NOTES
TO FINANCIAL STATEMENTS
FOR
THE THREE MONTHS ENDED DECEMBER 31, 2017 AND 2016
(Unaudited)
NOTE
1 - DESCRIPTION OF BUSINESS
Cipherloc
Corporation (the “Company”) was incorporated in Texas on June 22, 1953 as American Mortgage Company. On March 15,
2015, the Company changed its name to Cipherloc Corporation. The name change became effective by the Amended Certificate as of
March 23, 2015.
Cipherloc
is a data security solutions company. Our highly innovative, patented polymorphic encryption technology is designed
to enable an iron-clad layer of protection to be added to existing solutions.
NOTE
2 - BASIS OF PRESENTATION OF INTERIM FINANCIAL STATEMENTS
The
Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of
America. The accompanying interim unaudited financial statements have been prepared in accordance with generally accepted accounting
principles for interim financial information in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X.
In our opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have
been included.
Operating
results for the three months ended December 31, 2017 are not necessarily indicative of the results that may be expected for the
year ending September 30, 2018. Notes to the unaudited interim financial statements that would substantially duplicate the disclosures
contained in the audited financial statements for the year ended September 30, 2017 have been omitted; this report should
be read in conjunction with the audited financial statements and the footnotes thereto for the fiscal year ended September 30,
2017 included within the Company’s Form 10-K as filed with the Securities and Exchange Commission.
NOTE
3 - GOING CONCERN
The
accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United
States of America, which contemplate continuation of the Company as a going concern. The Company has incurred losses from operations
and has an accumulated deficit at December 31, 2017 of $51,614,878. The Company issued two convertible notes, which may
be repaid within 180 days from issuance, on September 26, 2017 and December 14, 2017, respectively, aggregating $849,000. If not
repaid, the conversion features become variable, hindering our ability to raise capital in the future on terms favorable to the
Company. The Company’s continued existence is dependent upon our ability to obtain additional funding to explore potential
strategic relationships, complete development and marketing of the Company’s technologies, and operate the business. These
factors raise doubt about the Company’s ability to continue as a going concern.
Management
is currently in the process of raising capital, which is expected to be completed by May 2018. Management intends to use the proceeds
from this financing to repay the two outstanding convertible notes. There are no assurances that management will be successful
in raising capital to be able to achieve the needs of the business.
The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty.
NOTE
4 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The
Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of
America. Significant accounting policies are as follows:
Cash
and Cash Equivalents
The
Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. At December
31, 2017 and September 30, 2017, cash and cash equivalents include 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. At December 31, 2017 and September
30, 2017, none of the Company’s cash balance was uninsured. The Company has not experienced any losses in such accounts.
Convertible
Debt and Embedded Derivatives
Convertible
debt is accounted for under the guidelines established by Accounting Standards Codification (“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, contingently convertible, or cash or net settlement is
in control of the Company. When equity instruments, such as 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. The amount of the warrants and beneficial conversion feature will reduce the carrying value
of the debt instrument to zero, but no further. The Company has the option to pay the convertible notes at a premium ranging from
0% to 140% within the first six (6) months before they become convertible. The discount relating to the initial recording of the
original issue discounts, issue costs, warrants and beneficial conversion feature are accreted, together with the premium, over
the estimated term of the debt, which is generally 180 days from the date of issuance. We initially accounted for the embedded
conversion feature in the FirstFire convertible note (see Note 5) in equity since management fully expected, at the time the loan
was made, to repay the note upon its scheduled maturity.
Many
of the conversion features embedded in the Company’s notes become variable upon the event of default or upon the passage
of time in the event the Company does not repay the notes, at a premium, at 180 days from issuance of the note. If the conversion
price is adjusted based on a discount to the market price of the Company’s common stock, the number of shares upon conversion
is potentially unlimited. In the event we cannot control the net share settlement and cash settlement, we record the embedded
conversion feature as a derivate instrument, at fair value. The excess of fair value of the embedded conversion feature, together
with the original issue discounts, warrants, and issue costs over the face value of the debt, is recorded as an immediate charge
in the accompanying statements of operations and cash flows. Each reporting period, the Company will compute the estimated fair
value of derivatives and record changes to operations. The discounts are accreted over the term of the debt, which is generally
nine months after the notes become convertible, using the effective interest method. We accounted for the embedded conversion
features in the FirstFire and Peak One convertible notes (see Note 5) as derivative liabilities in December 2017, even though
we fully expect to repay the notes upon their scheduled maturity, because we have lost control of that ability as a result of
the issuance of the Peak One note, and the financial burden these notes have placed on the Company. We continue to believe we
will repay these notes before they become convertible after 180 days.
ASC
470-50,
Extinguishments
, require entities to record an extinguishment when the terms of the original note are significantly
modified, defined as a greater than 10% change in expected cash flows. As a result of modifications made to one of the Company’s
convertible notes during the reporting period, we recorded a loss as reported in the accompanying statements of operations and
cash flows.
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 December 31, 2017 and September
30, 2017, the Company had 10,000,000 shares of preferred stock outstanding, which are convertible into 15,000,000 shares of common
stock. The Company’s convertible notes are not yet convertible, and management expects to repay the notes.
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.
Research
and Development and Software Development Costs
Capitalization
of certain software development costs are recorded after the determination of technological feasibility. Based on our product
development process, technological feasibility is determined upon the completion of a working model. To date, costs incurred by
us from the completion of the working model to the point at which the product is ready for general release do not have technological
feasibility. Accordingly, we have charged all such costs to research and development expense in the period incurred. Our research
and development costs for the three months ended December 31, 2017 and 2016 were $114,852 and $599,959, respectively.
Recent
Accounting Announcements
The
Financial Accounting Standards Board (“FASB”) issues Accounting Standards Updates (“ASU”) to amend the
authoritative literature in the Accounting Standards Codification (“ASC”). There have been a number of ASUs to date
that amend the original text of the ASC. The Company believes those updates 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.
NOTE
5 – CONVERTIBLE NOTE PAYABLE
FirstFire
Global Opportunities Fund, LLC
On
September 26, 2017, the Company issued a convertible note to FirstFire Global Opportunities Fund, LLC (“FirstFire”)
with a principal amount of $330,000, which includes an original issue discount of $30,000. The Company incurred $8,500 in direct
costs. The note accrues interest at 5% per annum and matures on March 26, 2018, six months following the issuance date. The
note was convertible at $2.00 per share, subject to adjustment. The Company 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 to $1.00 per share, subject to adjustment, reduced
the exercise price of the warrants from $4.50 to $2.00 and required the Company to issue an additional 87,500 shares of common
stock to FirstFire, which resulted in an extinguishment loss (see below).
The
note, as amended, provides the holder with the right, at any time on or after the note’s maturity date, to convert all or
a portion of the outstanding principal balance and accrued interest to shares of the Company’s common stock at a conversion
price of $1.00 per share, subject to certain adjustments to the conversion price under certain circumstances. In the event of
default, the conversion price shall equal the lower of $1.00 per share or 70% multiplied by the lowest bid price of the Company’s
common stock during the 25 trading days preceding the conversion date. An event of default, among other events, is the non-payment
of the note at maturity.
If
shares of the Company’s common stock trade below $1.00 per share on the day following the conversion date, the conversion
price shall be retroactively adjusted to equal 75% multiplied by the lowest traded price on the day following the conversion date.
If the Company consummates a registered or unregistered primary offering of its securities for capital raising purposes, the holder
of the note shall have the right to demand repayment in full or convert the outstanding principal balance and accrued interest
into shares of the Company’s common stock at the lower of $1.00 per share or a 20% discount to the offering price to investors
in the primary offering.
The
Company accounted for the amendment of the FirstFire note using derivative accounting and recognized a loss on
extinguishment of $358,038 during the three months ended December 31, 2017. The Company also recognized a derivative
liability of $320,312 as of the note’s amendment date. The Company valued the derivative liability with the
Black-Scholes 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%. On December 31, 2017, the Company recognized a loss of $48,911 related to the change in fair
value of the FirstFire derivative liability. The change in fair value was calculated using the stock price as of December 31,
2017 of $1.18 and an exercise price of $0.70, which is 70% multiplied by the lowest bid price of the Company’s common
stock during the preceding 25 trading days, per the terms of the note.
Upon
amendment of the FirstFire note, the Company recorded a debt discount of $330,000. The Company amortized $37,813 of the debt discount
to interest expense during the three months ending December 31, 2017. The remaining debt discount of $292,187 as of December 31,
2017 will be amortized to interest expense over the remaining term of the note. Total interest expense related to the FirstFire
note, including the debt discount amortization prior to the amendment, was $178,700 for the three months ending December 31, 2017.
Peak
One Opportunity Fund LP
On
December 14, 2017, the Company issued a convertible note to Peak One Opportunity Fund LP (“Peak One”) with a principal
amount of $300,000, which includes an original issue discount of $30,000. The Company incurred $27,400 in direct costs. The note
matures three years from the issuance date and provides the holder with the right to convert all or a portion of the outstanding
principal balance to shares of the Company’s common stock at a conversion price of $1.00 per share, subject to certain adjustments
to the conversion price under certain circumstances. If an event of default has occurred or if the conversion occurs more than
180 days from the issuance date, the conversion price shall equal the lower $1.00 per share or 70% of the lowest traded price
of the Company’s common stock during the 20 trading days preceding the conversion date. However, if the Company’s
common stock is not eligible for clearing through the Depository Trust Company’s Deposit Withdrawal Agent Commission system
on the conversion date, the conversion price shall equal the lower of $1.00 per share or 65% of the lowest traded price of the
Company’s common stock during the 20 trading days preceding the conversion date.
Together
with the convertible note, 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. The Company accounted for the convertible note to
Peak One using derivative accounting and recognized a derivative liability of $267,750 as of the note’s issuance date. The
Company valued the derivative liability with the Black-Scholes 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 derivative in the convertible note and of the equity instruments issued with the convertible note.
On December 31, 2017, the Company recognized a loss of $87,021 related to the change in fair value of the Peak One derivative
liability. The change in fair value was calculated using the stock price as of December 31, 2017 of $1.18 and an exercise price
of $0.70, which is 70% multiplied by the lowest bid price of the Company’s common stock during the preceding 25 trading
days, per the terms of the note.
The
Company recorded a debt discount of $300,000 upon issuance of the Peak One note. The Company amortized $4,645 of the debt discount
to interest expense during the three months ending December 31, 2017. The remaining debt discount of $295,355 as of December 31,
2017 will be amortized to interest expense over the remaining term of the note. The Peak One note was included in current liabilities
as management intends to repay the loan within the next 12 months.
Additionally,
the transaction with Peak One included a stock purchase agreement setting forth the details above, including the option for an
additional convertible note in the amount of $300,000 and an equity purchase agreement for up to $7,000,000 of the Company’s
common stock and related registration rights agreement, which will require a registration statement to be filed.
NOTE
6 - COMMITMENTS AND CONTINGENCIES
Terminated
Employment Agreement with Former Chief Financial Officer
The
Company previously had an employment agreement with its Chief Financial Officer, which terminated in 2015. There were amounts
that were accrued and unpaid as of December 31, 2017 and September 30, 2017, totaling $351,128 and $338,437, respectively. According
to the original agreement, the unpaid salaries were to accrue interest at each reporting date. Interest expense related to this
matter was $12,691 and $10,939 during the three months ended December 31, 2017 and 2016, respectively. Management believes that
such amounts were previously satisfied through the issuance of common stock and does not intend to pay such amounts.
NOTE
7 - STOCKHOLDERS’ DEFICIT
As
of December 31, 2017, the Company was authorized to issue 650,000,000 common shares and 10,000,000 preferred shares at a par value
of $0.01.
Common
Stock
Management
determines the fair value of stock issuances using the closing stock price on the grant date.
During
the three months ended December 31, 2017, there were 37,000 shares of common stock sold for $57,200, net of $16,800 in offering
costs.
During
the three months ended December 31, 2017, the Company issued 5,537 shares of common stock with a fair value of $10,000 to its
employees as part of their compensation.
Preferred
Stock
The
Company’s Series A Preferred Stock is convertible into the Company’s common stock at a rate of 1 to 1.5 common shares.
As of December 31, 2017, there are a total of 10,000,000 shares of the Series A Preferred Stock authorized and outstanding which
are convertible into a total of 15,000,000 shares of common stock. Each share of the Preferred Stock has 150 votes on all matters
presented to be voted by the holders of common stock. The holders of the Series A Preferred Stock can only convert the shares
if agreed upon by 50.1% vote of all preferred shareholders.
NOTE
8 – SUBSEQUENT EVENTS
On
January 22, 2018, the Board of Directors authorized Michael De La Garza, Chief Executive Officer of the Company, to convert his
9,000,000 preferred shares, at a conversion rate of 1 to 1.5 common shares, to 13,500,000 common shares, restricted pursuant to
Rule 144. On February 15, 2018, Michael De La Garza converted his 9,000,000 preferred shares to 13,500,000 common shares.