TELOS CORP 10-K

Item 7A. Quantitative and Qualitative Disclosures about Market Risk None. 39 Table of Contents Item 8. Consolidated Financial Statements and Supplementary Data TELOS CORPORATION AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Report of Independent Registered Public Accounting Firm 41 Consolidated Statements of Operations for the Years Ended December 31, 2020, 2019 and 2018 42 Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2020, 2019 and 2018 43 Consolidated Balance Sheets as of December 31, 2020 and 2019 44 - 45 Consolidated Statements of Cash Flows for the Years Ended December 31, 2020, 2019, and 2018 46 - 47 Consolidated Statements of Changes in Stockholders' Equity (Deficit) for the Years Ended December 31, 2020, 2019, and 2018 48 Notes to Consolidated Financial Statements 49 - 71 40 Table of Contents Report of Independent Registered Public Accounting Firm Shareholders and Board of Directors Telos Corporation Ashburn, Virginia Opinion on the Consolidated Financial Statements We have audited the accompanying consolidated balance sheets of Telos Corporation (the “Company”) and subsidiaries as of December 31, 2020 and 2019, the related consolidated statements of operations, comprehensive income (loss), changes in stockholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2020, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company and subsidiaries at December 31, 2020 and 2019, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2020 , in conformity with accounting principles generally accepted in the United States of America. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. /s/ BDO USA, LLP We have served as the Company's auditor since 2007. McLean, Virginia March 25, 2021 41 Table of Contents TELOS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (amounts in thousands , except earnings per share data) Years Ended December 31, 2020 2019 2018 Revenue (Note 5) Services $ 161,180 $ 143,581 $ 120,990 Products 18,737 15,637 17,026 179,917 159,218 138,016 Costs and expenses Cost of sales – Services 106,969 98,772 76,857 Cost of sales – Products 10,528 8,102 8,097 117,497 106,874 84,954 Selling, general and administrative expenses Sales and marketing 6,176 5,951 6,014 Research and development 14,243 10,647 8,755 General and administrative 41,704 30,721 29,279 62,123 47,319 44,048 Operating income 297 5,025 9,014 Other income (expenses) Gain on redemption of public preferred stock (Note 7) 14,012 — — Non-operating (expense) income (255 ) 201 12 Interest expense (7,259 ) (7,467 ) (7,258 ) Income (loss) before income taxes 6,795 (2,241 ) 1,768 Benefit from (provision for) income taxes (Note 9) 46 104 (31 ) Net income (loss) 6,841 (2,137 ) 1,737 Less: Net income attributable to non-controlling interest (Note 2) (5,154 ) (4,264 ) (3,377 ) Net income (loss) attributable to Telos Corporation $ 1,687 $ (6,401 ) $ (1,640 ) Net earnings (loss) per share attributable to Telos Corporation, basic $ 0.04 $ (0.17 ) $ (0.04 ) Net earnings (loss) per share attributable to Telos Corporation, diluted $ 0.04 $ (0.17 ) $ (0.04 ) Weighted-average shares of common stock outstanding, basic 41,642 37,729 36,762 Weighted-average shares of common stock outstanding, diluted 42,877 37,729 36,762 The accompanying notes are an integral part of these consolidated financial statements. 42 Table of Contents TELOS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (amounts in thousands) Years Ended December 31, 2020 2019 2018 Net income (loss) $ 6,841 $ (2,137 ) $ 1,737 Other comprehensive income (loss), net of tax: Foreign currency translation adjustments 38 (11 ) (15 ) Comprehensive income attributable to non-controlling interest (5,154 ) (4,264 ) (3,377 ) Comprehensive income (loss) attributable to Telos Corporation $ 1,725 $ (6,412 ) $ (1,655 ) The accompanying notes are an integral part of these consolidated financial statements. 43 Table of Contents TELOS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (amounts in thousands) ASSETS December 31, 2020 2019 Current assets Cash and cash equivalents $ 106,045 $ 6,751 Accounts receivable, net of reserve of $308 and $720 , respectively (Note 5) 30,913 27,942 Inventories, net of obsolescence reserve of $851 and $860 , respectively (Note 1) 3,311 1,965 Prepaid expenses 3,059 1,717 Deferred program expenses 5 673 Other current assets 781 1,197 Total current assets 144,114 40,245 Property and equipment (Note 1) Furniture, equipment, and capitalized software development costs 25,827 18,709 Leasehold improvements 2,669 2,536 Property and equipment under finance leases 30,792 30,792 59,288 52,037 Accumulated depreciation and amortization (36,891 ) (32,470 ) 22,397 19,567 Operating lease right-of-use assets 1,464 1,979 Goodwill (Note 3) 14,916 14,916 Other assets 926 985 Total assets $ 183,817 $ 77,692 The accompanying notes are an integral part of these consolidated financial statements. 44 Table of Contents TELOS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (amounts in thousands, except share data) LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) December 31, 2020 2019 Current liabilities Accounts payable and other accrued liabilities (Note 6) $ 20,899 $ 15,050 Accrued compensation and benefits 8,474 12,187 Contract liabilities (Notes 1 and 6) 5,654 6,337 Finance lease obligations – short-term (Note 10) 1,339 1,224 Operating lease obligations – short-term (Note 10) 677 602 Other current liabilities 1,903 1,903 Total current liabilities 38,946 37,303 Senior term loan, net of unamortized discount and issuance costs (Note 6) — 16,335 Subordinated debt (Note 6) — 2,927 Finance lease obligations - long-term (Note 10) 14,301 15,641 Operating lease obligations - long-term (Note 10) 941 1,553 Deferred income taxes (Note 9) 652 621 Public preferred stock (Note 7) — 139,210 Other liabilities (Note 9) 1,873 724 Total liabilities 56,713 214,314 Commitments and contingencies (Notes 10 and 13) Stockholders’ equity (deficit) (Note 8) Telos stockholders’ equity (deficit) Common stock, $0.001 par value, 250,000,000 shares authorized, 64,625,071 shares issued and outstanding as of December 31, 2020 103 — Class A common stock, no par value, 50,000,000 shares authorized, 35,826,200 shares issued and outstanding as of December 31, 2019 — 65 Class B common stock, no par value, 5,000,000 shares authorized, 3,204,293 shares issued and outstanding as of December 31, 2019 — 13 Additional paid-in capital 270,800 4,310 Accumulated other comprehensive income 44 6 Accumulated deficit (143,843 ) (145,530 ) Total Telos stockholders’ equity (deficit) 127,104 (141,136 ) Non-controlling interest in subsidiary (Note 2) — 4,514 Total stockholders’ equity (deficit) 127,104 (136,622 ) Total liabilities and stockholders’ equity (deficit) $ 183,817 $ 77,692 The accompanying notes are an integral part of these consolidated financial statements. 45 Table of Contents TELOS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (amounts in thousands) Years Ended December 31, 2020 2019 2018 Operating activities: Net income (loss) $ 6,841 $ (2,137 ) $ 1,737 Adjustments to reconcile net income (loss) to cash (used in) provided by operating activities: Gain on redemption of public preferred stock (14,012 ) — — Net loss on early extinguishment of debt and other transactions 275 — — Stock-based compensation 4 — — Dividends from preferred stock recorded as interest expense 3,384 3,823 3,822 Depreciation and amortization 5,353 4,972 3,028 Provision for inventory obsolescence (1 ) 376 30 (Benefit) provision for doubtful accounts receivable (412 ) 414 (105 ) Provision for doubtful non-trade receivables 569 — — Amortization of debt issuance costs 978 461 198 Deferred income tax provision (benefit) 31 (197 ) 77 Loss on disposal of fixed assets 1 15 3 Changes in assets and liabilities: (Increase) decrease in accounts receivable (2,559 ) 6,186 (9,917 ) (Increase) decrease in inventories (1,345 ) 2,048 9,101 Decrease (increase) in deferred program expenses 668 (429 ) 1,828 Increase in prepaid expenses, other current assets and other assets (1,606 ) (3,576 ) (465 ) Increase (decrease) in accounts payable and other accrued payables 3,413 (6,730 ) (3,914 ) (Decrease) increase in accrued compensation and benefits (3,713 ) 3,105 1,626 (Decrease) increase in contract liabilities (683 ) 1,106 (960 ) Increase in other current liabilities and other liabilities 710 2,379 179 Cash (used in) provided by operating activities (2,104 ) 11,816 6,268 Investing activities: Capitalized software development costs (6,681 ) (2,442 ) (1,649 ) Purchases of property and equipment (780 ) (4,090 ) (2,465 ) Cash used in investing activities (7,461 ) (6,532 ) (4,114 ) Financing activities: Proceeds from initial public offering 272,813 — — Redemption of public preferred stock (108,878 ) — — Purchase of Telos ID membership interest (30,000 ) — — Payment of senior term loan (17,351 ) — — Payment of subordinated debt (3,657 ) — — Proceeds from senior term loan — 4,881 — Payments under finance lease obligations (1,225 ) (1,115 ) (1,013 ) Amendment fee paid to lender (100 ) — — Distributions to Telos ID Class B member – non-controlling interest (2,743 ) (2,371 ) (1,669 ) Cash provided by (used in) financing activities 108,859 1,395 (2,682 ) Increase (decrease) in cash and cash equivalents 99,294 6,679 (528 ) Cash and cash equivalents, beginning of the year 6,751 72 600 Cash and cash equivalents, end of year $ 106,045 $ 6,751 $ 72 46 Table of Contents Supplemental disclosures of cash flow information: Cash paid during the year for: Interest $ 7,259 $ 3,299 2,483 Income taxes $ 64 $ 40 $ 19 Noncash: Dividends from preferred stock recorded as interest expense $ 3,384 $ 3,823 $ 3,822 Common stock issued on redemption of public preferred stock (Note 7) $ 19,213 $ — $ — Common stock issued on purchase of Telos ID membership interest (Note 2) $ 148,399 $ — $ — Distributions to Telos ID Class B member – non-controlling interest $ 2,436 $ — $ — Debt issuance costs and prepayment of interest on senior term loan $ — $ 119 $ — The accompanying notes are an integral part of these consolidated financial statements. 47 Table of Contents TELOS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT) (amounts in thousands) Common Stock Class A Common Stock Class B Common Stock Additional Paid–in Capital Accumulated Other Comprehensive Income Accumulated Deficit Non-Controlling Interest Total Stockholders’ Equity (Deficit) Balance December 31, 2017 $ — $ 65 $ 13 $ 4,310 $ 32 $ (141,370 ) $ 913 $ (136,037 ) Net (loss) income — — — — — (1,640 ) 3,377 1,737 Cumulative effect adjustment due to change in accounting policy — — — — — 3,881 — 3,881 Foreign currency translation loss — — — — (15 ) — — (15 ) Distributions — — — — — — (1,669 ) (1,669 ) Balance December 31, 2018 $ — $ 65 $ 13 $ 4,310 $ 17 $ (139,129 ) $ 2,621 (132,103 ) Net (loss) income — — — — — (6,401 ) 4,264 (2,137 ) Foreign currency translation loss — — — — (11 ) — — (11 ) Distributions — — — — — — (2,371 ) (2,371 ) Balance December 31, 2019 $ — $ 65 $ 13 $ 4,310 $ 6 $ (145,530 ) $ 4,514 $ (136,622 ) Net income — — — — — 1,687 5,154 6,841 Issuance of common stock 103 (65 ) (13 ) 291,997 — — — 292,022 Purchase of Telos ID membership interest — — — (25,511 ) — — (4,489 ) (30,000 ) Foreign currency translation gain — — — — 38 — — 38 Stock-based compensation — — — 4 — — — 4 Distributions — — — — — — (5,179 ) (5,179 ) Balance December 31, 2020 $ 103 $ — $ — $ 270,800 $ 44 $ (143,843 ) $ — $ 127,104 The accompanying notes are an integral part of these consolidated financial statements. 48 Table of Contents TELOS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary of Significant Accounting Policies Business and Organization Telos Corporation, together with its subsidiaries, (the “Company” or “Telos” or “We”), is an information technology solutions and services company addressing the needs of U.S. Government and commercial customers worldwide. We own all of the issued and outstanding share capital of Xacta Corporation, a subsidiary that develops, markets and sells government-validated secure enterprise solutions to government and commercial customers. We also own all of the issued and outstanding share capital of Ubiquity.com, Inc., a holding company for Xacta Corporation. We also have a 100% ownership interest in Telos Identity Management Solutions, LLC (“Telos ID”), Teloworks, Inc. (“Teloworks”) and Telos APAC Pte. Ltd. (Telos APAC). Initial Public Offering of Common Stock On November 19, 2020, we completed our initial public offering of shares of our common stock. 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 conversion of our outstanding shares of Exchangeable Redeemable Preferred Stock into the right to receive cash and shares of our common stock, $30.0 million to fund our acquisition of the outstanding Class B Units of Telos ID, and $21.0 million to repay our outstanding senior term loan and subordinated debt. We intend to use the remaining net proceeds for general corporate purposes. We also may use a portion of the net proceeds to acquire complementary businesses, products, services, or technologies. We do not, however, have agreements, commitments, or plans for any specific acquisitions at this time. The amounts and timing of our actual use of the net proceeds will vary depending on numerous factors. Principles of Consolidation and Basis of Presentation The accompanying consolidated financial statements include the accounts of Telos and its subsidiaries, including Ubiquity.com, Inc., Xacta Corporation, Telos ID, Teloworks, and Telos APAC, all of whose issued and outstanding share capital is owned by the Company. Intercompany transactions have been eliminated in consolidation. In December 2019, an outbreak of COVID-19 was reported in Wuhan, China. On March 11, 2020, the World Health Organization declared COVID-19 a global pandemic and on March 13, 2020, President Donald J. Trump declared the virus a national emergency. This highly contagious disease has spread to most of the countries in the world and throughout the United States, creating a serious impact on customers, workforces, and suppliers, disrupting economies and financial markets, and leading to a world-wide economic downturn. COVID-19, together with subsequently reported variants of this strain, have 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 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. We could see delays or changes in customer demand, particularly if government funding priorities change. 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. In preparing these consolidated financial statements, we have evaluated subsequent events through the date that these consolidated financial statements were issued. Segment Reporting Operating segments are defined as components of an enterprise for which separate financial information is available and evaluated regularly by the chief operating decision maker (“CODM”), or decision making group, in deciding how to allocate resources and assess performance. We currently operate in one operating and reportable business segment for financial reporting purposes. Our Chief Executive Officer is the CODM. The CODM only evaluates profitability based on consolidated results. Use of Estimates The preparation of consolidated financial statements in conformity with U.S. Generally Accepted Accounting Principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions used in the preparation of our consolidated financial statements include revenue recognition, allowance for doubtful accounts receivable, allowance for inventory obsolescence, the valuation allowance for deferred tax assets, income taxes, contingencies and litigation, potential impairments of goodwill and estimated pension-related costs for our foreign subsidiaries. Actual results could differ from those estimates. 49 Table of Contents Revenue Recognition We account for revenue in accordance with ASC Topic 606, “Revenue from Contracts with Customers.” The unit of account in ASC 606 is a performance obligation, which is a promise in a contract with a customer to transfer a good or service to the customer. ASC 606 prescribes a five-step model for recognizing revenue that includes identifying the contract with the customer, determining the performance obligation(s), determining the transaction price, allocating the transaction price to the performance obligation(s), and recognizing revenue as the performance obligations are satisfied. Timing of the satisfaction of performance obligations varies across our businesses due to our diverse product and service mix, customer base, and contractual terms. Significant judgment can be required in determining certain performance obligations, and these determinations could change the amount of revenue and profit recorded in a given period. Our contracts may have a single performance obligation or multiple performance obligations. When there are multiple performance obligations within a contract, we allocate the transaction price to each performance obligation based on our best estimate of standalone selling price. The majority of our revenue is recognized over time, as control is transferred continuously to our customers who receive and consume benefits as we perform, and is classified as services revenue. All of our business groups earn services revenue under a variety of contract types, including time and materials, firm-fixed price, firm fixed price level of effort, and cost plus fixed fee contract types, which may include variable consideration as discussed further below. Revenue is recognized over time using costs incurred to date relative to total estimated costs at completion to measure progress toward satisfying our performance obligations. Incurred cost represents work performed, which corresponds with, and thereby best depicts, the transfer of control to the customer. Contract costs include labor, material, subcontractor costs and indirect expenses. This continuous transfer of control to the customer is supported by clauses in our contracts with U.S. Government customers whereby the customer may terminate a contract for convenience and then pay for costs incurred plus a profit, at which time the customer would take control of any work in process. For non-U.S. Government contracts where we perform as a subcontractor and our order includes similar Federal Acquisition Regulation (the FAR) provisions as the prime contractor’s order from the U.S. Government, continuous transfer of control is likewise supported by such provisions. For other non-U.S. Government customers, continuous transfer of control to such customers is also supported due to general terms in our contracts and rights to recover damages which would include, among other potential damages, the right to payment for our work performed to date plus a reasonable profit. Due to the transfer of control over time, revenue is recognized based on progress towards completion of the performance obligation. The selection of the method to measure progress towards completion requires judgment and is based on the nature of the performance obligations. We generally use the cost-to-cost measure of progress on a proportional performance basis for our contracts because it best depicts the transfer of control to the customer which occurs as we incur costs on our contracts. Under the cost-to-cost measure of progress, the extent of progress towards completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. Revenues are recorded proportionally as costs are incurred. Due to the nature of the work required to be performed on certain of our performance obligations, the estimation of total revenue and cost at completion is complex, subject to many variables and requires significant judgment. Contract estimates are based on various assumptions including labor and subcontractor costs, materials and other direct costs and the complexity of the work to be performed. A significant change in one or more of these estimates could affect the profitability of our contracts. We review and update our contract-related estimates regularly and recognize adjustments in estimated profit on contracts on a cumulative catch-up basis, which may result in an adjustment increasing or decreasing revenue to date on a contract in a particular period that the adjustment is identified. Revenue and profit in future periods of contract performance are recognized using the adjusted estimate. Revenue that is recognized at a point in time is for the sale of software licenses in our Information Assurance / Xacta® (previously referred to as Cyber & Cloud Solutions) and Secure Communications (previously referred to as Secure Communications Cyber and Enterprise Solutions) business groups and for the sale of resold products in Telos ID (previously referred to as Telos ID Enterprise Solutions) and Secure Networks (previously referred to as Secure Mobility and Network Management/Defense Enterprise Solutions), and is classified as product revenue. Revenue on these contracts is recognized when the customer obtains control of the transferred product or service, which is generally upon delivery of the product to the customer for their use, due to us maintaining control of the product until that point. Orders for the sale of software licenses may contain multiple performance obligations, such as maintenance, training, or consulting services, which are typically delivered over time, consistent with the transfer of control disclosed above for the provision of services. When an order contains multiple performance obligations, we allocate the transaction price to the performance obligations using our best estimate of standalone selling price. Contracts are routinely and often modified to account for changes in contract requirements, specifications, quantities, or price. Depending on the nature of the modification, we determine whether to account for the modification as an adjustment to the existing contract or as a new contract. Generally, modifications are not distinct from the existing contract due to the significant interrelatedness of the performance obligations and are therefore accounted for as an adjustment to the existing contract, and recognized as a cumulative adjustment to revenue (as either an increase or reduction of revenue) based on the modification’s effect on progress toward completion of a performance obligation. 50 Table of Contents Our contracts may include various types of variable consideration, such as claims (for instance, indirect rate or other equitable adjustments) or incentive fees. We include estimated amounts in the transaction price based on all of the information available to us, including historical information and future estimations, and to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when any uncertainty associated with the variable consideration is resolved. We have revised and re-submitted several years of incurred cost submissions reflecting certain indirect rate structure changes as a result of regular DCAA audits of incurred cost submissions. This resulted in signed final rate agreement letters for fiscal years 2011 to 2013 and conformed incurred cost submissions for 2014 to 2015. We evaluated the resulting changes to revenue under the applicable cost plus fixed fee contracts for the years 2011 to 2015 as variable consideration, and determined the most likely amount to which we expect to be entitled, to the extent that no constraint exists that would preclude recognizing this revenue or result in a significant reversal of cumulative revenue recognized. We included these estimated amounts of variable consideration in the transaction price and as performance on these contracts is complete, we have recognized revenue of $6.0 million during the year ended December 31, 2018. Historically, most of our contracts do not include award or incentive fees. For incentive fees, we would include such fees in the transaction price to the extent we could reasonably estimate the amount of the fee. With limited historical experience, we have not included any revenue related to incentive fees in our estimated transaction prices. We may include in our contract estimates additional revenue for submitted contract modifications or claims against the customer when we believe we have an enforceable right to the modification or claim, the amount can be estimated reliably and its realization is probable. We consider the contractual/legal basis for the claim (in particular FAR provisions), the facts and circumstances around any additional costs incurred, the reasonableness of those costs and the objective evidence available to support such claims. For our contracts that have an original duration of one year or less, we use the practical expedient applicable to such contracts and do not consider the time value of money. We capitalize sales commissions related to proprietary software and related services that are directly tied to sales. We do not elect the practical expedient to expense as incurred the incremental costs of obtaining a contract if the amortization period would have been one year or less. For the sales commissions that are capitalized, we amortize the asset over the expected customer life, which is based on recent and historical data. Contract assets are amounts that are invoiced as work progresses in accordance with agreed-upon contractual terms, either at periodic intervals or upon achievement of contractual milestones. Generally, revenue recognition occurs before billing, resulting in contract assets. These contract assets are referred to as unbilled receivables and are reported within accounts receivable, net of reserve on our consolidated balance sheets. Billed receivables are amounts billed and due from our customers and are reported within accounts receivable, net of reserve on the consolidated balance sheets. The portion of the payments retained by the customer until final contract settlement is not considered a significant financing component due to the intent of the retainage being the customer’s protection with respect to full and final performance under the contract. Contract liabilities are payments received in advance and milestone payments from our customers on selected contracts that exceed revenue earned to date, resulting in contract liabilities. Contract liabilities typically are not considered a significant financing component because they are generally satisfied within one year and are used to meet working capital demands that can be higher in the early stages of a contract. Contract liabilities are reported on our consolidated balance sheets on a net contract basis at the end of each reporting period. We have one reportable segment. We treat sales to U.S. customers as sales within the U.S. regardless of where the services are performed. Substantially all of our revenues are from U.S. customers as revenue derived from international customers is de minimus. The following tables disclose revenue (in thousands) by customer type and contract type for the years ended December 31, 2020, 2019, and 2018. Prior period amounts have not been adjusted under the modified retrospective method. 2020 2019 2018 Federal $ 171,677 $ 149,257 $ 129,279 State & Local, and Commercial 8,240 9,961 8,737 Total $ 179,917 $ 159,218 $ 138,016 2020 2019 2018 Firm fixed-price $ 151,703 $ 131,629 $ 103,454 Time-and-materials 13,455 14,569 16,795 Cost plus fixed fee 14,759 13,020 17,767 Total $ 179,917 $ 159,218 $ 138,016 51 Table of Contents As of December 31, 2020 and 2019, we had $127.7 million and $112.4 million of remaining performance obligations, respectively, which we also refer to as funded backlog. We expect to recognize approximately 92.4% of our remaining performance obligations as revenue in 2021, an additional 2.5% by 2022 and the balance thereafter. For the years ended December 31, 2020, 2019 and 2018, the amount of revenue recognized during the year that was included in the opening contract liabilities balance was $5.3 million, $4.2 million, and $5.5 million, respectively. Contract liabilities were $5.7 million and $6.3 million as of December 31, 2020 and 2019, respectively. Cash and Cash Equivalents We consider all highly liquid investments with an original maturity of three months or less at the date of purchase to be cash equivalents. Our cash management program utilizes zero balance accounts. Accordingly, all book overdraft balances have been reclassified to accounts payable and other accrued liabilities. In accordance with ASC 275-10-50-16, in consideration that such a large amount of our working capital and total assets are held in cash and cash equivalents, we have considered that the balances held in our various treasury accounts may exceed federally insured limits as of the date of the financial statements. Due to the financial strength of the financial institution where the accounts are held, we do not believe that this concentration risk makes it reasonably possible that a near-term severe impact risk of loss will occur. Accounts Receivable Accounts receivable are stated at the invoiced amount, less an allowance for doubtful accounts. Collectability of accounts receivable is regularly reviewed based upon managements’ knowledge of the specific circumstances related to overdue balances. The allowance for doubtful accounts is adjusted based on such evaluation. Accounts receivable balances are written off against the allowance when management deems the balances uncollectible. Inventories Inventories are stated at the lower of cost or net realizable value, where cost is determined using the weighted average method. Substantially all inventories consist of purchased customer off-the-shelf hardware and software, and component computer parts used in connection with system integration services that we perform. An allowance for obsolete, slow-moving or nonsalable inventory is provided for all other inventory. This allowance is based on our overall obsolescence experience and our assessment of future inventory requirements. This charge is taken primarily due to the age of the specific inventory and the significant additional costs that would be necessary to upgrade to current standards as well as the lack of forecasted sales for such inventory in the near future. Gross inventory was $4.2 million and $2.8 million at December 31, 2020 and 2019, respectively. As of December 31, 2020, it is management’s judgment that we have fully provided for any potential inventory obsolescence. 52 Table of Contents The components of the allowance for inventory obsolescence are set forth below (in thousands): Balance Beginning of Year Additions Charge to Costs and Expense Recoveries Balance End of Year Year Ended December 31, 2020 $ 860 $ (1 ) $ (8 ) $ 851 Year Ended December 31, 2019 $ 520 $ 376 $ (36 ) $ 860 Year Ended December 31, 2018 $ 1,484 $ 30 $ (994 ) $ 520 Property and Equipment Property and equipment is recorded at cost. Depreciation is provided using the straight-line method at rates based on the estimated useful lives of the individual assets or classes of assets as follows: Furniture and equipment 3-5 Years Leasehold improvements Lesser of life of lease or useful life of asset Property and equipment under finance leases Lesser of life of lease or useful life of asset Leased property meeting certain criteria is capitalized at the present value of the related minimum lease payments. Amortization of property and equipment under finance leases is computed using the straight-line method over the lesser of the term of the related lease and the useful life of the related asset. Upon sale or retirement of property and equipment, the costs and related accumulated depreciation are eliminated from the accounts and any gain or loss on such disposition is reflected in the consolidated statements of operations. For the years ended December 31, 2020, 2019, and 2018, such amounts are negligible. Expenditures for repairs and maintenance are charged to operations as incurred. Long-lived assets, such as fixed assets, are reviewed for impairment whenever circumstances indicate that the carrying amount of the asset exceeds its estimated fair value. Considerable management judgment is necessary to estimate its fair value. Accordingly, actual results could differ from such estimates. No events have been identified that caused an evaluation of the recoverability of long-lived assets. Depreciation and amortization expense related to property and equipment, including property and equipment under finance leases was $5.4 million, $5.0 million, and $3.0 million for the years ended December 31, 2020, 2019, and 2018, respectively. Software Development Costs Our policy on accounting for development costs of software to be sold is in accordance with ASC Topic 985-20, “Software – Costs of Software to be Sold, Leased, or Marketed” and ASC Topic 350-40 “Internal Use Software” in so far as our Xacta products being available in various deployment modalities including on premises licenses and cloud-based Software as a Service (“SaaS”). Under both standards, software development costs are expensed as incurred until technological feasibility is reached, at which time additional costs are capitalized until the product is available for general release to customers or is ready for its intended use, as appropriate. Technological feasibility is established when all planning, designing, coding and testing activities have been completed, and all risks have been identified. Beginning with the second quarter of 2017, software development costs are capitalized and amortized over the estimated product life of 2 years on a straight-line basis. As of December 31, 2020 and 2019, we capitalized $12.3 million and $5.6 million of software development costs, respectively, which are included as a part of property and equipment. Amortization expense was $1.7 million, $1.8 million, and $1.1 million for the years ended December 31, 2020, 2019, and 2018, respectively. Accumulated amortization was $4.8 million and $3.1 million as of December 31, 2020 and 2019, respectively. The Company analyzes the net realizable value of capitalized software development costs on at least an annual basis and has determined that there is no indication of impairment of the capitalized software development costs as forecasted future sales are adequate to support amortization costs. 53 Table of Contents Income Taxes We account for income taxes in accordance with ASC 740, “Income Taxes.” Under ASC 740, deferred tax assets and liabilities are recognized for the estimated future tax consequences of temporary differences and income tax credits. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates that are applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized for differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Any change in tax rates on deferred tax assets and liabilities is recognized in net income in the period in which the tax rate change is enacted. We record a valuation allowance that reduces deferred tax assets when it is “more likely than not” that deferred tax assets will not be realized. We are required to establish a valuation allowance for deferred tax assets if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on available evidence, realization of deferred tax assets is dependent upon the generation of future taxable income. We considered projected future taxable income, tax planning strategies, and reversal of taxable temporary differences in making this assessment. As such, we have determined that a full valuation allowance is required as of December 31, 2020 and 2019. As a result of a full valuation allowance against our deferred tax assets, a deferred tax liability related to goodwill remains on our consolidated balance sheets at December 31, 2020 and 2019. Due to the tax reform enacted on December 22, 2017, net operating losses generated in taxable years beginning after December 31, 2017 will have an indefinite carryforward period, which will be available to offset future taxable income created by the reversal of temporary taxable differences related to goodwill. As a result, we have adjusted the valuation allowance on our deferred tax assets and liabilities at December 31, 2020 and 2019. See additional information on tax reform and its impact on our income taxes in Note 9 – Income Taxes. We follow the provisions of ASC 740 related to accounting for uncertainty in income taxes. The accounting estimates related to liabilities for uncertain tax positions require us to make judgments regarding the sustainability of each uncertain tax position based on its technical merits. If we determine it is more likely than not that a tax position will be sustained based on its technical merits, we record the impact of the position in our consolidated financial statements at the largest amount that is greater than fifty percent likely of being realized upon ultimate settlement. These estimates are updated at each reporting date based on the facts, circumstances and information available. We are also required to assess at each reporting date whether it is reasonably possible that any significant increases or decreases to our unrecognized tax benefits will occur during the next 12 months. Goodwill We evaluate the impairment of goodwill in accordance with ASC 350, which requires goodwill and indefinite-lived intangible assets to be assessed on at least an annual basis for impairment using a fair value basis. Between annual evaluations, if events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount, then impairment must be evaluated. Such circumstances could include, but are not limited to: (1) a significant adverse change in legal factors or business climate, or (2) a loss of key contracts or customers. As the result of an acquisition, we record any excess purchase price over the net tangible and identifiable intangible assets acquired as goodwill. An allocation of the purchase price to tangible and intangible net assets acquired is based upon our valuation of the acquired assets. Goodwill is not amortized, but is subject to annual impairment tests. We complete our goodwill impairment tests as of December 31st each year. Additionally, we make evaluations between annual tests if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The evaluation is based on the estimation of the fair values of our three reporting units, CO&D (comprised of Information Assurance / Xacta and Secure Networks), Telos ID, and Secure Communications, of which goodwill is housed in the CO&D reporting unit, in comparison to the reporting unit’s net asset carrying values. Our discounted cash flows required management’s judgment with respect to forecasted revenue streams and operating margins, capital expenditures and the selection and use of an appropriate discount rate. We utilized the weighted average cost of capital as derived by certain assumptions specific to our facts and circumstances as the discount rate. The net assets attributable to the reporting units are determined based upon the estimated assets and liabilities attributable to the reporting units in deriving its free cash flows. In addition, the estimate of the total fair value of our reporting units is compared to the market capitalization of the Company. The Company’s assessment resulted in a fair value that was greater than the Company’s carrying value, therefore no impairment of goodwill was recorded as of December 31, 2020. Subsequent reviews may result in future periodic impairments that could have a material adverse effect on the results of operations in the period recognized. Recent operating results have reduced the projection of future cash flow growth potential, which indicates that certain negative potential events, such as a material loss or losses on contracts, or failure to achieve projected growth could result in impairment in the future. We estimate fair value of our reporting unit and compare the valuation with the respective carrying value for the reporting unit to determine whether any goodwill impairment exists. If we determine through the impairment review process that goodwill is impaired, we will record an impairment charge in our consolidated statements of operations. . Goodwill is amortized and deducted over a 15-year period for tax purposes. 54 Table of Contents Stock-Based Compensation Compensation cost is recognized based on the requirements of ASC 718, “Stock Compensation,” for all share-based awards granted. Since June 2008, we have issued restricted stock to our executive officers, directors and employees. 79,361 shares were granted in 2020. Such stock is subject to a vesting schedule as follows: 25% of the restricted stock vests immediately on the date of grant, thereafter, an additional 25% will vest annually on the anniversary of the date of grant subject to continued employment or services. As of December 31, 2020, there were 59,521 shares of restricted stock that remained subject to vesting. In the event of death of the employee or a change in control, as defined by the Telos Corporation 2008 Omnibus Long-Term Incentive Plan, the 2013 Omnibus Long-Term Incentive Plan, or the 2016 Omnibus Long-Term Incentive Plan, all unvested shares shall automatically vest in full. In accordance with ASC 718, we recorded immaterial compensation expense for any of the issuances as the value of the common stock was nominal prior to the initial public offering of our common stock, based on the deduction of our outstanding debt, capital lease obligations, and preferred stock from an estimated enterprise value, which was estimated based on discounted cash flow analysis, comparable public company analysis, and comparable transaction analysis. Additionally, we determined that a significant change in the valuation estimate for common stock would not have a significant effect on the consolidated financial statements. Earnings (Loss) per Share Basic net earnings (loss) per share is computed by dividing the net loss by the weighted-average number of common shares outstanding for the period, without consideration for potentially dilutive securities. Diluted net earnings (loss) per share is computed by dividing the net earnings (loss) by the weighted-average number of shares of common stock and dilutive common stock equivalents outstanding for the period determined using the treasury-stock and if-converted methods. Dilutive common stock equivalents are comprised of unvested restricted common stock and warrants. For the year ended December 31, 2019, the Class A common basic and diluted net loss per share was $(0.17), and the Class A common basic and diluted weighted-average shares were 34,525, the Class B common basic and diluted net loss per share was $(0.17), and the Class B common basic and diluted weighted-average shares were 3,204. For the year ended December 31, 2018, the Class A common basic and diluted net loss per share was $(0.04), and the Class A common basic and diluted weighted-average shares were 33,558, the Class B common basic and diluted net loss per share was $(0.04), and the Class B common basic and diluted weighted-average shares were 3,204. Potentially dilutive securities not included in the calculation of diluted net earnings (loss) per share because to do so would be anti-dilutive are as follows (in common stock equivalent shares): Year Ended December 31, 2020 2019 Unvested restricted stock 60 945 Common stock warrants, exercisable at $1.665/sh. 901 901 Total 961 1,846 On November 12, 2020, we amended our Articles of Amendment and Restatement to effect an approximate 0.794-for-1 reverse stock split with respect to our common stock. The par value and the authorized shares of the common stock were not adjusted as a result of the reverse stock split. The accompanying consolidated financial statements and notes to the consolidated financial statements give retroactive effect to the reverse stock split for all periods presented. Comprehensive Income (Loss) Comprehensive income (loss) includes changes in equity (net assets) during a period from non-owner sources. Our accumulated other comprehensive income (loss) was comprised of a loss from foreign currency translation of $63,000 and $101,000 as of December 31, 2020 and 2019, respectively; and actuarial gain on pension liability adjustments in Teloworks of $107,000 as of December 31, 2020 and 2019. Financial Instruments We use various methods and assumptions to estimate the fair value of our financial instruments. Due to their short-term nature, the carrying value of cash and cash equivalents, accounts receivable and accounts payable approximates fair value. The fair value of long-term debt is based on the discounted cash flows for similar term borrowings based on market prices for the same or similar issues. Fair value estimates are made at a specific point in time, based on relevant market information. These estimates are subjective in nature and involve matters of judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. 55 Table of Contents Recent Accounting Pronouncements Adopted In June 2016, the FASB issued ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,” which introduces new guidance for estimating credit losses on certain types of financial instruments based on expected losses and the timing of the recognition of such losses. This standard is effective for interim and annual reporting periods beginning after December 15, 2019, which made this standard effective for us on January 1, 2020. The adoption of this ASU did not have a material impact on our consolidated financial position, results of operations and cash flows. In January 2017, the FASB issued ASU 2017-04, "Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment," which eliminates Step 2 of the current goodwill impairment test that requires a hypothetical purchase price allocation to measure goodwill impairment. A goodwill impairment loss instead is measured at the amount by which a reporting unit's carrying value exceeds its fair value, not to exceed the recorded amount of goodwill. The provisions of this ASU are effective for years beginning after December 15, 2019, which made this standard effective for us on January 1, 2020. The adoption of this ASU did not have a material impact on our consolidated financial position, results of operations and cash flows. In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820): Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement”, which modifies the disclosure requirement for fair value measurement under ASC 820 to improve the effectiveness of such disclosures. Those modifications include the removal and addition of disclosure requirements as well as clarifying specific disclosure requirements. This standard is effective for interim and annual reporting periods beginning after December 15, 2019, which made this standard effective for us on January 1, 2020. The adoption of this ASU did not have a material impact on our consolidated financial position, results of operations and cash flows. In August 2018, the FASB issued ASU 2018‑15, “Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract,” which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. This standard will be effective for interim and annual reporting periods beginning after December 15, 2019, which made this standard effective for us on January 1, 2020. The adoption of this ASU did not have a material impact on our consolidated financial position, results of operations and cash flows. Recent Accounting Pronouncements Not Yet Adopted In December 2019, the FASB issued ASU No. 2019-12, “Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes,” which simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740. The ASU also clarifies and amends existing guidance to improve consistent application. This standard will be effective for reporting periods beginning after December 15, 2020, with early adoption permitted. While we are currently assessing the impact of the adoption of this ASU, we do not believe the adoption of this ASU will have a material impact on our consolidated financial position, results of operations and cash flows. Note 2. Purchase of Telos ID/Non-Controlling Interests On October 5, 2020, we entered into a Membership Interest Purchase Agreement between the Company and Hoya ID Fund A, LLC (“Hoya”) to purchase all of the Class B Units of Telos ID (“Telos ID Units”) owned by Hoya (the “Telos ID Purchase”). Upon the closing of the Telos ID Purchase, Telos ID became our wholly owned subsidiary. On November 23, 2020, the Telos ID Purchase was consummated with the Company transferring $30.0 million in cash and issuing 7,278,040 shares of our common stock at $20.39 per share (which totals approximately $148.4 million); the total consideration transferred to Hoya was $178.4 million. As part of the common stock issuance, the Company recognized a credit to APIC of $148.4 million. The Company further recognized a debit to APIC of $173.9 million as part of the elimination of Hoya’s non-controlling interest in Telos ID. The net impact to APIC associated with the acquisition of the additional 50% interest in Telos ID was a debit of $25.5 million. On April 11, 2007, Telos ID was formed as a limited liability company under the Delaware Limited Liability Company Act. We contributed substantially all of the assets of our Telos ID Enterprise business line and assigned our rights to perform under our U.S. Government contract with the Defense Manpower Data Center (“DMDC”) to Telos ID at their stated book values. The net book value of assets we contributed totaled $17,000. Until April 19, 2007, we owned 99.999% of the membership interests of Telos ID and Hoya owned 0.001% of the membership interests of Telos ID. On April 20, 2007, we sold an additional 39.999% of the membership interests to Hoya in exchange for $6 million in cash consideration. In accordance with ASC 505, “Equity,” we recognized a gain of $5.8 million. As a result, we owned 60% of Telos ID, and therefore continued to account for the investment in Telos ID using the consolidation method. On December 24, 2014 (the “Closing Date”), we entered into a Membership Interest Purchase Agreement (the “Purchase Agreement”) between the Company and Hoya, pursuant to which Hoya acquired from the Company an additional ten percent (10%) membership interest in Telos ID in exchange for $5 million (the “Transaction”). In connection with the Transaction, the Company and Hoya entered into the Second Amended and Restated Operating Agreement (the “Operating Agreement”) governing the business, allocation of profits and losses and management of Telos ID. Under the Operating Agreement, Telos ID was managed by a board of directors comprised of five (5) members (the “Telos ID Board”). The Operating Agreement provided for two classes of membership units, Class A (owned by the Company) and Class B (owned by Hoya). The Class A member (the Company) owned 50% of Telos ID, was entitled to receive 50% of the profits of Telos ID, and could appoint three (3) members of the Telos ID Board. The Class B member (Hoya) owned 50% of Telos ID, was entitled to receive 50% of the profits of Telos ID, and could appoint two (2) members of the Telos ID Board. 56 Table of Contents As a result of the 2014 Transaction, the Class A and Class B members each owned 50% of Telos ID, as mentioned above, and as such each was allocated 50% of the profits, which was $5.2 million, $4.3 million, and $3.4 million for 2020, 2019, and 2018, respectively. The Class B member was the non-controlling interest. Distributions were made to the members only when and to the extent determined by Telos ID’s Board of Directors, in accordance with the Operating Agreement. During the years ended December 31, 2020, 2019, and 2018, the Class B member received a total of $2.8 million, $2.4 million, and $1.7 million, respectively, of such distributions. The Class B member also received a final distribution of $2.4 million in January 2021, which was accrued and presented in accounts payable and other accrued liabilities in the consolidated balance sheets as of December 31, 2020. The following table details the changes in non-controlling interest for the years ended December 31, 2020, 2019, and 2018 (in thousands): 2020 2019 2018 Non-controlling interest, beginning of period $ 4,514 $ 2,621 $ 913 Net income 5,154 4,264 3,377 Distributions (5,179 ) (2,371 ) (1,669 ) Sale of 50% membership interest (4,489 ) — — Non-controlling interest, end of period $ — $ 4,514 $ 2,621 Note 3. Goodwill The goodwill balance was $14.9 million as of December 31, 2020 and 2019. Goodwill is subject to annual impairment tests and in the interim if triggering events are present before the annual tests, we will assess impairment. For the years ended December 31, 2020, 2019 and 2018, no impairment charges were taken. Note 4. Fair Value Measurements The accounting standard for fair value measurements provides a framework for measuring fair value and expands disclosures about fair value measurements. The framework requires the valuation of investments using a three-tiered approach. The statement requires fair value measurement to be classified and disclosed in one of the following categories: Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets and liabilities; Level 2: Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; or Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity). As of December 31, 2020 and 2019, we did not have any financial instruments with significant Level 3 inputs and we did not have any financial instruments that are measured at fair value on a recurring basis. As of December 31, 2019, the carrying value of the Company’s 12% Cumulative Exchangeable Redeemable Preferred Stock, par value $.01 per share (the “Public Preferred Stock”) was $139.2 million, and the estimated fair market value was $60.5 million, based on quoted market prices. For certain of our non-derivative financial instruments, including receivables, accounts payable and other accrued liabilities, the carrying amount approximates fair value due to the short-term maturities of these instruments. 57 Table of Contents Note 5. Revenue and Accounts Receivable Revenue resulting from contracts and subcontracts with the U.S. Government accounted for 95.4%, 93.7%, and 93.7% of consolidated revenue in 2020, 2019, and 2018, respectively. As our primary customer base includes agencies of the U.S. Government, we have a concentration of credit risk associated with our accounts receivable, as 96.1% of our billed accounts receivable were directly with U.S. Government customers. While we acknowledge the potentially material and adverse risk of such a significant concentration of credit risk, our past experience of collecting substantially all of such receivables provide us with an informed basis that such risk, if any, is manageable. We perform ongoing credit evaluations of all of our customers and generally do not require collateral or other guarantee from our customers. We maintain allowances for potential losses. On July 15, 2016, the Company entered into an accounts receivable purchase agreement under which the Company could sell certain accounts receivable to a third party, or the “ Factor ” , without recourse to the Company. The Factor initially paid the Company 90% of U.S. Federal government receivables or 85% of certain commercial prime contractors’ receivables that were sold under the agreement. The remaining payment was deferred and based on the amount the Factor received from our customer, less a discount fee and a program access fee that was determined by the amount of time the receivable was outstanding before payment. The structure of the transaction provided for a true sale of the receivables transferred. Accordingly, upon transfer of the receivable to the Factor, the receivable was removed from the Company's consolidated balance sheet, a loss on the sale was recorded and the residual amount remains a deferred payment as an accounts receivable until payment was received from the Factor. The balance of the sold receivables could not exceed $10 million. There were no accounts receivable sold during 2020. During the year ended December 31, 2019, the Company sold approximately $12.6 million of accounts receivable, and recognized a related loss of approximately $0.1 million in selling, general and administrative expenses for the same period. As of December 31, 2020 and 2019, there were no outstanding sold accounts receivable. The components of accounts receivable and contract assets are as follows (in thousands): December 31, 2020 2019 Billed accounts receivable $ 12,060 $ 11,917 Unbilled receivables 19,161 16,745 Allowance for doubtful accounts (308 ) (720 ) Total $ 30,913 $ 27,942 The activities in the allowance for doubtful accounts are set forth below (in thousands): Balance Beginning of Year Bad Debt Expenses (1) Recoveries (2) Balance End of Year Year Ended December 31, 2020 $ 720 $ (412 ) $ — $ 308 Year Ended December 31, 2019 $ 306 $ 414 $ — $ 720 Year Ended December 31, 2018 $ 411 $ (105 ) $ — $ 306 (1) Accounts receivable reserves and reversal of allowance for subsequent collections, net (2) Accounts receivable written-off and subsequent recoveries, net Revenue by Major Market and Significant Customers We derived a substantial portion of our revenues from contracts and subcontracts with the U.S. Government. Revenue by customer sector for the last three fiscal years is as follows: 2020 2019 2018 (dollar amounts in thousands) Federal $ 171,677 95.4 % $ 149,257 93.7 % $ 129,279 93.7 % State & Local, and Commercial 8,240 4.6 % 9,961 6.3 % 8,737 6.3 % Total $ 179,917 100.0 % $ 159,218 100.0 % $ 138,016 100.0 % 58 Table of Contents Note 6. Current Liabilities and Debt Obligations Accounts Payable and Other Accrued Liabilities As of December 31, 2020 and 2019, the accounts payable and other accrued payables consisted of $14.7 million and $13.6 million, respectively, in trade account payables and $6.2 million and $1.5 million, respectively, in accrued liabilities. Contract Liabilities Contract liabilities are payments received in advance and milestone payments from our customers on selected contracts that exceed revenue earned to date, resulting in contract liabilities. Contract liabilities typically are not considered a significant financing component because they are generally satisfied within one year and are used to meet working capital demands that can be higher in the early stages of a contract. Contract liabilities are reported on our consolidated balance sheets on a net contract basis at the end of each reporting period. As of December 31, 2020 and 2019, the contract liabilities primarily related to product support services. Enlightenment Capital Credit Agreement On January 25, 2017, we entered into a Credit Agreement (the "Credit Agreement") with Enlightenment Capital Solutions Fund II, L.P., as agent (the "Agent") and the lenders party thereto (the "Lenders") (together referenced as “EnCap”). The Credit Agreement provided for an $11 million senior term loan (the "Loan") with a maturity date of January 25, 2022, subject to acceleration in the event of customary events of default. All borrowings under the Credit Agreement accrued interest at the rate of 13.0% per annum (the “Accrual Rate”). If, at the request of the Company, the Agent executed an intercreditor agreement with another senior lender under which the Agent and the Lenders subordinate their liens (an "Alternative Interest Rate Event"), the interest rate would increase to 14.5% per annum. After the occurrence and during the continuance of any event of default, the interest rate would increase 2.0%. The Company was obligated to pay accrued interest in cash on a monthly basis at a rate of not less than 10.0% per annum or, during the continuance of an Alternate Interest Rate Event, 11.5% per annum. The Company may elect to pay the remaining interest in cash, by payment-in-kind (by addition to the principal amount of the Loan) or by combination of cash and payment-in-kind. Upon thirty days prior written notice, the Company may prepay any portion or the entire amount of the Loan. The Credit Agreement contained representations, warranties, covenants, terms and conditions customary for transactions of this type. In connection with the Credit Agreement, the Agent had been granted, for the benefit of the Lenders, a security interest in and general lien upon various property of the Company, subject to certain permitted liens and any intercreditor agreement. The occurrence of an event of default under the Credit Agreement could result in the Loan and other obligations becoming immediately due and payable and allow the Lenders to exercise all rights and remedies available to them under the Credit Agreement or as a secured party under the UCC, in addition to all other rights and remedies available to them. In connection with the Credit Agreement, on January 25, 2017, the Company issued warrants (each, a "Warrant") to the Agent and certain of the Lenders representing in the aggregate the right to purchase in accordance with their terms 900,970 shares of the Class A Common Stock of the Company, no par value per share, which was equivalent to approximately 2.5% of the common equity interests of the Company on a fully diluted basis. The exercise price as $1.665 per share and each Warrant would expire on January 25, 2027. The value of the warrants was determined to be de minimis and no value was allocated to them on a relative fair value basis in accounting for the debt instrument. The Credit Agreement also included an $825,000 exit fee, which was payable upon any repayment or prepayment of the loan. This amount had been included in the total principal due and treated as an unamortized discount on the debt, which would be amortized over the term of the loan, using the effective interest method at a rate of 15.0%. We incurred fees and transaction costs of approximately $374,000 related to the issuance of the Credit Agreement, which are being amortized over the life of the Credit Agreement. On March 30, 2018, the Credit Agreement was further amended (the “Third Amendment”) to waive certain covenant defaults and to reset the covenants for 2018 measurement periods to more accurately reflect the Company’s projected performance for the year. The measurement against the covenants for consolidated leverage ratio and consolidated fixed charge coverage ratio were agreed to not be measured as of December 31, 2017 and were reset for 2018 measurement periods. Additionally, a minimum revenue covenant and a net working capital covenant were added. In consideration of these amendments, the interest rate on the loan was increased by 1%, which would revert back to the original rate upon achievement of two consecutive quarters of a specified fixed charge coverage ratio as defined in the agreement. The Company may elect to pay the increase in interest expense in cash or by payment-in-kind (by addition to the principal amount of the Loan). The increase in interest expense had been paid in cash. Contemporaneously with the Third Amendment, Mr. John B. Wood agreed to transfer 50,000 shares of the Company’s Class A Common Stock owned by him to EnCap. 59 Table of Contents On July 19, 2019, we entered into the Fourth Amendment to Credit Agreement and Waiver; First Amendment to Fee Letter (“Fourth Amendment”) to amend the Credit Agreement. As a result of the Fourth Amendment, several terms of the Credit Agreement were amended, including the following: • The Company borrowed an additional $5 million from the Lenders, increasing the total amount of the principal to $16 million. • The maturity date of the Credit Agreement was amended from January 25, 2022 to January 15, 2021. • The prepayment price was amended as follows: (a) from January 26, 2019 through January 25, 2020, the prepayment price was 102% of the principal amount, (b) from January 26, 2020 through October 14, 2020, the prepayment price was 101% of the principal amount, and (c) from October 15, 2020 to the maturity date, the prepayment price would be at par. However, the prepayment price for the additional $5 million loan attributable to the Fourth Amendment would be at par. • The following financial covenants, as defined in the Credit Agreement, were amended and updated: Consolidated Leverage Ratio, Consolidated Senior Leverage Ratio, Consolidated Capital Expenditures, Minimum Fixed Charge Coverage Ratio, and Minimum Consolidated Net Working Capital. • Any actual or potential non-compliance with the applicable provisions of the Credit Agreement were waived. • The borrowing under the Credit Agreement continued to be collateralized by substantially all of the Company’s assets including inventory, equipment and accounts receivable. • The Company paid the Agent a fee of $110,000 in connection with the Fourth Amendment. We incurred immaterial third party transaction costs which were expensed in the current period. • The exit fee was increased from $825,000 to $1,200,000. The exit fee had been included in the total principal due and treated as an unamortized discount on the debt, which was amortized over the term of the loan using the effective interest method at a rate of 17.3% over the remaining term of the loan. On March 26, 2020, the Credit Agreement was amended (the “Fifth Amendment”) to modify the financial covenants for 2020 through the maturity of the Credit Agreement to establish that the covenants would remain at the December 31, 2019 levels and to update the previously agreed-upon definition of certain financial covenants, specifically the amount of Capital Expenditures to be included in the measurement of the covenants. The Fifth Amendment also provided for the right for the Company to elect to extend the maturity date of the Credit Agreement which was scheduled to mature on January 15, 2021. The Fifth Amendment provided for four quarterly maturity date extensions, which would increase the Exit Fee payable under the Credit Agreement by $250,000 for each quarterly maturity date extension elected, for a total of $1 million increase to the Exit Fee were all four of the maturity date extensions to be elected. The Company paid EnCap an amendment fee of $100,000 and out-of-pocket costs and expenses in consideration for the Fifth Amendment. We incurred interest expense in the amount of $2.7 million, $2.2 million and $1.7 million for the years ended December 31, 2020, 2019 and 2018, respectively, under the Credit Agreement. On November 24, 2020, upon the closing of the IPO, the Company paid a total of $17.4 million which paid off the Credit Agreement in full including an exit fee of $1.2 million, accrued interest of $138,000, and legal fees of $13,000. As a result, we recognized a loss on debt extinguishment of $138,000 presented as a part of the non-operating expense in the consolidated statements of operations. Subordinated Debt On March 31, 2015, the Company entered into Subordinated Loan Agreements and Subordinated Promissory Notes (“Porter Notes”) with affiliated entities of Mr. John R. C. Porter (together referenced as “Porter”). Mr. Porter and Toxford Corporation, of which Mr. Porter is the sole shareholder, owned 35.0% of our Class A Common Stock. Under the terms of the Porter Notes, Porter lent the Company $2.5 million on or about March 31, 2015. Telos also entered into Subordination and Intercreditor Agreements (the “Subordination Agreements”) with Porter and a prior senior lender, in which the Porter Notes were fully subordinated to the financing provided by that senior lender, and payments under the Porter Notes were permitted only if certain conditions are met. According to the original terms of the Porter Notes, the outstanding principal sum bore interest at the fixed rate of twelve percent (12%) per annum which would be payable in arrears in cash on the 20th day of each May, August, November and February, with the first interest payment date due on August 20, 2015. The Porter Notes did not call for amortization payments and were unsecured. The Porter Notes, in whole or in part, may be repaid at any time without premium or penalty. The unpaid principal, together with interest, was originally due and payable in full on July 1, 2017. On April 18, 2017, we amended and restated the Porter Notes to reduce the interest rate from twelve percent (12%) to six percent (6%) per annum, to be accrued, and extended the maturity date from July 1, 2017 to July 25, 2022. Telos also entered into Intercreditor Agreements with Porter and EnCap, in which the Porter Notes were fully subordinated to the Credit Agreement and any subsequent senior lenders, and payments under the Porter Notes were permitted only if certain conditions were met. As a result of the amendment and restatement of the Porter Notes, we recorded a gain on extinguishment of debt of approximately $1 million, which consisted of the remeasurement of the debt at fair value. As the extinguishment was with a related party, the transaction was deemed to be a capital transaction and the gain was recorded in the Company’s stockholders’ deficit as of December 31, 2017. All other terms remained in full force and effect. We incurred interest expense in the amount of $319,000, $330,000, and $308,000 for 2020, 2019, and 2018, respectively, on the Porter Notes. On November 23, 2020, upon the closing of the IPO, the Porter Notes were paid in full. 60 Table of Contents Note 7. Exchangeable Redeemable Preferred Stock Conversion Public Preferred Stock Upon the closing of the IPO, which constituted a qualified initial public offering for the purposes of the terms of the Exchangeable Redeemable Preferred Stock, each issued and outstanding share of Exchangeable Redeemable Preferred Stock automatically was converted (the “ERPS Conversion”) into the right to receive (i) an amount of cash equal to (I) the ERPS Liquidation Value; multiplied by (II) 0.90; multiplied by (III) 0.85 and (ii) that number of shares of common stock (valued at the initial offering price to the public) equal to (I) the ERPS Liquidation Value; multiplied by (II) 0.90; multiplied by (III) 0.15. No fractional shares of common stock, however, were issued upon an ERPS Conversion Event but, in lieu thereof, the holder was entitled to receive an amount of cash equal to the fair market value of a share of common stock (valued at the initial offering price to the public) at the time of such ERPS Conversion Event multiplied by such fractional amount (rounded to the nearest cent). “ERPS Liquidation Value” means, per each share of Exchangeable Redeemable Preferred Stock, $10 together with all accrued and unpaid dividends (whether or not earned or declared) thereon calculated as of the actual date of an ERPS Conversion Event without interest, which, was approximately $142.3 million as of November 19, 2020. All shares of common stock issued upon an ERPS Conversion were validly issued, fully paid and non-assessable. On November 23, 2020, holders of Exchangeable Redeemable Preferred Stock received $108.9 million in cash and 1.1 million shares of our common stock at $17 per share for a total value of $19.2 million in connection with the ERPS Conversion. The difference in the redemption value of the ERPS and the carrying value has been accounted for as a gain on extinguishment of debt in accordance with ASC 470 and ASC 480. Approximately $220,000 of costs directly attributable to this redemption were applied against the gain, resulting in a net gain of $14.0 million. A maximum of 6,000,000 shares of the Public Preferred Stock, par value $0.01 per share, had been authorized for issuance. We initially issued 2,858,723 shares of the Public Preferred Stock pursuant to the acquisition of the Company during fiscal year 1990. The Public Preferred Stock was recorded at fair value on the date of original issue, November 21, 1989, and we made periodic accretions under the interest method of the excess of the redemption value over the recorded value. We adjusted our estimate of accrued accretion in the amount of $1.5 million in the second quarter of 2006. The Public Preferred Stock was fully accreted as of December 2008. We declared stock dividends totaling 736,863 shares in 1990 and 1991. Since 1991, no other dividends, in stock or cash, have been declared. In November 1998, we retired 410,000 shares of the Public Preferred Stock. The total number of shares issued and outstanding at December 31, 2019, was 3,185,586. The Public Preferred Stock was quoted as “TLSRP” on the OTCQB marketplace and the OTC Bulletin Board. Since 1991, no dividends were declared or paid on our Public Preferred Stock, based upon our interpretation of restrictions in our Articles of Amendment and Restatement, limitations in the terms of the Public Preferred Stock instrument, specific dividend payment restrictions in the various financing agreements to which the Public Preferred Stock is subject, other senior obligations currently or previously in existence, and Maryland law limitations in existence prior to October 1, 2009. Subsequent to the 2009 Maryland law change, dividend payments continue to be prohibited except under certain specific circumstances as set forth in Maryland Code Section 2-311, which the Company did not satisfy as of the measurement dates. Pursuant to the terms of the Articles of Amendment and Restatement, we were scheduled, but not required, to redeem the Public Preferred Stock in five annual tranches during the period 2005 through 2009. However, due to our substantial senior obligations currently or previously in existence, limitations set forth in the covenants in the Credit Agreement and the Porter Notes, foreseeable capital and operational requirements, and restrictions and prohibitions of our Articles of Amendment and Restatement, we were unable to meet the redemption schedule set forth in the terms of the Public Preferred Stock as of the measurement dates. Moreover, the Public Preferred Stock was not payable on demand, nor callable, for failure to redeem the Public Preferred Stock in accordance with the redemption schedule set forth in the instrument. Therefore, we classified these securities as noncurrent liabilities in the consolidated balance sheets as of December 31, 2019. We paid dividends on the Public Preferred Stock when and if declared by the Board of Directors. The Public Preferred Stock accrued a semi-annual dividend at the annual rate of 12% ($1.20) per share, based on the liquidation preference of $10 per share, and was fully cumulative. Dividends in additional shares of the Public Preferred Stock for 1990 and 1991 were paid at the rate of 6% per share for each $.60 of such dividends not paid in cash. For the cash dividends payable since December 1, 1995, we had accrued $107.4 million as of December 31, 2019. We accrued dividends on the Public Preferred Stock of $3.4 million $3.8 million and $3.8 million for the years ended December 31, 2020, 2019, and 2018, respectively, which was recorded as interest expense. Prior to the effective date of ASC 480 on July 1, 2003, such dividends were charged to stockholders’ accumulated deficit. Senior Redeemable Preferred Stock The Senior Redeemable Preferred Stock was senior to all other outstanding equity of the Company, including the Public Preferred Stock. The Series A-1 ranked on a parity with the Series A-2. The components of the authorized Senior Redeemable Preferred Stock were 1,250 shares of Series A-1 and 1,750 shares of Series A-2 Senior Redeemable Preferred Stock, each with $.01 par value. The Senior Redeemable Preferred Stock carried a cumulative per annum dividend rate of 14.125% of its liquidation value of $1,000 per share. The dividends were payable semiannually on June 30 and December 31 of each year. We had not declared dividends on our Senior Redeemable Preferred Stock since its issuance, other than in connection with the redemptions from 2010 to 2013. The liquidation preference of the Senior Redeemable Preferred Stock was the face amount of the Series A-1 and A-2 ($1,000 per share), plus all accrued and unpaid dividends. 61 Table of Contents Due to the terms of the Credit Agreement, the Porter Notes, other senior obligations currently or previously in existence, the Senior Redeemable Preferred Stock and applicable provisions of Maryland law governing the payment of distributions, we had been precluded from redeeming the Senior Redeemable Preferred Stock and paying any accrued and unpaid dividends on the Senior Redeemable Preferred Stock, other than the redemptions that occurred from 2010 to 2013. In addition, certain holders of the Senior Redeemable Preferred Stock had entered into standby agreements whereby, among other things, those holders would not demand any payments in respect of dividends or redemptions of their instruments and the maturity dates of the instruments have been extended. In accordance with the requirements of the Second Amendment to the EnCap Credit Agreement, we redeemed all outstanding shares of the Senior Redeemable Preferred Stock on April 18, 2017 for $2.1 million. Note 8. Stockholders' Deficit and Employee Benefit Plan General Our authorized capital stock consists of 250,000,000 shares of common stock, $0.001 par value per share, and 10,000,000 shares of preferred stock, $0.01 par value per share. Prior to our Second Amended and Restated Articles of Incorporation, which were effective November 12, 2020, the relative rights, preferences, and limitations of the Class A common stock and the Class B common stock were in all respects identical. The holders of the common stock had one vote for each share of common stock held. Our Second Amended and Restated Articles of Incorporation authorize our Board of Directors to classify or reclassify shares of our stock in one or more classes or series, to cause the issuance of additional shares of our stock, and to amend our charter without stockholder approval to increase or decrease the number of shares of stock that we have authority to issue. On November 12, 2020, we filed Articles of Amendment (the “Articles”) with the State Department of Assessments and Taxation of the State of Maryland, effective as of the same date (the “Effective Time”). The Articles amend the Company’s charter to effect a reverse stock split such that (1) every 1.259446 shares of Class A Common Stock that were issued and outstanding immediately prior to the Effective Time were changed into one issued and outstanding share of Class A Common Stock, and (2) every 1.259446 shares of Class B Common Stock that were issued and outstanding immediately prior to the Effective Time were changed into one issued and outstanding share of Class B Common Stock. Also on November 12, 2020, we filed the Second Articles of Amendment and Restatement (the “Second Amended Articles”) with the State Department of Assessments and Taxation of the State of Maryland, effective as of the same date (the “Effective Time”). The Second Amended Articles amend the Company’s charter to effect a conversion of each share of the Class B Common Stock that were issued and outstanding immediately prior to the Effective Time into one fully paid and nonassessable share of Class A Common Stock. From and after the Effective Time, certificates representing the Class B Common Stock now represent the number of shares of Class A Common Stock in which such Class B Common Stock was converted. Also at the Effective Time, the Class A Common Stock was renamed and redesignated as common stock, par value $0.001 per share, of the Corporation. As of December 31, 2020, there were 64,625,071 shares of common stock outstanding and no shares of preferred stock outstanding. Restricted Stock Grants Since June 2008, we have issued restricted stock to our executive officers, directors and employees. Such stock is subject to a vesting schedule as follows: 25% of the restricted stock vests immediately on the date of grant, thereafter, an additional 25% will vest annually on the anniversary of the date of grant subject to continued employment or services. In the event of death of the employee or a change in control, as defined by the Telos Corporation 2008 Omnibus Long-Term Incentive Plan, the 2013 Omnibus Long-Term Incentive Plan, or the 2016 Omnibus Long-Term Incentive Plan, all unvested shares shall automatically vest in full. In accordance with ASC 718, we recorded immaterial compensation expense for any of the issuances as the value of the common stock was nominal, based on the deduction of our outstanding debt, capital lease obligations, and preferred stock from an estimated enterprise value, which was estimated based on discounted cash flow analysis, comparable public company analysis, and comparable transaction analysis. Additionally, we determined that a significant change in the valuation estimate for common stock would not have a significant effect on the consolidated financial statements. In May 2017, we issued grants of 3,972,007 shares to our executive officers and employees. The shares vest according to the schedule set forth above. There were 3,948,199 shares outstanding at the beginning of 2018, and 43,649 shares were forfeited during 2018. There were no new grants in 2018. There were 3,904,550 shares outstanding at the beginning of 2019, and 11,904 shares were forfeited during 2019. There were no new grants in 2019. At the beginning of 2020 there were 3,892,646 shares outstanding and 47,616 were forfeited prior to May 2020, when the remaining 3,845,030 shares became fully vested. Upon vesting there were no remaining restrictions on these shares and they are able to be sold or disposed of, subject to any lock-up agreements subsequently entered into by certain holders of the shares in connection with the IPO of the Company’s common stock in November 2020. In May 2020, 79,361 shares were granted. As of December 31, 2020, there were 59,521 shares of restricted stock that remained subject to vesting. 62 Table of Contents Telos Shared Savings Plan We sponsor a defined contribution employee savings plan (the “Plan”) under which substantially all full-time employees are eligible to participate. As of December 31, 2020, the Plan held 2,391,552 shares of Telos common stock. We match one-half of employee contributions to the Plan up to a maximum of 2% of such employee’s eligible annual base salary. Participant contributions vest immediately, and Company contributions vest at the rate of 20% each year, with full vesting occurring after completion of five years of service. Our total contributions to the Plan for 2020, 2019, and 2018 were $998,000, $861,000, and $721,000, respectively. Additionally, Telos ID sponsors a defined contribution savings plan (the “Telos ID Plan”) under which substantially all full-time employees are eligible to participate. Telos ID matches one-half of employee contributions to the Telos ID Plan up to a maximum of 2% of such employee’s eligible annual base salary. The total 2020, 2019, and 2018 Telos ID contributions to this plan were $179,000, $151,000, and $125,000, respectively. 63 Table of Contents Note 9. Income Taxes The provision (benefit) for income taxes attributable to income from operations includes the following (in thousands): For the Years Ended December 31, 2020 2019 2018 Current (benefit) provision Federal $ — $ 25 $ (29 ) State (77 ) 68 (17 ) Total current (77 ) 93 (46 ) Deferred provision (benefit) Federal 27 88 15 State 4 (285 ) 62 Total deferred 31 (197 ) 77 Total (benefit) provision $ (46 ) $ (104 ) $ 31 The provision for income taxes related to operations varies from the amount determined by applying the federal income tax statutory rate to the income or loss before income taxes. The reconciliation of these differences is as follows: For the Years Ended December 31, 2020 2019 2018 Computed expected income tax provision 21.0 % 21.0 % 21.0 % State income taxes, net of federal income tax benefit 1.0 (0.7 ) 19.0 Change in valuation allowance for deferred tax assets 17.0 (24.7 ) (43.5 ) Cumulative deferred adjustments 0.7 (1.1 ) -- Provision to return adjustments 0.5 1.3 (1.7 ) Other permanent differences 1.0 (3.8 ) 6.1 Dividend and accretion on preferred stock 10.5 (35.8 ) 45.4 Gain on redemption of preferred stock (43.3 ) — — Section 162(m) limitation - covered employees 14.6 (6.9 ) 5.1 Capitalization of IPO transaction costs 4.4 — — FIN 48 liability 0.2 (3.7 ) 4.2 R&D credit (12.4 ) 19.0 (25.2 ) Non-controlling interest (15.9 ) 40.0 (40.1 ) Impact of Tax Act — — 11.4 (0.7 )% 4.6 % 1.7 % 64 Table of Contents The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2020 and 2019 are as follows (in thousands): December 31, 2020 2019 Deferred tax assets: Accounts receivable, principally due to allowance for doubtful accounts $ 78 $ 185 Allowance for inventory obsolescence and amortization 398 316 Accrued liabilities not currently deductible 2,204 1,649 Accrued compensation 1,161 1,655 Deferred rent 4,387 4,808 Section 163(j) interest limitation 306 804 Goodwill 41,534 — Net operating loss carryforwards - federal 3,814 2,583 Net operating loss carryforwards - state 1,002 796 Federal tax credit 1,986 1,326 Total gross deferred tax assets 56,870 14,122 Less valuation allowance (52,198 ) (7,206 ) Total deferred tax assets, net of valuation allowance 4,672 6,916 Deferred tax liabilities: Amortization and depreciation (4,471 ) (2,623 ) Unbilled accounts receivable, deferred for tax purposes (853 ) (1,611 ) Goodwill basis adjustment and amortization — (2,886 ) Telos ID basis difference — (417 ) Total deferred tax liabilities (5,324 ) (7,537 ) Net deferred tax liabilities $ (652 ) $ (621 ) The components of the valuation allowance are as follows (in thousands): Balance Beginning of Period Additions Recoveries Balance End of Period December 31, 2020 $ 7,206 $ 44,992 $ -- $ 52,198 December 31, 2019 $ 6,652 $ 554 $ -- $ 7,206 December 31, 2018 $ 7,219 $ -- $ (567 ) $ 6,652 In March 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was enacted. The CARES Act, among other things, includes certain changes to U.S. tax law that impact the Company, including deferment of employer social security payments, modifications to interest deduction limitation rules, a technical correction to tax depreciation methods for certain qualified improvement property, and alternative minimum tax credit refund. Beginning January 1, 2018, we are subject to several provisions of the Tax Act including computations under Section 162(m) executive compensation limitation and Section 163(j) interest limitation rules and we have considered the impact of each of these provisions as well as those under the CARES Act in our consolidated financial statements for the years ended December 31, 2020 and 2019. We are required to establish a valuation allowance for deferred tax assets if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on available evidence, realization of deferred tax assets is dependent upon the generation of future taxable income. We considered projected future taxable income, tax planning strategies, and reversal of taxable temporary differences in making this assessment. As such, we have determined that a full valuation allowance is required as of December 31, 2020 and 2019. As a result of a full valuation allowance against our deferred tax assets and liabilities, a deferred tax liability related to goodwill remained on our consolidated balance sheets at December 31, 2020 and 2019. We recorded deferred tax assets and liabilities related to the purchase of an additional 50% interest in the partnership Telos ID, including a deferred tax asset of $44.9 million for tax-deductible goodwill generated in the transaction. We also recorded a corresponding valuation allowance against the additional deferred taxes. 65 Table of Contents At December 31, 2020, for federal income tax purposes there was approximately a $18.2 million net operating loss available to be carried forward to offset future taxable income. Approximately $10.6 million of these net operating loss carryforwards expire between 2035 and 2037, the remaining will be carried forward indefinitely. As of December 31, 2020, there was approximately $2.5 million of research and development credit carryover which begins to expire in 2033. Certain tax attributes of the Company, including net operating losses and credits, would be subject to a limitation should an ownership change as defined under Section 382 of the Internal Revenue Code of 1986, as amended, occur. The limitations resulting from a change in ownership could affect the Company’s ability to utilize its tax attributes. A study was completed in 2020 which confirmed that no limitation applies to the Company's tax attributes as of December 31, 2020. Under the provisions of ASC 740, we determined that there were approximately $763,000, $714,000, and $649,000 of unrecognized tax benefits as of December 31, 2020, 2019, and 2018, respectively. Included in the balance of unrecognized tax benefits as of December 31, 2020, 2019, and 2018 were $278,000, $369,000, and $369,000, respectively, of tax benefits that, if recognized, would impact the effective tax rate. Also included in the balance of unrecognized tax benefits as of December 31, 2020, 2019, and 2018 were $485,000, $345,000, and $280,000, respectively, of tax benefits that, if recognized, would not impact the effective tax rate due to the Company’s valuation allowance. The Company had accrued interest and penalties related to the unrecognized tax benefits of $241,000 and $304,000, which were recorded in other liabilities as of December 31, 2020 and 2019, respectively. We believe that the total amounts of unrecognized tax benefits will not significantly increase or decrease within the next 12 months. The period for which tax years are open, 2017 to 2020, has not been extended beyond the applicable statute of limitations. As of December 31, 2020, the Company is not under examination by any federal or state tax jurisdiction. A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows (in thousands): 2020 2019 2018 Unrecognized tax benefits, beginning of period $ 714 $ 649 $ 585 (Decrease) increase in prior year tax positions (104 ) 1 3 Increase related to current year tax positions 213 101 92 Decrease related to lapse of statutes (60 ) (37 ) (31 ) Unrecognized tax benefits, end of period $ 763 $ 714 $ 649 66 Table of Contents Note 10. Commitments Leases We lease office space and equipment under noncancelable operating and finance leases with various expiration dates, some of which contain renewal options. Operating Leases We account for leases in accordance with ASC Topic 842, “Leases,” which requires lessees to recognize a right-of-use (“ROU”) asset and lease liability on the consolidated balance sheets and expands disclosures about leasing arrangements for both lessees and lessors, among other items, for most lease arrangements. In accordance with the adoption of ASC 842 on January 1, 2019, we recorded operating lease ROU assets, which represent our right to use an underlying asset for the lease term, and operating lease liabilities which represent our obligation to make lease payments. Generally, we enter into operating lease agreements for facilities. The amount of operating lease liabilities due within 12 months are recorded in other current liabilities, with the remaining operating lease liabilities recorded as non-current liabilities in our consolidated balance sheets based on their contractual due dates. The operating lease ROU assets and liabilities are recognized as of the lease commencement date at the present value of the lease payments over the lease term. Most of our leases do not provide an implicit rate that can readily be determined. Therefore, we use a discount rate based on our incremental borrowing rate which was 5.75% for all operating leases. Our operating lease agreements may include options to extend the lease term or terminate it early. We have included options to extend in the operating lease ROU assets and liabilities when we are reasonably certain that we will exercise such options. The weighted average remaining lease terms for our operating leases were approximately 2.5 years and 3.5 years at December 31, 2020 and 2019, respectively. The discount rates for our operating leases were 5.75% at December 31, 2020 and 2019. Operating lease expense is recognized as rent expense on a straight-line basis over the lease term. Some of our operating leases contain lease and non-lease components, which we account for as a single component. We evaluate ROU assets for impairment consistent with our property and equipment policy disclosure included in Note 1 – Summary of Significant Accounting Policies. As of December 31, 2020, operating lease ROU assets were $1.5 million and operating lease liabilities were $1.6 million, of which $0.9 million were classified as noncurrent. Finance Leases On March 1, 1996, we entered into a 20-year capital lease for a building in Ashburn, Virginia that serves as our corporate headquarters. We had accounted for this transaction as a capital lease and had accordingly recorded assets and a corresponding liability of approximately $12.3 million. Effective November 1, 2013, this lease was terminated and we entered into a 13-year lease (the “2013 lease”) that would have expired in October 31, 2026. The 2013 lease was treated as a modification in accordance with ASC 840, “Leases”. As a result of the 2013 lease, the corresponding capital asset and liability increased by $11.7 million, resulting in a net book value of the capital asset of $13.1 million, and capital obligation of $15.5 million. The 2013 lease included an option to purchase, assign to, or designate a purchaser on June 1, 2014, which required notice of intent to exercise the option by not later than March 31, 2014. On March 28, 2014, we entered into a definitive agreement with an unrelated third party to assign the purchase option to that third party in return for cash consideration of $1.7 million, payable upon the closing of the purchase transaction, and certain obligations under the agreement, including entering into a new 15-year lease with the third party upon the third party’s exercise of the purchase option and purchase of the building from the prior landlord. On March 28, 2014, we provided the prior landlord notice of our assignment and exercise of the purchase option. On May 28, 2014, the third party completed the purchase transaction and the 2013 lease was terminated, with no ongoing obligations, by mutual agreement between us and the prior landlord. On the same day we entered into a new lease (the “2014 lease”) with the third party that expires on May 31, 2029. The 2014 lease was treated as a modification of the prior lease on the property in accordance with ASC 840, and determined to be a capital lease. As a result of the 2014 lease, the corresponding capital asset increased by $5.7 million, resulting in a net book value of the capital asset of $18.3 million and the liability increased by $6.7 million, resulting in a capital obligation of $22.0 million. The weighted average remaining lease terms for finance leases were approximately 8.3 years and 9.3 years at December 31, 2020 and 2019, respectively. The discount rates for our finance leases were 5.04% at December 31, 2020 and 2019. In accordance with the 2014 Lease, the basic rent increases by a fixed 2.5% escalation annually. 67 Table of Contents Future minimum lease commitments at December 31, 2020 were as follows (in thousands): Operating Leases Finance Leases 2021 $ 752 $ 2,097 2022 592 2,149 2023 373 2,202 2024 27 2,258 2025 — 2,314 After 2025 — 8,344 Total minimum lease payments 1,744 19,364 Less imputed interest (126 ) (3,724 ) Net present value of minimum lease payments 1,618 15,640 Less current portion (677 ) (1,339 ) Long-term lease obligations at December 31, 2020 $ 941 $ 14,301 The components of lease expense were as follows (in thousands): Year Ended December 31, 2020 2019 Operating lease cost $ 724 $ 597 Short-term lease cost (1) 93 147 Finance lease cost Amortization of finance lease assets 1,221 1,221 Interest on finance lease liabilities 822 881 Total finance lease cost 2,043 2,102 Total lease costs $ 2,860 $ 2,846 (1) Leases that have terms of 12 months or less. Supplemental cash flow information related to leases was as follows (in thousands): Year Ended December 31, 2020 2019 Cash paid for amounts included in the measurement of lease liabilities: Cash flows from operating activities - operating leases $ 745 $ 604 Cash flows from operating activities - finance leases $ 820 $ 880 Cash flows from financing activities - finance leases $ 1,225 $ 1,115 Operating lease ROU assets obtained in exchange for operating lease liabilities $ 613 $ 488 Rent expense charged to operations totaled $1.1 million, $1.2 million, and $1.6 million for 2020, 2019, and 2018, respectively. 68 Table of Contents Warranties We provide product warranties for products sold through certain U.S. Government contract vehicles. We accrue a warranty liability at the time that we recognize revenue for the estimated costs that may be incurred in connection with providing warranty coverage. Warranties are valued using historical warranty usage trends; however, if actual product failure rates or service delivery costs differ from estimates, revisions to the estimated warranty liability may be required. Accrued warranties were $30,000 as of December 31, 2020 and 2019, and are reported as other current liabilities in the consolidated balance sheets. There were no activities in accrued warranties for years ended December 31, 2020, 2019, and 2018. Note 11. Certain Relationships and Related Transactions Information concerning certain relationships and related party transactions between us and certain of our current shareholders and officers is set forth below. The brother of our Chairman and CEO, Emmett J. Wood, has been an employee of ours since 1996. The amounts paid to this individual as compensation for 2020, 2019, and 2018 were $1,238,000, $529,000, and $552,000, respectively. Additionally, Mr. Wood owned 682,502 shares of the Company’s common stock as of December 31, 2020 and 2019. On March 31, 2015, the Company entered into the Porter Notes. Mr. Porter and Toxford Corporation, of which Mr. Porter is the sole shareholder, owned 35.0% of our Class A Common Stock. Under the terms of the Porter Notes, Porter lent the Company $2.5 million on or about March 31, 2015. According to the terms of the Porter Notes, the outstanding principal sum bore interest at the fixed rate of twelve percent (12%) per annum which would be payable in arrears in cash on the 20th day of each May, August, November and February, with the first interest payment date due on August 20, 2015. The Porter Notes did not call for amortization payments and were unsecured. The Porter Notes, in whole or in part, may be repaid at any time without premium or penalty. The unpaid principal, together with interest, was originally due and payable in full on July 1, 2017. On April 18, 2017, we amended and restated the Porter Notes to reduce the interest rate from twelve percent (12%) to six percent (6%) per annum, to be accrued, and extended the maturity date from July 1, 2017 to July 25, 2022. Telos also entered into Intercreditor Agreements with Porter and EnCap, in which the Porter Notes were fully subordinated to the Credit Agreement and any subsequent senior lenders (including Action Capital), and payments under the Porter Notes were permitted only if certain conditions were met. All other terms remained in full force and effect. We incurred interest expense in the amount of $319,000, $330,000, and $308,000 for the years ended December 31, 2020, 2019, and 2018, respectively, on the Porter Notes. On November 23, 2020, upon the closing of the IPO, the Porter Notes were paid in full. 69 Table of Contents Note 12. Summary of Selected Quarterly Financial Data (Unaudited) The following is a summary of selected quarterly financial data for the previous two fiscal years (in thousands): Quarters Ended March 31 June 30 Sept. 30 Dec. 31 2020 Revenue $ 38,980 $ 48,610 $ 47,440 $ 44,887 Gross profit 12,242 17,573 16,562 16,043 (Loss) income before income taxes and non-controlling interest (1,606 ) 3,074 2,502 2,825 Net (loss) income attributable to Telos Corporation (1)(2) (2,244 ) 266 (200 ) 3,865 Weighted-average common shares outstanding, basic 38,073 38,583 39,002 50,383 Weighted-average common shares outstanding, diluted 38,073 39,927 39,002 51,288 Basic net (loss) earnings per share (0.06 ) 0.01 (0.01 ) 0.08 Diluted net (loss) earnings per share (0.06 ) 0.01 (0.01 ) 0.08 2019 Revenue $ 31,166 $ 36,048 $ 45,531 $ 46,473 Gross profit 8,976 10,015 16,313 17,040 (Loss) income before income taxes and non-controlling interest (3,137 ) (1,974 ) 3,708 (838 ) Net (loss) income attributable to Telos Corporation (1)(3) (3,413 ) (1,741 ) 2,233 (3,480 ) Weighted-average common shares outstanding, basic 37,116 37,642 38,073 38,073 Weighted-average common shares outstanding, diluted 37,116 37,642 39,931 38,073 Basic net (loss) earnings per share (0.09 ) (0.05 ) 0.06 (0.09 ) Diluted net (loss) earnings per share (0.09 ) (0.05 ) 0.06 (0.09 ) (1) Changes in net income are the result of several factors, including seasonality of the government year-end buying season, as well as the nature and timing of other deliverables. (2) Net income for the second quarter of 2020 is attributable to a change in the mix and timing of Telos ID deliverables. (3) Net income for the third quarter of 2019 is attributable to $2.6 million in proprietary software sales which carry lower cost of sales. Note 13. Commitments, Contingencies, and Subsequent Events Financial Condition and Liquidity While a variety of factors related to sources and uses of cash, such as timeliness of accounts receivable collections, vendor credit terms, or significant collateral requirements, ultimately impact our liquidity, such factors may or may not have a direct impact on our liquidity, based on how the transactions associated with such circumstances impact our availability under our credit arrangements. For example, a contractual requirement to post collateral for a duration of several months, depending on the materiality of the amount, could have an immediate negative effect on our liquidity, as such a circumstance would utilize cash resources without a near-term cash inflow back to us. Likewise, the release of such collateral could have a corresponding positive effect on our liquidity, as it would represent an addition to our cash resources without any corresponding near-term cash outflow. Similarly, a slow-down of payments from a customer, group of customers or government payment office would not have an immediate and direct effect on our availability unless the slowdown was material in amount and over an extended period of time. Any of these examples would have an impact on our cash resources, our financing arrangements, and therefore our liquidity. Upon the closing of our initial public offering, 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 7 – Exchangeable Redeemable Preferred Stock Conversion), $30.0 million to fund our acquisition of the outstanding Class B Units of Telos ID (see Note 2 – Purchase of Telos ID/Non-controlling Interests), $21.0 million to repay our outstanding senior term loan and subordinated debt (see Note 6 – Debt Obligations). We intend to use the remaining net proceeds for general corporate purposes. We also may use a portion of the net proceeds to acquire complementary businesses, products, services, or technologies. However, we do not have agreements, commitments, or plans for any specific acquisitions at this time. 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. We currently anticipate that we will retain all available funds for use in the operation and expansion of our business, and we do not anticipate paying any cash dividends on our common stock in the foreseeable future. Our working capital was $105.2 million and $2.9 million as of December 31, 2020 and 2019, respectively. 70 Table of Contents Legal Proceedings Hamot et al. v. Telos Corporation As previously reported, beginning on August 2, 2007, Messrs. Seth W. Hamot (“Hamot”) and Andrew R. Siegel (“Siegel”), principals of Costa Brava Partnership III, L.P. (“Costa Brava”), were involved in litigation against the Company as Plaintiffs and Counter-defendants in the Circuit Court for Baltimore City, Maryland (the “Circuit Court”). Mr. Siegel was a Class D Director of the Company and Mr. Hamot was a Class D Director of the Company until his resignation on March 9, 2018. The Plaintiffs initially alleged that certain documents and records had not been provided to them promptly and were necessary to fulfill their duties as directors of the Company. Subsequently, Hamot and Siegel further alleged that the Company had failed to follow certain provisions concerning the noticing of Board committee meetings and the recording of Board meeting minutes and, additionally, that Mr. John Wood’s service as both CEO and Chairman of the Board was improper and impermissible under the Company’s Bylaws. On April 23, 2008, the Company filed a counterclaim against Hamot and Siegel for money damages and preliminary and injunctive relief based upon Hamot and Siegel’s interference with, and improper influence of, the Company’s independent auditors regarding, among other things, a specific accounting treatment. On June 27, 2008, the Circuit Court granted the Company’s motion for preliminary injunction and enjoined Hamot and Siegel from contacting the Company’s auditors until the completion of the Company’s Form 10-K for the preceding year, which injunction later expired by its own terms. As previously disclosed, trial on Hamot and Siegel’s claims and the Company’s counterclaims took place in July through September 2013, and the Court subsequently issued decisions on the various claims by way of memorandum opinions and orders dated September 11, 2017. Among other rulings, the Court found Hamot and Siegel liable for the intentional tort of tortious interference with the Company’s contractual relationship with one of its auditors and entered a monetary judgment in favor of the Company and against Hamot and Siegel for approximately $278,000. The Company’s subsequent appeal of the amount of damages awarded to it for Hamot and Siegel’s intentional interference was ultimately dismissed by way of the Mandate issued by the Court of Appeals of Maryland on October 11, 2019. Hamot (and later, his Estate) and Siegel on multiple occasions during this litigation have sought to be indemnified or to be awarded advancement of various attorney’s fees and expenses incurred by them in this litigation. On October 20, 2020, Hamot’s Estate and Siegel (together the “Plaintiffs”) filed their latest Motion for Indemnification of Legal Fees and Expenses against the Company in the Circuit Court for Baltimore City and a Request for a Hearing. The Motion demands that the Company indemnify the Plaintiffs for legal fees and expenses incurred in the sum of $2,540,000. The Company filed an Opposition to the Motion on November 4, 2020. On January 28, 2021, Plaintiffs filed a Motion for Leave to File Amended Motion for Indemnification of Legal Fees and Expenses, which the Company opposed, and which was granted by the Court on February 23, 2021, and briefing of the Amended Motion for Indemnification of Legal Fees and Expenses (“Amended Motion”) continues. A hearing is scheduled before the Court on Plaintiffs’ Amended Motion for Indemnification of Legal Fees and Expenses for May 18, 2021. The Company denies that it has any liability for indemnification to the Plaintiffs and intends to vigorously defend the matter through its opposition to the Amended Motion and further proceedings. At this stage of the litigation, it is impossible to reasonably determine the degree of probability related to the Company’s success in relation to this claim by Hamot’s Estate and Siegel for indemnification for certain attorney’s fees and expenses incurred in this litigation. The Company intends to vigorously defend the matter. Other Litigation In addition, the Company is a party to litigation arising in the ordinary course of business. In the opinion of management, while the results of such litigation cannot be predicted with any reasonable degree of certainty, the final outcome of such known matters will not, based upon all available information, have a material adverse effect on the Company's condensed consolidated financial position, results of operations or cash flows. Subsequent Events On January 25, 2021, we filed Form S-8 to register a total of 7,459,913 shares of common stock, par value $0.001 per share, to be issued under the terms and conditions of the 2016 Omnibus Long-Term Incentive Plan approved by the stockholders at a meeting held on October 26, 2020. 71 Table of Contents Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure N/A.