SideChannel, Inc. 10-K

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. 32 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 $450. 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. Revenue The following revenue metrics are for the twelve months ended September 30, 2024, versus the same period in 2023. These summary metrics are accompanied by pie charts that reflect the revenue by category in fiscal years 2024 and 2023. ● Total revenue grew by $828 thousand or 12.6%. ● vCISO Services category revenue grew by $223 thousand or 5.1%. ● Cybersecurity Software and Services category revenue grew by $605 thousand or 27.6%. 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 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. 33 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 chart provides details on our new and retained revenue for fiscal years 2024 and 2023: 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 2024 and 2023 by revenue category. Trailing Twelve Months Ended September 30, 2024 September 30, 2023 vCISO Services 67.7 % 60.8 % Cybersecurity Software & Services 72.2 % 89.4 % Total 69.2 % 71.0 % Results of Operations Fiscal Year Ended September 30, 2024, Compared to Fiscal Year Ended September 30, 2023 Twelve Months Ended September 30, 2024 2023 Revenues $ 7,400 $ 6,572 Cost of revenues 3,868 3,240 Gross profit 3,532 3,332 Gross margin 47.7 % 50.7 % Operating expenses General and administrative 3,155 3,586 Selling and marketing 771 1,337 Research and development 546 669 Intangible asset impairment - 4,940 Business Combination related costs - 214 Total operating expenses 4,472 10,746 Operating loss (940 ) (7,414 ) Other income, net 41 29 Net loss before income tax expense (899 ) (7,385 ) Income tax expense (benefit) 5 (379 ) Net loss $ (904 ) $ (7,006 ) Revenue. Our revenue was $7.4 million for the year ended September 30, 2024, compared to $6.6 million in the prior year, an increase of $0.8 million or 12.6%. We believe this increase reflects the factors previously discussed in the Overview section above. Gross Margins. Gross margins decreased to 47.7% in fiscal year 2024 from 50.7% in fiscal year 2023, which we attribute to lower utilization of our service delivery team employees and an increase in revenue from third-party software and services which have a lower gross margin. Operating Expenses . Total operating expenses during fiscal year 2024 were $4.5 million compared to fiscal year 2023 total operating expenses of $5.6 million excluding $214 thousand of prior year acquisition costs and intangible asset impairment of $4.9 million. In May 2023, we began eliminating operating expenses which, combined with our increase in gross profit, have enabled us to lower our breakeven revenue point and attain positive cash flow from operations during fiscal year 2024. The operating expense reductions were achieved by staff reductions in all areas of the business and the elimination of non-essential third-party supplier relationships. General and Administrative Expenses. Our general and administrative expenses were $3.2 million for the year ended September 30, 2024, compared to $3.6 million for the prior year, a decrease of $0.4 million or 12.0%. The decrease in general and administrative expenses primarily resulted from decreased staff and related costs and lower professional fees and insurance related to the listed nature of the Company. These favorable variances were partially offset by an increase in stock-based compensation and costs incurred for the settlement of a litigation matter. Selling and Marketing Expenses. Our selling and marketing expenses were $771 thousand for the year ended September 30, 2024, compared to $1,337 thousand for the prior year, a decrease of $566 thousand or 42.3% resulting from our decrease in sales and marketing staff and partially offset by increased spend on third-party marketing services. 34 Research and Development Expenses. Our research and development expenses were $546 thousand for the year ended September 30, 2024, compared to $669 thousand for the prior year, a decrease of $123 thousand or 18.4%. The decrease is the result of lower personnel related costs and reduction of software development expenses. Intangible Asset Impairment. The intangible asset impairment was zero ($0) for the year ended September 30, 2024, and $4.9 million 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 indicated a decrease in our emphasis on Enclave as a key initiative nor did it suggest a lack of market interest in the product. Business Combination related costs. Business Combination related costs were zero ($0) in fiscal year 2024 and $214 thousand 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. Other Income. Other Income was $41 thousand and $29 thousand for fiscal years 2024 and 2023 respectively, which reflect interest income from the cash on deposit at our bank. Income Tax Expense (Benefit). We recorded income tax expense of $5 thousand in the fiscal year ended September 30, 2024, compared to an income tax benefit of $379 thousand for the year ended September 30, 2023. The fiscal year 2024 expense is attributed to accruals for state income taxes in the various jurisdictions where we have customers, employees, or property while the fiscal year 2023 benefit occurred because of a favorable difference between actual and projected tax accounting at the time of the Business Combination. Liquidity and Capital Resources During fiscal year 2024, we incurred a net loss of $904 thousand, and we had $307 thousand of cash provided by operations. Our primary source of liquidity and capital resources has been the $1.1 million of cash at the beginning of fiscal year 2024 supplemented with the cash provided by operations during the fiscal year. We had an accumulated deficit of $19.8 million as of September 30, 2024. Three (3) non-operational expenses related to the Business Combination totaling $16.8 million are included in our accumulated deficit. The non-operational expenses are $6.2 million for the contingent consideration and business combination related costs, $5.7 million for the impairment of goodwill recorded as a result of the Business Combination, and $4.9 million for the impairment of intangible assets. The following table summarizes, for the periods indicated, selected items in our Statements of Cash Flows: (In thousands) 2024 2023 Net cash provided by (used in): Operating activities $ 307 $ (1,945 ) Investing activities (265 ) (32 ) Financing activities (50 ) - Total Cash Provided / (Used) $ (8 ) $ (1,977 ) Operating Activities . Net cash provided by operations for the year ended September 30, 2024, was $307 thousand as compared to $1.9 million used in operations for the year ended September 30, 2023. During fiscal year 2024, we recorded net, non-cash charges of $755 thousand for depreciation, amortization and stock-based compensation expense. Our net accounts receivable decreased by $102 thousand due to earlier payment of invoices by our clients and we experienced a $235 thousand increase in deferred revenue because of an increase in clients paying in advance of receiving software and services. Investing Activities . We purchased short-term investments of $250 thousand in the form of time deposits and used $15 thousand on the purchase of fixed assets related to the upgrade of our website during the twelve months ended September 30, 2024. Financing Activities . We paid a $50 thousand note to Akash Desai in December 2023. The note 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. As of September 30, 2024, we had $1.3 million in cash, cash equivalents, and short-term investments; and our working capital was $1.4 million. We believe that our existing cash balances are sufficient to fund our operations through at least December 31, 2025. 35 We expect to continue to generate cash flow from operations during fiscal year 2025; however, if this does not materialize, then our operations will be funded with our existing cash balance. We intend to manage our business such that our expenses will allow us to sustain positive cash flow from our operations, but we cannot assure this will occur. 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. 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 assets and liabilities including their related 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. Goodwill was $1.4 million at both September 30, 2024, and 2023. The fair value of the goodwill at September 30, 2024, as determined by our impairment analysis, was in excess of the carrying value; thus, we had no impairment of goodwill in fiscal year 2024. We did not record indefinite-lived intangible assets in the fiscal years ended September 30, 2024, and 2023. 36 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 $33 thousand in property and equipment at September 30, 2024. At September 30, 2024, and 2023, finite-lived intangibles and long-lived assets were zero ($0) and zero ($0), respectively. The intangible impairment was $4.9 million for the year ended September 30, 2023. 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 in fiscal year 2023 neither indicated a decrease in our emphasis on Enclave as a key initiative nor did 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. 37