SideChannel, Inc. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in our Management’s Discussion and Analysis of Financial Condition and Results of Operations, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended September 30, 2022 and elsewhere in this Form 10-Q. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. This information should be read in conjunction with the interim unaudited financial statements and the notes thereto included in this Report, and the audited financial statements and notes thereto and “Part II. Other Information – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations”, contained in our Annual Report on Form 10-K for the year ended September 30, 2022, filed with the Securities and Exchange Commission on December 20, 2022. Our logo and some of our trademarks and tradenames are used in this Report. Solely for convenience, trademarks, tradenames, and service marks referred to in this Report may appear without the ®, ™ and SM symbols. References to our trademarks, tradenames and service marks herein are not intended to indicate in any way that we will not assert to the fullest extent under applicable law our rights or the rights of the applicable licensors if any, nor that respective owners of other intellectual property rights will not assert, to the fullest extent under applicable law, their rights thereto. We do not intend the use or display of other companies’ trademarks and trade names herein to imply a relationship with, or endorsement or sponsorship of us by, any other persons, firm or entity, except as otherwise so expressly indicated. The market data and certain other statistical information used throughout this Report are based on independent industry publications, reports by market research firms or other independent sources that we believe to be reliable sources. Industry publications and third-party research, surveys and studies generally indicate that their information has been obtained from sources believed to be reliable, although they do not guarantee the accuracy or completeness of such information. We are responsible for all of the disclosures contained in this Report, and we believe these industry publications and third-party research, surveys and studies are reliable. We are not aware of any misstatements regarding any third-party information presented in this Report; however, their estimates, in particular, as they relate to projections, involve numerous assumptions, are subject to risks and uncertainties, and are subject to change based on various factors, including those discussed under, and incorporated by reference in, the section entitled “ Item 1A. Risk Factors ” of this Report. These and other factors could cause our future performance to differ materially from our assumptions and estimates. Some market and other data included herein, as well as the data of competitors as they relate to SideChannel (as defined herein), is also based on our good faith estimates. Unless the context requires otherwise, references to the “Company,” “we,” “us,” “our,” “SideChannel,” and “SideChannel, Inc.” refer specifically to SideChannel, Inc. and its consolidated subsidiaries. In addition, unless the context otherwise requires and for the purposes of this report only: ● “ Exchange Act ” refers to the Securities Exchange Act of 1934, as amended; ● “ SEC ” or the “ Commission ” refers to the United States Securities and Exchange Commission; and ● “ Securities Act ” refers to the Securities Act of 1933, as amended. 16 Table of Contents All references to years relate to the fiscal year ended September 30 of the particular year. Overview Our Business Our mission is to make cybersecurity simple and accessible for mid-market and emerging companies, a market we believe is currently underserved. Our cybersecurity offerings identify and develop cybersecurity, privacy, and risk management solutions for our customers. We target customers that need cost-effective security solutions. Our growth plan to address the needs of our customers is to provide more effective and cost-efficient products and tech-enabled services cybersecurity and related including virtual Chief Information Security Officer (“vCISO”), zero trust, third-party risk management, due diligence, privacy, threat intelligence, and managed end-point security solutions. The Company’s website is www.sidechannel.com . In support of securing new vCISO clients, we expanded the sales and marketing team from one (1) dedicated person to six (6) since July 1, 2022. vCISO engagements are typically multi-year relationships which consist of a monthly subscription and an annual renewal option as well as additional vCISO time and material projects, which such additional time’s cost to customers ranges from $350 to $450 per hour. Each of our vCISOs generally embed into the C-suite executive teams of between two (2) to five (5) of our clients, and generally report to the chief executive officer, chief financial officer, or general counsel. 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 licensing revenue on software engagements we generate through VARs. The following are revenue metrics for the three months ended June 30, 2023 versus the comparable prior year period: ● Total revenue grew by $474,000 or 37.1%. ● vCISO Services category revenue grew by $516,000 or 64.8%. ● Cybersecurity Software and Services category revenue decreased by $42,000 or 8.8%. ● VAR licensing revenue contributed 1.7% of our total revenue versus 3.0% during same quarter in the prior comparable period. Our selling and marketing efforts are gaining new vCISO Services clients which is the primary reason for the growth in that category. Our new Cybersecurity Software and Services revenue combined with the growth of this category at existing clients was not enough to exceed revenue from the unusually high number of non-recurring Cybersecurity Software and Services projects executed during the prior year quarter ended June 30, 2022. The following are revenue metrics for the nine months ended June 30, 2023 versus the comparable prior year period. ● Total revenue grew by $1.4 million or 38.0%. ● vCISO Services category revenue grew by $1.0 million or 45.9%. ● Cybersecurity Software and Services category revenue grew by $0.3 million or 24.9%. ● VAR licensing revenue contributed 6.1% during fiscal year 2023 versus 2.9% in the prior comparable period. We monitor new and retained revenue on a trailing twelve-month basis. 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 “retained”. The following table provides details on our new and retained revenue for the twelve months ended June 30, 2023 and 2022: Trailing Twelve Months Ended June 30, (In thousands) 2023 2022 % of Total % of Total $ Change % Change vCISO Services New $ 2,401 58.6 % $ 2,056 72.3 % $ 345 16.8 % Retained 1,693 41.4 % 789 27.7 % 904 114.6 % Total $ 4,094 $ 2,845 $ 1,249 43. 9% Cybersecurity Software and Services New $ 601 29.3 % $ 913 57.3 % $ (312 ) -34.2 % Retained 1,448 70.7 % 679 42.7 % 769 113.3 % Total $ 2,049 $ 1,592 $ 457 28.7 % Total (vCISO Services and Cybersecurity Software and Services combined) New $ 3,002 48.9 % $ 2,969 66.9 % $ 33 1.1 % Retained 3,141 51.1 % 1,468 33.1 % 1,673 114.0 % Total $ 6,143 $ 4,437 $ 1,706 38.4 % Further, we consider trailing twelve revenue retention a key performance indicator. Revenue retention is calculated by dividing retained revenue in the measurement period by the total revenue for the previous twelve-month time frame. The following table shows the revenue retention by category for the twelve months ended June 30, 2023 and September 30, 2022. We changed the revenue classification for certain invoice line items between vCISO and Cybersecurity Software and Services which impacted the retention calculations for each category for the twelve months ended September 30, 2022. The originally reported numbers from the Form 10-K and the revised retention rates after the line item classification changes are provided in the table below. Twelve Months Ended June 30, 2023 September 30, 2022 September 30, 2022 Revised Form 10-K Revenue Retention vCISO Services 59.5 % 73.7 % 75.3 % Cybersecurity Software and Services 91.0 % 80.8 % 78.1 % Total 70.8 % 76.5 % 76.5 % 17 Table of Contents Results of Operations Three Months Ended June 30, 2023 Versus Three Months Ended June 30, 2022 Comparison of Results The increases noted in each operating expense area are a trend that we expect to recur in the final quarter of the current fiscal year (three months ended September 30, 2023). We do not anticipate the same level of year-over-year variances during each quarter of our fiscal year ended September 30, 2024. Revenue. Our revenue was $1.8 million for the quarter ended June 30, 2023, compared to $1.3 million for the three-month comparable prior period; an increase of $474,000 or 37%. The factors driving this this revenue increase is a growth in vCISO Services revenue which was slightly offset by a decrease in Cybersecurity Software and Services revenue. Gross Margins. Our gross margins increased to 49.9% for the quarter ended June 30, 2023, from 44.0% for the quarter ended June 30, 2022, as a result of better utilization of service delivery employees and a more favorable mix of services. General and Administrative Expenses. Our general and administrative expense was $834,000 for the three months ended June 30, 2023, compared to $407,000 for the prior comparable period, an increase of $427,000 or 105%. The significant increase in general and administrative expenses primarily resulted from the costs associated with being a public company and the addition of administrative personnel. New costs related to being a public company include stock-based compensation, board compensation, investor relations services, and increased insurance and professional services. The costs associated with being a public company became part of our expense structure as a result of the Business Combination. Selling and Marketing Expenses. Our sales and marketing expense was $340,000 for the three months ended June 30, 2023, compared to $50,000 for the prior comparable period, an increase of $290,000 or 580%. The increase was driven by the recent additions to our staff discussed earlier and the related salary and independent contractor expense along with higher spend on third-party marketing services. Research and Development Expenses. Our research and development expense was $180,000 for the three months ended June 30, 2023, compared to $0 for the prior comparable period. These costs are driven by the personnel and independent contractor expenses related to the development of Enclave. The Enclave development costs became part of our expense structure as a result of the Business Combination. Business Combination Related Costs – We recorded Business Combination related costs of $214,000 for the three months ended June 30, 2023. These costs were associated with the shares issued during the quarter in connection with the working capital adjustment related to the Business Combination. Nine Months Ended June 30, 2023 Versus Nine Months Ended June 30, 2022 Comparison of Results Revenue. Our revenue was $4.9 million for the nine months ended June 30, 2023, compared to $3.6 million for the nine-month comparable prior period; an increase of $1.3 million or 38%. The growth is attributed to gaining new clients which was partially offset by a reduction in non-recurring project compared to the prior year. Gross Margins. Our gross margins increased to 50.4% for the nine months ended June 30, 2023, from 49.5% for the nine months ended June 30, 2022, which reflects cost reductions we achieved on our service lines through the increased use of employees versus independent contractors. General and Administrative Expenses. Our general and administrative expense was $2.9 million for the nine months ended June 30, 2023, compared to $0.8 million for the prior comparable period, an increase of $2.1 million or 263%. The significant increase in general and administrative expenses primarily resulted from the costs associated with being a public company and the addition of administrative personnel. New costs related to being a public company include stock-based compensation, board compensation, investor relations services, and increased insurance and professional services. Selling and Marketing Expenses. Our selling and marketing expense was $1.1 million for the nine months ended June 30, 2023, compared to $130,000 for the prior comparable period, an increase of $970,000 or 734%. The increase was driven by the recent additions to our staff discussed earlier and the related salary and independent contractor expense along with higher spend on third-party marketing services. Research and Development Expenses. Our research and development expense was $483,000 for the nine months ended June 30, 2023, compared to $0 for the prior year. These costs are driven by the personnel and independent contractor expenses related to the development of Enclave. The Enclave development costs became part of our expense structure as a result of the Business Combination. Business Combination Related Costs – We recorded Business Combination related costs of $214,000 for the three months ended June 30, 2023. These costs were associated with the shares issued during the quarter in connection with the working capital adjustment related to the Business Combination. Liquidity and Capital Resources We had an accumulated deficit of $14.1 million as of June 30, 2023. We expect to incur continued operating losses until we generate revenues sufficient to cover our expected ongoing obligations and expenses. On June 30, 2023, we had cash of $1.4 million. We maintain our cash in accounts held by reputable financial institutions which, at times, may exceed federally insured limits guaranteed by the Federal Deposit Insurance Corporation (“FDIC”). The FDIC insures these deposits up to $250,000. As of June 30, 2023, approximately $1.2 million of the Company’s cash balance was uninsured. The Company has not experienced any losses of cash in any of these financial institutions. We had working capital of $1.6 million as of June 30, 2023, compared to working capital of $3.0 million as of September 30, 2022. The decline in working capital is primarily attributed to the use of cash to fund operating losses during the last nine months. Cash Flows The following table summarizes, for the nine months ended June 30, selected items in our Consolidated Statements of Cash Flows: (In thousands) 2023 2022 Net cash provided by (used in): Operating activities $ (1,560 ) $ 564 Investing activities (24 ) — Financing activities — (483 ) 18 Table of Contents Operating Activities We receive cash each month from revenue generated from our clients. We use this cash and a portion of our cash reserves to pay for our monthly expenses. Material cash requirements include personnel costs and the expenses associated with being a public reporting company. We used $1.6 million of cash reserves for operating activities during the nine months ended June 30, 2023 and recorded a net loss of $2.1 million. During the same period, our non-cash charges totaled $721,000 comprised of $372,000 in stock-based compensation expense, $135,000 in amortization, and $214,000 in Business Combination related costs. The change in our net operating assets and liabilities was due to an $262,000 increase in accounts receivable due to a growth in monthly invoicing, a $158,000 decrease in prepaid expenses as we recognized our annual directors and officers insurance premium that is prepaid annually in July, a $247,000 decrease in accounts payable and accrued liabilities because of payments made on our directors and officers insurance note payable, and a $228,000 increase in deferred revenue due to a growth in annual software invoicing with our clients. Investing Activities We had fixed asset purchases of $24,000 during the nine months ended June 30, 2023 related to an upgrade in our website. Financing Activities The were no cash activities in financing for the nine months ended June 30, 2023. New or Recently Adopted Accounting Standards See the Notes to our consolidated financial statements in this Report for information concerning the implementation and impact of new or recently adopted accounting standards. Critical Accounting Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Certain of our accounts, including goodwill, identifiable intangibles, and deferred tax assets and liabilities, including related valuation allowances, are based upon estimates. 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. As of June 30, 2023, there have been no significant changes to the accounting estimates that we have deemed critical. Our critical accounting estimates are more fully described in our 2022 Form 10-K . Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements, as defined under applicable SEC rules, during the periods presented, nor do we currently have any such arrangements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Pursuant to Item 305(e) of Regulation S-K (§ 229.305(e)), the Company is not required to provide the information required by this Item as it is a “smaller reporting company,” as defined by Rule 229.10(f)(1) of the SEC.