Notes to Consolidated Financial Statements
Note 1: Nature of Operations
Castellum, Inc. (the “Company”) is focused on acquiring and growing technology companies in the areas of information technology, electronic warfare, information warfare and cybersecurity with businesses in the governmental and commercial markets. Services include intelligence analysis, software development, software engineering, program management, strategic planning, information assurance and cybersecurity and policy along with analysis support. These services, which largely focus on securing data and establishing related policies, are applicable to customers in the federal government, financial services, healthcare and other users of large data applications. The services can be delivered to legacy, customer owned networks or customers who rely upon cloud-based infrastructures. The Company has worked with multiple business brokers and contacts within their business network to identify potential acquisitions.
Bayberry Acquisition Corporation (“Bayberry”) was a wholly owned subsidiary of the Company. Jay Wright and Mark Fuller controlled and managed Bayberry and were named officers and directors of the Company upon the acquisition of Bayberry. The transaction was accounted for as a reverse merger. As a result, Bayberry was considered the accounting acquirer. On February 23, 2021, Bayberry was dissolved with the Nevada Secretary of State as there was no activity, and Bayberry was non-operational post-merger with Castellum.
Corvus Consulting, LLC (“Corvus”), acquired in November 2019, is a wholly owned subsidiary of the Company. Corvus provides scientific, engineering, technical, operational support, and training services to federal government and commercial clients. Corvus focuses on Cyberspace Operations, Electronic Warfare, Information Operations, Intelligence and Joint/Electromagnetic Spectrum Operations. The specialties of Corvus range from high-level policy development and Congressional liaison to requirements analysis, DOTMLPF-p development assistance and design services for hardware and software systems fulfilling the mission needs of the Department of Defense and Intelligence Communities.
The Company entered into a definitive merger agreement with Mainnerve Federal Services, Inc. dba MFSI Government Group, a Delaware corporation (“MFSI”), effective as of January 1, 2021. This acquisition closed on February 11, 2021. MFSI, a government contractor, has built strong relationships with numerous customers, in the software engineering and IT arena. MFSI provides services in data security and operations for Army, Navy and Intelligence Community clients, and currently works as a software engineering/development, database administration and data analytics subcontractor.
The Company acquired Merrison Technologies, LLC, a Virginia limited liability company (“Merrison”), on August 5, 2021. Merrison, is a government contractor with expertise in software engineering and IT in the classified arena.
Specialty Systems, Inc. (“SSI”) was acquired August 12, 2021. SSI is a New Jersey based government contractor that provides critical mission support to the Navy at Joint Base McGuire-Dix-Lakehurst in the areas of software engineering, cyber security, systems engineering, program support and network engineering.
The Company acquired the business assets that represented the Pax River from The Albers Group, LLC (“Pax River”) which closed on November 16, 2021 in an asset purchase for up to 550,000 shares of common stock and cash of $200,000 paid monthly over a 10-month period starting February 2022 upon the satisfaction of conditions in the acquisition agreement.
The Company acquired Lexington Solutions Group, LLC (“LSG”), on April 5, 2022. LSG is a government contractor with a wide range of national security, strategic communication, and management consulting services.
On July 19, 2021, the Company filed a Certificate of Amendment with the State of Nevada to change the par value of all common and preferred stock to all be $0.0001. All changes to the par value dollar amount for these classes of stock and adjustment to additional paid in capital have been made retroactively.
On October 13, 2022, the Company completed a $3,000,000 public offering, a 1-for-20 Reverse Stock Split of its common shares, and an uplisting to the NYSE American exchange. All share and per share figures related to the common stock have been retroactively adjusted in accordance with SEC Staff Accounting Bulletin (“SAB”) Topic 4C.
The unprecedented events related to COVID-19, the disease caused by the novel coronavirus (SARS-CoV-2), have had significant health, economic, and market impacts and may have short-term and long-term adverse effects on our business that we cannot predict as the global pandemic continues to evolve. The extent and effectiveness of responses by
governments and other organizations also cannot be predicted. Our ability to access the capital markets and maintain existing operations has not been significantly affected during the COVID-19 pandemic. Going forward any possible adverse effects on the business are uncertain given any possible limitations on available financing and how we conduct business with our customers and vendors.
Note 2: Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”).
Principles of Consolidation
The consolidated financial statements include the accounts of Castellum, Inc. and its subsidiaries, collectively referred to as “the Company”. All significant intercompany accounts and transactions have been eliminated in consolidation. Castellum, Inc. is a holding company that holds 100% of Corvus, MFSI, Merrison, SSI, and LSG.
The Company applies the guidance of Topic 805 Business Combinations of the Financial Accounting Standards Board Accounting Standards Codification (“ASC”).
The Company accounted for these acquisitions as business combinations and the difference between the consideration paid and the net assets acquired was first attributed to identified intangible assets and the remainder of the difference was applied to goodwill.
Reclassification
The Company has reclassified certain amounts in the 2020 financial statements to comply with the 2021 and 2022 presentation. These principally relate to classification of certain expenses and liabilities. The reclassifications had no impact on total net loss or net cash flows for the years ended December 31, 2022 or 2021.
Business Segments
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker (“CODM”) in deciding how to allocate resources and in assessing performance. The Company’s CODM, the Chief Executive Officer, reviews consolidated results of operations to make decisions. The Company maintains one operating and reportable segment, which is the delivery of products and services in the areas of information technology, electronic warfare, information warfare and cybersecurity in the governmental and commercial markets.
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and reported amounts of revenues and expenses during the reporting period. These estimates include, but are not limited to, management’s estimate of provisions required for uncollectible accounts receivable, the acquired value of the intangible assets, impaired value of intangible assets, liabilities to accrue, cost incurred in the satisfaction of performance obligations, fair value for consideration elements of business combinations, permanent and temporary differences related to income taxes and determination of the fair value of stock awards. Actual results could differ from those estimates.
Cash
Cash consists of cash and demand deposits with an original maturity of three months or less. The Company holds no cash equivalents as of December 31, 2022 and 2021, respectively. The Company maintains cash balances in excess of the FDIC insured limit at a single bank. The Company does not consider this risk to be material.
Fixed Assets and Long-Lived Assets, Including Intangible Assets and Goodwill
Fixed assets are stated at cost. Depreciation on fixed assets is computed using the straight-line method over the estimated useful lives of the assets, which range from three to fifteen years for all classes of fixed assets.
ASC 360 requires that long-lived assets and certain identifiable intangibles held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company has adopted Accounting Standard Update (“ASU”) 2017-04 Intangibles – Goodwill and Other (Topic 350), Simplifying the Test for Goodwill Impairment effective April 1, 2017.
The Company reviews recoverability of long-lived assets on a periodic basis whenever events and changes in circumstances have occurred which may indicate a possible impairment. The assessment for potential impairment is based primarily on the Company’s ability to recover the carrying value of its long-lived assets from expected future cash flows from its operations on an undiscounted basis. If such assets are determined to be impaired, the impairment recognized is the amount by which the carrying value of the assets exceeds the fair value of the assets.
Intangible assets with finite useful lives are stated at cost less accumulated amortization and impairment. Intangible assets capitalized as of December 31, 2022 represent the valuation of the Company’s customer relationships, trade names, backlog and non-compete agreements which were acquired in the acquisitions. These intangible assets are being amortized on either the straight-line basis over their estimated average useful lives (certain trademarks, tradenames, backlog and non-compete agreements) or are being amortized based on the present value of the future cash flows (customer relationships, certain tradenames, backlog and non-compete agreements). Amortization expense of the intangible assets runs through December 2035.
The Company assesses the impairment of identifiable intangibles whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors the Company considers to be important which could trigger an impairment review include the following:
1.Significant underperformance relative to expected historical or projected future operating results;
2.Significant changes in the manner of use of the acquired assets or the strategy for the overall business; and
3.Significant negative industry or economic trends.
When the Company determines that the carrying value of intangibles may not be recoverable based upon the existence of one or more of the above indicators of impairment and the carrying value of the asset cannot be recovered from projected undiscounted cash flows, the Company records an impairment charge. The Company measures any impairment based on undiscounted cash flows. Significant management judgment is required in determining whether an indicator of impairment exists and in projecting cash flows.
When the Company acquires a controlling financial interest through a business combination, the Company uses the acquisition method of accounting to allocate the purchase consideration to the assets acquired and liabilities assumed, which are recorded at fair value. Any excess of purchase consideration over the net fair value of the net assets acquired is recognized as goodwill.
Prior to 2022, the Company performed its annual goodwill and intangible asset impairment test at the end of the fourth quarter. In 2022, the Company changed the date of its annual goodwill and intangible asset impairment assessment to the first day of the fourth quarter. The Company believes this change does not represent a material change in method of applying an accounting principle. This voluntary change is preferable under the circumstances as it results in better alignment with the timing of the Company’s long-range planning and forecasting process and provides the Company with additional time to complete its annual goodwill impairment testing in advance of its year-end reporting. This change does not delay, accelerate, or avoid an impairment of goodwill.
In 2022, Management performed a qualitative analysis as of its annual measurement date, which included a quantitative market capitalization reconciliation. During the fourth quarter of 2022, due to the Company being in a net loss position, Management performed additional qualitative analysis, including a market capitalization reconciliation, to evaluate the performance of its reporting units. Management determined there were no indicators of impairment noted during the years ended December 31, 2022 and 2021.
Subsequent Events
Subsequent events were evaluated through March 15, 2023, the date the consolidated financial statements were issued.
Revenue Recognition
The Company accounts for revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers (“ASC 606”).
The Company accounts for a contract with a customer that is within the scope of this Topic only when the five steps of revenue recognition under ASC 606 are met.
The five core principles will be evaluated for each service provided by the Company and is further supported by applicable guidance in ASC 606 to support the Company’s recognition of revenue.
Revenue is derived primarily from services provided to the federal government. The Company enters into agreements with customers that create enforceable rights and obligations and for which it is probable that the Company will collect the consideration to which it will be entitled as services and solutions are transferred to the customer. The Company also evaluates whether two or more agreements should be accounted for as one single contract.
When determining the total transaction price, the Company identifies both fixed and variable consideration elements within the contract. The Company estimates variable consideration as the most likely amount to which the Company expects to be entitled limited to the extent that it is probable that a significant reversal will not occur in a subsequent period.
At contract inception, the Company determines whether the goods or services to be provided are to be accounted for as a single performance obligation or as multiple performance obligations. For most contracts, the customers require the Company to perform several tasks in providing an integrated output and, hence, each of these contracts are deemed as having only one performance obligation. When contracts are separated into multiple performance obligations, the Company allocates the total transaction price to each performance obligation based on the estimated relative standalone selling prices of the promised services underlying each performance obligation.
This evaluation requires professional judgment, and it may impact the timing and pattern of revenue recognition. If multiple performance obligations are identified, the Company generally uses the cost plus a margin approach to determine the relative standalone selling price of each performance obligation. The Company does not assess whether a contract contains a significant financing component if the Company expects, at contract inception, that the period between when payment by the client and the transfer of promised services to the client occur will be less than one year.
The Company currently generates its revenue from three different types of contractual arrangements: cost plus fixed fee (“CPFF”), firm-fixed-price contracts (“FFP”) and time-and-materials (“T&M”) contracts. The Company generally recognizes revenue over time as control is transferred to the customer, based on the extent of progress towards satisfaction of the performance obligation. The selection of the method used to measure progress requires judgment and is dependent on the contract type and the nature of the goods or services to be provided.
For CPFF contracts, the Company uses input progress measures to derive revenue based on hours worked on contract performance as follows: direct costs plus Defense Contract Audit Agency (“DCAA”) approved provisional burdens plus fee. The provisional indirect rates are adjusted and billed at actual at year end. Revenue from FFP contracts is generally recognized ratably over the contract term, using a time-based measure of progress, even if billing is based on other metrics or milestones, including specific deliverables. For T&M contracts, the Company uses input progress measures to estimate revenue earned based on hours worked on contract performance at negotiated billing rates, plus direct costs and indirect cost burdens associated with materials and the direct expenses incurred in performance of the contract.
These arrangements generally qualify for the “right-to-invoice” practical expedient where revenue is recognized in proportion to billable consideration. FFP Level-Of-Effort contracts are substantially similar to T&M contracts except that the Company is required to deliver a specified level of effort over a stated period. For these contracts, the Company estimates revenue earned using contract hours worked at negotiated bill rates as the Company delivers the contractually required workforce.
Revenue generated by Contract Support Service contracts is recognized over time as services are provided, based on the transfer of control. Revenue generated by FFP contracts is recognized over time as performance obligations are satisfied. Most contracts do not contain variable consideration and contract modifications are generally minimal. For these reasons, there is not a significant impact of electing these transition practical expedients.
Revenue generated from contracts with federal, state, and local governments is recorded over time, rather than at a point in time. Under the Contract Support Services contracts, the Company performs software design work as it is assigned by the customer, and bills the customer, generally semi-monthly, on either a CPFF or T&M basis, as labor hours are expended. Certain other government contracts for software development have specific deliverables and are structured as FFP contracts, which are generally billed as the performance obligations under the contract are met. Revenue recognition under FFP contracts require judgment to allocate the transaction price to the performance obligations. Contracts may have terms up to five years.
Contract accounting requires judgment relative to assessing risks and estimating contract revenue and costs and assumptions for schedule and technical issues. Due to the size and nature of contracts, estimates of revenue and costs are subject to a number of variables. For contract change orders, claims or similar items, judgment is required for estimating the amounts, assessing the potential for realization and determining whether realization is probable. Estimates of total contract revenue and costs are continuously monitored during the term of the contract and are subject to revision as the contract progresses. From time to time, facts develop that require revisions of revenue recognized or cost estimates. To the extent that a revised estimate affects the current or an earlier period, the cumulative effect of the revision is recognized in the period in which the facts requiring the revision become known.
The Company accounts for contract costs in accordance with ASC Topic 340-40, Contracts with Customers. The Company recognizes the cost of sales of a contract as expense when incurred or at the time a performance obligation is satisfied. The Company recognizes an asset from the costs to fulfill a contract only if the costs relate directly to a contract, the costs generate or enhance resources that will be used in satisfying a performance obligation in the future and the costs are expected to be recovered. The incremental costs of obtaining a contract are capitalized unless the costs would have been incurred regardless of whether the contract was obtained.
The following table disaggregates the Company’s revenue by contract type for the years ended December 31:
| | | | | | | | | | | | | | | | | |
| 2022 | | 2021 | | 2020 |
| Revenue: | | | | | |
| Time and material | $ | 25,302,224 | | | $ | 15,381,979 | | | $ | 10,419,729 | |
| Firm fixed price | 3,350,084 | | | 4,864,638 | | | 2,918,938 | |
| Cost plus fixed fee | 13,538,335 | | | 4,745,646 | | | — | |
| Other | — | | | 75,187 | | | — | |
| Total | $ | 42,190,643 | | | $ | 25,067,450 | | | $ | 13,338,667 | |
Contract Balances
Contract assets include unbilled amounts typically resulting from FFP contracts when the revenue recognized exceeds the amounts billed to the customer on uncompleted contracts. Contract liabilities consist of billings in excess of costs and estimated earnings on uncompleted contracts.
In accordance with industry practice, contract assets and liabilities related to costs and estimated earnings in excess of billings on uncompleted contracts, and billings in excess of costs and estimated earnings on uncompleted contracts, have been classified as current. The contract cycle for certain long-term contracts may extend beyond one year; thus, collection of the amounts related to these contracts may extend beyond one year.
Derivative Financial Instruments
Derivatives are recorded on the consolidated balance sheet at fair value. The conversion features of certain of the convertible instruments are embedded derivatives and are separately valued and accounted for on the consolidated balance sheet with changes in fair value recognized during the period of change as a separate component of other income/expense. Valuations derived from various models are subject to ongoing internal and external verification and review. The model used incorporates market-sourced inputs such as interest rates and stock price volatilities. Selection of these inputs involves management’s judgment and may impact net income (loss).
With the issuance of the July 2017 FASB ASU 2017-11, “Earnings Per Share (Topic 260) Distinguishing Liabilities from Equity (Topic 480) Derivatives and Hedging (Topic 815),” which addresses the complexity of accounting for certain financial instruments.
Under current GAAP, an equity-linked financial instrument that otherwise is not required to be classified as a liability under the guidance Topic 480 is evaluated under the guidance in Topic 815, Derivatives and Hedging, to determine whether it meets the definition of a derivative. If it meets that definition, the instrument (or embedded feature) is evaluated to determine whether it is indexed to an entity’s own stock as part of the analysis of whether it qualifies for a scope exception from derivative accounting.
Generally, for warrants and conversion options embedded in financial instruments that are deemed to have a debt host (assuming the underlying shares are readily convertible to cash or the contract provides for net settlement such that the embedded conversion option meets the definition of a derivative), a reporting entity is required to classify the freestanding financial instrument or the bifurcated conversion option as a liability, which the entity must measure at fair value initially and at each subsequent reporting date.
The amendments in this accounting standards update revise the guidance for instruments with embedded features in Subtopic 815-40, Derivatives and Hedging—Contracts in Entity’s Own Equity, which is considered in determining whether an equity-linked financial instrument qualifies for a scope exception from derivative accounting.
Accounts Receivable and Concentration of Credit Risk
An allowance is based on management’s estimate of the overall collectability of accounts receivable, considering historical losses. Based on these same factors, individual accounts are charged off against the allowance when management determines those individual accounts are uncollectible. Credit extended to customers is generally uncollateralized. Past-due status is based on contractual terms. The Company does not charge interest on accounts receivable; however, United States (“U.S.”) government agencies may pay interest on invoices outstanding more than 30 days. Interest income is recorded when received. As of December 31, 2022 and 2021, management did not consider an allowance necessary.
The Company’s customer base is concentrated with a relatively small number of customers. The Company does not generally require collateral or other security to support accounts receivable. To reduce credit risk, the Company performs ongoing credit evaluations on its customers’ financial condition. The Company establishes allowances for doubtful accounts based upon factors surrounding the credit risk of customers, historical trends and other information.
For the years ended December 31, 2022, 2021, and 2020, the Company had three customers represent 62%, 61%, and 81% of revenue earned, respectively. Any customer that represents 10% or greater of total revenue represents a risk. The Company also has four customers that represent 60% of the total accounts receivable as of December 31, 2022 and three customers that represented 78% of the total accounts receivable as of December 31, 2021 and 2020.
Accounting for Income Taxes
Income taxes are accounted for under the asset and liability method. We estimate our income taxes in each of the jurisdictions where the Company operates. This process involves estimating our current tax expense or benefit together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheets. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. When assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some or all of the deferred tax assets will not be realized. In making this assessment, we consider the availability of loss carryforwards, projected reversals of deferred tax liabilities, projected future taxable income, and ongoing prudent and feasible tax planning strategies.
We are subject to income taxes in the federal and state tax jurisdictions based upon our business operations in those jurisdictions. Significant judgment is required in evaluating uncertain tax positions. We record uncertain tax positions in accordance with ASC 740-10 on the basis of a two-step process whereby (1) we determine whether it is more likely than not that the tax positions will be sustained based on the technical merits of the position, and (2) with respect to those tax positions that meet the more-likely-than-not recognition threshold, we recognize the largest amount of tax benefit that is greater than 50% likely to be realized upon ultimate settlement with the related tax authority. Management evaluates its tax positions on a quarterly basis.
The Company files income tax returns in the U.S. federal tax jurisdiction and various state tax jurisdictions. The federal and state income tax returns of the Company are subject to examination by the Internal Revenue Service (“IRS”) and state taxing authorities, generally for three years after they were filed.
Share-Based Compensation
The Company follows ASC 718 Compensation – Stock Compensation and has adopted ASU 2017-09 Compensation – Stock Compensation (Topic 718) Scope of Modification Accounting. The Company calculates compensation expense for all awards granted, but not yet vested, based on the grant-date fair values. The Company recognizes these compensation costs, on a pro rata basis over the requisite service period of each vesting tranche of each award for service-based grants, and as the criteria is achieved for performance-based grants.
The Company adopted ASU 2016-09 Improvements to Employee Share-Based Payment Accounting. Cash paid when shares are directly withheld for tax withholding purposes is classified as a financing activity in the statement of cash flows.
Fair Value of Financial Instruments
ASC 825 Financial Instruments requires the Company to disclose estimated fair values for its financial instruments. Fair value estimates, methods, and assumptions are set forth below for the Company’s financial instruments: The carrying amount of cash, accounts receivable, prepaid and other current assets, accounts payable and accrued liabilities, approximate fair value because of the short-term maturity of those instruments. The fair value of debt reflects the price at which the debt instrument would transact between market participants, in an orderly transaction at the measurement date. The fair value of the equity consideration from business combinations are measured using the price of our common stock at the measurement date, along with applying an appropriate discount for lack of marketability. For contingent liabilities from business combinations, the fair value is measured on the acquisition date using an option pricing model. The Company does not utilize derivative instruments for hedging purposes.
Earnings (Loss) Per Share of Common Stock
Basic net income (loss) per common share is computed using the weighted average number of common shares outstanding, as well as a warrant to purchase 1,080,717 shares of common stock for a total aggregate exercise price of $1 granted in connection with the $5,600,000 note payable maturing September 30, 2024, as the cash consideration for the holder/grantee to receive common shares was determined to be nonsubstantive. Diluted earnings per share (“EPS”) include additional dilution from common stock equivalents, such as convertible notes, preferred stock, stock issuable pursuant to the exercise of stock options and all other warrants. Common stock equivalents are not included in the computation of diluted earnings per share when the Company reports a loss because to do so would be anti-dilutive for periods presented, so only the basic weighted average number of common shares are used in the computations. The Company subtracts dividends on preferred stock when calculating earnings (loss) per share.
Recent Accounting Pronouncements
The Company does not discuss recent pronouncements that are not anticipated to have an impact on or are unrelated to its financial condition, results of operations, cash flows or disclosures. There have been no recently issued accounting pronouncements as of December 31, 2022 that would materially impact the Company.
Note 3: Acquisitions
The Company has completed the following acquisitions to achieve its business purposes as discussed in Note 1. As the acquisitions made by the Company in 2022 and 2021 (MFSI, Merrison, SSI, and LSG) were of the common stock or membership interests of the companies, certain assets in some of the acquisitions (intangible assets and goodwill) are not considered deductible for tax purposes.
Mainnerve Federal Services, Inc.
The Company entered into a definitive merger agreement with MFSI, effective as of January 1, 2021. This acquisition closed on February 11, 2021. This acquisition was accounted for as a business combination whereby MFSI became a 100% owned subsidiary of the Company. The following represents the assets and liabilities acquired in this acquisition:
| | | | | |
| Cash | $ | 93,240 | |
| Accounts receivable | 33,540 | |
| Unbilled receivable | 45,316 | |
| Other assets | 329,509 | |
| Right of use asset – operating lease | 14,862 | |
| Customer relationships | 348,000 | |
| Non-compete agreement | 4,000 | |
| Goodwill | 685,072 | |
| Deferred tax liability | (97,419) | |
| Line of credit | (12,249) | |
| Lease liability – operating lease | (13,862) | |
| Accounts payable and accrued expenses | (47,572) | |
| Net assets acquired | $ | 1,382,437 | |
The consideration paid for the acquisition of MFSI was as follows:
The MFSI acquisition has been accounted for under the acquisition method of accounting. Under the acquisition method of accounting, the total acquisition consideration price was allocated to the assets acquired and liabilities assumed based on their preliminary estimated fair values. The fair value measurements utilize estimates based on key assumptions of the MFSI acquisition, and historical and current market data. The excess of the purchase price over the total of the estimated fair values assigned to tangible and identifiable intangible assets acquired and liabilities assumed is recognized as goodwill. In order to determine the fair values of tangible and intangible assets acquired and liabilities assumed for MFSI, the Company engaged a third-party independent valuation specialist. The Company had estimated the preliminary purchase price allocations based on historical inputs and data as of January 1, 2021. The Company had a valuation prepared by an independent consultant. Upon the finalization of the valuation of MFSI, the Company reclassified $352,000 from goodwill into other intangible assets. There were no transaction costs that were material to this transaction.
During the measurement period (which is the period required to obtain all necessary information that existed at the acquisition date, or to conclude that such information is unavailable, not to exceed one year), additional assets or liabilities may be recognized, or there could be changes to the amounts of assets or liabilities previously recognized on a preliminary basis, if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have resulted in the recognition of these assets or liabilities as of that date. The Company had reclassified a portion of the goodwill upon the finalization of an independent valuation report during the year ended December 31, 2021.
Merrison
The Company entered into a definitive merger agreement with Merrison, effective as of August 5, 2021. This acquisition was accounted for as a business combination whereby Merrison became a 100% owned subsidiary of the Company. The following represents the assets and liabilities acquired in this acquisition:
| | | | | |
| Cash | $ | 183,588 | |
| Accounts receivable and unbilled receivables | 391,049 | |
| Customer relationships | 322,000 | |
| Non-compete agreements | 7,000 | |
| Trademarks | 164,000 | |
| Backlog | 115,000 | |
| Goodwill | 780,730 | |
| Deferred tax liability | (243,730) | |
| Accounts payable and accrued expenses | (102,354) | |
| Net assets acquired | $ | 1,617,283 | |
The consideration paid for the acquisition of Merrison was as follows:
| | | | | |
| Common stock | $ | 1,595,000 | |
| Cash | 22,283 | |
| $ | 1,617,283 | |
The Merrison acquisition has been accounted for under the acquisition method of accounting. Under the acquisition method of accounting, the total acquisition consideration price was allocated to the assets acquired and liabilities assumed based on their preliminary estimated fair values. The fair value measurements utilize estimates based on key assumptions of the Merrison acquisition, and historical and current market data.
The excess of the purchase price over the total of the estimated fair values assigned to tangible and identifiable intangible assets acquired and liabilities assumed is recognized as goodwill. In order to determine the fair values of tangible and intangible assets acquired and liabilities assumed for Merrison, the Company engaged a third-party independent valuation specialist. The Company had estimated the preliminary purchase price allocations based on historical inputs and data as of August 5, 2021. Upon finalization of the valuation, the Company allocated $608,000 from goodwill to other intangible assets. There was a $105,000 adjustment in total purchase consideration upon finalization of the valuations that was applied to goodwill. There were no transaction costs that were material to this transaction. There were no additional adjustments made during the year ended December 31, 2022.
SSI
The Company entered into a definitive merger agreement with SSI, effective as of August 12, 2021. This acquisition was accounted for as a business combination whereby SSI became a 100% owned subsidiary of the Company. The following represents the assets and liabilities acquired in this acquisition:
| | | | | |
| Cash | $ | 998,935 | |
| Accounts receivable and unbilled receivables | 2,222,004 | |
| Prepaid expenses | 147,600 | |
| Other asset | 6,750 | |
| Furniture and equipment | 148,931 | |
| Right of use asset – operating lease | 169,063 | |
| Customer relationships | 3,102,000 | |
| Non-compete agreements | 65,000 | |
| Trademarks | 367,000 | |
| Backlog | 50,000 | |
| Goodwill | 8,461,150 | |
| Deferred tax liability | (880,150) | |
| Lease liability – operating lease | (167,333) | |
| Contract liability | (226,591) | |
| Accounts payable and accrued expenses | (1,134,509) | |
| Net assets acquired | $ | 13,329,850 | |
The consideration paid for the acquisition of SSI was as follows:
| | | | | |
| Common stock | $ | 7,872,850 | |
| Seller note | 400,000 | |
| Cash | 800,000 | |
| Contingent earnout | 257,000 | |
| Lender financing | 4,000,000 | |
| $ | 13,329,850 | |
The SSI acquisition has been accounted for under the acquisition method of accounting. Under the acquisition method of accounting, the total acquisition consideration price was allocated to the assets acquired and liabilities assumed based on their preliminary estimated fair values. The fair value measurements utilize estimates based on key assumptions of the SSI acquisition, and historical and current market data. The excess of the purchase price over the total of the estimated fair values assigned to tangible and identifiable intangible assets acquired and liabilities assumed is recognized as goodwill. In order to determine the fair values of tangible and intangible assets acquired and liabilities assumed for SSI, the Company engaged a third-party independent valuation specialist.
The Company had estimated the preliminary purchase price allocations based on historical inputs and data as of August 12, 2021. Upon finalization of the valuation, the Company allocated $3,584,000 from goodwill to other intangible assets. The Company paid $50,500 of SSI’s transaction costs. There was a $2,608,661 adjustment in total purchase consideration upon finalization of the valuations that was applied to goodwill.
During the measurement period, the Company reclassified a portion of the goodwill upon the finalization of an independent valuation report during the year ended December 31, 2021. There were no additional adjustments made during the year ended December 31, 2022.
Pax River
The Company entered into an acquisition agreement with The Albers Group, LLC, on October 22, 2021 which closed November 16, 2021 for certain assets represented by the Pax River business. This acquisition was accounted for as an asset purchase by the Company. The following represents the assets acquired in this acquisition:
| | | | | |
| Customer relationships (contracts) | $ | 2,400,000 | |
| |
| Net assets acquired | $ | 2,400,000 | |
The consideration paid for the acquisition of The Albers Group assets was as follows:
| | | | | |
| Common stock | $ | 1,925,000 | |
| Contingent consideration represented by obligation to issue shares (a) | 275,000 | |
| Cash (included in amounts due to seller as of December 31, 2021) | 200,000 | |
| $ | 2,400,000 | |
(a)It was determined that on March 31, 2022, that the requirements under section 1.5(b) of the acquisition agreement had not been achieved, and as a result the contingent consideration to issue the additional 68,750 common shares valued at $275,000 would not be issued. The Company adjusted the customer relationships by the $275,000 down to $2,125,000.
Lexington Solutions Group (“LSG”)
On April 15, 2022, the Company entered into Amendment No. 1 to Business Acquisition Agreement (“LSG Business Acquisition Agreement”) with LSG to acquire the assets of LSG. This LSG Business Acquisition Agreement superseded the Business Acquisition Agreement originally entered into on February 11, 2022. Under the terms of the LSG Business Acquisition Agreement, the Company acquired assets and assumed liabilities of LSG for consideration as follows: (a) 625,000 shares of common stock (600,000 shares paid at closing (issued on May 4, 2022) and 25,000 shares to be held and due within three business days of payment of the second tranche of cash described below); and (b) cash payments as follows: $250,000 due at closing (“initial cash payment”); $250,000 plus or minus any applicable post-closing adjustments (subsequently determined to be $21,003) which was paid within six months after the closing date (“second tranche”); and $280,000 that is due no later than 10 months after the closing date of the acquisition (this amount was paid in January 2023; refer to Note 16 of Item 8 in this Annual Report on Form 10-K).
The following represents the assets and liabilities acquired in this acquisition:
| | | | | |
| Receivable from Seller | $ | 413,609 | |
| Due from employee/travel advance | 5,000 | |
| Miscellaneous license | 2,394 | |
| Customer relationships | 785,000 | |
| Non-compete agreements | 10,000 | |
| Backlog | 489,000 | |
| Goodwill | 1,471,000 | |
| Net Assets acquired | 3,176,003 | |
| |
| The consideration paid for the acquisition of LSG was as follows: | |
| |
Common stock (600,000 shares issued May 4, 2022) | 2,280,000 | |
Holdback shares (25,000 shares due six months after the closing date) | 95,000 | |
| Cash | 521,003 | |
| Due to seller (cash) | 280,000 | |
| $ | 3,176,003 | |
The LSG acquisition has been accounted for under the acquisition method of accounting. Under the acquisition method of accounting, the total acquisition consideration price was allocated to the assets acquired and liabilities assumed based on their preliminary estimated fair values. The fair value measurements utilize estimates based on key assumptions of the LSG acquisition, and historical and current market data. The excess of the purchase price over the total of the estimated fair values assigned to tangible and identifiable intangible assets acquired and liabilities assumed is recognized as goodwill. To determine the fair values of tangible and intangible assets acquired and liabilities assumed for LSG, the Company engaged a third-party independent valuation specialist.
The Company had received a valuation from its specialist and recorded the value of the assets and liabilities acquired based on historical inputs and data as of April 15, 2022. The allocation of the purchase price is based on the best information available. The Company paid $44,752 in LSG’s transaction costs. The Company concluded that there were no measurement period adjustments during the year ended December 31, 2022. LSG is accounted for under the Corvus reporting unit and its goodwill is presented accordingly in Note 5.
For all acquisitions disclosed, there were no transaction costs that were not recognized as an expense.
The following table shows unaudited pro-forma results for the year ended December 31, 2022 and 2021, as if the acquisitions of Merrison, SSI, and LSG had occurred on January 1, 2021 (the Albers Group, LLC is not included below because it was an asset purchase). These unaudited pro forma results of operations are based on the historical financial statements of each of the companies.
| | | | | |
| For the year ended December 31, 2022 | |
| Revenues | $ | 43,710,119 | |
| Net loss | $ | (14,142,670) | |
| Net loss per share - basic | $ | (0.51) | |
| |
| For the year ended December 31, 2021 | |
| Revenues | $ | 21,205,940 | |
| Net loss | $ | (215,475) | |
| Net loss per share - basic | $ | — | |
Note 4: Fixed Assets
Fixed assets consisted of the following as of December 31:
| | | | | | | | | | | |
| 2022 | | 2021 |
| Equipment and software | $ | 141,732 | | | $ | 60,148 | |
| Furniture | 32,574 | | | 32,574 | |
| Leasehold improvements | 83,266 | | | 75,265 | |
| Total fixed assets | 257,572 | | | 167,987 | |
| Accumulated depreciation | (84,222) | | | (22,195) | |
| Fixed assets, net | $ | 173,350 | | | $ | 145,792 | |
Depreciation expense for the years ended December 31, 2022, 2021, and 2020 was $62,026, $19,120, and $1,901 respectively.
Note 5: Intangible Assets and Goodwill
Intangible assets consisted of the following as of December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2022 |
| | | Gross carrying value | | Accumulated Amortization | | Net carrying value |
| Customer relationships | 4.5 - 15 years | | $ | 9,535,000 | | | $ | (3,916,501) | | | $ | 5,618,499 | |
| Trade name | 4.5 years | | 266,000 | | | (245,336) | | | 20,664 | |
| Trademark | 15 years | | 533,864 | | | (88,119) | | | 445,745 | |
| Backlog | 2 years | | 1,436,000 | | | (1,077,616) | | | 358,384 | |
| Non-compete agreement | 3 - 4 years | | 684,000 | | | (493,125) | | | 190,875 | |
| | | $ | 12,454,864 | | | $ | (5,820,697) | | | $ | 6,634,167 | |
| | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2021 |
| | | Gross carrying value | | Accumulated Amortization | | Net carrying value |
| Customer relationships | 4.5 - 9 years | | $ | 9,025,000 | | | $ | (2,497,998) | | | $ | 6,527,002 | |
| Trade name | 4.5 years | | 266,000 | | | (143,123) | | | 122,877 | |
| Trademark | 15 years | | 533,863 | | | (24,387) | | | 509,476 | |
| Backlog | 2 years | | 947,000 | | | (858,089) | | | 88,911 | |
| Non-compete agreement | 3 - 4 years | | 674,000 | | | (326,667) | | | 347,333 | |
| | | $ | 11,445,863 | | | $ | (3,850,264) | | | $ | 7,595,599 | |
The intangible assets, with the exception of the trademarks, were recorded as part of the acquisitions of Corvus, MFSI, Merrison, LSG, and SSI. Amortization expense for the years ended December 31, 2022, 2021, and 2020 was $1,970,433, $1,867,108, and $1,828,353 respectively, and the intangible assets are being amortized based on the estimated future lives as noted above.
Future amortization of the intangible assets for the next five years as of December 31 are as follows:
| | | | | |
| 2023 | $ | 1,950,067 | |
| 2024 | 1,501,040 | |
| 2025 | 879,353 | |
| 2026 | 669,217 | |
| 2027 | 479,528 | |
| Thereafter | 1,154,962 | |
| Total | $ | 6,634,167 | |
The following table presents changes to goodwill for the years ended December 31, 2022 and 2021 for each reporting unit:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Corvus | | SSI | | MFSI | | Merrison | | Total |
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
| December 31, 2020 | 4,136,011 | | | — | | | — | | | — | | | 4,136,011 | |
| Goodwill acquired through acquisitions | — | | | 8,461,150 | | | 685,073 | | | 780,730 | | | 9,926,953 | |
| December 31, 2021 | 4,136,011 | | | 8,461,150 | | | 685,073 | | | 780,730 | | | 14,062,964 | |
| Goodwill acquired through acquisitions | 1,471,000 | | | — | | | — | | | — | | | 1,471,000 | |
| Merrison subsumed into Corvus | 780,730 | | | — | | | — | | | (780,730) | | | — | |
| December 31, 2022 | $ | 6,387,741 | | | $ | 8,461,150 | | | $ | 685,073 | | | $ | — | | | $ | 15,533,964 | |
There were no indicators of impairment noted in the periods presented.
Note 6: Convertible Promissory Notes – Related Parties
The Company entered into convertible promissory notes – related parties as follows as of December 31:
| | | | | | | | | | | |
| 2022 | | 2021 |
Convertible note payable with a trust related to one of the Company’s directors, convertible at $0.260 per share, at 5% interest, (extinguished on April 4, 2022 for new note) | $ | 3,209,617 | | | $ | 4,209,617 | |
| Total Convertible Notes Payable – Related Parties | $ | 3,209,617 | | | $ | 4,209,617 | |
| Add: Premium recorded on convertible note due to fair value adjustment at date of acquisition of Corvus | — | | | 2,569 | |
| Less: BCF Discount | (2,210,187) | | | (1,407,002) | |
| $ | 999,430 | | | $ | 2,805,184 | |
Interest expense which includes amortization of discount and premium for the years ended December 31, 2022 and 2021 was $1,535,840 and $1,638,057, respectively. The amount of the debt discount recorded related to the warrants granted to the note holder was evaluated for characteristics of liability or equity and was determined to be equity under ASC 470 and ASC 480. The Company recognized this as additional paid in capital, and the discount is being amortized over the life of the note.
On February 1, 2021, the two promissory notes with The Buckhout Charitable Remainder Trust (Laurie Buckhout – Trustee), were combined into one new note in the principal balance of $4,279,617, that has a new maturity date of February 1, 2024. The interest rate remains at 5% per annum. The conversion terms have remained at $0.26 per share. It was determined that under ASC 470, the debt amendment was considered a modification. Then again on August 12, 2021, the convertible note was amended to remove the principal payments and extend the debt further to September 30, 2024. It was determined that under ASC 470, the debt amendment was considered a modification.
On April 4, 2022, the Company entered into a letter agreement with The Buckhout Charitable Remainder Trust (Laurie Buckhout – Trustee) whereby the Company made a partial repayment of $500,000 (“First Payment”) to reduce the note from $4,209,617 to $3,709,617. The First Payment of $500,000 was paid from proceeds from Crom Cortana Fund, LLC (“Crom”) as part of a unit agreement under the Securities Purchase Agreement (“SPA”) entered into with Crom on April 4, 2022. The Company commenced accruing interest on March 1, 2022, however, no payment of interest was due through October 31, 2022. The Company originally intended to make a second payment (“Second Payment”) of $2,709,617 at the time of an anticipated secondary offering, initially expected to occur on or about August 1, 2022, subject to extensions through October 31, 2022. However, given the timing of our secondary offering, the Second Payment did not occur during the third quarter of 2022 and the Company negotiated an extension of the Second Payment to October 31, 2022. In October 2022, the Company made an advanced principal payment of $500,000, further reducing the principal of the convertible promissory note to $3,209,617.
The entire convertible promissory note – related parties balance is reflected in long-term liabilities.
Note 7: Notes Payable
The Company entered into notes payable as follows as of December 31:
| | | | | | | | | | | |
| 2022 | | 2021 |
Note payable at 7% originally due November 2023, now maturing September 30, 2024 (a) | $ | 5,600,000 | | | $ | 5,600,000 | |
Note payable at 10% interest dated February 28, 2022 and matures the earlier of (i) September 30, 2024 or (ii) the acceleration of the obligations as contemplated under the promissory note including the successful completion of an equity offering of at least $15,000,000 (b) | 400,000 | | | — | |
Convertible note payable, convertible at $1.60 per share, at 7%, maturing April 4, 2023 (c) | 890,000 | | | — | |
Note payable with bank, at prime plus 3% interest (6.25% at December 31, 2022) maturing August 11, 2024 | 2,324,236 | | | 3,588,374 | |
| Total Notes Payable | 9,214,236 | | | 9,188,374 | |
| Less: Debt Discount | (840,398) | | | (796,565) | |
| $ | 8,373,838 | | | $ | 8,391,809 | |
(a)On August 12, 2021, the note payable was amended to extend the debt to September 30, 2024. It was determined that under ASC 470, the debt amendment was considered a modification. The amount of the debt discount recorded related to the warrants granted to the note holder was evaluated for characteristics of liability or equity and was determined to be equity under ASC 470 and ASC 480.
(b)On February 28, 2022, the Company was obligated to issue 125,000 shares of common stock as further consideration for making this loan to the Company. The shares were issued in April 2022.
(c)On April 4, 2022, the Company entered into a Securities Purchase Agreement (“SPA”) with Crom. The SPA included (a) a Convertible Promissory Note dated April 4, 2022 in the amount of $1,050,000 at 7% interest per annum. This note matures April 4, 2023 (one-year) and is convertible at a conversion price of $1.60 per share; (b) the issuance of 656,250 warrants that mature April 4, 2027, with an exercise price of $1.84 per share; and (c) the issuance of 1,250,000 common shares at $0.40 per share ($500,000), the proceeds of which were paid to The Buckhout Charitable Remainder Trust for the First Payment. In addition, Crom was issued 125,000 common shares as further inducement to enter into the SPA. The Company analyzed the debt instrument with Crom, under ASC 815-10, and determined that the conversion option should be separated from the host debt instrument (i.e., bifurcated) and classified as a derivative liability, along with the value of the warrants as a derivative liability at the inception date of April 4, 2022. The fair value of the derivative liabilities at inception were reflected as a discount on the note, along with an original issue discount of $50,000, and the discount of $93,000 on the 1,250,000 shares of common stock issued to Crom that had a fair value of $593,000, which exceeded the $500,000 paid by Crom that will be amortized over the life of the note (one year). The derivative liabilities are marked to market each reporting period, and the Company recognized a loss on the change in fair value of the derivative liabilities of 132,000 from April 4, 2022 to December 31, 2022. Furthermore, on February 13, 2023 the Company entered into a series of transactions with Crom to pay off the total amount currently owed under the terms of the convertible promissory note. Refer to subsequent events in Note 16.
Interest expense, which includes amortization of discount, for the years ended December 31, 2022, 2021, and 2020 was $1,874,142, $859,744, and $748,092, respectively.
On April 4, 2022, the Company secured a $950,000 revolving credit facility with Live Oak Bank (“Revolving Credit Facility”). The Revolving Credit Facility matures on March 28, 2029, and draws on it are charged interest at the rate of prime plus 2.75% per annum. Interest is payable monthly. On April 12, 2022, the Company was advanced $300,025 under the Revolving Credit Facility.
Total principal payments on our notes payable for the next three years as of December 31, 2022 are as follows:
| | | | | |
| 2023 | $ | 2,244,627 | |
| 2024 | 6,969,609 | |
| 2025 | — | |
| Total | $ | 9,214,236 | |
Note 8: Note Payable – Related Party
The Company entered into a note payable – related party as follows as of December 31:
| | | | | | | | | | | |
| 2022 | | 2021 |
Note payable at 5% due December 31, 2024, in connection with the acquisition of SSI | $ | 400,000 | | | $ | 400,000 | |
Interest expense for the years ended December 31, 2022 and 2021 was $20,000 and $7,726, respectively.
The entire note payable – related party balance is reflected in long-term liabilities.
Note 9: Amount Due To Seller
In the acquisition of LSG, the Company was obligated to pay $3,176,003, which included cash of $780,000 and a working capital adjustment of $21,003. Of this amount, $521,003 was paid by December 31, 2022. The remaining $280,000 of this balance is recorded as a current liability under “Due to Seller” on the Consolidated Balance Sheet as of December 31, 2022.
In the acquisition of assets in The Albers Group, LLC transaction, the Company was obligated to pay $200,000 as part of the acquisition, post the effective date of October 22, 2021. This amount was paid over a 10-month period commencing February 2022. The $200,000 was non-interest bearing and was reflected as a current liability on the Consolidated Balance Sheet as of December 31, 2021 under “Due to seller”. This amount has been paid in full as of December 31, 2022 and is no longer reflected on the consolidated balance sheets.
Note 10: Stockholders’ Equity (Deficit)
On October 13, 2022, the Company effected a 1-for-20 reverse split of our authorized and outstanding shares of common stock. As a result of the Reverse Stock Split, all authorized and outstanding common stock and per share amounts in this Annual Report on Form 10-K, including but not limited to, the consolidated financial statements and footnotes included herein, have been adjusted to reflect the Reverse Stock Split for all periods presented.
On July 19, 2021, the Company filed a Certificate of Amendment with the State of Nevada to change the par value of all common and preferred stock to all be $0.0001. All changes to the par value dollar amount for these classes of stock and adjustment to additional paid in capital have been made retroactively.
Preferred Stock
The Company has 50,000,000 shares of preferred stock authorized. The Company has designated a Series A Preferred Stock, Series B Preferred Stock and Series C Preferred Stock. The Series B Preferred Stock was fully converted into Common Stock during 2022, and as such, there is no outstanding Series B Preferred Stock as of December 31, 2022.
Series A Preferred Stock
The Company has designated 10,000,000 shares of Series A Preferred Stock, par value of $0.0001.
On April 7, 2022, the Company amended the Certificate of Designation for its Series A Preferred Stock to (a) provide for an annualized dividend of $0.0125 per share to be paid monthly; (b) amend the conversion ratio for each share of Series A Preferred Stock to convert into two shares of common stock instead of 20 shares of common stock; and (c) provide for the Company to have the option to repurchase the Series A Preferred Stock at any time at a price of $1 per share. In connection with the Amendment to the Certificate of Designation, former officers of the Company (“Former Officers”) entered into a letter agreement dated April 4, 2022 with Crom and the Company for Crom to purchase 1,750,000 shares of Common
Stock from the officers for $445,000, the proceeds of which were paid directly to the Former Officers. The letter agreement also provided for the Former Officers to sell certain amounts of the common stock they own through the date of the public offering.
As of December 31, 2022 and December 31, 2021, the Company had 5,875,000 shares of Series A Preferred Stock issued and outstanding, respectively. The 5,875,000 shares were issued to the Former Officers of the Company in settlement of debt. For the year ended December 31, 2022, the Company has total preferred stock dividends recognized of $100,516, of which $54,988 is related to Series A Preferred Stock dividends.
Series B Preferred Stock
The Company has designated 10,000,000 shares of Series B Preferred Stock, par value of $0.0001. On October 17, 2022 the Company issued a total of 15,375,000 shares of Common Stock in connection with the conversion of all of its Series B preferred shares outstanding in connection with its public offering. As of December 31, 2022 and December 31, 2021, the Company had 0 and 3,610,000 shares of Series B Preferred Stock issued and outstanding, respectively. The 3,610,000 shares were issued to directors of the Company in June 2019.
Series C Preferred Stock
The Company has designated 10,000,000 shares of Series C Preferred Stock, par value of $0.0001 (effective July 19, 2021). In the year ended December 31, 2022, the Company raised $150,000 for 150,000 shares of Series C Preferred Stock. In the year ended December 31, 2021, the Company raised $620,000 for 620,000 shares of Series C Preferred Stock along with 1,240,000 common shares. Each share of the Series C Preferred Stock is convertible into 0.625 common shares, and the Series C Preferred Stock pays a $0.06 dividend per Series C Preferred share per year. The dividend commenced accruing when the Series C Preferred Shares were fully designated and issued.
For the year ended December 31, 2022, the Company has total preferred stock dividends recognized of $100,516 of which $45,528 is related to Series C Preferred Stock dividends. The Series C Preferred Stockholders under their subscription agreements were issued 0.1 common shares per Series C Preferred share for their investment. As a result, the Company issued 62,000 common shares for the 620,000 Series C Preferred shares purchased. As of December 31, 2021, another $25,000 was raised for an additional 25,000 Series C Preferred shares and 2,500 common shares that were not issued as of the balance sheet date. The $25,000 is reflected as an obligation to issue shares on the Consolidated Balance Sheet as of December 31, 2021.
Common Stock
The Company has 3,000,000,000 shares of common stock, par value $0.0001 authorized. The Company had 41,699,363 and 19,960,632 shares issued and outstanding as of December 31, 2022 and 2021, respectively. The holders of the Company’s Common Stock are entitled to one vote for each share of common stock held.
On October 17, 2022, the Company closed its public offering of 1,500,000 shares of common stock consisting of 1,350,000 shares sold by the Company and 150,000 shares sold by certain selling stockholders, at a public offering price of $2.00 per share. In connection therewith, the Company issued 1,231 shares of common stock to stockholders with fractional shares resulting from the Reverse Stock Split.
Warrants
The following represents a summary of warrants for the years ended December 31:
| | | | | | | | | | | | | | | | | | | | | | | |
| 2022 | | 2021 |
| Number | | Weighted
Average
Exercise
Price | | Number | | Weighted
Average
Exercise
Price |
| Beginning balance | 3,161,568 | | $ | 1.60 | | | 1,090,717 | | $ | 0.00 | |
| | | | | | | |
| Granted | 2,517,268 | | 2.22 | | | 2,070,851 | | 2.40 | |
| Ending balance | 5,678,836 | | $ | 1.84 | | | 3,161,568 | | $ | 1.60 | |
| Intrinsic value of warrants | $ | 1,374,303 | | | | | $ | 5,706,473 | | | |
| Weighted Average Remaining Contractual Life (Years) | 5.48 | | | | | | |
Options
On November 9. 2021. the Company approved the Stock Incentive Plan that authorizes the Company to grant up to 2,500,000 shares of common stock. Prior to this date, the granting of options was not done in accordance with a stock option plan. As of December 31, 2022, the Company has granted 62,500 shares of common stock under the Stock Incentive Plan.
The following represents a summary of options for the years ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| Number of Options | | Weighted-Average Exercise Price | | Weighted-Average Remaining Contractual Term (in Years) | | Weighted-Average Fair Value |
| Outstanding, December 31, 2020 | 1,856,250 | | | $ | 0.80 | | | 6.16 | | 1.98 | |
| Granted | 4,087,500 | | | 2.40 | | | | | |
| Exercised | (10,000) | | | (0.80) | | | | | |
| Forfeited | (1,339,062) | | | (0.60) | | | | | |
| Outstanding December 31, 2021 | 4,594,688 | | | 2.09 | | | 6.21 | | 3.72 | |
| Granted | 2,585,000 | | | 3.45 | | | 6.25 | | 3.34 | |
| Exercised | (15,000) | | | 0.80 | | | | | |
| Forfeited | (739,688) | | | 2.41 | | | | | |
| Outstanding December 31, 2022 | 6,425,000 | | | $ | 2.69 | | | 5.63 | | 4.26 | |
| | | | | | | |
| As of December 31, 2022 | | | | | | | |
| Vested and Exercisable | 2,529,397 | | | $ | 2.22 | | | 5.33 | | $ | 3.07 | |
Stock based compensation expense related to stock options for the years ended December 31, 2022 and 2021 was $4,985,233 and $3,113,261, respectively, which is comprised of $3,852,606 and $1,564,080 in service-based grants and $1,132,627 and $1,549,181 in performance-based grants, for the years ended December 31, 2022 and 2021, respectively.
In accordance with ASC 718-10-50, the Company measures the fair value of its share-based payment arrangements using the Black-Scholes model. The Company measures the share-based compensation on the grant date using the following assumptions:
| | | | | | | | | | | |
| Year Ended December 31, |
| 2022 | | 2021 |
| Expected term | 7 years | | 7 years |
| Expected volatility | 114 - 157% | | 135 - 177% |
| Expected dividend yield | — | | | — | |
| Risk-free interest rate | 2.00 - 4.18% | | 0.10 | % |
The Company measures the share-based compensation for all stock options and warrants that are not considered derivative liabilities using the Black-Scholes method with these assumptions, and any changes to these inputs can produce significantly higher or lower fair value measurements. The weighted average grant date fair value of the options granted during the years ended December 31, 2022 and 2021 was $3.34 and $2.40, respectively. The risk-free interest rate is based on the yield of a zero coupon U.S. Treasury Security with a maturity equal to the expected life of the stock option from the date of the grant. The assumption for expected volatility is based on the historical volatility of the Company. Aside from dividends paid on preferred shares, it is the Company's intent to retain all profits for the operations of the business for the foreseeable future, as such the dividend yield assumption is zero.
Note 11: Fair Value
Fair value is defined as the exit price, or the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. GAAP sets forth a three-level fair value hierarchy, which prioritizes the inputs used in measuring fair value. The three levels are as follows:
Level 1 – defined as observable inputs, such as quoted market prices in active markets.
Level 2 – defined as inputs other than quoted prices in active markets that are either directly or indirectly observable.
Level 3 – defined as unobservable inputs in which little or no market data exists, therefore, requiring an entity to develop its own assumptions.
Our financial assets and liabilities subject to the three-level fair value hierarchy consist principally of cash and cash equivalents, accounts receivable, accounts payable, contingent consideration and derivative liabilities. The estimated fair value of cash and cash equivalents, accounts receivable and accounts payable approximates their carrying value.
The Company issued common stock, a convertible note and warrants in a SPA with Crom. The Company evaluated the conversion option in the convertible note and the warrants (“Derivative Liabilities”) to determine proper accounting treatment and determined them to be Derivative Liabilities. The Derivative Liabilities identified have been accounted for utilizing ASC 815 Derivatives and Hedging. The Company has incurred a liability for the estimated fair value of Derivative Liabilities. The estimated fair value of the Derivative Liabilities has been calculated using binomial pricing model with key input variables by an independent third party, as of the date of issuance, with changes in fair value recorded as gains or losses on revaluation in other income (expense).
The contingent earnout included in total consideration for the SSI acquisition, included in current liabilities on the Condensed Consolidated Balance Sheets, is measured at fair value on a recurring basis using the present value approach, which incorporates factors such as revenue growth and forecasted adjusted EBITDA to estimate expected value. Changes in fair value of the contingent earnout are recorded as gains or losses on revaluation in operating expenses on the Consolidated Statements of Operations.
The Company determined that the significant inputs used to value the Derivative Liabilities and the contingent earnout fall within Level 3 of the fair value hierarchy. As a result, the Company has determined that the valuation of its Derivative Liabilities and contingent earnout are classified in Level 3 of the fair value hierarchy as shown in the table below:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Fair Value Measurements at December 31, 2022 |
| | Level 1 | | Level 2 | | Level 3 | | Total |
| Derivative Liabilities | | $ | — | | | $ | — | | | $ | 824,000 | | | $ | 824,000 | |
| Contingent earnout | | — | | | — | | | 812,000 | | | 812,000 | |
| Total | | $ | — | | | $ | — | | | $ | 1,636,000 | | | $ | 1,636,000 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Fair Value Measurements at December 31, 2021 |
| | Level 1 | | Level 2 | | Level 3 | | Total |
| | | | | | | | |
| Contingent earnout | | $ | — | | | $ | — | | | $ | 257,000 | | | $ | 257,000 | |
| Total | | $ | — | | | $ | — | | | $ | 257,000 | | | $ | 257,000 | |
The Company’s Derivative Liabilities as of December 31 are as follows:
| | | | | | | | | | | | | | | | | | | | |
| | 2022 | | 2021 | | Inception |
| Fair value of conversion option of Crom Cortana Fund LLC convertible note | | $ | 191,000 | | | $ | — | | | $ | 314,000 | |
Fair Value of 656,250 warrants on April 4, 2022 | | $ | 633,000 | | | $ | — | | | $ | 378,000 | |
| | $ | 824,000 | | | $ | — | | | $ | 692,000 | |
During the year ended December 31, 2022, 2021, and 2020 the Company recognized changes in the fair value of the Derivative Liabilities of $824,000, $0, and $0 respectively.
Activity related to the Derivative Liabilities for the year ended December 31, 2022 is as follows:
| | | | | | | | |
| Beginning balance as of December 31, 2021 | | $ | — | |
| Issuance of Derivative Liabilities | | (692,000) | |
| Warrants exchanged for common stock | | — | |
| Change in fair value of Derivative Liabilities | | (132,000) | |
| Ending balance as of December 31, 2022 | | $ | (824,000) | |
Changes to these inputs could produce a significantly higher or lower fair value measurement. The fair value of the Derivative Liabilities is estimated using a binomial valuation model. The assumptions, inputs and methodologies the Company uses in determining fair value result in inherent uncertainty due to the application of judgment. The following assumptions were used for the periods as follows:
| | | | | | | | | | | | | | |
| | December 31, 2022 | | Inception - April 4, 2022 |
| Expected term - conversion option | | 0.26 years | | 1 year |
| Expected term - warrants | | 4.26 years | | 5 years |
| Stock price as of measurement date | | $ | 1.26 | | | $ | 3.80 | |
| Equity volatility - unadjusted | | 161.00 | % | | 278.80 | % |
| Volatility haircut | | 5.00 | % | | 5.00 | % |
| Selected volatility - post haircut | | 156.50 | % | | 112.60 | % |
| Senior unsecured synthetic credit rating | | CCC+ | | CCC+ |
| B- market yield | | 6.30 | % | | 4.50 | % |
| OAS differential between CCC+ and B- bonds | | 387 bps | | 383 bps |
| Risk adjusted rate | | 10.30 | % | | 8.30 | % |
| Risk-free interest rate | | 4.40 | % | | 1.70 | % |
Note 12: Related-Party Transactions
In June 2021, the Company raised $220,000 for 220,000 shares of the to be designated Series C Preferred Stock along with 440,000 common shares from the newly hired Chief Growth Officer of the Company.
In January 2021, August 2021, November 2021 and April 2022, the Company granted warrants to two of its officers pursuant to the employment agreements with these officers as a bonus for closing the MFSI, Merrison, SSI, Pax River (assets purchased from The Albers Group, LLC) and LSG transactions.
During 2022, the Company repaid $1,000,000 of note principal to a member of its Board of Directors in relation to payments on its related party note payable. For details on this note payable refer to Note 6.
Note 13: Defined Contribution Plan
The Company maintains a 401(k) plan as a defined contribution retirement plan for all eligible employees. The 401(k) plan provides for tax-deferred contributions of employees’ salaries, limited to a maximum annual amount as established by the IRS. The plan enrolls employees immediately with no age or service requirement.
The 401(k) Plan employer match was $651,353, $434,267 and $271,647 in the years ended December 31, 2022, 2021 and 2020, respectively.
Note 14: Commitments
The Company, since April 2020, has entered into a series of employment agreements with management and key employees. The employment agreements are generally for terms ranging from three to four years and stipulate the compensation which include base pay and bonuses, as well as non-cash compensation (warrants or stock options) that are to be issued to the employee. The employment agreements run through June 30, 2025.
On April 1, 2020, the Company entered into employment agreements with both Mark Fuller and Jay Wright (the “Two Officers”). The agreements have a term of three years. Pursuant to the agreements, each of the Two Officers have a base salary of $240,000 per year and may be increased to $25,000 per month upon reaching an annualized revenue run rate of $25,000,000 or greater, $30,000 per month upon reaching an annualized revenue of $50,000,000 or greater, or $40,000 per month upon reaching an annualized revenue run rate of $75,000,000 or greater.
The Company shall pay to the Two Officers a cash bonus equal to the lesser of (i) one percent (1%) of the trailing twelve months revenues of each company acquired during the term of the employment agreement, or (ii) four percent (4%) of the trailing twelve month EBITDA of each business acquired during the term of the employment agreement, provided that, for a bonus to be due, such acquisition must be accretive to the Company on both a revenue per share and EBITDA per share basis. Additionally, the Company shall issue 1 warrant to each of the Two Officers for each $1 of revenue acquired in any such acquisition with a 7-year term and a strike price equal to the price used in such acquisition or if no stock is used, the 30-day moving average closing price of the Company’s stock.
An additional bonus of $50,000 and 500,000 warrants with a $2.00 strike price shall be paid to the the Two Officers upon the Company commencing trading on either the Nasdaq or the NYSE (which occurred on October 13, 2022), and an additional bonus of $125,000 and 1,250,000 warrants with a $2.40 strike price shall be paid to each of the Two Officers upon the Company joining the Russell 3000 and/or Russell 2000 stock index(ices).
On July 1, 2021, the Company entered into an employment agreement with its Chief Growth Officer for a period of four years, expiring June 30, 2025. Pursuant to the agreements, the Chief Growth Officer has a base salary of $250,000 per year and may be increased to $25,000 per month upon the Navy division reaching an annualized revenue run rate of $25,000,000 or greater, $30,000 per month upon the Navy division reaching an annualized revenue of $60,000,000 or greater, or $40,000 per month upon the Navy division reaching an annualized revenue run rate of $100,000,000 or greater.
The Chief Growth Officer is entitled to a bonus at the discretion of the Board of Directors annually. In addition, the Chief Growth Officer was granted 1,500,000 stock options, which 750,000 are considered time based grants over a vesting period of four years; and 750,000 are performance based grants as follows: (a) 250,000 upon the closing of an acquisition in the Navy division of a company with annualized revenue of $12 million or greater; (b) 250,000 upon the Navy division achieving $25 million in revenue and $2.5 million in EBITDA in any 12 month period; and (c) 250,000 upon the overall Company achieving $100 million in revenue run rate based on quarterly performance (i.e. $25 million in any calendar quarter).
On August 5, 2021, the Company and the former executive of Merrison (the “Executive”) entered into an employment agreement for a period of three years through August 5, 2024. Under the employment agreement, the Executive shall be paid a base salary of $220,000 annually and receive 150,000 stock options. In addition, the Executive will be provided a bonus of $80,000 payable annually on August 31 each year, starting August 31, 2022, if and only if Merrison maintains an annualized net income of $500,000 for the one-year period ending on the applicable August 31.
On August 12, 2021, the Company entered into several employment agreements for three-year periods with the two executives of SSI as well as three management personnel. These agreements all contain base salaries and bonus criteria. In addition, the three key management personnel received 300,000 stock options each, of which one of those three retired December 31, 2021.
On April 25, 2022, the Company entered into an employment agreement with its Chief Financial Officer (“CFO”). The employment agreement has a term of three years and five days and automatically renews for successive one-year periods unless terminated by the Company or the CFO, with 90 days advance notice of its intent not to renew. The agreement provides for an annual base salary of $275,000 (the “CFO Base Salary”). The CFO Base Salary will increase as follows: (i) $25,000 per month upon the Company achieving an annualized revenue run rate of $50,000,000 or greater; (ii) $35,000 per month upon the Company achieving an annualized revenue run rate of $75,000,000 or greater; (iii) $40,000 per month upon the Company reaching an annualized revenue run rate of $150,000,000 or greater and EBITDA margin of no less than 7%; and (iv) $45,000 per month upon the Company reaching an annualized revenue run rate of $300,000,000 or greater and adjusted EBITDA margin of no less than 8%. The CFO Base Salary shall be payable in regular installments in accordance with the Company’s general payroll practices.
Additionally, the CFO shall be eligible to earn a performance bonus at the discretion of the Board of the Company with target bonuses that are the following percentages of CFO Base Salary based on certain performance criteria set forth in the employment agreement: (i) 50% of CFO Base Salary of less than $35,000 per month; (ii) 60% of CFO Base Salary of $35,000 to less than $40,000 per month; and (iii) 100% of CFO Base Salary of $40,000 or more per month. The performance criteria include (a) ensure on time filing of all periodic filings (Form 10Q and Form 10K) and event driven filings (Schedule 13(d), Section 16 filings (Forms 3, 4, and 5) and Form 8K); (b) ensure on time filings and payment of all federal, state and local tax obligations; and (c) prepare an annual consolidated draft budget based on subsidiary budgets by October 31 each year. The CFO is entitled to earn an additional bonus of (i) $50,000 and 500,000 warrants to purchase the Company’s common stock with an exercise price of $2.00 upon the Company’s common stock trading on any tier of the Nasdaq or the New York Stock Exchange (which occurred on October 13, 2022), and (ii) $100,000 and 750,000 warrants to purchase the Company’s common stock with an exercise price of $2.40 upon the Company joining the Russell 3000 and/or Russell 2000 stock index(ices). The Board of the Company may pay an additional bonus (separate from any target) in its sole discretion.
As an additional incentive for entering into the employment agreement, the CFO was granted 1,800,000 stock options to purchase the Company’s common stock at an exercise price of $3.80 per share. The price amount is subject to adjustment in the event of a forward or reverse stock split, stock dividend or other similar mechanism. The stock options vest ratably
over the first 36 months of employment with the Company. In the event of a change in control of the Company, unvested options shall not vest unless (i) the CFO is not given a commensurate position in the resulting organization, or (ii) the change in control transaction results in a price to stockholders of at least $8.00 per share. The agreement entitles the CFO to receive various employee benefits generally made available to other officers and senior executives of the Company.
Note 15: Income Taxes
The following table summarizes the significant differences between the U.S. federal statutory tax rate and the Company’s effective tax rate for financial statement purposes for the years ended December 31:
| | | | | | | | | | | | | | | | | |
| 2022 | | 2021 | | 2020 |
| Federal income taxes at statutory rate | 21.00 | % | | 21.00 | % | | 21.00 | % |
| State income taxes at statutory rate | 3.50 | % | | 7.61 | % | | 4.76 | % |
| Change in tax rate | (2.90) | % | | (1.58) | % | | 2.17 | % |
| Permanent differences | (7.70) | % | | (0.98) | % | | 0.02 | % |
| Other | (1.70) | % | | (0.04) | % | | — | % |
| Change in valuation allowance | (17.90) | % | | 0.00 | % | | — | % |
| Totals | (5.70) | % | | 26.01 | % | | 27.95 | % |
The following is a summary of the net deferred tax asset (liability) as of December 31:
| | | | | | | | | | | | | | | | | |
| 2022 | | 2021 | | 2020 |
| Deferred tax assets: | | | | | |
| Net operating losses | $ | — | | | $ | — | | | $ | 53,457 | |
| Lease liabilities | 8,973 | | | — | | | — | |
| Accrued bonus/PTO/Vacation | 148,776 | | | 95,673 | | | 73,390 | |
| Stock options/consultant stock | 3,008,318 | | | 2,358,218 | | | 243,628 | |
| Section 195 costs | 41,817 | | | 53,881 | | | 52,416 | |
| Other | 149,153 | | | 2,407 | | | 1,281 | |
| Total deferred tax assets | 3,357,037 | | | 2,510,179 | | | 424,172 | |
| | | | | |
| Deferred tax liabilities: | | | | | |
| Intangible assets | (939,607) | | | (1,334,460) | | | (620,722) | |
| ROU Assets | (9,052) | | | — | | | — | |
| Property and equipment | (8,569) | | | (14,312) | | | (1,438) | |
| Debt discount | (741,579) | | | (400,064) | | | (707,703) | |
| Section 481(a) adjustment | (43,443) | | | (151,310) | | | (159,554) | |
| | | | | |
| Total deferred tax liabilities | (1,742,250) | | | (1,900,146) | | | (1,489,417) | |
| | | | | |
| Valuation allowance | $ | (1,614,787) | | | $ | — | | | $ | — | |
| | | | | |
| Net deferred tax assets (liabilities) | $ | — | | | $ | 610,033 | | | $ | (1,065,245) | |
| | | | | |
A full valuation allowance was established in the second quarter of 2022 due to the uncertainty of the utilization of deferred tax assets in future periods. In evaluating the Company’s ability to realize the deferred tax assets, management considered all available positive and negative evidence, including cumulative historic earnings, reversal of temporary differences, projected taxable income and tax planning strategies. The Company’s negative evidence, largely related to the Company's historical pre-tax net losses, currently outweighs its positive evidence of future taxable income therefore it is more-likely-
than-not that the Company will not realize a significant portion of our deferred tax assets. The amount of the deferred tax asset to be realized in the future could however be adjusted if objective negative evidence is no longer present.
Section 382 of the Internal Revenue Code provides an annual limitation on the amount of federal NOLs and tax credits that may be used in the event of an ownership change. The Company had a net operating loss carryforward totaling approximately $286,760 at December 31, 2020 that was used to offset 2021 taxable income.
The Company classifies accrued interest and penalties, if any, for unrecognized tax benefits as part of income tax expense. The Company did not accrue any penalties or interest as of December 31, 2022 and 2021.
The provision (benefit) for income taxes for the years ended December 31 are as follows:
| | | | | | | | | | | | | | | | | |
| 2022 | | 2021 | | 2020 |
| Current | $ | 209,563 | | | $ | 238,928 | | | $ | 174,362 | |
| Deferred | 610,033 | | | (2,895,571) | | | (1,230,924) | |
| | | | | |
| Total | $ | 819,596 | | | $ | (2,656,643) | | | $ | (1,056,562) | |
Note 16: Subsequent Events
On January 18, 2023, the Company signed a non-binding letter of intent to acquire an East Coast based government contractor which focuses on cybersecurity, data analysis, and other IT services for federal civilian agencies.
On January 23, 2023, the Company made a final payment of $280,000 pursuant to the terms of the LSG Business Acquisition Agreement.
On February 13, 2023, the Company entered into a series of transactions with Crom Cortana Fund LLC (“Crom”), the primary purpose of which is to fund the pending acquisition related to a non-binding letter of intent signed on November 7, 2022. In connection therewith, the Company and Crom entered into an agreement to pay off the amount currently owed to Crom under the terms of the convertible promissory note in the original principal amount of $1,050,000 due April 4, 2023 (the “2022 Note Payable”). In consideration of a cash payment of $300,000 and 556,250 shares of common stock representing conversion of the remaining principal balance the Company’s obligations under the 2022 Note Payable are deemed satisfied reducing the balance to zero.
Simultaneously therewith, the parties entered into the Securities Purchase Agreement (the “2023 SPA”) pursuant to which Crom purchased (a) a convertible promissory note in the principal amount of $840,000 (the “2023 Note Payable”), which matures February 13, 2024 and bears interest at a per annum rate equal to 10% to be paid monthly, and (b) a warrant pursuant to which Crom has the right to purchase up to 700,000 shares of the Company’s common stock (the “2023 Warrant”) at an exercise price of $1.38 which expire 60 months from the date of issuance. The proceeds of the 2023 Note Payable will be used primarily to fund a pending acquisition, as well as fund the debt repayment referred to in the foregoing paragraph. As a result of these transactions, the current Crom note payable of $890,000, reported in current liabilities on the consolidated balance sheets as of December 31, 2022, will be reported in noncurrent liabilities in 2023.