Shoals Technologies Group, 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 our financial statements and the related notes and other financial information included in this Annual Report on Form 10-K. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under the sections of this Form 10-K captioned “Forward-Looking Statements” and “Risk Factors.” Overview We are a leading provider of electrical balance of system or “EBOS” solutions for solar energy projects in the United States. EBOS encompasses all of the components that are necessary to carry the electric current produced by solar panels to an inverter and ultimately to the power grid. EBOS components are mission-critical products that have a high consequence of failure, including lost revenue, equipment damage, fire damage, and even serious injury or death. As a result, we believe customers prioritize reliability and safety over price when selecting EBOS solutions. EBOS components that we produce include cable assemblies, inline fuses, combiners, disconnects, recombiners, wireless monitoring systems, junction boxes, transition enclosures and splice boxes. We derive the majority of our revenue from selling “system solutions” which are complete EBOS systems that include several of our products, many of which are customized for the customer’s project. We believe our system solutions are unique in our industry because they integrate design and engineering support, proprietary components and innovative installation methods into a single offering that would otherwise be challenging for a customer to obtain from a single provider or at all. We sell our products principally to EPCs that build solar energy projects. However, the decision to use our products typically involves input from both the EPC and the owner of the solar energy project, given the 47 Table of Con tents mission-critical nature of EBOS. The custom nature of our system solutions and the long development cycle for solar energy projects typically gives us 12 months or more of lead time to quote, engineer, produce and ship each order we receive, and we do not stock large amounts of finished goods. We derived approximately 66% of our revenue from the sale of system solutions for the year ended December 31, 2020. For the year ended December 31, 2020, we derived 99% and 1% of our revenue from customers in the U.S. and the rest of the world, respectively. Key Components of Our Results of Operations The following discussion describes certain line items in our Consolidated Statements of Operations. Revenue We generate revenue from the sale of EBOS systems and components for homerun and combine-as-you-go architectures. Our customers include EPCs, utilities, solar developers, independent power producers and solar module manufacturers. We derive the majority of our revenue from selling system solutions. When we sell a system solution, we enter into a contract with our customers covering the price, specifications, delivery dates and warranty for the products being purchased, among other things. Our contractual delivery period for system solutions can vary from one to three months whereas manufacturing typically requires a shorter time frame. Contracts for system solutions can range in value from several hundred thousand to several million dollars. Our revenue is affected by changes in the price, volume and mix of products purchased by our customers. The price and volume of our products is driven by the demand for our products, changes in product mix between homerun and combine-as-you-go EBOS, geographic mix of our customers, strength of competitors’ product offerings, and availability of government incentives to the end-users of our products. Our revenue growth is dependent on continued growth in the amount of solar energy projects constructed each year and our ability to increase our share of demand in the geographies where we currently compete and plan to compete in the future as well as our ability to continue to develop and commercialize new and innovative products that address the changing technology and performance requirements of our customers. Cost of Revenue and Gross Profit Cost of revenue consists primarily of product costs, including purchased materials and components, as well as costs related to shipping, customer support, product warranty, personnel and depreciation of manufacturing and testing equipment. Personnel costs in cost of revenue include both direct labor costs as well as costs attributable to any individuals whose activities relate to the transformation of raw materials or component parts into finished goods or the transportation of materials to the customer. Our product costs are affected by the underlying cost of raw materials, including copper and aluminum; component costs, including fuses, resin, enclosures, and cable; technological innovation; economies of scale resulting in lower component costs; and improvements in production processes and automation. We do not currently hedge against changes in the price of raw materials. Some of these costs, primarily personnel and depreciation of manufacturing and testing equipment, are not directly affected by sales volume. Gross profit may vary from year to year and is primarily affected by our sales volume, product prices, product costs, product mix, customer mix, geographical mix, shipping method, warranty costs and seasonality. Operating Expenses 48 Table of Con tents Operating expenses consist of general and administrative costs as well as depreciation and amortization expense. Personnel-related costs are the most significant component of our operating expenses and include salaries, equity-based compensation, benefits, payroll taxes and commissions. The number of full-time employees in our general and administrative departments increased from 42 to 52 from December 31, 2019 to December 31, 2020, and we expect to hire new employees in the future to support our growth. The timing of these additional hires could materially affect our operating expenses in any particular period, both in absolute dollars and as a percentage of revenue. We expect to invest in additional resources to support our growth which will increase our operating expenses. General and Administrative Expenses General and administrative expenses consist primarily of salaries, equity-based compensation expense, employee benefits and payroll taxes related to our executives, and our sales, finance, human resources, information technology, engineering and legal organizations, travel expenses, facilities costs, marketing expenses, bad debt expense and fees for professional services. Professional services consist of audit, legal, tax, insurance, information technology and other costs. We expect to increase our sales and marketing personnel as we expand into new geographic markets. The majority of our sales in 2020 were in the U.S. We currently have a sales presence in the U.S. and Australia. We intend to expand our sales presence and marketing efforts to additional countries in the future. We also expect that as a result of our recent initial public offering, we will incur additional audit, tax, accounting, legal and other costs related to compliance with applicable securities and other regulations, as well as additional insurance, investor relations and other costs associated with being a public company. Depreciation Depreciation in our operating expenses consists of costs associated with property, plant and equipment (“PP&E”) not used in manufacturing our products. We expect that as we increase both our revenue and the number of our general and administrative personnel, we will invest in additional PP&E to support our growth resulting in additional depreciation expense. Amortization Amortization of intangibles consists of customer relationships, developed technology, trade name and non-compete agreements over their expected period of use. Non-operating Expenses Interest Expense Interest expense consists of interest and other charges paid in connection with our current Senior Secured Credit Agreement (as defined below) and our former Senior Debt which included a revolving line of credit and term loan, which was fully repaid on October 8, 2020. 49 Table of Con tents Results of Operations The following table summarizes our results of operations (dollars in thousands): Year Ended December 31, Increase / (Decrease) 2020 2019 Revenue $ 175,518 $ 144,496 $ 31,022 21 % Cost of Revenue 108,972 100,284 8,688 9 % Gross Profit 66,546 44,212 22,334 51 % Operating Expenses General and administrative expenses 21,008 9,065 11,943 132 % Depreciation and amortization 8,262 8,217 45 1 % Total Operating Expenses 29,270 17,282 11,988 69 % Income from Operations 37,276 26,930 10,346 38 % Interest expense, net (3,510) (1,787) 1,723 96 % Net Income $ 33,766 $ 25,143 $ 8,623 34 % Years Ended December 31, 2020 and 2019 Revenue Revenue increased by $31.0 million, or 21%, for the year ended December 31, 2020 as compared to the year ended December 31, 2019, driven by higher sales volumes as a result of increased demand for solar EBOS generally and our combine-as-you-go system solutions specifically. Our total number of customers increased by 43 in 2020 as compared to 2019. We believe customer recognition of the benefits of our combine-as-you-go system is resulting in increased demand for our products. Cost of Revenue and Gross Profit Cost of revenue increased by $8.7 million, or 9%, for the year ended December 31, 2020 as compared to the year ended December 31, 2019, primarily driven by an increase in production volumes. Gross profit as a percentage of revenue increased from 31% in 2019 to 38% in 2020 in part due to purchasing efficiencies from increased volumes, improved material planning which reduced logistics costs, enhancements to product design that lowered manufacturing costs and other manufacturing efficiencies resulting from higher production volumes. Changes in product mix also contributed to the increase in margins as sales of system solutions for combine-as-you-go EBOS, which have higher margins than our other products, increased as a percentage of our total revenue. Our gross profit was negatively impacted in the year ended December 31, 2020 as a result of certain COVID-19 related costs totaling $2.6 million. Operating Expenses General and Administrative General and administrative expenses increased $11.9 million, or 132%, for the year ended December 31, 2020 as compared to the year ended December 31, 2019. The increase in general and administrative expenses was primarily the result of $8.3 million in equity-based compensation related to Class C units issued, an increase in professional fees of $1.5 million related to preparation for our IPO, wages and related taxes of $1.8 million related to increased head counts and year-end bonuses, insurance expense of $0.2 million, franchise and other related taxes of $0.2 million and certain COVID-19 related costs of $0.3 million, offset by a decrease in travel and trade shows of $0.7 million as a result of COVID-19. 50 Table of Con tents Depreciation and Amortization Depreciation expense increased by $45 thousand, or 1%, for the year ended December 31, 2020 as compared to the year ended December 31, 2019, due to the addition of machines and equipment to increase production. Interest Expense Interest expense, net increased by $1.7 million or 96%, for the year ended December 31, 2020 as compared to the year ended December 31, 2019, due to increased borrowings under our Senior Secured Credit Facility that we entered into on November 25, 2020. We expect interest expense to increase in 2021 as a result of our higher average borrowings under the Senior Secured Credit Facility (see description under “Debt Obligations”). We estimate the $150 million prepayment we made on the Term Loan Facility in January 2021 will result in us recording a $16.0 million loss on debt repayment in the first quarter of 2021 as a result of the write-off of financing costs and the prepayment premium. Year Ended December 31, 2018 Discussion and analysis covering the year ended December 31, 2018 is included in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Registration Statement on Form S-1, as amended, that was filed on January 25, 2021. Non-GAAP Financial Measures Adjusted EBITDA and Adjusted Net Income We define Adjusted EBITDA as net income plus (i) interest expense, (ii) income taxes, (iii) depreciation expense, (iv) amortization of intangibles, (v) equity-based compensation, (vi) COVID-19 expenses and (vii) non-recurring and other expenses. We define Adjusted Net Income as net income plus (i) amortization of intangibles, (ii) amortization of deferred finance costs, (iii) equity-based compensation, (iv) COVID-19 expenses and (v) non-recurring and other expenses, all net of applicable income taxes. Adjusted EBITDA and Adjusted Net Income are intended as supplemental measures of performance that are neither required by, nor presented in accordance with, GAAP. We present Adjusted EBITDA and Adjusted Net Income because we believe they assist investors and analysts in comparing our performance across reporting periods on a consistent basis by excluding items that we do not believe are indicative of our core operating performance. In addition, we use Adjusted EBITDA and Adjusted Net Income: (i) as factors in evaluating management’s performance when determining incentive compensation; (ii) to evaluate the effectiveness of our business strategies; and (iii) because our credit agreement uses measures similar to Adjusted EBITDA and Adjusted Net Income to measure our compliance with certain covenants. Among other limitations, Adjusted EBITDA and Adjusted Net Income do not reflect our cash expenditures, or future requirements for capital expenditures or contractual commitments; do not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations; in the case of Adjusted EBITDA, does not reflect income tax expense or benefit; and may be calculated by other companies in our industry differently than we do or not at all, which may limit their usefulness as comparative measures. Because of these limitations, Adjusted EBITDA and Adjusted Net Income should not be considered in isolation or as substitutes for performance measures calculated in accordance with GAAP. We compensate for these limitations by relying primarily on our GAAP results and using Adjusted EBITDA and Adjusted Net 51 Table of Con tents Income on a supplemental basis. You should review the reconciliation of net income to Adjusted EBITDA and Adjusted Net Income below and not rely on any single financial measure to evaluate our business. The following table reconciles net income to Adjusted EBITDA (in thousands): Year Ended December 31, 2020 2019 2018 Net income $ 33,766 $ 25,143 $ 8,647 Interest expense, net 3,510 1,787 2,440 Depreciation expense 1,420 1,179 1,006 Amortization of intangibles 7,985 7,984 7,984 Equity-based compensation 8,251 — — COVID-19 expenses (a) 2,890 — — Non-recurring and other expenses (b) 3,077 686 1,053 Adjusted EBITDA $ 60,899 $ 36,779 $ 21,130 (a) Represents costs incurred as a direct impact from the COVID-19 pandemic, disinfecting and reconfiguration of facilities, medical professionals to conduct daily screenings of employees, premium pay during the pandemic to hourly workers and direct legal costs associated with the pandemic. (b) Represents certain costs associated with non-recurring professional services, Oaktree’s expenses and other costs. The following table reconciles net income to Adjusted Net Income (in thousands): Year Ended December 31, 2020 2019 2018 Net income $ 33,766 $ 25,143 $ 8,647 Amortization of intangibles 7,985 7,984 7,984 Amortization of deferred finance costs 351 38 38 Equity-based compensation 8,251 — — COVID-19 expenses (a) 2,890 — — Non-recurring and other expenses (b) 3,077 686 1,053 Adjusted Net Income $ 56,320 $ 33,851 $ 17,722 (a) Represents costs incurred as a direct impact from the COVID-19 pandemic, disinfecting and reconfiguration of facilities, medical professionals to conduct daily screenings of employees, premium pay during the pandemic to hourly workers and direct legal costs associated with the pandemic. (b) Represents certain costs associated with non-recurring professional services, Oaktree’s expenses and other costs. 52 Table of Con tents Liquidity and Capital Resources Year Ended December 31, 2020 2019 Net cash provided by operating activities $ 54,082 $ 36,182 Net cash used in investing activities (3,236) (1,719) Net cash used in financing activities (47,855) (27,489) Increase in cash and cash equivalents $ 2,991 $ 6,974 We finance our operations primarily with operating cash flows and short and long-term borrowings. Our ability to generate positive cash flow from operations is dependent on the strength of our gross margins as well as our ability to quickly turn our working capital. Based on our past performance and current expectations, we believe that operating cash flows will be sufficient to meet our near-term future cash needs. The Company generated cash from operating activities of $54.1 million and $36.2 million in the years ended December 31, 2020 and 2019, respectively. As of December 31, 2020, our cash and cash equivalents were $10.1 million and we had outstanding borrowings of $370.0 million. We also had $80 million available for additional borrowings under our $100.0 million revolving line of credit. Operating Activities For the year ended December 31, 2020, cash provided by operating activities was $54.1 million, primarily due to operating results that included $33.8 million of net income. An increase of $6.5 million in inventories, $1.0 million in receivables was offset by an increase in accounts payable and accrued expenses of $9.0 million. For the year ended December 31, 2019, cash provided by operating activities was $36.2 million, primarily due to operating results that included $25.1 million of net income. An increase of $0.7 million in inventories and $1.8 million in receivables was partially offset by $3.9 million of accounts payable and accrued expenses. Investing Activities For the year ended December 31, 2020, net cash used in investing activities was $3.2 million, attributable to the purchase of property and equipment. For the year ended December 31, 2019, net cash used in investing activities was $1.7 million, attributable to the purchase of property and equipment. Financing Activities For the year ended December 31, 2020, net cash used in financing activities was $47.9 million, including $26.3 million of payments on senior debt, a $355.8 million special distribution to members and $20.2 million in tax distributions to members, partially offset by borrowings of $370.0 million under the Senior Secured Credit Agreement, net of $11.8 million in debt discount and financing costs. For the year ended December 31, 2019, net cash used in financing activities was $27.5 million, of which $16.0 million was payments on senior debt and $14.0 million was tax distributions to members, which was partially offset by $2.5 million of borrowings of the revolving line of credit. Historical Cash Flows 53 Table of Con tents Discussion and analysis covering historical cash flows the year ended December 31, 2018 is included in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Registration Statement on Form S-1, as amended, that was filed on January 25, 2021. Debt Obligations Senior Secured Credit Agreement On November 25, 2020 (the “Senior Secured Credit Agreement Closing Date”), Holdings, as borrower, and Intermediate, as holdings, entered into that certain Credit Agreement with the lenders party thereto from time to time and Wilmington Trust, National Association, as administrative agent and collateral agent (the “Senior Secured Credit Agreement”), which sets forth the terms and conditions for a Senior Secured Credit Agreement consisting of (i) a $350.0 million senior secured six-year term loan facility (the “Term Loan Facility”), (ii) a $30.0 million senior secured delayed draw term loan facility, which matures concurrently with the six-year Term Loan Facility (the “Delayed Draw Term Loan Facility”) and (iii) an uncommitted super senior first out revolving credit facility (the “Revolving Credit Facility”). The proceeds of the Term Loan Facility and a $10.0 million draw under the Delayed Draw Term Loan Facility funded on the Senior Secured Credit Agreement Closing Date were used to (i) make certain distributions from Shoals Holdings to Shoals Intermediate Holdings and from there to certain of our direct or indirect equity holders in an aggregate amount not in excess of $350.0 million plus amounts funded from cash on the balance sheet, (ii) pay any transaction expenses related thereto, (iii) repay and terminate all outstanding commitments under the Senior Debt and (iv) finance working capital and general corporate purposes. An additional $10.0 million draw under the Delayed Draw Term Loan Facility funded on December 14, 2020. On December 22, 2020, Shoals Holdings entered into an amendment to the Senior Secured Credit Agreement in order to obtain a $100.0 million increase (the “Revolver Upsize”) to the Revolving Credit Facility. At December 31, 2020, the Company had $80.0 million of availability under the Revolving Credit Facility. The proceeds of the Revolver Upsize will be used to finance working capital and general corporate purposes, and any description of the Revolving Credit Facility set forth below shall be deemed to include the Revolver Upsize. On December 23, 2020, we repaid and terminated all outstanding commitments under the Delayed Draw Term Loan Facility. On December 30, 2020, Shoals Holdings entered into a second amendment to the Senior Secured Credit Agreement. Interest Rate The interest rates applicable to the loans under the Term Loan Facility (4.25% at December 31, 2020) are based on a rate of interest determined by reference to either: (i) a base rate plus an applicable margin equal to (a) on and after December 30, 2020 until the later of either (1) February 28, 2021 or (2) December 31, 2022 so long as Holdings has prepaid the loans under the Term Loan Facility on or prior to February 28, 2021 in an amount that results in the aggregate outstanding principal amount of loans under the Term Loan Facility being equal to or less than the sum of (A) $200.0 million minus (B) any mandatory prepayments of the principal amount of loans under the Term Loan Facility or amortization payments made prior to February 28, 2021, 2.25% and(b) thereafter, either (1) if Holdings has consummated an IPO the net cash proceeds of which have been used to repay the principal amount of the loans under the Term Loan Facility in an amount no less than $70.0 million, 4.75% or (2) otherwise, 5.00%; or (ii) a eurocurrency rate plus an applicable margin equal to (a) on and after December 30, 2020 until the later of either (1) February 28, 2021 or (2) December 31, 2022 so long as Holdings has prepaid the loans under the Term Loan Facility on or prior to February 28, 2021 in an amount that results in the aggregate outstanding principal amount of loans under the Term Loan Facility being equal to or less than the sum of (A) $200.0 million minus (B) any mandatory prepayments of the principal 54 Table of Con tents amount of loans under the Term Loan Facility or amortization payments made prior to February 28, 2021, 3.25% and (b) thereafter, either (1) if Holdings has consummated an IPO the net cash proceeds of which have been used to repay the principal amount of the loans under the Term Loan Facility in an amount no less than $70.0 million, 5.75% or (2) otherwise, 6.00%. The interest rates applicable to the loans under the Revolving Credit Facility (3.75% at December 31, 2020) are based on a rate of interest determined by reference to either (i) a base rate plus an applicable margin equal to 2.25% or (ii) a eurocurrency rate plus an applicable margin equal to 3.25%. Guarantees and Security The obligations under the Senior Secured Credit Agreement are guaranteed by Shoals Intermediate Holdings and its wholly owned domestic subsidiaries other than certain immaterial subsidiaries and other excluded subsidiaries. The obligations under the Senior Secured Credit Agreement are secured by a first priority security interest in substantially all of Holdings’ and the other guarantors’ existing and future property and assets, including accounts receivable, inventory, equipment, general intangibles, intellectual property, investment property, other personal property, material owned real property, cash and proceeds of the foregoing. Prepayments and Amortization Loans under the Revolving Credit Facility may be voluntarily prepaid, at Shoals Holdings’ option, in whole, or in part, in each case without premium or penalty. Loans under the Term Loan Facility may be voluntarily prepaid, at Holdings’ option, in whole, or in part, in each case without premium or penalty other than (i) a prepayment premium in an amount equal to (a) if such prepayment occurs prior to the first anniversary of the Senior Secured Credit Agreement Closing Date, a make-whole premium, (b) if such prepayment occurs on or after the first anniversary but prior to the second anniversary of the Senior Secured Credit Agreement Closing Date, 2.00% and (c) if such prepayment occurs on or after the second anniversary but prior to the third anniversary of the Senior Secured Credit Agreement Closing Date, 1.00% and (ii) with respect to prepayments in connection with an IPO, a change of control or a transformative disposition subject to certain exceptions and conditions, a prepayment premium equal to (a) if such prepayment occurs prior to the first anniversary of the Senior Secured Credit Agreement Closing Date, 2.00% and (b) if such prepayment occurs after the first anniversary of the Senior Secured Credit Agreement Closing Date but prior to the second anniversary of the Senior Secured Credit Agreement Closing Date, 1.00%. Notwithstanding anything to the contrary in the preceding paragraph, in the event that, on or after December 30, 2020 but prior to February 28, 2021, Shoals Holdings makes any prepayment (including with respect to any acceleration) of any loans under the Term Loan Facility, Holdings shall pay a premium on such prepayments made up to $150.0 million of the principal amount of such loans prepaid in an amount equal to 7.50% multiplied by the principal amount of such loans prepaid, which, if applicable, shall be in lieu of any applicable prepayment premium set forth in the preceding paragraph or in the paragraph below; provided that no amortization payments or mandatory prepayments required under the Senior Secured Credit Agreement shall be subject to the prepayment premium set forth in this paragraph. Additionally, after February 28, 2021 but prior to the second anniversary of the Senior Secured Credit Agreement Closing Date, up to $175.0 million of the outstanding principal amount of the Term Loan Facility may be voluntarily prepaid upon the consummation of an IPO with proceeds from such IPO, subject to a prepayment premium in an amount equal to 1.00% in lieu of any applicable call protection premiums set forth in the second preceding paragraph. 55 Table of Con tents The Senior Secured Credit Agreement requires mandatory prepayments, but not permanent reductions of commitments thereunder, for excess cash flow, asset sales, subject to a right of reinvestment, and refinancing facilities. The Term Loan Facility amortizes in equal quarterly installments in aggregate annual amounts equal to 1.00% per annum of the original principal amount of the loans funded thereunder. There is no scheduled amortization under the Revolving Credit Facility. Restrictive Covenants and Other Matters The Senior Secured Credit Agreement contains affirmative and negative covenants that are customary for financings of this type, including covenants that restrict our incurrence of indebtedness, incurrence of liens, dispositions, investments, acquisitions, restricted payments, and transactions with affiliates. The Senior Secured Credit Agreement also includes customary events of default, including the occurrence of a change of control. The Revolving Credit Facility also includes a springing financial maintenance covenant that is tested on the last day of each fiscal quarter if the outstanding loans under the Revolving Credit Facility exceed 35% of the aggregate amount of commitments thereunder, subject to customary exclusions and conditions. If the financial maintenance covenant is triggered, Shoals Intermediate Holdings’ first lien net leverage ratio will be tested for compliance not to exceed 8.25 to 1.00. As of December 31, 2020, the Company was in compliance with all the required covenants. Senior Debt Intermediate and subsidiaries were party to a credit agreement (the “Senior Debt”) under which Holdings and its subsidiaries were borrowers and Intermediate was a guarantor. The debt was collateralized by all of the assets of the guarantor and borrowers. The amended agreement provided a term loan of $35 million and a revolving line of credit of $25 million. On October 8, 2020, the Company paid the outstanding amount due on the term loan and settled all obligations with respect to the Senior Debt. The Senior Debt provided for an interest rate to equal the Base Rate plus margin. The Base Rate charged is the highest rate of three defined methods as follows: 1) Federal Funds Rate plus 0.5%, 2) Fifth Third Bank N.A. Rate or 3) LIBOR Rate plus 1%. The Base Rate ranges from 1% to 2.5% depending on the EBITDA Rate calculation as defined in the Senior Debt (the “EBITDA Rate calculation”) for the Federal Funds Rate. The Base Rate for the LIBOR Rate ranges from 2% to 3.5% depending on the EBITDA Rate calculation. Surety Bonds The Company provides surety bonds to various parties as required for certain transactions initiated during the ordinary course of business to guarantee the Company’s performance in accordance with contractual or legal obligations. As of December 31, 2020, the maximum potential payment obligation with regard to surety bonds was $11.8 million. 56 Table of Con tents Critical Accounting Policies and Significant Management Estimates We prepare our consolidated financial statements in accordance with generally accepted accounting principles in the U.S. (“GAAP”). The preparation of consolidated financial statements also requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ significantly from the estimates made by our management. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Critical accounting policies and estimates are those that we consider the most important to the portrayal of our financial condition and results of operations because they require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain. Revenue Recognition - 2020 and 2019 We recognized revenue from the sale of EBOS systems and components. We determine our revenue recognition through the following steps: (i) identification of the contract or contracts with a customer, (ii) identification of the performance obligations within the contract, (iii) determination of the transaction price, (iv) allocation of the transaction price to the performance obligations within the contract, and (v) recognition of revenue as the performance obligation has been satisfied. Our contracts with customers are predominately accounted for as one performance obligation, as the majority of the obligations under the contracts relate to single projects. For each contract entered into, we determine the transaction price based on the consideration expected to be received. The transaction price identified is allocated to each distinct performance obligation to deliver a good or service based on the relative standalone selling prices. We believe that the prices negotiated with each individual customer are representative of the stand-alone selling price of the product. We recognize revenue over time as a result of the continuous transfer of control of our product to the customer using the output method based on units manufactured. This continuous transfer of control to the customer is supported by clauses in the contracts that provide rights to payment of the transaction price associated with work performed to date on products that do not have an alternative use to us. The accounting for each contract involves a process of estimating total sales, costs, and profit for each performance obligation. Cost of revenue is recognized based on the unit of production. The amount reported as revenue is determined by adding a proportionate amount of the estimated profit to the amount reported as cost of revenue. We believe that recognizing revenue using the output method based on units manufactured best depicts the extent of transfer of control to the customer. Certain contracts contain retainage provisions. Retainage represents a contract asset for the portion of the contract price earned by us for work performed but held for payment by the customer as a form of security until we reach specified milestones. We typically bill retainage amounts as work is performed. Retainage provisions are not considered a significant financing component because they are intended to protect the customer in the event that some or all of the obligations under the contract are not completed. We had outstanding retainage billings of $2.8 million and $1.5 million as of December 31, 2020 and 2019, respectively. We have elected to adopt certain practical expedients and exemptions as allowed under the new revenue recognition guidance such as (i) recording sales commissions as incurred because the amortization period is less than one year, (ii) excluding any collected sales tax amounts from the calculation of revenue, and (iii) accounting for shipping and handling activities that are incurred after the customer has obtained control of 57 Table of Con tents the product as fulfillment costs rather than a separate service provided to the customer for which consideration would need to be allocated. Revenue Recognition - 2018 During the year ended December 31, 2018, the Company recognized revenue net of returns and allowances when persuasive evidence of an arrangement existed; price was fixed and determinable; title and risk passed to its customers, which typically occurs upon shipment of its products; and collectability was reasonably assured. Equity-Based Compensation The Company accounts for equity grants to employees (Class C units) as equity-based compensation. The Class C units contain vesting provisions as defined in the agreement. Vested units do not forfeit upon termination and represent a residual interest in the Company. Equity-based compensation cost is measured at the grant date fair value and is recognized on a straight-line basis over the requisite service period, including those units with graded vesting with a corresponding credit to members’ equity. However, the amount of equity-based compensation at any date is at least equal to the portion of the grant date value of the award that is vested. In May 2020, the Company issued 11,150,000 Class C units to certain employees of the Company of which approximately 77% were vested on the grant date. The fair value of such units was determined by management with the assistance of a third party valuation by considering a number of factors, including comparable companies, operating and financial performance, the lack of liquidity of the units, and general and industry specific economic outlook, amongst other factors. The grant date fair value of the Class C granted during 2020 was $0.74 per unit. In November 2020, the Company modified the vesting period of the Class C units to immediately accelerate vesting of any unvested Class C units. For the year ended December 31, 2020 the Company recognized $8.3 million in equity-based compensation. At December 31, 2020, the Company had no unrecognized compensation costs related to Class C units as a result of the November 2020 modification. There were no forfeitures during 2020. Inventory Valuation Inventories consist of raw materials. Inventories are stated at the lower of cost or net realizable value. Cost is calculated using the weighted average cost method. Provisions are made to reduce excess or obsolete inventories to their estimated net realizable values.