AWARE INC /MA/ - Quarter Report: 2020 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Quarterly Report Pursuant To Section 13 Or 15(d) Of The

Securities Exchange Act of 1934

For the quarter ended September 30, 2020

Commission file number 000-21129

AWARE, INC.

(Exact Name of Registrant as Specified in Its Charter)

40 Middlesex Turnpike, Bedford, Massachusetts, 01730

(Address of Principal Executive Offices)

(Zip Code)

(781) 276-4000

(Registrant’s Telephone Number, Including Area Code)

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

Indicate by check 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 past 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, smaller reporting company, or an emerging growth company.  See the 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

The number of shares outstanding of the registrant’s common stock as of October 28, 2020 was 21,447,338.

AWARE, INC.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2020

TABLE OF CONTENTS

PART 1. FINANCIAL INFORMATION

ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS

AWARE, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS 

(in thousands, except per share data)

(unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)

(unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1 – Description of the Company and Basis of Presentation

Description of the Company

We are a leading provider of software and services to the biometrics industry. Our software products are used in government and commercial biometrics systems, which are capable of determining or verifying an individual’s identity. We offer engineering services related to software configuration, integration, and installation, as well as complete systems development. We sell our biometrics software products and services globally through systems integrators, OEMs, and directly to end user customers. We also derive a portion of our revenue from the sale of imaging software.

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and therefore do not include all information and notes necessary for a complete presentation of our financial position, results of operations and cash flows, in conformity with generally accepted accounting principles. We filed audited financial statements which included all information and notes necessary for such presentation for the two years ended December 31, 2019 in conjunction with our 2019 Annual Report on Form 10-K. This Form 10-Q should be read in conjunction with that Form 10-K.

The accompanying unaudited consolidated balance sheets, statements of operations, statements of cash flows, and statements of stockholders’ equity reflect all adjustments (consisting only of normal recurring items) which are, in the opinion of management, necessary for a fair presentation of financial position at September 30, 2020, and of operations and cash flows for the interim periods ended September 30, 2020 and 2019.

The results of operations for the interim period ended September 30, 2020 are not necessarily indicative of the results to be expected for the year.

Principles of Consolidation

The consolidated financial statements include the accounts of Aware and its subsidiary. Intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. The most significant estimates included in the financial statements pertain to revenue recognition, reserves for doubtful accounts, useful lives of fixed assets, valuation allowance for deferred income tax assets, and accrued liabilities. Actual results could differ from those estimates.

Recent Accounting Pronouncements

In December 2019, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. The ASU was issued to reduce the complexity of the reporting information for financial statement users. We adopted the standard on January 1, 2020. The adoption of the standard did not result in any adjustment to our financial statements.

In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments, which changes the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded.  This guidance was to be effective for reporting periods beginning after December 15, 2019, with early adoption permitted. In November 2019, the FASB issued ASU 2019-10, Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842) Effective Dates, which deferred the effective dates for us, as a smaller reporting company, until fiscal year 2023. We are continuing to assess the impact of the standard on our consolidated financial statements.

Note 2 – Revenue Recognition

We recognize revenue in accordance with ASC 606, “Revenue from Contracts with Customers” (“ASC 606”). Under ASC 606, we apply the following five step model:

We categorize revenue as software licenses, software maintenance, or services. Revenue from software licenses is recognized at a point in time upon delivery, provided all other revenue recognition criteria are met. We recognize software maintenance revenue over time on a straight-line basis over the contract period. Services revenue is recognized over time as the services are delivered using an input method (i.e., labor hours incurred as a percentage of total labor hours budgeted), provided all other revenue recognition criteria are met.

In addition to selling software licenses, software maintenance and software services on a standalone basis, a significant portion of our contracts include multiple performance obligations, which require an allocation of the transaction price to each distinct performance obligation based on a relative standalone selling price (“SSP) basis. The SSP is the price at which we would sell a promised good or service separately to a customer. The best estimate of SSP is the observable price of a good or service when we sell that good or service separately. A contractually stated price or a list price for a good or service may be the SSP of that good or service. We use a range of amounts to estimate SSP when we sell each of the goods and services separately and need to determine whether there is a discount that needs to be allocated based on the relative SSP of the various goods and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we typically determine the SSP using an adjusted market assessment approach using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual goods and services due to the stratification of those goods and services by customers and circumstances. In these instances, we may use information such as the nature of the customer and distribution channel in determining the SSP.

When software licenses and significant customization engineering services are sold together, they are accounted for as a combined performance obligation, as the software licenses are generally highly dependent on, and interrelated with, the associated customization services and therefore are not distinct performance obligations. Revenue for the combined performance obligation is recognized over time as the services are delivered using an input method (i.e., labor hours incurred as a percentage of total labor hours budgeted).

The amount of consideration is not adjusted for a significant financing component if the time between payment and the transfer of the related good or service is expected to be one year or less under the practical expedient in ASC 606-10-32-18. Our revenue arrangements are typically accounted for under such expedient, as payment is typically due within 30 to 60 days. As of September 30, 2020 and 2019, none of our contracts contained a significant financing component.

Disaggregation of Revenues

We organize ourselves into a single segment that reports to the chief operating decision maker. We conduct our operations in the United States and sell our products and services to domestic and international customers. Revenues were generated from the following geographic regions for the three and nine months ended September 30, 2020 and 2019 (in thousands):

Revenue by product group for the three and nine months ended September 30, 2020 and 2019 was (in thousands):

Revenue by timing of transfer of goods or services for the three and nine months ended September 30, 2020 and 2019 was (in thousands):

Contract Balances

When the timing of our delivery of goods or services is different from the timing of payments made by customers, we recognize either a contract asset (performance precedes contractual due date) or a contract liability (customer payment precedes performance). Customers that prepay are represented by the deferred revenue below until the performance obligation is satisfied.

Our contract assets consist of unbilled receivables. Our contract liabilities consist of deferred (unearned) revenue, which is generally related to software maintenance contracts. We classify deferred revenue as current or noncurrent based on the timing of when we expect to recognize revenue.

The following table presents changes in our contract assets and liabilities during the nine months ended September 30, 2019 and 2020 (in thousands):

Remaining Performance Obligations

Remaining performance obligations represent the transaction price from contracts for which work has not been performed or goods and services have not been delivered. We expect to recognize revenue on approximately 63% of the remaining performance obligations over the next 12 months, with the remainder recognized thereafter. As of September 30, 2020, the aggregate amount of the transaction price allocated to remaining performance obligations for software maintenance contracts with a duration greater than one year was $2.4 million.

Note 3 – Fair Value Measurements

The FASB Codification defines fair value, and establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The three levels of the fair value hierarchy under the FASB Codification are: i) Level 1 – valuations that are based on quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date; ii) Level 2 – valuations that are based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly; and iii) Level 3 – valuations that require inputs that are both significant to the fair value measurement and unobservable.

Cash and cash equivalents, which primarily include money market mutual funds, were $42.3 million and $47.7 million as of September 30, 2020 and December 31, 2019, respectively. As of September 30, 2020, our assets that are measured at fair value on a recurring basis and whose carrying values approximate their respective fair values included the following (in thousands):

As of December 31, 2019, our assets that are measured at fair value on a recurring basis and whose carrying values approximate their respective fair values included the following (in thousands):

Note 4 – Computation of Earnings per Share

Basic earnings per share is computed by dividing net income or loss by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing net income or loss by the weighted average number of common shares outstanding plus additional common shares that would have been outstanding if dilutive potential common shares had been issued. For the purposes of this calculation, stock options are considered common stock equivalents in periods in which they have a dilutive effect. Stock options that are anti-dilutive are excluded from the calculation. Potential common stock equivalents were not included in the per share calculation for diluted earnings per share, because we had a net loss and the effect of their inclusion would be anti-dilutive.

Net income (loss) per share is calculated as follows (in thousands, except per share data):

Note 5 – Stock-based compensation

The following table presents stock-based employee compensation expenses included in our unaudited consolidated statements of comprehensive income (in thousands):

Stock Options. We granted stock option for 260,000 shares in the three and nine months ended September 30, 2019. We granted stock options for 50,000 shares in the nine months ended September 30, 2020. We did not grant any stock options in the three months ended September 30, 2020.

Unrestricted Stock Grants. We grant unrestricted shares of stock under our 2001 Nonqualified Stock Plan. Stock-based compensation expense for stock grants is determined based on the fair market value of our stock on the date of grant, provided the number of shares in the grant is fixed on the grant date.

We granted shares of unrestricted stock in 2020 and 2019 that affected financial results for the three and nine month periods ended September 30, 2020 and 2019. These grants are described below.

We did not grant any shares of unrestricted stock in the three months ended September 30, 2020. In March and May 2020 we granted an aggregate 243,000 shares of unrestricted stock to directors, officers, and employees. The shares were scheduled to be issued in two equal installments shortly after June 30, 2020 and December 31, 2020, provided each grantee is serving as a director, officer or employee on those dates. The total stock-based compensation expense related to these grants is $0.7 million, of which $0.4 million was charged to expense in the nine months ended September 30, 2020. We anticipate the remaining $0.3 million will be charged to expense in the fourth quarter of 2020. We issued 109,773 shares of common stock related to the March and May 2020 grants in early July 2020 after employees surrendered 11,727 shares for which we paid $75,000 of withholding taxes on their behalf.

In 2019 we granted 285,500 shares of unrestricted stock to directors, officers, and employees. We granted 120,000 shares which will be issued in four equal installments on their anniversary in September and October of 2020, 2021, 2022, and 2023, provided the grantee is serving as a director, officer, or employee on those dates.  We also granted 165,500 shares throughout March, September, and October of 2019.  We issued 71,500 and 94,000 shares shortly after September 30 2019 and December 31, 2019, respectively.  The total stock-based compensation expense related to the 285,500 shares granted in 2019 is $947,000, of which $633,000 was charged to expense in the 2019 and $63,000 was charged to expense in the nine months ended September 30, 2020. We anticipate the remaining $251,000 will be charged to expense ratably through 2023. We issued shares of common stock related to the March 2019 grant as follows: i) 58,548 net shares of common stock were issued in early July 2019 after employees surrendered 12,952 shares for which we paid $43,000 of withholding taxes on their behalf; and ii) 56,605 net shares of common stock were issued in early January 2020 after employees surrendered 14,895 shares for which we paid $50,000 of withholding taxes on their behalf. We also issued 20,000 shares of common stock related to a September 2019 grant in September 2020.

We issued shares of common stock related to the March 2019 grant as follows: i) 58,548 net shares of common stock were issued in early July 2019 after employees surrendered 12,952 shares for which we paid $43,000 of withholding taxes on their behalf; and ii) 56,605 net shares of common stock were issued in early January 2020 after employees surrendered 14,895 shares for which we paid $50,000 of withholding taxes on their behalf.

We issued 109,773 shares of common stock related to the March and May 2020 grant in early July 2020 after employees surrendered 11,727 shares for which we paid $75,000 of withholding taxes on their behalf. We also issued 20,000 shares of common stock related to September 2019 grant in September 2020.

Performance Share Award. In September 2019, we granted 20,000 shares of stock to an officer as a performance share award under our 2001 Nonqualified Stock Plan. The shares were issued in September 2019 and were forfeitable if the grantee was not serving as a director, officer or employee on March 19, 2020. Stock-based compensation expense for this stock grant was determined based on the fair market value of our stock on the date of grant, as the number of shares in the grant was fixed on the grant date. The total stock-based compensation expense related to this grant was $55,000, of which $31,000 was charged to expense in 2019 and $24,000 was charged to expense in the nine months ended September 30, 2020.

In October 2019, we granted 10,000 shares of stock to an officer as a performance share award under our 2001 Nonqualified Stock Plan. The shares were issued in October 2019 and were forfeitable if the grantee was not serving as a director, officer or employee on April 1, 2020. Stock-based compensation expense for this stock grant was determined based on the fair market value of our stock on the date of grant, as the number of shares in the grant was fixed on the grant date. The total stock-based compensation expense related to this grant was $29,000, of which $15,000 was charged to expense in 2019 and $14,000 was charged to expense in the nine months ended September 30, 2020.

Note 6 – Stock Repurchase Program

On April 30, 2020, the Board of Directors approved a program authorizing the Company to purchase up to $10 million of its common stock, of which $0.7 million had been utilized as of September 30, 2020. During the three and nine months ended September 30, 2020, the Company repurchased 83,000 shares and 222,000 shares of its common stock for $0.2 million and $0.7 respectively. The shares may be purchased from time to time in the open market or through privately negotiated transactions at management’s discretion, depending upon market conditions and other factors. The authorization to repurchase Company stock expires on December 31, 2021. Repurchases will be made under the program using the Company’s own cash resources and will been accordance with Rule 10b-18 under the Securities Exchange Act of 1934 and other applicable laws, rules and regulations. The program does not obligate the Company to acquire any particular amount of common stock and the program may be modified or suspended at any time at the Company’s discretion.

Note 7 – Income Taxes

Income tax benefit was $0.7 million and $1.4 million for the three and nine months ended September 30, 2020, respectively. Income tax expense for the three and nine month periods ended September 30, 2020 were based on the U.S. statutory rate of 21%, increased by state income taxes, and reduced by permanent adjustments and research tax credits. The Coronavirus Aid, Relief and Economic Security Act (CARES Act) was signed into law on March 27, 2020. The CARES Act contained specific relief and stimulus measures including allowing net operating losses originating in 2018 through 2020 to be carried back five years to offset taxable income in the carryback period.

Separately, the enactment of the Tax Cut and Jobs Act in 2017 allowed taxpayers to claim a refund for alternative minimum tax credits over a period of years. The CARES Act enacted during the first quarter of 2020 allows for the entire amount of the credit to be refunded in 2020.

We have reviewed the impact of the CARES Act enactment on the income tax provision and have determined that, as a result of the net operating loss carryback provision, we can obtain a tax benefit if we were to carry back the forecasted 2020 net operating loss to the five year carryback period.

The carryback of the estimated loss would result in a refundable federal tax credit of approximately $1.5 million and an increase in research credit carryforwards previously utilized. The federal tax credit can be refunded in the future, if we decide to carry back the loss reported on the filed 2020 tax return instead of electing to carry the loss forward. Due to the recent loss history, continued investments in the company, and our future projections of income, we will benefit from the current year loss to the extent of the available tax refund and will maintain a full valuation allowance on all other deferred tax assets, including any increase in research credit carryforward resulting from a potential carryback.

As of the end of the period, we have not made a determination on whether to elect to carry forward the 2020 operating loss, however, the federal tax refund potential on carryback represents a minimum tax benefit we can obtain from the estimated 2020 loss. We can realize a tax benefit to the extent of the carryback refund potential as it is considered a source of income against which to utilize the 2020 estimated loss.

The total estimated benefit of the federal tax refund of $1.5 million is included in our projection of our annual effective rate and results in a year to date benefit of approximately $1.2 million. We recorded the year to date tax benefit as a long term tax receivable.

ITEM 2:

Management’s Discussion and Analysis of

Financial Condition and Results of Operations

Cautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995

Some of the information in this Quarterly Report on Form 10-Q contains forward-looking statements that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate,” “continue” and similar words. You should read statements that contain these words carefully because they: (1) discuss our future expectations; (2) contain projections of our future operating results or financial condition; or (3) state other “forward-looking” information. However, we may not be able to predict future events accurately. The risk factors listed in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2019, as well as any cautionary language in this Quarterly Report on Form 10-Q, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should be aware that the occurrence of any of the events described in these risk factors and elsewhere in this Quarterly Report on Form 10-Q could materially and adversely affect our business.

Summary of Operations

We are primarily engaged in the development and sale of biometrics products, solutions and services. Our software products are used in government and commercial systems and applications and fulfill a broad range of functions critical to secure biometric enrollment, authentication, identification and transactions. Principal government applications of biometrics systems include border control, visa applicant screening, law enforcement, national defense, intelligence, secure credentialing, access control, and background checks. Principal commercial applications include: i) user enrollment and authentication used for login to mobile devices, computers, networks, and software programs; ii) user authentication for financial transactions and purchases (online and in-person); iii) physical access control to buildings; and iv) identity proofing of prospective employees and customers. We sell our biometrics software products and services globally through a multifaceted distribution strategy using systems integrators, OEMs, VARs, partners, and directly to end user customers. We also derive a portion of our revenue from the sale of imaging software licenses to OEMs and systems integrators that incorporate our software into medical imaging products and medical systems.

Due to the COVID-19 pandemic we have been unable to: (i) conduct face-to-face meetings with customers and prospective customers, (ii) present in-person demonstrations of our software solutions, (iii) attend trade shows and conferences which typically generate future sales opportunities or (iv) meet with prospective strategic partners. We believe that these effects caused by the COVID-19 pandemic adversely impacted our revenue in the second and third quarters of 2020 and will likely have an adverse impact on our revenue over the next several quarters.

Summary of Financial Results

We use revenue and results of operations to summarize financial results as we believe these measurements are the most meaningful way to understand our operating performance.

Revenue and operating loss for the three months ended September 30, 2020 were $2.4 million and $2.6 million, respectively. These results compared to revenue of $3.0 million and operating loss of $1.2 million for the three months ended September 30, 2019. Lower revenue in the current three month period was primarily due to lower license and services revenue associated with delays caused by the COVID-19 pandemic. Higher operating loss in the current three month period was primarily due to lower revenue and higher operating expenses including previous investment in sales and engineering resources driving growth in new product areas and expenses related to turnover of administrative personnel and COVID-19 remote working costs.

Revenue and operating loss for the nine months ended September 30, 2020 were $7.8 million and $7.7 million, respectively. These results compared to revenue of $9.8 million and operating loss of $2.4 million in the nine months ended September 30, 2019. Lower revenue was primarily due to lower license and services revenue. Higher operating loss was primarily due to lower revenue and higher operating expenses including previous investment in sales and engineering resources driving growth in new product areas and expenses related to turnover of administrative personnel and COVID-19 remote working costs.

These and all other financial results are discussed in more detail in the results of operations section that follows.

Results of Operations

Software licenses. Software licenses consist of revenue from the sale of biometrics and imaging software products. Sales of software products depend on our ability to win proposals to supply software for biometrics systems projects either directly to end user customers or indirectly through channel partners.

Software license revenue decreased 42% from $1.1 million in the three months ended September 30, 2019 to $0.7 million in the same three month period in 2020. As a percentage of total revenue, software license revenue decreased from 38% in the second quarter of 2019 to 28% in the current year quarter. The $0.4 million decrease in software license revenue was due primarily to a decrease in biometrics software license sales to $0.4 million in the third quarter of 2020 versus $0.7 million in the same quarter last year. The dollar decrease was primarily due to delays in new software procurements caused by the COVID-19 pandemic and lower revenue from the software license agreement we entered into with a systems integrator in the second quarter of 2018 for a large project with follow-on sales in 2019 and 2020. We recognized $0.1 million of software license revenue from this agreement in the third quarter of 2019.

As described in the strategy section of our Form 10-K for the year ended December 31, 2019, our market strategy is to continue to focus on our legacy government biometrics markets and expand into new commercial biometrics markets. We are unable to predict future revenue from commercial markets as these are emerging markets.

Software license revenue decreased 21% from $3.9 million in the nine months ended September 30, 2019 to $3.0 million in the same nine month period in 2020. As a percentage of total revenue, software license revenue decreased from 40% in the first nine months of 2019 to 39% in the current year nine month period. The $0.8 million decrease in software license revenue was primarily due to a $0.7 million decrease in biometrics software license sales. The dollar decrease was primarily due to aforementioned delays in new software procurements caused by the COVID-19 pandemic and lower revenue from the aforementioned software license agreement we entered into with a systems integrator in 2018. We recognized $0.5 million of software license revenue from this agreement in the nine months ended September 30, 2019.

Software maintenance. Software maintenance consists of revenue from the sale of software maintenance contracts. Software maintenance contracts entitle customers to receive software support and software updates, if and when they become available, during the term of the contract.

Software maintenance revenue increased 6% from $1.3 million in the three months ended September 30, 2019 to $1.4 million in the same three month period in 2020. As a percentage of total revenue, software maintenance revenue increased from 43% in the third quarter of 2019 to 58% in the current year quarter.

Software maintenance revenue increased 4% from $4.0 million in the nine months ended September 30, 2019 to $4.1 million in the same nine month period in 2020. As a percentage of total revenue, software maintenance revenue increased from 40% for the first nine months of 2019 to 53% in the current year nine month period.

For the three and nine month periods ended September 30, 2020, the slight dollar increase in software maintenance revenue was primarily due to slightly higher retention of maintenance renewals in those periods.

Services. Services consist of fees we charge to perform software development, integration, installation, and customization services. Similar to software license revenue, services revenue depends on our ability to win biometrics systems projects either directly with end user customers or in conjunction with channel partners. Services revenue will fluctuate when we commence new projects and/or when we complete projects that were started in previous periods.

Services revenue decreased from $0.6 million in the three months ended September 30, 2019 to $0.3 million in the same three month period in 2020. As a percentage of total revenue, services revenue decreased from 19% in the third quarter of 2019 to 14% in the current year quarter.

For the three month period ended September 30, 2020, the dollar decrease in services revenue was primarily due to lower services revenue in the current year quarter related to the software license agreement we entered into with a systems integrator in the second quarter of 2018 for a large project. This decrease was partially offset by higher services revenue from other service customers.

Services revenue decreased 68% from $1.9 million in the nine months ended September 30, 2019 to $0.6 million in the same nine month period in 2020. As a percentage of total revenue, services revenue decreased from 20% in the first nine months of 2019 to 8% in the corresponding period of 2020.

For the nine month period ended September 30, 2020, the dollar decrease in services revenue was primarily due to lower services revenue related to the software license agreement we entered into with a systems integrator in the second quarter of 2018 for a large project, and lower service revenue from other direct to government customers.

Cost of services. Cost of services consists of engineering costs to perform customer services projects. Such costs primarily include: i) engineering salaries, stock-based compensation, fringe benefits, and facilities; and ii) engineering consultants and contractors.

Cost of services decreased from $0.3 million in the three months ended September 30, 2019 to $0.1 million in the same three month period in 2020. Cost of services as a percentage of services decreased from 46% in the second quarter of 2019 to 45% in the current year quarter, which means that gross margins increased from 54% to 55%. The decrease in cost of services expense was primarily due to lower service revenue in the third quarter of 2020 resulting from fewer active contracts with services.

Cost of services decreased 56% from $1.1 million in the nine months ended September 30, 2019 to $0.5 million in the same nine month period in 2020. Cost of services as a percentage of services increased from 57% in the first nine months of 2019 to 78% in the corresponding period of 2020, which means that gross margins decreased from 43% to 22%. The decrease in cost of services expense was primarily due to lower service revenue in the nine months ended September 30, 2020 resulting from fewer active contracts with services during this period. The decrease in the gross margin was primarily due to the aforementioned timing of costs compared to the recognition of revenue on projects.

Research and development expense. Research and development expense consists of costs for: i) engineering personnel, including salaries, stock-based compensation, fringe benefits, and facilities; ii) engineering consultants and contractors, and iii) other engineering expenses such as supplies, equipment depreciation, dues and memberships and travel. Engineering costs incurred to develop our technology and products are classified as research and development expense. As described in the cost of services section, engineering costs incurred to provide engineering services for customer projects are classified as cost of services, and are not included in research and development expense.

The classification of total engineering costs to research and development expense and cost of services was (in thousands):

Research and development expense increased 13% from $2.1 million in the three months ended September 30, 2019 to $2.3 million in 2020. As a percentage of total revenue, research and development expense increased from 69% in 2019 to 99% in 2020.

Research and development expense increased from $5.9 million in the nine months ended September 30, 2019 to $7.0 million in the same nine month period in 2020. As a percentage of total revenue, research and development expense increased from 61% in the first nine months of 2019 to 90% in the corresponding period of 2020.

As the table immediately above indicates, total engineering costs in the third quarter of 2020 increased by $0.1 million compared to the same period last year. Total engineering costs increased by $0.5 million for the nine months ended September 30, 2020 as compared to the same period last year. For both the three and nine month periods, the spending increase was primarily due to higher employee costs due to increased headcount. This increase was partially offset by a decrease in spending on third-party development costs. Lower spending on third-party development costs was primarily due to a decrease in spending with a third-party software development vendor that has been providing services since 2016.

We anticipate that we will continue to focus our future research and development activities on enhancing our existing products and developing new products with our growing internal resources.

Selling and marketing expense. Selling and marketing expense primarily consists of costs for: i) sales and marketing personnel, including salaries, sales commissions, stock-based compensation, fringe benefits, travel, and facilities; and ii) advertising and promotion expenses.

Sales and marketing expense increased 40% from $0.9 million in the three months ended September 30, 2019 to $1.3 million in the same three month period of 2020. As a percentage of total revenue, sales and marketing expense increased from 31% in the third quarter of 2019 to 55% in the corresponding period in 2020. The dollar increase in sales and marketing expense was primarily due to higher employee costs due to increased headcount and contracted sales agents.

Sales and marketing expense increased 42% from $2.7 million in the nine months ended September 30, 2019 to $3.8 million in the same nine month period of 2020. As a percentage of total revenue, sales and marketing expense increased from 27% in the first nine months of 2019 to 49% in the corresponding period in 2020. The dollar increase in sales and marketing expense was primarily due to higher employee costs due to increased headcount and contracted sales agents.

General and administrative expense. General and administrative expense consists primarily of costs for: i) officers, directors and administrative personnel, including salaries, bonuses, director compensation, stock-based compensation, fringe benefits, and facilities; ii) professional fees, including legal and audit fees; iii) public company expenses; and iv) other administrative expenses, such as insurance costs and bad debt provisions.

General and administrative expense increased 32% from $0.9 million in the three months ended September 30, 2019 to $1.2 million in the same three month period in 2020. As a percentage of total revenue, general and administrative expense increased from 30% in the third quarter of 2019 to 51% in the corresponding period in 2020. The increase in general and administrative expense was primarily due to costs related to the COVID-19 pandemic and higher employee related costs of our administrative personnel.

General and administrative expense increased 66% from $2.5 million in the nine months ended September 30, 2019 to $4.2 million in the same nine month period in 2020. As a percentage of total revenue, general and administrative expense increased from 26% in the first nine months of 2019 to 54% in the corresponding period in 2020. The increase in general and administrative expense was primarily due to costs related to the COVID-19 pandemic and turnover of over 50% our administrative personnel. Costs included $0.7 million of severance and transition expense, $0.2 million of legal fees, $0.1 million of bad debt expense and $0.2 million computer hardware and software related to remote working.

Patent related income. We entered into an arrangement with an unaffiliated third party in 2010 under which we assigned certain patents in return for royalties on proceeds from patent monetization efforts by the third party. The third party has engaged in various patent monetization activities, including enforcement, litigation and licensing. In the three and nine months ended September 30, 2020, there was no revenue from this arrangement. For three and nine months ended September 30, 2019, revenue was $0 and $49,000 respectively from this arrangement. We continue to have a contractual relationship with this third party. However, we are unable to predict how much more income we might receive from this arrangement, if any, because we do not know whether any patent monetization efforts by the third party will be successful.

Interest income. Interest income decreased 97% from $0.3 million in the three months ended September 30, 2019 to $7,000 in the same three month period in 2020. Interest income decreased 78% from $0.8 million in the nine months ended September 30, 2019 to $0.2 million in the same nine month period in 2020. For the three and nine month periods, the decrease in interest income was primarily due to lower interest rates within our money market accounts as a result of the financial markets response to the COVID-19 pandemic. We expect these lower interest rates to continue for the foreseeable future.

Income taxes. Income tax benefit was $0.7 million and $1.4 million for the three and nine months ended September 30, 2020, respectively. Income tax benefit for the three and nine month periods ended September 30, 2020 were based on the U.S. statutory rate of 21%, increased by state income taxes, and reduced by permanent adjustments and research tax credits.

The Coronavirus Aid, Relief and Economic Security Act (CARES Act) was signed into law on March 27, 2020. The Act contained specific relief and stimulus measures including allowing net operating losses originating in 2018 through 2020 to be carried back five years to offset taxable income in the carryback period.

Separately, the enactment of the Tax Cut and Jobs Act in 2017 allowed taxpayers to claim a refund for federal tax credits over a period of years. The CARES Act enacted during the first quarter allows for the entire amount of the credit to be refunded.

We have reviewed the impact of the CARES Act enactment on the income tax provision and have determined that, as a result of the net operating loss carryback provision, we can obtain a tax benefit if we were to carry back the forecasted 2020 net operating loss to the five year carryback period.

The carryback of the estimated loss would result in a refundable federal tax credit of approximately $1.5 million and an increase in research credit carryforwards previously utilized. The federal tax credit can be refunded in the future, if we decide to carry back the loss reported on the filed 2020 tax return instead of electing to carry the loss forward. Due to the recent loss history and continued uncertainty surrounding our future projections of income, we will benefit from the current year loss to the extent of the available tax refund and will maintain a full valuation allowance on all other deferred tax assets, including any increase in research credit carryforward resulting from a potential carryback.

As of the end of the period, we have not made a determination on whether to elect to carry forward the 2020 operating loss, however, the federal tax refund potential on carryback represents a minimum tax benefit we can obtain from the estimated 2020 loss. We can realize a tax benefit to the extent of the carryback refund potential as it is considered a source of income against which to utilize the 2020 estimated loss.

The total estimated benefit of the federal tax refund of $1.5 million is included in our projection of our annual effective rate and results in a year to date benefit of approximately $1.2 million as of September 30, 2020. We recorded the year to date tax benefit as a long term tax receivable.

Liquidity and Capital Resources

At September 30, 2020, we had cash and cash equivalents of $42.3 million, which represented a decrease of $5.4 million from December 31, 2019. The decrease in cash and cash equivalents was primarily due to the following factors:

Cash used in operations was $4.2 million in the first nine months of 2020. Cash used in operations was primarily the result of $6.1 million of net loss that was partially offset by $0.9 million of changes in assets and liabilities, and the add back of $1.0 million of non-cash items primarily for depreciation, amortization and stock-based compensation.

Cash used in investing activities was $0.5 million in the first nine months of 2020. This cash usage consisted of purchases of property and equipment primarily for software development.

Cash used in financing activities was $0.8 million in the first nine months of 2020. Financing activity cash usage was the primarily the result of $0.7 million used to buy back stock under our stock repurchase program and $0.1 million used to pay income taxes for employees who surrendered shares in connection with stock grants.

While we cannot assure you that we will not require additional financing, or that such financing will be available to us, we believe that our cash and cash equivalents will be sufficient to fund our operations for at least the next twelve months.

Recently Adopted Accounting Pronouncements

See Note 1 to our Consolidated Financial Statements in Item 1.

ITEM 4:

Controls and Procedures

Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective.

There were no changes in our internal control over financial reporting during the quarter ended September 30, 2020 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

From time to time we are involved in litigation incidental to the conduct of our business. We are not party to any lawsuit or proceeding that, in our opinion, is likely to seriously harm our business.

ITEM 1A:

Risk Factors

Investing in our common stock involves a high degree of risk. Our Annual Report on Form 10-K for the year ended December 31, 2019 includes a detailed discussion of our risk factors under the heading “Part I, Item 1A—Risk Factors.” Except as set forth below, there have been no material changes from such risk factors during the nine months ended September 30, 2020. You should consider carefully the risk factors discussed in our Annual Report on Form 10-K for the year ended December 31, 2019, and all other information contained in or incorporated by reference in this Quarterly Report on Form 10-Q before making an investment decision. If any of the risks discussed in the Annual Report on Form 10-K or herein actually occur, they may materially harm our business, financial condition, operating results, cash flows or growth prospects. As a result, the market price of our common stock could decline, and you could lose all or part of your investment. Additional risks and uncertainties that are not yet identified or that we think are immaterial may also materially harm our business, financial condition, operating results, cash flows or growth prospects and could result in a complete loss of your investment.

While we expect the impacts of COVID-19 to have an adverse effect on our business, financial condition and results of operations, we are unable to predict the extent or nature of these impacts at this time.

Due to the COVID-19 pandemic we have been unable to: (i) conduct face-to-face meetings with customers and prospective customers, (ii) present in-person demonstrations of our software solutions, (iii) attend trade shows and conferences which typically generate future sales opportunities or (iv) meet with prospective strategic partners . We believe that these effects caused by the COVID-19 pandemic adversely impacted our revenue in 2020 and will likely have an adverse impact on our revenue over the next several quarters.

ITEM 2:

Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities

(1) On May 4, 2020, the Company announced that the board of directors had approved the repurchase of up to $10,000,000 of our common stock from time to time through December 31, 2021. During the three and nine months ended September 30, 2020, we purchased 138,601 and 221,502 shares respectively under this plan at an aggregate purchase price of $705,753.

ITEM 6:

Exhibits

(a)  Exhibits

* Management contract or compensatory plan

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.