SideChannel, Inc. 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our financial statements, including the notes thereto, appearing elsewhere in this Annual Report on Form 10-K. Our Business We are developing products and services around our patented polymorphic encryption technology, which is designed to enable secure and private data transmission. Through a licensing program, we are offering our Polymorphic Encryption Core, or PEC, which we believe to be the first secure commercially viable, advanced polymorphic data-in-motion product that is designed to be used in any commercial data security industry or in sensitive applications. To supplement our potential licensing revenue, we are building our own applications that leverage our PEC. We believe that our innovative and patented polymorphic technology provides resistant and performant solutions to the problem of quantum cracking through rapid deployment of our quantum encryption algorithm, which has been approved by the National Institute of Standards and Technology. We anticipate that our operating expenses for the next twelve months will require between $2.5 and $3.5 million of cash, which will come from the net proceeds we received from a private placement of our securities held between March 31, 2021 and April 16, 2021. We intend to manage our business such that our current cash reserves will allow us to reach positive cash flow from our operations, but we cannot assure you that will occur. Our proposed approach to managing our cash will initially emphasize demonstrating our products’ capabilities with our current customers. We will follow those efforts with using our remaining cash to scale all of our functional areas, including product development, marketing, sales, customer support, and administration. We intend to focus our product development efforts on building new software and services to work with our existing core technology, while continuing to support our existing licensees. These efforts will require more personnel, as well as more infrastructure. We expect the increase in product development activities will require approximately $1.0 million of our cash over the next 12 months. We plan to build the infrastructure we need to perform these new functions on modern technology, with scale and reliability. We plan to utilize cloud services to provide our customers with an interface that modern software provides, but also an ease of use that we believe encryption technologies desperately need. We believe that, if we are able to build our infrastructure, as described above, we will have a competitive advantage over most other participants in our market. We intend to have our sales and marketing efforts emphasize qualified lead generation, using very focused industry messaging and engagement. We plan to participate in relevant cybersecurity and quantum computing industry events. We have also formed a board of advisors designed to help us identify the correct product focus areas and market segmentation. This board of advisors includes professionals from cybersecurity, technology business development and software marketing. We estimate that the expenses we will incur for sales and marketing during the next fiscal year will range between $500,000 and $750,000. Our administration costs are currently minimal. However, we expect that we will have to increase these costs if we are able to generate sufficient revenues and hire additional employees. Our administrative resources will have to be increased according to our demand to support our employees, increase accounting capacities, and expand our reporting and compliance capabilities. We expect that we will need additional personnel in our accounting and human resources functions to support these expected staff additions. We also plan to add software tools to help us manage our internal processes. We expect that we will need to add customer support teams if and when potential customers adopt each of our product offerings. We project the costs of customer support for our fiscal year 2022 will likely range from $100,000 to $300,000. We believe that these funds will be used primarily for salaries and technology to support these efforts. These expenses will be included in our cost of goods sold. 31 Critical Accounting Policies Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The preparation of these financial statements requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Our management periodically evaluates the estimates and judgments made. Our management bases its estimates and judgments on historical experience and on various factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates as a result of different assumptions or conditions. The methods, estimates, and judgment we use in applying our most critical accounting policies have a significant impact on the results we report in our financial statements. The SEC has defined “critical accounting policies” as those accounting policies that are most important to the portrayal of our financial condition and results and require us to make our most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based upon this definition, our most critical estimates are accounting for software revenue recognition, and stock issued to employees and non-employees. Our most critical accounting policies applicable to the periods presented are noted below. For additional information see Note 3 Significant Accounting Policies in the notes to our financial statements appearing elsewhere in this report. Although we believe that our estimates and assumptions are reasonable, they are based upon information presently available, and actual results may differ significantly from these estimates. Our critical accounting policies and estimates are those related to revenue recognition, deferred income taxes, accounting for share-based payments, and litigation. Revenue Recognition . We adopted the new accounting revenue standard for revenue recognition, effective October 1, 2018, using the modified retrospective transition method applied to those contracts that were not completed as of October 1, 2018. We present our results for reporting periods beginning after October 1, 2018 under this new guidance, while prior period amounts are not adjusted and continue to be reported in accordance with our historic accounting under previous revenue guidance. See Note 3 Significant Accounting Policies in the notes to our financial statements appearing elsewhere in this report. Our contracts with customers often include promises to transfer multiple products and services to a customer. Our determination whether products and services are considered distinct performance obligations that should be accounted for separately, versus together, may require significant judgment. Our judgment is required to determine the standalone selling price, or SSP, for each distinct performance obligation. For products and services aside from maintenance and support, we estimate SSP by adjusting the list price by historical discount percentages. SSP for software and hardware maintenance and support fees is based on the stated percentages of the fees charged for the respective products. Our perpetual and term software licenses have significant standalone functionality, and therefore revenue allocated to these performance obligations are recognized at a point in time upon electronic delivery of the download link and the license keys. For certain arrangements, we recognize revenue based upon usage or ratably over the term of the arrangement. Our product maintenance and support services are satisfied over time, as they are stand-ready obligations throughout the support period. As a result, we defer revenues associated with maintenance services and recognize the revenue ratably over the term of the applicable contract. We recognize revenues associated with professional services upon customer acceptance. 32 Accounting for Share-Based Payments . As discussed further in Note 8 (Stockholders Equity (Deficit)) to our financial statements appearing elsewhere in this report, we account for share-based awards in accordance with the authoritative guidance issued by the FASB on stock compensation. We have used and expect to continue to use the Black-Scholes option-pricing model to compute the estimated fair value of share-based compensation expense. The Black-Scholes option-pricing model includes assumptions regarding dividend yields, expected volatility, expected option term and risk-free interest rates. The assumptions used in computing the fair value of share-based compensation expense reflect our best estimates, but involve uncertainties relating to market and other conditions, many of which are outside of our control. We estimate expected volatility based primarily on historical daily price changes of our stock and other factors. The expected option term is the number of years that we estimate that the stock options will be outstanding prior to exercise. We determine the estimated expected term of the stock awards issued pursuant to SEC Staff Accounting Bulletin SAB No. 110. If we had used other assumptions or estimates, the share-based compensation expense that we recorded for the years ended September 30, 2019 and September 30, 2018 could have been materially different. Furthermore, if we use different assumptions or estimates in future periods, our share-based compensation expense could be materially impacted. Pursuant to ASC 718-20-35-7, Repurchase or Cancellation of Equity Awards, we charge to equity the amount of cash or other assets transferred (or liabilities incurred) to repurchase an equity award, to the extent that the amount paid does not exceed the fair value of the equity instruments repurchased at the repurchase date. We recognize any excess of the repurchase price over the fair value of the instruments repurchased as additional compensation cost. Fiscal Year Ended September 30, 2021 Compared to Fiscal Year Ended September 30, 2020 Our revenue for the year ended September 30, 2021 was $15,417, a decrease of $32,566 from revenue of $47,983 for the year ended September 30, 2020. Our revenue recognized during the year ended September 30, 2021 was from sales that occurred during the prior fiscal year, with the revenue being recognized over the 12 months following the invoice as cash was collected from the applicable customers. We had no new sales during our fiscal year ended September 30, 2021, even though we were expecting sales during the period based upon information we received from our licenses. We did not record any cost of revenues for the years ended September 30, 2021 or September 30, 2020. Our general and administrative expenses decreased from $4,573,673 for the year ended September 30, 2020, to $2,597,881 for the year ended September 30, 2021. The decrease in general and administrative expenses in 2021, compared to 2020, primarily resulted from lower legal expenses of $845,228, an impairment gain related to our operating leases of $824,559, a decrease in payroll related expenses of $390,788, and decreases in various other office expenses of $139,775, such as professional fees and subscriptions, partially offset by an increase in corporate insurance of $174,558. Our sales and marketing expenses decreased to $96,125 for the year ended September 30, 2021, from $710,595 for the year ended September 30, 2020. The decrease in sales and marketing expenses was primarily due to a decrease in payroll expense of $323,904, a decrease in consulting of $192,650, a decrease in marketing costs of $59,301 and a decrease in travel related expenses of $38,615. Our research and development expenses decreased to $616,746 for the year ended September 30, 2021, from $1,689,455 for the year ended September 30, 2020. The decrease in research and development expenses was primarily due to a decrease in consulting expense of $771,125 and a decrease in payroll expense of $301,584. Our total other income increased to $191,052 for the year ended September 30, 2021, from $44,332 of other expense for the year ended September 30, 2020. The income resulted from the partial forgiveness of our PPP loan. Our other expenses for the year ended September 30, 2020 was the result of losses be recognized on the disposal of some of our fixed assets. We had a net loss of $3,104,283 for the year ended September 30, 2021, compared to a net loss of $6,970,072 for the year ended September 30, 2020. The decrease in our net loss was due to a significant reduction in expenses during the latter half of the year ended September 30, 2020. 33 Liquidity and Capital Resources We had an accumulated deficit as of September 30, 2021 of $71,530,891. We expect to continue to generate operating losses until we can generate revenues sufficient to exceed our operating expenses. As of September 30, 2021, we had $5,783,994 in cash. We believe that our existing cash balances are sufficient to fund our operations for the next 12 months. Cash Flows The following table summarizes, for the periods indicated, selected items in our Statements of Cash Flows: Year Ended September 30, 2021 2020 Net cash (used in) provided by: Operating activities $ (3,630,806 ) $ (6,646,091 ) Investing activities $ — $ (28,972 ) Financing activities $ 8,334,961 $ (84,570 ) Operating Activities For the year ended September 30, 2021, we used $3,630,806 in operating activities, primarily attributable to our net loss of $3,104,283 during the period and negative non-cash items of $633,649, which were partially offset by a net positive change in net operating assets and liabilities of $107,126. Our non-cash items primarily consisted of an of impairment loss of $441,597 related to an operating lease that was terminated, and forgiveness of our PPP loan of $192,502. The change in our net operating assets and liabilities was primarily due to an increase in prepaid and other assets of $511,408, offset by an increase in accounts payable and accrued liabilities of $618,951. We used cash during the year to pay for the cost of general and administrative, sales and marketing, and research and development activities, totaling $3,310,752. For the year ended September 30, 2020, we used $6,646,091in cash in operating activities, primarily attributable to our net loss of $6,970,072, non-cash items of $640,433 and a net change in net operating assets and liabilities of $316,452. Non-cash items primarily consisted of an impairment loss of $382,961 related to the termination of operating leases, stock compensation expense of $194,896, a net loss on disposal of assets of $44,332 and depreciation of $18,243. The change in our net operating assets and liabilities was primarily due to an increase in prepaid and other assets of $322,912 and an increase in accounts payable and accrued liabilities of $6,460. We used cash during the year to pay for the cost of general and administrative, sales and marketing, and research and development activities, which combined to be $6,973,723. Investing Activities We used no cash in investing activities for the year ended September 30, 2021. For the year ended September 30, 2020, we used $28,972 of cash in investing activities, attributable to purchases of property and equipment. Financing Activities For the year ended September 30, 2021, we received $8,334,961 in cash from financing activities, primarily derived from the net proceeds from our capital raise of $8,558,339 offset by a repayment of $173,378 of our PPP loan and payments for the repurchase of treasury stock and preferred stock of $40,000 and $10,000, respectively. For the year ended September 30, 2020, we used $84,570 in cash due to financing activities, primarily due to a payment $450,000 we made for the repurchase of treasury stock, partially offset by the proceeds from the PPP loan of $365,430. Off-Balance Sheet Arrangements We did not have during the periods presented, nor do we currently have, any off-balance sheet arrangements as defined under applicable SEC rules. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is not required to provide the information required by this Item as it is a “smaller reporting company,” as defined in Rule 229.10(f)(1). 34