Airship AI Holdings, Inc. 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. On December 21, 2023, the Company entered into the Merger Agreement which is summarized in Note 13 — Reverse Recapitalization, of the audited consolidated financial statements included elsewhere in this report. The following discussion and analysis summarizes the significant factors affecting our operating results, financial condition, liquidity and cash flows as of and for the periods presented below. The following discussion and analysis should be read in conjunction with our financial statements and the related notes thereto included elsewhere in this report. The discussion contains forward-looking statements that are based on the beliefs of management, as well as assumptions made by, and information currently available to, management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed below and elsewhere in this report, particularly in the sections titled “Risk Factors” and “ Special Note Regarding Forward-Looking Statements. ” Overview We are a robust AI-driven data management platform that solves complex data challenges for large institutions operating in dynamic and mission-critical environments with rapidly increasing volumes of data being ingested from a similarly rapidly growing number of data sources. We solve these challenges by structuring “dark” or unstructured data at the edge, the location at which the data is generated and collected, and leveraging purpose-built AI models. Unstructured, or “dark” data, which is typically categorized as qualitative data, cannot be processed and analyzed via conventional data tools and methods. Conversely, structured data, typically categorized as quantitative data, is highly organized and easily decipherable by machine learning algorithms. Structuring and then analyzing data using AI models at the edge, versus transmitting the data from the edge back to a central processing location for structuring and analysis, enables real-time decision making and data-driven operational efficiency. We specialize in ingesting all available metadata from edge-based sensors used by government and law enforcement agencies around the world, including surveillance cameras (video), audio, telemetry, acoustic, seismic, and autonomous devices, along with large commercial corporations with fundamentally similar capabilities and requirements. Data generated by these edge-based sensors, including video, can then be run through our trained AI models to detect objects present within the video frame. Once an object is detected, for example an automobile, additional identifying characteristics of the object can be extracted from the image including the license plate characters and the make, model, and color of the automobile. This process of analyzing, logging and categorizing ingested data is referred to as “structuring” the data. Airship AI’s software allows customers to view structured data both in real-time as well as to conduct searches on the structured data at a later point in time. Real-time structured data use includes, for example, alarms on a specific license plate or a specific make, model or color of automobile. Non-real-time structured data use includes, for example, searching a database of video data that has been previously ingested and stored to find instances of a particular license plate being visible, along with other logged vehicle characteristics such as make, model and color of an automobile. Additional edge deployed AI models enable similar object detection and recognition of common and custom trained objects, such as an aircraft, boat, person, animal, bag, or weapon. Airship AI’s models provide similar data points for these object types allowing analysts the ability to be notified in real-time of the detection of a specified object and similarly search for historically detected objects. Examples include detecting aircrafts and boats along with their respective tail numbers and hull registration numbers. Our AI modelling process starts with pre-trained AI models from our technology ecosystem partners which we then customize using proprietary datasets tailored towards our customers unique workflow requirements. Where customers have pre-existing AI models or engines, we integrate those models or engines into our edge platform allowing customers to leverage proprietary models within the Airship AI software ecosystem. Our primary offerings include Outpost AI, Acropolis, and Airship Command. Our offerings allow customers to manage their data across the full data lifecycle, when and where they need it, using a highly secure permissioned based architecture. 46 Table of Contents Recent Developments On June 27, 2023, BYTS entered into the Merger Agreement, by and among BYTS, Merger Sub, and Airship AI. The Merger Agreement was amended on September 22, 2023. On December 21, 2023, the Merger with BYTS closed. Airship AI Holdings, Inc. became the accounting acquiror and the combined entity became the successor SEC registrant under the ticker symbol “AISP”. Key Performance Indicators Historically, a majority of our product revenue has consisted primarily of a bundled hardware and software product and to date we have sold or licensed a minimal amount of standalone software. In the future, we expect to see more delivery of our products using a cloud based software solution which will allow us to create additional subscription revenue. We have historically evaluated our business solely based on revenue generated from customers and we have not tracked any other customer-related metrics. As we grow and increase our product offerings and customer base, we intend to modify and develop more advanced performance indicators. We believe the following key performance indicators apply to us in the future: · Growth within existing government customers . While we currently have a strong footprint across multiple large U.S. government agencies, growing our business within these agencies outside of the investigation focused departments is a fundamental area of our projected growth. Our ability to expand our footprint by implementing AI based solutions that leverage our core existing competencies within the agencies will be a critical indicator of the success of this strategy. We will measure progress against this objective through the disclosure of awards for new business within these agencies during the affected timeframe, providing tangible evidence of the success of our strategy to both management and investors alike. · Greater penetration into the commercial marketplace . While we have several existing customers in the commercial marketplace, our ability to build on the solutions we provide those customers and expand that base will be critical to our projected growth objectives. We will measure progress against this objective through the disclosure of the number of new commercial customers added during the affected timeframe, providing tangible evidence of the success of our strategy to both management and investors alike. · Expansion of our edge AI based solutions . We began to sell AI based solutions in late 2022. Our current strategy is highly focused on the transition of data management and analysis workloads to the edge, driving efficiency and cost savings for our customers. This strategy also includes new models being trained to extract data at the edge which enables real-time intelligent decision making for our customers. We will measure progress against this objective through the disclosure of the numbers of edge AI hardware devices we are selling as well as the growth of our edge AI analytic capabilities, providing tangible evidence of the success of our strategy to both management and investors alike. Principal Factors Affecting Our Financial Performance We believe the following factors and trends may cause previously reported financial information not to be necessarily indicative of future operating results or future financial conditions: · Increase in the sales of lower margin solutions as we expand our operational footprint . While our current focus remains on expanding our AI driven software application portfolio, opportunities will continue to present themselves to provide those software-based solutions as part of a larger hardware-based turn-key solutions where Airship AI can provide a unique value-add to the customer. While these solutions will positively affect revenue we anticipate our operating profits in future periods may be adversely affected as compared to previous years due to the lower operating margin for hardware versus software applications. · Challenges due to geo-political driven supply-chain constraints . While many of the COVID-19 driven supply chain issues have been resolved, challenges to the timely production and delivery of Taiwan based products we utilize for our edge AI platform due to geo-political factors is a concern looking forward. In the event that our suppliers are unable to provide timely delivery of those supplies it will significantly impact our ability to meet delivery schedules for existing and anticipated edge AI hardware-based solutions. · Near-term impacts due to merger and acquisition activity . If Airship AI merges with or acquires another company following the Business Combination, it is reasonably expected that there will be increased operating expenses and costs associated with the merger that could negatively impact operating profits in the future periods immediately following the M&A event. The extent and longevity of those impacts is not possible to quantify. 47 Table of Contents Segment Reporting The Financial Accounting Standards Board, or FASB, Accounting Standard Codification, or ASC, Topic 280, Segment Reporting , requires that an enterprise report selected information about reportable segments in its financial reports issued to its stockholders. Management monitors the revenue and expense components of the various products and services the Company offers, but operations are managed and financial performance is evaluated on a corporation-wide basis in comparison to a business plan which is developed each year. Accordingly, all operations are considered by management to be one operating segment and one reportable segment as contained in the Consolidated Statements of Operations and Comprehensive Loss to the consolidated financial statements. Results of Operations The following table sets forth key components of our results of operations during the years ended December 31, 2023 and 2022. (dollars in thousands) Year Ended December 31, 2023 2022 $ Variance % Variance Net revenues $ 12,300 $ 14,549 $ (2,249 ) -15.5 % Cost of net revenues 6,536 6,128 (408 ) -6.7 % Gross profit 5,764 8,421 (2,657 ) -31.6 % Research and development expenses 2,729 3,615 886 24.5 % Selling, general and administrative expenses 9,675 7,630 (2,045 ) -26.8 % Total operating expenses 12,404 11,245 (1,159 ) -10.3 % Operating loss (6,640 ) (2,824 ) (3,816 ) -135.1 % Other income (expense): Gain from change in fair value of warrants 1,341 - 1,341 100.0 % Gain from change in fair value of earnout liability 21,977 - 21,977 100.0 % Loss from change in fair value of convertible debt (241 ) - (241 ) -100.0 % Interest income - 43 (43 ) -100.0 % Interest expense (56 ) (75 ) 19 25.3 % Other expense (10 ) - (10 ) -100.0 % Other income- PPP loan forgiveness - 1,146 (1,146 ) -100.0 % Other income- Employee retention tax credit - 1,233 (1,233 ) -100.0 % Total other income, net 23,011 2,347 20,664 880.4 % Income (loss) before income taxes 16,371 (477 ) 16,848 3532.1 % Income tax benefit (expense) - (10 ) 10 100.0 % Net income (loss) $ 16,371 $ (487 ) $ 16,858 3461.6 % Net Revenues — Revenues for the year ended December 31, 2023 decreased $2,249,000 to $12,300,000 as compared to $14,549,000 for the year ended December 31, 2022, as a result of lower product sales. We have also recently received purchase orders from various government agency customers totaling over $13 million from which we expect to start receiving cash in the first quarter of 2024. As a result of supply chain issues that existed at December 31, 2021, we were unable to fulfill many orders and had a backlog of new orders of $6.8 million that shipped during the year ended December 31, 2022. Cost of Net Revenues — Cost of net revenues primarily consists of product costs and post customer support. For the year ended December 31, 2023, cost of sales increased $408,000 to $6,536,000 as compared to $6,128,000 for the year ended December 31, 2022. The increase was due to higher product costs and increased post contract support costs. Research and Development Expenses — Research and development expenses for the year ended December 31, 2023 decreased $886,000 to $2,729,000 as compared to $3,615,000 for the year ended December 31, 2022. The decrease was due to reduced personnel (17 personnel as compared to 18 personnel) and reduced funding of $694,000 of the AI expenses in Taiwan. 48 Table of Contents Selling, General and Administrative Expenses — Selling, general and administrative expenses for the year ended December 31, 2023 increased $2,045,000 to $9,675,000 as compared to $7,630,000 for the year ended December 31, 2022. The increase was due to (i) increased stock based compensation of $2,305,000; and offset by (iii) reduced other expenses of $260,000. The stock based compensation increase includes $2,100,000 for warrants to purchase 1,344,951 shares of common stock issued to each of Victor Huang and Derek Xu. Other Income — Other income for the year ended December 31, 2023 was $23,011,000 as compared to other income of $2,347,000 for the year ended December 31, 2022. Other income for the year ended December 31, 2023 consisted of (i) gain from change in fair value of warrant liability of $1,341,000; (ii) gain from change in fair value of earnout liability of $21,977,000; and offset by (iii) unrealized loss for increase in fair value of convertible promissory note of $241,000 and (iv) noncash interest and other, net of $66,000. Other income for the year ended December 31, 2022 related primarily to (i) gain on forgiveness of Paycheck Protection Program loan of $1,146,000 and (ii) $1,233,000 income from employee retention tax credit. Net Income (Loss) — Net income for the year ended December 31, 2023 was $16,371,000 as compared to net loss of $487,000 for the year ended December 31, 2022. The change was the result of $2.7 million lower gross profit in 2023 from decreased revenue and higher cost of revenue, higher operating expenses in 2023 of $1.2 million due mostly to increased stock based compensation offset by $20.6 million increase in other income as discussed in other income above. The net income for the year ended December 31, 2023 included noncash income of $19,627,000. Net loss for the year ended December 31, 2022 included net noncash expenses of $50,000. Liquidity and Capital Resources as of December 31, 2023 and 2022 Liquidity is the ability of a company to generate funds to support its current and future operations, satisfy its obligations, and otherwise operate on an ongoing basis. Significant factors in the management of liquidity are funds generated by operations, levels of accounts receivable and accounts payable and capital expenditures. We formally evaluated our liquidity and cash position most recently in March 2024 when preparing our December 31, 2023 audited financial statements. During this process we concluded, based upon existing assets and liabilities, our order backlog and projections, plus the ability to borrow up to $2.5 million in short term loans from our founder, that we would be able to operate at least for the next twelve months. We have also recently received purchase orders from various government agency customers totaling over $13 million from which we expect to start receiving cash in the first quarter of 2024. As of December 31, 2023, we had cash of approximately $3,124,000 and net capital deficit of approximately $6,174,000. The net working capital deficit includes a couple of items that are expected to require limited future cash outlays including current portion of deferred revenue totaling $4,009,000 and convertible debt totaling $2,825,000 which we expect to be converted to equity. As of December 31, 2023, we had an accumulated deficit of $16,582,000. On December 21, 2023, the merger with BYTS closed from which we received $2.8 million in net proceeds. Airship AI Holdings, Inc. became the accounting acquiror. a. Operating Activities Net cash used in operating activities for the year ended December 31, 2023 was $3,291,000. This amount was primarily related to (i) net income of $16,371,000; (ii) depreciation of $15,000; (iii) stock based compensation of $2,852,000; (iv) net amortization of operating lease right of use asset of $597,000; (v) unrealized loss for increase in fair value of convertible promissory note of $240,000; (vi) non cash interest, net of $65,000; offset by (vii) gain from change in fair value of warrant liability of $1,341,000; (viii) gain from change in fair value of earnout liability of $21,976,000; and (ix) working capital changes of $36,000. Net cash used in operating activities for the year ended December 31, 2022 was $2,903,000. This amount was primarily related to (i) a net loss of $487,000; (ii) working capital changes of $2,365,000; (iii) gain on forgiveness of note payable — PPP of $1,146,000; offset by (iv) depreciation of $15,000; (v) stock based compensation of $546,000; (vi) amortization of operating lease right of use asset of $517,000; and (vii) other of $17,000. b. Financing Activities 49 Table of Contents Net cash provided by financing activities for the year ended December 31, 2023 was $6,120,000 and consisted of (i) issuance of a senior secured convertible promissory note of $2,585,000; (ii) net advances provided by the founders of $1,150,000; (iii) proceeds from reverse capitalization of $2,800,000; and offset by (iv) the payoff of small business loan and line of credit of $425,000. Net cash provided by financing activities for the year ended December 31, 2022 was $1,866,000 and consisted of (i) $565,000 from a small business loan and a line of credit; (ii) proceeds from notes receivable — related parties of $842,000; (iii) the founders advances of $1,900,000 and repayment of advances to the founders of $1,300,000; and (iv) repayment of small business loan and line of credit of $140,000. Our contractual cash obligations as of December 31, 2023 (excluding debt financing arrangements below) are summarized in the table below: Less Than Contractual Cash Obligations Total 1 Year 1-3 Years 4-5 Years Operating lease cash payments $ 1,291,754 $ 245,051 $ 729,919 $ 316,784 Debt Financing Arrangements On June 22, 2023, we entered into a Senior Secured Convertible Promissory Note with Platinum Capital Partners Inc. and received $2,000,000. As a condition of funding, we paid off three small notes and accounts payable totaling $374,000. At the option of the holder, the note is convertible into cash, common stock or a combination of cash and stock. We expect the convertible debt to be converted to equity. On November 2 2023, we issued senior secured convertible promissory notes for $600,000 to two private investors. At the option of the holders, the notes are convertible into cash, common stock or a combination of cash and stock. On March 5, 2024, the two private investors converted the debt to equity. Mr. Huang has committed to providing $2.5 million in additional temporary funding if it is necessary. 50 Table of Contents We believe that our cash on hand, funding from the completion of the business combination, results of operations and financing transactions will be sufficient to fund our operations for the next twelve months. Equity financing, if obtained, could result in dilution to our then-existing stockholders and/or require such stockholders to waive certain rights and preferences. If such financing is not available on satisfactory terms, or is not available at all, we may be required to delay, scale back, or eliminate the development of business opportunities and our operations and financial condition may be materially adversely affected. Contractual Obligations and Commitments On July 13, 2023, we entered into a lease in Redmond, WA for 15,567 square feet of office and warehouse space which started October 1, 2023. The monthly payment is $25,000 per month. The lease expires October 31, 2027 and the monthly payment increases 3% on July 31, 2024 and each year thereafter. There is a one three year option to extend based on the fair market rate on October 31, 2027. On February 29, 2024, we extended a lease in Moorestown, North Carolina. The Company leases 3,621 square feet and the net monthly payment is $6,488. The lease expires on July 29, 2024. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements (as that term is defined in Item 303 of Regulation S-K) that are reasonably likely to have a current or future material effect on our financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results could differ materially from those estimates due to risks and uncertainties, including uncertainty in the current economic environment. To the extent that there are material differences between these estimates and our actual results, our future consolidated financial statements will be affected. 51 Table of Contents We believe that the significant accounting policies described in “ Note 2, Summary of Significant Accounting Policies ” to our audited consolidated financial statements are accurate and complete. The critical accounting estimates, assumptions, and judgments that have the most significant impact on our consolidated financial statements are described below. Revenue Recognition The majority of our contracts with our customers include various combinations of our products and post contract support (“PCS”) services. Our products and PCS offerings have significant standalone functionalities and capabilities. Accordingly, the products are distinct from our PCS services as customers can benefit from the products without the PCS services and such PCS services are separately identifiable within the contracts. We account for multiple agreements with a single customer as a single contract if the contractual terms and/or substance of those agreements indicate that they may be so closely related that they are, in effect, parts of a single contract. The amount of consideration we expect to receive in exchange for delivering on the contract is allocated to each performance obligation based on its relative standalone selling price. We establish the standalone selling price using the prices charged for a deliverable when sold separately. If the standalone selling price is not observable through past transactions, we estimate the standalone selling price based on our pricing model and offering type (products or PCS services). As our business offerings evolve over time, we may be required to modify our estimated standalone selling prices, and as a result the timing and classification of our revenue could be affected. Income Taxes We account for income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. In addition, deferred tax assets are recorded for all future benefits including, but not limited to, net operating losses, research and development credit carryforwards, and basis differences with certain assets and liabilities. Significant judgment is required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence, including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision or benefit for income taxes in the period in which such determination is made. We recognize liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step requires us to estimate and measure the tax benefit as the largest amount that is more likely than not to be realized upon ultimate settlement. We do not believe that we currently have any material uncertain tax positions and no reserves are currently required given our deferred tax asset has a 100% valuation allowance. Stock Based Compensation The Company records stock-based compensation expense associated with stock options, warrants, SARs, unvested earnout shares and other equity-based compensation using the Black-Scholes-Merton option valuation and Monte Carlo valuation models for estimating fair value of such equity instruments. The fair value of such equity instruments is determined at the date of grant and such value is recognized as an expense over the service period of the recipient. The Black Scholes and Monte Carlo pricing model uses various inputs and assumptions, including the estimated fair value of the common stock, stock volatility, risk free interest rate over the expected term of the instrument, estimated life of the award, and forfeiture rates of such awards. All of these estimates impact stock based compensation which is a non-cash expense. Changes in the assumptions used in the calculation would impact the recorded stock based compensation. The fair value of the equity instrument is usually calculated at issuance and is not required to be remeasured in the future. Management uses third party experts to assist with certain elements of the fair value calculation and it constantly adjusts the variables used in estimating the fair value of equity instruments issued as compensation. Fair Value Measurements Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This topic also establishes a fair value hierarchy, which requires classification based on observable and unobservable inputs when measuring fair value. The fair value hierarchy distinguishes between assumptions based on market data (observable inputs) and an entity’s own assumptions (unobservable inputs). The hierarchy consists of three levels: 52 Table of Contents Level 1 — Quoted prices in active markets for identical assets and liabilities; Level 2 — Inputs other than level one inputs that are either directly or indirectly observable; and Level 3 — Inputs to the valuation methodology are unobservable and significant to the fair value measurement. The recorded value of other financial assets and liabilities, which consist primarily of cash and cash equivalents, accounts receivable, other current assets, accounts payable and accrued expenses approximate the fair value of the respective assets and liabilities as of December 31, 2023 and 2022 are based upon the short-term nature of the assets and liabilities. The Company recorded its Senior Secured Convertible Promissory Note, earnout liability, Private Warrants and the warrants that were issued with this Note at fair value, remeasured on a recurring basis. The Company classifies as liabilities any contracts that (i) require net-cash settlement (including a requirement to net- cash settle the contract if an event occurs and if that event is outside the control of the Company) or (ii) give the counterparty a choice of net-cash settlement or settlement in shares (physical settlement or net-share settlement). Recent Accounting Pronouncements For further information on recent accounting pronouncements, see “ Note 2, Summary of Significant Accounting Policies ” to our audited consolidated financial statements included herein. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not applicable.