AWARE INC /MA/ 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The following table sets forth, for the years indicated, certain line items from our consolidated statements of operations stated as a percentage of total revenue: Year ended December 31, Revenue: 2021 2020 Software licenses 47 % 45 % Software maintenance 40 48 Services and other 13 7 Total revenue 100 100 Costs and expenses: Cost of services and other 7 7 Research and development 55 80 Selling and marketing 38 48 General and administrative 37 48 Total costs and expenses 137 183 Operating loss (37 ) (83 ) Interest income - 2 Loss before benefit from income taxes (37 ) (81 ) Benefit from income taxes (2 ) (14 ) Net loss (35 %) (67 %) Summary of Operations We are primarily engaged in the development and sale of biometrics products, solutions and services. Our software products are used in government and commercial systems and applications and fulfill a broad range of functions critical to secure biometric enrollment, authentication, identification and transactions. Principal government applications of biometrics systems include border control, visa applicant screening, law enforcement, national defense, intelligence, secure credentialing, access control, and background checks. Principal commercial applications include: i) user enrollment and authentication used for login to mobile devices, computers, networks, and software programs; ii) user authentication for financial transactions and purchases (online and in-person); iii) physical access control to buildings; and iv) identity proofing of prospective employees and customers. We sell our biometrics software products and services globally through a multifaceted distribution strategy using systems integrators, OEMs, VARs, partners, and directly to end user customers. We also derive a portion of our revenue from the sale of imaging software licenses to OEMs and systems integrators that incorporate our software into medical imaging products and medical systems. In November 2020, we acquired certain assets and assumed certain liabilities of Radiant’s AFIX product line for cash consideration of approximately $2.4 million. The acquisition of AFIX provides turnkey face and fingerprint biometric and forensic analysis software for small and medium-sized law enforcement and government agencies and extends our ABIS product family. In December 2021, we acquired 100% of the outstanding shares of FortressID in exchange for $2.5 million in cash. Additionally, the purchase consideration includes a contingent consideration arrangement wherein the seller is entitled to cash payments of up to $4.0M based on revenue targets in 2022 and 2023. The fair value of the contingent consideration was determined to be $0.9M at December 31, 2021 and is included in the purchase price consideration. The acquisition of FortressID, expands the Company’s offerings around identity proofing, enhancing its onboarding, verification and authentication offerings to directly address financial compliance requirements and enable organizations to mitigate risk and curtail increasing fraud. Summary of Financial Results We used revenue and operating loss to summarize financial results over the past two years as we believe these measurements are the most meaningful way to understand our operating performance. 17 20 2 1 compared to 20 20 Revenue and operating loss in 2021 were $16.9 million and $6.1 million, respectively, which compared to revenue and operating loss in 2020 of $11.3 million and $9.4 million, respectively. Higher revenue in 2021 as compared to 2020 was primarily due to an increase in software license revenue from subscription-based contracts and fixed fee license contracts, as well as maintenance revenue related to our acquisition of AFIX in the fourth quarter of 2020 and services revenue related to additional service projects. Lower operating loss in 2021 as compared 2020 was primarily due to the increase in revenue, which was partially offset by increased operating expenses. Software License Revenue Software license revenue consists of revenue from the sale of biometrics and imaging software products. Sales of software products depend on our ability to win proposals to supply software for biometrics systems projects either directly to end user customers or indirectly through channel partners. Software license revenue increased 58% from $5.0 million in 2020 to $8.0 million in 2021. As a percentage of total revenue, software license revenue increased from 45% in 2020 to 47% in 2021. The $3.0 million increase in software license revenue was attributable to a $1.6 million increase in subscription-based contracts and $1.4 million increase in fixed fee license contracts. Software Maintenance Revenue Software maintenance revenue consists of revenue from the sale of software maintenance contracts. Software maintenance contracts entitle customers to receive software support and software updates, if and when they become available, during the term of the contract. Software maintenance revenue increased 23% from $5.4 million in 2020 to $6.7 million in 2021. As a percentage of total revenue, software maintenance revenue decreased from 48% in 2020 to 40% in 2021. The dollar increase in software maintenance revenue was primarily due to software maintenance revenue related to our acquisition of AFIX in the fourth quarter of 2020. A majority of our customers purchase software maintenance contracts when they initially purchase software licenses. Since our software is used in active biometrics systems, many of our customers continue to renew their maintenance contracts in subsequent years while systems remain operational. Services and Other Revenue Services revenue consists of fees we charge to perform software development, integration, installation, and customization services. Similar to software license revenue, services revenue depends on our ability to win biometrics systems projects either directly with end user customers or in conjunction with channel partners. Other revenue consists of hardware fees that are included with some of our software license. Services and other revenue fluctuate when we commence new projects and/or when we complete projects that were started in previous periods. Services and other revenue increased 162% from $0.8 million in 2020 to $2.2 million in 2021. As a percentage of total revenue, services and other revenue increased from 7% in 2020 to 13% in 2021. The dollar increase in services and other revenue was primarily due to additional services performed by us with system integrators. Cost of Services and Other Revenue Cost of services and other revenue consists primarily of engineering costs to perform customer services projects. Such costs primarily include: i) engineering salaries, stock-based compensation, fringe benefits, and facilities; ii) engineering consultants and contractors; iii) software license fees; and iv) hardware costs. Cost of services and other revenue increased 49% from $0.8 million in 2020 to $1.2 million in 2021. When compared to services and other revenue, cost of services and other revenue as a percentage decreased from 96% in 2020 to 55% in 2021, which resulted in gross margins increasing from 4% in 2020 to 45% in 2021. The dollar increase in cost of services and other revenue was primarily due to third-party software and hardware costs related to a project from our AFIX product line as well as higher allocation of engineering costs to service and other revenue resulting from higher active contracts with services. 18 G ross margins on services and other revenue are a fu nction of: i) the nature of the project s ; ii) the level of engineering difficulty and labor hours required to complete project tasks; and iii) how much we were able to charge. Gross margins in these years reflect the profitability mix of customer projects . W e expect that gross margins on services and other revenue will continue to fluctuate in future periods based on the nature , complexity, and pricing of future projects. Research and Development Expense Research and development expense consists of costs for: i) engineering personnel, including salaries, stock-based compensation, fringe benefits, and facilities; ii) engineering consultants and contractors, and iii) other engineering expenses such as supplies, equipment depreciation, dues and memberships and travel. Engineering costs incurred to develop our technology and products are classified as research and development expense. As described in the cost of services section, engineering costs incurred to provide engineering services for customer projects are classified as cost of services and are not included in research and development expense. The classification of total engineering costs to research and development expense and cost of services was (in thousands): Years ended December 31, 2021 2020 Research and development expense $ 9,259 $ 9,093 Cost of services and other 1,210 810 Total engineering costs $ 10,469 $ 9,903 Total engineering costs increased 6% from 2020 to 2021. As a percentage of total revenue, total engineering costs decreased from 87% in 2020 to 62% in 2021. Total engineering costs increased by $0.6 million in 2021 as compared to 2020. The spending increase was primarily due to higher employee costs. Our engineering headcount of 49 in 2021 remained consistent compared to 2020. We believe our engineering organization was adequately staffed as of December 31, 2021. As we described in the Part I—Business of this Form 10-K, we intend to introduce new products that will allow us to offer more complete biometrics solutions. We believe this strategy will allow us to sell more software into biometrics systems projects in order to grow our revenue. Our preference is to develop such products internally, however to the extent we are unable to do that, we may purchase or license technologies from third parties. We anticipate that we will continue to focus our future research and development activities on enhancing existing products and developing new products. We expect research and development expenses to increase in absolute dollars, but to decrease as a percentage of net revenues. Selling and Marketing Expense Selling and marketing expense primarily consists of costs for: i) sales and marketing personnel, including salaries, sales commissions, stock-based compensation, fringe benefits, travel, and facilities; and ii) advertising and promotion expenses. Sales and marketing expense increased by 18% from $5.4 million in 2020 to $6.3 million in 2021. As a percentage of total revenue, sales and marketing expense decreased from 48% in 2020 to 38% in 2021. The dollar increase in selling and marketing expense was primarily due to increased headcount and contracted sales agents. We expect to expand our sales and marketing force to address additional opportunities. General and Administrative Expense General and administrative expense consists primarily of costs for: i) officers, directors and administrative personnel, including salaries, bonuses, director compensation, stock-based compensation, fringe benefits, and facilities; ii) professional fees, including legal and audit fees; iii) public company expenses; and iv) other administrative expenses, such as insurance costs and bad debt provisions. General and administrative expense increased by 14% from $5.4 million in 2020 to $6.2 million in 2021. As a percentage of total revenue, general and administrative expense decreased from 48% in 2020 to 37% in 2021. The increase in general and administrative expense in 2021 was primarily due to higher employee related costs of our 19 administrative personnel and professional services in 2021. We expect general and administrative expenses to increase in absolute dollars, but to decrease as a percentage of net revenues and may fluctuate depending on specific activities in a period. Interest Income Interest income decreased by 98% from $0.2 million in 2020 to $4,000 in 2021. The dollar decrease was primarily due to lower interest rates within our money market accounts. Income Taxes We are subject to income taxes in the United States and we use estimates in determining our provisions for income taxes. We account for income taxes using the asset and liability method for accounting and reporting income taxes. Deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. A discussion of income taxes for the years ended December 31, 2021, and 2020 follows: Year ended December 31, 2021 . Total income tax benefit for the year ended December 31, 2021 was $0.3 million. The income tax benefit for 2021 relates to a release of our valuation allowance as a result of deferred taxes recorded as part of the FortressID acquisition. Year ended December 31, 2020 . Total income tax benefit for the year ended December 31, 2020 was $1.6 million. The income tax benefit for 2020 was primarily due to the tax benefit of the current year tax loss which can be carried back due to changes made by the CARES Act. LIQUIDITY AND CAPITAL RESOURCES In recent years, we have financed the company with our cash balances, cash generated from operations, and cash received from the sale of patent assets. Equity financing has not been a meaningful source of financing for us in recent years. Cash flows from operating, investing and financing activities are described below. Cash flows from operating activities A discussion of cash flow from operating activities for each of the last two years is as follows: Year ended December 31, 2021. Cash used in operating activities was $6.2 million in 2021. Cash used by operations was primarily the result of $5.8 million of net loss and $2.3 million of changes in assets and liabilities, partially offset by the add back of $1.9 million of non-cash items for depreciation, amortization and stock-based compensation. Year ended December 31, 2020. Cash used in operating activities was $5.3 million in 2020. Cash used by operations was primarily the result of $7.6 million of net loss, partially offset by $0.8 million of changes in assets and liabilities and by the add back of $1.5 million of non-cash items for depreciation, amortization and stock-based compensation. Cash flows from investing activities A discussion of cash flow from investing activities for each of the last two years is as follows: Year ended December 31, 2021. Investing activity cash usage of $2.5 million was primarily the result of $2.5 million used in connection with our acquisition of FortressID. Year ended December 31, 2020. Investing activity cash usage of $2.9 million was primarily the result of $2.4 million used in connection with our acquisition of the AFIX product suite and $0.5 million of purchases of property and equipment. Cash flows from financing activities A discussion of cash flow from financing activities for each of the last two years is as follows: 20 Year ended December 31, 20 2 1 . Financing activity cash provided of $0.1 million was primarily the result of the issuance of common stock fr o m stock grants which was partially offset by cash used to pay income taxes for employees who surrendered shares in connection with stock grants. Year ended December 31, 2020. Financing activity cash usage of $1.0 million was primarily the result of $0.9 million used to buy back stock under our stock repurchase program and $0.1 million used to pay income taxes for employees who surrendered shares in connection with stock grants. At December 31, 2021, we had cash and cash equivalents of $30.0 million. While we cannot assure you that we will not require additional financing, or that if needed such financing will be available to us, we believe that our cash and cash equivalents will be sufficient to fund our operations for at least the next twelve months from the filing date of this Annual Report on Form 10-K and to meet our known long-term cash requirements. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our future growth, operating results, and the investments needed to support our operations. If we required additional capital resources, we may utilize available funds or additional external financing. To date, inflation has not had a material impact on our financial results. There can be no assurance, however, that inflation will not adversely affect our financial results in the future. OFF-BALANCE SHEET ARRANGEMENTS We do not currently have any arrangements with unconsolidated entities, such as entities often referred to as structured finance, special purpose entities, or variable interest entities which are often established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not exposed to any financing, liquidity, market or credit risk if we had such relationships. CRITICAL ACCOUNTING POLICIES The Company’s significant accounting policies are discussed in Note 2, Summary of Significant Accounting Policies, to our financial statements, included elsewhere in this Annual Report. We have identified the following as our significant accounting policies and estimates, which are defined as those that are reflective of significant judgments and uncertainties, are the most pervasive and important to the presentation of our financial condition and results of operations and could potentially result in materially different results under different assumptions, judgments or conditions. Revenue recognition . In accordance with Accounting Standards Codification (“ASC”), Topic 606, Revenue from Contracts with Customers (“ASC 606”), revenue is recognized when a customer obtains control of promised goods and services. The amount of revenue recognized reflects the consideration to which we expect to be entitled to receive in exchange for these goods and services. In addition, ASC 606 requires disclosures of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The core principle of the standard is that we should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which we expect to be entitled in exchange for those goods or services. To achieve that core principle, we apply the following five step model: 1. Identify the contract with the customer; 2. Identify the performance obligations in the contract; 3. Determine the transaction price; 4. Allocate the transaction price to the performance obligations in the contract; and 5. Recognize revenue when (or as) each performance obligation is satisfied. We categorize revenue as software licenses, software maintenance, or services and other revenue. Revenue from software licenses is recognized at a point in time upon delivery, provided all other revenue recognition criteria are met. We recognize software maintenance revenue over time on a straight-line basis over the contract period. Services revenue is recognized over time as the services are delivered using an input method (i.e., labor hours incurred as a percentage of total labor hours budgeted), provided all other revenue recognition criteria are met. 21 In addition to selling software licenses, software maintenance and software services on a standalone basis, a significant portion of our contracts include multiple performance obligations , which require an allocation of the transaction price to each distinct performance obligation based on a relative standalone selling price (“SSP ” ) basis. The SSP is the price at which we would sell a promised good or service separately to a customer. The best estimate of SSP is the observable price of a good o r service when we sell that good or service separately. A contractually stated price or a list price for a good or service may be the SSP of that good or service. We use a range of amounts to estimate SSP when we sell each of the goods and services separately and need to determine whether there is a discount that needs to be allocated based on the relative SSP of the various goods and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we typically determine the SSP using an adjusted market assessment approach using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual goods and services due to the stratification of those goods and services by customers and circumstances. In these instances, we may use information such as the nature of the customer and distribution channel in determining the SSP. When software licenses and significant customization engineering services are sold together, they are accounted for as a combined performance obligation, as the software licenses are generally highly dependent on, and interrelated with, the associated customization services and therefore are not distinct performance obligations. Revenue for the combined performance obligation is recognized over time as the services are delivered using an input method (i.e., labor hours incurred as a percentage of total labor hours budgeted). When subscription-based software is sold, the software license and software maintenance are generally considered distinct performance obligations. The transaction price is allocated to the software license and the software maintenance based on relative SSP. We sell our software subscription license for a fixed fee or a subscription-based royalty fee, sometimes subject to a minimum guarantee. When the amount is in the form of a fixed fee, including the guaranteed minimum usage-based royalty, revenue allocated to the software license is recognized at a point in time upon delivery, provided all other revenue recognition criteria are met. Any royalties not subject to the guaranteed minimum or earned in excess of the minimum amount are recognized as revenue when the subsequent usage occurs. Revenue allocated to the software maintenance is recognized over the contract term. Our arrangements can include variable fees, such as the option to purchase additional usage of a previously delivered software license. The Company may also provide pricing concessions to clients, a business practice that also gives rise to variable fees in contracts. For variable fees arising from the client’s purchase of additional usage of a previously delivered software license, we apply the sales and usage-based royalties guidance related to a license of intellectual property and recognizes the revenue in the period the underlying sale or usage occurs. We include variable fees in the determination of total transaction price if it is not probable that a future significant reversal of revenue will occur. We use the expected value or most likely value amount, whichever is more appropriate for specific circumstances, to estimate variable consideration, and the estimates are based on the level of historical price concessions offered to clients. The amount of consideration is not adjusted for a significant financing component if the time between payment and the transfer of the related good or service is expected to be one year or less under the practical expedient in ASC 606-10-32-18. Our revenue arrangements are typically accounted for under such expedient, as payment is typically due within 30 to 60 days. As of December 31, 2021 and 2020, none of our contracts contained a significant financing component. Goodwill and intangible assets impairment. Our goodwill and intangible assets result from our previous business acquisitions. Goodwill and intangible assets with indefinite useful lives are not amortized but are tested for impairment at least annually or as circumstances indicate their value may no longer be recoverable. We do not carry any intangible assets with indefinite useful lives other than goodwill. We perform our annual goodwill impairment test in the fourth quarter. To assess if goodwill is impaired, we first review qualitative factors to determine whether further impairment testing is necessary. If based on the qualitative assessment, we consider it more-likely-than-not that our reporting unit's fair value is less than its carrying amount, we perform a quantitative impairment test. An excess of carrying value over fair value would indicate that goodwill may be impaired. We periodically reevaluate our business and have determined that we have one operating segment and one reporting unit. If our assumptions change in the future, we may be required to record impairment charges to reduce our goodwill's carrying value. If indicators of impairment are present, we compare the estimated undiscounted cash flows that the asset is expected to generate to the carrying value. The key assumptions of the cash flow model involve significant subjectivity. If 22 such assets are impaired, an impairment is measured by the amount by which the carrying amount of the asset exceeds its fair value. As of December 31, 2021, we had $3.1 million of goodwill and $3.2 million of intangible assets. Impairment in the valuation of long-lived assets could materially impact our operating results and financial position. To date, there have been no impairments of goodwill or intangible assets. Stock-Based Compensation. We grant stock and stock options to our employees and directors. We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize it as expense over the applicable vesting period of the award on a straight-line basis. For stock awards, we determine the fair value of the award by using the fair market value of our stock on the date of grant; provided the number of shares in the grant is fixed on the grant date. For stock options, we use the Black-Scholes valuation model to estimate the fair value of the award. This valuation model takes into account the exercise price of the award, as well as a variety of significant assumptions. The assumptions used to estimate the fair value of stock options include the expected term, the expected volatility of our stock over the expected term, the risk-free interest rate over the expected term, and our expected annual dividend yield. Income taxes . As part of the process of preparing our consolidated financial statements we are required to estimate our actual current tax expense. We must also estimate temporary and permanent differences that result from differing treatment of certain items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period for deferred tax assets, which have been recognized, we must include an expense with the tax provision in the statement of operations. Conversely, to the extent we decrease our valuation allowance in a period for deferred tax assets, which have been previously reserved, we must include a tax benefit with the tax provision in the statement of operations. The Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) was signed into law on March 27, 2020. The Act contained specific relief and stimulus measures including allowing net operating losses originating in 2018 through 2020 to be carried back five years to offset taxable income in the carryback period. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets, and any valuation allowance recorded against our net deferred tax assets. Our deferred tax assets primarily relate to: i) research and development tax credit carryforwards related to excess stock compensation benefits; ii) net operating loss carryforwards; and iii) temporary differences that result from differing treatment of certain items for tax and accounting purposes. As of December 31, 2021, we had a total of $10.7 million of deferred tax assets for which we have recorded a $10.7 million valuation allowance. We will continue to assess the level of valuation allowance required in future periods. Should evidence regarding the realizability of tax assets change at a future point in time, the valuation allowance will be adjusted accordingly. Allowance for doubtful accounts. We make judgments as to our ability to collect outstanding receivables and provide allowances for receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding invoices. If the judgments we make to determine the allowance for doubtful accounts do not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be required. RECENT ACCOUNTING PRONOUNCEMENTS Recent Accounting Pronouncements. In October 2021, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No. 2021-08, Business Combinations (Topic 805): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers . The ASU requires contract assets and contracts liabilities to be accounted for as if they (“the acquirer”) entered into the original contract at the same time and same date as the acquiree. The guidance is to be effective for reporting periods beginning after December 15, 2022, with early adoption permitted. We have elected not to early adopt and we are continuing to assess the impact of the standard on our consolidated financial statements. 23 In December 2019, FASB issued Accounting Standard Update (“ASU”) No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes . The ASU was issued to reduce the complexity of the reporting information for financial statement users. We adopted the standard on January 1, 2020. The adoption of the standard did not result in any adjustment to our financial statements. In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments , which changes the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. This guidance was to be effective for reporting periods beginning after December 15, 2019, with early adoption permitted. In November 2019, the FASB issued ASU 2019-10, Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic842) Effective Dates, which deferred the effective dates for us, as a smaller reporting company, until fiscal year 2023. We are continuing to assess the impact of the standard on our consolidated financial statements. 24