Item 7. Management’s Discussion and Analysis
ITEM
7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This
Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the accompanying
consolidated financial statements and the notes thereto. In addition, please refer to the discussion of our business and markets contained
in Part 1, Item 1 of this Annual Report on Form 10-K.
Overview
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.
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
We internally report our revenue using two categories.
The first, “vCISO Services,” captures the revenue 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.
vCISO engagements typically include a fixed monthly
subscription fee with durations longer than twelve (12) months. Hourly rates for vCISO time and material projects range from $350 to $425.
Each of our vCISOs is generally embedded into the C-suite executive teams of two (2) to four (4) of our clients.
Our second revenue category encompasses an array of Cybersecurity Software and Services that our clients deem necessary
to protect their digital assets. These augment our vCISO offering and include a full range of other cybersecurity products and services
delivered through a team of security engineers along with a network of third-party service providers and value-added resellers
(“VARs”). Commercial relationships with third-party service providers and VARs provide SideChannel with additional internal
capabilities to mitigate cybersecurity risks. We earn licensing revenue from software contracts and commissions from third-party service
provider partnerships which are included in this revenue category.
During
September 2022 we announced a proprietary product called Enclave which simplifies important cybersecurity tasks called
“asset inventory” and “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.
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Revenue
The following revenue metrics are for the twelve months ended September 30, 2023, versus the same period in 2022. These summary metrics are accompanied by a table that reflects the revenue by category in fiscal years 2023 and 2022.
●
Total revenue grew by $1.8 million or 37.2%.
●
vCISO Services category revenue grew by $1.3 million or 42.4%.
●
Cybersecurity Software and Services category revenue grew by $0.5 million or 27.9%.
2023
2022
(000’s)
% of Total
(000’s)
% of Total
$ Change
% Change
Revenue
vCISO Services
$ 4,383
66.7 %
$ 3,077
64.3 %
$ 1,306
42.4 %
Cybersecurity Software
& Services
2,189
33.3 %
1,712
35.7 %
477
27.9 %
Total
$ 6,572
$ 4,789
$ 1,783
37.2 %
The
growth in vCISO Services reflects both growth in clients served and an increase in revenue per client.
Cybersecurity Software & Services revenue grew from 2022 to 2023 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 retained 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 retained. The following
table provides details on our new and retained revenue for fiscal years 2023 and 2022:
2023
2022
Revenue
(000’s)
% of Total
(000’s)
% of Total
$ Change
% Change
vCISO
New
$ 2,512
57.3 %
$ 1,923
62.5 %
$ 589
30.6 %
Retained
1,871
42.7 %
1,154
37.5 %
717
62.1 %
Total
$ 4,383
$ 3,077
$ 1,306
42.4 %
Cybersecurity Software &
Services
New
$ 659
30.1 %
$ 813
47.5 %
$ (154 )
(18.9 )%
Retained
1,530
69.9 %
899
52.5 %
631
70.2 %
Total
$ 2,189
$ 1,712
$ 477
27.9 %
Total Revenue
New
$ 3,171
48.3 %
$ 2,736
57.1 %
$ 435
15.9 %
Retained
3,401
51.7 %
2,053
42.9 %
1,348
65.7 %
Total
$ 6,572
$ 4,789
$ 1,783
37.2 %
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Further,
we consider revenue retention a key performance indicator. Revenue retention is calculated by dividing retained revenue by the prior
year total revenue. The following table shows the revenue retention for fiscal years 2023 and 2022 by revenue category.
2023
2022
vCISO Services
60.8 %
74.2 %
Cybersecurity Software & Services
89.4 %
80.7 %
Total
71.0 %
76.5 %
Results
of Operations
Fiscal
Year Ended September 30, 2023, Compared to Fiscal Year Ended September 30, 2022
Revenue.
Our revenue was $6.6 million for the year ended September 30, 2023, compared to $4.8 million in the prior year, an increase of $1.8
million or 37.2%. We believe this increase reflects the factors previously discussed in the Overview section above.
Gross
Margins. Gross margins increased to 50.7% in fiscal year 2023 from 48.5% in fiscal year 2022, which we attribute to better utilization
of our service delivery team.
General
and Administrative Expenses. Our general and administrative expenses were $3.6 million for the year ended September 30, 2023, compared
to $1.5 million for the prior year, an increase of $2.1 or 142.5%. The increase in general and administrative expenses primarily resulted
from increased staff and related costs including equity-based compensation; higher professional fees and insurance related to the listed
nature of the Company. To a lesser extent there were increases in amortization and travel-related costs.
Sales
and Marketing Expenses. Our sales and marketing expenses were $1.3 million for the year ended September 30, 2023, compared to $367,000
for the prior year, an increase of $970,000 or 264.3% resulting from our increase in sales and marketing staff and the related costs
combined with a higher spend on third-party marketing services.
Research
and Development Expenses. Our research and development expenses were $669,000 for the year ended September 30, 2023, compared to
$178,000 for the prior year, an increase of $491,000 or 275.8%. 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.
Goodwill Impairment .
The goodwill impairment was zero ($0) for the year ended September 30, 2023. 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.
Intangible
Asset Impairment. The intangible asset impairment was $4.9 million for the year ended September 30, 2023, and zero ($0) for the
prior year. We recorded a finite-lived intangible asset of $4.9 million as a result of acquiring Enclave in the Business
Combination. Our impairment testing indicated the full value of this finite-lived intangible asset should be impaired as of
September 30, 2023. Incurring impairment neither indicates a decrease in our emphasis on Enclave as a key initiative nor does it
suggest a lack of market interest in the product.
Acquisition
Costs. Acquisition costs were $214,000 for the year ended September 30, 2023, which are attributed to an increase in the Second
Tranche shares due to the Closing Working Capital Adjustment from the Business Combination. The costs totaling $6.2 million in the prior year were driven by the Business Combination.
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Other Income.
Other Income was $29,000 and $13,000 for fiscal years 2023 and 2022 respectively, which reflect interest income from the cash on deposit
at our bank.
Income
Tax Expense (Benefit). We recorded an income tax benefit of $379,000 for the year ended September 30, 2023, compared to an
income tax expense of $195,000 for the year ended September 30, 2022. The fiscal year 2022 expense was an estimate of federal and
state income tax liability for SCS which was accounted for as a liability on our September 30, 2022, balance sheet. The actual amount of federal and state income taxes due by SCS of $27,000. The net of these two amounts
is a $168,000 tax benefit that we recognized in the current fiscal year. In addition, a deferred state tax liability was recognized for
a book versus tax basis difference upon the Business Combination. During the year ended September 30, 2023, this deferred tax liability
was reduced to zero resulting in a deferred income tax benefit of $211,000.
Liquidity
and Capital Resources
Cash Flows
During fiscal year 2023, we incurred a net loss of
$7.0 million and used $1.9 million of cash in operations. Our primary source of liquidity and capital resources has been the $3.6 million
in cash received from Cipherloc in the Business Combination in the prior fiscal year. We had an accumulated deficit of $11.9 million as
of September 30, 2022. Three (3) non-recurring expenses totaling $16.8 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, $5.7 million impairment of goodwill recorded as a result of the Business Combination, and $4.9 million impairment of intangible assets.
Our accumulated deficit at September 30, 2023 was
$18.9 million.
The following table summarizes, for the periods indicated,
selected items in our Statements of Cash Flows ($000’s):
Year Ended September 30,
2023
2022
Net cash (used in) provided by:
Operating activities
$ (1,945 )
$ (396 )
Investing activities
$ (32 )
$ 3,589
Financing activities
$ —
$ (511 )
Operating Activities . Net cash used
in operations for the year ended September 30, 2023, was $1.9 million as compared to $396,000 for the year ended September 30, 2022.
During fiscal year 2023, we recorded intangible asset impairment of $4.9 million and non-cash charges of $805,000 for amortization and
stock compensation expense. Our net accounts receivable grew by $222,000 compared to one year ago due to increased sales activity
and we experienced a $547,000 decrease in accounts payable and accrued liabilities primarily due to adjustments made to tax liabilities. These uses of cash were offset by a $150,000 increase in our deferred revenue balance.
Investing Activities . We used $32,000
on the purchase of fixed assets during the twelve months ended September 30, 2023.
Financing Activities . During the year
ended September 30, 2023, there was no cash provided by or used in financing activities.
As of September 30, 2023, we had $1.1 million
in cash and our working capital was $1.5 million. We believe that our existing cash balances are sufficient to fund our operations
through at least December 31, 2024.
Total
operating expenses during fiscal year 2023 were $5.6 million excluding $214,000 of acquisition costs and intangible asset
impairment of $4.9 million. Since May, 2023 through the date of this report, we have eliminated approximately $1.2
million of annual operating expenses which have enabled us to lower our breakeven revenue point and allowed us to expect a lower amount
of total operating expenses for fiscal year 2024 than we incurred during 2023. The operating expense reductions are being achieved
by staff reductions in all areas of the business and the elimination of non-essential third-party supplier relationships.
We
anticipate total operating expenses to range between $3.7 million and $4.3 million in the next fiscal year with cash flow from operations
ranging between negative $300,000 and positive $100,000, which, if negative, will be funded with our existing cash balances. W e 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 if and when positive cash flow will be achieved. We don’t currently have any credit facilities available to us; however,
we have had discussions with several lenders about establishing a line of credit secured by our accounts receivable.
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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.
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, 2023 and 2022, goodwill was $1.4 million.
In 2022, 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. The fair value of the goodwill at September 30, 2023, as determined by our impairment analysis, is in excess of the
carrying value; thus, we have incurred no impairment of goodwill in fiscal year 2023.
We
did not record indefinite-lived intangible assets in the fiscal years ended September 30, 2023, and 2022.
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 $30,000 in
property and equipment. At September 30, 2023 and 2022, finite-lived intangibles and long-lived assets were zero ($0) and $4.9
million, respectively. The intangible impairment was $4.9 million for the year ended September 30, 2023 and zero ($0) for the prior
year. We recorded a finite-lived intangible asset of $4.9 million as a result of acquiring Enclave through the Business Combination.
The difficulty of projecting the amount and timing of future revenues caused us to conclude a full impairment of the asset was
appropriate. Incurring
impairment neither indicates a decrease in our emphasis on Enclave as a key initiative nor does it suggest a lack of market interest
in the product.
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.
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