NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NINE MONTHS ENDED SEPTEMBER 30, 2018 AND 2017
(UNAUDITED)
1.
BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of Cynergistek, Inc. and its subsidiaries (the “Company”, “we”, “us” or “Cynergistek”) have been prepared in accordance with generally accepted accounting principles of the United States of America (“GAAP”) for interim financial statements pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, these financial statements do not include all of the information and notes required by GAAP for complete financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2017, as filed with the Securities and Exchange Commission (“SEC”) on March 28, 2018.
The unaudited condensed consolidated financial statements included herein reflect all adjustments (which include only normal, recurring adjustments) that are, in the opinion of management, necessary to state fairly our financial position and results of operations as of and for the periods presented. The results for such periods are not necessarily indicative of the results to be expected for the full year.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. As a result, actual results could differ from those estimates.
The accompanying unaudited condensed consolidated financial statements include the accounts of Cynergistek and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated.
Based on the Company’s recent integration with CTEK Security and an analysis of how our Chief Operating Decision Maker reviews, manages and is compensated, we have determined that the Company operates in two segments, services and equipment & software resale. The equipment & software resale operating segment is not reported separately in the accompanying condensed consolidated financial statements, as this segment did not meet the quantitative thresholds established in ASC 280-10-50-12. For the periods presented, all revenues were derived from domestic operations.
We have performed an evaluation of subsequent events through the date of filing these unaudited condensed consolidated financial statements with the SEC.
2
.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In May 2014, the FASB issued guidance which provides a single, comprehensive accounting model for revenue arising from contracts with customers (“Topic 606”). This guidance supersedes most of the existing revenue recognition guidance, including industry-specific guidance. Under this model, revenue is recognized at an amount that a company expects to be entitled to upon transferring control of goods or services to a customer, as opposed to when risks and rewards transfer to a customer. The new guidance also requires additional disclosures about the nature, timing and uncertainty of revenue and cash flow arising from customer contracts, including significant judgments and changes in judgments. We adopted this standard beginning January 1, 2018 and are using the modified retrospective method of adoption. Under the new guidance, based on the nature of our contracts, we will continue to recognize revenue in a similar manner as with the current guidance. Additionally, the unit of accounting, that is, the identification of performance obligations, is consistent with current revenue guidance. Accordingly, the adoption of this standard did not significantly impact our revenues. The additional disclosures required by Topic 606 are presented in Notes 3, 7, 9 and 10.
In February 2016, the FASB issued a new accounting standard on leasing. The new standard will require companies to record most leased assets and liabilities on the balance sheet, and also proposes a dual model for recognizing
9
expense. This guidance will be effective in the first quarter of 2019 with early adoption permitted. We have evaluated the impact of adopting this guidance and we are preparing for the changes to be made to our consolidated financial statements. We expect the adoption of these accounting changes will materially increase our assets and liabilities but will not have a material impact on our net income or equity.
In January 2017, the FASB issued a new accounting standard simplifying the test for goodwill impairment. Currently, the fair value of the reporting unit is compared with the carrying value of the reporting unit (identified as “Step 1”). If the fair value of the reporting unit is lower than its carrying amount, then the implied fair value of goodwill is calculated. If the implied fair value of goodwill is lower than the carrying value of goodwill an impairment is recognized (identified as “Step 2”). The new standard eliminates Step 2 from the impairment test; therefore, goodwill impairment will be recognized as the difference between the fair value and the carrying value. The new standard becomes effective on January 1, 2020 with early adoption permitted. We are currently evaluating the impact that the new standard will have on our financial position, results of operations and cash flows.
In August 2016, the FASB issued a new accounting standard which is intended to reduce the existing diversity in practice in how certain cash receipts and cash payments are classified in the statement of cash flows. This guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years with early adoption permitted, provided that all of the amendments are adopted in the same period. We are currently evaluating the impact of adopting this standard on our consolidated financial statements.
In January 2017, the FASB issued a new accounting standard which clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions or disposals of assets or businesses. This guidance will be effective for the Company for the year ending December 31, 2019 and interim reporting periods within that year. Early adoption is permitted for transactions that have not been reported in financial statements that have been issued or made available for issuance. We are currently evaluating the effect of the adoption of this guidance on our consolidated financial statements.
In May 2017, the FASB issued new accounting standard which provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in ASC Topic 718. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. This guidance will be effective for the year ending December 31, 2019 and interim reporting periods within that year. Early adoption is permitted. We expect the adoption of this guidance will not have a material effect on our consolidated financial statements or footnotes.
3.
REVENUES
On January 1, 2018, we adopted Topic 606 using a modified retrospective method applied to those customer contracts which were not completed as of January 1, 2018. There was no change in revenues reported using this method as compared to the previous guidance. Below is a summary of our revenues disaggregated by revenue source.
|
Three Months Ended September 30,
|
Nine Months Ended September 30,
|
|
2018
|
2017
|
2018
|
2017
|
Managed services
|
$
13,594,227
|
$
15,175,852
|
$
40,155,977
|
$
45,530,347
|
Consulting & professional services
|
2,911,982
|
1,931,169
|
6,708,121
|
4,837,297
|
Office equipment, hardware & software resales
|
2,709,857
|
790,055
|
5,672,219
|
2,583,034
|
Net revenues
|
$
19,216,066
|
$
17,897,076
|
$
52,536,317
|
$
52,950,678
|
10
4.
OPTIONS, WARRANTS AND RESTRICTED STOCK UNITS
Below is a summary of stock option, warrant and restricted stock activity during the nine-month period ended September 30, 2018:
Options
|
Shares
|
Weighted Average Exercise Price
|
Weighted Average Remaining Term in Years
|
Aggregate
Intrinsic Value
|
Outstanding at December 31, 2017
|
724,400
|
$
3.09
|
|
|
Granted
|
-
|
-
|
|
|
Exercised
|
(40,105)
|
2.74
|
|
|
Cancelled
|
(105,756)
|
3.88
|
|
|
Outstanding at September 30, 2018
|
578,539
|
$
2.97
|
3.82
|
$
520,796
|
Exercisable at September 30, 2018
|
543,423
|
$
2.97
|
3.82
|
$
488,666
|
Warrants
|
Shares
|
Weighted Average Exercise Price
|
Weighted Average Remaining Term in Years
|
Aggregate
Intrinsic Value
|
Outstanding at December 31, 2017
|
77,779
|
$
3.03
|
|
|
Granted
|
-
|
-
|
|
|
Exercised
|
-
|
-
|
|
|
Cancelled
|
-
|
-
|
|
|
Outstanding at September 30, 2018
|
77,779
|
$
3.03
|
4.55
|
$
63,779
|
Exercisable at September 30, 2018
|
77,779
|
$
3.03
|
4.55
|
$
63,779
|
Restricted Stock Units
|
Shares
|
Weighted Average Price
|
Weighted Average Remaining Term in Years
|
Outstanding at December 31, 2017
|
506,500
|
$
3.35
|
|
Granted
|
-
|
-
|
|
Exercised
|
-
|
-
|
|
Cancelled
|
(65,500)
|
3.68
|
|
Outstanding at September 30, 2018
|
441,000
|
$
3.30
|
1.75
|
For the three and nine months ended September 30, 2018 and 2017, stock-based compensation expense recognized in the consolidated statements of operations as follows:
|
Three Months Ended September 30,
|
Nine Months Ended September 30,
|
|
2018
|
2017
|
2018
|
2017
|
Cost of revenues
|
$ 21,148
|
$ 5,585
|
$ 82,173
|
$ 32,509
|
Sales and marketing
|
42,625
|
51,000
|
87,875
|
95,602
|
General and administrative
|
97,492
|
13,287
|
293,350
|
45,209
|
Total stock-based compensation expense
|
$ 161,264
|
$ 69,872
|
$ 463,398
|
$ 173,320
|
11
5.
NET INCOME PER SHARE
Basic net income per share is calculated using the weighted average number of shares of our common stock issued and outstanding during a certain period and is calculated by dividing net income by the weighted average number of shares of our common stock issued and outstanding during such period. Diluted net income per share is calculated using the weighted average number of common and potentially dilutive common shares outstanding during the period, using the as-if-converted method for secured convertible notes, and the treasury stock method for options and warrants. Diluted net income per share does not include potentially dilutive securities because such inclusion in the computation would be anti-dilutive.
For the three months ended September 30, 2018, potentially dilutive securities consisted of options and warrants to purchase 656,318 shares of common stock at prices ranging from $0.90 to $6.45 per share and 441,000 shares of restricted stock units. Of these potentially dilutive securities, only 146,237 of the shares to purchase common stock from the options and warrants and none of the shares related to the restricted stock units are included in the computation of diluted earnings per share because the effect of including these instruments would be anti-dilutive.
For the nine months ended September 30, 2018, potentially dilutive securities consisted of options and warrants to purchase 656,318 shares of common stock at prices ranging from $0.90 to $6.45 per share and 441,000 shares of restricted stock units. Of these potentially dilutive securities, only 207,562 of the shares to purchase common stock from the options and warrants and none of the shares related to the restricted stock units are included in the computation of diluted earnings per share because the effect of including these instruments would be anti-dilutive.
For the three months ended September 30, 2017, potentially dilutive securities consisted of options and warrants to purchase 1,416,747 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, 379,476 of the shares to purchase common stock from the options and warrants are included in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.
For the nine months ended September 30, 2017, potentially dilutive securities consisted of options and warrants to purchase 1,416,747 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, 448,164 of the shares of common stock underlying the options and warrants are included in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.
|
Three Months Ended September 30,
|
Nine Months Ended September 30,
|
|
2018
|
2017
|
2018
|
2017
|
Numerator:
|
|
|
|
|
Net income
|
$
1,154,126
|
$
1,089,661
|
$
567,916
|
$
1,170,133
|
|
|
|
|
|
Denominator:
|
|
|
|
|
Denominator for basic calculation weighted average shares
|
9,616,133
|
9,501,760
|
9,605,536
|
9,387,264
|
Dilutive common stock equivalents:
|
|
|
|
|
Options and warrants
|
146,237
|
379,476
|
207,562
|
448,164
|
|
|
|
|
|
Denominator for diluted calculation weighted average shares
|
9,762,370
|
9,881,236
|
9,813,098
|
9,835,428
|
|
|
|
|
|
Net income per share:
|
|
|
|
|
Basic net income per share
|
$
0.12
|
$
0.11
|
$
0.06
|
$
0.12
|
Diluted net income per share
|
$
0.12
|
$
0.11
|
$
0.06
|
$
0.12
|
12
6.
ACCOUNTS RECEIVABLE
A summary of accounts receivable is as follows:
|
September 30, 2018
|
December 31, 2017
|
Trade receivables
|
$
11,051,436
|
$
14,451,899
|
Unbilled revenue, net and unapplied advances
|
(1,662,029)
|
(1,081,525)
|
Allowance for doubtful accounts
|
-
|
(106,551)
|
Total accounts receivable, net
|
$
9,389,407
|
$
13,264,323
|
7.
DEFERRED COMMISSIONS
Our incremental costs of obtaining a contract, which consist of sales commissions on multi-year contracts, are deferred and amortized over the period of contract performance. Effective January 1, 2018, when we adopted the modified retrospective method of the new revenue recognition pronouncement, we increased deferred commissions by $879,666 with a corresponding increase in beginning retained earnings. Deferred commissions are included in prepaid and other current assets in our consolidated balance sheets. As of September 30, 2018, we had $1,016,751 related to unamortized deferred commissions. We had $211,920 and $633,060 of commissions expense for the three and nine months ended September 30, 2018, respectively. Commissions expense for the three and nine months ended September 30, 2017 were $232,968 and $611,059, respectively. If we had recognized commissions expense under the full retrospective approach, commission expense would have been $171,611 and $507,799, respectively, for the three and nine months ended September 30, 2017.
8.
INTANGIBLE ASSETS
Intangible assets are amortized over expected useful lives ranging from 1.5 to 10 years and consist of the following:
|
September 30, 2018
|
December 31, 2017
|
|
Gross
Carrying
Amount
|
Accumulated
Amortization
|
Accumulated
Impairment
|
Gross
Carrying
Amount
|
Accumulated
Amortization
|
Accumulated
Impairment
|
Delphiis, Inc.
|
|
|
|
|
|
|
Acquired technology
|
$
900,000
|
$
(254,754)
|
$
(547,484)
|
$
900,000
|
$
(242,002)
|
$
(547,484)
|
Customer relationships
|
400,000
|
(233,257)
|
(166,743)
|
400,000
|
(233,257)
|
(166,743)
|
Trademarks
|
50,000
|
(50,000)
|
-
|
50,000
|
(50,000)
|
-
|
Non-compete agreements
|
20,000
|
(17,292)
|
(2,708)
|
20,000
|
(17,292)
|
(2,708)
|
Total Delphiis, Inc.
|
$
1,370,000
|
$
(555,303)
|
$
(716,935)
|
$
1,370,000
|
$
(542,551)
|
$
(716,935)
|
|
|
|
|
|
|
|
Redspin
|
|
|
|
|
|
|
Acquired technology
|
$
1,050,000
|
$
(297,095)
|
$
(331,908)
|
$
1,050,000
|
$
(248,519)
|
$
(331,908)
|
Customer relationships
|
600,000
|
(550,000)
|
(50,000)
|
600,000
|
(550,000)
|
(50,000)
|
Trademarks
|
200,000
|
(93,978)
|
(106,022)
|
200,000
|
(93,978)
|
(106,022)
|
Non-compete agreements
|
100,000
|
(46,951)
|
(53,049)
|
100,000
|
(46,951)
|
(53,049)
|
Total Redspin
|
$
1,950,000
|
$
(988,024)
|
$
(540,979)
|
$
1,950,000
|
$
(939,448)
|
$
(540,979)
|
|
|
|
|
|
|
|
CTEK Security, Inc.
|
|
|
|
|
|
|
Acquired technology
|
$
8,150,000
|
$
(1,426,250)
|
$
-
|
$
8,150,000
|
$
(815,000)
|
$
-
|
Customer relationships
|
2,150,000
|
(940,625)
|
-
|
2,150,000
|
(537,500)
|
-
|
Trademarks
|
1,550,000
|
(542,500)
|
-
|
1,550,000
|
(310,000)
|
-
|
Non-compete agreements
|
200,000
|
(116,662)
|
-
|
200,000
|
(66,663)
|
-
|
Total CTEK Security, Inc.
|
$
12,050,000
|
$
(3,026,037)
|
$
-
|
$
12,050,000
|
$
(1,729,163)
|
$
-
|
|
|
|
|
|
|
|
Total intangible assets
|
$
15,370,000
|
$
(4,569,364)
|
$
(1,257,914)
|
$
15,370,000
|
$
(3,211,162)
|
$
(1,257,914)
|
13
9.
DEFERRED REVENUE
We record deferred revenues when amounts are billed to customers, or cash is received from customers, in advance of our performance. $578,725 and $932,994 of managed services revenues were recognized during the nine months ended September 30, 2018 and 2017, respectively, that was included in deferred revenue at the beginning of the respective periods. $523,505 and $250,766 of consulting and professional services revenues were recognized during the nine months ended September 30, 2018 and 2017, respectively, that was included in deferred revenue at the beginning of the respective periods.
10.
REMAINING PERFORMANCE OBLIGATIONS
Remaining performance obligations represent the amount of revenue from fixed-fee contracts, including those which have potential early cancellation provisions, for which work has not been performed. As of September 30, 2018, approximately $23,000,000 of revenue from fixed-fee contracts is expected to be recognized from these remaining performance obligations. We expect to recognize revenue on approximately 88% of these remaining performance obligations over the next 24 months, with the balance thereafter. We elected to utilize the practical expedient exemption to exclude from this disclosure the amount of revenue from contracts which are not fixed-fee and where we do not have the right to invoice until the services have been performed.
11.
LINE OF CREDIT AND TERM LOAN
On January 13, 2017, as part of the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.), we entered into an Amended and Restated Credit Agreement (the “A&R Credit Agreement”) with California Bank and Trust and Avidbank Corporate Finance, a Division of Avidbank (collectively the “Lenders”). The A&R Credit Agreement amended a loan and security agreement originally entered into on May 4, 2012, as amended by several amendments, between the Company and AvidBank Corporate Finance. Under the A&R Credit Agreement, the term of the revolving line-of-credit was available through January 13, 2019 at an interest rate of prime plus 1.0% per annum. The amount available to us at any given time was the lesser of (a) $5.0 million, or (b) the amount available under our borrowing base (80% of our eligible accounts receivable, minus (1) accrued client lease payables, and minus (2) accrued equipment pool liability). As of December 31, 2017, no amounts were outstanding under the line of credit. The A&R Credit Agreement provided a term loan facility for $14,000,000. As of December 31, 2017, outstanding borrowings under the term loan were $11,818,333 at an interest rate of 6.0%. We were in compliance with all covenants set forth in the A&R Credit Agreement as of December 31, 2017.
The foregoing descriptions of the A&R Credit Agreement is qualified in its entirety by reference to the actual terms and conditions of such agreement, which is found in our Form 8-K filed on January 17, 2017 as Exhibit 99.7 thereto.
Interest charges associated with borrowings on the line of credit for the three and nine months ended September 30, 2017 were $1,285 and $1,285, respectively. In addition, on January 13, 2017, we paid a $25,000 revolving loan commitment fee.
Interest charges associated with the term loans totaled $184,964 and $343,028, respectively, for the three and nine months ended September 30, 2017. In addition, on January 13, 2017, we paid a $70,000 term loan commitment fee.
Debt Restructuring
On March 12, 2018, we entered into a Credit Agreement (together with the other related documents defined therein, the “Credit Agreement”) with BMO Harris Bank N.A., a national banking association (“Bank”), as lender (the “BMO Loan”).
The purposes of the BMO Loan are (1) to refinance and replace the facilities under the A&R Credit Agreement, thus terminating that agreement as of March 12, 2018, (2) to refinance $2,250,000 of a promissory note held by Michael McMillan (the “McMillan Seller Note”), (3) to finance payments to Dr. Michael Hernandez (f/k/a Dr. Michael G.
14
Mathews), including the full repayment of a promissory note held by Hernandez (the “Hernandez Seller Note”; together with the McMillan Seller Note, the “Seller Notes”) in the original principal amount of $4,500,000, also issued as part of the Original SPA (as defined below), (4) to finance working capital, (5) for general corporate purposes and (6) to fund certain fees and expenses associated with the closing of the BMO Loan.
Loan Facilities
Term Loan: Pursuant to the Credit Agreement, the Bank agreed to provide a term loan in the amount of $17,250,000 to the Company, which was paid in accordance with the purpose of the BMO Loan as described above. Pursuant to the Credit Agreement, the Company may elect that the term loan be outstanding as Base Rate Loans or Eurodollar Loans. The term loan is payable in principal payment installments on the last day of each fiscal quarter, commencing on June 30, 2018. All principal and interest not sooner paid on the term loan shall be due and payable on September 12, 2022, the final maturity thereof. As of September 30, 2018, outstanding borrowings under the term loan were $16,017,857 at an interest rate of 5.64%.
Revolving Line of Credit: Additionally, pursuant to the Credit Agreement, the Bank agreed to provide a revolving loan or loans to the Company in an aggregate amount of up to $5,000,000 with a $500,000 sublimit for the issuance of letters of credit. Pursuant to the Credit Agreement, the Company may elect that each borrowing of revolving loans be either Base Rate Loans or Eurodollar Loans. Each revolving loan, both for principal and interest then outstanding, shall mature and be due and payable on March 12, 2020, or such earlier date on which the Revolving Credit Commitment (as defined in the Credit Agreement) is terminated in whole pursuant to the Credit Agreement.
Beginning June 30, 2018, we are required to maintain certain financial covenants in connection with the Credit Agreement, including a total leverage ratio, a senior leverage ratio, and a fixed charge coverage ratio. These covenants contain ratios which change over relevant periods of the Credit Agreement and can be found in Section 7.13 of the Credit Agreement. As of September 30, 2018, we were in compliance with all of the Credit Agreement’s financial covenants.
Interest Rates
Base rate loans (“Base Rate Loans”) bear interest at an annual rate equal to the base rate (defined as the highest of (a) the rate of interest quoted in The Wall Street Journal, Money Rates Section as the prime rate in effect on such day, with any change in the Base Rate resulting from a change in such prime rate to be effective as of the date of the relevant change in such prime rate, (b) the sum of (i) the rate determined by the Bank to be the average of the rates per annum quoted to the Bank by two or more Federal funds brokers selected by the Bank for sale to the Bank at face value of Federal funds in the secondary market in an amount equal or comparable to the principal amount for which such rate is being determined, plus (ii) 1/2 of 1%, and (c) the overnight LIBOR rate plus 1.0%) plus an applicable margin of between 1.50% and 2.50%, depending upon the Company’s leverage ratio.
Eurodollar loans (“Eurodollar Loans”) bear interest at a rate per annum equal to the sum of the Adjusted LIBOR rate (defined as the quotient obtained by dividing (a) the LIBOR index rate by (b) the maximum reserve percentage, expressed as a decimal, at which reserves are imposed by the Board of Governors of the Federal Reserve System (or any successor) on “eurocurrency liabilities,” as defined in such Board’s Regulation D (or any successor thereto), subject to any amendments of such reserve requirement by such Board or its successor, taking into account any transitional adjustments thereto) plus an applicable margin of between 2.50% and 3.50%, depending upon the Company’s leverage ratio.
There were no borrowings on the BMO line of credit for the nine months ended September 30, 2018. During the nine months ended September 30, 2018, we paid $37,638 in revolving loan commitment fees associated with the line of credit.
Interest charges associated with the BMO term loan totaled $234,989 and $521,785 for the three and nine months ended September 30, 2018. In addition, in March 2018, we paid a $86,250 commitment fee associated with the term loan.
15
Acceleration
Pursuant to the Credit Agreement, the Bank may, by written notice to the Company, declare the principal of and the accrued interest on all outstanding loans to be forthwith due and payable upon the occurrence of certain Events of Default. The Credit Agreement defines Events of Default to include, inter alia, (i) a default in payment when due of all or any part of any obligation payable by the Company under the BMO Loan, (ii) a default in the observance or performance of certain of the covenants set forth in the BMO Loan, (iii) any representation or warranty made in connection with the BMO Loan proves untrue in any respect (or in any material respect if such representation, warranty, certification or statement is not by its terms already qualified as to materiality), (iv) default on any subordinated debt, (v) any judgment or judgments, writ or writs or warrant or warrants of attachment shall be entered or filed against the Company or any of its subsidiaries, or against any of its Property, in an aggregate amount in excess of $250,000 (except to the extent fully covered by insurance as to which the insurer has been notified of such judgment and has not denied coverage) which remains undischarged, unvacated, unbonded or unstayed for a period of 30 days, (vi) any change of control of the Company shall occur, and (vii) any other specified event of default.
Security Agreement
In connection with the Credit Agreement, the Company, including its subsidiaries as guarantors (“Guarantors”), and the Bank entered into a Pledge and Security Agreement (the “Security Agreement”), pursuant to which each of the Company and the Guarantors agreed to grant to the Bank a lien on and security interest in certain collateral to secure prompt payment and performance of the secured obligations under the Credit Agreement. Pursuant to the Security Agreement, the “Collateral” was defined as including, inter alia, any and all (all such terms as defined in the Security Agreement) of the Accounts, Chattel Paper, Instruments (including Promissory Notes), Documents, General Intangibles, Letter-of-Credit Rights, Supporting Obligations, Deposit Accounts, Pledged Collateral and other Investment Property (including all certificated and uncertificated Securities, Securities Accounts, Security Entitlements, Commodity Accounts, and Commodity Contracts), Goods, Fixtures, Inventory and Equipment, Commercial Tort Claims, and Rights to merchandise and other Goods, any Monies, personal property, and interests in personal property, in each case whether now existing or hereafter acquired or created, any money or other assets of any grantor that now or hereafter come into the possession, custody, or control of Bank and any Proceeds or products of any of the foregoing, or any portion thereof. In connection with the grant of the security interest in the Collateral, each of the Company and the Guarantors made standard representations and warranties relating to ownership of the collateral, location and control of the collateral, and certain rights to payment.
The foregoing summary of the Credit Agreement and related agreements is qualified in its entirety by reference to the full context of the agreements, which are found in our Current Report on Form 8-K filed with the SEC on March 12, 2018.
Separation Agreement and Mutual Release with Hernandez
On March 12, 2018, the Company, CTEK Security and Hernandez entered into a Separation Agreement and Mutual Release (the “Separation Agreement”).
Pursuant to the Separation Agreement, Hernandez’s employment with the Company as the Company’s Chief Operating Officer was terminated and the Company and Hernandez mutually agreed to release the other from any and all claims, disputes, demands, actions, liabilities, damages, suits (whether at law or in equity), promises, accounts, costs, expenses, setoffs, contributions, attorneys’ fees and/or causes of action of whatever kind or character, whether past, present, future, known or unknown, liquidated or unliquidated, accrued or unaccrued, from the beginning of time, or which may hereinafter accrue as a result of the discovery of new and/or additional facts, which such party has had, may now have, or might claim to have, arising out of the agreements between the parties or any transaction contemplated thereby, based upon the acts or omissions of the other party prior to the date of the Separation Agreement.
Further, pursuant to the Separation Agreement, in lieu of any earn-out payments (as described in the Original SPA (as defined below)) that could be earned by Hernandez under the Original SPA, the Company agreed to pay Hernandez the amount of $3,750,000 in the form of a promissory note (the “Earn-out Note”). The Earn-out Note
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provides for (i) a maturity date of March 12, 2023, at which all principal and accrued and unpaid interest is due, (ii) a simple interest rate of 5% per annum commencing on January 1, 2018, and compounding annually, and (iii) the right of the Company to prepay all or any portion of the Earn-out Note without premium or penalty. As a result, the Company recorded an additional accrual of $1,394,000 at December 31, 2017 related to the earn-out contingent liability.
Also pursuant to the Separation Agreement, the Company paid off the outstanding amount due under the Hernandez Seller Note and paid Hernandez a severance payment consisting of a $250,000 payment upon execution of the Separation Agreement and the delivery of a promissory note in the original principal amount of $343,750 (the “Severance Payment Note”). The Severance Payment Note bears interest at a rate of 5% per annum, compounds annually, allows for prepayment by the Company and matures on January 10, 2019, at which time all principal and accrued and unpaid interest is due.
Amounts due and owing under the Earn-out Note and Severance Payment Note are subordinate to the right of payment due under the BMO Loan pursuant to a Subordination Agreement among the Company, the Bank and Hernandez.
Amendment to CTEK Security, Inc. (formerly CynergisTek, Inc.) Stock Purchase Agreement; Amended and Restated Promissory Note
On March 12, 2018, the Company, CTEK Security and McMillan entered into an Amendment to Stock Purchase Agreement (“Amendment”). Pursuant to the Amendment, certain provisions of the Stock Purchase Agreement dated as of January 13, 2017 which memorialized the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.) (the “Original SPA”) related to the Earn-Out (as defined in the Original SPA and described in the Company’s Form 8-K dated January 13, 2017) were amended. The earn-out provisions were amended to remove all obligations to make earn-out payments to Hernandez. As to McMillan, the Amendment modified the maximum earn-out payment which could be earned by McMillan to $1,200,000, with a maximum of $400,000 per year based on revised performance metrics (rather than the benchmarks described in the Original SPA) during the 2018, 2019 and 2020 calendar years, as determined by the Company’s board of directors and/or a committee thereof.
On March 12, 2018, the Company repaid $2,250,000 plus accrued interest on the McMillan Seller Note. The Company and Mr. McMillan agreed to amend and restate the McMillan Seller Note pursuant to an Amended and Restated Promissory Note (the “A&R McMillan Seller Note”). The A&R McMillan Seller Note is in the principal amount of $2,250,000, bears interest at a rate of 8% per annum, provides for quarterly payments of principal and interest and matures on March 31, 2022. Amounts due and owing under the A&R McMillan Seller Note are subordinate to the right of payment due under the BMO Loan pursuant to a Subordination Agreement among the Company, the Bank and Mr. McMillan. Mr. McMillan is a director and the President and Chief Executive Officer of the Company.
12.
PROMISSORY NOTES
In connection with the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.) we issued two promissory notes totaling $9,000,000 to Michael Hernandez and Michael McMillan (the “Seller Notes”), with each of the Seller Notes having an initial principal amount of $4,500,000. These Seller Notes bear interest at 8% per annum, require quarterly interest-only payments during the first 12 months, quarterly payments of principal and interest during the last 24 months, using a 36-month amortization period commencing from that point, with a balloon payment due on the maturity date.
On March 12, 2018, the Company fully repaid the $4,500,000 plus accrued interest on the Hernandez Seller Note.
As part of the debt restructuring with BMO Harris Bank N.A. (Note 10), on March 12, 2018, the Company repaid $2,250,000 plus accrued interest on the McMillan Seller Note. The Company and Mr. McMillan agreed to amend and restate the McMillan Seller Note pursuant to the A&R McMillan Seller Note. The A&R McMillan Seller Note is in the principal amount of $2,250,000, bears interest at a rate of 8% per annum, provides for quarterly payments of principal and interest and matures on March 31, 2022. Accordingly, principal payments totaling $281,250 plus
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interest of $81,986 were made in 2018. Amounts due and owing under the A&R McMillan Seller Note are subordinate to the right of payment due under the BMO Loan pursuant to a Subordination Agreement among the Company, the Bank and Mr. McMillan.
The foregoing descriptions of the Seller Notes are qualified in their entirety by reference to such notes. The Seller Notes are found in our Form 8-K filed on January 17, 2017 as Exhibits 99.3 and 99.4. The foregoing descriptions of the A&R McMillan Seller Note are qualified in their entirety by reference such note, which is found in our Form 8-K filed on March 13, 2018 as Exhibit 10.5.
Interest charges associated with the Seller Notes totaled $41,610 and $234,986, respectively for the three and nine months ended September 30, 2018, and $179,507 and $331,397, respectively for the three months and nine months ended September 30, 2017.
Pursuant to the Separation Agreement (see Note 11), in lieu of any earn-out payments (as described in the Original SPA) that could be earned by Hernandez under the Original SPA, the Company agreed to pay Hernandez the amount of $3,750,000 in the form of a promissory note (the “Earn-out Note”). The Earn-out Note provides for (i) a maturity date of March 12, 2023, at which all principal and accrued and unpaid interest is due, (ii) a simple interest rate of 5% per annum commencing on January 1, 2018, and compounding annually, and (iii) the right of the Company to prepay all or any portion of the Earn-out Note without premium or penalty.
Interest charges associated with the Earn-out Note totaled $47,713 and $140,721, respectively, for the three and nine months ended September 30, 2018.
Pursuant to the Separation Agreement, the Company also issued a Severance Payment Note to Hernandez in the original principal amount of $343,750 (the “Severance Payment Note”). The Severance Payment Note bears interest at a rate of 5% per annum, compounds annually, allows for prepayment by the Company and matures on January 10, 2019, at which time all principal and accrued and unpaid interest is due.
Interest charges associated with the Severance Payment Note totaled $4,332 and $12,808, respectively for the three and nine months ended September 30, 2018.
Amounts due and owing under the Earn-out Note and Severance Payment Note are subordinate to the right of payment due under the BMO Loan pursuant to a Subordination Agreement among the Company, the Bank and Hernandez.
13.
EMPLOYMENT AGREEMENTS
Michael H. McMillan
In January 2017, we entered into an employment agreement with Michael H. McMillan (“McMillan”) (the “McMillan Employment Agreement”), pursuant to which we employed McMillan as President and Chief Strategy Officer of the Company. The initial term of the McMillan Employment Agreement is 36 months and will automatically renew for subsequent 12-month terms unless either party provides written notice to the other party of a desire to not renew the agreement.
Pursuant to the McMillan Employment Agreement, the Company has the right to terminate McMillan’s employment without cause at any time on thirty (30) days’ advance written notice to McMillan. Additionally, McMillan has the right to resign for “Good Reason” (as defined in the McMillan Employment Agreement) on thirty (30) days’ written notice. In the event of (i) such termination without cause, or (ii) McMillan’s inability to perform the essential functions of his position due to a mental or physical disability or his death, or (iii) McMillan’s resignation for Good Reason, McMillan is entitled to receive the base salary then in effect and full target annual bonus, prorated to the date of termination, and a “Severance Payment” equivalent to (a) payment of compensation for an additional twelve months, payable as a lump sum, and (b) the acceleration of all unvested stock options and warrants then held by McMillan, subject to certain conditions set forth in the McMillan Employment Agreement. If McMillan resigns for other than Good Reason, he will be entitled to receive the base salary for the thirty (30) day written notice period, but no other amounts. On October 2, 2017, the Board appointed McMillan as Chief Executive Officer and his base salary was increased to $325,000.
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In February 2018, the Company amended the McMillan Employment Agreement to extend the term thereof through December 31, 2020 and increased his base salary to $334,700 for 2018, $359,700 for 2019, and the 2020 base salary to be determined by the Board of Directors at the end of the 2019 calendar year. He will also be eligible for a bonus of up to $219,375 and $242,798 in 2018 and 2019, respectively, and his 2020 bonus will be up to 67.5% of his base salary. The foregoing summary of the McMillan Employment Agreement is qualified in its entirety by reference to the full context of the agreement, which is found as Exhibit 99.6 to our Current Report on Form 8-K filed with the SEC on January 17, 2017, and the amendment to the McMillan Employment Agreement, which is found as Exhibit 10.44 to our Annual Report on Form 10-K filed with the SEC on March 28, 2018.
Paul T. Anthony
Effective January 1, 2016, we entered into an employment agreement with Paul T. Anthony (the “Anthony Agreement”). The Anthony Agreement provides that Mr. Anthony will continue to serve as our Executive Vice President and CFO. The Anthony Agreement has a term of two years and provided for an annual base salary of $245,000. The Anthony Agreement will automatically renew for subsequent twelve (12) month terms unless either party provides advance written notice to the other that such party does not wish to renew the agreement for a subsequent twelve (12) months. Mr. Anthony also receives the customary employee benefits available to our employees. Mr. Anthony was also entitled to receive a bonus of up to $132,000 per year, the achievement of which is based on Company performance metrics. We may terminate Mr. Anthony’s employment under the Anthony Agreement without cause at any time on thirty (30) days advance written notice, at which time Mr. Anthony would receive severance pay for twelve months and be fully vested in all options and warrants granted to date. The foregoing summary of the Anthony Agreement is qualified in its entirety by reference to the full context of the employment agreement, which is found as Exhibit 10.32 to our Annual Report on Form 10-K filed with the SEC on March 30, 2016. In March 2017, the Board of Directors authorized an increase in Mr. Anthony’s base salary to $250,000 and increased his potential annual bonus amount to $150,000.
In February 2018, the Company amended the Anthony Agreement to extend the term thereof through December 31, 2020 and increased his base salary to $284,700 for 2018, and $309,700 for 2019, with the 2020 base salary to be determined by the Board of Directors at the end of the 2019 calendar year. He will also be eligible for a bonus of up to $185,625 and $209,047 in 2018 and 2019, respectively, and his 2020 bonus will be up to 67.5% of his base salary.The foregoing summary of the Anthony Agreement is qualified in its entirety by reference to the full context of the agreement, which is found as Exhibit 10.32 to our Annual Report on Form 10-K filed with the SEC on March 30, 2016, and the amendment to the Anthony Agreement, which is found as Exhibit 10.45 to our Annual Report on Form 10-K filed with the SEC on March 28, 2018.
14.
CONCENTRATIONS
Cash Concentrations
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
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Major Customers
Our two largest customers accounted for approximately 57% of our revenues for the nine months ended September 30, 2018 and our two largest customers accounted for approximately 44% of our revenues for the nine months ended September 30, 2017. Our largest customers had accounts receivable totaling approximately $4,100,000 and $5,600,000 as of September 30, 2018 and December 31, 2017, respectively.
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