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Item 2. Management’s Discussion and Analysis

2021-05-10 compared with 2020-11-06 · 54 added, 89 removed, 44 unchanged (76% of the section changed)

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Company Overview

We are an Internet security software and technology company with patented technology for secure communications including 5G and 4G LTE security.

Our software and technology solutions, including our Secure Domain Name Registry and GABRIEL Connection Technology™, are designed to facilitate secure communications and provide the security platform required by next- generation Internet-based applications such as instant messaging, or IM, voice over Internet protocol, or VoIP, mobile services, streaming video, file transfer, remote desktop and Machine-to-Machine, or M2M communications.

We are an Internet security software and technology company with patented technology for various types of secure network communications, including 5G and 4G LTE network security.

Our patented Secure Domain Name Registry and GABRIEL Connection Technology™, are the foundation for our GABRIEL Secure Communication Platform™ that protects communications using Zero Trust Network Access (ZTNA).

Our technology generates secure connections on a “zero-click” or “single-click” basis, significantly simplifying the deployment of secure real-time communication solutions by eliminating the need for end-users to enter any encryption information.

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patents/patent applications and 124 foreign patents/validations/pending applications.

Our patent portfolio is primarily focused on securing real-time communications over the Internet, as well as related services such as the establishment and maintenance of a secure domain name registry.

Our patented methods also have additional applications in the key areas of device operating systems and network security for Cloud services, M2M communications in the new initiatives like “Smart City”, “Connected Car” and “Connected Home” that would connect everything from social services and citizen engagement to public safety, transportation and economic development to the internet to enable more productivity, features and efficiency in our everyday lives.

The subject matter of all our U.S.

and foreign patents and pending applications relates generally to securing communication over the internet, and as such covers all our technology and other products.

Our issued U.S.

and foreign patents expire at various times during the period from 2020 to 2024.

Some of our issued patents and pending patent applications were acquired by our principal operating subsidiary;

VirnetX, Inc., from Leidos, Inc., or Leidos, (f/k/a Science Applications International Corporation, or SAIC) in 2006 and we are required to make payments to Leidos, based on cash or certain other values generated from those patents.

The amount of such payments depends upon the type of value generated, and certain categories are subject to maximums and other limitations.

Our product GABRIEL Secure Communication Platform™ includes a set of sophisticated software libraries with application interfaces available for securing third-party applications seamlessly across multiple operating system platforms.

Unlike other collaboration and communication products and services on the market today, this product does not require access to user’s confidential data and reduces the threat of hacking and data mining.

Our patent portfolio is primarily focused on securing real-time communications over the Internet, and related services, and is used in all our technology and products, some of which were acquired by our principal operating subsidiary;

VirnetX, Inc., from Leidos, Inc., or Leidos, (f/k/a Science Applications International Corporation, or SAIC) in 2006.

Our product portfolio includes sophisticated technologies, products and services that are available for sale worldwide.

Our GABRIEL Secure Communication Platform™ includes a set of software libraries with application interfaces available for securing third-party applications seamlessly across multiple operating systems.

It enables individuals and organizations to maintain complete ownership and control over their personal and confidential data, secured within their own private network, while enabling authorized secure encrypted access from anywhere at any time.

Our GABRIEL Gateway product extends our Secure Communication Platform™ by allowing existing networked devices and services to seamlessly join the “GABRIEL SECURED” network without requiring any modifications.

All these devices or services, including cloud-based services, can now be assigned a VirnetX Secure Domain Name and use a fully authenticated secure communication channels for its communications.

Our GABRIEL Collaboration Suite™ is a set of communication tools that use our GABRIEL Secure Communication Platform™.

It enables seamless and secure cross-platform communications between devices that are enrolled in our security fabric and have our software installed.

Our GABRIEL Collaboration Suite™ is available for download and free trial, for Android, iOS, Windows, Linux and Mac OS X platforms, at http://www.gabrielsecure.com/ .

We continue to enhance our products and add new functionality to our products.

We will provide updates to new and existing customers as they are released to the general public.

A large number of small and medium businesses have installed our GABRIEL Secure Communication Platform™ and GABRIEL Collaboration Suite™ products in their corporate networks.

All these devices or services, including on-premise or cloud-based services, can now be assigned a VirnetX Secure Domain Name and use fully authenticated, secure communication channels for its communications.

Our GABRIEL Collaboration Suite™ is a set of communication applications and tools that use our GABRIEL Secure Communication Platform™.

It enables seamless and secure cross-platform communications between devices that are enrolled in our “GABRIEL SECURED” network and have our software installed.

Our GABRIEL Collaboration Suite™ is available for download and free trial, for Android, iOS, Windows, Linux, and Mac OS X platforms, at https://virnetx.com .

We continue to enhance our products and add new functionality.

We will provide updates to new and existing customers as they are released to the public.

Many small and medium businesses have installed our GABRIEL Secure Communication Platform™ and GABRIEL Collaboration Suite™ products in their corporate networks.

We intend to continue to expand our customer base with targeted promotions and direct sales initiatives.

We are actively recruiting partners in various vertical markets including, healthcare, finance, government, etc., to help us rapidly expand our enterprise customer base.

A number of International Association of Certified ISAO (IACI) including ISAO’s for Maritime & Ports ISAO, Credit Union ISAO, City of Chicago ISAO, Human Trafficking ISAO, have chosen to deploy our software as private and secure e-technology to protect their communications.

Several other ISAOs are completing their evaluations before deploying our products within their networks.

We have executed a number of patent and technology licenses and intend to seek further licensees for our technology, including our GABRIEL Connection Technology™ to original equipment manufacturers, or OEMs, of chips, servers, smart phones, tablets, e-Readers, laptops, net books and other devices, within the IP-telephony, mobility, fixed-mobile convergence and unified communications markets including 5G and 4G/LTE Advanced.

We have submitted a declaration with the 3rd Generation Partnership Project, or 3GPP, identifying a group of our patents and patent applications that we believe are or may become essential to certain developing specifications in the 3GPP LTE, Systems Architecture Evolution, or SAE project.

We have agreed to make available a non-exclusive patent license under fair, reasonable and non-discriminatory terms and conditions, with compensation, or FRAND, to 3GPP members desiring to implement the technical specifications identified by us.

We believe that we are positioned to license our essential security patents to 3GPP members as they move into deploying 5G and 4G/LTE Advanced devices and solutions.

We have an ongoing GABRIEL Licensing Program under which we offer licenses to a portion of our patent portfolio, technology, and software, including our secure domain name registry service, to domain infrastructure providers, communication service providers as well as to system integrators.

Our GABRIEL Connection Technology™ License is offered to OEM customers who want to adopt the GABRIEL Connection Technology™ as their solution for establishing secure connections using secure domain names within their products.

We have developed GABRIEL Connection Technology™ Software Development Kit (SDK) to assist with rapid integration of these techniques into existing software implementations with minimal code changes and include object libraries, sample code, testing and quality assurance tools and the supporting documentation necessary for a customer to implement our technology.

We have developed GABRIEL Connection Technology™ Software Development Kit (SDK) to assist with rapid integration of these techniques into existing software implementations.

Customers who want to develop their own implementation of the VirnetX patented techniques for supporting secure domain names, or other techniques that are covered by our patent portfolio for establishing secure communication links, can purchase a patent license.

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These licenses will typically include an initial license fee, as well as an ongoing royalty.

We have signed Patent License Agreements with Avaya Inc., Aastra USA, Inc., Microsoft Corporation, Mitel Networks Corporation, NEC Corporation and NEC Corporation of America, Siemens Enterprise Communications GmbH & Co.

KG, and Siemens Enterprise Communications Inc.

to license certain of our patents, for a one-time payment and/or an ongoing royalty for all future sales through the expiration of the licensed patents with respect to certain current and future IP-encrypted products.

We believe that the market opportunity for our software and technology solutions is large and expanding as secure domain names are now an integral part of securing the next generation 5G and 4G/LTE Advanced wireless networks and M2M communications in areas including Smart City, Connected Car and Connected Home.

We also believe that all 5G and 4G/LTE Advanced mobile devices will require unique secure domain names and become part of a secure domain name registry.

We intend to continue to license our patent portfolio, technology and software, including our secure domain name registry service, to domain infrastructure providers, communication service providers as well as to system integrators.

We intend to seek further license of our technology, including our GABRIEL Connection Technology™ to enterprise customers, developers and original equipment manufacturers, or OEMs, of chips, servers, smart phones, tablets, e-Readers, laptops, net books and other devices, within the IP-telephony, mobility, fixed-mobile convergence and unified communications markets including 5G and 4G/LTE.

Our employees include the core development team behind our patent portfolio, technology, and software.

This team has worked together for over ten years and is the same team that invented and developed this technology while working at Leidos, Inc.

Leidos is a FORTUNE 500® scientific, engineering and technology applications company that uses its deep domain knowledge to solve problems of vital importance to the nation and the world, in national security, energy and the environment, critical infrastructure and health.

The team has continued its research and development work started at Leidos and expanded the set of patents we acquired in 2006 from Leidos, into a larger portfolio of approximately 194 U.S.

and foreign patents, patent validations and pending applications.

This portfolio now serves as the foundation of our licensing business and planned service offerings and is expected to generate the majority of our future revenue in license fees and royalties.

We intend to continue our research and development efforts to further strengthen and expand our patent portfolio.

Some members of this team have worked together for over twenty years and were on same team that invented and developed this technology while working at Leidos.

The team has continued its research and development work and expanded the set of patents we acquired in 2006 from Leidos, into a larger patent portfolio.

This portfolio now serves as the foundation of our products, services, and our licensing business.

It is expected to generate most of our future revenue in license fees and royalties.

We intend to continue our efforts to develop new products and technologies and further strengthen and expand our patent portfolio.

We intend to continue using an outsourced and leveraged model to maintain efficiency and manage costs as we grow our licensing business by, for example, offering incentives to early licensing targets or asserting our rights for use of our patents.

We also intend to expand our design pilot in participation with leading 5G and 4G/LTE companies (domain infrastructure providers, chipset manufacturers, service providers and others) and build our secure domain name registry.

New Accounting Pronouncements

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The amendments in this ASU simplify the accounting for income taxes by removing certain exceptions to the general principles in Topic 740.

The amendments also improve consistent application of and simplify U.S.

GAAP for other areas of Topic 740 by clarifying and amending existing guidance.

The amendments also improve consistent application of and simplify GAAP for other areas of Topic 740 by clarifying and amending existing guidance.

The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020.

We are currently evaluating the impact, if any this ASU will have on our consolidated financial statements and related disclosures.

In June 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-13, Measurement of Credit Losses on Financial Instruments, and issued subsequent amendments to the initial guidance within ASU 2019-04 and ASU 2019-05 (collectively, "ASU 2016-13").

The amendments in ASU 2016-13 replace the incurred loss impairment methodology with the current expected credit loss model, which requires consideration of a broader range of reasonable and supportable information to estimate credit losses.

The Company adopted this ASU effective January 1, 2020 and the adoption did not have a material impact.

on the Company's financial position, results of operations or cash flows.

Results of Operations

Three and Nine Months Ended September 30, 2020

Compared with Three and Nine Months Ended September 30, 2019

We adopted this ASU on January 1, 2021 with no material impact on our financial position, results of operations or cash flows.

Results of Operation

Three Months Ended March 31, 2021

Compared with the Three Months Ended March 31, 2020

(in thousands, except per share amounts)

For the three and nine months ended September 30, 2020 we recognized revenue of $26 and $302,620, respectively compared to the three and nine months ended September 30, 2019 of $4 and $50, respectively.

During the nine months ended September 30, 2020, the Company collected a lump sum payment of $454,034 from Apple, Inc.

For the three months ended March 31, 2021 and 2020, we recognized revenue of $5 and $302,576, respectively.

During the quarter ended March 31, 2020, the Company collected a lump sum payment of $454,034 from Apple, Inc.

(see “Legal Proceedings”), as a result of a favorable court decision relating to a patent infringement case.

The one-time payment includes past royalties, damages for willful infringement, interest, court costs and attorneys’ fees.

The elements of the payment were recognized in the Company’s condensed consolidated statement of operations as follow (see Note 2 in the Condensed Consolidated Financial Statements):

Classification of Payment Received in the Company’s Condensed Consolidated Statement of Operations for the Nine Months Ended September 30, 2020

The payment includes past royalties, damages for willful infringement, interest, court costs and attorneys’ fees.

The elements of the payment were recognized in the Company’s condensed consolidated statement of operations as follows:

Classification in the Company’s Condensed Consolidated

Statement of Operations for the Three Months Ended March 31,

Revenue (royalties)

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Licensing Costs

Included in operating expenses for the nine months ended September 30, 2020, is $90,101 in licensing costs we have incurred in conjunction with the proceeds received from Apple, Inc., pursuant to a favorable court decision relating to a patent infringement case.

Included in operating expenses for the three months ended March 31, 2020, is $90,101 in licensing costs accrued in conjunction with the proceeds received from Apple, Inc., pursuant to the favorable court decision relating to a patent infringement case.

Accrued licensing costs of $9,438 were reversed during the three months ended March 31, 2021, as a result of the McKool award (See Note 7 - Litigation).

Research and Development Expenses

Research and development expenses were $1,091 and $964 for the three months ended September 30, 2020 and 2019, respectively, representing an increase of $127 due primarily to an increase in staff expense.

Research and development expenses were $6,799 and $2,886 for the nine months ended September 30, 2020 and 2019, respectively, representing an increase of $3,913 due primarily to an increase in staff expense.

Our research and development expenses decreased by $753 to $1,152 for the three months ended March 31, 2021, from $1,905 for the three months ended March 31, 2020.

This decrease in 2021 was primarily due to increase in employee benefits in 2020.

Selling, General and Administrative Expenses

Selling, general and administrative expenses includes wages and benefits of management and administrative personnel, as well as outside legal, accounting, and consulting services.

Our selling, general and administrative expenses for the three months ended September 30, 2020 compared to September 30, 2019 increased by $254 to $4,270.

The change is primarily due to an increase in staff expenses.

For the nine months ended September 30, 2020 our selling, general and administrative expenses increased by $26,021 to $38,347 compared to the nine months ended September 30, 2019.

The change was primarily due to a $22,445 increase in legal fees associated with our patent infringement actions, after reflecting reimbursement of $2,114, pursuant to a judgment collected from Apple.

We expect to incur the same levels or decreased levels of legal fees over the next two quarters and expect to report losses from operations as a result.

(See “Legal Proceedings” for additional information regarding these infringement actions.)

Other Income and Expenses

For the nine months ended September 30, 2020, we recognized a gain of $41,271 and interest and other income of $108,272 which included interest received of $108,221 pursuant to a judgment collected from Apple.

For the three months ended September 30, 2020, we recognized an income tax benefit of $1,293 on loss before income taxes of $5,318, which is an effective tax rate of a 24.3%.

For the nine months ended September 30, 2020, we recognized income tax expense of $29,036 on income before income taxes of $316,916 which is an effective tax rate of 9.2%.

For the three and nine months ended September 30, 2019, we had an income tax benefit of zero and $393, respectively, due to a release of a state reserve as the statute of limitation for the tax return expired.

The effective tax rate for the 2020 nine-month period was favorably impacted by the reversal of valuation allowance reserves totaling $37,585, which were established in prior years on our deferred tax assets primarily associated with net operating loss (“NOL”) carryforwards.

For the three and nine months ended September 30, 2019, we had NOLs which generated deferred tax assets for NOL carryforwards.

During 2019, we provided valuation allowances against the net deferred tax assets including the deferred tax assets for NOL carryforwards.

At September 30, 2020, we had deferred tax assets of $8,754.

(see Note 3 in the Condensed Consolidated Financial Statements for a further discussion of income taxes)

Net Income (Loss)

Net (loss) income for the three and nine months ended September 30, 2020 was ($4,025) and $287,880, respectively.

Net losses for the three and nine months ended September 30, 2019 were ($4,956) and ($14,694), respectively.

The change is primarily due to the judgment collected from Apple associated with our patent infringement action.

Our selling, general and administrative expenses increased by $14,567 to $41,943 for the three months ended March 31, 2021, from $27,376 for the three months ended March 31, 2020.

The increase is primarily due to $38,284 disputed legal fees accrued to McKool (See Note - 7 Litigation), offset by a $22,407 decrease in attorney fees.

Gain on Settlement

For the three months ended March 31, 2020, we recorded a gain of $41,271 pursuant to the favorable court ruling in the case regarding Apple, Inc.

discussed above.

Interest and other income, net

For the three months ended March 31, 2020, we recognized interest income of $108,221 pursuant to the favorable ruling against Apple, Inc.

discussed above.

Liquidity and Capital Resources

As of September 30, 2020, our cash and cash equivalents totaled approximately $225,911 and our short-term investments totaled approximately $22,077, compared to cash and cash equivalents of approximately $3,135 and short-term investments of approximately $2,394 at December 31, 2019, respectively.

Working capital was $220,603 at September 30, 2020, and $3,945 at December 31, 2019.

The increase in cash and investments during the nine months September 30, 2020, will be sufficient to fund our current level of selling, general and administration costs, including legal expenses and provide related working capital for the foreseeable future.

As of March 31, 2021, our cash and cash equivalents totaled approximately $197,198 and our short-term investments totaled approximately $19,835, compared to cash and cash equivalents of approximately $192,908 and short-term investments of approximately $28,348 at December 31, 2020, respectively.

Working capital was $181,405 at March 31, 2021, and $214,076 at December 31, 2020.

The decrease in cash and investments during the three months ended March 31, 2021 was primarily attributed to operating expenses.

We expect that our cash and cash equivalents and short-term investments as of March 31, 2021, will be sufficient to fund our current level of selling, general and administration costs, including legal expenses and provide related working capital for the foreseeable future.

Over the longer term, we expect to derive the majority of our future revenue from license fees and royalties associated with our patent portfolio, technology, software and secure domain name registry in the United States and other markets around the world.

On May 8, 2020, we declared a one-time cash dividend to shareholders of record as of the close of business on May 18, 2020 of $1 per share of common stock, payable on May 26, 2020.

The timing and amounts of future dividends, if any, will depend on market conditions, corporate business and financial considerations and regulatory requirements.

Universal Shelf Registration Statement and ATM Offering

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We use the ATM proceeds for GABRIEL product development, marketing and general corporate purposes, which may include working capital, capital expenditures, other corporate expenses and acquisitions of complementary products, technologies or businesses.

As of September 30, 2020, common stock with an aggregate value of up to $21,964 remained available for offer and sale under the ATM agreement.

During the nine months ended September 30, 2020, we sold 1,049,382 shares under the ATM.

As of March 31, 2021, common stock with an aggregate value of up to $21,964 remained available for offer and sale under the ATM agreement.

We sold no shares under the ATM for the three months ended March 31, 2021 and 1,049,382 shares during the three months ended March 31, 2020.

The average sales price per common share was $4.41 and the aggregate proceeds from the sales totaled $4,627 during the period.

Sales commissions, fees and other costs associated with the ATM totaled $139.

No sales were made under the ATM during the three months ended September 30, 2020.

For the three months ended March 31, 2021, we recognized income tax benefit of $7,193 on a loss before income taxes of $33,636, which is an effective tax rate of 21.38%.

The effective tax rate was higher than the statutory federal income tax rate primarily due to the effect of research and development tax credits.

During the three month period ended March 31, 2021 we had net operating losses (“NOLs”) which increased our deferred tax assets by $7,196 to $16,245 for NOL carryforwards.

We continue to provide a partial allowance against California net operating loss and research credit carryovers due to the fact that we have no income in California.

For the three months ended March 31, 2020, income tax expense was $32,759 on income before taxes of $332,704 and an effective tax rate of 9.9%.

The effective tax rate for the three-month period ended March 31, 2020 was favorably impacted by the reversal of valuation allowance reserves totaling $38,112 which were established in prior years on our deferred tax assets primarily associated with net operating loss (“NOL”) carryforwards.

Contractual Obligations

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 2. Management’s Discussion and Analysis