SideChannel, Inc. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following information should be read in conjunction with the unaudited consolidated financial statements and the accompanying notes included in Part I, Item 1 of this Report. 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. All references to years relate to the fiscal year ended September 30 of the particular year. Business Overview Our efforts are focused on protecting and enabling the critical business functions of our clients and customers through comprehensive cybersecurity programs. This specifically includes: ● Embedding virtual Chief Information Security Officers (“vCISOs”) as a fractional resource into the leadership teams of our clients, ● Deploying a proprietary SaaS platform called Enclave that simplifies the segmentation of digital networks, ● Assessing, identifying, and mitigating cybersecurity and privacy risks through tech-enabled security engineering processes, and ● Reselling third-party cybersecurity services and software when appropriate. 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. 16 Table of Contents 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. Our growth strategy focuses on these three initiatives: 1. Securing new vCISO clients, 2. Adding new Cybersecurity Software and Services offerings, and 3. Increasing adoption of Cybersecurity Software, including Enclave and Services offerings at vCISO clients We are offering proprietary software called Enclave which simplifies important cybersecurity tasks including “asset inventory”, “vulnerability management”, and “microsegmentation.” Enclave seamlessly combines access control, microsegmentation, encryption and other secure networking concepts to create a novel solution for simplifying the deployment and management of these cybersecurity controls. It allows IT professionals to easily segment the enterprise network, place the right staff in those segments and direct traffic. Enclave revenue is currently included within the Cybersecurity Software and Services category. Revenue Category Performance for the Six Months Ended March 31, 2024 and 2023 The revenue metrics discussed in this section are for the six months ended March 31, 2024, versus the same period in fiscal year 2023. The following table contains the revenue by category. (in thousands) 2024 2023 % of Total % of Total $ Change % Change Revenue vCISO Services $ 2,236 61.0 % $ 1,952 61.7 % $ 284 14.5 % Cybersecurity Software & Services 1,427 39.0 % 1,211 38.3 % 216 17.8 % Total $ 3,663 $ 3,163 $ 500 15.8 % The growth in vCISO Services reflects both growth in clients served and an increase in revenue per client. Cybersecurity Software & Services revenue grew from 2023 to 2024 because of an increase in the use of these services by existing clients and because of an expansion of the services and software offered. 17 Table of Contents 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 the six months ended March 31, 2024 and 2023. (in thousands) 2024 2023 % of Total % of Total $ Change % Change Revenue vCISO New $ 702 31.4 % $ 1,192 61.1 % $ (490 ) (41.1 )% Retained 1,534 68.6 % 760 38.9 % 774 101.8 % Total $ 2,236 $ 1,952 $ 284 14.5 % Cybersecurity Software & Services New $ 587 41.1 % $ 403 33.3 % $ 184 45.7 % Retained 840 58.9 % 808 66.7 % 32 4.0 % Total $ 1,427 $ 1,211 $ 216 17.8 % Total Revenue New $ 1,289 35.2 % $ 1,595 50.4 % $ (306 ) (19.2 )% Retained 2,374 64.8 % 1,568 49.6 % 806 51.4 % Total $ 3,663 $ 3,163 $ 500 15.8 % We initiated fewer new vCISO Services engagements during the six months ended March 31. 2024 than we did during the six months ended March 31, 2023. We attribute the decrease to ineffective lead generation campaigns launched during the last half of fiscal year 2023. We had more success at securing Cybersecurity Software and Services work in new engagements during the six months ended March 31, 2024 than we did during the prior year. 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 March 31, 2024 and September 30, 2023. Trailing Twelve Months Ended March 31, 2024 September 30, 2023 vCISO Services 74.5 % 60.8 % Cybersecurity Software & Services 74.8 % 89.4 % Total 74.6 % 71.0 % Increase in Cash from December 31, 2023 to March 31, 2024 In May 2023, we announced our intention to accelerate the attainment of positive cash flow from operations by making significant reductions in operating expenses. For the three months ended March 31, 2024, our operating expenses are $467,000 lower than the prior year. For the six months ended March 31, 2024, our operating expenses are $837,000 lower than the prior year. On a percentage basis these decreases equate to a 29.3% reduction for the three month period and a 27.2% reduction for the six month period. We expect decreases compared to the prior year to occur in the remaining two quarters of this fiscal year. These reductions have had the desired impact. Our cash balance grew slightly, $32,000, from December 31, 2023 to March 31, 2024. Our revenue growth is also contributing to our improved profitability and cash flow. If revenue continues to grow on a year-over-year basis and we maintain our operating expenses in line with current revenues, then we may experience further improvements in profitability and cash flow. 18 Table of Contents RESULTS OF OPERATIONS Three Months Ended March 31, 2024, Compared to the Three Months Ended March 31, 2023 Selected consolidated financial data for the three months ended March 31, 2024 and 2023 are as follows: Three Months Ended March 31, 2024 2023 Revenues $ 1,927 $ 1,617 Cost of revenues 1,059 880 Gross profit 868 737 Operating expenses General and administrative 849 990 Selling and marketing 156 437 Research and development 123 168 Total operating expenses 1,128 1,595 Operating loss $ (260 ) $ (858 ) Revenue. Our revenue was $1.9 million for the quarter ended March 31, 2024, compared to $1.6 million for the three-month comparable prior period; an increase of $310,000 or 19.5%. The factors driving this revenue increase include improved revenue retention and a growth in both consulting engagements and sales of third-party services. Gross Margins. Our gross margin was 45.0% for the quarter ended March 31, 2024, compared 45.6% for the quarter ended March 31, 2023. The decline in our gross margin was the result of less effective utilization of our service delivery employees and an increase in sales of third-party software and services, which have a lower margin. Operating Expenses. We initiated expense reductions beginning in May 2023 that were fully implemented by March 2024. These reductions impacted all areas of our company. These reductions resulted in a $467,000 or 29.3% decrease in total operating expenses for the three months ended March 31, 2024, compared to the three months ended to March 31, 2023. The changes for each operating expense area are discussed below. The expense reductions were intended to increase the likelihood of achieving positive cash flow from operating activities during fiscal year 2024. ● General and Administrative Expenses. Our general and administrative expense was $849,000 for the three months ended March 31, 2024, compared to $990,000 for the prior comparable period, a decrease of $141,000 or 14.2%. The decrease was achieved by reducing executive positions and eliminating investor relations costs. ● Selling and Marketing Expenses. Our sales and marketing expense was $156,000 for the three months ended March 31, 2024, compared to $437,000 for the prior comparable period, a decrease of $281,000 or 64.3%. The decrease was driven by a reduction in staff and third-party service provider costs. ● Research and Development Expenses. Our research and development expense was $123,000 for the three months ended March 31, 2024, compared to $168,000 for the prior comparable period, a decrease of $45,000 or 26.8%. The decrease is the result of a staff reduction as well as some expenses being reallocated to cost of goods sold following the launch of Enclave. 19 Table of Contents Six Months Ended March 31, 2024, Compared to the Six Months Ended March 31, 2023 Selected consolidated financial data for the six months ended March 31, 2024 and 2023 are as follows: Six Months Ended March 31, 2024 2023 Revenues $ 3,663 $ 3,163 Cost of revenues 1,950 1,561 Gross profit 1,713 1,602 Operating expenses General and administrative 1,558 2,020 Selling and marketing 425 744 Research and development 249 303 Total operating expenses 2,232 3,067 Operating loss $ (519 ) $ (1,465 ) Revenue. Our revenue was $3.7 million for the six months ended March 31, 2024, compared to $3.2 million for the six-month comparable prior period; an increase of $500,000 or 15.8%. The factors driving this revenue increase include improved revenue retention and growth in vCISO engagements. Gross Margins. Our gross margin was 46.8% for the six months ended March 31, 2024, compared to 50.6% for the six months ended March 31, 2023. The decline in our gross margin was the result of less effective utilization of our service delivery employees and an increase in sales of third-party software and services, which have a lower margin. Operating Expenses. We initiated expense reductions beginning in May 2023 that were fully implemented by March 2024. These reductions impacted all areas of our company. These reductions resulted in a $835,000 or 27.2% decrease in total operating expenses for the six months ended March 31, 2024 compared to the six months ended March 31, 2023. The changes for each operating expense area are discussed below. The expense reductions were intended to increase the likelihood of achieving positive cash flow from operating activities during fiscal year 2024. ● General and Administrative Expenses. Our general and administrative expense was $1.6 million for the six months ended March 31, 2024, compared to $2.0 million for the prior comparable period, a decrease of $462,000 or 22.9%. The decrease was achieved by reducing executive positions and eliminating investor relations costs. ● Selling and Marketing Expenses. Our sales and marketing expense was $425,000 for the six months ended March 31, 2024, compared to $744,000 for the prior comparable period, a decrease of $319,000 or 42.9%. The decrease was driven by a reduction in staff and third-party service provider costs. ● Research and Development Expenses. Our research and development expense was $249,000 for the six months ended March 31, 2024, compared to $303,000 for the prior comparable period, a decrease of $54,000 or 17.8%. The decrease is the result of a staff reduction as well as some expenses being reallocated to cost of goods sold as Enclave has been launched. LIQUIDITY AND CAPITAL RESOURCES We had an accumulated deficit of $19.4 million as of March 31, 2024. Our accumulated deficit has been primarily driven by three non-recurring expenses totaling $16.8 million: $6.2 million for 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. 20 Table of Contents On March 31, 2024, we had cash of $851,000. 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 March 31, 2024, approximately $601,000 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 $1.3 million as of March 31, 2024, compared to working capital of $1.5 million as of September 30, 2023. The decline in working capital is primarily attributed to the use of cash to fund operating losses during the last six months. We expect to incur continued operating losses until we generate revenues sufficient to cover our expected ongoing obligations and expenses. W e intend to manage our business such that our current cash reserves will allow us to reach sustainable, positive cash flow from our operations, but we cannot assure if and when that will be achieved. We don’t currently have any credit facilities available to us. We believe that our existing cash balance is sufficient to fund our operations through at least June 30, 2025. Cash Flows The following table summarizes selected items in our Consolidated Statements of Cash Flows for the six months ended March 31: (In thousands) 2024 2023 Net cash provided by (used in): Operating activities $ (152 ) $ (1,128 ) Investing activities - - Financing activities (50 ) - 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 $152,000 of cash for operating activities during the six months ended March 31, 2024 and recorded a net loss of $499,000. During the same period, our non-cash charges totaled $330,000 comprised of $234,000 in stock-based compensation expense net of cash used to purchase RSUs from employees to cover income taxes due on vested RSU’s and $96,000 in amortization and depreciation. The change in our net operating assets and liabilities was primarily due to a $126,000 decrease in accounts payable and accrued liabilities primarily because of payments made on our directors and officers insurance note payable and a $284,000 increase in our deferred revenue balance. Investing Activities There were no cash activities in investing for this reporting period. Financing Activities We paid a $50,000 note payable to Mr. Akash Desai in December 2023. The note payable was related to a December 2021 agreement for the redemption of Mr. Desai’s interest in SideChannel LLC. The December 2023 payment completed our obligations to Mr. Desai. 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. Liquidity There have been no material updates to our expectations for our short-term and long-term liquidity and operating capital requirements since our 2023 Form 10-K. 21 Table of Contents 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.