Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Note Concerning Forward-Looking Statements
This Annual Report on Form 10-K contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about Safeguard Scientifics, Inc. (“Safeguard” or “we”), the industries in which we operate and other matters, as well as management's beliefs and assumptions and other statements regarding matters that are not historical facts. These statements include, in particular, statements about our plans, strategies and prospects. For example, when we use words such as “projects,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “should,” “would,” “could,” “will,” “opportunity,” “potential” or “may,” variations of such words or other words that convey uncertainty of future events or outcomes, we are making forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Our forward-looking statements are subject to risks and uncertainties. Factors that could cause actual results to differ materially include, among others, our ability to make good decisions about the deployment of capital, the fact that our ownership interests may vary from period to period, our substantial capital requirements and absence of liquidity from our holdings, competition, our inability to obtain maximum value for our ownership interess, our ability to attract and retain qualified employees, our ability to execute our strategy, market valuations in sectors in which our ownership interests operate, our inability to control our ownership interests companies, our need to manage our assets to avoid registration under the Investment Company Act of 1940, and risks associated with our ownership interests and their performance, including the fact that most of the companies in which we have an ownership interest have a limited history and a history of operating losses, face intense competition and may never be profitable, the effect of economic conditions in the business sectors in which they operate, compliance with government regulation and legal liabilities, all of which are discussed in Item 1A. “Risk Factors.” Many of these factors are beyond our ability to predict or control. In addition, as a result of these and other factors, our past financial performance should not be relied on as an indication of future performance. All forward-looking statements attributable to us, or to persons acting on our behalf, are expressly qualified in their entirety by this cautionary statement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this report might not occur.
Overview
Over the recent past, Safeguard has provided capital and relevant expertise to fuel the growth of technology-driven businesses. In many, but not all cases, we are actively involved, influencing development through board representation and management support, in addition to the influence we exert through our equity ownership. We also continue to hold relatively small equity interests in other enterprises where we do not exert significant influence and do not participate in management activities. In some cases, those interests relate to residual interests from prior larger interests or from companies that acquired companies in which we had ownership interests.
In January 2018, Safeguard announced that we will not deploy any capital into new opportunities and will focus on supporting our existing companies and maximizing monetization opportunities to enable returning value to shareholders. In that context, we have, are and will consider initiatives including, among others: the sale of our ownership interests, the sale of certain or all ownership interests in secondary market transactions, or a combination thereof, as well as other opportunities to maximize shareholder value. We initiated the return of value to shareholders in 2019 with a $1.00 per share special dividend. Moving forward, we anticipate additional actions in the form of stock repurchases and/or special dividends based on available cash resources, prevailing market conditions and other factors.
Principles of Accounting for Ownership Interests
We account for our ownership interests using one of the following methods: Equity or other. The accounting method applied is generally determined by the degree of our influence over the entity, primarily determined by our voting interest in the entity.
Equity Method. We account for companies whose results are not consolidated, but over whom we exercise significant influence, using the equity method of accounting. We also account for our interests in some private equity funds under the equity method of accounting, based on our non-controlling general and/or limited partner interests. Under the equity method of accounting, our share of the income or loss of the company is reflected in Equity income (loss) in the Consolidated Statements of Operations. We report our share of the income or loss of the equity method companies on a one quarter lag. We include the carrying value of equity method companies in Ownership interests and advances on the Consolidated Balance Sheets.
When the carrying value of our holdings in an equity method company is reduced to zero, no further losses are recorded in our Consolidated Statements of Operations unless we have outstanding guarantee obligations or have committed additional
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funding to the equity method company. When the equity method company subsequently reports income, we will not record our share of such income until it equals the amount of our share of losses not previously recognized.
Other Method. We account for our equity interests in companies which are not accounted for under the equity method or fair value method as equity securities without readily determinable fair values. We account for of these securities based on our original cost less impairments, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar securities of the same issuer. Under this method, our share of the income or losses of such companies is not included in our Consolidated Statements of Operations. We include the carrying value of these investments in Ownership interests and advances on the Consolidated Balance Sheets.
Critical Accounting Policies and Estimates
Accounting policies, methods and estimates are an integral part of the Consolidated Financial Statements prepared by management and are based upon management’s current judgments. These judgments are normally based on knowledge and experience with regard to past and current events and assumptions about future events. Certain accounting policies, methods and estimates are particularly important because of their significance to the financial statements and because of the possibility that future events affecting them may differ from management’s current judgments. While there are a number of accounting policies, methods and estimates affecting our financial statements as described in Note 1 to our Consolidated Financial Statements, the most significant relate to impairment of ownership interests and advances.
Impairment of Ownership Interests and Advances
On a periodic basis, but no less frequently than at the end of each quarter, we evaluate the carrying value of our ownership interests for possible impairment based on achievement of business plan objectives and milestones, the financial condition and prospects of the company, market conditions and other relevant factors. The business plan objectives and milestones we consider include, among others, those related to financial performance, such as achievement of planned financial results or completion of capital raising activities, and those that are not primarily financial in nature, such as hiring of key employees or the establishment of strategic relationships. We then determine whether there has been an other than temporary decline in the value of our ownership interest in the company. Any impairment to be recognized is measured as the amount by which the carrying value of an asset exceeds its fair value. The adjusted carrying value of an ownership interest is not increased if circumstances suggest the value of the company has subsequently recovered.
The fair value of privately held companies is generally determined based on the value at which independent third parties have invested or have committed to invest in these companies, or based on other valuation methods including discounted cash flows, valuations of comparable public companies and valuations of acquisitions of comparable companies.
Our companies operate in industries which are rapidly evolving and extremely competitive. It is reasonably possible that our accounting estimates with respect to the ultimate recoverability of the carrying value of ownership interests and advances could change in the near term and that the effect of such changes on our Consolidated Financial Statements could be material. While we believe that the current recorded carrying values of our equity and other method companies are not impaired, there can be no assurance that our future results will confirm this assessment or that a significant write-down or write-off will not be required in the future.
Total impairment charges related to our ownership interests and advances were as follows:
Year Ended December 31,
Accounting Method
2019
2018
(In thousands)
Equity
$
2,965
$
12,626
Other
47
1,097
Total
$
3,012
$
13,723
Impairment charges related to equity method companies are included in Equity income (loss) in the Consolidated Statements of Operations. Impairment charges related to other investments are included in Other income (loss), net in the Consolidated Statements of Operations.
Results of Operations
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We operate as one operating segment based upon the similar nature of our technology-driven companies, the functional alignment of the organizational structure, and the reports that are regularly reviewed by the chief operating decision maker for the purpose of assessing performance and allocating resources.
There is intense competition in the markets in which our companies operate. Additionally, the markets in which these companies operate are characterized by rapidly changing technology, evolving industry standards, frequent introduction of new products and services, shifting distribution channels, evolving government regulation, frequently changing intellectual property landscapes and changing customer demands. Their future success depends on each company’s ability to execute its business plan and to adapt to its respective rapidly changing market.
The following is a listing of certain of our ownership interests as of December 31, 2019 and December 31, 2018.
Safeguard Primary Ownership
as of December 31,
Company Name
2019
2018
Accounting Method
Aktana, Inc.
17.8%
18.9%
Equity
Clutch Holdings, Inc.
41.2%
41.2%
Equity
Flashtalking *
10.1%
10.1%
Other
InfoBionic, Inc.
25.2%
25.4%
Equity
Lumesis, Inc.
43.5%
43.7%
Equity
MediaMath, Inc. **
13.3%
13.4%
Other
meQuilibrium
32.7%
33.1%
Equity
Moxe Health Corporation
29.9%
32.4%
Equity
Prognos Health Inc.
28.7%
28.7%
Equity
QuanticMind, Inc.
24.2%
24.2%
Equity
Sonobi, Inc.
21.6%
21.6%
Equity
Syapse, Inc.
20.0%
20.0%
Equity
T-REX Group, Inc.
13.7%
21.1%
Other
Trice Medical, Inc.
16.6%
17.4%
Equity
WebLinc, Inc.
38.5%
38.5%
Equity
Zipnosis, Inc
37.7%
34.7%
Equity
* Spongecell, Inc. merged into Flashtalking in January 2018.
** The Company sold 39.1% of its ownership interest back to MediaMath, Inc. for $45 million of proceeds in July 2018.
Year ended December 31, 2019 versus year ended December 31, 2018
Year Ended December 31,
2019
2018
Variance
(In thousands)
General and administrative expense
$
(9,982
)
$
(16,871
)
$
6,889
Other income (loss), net
12,255
(5,158
)
17,413
Interest income
2,044
2,806
(762
)
Interest expense
(14,023
)
(16,067
)
2,044
Equity income (loss), net
64,267
19,661
44,606
Net income (loss)
$
54,561
$
(15,629
)
$
70,190
General and Administrative Expense. Our general and administrative expenses consist primarily of employee compensation, insurance, office costs, travel-related costs, depreciation, office rent and professional services such as consulting, legal, and accounting. General and administrative expense also includes stock-based compensation expense which consists primarily of expense related to grants of stock options, restricted stock and deferred stock units to our employees and directors. General and administrative expense decreased $6.9 million for the year ended December 31, 2019 compared to the
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prior year primarily due to a $1.1 million decrease in employee compensation from the lower overall level of staffing, the absence of the $3.8 million severance charge for employees who were terminated in connection with our change in strategy in 2018, and $2.2 million of lower professional fees, primarily due to costs associated with activist shareholder matters in the prior year. These amounts were partially offset by an increase of $0.4 million in stock-based compensation.
Other income (loss), net. Other income (loss), net improved by $17.4 million for the year ended December 31, 2019, compared to the prior year. Other income (loss), net for the year ended December 31, 2019 included $5.1 million of income related to the decrease in the fair value of the amended credit facility repayment feature liability as compared to a $4.5 million loss related to the same liability in the prior comparable period. The 2019 year also included $4.5 million of non-cash gains on the increase in the value of certain equity securities based upon observable price changes as compared to $1.4 million in 2018. The 2019 year also included a $1.7 million gain resulting from the elimination of the remaining estimated liability established related to the retirement benefit for a former Chairman and CEO of the Company. Other income (loss), net for the year ended December 31, 2018 also reflected a $1.2 million loss from the decrease in the fair value of escrow shares of Invitae Corporation common stock obtained in connection with the sale of Good Start Genetics in 2017.
Interest Income. Interest income includes all interest earned on available cash and marketable security balances as well as interest earned on notes receivable from certain of our ownership interests. Interest income decreased $0.8 million compared to the prior year due to lower average notes receivable, which was partially offset by higher average investment balances in marketable securities during the early portion of 2019.
Interest Expense. Interest expense is primarily related to our Credit Facility and, in 2018, our convertible senior debentures. Interest expense decreased $2.0 million compared to the prior year primarily due to the repayment of all remaining Credit Facility debt in July 2019. As a result, 2018 included a full year of borrowings while 2019 was a partial year. However, 2019 also included $7.0 million of accelerated interest expense resulting from the make-whole interest provisions of the Credit Facility and accelerated debt issue cost amortization both related to the prepayment of debt associated with the Credit Facility.
Equity Income (Loss). Equity income (loss) fluctuates with the number of companies accounted for under the equity method, our voting ownership percentage in those companies and the net results of operations of those companies. We recognize our share of losses to the extent we have cost basis in the equity of the company or we have outstanding commitments or guarantees. Certain amounts recorded to reflect our share of the income or losses of our companies accounted for under the equity method are based on estimates and on unaudited results of operations of those companies and may require adjustments in the future when audits of these entities are made final. We report our share of the results of our equity method companies on a one quarter lag basis.
Equity income (loss) increased $44.6 million for the year ended December 31, 2019 compared to the prior year. The components of equity income (loss) for the years ended December 31, 2019 and 2018 were as follows:
Year ended December 31:
2019
2018
(In thousands)
Gains on sales of ownership interests
$
85,834
$
67,980
Unrealized dilution gains
3,206
9,154
Gains from proceeds received from escrow
4,305
1,838
Loss on impairments
(2,965
)
(12,626
)
Share of losses of our equity method companies, net
(26,113
)
(46,685
)
$
64,267
$
19,661
The gains on sale of ownership interests for the year ended December 31, 2019 is comprised primarily of gains related to the sale of Propeller in the amount of $35.1 million and Transactis in the amount of $50.7 million. The gain on sale of ownership interests for the year ended December 31, 2018 is comprised primarily of gains related to MediaMath in the amount of $45.0 million, Nexxt (fka Beyond.com) in the amount of $9.5 million, AdvantEdge Healthcare Solutions in the amount of $5.5 million and Cask Data in the amount of $4.2 million.
The unrealized dilution gains for the year ended December 31, 2019 were the result of meQuilibrium, Syapse, Trice, T-REX and Moxe, who each raised additional equity capital that diluted the Company's interest in those entities. The unrealized dilution gains (losses) for the year ended December 31, 2018 were related to Aktana, Clutch, meQuilibrium, Propeller, Transactis, Trice and QuanticMind.
The gains from proceeds received from escrow for the year ended December 31, 2019 was primarily related to additional amounts received for holdbacks and escrows related to the sale of Cask, but also included incremental proceeds of Invitae shares received in connection with the Good Start Genetics sale.
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The loss on impairments for the year ended December 31, 2019 is related solely to NovaSom, Inc. The loss on impairments for the year ended December 31, 2018 is comprised of Apprenda in the amount of $6.6 million, CloudMine in the amount of $4.8 million and Brickwork in the amount of $1.2 million.
The decrease in our share of losses of our equity method companies for the 2019 year was due to a decrease in the number of equity method companies and a net decrease in losses associated with the individual companies.
Income Tax Benefit (Expense)
Income tax benefit (expense) was $0.0 million for the years ended December 31, 2019 and 2018 . We have recorded a valuation allowance to reduce our net deferred tax asset to an amount that is more likely than not to be realized in future years. Accordingly, the benefit of the net operating loss that would have been recognized in each year was offset by changes in the valuation allowance.
Liquidity And Capital Resources
As of December 31, 2019, the Company had $25.0 million of cash and cash equivalents.
During April 2019, the Company made a $24.0 million principal payment to its Lender and a related make-whole interest payment of $2.9 million. During July 2019, the Company made a $49.5 million payment to its Lender consisting of $44.5 million of principal, $4.1 million of make-whole interest and $0.9 million of accrued interest, which satisfied all obligations under the Credit Facility.
In January 2018, Safeguard announced that, from that date forward, we will not deploy any capital into new opportunities and will focus on supporting our existing companies and maximizing monetization opportunities to return value to shareholders. In that context, we have, are and will consider initiatives including, among others: the sale of our individual ownership interests, the sale of certain ownership interests in secondary market transactions, or a combination thereof, as well as other opportunities to maximize shareholder value.
Subsequent to the debt repayment, on November 7, 2019, the Company's Board of Directors declared a special cash dividend of $1.00 per share, payable on December 30, 2019 to shareholders of record as of the close of business on December 23, 2019. We anticipate continuing to return value to shareholders in the form of stock repurchases and/or dividends based on prevailing market conditions and other factors when and if additional liquidity becomes available.
In 2015, the Company's Board of Directors authorized us, from time to time and depending on market conditions, to repurchase up to $25.0 million of the Company's outstanding common stock. During the years ended December 31, 2019 and 2018, we did not repurchase any shares under this authorization.
Our ability to generate liquidity from transactions involving our ownership interests has been adversely affected from time to time by adverse circumstances in the U.S. capital markets and other factors. The transactions we enter into in pursuit of our strategy could increase or decrease our liquidity at any point in time. As we seek to provide additional funding to existing companies where we have an ownership interest or commit capital to other initiatives, we may be required to expend our cash or incur debt, which will decrease our liquidity. Conversely, as we dispose of our interests in our ownership interests, we may receive proceeds from such sales, which could increase our liquidity. From time to time, we are engaged in discussions concerning deployments and dispositions which, if consummated, could impact our liquidity, perhaps significantly. The Company believes that its cash and cash equivalents at December 31, 2019 will be sufficient to fund operations past one year from the issuance of these financial statements.
Analysis of Consolidated Cash Flows
Cash flow activity was as follows:
Year Ended December 31,
2019
2018
(In thousands)
Net cash used in operating activities
$
(19,970
)
$
(26,035
)
Net cash provided by investing activities
126,303
32,103
Net cash used in financing activities
(89,483
)
(24,952
)
$
16,850
$
(18,884
)
Net Cash Used In Operating Activities
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Year ended December 31, 2019 versus year ended December 31, 2018. Net cash used in operating activities decreased by $6.1 million for the year ended December 31, 2019 compared to the prior year. The activity during the year ended December 31, 2019 was primarily the result of various non-cash adjustments to net income, including the $64.3 million of equity income, a $5.1 million gain from the decrease in the fair value of the repayment feature derivative, non-cash gains of $4.5 million for observable price changes, depreciation, and the $3.5 million amortization of debt discount. Also, the Company made $11.5 million of cash interest payments for the year ended December 31, 2019 as compared to $10.0 million of cash interest payments for the year ended December 31, 2018. The activity during the year ended December 31, 2018 was primarily the result of various non-cash adjustments to net income, including $19.7 million of equity income, a $4.5 million loss from the increase in the fair value of the repayment feature derivative, a $1.4 million gain for an observable price change, and the $4.5 million amortization of debt discount.
Net Cash Provided by Investing Activities
Year ended December 31, 2019 versus year ended December 31, 2018. Net cash provided by investing activities increased by $94.2 million for the year ended December 31, 2019 compared to the prior year. The increase related to $104.3 million in proceeds from the sale and distributions from companies, including Propeller and Transactis as compared to $67.4 million in proceeds from the sales of and distributions from companies and $10.7 million repayment of outstanding notes, primarily from Nexxt, Inc. in the previous year. The Company also had $37.9 million of marketable securities mature in excess of purchases during the year ended December 31, 2019 as compared to $29.7 million of marketable securities purchases that exceeded maturities during the year ended December 31, 2018. We also deployed $16.7 million during 2019 for the acquisition of additional ownership interests and advances and loans to our companies, which was consistent with the $16.4 million deployed in 2018.
Net Cash Used In Financing Activities
Year ended December 31, 2019 versus year ended December 31, 2018. Net cash used in financing activities increased by $64.5 million for the year ended December 31, 2019 compared to the prior year. The primary financing activities in 2019 were the $20.7 million special dividend and the repayment of the Credit Facility for $68.6 million. The primary financing activities in 2018 were primarily the repayment of $41.0 million of our 2018 Debentures, $32.7 million of net proceeds from additional borrowings under our Amended Credit Facility and the $16.4 million Credit Facility payment in the fourth quarter.
Contractual Cash Obligations and Other Commercial Commitments
The following table summarizes our contractual obligations and other commercial commitments as of December 31, 2019 , by period due or expiration of the commitment.
Payments Due by Period
Total
2020
2021 and
2022
2023 and
2024
After
2024
(In millions)
Contractual Cash Obligations:
Operating leases (a)
$
3.9
$
0.7
$
1.2
$
1.2
$
0.8
Severance payments
0.1
0.1
—
—
—
Total Contractual Cash Obligations (b)
$
4.0
$
0.8
$
1.2
$
1.2
$
0.8
(a)
In 2015, we entered into an agreement for the lease of our former principal executive offices which expires in April 2026. In March 2019, we entered into a sublease for these offices which is expected to result in future aggregate sublease receipts of $3.5 million through April 2026.
(b)
The maximum aggregate exposure under employment and severance agreements for remaining employees was approximately $4.0 million at December 31, 2019 (not reflected in the table above).
We are involved from time to time in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of any of these matters which are currently pending will not have a material adverse effect on our consolidated financial position or results of operations.
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Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Not applicable for a smaller reporting company.
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