comprised mainly of unearned revenue related maintenance and technical support on term and perpetual licenses. Maintenance
and technical support revenue are recognized ratably over the coverage period. Deferred revenue also includes contracts
for professional services to be performed in the future which are recognized as revenue when the company delivers the related
service pursuant to the terms of the customer arrangement.
Changes
in deferred revenue were as follows:
Twelve Months Ended September 30, 2019
|
|
|
|
Balance at September 30, 2018
|
|
$
|
-
|
|
Cumulative effect
of applying ASC 606 under the modified retrospective method*
|
|
|
-
|
|
Deferral of revenue
|
|
|
75,000
|
|
Recognition of revenue
|
|
|
(46,600
|
)
|
Balance at September 30, 2019
|
|
$
|
28,400
|
|
*See
Note (1) Summary of Significant Accounting Policies, section (s) to our Financial Statements for further information.
Deferred
revenue includes invoiced revenue allocated to remaining performance obligations that has not yet been recognized and will be
recognized as revenue in future periods. Deferred revenue was $28,400 as of September 30, 2019, of which the Company expects
to recognize 100% of the revenue over the next 12 months.
Payment
terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 90 days. In
instances where the timing of revenue recognition differs from the timing of invoicing, the Company has determined its contracts
generally do not include a significant financing component. The primary purpose of the Company’s invoicing terms is to provide
customers with simplified and predictable ways of purchasing its products and services, not to receive financing from our customers
or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with maintenance and
support revenue recognized ratably over the contract period, and multi-year on-premises licenses that are invoiced annually with
product revenue recognized upon delivery.
Significant
Judgments
The
Company’s contracts with customers often include promises to transfer multiple products and services to a customer. Determining
whether products and services are considered distinct performance obligations that should be accounted for separately versus together
may require significant judgment.
Judgment
is required to determine the standalone selling price (“SSP”) for each distinct performance obligation. For products
and services aside from maintenance and support, the Company estimates SSP by adjusting the list price by historical discount
percentages. SSP for software and hardware maintenance and support fees is based on the stated percentages of the fees charged
for the respective products. The Company’s perpetual and term software licenses may have significant standalone functionality
and therefore revenue allocated to these performance obligations are recognized at a point in time upon electronic delivery of
the download link and the license keys. In cases where the license is being modified at the direction of the customer the revenue
is being recognized ratably over the term of the arrangement. Product maintenance and support services are satisfied over time
as they are stand-ready obligations throughout the support period. As a result, revenues associated with maintenance services
are deferred and recognized as revenue ratably over the term of the contract.
Revenues
associated with professional services are recognized at a point in time upon customer acceptance.
Assets
Recognized from Costs to Obtain a Contract with a Customer
The
Company recognizes an asset for the incremental costs of obtaining a contract with a customer if it expects the benefit of those
costs to be longer than one year. The Company has determined that its sales commission program meets the requirements for cost
capitalization. Total capitalized costs to obtain a contract were immaterial during the periods presented. The Company applies
a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period
would have been one year or less.
Software
license revenue is generally recognized when a signed contract or other persuasive evidence of an arrangement exists, the software
has been electronically delivered, the license fee is fixed or is measured on a paid user basis, and collection of the resulting
receivable is probable. When contracts contain multiple elements wherein Vendor-Specific Objective Evidence (“VSOE”)
exists for all undelivered elements, we account for the delivered elements in accordance with the “Residual Method.”
VSOE of fair value for maintenance and support is established by a stated renewal rate, if substantive, included in the license
arrangement or rates charged in stand-alone sales of maintenance and support. Revenue from subscription license agreements, which
include software, rights to unspecified future products and maintenance, is recognized ratably over the term of the subscription
period. When the fair value of VSOE of post contract customer support cannot be determined, the revenue is recognized ratably
over the contract period. The only remaining undelivered element was post contract support services, and accordingly, the revenues
were recognized on a pro rata basis prospectively over the terms of the related contracts. Deferred revenue results from fees
billed to or collected from customers for which revenue has not yet been recognized.
The
Company had deferred revenue of $28,400 and $0 as of September 30, 2019 and 2018, respectively.
Research
and Development and Software Development Costs
The
Company expenses all research and development costs, including patent and software development costs. Our research and development
costs incurred for the years ended September 30, 2019 and 2018 were $1,744,480 and $873,107, respectively.
Stock-Based
Compensation
The
Company measures the cost of services provided by employees and non-employees in exchange for an award of an equity instrument
based on the grant-date fair value of the award. There were both fully vested stock grants and stock options granted to employees
and non-employees during the year ended September 30, 2019. As such, compensation cost was recognized for grant as well as a ratable
portion for the stock options vesting over a three-year time frame. All equity awards granted to employees and non-employees during
the year ended September 30, 2018 were fully vested upon grant. As such, compensation cost was recognized at the time of the grant.
The
Company accounts for share-based payments in accordance with the authoritative guidance issued by the FASB on share-based compensation,
which establishes the accounting for transactions in which an entity exchanges its equity instruments for goods or services. Under
the provisions of the authoritative guidance, share-based compensation expense is measured at the grant date, based on the fair
value of the award, and is recognized as an expense over the requisite employee service period (generally the vesting period),
net of actual forfeitures. The Company estimates the fair value of share-based payments using the Black-Scholes option-pricing
model. Additionally, share-based awards to non-employees are expensed over the period in which the related services are rendered
at their fair value. All share-based awards are expected to be fulfilled with new shares of common stock.
Income
Taxes
The
Company utilizes the asset and liability method in accounting for income taxes. Under this method, deferred tax assets and liabilities
are recognized for operating loss and tax credit carryforwards and for the future tax consequences attributable to differences
between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the year 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 the results of operations in the period that includes the enactment date. A valuation allowance is recorded to
reduce the carrying amounts of deferred tax assets unless it is more likely than not that the value of such assets will be realized.
The
Company uses the two-step approach to recognize and measure uncertain tax positions. The first step is to evaluate
the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not, that
the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step
is to measure the tax benefit as the largest amount, which is more than 50% likely of being realized upon ultimate settlement.
The Company considers many factors when evaluating and estimating the Company’s tax positions and tax benefits, which may
require periodic adjustments. The Company did not record any liabilities for uncertain tax positions during the years ended September
30, 2019 or 2018.
Basic
and Diluted Net Loss per Common Share
Basic
loss per share is computed by dividing net loss available to common shareholders by the weighted average number of common shares
outstanding during the reporting period. The weighted average number of shares is calculated by taking the number of shares outstanding
and weighting them by the amount of time that they were outstanding. Diluted earnings per share reflects the potential dilution
that could occur if stock options, warrants, and other commitments to issue common stock were exercised or equity awards vest
resulting in the issuance of common stock that could share in the earnings of the Company. As of September 30, 2019, and 2018,
the Company had 1,000,000 shares of preferred stock outstanding, which are convertible into 1,500,000 shares of common
stock.
Diluted
loss per share is the same as basic loss per share during periods where net losses are incurred since the inclusion of the potential
common stock equivalents would be anti-dilutive as a result of the net loss. During the years ended September 30, 2019 and 2018,
24,290,866 warrants, 1,100,000 stock options, and 1,000,000 shares of convertible preferred stock were excluded from the calculation
of diluted loss per share because their effect would be anti-dilutive.
Liquidity
and Going Concern Considerations
The
Company feels the cash on hand is sufficient to enable the Company to continue in operation through January 2021.
Recent
Accounting Announcements
The
Financial Accounting Standards Board (“FASB”) issues Accounting Standards Updates (“ASU”) to amend the
authoritative literature in the ASC. There have been several ASUs to date that amend the original text of the ASCs. Other
than those discussed below, the Company believes those ASUs issued to date either (i) provide supplemental guidance, (ii) are
technical corrections, (iii) are not applicable to the Company or (iv) are not expected to have a significant impact on the Company.
In
August 2018, the FASB issued ASU 2018-13, Fair Value Measurements (Topic 820) – Disclosure Framework – Changes
to the Disclosure Requirements for Fair Value Measurement, to modify the disclosure requirements for fair value measurements.
The ASU removes certain disclosure requirements related to transfers between fair value hierarchy levels and valuation processes
for Level 3 fair value measurements. It modifies certain disclosure requirements for investments in entities that calculate net
asset value. It adds certain disclosure requirements regarding gains and losses for recurring Level 3 fair value measurements
and unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 is effective for fiscal years, and interim
periods within those fiscal years, beginning after December 15, 2019. The Company is currently in the process of evaluating the
effect this guidance will have on its financial statements and related disclosures.
In
June 2018, the FASB issued ASU 2018-07, Compensation – Stock Compensation (Topic 718) – Improvements to Nonemployee
Share-Based Payment Accounting, to expand the scope of Topic 718, Compensation – Stock Compensation, which currently
only includes share-based payments to employees, to include share-based payments issued to nonemployees for goods or services.
Thus, accounting for share-based payments to nonemployees and employees will be substantially aligned. ASU 2018-07 is effective
for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is currently in
the process of evaluating the effect this guidance will have on its financial statements and related disclosures.
In
February 2016, the FASB issued ASU 2016-02, Leases (Topic 840), to increase transparency and comparability among organizations
by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements.
Early adoption of the amendments in this standard is permitted for all entities, and the Company may recognize and measure leases
at the beginning of the earliest period presented using a modified retrospective approach. In July 2018, the FASB issued ASU 2018-11,
Leases (Topic 840): Targeted Improvements, to provide a new transition method and practical expedient for separating components
of a contract. The amendments in this standard are effective for fiscal years, and interim periods within those fiscal years,
beginning after December 15, 2018. The Company is currently in the process of evaluating the effect this guidance will have on
its financial statements and related disclosures.
NOTE
3 – FIXED ASSETS, NET
As
of September 30, 2019, and 2018, fixed assets consisted of the following:
|
|
September
30,
|
|
|
|
2019
|
|
|
2018
|
|
Equipment and furniture
|
|
$
|
37,875
|
|
|
$
|
11,042
|
|
Leasehold improvements
|
|
|
17,630
|
|
|
|
10,542
|
|
Software
|
|
|
12,676
|
|
|
|
9,538
|
|
|
|
|
68,181
|
|
|
|
31,122
|
|
Accumulated depreciation
|
|
|
(27,999
|
)
|
|
|
(11,072
|
)
|
Fixed
assets, net
|
|
$
|
40,182
|
|
|
$
|
20,050
|
|
Depreciation
expense for the years ended September 30, 2019 and 2018 was $16,927 and $5,548, respectively.
NOTE
4 – SOFTWARE LICENSES
SoundFi
– Software License Agreement
The
Company entered into a one-year agreement renewable for up to 4 years for an annual $50,000 Shield license fee and $25,000 watermark
base license fee with SoundFi LLC (“SoundFi”). Residual income to the Company is earned based on the number of audio
files downloaded per year with residual earnings of $.012 per download exceeding 3,000,001 and scaling up to $.00075 per download
exceeding 100,000,000. During the year ended September 30, 2019, the Company recognized $46,600 in licensing revenue. The Company
has determined the best method for measuring licensing revenue to be the passage of time and more specifically on a monthly basis
because the customer can request modifications over the term of the arrangement. The recognition of residual income occurs on
an annual basis based on download volume provided by Soundfi. A download is defined as an audio file downloaded to a mobile device
from the Soundfi servers.
Gawk
On
June 14, 2014, the Company entered into a license agreement with Gawk to use the Cipherloc engine for $1,125,000 for a period
of four (4) years. This customer licensed the CipherShop-Cipherloc encryption software technology and support services. The Company
was not required to make significant modifications at the time the contract was executed. Prior to this, the Company had never
sold or licensed the CipherShop-Cipherloc encryption software, nor any support services for such. Under the license agreement,
the Company was to provide access to its software on an operational basis and provide training. The Company would also provide
unspecified upgrades, if and when available, and 24/7 support over the license term. No VSOE was known for any of the elements.
After the agreement was executed, the licensee requested modifications to the software because they could not otherwise use the
software. The Company made the requested modifications to the software and delivered the finished product in late December 2015;
thus, delivery had not deemed to have occurred until such date. The contract termination date was not extended beyond the
initial date of June 2018. Revenues were recorded from the date of delivery over the remaining term of the agreement or approximately
30 months. For these reasons, revenue is recognized ratably from December 2015 until June 2018. During the year ended September
30, 2018, the Company recognized revenues of $316,248.
NOTE
5 – CONVERTIBLE NOTES PAYABLE
FirstFire
Global Opportunities Fund, LLC
On
September 26, 2017, the Company issued a convertible note payable to FirstFire Global Opportunities Fund, LLC (“FirstFire”)
with a principal amount of $330,000, which included an original issue discount of $30,000. The Company incurred $8,500 in debt
issuance costs. The note accrued interest at 5% per annum and was to mature on March 26, 2018. The note was convertible at $2.00
per share, subject to adjustment due to ratchet or down round protection, among other adjustments. The Company also issued 50,000
shares of its common stock, as well as warrants to purchase an additional 165,000 shares of common stock at $4.50 per share with
a term of two years. The note was amended on December 20, 2017, which reduced the conversion price of the note from $2.00 to $1.00
per share and the exercise price of the warrants from $4.50 to $2.00. The amendment also required the Company to issue an additional
87,500 shares of common stock to FirstFire. The Company also received the right to prepay the convertible note at any time from
the 151st through the 180th day following September 26, 2017, then the Company could repay FirstFire at 130% multiplied by the
outstanding principal amount plus accrued and unpaid interest.
The
reduction of the conversion price from $2.00 to $1.00 was deemed to create a beneficial conversion feature, therefore, the Company
accounted for the amendment of the FirstFire note using ASC 815, Derivatives and Hedging, and recognized a loss on extinguishment
of $358,038 during the three months ended December 31, 2017. The Company also recognized a beneficial conversion feature derivative
liability of $320,312 as of the note’s amendment date. The Company valued the beneficial conversion feature derivative liability
with the Black-Scholes-Merton valuation model on the date of the amendment using an expected life of one (1) year, volatility
of 150%, and risk-free rate of 1.87%.
During
the year ended September 30, 2018, the Company recognized a gain of $11,234 related to the change in fair value of the FirstFire
beneficial conversion feature derivative liability. The Company valued the beneficial conversion feature derivative liability
with the Black-Scholes-Merton valuation model as of March 21, 2018, immediately prior to the settlement of the note as described
below, using an expected life of 0.78 years, volatility of 150%, and risk-free rate of 1.71%.
Additionally,
upon the December 20, 2017 amendment of the FirstFire note, the Company recorded a debt discount of $330,000. The Company amortized
$312,813 of the debt discount to interest expense during the year ended September 30, 2018. Total interest expense related to
the FirstFire note, including the debt discount amortization, was $453,700 for the year ended September 30, 2018.
On
March 21, 2018, the Company entered into a settlement agreement with FirstFire, under which FirstFire converted $77,500 of the
note payable into 50,000 shares of common stock, and the Company paid $350,000 to satisfy the convertible note payable in full.
In connection with the settlement of the FirstFire note, the Company recognized a gain on extinguishment of $194,391.
Peak
One Opportunity Fund LP
On
December 14, 2017, the Company issued a convertible note payable to Peak One Opportunity Fund LP (“Peak One”) with
a principal amount of $300,000. The Company incurred $27,400 in debt issuance costs. The note was to mature on December 14, 2020.
The note was convertible at $1.00 per share. The Company also issued 275,000 shares of its common stock, as well as warrants to
purchase an additional 75,000 shares of common stock at $2.00 per share with a term of five years at the time of note issuance.
The
Company accounted for the Peak One note using ASC 815, Derivatives and Hedging, and recognized a beneficial conversion
feature derivative liability of $267,750 as of the note’s issuance date. The Company valued the beneficial conversion feature
derivative liability with the Black-Scholes-Merton valuation model on the date of issuance using an expected life of 1.25 years,
volatility of 150%, and risk-free rate of 1.82%. The Company also recognized a loss of $486,745 resulting from the excess fair
value of the beneficial conversion feature derivative in the Peak One note and of the equity instruments issued with the convertible
note.
During
the year ended September 30, 2018, the Company recognized a loss of $19,770 related to the change in fair value of the beneficial
conversion feature derivative liability. The Company valued the beneficial conversion feature derivative liability with the Black-Scholes-Merton
valuation model as of April 30, 2018, immediately prior to the redemption of the note as described below, using an expected life
of 1.17 years, volatility of 150%, and risk-free rate of 1.65%.
Additionally,
upon issuance of the Peak One note, the Company recorded a debt discount of $300,000. The Company amortized $37,432 of the debt
discount to interest expense during the year ended September 30, 2018.
On
April 30, 2018, the Company settled the Peak One note for $375,000 and issued 71,429 shares of common stock with a fair value
of $103,572 to Peak One. The Company recognized a loss on extinguishment of $153,621.
NOTE
6 – RELATED PARTY TRANSACTIONS
Employees
related to Ex Chief Executive Officer
Skylar,
Olivia and Robin De La Garza earned $52,278, $47,176 and $53,000, respectively, in compensation for the year ended September 30,
2019. In August 2019, Robin and Skylar De La Garza were terminated as employees of the Company. The Company also paid $11,394
in educational costs of Skylar De La Garza and $6,200 in moving expenses of Olivia De La Garza
Notes
Payable to Ex Chief Executive Officer
In
September 2017, the Company’s Chief Executive Officer (“CEO”) issued four notes with an aggregate principal
amount of $70,000 to the Company. The notes bore interest at 3% per annum and matured one year from the issuance date. The Company
repaid all four notes in full during September 2018. As of September 30, 2018, there were no outstanding notes payable to the
CEO.
See
Note 8 for additional related party transactions.
NOTE
7 – COMMITMENTS AND CONTINGENCIES
Litigation
The
Company is currently not involved in any litigation that it believes could have a material adverse effect on its financial condition
or results of operations.
A
disgruntled former consultant has brought an action in Texas state court against the Company and its former chief executive officer,
alleging fraud and misrepresentation pertaining to stock and payments alleged to be owed to the consultant. The Company believes
it has made all required payments and delivered the stock to the consultant. The consultant has also included a claim of partial
ownership of certain of the Company’s patents, which management believes is without merit. The case is currently being defended
by the Company and costs relating thereto have been submitted to the Company’s insurance carrier.
In
August 2019, the Board of Directors formed a special committee of independent directors (“Special Committee”) to investigate
certain activities of Michael De La Garza (“De La Garza”). The Special Committee has retained legal counsel, and is
authorized to retain forensic accountants, to assist the investigation.
In
August 2019, the Company initiated litigation against its former Chief Executive Officer, De La Garza in order to stop him from
misappropriating the company’s trade secrets, depleting its monies and other assets, damaging the value of the company in
the marketplace, and holding himself out as the company’s CEO. On September 25, 2019, the Court entered a temporary injunction
against De La Garza enjoining him from numerous acts including representing himself as CipherLoc’s CEO and from interfering
with the current CEO’s running the company. This litigation is ongoing, and its resolution is unknown. The Special Committee
is investigating certain activities of the former CEO including the Ageos, LLC Operating Agreement, the QHCI/Noun note receivable,
an advance/bonus, personal expenditures, and other items. All amounts expended have been expensed as of September 30, 2019. No
amounts have been recorded in these financial statements as expected recoveries.
On
July 26, 2019, the Board of Directors accepted the resignation of Michael De La Garza as Chief Executive Officer and appointed
Tom Wilkinson as Interim Chief Executive Officer. Mr. De La Garza was subsequently terminated as an employee on August 11, 2019.
On August 14, 2019, the Board of Directors formed an Executive Committee, as allowed by the Bylaws, consisting of Mr. Wilkinson,
Mr. Ambrose, Dr. Carlson and Dr. Davis. In accordance with the bylaws, the Executive Committee is empowered to execute all business
on behalf of the Board of Directors to the fullest extent permitted under Texas law.
On
August 8, 2019, the operating agreement with Ageos was terminated.
In
August 2019, it was determined that the previously disclosed note receivable from QHI would not be collectible. While the note
receivable had been presented to the board for approval, a vast majority of the funds had been paid to Noun Energy, rather
than to QHI. Noun Energy is a company doing business in the United Arab Emirates that is believed to be controlled by Mr. De La
Garza’s brother. This agreement and the funding are part of an ongoing investigation related to the litigation against Mr.
De La Garza discussed in Note 4. The note receivable has been written off as a loss for the quarter ended June 30, 2019 and is
included in general and administrative expenses on the statements of operations.
Leases
In
March 2019, the Company guaranteed a lease on behalf of Ageos, LLC in McLean, Virginia. The lease has a term of three years for
4,359 square feet of space in McClean, Virginia. The initial rent cost is $7,991 per month and the lease agreement provides for
annual rent increases of approximately 4.0%. The amount of future payments guaranteed is $267,389. The agreement with Ageos was
terminated in August 2019 and the Company has made an unwritten offer to assume the lease. No amounts have been accrued for this
commitment as of September 30, 2019.
In
February 2019, the Company and the landlord for its leased office space in Buda, Texas entered into a new lease agreement, and
the Company reduced its rented space from approximately 3,900 to 1,302 square feet. The new lease was effective February 1, 2019
and has a three-year term. The initial monthly rent is $2,566, and the lease agreement provides for annual rent increases of approximately
2.7%. The lease automatically renews for a three-year term, unless either party to the lease agreement notifies the other of the
intent to terminate the lease in writing at least 180 days prior to the expiration of the current term. The amount of future payments
guaranteed is $74,388.
In
October 2018, the Company leased approximately 3,900 square feet of office space on North Scottsdale Road in Scottsdale, Arizona.
The lease for this facility began on October 4, 2018 and continues until October 31, 2021. Annual rent of $77,180 was prepaid
for the first year from November 1, 2018 to October 31, 2019, and the lease agreement provides for annual rent increases of approximately
5.0%. The amount of future payments guaranteed is $172,369.
Future
annual minimum lease obligations at September 30, 2019 are as follows:
Year
Ending September 30,
|
|
Amount
|
|
2020
|
|
$
|
112,074
|
|
2021
|
|
|
87,433
|
|
2022
|
|
|
47,249
|
|
|
|
$
|
246,756
|
|
Rent
expense totaled $150,575 and $99,209 for the years ended September 30, 2019 and 2018, respectively.
Ageos,
LLC – Operating Agreement
An
operating agreement was entered into with Ageos, LLC and the Company on April 18, 2019. Ageos, LLC agreed to hire competent professionals,
establish and maintain an approved government facility and guide engineers to customize the Company’s base products for
governmental agency use. The Company agreed to advance Ageos, LLC $1,600,000 commiserate with the responsibilities and operating
expense budget provided by Ageos, LLC on a periodic basis. The Company had advanced $974,188 through September 30, 2019. Under
the operating agreement, Ageos, LLC was to reimburse the Company from the sale of the software by applying 50% of net revenues
earned to repay the advanced operating expenses. The operating agreement was terminated on August 8, 2019.
In
August 2019, it was determined that the previously disclosed note receivable from Quality Healthcare International, Inc. (“QHI”)
would not be collectible. While the note receivable had been presented to the board for approval, a vast majority of the
funds had been paid to Noun Energy, rather than to QHI. Noun Energy is a company doing business in the United Arab Emirates that
is believed to be controlled by Mr. De La Garza’s brother. This agreement and the funding are part of an ongoing investigation
related to the litigation against Mr. De La Garza discussed in Note 4. The note receivable has been written off as a loss for
the quarter ended June 30, 2019 and is included in general and administrative expenses on the statements of operations.
NOTE
8 - STOCKHOLDERS’ EQUITY (DEFICIT)
Common
Stock
As
of September 30, 2019, and 2018, the Company had 40,792,510 and 40,743,917 shares of common stock outstanding, respectively, and
were authorized to issue 681,000,000 shares of common stock at a par value of $0.01.
Common
Stock Issued for Cash
During
the year ended September 30, 2019, the Company refunded $40,000 for an oversubscription of common stock made by an investor related
to the private placement of shares in fiscal year 2018. The refund was made in lieu of an issuance of shares.
During
the year ended September 30, 2018, through the utilization of Private Placement Memorandums (PPMs) and upon receipt of executed
Subscription Agreements, the Company issued 18,909,900 shares of common stock for $16,625,238 in net cash proceeds pursuant to
the exemption from the registration provisions of the Securities Act, as amended, afforded by Rule 506 of Regulation D.
Common
Stock and Stock Options Issued to Directors and Offices
During
the year ended September 30, 2019, the Company issued 9,346 vested shares of common stock with a fair value of $11,216 to an employee,
which was recorded as stock-based compensation expenses in research and development expense in the statement of operations.
During
the year ended September 30, 2019, the Company issued 1,100,000 shares of stock options to the Board of Directors and officers
with a fair value of $862,000, of which $42,942 was recorded as stock-based compensation expenses in research and development
and general administration expense. Options will vest over a three-year period ratably. Of the 1,100,000, 1,000,000 options have
a strike price of $0.85 and the remaining 100,000 have a strike price of $0.75.
During
the year ended September 30, 2018, the Company issued 766,033 fully vested shares of common stock with a fair value of $1,472,601
to its officers and other employees as part of their compensation. Of this amount, $950,056 was recorded in general and administrative
expenses, $279,500 was recorded in sales and marketing expenses, and $243,045 was recorded in research and development expenses.
Common
Stock Issued for Services
During
the year ended September 30, 2019, the Company issued 20,000 shares of common stock with a fair value of $40,000 to Pycnocline,
LLC for management consulting services, which was recorded in research and development expense.
During
the year ended September 30, 2018, the Company issued 10,000 shares of fully vested common stock with a fair value of $15,000
to Magnolia Investor Relations for investor relations services rendered.
Common
Stock Issued for Settlement
During
the year ended September 30, 2018, the Company issued 50,000 shares of fully vested common stock with a fair value of $81,000
for to settle a legal matter by two shareholders who claimed that they were entitled to 125,000 shares of common stock because
of funds allegedly paid to the Company and promises allegedly made by the Company. The Company denied these allegations and settled
the matter for 50,000 shares of common stock.
Common
Stock Issued with Convertible Notes
During
the year ended September 30, 2018, the Company issued 275,000 and 71,429 shares of fully vested common stock in connection with
the issuance and redemption, respectively, of the Peak One note. The Company also issued 87,500 and 50,000 shares of common stock
in connection with the amendment and conversion, respectively, of the FirstFire note. Refer to Note 5 for further discussion.
Preferred
Stock
As
of September 30, 2019, and 2018, the Company had 1,000,000 and 1,000,000 shares of restricted preferred stock outstanding, respectively,
and was authorized to issue 10,000,000 shares of preferred stock at a par value of $0.01. Each share of preferred stock is convertible
into the Company’s common stock at a rate of one (1) preferred share to 1.5 common shares. Each share of preferred stock
has 1.5 votes on all matters presented to be voted by the holders of common stock. The holders of preferred stock can only convert
the shares if agreed to by the Board of Directors. If declared by the Board of Directors, holders of preferred stock are entitled
to receive dividends prior and in preference to any declaration or payment of any dividend on the common stock of the Company.
In the event of liquidation or dissolution of the Company, holders of preferred stock shall be paid out of the assets of the Company
prior and in preference to any payment or distribution to holders of common stock of the Company.
During
the year ended September 30, 2018, the Company’s Chief Executive Officer converted 9,000,000 shares of preferred stock into
13,500,000 shares of common stock.
Warrants
During
the year ended September 30, 2018, the Company issued warrants to purchase 75,000 shares of common stock in connection with the
Peak One convertible note discussed in Note 5. These warrants were issued with an exercise price of $2.00 and a term of five years.
The Company valued these warrants at $90,345 with the Black-Scholes-Merton valuation model using an expected life of five years,
volatility of 150%, and risk-free rate of 2.14%.
Additionally,
in connection with shares sold through a PPM, the Company issued warrants to purchase 144,000 shares of common stock. These warrants
were issued with an exercise price of $4.50 and a term of two years. The Company valued these warrants at $93,198 with the Black-Scholes-Merton
valuation model using an expected life of two years, volatility of 150%, and risk-free rates ranging from 1.89% to 2.27%.
Lastly,
in connection with shares sold through an additional PPM, the Company issued warrants to purchase 18,837,900 shares of common
stock. These warrants were issued with an exercise price of $1.20 and a term of five years. The company issued warrants to
purchase an additional 5,398,970 shares of common stock to its underwriters. These warrants were issued with an exercise price
of $1.00 and a term of ten years.
Warrant
activity for the years ended September 30, 2019 and 2018 is as follows:
|
|
Number
of Warrants
|
|
|
Weighted
Average Exercise Price
|
|
|
Weighted
Average Remaining Life
|
|
Outstanding at September 30, 2017
|
|
|
725,000
|
|
|
$
|
4.50
|
|
|
|
2.00
|
|
Granted
|
|
|
25,033,366
|
|
|
|
1.18
|
|
|
|
5.99
|
|
Exercised
|
|
|
(742,500
|
)
|
|
|
1.20
|
|
|
|
1.50
|
|
Canceled/Forfeited
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Outstanding at September 30, 2018
|
|
|
25,015,866
|
|
|
|
1.27
|
|
|
|
5.83
|
|
Granted
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Exercised
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Canceled/Forfeited
|
|
|
(725,000
|
)
|
|
|
4.50
|
|
|
|
—
|
|
Outstanding at September 30, 2019
|
|
|
24,290,866
|
|
|
$
|
1.14
|
|
|
|
4.84
|
|
NOTE
9 - INCOME TAXES
The
provision (benefit) for income taxes from continued operations for the years ended September 30, 2019 and 2018 consist of the
following:
|
|
September
30,
|
|
|
|
2019
|
|
|
2018
|
|
Current:
|
|
|
|
|
|
|
|
|
Federal
|
|
$
|
—
|
|
|
$
|
—
|
|
State
|
|
|
—
|
|
|
|
—
|
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
|
|
|
|
|
|
|
|
Deferred:
|
|
|
|
|
|
|
|
|
Federal
|
|
$
|
(1,301,000
|
)
|
|
$
|
(2,558,000
|
)
|
State
|
|
|
—
|
|
|
|
—
|
|
|
|
|
(1,301,000
|
)
|
|
|
(2,558,000
|
)
|
Valuation
allowance
|
|
|
1,301,000
|
|
|
|
2,558,000
|
|
Provision
(benefit) for income taxes, net
|
|
$
|
—
|
|
|
$
|
—
|
|
The
difference between income tax expense computed by applying the federal statutory corporate tax rate and actual income tax expense
is as follows:
|
|
September
30,
|
|
|
|
2019
|
|
|
2018
|
|
Statutory
federal income tax rate
|
|
|
21.0
|
%
|
|
|
21.0
|
%
|
Non-deductible
stock-based compensation
|
|
|
(0.07
|
)
|
|
|
(7.0
|
)
|
Change
in statutory tax rate
|
|
|
(13.0
|
)
|
|
|
(19.0
|
)
|
Valuation
allowance
|
|
|
(20.93
|
)
|
|
|
5.0
|
|
Effective
tax rate
|
|
|
0.0
|
%
|
|
|
0.0
|
%
|
Deferred
income taxes result from temporary differences in the recognition of income and expenses for the financial reporting purposes
and for tax purposes. The tax effect of these temporary differences representing deferred tax asset and liabilities result principally
from the following:
|
|
September
30,
|
|
|
|
2019
|
|
|
2018
|
|
Net operating loss carry
forward
|
|
$
|
4,778,000
|
|
|
$
|
3,536,000
|
|
Deferred compensation
|
|
|
3,806,000
|
|
|
|
3,747,000
|
|
Valuation allowance
|
|
|
(8,584,000
|
)
|
|
|
(7,283,000
|
)
|
Deferred income
tax asset
|
|
$
|
—
|
|
|
$
|
—
|
|
The
Company has a net operating loss carry forward of $22.7 million available to offset future taxable income. Of which, $2.6 million
will expire within the next five years, and the remaining $20.13 million will expire thereafter. For income tax reporting purposes,
the Company’s aggregate unused net operating losses were subject to the limitations of Section 382 of the Internal Revenue
Code, as amended. The Company has adjusted the net operating losses incurred prior to 2015 to reflect only the losses not subject
to limitation. The Company has provided for a valuation reserve against the net operating loss benefit, because in the opinion
of management based upon the earning history of the Company; it is more likely than not that the benefits will not be realized.
For income tax reporting purposes, Management has determined that net operating losses prior to February 5, 2015 are subject to
an annual limitation of approximately $525,000.
For
the years ended September 30, 2019 and 2018, the difference between the amounts of income tax expense or benefit that would result
from applying the statutory rates to pretax income to the reported income tax expense of $0 is the result of the net operating
loss carry forward and the related valuation allowance, as well as non-deductible stock-based compensation.
The
Company anticipates it will continue to record a valuation allowance against the losses of certain jurisdictions, primarily federal
and state, until such time as it is able to determine it is “more-likely-than-not” the deferred tax asset will be
realized. Such position is dependent on whether there will be sufficient future taxable income to realize such deferred tax assets.
The Company’s effective tax rate may vary from period to period based on changes in estimated taxable income or loss by
jurisdiction, changes to the valuation allowance, changes to federal, state or foreign tax laws, future expansion into areas with
varying country, state, and local income tax rates, deductibility of certain costs and expenses by jurisdiction.
The
Company is current on all its federal income tax filings. An extension will be filed for the September 30, 2019
tax return.
On
December 22, 2017, the Tax Cuts and Jobs Act (“Tax Act”) was signed into law in the U.S. The Tax Act has resulted
in significant changes to the U.S. corporate income tax system. These changes include a federal statutory rate reduction from
35% to 21%, the elimination or reduction of certain domestic deductions and credits, and limitations on the deductibility of interest
expense and executive compensation. These changes were effective beginning in 2018.
NOTE
10 - SUBSEQUENT EVENTS
On
November 14, 2019, the Company terminated Olivia De La Garza’s employment and was given one month’s severance
On November 21, 2019, the Company issued stock options 140,000 shares to employees with strike price to be determined.
Effective
November 25, 2019, the board of directors appointed Andrew Borene as Chief Executive Officer of the Company. Mr Borene replaces
Tom Wilkinson, the Company’s interim Chief Executive Officer, who will remain as chairman of the board. Effective December
13, 2019, Gino Mauriello resigned from his position as Chief Financial Officer. On December 13, 2019, the Company terminated the
members of the R&D team On December 17, 2019, Albert Carlson, Ph.D., resigned from his position as Chief Scientific Officer
and as member of the board of directors of the Company. On December 20, 2019, the board of directors of the Company appointed
Andrew Borene, the Company’s Chief Executive Officer, a member of the board.