CYNERGISTEK, INC - Quarter Report: 2017 June (Form 10-Q)

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PART I – FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS.

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

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AUXILIO, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

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

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AUXILIO, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

SIX MONTHS ENDED JUNE 30, 2017

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements

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AUXILIO, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

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

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AUXILIO, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(UNAUDITED)

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SIX MONTHS ENDED JUNE 30, 2017 AND 2016

(UNAUDITED)

1.BASIS OF PRESENTATION 

The accompanying unaudited condensed consolidated financial statements of Auxilio, Inc. and its subsidiaries (the “Company”, “we”, “us” or “Auxilio”) have been prepared in accordance with generally accepted accounting principles of the United States of America (“GAAP”) for interim financial statements pursuant to the rules and regulations of the Securities and Exchange Commission.  Accordingly, these financial statements do not include all of the information and notes required by GAAP for complete financial statements.  These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016, as filed with the Securities and Exchange Commission (“SEC”) on March 29, 2017.

The unaudited condensed consolidated financial statements included herein reflect all adjustments (which include only normal, recurring adjustments) that are, in the opinion of management, necessary to state fairly our financial position and results of operations as of and for the periods presented.  The results for such periods are not necessarily indicative of the results to be expected for the full year.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  As a result, actual results could differ from those estimates.

The accompanying unaudited condensed consolidated financial statements include the accounts of Auxilio and its wholly owned subsidiaries.  All intercompany balances and transactions have been eliminated.

Based on our integration and management strategies, we operate in a single business segment. For the periods presented, all revenues were derived from domestic operations.

As described in Note 11, the Company acquired the outstanding shares of CynergisTek, Inc. on January 13, 2017.

We have performed an evaluation of subsequent events through the date of filing these unaudited condensed consolidated financial statements with the SEC.

2.RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS 

In November 2015, the FASB issued guidance related to the presentation of deferred income taxes. The guidance requires that deferred tax assets and liabilities be 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. While the Company is in the process of evaluating the impact of the new guidance, primarily by analyzing our revenue streams, currently we do not expect that this standard will have a material impact on the Company’s consolidated financial statements.

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In March 2016, the FASB issued a new accounting standard regarding stock compensation: improvements to employee share-based payment accounting, that simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The new standard was effective for fiscal years beginning after December 15, 2016, including interim periods within those annual years, and early adoption was permitted. We adopted the new standard prospectively in 2017. The adoption of the new standard did not have a material effect on our consolidated financial statements for the three months and six months ended June 30, 2017, and we do not expect that the adoption of the new standard will have a material effect on our consolidated financial statements for the year ended December 31, 2017.

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 of adopting this guidance and we are preparing for the changes to be made to our consolidated financial statements. We expect the adoption of these accounting changes will materially increase our assets and liabilities, but will not have a material impact on our net income or equity.

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 our financial position, results of operations and cash flows.

3.OPTIONS, WARRANTS AND RESTRICTED STOCK UNITS 

Below is a summary of stock option, warrant and restricted stock activity during the six month period ended June 30, 2017:

During the six months ended June 30, 2017, we granted a total of 25,000 options to our employees and directors to purchase shares of our common stock at an exercise price of $3.06 per share. The exercise price equals the fair value of our stock on the grant date.  The options have graded vesting annually over three years.  The fair value of the options was determined using the Black-Scholes option-pricing model.  The assumptions used to calculate the fair market value are as follows: (i) risk-free interest rate of 0.38%; (ii) estimated volatility of 46.29%; (iii) dividend yield of 0.0%; and (iv) expected life of the options of 3 years.

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On April 1, 2017, we issued to key employees a total of 120,000 shares of restricted stock units. The shares vest after three years of continuous employment. The price of the stock on the grant date was $4.77. The cost recognized for these restricted stock units totaled $44,183 for the three and six months ended June 30, 2017, and is included in sales and marketing expense in the accompanying Condensed Consolidated Statement of Operations.

For the three and six months ended June 30, 2017 and 2016, stock-based compensation expense recognized in the consolidated statements of operations as follows:

4.NET INCOME PER SHARE 

Basic net income per share is calculated using the weighted average number of shares of our common stock issued and outstanding during a certain period, and is calculated by dividing net loss by the weighted average number of shares of our common stock issued and outstanding during such period. Diluted net income per share is calculated using the weighted average number of common and potentially dilutive common shares outstanding during the period, using the as-if-converted method for secured convertible notes, and the treasury stock method for options and warrants. Diluted net income per share does not include potentially dilutive securities because such inclusion in the computation would be anti-dilutive.

For the three months ended June 30, 2017, potentially dilutive securities consisted of options and warrants to purchase 1,425,082 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, only 842,052 of the shares to purchase common stock from the options and warrants are included

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in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.

For the six months ended June 30, 2017, potentially dilutive securities consisted of options and warrants to purchase 1,425,082 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, only 709,512 of the shares of common stock underlying the options and warrants are included in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.

For the three months ended June 30, 2016, potentially dilutive securities consisted of options and warrants to purchase 1,992,040 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, only 100,586 of the shares of common stock underlying the options and warrants are included in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.

For the six months ended June 30, 2016, potentially dilutive securities consisted of options and warrants to purchase 1,992,040 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, only 142,033 of the shares of common stock underlying the options and warrants are included in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.

5.ACCOUNTS RECEIVABLE 

A summary of accounts receivable is as follows:

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6.INTANGIBLE ASSETS 

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

7.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”). 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.  On January 13, 2017, as part of the acquisition of CynergisTek, Inc., we entered into an Amended and Restated Credit Agreement (the “A&R Credit Agreement”) with California Bank and Trust and Avidbank (collectively the “Lenders”). Under the A&R Credit Agreement, the term of the revolving line-of-credit is available through January 13, 2019 at an interest rate of prime plus 1.0% per annum. As of June 30, 2017, the interest rate was 5.25%.  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) $5.0 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). As of June 30, 2017, and December 31, 2016, no amounts were outstanding under the line of credit.

The Fourth Avidbank Amendment provided for a term loan facility which allowed for advances up to $4,000,000 through June 19, 2016. Our initial draw was for $2,000,000 in 2015. As of December 31, 2016, outstanding borrowings under the term loan were $1,250,000 at an interest rate of 4.75%. On January 13, 2017, this loan was repaid in full. On that date, we entered into the A&R Credit Agreement which provided a term loan facility for $14,000,000. Term loan repayments shall be in 48 monthly principal installments of $198,333, plus accrued interest at an interest rate of prime plus 1.5% per annum, followed by 12 monthly principal installments of

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$373,333, plus accrued interest at an interest rate of prime plus 1.5%.  As of June 30, 2017, outstanding borrowings under the term loan are $13,008,333 at an interest rate of 5.75%.

While there are outstanding credit extensions, we are to maintain an asset coverage ratio of cash plus accounts receivable divided by all obligations owing to the bank within one year of at least 1.50 to 1.00, measured monthly, and a fixed charge coverage ratio, whereby adjusted EBITDA for the most recent twelve months shall be no less than 1.15 to 1.00 of the sum of the following: (i) Non-Financed Capital Expenditures, (ii) taxes paid in cash during such period, (iii) Distributions paid in cash during such period, (iv) any Earnout Payment paid in cash during such period, and (v) Debt Service for such period, all as determined in accordance with GAAP. We were in compliance with all covenants as of June 30, 2017 and December 31, 2016.

In connection with the A&R Credit Agreement, Auxilio, and its subsidiaries Auxilio Solutions, Inc., Delphiis, Inc., and CynergisTek, Inc. (collectively the “Borrowers”) entered into a security agreement (the “Security Agreement”), pursuant to which each of the Borrowers agreed to grant to Avidbank, in its capacity as contractual representative for itself and the other lender (the “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.

Additionally, in connection with the A&R Credit Agreement and the CynergisTek transaction, (see Note 11), Michael Mathews, (“Mathews”), Michael McMillan (“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 have 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 promissory notes due to Mathews and McMillan (the “Seller Notes”) or (b) in respect of the Earn Out Payments (described in Note 11), 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 Mathews and McMillan under the Seller Notes.

The foregoing description of the Fourth Amendment to the Loan and Security Agreement between Avidbank and Auxilio is qualified in its entirety by reference to the terms of the Fourth Amendment to the Loan and Security Agreement, which is found as Exhibit 10.1 of our Form 10-Q filed on August 14, 2015. The foregoing descriptions of the A&R Credit Agreement, Security Agreement and Subordination Agreement are qualified in their entirety by reference to the respective agreements.  These agreements are found in our Form 8-K filed on January 17, 2017 as Exhibits 99.7, 99.8, and 99.9, respectively.

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Interest charges associated with borrowings on the line of credit for the three and six months ended June 30, 2017 were $1,285 and $1,285, respectively. In addition, on January 13, 2017, we paid a $25,000 revolving loan commitment fee. There were no borrowings on the line of credit for the three and six months ended June 30, 2016.

Interest charges associated with the term loans totaled $184,964 and $343,028 for the three and six months ended June 30, 2017, respectively. In addition, on January 13, 2017, we paid a $70,000 term loan commitment fee. Interest charges associated with the term loans totaled $19,016 and $39,516 for the three and six months ended June 30, 2016, respectively.

As additional consideration for the original 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 $4.16 per share. We entered into a warrant repurchase agreement with Avidbank whereby on April 6, 2017 we paid Avidbank $4,743 to repurchase these warrants.

8.PROMISSORY NOTES 

In connection with the acquisition of CynergisTek, Inc. (Note 11) we issued two promissory notes totaling $9,000,000 to Dr. Michael G. Mathews and Michael McMillan (the “Seller Notes”), with each of the Seller Notes having an initial principal amount of $4,500,000.  These Seller Notes bear interest at 8% per annum, require quarterly interest-only payments during the first 12 months, quarterly payments of principal and interest 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 A&R Credit Agreement pursuant to the Subordination Agreement (Note 7).  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.

The foregoing descriptions of the Seller Notes and Subordination Agreement are qualified in their entirety by reference to the respective agreements.  These agreements are found in our Form 8-K filed on January 17, 2017 as Exhibits 99.3, 99.4 and 99.9, respectively.

Interest charges associated with the Seller Notes totaled $179,507 and $331,397, respectively for the three months and six months ended June 30, 2017.

9.EMPLOYMENT AGREEMENTS 

Effective January 1, 2016, we entered into an employment agreement with Joseph Flynn (the “2016 Flynn Agreement”). The 2016 Flynn Agreement provides that Mr. Flynn will continue his employment as our President and CEO.  The 2016 Flynn Agreement has a term of two years, provides for an annual base salary of $300,000, and 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. Flynn also receives the customary employee benefits available to our employees. Mr. Flynn is also entitled to receive a bonus of up to $180,000 per year, the achievement of which is based on Company performance metrics.  We may terminate Mr. Flynn’s employment under the 2016 Flynn Agreement without cause at any time on thirty (30) days advance written notice, at which time Mr. Flynn would receive severance pay for twelve months and be fully vested in all options and warrants granted to date.  In January 2017, Mr. Flynn resigned as President, and continues to serve as CEO.  The foregoing summary of the 2016 Flynn Agreement is qualified in its entirety by reference to the full context of the employment agreement, which is found as Exhibit 10.31 to our Annual Report on Form 10-K filed with the SEC on March 30, 2016.

Effective January 1, 2016, we entered into an employment agreement with Paul 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

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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 2017, the Board of Directors authorized an increase in Mr. Anthony’s base salary to $250,000 and increased his potential annual bonus amount to $150,000.

The employment agreements of Dr. Michael G. Mathews and Michael McMillan are described in Note 11 as part of the acquisition of CynergisTek, Inc.

10.CONCENTRATIONS 

Cash Concentrations

At times, cash balances held in financial institutions are in excess of federally insured limits.  Management performs periodic evaluations of the relative credit standing of financial institutions and limits the amount of risk by selecting financial institutions with a strong credit standing.

Major Customers

Our two largest customers accounted for approximately 44% of our revenues for the six months ended June 30, 2017 and our two largest customers accounted for approximately 49% of our revenues for the six months ended June 30, 2016. Our largest customers had accounts receivable totaling approximately $4,300,000 and $4,000,000 as of June 30, 2017 and December 31, 2016 respectively.

11.STOCK PURCHASE AGREEMENT – CYNERGISTEK, INC. 

As previously disclosed in our Current Report on Form 8-K, filed with the SEC on January 17, 2017, on January 13, 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. The total purchase price was approximately $28.3 million.

·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 $14,202,645. Auxilio funded $14 million of the cash consideration through a term loan (Note 7). 

·Securities Consideration.  Auxilio issued a total of 1,166,666 shares of Auxilio common stock, par value $0.001 per share to the Stockholders, with each of the Stockholders receiving 583,333 shares. The estimated fair value of the Common Stock issued was approximately $2.8 million at closing. 

·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, with quarterly interest-only payments in the first year, and quarterly payments of principal and interest in the next 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  

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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”). The estimated fair value of the earn-out was approximately $2.3 million at closing.  

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. By agreement of the parties, the effective date of the CynergisTek Transaction for accounting purposes was January 1, 2017.

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.

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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 agreement.

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 was also appointed Chief Operation Officer on April 27, 2017). 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 agreement.

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.

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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 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.  

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.

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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 have 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.

The preliminary 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. Estimated useful lives of the identifiable intangible assets acquired ranges from three to ten years. We also recognized goodwill of $16,416,063. 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.

The Company incurred approximately $330,000 in legal, accounting and other professional fees related to this acquisition, of which approximately $174,000 were expensed during the six months ended June 30, 2017.

As of the date of this report, management is still in the process of determining the final accounting related to the CynergisTek transaction. Because management’s analysis has not yet been completed, the Company’s determination of the purchase price and the resulting purchase price allocation is preliminary.

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Pro Forma Information

The following supplemental unaudited pro forma information presents the combined operating results of the Company and the acquired business during the three and six months ended June 30, 2017 and 2016, 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.

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q.  This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Section 27A of the Securities Act, and is subject to the safe harbors created by those sections.  Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “may,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements.  In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements.  These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict.  Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. We undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements.  

Due to possible uncertainties and risks, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Quarterly Report, which speak only as of the date of this Quarterly Report, or to make predictions about future performance based solely on historical financial performance.  We disclaim any obligation to update forward-looking statements contained in this Quarterly Report.

Readers should carefully review the risk factors described in other documents we file from time to time with the SEC, including our Form 10-K for the fiscal year ended December 31, 2016.  Our filings with the SEC, including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those filings, pursuant to Sections 13(a) and 15(d) of the Exchange Act, are available free of charge at www.auxilioinc.com, when such reports are available via the EDGAR system maintained by the SEC at www.sec.gov.

OVERVIEW

We are engaged in the business of providing IT and related consulting services, including managed print services, cyber security, and IT security consulting services to the healthcare industry.   Our business is operated throughout the United States.

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We have been an industry leader in document solutions for the healthcare industry for many years, offering hospitals and health systems comprehensive services and solutions to support the document life cycle. We provide a vendor neutral program that enhances security of printed, stored data and digital documents while driving out costs and inefficiencies within the patient information logistical chain. We also provide IT security consulting services through our proprietary Delphiis™ IT Risk Manager SaaS Solution and Redpsin.

In January 2017, we acquired CynergisTek, Inc., a top-ranked cybersecurity and privacy consulting firm, transforming and significantly expanding our cybersecurity and IT security consulting services capabilities. Our security experts perform technical assessments, penetration testing and remediation services, in addition to providing 24/7 advisory services to our Compliance Assist Partner Program customers. With our proven and prescriptive methodology, we help build the foundation needed to ensure the confidentiality, integrity and security of patient health information (PHI). Our proprietary RiskSonar IT Risk Manager SaaS Solution streamlines how covered entities perform annual and on-going risk assessments on their business associates, clinics, projects and hospitals.

Following the acquisition of CynergisTek, Inc., we have integrated our documents solutions, IT security and cybersecurity operations and are going to market as an integrated cybersecurity and document management solution.  We believe that offering our current and prospective hospital customers with a comprehensive integrated offering to address privacy, security and compliance of their IT environment and related electronic and physical records provides a significant competitive advantage to Auxilio.

Our common stock currently trades on the NYSE MKT under the stock symbol “AUXO”.

Where appropriate, references to “Auxilio,” the “Company,” “we,” “us” or “our” include Auxilio, Inc. and its wholly-owned subsidiaries, Auxilio Solutions, Inc., a California corporation, CynergisTek, Inc., a Texas corporation, and Delphiis, Inc., a California corporation.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with GAAP.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities.  We evaluate these estimates on an on-going basis, including those estimates related to customer programs and incentives, product returns, bad debts, supplies, investments, intangible assets, income taxes, contingencies and litigation.  We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances.  The results of these estimates form the basis for our judgments about the carrying values of assets and liabilities which are not readily apparent from other sources.  As a result, actual results may differ from these estimates under different assumptions or conditions.

We consider the following accounting policies to be most important to the portrayal of our financial condition and those that require the most subjective judgment:

· Revenue recognition and deferred revenue

The Company, operating under a consolidated strategy and management structure, derives its revenue from the following sources: (1) document solution services revenue; (2) equipment revenue; (3) security managed services revenue; (4) software subscriptions; (5) consulting services revenue; and (6) hardware and software resale revenue.

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. 

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Document Solution Services and Equipment Revenue

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.

Security Managed Services Revenue and Software Subscriptions

Managed service revenue and software subscriptions are recognized ratably over the contract terms beginning on the commencement date of each contract, which is the date the use of the software 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.

Consulting Services Revenue

Consulting services contracts are on either a fixed fee or a time and materials basis. For fixed fee arrangements, revenue is recognized ratably over the term of the project. For time and materials arrangements, revenues are recognized as the services are rendered.

Hardware and Software Resale Revenue

For hardware and software resales, the Company recognizes revenue on a gross basis, as the Company is deemed to be the primary obligor in these arrangements. Revenue from the resale of hardware is recognized when delivered to the customer. For software resales, when the Company does not provide any services that are considered essential to the functionality of the software, revenue is recognized upon delivery of the software. All product warranties and upgrades or enhancements are provided exclusively by the manufacturer. The Company does not sell any internally-developed software.

For hardware and software maintenance arrangements, the Company recognizes revenue at the time of sale on a net basis, as a third-party service provider is deemed to be the primary obligor. Under net sales recognition, the cost of the third-party service provider or vendor is recorded as a direct reduction to net revenues on the statements of operations.

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Deferred Revenue

Deferred revenue primarily consists of billings or payments received in advance of the amount of revenue recognized and such amounts are recognized as the revenue recognition criteria are met.

· 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 operations and cash flows during the implementation phase.

· Goodwill and intangible assets with indefinite lives

The Company accounts for its business combinations in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) 805-10 through ASC 805-50, “Business Combinations” which requires that the purchase method of accounting be applied to all business combinations and addresses the criteria for initial recognition of intangible assets and goodwill. In accordance with FASB ASC 350-10 through ASC 350-30, goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment annually, or more frequently if circumstances indicate the possibility of impairment. If the carrying value of goodwill or an indefinite lived intangible asset exceeds its fair value, an impairment loss shall be recognized.

To test for goodwill impairment, first we perform a qualitative assessment. If we determine, based on qualitative factors, that the fair value of goodwill is more likely than not greater than the carrying amount, a quantitative calculation would not be needed. Our methodology for a quantitative assessment of testing for goodwill impairment consists of one, and possibly two steps. In step one of the goodwill impairment test, management compares the carrying amount (including goodwill) of the reporting unit and the fair value. If the carrying value of the reporting unit exceeds the fair value of the reporting unit, then an impairment charge is recognized for the amount by which the goodwill carrying value exceeds the implied fair value of goodwill.

· Long-lived assets

In accordance with ASC Topic 350, long-lived assets, such as definite lived intangible assets, to be held and used are analyzed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If there are indications of impairment, we use future undiscounted cash flows of the related asset or asset grouping over the remaining life in measuring whether the assets are recoverable. In the event such cash flows are not expected to be sufficient to recover the recorded asset values, the assets are written down to their estimated fair value. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value of asset less the cost to sell.

· 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

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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, share-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 share-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 of the deferred tax assets will not be realized.

Reference is made to our Annual Report on Form 10-K for the fiscal year ended December 31, 2016 filed with the SEC on March 29, 2017 for additional discussion of our critical accounting policies.

RESULTS OF OPERATIONS

For the Three Months Ended June 30, 2017 Compared to the Three Months Ended June 30, 2016

Revenue

Revenue increased by approximately $1,600,000 to $16,798,912 for the three months ended June 30, 2017, as compared to the same period in 2016.  This increase is largely attributable to the growth in our cyber security professional services as a result of the acquisition of CynergisTek, Inc. (“CynergisTek”) in January 2017. Revenues from these services increased by approximately $3,200,000. Revenue from managed document services were approximately $12,200,000 in the second quarter of 2017 compared to $13,500,000 in the second quarter of 2016. New customers and expansion of services at existing customers were more than offset by terminations as well as volume and negotiated rate reductions at existing customers. Equipment sales for the second quarter of 2017 were approximately $500,000 as compared to approximately $900,000 in 2016. Equipment revenues are primarily from copier fleet refresh activities at customers. These fleet refreshes are sporadic since they are typically done every five years at any one customer facility. The Company has seen some recent slowdown in copier refresh activities from its healthcare provider customers as they reevaluate their capital equipment priorities. We expect this trend to continue throughout the rest of this year.

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Cost of Revenue

Cost of revenue consists of salaries and expenses of direct labor and indirect support staff as well as document imaging equipment, parts and supplies.  Cost of revenue was $12,435,758 for the three months ended June 30, 2017, as compared to $12,070,163 for the same period in 2016. We incurred approximately $1,200,000 in additional staffing costs, including contract labor, largely as a result of the recent acquisition of CynergisTek, Inc. Our service and supply costs decreased by approximately $700,000 as a result of the reduction in the document solutions services revenue. Also, equipment costs decreased by approximately $200,000 in 2017, primarily as a result of the decrease in equipment revenues from the copier fleet refresh activities.

Gross margin increased to 26% of revenue for the three months ended June 30, 2017 as compared to 20% for the same period in 2016. The increase is largely attributable to higher gross margins attained from professional services rendered though the newly acquired CynergisTek, Inc. business.

Sales and Marketing

Sales and marketing expenses include salaries, commissions and expenses for sales and marketing personnel, travel and entertainment, and other selling and marketing costs. Sales and marketing expenses were $1,371,847 for the three months ended June 30, 2017, as compared to $730,149 for the same period in 2016. The increase is primarily attributable to the addition of the CynergisTek sales and marketing team. Also in 2017, we incurred a nonrecurring charge of approximately $120,000 in severance pay for a terminated sales executive related to the integration of CynergisTek, Inc.

General and Administrative

General and administrative expenses include personnel costs for finance, administration, information systems, and general management, as well as facilities expenses, professional fees, legal expenses and other administrative costs. General and administrative expenses increased by $823,570 to $2,472,576 for the three months ended June 30, 2017, as compared to $1,649,006 for the three months ended June 30, 2016. The increase in general and administrative expenses is attributed to 1) approximately $230,000 in staffing cost due primarily to the addition of executives, accounting and other administrative staff related to CynergisTek; 2) approximately $80,000 increase in rent for CynergisTek offices; 3) approximately $60,000 increase in professional fees much of which was incurred in connection with the acquisition of CynergisTek; and 4) approximately $430,000 of amortization charges against the identified intangible assets acquired with CynergisTek.

Other Income (Expense)

Interest expense for the three months ended June 30, 2017 was $376,547, compared to $23,554 for the same period in 2016. The increase is due primarily to interest paid on the term loan of $14,000,000 and promissory notes totaling $9,000,000 which were used to finance the acquisition of CynergisTek.

Income Tax Expense

Income tax expense for the three months ended June 30, 2017 was $68,000 compared to $41,600 for the same period in 2016. The increase is due primarily to temporary book to tax differences giving rise to a greater expense in 2017.

For the Six Months Ended June 30, 2017 Compared to the Six Months Ended June 30, 2016

Revenue

Revenue increased by approximately $5,400,000 to $35,053,601 for the six months ended June 30, 2017, as compared to the same period in 2016.  This increase is largely attributable to the growth in our cyber security professional services as a result of the acquisition of CynergisTek, Inc. (“CynergisTek”) in January 2017. Revenues from these services increased by approximately $6,300,000. Revenue from document solution services were approximately $25,500,000 in 2017 compared to $26,700,000 in 2016. New customers and expansion of services at

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existing customers were more than offset by terminations as well as volume and negotiated rate reductions at existing customers. Equipment sales for 2017 were approximately $1,700,000 as compared to approximately $1,400,000 in 2016. Equipment revenues are primarily from copier fleet refresh activities at customers. These fleet refreshes are sporadic since they are typically done every five years at any one customer facility.

Cost of Revenue

Cost of revenue consists of salaries and expenses of direct labor and indirect support staff as well as document imaging equipment, parts and supplies.  Cost of revenue was $26,103,300 for the six months ended June 30, 2017, as compared to $24,276,490 for the same period in 2017. We incurred approximately $2,200,000 in additional staffing costs, including contract labor, largely as a result of the recent acquisition of CynergisTek, Inc. Our service and supply costs decreased approximately $1,000,000 as a result in the reduction in document solution services business. Our travel costs increased by approximately $200,000 in 2017 due to the acquisition of CynergisTek and additional travel related to recent implementations for our document solution services business. Also, equipment costs increased by approximately $400,000 in 2017, primarily as a result of the increase in equipment revenues from the copier fleet refresh activities.

Gross margin increased to 26% of revenue for the six months ended June 30, 2017 as compared to 18% for the same period in 2016. The increase is largely attributable to higher gross margins attained from professional services rendered though the newly acquired CynergisTek.

Sales and Marketing

Sales and marketing expenses include salaries, commissions and expenses for sales and marketing personnel, travel and entertainment, and other selling and marketing costs. Sales and marketing expenses were $2,740,855 for the six months ended June 30, 2017, as compared to $1,401,496 for the same period in 2016. The increase is primarily attributable to the addition of the CynergisTek sales and marketing team. Also in 2017, we incurred a nonrecurring charge of approximately $120,000 in severance pay for a terminated sales executive related to the integration of CynergisTek, Inc.

General and Administrative

General and administrative expenses include personnel costs for finance, administration, information systems, and general management, as well as facilities expenses, professional fees, legal expenses and other administrative costs. General and administrative expenses increased by $1,846,550 to $5,258,577 for the six months ended June 30, 2017, as compared to $3,412,027 for the same period in 2016. The increase in general and administrative expenses is attributed to 1) approximately $370,000 in staffing cost due primarily to the addition of CynergisTek executives, accounting and other administrative staff; 2) approximately $150,000 increase in rent for CynergisTek offices; 3) approximately $260,000 increase in professional fees, most of which were incurred in connection with the acquisition of CynergisTek; 4) approximately $80,000 paid to the NYSE MKT to uplist to their exchange in February 2017; 5) approximately $860,000 of amortization charges against the identified intangible assets acquired with CynergisTek; and 5) approximately $140,000 in increase travel, office and related charges as a result of acquiring CynergisTek.

Other Income (Expense)

Interest expense for the six months ended June 30, 2017 was $788,881 compared to $49,254 for the same period in 2016.  The increase is due primarily to interest paid on the term loan of $14,000,000 and promissory notes totaling $9,000,000 which were used to finance the acquisition of CynergisTek.

Income Tax Expense

Income tax expense for the six months ended June 30, 2017 was $81,539 compared to $44,000 for the same period in 2016. The increase is due primarily to taxable items arising in 2017 which result in greater expense.

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LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2017, our cash and cash equivalents were $2,834,859 and our working capital deficit was $1,504,509.  Our principal cash requirements are for operating expenses, including equipment, supplies, employee costs, and capital expenditures and funding of the operations. Our primary sources of cash are revenues from operations and our bank line of credit.

During the six months ended June 30, 2017, our cash used for operating activities amounted to $1,324,358, as compared to $1,614,708 used by operating activities for the same period in 2016.  The cash used by operating activities in 2017 is partially due to an increase in interest payments made on the bank term loan and sellers notes we entered into in connection with the acquisition of CynergisTek. Another use of funds in 2017 was the professional fees and related costs incurred in connection with the acquisition of CynergisTek. The decrease in cash from operating activities in 2016 was primarily due to an increase in accounts receivable, primarily from customers who were near the end of their implementation periods and had higher than normal balances due. In both 2017 and 2016 there was a decrease in accounts payable and accrued expenses as we have reduced the number of days to validate expense related vendors of recently implemented clients.

We expect to continue to establish recurring revenue contracts with new customers throughout 2017. We expect to have higher cost of revenues at the start of the engagements with most new customers. In January 2017, we borrowed $14,000,000 under a five-year term loan agreement with a financial institution where we also have in place the availability of a $5,000,000 line of credit, subject to borrowing base limits. The term loan was used to finance the acquisition of CynergisTek. We may seek additional financing or equity raises; however there can be no assurance that additional financing will be available on acceptable terms, if at all. Any financing or equity raises may result in dilution to existing stockholders and any debt financing may include restrictive covenants.  Management believes that cash generated from debt and/or equity financing arrangements along with future cash flows from operations, together with cash reserves will be sufficient to sustain our business operations over the next twelve months.

OFF-BALANCE SHEET ARRANGEMENTS

Our off-balance sheet arrangements consist primarily of conventional operating leases arising in the normal course of business, as further discussed below under “Contractual Obligations and Contingent Liabilities and Commitments.” As of June 30, 2017, we did not have any other relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS

As of June 30, 2017, expected future cash payments related to contractual obligations and commercial commitments were as follows:

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

As a “smaller reporting company” as defined by Rule 229.10(f)(1), we are not required to provide the information

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required by this Item 3.

ITEM 4.  CONTROLS AND PROCEDURES.

We maintain disclosure controls and procedures (as defined in Rules 13a-15(c) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in our reports under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as of the end of the period covered by this Quarterly Report.  Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including each of such officers as appropriate to allow timely decisions regarding required disclosure.

On January 13, 2017, we completed the acquisition of privately-held CynergisTek, Inc. (“CynergisTek”). CynergisTek’s assets constitute approximately 58% of our consolidated total assets as of June 30, 2017, and approximately 20% of our consolidated revenues for the six months ended June 30, 2017. As permitted by SEC guidance for recently acquired businesses, we elected to exclude CynergisTek from our evaluation of disclosure controls and procedures and management’s report on changes in internal control over financial reporting from the date of such acquisition through June 30, 2017. Since the acquisition of CynergisTek, we have been reviewing its operations, integrating certain functions and designing and implementing key internal controls over the acquired operations, and these activities are currently still in process.

No change in our internal control over financial reporting that occurred during our last fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting. As disclosed in the paragraph above, we acquired CynergisTek, Inc. on January 13, 2017, and are currently implementing appropriate internal controls over financial reporting for this recent acquisition.

PART –II - OTHER INFORMATION

ITEM 1A.  RISK FACTORS.

As of the date of this filing, there have been no material changes to the Risk Factors included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016, filed with the SEC on March 29, 2017 (the “2016 Form 10-K”).  The Risk Factors set forth in the 2016 Form 10-K should be read carefully in connection with evaluating our business and in connection with the forward-looking statements contained in this Quarterly Report on Form 10-Q.  Any of the risks described in the 2016 Form 10-K could materially adversely affect our business, financial condition or future results and the actual outcome of matters as to which forward-looking statements are made.  These are not the only risks we face.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

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ITEM 6.  EXHIBITS.

†Filed herewith. 

+Furnished herewith.  In accordance with Item 601(b)(32)(ii) of Regulation S-K, this exhibit shall not be deemed “filed” for the purposes of Section 18 of the Securities and Exchange Act of 1934 or otherwise subject to the liability of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934. 

* Pursuant to Rule 406T of Regulation S-T, this XBRL information will not be deemed “filed” for the purpose of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liability of that section, nor will it be deemed filed or made a part of a registration statement or prospectus for purposes of Sections 11 and 12 of the Securities Act of 1933, or otherwise subject to liability under those sections.

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SIGNATURES

In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

AUXILIO, INC.

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