NOTES
TO FINANCIAL STATEMENTS
FOR
THE THREE AND NINE MONTHS ENDED JUNE 30, 2018 AND 2017
(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, 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 and nine months ended June 30, 2018 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
- 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 June
30, 2018 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 June 30, 2018, $9,980,369
of the Company’s cash balance was uninsured, and at September 30, 2017, none of its cash balance was uninsured. The Company
has not experienced any losses in such accounts.
Risks
and Uncertainties
The
Company’s continued existence is dependent upon sufficient capital to explore potential strategic relationships, complete
development and marketing of the Company’s technologies, and operate the business. The Company raised $10,009,925 through
the issuance of investment units, each consisting of one share of common stock and one warrant to purchase one additional share
of common stock for $1.20 within five years (“Units”), during the nine months ended June 30, 2018, and it intends
to continue raising money through a private placement memorandum. Management used $725,000 of the proceeds from this financing
to repay its two convertible notes.
The
Company has yet to establish profitable operations and has an accumulated deficit at June 30, 2018 of $52,932,001. It also has
negative operating cash flows. These adverse conditions could affect the Company’s financial condition and its results of
operations if capital raised through equity and/or debt financing is not sufficient for the Company to achieve its objectives.
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 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.
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.
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.
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. Research
and development costs were $210,126 and $576,114 for the three and nine months ended June 30, 2018, respectively, and $198,004
and $954,499 for the three and nine months ended June 30, 2017, respectively.
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 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
4 – CONVERTIBLE NOTES 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 accrued interest at 5% per annum and was to mature 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.
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%.
During
the three and nine months ended June 30, 2018, the Company recognized a gain of $0 and $11,234, respectively, related to the change
in fair value of the FirstFire derivative liability. The Company valued the derivative liability with the Black-Scholes 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%.
Upon
amendment of the FirstFire note, the Company recorded a debt discount of $330,000. The Company amortized $0 and $312,813 of the
debt discount to interest expense during the three and nine months ended June 30, 2018, respectively. Total interest expense related
to the FirstFire note, including the debt discount amortization prior to the amendment, was $0 and $453,700 for the three and
nine months ended June 30, 2018, respectively.
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 derivative liability of $309,078
and the 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 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
was to mature 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.
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.
During
the three and nine months ended June 30, 2018, the Company recognized a loss of $1,794 and $19,770, respectively, related to the
change in fair value of the Peak One derivative liability. The Company valued the derivative liability with the Black-Scholes
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%.
The
Company recorded a debt discount of $300,000 upon issuance of the Peak One note. The Company amortized $8,197 and $37,432 of the
debt discount to interest expense during the three and nine months ended June 30, 2018, respectively.
On
April 30, 2018, the Company redeemed the Peak One note for $375,000 prior to the maturity date in accordance with the terms of
the note. The Company also 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
5 - COMMITMENTS AND CONTINGENCIES
Terminated
Employment Agreement with Former Chief Financial Officer
The
Company previously had an employment agreement with its Chief Financial Officer (“CFO”), which terminated in 2015.
There were amounts that were accrued and unpaid as of June 30, 2018 and September 30, 2017, totaling $376,512 and $338,437, respectively.
According to the original agreement, the unpaid salaries were to accrue interest at 15%, which has been accrued at each reporting
date. Related interest expense was $12,692 and $38,075 during the three and nine months ended June 30, 2018, respectively. Management
believes that such amounts were previously satisfied through the issuance of common stock and does not intend to pay such amounts.
Employment Agreement with Chief Executive
Officer
During the nine months ended June 30, 2018
and 2017, cash compensation to the Chief Executive Officer (“CEO”) amounted to $356,756 and $310,485, including benefits
and $60,000 bonuses, respectively.
During the nine months ended June 30, 2018
and 2017, stock-based compensation for the CEO amounted to $0 and $1,629,000, respectively.
Litigation
We
are currently not involved in any litigation that we believe could have a material adverse effect on our financial condition or
results of operations. A disgruntled former contracted consultant has brought an action in the Texas State court against the CEO
and the Company alleging fraud and misrepresentation pertaining to stock and payments, all of which have been paid, and all stock
has been delivered to him. He has also included a claim of partial ownership of some of the Company’s patent which is without
merit in that any interest he may have had has been assigned to the Company. The claim is frivolous and without merit. The case
is being vigorously defended on our behalf by our insurance carrier.
NOTE
6 - STOCKHOLDERS’ DEFICIT
As
of June 30, 2018, 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.
Under
the Company’s active Private Placement Memorandum, the Company issues Units, each consisting of one share of common stock
and one warrant to purchase one additional share of common stock for $1.20 within five years. Additionally, the Company pays a
12.5% commission to the Paulson Investment Company.
During
the three months ended June 30, 2018, there were 10,094,400 Units sold for $8,832,600, net of $1,261,800 in offering costs.
During the nine months ended June 30, 2018, there were 11,407,400 Units sold for $10,009,925, net of $1,469,475 in offering
costs. As of June 30, 2018, the Company had private placement deposits totaling $2,262,000, for which the related shares have
not yet been authorized. As such, this amount was included in common stock subscription deposit as of June 30, 2018. The related
offering costs of $282,750 were included in deferred offering costs as of June 30, 2018.
During
the three months ended June 30, 2018, the Company issued 24,697 shares of common stock with a fair value of $37,045 to its employees
as part of their compensation. During the nine months ended June 30, 2018, the Company issued 113,151 shares of common stock with
a fair value of $204,788 to its employees as part of their compensation.
During
the nine months ended June 30, 2018, the Company issued 50,000 shares of common stock with a fair value of $81,000
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.
During
the three months ended June 30, 2018, the Company issued 10,000 shares of common stock with a fair value of $15,000 to Magnolia
Investor Relations for services rendered.
Preferred
Stock
The
Company’s Series A 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 the Preferred Stock has 1.5 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 to by the Board of Directors.
As
of June 30, 2018 and September 30, 2017, the Company had 1,000,000 and 10,000,000 shares, respectively, of preferred stock outstanding,
which are convertible into common stock at a rate of 1 preferred share to 1.5 common shares. See Note 7 below.
NOTE
7 – RELATED PARTY TRANSACTIONS
In
February 2018, the Company’s Chief Executive Officer converted his 9,000,000 shares of preferred stock into 13,500,000
shares of common stock.
NOTE
8 – SUBSEQUENT EVENTS
Subsequent
to June 30, 2018, there were 5,924,600 Units sold for net proceeds of $5,466,775.
In
July 2018, the Company entered into a new lease agreement for office space in Scottsdale, Arizona. The lease has a term of three
years and monthly lease payments ranging from $1,608 to $1,705.
There
have been no other reportable events that have occurred after June 30, 2018.