CYNERGISTEK, INC - Annual Report: 2016 (Form 10-K)

FORM 10-K

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Our document solutions group provides workflow solutions, and is a risk-free program with guaranteed savings. We assume all costs related to print environments through customized streamlined and seamless integration of services at predictable fixed rates. Our on-site staff creates manageable, dependable print management programs by managing the back-office processes of our hospital clients.  The process is initiated through a detailed proprietary assessment.  The assessment is a strategic, operational and financial analysis that is performed at the customer’s premises using a combination of proprietary processes and innovative technology for data collection and report generation.  After the assessment and upon engagement, we charge the customer on a per print basis.  This charge covers the entire print management process and includes placement of a highly trained on-site resident team.

Our IT security consulting group serves the most common security needs: technical risk and penetration testing, process and procedure development and risk management utilizing our proprietary Delphiis™ IT Risk Manager SaaS Solution. Through our proven and prescriptive methodology we help build the foundation needed to ensure the confidentiality, integrity and security of patient health information (PHI). And our software application suite streamlines how covered entities perform annual and on-going risk assessments on their business associates, clinics, projects and hospitals.

Most of the competition in the healthcare industry market for IT security services comes from large or niche consulting and technology firms such as Accenture, KPMG, Dell Secureworks, and Coal Fire.

Nevertheless, our analysis of the competitive landscape shows a very strong opportunity for fully-outsourced document solution services and data security services to the healthcare industry, and we believe that we have a strong competitive position in the marketplace due to several important factors:

 We are primarily focused on the healthcare industry.  We are not aware of any other vendor/service provider which has a majority of its business dedicated to solving issues of HIPAA compliance, including printed and stored documents and improving efficiency for the healthcare industry. Our expertise and knowledge base is unmatched in the market. 

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 By focusing solely on the hospital campus, we enjoy much lower turn-around times for service, greater up-sell opportunities and a much deeper service relationship with the customer. 

 We have technology that is revolutionizing the way in which healthcare providers perform their annual HIPAA analysis, regulatory and on-going risk assessments, by making it fast, effective and affordable for both the assessor and responder. 

 We believe that we are the only provider offering a unique approach to managed security services.  We can deploy a knowledgeable resource allocated 100% to perform a predefined security role on-site or virtually for a defined amount of time, which results in hospital gaining the staff with expertise they need. 

 We have a unique approach to providing fully-outsourced managed document services program.  Our program is completely outsourced and hospitals need only pay a single invoice.  We operate the document management process as a department in the hospital with full-time staff on-site.  In contrast, other print vendors and dealers in the majority of instances do not provide full-time staff on-site, which results in delays in providing service and supplies to the hospitals. 

 We are not restricted to any single equipment vendor, which allows us to bring the best printer and copier hardware and software solutions to our customers.  Our approach is to use the most appropriate technology to provide a superior solution without any prejudice as to equipment. 

 We maintain a daily connection with the hospital, which allows us to provide a detailed strategy and plan on printer and copier equipment acquisitions saving the organization a great deal of time, effort and money in this process. 

Recent Developments

Acquisition of CynergisTek, Inc.

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Stock Purchase Agreement – CynergisTek, Inc.

On January 13, 2017, Auxilio, Inc. entered into a Stock Purchase Agreement (the “SPA”) with CynergisTek, Inc., a Texas corporation (“CynergisTek”), Dr. Michael G. Mathews (“Mathews”) and Michael H. McMillan (“McMillan,” and together with Mathews, the “Stockholders”), pursuant to which Auxilio acquired 100% of the issued and outstanding shares of common stock (the “Shares”) of CynergisTek from the Stockholders (the “CynergisTek Transaction”). We reported additional details of the CynergisTek Transaction in a Current Report on Form 8-K filed on January 17, 2017 (the “January Current Report”).

Pursuant to the SPA, the purchase price paid for the Shares consisted of four components: the Cash Consideration, the Securities Consideration, the Debt Consideration, and the Earn-out Consideration.

• Cash Consideration.  We paid the Stockholders a cash payment of $15,000,000, less Closing Net Working Capital Deficit, Funded Indebtedness and Designated Transaction Expenses (defined as certain expenses of the Stockholders and certain expenses of CynergisTek). The net cash amount paid to the Stockholders was $14,202,644.76. 

• Securities Consideration.  We issued a total of 1,166,666 shares of Auxilio common stock, par value $0.001 per share (the “Auxilio Stock”) to the Stockholders, with each of the Stockholders receiving 583,333 shares. 

• Debt Consideration.  We issued promissory notes totaling $9,000,000 to the Stockholders (the “Seller Notes”), with each of the Seller Notes having an initial principal amount of $4,500,000.  The Seller Notes bear interest at 8% per annum, are quarterly interest-only payments due during the first 12 months, quarterly payments of principal and interest due during the last 24 months, using a 36-month amortization period commencing from that point, with a balloon payment due on the maturity date.  Additional details relating to the Debt Consideration is included in the January Current Report. 

• Earn-out Consideration.   The Stockholders may be entitled to an additional $7,500,000 based upon the financial performance of CynergisTek after closing of the CynergisTek Transaction, to be calculated based upon EBITDA generated by the CynergisTek business during the earn-out period, which began as of January 1, 2017, and ends on December 31, 2021 (the “Earn-out Payments”). 

Pursuant to the SPA, CynergisTek and the Stockholders agreed to deliver to Auxilio certificates representing the Shares; the corporate record books of CynergisTek; and the employment agreements (described below). Auxilio agreed to deliver the Cash Consideration, the Securities Consideration, the Debt Consideration and the signed employment agreements.

CynergisTek is a top-ranked cybersecurity and privacy consulting firm focused on healthcare, and offers an array of solutions that help organizations measure privacy and security programs against regulatory requirements and assists in developing a best practice approach to risk management. Since 2004, CynergisTek has served as a partner to hundreds of healthcare providers, payers and vendors with a consulting team comprised of subject matter experts that have a passion for helping clients achieve success. CynergisTek is also dedicated to supporting and educating the industry by contributing to relevant associations such as HIMSS, AHIMA, HFMA, HCCA, AHIA, AHLA, IAPP and CHIME.  As disclosed in the January Current Report, Auxilio management believes that the acquisition of CynergisTek will allow Auxilio to improve its ability to help clients and other healthcare industry participants to meet their IT security requirements.  Auxilio management believes that CynergisTek is a strong provider of high quality security and compliance services to the healthcare industry.

In connection with the SPA, the Company and the Stockholders also entered into a registration rights agreement (the “Registration Rights Agreement”) and employment agreements, each of which is discussed in more detail in the January Current Report.

Changes in Management; Appointment of Directors; Resignation of Officer; Appointment of New Officers

Employment Agreements

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In connection with the SPA, Auxilio and each of the Stockholders entered into an employment agreement, pursuant to which McMillan was appointed President and Chief Strategy Officer of Auxilio, and Mathews was appointed Executive Vice President of Auxilio.  Detailed information about the employment agreements and biographical information about Messrs. McMillan and Mathews were included in the January Current Report.

Appointment of New Directors; Resignation of Officer; Appointment of New Officers

In addition to their appointments as officers of Auxilio, in connection with the closing of the CynergisTek Transaction, on January 13, 2017, McMillan and Mathews were appointed to fill newly created seats on the Board of Directors of Auxilio.  As of the date of this Report, Auxilio had not determined what committees to which, if any, McMillan or Mathews may be named.

In connection with Mr. McMillan's appointment, on January 13, 2017, Joseph J. Flynn resigned from his position as President of Auxilio. He remains its Chief Executive Officer.  Mr. Flynn’s resignation was in connection with the closing of the CynergisTek Transaction, and was not due to any dispute or disagreement with Auxilio.

Sales of Unregistered Equity Securities

Issuance of Auxilio Common Stock as Securities Consideration

As noted above, the Company issued the Auxilio Stock in connection with the CynergisTek Transaction. The Auxilio Stock was issued in reliance upon the exemption from securities registration afforded by the provisions of Section 4(a)(2) of the Securities Act, together with regulations promulgated thereunder by the U.S. Securities and Exchange Commission under the Securities Act, based upon the following: (a) there was no public offering or general solicitation with respect to the offering of such shares, (b) each Stockholder was provided with certain disclosure materials and all other information requested with respect to Auxilio, (c) each Stockholder acknowledged that the Auxilio Stock was being acquired for investment intent and constitute “restricted securities” for purposes of the Securities Act, and agreed to transfer such securities only in a transaction registered under the Securities Act or exempt from registration under the Securities Act, (d) each Stockholder represented and warranted that he is an “accredited investor” as defined in Rule 501(a) under the Securities Act, and (e) a legend has been, or will be, placed on the certificates representing each such security stating that it was restricted and could only be transferred if subsequently registered under the Securities Act or transferred in a transaction exempt from registration under the Securities Act.

Amended and Restated Credit Agreement and Related Agreements

As described in the January Current Report, also on January 13, 2017,  Auxilio, and its subsidiaries Auxilio Solutions, Inc., a California corporation (“Solutions”), Delphiis, Inc., a California corporation (“Delphiis”), and immediately upon the consummation of the CynergisTek Transaction, CynergisTek (with Auxilio, Solutions, Delphiis, CynergisTek and such other subsidiaries collectively referred to as “Borrowers”), entered into an Amended and Restated Credit Agreement (the “A&R Credit Agreement”) with ZB, N.A., dba California Bank and Trust (“CBT”), and Avidbank, a California banking corporation (“Avidbank,” and together with CBT, the “Lenders”), as well as Avidbank in its capacity as contractual representative for itself and the other lender (“Agent”).

In connection with the A&R Credit Agreement, Auxilio and the other Borrowers also entered into loan facilities including Term Loans and Revolving Line of Credit; a Security Agreement; and certain subordination agreements. Additional details relating to the A&R Credit Agreement and the related agreements are provided in the January Current Report.

Reverse Stock Split

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On January 12, 2017, the Company announced that it had received approval from the Financial Industry Regulatory Authority (“FINRA”) of the Company's Company Related Action Notification Form (the “Notification Form”) relating to the implementation of a reverse split of its common stock, par value $0.001 per share (the “Reverse Stock Split”) at a ratio of one-for-three, that is, one new share for each three old shares of the Company’s common stock.

On December 22, 2016, the Company filed a Certificate of Amendment (the “Amendment”) to its Articles of Incorporation relating to the Reverse Stock Split.  The Amendment provides that no fractional shares of Common Stock will be issued to the holders of record of Common Stock prior to the Reverse Stock Split. Instead, all fractional shares will be rounded up to the next whole number of shares.

The Reverse Stock Split was approved at the 2015 Annual Meeting of the Company’s shareholders.  At that meeting, the Company’s shareholders voted to approve a reverse split at a ratio between 1-for-1.5 shares and 1-for-3 shares, to be determined by the Company’s Board of Directors.  The Board determined to implement the Reverse Stock Split at the ratio of 1-for-3 shares.

The Reverse Stock Split became effective with FINRA and in the marketplace at the open of business on Friday, January 13, 2017 (the “Effective Date”), whereupon the shares of common stock began trading on a reverse-split-adjusted basis.

All information related to common stock, stock options, warrants and share price for prior periods has been retroactively adjusted in this Annual Report to give effect to the Reverse Stock Split.

Listing on NYSE MKT

Since February 14, 2017, our Common Stock has been listed on the NYSE MKT under the symbol “AUXO.” Our common stock had previously traded on the OTCQB market.

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Healthcare legislation and regulation.  

The healthcare industry is highly regulated.  Legislation such as the Patient Protection and Affordable Care Act of 2010 (the “Affordable Care Act”) has changed and will likely continue to change how healthcare services are provided and managed.  In addition, legislation related to electronic medical records may impact our business.  In 2009, the American Recovery and Reinvestment Act of 2009 included incentives and penalties related to electronic medical records.  For example, Medicare/Medicaid reimbursements will be less for providers who failed to use electronic medical records by 2015.  

The use of electronic medical records does not necessarily mean a hospital’s printing demands will decrease, but we cannot be sure whether this will be the case.  Increased adoption and use of electronic medical records may negatively impact our business.  

New legislation or regulation.

As to prospective legislation and regulation, we cannot determine what effect additional state or federal governmental legislation, regulations, or administrative orders would have on our business in the future. New legislation or regulation may require the reformulation of our business to meet new standards, require us to cease operations, impose stricter qualification and/or registration standards, impose additional record keeping, or require expanded consumer protection measures.  Congressional leaders and the current administration have announced plans to repeal or modify the Affordable Care Act.  At this time the Company is not certain as to the impact of federal health care legislation on its business.

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Our business depends on generating and maintaining ongoing, profitable customer demand for our services and solutions, including through the adaptation and expansion of our services and solutions in response to ongoing changes in technology and offerings, and a significant reduction in such demand or an inability to respond to the evolving technological environment could materially affect our results of operations.

Our revenue and profitability depend on the demand for our services and solutions with favorable margins, which could be negatively affected by numerous factors, many of which are beyond our control and unrelated to our work product. Volatile, negative or uncertain global economic conditions and lower growth in the markets we serve have adversely affected and could in the future adversely affect customer demand for our services and solutions. Our success depends, in part, on our ability to continue to develop and implement services and solutions that anticipate and respond to rapid and continuing changes in technology and offerings to serve the evolving needs of our customers. Technological developments may materially affect the cost and use of technology by our customers. Some technologies may replace some of our services and solutions in the future. This may cause customers to delay spending under existing contracts and engagements and to delay entering into new contracts while they evaluate new technologies. Such delays can negatively impact our results of operations if the pace and level of spending on new technologies is not sufficient to make up any shortfall.

Developments in the industries we serve, which may be rapid, also could shift demand to new services and solutions. If, as a result of new technologies or changes in the industries we serve, our customers demand new services and solutions, we may be less competitive in these new areas or need to make significant investment to meet that demand. Our growth strategy focuses on responding to these types of developments by driving innovation that will enable us to expand our business into new growth areas. If we do not sufficiently invest in new technology and adapt to industry developments, or evolve and expand our business at sufficient speed and scale, or if we do not make the right strategic investments to respond to these developments and successfully drive innovation, our services and solutions, our results of operations, and our ability to develop and maintain a competitive advantage and to execute on our growth strategy could be negatively affected.

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We operate in a rapidly evolving environment in which there currently are, and we expect will continue to be, new technology entrants. New services or technologies offered by competitors or new entrants may make our offerings less differentiated or less competitive when compared to other alternatives, which may adversely affect our results of operations. In addition, companies in the industries we serve sometimes seek to achieve economies of scale and other synergies by combining with or acquiring other companies. If one of our current customers merges or consolidates with a company that relies on another provider for the services and solutions we offer, we may lose work from that customer or lose the opportunity to gain additional work if we are not successful in generating new opportunities from the merger or consolidation.

Many of our contracts allow customers to terminate, delay, reduce or eliminate spending on the services and solutions we provide. Additionally, a customer could choose not to retain us for additional stages of a project, try to renegotiate the terms of its contract or cancel or delay additional planned work. When contracts are terminated or not renewed, we lose the anticipated revenues, and it may take significant time to replace the level of revenues lost. Consequently, our results of operations in subsequent periods could be materially lower than expected. The specific business or financial condition of a customer, changes in management and changes in a customer’s strategy are also all factors that can result in terminations, cancellations or delays.

Achieving the desired benefits of the acquisition of Delphiis, Inc., certain assets of Redspin, Inc. and CynergisTek, Inc. may be subject to a number of challenges and uncertainties which make it hard to predict the future success of each entity.

We acquired Delphiis, Inc., certain assets of Redspin, Inc. and CynergisTek, Inc. with expected benefits including, among other things, operating efficiencies, procurement savings, innovation, sharing of best practices and increased market share that may allow for future growth.  Achieving the anticipated benefits may be subject to a number of significant challenges and uncertainties, including, without limitation, whether unique corporate cultures will work collaboratively in an efficient and effective manner, the coordination of separate organizations, the possibility of imprecise assumptions underlying expectations regarding potential synergies and the integration process, unforeseen expenses and delays, and competitive factors in the marketplace.  We could also encounter unforeseen transaction and integration-related costs or other circumstances such as unforeseen liabilities or other issues.  Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies and the diversion of management time and attention.  If we are unable to achieve our objectives within the anticipated time frame, or at all, the expected benefits may not be realized fully or at all, or may take longer to realize than expected, which could have an adverse effect on our business, financial condition and results of operations.

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We are party with ZB, N.A., dba California Bank and Trust and AvidBank (the “Lenders”), to, and jointly and severally liable with our subsidiaries for $14.0 million of outstanding debt under term loans issued under our Amended and Restated Credit Agreement, as amended (the “Credit Agreement”). The maturity date of the outstanding term loans is January 12, 2022.  We also have available a revolving line of credit from the Lenders of up to $5.0 million.  Further, we are indebted to the former shareholders of CynergisTek, Inc. in the aggregate amount of $9.0 million pursuant to promissory notes with maturity dates of January 13, 2020.  Our resulting substantial level of indebtedness and other financial obligations increase the possibility that we may be unable to pay, when due, the principal of, interest on, or other amounts due in respect of, our indebtedness.  Further, under the Credit Agreement, we are subject to certain restrictive covenants that, among other things, may limit our ability to obtain additional financing for working capital requirements, product development activities, debt service requirements, and general corporate or other purposes. These restrictive covenants include, without limitation, restrictions on our ability to: (1) change the nature of our business; (2) incur additional indebtedness; (3) incur liens; (4) make certain investments; (5) make certain dispositions of assets; (6) merge, dissolve, consolidate or sell all or substantially all of our assets; (7) enter into certain transactions with affiliates; and (8) transfer more than designated amounts to our subsidiaries during the term of the Credit Agreement.  If we breach any of these restrictive covenants or are unable to pay our indebtedness under the Credit Agreement when due, this could result in a default under the Credit Agreement. In such event, the Lenders may elect (after the expiration of any applicable notice or grace periods) to declare all outstanding borrowings, together with accrued and unpaid interest and other amounts payable under the Credit Agreement, to be immediately due and payable. Any such occurrence would have an immediate and materially adverse impact on our business and results of operations. The Credit Agreement is secured by a security interest in all assets of the Company and its current and future subsidiaries.  

Risks Related to the Market for Our Securities

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In addition, we issued 1,166,666 shares of common stock in connection with the January 2017 acquisition of CynergisTek, Inc.

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The forward looking statements contained in this Annual Report may prove incorrect.

This Annual Report contains certain forward-looking statements. These forward-looking statements are based largely on our current expectations and are subject to a number of risks and uncertainties. Actual results could differ materially from these forward-looking statements. In addition to the other risks described elsewhere in this “Risk Factors” discussion, important factors to consider in evaluating such forward-looking statements include: (i) changes to external competitive market factors or in our internal budgeting process which might impact trends in our results of operations; (ii) anticipated working capital or other cash requirements; (iii) changes in our business strategy or an inability to execute our strategy due to unanticipated changes in our industry; and (iv) various competitive factors that may prevent us from competing successfully in the marketplace. In light of these risks and uncertainties, many of which are described in greater detail elsewhere in this “Risk Factors” discussion, there can be no assurance that the events predicted in forward-looking statements contained in this Annual Report will, in fact, transpire.  Any negative change in the factors listed above could adversely affect the financial condition and operating results of the Company and its products and services.  

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PART II

On January 13, 2017, the Company effectuated a reverse stock split of its issued and outstanding shares of common stock at a ratio of 1 for 3 (the “Reverse Stock Split”). As a result of the Reverse Stock Split, the Company’s issued and outstanding stock decreased from 24,557,224 to 8,185,936 shares of common stock, all with a par value of $0.001. All information related to common stock, stock options, warrants and share price for prior periods has been retroactively adjusted in this Annual Report to give effect to the Reverse Stock Split.

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Our document solutions group provides workflow solutions, and is a risk-free program with guaranteed savings. We assume all costs related to print environments through customized streamlined and seamless integration of services at predictable fixed rates. Our on-site staff creates manageable, dependable print management programs by managing the back-office processes of our hospital clients.  The process is initiated through a detailed proprietary assessment.  The assessment is a strategic, operational and financial analysis that is performed at the customer’s premises using a combination of proprietary processes and innovative technology for data collection and report generation.  After the assessment and upon engagement, we charge the customer on a per print basis.  This charge covers the entire print management process and includes placement of a highly trained on-site resident team.

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Our IT security consulting group serves the most common security needs: technical risk and penetration testing, process and procedure development and risk management utilizing our proprietary Delphiis™ IT Risk Manager SaaS Solution. Through our proven and prescriptive methodology we help build the foundation needed to ensure the confidentiality, integrity and security of patient health information (PHI). And our software application suite streamlines how covered entities perform annual and on-going risk assessments on their business associates, clinics, projects and hospitals.

The Company derives its revenue from four sources: (1) document solution services revenue; (2) equipment revenue; (3) software subscription services revenue, which is comprised of subscription fees from customers accessing the Company’s enterprise cloud computing services and customers purchasing additional ongoing managed services beyond the standard support that is included in the basic software subscription fees; and (4) cyber security professional services such as penetration testing, cyber security risk assessments and security program strategy development.

The Company commences revenue recognition when all of the following conditions are satisfied:

 there is persuasive evidence of an arrangement;  

 the service has been or is being provided to the customer;  

 the collection of the fees is reasonably assured; and  

 the amount of fees to be paid by the customer is fixed or determinable. 

 Document Solution Services and Equipment Revenue 

Revenue is recognized pursuant to ASC Topic 605, “Revenue Recognition” (ASC 605).  Monthly service and supply revenue is earned monthly during the term of the contract, as services and supplies are provided. Revenues from equipment sales transactions are earned when there is persuasive evidence of an arrangement, delivery has occurred, the sales price has been determined and collectability has been reasonably assured. For equipment that is to be placed at a customer’s location at a future date, revenue is deferred until the placement of such equipment.

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We enter into arrangements that include multiple deliverables, which typically consist of the sale of Multi-Function Device (“MFD”) equipment and a support services contract.  We account for each element within an arrangement with multiple deliverables as separate units of accounting.  Revenue is allocated to each unit of accounting under the guidance of ASC Topic 605-25, Multiple-Deliverable Revenue Arrangements, which provides criteria for separating consideration in multiple-deliverable arrangements by establishing a selling price hierarchy for determining the selling price of a deliverable.  The selling price used for each deliverable is based on vendor-specific objective evidence (“VSOE”) if available, third-party evidence if VSOE is not available, or estimated selling price if neither VSOE nor third-party evidence is available.  We are required to determine the best estimate of selling price in a manner that is consistent with that used to determine the price to sell the deliverable on a standalone basis.  We generally do not separately sell MFD equipment or service on a standalone basis.  Therefore, we do not have VSOE for the selling price of these units. As we purchase the equipment, we have third-party evidence of the cost of this element.  We estimate the proceeds from the arrangement to allocate to the service unit based on historical cost experiences.  Based on the relative costs of each unit to the overall cost of the arrangement, we utilize the same relative percentage to allocate the total arrangement proceeds.

The Company’s contracts with customers may include provisions that relate to guaranteed savings amounts and shared savings. Such provisions are considered by management during the Company’s initial proprietary client assessment and are charged and accrued when deemed by management to be probable. The Company’s historical settlement of such amounts has been within management’s estimates.

 Software Subscriptions and Managed Services Revenue 

Software subscriptions and managed services revenues are recognized ratably over the contract terms beginning on the commencement date of each contract, which is the date the Company’s service is made available to customers.

Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met.

The Company’s software subscription service arrangements are non-cancelable and do not contain refund-type provisions.

 Cyber Security Professional Services Revenue  

The majority of the Company’s cyber security services contracts are on a time and material basis. When these services are not combined with subscription revenues as a single unit of accounting, these revenues are recognized as the services are rendered for time and material contracts, and when the milestones are achieved and accepted by the customer for fixed price contracts.

Accounts Receivable Valuation and Related Reserves

We estimate the losses that may result from that portion of our accounts receivable that may not be collectible as a result of the inability of our customers to make required payments.  Management specifically analyzes customer concentration, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts.  We review past due accounts on a monthly basis and record an allowance for doubtful accounts where we deem appropriate.

New Customer Implementation Costs

We ordinarily incur additional costs to implement our services for new customers.  These costs are comprised primarily of additional labor and support.  These costs are expensed as incurred, and have a negative impact on our statements of income and cash flows during the implementation phase.

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Impairment Review of Goodwill and Intangible Assets

We periodically evaluate our intangible assets and goodwill relating to acquisitions for impairment. Goodwill is not amortized, but is evaluated annually at year end for any impairment in the carrying value. We review our intangible assets for impairment on an annual basis or whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors we consider important which could trigger an impairment review include, but are not limited to, the following: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and a significant negative industry or economic trend for a sustained period. Goodwill and intangible asset impairment assessments are generally determined based on fair value techniques, including determining the estimated future discounted and undiscounted cash flows over the remaining useful life of the asset. Those models require estimates of future revenue, profits, capital expenditures and working capital for each reporting unit. We estimate these amounts by evaluating historical trends, the current state of the Company’s industries and the economy, current budgets, and operating plans. Determining the fair value of reporting units and goodwill includes significant judgment by management and different judgments could yield different results. Any resulting impairment loss could have a material impact on our financial condition and results of operations.

Stock-Based Compensation

Under the fair value recognition provisions of the authoritative guidance, stock-based compensation cost granted to employees is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service or performance period, which is the vesting period.  Stock options and warrants issued to consultants and other non-employees as compensation for services to be provided to us are accounted for based upon the fair value of the services provided or the estimated fair value of the option or warrant, whichever can be more clearly determined.  We currently use the Black-Scholes option pricing model to determine the fair value of stock options.  The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables.  These variables include our expected stock price volatility over the term of the awards, the expected term of the award, the risk-free interest rate and any expected dividends.  Compensation cost associated with grants of restricted stock units are also measured at fair value.  We evaluate the assumptions used to value restricted stock units on a quarterly basis.  When factors change, including the market price of the stock, stock-based compensation expense may differ significantly from what has been recorded in the past.  If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense.

Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial reporting requirements and those imposed under federal and state tax laws.  Deferred taxes are provided for timing differences in the recognition of revenue and expenses for income tax and financial reporting purposes and are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  Deferred income tax expense represents the change during the period in the deferred tax assets and liabilities.  Realization of the deferred tax asset is dependent on generating sufficient taxable income in future years.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all the deferred tax assets will not be realized. Use of our net operating loss deferred assets may be limited by changes in our ownership.

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Gross margin increased to 20% of revenue in 2016 as compared to 17% in 2015. This increase is primarily a result of a maturing of our recurring revenue customer base in 2016. In addition to the costs associated with implementing our services, we absorb our new customers’ legacy contracts with third-party vendors.  As we implement our programs, we strive to improve upon these legacy contracts, thus reducing costs over the term of the contract resulting in improved margins with our mature accounts. We anticipate this trend to continue but anticipate an overall increase in cost of revenues as a result of the expansion of our customer base.

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Impairment of Goodwill and Intangible Assets

In 2016, we recognized an impairment charge of $2,633,701 related to the identified intangible assets and goodwill we acquired with Delphiis, Inc. and Redspin. There was no impairment charge in 2015.

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On February 13, 2017, our Common Stock was eligible to be listed on the NYSE MKT and began trading on such exchange on February 14, 2017.

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As described in Note 16, in January 2017, the Company acquired 100% of the outstanding common stock of CynergisTek, Inc. in exchange for cash of $14,202,645, promissory notes of $9,000,000, 1,166,666 shares of its common stock, and a potential earn-out payment of $7,500,000. Our opinion is not modified with respect to this matter.

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AUXILIO, INC. AND SUBSIDIARIES

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AUXILIO, INC. AND SUBSIDIARIES

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AUXILIO, INC. AND SUBSIDIARIES

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AUXILIO, INC. AND SUBSIDIARIES

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AUXILIO, INC. AND SUBSIDIARIES

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AUXILIO, INC. AND SUBSIDIARIES

(1) Basis of Presentation and Summary of Significant Accounting Policies 

Use of Estimates

The Company derives its revenue from four sources: (1) document solution services revenue; (2) equipment revenue; (3) software subscriptions and managed services revenue, which is comprised of subscription fees from customers accessing the Company’s enterprise cloud computing services and customers purchasing additional ongoing managed services beyond the standard support that is included in the basic software subscription fees; and (4) cyber security professional services such as penetration testing, cyber security risk assessments and security program strategy development.

The Company commences revenue recognition when all of the following conditions are satisfied:

• there is persuasive evidence of an arrangement;  

• the service has been or is being provided to the customer;  

• the collection of the fees is reasonably assured; and  

• the amount of fees to be paid by the customer is fixed or determinable. 

 Document Solution Services and Equipment Revenue 

F-7

Revenue is recognized pursuant to ASC Topic 605, “Revenue Recognition” (ASC 605).  Monthly service and supply revenue is earned monthly during the term of the contract, as services and supplies are provided. Revenues from equipment sales transactions are earned when there is persuasive evidence of an arrangement, delivery has occurred, the sales price has been determined and collectability has been reasonably assured. For equipment that is to be placed at a customer’s location at a future date, revenue is deferred until the placement of such equipment.

We enter into arrangements that include multiple deliverables, which typically consist of the sale of Multi-Function Device (“MFD”) equipment and a support services contract.  We account for each element within an arrangement with multiple deliverables as separate units of accounting.  Revenue is allocated to each unit of accounting under the guidance of ASC Topic 605-25, Multiple-Deliverable Revenue Arrangements, which provides criteria for separating consideration in multiple-deliverable arrangements by establishing a selling price hierarchy for determining the selling price of a deliverable.  The selling price used for each deliverable is based on vendor-specific objective evidence (“VSOE”) if available, third-party evidence if VSOE is not available, or estimated selling price if neither VSOE nor third-party evidence is available.  We are required to determine the best estimate of selling price in a manner that is consistent with that used to determine the price to sell the deliverable on a standalone basis.  We generally do not separately sell MFD equipment or service on a standalone basis.  Therefore, we do not have VSOE for the selling price of these units. As we purchase the equipment, we have third-party evidence of the cost of this element.  We estimate the proceeds from the arrangement to allocate to the service unit based on historical cost experiences.  Based on the relative costs of each unit to the overall cost of the arrangement, we utilize the same relative percentage to allocate the total arrangement proceeds.

The Company’s contracts with customers may include provisions that relate to guaranteed savings amounts and shared savings. Such provisions are considered by management during the Company’s initial proprietary client assessment and are charged and accrued when deemed by management to be probable. The Company’s historical settlement of such amounts has been within management’s estimates.     

 Software Subscriptions and Managed Services Revenue  

Software subscriptions and managed services revenues are recognized ratably over the contract terms beginning on the commencement date of each contract, which is the date the Company’s service is made available to customers.

Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met.

The Company’s software subscription service arrangements are non-cancelable and do not contain refund-type provisions.

 Cyber Security Professional Services Revenues  

The majority of the Company’s cyber security services contracts are on a time and material basis. When these services are not combined with subscription revenues as a single unit of accounting, these revenues are recognized as the services are rendered for time and material contracts, and when the milestones are achieved and accepted by the customer for fixed price contracts.

F-8

New Customer Implementation Costs

We ordinarily incur additional costs to implement our managed print services for new customers.  These costs are comprised primarily of additional labor and support.  These costs are expensed as incurred, and have a negative impact on our statements of income and cash flows during the implementation phase.

Goodwill and Intangible Assets

F-9

The fair value hierarchy consists of three broad levels, which are described below:

Level 1 - Quoted prices in active markets for identical assets or liabilities that the entity has the ability to access.

Level 2 - Observable inputs, other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets and liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.

F-10

We account for stock options granted to consultants using the accounting guidance included in ASC 505-50 “Equity-Based Payments to Non-Employees.”  In accordance with ASC 505-50, we estimate the fair value of service-based stock options and performance-based options at each reporting period using the Black-Scholes pricing model.  The measurement date of the fair value of the equity instrument issued is the earlier of the date on which the counterparty’s performance is complete or the date on which it is probable that performance will occur.

F-11

F-12

In November 2015, the FASB issued guidance related to the presentation of deferred income taxes. The guidance requires that deferred tax assets and liabilities are classified as non-current in a consolidated balance sheet. This guidance was adopted early by us and resulted in the Company classifying its deferred tax assets as non-current assets.

In May 2014, the FASB issued guidance which provides a single, comprehensive accounting model for revenue arising from contracts with customers. This guidance supersedes most of the existing revenue recognition guidance, including industry-specific guidance. Under this model, revenue is recognized at an amount that a company expects to be entitled to upon transferring control of goods or services to a customer, as opposed to when risks and rewards transfer to a customer. The new guidance also requires additional disclosures about the nature, timing and uncertainty of revenue and cash flow arising from customer contracts, including significant judgments and changes in judgments. Considering the one-year delay in the required adoption date for the guidance as issued in July 2015, the new guidance is effective for us beginning in 2018 and may be applied retrospectively to all prior periods presented or through a cumulative adjustment to the opening retained earnings balance in the year of adoption. We are in the process of evaluating the impact of the new guidance on our consolidated financial statements.

In February 2016, the FASB issued a new accounting standard on leasing. The new standard will require companies to record most leased assets and liabilities on the balance sheet, and also proposes a dual model for recognizing expense. This guidance will be effective in the first quarter of 2019 with early adoption permitted. We have evaluated the impact that adopting this guidance and we are preparing for the changes to be made to our consolidated financial statements.

In January 2017, the FASB issued a new accounting standard simplifying the test for goodwill impairment. Currently, the fair value of the reporting unit is compared with the carrying value of the reporting unit (identified as "Step 1"). If the fair value of the reporting unit is lower than its carrying amount then, the implied fair value of goodwill is calculated. If the implied fair value of goodwill is lower than the carrying value of goodwill an impairment is recognized (identified as "Step 2"). The new standard eliminates Step 2 from the impairment test; therefore, a goodwill impairment will be recognized as the difference of the fair value and the carrying value. The new standard becomes effective on January 1, 2020 with early adoption permitted. We are currently evaluating the impact that the new standard will have on its financial position, results of operations and cash flows.

(2) Accounts Receivable 

F-13

F-14

(4) Intangible Assets and Goodwill 

Intangible assets are amortized over expected useful lives ranging from 1.5 to 10 years and consist of the following as of December 31, 2015:

The Company performed its annual impairment testing for Delphiis and Redspin as of December 31, 2016, and concluded there were indicators of potential intangible asset and goodwill impairment based on the performance of these business units and changes in the Company’s short and long-term strategy and outlook for these units.

The Company first performed a quantitative impairment analysis of the intangible assets and then a quantitative impairment analysis of goodwill as of December 31, 2016. With respect to the intangible asset analysis, management estimated future undiscounted free cash flows associated with the intangibles assets and determined that they were less than the related carrying values. As a result, the Company recognized an aggregate impairment charge of $1,077,188. With respect to the goodwill analysis, management estimated the fair value of the reporting units and determined that such amounts were less than the carrying values. Management then determined that the implied fair value of goodwill of the reporting units was less than the carrying value of goodwill and an aggregate $1,556,513 impairment charge was recorded.

A summary of the Company’s intangible assets and goodwill carrying amounts and impairment charges as of December 31, 2016 follows:

F-15

Intangible Assets

Goodwill

F-16

(5) Line of Credit and Term Loan 

On May 4, 2012, we entered into a Loan and Security Agreement (the “Loan and Security Agreement”) with Avidbank Corporate Finance, a Division of Avidbank (“Avidbank”).  On April 26, 2013, we amended the Loan and Security Agreement with Avidbank. On April 25, 2014, we again amended the Loan and Security Agreement with Avidbank (the “Second Avidbank Amendment”). Under the Second Avidbank Amendment, the term of the revolving line-of-credit of up to $2.0 million was extended through April 25, 2015, at an interest rate of prime plus 1.0% per annum. This line of credit was further extended through June 25, 2015 under the third amendment to the Loan and Security Agreement. On June 19, 2015, we again amended the Loan and Security Agreement with Avidbank (the “Fourth Avidbank Amendment”). Under the Fourth Avidbank Amendment, the term of the revolving line-of-credit of up to $2.0 million was extended through June 19, 2017, at an interest rate of prime plus 0.75% per annum.  As of December 31, 2016, the interest rate was 4.25%. There will be no minimum interest payable with respect to any calendar quarter. The amount available to us at any given time is the lesser of (a) $2.0 million, or (b) the amount available under our borrowing base (80% of our eligible accounts, minus (1) accrued client lease payables, and minus (2) accrued equipment pool liability). The Fourth Avidbank Amendment also provided for a term loan facility which allows for advances up to $4,000,000 through June 19, 2016. Our initial draw was for $2,000,000 in 2015. Term loan repayments shall be in 48 equal installments of principal, plus accrued interest at an interest rate of prime plus 1.25% per annum.

While there are outstanding credit extensions, we are to maintain a liquidity ratio of cash plus accounts receivable divided by all obligations owing to the bank of at least 1.75 to 1.00, measured monthly, and a debt coverage ratio, whereby adjusted EBITDA for the most recent twelve months shall be no less than 1.50 to 1.00 of the sum of the annual principal payments to come due in respect of the term loan advances plus the annualized interest expense of the quarter ending on the measurement date. We were in compliance with all of the Avidbank agreement covenants during each of the years ended December 31, 2016 and December 31, 2015.

The foregoing description is qualified in its entirety by reference to the Fourth Amendment to the Loan and Security Agreement between Avidbank Corporate Finance and Auxilio, Inc., which is found as Exhibit 10.1 of our form 10-Q filed on August 14, 2015.

In connection with our entry into the Loan and Security Agreement, we granted Avidbank (a) a general, first-priority security interest in all of our assets, equipment and supplies, and (b) a security interest in all of our intellectual property under an Intellectual Property Security Agreement.  As additional consideration for the Loan and Security Agreement, we issued Avidbank a 5-year warrant to purchase up to 24,033 shares of our common stock at an exercise price of $4.17 per share.  The foregoing descriptions are qualified in their entirety by reference to the respective agreements.  These agreements are found in our Form 8-K filed on May 9, 2012 as Exhibits 10.1, 10.2, 10.3 and 10.4.

Interest charges associated with the Avidbank line of credit, including loan origination costs, totaled $0 and $16,347, respectively, for the years ended December 31, 2016 and 2015, respectively. Interest charges associated with the Avidbank term loan, including loan origination costs, totaled $75,801 and $59,385, respectively for the years ended December 31, 2016 and 2015, respectively.

As of December 31, 2016 outstanding borrowings under the term loan was $1,250,000 and the interest rate was 5.0%. On January 13, 2017, this term loan was repaid as part of the acquisition of CynergisTek, Inc. Please see Note 16 regarding the acquisition.

F-17

We assumed debt totaling $463,723 when we acquired Delphiis, Inc. effective July 1, 2014 (see Note 15).  In July 2014, we paid $100,000 to the note holders upon Delphiis’s collection of $100,000 from accounts receivable outstanding as of June 30, 2014. On February 19, 2015, a holder of $257,835 of the notes agreed to convert the principal amount of his note into 85,945 shares of our common stock and the other note holder was paid $52,944. The remaining $52,944 principal was repaid in September 2015 when, pursuant to the terms of the note, we accelerated payment on the outstanding amount due at such time as Delphiis, Inc. achieved $4,000,000 of bookings measured from July 1, 2014.

Pursuant to a Note Conversion Agreement, dated February 19, 2015 (the “Conversion Agreement”), the holder of the $257,835 note agreed to convert the principal amount of his note into 85,945 shares of our common stock. In February 2015 he received 42,972 shares of common stock, and in October 2015 he received the remaining 42,973 shares when, under the terms of the Conversion Agreement, we accelerated the issuance at such time as Delphiis, Inc. achieved $4,000,000 of bookings measured from July 1, 2014. The foregoing summary of the note conversion is qualified in its entirety by reference to the full context of the Conversion Agreement which is found as Exhibit 99.1 to our 8-K filing on February 27, 2015.

Interest expense on the notes, including amortization of the discount, was $33,258 for the year ended December 31, 2015.

(7) Warrants 

F-18

In March 2014, one of the executives separated from the Company which resulted in the full vesting of all 66,667 shares of his remaining warrant grants. We have recorded stock compensation for the shares totaling $105,059 for the year ended December 31, 2014. Also in 2014, three of the executives’ employment agreements provided for a modification of the vesting of this warrant grant. The revised vesting schedule is as follows:

Our Board of Directors determined that the performance measures for 2014 were not met. As such the warrants for 2014 did not vest to the three executives. This tranche of warrants was cancelled. Our Board of Directors determined that the performance measures for 2015 and 2016 were met. As such the warrants for 2015 and 2016 vested to the three remaining executives. We have recorded stock compensation for the warrants totaling $122,569 for the year ended December 31, 2015 and $122,568 for the year ended December 31, 2016.

(8) Stock Option and Stock Incentive Plans 

F-19

The following table summarizes information about stock options outstanding and exercisable at December 31, 2016:

F-20

(9) Restricted Stock 

In July 2014, in connection with our acquisition of the common stock of Delphiis, Inc., we issued to a key employee 133,333 shares of restricted stock as part of his employment agreement. The shares vest as follows:

In August 2015, the key employee’s employment agreement was revised such that the first 33,333 shares became fully vested and the remaining shares were cancelled on January 1, 2016. The stock-based compensation expense recognized for these shares totaled $101,881 for the year ended December 31, 2015.

(10) Income Taxes 

For the years ended December 31, 2016 and 2015, the components of income tax benefit (expense) are as follows:

Income tax benefit (expense) amounted to $5,074,439 and ($152,436) for the years ended December 31, 2016 and 2015, respectively (an effective rate of (7,851)% for 2016 and 10.4% for 2015).  A reconciliation of the provision for income taxes with amounts determined by applying the statutory U.S. federal income tax rate to income before income taxes is as follows:

F-21

Realization of deferred tax assets is dependent on future earnings, if any, the timing and amount of which is uncertain.  A valuation allowance, in an amount equal to the net deferred tax asset as of December 31, 2015 has been established to reflect these uncertainties.  As of December 31, 2016, following four consecutive years of pretax earnings and with the expectation of future earnings, management removed 100% of the valuation allowance against the net deferred tax assets and recognized a corresponding income tax benefit. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.  Significant components of our deferred tax assets and liabilities are as follows:

At December 31, 2016, we have available unused net operating loss carryforwards of approximately $9,497,000 for federal purposes and $7,079,000 for state purposes that may be applied against future taxable income and that, if unused, expire beginning in 2023 through 2032.

Utilization of the net operating loss carryforwards may be subject to a substantial annual limitation due to ownership change limitations provided by the Internal Revenue Code under section 382.  The annual limitation may result in the expiration of net operating loss carryforwards before utilization. Our federal and state net operating loss carryforwards will begin to expire in 2023 and 2020, respectively.

We evaluate our tax positions each reporting period to determine the uncertainty of such positions based upon one of the following conditions: (1) the tax position is not ‘‘more likely than not’’ to be sustained, (2) the tax position is ‘‘more likely than not’’ to be sustained, but for a lesser amount, or (3) the tax position is ‘‘more likely than not’’ to be sustained, but not in the financial period in which the tax position was originally taken. We have evaluated our tax positions for all jurisdictions and all years for which the statute of limitations remains open. We have determined that no additional liability for unrecognized tax benefits and interest was necessary.

(11) Retirement Plan 

F-22

F-23

Effective January 1, 2016, we entered into a new employment agreement with Mr. Anthony (the “2016 Anthony Agreement”). The 2016 Anthony Agreement provides that Mr. Anthony will continue to serve as our Executive Vice President (“EVP”) and CFO. The 2016 Anthony Agreement has a term of two years, and provides for an annual base salary of $245,000. The 2016 Anthony Agreement will automatically renew for subsequent twelve (12) month terms unless either party provides advance written notice to the other that such party does not wish to renew the agreement for a subsequent twelve (12) months.  Mr. Anthony also receives the customary employee benefits available to our employees. Mr. Anthony is also entitled to receive a bonus of up to $132,000 per year, the achievement of which is based on Company performance metrics.  We may terminate Mr. Anthony’s employment under the 2016 Anthony Agreement without cause at any time on thirty (30) days advance written notice, at which time Mr. Anthony would receive severance pay for twelve months and be fully vested in all options and warrants granted to date.  The foregoing summary of the 2016 Anthony Agreement is qualified in its entirety by reference to the full context of the employment agreement, which is found as Exhibit 10.32 to our Annual Report on Form 10-K filed with the SEC on March 30, 2016. In March 2017, the Board of Directors authorized an increase in Mr. Anthony’s base salary to $250,000 retroactive to January 1, 2017, and increased his potential annual bonus amount to $150,000.

F-24

(14) Asset Purchase Agreement – Redspin 

On March 31, 2015, Auxilio entered into an Asset Purchase Agreement (the “Purchase Agreement”) with Redspin, Inc., a California corporation (“Redspin”) and certain owners of Redspin, to acquire substantially all of the assets and certain liabilities of Redspin (the “Acquired Assets”).  A copy of the Purchase Agreement was filed as an exhibit to the Current Report on Form 8-K filed with the SEC on April 6, 2015.   On April 7, 2015, the Company completed its acquisition of the Acquired Assets in an asset purchase transaction (the “Transaction”) pursuant to the terms and conditions of the Purchase Agreement.

As a result of the consummation of the Purchase Agreement, on April 7, 2015, in consideration for the Acquired Assets, the Company paid Redspin $2,076,966 in cash, less a holdback of $200,000 to cover any indemnification claims made pursuant to the Transaction, and issued 150,761 shares of the Company’s restricted common stock, par value $0.001, which was the number of shares having an aggregate value of $500,000, with the price per share equal to the average of the closing price of Auxilio common stock on the OTC Markets for the 20 most recent trading days prior to the date of the Purchase Agreement, rounded up to the nearest whole number of shares. The Company also agreed to pay a cash Earn-out Payment, as defined in the Purchase Agreement, upon the achievement of certain earnings targets in the first year following the date of the Purchase Agreement. Management estimated the fair value of the contingent consideration to be approximately $623,000. Because the earnings targets were not met, this portion of the acquisition purchase price is recorded as other income on the consolidated statement of income for the year ended December 31, 2015.

The Purchase Agreement also provided for the Company to pay employee bonus shares of common stock upon the achievement of the same certain earnings targets and provided they remain with the Company for one year subsequent to the acquisition date. Management previously had considered the $124,000 of fair value of these employee bonus shares to be a component of the acquisition cost. After completing the analysis of the earn-out provisions, Management has determined that the employee bonus shares would be post-combination compensation. Because the minimum earnings targets were not be achieved, no related stock compensation expense has been recorded for the year ended December 31, 2015.

The allocation of the purchase price of the assets acquired and liabilities assumed based on their fair values was as follows: 

Purchased identifiable intangible assets are amortized on a straight-line basis over the respective useful lives. Our estimated useful life of the identifiable intangible assets acquired ranges from three to ten years. We recognized goodwill of $1,192,000. Goodwill is recognized as we expect to be able to realize synergies between the two companies, primarily our ability to provide market and reach for the Redspin products and services to Auxilio’s customers. During 2016, certain intangible assets and goodwill were deemed impaired (Note 4).

The Company incurred approximately $70,000 in legal, accounting and other professional fees related to this acquisition, all of which were expensed during the year ended December 31, 2015.

F-25

Employment Agreement

In connection with the Purchase Agreement, Auxilio and Daniel Berger (“Berger”), CEO of Redspin, entered into an employment agreement (the “Berger Employment Agreement”), pursuant to which Berger was employed to serve as Executive Vice President of Auxilio.  The initial term of the Berger Employment Agreement was for two years (unless sooner terminated), and automatically renews for subsequent twelve-month periods unless either party determines to not renew.  Berger’s base annual salary was $250,000, and Berger was eligible to receive incentive compensation, consistent with that generally offered to executives of the Company.  In addition, Auxilio and John Abraham (“Abraham”), Founder of Redspin, entered into an independent contractor agreement (the “Abraham Agreement”), pursuant to which Abraham was retained to perform the work assigned by the Company.  The term of the Abraham Agreement was for two years (unless sooner terminated).  In consideration for such services, the Company agreed to pay Abraham $11,000 per month.

Pro Forma Information

The following supplemental unaudited pro forma information presents the combined operating results of the Company and the acquired business during the years ended December 31, 2016 and 2015, as if the acquisition had occurred at the beginning of each of the periods presented. The pro forma information is based on the historical financial statements of the Company and that of the acquired business. Amounts are not necessarily indicative of the results that may have been attained had the combinations been in effect at the beginning of the periods presented or that may be achieved in the future.

(15) Subsequent events 

Stock Purchase Agreement – CynergisTek, Inc.; Amended and Restated Credit Agreement

As previously disclosed in our Current Report on Form 8-K, filed with the Commission on January 17, 2017, we entered into a Stock Purchase Agreement (the “SPA”) with CynergisTek, Inc., a Texas corporation (“CynergisTek”), Dr. Michael G. Mathews (“Mathews”) and Michael H. McMillan (“McMillan,” and together with Mathews, the “Stockholders”), pursuant to which Auxilio acquired 100% of the issued and outstanding shares of common stock (the “Shares”) of CynergisTek from the Stockholders (the “CynergisTek Transaction”).

Pursuant to the SPA, the purchase price paid for the Shares consisted of four components: the Cash Consideration, the Securities Consideration, the Debt Consideration, and the Earn-out Consideration.  

 Cash Consideration.  Auxilio paid the Stockholders a cash payment of $15,000,000, less Closing Net Working Capital Deficit, Funded Indebtedness and Designated Transaction Expenses (defined as certain expenses of the Stockholders and certain expenses of CynergisTek). The net cash amount paid to the Stockholders was $14,202,644.76.  

 Securities Consideration.  Auxilio issued a total of 1,166,666 shares of Auxilio common stock, par value $0.001 per share (the “Auxilio Stock”) to the Stockholders, with each of the Stockholders receiving 583,333 shares. 

F-26

 Debt Consideration.  Auxilio issued promissory notes totaling $9,000,000 to the Stockholders (the “Seller Notes”), with each of the Seller Notes having an initial principal amount of $4,500,000.  The Seller Notes bear interest at 8% per annum, are quarterly interest-only payments due during the first 12 months, quarterly payments of principal and interest due during the last 24 months, using a 36-month amortization period commencing from that point, with a balloon payment due on the maturity date.  Amounts due and owing under the Seller Notes are subordinate to the right of payment due under the AvidBank Loan (described below) pursuant to the Subordination Agreement.  Auxilio has the right to prepay all or any portion of the outstanding principal balance of the Seller Notes, provided that such prepayment is accompanied by accrued interest on the amount of principal prepaid, calculated to the date of such prepayment. 

 Earn-out Consideration.   The Stockholders may be entitled to an additional $7,500,000 based upon the financial performance of CynergisTek after closing of the CynergisTek Transaction, to be calculated based upon EBITDA generated by the CynergisTek business during the earn-out period, which began as of January 1, 2017, and ends on December 31, 2021 (the “Earn-out Payments”).   

Pursuant to the SPA, CynergisTek and the Stockholders agreed to deliver to Auxilio certificates representing the Shares; the corporate record books of CynergisTek; and the employment agreements (described below). Auxilio agreed to deliver the Cash Consideration, the Securities Consideration, the Debt Consideration and the signed employment agreements.  

 In connection with the SPA, the Company and the Stockholders also entered into a registration rights agreement (the “Registration Rights Agreement”) and employment agreements, each of which is discussed below. 

Registration Rights Agreement

Pursuant to the Registration Rights Agreement between Auxilio and the Stockholders, Auxilio agreed to grant piggy-back registration rights under certain circumstances, and demand registration rights under other circumstances.  Briefly, for the piggy-back rights, if Auxilio proposes to register the sale of any of its stock or other securities under the Securities Act of 1933, as amended (the “Securities Act”) in connection with the public offering of such securities solely for cash, or the resale of shares of its common stock by other selling stockholders, Auxilio agreed that prior to such filing, it will give written notice to the Stockholders of its intention to do so. Upon the written request of a Stockholder given within twenty (20) days after Auxilio provides such notice (which request shall state the intended method of disposition of such registrable securities by the Stockholder), Auxilio will file a registration statement to register the resale of all such registrable securities which Auxilio has been requested by such Stockholder to register. With respect to the demand registration rights, Auxilio agreed that in the event that Auxilio fails to file timely public reports with the U.S. Securities and Exchange Commission if and as required by the Securities Exchange Act of 1934, as amended, then the Stockholders shall have the right, by delivering written notice to Auxilio (a “Demand Notice”), to require Auxilio to register the number of registrable securities requested to be so registered pursuant to the terms of the Registration Rights Agreement (a “Demand Registration”). Following the receipt of a Demand Notice for a Demand Registration, Auxilio agreed to file a registration statement not later than sixty (60) days after such Demand Notice, and will use its commercially reasonable efforts to cause such registration statement to be declared effective under the Securities Act as promptly as practicable after the filing thereof. Additionally, pursuant to the Registration Rights Agreement, the rights of the Stockholders to deliver a Demand Notice for a Demand Registration shall not be effective at any time when the registrable securities held by such Stockholder may be resold under Rule 144 of the Securities Act without regard to any volume limitation requirements under Rule 144 of the Securities Act.

Employment Agreements

In connection with the SPA, Auxilio and each of the Stockholders entered into an employment agreement, pursuant to which McMillan was appointed President and Chief Strategy Officer of Auxilio, and Mathews was appointed Executive Vice President of Auxilio.

F-27

McMillan Employment Agreement.

Auxilio and McMillan entered into an employment agreement (the “McMillan Employment Agreement”), pursuant to which Auxilio employs McMillan as President and Chief Strategy Officer of Auxilio. McMillan agreed that his duties for Auxilio and its subsidiaries CynergisTek, Inc. and Delphiis, Inc. would be substantially similar to those duties that McMillan has performed on behalf of CynergisTek, and would include, without limitation, responsibility for executive leadership and business development strategy.  McMillan also agreed to perform additional duties as reasonably assigned by Auxilio’s Chief Executive Officer, and/or Board of Directors in order to advance the interests of Auxilio and its subsidiaries. The initial term of the McMillan Employment Agreement is 36 months from January 13, 2017, and will automatically renew for subsequent 12-month terms unless either party provides written notice to the other party of a desire to not renew the employment.

Pursuant to the McMillan Employment Agreement, McMillan’s base salary is $250,000, and he is entitled to incentive bonus compensation and equity compensation (consisting of stock options), as set forth in the McMillan Employment Agreement.  Auxilio has the right to terminate McMillan’s employment without cause at any time on thirty (30) days’ advance written notice to McMillan. Additionally, McMillan has the right to resign for “Good Reason” (as defined in the McMillan Employment Agreement) on thirty (30) days’ written notice.  In the event of (i) such termination without cause, or (ii) McMillan’s inability to perform the essential functions of his position due to a mental or physical disability or his death,  or (iii) McMillan’s resignation for Good Reason, McMillan is entitled to receive the base salary then in effect and full target annual bonus, prorated to the date of termination, and a “Severance Payment” equivalent to (a) payment of compensation for an additional twelve months, payable as a lump sum, and (b) the acceleration of all unvested stock options and warrants then held by McMillan, subject to certain conditions set forth in the McMillan Employment Agreement.  In addition, if McMillan is terminated by Auxilio without cause (as defined in the McMillan Employment Agreement), certain of the Earn-out Payments will accelerate and become immediately due and payable, as set forth in the SPA.  If McMillan resigns for other than Good Reason, he will be entitled to receive the base salary for the thirty (30) day written notice period, but no other amounts.

Mathews Employment Agreement.

Auxilio and Mathews entered into an employment agreement (the “Mathews Employment Agreement”), pursuant to which Auxilio employs Mathews as Executive Vice President of Auxilio. Mathews agreed that his duties for Auxilio and its subsidiaries CynergisTek, Inc. and Delphiis, Inc. would be substantially similar to those duties that Mathews has performed on behalf of CynergisTek, and would include, without limitation, day-to-day P&L responsibility for the cybersecurity service business line.  Mathews also agreed to perform additional duties as reasonably assigned by Auxilio’s President, Chief Executive Officer, and/or Board of Directors in order to advance the interests of Auxilio and its subsidiaries. The initial term of the Mathews Employment Agreement is 36 months from January 13, 2017, and will automatically renew for subsequent 12-month terms unless either party provides written notice to the other party of a desire to not renew the employment.

F-28

Pursuant to the Mathews Employment Agreement, Mathew’s base salary is $250,000, and he is entitled to incentive bonus compensation and equity compensation (consisting of stock options), as set forth in the Mathews Employment Agreement.  Auxilio has the right to terminate Mathew’s employment without cause at any time on thirty (30) days’ advance written notice to Mathews. Additionally, Mathews has the right to resign for “Good Reason” (as defined in the Mathews Employment Agreement) on thirty (30) days’ written notice.  In the event of (i) such termination without cause, or (ii) Mathew’s inability to perform the essential functions of his position due to a mental or physical disability or his death,  or (iii) Mathew’s resignation for Good Reason, Mathews is entitled to receive the base salary then in effect and full target annual bonus, prorated to the date of termination, and a “Severance Payment” equivalent to (a) payment of compensation for an additional twelve months, payable as a lump sum, and (b) the acceleration of all unvested stock options and warrants then held by Mathews, subject to certain conditions set forth in the Mathews Employment Agreement.  In addition, if Mathews is terminated by Auxilio without cause (as defined in the Mathews Employment Agreement), certain of the Earn-out Payments will accelerate and become immediately due and payable, as set forth in the SPA.  If Mathews resigns for other than Good Reason, he will be entitled to receive the base salary for the thirty (30) day written notice period, but no other amounts.

Amended and Restated Credit Agreement and Related Agreements

Also on January 13, 2017,  Auxilio, and its subsidiaries Auxilio Solutions, Inc., a California corporation (“Solutions”), Delphiis, Inc., a California corporation (“Delphiis”), and immediately upon the consummation of the CynergisTek Transaction, CynergisTek (with Auxilio, Solutions, Delphiis, CynergisTek and such other subsidiaries collectively referred to as “Borrowers”), entered into an Amended and Restated Credit Agreement (the “A&R Credit Agreement”) with ZB, N.A., dba California Bank and Trust (“CBT”), and Avidbank, a California banking corporation (“Avidbank,” and together with CBT, the “Lenders”), as well as Avidbank in its capacity as contractual representative for itself and the other lender (“Agent”).

By way of background, Auxilio and Solutions on the one hand and Avidbank on the other hand previously entered into a Loan and Security Agreement, dated as of April 19, 2012 (as amended to date, the “Original Credit Agreement”), pursuant to which Avidbank extended to Auxilio and Solutions a term loan and a revolving line of credit.  Subsequently, Auxilio advised Agent that Auxilio desired to acquire 100% of the ownership interests of CynergisTek pursuant to the SPA.  The CynergisTek Transaction is prohibited by Section 7.3 of the Original Credit Agreement.  

Borrowers requested that Lenders (1) consent to the CynergisTek Transaction, and (2) provide additional financing in order to finance, in part, Auxilio’s obligations under the SPA.  Agent and Lenders agreed with such request in accordance with and subject to the terms and conditions of the A&R Credit Agreement and other related documents defined in the A&R Credit Agreement (the “Loan Documents”).  In connection with the entry into the A&R Credit Agreement, the parties to the A&R Credit Agreement agreed that CynergisTek automatically would become a Borrower under the A&R Credit Agreement and under the Loan Documents on the closing date immediately upon consummation of the CynergisTek Transaction (and not prior thereto), without further action required by any party.

Accordingly, the parties to the A&R Credit Agreement agreed that the A&R Credit Agreement and the Loan Documents would amend and restate the Original Credit Agreement in its entirety, and continue the obligations incurred thereunder and evidenced thereby.  Additionally, any amounts outstanding under the Original Credit Agreement were repaid in full immediately prior to the execution of the A&R Credit Agreement.

Loan Facilities

Term Loans:  Pursuant to the A&R Credit Agreement, the Lenders agreed to provide term loans in the aggregate amount of $14,000,000.00 to Auxilio, which was paid to the Stockholders as part of the Cash Consideration in the CynergisTek Transaction (described above).  The term loans bear interest at a rate of Prime plus 1.5%, and the loans mature on January 12, 2022.  

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Revolving Line of Credit: Additionally, pursuant to the A&R Credit Agreement, the Lenders agreed to provide revolving loans to the Borrowers in an aggregate amount of up to $5,000,000. At the closing of the CynergisTek Transaction, no draws were made on the revolving loans.

Security Agreement

In connection with the A&R Credit Agreement, the Borrowers and the Agent entered into a security agreement (the “Security Agreement”), pursuant to which each of the Borrowers agreed to grant to Agent, for the ratable benefit of itself, the Lenders and the other secured parties, a first priority security interest in certain collateral to secure prompt payment and performance of the secured obligations under the A&R Credit Agreement.  Pursuant to the Security Agreement, the “Collateral” was defined as including any and all (all such terms as defined in the Security Agreement) of the Accounts, Chattel Paper, Commercial Tort Claims, Deposit Accounts, Documents, Equipment, Instruments, Inventory, Investment Property, General Intangibles, Letter of Credit Rights, Negotiable Collateral, Supporting Obligations, Vehicles, Grantors’ Books, in each case whether now existing or hereafter acquired or created, any money or other assets of any Grantor that now or hereafter come into the possession, custody, or control of Agent and any Proceeds or products of any of the foregoing, or any portion thereof.  In connection with the grant of the security interest in the Collateral, each of the Borrowers made standard representations and warranties relating to ownership of the collateral, location and control of the collateral, and certain rights to payment.

Seller Subordination Agreement

Additionally, in connection with the A&R Credit Agreement and the CynergisTek transaction, Mathews, McMillan, Auxilio, and Avidbank entered into a subordination agreement (the “Subordination Agreement”), pursuant to which Mathews and McMillan agreed that unless and until all of Auxilio’s obligations under the A&R Credit Agreement has been repaid in full, Mathews and McMillan would not, except as provided in the Subordination Agreement, ask, demand, sue for, take or receive, or retain, from Auxilio or any other person or entity, by setoff or in any other manner, payment of all or any part of the Subordinate Debt (as defined below), or take any other action with respect to the Subordinate Debt; forgive, cancel or discharge any of the Subordinate Debt; ask, demand or receive any security for the Subordinate Debt; amend any documents relating to the Subordinate Debt or any other agreement, instrument or document evidencing or executed in connection with the Subordinate Debt in a manner that could reasonably be expected to be adverse to Lenders or Agent (or any other holders of the obligations arising under the A&R Credit Agreement); or bring or join with any creditor in bringing any insolvency proceeding against Auxilio. Additionally, Mathews and McMillan each directed Auxilio to make, and Auxilio agreed to make, such prior payment of Auxilio’s obligations under the A&R Credit Agreement to Agent and the Lenders.  The Subordination Agreement defines “Subordinate Debt” to include all debt of Auxilio owing to Mathews and McMillan (or either of them) (a) under the Seller Notes or (b) in respect of the Earn Out Payments (described above), in either case whether now existing or hereafter arising and including all principal, premium, interest, fees, attorneys’ fees, costs, charges, expenses, reimbursement obligations, any other indemnities or guarantees in each case with respect thereto, in each case whether direct or indirect, absolute or contingent, joint or several, due or not due, primary or secondary, liquidated or unliquidated, secured or unsecured.  So long as the Borrowers are not in default under the terms of the A&R Credit Agreement, Auxilio may make regular payments to the Stockholders under the Seller Notes.

Reverse Stock Split

On January 12, 2017, Auxilio, Inc. announced that it had received approval from the Financial Industry Regulatory Authority ("FINRA") of the Company's Company Related Action Notification Form relating to the implementation of a reverse split of its common stock, par value $0.001 per share  at a ratio of one-for-three, that is, one new share for each three old shares of the Company's common stock, whereby 24,557,224 outstanding shares of the Company’s common stock were exchanged for 8,185,936 newly issued shares of the Company's common stock. Under the terms of the reverse stock split, fractional shares issuable to stockholders were rounded up to the nearest whole share, resulting in a reverse split slightly less than one for three in the aggregate.

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On December 22, 2016, the Company filed a Certificate of Amendment to its Articles of Incorporation relating to the reverse split.  The Amendment provides that no fractional shares of Common Stock will be issued to the holders of record of Common Stock prior to the reverse split. Instead, all fractional shares will be rounded up to the next whole number of shares.

The reverse split was approved at the 2015 Annual Meeting of the Company's Shareholders.  At that meeting, the Company's shareholders voted to approve a reverse split at a ratio between 1-for-1.5 shares and 1-for-3 shares, to be determined by the Company's Board of Directors.  The Board determined to implement the reverse split at the ratio of one for three shares.

The reverse stock split became effective with FINRA and in the marketplace at the open of business on Friday, January 13, 2017, whereupon the shares of common stock began trading on a reverse-split-adjusted basis.

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PART IV

ITEM 15.   EXHIBITS AND FINANCIAL STATEMENT SCHEDULES. 

POWER OF ATTORNEY AND SIGNATURES