AUDIOEYE INC - Quarter Report: 2017 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2017

For the transition period from [                     ] to [                     ]

Commission file number 333-177463 

AudioEye, Inc.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code:  866-331-5324

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the last 90 days. Yes x   No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x     No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

As of November 14, 2017, 130,262,723 shares of the registrant’s common stock were issued and outstanding

PART I — FINANCIAL INFORMATION

Item 1.  Financial Statements

The financial information set forth below with respect to the financial statements as of September 30, 2017 and 2016 and for the three and nine month periods ended September 30, 2017 and 2016 is unaudited. This financial information, in the opinion of our management, includes all adjustments consisting of normal recurring entries necessary for the fair presentation of such data. The results of operations for the three and nine month periods ended September 30, 2017 are not necessarily indicative of results to be expected for any subsequent period. Our fiscal year end is December 31.

AUDIOEYE, INC.

CONSOLIDATED BALANCE SHEETS

(unaudited)

See Notes to Unaudited Consolidated Financial Statements

AUDIOEYE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

See Notes to Unaudited Consolidated Financial Statements

AUDIOEYE, INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS' (DEFICIT) EQUITY

NINE MONTHS ENDED SEPTEMBER 30, 2017

(unaudited)

See Notes to Unaudited Consolidated Financial Statements

AUDIOEYE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

See Notes to Unaudited Consolidated Financial Statements

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

NOTE 1: ORGANIZATION AND BASIS OF PRESENTATION

The accompanying unaudited interim financial statements of AudioEye, Inc. and its wholly-owned subsidiary (collectively, the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America and the rules of the Securities and Exchange Commission, and should be read in conjunction with the audited financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 30, 2017.

In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. Notes to the financial statements that would substantially duplicate the disclosures contained in the audited financial statements for the year ended December 31, 2016 as reported in the Company’s Annual Report on Form 10-K have been omitted.

Corporate Information and Background

AudioEye, Inc. was formed as a Delaware corporation on May 20, 2005. The Company focuses on providing its customers with the most complete and inclusive web accessibility solution available. The Company’s suite of technologies allows its customers to provide their site visitors with an enhanced web experience. When implemented, the Company believes its solutions offer businesses the opportunity to reach more customers, improve brand image, and build additional brand loyalty. In addition, the Company’s solutions provide organizations with the ability to comply with internationally accepted web content accessibility guidelines (WCAG) as well as United States, Canadian and United Kingdom accessibility laws.

Revenue Recognition

Revenue is recognized when all applicable recognition criteria have been met, which generally include (a) persuasive evidence of an existing arrangement; (b) fixed or determinable price; (c) delivery has occurred or service has been rendered; and (d) collectability of the sales price is reasonably assured. For software and technology development contracts the Company recognizes revenues on a percentage of completion method based upon several factors including but not limited to (a) estimate of total hours and milestones to complete; (b) total hours completed; (c) delivery of services rendered; (d) change in estimates; and (e) collectability of the contract.

The Company had two major customers including their affiliates which generated approximately 30% (20% and 10%) of its revenue in the three months ended September 30, 2017.

The Company had two major customers including their affiliates which generated approximately 29% (18% and 11%) of its revenue in the nine months ended September 30, 2017.

At September 30, 2017, the Company had four customers representing 44%, 17%, 14% and 12% (an aggregate of approximately 87%) of the outstanding accounts receivable.

Certain Software as a Service (SaaS) are prepared and invoiced on an annual basis. Any funds received for services not provided yet are held in deferred revenue, and are recorded as revenue when earned.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include the fair value of the Company’s stock, stock-based compensation, fair values relating to derivative liabilities, debt discounts and the valuation allowance related to deferred tax assets. Actual results may differ from these estimates.

Stock based compensation

The Company measures the cost of services received in exchange for an award of equity instruments based on the fair value of the award. For employees and directors, the fair value of the award is measured on the grant date and for non-employees the fair value of the award is generally re-measured on vesting dates and interim financial reporting dates until the service period is complete. The fair value amount is then recognized over the period during which services are required to be provided in exchange for the award, usually the vesting period. Stock-based compensation expense is recorded by the Company in the same expense classifications in the consolidated statements of operations, as if such amounts were paid in cash.

Derivative Instrument Liability

The Company accounts for derivative instruments in accordance with ASC 815, which establishes accounting and reporting standards for derivative instruments and hedging activities, including certain derivative instruments embedded in other financial instruments or contracts and requires recognition of all derivatives on the balance sheet at fair value, regardless of hedging relationship designation. Accounting for changes in fair value of the derivative instruments depends on whether the derivatives qualify as hedging relationships and the types of relationships designated are based on the exposures hedged. At September 30, 2017 and December 31, 2016, the Company did not have any derivative instruments that were designated as hedges.

On October 9, 2015, the Company issued convertible promissory notes representing $2,500,000 in aggregate principal together with warrants exercisable for up to 25,000,000 shares of the Company’s common stock. The warrants have a strike price of $0.10 and term of 5 years. Also, on April 11, 2017, pursuant to the terms of the purchase agreement entered into in connection with the convertible promissory notes and warrants issued on October 9, 2015, the Company issued an additional $50,000 convertible promissory note together with warrants exercisable for up to 500,000 shares of the Company’s common stock on the same terms and conditions as the convertible promissory notes and warrants issued by the Company on October 9, 2015.

In addition, in 2016 and the nine months ended September 30, 2017, in connection with the sale of the Company’s common stock, the Company issued warrants exercisable for up to 1,792,000 shares of the Company’s common stock. The warrants have a strike price of $0.25 and a term of 5 years.

In accordance with ASC 815, these outstanding warrants are deemed to be derivatives. The value of the derivative instrument will fluctuate with the price of the Company’s common stock and is recorded as a current liability on the Company’s Consolidated Balance Sheets. The change in the value of the liability is recorded as “unrealized gain (loss) on derivative liability” on the Consolidated Statements of Operations. This is a non-cash income (expense) item and is adjusted in the “operating activities” of the Consolidated Statements of Cash Flow. At September 30, 2017 and December 31, 2016, the derivative liability was stated at $3,258,208 and $3,478,626, respectively. The change in fair value of $131,855 was driven by the increased value of the Company’s common stock in the period and recorded as the “Gain on change in derivative liability” in the Consolidated Statements of Operations for the nine months ended September 30, 2017. As the warrants are exercised or expire, the derivative liability will be adjusted on the balance sheet and an adjustment will be reflected in stockholders equity under additional paid-in capital.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

Earnings per Share

Basic earnings per share is calculated by dividing net income (loss) available to common stockholders by the weighted average number of shares of the Company’s common stock outstanding during the period. “Diluted earnings per share” reflects the potential dilution that could occur if our share-based awards and convertible securities were exercised or converted into common stock. The dilutive effect of our share-based awards is computed using the treasury stock method, which assumes all share-based awards are exercised and the hypothetical proceeds from exercise are used to purchase common stock at the average market price during the period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they would have been dilutive, are included in the denominator of the diluted EPS calculation. The dilutive effect of our convertible preferred stock and convertible debentures is computed using the if-converted method, which assumes conversion at the beginning of the year.

The following represents a reconciliation of the numerators and denominators of the basic and diluted earnings per share computation for the three and nine months ended September 30, 2017 and 2016

As of September 30, 2017 and 2016, common stock equivalents relating to convertible debt and preferred stock were not included in the denominators of the diluted earnings per share as their effect would be anti-dilutive.

Fair Value Measurements

Fair value is an estimate of the exit price, representing the amount that would be received to upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants (i.e., the exit price at the measurement date). Fair value measurements are not adjusted for transaction cost. Fair value measurement under generally accepted accounting principles provides for use of a fair value hierarchy that prioritizes inputs to valuation techniques used to measure fair value into three levels: 

Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2: Inputs other than quoted market prices that are observable, either directly or indirectly, and reasonably available. Observable inputs reflect the assumptions market participants would use in pricing the asset or liability and are developed based on market data obtained from sources independent of the Company.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

Level 3: Unobservable inputs reflect the assumptions that the Company develops based on available information about what market participants would use in valuing the asset or liability.

An asset or liability’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. Availability of observable inputs can vary and is affected by a variety of factors. The Company uses judgment in determining fair value of assets and liabilities and Level 3 assets and liabilities involve greater judgment than Level 1 and Level 2 assets or liabilities.

In October and November 2015 and April 2017, the Company issued warrants with an exercise price of $0.10 in connection with a convertible debt instruments. The five year warrants also contain a provision that the warrant exercise price will automatically be adjusted for any common stock equity issuances at less than $0.10 per share. The Company determined that the warrants were not afforded equity classification because the warrants are not considered to be indexed to the Company’s own stock due to the anti-dilution provision. Accordingly, the warrants are treated as a derivative liability and are carried at fair value.

The Company estimated the fair value of these derivative warrants at initial issuance and again at each balance sheet date. The changes in fair value are recognized in earnings in the Consolidated Statements of Operations under the caption “unrealized gain/(loss) – derivative liability” until such time as the derivative warrants are exercised or expire. The Company used the Black-Scholes Option Pricing model to estimate the fair value as of the dates of issuance, the price of the Company stock ranged $0.031 to $0.187, volatility was estimated to be 102% to 172%, the risk free rate ranged 1.14% to 1.79% and the remaining term was 5 years.

In 2016 and the nine months ended September 30, 2017, the Company issued warrants with an exercise price of $0.25 in connection with the sale of the Company’s common stock. The five year warrants also contain a provision that the warrant exercise price will automatically be adjusted for any common stock equity issuances at less than $0.25 per share. The Company determined that the warrants were not afforded equity classification because the warrants are not considered to be indexed to the Company’s own stock due to the anti-dilution provision. Accordingly, the warrants are treated as a derivative liability and are carried at fair value.

The Company estimated the fair value of these derivative warrants at initial issuance and again at each balance sheet date. The changes in fair value are recognized in earnings in the Consolidated Statements of Operations under the caption “unrealized gain/(loss) – derivative liability” until such time as the derivative warrants are exercised or expire. The Company used the Black-Scholes Option Pricing model to estimate the fair value and as of the dates of issuance, the price of the Company stock ranged $0.152 to $0.195, volatility was estimated to be from 169% to 178%, the risk free rate ranged 1.22% to 1.87% and the remaining term was 5 years. The estimated initial fair value of these warrants of $280,777 during 2016 and $6,062 during the nine months ended September 30, 2017 was reclassified from equity to liability at the date of issuance.

On May 2, 2017, a warrant holder exercised a warrant to acquire 1,000,000 shares of the Company’s common stock under a cashless provision. The Company used the Black-Scholes Option Pricing model to estimate the fair value and as of the date of exercise, the price of the Company stock was $0.20, volatility was estimated at 171%, the risk free rate of 1.45% and the remaining term was 3.4 years. The estimated fair value of the warrant of $184,569 was reclassified from liability to equity at the date of exercise.

At September 30, 2017, the price of the Company stock was $0.1405, volatility was estimated to be 166.7%, the risk free rate from 1.62% to 1.92% and the remaining term ranged from 3.02 to 4.53 years. As of September 30, 2017, the fair value of the warrants was determined to be $3,258,208, resulting in an unrealized gain on the change in the fair value of this derivative liability of $1,086,044 and $131,855 for the three and nine months ended September 30, 2017, respectively.

The following are the Company’s assets and liabilities, measured at fair value on a recurring basis, as of September 30, 2017 and December 31, 2016:

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

Recent Accounting Pronouncements

In July 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480), Derivatives and Hedging (Topic 815). The amendments in Part I of this ASU change the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features. When determining whether certain financial instruments should be classified as liabilities or equity instruments, a down round feature no longer precludes equity classification when assessing whether the instrument is indexed to an entity’s own stock. The amendments also clarify existing disclosure requirements for equity-classified instruments. As a result, a freestanding equity-linked financial instrument (or embedded conversion option) no longer would be accounted for as a derivative liability at fair value as a result of the existence of a down round feature. For freestanding equity classified financial instruments, the amendments require entities that present earnings per share (EPS) in accordance with Topic 260 to recognize the effect of the down round feature when it is triggered. That effect is treated as a dividend and as a reduction of income available to common shareholders in basic EPS. Convertible instruments with embedded conversion options that have down round features are now subject to the specialized guidance for contingent beneficial conversion features (in Subtopic 470-20, Debt—Debt with Conversion and Other Options), including related EPS guidance (in Topic 260). The amendments in Part II of this ASU, recharacterizes the indefinite deferral of certain provisions of Topic 480 that now are presented as pending content in the Codification, to a scope exception.

Those amendments do not have an accounting effect. For public business entities, the amendments in Part I of this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted for all entities, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The Company anticipates early adoption of this pronouncement effective January 1, 2018. Such early adoption would result in the reclassification of the December 31, 2017 fair values of our outstanding warrants liabilities to equity.

There are various other updates recently issued, most of which represented technical corrections to the accounting literature or application to specific industries and are not expected to a have a material impact on the Company's financial position, results of operations or cash flows.

NOTE 2 – MANAGEMENT’S LIQUIDITY PLANS

As of September 30, 2017, the Company had cash of $1,562,115 and a working capital deficit of $2,750,609, principally due to the inclusion of non-cash derivative liability recorded in current liabilities. Excluding the derivative liability, the Company’s working capital would have been $507,599. In addition, the Company used actual net cash in operations of $1,121,558 during the nine months ended September 30, 2017.

During the nine months ended September 30, 2017, the Company sold shares of common stock and warrants and received common stock subscriptions for net proceeds, after commissions and other costs, of $1,500,000. In addition, in April 2017, the Company issued a convertible promissory note for net proceeds of $50,000. It is anticipated that the Company has cash sufficient to fund operations through October 2018.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

The Company expects that cash used in operations will decrease significantly over the next several years as the Company executes its business plan. In the event that the Company is not able to fully achieve its plan, the Company may need to raise additional funds through equity or debt financing. If the Company is unsuccessful in raising additional financing, it will need to reduce costs and operations in the future.

NOTE 3 – PROPERTY AND EQUIPMENT

Property and equipment as of September 30, 2017 and December 31, 2016 is summarized as follows:

Property and equipment are stated at cost and depreciated using the straight-line method over their estimated useful life of 3 years. When retired or otherwise disposed, the related carrying value and accumulated depreciation are removed from the respective accounts and the net difference less any amount realized from disposition, is reflected in earnings.

The Company spent $22,904 in purchase of equipment during nine months ended September 30, 2017. Depreciation expense was $1,718 and $2,979 for the three and nine months ended September 30, 2017, respectively; and $0 for the three and nine months ended September 30, 2016.

NOTE 4 — RELATED PARTY TRANSACTIONS

Dr. Carr Bettis, Executive Chairman and Chairman of Board of Directors

As of September 30, 2017 and December 31, 2016, the Company owed Dr. Bettis $5,992 and $20,575, respectively in accrued salary. In addition, AudioEye sub-leases office space in Scottsdale, Arizona for certain Company employees, including Todd Bankofier, CEO, from Verus Analytics, Inc, a company in which Dr. Bettis has a controlling interest. As the Company has taken on more employees and space, the sub-lease amount increased from $500 per month to $1,084 per month totaling $3,252 and $8,004 for the three and nine months ended September 30, 2017, respectively; and $1,500 and $4,500 for the three and nine months ended September 30, 2016. The amount of $0 was due as of September 30, 2017 and December 31, 2016. At September 30, 2017 and December 31, 2016, respectively an estimated $8,000 was due and accrued to Dr. Bettis for unreimbursed travel related expenses.

Sean Bradley, President, Chief Technology Officer, and Secretary

As of September 30, 2017 and December 31, 2016, the Company owed Sean Bradley $3,543 in accrued salary. 

Other

The Company holds 60,000 shares in Peartrack Security Systems, formerly Ecologic Transportation, as of September 30, 2017, resulting from the conversion of a $60,000 accounts receivable balance in 2014. Peartrack Security Systems is an entity whose Executive Chairman was former Company director, Edward Withrow III.

In summary, as of September 30, 2017 and December 31, 2016, the total balances of related party payables were $17,535 and $32,118, respectively.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

NOTE 5 — INTANGIBLE ASSETS

For the nine months ended September 30, 2017, the Company invested in software development and patents in the amounts of $234,841 and $42,007 for the nine months ended September 30, 2016, respectively.

Prior to December 31, 2015, patents, technology and other intangibles with contractual terms were generally amortized over their estimated useful lives of ten years. When certain events or changes in operating conditions occur, an impairment assessment is performed and lives of intangible assets with determinable lives may be adjusted.

Software development costs are amortized over their estimated useful life of three years.

Prior to any impairment adjustment, intangible assets consisted of the following:

Amortization expense for patents totaled $93,648 and $278,878 for the three and nine months ended September 30, 2017, respectively; and $94,209 and $281,064 for the three and nine months ended September 30, 2016, respectively. Amortization expense for software development totaled $48,295 and $155,213 for the three and nine months ended September 30, 2017, respectively; and $56,119 and $147,637 for the three and nine months ended September 30, 2016, respectively.

Total amortization expense totaled $434,091 and $428,701 for the nine months ended September 30, 2017 and 2016, respectively.

NOTE 6 — NOTES PAYABLE

As of September 30, 2017 and December 31, 2016, the Company has short term and long term notes payable of $5,800 and $15,751 and $23,800 and $0, respectively as shown in the table below. 

Maryland TEDCO

As of December 31, 2012, the Company had an outstanding loan to a third party in the amount of $74,900, which was originally issued during 2006 as part of an Investment Agreement. The loan was unsecured and bore interest at 25% per year for four years. The Company had accrued interest of $74,900, which was included in accounts payable and accrued expenses on the consolidated balance sheets. The note was in default until October 24, 2011, at which time the Company entered into a Termination and Release Agreement (“Release”) with the third party.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

The terms of the Release, among other things, terminated the Investment Agreement between the parties, and required the Company to issue a Promissory Note to the third-party in the combined amount of principal and accrued interest to date, for a total principal amount of $149,800. The note is interest free, and is payable in monthly installments of $2,000 beginning November 1, 2011. As of September 30, 2017 and December 31, 2016, the principal amount owing was $5,800 and $23,800, respectively, all of which is current. The Company has paid $18,000 for the nine months ended September 30, 2017.

Convertible Secured Note

On April 11, 2017, the Company issued a convertible promissory note in the principal amount of $50,000 (the “Note”) and warrant (the “Warrant”) to purchase 500,000 shares of common stock of the Company. The Note and Warrant were issued in connection with an election granted under our October 9, 2015 Note and Warrant Purchase Agreement (the “October 2015 Purchase Agreement”) whereby any investor in the October 2015 Purchase Agreement within the three-year period immediately following the initial closing date, may purchase an additional note in the principal amount equal to 50% of the principal amount of the initial note purchased by such investor at previous closings and an additional warrant with an aggregate exercise price equal to such investor’s the principal amount of such additional note.

The Note bears interest at 10% and matures the earlier of October 9, 2018 or after the occurrence an event of default (as defined in the Note). In the event of any conversion, all interest shall be also converted into equity and shall not be payable in cash.

If the Company sells equity securities in a single transaction or series of related transactions for cash of at least $1,000,000 (excluding the conversion of the Note and excluding the shares of common stock to be issued upon exercise of the warrants) on or before the maturity date, all of the unpaid principal on the Note plus accrued interest shall be automatically converted at the closing of the equity financing into a number of shares of the same class or series of equity securities as are issued and sold by the Company in such equity financing (or a class or series of equity securities identical in all respects to and ranking pari passu with the class or series of equity securities issued and sold in such equity financing) as is determined by dividing (i) the principal and accrued and unpaid interest amount of the Note by (ii) 60% of the price per share at which such equity securities are issued and sold in such equity financing.

The Warrant is exercisable at $0.10 per share and expires 5 years following the date of issuance. The Warrant is subject to anti-dilution protection, subject to certain customary exceptions.

The estimated fair value of the issued warrant of $89,944 was charged as a debt discount up to the net proceeds of the note ($50,000) and the excess ($39,944) recorded as current period interest expense. The Company amortized $8,425 and $15,751 of the debt discount to current period operations as interest expense for the three and nine months ended September 30, 2017.

NOTE 7 — STOCKHOLDERS’ EQUITY

As of September 30, 2017 and December 31, 2016, the Company had 112,564,118 and 111,512,001 shares of common stock issued and outstanding, respectively, and the Company had 160,000 shares of Series A Convertible Preferred Stock issued at $10 per share, paying a 5% cumulative annual dividend and convertible at 0.1754 per share of common stock.

In January 2017, the Company sold 357,143 shares of common stock of the Company and 40,000 warrants to purchase the Company’s common stock to an accredited investor for net proceeds of $50,000.  The warrants have a term of five years, an exercise price of $0.25 per share and are subject to anti-dilution protection, as defined.

In January 2017, the Company issued 41,666 shares of its common stock in payment for consulting services at a fair value of $6,625.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

In February 2017, the Company issued 41,666 shares of its common stock in payment for consulting services at a fair value of $5,333.

In March 2017, the Company issued 41,666 shares of its common stock in payment for consulting services at a fair value of $5,917.

In April 2017, the Company issued 41,674 shares of its common stock in payment for consulting services at a fair value of $7,126.

In May 2017, the Company issued 528,302 shares of its common stock upon the cashless exercise of outstanding warrants to purchase 1,000,000 shares of common stock.

In September 2017, the Company received proceeds of $1,450,000 in common stock subscription for the sale of 10,714,286 common shares at $0.14 per share.

Options

As of September 30, 2017 and December 31, 2016, the Company has outstanding options to purchase 26,277,057 and 25,731,207 shares of common stock, respectively.

On January 17, 2017, the Company granted 100,000 options, which vest 50% after one year and 2.08% every month thereafter, have an exercise price of $0.159, and expire on January 17, 2022. The value on the grant date of the options was $11,119.

On March 10, 2017, the Company granted 100,000 options, which vest 50% after one year and 2.08% every month thereafter, have an exercise price of $0.145, and expire on March 10, 2022. The value on the grant date of the options was $12,541.

On July 10, 2017, the Company granted 1,250,000 employee options (including 1,000,000 of which to a board director) with an exercise price of $0.166 per share and expiration date five years from the date of grant, of which 1,000,000 options vested immediately and 250,000 options vest 50% after approximately nine months, with an additional 4.17% vesting every month thereafter.

Option grants during the nine months ended September 30, 2017 were valued using the Black-Scholes pricing model. Significant assumptions used in the valuation include expected term of 2.50 to 3.50 years, expected volatility of 169.46% to 175.56%, risk free interest rate of 1.42% to 1.66%, and expected dividend yield of 0%.

For the three and nine months ended September 30, 2017 and 2016, total stock compensation expense related to the options totaled $78,746 and $503,779 and $166,111 and $706,230, respectively.

The outstanding unamortized stock compensation expense related to options was $166,086 (which will be recognized through March 2020) as of September 30, 2017.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

Warrants

Below is a table summarizing the Company’s outstanding warrants as of September 30, 2017 and December 31, 2016:

In January 2017, the Company issued 40,000 warrants with an exercise price of $0.25 in connection with the sale of the Company’s common stock. The five-year warrants also contain a provision that the warrant exercise price will automatically be adjusted for any common stock equity issuances at less than $0.25 per share.

In January 2017, in exchange for services rendered, the Company issued 250,000 warrants to purchase shares of the Company’s common stock with an exercise price of $0.12 per share that vested immediately. The fair value on the grant date of the warrants was $29,433.

In April 2017, the Company issued 500,000 warrants with an exercise price of $0.10 in connection with issuance of a convertible note. The-five year warrants also contain a provision that the warrant exercise price will automatically be adjusted for any common stock equity issuances at less than $0.10 per share. (Note 6)

The warrant grants for services during the nine months ended September 30, 2017 were valued using the Black-Scholes pricing model. Significant assumptions used in the valuation include expected term of 3.0 years, expected volatility of 175.64%, risk free interest rate of 1.48%, and expected dividend yield of 0%.

For the three and nine months ended September 30, 2017 and 2016, the Company has incurred warrant-based expense of $12,762 and $71,545 and $58,599 and $206,722, respectively. The outstanding unamortized stock compensation expense related to warrants was $5,572 (which will be recognized through March 2018) as of September 30, 2017.

Restricted stock units (“RSU”)

The following table summarizes the restricted stock unit activity for the nine months ended September 30, 2017:

On August 10, 2017, the Company amended 402,297 RSUs granted on February 23, 2017 for accrued and unpaid compensation for the period from December 1, 2016 through March 31, 2017 in the amount of $66,379. The RSUs as amended, vest upon the earlier of (i) on July 1, 2017 provided that service is not terminated and (ii) and the date of a meeting of the stockholders of the Company at which the director, being willing and available to serve as a director, is nominated for election but is not reelected by the stockholders. The settlement date for such RSUs, as amended, is the earlier of (i) July 1, 2024 or (ii) the date on which the Company undergoes a change of control.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

On August 10, 2017, the Company amended 263,554 RSUs granted June 22, 2017 for accrued and unpaid compensation for the period from April 1, 2017 through June 30, 2017 in the amount of $43,486. The RSUs, as amended, vest upon the earlier of (i) on July 1, 2017 provided that service is not terminated and (ii) and the date of a meeting of the stockholders of the Company at which the director, being willing and available to serve as a director, is nominated for election but is not reelected by the stockholders. The settlement date for such RSUs, as amended, is the earlier of (i) July 1, 2024 or (ii) date on which the Company undergoes a change of control during the seven-year term of the award.

In connection with the issuance of the above described RSUs as payment for accrued compensation, the Company reclassified to equity the settled aggregate salary accrual of $102,083 and recorded addition compensation costs of $7,782 during the nine months ended September 30, 2017. Out of the total settled accrued salary of $102,083 during nine months ended September 30, 2017, $14,583 was for the compensation accrued as of December 31, 2016 and $87,500 was for compensation expense earned during the nine months ended September 30, 2017. Due to the August 10, 2017 modification to the 602,620 RSU’s granted in 2016, the Company recorded an incremental expense of $26,515 in current period.

On June 22, 2017, the Company granted 665,000 RSUs for services provided by a board member. The RSUs vest upon the earlier of (i) on July 1, 2018 provided that service is not terminated and (ii) and the date of a meeting of the stockholders of the Company at which the director, being willing and available to serve as a director, is nominated for election but is not reelected by the stockholders. The settlement date for such RSUs is (i) July 1, 2024 or (ii) the date on which the Company undergoes a change of control during the seven-year term of the award.

On August 10, 2017, the Company granted 415,000 RSUs to each of Alexandre Zyngier, Ernest Purcell and Anthony Coelho for their continued service on the Board of Directors and 40,000 RSUs to each Alexandre Zyngier and Ernest Purcell for their continued service as the chairs of committees of the Board of Directors (for an aggregate grant of 1,325,000 RSUs). Such RSUs vest upon the first to occur of the following: (i) April 30, 2018 provided that the director’s service with the Company has not terminated prior to such date and (ii) the date of a meeting of the stockholders of the Company at which the director, being willing and available to serve as a director, is nominated for election but is not reelected by the stockholders. The settlement date for such RSUs is the earlier of (i) April 30, 2024 or (ii) the date on which the Company undergoes a change of control.

On August 10, 2017, the Company amended the terms of an aggregate of 650,000 RSUs previously granted in 2016. The vesting terms were amended from conditional based on a change of control to vesting as of July 1, 2017. The settlement date for such RSUs, as amended, in the earlier of (i) July 1, 2024 or (ii) the date on which the Company undergoes a change of control. The Company recorded the fair value of the previously issued RSUs of $107,250 as a charge to current period operations.

For the three and nine months ended September 30, 2017 and 2016, the Company has incurred RSU-based expense of $213,281 and $315,364 (of which $14,583 related to settlement of prior year accrued compensation and $300,781 to current year RSU related expense) and $0 and $0, respectively. The outstanding unamortized stock compensation expense related to RSU was $281,584 (which will be recognized through July 2018) as of September 30, 2017.

NOTE 8 — COMMITMENTS AND CONTINGENCIES

Litigation

In April 2015, two shareholder class action lawsuits were filed against the Company and former officers Nathaniel Bradley and Edward O’Donnell in the U.S. District Court for the District of Arizona. The plaintiffs alleged various causes of action against the defendants arising from our announcement that our previously issued financial results for the first three quarters of 2014 and the guidance for the fourth quarter of 2014 and the full year of 2014 could no longer be relied upon. The complaints sought among other relief, compensatory damages and plaintiff’s counsel’s fees and experts’ fees. The Court appointed a lead plaintiff and lead counsel, and consolidated the actions. A consolidated amended complaint was filed under the caption In re AudioEye, Inc. Sec. Litigation. The Company and individual defendants filed a motion to dismiss. 

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

On July 25, 2016, in connection with a voluntary mediation, the parties reached an agreement in principle to settle the consolidated actions. The terms of the agreement include a settlement payment to the class of $1,525,000 from the Company’s insurer, with no admission of liability by any party. In 2015, the Company paid a deductible under its D&O insurance policy in the amount of $100,000 regarding this matter. On May 8, 2017, the Court approved the settlement in all respects, and dismissed the case with prejudice.

On July 26, 2016, a shareholder derivative complaint entitled Denese M. Hebert, derivatively on Behalf of Nominal Defendant AudioEye, Inc., v. Bradley, et al., was filed in the State of Arizona Superior Court for Pima County. The complaint generally asserted causes of action related to the Company’s restatement of its financial statements for the first three fiscal quarters of 2014. As a derivative complaint, the plaintiff-shareholder purported to act on behalf of the Company against the Named Individuals. The Company was named as a nominal defendant.

The defendants filed a motion to dismiss, which the Court granted on May 8, 2017, while also denying Plaintiff’s request for leave to amend the complaint. While the Company believes that its legal defense costs may be reimbursed by the Company’s insurance carrier, no reasonable estimate of the outcome of the litigation, the related legal fees, or the impact on the financial results of the Company can be made as of the date of this statement.

We may become involved in various other routine disputes and allegations incidental to our business operations. While it is not possible to determine the ultimate disposition of these matters, our management believes that the resolution of any such matters, should they arise, is not likely to have a material adverse effect on our financial position or results of operations.

NOTE 9 — SUBSEQUENT EVENTS

Second Amendment to the Note and Warrant Purchase Agreement and Omnibus Amendment to Warrants

 On October 11, 2017, the “Company entered into a Second Amendment to the Note and Warrant Purchase Agreement (the “Purchase Agreement Amendment”) and an Omnibus Amendment to Common Stock Warrants (the “Warrant Amendment”), which collectively amend that certain Note and Warrant Purchase Agreement dated as of October 9, 2015 (the “Original Agreement”) and the warrants previously issued thereunder (the “Warrants”) to, among other things; (i) for the period from the Closing Date until November 8, 2017 (the “Discount Period”), provide parties to the Original Agreement the option to purchase additional notes (in an amount of up to 50% of their respective original investment as provided in the Original Agreement) that will immediately convert to shares of common stock of the Company (“Common Stock”) at a price of $0.0672 per share along with warrants exercisable for shares of Common Stock at a price of $0.07 per share if exercised during the Discount Period or $0.10 per share if exercised during the term of the warrant following the Discount Period; (ii) provide for certain registration rights for shares of Common Stock issued pursuant to the Original Purchase Agreement, as amended, at any time after 30 days subsequent to the listing of the Common Stock on a national securities exchange; and (iii) amend the Warrants such that they are exercisable for shares of Common Stock at a price of $0.07 per share if exercised during the Discount Period or $0.10 per share if exercised during the term of the warrant following the Discount Period.

In November 2017, the Company issued convertible promissory notes in aggregate of $50,000 and 500,000 warrants to acquire the Company’s common stock at $0.07 per share for five years under the above described terms. The notes were immediately converted into 744,048 shares of the Company’s common stock at a conversion rate of $0.0672 per share and the issued 500,000 warrants were exercised at $0.07 per share for net proceeds of $35,000.

In November 2017, the Company issued an aggregate of 1,750,000 shares of its common stock upon exercise of previously issued warrants for net proceeds of $122,500, at an amended exercise price of $0.07 per share.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017 (Unaudited)

Warrant Amendments

 On October 11, 2017, the Company entered into amendments of 41,953,282 warrants in order to remove “blocker” provisions which prevented the holder from exercising the warrants to the extent such exercise would increase such holder’s beneficial ownership in excess of 9.99% of the outstanding Common Stock at the time of such issuance (the “Blocker Amendments”).

Equity transactions

In October 2017, the Company issued 10,357,144 shares of its common stock for previously received common stock subscriptions of $1,450,000.

In October 2017, the Company issued 357,142 shares of its common stock for common stock of $50,000.

In October 2017, the company issued 3,204,027 shares of its common stock in connection with the conversion of 50,000 shares of Series A Convertible Preferred Stock and accumulated dividends.

On October 23, 2017, the Company granted 250,000 warrants to purchase the Company’s common stock for services at an exercise price of $0.179 per share for three years, vesting immediately.

In November 2017, the Company issued 786,244 shares of its common stock in settlement of a convertible promissory note and accrued interest of $50,000 and $2,836, respectively. The promissory note and interest was converted at an amended rate of $0.0672 per share, see above.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations or MD&A, should be read in conjunction with our consolidated financial statements and related notes in Part I, Item 1 of this report.

As used in this quarterly report, the terms “we,” “us,” “our” and similar references refer to AudioEye, Inc. and our wholly-owned subsidiary, unless otherwise indicated.

Cautionary Note Regarding Forward-Looking Statements

Any statements in this Quarterly Report on Form 10-Q about our expectations, beliefs, plans, objectives, prospects, financial condition, assumptions or future events or performance are not historical facts and are “forward-looking statements” as that term is defined under the federal securities laws. These statements are often, but not always, made through the use of words or phrases such as “believe”, “anticipate”, “should”, “intend”, “plan”, “will”, “expects”, “estimates”, “projects”, “positioned”, “strategy”, “outlook” and similar words. You should read the statements that contain these types of words carefully. Such forward-looking statements are subject to a number of risks, uncertainties and other factors that could cause actual results to differ materially from what is expressed or implied in such forward-looking statements. There may be events in the future that we are not able to predict accurately or over which we have no control. Potential risks and uncertainties include, but are not limited to, those discussed in “Part I, Item 1A. Risk Factors” in our Annual Report filed on Form 10-K for the year ended December 31, 2016. We urge you not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We do not undertake any obligation to release publicly any revisions to such forward-looking statements to reflect events or uncertainties after the date hereof or to reflect the occurrence of unanticipated events.

Overview

AudioEye is a marketplace leader providing web accessibility solutions for our clients’ customers through our Ally Platform Products. Our technology advances accessibility with patented technology solutions that reduce barriers, expand access for individuals with disabilities, and enhance the user experience for a broader audience of users. When implemented, we believe that our solutions offer businesses the opportunity to reach more customers, improve brand image, and build additional brand loyalty.  In addition, our solutions help organizations comply with internationally accepted Web Content Accessibility Guidelines (WCAG) as well as US, Canadian, Australian, and United Kingdom accessibility laws.

We generate revenues through the sale of subscriptions of our software as a service (SaaS) technology platform, called the AudioEye Ally Platform, to website owners, publishers, developers, and operators and through the delivery of managed services combined with the implementation of the AudioEye solution. Our solutions have been adopted by some of the largest and most influential companies in the world. Our customers span disparate industries and target market verticals, which encompass (but are not limited to) the following categories: human resources, finance, transportation, media, and education. Government agencies have also integrated our software in their digital platforms.

The AudioEye Solution

AudioEye uses proprietary technology and development tools to offer web accessibility solutions that offer significant savings in time and money relative to traditional solutions. Our compliance solutions focus on rapid remediation of the most important accessibility issues, followed by in-depth analysis identifying and addressing a more comprehensive compliance program. Our technology was built to not only provide users with a cloud-based assistive toolset that gets embedded and made freely available to users within our client websites, but to also improve the code in a way that optimizes the user experience for users of existing third-party assistive technologies, such as screen readers.

Intellectual Property

Our technology development was initiated at the University of Arizona Science & Technology Park in Tucson, Arizona. In 2006, we received technology development venture funding from the Maryland Technology Development Corporation (TEDCO), which contributed to the development of our platform strategy. Beginning in 2009, we engaged in a multi-year technology development program with the Eller College of Management’s Department of Management Information Systems at the University of Arizona.  In connection with our proprietary technology, our company has been issued a number of U.S. patents in two distinct patent families.  Today, an experienced team of in-house engineers, designers, and developers in our Atlanta, GA, and Tucson, AZ, offices develop the Company’s technology & software and are actively engaged in the expansion of the AudioEye IP Portfolio.

Our patented technology was a 2013 Edison Gold Award winner for innovation in the category of “Quality of Life.”

Our intellectual property is primarily comprised of trade secrets, trademarks, issued and pending patents, copyrights and technological innovation. We have a patent portfolio comprised of six patents issued in the United States, we have received a notice of allowance from the U.S. Patent and Trademark Office for a seventh patent, and we have several additional patents that are either pending or are being prepared for filing in the United States and internationally.

Our current patented invention relates to a server-side method and apparatus that enables users to audibly navigate websites and hear high-quality streaming audio narration and descriptions of websites.  This patented invention involves creating an audio-enabled web experience by utilizing voice talent and automated text-to-speech conversion methods to read and describe web content. It involves the creation of audio files for each section within a website, and then assigning a hierarchy and navigation system in line with the website design.  To implement the system, a script is installed across the pages of the website and, when loaded, it plays an audible tone upon a user’s visit indicating that the website is enhanced with our proprietary technology.  Upon hearing the tone, a user presses a key on the keyboard to enter the audible website.  Audible narration is played through the user’s computer, reading text and describing non-text information, such as images.  The narration includes menus for navigating the site which have a hierarchy in line that of the original website.  Users navigate the website menus and move from webpage to webpage by making keystrokes or using a mouse.

Our current portfolio has established a foundation for building unique technology solutions that contribute to the way in which we differentiate ourselves from other competitors in the B2B Web Accessibility marketplace. We plan to continue to invest in research and development, and expand our portfolio of proprietary intellectual property.

Our Annual Report filed on Form 10-K for the year ended December 31, 2016 provides additional information about our business and operations.

Results of Operations

Our consolidated audited financial statements are stated in United States Dollars and are prepared in accordance with United States Generally Accepted Accounting Principles (“GAAP”). The discussion of the results of our operations compares the three and nine months ended September 30, 2017 with the three and nine months ended September 30, 2017 and are not necessarily indicative of the results which may be expected for any subsequent period.  Our prospects should be considered in light of the risks, expenses and difficulties encountered by companies in similar positions.  We may not be successful in addressing these risks and difficulties.

Comparative for the Three Months ended September 30, 2017 and September 30, 2016

Results of Operations

Revenue

For the three months ended September 30, 2017 and 2016, revenue was $744,380 and $282,676, respectively, consisting primarily of revenues from various levels of subscriptions and technology development. Revenues increased due to a change of marketing focus.

Cost of Sales

For the three months ended September 30, 2017 and 2016, cost of sales was $262,738 and $311,519, respectively, consisting primarily of sub-contracting to outside sources, direct labor and direct technology costs.

Gross Profit (Loss)

An increase in our revenues resulted in a gross profit of $481,642 for the current period, as compared to a gross loss of $28,843 during the three months ended September 30, 2016. Gross profit increased as a result of lower implementation costs as compared to the same period in 2016.

Selling and Marketing Expenses

Selling and marketing expenses were $363,951 and $192,881 for the three months ended September 30, 2017 and 2016, respectively.  The increase resulted from the higher sales activity in 2017 as compared to 2016.

Research and Development Expenses

Research and development expenses were $44,704 and $85,192 for three months ended September 30, 2017 and 2016, respectively. Research and development expenses decreased from period to period and reflect continued developments of our product.

General and Administrative Expenses

General and administrative expenses were $822,310 and $602,041 for the three months ended September 30, 2017 and 2016, respectively. General and administrative expenses increased $220,269 due primarily to higher service provider costs as compared to 2016. Stock based compensation for the three months ended September 30, 2017 was $304,789 as compared to $243,710 for the same period last year.

Amortization and Depreciation

Amortization and depreciation expenses were $143,661 and $150,328 for the three months ended September 30, 2017 and 2016, respectively. The decrease in expense was primarily related to expiring software development costs in 2017.

Gain on change in Fair Value of Derivative Liabilities

In October 2015, 2016 and 2017, we issued warrants with an embedded reset provisions requiring us to fair value the derivatives each reporting period and mark to market as a non-cash adjustment to our current period operations. This resulted in a gain of $1,086,044 on change in fair value of derivative liabilities for the three months ended September 30, 2017 as compared to a gain of $351,055 for the same period last year. The primary driver of the change in our derivative liability is our stock price. Generally, as our stock price decreases, the liability decreases resulting in a larger non-cash gain for the period to period change.

Interest Income (Expense), net

Interest income (expense), net during the three months ended September 30, 2017 was $(9,639) compared to $266 for the three months ended September 30, 2016. For 2017, we incurred non cash amortization of debt discounts relating to our issued notes of $8,425, as compared to 2016 of $0.

Comparative for the Nine Months ended September 30, 2017 and September 30, 2016

Results of Operations

Revenue

For the nine months ended September 30, 2017 and 2016, revenue was $1,863,111 and $594,237, respectively, consisting primarily of revenues from various levels of subscriptions and technology development. Revenues increased due to a change of marketing focus.

Cost of Sales

For the nine months ended September 30, 2017 and 2016, cost of sales was $1,043,813 and $904,091, respectively, consisting primarily of sub-contracting to outside sources, direct labor and direct technology costs.

Gross Profit (Loss)

An increase in our revenues resulted in a gross profit of $819,298 for the current period, as compared to a gross loss of $309,854 during the nine months ended September 30, 2016. Gross profit increased as a result of lower implementation costs as compared to the same period in 2016.

Selling and Marketing Expenses

Selling and marketing expenses were $980,834 and $510,448 for the nine months ended September 30, 2017 and 2016, respectively.  The increase resulted from the higher sales activity in 2017 as compared to 2016.

Research and Development Expenses

Research and development expenses were $138,673 and $255,805 for nine months ended September 30, 2017 and 2016, respectively. Research and development expenses decreased from period to period and reflect continued developments of our product.

General and Administrative Expenses

General and administrative expenses were $2,175,519 and $1,894,964 for the nine months ended September 30, 2017 and 2016, respectively. General and administrative expenses increased $280,555 due primarily to increases in support staff and service providers, net with a reduction in stock based compensation. Stock based compensation for the nine months ended September 30, 2017 was $915,689 as compared to $960,460 for the same period last year.

Amortization and Depreciation

Amortization and depreciation expenses were $437,070 and $428,701 for the nine months ended September 30, 2017 and 2016, respectively. The increase in expense was primarily related to added patent costs in later 2016 and 2017.

Loss on change in Fair Value of Derivative Liabilities

In October 2015, 2016 and 2017, we issued warrants with an embedded reset provisions requiring us to fair value the derivatives each reporting period and mark to market as a non-cash adjustment to our current period operations. This resulted in a gain of $131,855 on change in fair value of derivative liabilities for the nine months ended September 30, 2017 as compared to a loss of $2,990,096 for the same period last year. The primary driver of the change in our derivative liability is our stock price. Generally, as our stock price increases, the liability increases resulting in a larger non-cash loss for the period to period change.

Loss on settlement of Debt

In April 2016, we issued common stock warrants in settlement of convertible debt and accrued interest. As such, we incurred a non-cash loss on debt settlement between the estimated fair value of the issued warrants and the carrying value of the debt and accrued interest of $1,664,281 for the nine months ended September 30, 2016.

Interest Income (Expense), net

Interest income (expense), net during the nine months ended September 30, 2017 was $(57,759) compared to $(676,181) for the nine months ended September 30, 2016. For 2017, we incurred non cash interest charges and amortization of debt discounts relating to our issued notes of $39,644 and $15,751, respectively, as compared to 2016 of $0 and $600,301, respectively.

Contracts in Process/Revenue Recognition

Under current accounting procedures, the Company only recognizes revenue on new contracts for the actual services delivered in the period under the following criteria: (i) the contract has been signed and delivered to the Company; (ii) the services have been performed or delivered; and (iii) the client has been billed for the services delivered. The Company does not record deferred revenues for new contracts until the first payment for services has been received. The Company only records accounts receivable for the amount of revenue recognized as service is rendered, even if the client has been billed for the entire contract value. The table below summarizes the amount of contract value in excess of the revenue recognized of $2,756,360, our deferred revenue of $1,068,376 and amount recognized in the amount of $1,863,108 in 2017. Contract and deferred revenues are expected to be recognized in future periods. The Company also receives contracts for service hours but whose total contract value is uncertain. These “fee for service contracts” are recorded in the table below only if the services have been delivered and the associated revenue has been recognized.

A summary of our contracts in process is as follows:

Liquidity and Capital Resources

Working Capital

The working capital (deficit) (current liabilities in excess of current assets) for the periods ended September 30, 2017 and December 31, 2016 was $(2,750,609) and $(2,692,090) respectively. The increase in working capital deficit was primarily due to decrease in our accounts receivable of $27,856 and increase in our deferred revenue of $681,891, net with a decrease in derivative liability of $220,418 and with a decrease in accounts payable and accrued expenses of $198,767. Adjusting for the non-cash derivative liability, working capital would have been $507,599 at September 30, 2017. In addition, the Company used actual net cash in operations of $1,121,558 during the nine months ended September 30, 2017. The Company has incurred net losses since inception.

During the nine months ended September 30, 2017, the Company sold shares of common stock and warrants and received common stock subscriptions for net proceeds, after commissions and other costs, of $1,500,000. In addition, in April 2017, the Company issued a convertible promissory note for net proceeds of $50,000. It is anticipated that the Company has cash sufficient to fund operations through October 2018.

The Company expects that cash used in operations will decrease significantly over the next several years as the Company executes its business plan. In the event that the Company is not able to fully achieve its plan, the Company may need to raise additional funds through equity or debt financing. If the Company is unsuccessful in raising additional financing, it will need to reduce costs and operations in the future.

Cash Flows

We had cash in the amount of $1,562,115 and $1,409,418 as of September 30, 2017 and December 31, 2016, respectively.

On January 12, 2017, we entered into a Common Stock and Warrant Purchase Agreement with an investor for the issuance and sale of 357,143 shares of common stock of the Company and warrants to purchase up to an aggregate of 40,000 shares of common stock of the Company, representing $50,000 of proceeds. The warrants are exercisable at $0.25 per share for five years from the date of issuance and subject to anti-dilution protection as defined.

On April 11, 2017, the Company issued a convertible promissory note in the principal amount of $50,000 (the “Note”) and warrant (the “Warrant”) to purchase 500,000 shares of common stock of the Company. The Note and Warrant were issued in connection with an election granted under our October 9, 2015 Note and Warrant Purchase Agreement (the “October 2015 Purchase Agreement”) whereby any investor in the October 2015 Purchase Agreement within the three-year period immediately following the initial closing date may purchase an additional note in the principal amount equal to 50% of the principal amount of the initial note purchased by such investor at previous closings and an additional warrant with an aggregate exercise price equal to such investor’s the principal amount of such additional note.

The Note bears interest at 10% and matures the earlier of October 9, 2018 or after the occurrence an event of default (as defined in the Note). In the event of any conversion, all interest shall be also converted into equity and shall not be payable in cash.

On September 29, 2017, the Company entered into a Common Stock Purchase Agreement (the “September 2017 Purchase Agreement”) with certain investors for the issuance and sale of up to 12,500,000 shares of common stock of the Company (the “Common Stock” or “Shares”) at a purchase price of $.14 per share. As of September 30, 2017, the Company had received $1,450,000 common stock subscriptions under the September 2017 Purchase Agreement.

Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with the accounting principles generally accepted in the United States. Preparing financial statements requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by our management’s application of accounting policies. We believe that understanding the basis and nature of the estimates and assumptions involved with the following aspects of our financial statements is critical to an understanding of our financial statements.

Our critical accounting policies, as described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016, relate to capitalized legal patent costs, income taxes, goodwill, intangible assets, share-based payments, revenue recognition, and research and other accounting descriptions. There have been no material changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Not applicable.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As required under Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), we carried out an evaluation under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2017. Based upon that evaluation, the Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures as of September 30, 2017 were not effective, for the same reasons as previously disclosed under Item 9A. “Controls and Procedures” in our Annual Report on Form 10-K for our fiscal year ended December 31, 2016. 

Changes in Internal Controls over Financial Reporting

There have been no changes in our internal controls over financial reporting (as defined in Rule 13a-15(f) and 15d-(f) of the Exchange Act) that occurred during the our last fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

In April 2015, two shareholder class action lawsuits were filed against the Company and former officers Nathaniel Bradley and Edward O’Donnell in the U.S. District Court for the District of Arizona. The plaintiffs alleged various causes of action against the defendants arising from our announcement that our previously issued financial results for the first three quarters of 2014 and the guidance for the fourth quarter of 2014 and the full year of 2014 could no longer be relied upon. The complaints sought among other relief, compensatory damages and plaintiff’s counsel’s fees and experts’ fees. The Court appointed a lead plaintiff and lead counsel, and consolidated the actions. A consolidated amended complaint was filed under the caption In re AudioEye, Inc. Sec. Litigation. The Company and individual defendants filed a motion to dismiss. 

On July 25, 2016, in connection with a voluntary mediation, the parties reached an agreement in principle to settle the consolidated actions. The terms of the agreement include a settlement payment to the class of $1,525,000 from the Company’s insurer, with no admission of liability by any party. In 2015, the Company paid a deductible under its D&O insurance policy in the amount of $100,000 regarding this matter. On May 8, 2017, the Court approved the settlement in all respects, and dismissed the case with prejudice.

On July 26, 2016, a shareholder derivative complaint entitled Denese M. Hebert, derivatively on Behalf of Nominal Defendant AudioEye, Inc., v. Bradley, et al., was filed in the State of Arizona Superior Court for Pima County. The complaint generally asserted causes of action related to the Company’s restatement of its financial statements for the first three fiscal quarters of 2014. As a derivative complaint, the plaintiff-shareholder purported to act on behalf of the Company against the Named Individuals. The Company was named as a nominal defendant.

The defendants filed a motion to dismiss, which the Court granted on May 8, 2017, while also denying Plaintiff’s request for leave to amend the complaint. While the Company believes that its legal defense costs may be reimbursed by the Company’s insurance carrier, no reasonable estimate of the outcome of the litigation, the related legal fees, or the impact on the financial results of the Company can be made as of the date of this statement.

We may become involved in various other routine disputes and allegations incidental to our business operations. While it is not possible to determine the ultimate disposition of these matters, our management believes that the resolution of any such matters, should they arise, is not likely to have a material adverse effect on our financial position or results of operations.

Item 1A. Risk Factors

There have been no material changes from the risk factors disclosed in Item 1.A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2016.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

None.

Item 5. Other Information

None.

Item 6. Exhibits

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 14th day of November 2017.