AWARE INC /MA/ - Quarter Report: 2020 March (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 March 31, 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 April 27, 2020 was 21,521,886.

AWARE, INC.

FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 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)

Three Month Period Ended March 31, 2020

Three Month Period Ended March 31, 2019

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

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

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 March 31, 2020, and of operations and cash flows for the interim periods ended March 31, 2020 and 2019.

The results of operations for the interim period ended March 31, 2020 are not necessarily indicative of the results to be expected for the year.

The core principle of the standard is that we recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which we expect to be entitled in exchange for those goods or services. To achieve that core principle, we apply the following five step model:

1) Identify the contract with the customer

A contract with a customer exists when (i) we enter into an enforceable contract with a customer that defines each party’s rights regarding the goods or services to be transferred and identifies the related payment terms, (ii) the contract has commercial substance, and (iii) we determine that collection of substantially all consideration for goods and services that are transferred is probable based on the customer’s intent and ability to pay the promised consideration. We apply judgment in determining the customer’s intent and ability to pay, which is based on a variety of factors including the customer’s historical payment experience, or in the case of a new customer, published credit and financial information pertaining to the customer.

We evaluate contract modifications for the impact on revenue recognition if they have been approved by both parties such that the enforceable rights and obligations under the contract have changed. Contract modifications are either accounted for using a cumulative effect adjustment or prospectively over the remaining term of the arrangement. The determination of which method is more appropriate depends on the nature of the modification, which we evaluate on a case-by-case basis.

We combine two or more contracts entered into at or near the same time with the same customer and account for them as a single contract if (i) the contracts are negotiated as a package with a common commercial objective, (ii) the amount of consideration to be paid in one contract depends on the price or performance of the other contract, or (iii) some or all of the goods or services in one contract would be combined with some or all of the goods and services in the other contract into a single performance obligation. If two or more contracts are combined, the consideration to be paid is aggregated and allocated to the individual performance obligations without regard to the consideration specified in the individual contracts.

2) Identify the performance obligations in the contract

Performance obligations promised in a contract are identified based on the goods and services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the good or service either on its own or together with other available resources, and are distinct in the context of the contract, whereby the transfer of the good or service is separately identifiable from other promises in the contract. To the extent a contract includes multiple promised goods and services, we apply judgment to determine whether promised goods and services are capable of being distinct and distinct in the context of the contract. If these criteria are not met, the promised goods and services are accounted for as a combined performance obligation. To identify performance obligations, we consider all of the goods or services promised in a contract regardless of whether they are explicitly stated or are implied by customary business practices.

3) Determine the transaction price

The transaction price is determined based on the consideration we expect to be entitled in exchange for transferring promised goods and services to the customer. Determining the transaction price requires significant judgment. To the extent the transaction price includes variable consideration, we estimate the amount of variable consideration that should be included in the transaction price utilizing either the expected value method or the most likely amount method depending on the nature of the variable consideration. Variable consideration is included in the transaction price if, in our judgment, it is probable that a significant future reversal of cumulative revenue recognized under the contract will not occur. Any estimates, including the effect of the constraint on variable consideration, are evaluated at each reporting period. 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 March 31, 2020 and 2019, none of our contracts contained a significant financing component.

4) Allocate the transaction price to performance obligations in the contract

If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (“SSP”) basis unless the transaction price is variable and meets the criteria to be allocated entirely to a performance obligation or to a distinct service that forms part of a single performance obligation. The consideration to be received is allocated among the separate performance obligations based on relative SSPs. 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.

5) Recognize revenue when or as we satisfy a performance obligation

We satisfy performance obligations either over time or at a point in time as discussed in further detail below. Revenue is recognized over time if 1) the customer simultaneously receives and consumes the benefits provided by our performance, 2) our performance creates or enhances an asset that the customer controls as the asset is created or enhanced, or 3) our performance does not create an asset with an alternative use to us and we have an enforceable right to payment for performance completed to date. If we do not satisfy a performance obligation over time, the related performance obligation is satisfied at a point in time by transferring the control of a promised good or service to a customer.

We categorize revenue as software licenses, software maintenance, or services. In addition to the general revenue recognition policies described above, specific revenue recognition policies apply to each category of revenue.

Software licenses

Software licenses consist of revenue from the sale of software licenses for biometrics and imaging applications. Our software licenses are functional intellectual property and typically provide customers with the right to use our software under a perpetual license or subscription based model for either a fixed term or in perpetuity as it exists when made available to the customer. We recognize revenue from software licenses at a point in time upon delivery, provided all other revenue recognition criteria are met.

Software maintenance

Software maintenance consists of revenue from the sale of software maintenance contracts for biometrics and imaging software. Software maintenance contracts entitle customers to receive software support and software updates, if and when they become available, during the term of the maintenance contract. Software support and software updates are considered distinct services. However, these distinct services are considered a single performance obligation consisting of a series of distinct services that are substantially the same and have the same pattern of transfer to the customer. We recognize software maintenance revenue over time on a straight-line basis over the contract period.

Services

Service revenue consists of fees from biometrics customers for software engineering services we provide to them. We recognize services revenue 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.

Refer to Note G – Business Segments for further information on the disaggregation of revenue, including revenue by geography and category.

Arrangements with multiple performance obligations

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. The various combinations of multiple performance obligations and our revenue recognition for each are described as follows:

Returns

We do not offer rights of return for our products and services in the normal course of business.

Customer Acceptance

Our contracts with customers generally do not include customer acceptance clauses.

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. Contract assets represent arrangements in which the good or service has been delivered but payment is not yet due. Our contract assets consist of unbilled receivables. Our contract liabilities consisted 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 three months ended March 31, 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 66% of the remaining performance obligations over the next 12 months, with the remainder recognized thereafter. As of March 31, 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 $1.4 million.

Contract Costs

We recognize an other asset for the incremental costs of obtaining a contract with a customer if we expect the benefit of those costs to be longer than one year. We have determined that certain sales commissions meet the requirements to be capitalized, and we amortize these costs on a consistent basis with the pattern of transfer of the goods and services in the contract. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in other current and long-term assets on our consolidated balance sheets.

We apply a practical expedient to expense costs as incurred for costs to obtain a contract when the amortization period is one year or less. These costs include sales commissions on software maintenance contracts with a contract period of one year or less as sales commissions paid on contract renewals are commensurate with those paid on the initial contract.

Cash and cash equivalents, which primarily include money market mutual funds, were $46.9 million and $47.7 million as of March 31, 2020 and December 31, 2019, respectively. We classified our cash equivalents of $46.3 million and $46.2 million as of March 31, 2020 and December 31, 2019, respectively, within Level 1 of the fair value hierarchy because they are valued using quoted market prices.

As of March 31, 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):

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

Stock Option Grants. We may grant stock options under our 2001 Nonqualified Stock Plan. When we grant stock options, we estimate their fair value using the Black-Scholes valuation model. This valuation model takes into account the exercise price of the award, as well as a variety of significant assumptions. The assumptions used to estimate the fair value of stock options include the expected term, the expected volatility of our stock over the expected term, the risk-free interest rate over the expected term, and our expected annual dividend yield. We believe that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of our stock options. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by persons who receive equity awards.

We did not grant any stock options during the three months ended March 31, 2019 or 2020.

Unrestricted Stock Grants. We also 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 month periods ended March 31, 2020 and 2019. The accounting treatment of unrestricted stock awards is described below:

On March 27, 2020, we granted 210,000 shares of unrestricted stock to directors, officers and employees. The shares will 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 this grant is $533,000, of which $10,000 was charged to expense in the three months ended March 31, 2020. We anticipate the remaining $523,000 will be charged to expense ratably over the remaining three quarters of 2020.

In September 2019, we granted 15,000 shares of unrestricted stock to an officer, which were issued in January 2020. The total stock-based compensation expense related to this grant was $41,000 and was expensed in 2019

In September 2019, we granted 80,000 shares of unrestricted stock to an officer, which are to be issued in four equal installments shortly after September 19, 2020, September 19, 2021, September 19, 2022 and September 19, 2023, provided the grantee is serving as a director, officer or employee on those dates. The total stock-based compensation expense related to this grant is $220,000, of which $16,000 was charged to expense in 2019 and $14,000 was charged to expense in the first quarter of 2020. We anticipate the remaining $190,000 will be charged to expense ratably over the next fourteen quarters.

In October 2019, we granted 7,500 shares of unrestricted stock to an officer, which were issued in January 2020. The total stock-based compensation expense related to this grant was $22,000 and was expensed in 2019.

In October 2019, we granted 40,000 shares of unrestricted stock to an officer, which are to be issued in four equal installments shortly after October 1, 2020, October 1, 2021, October 1, 2022 and October 1, 2023, provided the grantee is serving as a director, officer or employee on those dates. The total stock-based compensation expense related to this grant is $117,000, of which $7,000 was charged to expense in 2019 and $7,000 was charged to expense in the first quarter of 2020. We anticipate the remaining $103,000 will be charged to expense ratably over the next fourteen quarters.

In March 2019, we granted 143,000 shares of unrestricted stock to directors, officers and employees. The shares were issued in two equal installments shortly after June 30, 2019 and December 31, 2019. We expensed $547,000 of stock-based compensation expense related to this grant in the year ended December 31, 2019. There was no unamortized stock-based compensation charge associated with this stock grant as of December 31, 2019.

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.

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 first quarter of 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 first quarter of 2020.

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 months ended March 31, 2020 and 2019 (in thousands):

Revenue by product group for the three months ended March 31, 2020 and 2019 was (in thousands):

Revenue by timing of transfer of goods or services for the three months ended March 31, 2020 and 2019 was (in thousands):

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 alternative minimum tax credits over a period of years. The CARES Act enacted during the quarter 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 alternative minimum tax credit of approximately $736,000 and an increase in research credit carryforwards previously utilized. The alternative minimum 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 alternative minimum 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 alternative minimum tax refund of $736,000 is included in our projection of our annual effective rate and results in a year to date benefit of approximately $146,000 as of March 31, 2020. We recorded the year to date tax benefit as a long term tax receivable.

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.

Future patent sales are likely to be minimal as our remaining patents and patent applications pertain primarily to biometrics and imaging compression. Our current intent is to retain these patents for use in the business.

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 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 March 31, 2020 were $3.5 million and $1.3 million, respectively. These results compared to revenue of $3.7 million and operating loss of $44,000 for the three months ended March 31, 2019. Lower revenue in the current three month period was primarily due to lower services revenue that was partially offset by higher biometrics software license revenue. Higher operating loss in the current three month period was primarily due to lower revenue and higher operating expenses.

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 increased 28% from $1.5 million in the three months ended March 31, 2019 to $2.0 million in the same three month period in 2020. As a percentage of total revenue, software license revenue increased from 41% in the first quarter of 2019 to 56% in the current year quarter. The dollar increase in software license revenue was due to a $0.4 million increase in biometrics software license sales. The reasons for the changes in biometrics and imaging software license sales were:

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 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 was $1.4 million for both the three months ended March 31, 2019 and 2020. As a percentage of total revenue, software maintenance revenue increased from 36% in the first quarter of 2019 to 39% in the current year quarter.

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 $0.8 million in the three months ended March 31, 2019 to $0.2 million in the same three month period in 2020. As a percentage of total revenue, services revenue decreased from 23% in the first quarter of 2019 to 5% in the current year quarter.

For the three month period ended March 31, 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, and to a lesser extent lower service revenue due to fewer service projects.

We expect our development effort on this large project to continue for approximately one more quarter.

Services backlog was $0.4 million as of March 31, 2020.

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 67% from $518,000 in the three months ended March 31, 2019 to $170,000 in the same three month period in 2020. Cost of services as a percentage of services increased from 62% in the first quarter of 2019 to 91% in the current year quarter, which means that gross margins decreased from 38% to 9%. The dollar decrease in cost of services was primarily due to lower services revenue in the first quarter of 2020.

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 29% from $1.8 million in the three months ended March 31, 2019 to $2.3 million in 2020. As a percentage of total revenue, research and development expense increased from 47% in 2019 to 65% in 2020.

As the table immediately above indicates, total engineering costs in the first quarter of 2020 increased by $164,000 compared to the same period last year. The spending increase was primarily due to higher employee costs due to higher headcount, higher recruiting costs and to a lesser extent higher other costs. The increase was partially offset by lower spending on third-party development costs with third-party vendors we engaged to assist in our software development.

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 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 56% from $0.8 million in the three months ended March 31, 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 22% in the first quarter of 2019 to 37% in the corresponding period in 2020. The dollar increase in sales and marketing expense was primarily due to higher employee costs due to higher headcount and to a lesser extent higher spending on sales agents, and higher other costs, including engagement of a third- party marketing firm. The increase was partially offset by lower sales commissions.

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 58% from $0.7 million in the three months ended March 31, 2019 to $1.1 million in the same three month period in 2020. As a percentage of total revenue, general and administrative expense increased from 19% in the first quarter of 2019 to 32% in the corresponding period in 2020. The increase in general and administrative expense was primarily due to: i) higher employee costs due to higher headcount; ii) higher legal fees; iii) higher recruiting fees; and iv) higher stock-based compensation expense.

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 months ended March 31, 2020, there was no revenue from this arrangement. In the three months ended March 31, 2019, the third party reported and we recorded $49,000 of income 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 46% from $275,000 in the three months ended March 31, 2019 to $148,000 in the same three month period in 2020. For the three month period, the dollar decrease in interest income was primarily due to lower interest rates within our money market accounts and to a lesser extent lower cash and cash equivalents balances.

Income taxes. Income tax benefit was $0.1 million for the three months ended March 31, 2020. Income tax benefit for the three month period ended March 31, 2020 was 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 alternative minimum tax credits over a period of years. The CARES Act enacted during the quarter 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 alternative minimum tax credit of approximately $736,000 and an increase in research credit carryforwards previously utilized. The alternative minimum 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 alternative minimum 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 alternative minimum tax refund of $736,000 is included in our projection of our annual effective rate and results in a year to date benefit of approximately $146,000 as of March 31, 2020. We recorded the year to date tax benefit as a long term tax receivable.

Liquidity and Capital Resources

At March 31, 2020, we had cash and cash equivalents of $46.9 million, which represented a decrease of $0.9 million from December 31, 2019. The decrease in cash and cash equivalents was primarily due to the following factors:

Cash used in operations was $0.5 million in the first three months of 2020. Cash used in operations was primarily the result of $1.1 million of net loss that was partially offset by $0.3 million of changes in assets and liabilities, and the add back of $0.2 million of non-cash items primarily for depreciation, amortization and stock-based compensation.

Cash used in investing activities was $0.3 million in the first three months of 2020. This cash usage consisted of purchases of property and equipment.

Cash used in financing activities was $50,000 in the first three months of 2020. Financing activity cash usage was the result of $50,000 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 J 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 March 31, 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 three months ended March 31, 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 will likely have an adverse impact on our revenue over the next several quarters.

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.