TELOS CORP 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the Company’s actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth in the risk factors section included in the Company’s Form 10-K for the year ended December 31, 2020, as filed with the SEC. General and Business Overview We offer technologically advanced, software-based security solutions that empower and protect the world’s most security-conscious organizations against rapidly evolving, sophisticated and pervasive threats. Our portfolio of security products, services and expertise empower our customers with capabilities to reach new markets, serve their stakeholders more effectively, and successfully defend the nation or their enterprise. We protect our customers’ people, information, and digital assets so they can pursue their corporate goals and conduct their global missions with confidence in their security and privacy. Our mission is to protect our customers’ people, systems, and vital information assets with offerings for cybersecurity, cloud security, and enterprise security. In the current global environment, our mission is more critical than ever. The emergence of each new information and communications technology ("ICT") introduces new vulnerabilities, as security is still too often overlooked in solution development. Networks and applications meant to enhance productivity and profitability often jeopardize an organization due to poor planning, misconfiguration, or an unknown gap in security. Ransomware, insider threats, cybercrime, and advanced persistent threats continue to menace public and private enterprises across all industries. Cybersecurity, cloud security, and enterprise security of the modern organization share much in common, yet also call for a diverse range of skills, capabilities, and experience in order to meet the requirements of security-conscious customers. Decades of experience in developing, orchestrating, and delivering solutions across these three domains gives us the vision and the confidence to provide solutions that empower and protect the enterprise at an integrated, holistic level. Our experience in addressing challenges in one area of an enterprise helps us meet requirements in others. We understand that a range of complementary capabilities may be needed to solve a single challenge, and we also recognize when a single solution might address multiple challenges. Our security solutions span across the following domains: • Cybersecurity – We help our customers ensure the ongoing security, integrity, and compliance of their on-premises and related cloud-based systems, reducing threats and vulnerabilities to foil cyber adversaries before they can attack. Our consultants assess our customers’ security environments and design, engineer, and operate the systems they need to strengthen their cybersecurity posture. • Cloud Security – The cloud as an organizational resource is more than two decades old, yet the needs of cloud users are constantly changing. Telos offers the specialized skills and experience needed to help our customers plan, engineer, and execute secure cloud migration strategies and then assure ongoing management and security in keeping with the leading standards for cloud-based systems and workloads. • Enterprise Security – Securing the enterprise means protecting the essential and timeless elements common to every organization: its people and processes, its supply chain and inventories, its finances and facilities, and its information and communications. As ICT and operational technology (“OT”) have become part of the organizational make-up, we have offered solutions that ensure personnel can work securely and productively across and beyond the enterprise. We refer to our cyber and cloud applications as Security Solutions, which includes Information Assurance / Xacta® (previously referred to as Cyber & Cloud Solutions), Secure Communications (previously referred to as Secure Communications Cyber and Enterprise Solutions), and Telos ID (previously referred to as Telos ID Enterprise Solutions). We refer to our offerings for enterprise security as Secure Networks (previously referred to as Secure Mobility and Network Management/Defense Enterprise Solutions). 24 Table of Contents Security Solutions • Information Assurance / Xacta: a premier platform for enterprise cyber risk management and security compliance automation, delivering security awareness for systems in the cloud, on-premises, and in hybrid and multi-cloud environments. Xacta delivers automated cyber risk and compliance management solutions to large commercial and government enterprises. Across the U.S. federal government, Xacta is the de facto commercial cyber risk and compliance management solution. • Secure Communications: ◦ Telos Ghost: a virtual obfuscation network-as-a-service with encryption and managed attribution capabilities to ensure the safety and privacy of people, information, and resources on the network. Telos Ghost seeks to eliminate cyber-attack surfaces by obfuscating and encrypting data, masking user identity and location, and hiding network resources. It provides the additional layers of security and privacy needed for intelligence gathering, cyber threat protection, securing critical infrastructure, and protecting communications and applications when operations, property, and even lives can be jeopardized by a single error in security. ◦ Telos Automated Message Handling System (“AMHS”): web-based organizational message distribution and management for mission-critical communications; the recognized gold standard for organizational messaging in the U.S. government. Telos AMHS is used by military field operatives for critical communications on the battlefield and is the only web-based solution for assured messaging and directory services using the DISA Organizational Messaging Service and its specialized communications protocols. • Telos ID: offering Identity Trust and Digital Services through IDTrust360 ® – an enterprise-class digital identity risk platform for extending SaaS and custom digital identity services that mitigate threats through the integration of advanced technologies that fuse biometrics, credentials, and other identity-centric data used to continuously monitor trust. We maintain government certifications and designations that distinguish Telos ID, including TSA PreCheck ® enrollment provider, Designated Aviation Channeling provider, FBI-approved Channeler, and FINRA Electronic Fingerprint Submission provider. Secure Networks • Secure Mobility: solutions for business and government that enable remote work and minimize concern across and beyond the enterprise. Our secure mobility team brings credentials to every engagement, supplying deep expertise and experience as well as highly desirable clearances and industry recognized certifications for network engineering, mobility, and security. • Network Management and Defense: services for operating, administrating, and defending complex enterprise networks and defensive cyber operations. Our diverse portfolio of capabilities addresses common and uncommon requirements in many industries and disciplines, ranging from the military and government agencies to Fortune 500 companies. Business Environment Our business performance continues to be heavily affected by the overall level of U.S. Government spending and the alignment of our solutions with the priorities of the U.S. Government. U.S. Government spending and contracts continue to be affected by the federal budget and appropriations process and related legislation. Due to delays in the passage of FY 2022 appropriations legislation, the federal government is operating under the terms of a Continuing Resolution ("CR"), which limits spending to the prior year’s funding levels and generally prohibits new spending initiatives and contract starts. The current CR will expire December 3, and unless the individual appropriations bills are enacted by then, another CR will be needed to avert a government shutdown. 25 Table of Contents Cybersecurity Landscape Despite the massive shift to teleworking by federal employees and contractors as a result of the pandemic, the government has successfully maintained continuity of services. More recently, as the government has proceeded to develop and implement its reopening process, officials have said they will seek to continue to maximize use of teleworking by federal employees. As such, with much of the business of government still being conducted by federal employees working remotely using information technology systems, we believe there will continue to be a need on the part of the government for the types of solutions and services provided by Telos. Over the past year, continued and increasingly damaging ransomware and other cyberattacks against federal, state and local government and K-12 education (SLED), and higher education, and private sector enterprises have resulted in intensified efforts to better defend against such attacks. The growing demand for these solutions continues to provide Telos with the privilege of offering our expertise to protect these vitally important organizations. Ransomware remains arguably the most severe cyber threat to enterprises in the commercial and SLED sectors. Our Xacta offering empowers these organizations and institutions to maintain a strong cyber risk posture to minimize the risk of ransomware gaining a foothold in their IT environment. Should ransomware get loose in the enterprise network, Telos Ghost, our virtual obfuscation network offering, can hide vital resources from view to prevent the payload from reaching them. Critical infrastructure and industrial Internet of things are among the categories at greatest risk of cyberattacks. Energy, utilities, transportation, and food supply were among the critical infrastructure sectors that experienced high-profile breaches or ransomware attacks over the past year. Telos Ghost can hide critical OT and industrial control systems (ICS) from the public internet to keep them from being compromised. It can also cordon off financial data, medical records, intellectual property, and other crown-jewel assets from visibility or accessibility by adversaries. Government mandates and initiatives to assure stronger security in highly regulated industries also lead to opportunities for Xacta. A pending update to the research study Telos conducted last year reveals that audit fatigue continues to burden these organizations, with automation solutions being recognized as the most effective remedy for the many repetitive and redundant tasks that security compliance requires. Xacta streamlines, harmonizes, and automates the security controls and processes that comprise the leading cybersecurity standards and frameworks, in on-premises, cloud, hybrid, and multi-cloud environments. President Biden’s May 12 Executive Order on “Improving the Nation’s Cybersecurity” acknowledged the severity and scope of the cybersecurity challenges facing the public and private sectors, the American people and our economy. It gave direction for federal departments and agencies to modernize government cybersecurity by: moving more rapidly to adopt secure cloud services; adopting multifactor authentication; pushing for increased use in government of such practices as zero trust architecture; and improving the security and integrity of the software supply chain, with a priority on addressing critical software. The executive order also called for improving communications with cloud service providers through automation and standardization of messages at each stage of the Federal Risk and Authorization Management Program ("FedRAMP") process, and for other changes in an effort to accelerate and improve the process. Subsequently, federal agencies, including the Cybersecurity & Infrastructure Security Agency and the Transportation Security Administration, which have specific responsibilities for various aspects of government and private sector cybersecurity, have taken steps to enhance public sector and critical infrastructure cybersecurity. Congress has given final approval to a $1.2 trillion infrastructure package which contains a number of provisions dealing with cybersecurity and would provide considerable funding for infrastructure-related cybersecurity. We believe many of these actions could ultimately result in increased need for solutions and services provided by Telos. Congress is also considering a potentially $2 trillion budget reconciliation measure that could, among other things, also boost federal support for cybersecurity and provide additional opportunities for Telos. For example, Telos Ghost is a perfect complement to zero trust security, creating an additional layer of defense against intruders by hiding critical resources and users in an anonymous undiscoverable network. As noted earlier, it is also ideal for protecting the crown-jewel assets of critical infrastructure from unauthorized access. Xacta streamlines and automates the critical processes of the leading cybersecurity standards and frameworks, in particular FedRAMP, allowing all process participants to collaborate within the same Xacta application to attain a FedRAMP Authority to Operate. Xacta is also a trailblazer in adopting the Open Security Controls Assessment Language, a multi-format framework adopted by FedRAMP to allow security professionals to automate security assessment, auditing, and continuous monitoring processes. 26 Table of Contents Finally, as a whole, the COVID-19 pandemic has resulted in acceleration of digital transformation and cloud adoption within the government and beyond, which will likely increase demand for Xacta and Telos Ghost. Xacta is engineered to manage risk and compliance of complex cloud and multi-cloud environments, a key capability for federal agencies and regulated industries that need to gain and maintain compliance with cloud-specific security regulations. Telos Ghost is a cloud-native, as-as-service offering that delivers network obfuscation and managed attribution capabilities on a global scale to support the cloud-enabled enterprise. COVID-19 Pandemic The coronavirus disease 2019 ("COVID-19") pandemic has caused a disruption of the normal operations of many businesses, including the temporary closure or scale-back of business operations and/or the imposition of either quarantine or remote work or meeting requirements for employees, either by government order or on a voluntary basis. The ongoing pandemic may adversely affect our customers’ ability to perform their missions and is in many cases disrupting their operations. It may also impact the ability of our subcontractors, partners, and suppliers to operate and fulfill their contractual obligations, and result in an increase in their costs and cause delays in performance. These supply chain effects, and the direct effect of the virus and the disruption on our operations, may negatively impact both our ability to meet customer demand and our revenue and profit margins. Our employees, in some cases, are working remotely due either to safety concerns or to customer imposed limitations and using various technologies to perform their functions. On September 24, 2021, Executive Order 14042 on Ensuring Adequate COVID Safety Protocols for Federal Contractors was issued requiring, amongst other things, all employees, sub-contractors and vendors working on certain federal contracts or who do work related to these federal contracts be fully vaccinated by December 8, 2021. While that deadline to be fully vaccinated has been pushed back to January 18, 2022, this new requirement may negatively impact our ability to hire and retain talent, and to utilize certain sub-contractors and/or vendors to meet our customer demands and/or contractual requirements. Additionally, the disruption and volatility in the global and domestic capital markets may increase the cost of capital and limit our ability to access capital. Both the health and economic aspects of COVID-19 are highly fluid and the future course of each is uncertain. Backlog We develop our annual budgeted revenue by estimating for the upcoming year our continuing business from existing customers and active contracts. We consider backlog, both funded and unfunded (as explained below), other expected annual renewals, and expansion planned by our current customers. In the context of our current customer portfolio, we view “recurring revenue” as revenue that occurs often and repeatedly. In each of the last three years, recurring revenue has exceeded 85% of our annual revenue. Total backlog, a component of recurring revenue, consists of the aggregate contract revenues remaining to be earned by us at a given time over the life of our contracts, whether funded or unfunded. Funded backlog consists of the aggregate contract revenues remaining to be earned at a given time, which, in the case of U.S. government contracts, means that they have been funded by the procuring agency. Unfunded backlog is the difference between total backlog and funded backlog and includes potential revenues that may be earned if customers exercise delivery orders and/or renewal options to continue these contracts. Based on historical experience, we generally assume option year renewals to be exercised. Most of our customers fund contracts on a basis of one year or less and, as a result, funded backlog is generally expected to be earned within one year from any point in time, whereas unfunded backlog is expected to be earned over a longer period. 27 Table of Contents Consolidated Results of Operations (Unaudited) The following table sets forth selected data as a percentage of sales for the three and nine months ended September 30, 2021 and 2020 are as follows: Three Months Ended September 30, Nine Months Ended September 30, 2021 2020 2021 2020 (unaudited) (unaudited) Revenue 100.0 % 100.0% 100.0% 100.0% Cost of sales 62.8 65.1 65.8 65.7 Selling, general and administrative expenses 44.7 25.4 55.1 26.9 Operating (loss) income (7.5) 9.5 (20.9) 7.4 Other income (expense) — — (0.6) — Interest expense (0.2) (4.2) (0.3) (4.5) (Loss) income before income taxes (7.7) 5.3 (21.8) 2.9 Benefit from (provision for) income taxes — — — 0.1 Net (loss) income (7.7) 5.3 (21.8) 3.0 Less: Net income attributable to non-controlling interest — (5.7) — (4.6) Net loss attributable to Telos Corporation (7.7) % (0.4) % (21.8) % (1.6) % Three Months Ended September 30, 2021 Compared with Three Months Ended September 30, 2020 Revenue increased by 47.7% to $70.1 million for the third quarter of 2021, from $47.4 million for the same period in 2020. Revenue for the third quarter, excluding the contract with the U.S. Census Bureau of $1.6 million in 2021 and $9.4 million in 2020, would have grown by 79.9% in the current quarter compared with prior year same period. Security Solutions revenue was $35.7 million and $31.2 million for the third quarter of 2021 and 2020, respectively. This increase of approximately 14.4% was driven primarily by the increases in sales of Telos ID and Information Assurance offerings, offset by the decrease in Secure Communications offerings. Secure Networks revenue was $34.4 million and $16.2 million for the third quarter of 2021 and 2020, respectively. This increase of approximately 112.3% resulted from various contracts with the DoD, primarily in our Secure Mobility Solutions offerings. Due to the various solutions offerings within the business groups, sales may vary from period to period according to the solution mix and timing of deliverables for a particular period. Cost of sales increased by 42.5% to $44.0 million for the third quarter of 2021, from $30.9 million for the same period in 2020 as a result of increases in revenue. Cost of sales for Security Solutions decreased to $15.3 million (inclusive of $0.4 million of stock-based compensation) for the third quarter of 2021 from $17.2 million for the same period in 2020 (which had no stock-based compensation), which translates as a decrease in the cost of sales as a percentage of revenue to 42.9% from 55.1%, due to a change in the mix and nature of the programs. Cost of sales for Secure Networks increased to $28.7 million (inclusive of $0.1 million stock-based compensation) for the third quarter of 2021 from $13.7 million for the same period in 2020 (which had no stock-based compensation). While the cost of sales increased between periods, the sales mix improved, which translates to a decrease in the cost of sales as a percentage of revenue to 83.4% from 84.6%. Gross profit increased by 57.4% to $26.1 million for the third quarter of 2021 from $16.6 million for the same period in 2020. Gross profit for Security Solutions increased to $20.4 million for the third quarter of 2021 from $14.0 million for the same period in 2020. Gross profit for Secure Networks increased to $5.7 million for the third quarter of 2021 from $2.6 million for the same period in 2020. Gross margin increased to 37.2% for the third quarter of 2021 from 34.9% for the same period in 2020, due to various changes in the mix of higher profit margin contracts in all business lines as discussed above. Gross margin for Security Solutions increased to 57.1% for the third quarter of 2021 from 44.9% for the same period in 2020. Gross margin for Secure Networks increased to 16.6% for the third quarter of 2021 from 15.8% for the same period in 2020. Selling, general, and administrative (“SG&A”) expense increased by 160.0% to $31.3 million for the third quarter of 2021, from $12.0 million for the same period in 2020, primarily attributable to increases in stock-based compensation of $11.8 million, labor costs of $5.5 million, and outside services of $1.2 million. Operating loss was $5.3 million for the third quarter of 2021, compared to $4.5 million operating income for the same period in 2020, primarily due to the stock-based compensation expense related to the RSUs granted in fiscal year 2021. 28 Table of Contents Interest expense decreased by 90.3% to $0.2 million for the third quarter of 2021, from $2.0 million for the same period in 2020, primarily due to the repayment of the EnCap loan, subordinated debt, and redemption of public preferred stock upon the closing of our IPO in November 2020. Income tax benefit was $41,000 for the third quarter of 2021, compared to $8,000 income tax provision for the same period in 2020, which is based on the estimated annual effective tax rate applied to the pretax loss incurred for the quarter plus discreet tax items, based on our expectation of pretax loss for the fiscal year. Net loss attributable to Telos Corporation was $5.4 million for the third quarter of 2021, compared to $0.2 million for the same period in 2020, primarily due to the stock-based compensation recorded in the third quarter of 2021 as mentioned above. Nine Months Ended September 30, 2021 Compared with Nine Months Ended September 30, 2020 Revenue increased by 32.1% to $178.4 million for the nine months ended September 30, 2021, from $135.0 million for the same period in 2020. Revenue, excluding the contract with the U.S. Census Bureau of $4.2 million in 2021 and $29.9 million in 2020, would have grown by 65.8% year-over-year. Security Solutions revenue was $89.7 million and $92.5 million for the nine months ended September 30, 2021 and 2020, respectively. This decrease of approximately 3.0% was driven primarily by decreases in sales of offerings in Telos ID, as the Census contract ramps down, and Secure Communication offerings, offset by an increase in Information Assurance offerings. Secure Networks revenue was $88.7 million and $42.5 million for the nine months ended September 30, 2021 and 2020, respectively. This increase of approximately 108.7% resulted from various contracts with the DoD, primarily in our Secure Mobility Solutions offerings. Due to the various solutions offerings within the business groups, sales may vary from period to period according to the solution mix and timing of deliverables for a particular period. Cost of sales increased by 32.4% to $117.4 million for the nine months ended September 30, 2021, from $88.7 million for the same period in 2020 as a result of increases in revenue. Cost of sales for Security Solutions decreased to $44.5 million (inclusive of $1.7 million of stock-based compensation) for the nine months ended September 30, 2021 from $53.8 million for the same period in 2020 (which had no stock-based compensation), which translates as a decrease in the cost of sales as a percentage of revenue to 49.6% from 58.2%, due to a change in the mix and nature of the programs. Cost of sales for Secure Networks increased to $72.9 million (inclusive of $0.3 million of stock-based compensation) for the nine months ended September 30, 2021 from $34.9 million for the same period in 2020 (which had no stock-based compensation), which translates as an increase in the cost of sales as a percentage of revenue to 82.2% from 82.1%. Gross profit increased by 31.5% to $61.0 million for the nine months ended September 30, 2021 from $46.4 million for the same period in 2020. Gross profit for Security Solutions increased to $45.2 million for the nine months ended September 30, 2021 from $38.7 million for the nine months ended September 30, 2020. Gross profit for Secure Networks increased to $15.8 million for the nine months ended September 30, 2021 from $7.6 million for the nine months ended September 30, 2020. Gross margin decreased to 34.2% as of the third quarter of 2021 from 34.3% for the same period in 2020, due to various changes in the mix of contracts in all business lines as discussed above. Gross margin for Security Solutions increased to 50.4% as of the third quarter of 2021 from 41.8% for the same period in 2020. Gross margin for Secure Networks decreased to 17.8% as of the third quarter of 2021 from 17.9% for the same period in 2020. SG&A expense increased by 170.1% to $98.3 million for the nine months ended September 30, 2021, from $36.4 million for the same period in 2020, primarily attributable to increases in stock-based compensation of $45.2 million, labor costs of $11.9 million, outside services of $3.2 million, insurance costs of $1.0 million, and trade show costs of $1.1 million, offset by the decrease in bonus costs of $1.6 million. Operating loss was $37.3 million for the nine months ended September 30, 2021, compared to $10.0 million of operating income for the same period in 2020, primarily due to the stock-based compensation recorded as of the third quarter of 2021 as mentioned above. Other expense for the nine months ended September 30, 2021 was $1.0 million compared to $14,000 of other income for the nine months ended September 30, 2020 was as a result of the settlement of outstanding litigation. Interest expense decreased by 90.3% to $0.6 million for the nine months ended September 30, 2021, from $6.0 million for the same period in 2020, primarily due to the repayment of the EnCap loan, subordinated debt, and redemption of public preferred stock upon the closing of our IPO in November 2020. 29 Table of Contents Income tax provision was $6,000 for the nine months ended September 30, 2021, compared to $136,000 income tax benefit for the same period in 2020, which is based on the estimated annual effective tax rate applied to the pretax loss incurred for the nine months period plus discreet tax items, based on our expectation of pretax loss for the fiscal year. Net loss attributable to Telos Corporation was $38.9 million for the nine months ended September 30, 2021, compared to $2.2 million for the same period in 2020, primarily attributable to the stock-based compensation recorded in 2021 as mentioned above. Balance Sheet Review Assets The Company's total assets as of September 30, 2021 were $242.7 million compared to $183.8 million as of December 31, 2020. The increase in total assets was primarily attributable to an increase in cash and cash equivalents provided by the follow-on offering, an increase in accounts receivables due to higher revenue generation and increase in intangible assets and goodwill as a result of the acquisition during the nine months ended September 30, 2021. Liabilities The Company's total liabilities as of September 30, 2021 were $71.2 million compared to $56.7 million as of December 31, 2020. The increase in total liabilities was primarily attributable to the increase in accounts payable and other accrued liabilities as a result of the increase in cost of sales as of September 30, 2021. Equity As of September 30, 2021, the Company had a total equity of $171.5 million compared to $127.1 million as of December 31, 2020. The increase in equity is primarily driven by the follow-on offering that raised $64.3 million and stock-based compensation of $47.2 million; offset by the repurchase of the common stock and outstanding warrants held by EnCap for $1.3 million and $26.9 million, respectively. The Company reported a net loss of $38.9 million for the nine months ended September 30, 2021. Non-GAAP Financial Measures In addition to our results determined in accordance with GAAP, we believe the non-GAAP financial measures of Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss), Adjusted EPS and Free Cash Flow are useful in evaluating our operating performance. We believe that this non-GAAP financial information, when taken collectively with our GAAP results, may be helpful to readers of our financial statements because it provides consistency and comparability with past financial performance and assists in comparisons with other companies, some of which use similar non-GAAP financial information to supplement their GAAP results. The non-GAAP financial information is presented for supplemental informational purposes only, should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly-titled non-GAAP measures used by other companies. A reconciliation is provided below for each of these non-GAAP financial measures to the most directly comparable financial measure stated in accordance with GAAP. We use the following non-GAAP financial measures to understand and evaluate our core operating performance and trends, to prepare and approve our annual budget, to develop short-term and long-term operating plans, and to evaluate the performance of certain management personnel when determining incentive compensation. We believe these non-GAAP financial measures facilitate comparison of our operating performance on a consistent basis between periods by excluding certain items that may, or could, have a disproportionate positive or negative impact on our results of operations in any particular period. When viewed in combination with our results prepared in accordance with GAAP, these non-GAAP financial measures help provide a broader picture of factors and trends affecting our results of operations. 30 Table of Contents Enterprise EBITDA and Adjusted EBITDA Both Enterprise EBITDA and Adjusted EBITDA are supplemental measures of operating performance that are not made under GAAP and do not represent, and should not be considered as, an alternative to net loss as determined by GAAP. We define Enterprise EBITDA as net loss attributable to Telos Corporation, adjusted for net income attributable to non-controlling interest, non-operating (income) expense, interest expense, provision for (benefit from) income taxes, and depreciation and amortization. We define Adjusted EBITDA as Enterprise EBITDA, adjusted for transaction gains/losses/expenses related to our IPO and stock-based compensation expense. A reconciliation of net loss attributable to Telos Corporation to Enterprise EBITDA and Adjusted EBITDA, the most directly comparable GAAP measure, is as follows (in thousands): Three Months Ended September 30, Nine Months Ended September 30, 2021 2020 2021 2020 Net loss attributable to Telos Corporation $ (5,387) $ (200) $ (38,894) $ (2,178) Adjustments: Net income attributable to non-controlling interest — 2,694 — 6,284 Non-operating (income) expense (20) (2) 1,001 (14) Interest expense 195 2,013 583 6,026 (Benefit from) provision for income taxes (41) 8 6 (136) Depreciation and amortization 1,459 1,284 4,223 4,018 Enterprise EBITDA (3,794) 5,797 (33,081) 14,000 Stock-based compensation expense 12,191 4 47,197 4 Adjusted EBITDA $ 8,397 $ 5,801 $ 14,116 $ 14,004 Adjusted Net Income (Loss) and Adjusted EPS Adjusted Net Income (Loss) and Adjusted EPS are supplemental measures of operating performance that are not made under GAAP and do not represent, and should not be considered as, alternatives to net income (loss) as determined by GAAP. We define Adjusted Net Income (Loss) as net income (loss) attributable to Telos Corporation, adjusted for non-operating expense (income) and stock-based compensation expense. We define Adjusted EPS as Adjusted Net Income (Loss) divided by the weighted-average number of common shares outstanding for the period. A reconciliation of net loss attributable to Telos Corporation to Adjusted Net Income (Loss) and Adjusted EPS, the most directly comparable GAAP measure, is as follows: Three Months Ended September 30, 2021 2020 Adjusted Net Income (Loss) Adjusted Earnings Per Share Adjusted Net Income (Loss) Adjusted Earnings Per Share (in thousands) (in thousands) Reported GAAP measure $ (5,387) $ (0.08) $ (200) $ (0.01) Adjustments: Non-operating income (20) — (2) — Stock-based compensation expense 12,191 0.18 4 — Adjusted non-GAAP measure $ 6,784 $ 0.10 $ (198) $ (0.01) Weighted-average shares of common stock outstanding 66,755 39,002 31 Table of Contents Nine Months Ended September 30, 2021 2020 Adjusted Net Income (Loss) Adjusted Earnings Per Share Adjusted Net Income (Loss) Adjusted Earnings Per Share (in thousands) (in thousands) Reported GAAP measure $ (38,894) $ (0.59) $ (2,178) $ (0.06) Adjustments: Non-operating expense (income) 1,001 0.01 (14) — Stock-based compensation expense 47,197 0.72 4 — Adjusted non-GAAP measure $ 9,304 $ 0.14 $ (2,188) $ (0.06) Weighted-average shares of common stock outstanding 65,999 38,554 Free Cash Flow Free cash flow, as reconciled in the table below, is a non-GAAP financial measure defined as net cash provided by or used in operating activities, less capital expenditure and adjusted for the final distribution to Telos ID Class B members included in cash from operating activities. This non-GAAP financial measure may be a useful measure for investors and other users of our financial statements as a supplemental measure of our cash performance and assess the quality of our earnings as a key performance measure in evaluating management. Nine Months Ended September 30, 2021 2020 (in thousands) (in thousands) Net cash flows provided by operating activities $ 6,668 $ 11,957 Adjustments: Capital expenditure (7,784) (6,083) Final distribution to Telos ID Class B member - included in cash from operating activities 2,436 — Free cash flow $ 1,320 $ 5,874 Each of Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss), Adjusted EPS and Free Cash Flow has limitations as an analytical tool, and you should not consider any of them in isolation, or as a substitute for analysis of our results as reported under GAAP. Among other limitations, each of Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss), Adjusted EPS and Free Cash Flow does not reflect our future requirements for capital expenditures or contractual commitments, does not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations, and does not reflect income tax expense or benefit. Other companies in our industry may calculate Adjusted EBITDA, Adjusted Net Income (Loss), Adjusted EPS and Free Cash Flow differently than we do, which limits its usefulness as a comparative measure. Because of these limitations, neither Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss), Adjusted EPS nor Free Cash Flow should be considered as a replacement for net income (loss), earnings per share or net cash flows provided by operating activities, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. Liquidity and Capital Resources Upon the closing of the IPO in November 2020, we issued 17.2 million shares of our common stock at a price of $17.00 per share, generating net proceeds of approximately $272.8 million. We used approximately $108.9 million of the net proceeds in connection with the ERPS Conversion (see Note 9 – Exchangeable Redeemable Preferred Stock Conversion), $30.0 million to fund our acquisition of the outstanding Class B Units of Telos ID (see Note 3 – Non-controlling Interests / Purchase of Telos ID), and $21.0 million to repay our outstanding senior term loan and subordinated debt (see Note 8 – Debt Obligations). 32 Table of Contents On April 6, 2021, we completed our follow-on offering of 9.1 million shares of our common stock at a price of $33.00 per share, including 7.0 million shares of common stock by certain existing stockholders of Telos. The offering generated approximately $64.3 million of net proceeds to Telos. We did not receive any proceeds from the shares of common stock sold by the selling stockholders. On April 19, 2021, we used approximately $1.3 million of the net proceeds to repurchase 39,682 shares of our common stock and $26.9 million to repurchase warrants to purchase 900,970 shares our common stock owned by EnCap (see Note 8 - Debt Obligations). Further, on July 30, 2021, we used approximately $5.9 million of the net proceeds to acquire the assets of DFT (see Note 4 - Acquisition). We intend to use the remaining net proceeds of the IPO and the follow-on offering for general corporate purposes. We also may use a portion of the net proceeds to acquire complementary businesses, products, services, or technologies. The amounts and timing of our actual use of the net proceeds will vary depending on numerous factors. Proceeds held by us is invested in short-term investments until needed for the uses described above. Our working capital was $137.9 million and $105.2 million as of September 30, 2021 and December 31, 2020, respectively. Although no assurances can be given, we expect our current sources of liquidity are sufficient to support our operating, investing and financing needs for the next 12 months. We ended the third quarter of 2021 with a cash and cash equivalent balance of $134.1 million compared to $106.0 million at the end of 2020. We believe we have adequate funds on hand to execute our financial and operating strategy. The following is a discussion of our major operating, investing and financing activities in the first nine months of 2021 and 2020, as classified on the Condensed Statements of Cash Flows in Part I, Item 1. Cash provided by operating activities was $6.7 million for the nine months ended September 30, 2021, compared to cash provided by operating activities of $12.0 million for the same period in 2020. Cash provided by or used in operating activities is primarily driven by the timing of receipt of customer payments, the timing of payments to vendors and employees, and the timing of inventory turnover. Cash used in investing activities was approximately $13.7 million and $6.1 million for the nine months ended September 30, 2021 and 2020, respectively, primarily driven by the $5.9 million of cash paid for the acquisition completed in July 2021 (see Note 4 - Acquisition). Cash provided by financing activities was $35.1 million for the nine months ended September 30, 2021 compared to cash used in financing activities of $2.3 million for the same period in 2020, primarily attributable to the proceeds from the follow-on offering that generated $64.3 million of net proceeds, reduced by $26.9 million used to repurchase the outstanding warrants and $1.3 million to repurchase the common stock held by EnCap. Recent Accounting Pronouncements See Note 1 of the Condensed Consolidated Financial Statements for a discussion of recently issued accounting pronouncements. Critical Accounting Policies During the three months ended September 30, 2021, there were no material changes to our critical accounting policies as reported in our Annual Report on Form 10-K for the year ended December 31, 2020 as filed with the SEC on March 25, 2021. Item 3. Quantitative and Qualitative Disclosures about Market Risk None. 33 Table of Contents