VirnetX Holding Corp 10-Q

ITEM 1- FINANCIAL STATEMENTS. VIRNETX HOLDING CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts) As of September 30, 2022 As of December 31, 2021 ASSETS (unaudited) Current assets: Cash and cash equivalents $ 105,805 $ 142,018 Investments available for sale 53,195 27,254 Accounts receivables 20 17 Prepaid expenses and other current assets 370 203 Total current assets 159,390 169,492 Prepaid expenses and other assets 791 1,056 Property and equipment, net 13 18 Deferred tax assets 17,122 15,950 Total assets $ 177,316 $ 186,516 LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable and accrued liabilities $ 1,477 $ 338 Accrued payroll and related expenses 367 270 Accrued licensing costs — 355 Income tax liability 2 6 Other liabilities, current 54 52 Total current liabilities 1,900 1,021 Other liabilities 4 46 Total liabilities 1,904 1,067 Commitments and contingencies (Note 4) Stockholders’ equity: Preferred stock, par value $ 0.0001 per share Authorized: 10,000,000 shares at September 30 , 2022 and December 31, 2021 ; Issued and outstanding: 0 shares at September 30 , 2022 and December 31, 2021 — — Common stock, par value $ 0.0001 per share Authorized: 100,000,000 shares at September 30 , 2022 and December 31, 2021 ; Issued and outstanding: 71,424,650 shares at September 30 , 2022 and 71,232,856 at December 31, 2021 7 7 Additional paid-in capital 238,880 236,445 Accumulated deficit ( 62,972 ) ( 50,935 ) Accumulated other comprehensive loss ( 503 ) ( 68 ) Total stockholders’ equity 175,412 185,449 Total liabilities and stockholders’ equity $ 177,316 $ 186,516 See accompanying notes to condensed consolidated financial statements. 2 Index VIRNETX HOLDING CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (in thousands, except per share amounts) Three Months Ended Nine Months Ended September 30, 2022 September 30, 2021 September 30 , 2022 September 30 , 2021 Revenue $ 4 $ 4 $ 43 $ 24 Operating expense: Licensing costs — — ( 4 ) ( 9,438 ) Research and development 1,216 1,151 3,698 3,452 Selling, general and administrative 4,143 3,089 10,374 48,040 Total operating expense 5,359 4,240 14,068 42,054 Income (loss) from operations ( 5,355 ) ( 4,236 ) ( 14,025 ) ( 42,030 ) Interest and other income, net 589 10 817 36 Income (loss) before taxes ( 4,766 ) ( 4,226 ) ( 13,208 ) ( 41,994 ) Income tax (expense) benefit 486 895 1,171 5,369 Net income (loss) $ ( 4,280 ) $ ( 3,331 ) $ ( 12,037 ) $ ( 36,625 ) Basic income (loss) per share $ ( 0.06 ) $ ( 0.05 ) $ ( 0.17 ) $ ( 0.51 ) Diluted income (loss) per share $ ( 0.06 ) $ ( 0.05 ) $ ( 0.17 ) $ ( 0.51 ) Weighted average shares outstanding - basic 71,425 71,233 71,305 71,135 Weighted average shares outstanding - diluted 71,425 71,233 71,305 71,135 See accompanying notes to condensed consolidated financial statements. 3 Index VIRNETX HOLDING CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited) (in thousands) Three Months Ended Nine Months Ended September 30, 2022 September 30, 2021 September 30 , 2022 September 30 , 2021 Net income (loss) $ ( 4,280 ) $ ( 3,331 ) $ ( 12,037 ) $ ( 36,625 ) Other comprehensive income (loss): Change in unrealized gain (loss) on investments, net of tax ( 153 ) ( 3 ) ( 434 ) ( 1 ) Change in foreign currency translation, net of tax 5 — ( 1 ) ( 3 ) Total other comprehensive income (loss) ( 148 ) ( 3 ) ( 435 ) ( 4 ) Comprehensive income (loss) $ ( 4,428 ) $ ( 3,334 ) $ ( 12,472 ) $ ( 36,629 ) See accompanying notes to condensed consolidated financial statements. 4 Index VIRNETX HOLDING CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS ’ EQUITY (Unaudited) (in thousands) Three Months Ended September 30, Nine Months Ended September 30 , 2022 2021 2022 2021 Total shareholders’ equity, beginning balances $ 178,966 $ 192,799 $ 185,449 $ 224,437 Common stock and additional paid-in capital: Beginning balances 238,013 234,121 236,452 232,464 Common stock issued for options/RSUs, net — — ( 29 ) ( 196 ) Stock-based compensation 874 1,176 2,464 3,029 Ending balances 238,887 235,297 238,887 235,297 Accumulated deficit (retained earnings): Beginning balances ( 58,692 ) ( 41,308 ) ( 50,935 ) ( 8,014 ) Net (loss) income ( 4,280 ) ( 3,331 ) ( 12,037 ) ( 36,625 ) Ending balances ( 62,972 ) ( 44,639 ) ( 62,972 ) ( 44,639 ) Accumulated other comprehensive loss: Beginning balances ( 355 ) ( 14 ) ( 68 ) ( 13 ) Change in unrealized investment gain/loss, net ( 153 ) ( 3 ) ( 434 ) ( 1 ) Change in foreign currency translation, net 5 — ( 1 ) ( 3 ) Ending balances ( 503 ) ( 17 ) ( 503 ) ( 17 ) Total shareholders’ equity, ending balances $ 175,412 $ 190,641 $ 175,412 $ 190,641 See accompanying notes to condensed consolidated financial statements. 5 Index VIRNETX HOLDING CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands) Nine Months Ended September 30, 2022 2021 Cash flows from operating activities: Net (loss) income $ ( 12,037 ) $ ( 36,625 ) Adjustments to reconcile net (loss) income to cash flows from operating activities: Depreciation 5 3 Deferred tax assets ( 1,171 ) ( 5,372 ) Amortization of warrant issuance costs — 34 Stock-based compensation 2,464 3,029 Changes in assets and liabilities: Accounts receivables ( 3 ) ( 7 ) Prepaid expenses and other assets 98 169 Accounts payable 1,139 ( 407 ) Accrued payroll and related expenses 97 99 Accrued licensing costs ( 355 ) ( 9,438 ) Income tax payable ( 4 ) 2 Other liabilities ( 40 ) ( 40 ) Net cash (used in) operating activities ( 9,807 ) ( 48,553 ) Cash flows from investing activities: Purchase of property and equipment ( 11 ) Purchase of investments ( 36,737 ) ( 18,735 ) Proceeds from sale or maturity of investments 10,360 22,629 Net cash (used in) provided by investing activities ( 26,377 ) 3,883 Cash flows from financing activities: Payment of payroll taxes on vested restricted stock units ( 29 ) ( 196 ) Net cash used in financing activities ( 29 ) ( 196 ) Net change in cash and cash equivalents ( 36,213 ) ( 44,866 ) Cash and cash equivalents, beginning of period 142,018 192,908 Cash and cash equivalents, end of period $ 105,805 $ 148,042 Cash paid for income taxes $ 2 $ — See accompanying notes to condensed consolidated financial statements. 6 Index VIRNETX HOLDING CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (in thousands, except per share amounts) (Unaudited) Note 1 — Business Description and Basis of Presentation VirnetX Holding Corporation, which we refer to as “we,” “us,” “our,” “the Company” or “VirnetX,” is engaged in the business of commercializing a portfolio of patents. We derive revenue licensing technology, including GABRIEL Connection Technology™, to various original equipment manufacturers (“OEMs”), that use our technologies in the development and manufacturing of their own products within the IP-telephony, mobility, fixed-mobile convergence, and unified communications markets. We also may derive future revenue from sales of software services, including War Room™ and VirnetX Matrix™. Our portfolio of intellectual property is the foundation of our business model. We currently own approximately 205 total patents and pending applications, including 72 U.S. patents/patent applications and 133 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 areas of Smart City, Connected Car and Connected Home. The subject matter of all our U.S and foreign patents and pending applications relates generally to securing communications over the Internet and such covers all our technology and other products. Some of our issued U.S. and foreign patents expire at various times during the period from 2022 to 2034. Note 2 — Summary of Significant Accounting Policies Unaudited Interim Financial Information The accompanying Condensed Consolidated Balance Sheet as of September 30, 2022, the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2022 and 2021, the Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2022 and 2021, the Condensed Consolidated Statements of Shareholders’ Equity for the three and nine months ended September 30, 2022 and 2021, and the Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2022 and 2021 are unaudited. These unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”). In our opinion, the unaudited interim consolidated financial statements include all adjustments of a normal recurring nature necessary for the fair presentation of our financial position as of September 30, 2022, our results of operations for the three and nine months ended September 30, 2022 and 2021, and our cash flows for the nine months ended September 30, 2022 and 2021. The results of operations for interim periods are not necessarily indicative of the results to be expected for a full year. These unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2021, filed with the SEC on May 13, 2022. Use of Estimates We prepare our consolidated financial statements in accordance with U.S. GAAP. In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, and expenses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit committee of our Board of Directors. 7 Index Basis of Consolidation The consolidated financial statements include the accounts of VirnetX Holding Corporation and our wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated. Leases The Company determines if an arrangement is a lease at inception in accordance with Accounting Standards Codification (“ASC”) Topic 842. Operating lease right-of-use (“ROU”) assets are included in Prepaid expenses, and other assets on the Condensed Consolidated Balance Sheets. ROU assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at the commencement date based on the present value of lease payments over the lease term (see Note 8 – Leases). Revenue Recognition The Company derives revenue from licensing and royalty fees from contracts with customers which can span several years. We account for this revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers. A performance obligation is a promise in a contract to transfer a distinct good or service to the customer. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. Our revenue arrangements may consist of multiple-element arrangements, with revenue for each unit of accounting recognized as the product or service is delivered to the customer. With the licensing of our patents, performance obligations are generally satisfied at a point in time as work is complete when our patent rights are transferred to our customers. We generally have no further obligation to our customers regarding our technology. Certain contracts may require our customers to enter into a hosting arrangement with us and for these arrangements, revenue is recognized over time, generally over the life of the servicing contract. The Company actively monitors and enforces its intellectual property rights, including seeking appropriate compensation from third parties that utilize the Company’s intellectual property without a license. As a result, the Company may, from time to time, receive payments as part of a settlement or compensation for a patent infringement dispute. Proceeds received are allocated to each element identified in the settlement or compensation, based on the fair value of each element. Generally, settlements and compensation may include the following elements: the value of a license or royalty agreement, cost reimbursement, damages, and interest. Elements identified related to licensing and royalty are recognized as revenue. Elements identified as reimbursed costs are generally recorded as a reduction to the reported expenses. Elements identified as damages or interest are generally recorded in other income in the condensed consolidated statement of operations. Licensing Costs Included in operating expenses primarily in 2021 are licensing costs we incurred in conjunction with the proceeds received from Apple Inc., pursuant to a favorable court decision relating to a patent infringement case. Contingent Gains ASC Topic 450-30-25, Contingent Gains, prohibits recognition of contingent gains until realized. Accordingly, we do not record contingent gains ahead of such realization. Management generally considers any such gains as realized only upon the collection of cash. 8 Index Cash and Cash Equivalents We consider all highly liquid investments purchased with maturities of three months or less at the date of purchase to be cash equivalents. Our cash and cash equivalents are not subject to significant interest rate risk due to the short maturities of these investments. Investments Investments are classified as available-for-sale and are recorded at fair market value. Unrealized gains and losses are reported as other comprehensive income. Realized gains and losses are recorded in income in the period they are realized using specific identification of each security’s cost basis. We invest our excess cash primarily in highly liquid debt instruments including corporate, government and federal agency securities, with contractual maturities less than two years . By policy, we limit the amount of credit exposure to any one issuer. Property and Equipment Property and equipment are stated at historical cost, less accumulated depreciation and amortization. Depreciation and amortization are computed using the accelerated and straight-line methods over the estimated useful lives of the assets, which range from five to seven years . Repair and maintenance costs are charged to expense as incurred. Concentration of Credit Risk and Other Risks and Uncertainties Our cash and cash equivalents are primarily maintained at two major financial institutions in the United States. Deposits held with these financial institutions may exceed the amount of insurance provided on such deposits. A portion of those balances are insured by the Federal Deposit Insurance Corporation, or FDIC. During the nine months ended September 30, 2022, we had, at times, funds that were uninsured. We do not believe that we are subject to any unusual financial risk beyond the normal risk associated with commercial banking relationships. We have not experienced any losses on our deposits of cash and cash equivalents. Fair Value The carrying amounts of our financial instruments, including cash equivalents, accounts payable, and accrued liabilities, approximate fair value because of their generally short maturities. Intangible Assets We record intangible assets at cost, less accumulated amortization. Amortization of intangible assets is provided over their estimated useful lives, which can range from 3 to 15 years , on either a straight-line basis or as revenue is generated by the assets. Impairment of Long-Lived Assets We identify and record impairment losses on long-lived assets used in operations when events and changes in circumstances indicate that the carrying amount of an asset might not be recoverable, but not less than annually. Recoverability is measured by comparison of the anticipated future net undiscounted cash flows to the related assets’ carrying value. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the projected discounted future net cash flows arising from the asset. Research and Development Research and development costs include expenses paid to outside development consultants and compensation related expenses for our engineering staff. Research and development costs are expensed as incurred. 9 Index Income Taxes We account for income taxes using the asset and liability method. The asset and liability method requires the recognition of deferred tax assets and liabilities for expected future tax consequences of temporary differences that currently exist between the tax basis and financial reporting basis of our assets and liabilities. We calculate current and deferred tax provisions based on estimates and assumptions that could differ from actual results reflected on the income tax returns filed during the following years. Adjustments based on filed returns are recorded when identified in the subsequent years. The effect on deferred taxes for a change in tax rates is recognized in income in the period that the tax rate change is enacted. In assessing our deferred tax assets, we consider whether it is more likely than not that all or some portion of the deferred tax assets will not be realized. A valuation allowance is provided for deferred income tax assets when, in our judgment, based upon currently available information and other factors, it is more likely than not that all or a portion of such deferred income tax assets will not be realized. The determination of the need for a valuation allowance is based on an on-going evaluation of current information including, among other things, historical operating results, estimates of future earnings in different taxing jurisdictions and the expected timing of the reversals of temporary differences. We believe the determination to record a valuation allowance to reduce a deferred income tax asset is a significant accounting estimate because it is based, among other things, on an estimate of future taxable income in the United States and certain other jurisdictions, which is susceptible to change and may or may not occur, and because the impact of adjusting a valuation allowance may be material. In determining when to release the valuation allowance established against our net deferred income tax assets, we consider all available evidence, both positive and negative. We continually assess our ability to generate sufficient taxable income during future periods in which our deferred tax assets may be realized. If and when we believe it is more likely than not that we will recover our deferred tax assets, we will reverse the valuation allowance as an income tax benefit in our statements of operations. We account for our uncertain tax positions in accordance with U.S. GAAP, which utilizes a two-step approach to evaluate tax positions. Step one, recognition, requires evaluation of the tax position to determine if based solely on technical merits it is more likely than not to be sustained upon examination. Step two, measurement, is addressed only if a position is more likely than not to be sustained. In step two, the tax benefit is measured as the largest amount of benefit, determined on a cumulative probability basis, which is more likely than not to be realized upon ultimate settlement with tax authorities. If a position does not meet the more likely than not threshold for recognition in step one, no benefit is recorded until the first subsequent period in which the more likely than not standard is met, the issue is resolved with the taxing authority, or the statute of limitations expires. Positions previously recognized are reversed if and when we subsequently determine the position no longer is more likely than not to be sustained. Evaluation of tax positions, their technical merits, and measurements using cumulative probability are highly subjective management estimates. Actual results could differ materially from these estimates. Stock-Based Compensation We account for stock-based compensation using the fair value recognition method in accordance with U.S. GAAP. We recognize these compensation costs on a straight-line basis over the requisite service period of the award, which is generally a vesting term of 4 years . We recognize forfeitures, if any, when they occur. In addition, we record stock-based compensation expense for awards granted to non-employees at fair value of the consideration received or the fair value of the equity instruments issued, as they vest, over the performance period (See Note 5 - Stock-Based Compensation). Earnings per Share Basic earnings per share are computed by dividing earnings available to common stockholders by the weighted average number of outstanding common shares during the period. Diluted earnings per share is computed by dividing net income by the weighted average number of shares outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. 10 Index Fair Value of Financial Instruments Fair value is the price that would result from an orderly transaction between market participants at the measurement date. A fair value hierarchy prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). Level 2 measurements utilize either directly or indirectly observable inputs in markets other than quoted prices in active markets. Our financial instruments are stated at amounts that equal, or approximate, fair value. When we estimate fair value, we utilize market data or assumptions that we believe market participants would use in pricing the financial instrument, including assumptions about risk and inputs to the valuation technique. We use valuation techniques, primarily the income and market approach, which maximizes the use of observable inputs and minimize the use of unobservable inputs for recurring fair value measurements. Mutual funds: Valued at the quoted net asset value of shares held. U.S. agency and treasury securities : Fair value measured at the closing price reported on the active market on which the individual securities are traded. The following tables show the adjusted cost, gross unrealized gains, gross unrealized losses, and fair value of our securities by significant investment category as of September 30, 2022 and December 31, 2021. September 30, 2022 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Investments Available for Sale Cash $ 24,921 $ — $ — $ 24,921 $ 24,921 $ — Level 1: Mutual funds 65,437 — — 65,437 65,437 — U.S. agency securities 40,127 2 ( 312 ) 39,817 10,450 29,367 U.S. treasury securities 28,998 1 ( 174 ) 28,825 4,997 23,828 134,562 3 ( 486 ) 134,079 80,884 53,195 Total $ 159,483 $ 3 $ (486 ) $ 159,000 $ 105,805 $ 53,195 December 31, 2021 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Investments Available for Sale Cash $ 35,428 $ — $ — $ 35,428 $ 35,428 $ — Level 1: Mutual funds 106,590 — — 106,590 106,590 — U.S. agency securities 16,658 — ( 26 ) 16,632 — 16,632 U.S. treasury securities 10,646 — ( 24 ) 10,622 — 10,622 133,894 — ( 50 ) 133,844 106,590 27,254 Total $ 169,322 $ - $ (50 ) $ 169,272 $ 142,018 $ 27,254 New Accounting Pronouncements In December 2019, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2019-12 Income Taxes (Topic 740). 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 in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. We adopted this ASU on January 1, 2021 and there was no material impact on our financial position or cash flows as a result. 11 Index Note 3 — Income Taxes For the three months ended September 30, 2022, we recognized an income tax benefit of $ 486 on loss before taxes of $ 4,766 , which is an effective tax rate of 10.3 %. For the nine months ended September 30, 2022, we recognized an income tax benefit of $ 1,171 on loss before taxes of $ 13,208 which is an effective rate of 8.3 %. The effective tax rate was lower than the statutory federal income tax rate primarily due to the effect of stock-based compensation and expiring options, requiring us to reduce our deferred tax asset. During the nine months ended September 30, 2022, our deferred tax asset increased to $ 17,122 . On May 13, 2022, the Company notified the public of the restatement via Form 8-K stating the Company’s previously issued 2021 Financials because of an error in our deferred tax assets affecting the annual period covered by the financial statements. The Company determined that the nine months ended September 30, 2021 interim statements should be revised as the 2021 restatement related primarily to options expiring in second quarter 2021. The accompanying Deferred tax asset previously reported as $ 17,749 has now been reduced to $ 14,421 as of September 30, 2021. The income tax benefit for the nine months ended September 30, 2021, previously reported as $ 8,697 has been reduced to $ 5,369 . For the three months ended September 30, 2021, we recognized an income tax benefit of $ 895 on loss before taxes of $ 4,226 . For the nine months ended September 30, 2021, we recognized an income tax benefit of $ 5,369 on loss before income taxes of $ 41,994 . Income tax for the nine months was primarily affected by expiring options and research and development credits. During the nine months ended September 30, 2021, our deferred tax asset increased by $ 5,372 to $ 14,421 . A valuation allowance is provided for deferred tax assets when, in our judgment, based upon currently available information and other factors, it is more likely than not that all or a portion of such deferred income tax assets will not be realized. The determination of the need for a valuation allowance is based on an on-going evaluation of current information including, among other things, historical operating results, estimates of future earnings in different taxing jurisdictions and the expected timing of the reversals of temporary differences. We believe the determination to record, or reduce, a valuation allowance associated with a deferred income tax asset is a significant accounting estimate because it is based, among other things, on an estimate of future taxable income in the United States and certain other jurisdictions, which is susceptible to change and may or may not occur, and because the impact of adjusting a valuation allowance may be material. In determining when to release the valuation allowance established against our net deferred income tax assets, we consider all available evidence, both positive and negative. Our tax years for 2005 and forward are subject to examination by the U.S. tax authority and various state tax authorities. These years are open due to NOLs, and tax credits generated in these years were utilized in 2020. The statute of limitation for these years shall expire three years after the date of filing 2020 income tax returns. We are required to recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. At December 31, 2021 and September 30, 2022, we have no uncertain tax positions. Our policy is to recognize interest and penalties accrued on uncertain tax positions as a component of income tax expense. We had no accrued interest or penalties related to uncertain tax positions at September 30, 2022. Note 4 — Commitments and Related Party Transactions We lease our office under an operating lease with a third party which expires on October 31, 2023 (see Note 8 - Leases). We entered into a service agreement for the use of an aircraft from K2 Investment Fund LLC (“LLC”) for business travel for employees of the Company. We incurred approximately $ 268 and $ 782 compared to $ 280 and $ 454 in fees and reimbursements to the LLC during the three and nine months ended September 30, 2022 and 2021, respectively. We pay for the Company’s usage of the aircraft and have no rights to purchase. Our Chief Executive Officer and Chief Administrative Officer are the managing partners of the LLC and control the equity interests of the LLC. We entered into a 12 -month non-exclusive agreement with the LLC for use of the plane at a rate of $ 8 per flight hour, with no minimum usage requirement. The agreement contains other terms and conditions and can be cancelled by either us or the LLC with 30 days’ notice. The agreement renews on an annual basis unless terminated by either party. Neither party has exercised their termination rights. 12 Index Note 5 — Stock Based Compensation We have a stock incentive plan for employees and others called the VirnetX Holding Corporation 2013 Equity Incentive Plan (the “2013 Plan”), which has been approved by our stockholders. To the extent that any award should expire, become un-exercisable or is otherwise forfeited, the shares subject to such award will again become available for issuance under the 2013 Plan. The 2013 Plan provides for the granting of stock options and restricted stock units purchase rights (“RSUs”) to our employees and consultants. Stock options granted under the 2013 Plan may be incentive stock options or nonqualified stock options. Incentive stock options (“ISOs”) may only be granted to our employees (including officers and directors). Nonqualified stock options (“NSOs”) and stock purchase rights may be granted to our employees and consultants. The 2013 Plan expires in 2023. Options may be granted under the 2013 Plan with an exercise price determined by our Board of Directors, or a duly appointed committee thereof, provided, however, that the exercise price of an option granted to any employee shall be not less than 100 % of the fair market value at the date of grant in the case of ISOs or 85 % of the fair market value at the date of grant in the case of an NSO. The exercise price of an ISO or NSO granted to one of our Named Executive Officers shall not be less than 100 % of the fair market value of the shares at the date of grant and the exercise price of an ISO granted to a 10% shareholder shall not be less than 110 % of the fair market value of the shares on the date of grant. Stock options granted under the 2013 Plan typically vest over four years and have a 10 -year term. All RSUs are considered to be granted at the fair value of our stock on the date of grant because they have no exercise price. RSUs typically vest over four years . As of September 30, 2022, there were 1,513,345 shares available for grant under the 2013 Plan. Stock-based compensation expense included in general and administrative expense was $ 573 and $ 703 , and in research and development expense was $ 301 and $ 473 , for the three months ended September 30, 2022 and 2021, respectively. Stock-based compensation expense included in general and administrative expense was $ 1,526 and $ 1,549 , and in research and development expense was $ 938 and $ 1,480 , for the nine months ended September 30, 2022 and 2021, respectively. During the three months ended September 30, 2022, we did no t grant any options. During the three months ended September 30, 2021, we granted options for a total of 170,000 shares with a weighted average grant date fair value of $ 3.10 per option. During the nine months ended September 30, 2022, we granted options for a total of 801,004 shares with a weighted average grant date fair value of $ 1.09 per option. We estimated the fair value of the options on the date of grant utilizing the Black-Scholes valuation model with the following assumptions: (i) 0 percent dividend yield, (ii) 86 percent volatility, (iii) 3 percent risk free rate and (iv) 6 years expected term. During the nine months ended September 30, 2021, we granted options for a total of 949,500 shares with a weighted average grant date fair value of $ 3.39 per option. We estimated the fair value of the options on the date of grant utilizing the Black-Scholes valuation model with the following assumptions: (i) 0 percent dividend yield, (ii) 90 percent volatility, (iii) 1 percent risk free rate and (iv) 6 years expected term. During the three months ended September 30, 2022 and 2021, we did no t grant any RSUs. During the nine months ended September 30, 2022 and 2021, we granted 258,363 and 236,661 RSUs respectively, with weighted average fair values at the date of grant of $ 1.46 and $ 4.61 , respectively. RSUs, which are subject to forfeiture if service terminates prior to the shares vesting, are expensed ratably over the vesting period. During the nine months ended September 30, 2022 and 2021, we paid $ 29 and $ 196 in withholding taxes on shares issued upon conversion of RSUs, respectively. The underlying shares were cancelled. The amounts are reflected as financing costs in the accompanying statement of cash flows. As of September 30, 2022, the unrecognized stock-based compensation expense related to non-vested stock options and RSUs was $ 4,571 and $ 1,716 , respectively, which will be amortized over an estimated weighted average period of approximately 2.86 and 2.68 years, respectively. 13 Index During the three and nine months ended September 30, 2022, and 2021 no options were exercised. During the nine months ended September 30, 2022 and 2021, we issued 191,795 and 174,285 shares, respectively, as a result of vesting RSUs, all of which occurred in the second quarter of each respective year. During the nine months ended September 30, 2022 and 2021, there were 332,416 and 390,000 options returned to the plan due to the expiration of unexercised options, respectively. Note 6 — Equity Common Stock We issued no shares for options exercised during the three and nine months ended September 30, 2022 or 2021, respectively. No shares were issued during the three months ended September 30, 2022 or 2021 as a result of vesting RSUs. We issued 191,795 and 174,285 shares as a result of vesting RSUs during the nine months ended September 30, 2022 and 2021, respectively. Warrants In 2020, we issued warrants for the purchase of 25,000 shares of common stock at an exercise price of $ 5.75 per share, exercisable on the date of grant, expiring in April 2025 . The weighted average fair value at the grant date was $ 4.16 per warrant. The fair value at the grant date was estimated utilizing the Black-Scholes valuation model with the following weighted average assumptions (i) dividend yield on our common stock of 0 percent (ii) expected stock price volatility of 97 percent (iii) a risk-free interest rate of 0.27 percent and (iv) and expected option term of 5 years. Warrants Issued Exercise Price Outstanding and Exercisable December 31, 2021 Issued Exercised Terminated / Cancelled Outstanding and Exercisable September 30, 2022 Expiration Date 25,000 $ 5.75 25,000 — — — 25,000 April 30, 2025 Note 7 — Litigation (all dollar amounts in this section are expressed in thousands except for rates per device) We have several intellectual property infringement lawsuits pending in the United States Court of Appeals for the Federal Circuit (“USCAFC”). VirnetX Inc. v. Apple, Inc. (Case 6:12-CV-00855-LED) (“Apple II”) This case began on November 6, 2012, when we filed a complaint against Apple in United States District Court (“USDC”) in which we alleged that Apple infringed on certain of our patents, (U.S. Patent Nos. 6,502,135, 7,418,504, 7,921,211 and 7,490,151). We sought damages and injunctive relief. The accused products include the iPhone 5, iPod Touch 5th Generation, iPad 4th Generation, iPad mini, and the latest Macintosh computers. Post-trial motions hearing was held on July 18, 2018. On August 31, 2018, the USDC entered a Final Judgment and issued its Memorandum Opinion and Order regarding post-trial motions, affirming the jury’s verdict of $ 502,600 and granting VirnetX motions for supplemental damages, a sunset royalty, and the royalty rate of $ 1.20 per infringing iPhone, iPad and Mac products, pre-judgment and post-judgment interest and costs. Apple filed a notice of appeal with the United States Court of Appeals for the Federal Circuit (“USCAFC”) in the Apple II case. On October 9, 2018, USCAFC docketed the appeal as Case No. 19-1050 - VirnetX Inc. v. Apple Inc. On January 24, 2019 Apple filed its opening brief. We filed our response brief on March 1, 2019. Apple filed its reply brief on April 5, 2019. The oral arguments were heard on October 4, 2019. On November 22, 2019, the USCAFC issued an opinion affirming the district court’s findings that Apple is precluded from making certain invalidity arguments and that Apple infringed the ‘135 and ‘151 patents; reversing the USDC’s finding that Apple infringed the ‘504 and ‘211 patents; and remanding the case for proceedings on damages. Apple sought panel and en banc rehearing, which the USCAFC denied on February 10, 2020. 14 Index On February 22, 2020, the USDC issued a scheduling order for the parties to brief the court about the need for a new trial for recalculating the damages. We filed our motion for entry of judgment on February 28, 2020. The arguments on this matter were heard on April 14, 2020. In its order, unsealed on May 1, 2020, the USDC denied VirnetX’s motion for entry of a new judgment based on the prior jury verdict and ordered a new jury trial on damages. On August 10, 2020, the USDC granted Apple’s motion for continuance and reset the date to October 26, 2020. On October 30, 2020, a jury returned a $ 502,800 verdict in favor of VirnetX based on Apple’s infringement of two network security patents: VirnetX US Patents No. 6,502,135 and No. 7,490,151. The jury verdict called for damages of $ 0.84 per accused device since the 2013 launch of Apple’s iOS 7 operating system and represents 598,629,580 infringing units from US sales only. On January 15, 2021, the district court denied Apple’s motion for judgment as a matter of law, and on February 4, 2021, Apple filed a notice of appeal to the USCAFC. On February 22, 2021, USCAFC docketed the appeal as Case No. 19-1672. Apple’s opening brief was filed on June 2, 2021. VirnetX filed its responsive brief on July 26, 2021. Apple filed its reply brief on September 13, 2021. The briefing is complete, and oral arguments were held on September 8, 2022. We are currently waiting for the USCAFC ruling. VirnetX Inc. v. Mangrove Partners Master Fund, Ltd., Apple Inc. (USCAFC Case 20-2271) and VirnetX Inc. v. Mangrove Partners Master Fund, Ltd., Apple Inc., and Black Swamp, LLC (USCAFC Case 20-2272) On September 15, 2020, we filed with the USCAFC an appeal of the invalidity findings by the Patent Trial and Appeal Board (“PTAB”) in inter-partes review proceedings IPR2015-01046 and IPR2016-00062 involving our U.S. Patent No. 6,502,135, and an appeal of the invalidity findings by the PTAB in inter-partes review proceedings IPR2015-1047, IPR2016- 00063, and IPR2016-00167 involving our U.S. Patent No. 7,490,151. On September 25, 2020, the USCAFC issued an order consolidating the two appeals. On December 15, 2020, we filed a motion to vacate the PTAB decisions below and to remand these appeals to the PTAB. On March 16, 2021, the USCAFC denied the motion without prejudice to us raising the challenges made in the motion in our opening brief. Our opening brief was filed on June 7, 2021. On June 23, 2021, the USCAFC entered an order directing us (and parties in other appeals that raised Appointments Clause challenges) to file a brief explaining how they believe their cases should proceed in light of the Supreme Court’s decision in United States v. Arthrex, Inc., 141 S. Ct. 1970 (2021). On July 7, 2021, we filed a brief in response to the court’s order. Other parties, including the U.S. Patent and Trademark Office (“USPTO”) filed their responses on July 21, 2021. On August 19, 2021, USCAFC issued an order remanding these appeals for the limited purpose of allowing VirnetX the opportunity to request rehearing of the PTAB’s final written decisions by the Director of the USPTO. The USCAFC retained jurisdiction over the appeals in the meantime. On September 20, 2021, we filed our requests for Director rehearing with the USPTO. On October 29, 2021, our requests for Director rehearing were denied. We subsequently filed an amended opening brief to the USCAFC on December 10, 2021, the other parties filed response briefs on February 2, 2022, and we filed a reply brief on February 22, 2022. All the briefings have been completed. The oral arguments in this matter were held on September 8, 2022. We are currently waiting for the USCAFC ruling. VirnetX Inc. v. Hirshfeld (USCAFC Case 17-2593, -2594) On September 22, 2017, we filed with the USCAFC an appeal of the invalidity findings by the PTAB in inter-partes review proceeding IPR2016-00693 involving our U.S. Patent No. 7,418,504, and an appeal of the invalidity findings by the PTAB in inter-partes review proceeding IPR2016-00957 involving our U.S. Patent No. 7,921,211. On September 16, 2021, USCAFC issued an order remanding these appeals for the limited purpose of allowing VirnetX the opportunity to request rehearing of the PTAB’s final written decisions by the Director of the USPTO. The USCAFC retained jurisdiction over the appeals in the meantime. On October 18, 2021, we filed our requests for Director rehearing with the USPTO. On January 7, 2022, our requests for Director rehearing were denied. On January 21, 2022, we informed the USCAFC about the denial of Director rehearing and requested that the court dismiss the appeal involving IPR2016-00957 as moot and vacate the PTAB’s underlying decision. On April 4, 2022, the USCAFC vacated the PTAB’s decision in IPR2016-00957 and remanded Appeal No. 17-2594 with instructions to dismiss. In the April 4, 2022 order, the USCAFC further set a briefing schedule, in Appeal No. 17-2593. VirnetX filed its opening brief on September 12, 2022. The USPTO’s response brief is currently due December 2, 2022. 15 Index VirnetX Inc. v. Cisco Systems, Inc. (USCAFC Case 19-1671) On March 18, 2019, we filed with the USCAFC an appeal of the invalidity findings by the PTAB in inter-partes re-examination proceeding 95/001,679 involving our U.S. Patent No. 6,502,135. On October 5, 2021, USCAFC issued an order remanding these appeals for the limited purpose of allowing VirnetX the opportunity to request rehearing of the PTAB’s final written decisions by the Director of the PTO. The USCAFC retained jurisdiction over the appeals in the meantime. Our request for Director rehearing with the PTO was filed on November 5, 2021. On January 10, 2022, our request for Director rehearing was denied. We informed the USCAFC about the denial of Director rehearing. VirnetX’s opening brief was filed on June 23, 2022. The USPTO’s response brief was filed on August 2, 2022, and Cisco’s response brief was filed on September 2, 2022. VirnetX filed its reply brief on October 7, 2022, and we currently await scheduling of oral arguments. VirnetX Inc. v. Apple Inc. (USCAFC Case 22-1523) (“Apple Reexam I”) On March 10, 2022, we filed with the USCAFC an appeal of the invalidity findings by the PTAB in inter-partes re-examination proceeding 95/001,682 involving our U.S. Patent No. 6,502,135. Our opening brief was filed on August 22, 2022. Apple’s response brief is currently due November 17, 2022. VirnetX Inc. v. Apple Inc. (USCAFC C ase 22 - 1997 ) (“Apple Reexam II”) On July 6, 2022, we filed with the USCAFC an appeal of the invalidity findings by the PTAB in inter-partes re-examination proceeding 95/001,697 involving our U.S. Patent No. 7,490,151. On October 17, 2022, we filed a motion to remand the appeal in light of the PTAB’s refusal to permit Director rehearing . VirnetX Inc. v. Cisco Systems, Inc. (USCAFC Case 22-2234) On September 16, 2022, we filed with the USCAFC an appeal of the invalidity findings by the PTAB in inter-partes re-examination proceeding 95/001,851 involving our U.S. Patent No. 7,418,504. Our opening brief is currently due December 30, 2022 . McKool Smith P.C. v. VirnetX, Inc., AAA Case No. 01-20-0003-7975 On March 23, 2020, the law firm of McKool Smith, P.C. (“McKool”) filed a Demand for Arbitration against VirnetX, Inc. with the American Arbitration Association (“AAA”). In its demand, McKool claimed that a retention agreement it entered into in 2010 with VirnetX entitled it to a contingency fee arising from the recent 2020 payment made in the Apple I case. McKool claimed it was owed approximately $ 36,300 (or 8 % of the Apple I payment). We filed a general response with the AAA denying McKool’s claim and contested the matter vigorously. An evidentiary hearing was held on the matter during the week of February 22, 2021 and the parties submitted additional briefings. On April 19, 2021, the arbitrator awarded McKool $ 36,323 in damages, plus pre-judgment interest in the amount of 5 % simple interest from March 23, 2020 to April 18, 2021, and post-judgment interest in the amount of 5 %, compounded annually, until payment of the award. We accrued the resulting $ 38,284 as of March 31, 2021 and paid that amount to McKool on April 20, 2021. This matter is now closed. Other Legal Matters One or more potential intellectual property infringement claims may also be available to us against certain other companies who have the resources to defend against any such claims. Although we believe these potential claims are likely valid, commencing a lawsuit can be expensive and time-consuming, and there is no assurance that we could prevail on such potential claims if we made them. In addition, bringing a lawsuit may lead to potential counterclaims which may distract our management and our other resources, including capital resources, from efforts to successfully commercialize our products. Currently, we are not a party to any other pending legal proceedings and are not aware of any proceeding threatened or contemplated against us. 16 Index Note 8 — Leases We lease office space under an operating lease which expires on October 31, 2023. On September 30, 2022, the underlying ROU asset and lease liability totaled $ 58 . On December 31, 2021, the underlying ROU asset and lease liability totaled $ 98 . For the three and nine months ended September 30, 2022, lease expense totaled $ 13 and $ 40 , respectively. For the three and nine months ended September 30, 2021, the lease expense totaled $ 14 and $ 42 , respectively. We also lease a facility for corporate promotional and marketing purposes which was prepaid at inception and expires in 2025, as amended. On September 30, 2022 and December 31, 2021, the ROU asset totaled $ 724 and $ 948 , respectively. For the three and nine months ended September 30, 2022, lease expense totaled $ 75 and $ 224 , respectively. For the three and nine months ended September 30, 2021, lease expense totaled $ 75 and $ 225 , respectively. Note 9 — Earnings Per Share Basic earnings per share are based on the weighted average number of common shares outstanding for the period. Diluted earnings per share are based on the weighted average number of common shares and potentially dilutive common shares outstanding. Potential common shares outstanding principally include stock options, RSUs and warrants, excluding any potentially dilutive shares convertible at a price higher than the closing price of our stock at the end of each reporting period. The following table shows the computation of basic and diluted earnings per share for the three and nine months ended September 30, 2022 and 2021 (in thousands, except per share amounts): Three Months Ended Nine Months Ended September 30, September 30 , 2022 2021 2022 2021 Numerator: Net (loss) income $ ( 4,280 ) $ ( 3,331 ) $ ( 12,037 ) $ ( 36,625 ) Denominator: Weighted-average basic shares outstanding 71,425 71,233 71,305 71,135 Effect of dilutive securities — — — — Weighted-average diluted shares 71,425 71,233 71,305 71,135 Basic (loss) earnings per share $ ( 0.06 ) $ ( 0.05 ) $ ( 0.17 ) $ ( 0.51 ) Diluted (loss) earnings per share $ ( 0.06 ) $ ( 0.05 ) $ ( 0.17 ) $ ( 0.51 ) We incurred a net loss for the three and nine months ended September 30, 2022 and 2021; therefore, all potentially dilutive securities representing shares of common stock ( 7,443,130 in 2022 and 6,906,176 in 2021) were excluded from the computation of diluted earnings per share, because their effect would have been antidilutive. Note 10 — Subsequent Events None 17 Index