SideChannel, Inc. 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This MD&A should be read in conjunction with the accompanying consolidated financial statements. In addition, please refer to the discussion of our business and markets contained in Part 1, Item 1 of this Report. Our Business Our mission is to make cybersecurity simple and accessible for mid-market and emerging companies, a market that we believe is currently underserved. We believe that our cybersecurity offerings will identify and develop cybersecurity, privacy, and risk management solutions for our customers. We anticipate that our target customers will continue to need cost-effective security solutions. We intend to provide more tech-enabled services to address the needs of our customers, including virtual Chief Information Security Officer (vCISO), zero trust, third-party risk management, due diligence, privacy, threat intelligence, and managed end-point security solutions. We now have over 20 C-suite level information security officers, who possess combined experience of over 400 years in the industry. To date, SideChannel has created over 50 multi-layered cybersecurity programs for its clients. Our growth strategy focuses on these three initiatives: 1. Securing new vCISO clients 2. Adding new Cybersecurity Software and Services offerings 3. Increasing adoption of Cybersecurity Software, including Enclave and Services offerings at vCISO clients In support of securing new vCISO clients, we expanded the sales and marketing team from one dedicated person to five during the fiscal quarter ended during September 30, 2022. On October 27, 2022, we announced that during the same fiscal quarter we acquired six (6) new clients with potential annual revenue of $1.3 million. vCISO engagements are typically twelve (12) month engagements containing a monthly subscription and an annual renewal option and hourly rates for vCISO time and material projects range from $350 to $400. Each of our vCISO’s is generally embedded into the C-suite executive teams of two (2) to four (4) of our clients. Collectively, our cybersecurity professionals collaborate on the development of proprietary software and pursue partnerships with cybersecurity software value added resellers (“VARs”). Commercial relationships with VARs provide SideChannel with additional internal capabilities to mitigate cybersecurity risks. We earn a commission on software engagements we generate through VARs. In 2022 VAR commissions contributed 2.4% of our revenue versus 3.2% during 2021. During September 2022 we announced a proprietary product called Enclave which simplifies an important cybersecurity task called “microsegmentation”. Enclave seamlessly combines access control, microsegmentation, encryption and other secure networking concepts to create a comprehensive solution. It allows Information Technology to easily segment the enterprise network, place the right staff in those segments and direct traffic. We expect to begin recognizing revenue from Enclave during fiscal year 2023. Revenue We internally report our revenue using two categories. The first, “vCISO Services”, captures the revenue and related cost of goods sold for the Chief Information Security Officer services that we provide to our clients on a “virtual” or outsourced basis, thus the acronym “vCISO”. Services delivered by SideChannel through our team of vCISOs include assessing the cybersecurity risk profile, implementing policies and programs to mitigate risks, and managing the day-to-day tasks to ensure compliance with the adopted cybersecurity framework. Most of our clients use our vCISO services. Our second revenue category encompasses an array of Cybersecurity Software and Services that our clients deem necessary to protect their digital assets. These include cybersecurity software owned by SideChannel and software sourced from third parties. SideChannel earns commissions on third-party software sales which it recognizes as revenue. Cybersecurity services are also delivered directly by SideChannel employees and indirectly by third party service providers. 34 The table below reflects the revenue by category in fiscal years 2022 and 2021: 2022 2021 Variance % Change Revenue (000’s) Percent of Total Revenue (000’s) Percent of Total vCISO Services $ 3,107 64.9 % $ 1,615 57.7 % $ 1,492 92.4 % Cybersecurity Software & Services 1,682 35.1 % 1,184 42.3 % 498 42.1 % Total $ 4,789 $ 2,799 $ 1,990 71.1 % The growth in vCISO Services is primarily the result of client growth and secondarily because of an increase in the revenue per client. Cybersecurity Software & Services revenue grew from 2021 to 2022 primarily because of an increase in the use of these services by existing Cybersecurity Software and Services clients and secondarily because of an expansion of the services and software offered. We also monitor new and recurring revenue. The revenue earned from clients during our first twelve months of working with them is classified as new; while the revenue earned with clients after our first twelve months of working with them is classified as recurring. The following table provides details on our new and recurring revenue for fiscal years 2022 and 2021: 2022 2021 Variance % Change (000’s) Percent of Total (000’s) Percent of Total vCISO Revenue New $ 1,890 60.8 % $ 1,431 88.6 % $ 460 32.1 % Recurring 1,217 39.2 % 184 11.4 % 1,033 561.8 % Total $ 3,107 $ 1,615 $ 1,492 92.4 % Cybersecurity Software & Services Revenue New $ 758 45.0 % $ 986 83.3 % $ (228 ) -23.2 % Recurring 924 55.0 % 198 16.7 % 726 366.7 % Total $ 1,682 $ 1,184 $ 498 42.1 % Total Revenue New $ 2,648 55.3 % $ 2,417 86.4 % $ 231 9.6 % Recurring 2,141 44.7 % 382 13.6 % 1,759 460.6 % Total $ 4,789 $ 2,799 $ 1,990 71.1 % 35 Further, we consider revenue retention a key performance indicator. Revenue retention is calculated by dividing recurring revenue by the prior year total revenue. The following table shows the revenue retention for fiscal year 2022 by revenue category. 2022 vCISO Services 75.3 % Cybersecurity Software & Services 78.1 % Total Revenue Retention 76.5 % Results of Operations Fiscal Year Ended September 30, 2022 Compared to Fiscal Year Ended September 30, 2021 Revenue. Our revenue was $4.8 million for the year ended September 30, 2022, compared to $2.8 million in the prior year, an increase of $2.0 million or 71%. We believe this increase reflects the factors previously discussed in the Overview section above. Gross Margins. Gross margins increased to 48.5% in fiscal year 2022 from 45.1% in fiscal year 2021 which we attribute to better utilization of our service delivery team. General and Administrative Expenses. Our general and administrative expenses were $1.5 million for the year ended September 30, 2022, compared to $656,000 for the prior year, an increase of $826,000 or 126%. The increase in general and administrative expenses primarily resulted from increased staff and related salary and independent contractor expense; higher professional fees and insurance related to the listed nature of the Company. To a lesser extent there where increase in amortization and travel related costs. Sales and Marketing Expenses. Our sales and marketing expenses were $367,000 for the year ended September 30, 2022, compared to $96,000 for the prior year, an increase of $271,000 or 282% resulting from our increase in sales and marketing staff and the related salary and independent contractor expense; higher spend on third-party marketing services. 36 Research and Development Expenses. Our research and development expenses were $178,000 for the year ended September 30, 2022, compared to $0 for the prior year. These costs arose as a result of the Business Combination and are driven by personnel expenses and costs incurred from independent contractors related to the development of Enclave. Acquisition Expenses. Expenses incurred because of the Business Combination were $6.2 million for the year ended September 30, 2022. These costs, which included the recognition of the $6.1 million of contingent consideration for 59.9 million common shares to be issued in the Second Tranche and $100,000 of expenses for related professional services. Goodwill Impairment. We recorded a $5.7 million goodwill impairment charge during the year ended September 30, 2022. The goodwill was related to the acquisition that occurred on July 1, 2022. Income Tax Expense. Our income tax expense was $195,000 for the year ended September 30, 2022 compared to $0 in the prior year. This expense is associated with the estimated federal and state income tax liability for SCS from January 1, 2022 through June 30, 2022. Liquidity and Capital Resources Our primary source of liquidity and capital resources has been cash flow from operations. As part of the Business Combination, we received $3.6 million in cash from Cipherloc. We had an accumulated deficit of $11.9 million as of September 30, 2022. Two (2) non-recurring expenses totaling $11.9 million are included in our accumulated deficit. The non-recurring expenses are $6.2 million for the acquisition costs including $6.1 million related to the contingent consideration from the Business Combination and $5.7 million impairment of goodwill recorded as a result of the Business Combination. Since the Business Combination on July 1, 2022 we expect to continue to generate operating losses until we can generate revenues sufficient to exceed our operating expenses. We anticipate total operating expenses to range between $4.0 million and $4.7 million in the next fiscal year with cash used by operations to range between $1.5 million and $2.0 million. which will be funded with our existing cash balances. 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 this positive cash flow will be achieved. As of September 30, 2022, we had $3.0 million in cash and our working capital was $3.0 million. We believe that our existing cash balances are sufficient to fund our operations through December 31, 2023. Cash Flows The following table summarizes, for the periods indicated, selected items in our Statements of Cash Flows ($000’s): Year Ended September 30, 2022 2021 Net cash (used in) provided by: Operating activities $ (396 ) $ 157 Investing activities $ 3,589 $ — Financing activities $ (511 ) $ (300 ) Operating Activities . Net cash used in operations for the year ended September 30, 2022, was $396,000. For the year ended September 30, 2022, we recorded a net loss of $11.6 million. During this same period, our non-cash charges primarily consisted of $6.1 million for acquisition-related costs associated with the second tranche of common stock to be issued in connection with the Business Combination, $5.7 million for a goodwill impairment charge, as well as $51,000 for stock-based compensation costs and $46,000 for depreciation and amortization. Accounts receivable increased $461,000 due to the aforementioned revenues, which increased in 2022 compared to 2021. Investing Activities . During the year ended September 30, 2022, we received $3.6 million in cash from the Business Combination that took place on July 1, 2022. 37 Financing Activities . During the year ended September 30, 2022, we had equity distributions of $461,000 and membership redemptions of $100,000, of which $50,000 was paid in cash and $50,000 was through the issuance of a note payable, both related to SideChannelSec LLC prior to its incorporation in Massachusetts as SideChannel, Inc. on December 29, 2021. Critical Accounting Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to long-lived assets, goodwill, identifiable intangibles and deferred income tax valuation allowances. We base our estimates on historical experience and on appropriate and customary assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Some of these accounting estimates and assumptions are particularly sensitive because of their significance to our consolidated financial statements and because of the possibility that future events affecting them may differ markedly from what had been assumed when the financial statements were prepared. Revenue Recognition Please reference Note 2 – Summary of Significant Accounting Policies. Goodwill, Intangible and Long-Lived Assets We account for goodwill and intangible assets in accordance with Accounting Standards Codification (“ASC”) Topic 350 (Intangibles- Goodwill and Other). Finite-lived intangible assets are amortized over their estimated useful economic life and are carried at cost less accumulated amortization. Goodwill is assessed for impairment at least annually in the fourth quarter, on a reporting unit basis, or more frequently when events and circumstances occur indicating that the recorded goodwill may be impaired. As a part of the goodwill impairment assessment, we have the option to perform a qualitative assessment to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount. If, as a result of our qualitative assessment, we determine this is the case, we are required to perform a goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized. The test is discussed below. If, as a result of our qualitative assessment, we determine that it is more-likely-than-not that the fair value of the reporting unit is greater than its carrying amounts, the goodwill impairment test is not required. The quantitative goodwill impairment test, used to identify both the existence of impairment and the amount of impairment loss, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. The goodwill impairment assessment is based upon the income approach, which estimates the fair value of our reporting units based upon a discounted cash flow approach. This fair value is then reconciled to our market capitalization at year end with an appropriate control premium. The determination of the fair value of our reporting units requires management to make significant estimates and assumptions including the selection of control premiums, discount rates, terminal growth rates, forecasts of revenue and expense growth rates, income tax rates, changes in working capital, depreciation, amortization and capital expenditures. Changes in assumptions concerning future financial results or other underlying assumptions could have a significant impact on either the fair value of the reporting unit or the amount of the goodwill impairment charge. At September 30, 2022 and 2021, goodwill was $1.4 million and $0, respectively. We evaluated the initial goodwill recorded from the Business Combination of $7.1 million and determined that the carrying value exceeded the fair value and recorded $5.7 million impairment of goodwill during the year ended September 30, 2022. No impairment was recorded during our fiscal year 2021. We did not record indefinite-lived intangible assets in the fiscal years ended September 30, 2022 and 2021. Long-lived assets, which consist of finite-lived intangible assets and property and equipment, are assessed for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. Each impairment test is based on a comparison of the estimated undiscounted cash flows to the recorded value of the asset. If impairment is indicated, the asset is written down to its estimated fair value. The cash flow estimates used to determine the impairment, if any, contain management’s best estimates using appropriate assumptions and projections at that time. We have a finite-lived intangible asset of $4.9 million and we have less than $1,000 in property and equipment. At September 30, 2022 and 2021, finite-lived intangibles and long-lived assets were $4.9 million and $0, respectively. We recorded no impairment charges during either fiscal year. 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) of Regulation S-K promulgated by the SEC. 38