AUDIOEYE INC - Quarter Report: 2019 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, 2019

For the transition period from [                     ] to [                     ]

Commission file number 001-38640

AudioEye, Inc.

(Exact name of registrant as specified in its charter)

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

Securities registered pursuant to Section 12(b) of the Act:

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 every Interactive Data File required to be submitted 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 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 ¨   No x

As of November 13, 2019, 8,876,555 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 consolidated financial statements as of September 30, 2019 and December 31, 2018 and for the three- and nine-month periods ended September 30, 2019 and 2018 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, 2019 are not necessarily indicative of results to be expected for any subsequent period. Our fiscal year end is December 31. Certain prior period amounts have been reclassified to conform to current period classification.

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 STATEMENTS OF STOCKHOLDERS' EQUITY

THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018

(unaudited)

See Notes to Unaudited Consolidated Financial Statements

AUDIOEYE, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

THREE AND NINE MONTHS ENDED SEPTEMBER 31, 2019 AND 2018

(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, 2019 (unaudited)

NOTE 1 — ORGANIZATION AND BASIS OF PRESENTATION

The accompanying unaudited interim financial statements of AudioEye, Inc. (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 (the “SEC”), 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 for the fiscal year ended December 31, 2018, as filed with the SEC on March 27, 2019.

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. Certain prior period amounts have been reclassified to conform to current period classification. Notes to the financial statements that would substantially duplicate the disclosures contained in the audited financial statements for the year ended December 31, 2018 as reported in the Company’s Annual Report on Form 10-K have been omitted.

Corporate Information and Background

AudioEye, Inc. (“we”, “our” or the “Company”) was incorporated on May 20, 2005 in the state of Delaware. The Company has developed patented, Internet content publication and distribution software that enables conversion of media into accessible formats and allows for real time distribution to end users on any Internet connected device. The Company’s focus is to create more comprehensive access to Internet and other media to all people regardless of their network connection, device, location, or disabilities.

The Company is focused on developing innovations in the field of networked and device embedded audio technology. Our intellectual property is primarily comprised of trade secrets, trademarks, issued, published and pending patent applications, copyrights and technological innovation. We have a patent portfolio comprised of eight issued patents in the United States. We also have one published/pending patent application and two patent applications being prepared for filing via the Patent Cooperation Treaty (“PCT”) (international). We have a trademark portfolio comprised of seven United States trademark registrations.

Our common stock has been listed on the NASDAQ Capital Market under the symbol “AEYE” since September 4, 2018. Prior to September 4, 2018, our common stock was quoted on the OTCQB and the OTC Bulletin Board beginning on April 15, 2013 under the same symbol.

In August 2018, the Company sold 1,000,000 shares (the “Shares”) of its common stock at $6.25 per share for net proceeds of $5,609,215, after costs and expenses of $640,785 (the “Private Placement”). At the closing of the Private Placement, the Company entered into a registration rights agreement (the “Registration Rights Agreement”) with the investors pursuant to which the Company agreed to register the Shares for resale. On September 4, 2018, the Company filed a registration statement on Form S-1 covering the resale of the securities subject to the Registration Rights Agreement, as well as certain other securities of the Company. On July 5, 2019, the Company filed a post-effective amendment to the registration statement on Form S-1 covering the resale of such securities in order to, among other things, incorporate into the filing information included in the Company’s Annual Report on Form 10-K filed with the SEC on March 27, 2019.

On August 1, 2018, the Company amended its Certificate of Incorporation to implement a reverse stock split in the ratio of 1 share for every 25 shares of common stock and to reduce the number of authorized shares of common stock from 250,000,000 to 50,000,000. As a result, 186,994,384 shares of the Company’s common stock were exchanged for 7,479,775 shares of the Company's common stock. These financial statements have been retroactively restated to reflect the reverse stock split.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

Revenue Recognition

Revenue is recognized when delivery of the promised goods or services is transferred to the Company’s customers, in an amount that reflects the consideration that the Company expects to be entitled to in exchange for those goods or services.

We determine revenue recognition through the following five steps:

Certain Software as a Service (“SaaS”) invoices are prepared on an annual basis. Any funds received for services not provided yet are held in deferred revenue and are recorded as revenue when earned. Subscription revenue is recognized on a ratable basis over the contractual subscription term of the arrangement beginning on the date that our service is made available to the customer. Payments received in advance of services being rendered are recorded as deferred revenue. Any funds received for services not provided yet are held in deferred revenue and are recorded as revenue when earned. We generate most of our revenue from subscription services, which are primarily comprised of subscription fees from customers on the Ally Platform.

The following table presents our revenue disaggregated by type of good or service and sales channel:

In accordance with Accounting Standard ASU 2014-09 Revenue from Contracts with Customers and all subsequent amendments to the ASU (collectively, “ASC 606”), the Company records accounts receivable for amounts invoiced to customers for which service has been rendered and for amounts invoiced and are in deferred revenue but for which the Company has an unconditional right to consideration as provided under the contractual arrangement.

The table below compares the deferred revenue balance as of September 30, 2019 versus December 31, 2018:

As of September 30, 2019, $4,119,567 was classified as short term deferred revenue and is expected to be recognized over the next twelve months following September 30, 2019. The remaining $192,121 is long-term deferred revenue to be recognized thereafter. $2,128,766 (70%) of deferred revenue from December 31, 2018 has been recognized to revenue through September 30, 2019.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

At September 30, 2019, the Company had one customer representing 17% of the outstanding accounts receivable. At December 31, 2018, the Company had a different customer representing 22% of the outstanding accounts receivable.

The Company had one major customer (including such customer’s affiliates) which generated approximately 9% and 10% of the Company’s revenue in the three and nine months ended September 30, 2019, respectively, and 11% and 12% of the Company’s revenue in the three and nine months ended September 30, 2018, respectively.

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 revenue and expenses during the reporting period. Significant estimates include the fair value of the Company’s stock, stock-based compensation 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. The fair value of the award is measured on the grant date. 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.

Earnings (Loss) Per Share

Basic earnings (loss) 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 (i.e., the 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 is computed using the if-converted method, which assumes conversion at the beginning of the year. However, when a net loss exists, no potential common stock equivalents are included in the computation of the diluted per-share amount because the computation would result in an anti-dilutive per-share amount.

Potentially dilutive securities excluded from the computation of basic and diluted net earnings (loss) per share for the nine months ended September 30, 2019 and 2018 are as follows:

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

Fair Value Measurements

Fair value is an estimate of the exit price, representing the amount that would be received 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.

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.

The Company has no liabilities measured at fair value on a recurring basis as of September 30, 2019 and December 31, 2018. The following are the Company’s assets measured at fair value on a recurring basis as of September 30, 2019 and December 31, 2018:

Leases

In February 2016, the Financial Accounting Standards Board (“FASB”) established ASC Topic 842, Leases (Topic 842), by issuing ASU No. 2016-02, which requires lessees to recognize leases on the balance sheet and disclose key information about leasing arrangements. Topic 842 was subsequently amended by ASU No. 2018-01, Land Easement Practical Expedient for Transition to Topic 842; ASU No. 2018-10, Codification Improvements to Topic 842, Leases; and ASU No. 2018-11, Targeted Improvements. The new standard establishes a right-of-use (ROU) model that requires a lessee to recognize an ROU asset and lease liability on the balance sheet. Leases are classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the statement of operations. The Company adopted the new standard on January 1, 2019 using the modified-retrospective method, with an effective date or application date of January 1, 2019 and thus did not adjust comparative periods.

The new standard provides a number of optional practical expedients in transition. The Company has elected the “package of practical expedients”, which permits it not to reassess under the new standard its prior conclusions about lease identification, lease classification and initial direct costs. The Company did not elect the use-of-hindsight practical expedient.

The new standard had a material effect on the Company’s financial statements. The most significant effects of adoption relate to (1) the recognition of new ROU assets and lease liabilities on the Company’s balance sheet for real estate operating leases; and (2) providing significant new disclosures about the Company’s leasing activities.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

As of January 1, 2019, the Company recognized additional operating lease liabilities of $568,268 based on the present value of the remaining minimum rental payments under current leasing standards for existing operating leases. The Company recognized corresponding ROU assets of $557,212. In February 2019, the Company entered into a new lease in Marietta, Georgia, which resulted in ROU assets of an incremental $483,565 being recognized on the balance sheet upon lease commencement in June 2019.

The new standard also provides practical expedients for an entity’s ongoing accounting. The Company elected the short-term lease recognition exemption for all leases that qualify. This means, for those leases that qualify, that the Company does not recognize ROU assets or lease liabilities, and this includes not recognizing ROU assets or lease liabilities for existing short-term leases of those assets in transition. The Company changed its disclosed lease recognition policies and practices, as well as to other related financial statement disclosures due to the adoption of this standard. See Note 6 for these revised disclosures for fiscal year 2019.

Recent Accounting Pronouncements

There are various 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, 2019, the Company had cash of $3,463,899 and a working capital of $341,009. In addition, the Company used actual net cash in operations of $1,404,992 and $4,322,064 during the three- and nine-months ended September 30, 2019, respectively.

In August 2018, the Company sold 1,000,000 shares of its common stock at $6.25 per share for net proceeds of $5,609,215, after costs and expenses of $640,785. In connection with the October 9, 2015 Note and Warrant Purchase Agreement, the Company received proceeds from the issuance of convertible notes payable of $100,000 in September 2018 and $124,975 in October 2018.

In August 2019, the Company negotiated with holders of certain warrants to purchase the Company’s common stock with respect to a transaction in which the Company and the holders agreed to amend certain warrant agreements to provide that from the date of amendment through August 16, 2019, the exercise price was reduced from $2.50 to $1.63 per share for warrants to purchase an aggregate of 1,194,990 shares and from $6.25 to $4.07 per share for warrants to purchase an aggregate of 85,719 shares, provided that any exercise during such period was in full and the exercise price was paid in cash. Proceeds from the amended warrants exercised was approximately $2.1 million.

In August 2019, the Company negotiated an agreement for a $2.0 million Line of Credit (the “LOC”) with Sero Capital LLC, a shareholder who owns more than 10% of the outstanding shares of the Company’s common stock. The Company’s primary source of operating funds has been from revenue generated from sales and cash proceeds from the sale of common stock and the issuance of convertible and other debt. With the August warrant exercises and the LOC, it is anticipated that the Company will have cash sufficient to fund operations for the next twelve months.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

NOTE 3 — PROPERTY AND EQUIPMENT

Property and equipment as of September 30, 2019 and December 31, 2018 is summarized as follows:

Property and equipment are stated at cost and depreciated using the straight-line method over their estimated useful life or term of the lease. When property or equipment is retired or otherwise disposed of, 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.

Included in net property and equipment are assets under finance leases (formerly known as capital leases) of $156,858, less accumulated depreciation of $46,706 as of September 30, 2019 and $95,506, less accumulated depreciation of $16,117, as of December 31, 2018.

The Company spent $45,803 and $10,893 in the purchase of furniture and equipment during the nine months ended September 30, 2019 and 2018, respectively. The Company also leased $61,352 and $77,864 in equipment during the nine months ended September 30, 2019 and 2018, respectively. Depreciation expense was $19,480 and $47,357 for the three and nine months ended September 30, 2019, respectively. Depreciation expense was $9,851 and $21,600 for the three and nine months ended September 30, 2018, respectively.

NOTE 4 — INTANGIBLE ASSETS

For the nine months ended September 30, 2019 and 2018, the Company invested in software development costs in the amounts of $137,373 and $308,933, respectively.

Patents, technology and other intangibles with contractual terms are 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.

Intangible assets consisted of the following:

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

Amortization expense for patents totaled $93,658 and $280,974 for the three and nine months ended September 30, 2019, respectively; and $93,657 and $274,341 for the three and nine months ended September 30, 2018, respectively. Amortization expense for software development totaled $72,238 and $206,153 for the three and nine months ended September 30, 2019, respectively; and $25,653 and $98,297 for the three and nine months ended September 30, 2018, respectively.

Total amortization expense was $487,127 and $372,638 for the nine months ended September 30, 2019 and 2018, respectively.

NOTE 5 — DEFERRED COSTS

Effective January 1, 2018, the Company capitalizes new and 12-month or longer renewal sales commission payments in the period a customer contract is obtained, and payment is received; and the commissions are amortized consistent with the transfer of the goods or services to the customer over the expected period of benefit, which we have deemed to be the contract term.

Such commissions are amortized over the greater of contract term or technological obsolescence period when the underlying contracted products are technology-based, such as for the SaaS-based platforms, or the contract term when the underlying contracted products are not technology-based. The table below summarizes the activity within the deferred commission costs account, during the nine months ended September 30, 2019:

During the three and nine months ended September 30, 2019, the Company deferred an aggregate of $123,054 and $259,792, respectively, for commissions paid. Amortization of deferred costs for the three and nine months ended September 30, 2019 was $66,766 and $174,841, respectively.

During the nine months ended September 30, 2018, the Company deferred an aggregate of $201,142 for commissions paid and reclassified from equity $80,153 previously paid amounts that were originally expensed as commissions. Amortization of deferred costs for the three and nine months ended September 30, 2018 was $34,214 and $59,705, respectively.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

NOTE 6 — LEASE LIABILITIES AND RIGHT OF USE ASSETS

Finance Leases

During the nine months ended September 30, 2019, the Company entered into three finance leases for computer equipment, each for a three-year term.  The Company recognized these arrangements as finance leases based on the determination that the leases exceeded 75% of the economic life of the underlying assets.  The Company initially recorded the equipment and the finance leases liability at the estimated present value of the minimum lease payments of $19,754, $20,903 and $20,695, respectively.

During the year ended December 31, 2018, the Company entered into five finance leases (formerly known as capital leases) for computer equipment for a three-year term.  The Company recognized these arrangements as finance leases based on the determination that the leases exceeded 75% of the economic life of the underlying assets.  The Company initially recorded the equipment and the finance lease liability at the estimated present value of the minimum lease payments of $95,506.

The leases include base monthly payments in the aggregate of $4,761, due on the monthly anniversary of each contract.  At the expiration of the lease, the Company is required to return all leased equipment to the lessor with right of repurchase at fair value. The Company has made payments under these leases in the total amount of $29,053 during the nine months ended September 30, 2019. The effective interest rate of the finance leases is estimated at 6% based on the implicit rate in the lease agreements.

The following summarizes the right to use assets under finance leases included in property and equipment: 

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

The following summarizes total future minimum finance lease payments at September 30, 2019:

Operating Leases

The Company’s principal offices are located at 5210 E. Williams Circle, Suite 750, Tucson, Arizona 85711, consisting of approximately 5,151 square feet as of September 30, 2019. The Company’s principal office originally consisted of approximately 2,362 square feet. On December 21, 2017, effective February 1, 2018, the Company amended its existing lease to expand its principal office to approximately 4,248 square feet and to extend the expiration date to September 30, 2021. Beginning February 1, 2018, the basic rent increased to $9,598 per month. On October 2, 2018, effective December 1, 2018, the Company further amended its existing lease to expand its principal office to approximately 5,151 square feet. In accordance with the amended lease, rent increased to $11,810 on January 1, 2019, escalating over time to $12,977 at the end of the lease, which was further extended to October 31, 2022.

The Company also had offices in Atlanta, Georgia located at 3901 Roswell Road, Suite 134, leased for an aggregate of $3,937 per month as of December 31, 2017 under a lease that expired on September 30, 2019. On December 29, 2017, effective February 1, 2018, the Company amended its existing lease to expand its Atlanta office from approximately 2,739 square feet to approximately 3,831 square feet. Beginning February 1, 2018, the basic rent increased by $1,500 through the remainder of the lease term. In February 2019, the Company entered into a lease for new offices in Marietta, Georgia located at 450 Franklin Gateway, Marietta, Georgia consisting of approximately 9,662 square feet. The new lease commenced on June 1, 2019, with move-in on June 15, 2019.

Beginning in 2017, the Company leased office space in New York for $300 per month, which was increased to $850 per month in October 2018 through May 31, 2019. Beginning in June 2019, the Company moved to larger office space in New York, leased for $4,482 per month, for a term of 12 months ending May 31, 2020. Beginning November 1, 2015, we subleased an office in Scottsdale, Arizona from a company controlled by our Executive Chairman for $3,578 per month, which continues on a month to month basis as of September 30, 2019. These New York and Scottsdale properties were considered short-term leases and therefore were not measured under Topic 842.

The Company has made operating lease payments in the amount of $222,564 during the nine months ended September 30, 2019. Rent expense charged to operations, which differs from rent paid due to rent credits and to increasing amounts of base rent, is calculated by allocating total rental payments on a straight-line basis over the term of the lease. Operating lease liabilities at September 30, 2019 and January 1, 2019 consist of:

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

As of January 1, 2019, the Company adopted the provisions of ASC Topic 842 using the modified retrospective method. In adopting ASC Topic 842, Leases (Topic 842), the Company elected the ‘package of practical expedients’, which permitted it not to reassess under the new standard its prior conclusions about lease identification, lease classification and initial direct costs. The Company did not elect the use-of-hindsight or the practical expedient pertaining to land easements; the latter is not applicable to the Company. In addition, the Company elected not to apply ASC Topic 842 to arrangements with lease terms of 12 month or less. Effective January 1, 2019, the Company initially recognized operating lease liabilities of $568,268 based on the present value of the remaining minimum rental payments under current leasing standards for existing operating leases. The discount rate utilized in such present value calculation was 6% based on an estimate of the Company’s incremental borrowing rate. At such time, the Company also recognized corresponding right-of-use (ROU) assets of $557,212 and eliminated the prior period deferred rent of $11,056.

During the nine months ended September 30, 2019, the Company entered into an operating lease for new office space in Marietta, Georgia, for a five-year term. The Company measured and recorded a right of use asset and corresponding operating lease liability of $483,565 at the lease commencement date in June 2019.

The following summarizes total future minimum operating lease payments at September 30, 2019:

The following summarizes lease expenses for the nine months ended September 30, 2019:

NOTE 7 — CREDIT FACILITY-RELATED PARTY

On August 14, 2019, the Company entered into a Loan Agreement (the “Loan Agreement”) with Sero Capital LLC, a shareholder who owns more than 10% of the outstanding shares of common stock of the Company. The beneficial owner of Sero Capital LLC is David Moradi, who became a director of the Company on November 8, 2019. The Loan Agreement provides the Company with an unsecured credit facility under which the Company may borrow up to the aggregate principal amount of $2,000,000. Any advances under the Loan Agreement will bear interest at a per annum rate of 10% (subject to increase in the event of a default), which is payable monthly and may, at the Company’s option, be paid either in cash or by the issuance of shares of the Company’s common stock. The term of the Loan Agreement extends through August 14, 2020, subject to earlier termination as provided in the Loan Agreement. The Company’s obligations under the Loan Agreement are subject to acceleration upon the occurrence of an event of default (as defined in the Loan Agreement). The Company may prepay its obligations under the Loan Agreement without penalty, but subject to certain limitations regarding the number, timing and dollar amounts of prepayments. The Loan Agreement provides for certain customary covenants, representations and events of default. No amounts have been drawn under the Loan Agreement as of September 30, 2019.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

In consideration of the credit facility, the Company issued to Sero Capital LLC a common stock warrant to acquire up to a total of 146,667 shares of the Company’s common stock at an exercise price of $6.00 per share, which exercise price may be paid in cash or, at the election of the holder, in a cashless, or “net,” exercise transaction. The warrant expires one year from the date of issuance.

The estimated fair value of the Sero Capital LLC warrant was $219,335 at date of issuance. The Company valued the warrants using the Black-Scholes pricing model and the following assumptions: contractual term of 1 year, a risk-free interest rate of 1.86%, a dividend yield of 0%, and volatility of 75.9%. The deferred costs attributed to the value of the warrants of $219,335 is amortized ratably over the term of the credit facility as interest expense. As of September 30, 2019, the unamortized balance was $182,779 and included in prepaid expenses and other current assets on the consolidated balance sheet.

NOTE 8 — RELATED PARTY TRANSACTIONS

As of September 30, 2019, and December 31, 2018, the total balances of related party payable were $4,541 and $14,467, respectively, related to reimbursement for employee paid travel on behalf of the Company. Sero Capital LLC, beneficially owned by David Moradi who became a director of the Company on November 8, 2019, was paid $30,000 in consulting fees through September 30, 2019.

See Note 7 relating to our Credit Facility.

NOTE 9 — STOCKHOLDERS’ EQUITY

Preferred Stock

As of September 30, 2019, and December 31, 2018, the Company had 105,000 shares of Series A Convertible Preferred Stock (the “Preferred Stock”), issued at $10 per share, paying a 5% cumulative annual dividend and convertible for common stock at a price of $4.385 per share. For the nine months ended September 30, 2019, preferred stockholders earned, but were not paid, $39,267 in annual dividends, or equivalent to 8,955 shares of common stock based on a conversion price of $4.385 per share. As of September 30, 2019, and December 31, 2018, cumulative and unpaid dividends were $232,007 and $192,740, respectively, or equivalent to 52,909 and 43,954 shares of common stock, respectively, based on a conversion price of $4.385 per share.

On any matter presented to the stockholders of the Company, holders of Preferred Stock are entitled to cast the number of votes equal to the number of shares of common stock into which the shares of Preferred Stock are convertible as of the record date to vote on such matter. As long as any shares of Preferred Stock are outstanding, the Company has certain restrictions on share repurchases or amendments to the Certificate of Incorporation in a manner that adversely affects any rights of the preferred stockholders.

In addition, the preferred stockholders have a liquidation preference for purposes of which the Preferred Stock would be valued at $10 per share plus accrued cumulative annual dividend. At September 30, 2019 and December 31, 2018, the total liquidation preference was valued at $1,287,007 and $1,242,740, respectively. In the event of any liquidity event, holders of each share of Preferred Stock shall be entitled to be paid the liquidation preference out of the assets of the Company legally available before any sums shall be paid to holders of common stock.

Common Stock

As of September 30, 2019, and December 31, 2018, the Company had 8,876,555 and 7,579,995 shares, respectively, of common stock issued and outstanding.

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

In the nine months ended September 30, 2019, the Company issued 21,932 shares of its common stock upon the exercise of options, for aggregate proceeds of $24,897. In the nine months ended September 30, 2019, the Company issued 1,252,319 shares of its common stock, upon the exercise of outstanding warrants to purchase an aggregate of 1,252,319 shares of common stock, for aggregate proceeds of $2,231,745. In the nine months ended September 30, 2019, the Company issued an aggregate of 11,055 shares of its common stock upon the net exercise of 15,596 outstanding options and issued an aggregate of 11,254 shares of its common stock upon the net exercise of outstanding warrants to purchase 27,231 shares of common stock.

Options

The following table summarizes the Company’s outstanding options activity during the nine months ended September 30, 2019:

On February 7, 2019, the Company granted an aggregate of 28,700 incentive stock options to employees newly hired since June 4, 2018. The options to purchase shares of common stock are exercisable at $10.55 per share, have a term of five years, and vest as to 50% of the options at the vesting commencement date, which is generally one year from the date of hire (vesting commencement dates range from June 4, 2019 through January 25, 2020), and vest as to the remaining 50% of the options in eight equal quarterly installments commencing on the first day of each calendar quarter following the vesting commencement date and installments continuing on the first day of each of the seven calendar quarters thereafter. All vesting is subject to the employee’s continued service through the vesting date. The exercise price was determined using the closing price of the Company’s common stock on February 7, 2019. The Black-Scholes value on the grant date of the options was $258,392.

On June 3, 2019, the Company granted an aggregate of 92,939 nonqualified stock options to employees newly hired since February 7, 2019, and longer-tenured employees for performance in 2018. The options to purchase shares of common stock are exercisable at $6.53 per share, have a term of ten years, and vest in three approximately equal annual installments on the first three anniversaries of the grant date. All vesting is subject to the employee’s continued service through the vesting date. The exercise price was determined using the closing price of the Company’s common stock on June 3, 2019. The Black-Scholes value on the grant date of the options was $571,471.

Option grants during the nine months ended September 30, 2019 were valued using the Black-Scholes pricing model. Significant assumptions used in the valuation include expected term of 3.25 to 6.00 years, expected volatility of 152.58% to 156.23%, risk free interest rate of 1.83% to 2.48%, and expected dividend yield of 0%. For the three and nine months ended September 30, 2019, total stock compensation expense related to options totaled $71,002 and $236,771, respectively. For the three and nine months ended September 30, 2018, total stock compensation expense related to options totaled $60,020 and $283,218, respectively. As of September 30, 2019, the outstanding unamortized stock compensation expense related to options was $600,845 (which will be recognized through June 2022).

AUDIOEYE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2019 (unaudited)

Warrants

The following table summarizes the Company’s outstanding warrants activity for the nine months ended September 30, 2019:

In August 2019, the Company negotiated with holders of certain warrants to purchase the Company’s common stock with respect to a transaction in which the Company and the holders agreed to amend certain warrant agreements to provide that from the date of amendment through August 16, 2019, the exercise price was reduced from $2.50 to $1.63 per share for warrants to purchase an aggregate of 1,194,990 shares and from $6.25 to $4.07 per share for warrants to purchase an aggregate of 85,719 shares, provided that any exercise during such period was in full and the exercise price was paid in cash. During the August period, an aggregate of 1,212,136 warrants to purchase the Company’s common stock were exercised for net proceeds of $2,114,918.

On August 14, 2019, the Company issued 146,667 warrants to acquire the Company’s common stock at an exercise price of $6.00 per share for a term of one year (See Note 7).

For the three and nine months ended September 30, 2019, warrant-based compensation expense was $0. For the three and nine months ended September 30, 2018, the Company incurred warrant-based compensation expense of $0 and $110,600, respectively. There was no outstanding unamortized stock-based compensation expense related to warrants as of September 30, 2019.

Restricted stock units (“RSUs”)

The following table summarizes the restricted stock unit activity for the nine months ended September 30, 2019:

On June 3, 2019, the Company granted 11,280 RSUs to each of Alexandre Zyngier, Ernest Purcell and Anthony Coelho for their continued service on the Board of Directors. Such RSUs will vest on June 3, 2020, subject to the director’s continuous service through the vesting date. The settlement date for such RSUs is the earlier of (i) June 3, 2026 or (ii) the date on which the Company undergoes a change of control. The fair value of the RSUs at grant date was $220,975.

On June 3, 2019, the Company granted 11,280 RSUs to each of Alexandre Zyngier, Ernest Purcell and Anthony Coelho for their continued service on the Board of Directors. Such RSUs will vest on June 3, 2020 , subject to the director’s continuous service through the vesting date. The settlement date for such RSUs is the earlier of (i) June 3, 2026 or (ii) the date on which the Company undergoes a change of control. The fair value of the RSUs at grant date was $220,975.

On June 3, 2019, the Company granted 80,900 RSUs to Sachin Barot, its Chief Financial Officer, in accordance with his employment agreement. Such RSUs will vest annually over a three-year period, in installments of (i) 26,967 RSUs on June 3, 2020, (ii) 26,967 RSUs on June 3, 2021 and (iii) 26,966 RSUs on June 3, 2022, subject to Mr. Barot’s continuous service through the vesting date. The settlement date for such RSUs is the earlier of (a) promptly after each vesting date or (b) in any event no later than March 15 of the calendar year following the calendar year in which such vesting occurs. The fair value of the RSUs at grant date was $528,277.

On August 19, 2019, the Company granted 24,105 RSUs to Joel Horwitz in accordance with a consulting agreement. Such RSUs will vest in installments according to performance conditions establishing certain milestones to be achieved within a timeframe stipulated by the consulting agreement, and as determined quarterly and certified by the Compensation Committee of the Board of Directors. The settlement date for such RSUs is the earlier of (a) promptly after each vesting date or (b) in any event no later than March 15 of the calendar year following the calendar year in which such vesting occurs. The fair value of the RSUs at grant date was $95,697.

For the three and nine months ended September 30, 2019, the Company incurred RSU-based compensation expense of $202,213 and $760,596, respectively. For the three and nine months ended September 30, 2018, the Company incurred RSU-based compensation expense of $32,398 and $336,625, respectively. The outstanding unamortized stock-based compensation expense related to RSUs was $703,174 (which will be recognized through May 2022) as of September 30, 2019.

NOTE 10 — COMMITMENTS AND CONTINGENCIES

Litigation

We may become involved in various 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 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., 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, 2018. 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.

Background

AudioEye, Inc. (“AudioEye” or the “Company”) was formed as a Delaware corporation on May 20, 2005. On August 1, 2018, the Company amended its Certificate of Incorporation to implement a reverse stock split in the ratio of 1 share for every 25 shares of common stock and to reduce the number of authorized shares of common stock from 250,000,000 to 50,000,000. As a result, 186,994,384 shares of the Company’s common stock were exchanged for 7,479,775 shares of the Company's common stock. The financial statements have been retroactively restated to reflect the reverse stock split.

In August 2018, the Company completed a private placement of common stock for $6.25 million (before expenses) growth equity financing with institutional investors to accelerate expansion efforts for the Company's direct and indirect sales channels as well as development of new channels in the kiosk and PDF markets. Further, we listed the Company's common stock on the NASDAQ Capital Market.

Overview

AudioEye is a marketplace leader providing web accessibility solutions for our clients’ customers primarily through our Accessibility Platform products (previously called “Ally”, now named “AudioEye Managed”). Our technology advances accessibility with patented technology solutions that reduce barriers, expand access for individuals with disabilities, and enhance the user experience for many users. When implemented, we believe that our solutions offer businesses, educational institutions, and governments 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 2.1”) as well as U.S., Canadian, Australian, and United Kingdom accessibility laws.

We generate revenue primarily through the sale of subscriptions of our software as a service (“SaaS”) technology platform, called the AudioEye Managed Platform, to website owners, publishers, developers, Content Management System (“CMS”) platform providers and operators and through the delivery of managed services combined with the implementation of our solutions. Our solutions have been adopted by some of the largest and most influential companies in the world.

On November 6, 2019 we unveiled AudioEye Digital Marketplace, enabling companies of all sizes to accelerate accessibility easily and affordably. The machine learning powered-platform helps companies achieve digital inclusion standards and meet legal requirements.

New products introduced on November 6, 2019 include AudioEye Free and AudioEye Pro, which join market-leading AudioEye Managed in the AudioEye Digital Marketplace, a new suite of digital accessibility commerce and machine-learning solutions for all price points.

AudioEye is powered by dynamic remediation technology that streamlines the digital accessibility process by evaluating, analyzing and repairing massive amounts of digital content. AudioEye’s real-time monitoring systems run over 360 core accessibility tests, against more than 1,500,000 unique pages each week. That system has catalogued well over 600,000,000 individual issues of accessibility, and it tracks the delivery of nearly 40,000,000 individual remediations. AudioEye automatically evaluates and dynamically adjusts website content to be accessible.

Our customers span disparate industries and target market verticals, which encompass (but are not limited to) the following categories: human resources, finance, retail/ecommerce, food services, automotive, transportation, hospitality, media, and education. Government agencies, both at the federal and state and local levels have also integrated our software in their digital platforms.

AudioEye customers fall into one of two distinct sales channels: Direct and Indirect. In the Direct channel, AudioEye sales personnel engage directly with the customer. In the Indirect channel, AudioEye engages with customers, who are referred to as Indirect Channel Partners, who provide a website hosting platform for their end-user customers, and who serve as authorized resellers of the AudioEye solution to their customers. Indirect channel sales have been a factor in the acceleration of the AudioEye sales and marketing strategy. We work with strategically identified reseller Partners that provide a unique opportunity for AudioEye to onboard more customers in a shorter period of time. By working with providers of proprietary content management systems, AudioEye leverages economies of scale to deliver the AudioEye solution in a cost-effective and highly efficient way. In middle and lower markets, this strategy has helped make accessibility available to industries that might otherwise neglect the important issue of digital inclusion altogether. We believe that there is significant opportunity for us to increase revenue in the future by delivering our solutions through this Indirect channel and therefore will continue to invest capital and resources in expanding our strategic partner business.

We have seen momentous growth in both our Direct and Indirect or “Partner” business channels. Since most of these Partners' underlying clients are billed monthly, we believe our bookings, revenue, and cash flow will converge in this segment. Customer renewal rates for the Direct channel continue in the range of low-mid 90%'s which further illustrates the confidence our customers have in the AudioEye accessibility solution.

Our accelerating topline growth is a testament to the ongoing demand for solutions aimed at addressing the broad issues of digital accessibility, and more specifically, to our internal efforts at continually refining our go-to-market strategy as well as expanding our sales and implementation teams to meet the building demand we are experiencing. AudioEye presents the only “all-in-one solution” created to address the public call for compliance with WCAG 2.1 standards.

During the first three quarters of 2019, as we saw throughout 2018, we continued to see significant growth within our direct and indirect sales channels, which was fueled by a number of factors. The increasing number of legal cases related to issues of accessibility has driven adoption of our solutions from a compliance perspective. Further, more companies are recognizing the business value of making their sites accessible to millions more consumers. Recognition of these tremendous business opportunities is sparked by demand from end-users who are letting companies and organizations know of the significant importance of accessibility to their websites.

Beyond this secular momentum, we have remained focused on several internal initiatives that are designed to make us more effective at an operational level. More specifically, we have made refinements to our lead generation processes, which has led to expansion of our overall sales pipeline, and we have continued to make enhancements to the technology that underlies our solution.

According to Forrester Research, there is a significant business opportunity considering that individuals with disabilities worldwide have more than $1.2 trillion in disposable income. More than a million new websites are active daily, representing commerce, jobs, and key parts of everyday life, and yet, despite the ever-growing digital world, digital accessibility on the web is not improving. Many current and new websites are not ADA / WCAG compliant and exclude individuals using assistive technology. AudioEye’s mission is to eradicate these access barriers, bringing thousands of new sites into compliance and, through a perpetual combination of technological and human-based oversight from AudioEye, supporting them into the future as the standards and regulations continue to evolve.

Overall, AudioEye believes that it has an opportunity to capitalize on the market in front of it. At the same time, we are dedicated to serving a vital role in leading the charge toward a more accessible online future for all.

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 solutions help with compliance and focuses 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 in and is made freely available to users within our customers’ 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 intellectual property is primarily comprised of trade secrets, trademarks, issued, published and pending patent applications, copyrights and technological innovation. We have a patent portfolio comprised of eight issued patents in the United States. We also have one published/pending patent application and two patent applications being prepared for filing via the Patent Cooperation Treaty (“PCT”) (international).

We have a trademark portfolio comprised of seven United States trademark registrations.

Our current patented inventions relate to:

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 on Form 10-K for the year ended December 31, 2018 provides additional information about our business and operations.

Results of Operations

Our consolidated 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, 2019 with the three and nine months ended September 30, 2018, which 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, 2019 and September 30, 2018

Results of Operations

Revenue

For the three months ended September 30, 2019 and 2018, revenue was $2,776,436 and $1,494,313, respectively, consisting primarily of revenue from core product sales and subscription services. Revenue increased due to the execution of the Company’s business plan which included growing our direct sales channel, securing new negotiated channel partnerships, and continued marketing focus on highly transactional industry verticals.

The following table presents our revenue disaggregated by type of good or service and sales channel:

Cost of Revenue

For the three months ended September 30, 2019 and 2018, cost of revenue was $1,121,307 and $672,589, respectively, consisting primarily of employee-related costs, including payroll, benefits and stock-based compensation expense for a portion of our technology operations and customer experience teams, fees paid to our managed hosting providers and other third-party service providers, amortization of capitalized software development costs and acquired technology, and allocated overhead costs. The increase in cost of revenue was due to a significant increase in direct labor headcount and related payroll and the use of sub-contracting to support the increase in revenue.

Gross Profit

An increase in our revenue and increase in cost of revenue resulted in a gross profit of $1,655,129 for the current period, as compared to a gross profit of $821,724 during the three months ended September 30, 2018. Gross profit increased as a result of increased revenue through higher sales and through recognition of deferred revenue as contractual obligations are fulfilled, offset in part by an increase in sub-contracting and direct labor costs.

Selling and Marketing Expenses

Selling and marketing expenses were $1,424,210 and $625,789 for the three months ended September 30, 2019 and 2018, respectively.  The increase resulted primarily from staff additions and salary increases as we expand our business lines.

Research and Development Expenses

Research and development expenses were $139,570 and $48,860 for the three months ended September 30, 2019 and 2018, respectively. Research and development expenses increased primarily as a result of an increase in technology staff as we continue to focus on improving our technology and introduce new products.

General and Administrative Expenses

General and administrative expenses were $2,249,302 and $1,445,539 for the three months ended September 30, 2019 and 2018, respectively. General and administrative expenses increased $803,763 due primarily to higher salaries and service provider costs in the 2019 period as compared to the 2018 period. Salaries, wages and benefits expenses increased to $509,725 in the current year period compared to $182,310 in the third quarter of 2018. Legal, consulting and recruiting fees increased significantly over such fees for the prior year period and were $583,423 in the third quarter of 2019 compared to $351,548 in the prior year comparable period.

Interest Income (Expense), net

Interest expense, net, during the three months ended September 30, 2019 was $37,746 compared to $32,892 for the three months ended September 30, 2018. During the three months ended September 30, 2019, we issued a warrant in connection with a credit facility incurring a $36,556 noncash interest expense in current period as compared to a noncash interest expense of $32,430 relating to issued convertible notes for the same period, last year.

Comparative for the Nine Months ended September 30, 2019 and September 30, 2018

Results of Operations

Revenue

For the nine months ended September 30, 2019 and 2018, revenue was $7,197,736 and $3,878,552, respectively, consisting primarily of revenue from core product sales and subscription services. Revenue increased due to the execution of the Company’s business plan which included growing our direct sales channel, securing new negotiated channel partnerships, and continued marketing focus on highly transactional industry verticals.

The following table presents our revenue disaggregated by type of good or service and sales channel:

Cost of Revenue

For the nine months ended September 30, 2019 and 2018, cost of revenue was $3,171,715 and $1,882,698, respectively, consisting primarily of employee-related costs, including payroll, benefits and stock-based compensation expense for a portion of our technology operations and customer experience teams, fees paid to our managed hosting providers and other third-party service providers, amortization of capitalized software development costs and acquired technology, and allocated overhead costs. The increase in cost of revenue was due to a significant increase in direct labor headcount and related payroll and the use of sub-contracting to support the increase in revenue.

Gross Profit

An increase in our revenue and increase in cost of revenue resulted in a gross profit of $4,026,021 for the nine months ended September 30, 2019, as compared to a gross profit of $1,995,854 during the nine months ended September 30, 2018. Gross profit increased as a result of increased sales volume, an increasing revenue renewal rate and recognition of deferred revenue as contractual obligations are fulfilled, offset in part by an increase in sub-contracting and direct labor costs.

Selling and Marketing Expenses

Selling and marketing expenses were $3,389,912 and $1,813,345 for the nine months ended September 30, 2019 and 2018, respectively.  The increase resulted primarily from staff additions and salary increases as we expand our business lines.

Research and Development Expenses

Research and development expenses were $501,400 and $147,889 for the nine months ended September 30, 2019 and 2018, respectively. Research and development expenses increased primarily as a result of an increase in technology staff as we continue to focus on improving our technology and introduce new products.

General and Administrative Expenses

General and administrative expenses were $6,452,315 and $3,592,004 for the nine months ended September 30, 2019 and 2018, respectively. General and administrative expenses increased $2,860,311 due primarily to higher salaries and service provider costs in the 2019 period as compared to the 2018 period. Salaries, wages and benefits expenses increased to $1,976,598 in the current year period compared to $655,541 in the nine months ended September 30, 2018. Legal, consulting and recruiting fees increased significantly over such fees for the prior year period and were $1,537,656 in the nine months ended September 30, 2019 compared to $491,047 in the prior year comparable period.

Contracts in Process/Revenue Recognition

Under current accounting procedures, revenue is recognized when delivery of the promised goods or services is transferred to customers, in an amount that reflects the consideration that the Company expects to be entitled to in exchange for those goods or services. Certain invoices are prepared on an annual basis. Any funds received for services not provided yet are held in deferred revenue and are recorded as revenue when earned. Subscription revenue is recognized on a ratable basis over the contractual subscription term of the arrangement beginning on the date that our service is made available to the customer.

Payments received in advance of services being rendered are recorded as deferred revenue. In accordance with Accounting Standard ASU 2014-09 Revenue from Contracts with Customers and all subsequent amendments to the ASU (collectively, “ASC 606”), the Company records accounts receivable for amounts invoiced to customers for which service has been rendered and for amounts invoiced and are in deferred revenue but for which the Company has an unconditional right to consideration as provided under the contractual arrangement. The table below summarizes the amount of contract value in excess of revenue recognized prior to 2019 of $4.9 million, our deferred revenue of $4.3 million and the amount recognized as revenue in 2019 of $7.2 million. Contract amount in excess and deferred revenue are expected to be recognized in future periods. The Company also receives contracts for service hours where 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: 

Revenues for the first three quarters ended September 30, 2019 were a record $7.2 million, representing an increase of 86% from $3.9 million in the prior year comparable period. Revenues for the third quarter of 2019 were $2.8 million, an increase of 86% from $1.5 million in the third quarter of 2018. The revenues for the third quarter of 2019 represent the 15^th consecutive quarter of topline growth for the Company. In addition, contract amounts in excess of revenue, or the Company’s pipeline, continue to grow.

Contract bookings (as defined below) for the third quarter of 2019 were approximately $5.7 million. This represents an increase of 102% from $2.8 million in the prior year comparable period.

About Key Operating Metrics

To supplement our financial information presented in accordance with GAAP, we consider certain operating measures that are not GAAP measures, including contract bookings and contract amount in excess of deferred revenue and recognized revenue. AudioEye reviews a number of operating metrics such as these to evaluate its business, measure performance, identify trends, formulate business plans, and make strategic decisions. We believe these metrics and measures are useful to facilitate period-to-period comparisons of our business and to facilitate comparisons of our performance to that of other similar companies.

AudioEye's “Contract Bookings” or “Bookings” are the amount of money the customer commits to spend with the Company over an agreed amount of time, generally ranging from 12 to 60 months. Contract Bookings are stated at total contract value committed during a specified time and recognized as revenue when services are delivered. While some contracts are cancellable under certain circumstances during the contract period, the Company has a very good track record of customer retention.

“Partner” or “Vertical Partner” is a company which provides a web-hosting platform for private and public entities and resells the AudioEye services as a new accessibility service offering to its customers.

Liquidity and Capital Resources

Working Capital

As of September 30, 2019, the Company had cash of $3,463,899 and a working capital of $341,009. While the Company has been successful in raising capital in the past, there is no assurance that it will be successful at raising additional capital in the future. Additionally, if the Company’s plans are not achieved and/or if significant unanticipated events occur, the Company may have to further modify its business plan, which may require us to raise additional capital.

The working capital for the periods ended September 30, 2019 and December 31, 2018 was $341,009 and $3,370,983, respectively. The decrease in working capital was primarily due to uses of cash described below. The Company has incurred net losses since inception.

Cash Flows

We had cash in the amount of $3,463,899 and $5,741,549 as of September 30, 2019 and December 31, 2018, respectively. The Company used actual net cash in operations of $4,322,063 during the nine months ended September 30, 2019 compared to $1,251,559  during the nine months ended September 30, 2018. Cash used in operating activities resulted from increased headcount, personnel, legal, sales and marketing costs, an increase in our accounts receivable of $1,190,016, and deferred costs of $259,792, partially offset by an increase in accounts payable and accrued expenses of $576,585 and an increase in deferred revenue of $1,282,901.

In August 2019, the Company negotiated with holders of certain warrants to purchase the Company’s common stock with respect to a transaction in which the Company and the holders agreed to amend certain warrant agreements to provide that from the date of amendment through August 16, 2019, the exercise price was reduced from $2.50 to $1.63 per share for warrants to purchase an aggregate of 1,194,990 shares and from $6.25 to $4.07 per share for warrants to purchase an aggregate of 85,719 shares, provided that any exercise during such period was in full and the exercise price was paid in cash. Proceeds from the amended warrants exercised was approximately $2.1 million.

In August 2019, the Company negotiated an agreement for a $2.0 million Line of Credit (the “LOC”) with Sero Capital LLC, a shareholder who owns more than 10% of the outstanding shares of common stock of the Company. The Company’s primary source of operating funds has been from revenue generated from sales and cash proceeds from the sale of common stock and the issuance of convertible and other debt. With the August warrant exercises and the LOC, it is anticipated that the Company will have cash sufficient to fund operations for the next twelve months.

We may raise additional capital through the sale of equity or debt securities or borrowings from financial institutions or third parties or a combination of the foregoing. Capital raised will be used to implement our business plan, grow current operations, make acquisitions and/or start new vertical businesses among some of the anticipated uses of such capital.

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 U.S. GAAP. 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, 2018, relate to revenue recognition, cost of revenue, capitalized legal patent costs, income taxes, goodwill, intangible assets, share-based payments, and research and development. 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, 2018.

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, 2019. Based upon that evaluation, the Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures as of September 30, 2019 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, 2018. 

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 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

We may become involved in various 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 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2018.

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

On July 15, 2019, an executive officer who is also a director received 7,317 shares of common stock of the Company for the cashless exercise of 15,785 warrants to purchase shares of common stock of the Company.

The shares of common stock were offered and sold pursuant to exemptions from registration provided by Section 4(a)(2) of the Securities Act of 1933, as amended. The Company intends to use any cash proceeds received in connection with such exercises for general corporate and working capital purposes.

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 13^th day of November 2019.