CYNERGISTEK, INC - Quarter Report: 2022 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

☒     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2022

OR

☐     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 000-27507

(949) 614-0700

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒     No ☐.

Indicated by check mark whether the registrant has submitted electronically every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒      No ☐.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standard provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined by Section 12b-2 of the Exchange Act).

Yes ☐     No ☒.

The number of shares of the issuer’s common stock, $0.001 par value, outstanding as of August 15, 2022, was 13,256,570.

CYNERGISTEK, INC.

FORM 10-Q

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS.

CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

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

CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

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

CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

THREE MONTHS ENDED JUNE 30, 2022 and 2021

(UNAUDITED)

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

CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

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

CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(UNAUDITED)

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

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SIX MONTHS ENDED JUNE 30, 2022 AND 2021

(UNAUDITED)

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of CynergisTek, Inc. and its subsidiaries (the “Company,” “we,” “us,” or “CynergisTek”) 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 (the “Commission” or the “SEC”). Accordingly, these financial statements do not include all of the information and notes required by GAAP for complete financial statements. These unaudited 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, 2021, as filed with the SEC on March 28, 2022.

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 CynergisTek and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated.

Based on our integration strategies, and an analysis of how our Chief Operating Decision Makers review, manage and are compensated, we have determined that the Company operates as one segment. For the periods presented, all revenues were derived from domestic operations.

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

On May 23, 2022, we entered into the Merger Agreement (defined below) as described in Note 2 to the condensed consolidated financial statements below.

Liquidity and Capital Resources

As of June 30, 2022, our cash balance was $1.4 million, current assets minus current liabilities was positive $2.4 million and we have no long-term liabilities. In April of 2022 we received a $1.4 million tax refund and in August of 2022 we delivered a revolving promissory note to Clearwater (defined below) in the principal amount not to exceed $750,000 in connection with the Clearwater Revolving Loan (defined below), as described in Note 10 to the condensed consolidated financial statements below. The level of additional cash needed to fund operations and our ability to conduct business for the next twelve months will be influenced primarily by the following factors:

We have historically funded our operating costs, acquisition activities, working capital requirements and capital expenditures with cash from operations, proceeds from the issuances of our common stock and other financing arrangements. As of the date of this Report on Form 10-Q, we are generating negative cash from operations and our overall revenue and business levels have been impacted by the COVID-19 pandemic over the past twenty-four months. Our customer base is heavily concentrated in the healthcare provider space. The healthcare industry has experienced financial and operational disruption due to the pandemic. Sales cycles are longer, cybersecurity projects have been delayed and budgets have been constrained as healthcare providers focus on patient care and navigating the pandemic. If the pandemic continues or there are resurgences in 2022 and beyond that impact our customers’ operations and resources available for cybersecurity and privacy projects, our cash flows, financial position and operating results for fiscal year 2022 and beyond could be negatively impacted.

During 2020 and 2021, we took actions to reduce expenses, conserve cash, and raise additional capital. During 2021, we raised $1.4 million in additional capital through an “at-the-market” or ATM offering. In addition, we received a $2.8 million PPP Loan (as described in Note 9 to the condensed consolidated financial statements below) which was fully forgiven in August 2021. We also received approximately $0.7 million per quarter in employee retention tax credits in the first three quarters of 2021 and a $1.4 million tax refund in April 2022. With the proceeds from the tax refund, PPP Loan and the employee retention tax credits, we were able to minimize staff reductions in the areas of Sales and Delivery, our primary customer facing roles, to lessen the impact to our customers during this time of heightened security risks for the healthcare industry. If necessary, we could further reduce personnel and other variable and semi-variable costs to conserve cash and operate as a going concern. However, those actions if required, could negatively impact our ability to grow the business as well as the overall long-term outlook of the business.

We recently delivered a revolving promissory note in the principal amount up to $750,000 to Clearwater which allows the Company to draw upon the available credit in increments of at least $50,000 as and when needed, as described in Note 10 to the condensed consolidated financial statements below.

We believe that our existing sources of liquidity, including cash and cash equivalents, the ability to raise equity under our effective Registration Statement on Form S-3, the $750,000 Clearwater Revolving Loan as well as our ability to manage the business to decrease expenses, if necessary, will be sufficient to meet our projected capital needs for at least the next twelve months. If the Merger does not consummate in the short-term, as we execute our plans over the next twelve months, we intend to carefully monitor the impact of growth initiatives on our operating expenses, working capital needs and cash balances relative to the availability of cost-effective debt and equity financing. Based on the Company’s current liquidity, and its potential merger-related costs, including payments which would be accelerated under the revolving promissory note if the merger were not consummated, it is anticipated that the Company would be required to raise additional capital to meet its obligations and such capital may not be available, or may not be available on acceptable terms at that time. In the event that capital is not available, we may then have to scale back operations, reduce expenses, and/or curtail future plans to manage our liquidity and capital resources. However, we cannot provide assurance that we will be able to raise additional capital. The lingering impact of the COVID-19 pandemic, the conflict in Ukraine and related sanctions against Russia and Belarus, and inflationary pressures (including specifically, but not limited to, human capital costs which are essential to CynergisTek’s business), as well as the impact that such uncertainty has had, and could continue to have, on CynergisTek’s customers and industry and business and operating results create uncertainty and volatility in the financial markets which may impact our operations and our ability to access capital and/or the terms under which we can do so.

The accompanying condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

2. PENDING MERGER WITH CLEARWATER COMPLIANCE LLC

On May 23, 2022, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Clearwater Compliance LLC, a Tennessee limited liability company ( “Clearwater”), and Clearwater Compliance Acquisition Company I, a Delaware corporation and a wholly owned subsidiary of the Clearwater (the “Merger Sub”). Clearwater is a portfolio company of funds affiliated with Altaris Capital Partners, LLC. The Merger Agreement provides, subject to its terms and conditions, for the acquisition of the Company by Clearwater through the merger of Merger Sub with and into the Company, with the Company surviving the Merger as a wholly owned subsidiary of Clearwater (the “Merger”).

As a result of the Merger, each share of common stock of the Company (“Common Stock”) that is issued and outstanding immediately prior to the effective time of the Merger (the “Effective Time”) (other than shares owned by any subsidiary of the Company, the Merger Sub, Clearwater or any other subsidiary of Clearwater immediately prior to the Effective Time (all of which will be canceled) and shares held by any holder who is entitled to, and who has perfected, appraisal rights under Delaware law) will be automatically converted into the right to receive cash in an amount of $1.25 per share, without interest, subject to any required withholding of taxes (the “Merger Consideration”). Additionally, each outstanding and unexercised Company stock option at the Effective Time shall vest in full and automatically be canceled and converted into the right to receive the excess, if any, of the Merger Consideration over the exercise price per share of such stock option; provided that, in the event that the exercise price of any such stock option is equal to or greater than the Merger Consideration, such stock option will be canceled, without any consideration being payable in respect thereof and have no further force or effect; and each Company restricted stock unit that is then outstanding and unvested shall vest in full and automatically be canceled and converted into the right to receive the Merger Consideration. Also, at or prior to the Effective Time, any outstanding but unexercised warrants to purchase Common Stock shall be canceled and, in certain circumstances, payment therefor will be paid to such warrant holders in accordance with the terms of their respective warrants.

In connection with the negotiation and execution of the Merger Agreement, the Company has incurred legal, consulting and accounting fees of approximately $406,000 through the quarter ended June 30, 2022.

A special meeting of stockholders of the Company will be held at 3:00 p.m. Central Time on August 31, 2022, to approve and adopt the Merger Agreement and approve the Merger, among other matters.

3. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

Recently Issued Accounting Pronouncements Not Yet Adopted

In June 2016, the Financial Accounting Standards Board (“FASB”) issued an amendment to the guidance on the measurement of credit losses on financial instruments. The amendment updates the guidance for measuring and recording credit losses on financial assets measured and amortized cost by replacing the “incurred loss” model with an “expected loss” model. Accordingly, these financial assets will be presented at the net amount expected to be collected. The amendment also requires that credit losses related to available-for-sale debt securities be recorded as an allowance through net income rather than reducing the carrying amount under the current, other-than-temporary-impairment model. The guidance is effective for smaller reporting companies for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted for annual periods after December 15, 2018. Management does not expect the impact from this guidance will have a material impact on our consolidated financial statements.

4. DEFERRED COMMISSIONS

Our incremental costs of obtaining a contract, which consist of sales commissions, are deferred and amortized over the period of contract performance. Deferred commissions are included in prepaid and other current assets in our consolidated balance sheets. We had $553,000 and $760,000 of unamortized deferred commissions as of June 30, 2022, and December 31, 2021, respectively. We had $241,000 and $406,000 of commissions expense for the three and six months ended June 30, 2022, respectively. Commissions expense for the three and six months ended June 30, 2021, was $184,000 and $367,000, respectively.

5. PROPERTY AND EQUIPMENT

A summary of property and equipment follows:

6. LEASES

We previously leased approximately 9,600 square feet of office space in Austin, Texas. In March 2020, we amended this lease reducing the office space to 5,000 square feet and extended the lease term to May 31, 2022. We extended the lease term to May 31, 2023. We leased approximately 3,700 square feet of office space in Minneapolis, Minnesota. This lease term expired on January 31, 2022 and we no longer use this office space since the employees who worked from this location are now working remote. We leased approximately 18,000 square feet of office space in Mission Viejo, California. This lease expired in April 2021. During the first quarter of 2019, we subleased this space to two subtenants. The terms of these subleases ended concurrently with the end of our lease obligation in April 2021.

We used a discount rate of 5.5% in determining our operating lease liabilities, which represented our incremental borrowing rate. Short-term leases with initial terms of twelve months or less are not capitalized.

We determine if a contract is or contains a lease at inception or modification of a contract. A contract is or contains a lease if the contract conveys the right to control the use of an identified asset for a period in exchange for consideration. Control over the use of the identified asset means the lessee has both (a) the right to obtain substantially all of the economic benefits from the use of the asset and (b) the right to direct the use of the asset.

Right-of-use assets and liabilities are recognized based on the present value of future minimum lease payments over the expected lease term at commencement date. Certain lease agreements contain extension options; however, we have not included such options as part of right-of-use assets and lease liabilities because we originally did not expect to extend the leases. We measure and record a right-of-use asset and lease liability based on the discount rate implicit in the lease, if known. In cases where the discount rate implicit in the lease is not known, we measure the right-of-use assets and lease liabilities using a discount rate equal to our estimated incremental borrowing rate for loans with similar collateral and duration.

For all asset classes, we elected to (i) not recognize a right-of-use asset and lease liability for leases that we leased with a term of 12 months or less and (ii) not separate non-lease components from lease components, and we have accounted for combined lease and non-lease components as a single lease component.

Operating lease expense was comprised of the following:

7. INTANGIBLE ASSETS

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

8. DEFERRED REVENUE

We record deferred revenues when amounts are billed to customers, or cash is received from customers, in advance of our performance. During the three months ended June 30, 2022 and 2021, $575,000 and $654,000, respectively, of managed services revenues were recognized, that were included in deferred revenue at the beginning of the respective periods. During the three months ended June 30, 2022 and 2021, $276,000 and $243,000, respectively, of consulting and professional services revenues were recognized, that were included in deferred revenue at the beginning of the respective periods.

During the six months ended June 30, 2022 and 2021, $833,000 and $798,000, respectively, of managed services revenues were recognized, that were included in deferred revenue at the beginning of the respective periods. During the six months ended June 30, 2022 and 2021, $681,000 and $260,000, respectively, of consulting and professional services revenues were recognized, that were included in deferred revenue at the beginning of the respective periods.

9. PAYCHECK PROTECTION PROGRAM LOAN

On April 20, 2020, we received $2.8 million in loan funding from the Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”), established pursuant to the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”). The unsecured loan (the “PPP Loan”) is evidenced by a promissory note issued by the Company (the “Note”) in favor of BMO Harris Bank N.A.

The Company used the PPP Loan proceeds to cover payroll costs, rent and utilities in accordance with the relevant terms and conditions of the CARES Act.

Under the terms of the Note and the PPP Loan, interest accrued on the outstanding principal at the rate of 1.0% per annum. The term of the Note was two years, unless sooner provided in connection with an event of default under the Note. To the extent the PPP Loan amount was not forgiven, the Company would have been obligated to make equal monthly payments of principal and interest, beginning seven months from the date of the Note, until the maturity date. The Company had not started making interest payments prior to its notice of forgiveness decision received from the SBA in August 2021. Details regarding the Note can be found in our Current Report on Form 8-K filed on April 20, 2020.

The Company recognized interest charges of approximately $7,000 and $14,000, respectively for the three and six months ended June 30, 2021. The Company received notice from the SBA in August 2021 that the full principal balance and related interest were forgiven.

10. PROMISSORY NOTES

In connection with the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.), we issued a promissory note totaling $4,500,000 to Michael McMillan (the “Seller Note”). In March 2018, the Company repaid $2,250,000 plus accrued interest on the Seller Note and agreed to amend and restate the Seller Note in the remaining principal amount of $2,250,000. The Seller Note bore interest at a rate of 8% per annum, provided for quarterly payments of principal and interest and matured on March 31, 2022. As of June 30, 2022, and December 31, 2021, the outstanding principal balance due under the Seller Note was $0 and $0.1 million, respectively.

Interest charges associated with the Seller Note totaled approximately $0 and $2,000, respectively for the three and six months ended June 30, 2022, and $10,000 and $23,000, respectively for the three and six months ended June 30, 2021.

In August of 2022, we issued a revolving promissory note in a principal amount of up to $750,000 to Clearwater (the “Clearwater Note”). The Clearwater Note bears interest at a rate of 10.0% per annum and provides for quarterly payments of principal and interest. CynergisTek may make advances under the Clearwater Note in such amounts and at such times as we request from time to time in increments of at least $50,000, but not more than $750,000 in the aggregate (“the Clearwater Revolving Loan”).

The Clearwater Note matures and any remaining outstanding principal balance and all accrued and unpaid interest shall become due and payable upon the earliest to occur of (i) the five-year anniversary of the date hereof, (ii) the termination of the Merger Agreement, or (iii) the incurrence by CynergisTek or any of its subsidiaries of any debt of any kind whatsoever from a third party, other than payables incurred in the ordinary course of business; provided, however, that (x) if the Merger Agreement is terminated pursuant to Sections 7.1(a), 7.1(b), 7.1(c), 7.1(d), or 7.1(g) of the Merger Agreement, then all outstanding principal and interest under the Clearwater Note shall be due and payable by the 60th day following such termination; and (y) if the Merger Agreement is terminated in connection with the entry into an Acquisition Transaction (as such term is defined in the Merger Agreement), then CynergisTek shall be required to repay all outstanding interest and principal then due under the Clearwater Note as a condition to, and prior to or concurrently with, the termination of the Merger Agreement by CynergisTek.

11. REVENUES

Below is a summary of our revenues disaggregated by revenue source.

12. WARRANTS, OPTIONS AND RESTRICTED STOCK UNITS

Warrant Issued for Securities Purchase Agreement

On April 3, 2020, we entered into a Securities Purchase Agreement (“Securities Purchase Agreement “) with Horton Capital Management, LLC (“Horton”) which provided that Horton was committed to purchase up to an aggregate of $2.5 million of shares of the Company’s common stock over the term of the agreement, at the election of the Company. The Stock Purchase Agreement expired on March 31, 2021. No purchases were made under the Securities Purchase Agreement.

Upon signing the agreement, the Company issued Horton a warrant (the “Horton Warrant”) to purchase up to 500,000 shares of common stock in consideration of Horton’s obligation to purchase the shares, at an exercise price of $2.50 per share, subject to certain anti-dilution adjustments as set forth in the warrant. The fair value of this warrant of $0.4 million was determined using the Black-Scholes option-pricing model and was expensed during the second quarter of 2020.

During 2020 and 2021, the Company issued common stock under the Equity Distribution Agreement that resulted in required anti-dilution adjustments. These adjustments increased the number of shares under the Horton Warrant to 524,170 and reduced the exercise price to $2.38. The resulting difference in fair value of the Horton Warrant was $14,000, determined using the Black-Scholes option-pricing model and recorded as a deemed dividend in our consolidated statements of stockholders’ equity. As the Company has an accumulated deficit, the deemed dividends were recorded within additional paid-in capital.

The Horton Warrant provides that in the event of a fundamental transaction, including the consolidation or merger of CynergisTek with or into another person (such as the Merger as described in Note 2 to the condensed consolidated financial statements above), CynergisTek may elect to purchase the Horton Warrant from the holder thereof by paying an amount of cash equal to the Black Scholes Value (as determined based on the Black and Scholes Option Pricing Model obtained from the “OV” function on a Bloomberg Terminal as of the day of consummation of the applicable fundamental transaction, as described in the Horton Warrant) of the remaining unexercised portion of the Horton Warrant, subject to a cap of $300,000. Because the actual Black Scholes Value of the remaining unexercised portion of the Horton Warrant is projected to exceed the cap, CynergisTek will be required, prior to the Merger, to purchase or cancel the Horton Warrant in exchange for payment of $300,000. The payment of such amount for the cancellation of the Horton Warrant has been included in the overall equity value of the proposed Merger transaction.

The detailed terms and conditions of the Horton Securities Purchase Agreement and the Horton Warrant can be found in the documents, which were included as Exhibits 10.1 and 10.3, respectively, to our Current Report on Form 8-K, filed with the SEC on April 7, 2020.

Below is a summary of warrant activities during the six-month period ended June 30, 2022:

2020 Equity Incentive Plan

The 2020 Equity Incentive Plan provides for a total number of shares available for issuance of 3,745,621 shares of our common stock, and it provides for the granting of stock options, stock appreciation rights, restricted stock units and restricted stock to our employees, members of the Board of Directors and service providers. As of June 30, 2022, there were 211,000 shares available for issuance under the 2020 Plan.

Below is a summary of stock option activities during the six-month period ended June 30, 2022:

Each stock option (whether vested or unvested) that is outstanding as of immediately prior to the Merger as described in Note 2 to the condensed consolidated financial statements above shall vest in full effective immediately prior to the Merger and shall automatically be canceled and converted into the right to receive an amount in cash, without interest, equal to the product of (i) the total number of shares of CynergisTek common stock underlying such stock option, multiplied by (ii) the excess, if any, of the Merger Consideration over the applicable exercise price per share of such stock option. Because the applicable exercise price of all stock options is greater than the Merger Consideration, all stock options will be canceled at the time of the Merger without any consideration.

Below is a summary of restricted stock unit activity during the six-month period ended June 30, 2022:

There are 232,800 shares of restricted stock units which have vested but had not yet been issued as of June 30, 2022.

Each restricted stock unit that is outstanding and unvested as of immediately prior to the Merger shall vest in full, effective immediately prior to the Merger, and shall automatically be canceled and converted into the right to receive from an amount in cash, without interest, equal to the product of (i) the aggregate number of shares of CynergisTek common stock underlying the restricted stock unit multiplied by (ii) the Merger Consideration.

For the three and six months ended June 30, 2022 and 2021, stock-based compensation and other equity instrument related expenses recognized in the consolidated statements of operations were as follows:

13. Income Taxes

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. 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 of $6,853,130 as of June 30, 2022 has been established to reflect these uncertainties.

14. BASIC AND DILUTED NET LOSS PER SHARE

Basic net loss 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 loss 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 loss per share does not include potentially dilutive securities because such inclusion in the computation would be anti-dilutive.

For the three and six months ended June 30, 2022, potentially dilutive securities consisted of options and warrants to purchase 1,484,452 shares of common stock at prices ranging from $1.44 to $3.30 per share. Of these potentially dilutive securities, none of the shares to purchase common stock from 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. Also excluded from potentially dilutive securities are 449,450 shares of non-vested restricted stock units and 232,800 shares of restricted stock units which vested but had not been issued as of June 30, 2022.

For the three and six months ended June 30, 2021, potentially dilutive securities consisted of options and warrants to purchase 1,705,199 shares of common stock at prices ranging from $1.08 to $4.86 per share. Of these potentially dilutive securities, none of the shares to purchase common stock from 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. Also excluded from potentially dilutive securities are 741,850 shares of non-vested restricted stock units and 125,000 shares of restricted stock units which have vested but had not been issued as of June 30, 2021.

15. REMAINING PERFORMANCE OBLIGATIONS

We had remaining performance obligations of approximately $17.4 million as of June 30, 2022. Our remaining performance obligations represent the amount of transaction price for which work has not been performed and revenue has not been recognized. When applying Accounting Standards Codification (“ASC”) Topic 606, with only the non-cancelable portion of these contracts included in our performance obligations we had approximately $15.3 million as of June 30, 2022. We expect to recognize revenue on approximately 94% of the remaining non-cancelable portion of these performance obligations over the next 24 months, with the balance thereafter.

16. 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 largest customer accounted for approximately 15% and 14% of our revenues for the six months ended June 30, 2022 and 2021, respectively. Our largest customer had accounts receivable totaling approximately $164,000 and $95,000 as of June 30, 2022, and December 31, 2021, respectively.

17. EARNOUT LIABILITY – BACKBONE ENTERPRISES

On October 31, 2019, we entered into a Stock Purchase Agreement (the “Backbone Purchase Agreement”) with Backbone Enterprises Inc., a Minnesota corporation (“Backbone”), and its stockholders, (the “Stockholders”), pursuant to which we acquired 100% of the issued and outstanding shares of common stock (the “Shares”) of Backbone from the Stockholders.

Pursuant to the Backbone Purchase Agreement, the aggregate purchase price paid for the Shares consisted of (i) a cash payment of $5.5 million, less certain transaction expenses (the “Cash Consideration”), (ii) the issuance of 491,804 shares of our common stock to the Stockholders, pro rata among the Stockholders in proportion to each Stockholder’s ownership of the Shares, and (iii) an earn-out, pursuant to which the Stockholders may be entitled to an additional $4.0 million based upon the post-closing financial performance of Backbone, to be calculated annually based upon revenue generated by the Backbone business during each year of the three-year earn-out period. The Cash Consideration was subject to adjustment based on closing working capital of Backbone, and $1.5 million of the Cash Consideration was placed into a third-party escrow account by us, against a portion of which we may make claims for indemnification.

There was no earnout paid for the first year of the earnout period. We performed a valuation of the contingent earn-out and marked down the fair value balance from $2.4 million to $1.3 million based on the potential of achieving a portion of the year two and three targets. This resulted in a gain from the reduction of the contingent earnout liability of $1.1 million in 2020. We performed an updated valuation of the contingent earn-out as of June 30, 2021, which resulted in a full write-off of the previous estimate of $1.3 million.

The Company renegotiated the terms of the earnout and as a result performed an updated valuation of the contingent earn-out as of September 30, 2021, which resulted in a recovery from the previous estimate of $0.3 million. As of December 31, 2021 we updated our valuation of the contingent earn-out which resulted in an additional recovery of $0.5 million. The earnout for year two of the earnout period totaled $0.3 million. Total cumulative amount earned for the year three earnout period through June 30, 2022 totaled $359,000 with payments related to year three earnout period during the six months ended June 30, 2022 were $259,000.

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 of 1933, 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 this quarterly report and in other documents we file from time to time with the SEC, including our Form 10-K for the fiscal year ended December 31, 2021. You should interpret many of the risks identified in these reports as being heightened as a result of the ongoing and numerous adverse impacts of the COVID-19 pandemic and the global economic effect of ongoing geopolitical tensions and related economic sanctions. 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.CynergisTek.com, when such reports are available via the EDGAR system maintained by the SEC at www.sec.gov.

On May 23, 2022, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Clearwater Compliance LLC, a Tennessee limited liability company ( “Clearwater”), and Clearwater Compliance Acquisition Company I, a Delaware corporation and a wholly owned subsidiary of Clearwater (the “Merger Sub”). Clearwater is a portfolio company of funds affiliated with Altaris Capital Partners, LLC. The Merger Agreement provides, subject to its terms and conditions, for the acquisition of the Company by Clearwater through the merger of Merger Sub with and into the Company, with the Company surviving the Merger as a wholly owned subsidiary of Clearwater (the “Merger”).

As a result of the Merger, each share of common stock of the Company (“Common Stock”) that is issued and outstanding immediately prior to the effective time of the Merger (the “Effective Time”) (other than shares owned by any subsidiary of the Company, the Merger Sub, Clearwater or any other subsidiary of Clearwater immediately prior to the Effective Time (all of which will be canceled) and shares held by any holder who is entitled to, and who has perfected, appraisal rights under Delaware law) will be automatically converted into the right to receive cash in an amount of $1.25 per share, without interest, subject to any required withholding of taxes (the “Merger Consideration”). Additionally, each outstanding and unexercised Company stock option at the Effective Time shall vest in full and automatically be canceled and converted into the right to receive the excess, if any, of the Merger Consideration over the exercise price per share of such stock option; provided that, in the event that the exercise price of any such stock option is equal to or greater than the Merger Consideration, such stock option will be canceled, without any consideration being payable in respect thereof and have no further force or effect; and each Company restricted stock unit that is then outstanding and unvested shall vest in full and automatically be canceled and converted into the right to receive the Merger Consideration. Also, at or prior to the Effective Time, any outstanding but unexercised warrants to purchase Common Stock shall be canceled and, in certain circumstances, payment therefor will be paid to such warrant holders in accordance with the terms of their respective warrants.

In connection with the negotiation and execution of the Merger Agreement, the Company has incurred legal, consulting and accounting fees of approximately $406,000 through the quarter ended June 30, 2022.

A special meeting of stockholders of the Company will be held at 3:00 p.m. Central Time on August 31, 2022, to approve and adopt the Merger Agreement and approve the Merger, among other matters.

OVERVIEW

We are engaged in the business of helping U.S. based companies in highly regulated industries, including healthcare, be prepared to handle unforeseen cyber threats, comply with regulations, and gain the confidence that their efforts are strengthening their security posture and building resilience. This is achieved through our cybersecurity, privacy, compliance and audit services.

CynergisTek was born in healthcare and is one of the few consulting and advisory companies focused on converging security and privacy with a methodology to validate the rigor and effectiveness of the programs as a managed service. We believe that our years of experience of understanding our clients’ unique challenges allows us to provide our customers with services designed around industry best practices to improve security controls, policies and procedures and to protect sensitive information. Our team of subject matter experts and consultants are comprised of knowledgeable professionals who have learned their craft both in the classroom and through years of practical on-the-job experience, including as policy makers, attorneys and leaders in cybersecurity, privacy, compliance and audit.

Our services are grouped to facilitate and assist our clients in implementing their programs, those groups follow a cyclical approach: assess, build, manage, and validate. These services are designed to meet the client where they are in their security journey as recurring managed services under long-term contracts structured to provide a sustainable and growing program, or under shorter duration consulting or professional services engagements.

Impact of COVID-19 Pandemic and Recent Capital Markets Disruption

U.S. and global markets are experiencing volatility and disruption following the escalation of geopolitical tensions and the start of the military conflict between Russia and Ukraine. On February 24, 2022, a full-scale military invasion of Ukraine by Russian troops was reported. Although the length and impact of the ongoing military conflict is highly unpredictable, the conflict in Ukraine could lead to market disruptions, including significant volatility in commodity prices, credit and capital markets, as well as supply chain interruptions. We are continuing to monitor the situation in Ukraine and globally and assessing its potential impact on our business.

Additionally, Russia’s prior annexation of Crimea, recent recognition of two separatist republics in the Donetsk and Luhansk regions of Ukraine and subsequent military interventions in Ukraine have led to sanctions and other penalties being levied by the United States, European Union and other countries against Russia, Belarus, the Crimea Region of Ukraine, the so-called Donetsk People’s Republic, and the so-called Luhansk People’s Republic, including agreement to remove certain Russian financial institutions from the Society for Worldwide Interbank Financial Telecommunication (“SWIFT”) payment system. Additional potential sanctions and penalties have also been proposed and/or threatened. Russian military actions and the resulting sanctions could adversely affect the global economy and financial markets and lead to instability and lack of liquidity in capital markets, potentially making it more difficult for us to obtain additional funds.

Additionally, the markets, and more specifically healthcare, have experienced an increase in pressures from rising inflation, rising interest rates, lowering bond rates and the impact to their revenues and operating margins. The resultant effect of these pressures is healthcare entities have slowed down their spend on things considered not mission critical or discretionary. Cybersecurity is discretionary as it relates to an organization’s propensity for managing risk, but it has a regulatory component which assures that organizations will continue to spend on cybersecurity.

The ongoing COVID-19 pandemic and ensuing governmental responses has caused significant uncertainty in the United States and global economies as well as the markets we serve has negatively impacted and could further materially adversely affect our business, financial condition and results of operations.

COVID-19 cases (including the spread of variants and mutant strains, such as the omicron variant) continue to surge in certain parts of the world and have resulted in authorities implementing numerous measures to contain the virus, including travel bans and restrictions, quarantines, shelter-in-place orders, and business limitations and shutdowns. We remain unable to accurately predict the full impact that COVID-19 will have on our results of operations, financial condition, liquidity and cash flows due to numerous uncertainties, including the duration and severity of the pandemic and containment measures. Our compliance with containment and mitigation measures materially impacted our day-to-day operations, and there can be no guaranty that the pandemic will not disrupt our business and operations or impair our ability to implement our business plan successfully.

More generally, the pandemic raises the possibility of an extended global economic downturn and has caused volatility in financial markets, which could affect demand for our products and services and impact our results and financial condition even after the pandemic is contained. For example, we may be unable to collect receivables from those customers significantly impacted by COVID-19. Also, a decrease in bookings in a given period could negatively affect our revenues in future periods, particularly if experienced on a sustained basis. The pandemic may also have the effect of heightening many of the other risks described in these Risk Factors and the Risk Factors set forth in the Company’s 2021 Form 10-K, particularly those risks associated with our customers.

Our current and potential customers’ businesses, specifically in the healthcare industry, have been directly impacted both financially and operationally in many ways by the pandemic. During this time, cybersecurity risks in healthcare have increased particularly with increased adoption of remote access and increased adoption of telehealth, as well as decreased budgets, diversion of resources and focus from all areas not directly related to patient care. In the current periods, the pandemic has led to customers delaying or deferring cybersecurity buying decisions, has limited our ability to visit customers and potential customers, and has resulted in an overall decrease in our orders, bookings and revenues in 2022 and 2021.

We took steps to reduce expenses throughout the Company over the past twenty-four months, including workforce reductions, substantially reducing Company travel, trade shows and other business meetings and decreasing expenditures. We have modified our business practices and implemented certain policies at our offices in accordance with best practices to accommodate, and at times mandate, remote work practices, including restricting employee travel, modifying employee work locations, and cancelling attendance at events and conferences. In addition, we have adapted new processes for interactions with our customers to safely manage our operations. Many of our customers have made similar modifications. If necessary, we may take further actions in the best interests of our employees, customers, partners and suppliers. There is no certainty that such measures will be sufficient to mitigate the risks posed by COVID-19, in which case our employees may become sick, our ability to perform critical functions could be harmed, and our business and operations could be negatively impacted.

With less resources allocated to cybersecurity in healthcare over the past twenty-four months, we believe risks are increasing and expect the industry will need to increase attention and spend on cybersecurity in the near future. However, the ultimate duration and impact of the COVID-19 pandemic on our business, results of operations, financial condition and cash flows is uncertain. Even after the COVID-19 pandemic has subsided, we may continue to experience an adverse impact to our business, and we anticipate that our results of operations in future periods may continue to be adversely impacted by the COVID-19 pandemic and its negative effects on global economic conditions.

As we expect the industry to begin emerging from the pandemic, we have begun to increase our sales and marketing efforts and building our sales and operational teams for growth. However, our current and potential customers’ businesses could continue to be disrupted or they could seek to limit spending due to decreased budgets, reduced access to credit or various other factors, any of which could negatively impact the willingness or ability of such customers to order new, or any, services with us and ultimately adversely affect our revenues, as well as negatively impact the payment of accounts receivable and collections and potentially lead to write-downs or write-offs.

The ultimate duration and impact of the COVID-19 pandemic on our business, results of operations, financial condition and cash flows is dependent on future developments, including the duration of the pandemic and the related length of its impact on the global economy, which remain uncertain and cannot be predicted at this time. Furthermore, the extent to which our mitigation efforts are successful, if at all, is not presently ascertainable.

Impact if the Merger Agreement is Not Approved by Stockholders or if the Merger is Not Completed for Any Other Reason

If the Merger Agreement is not approved and adopted by stockholders and the Merger is not approved by stockholders, or if the Merger is not completed for any other reason:

Our common stock currently trades on the NYSE American exchange under the stock symbol “CTEK”.

Where appropriate, references to “CynergisTek,” the “Company,” “Redspin,” “we,” “us,” or “our” include CynergisTek, Inc., a Delaware corporation and its wholly-owned subsidiaries, CTEK Solutions, Inc., a California corporation, CTEK Security, Inc., a Texas corporation, Delphiis, Inc., a California corporation and, Backbone Enterprises, Inc., a Minnesota corporation.

RESULTS OF OPERATIONS

For the Three Months Ended June 30, 2022, Compared to the Three Months Ended June 30, 2021

Revenue

Revenue increased $0.1 million to $3.9 million for the three months ended June 30, 2022, as compared to the same period in 2021. Managed Services revenue was comparable at $2.1 million and Consulting and professional services increased $0.1 million to $1.8 million due to certain projects being completed during the quarter. The Company is starting to see extended sales cycles and delays in renewals as a result of recent economic conditions that could negatively impact future revenue growth.

Cost of Revenue

Cost of revenue consists primarily of salaries and related expenses of direct labor and indirect support staff. Cost of revenue was $2.6 million for the three months ended June 30, 2022, as compared to $2.1 million for the same period in 2021. The increase was due to the prior year benefitting from the $0.5 million employee retention credit provided under the CARES Act.

Gross margin was down 13% to 33% of revenue for the three months ended June 30, 2022. After adjusting for the prior year benefit from the employee retention tax credit, gross margin was comparable at 33% for the same period in 2021.

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 flat at $1.2 million for the three months ended June 30, 2022 and 2021. This was due to $0.1 million in lower marketing expenses in 2022 offsetting $0.1 million of employee retention tax credits provided under the CARES Act for 2021.

General and Administrative

General and administrative expenses include personnel costs for finance, administration, information systems, general management, facilities expenses, professional fees, legal expenses and other administrative costs including those required to be a publicly traded company. General and administrative expenses increased to $1.7 million for the three months ended June 30, 2022, compared to $1.5 million for the three months ended June 30, 2021. The increase is due to prior year benefitting from a $0.1 million employee retention tax credit, an additional $0.1 million in additional payroll and benefits offset by $0.2 million lower stock-based compensation and $0.2 million increase in professional fees related to the Merger transaction (as described in Note 2 to the condensed consolidated financial statements).

Change in Valuation of Contingent Earn-out

We performed a valuation of the contingent earn-out to the sellers of Backbone Enterprises, Inc. as of June 30, 2021 which resulted in a reduction of the previous estimate of $1,300,000 related to the potential for payout for not meeting earn-out criteria in the final two years of the annual earn-out measurement periods.

Depreciation

Depreciation expense was $37,000 for the three months ended June 30, 2022, compared to $48,000 for the same period in 2021.

Amortization of Acquisition-Related Intangibles

Amortization of acquisition-related intangibles was $0.3 million for the three months ended June 30, 2022 and 2021.

Net Interest Expense

Net interest expense for the three months ended June 30, 2022, was $0, compared to net interest expense of $17,000 for the same period in 2021. The decrease was due to a lower outstanding debt balance.

Income Tax

Income tax expense for the three months ended June 30, 2022, was $6.4 million, compared to $20,000 for the same period in 2021. The expense in 2022 is a result of the recording of a valuation allowance against our deferred tax assets from timing differences on recognizing future deductions against taxable income, including NOL carryforwards. Management recorded the valuation allowance given recent consecutive years of losses and its determination that it is more likely that such assets will not be realized in future periods. 2021 amount was based on estimated annual income tax rates we anticipated for the year.

For the Six Months Ended June 30, 2022, Compared to the Six Months Ended June 30, 2021

Revenue

Revenue increased $0.5 million to $8.6 million for the six months ended June 30, 2022, as compared to the same period in 2021. Managed Services revenue was down $0.1 million to $4.5 million. Consulting and professional services increased $0.6 million primarily due to a larger number of consulting projects being completed during this period. The Company is starting to see extended sales cycles and delays in renewals as a result of recent economic conditions that could negatively impact future revenue growth.

Cost of Revenue

Cost of revenue was $5.4 million for the six months ended June 30, 2022, as compared to $4.2 million for the same period in 2021. The increase was due to the prior year benefitting from the $1.0 million employee retention credit provided under the CARES Act, an additional $0.1 million in additional stock compensation and $0.1 million in higher costs associated with third party tools required to deliver our services.

Gross margin was 37% of revenue for the six months ended June 30, 2022. After adjusting for the benefit from the employee retention tax credit, gross margin would have been 38% for the same period in 2021.

Sales and Marketing

Sales and marketing expenses decreased to $2.4 million for the six months ended June 30, 2022, as compared to $2.5 million for the same period in 2021. This was due to $0.2 million of employee retention tax credits benefit provided under the CARES Act for 2021 offset by $0.1 million in lower recruiting costs and $0.2 million in lower marketing and other expenses as we looked to cut costs in 2022.

General and Administrative

General and administrative expenses increased $0.2 million to $3.3 million for the six months ended June 30, 2022, compared to $3.1 million for the same period in 2021. The increase is due to $0.2 million higher in professional fees due to the Merger transaction (as described in Note 2 to the condensed consolidated financial statements) and the prior year benefitting from a $0.2 million employee retention tax credit offsetting $0.2 million lower stock-based compensation.

Change in Valuation of Contingent Earn-out

We performed a valuation of the contingent earn-out to the sellers of Backbone Enterprises, Inc. as of June 30, 2021, which resulted in a reduction of the previous estimate of $1,300,000 related to the potential for payout for not meeting earn-out criteria in the final two years of the annual earn-out measurement periods.

Depreciation

Depreciation remained relatively consistent at $85,000 for the six months ended June 30, 2022, as compared to $96,000 for the same period in 2021.

Amortization of Acquisition-Related Intangibles

Amortization of acquisition-related intangibles was $0.5 million for the six months ended June 30, 2022, compared to $0.7 million for the six months ended June 30, 2021. Amortization expense decreased over the comparable periods as a portion of the intangible assets are now fully amortized.

Net Interest Expense

Net interest expense for the six months ended June 30, 2022, was $2,000, compared to $37,000 for the same period in 2021. The decrease was due to a lower outstanding debt balance.

Income Tax

Income tax expense for the six months ended June 30, 2022, was $6.1 million, compared to income tax benefit of $0.3 million for the same period in 2021. The expense in 2022 is primarily a result of the recording of a valuation allowance against our deferred tax assets from timing differences on recognizing future deductions against taxable income, including NOL carryforwards. Management recorded the valuation allowance given recent consecutive years of losses and its determination that it is more likely that such assets will not be realized in future periods.

Liquidity and Capital Resources

As of June 30, 2022, our cash balance was $1.4 million, current assets minus current liabilities was positive $2.4 million and we have no long-term liabilities. In April of 2022 we received a $1.4 million tax refund and in August of 2022 we entered in to the Clearwater Revolving Loan (defined below), which we can use to finance ongoing operations and costs related to the Merger as and when needed, as described in Note 10 to the condensed consolidated financial statements above.. The level of additional cash needed to fund operations and our ability to conduct business for the next twelve months will be influenced primarily by the following factors:

We have historically funded our operating costs, acquisition activities, working capital requirements and capital expenditures with cash from operations, proceeds from the issuances of our common stock and other financing arrangements. As of the date of this Report on Form 10-Q, we are generating negative cash from operations and our overall revenue and business levels have been impacted by the COVID-19 pandemic over the past twenty-four months. Our customer base is heavily concentrated in the healthcare provider space. The healthcare industry has experienced financial and operational disruption due to the pandemic. Sales cycles are longer, cybersecurity projects have been delayed and budgets have been constrained as healthcare providers focus on patient care and navigating the pandemic. If the pandemic continues or there are resurgences in 2022 and beyond that impact our customers’ operations and resources available for cybersecurity and privacy projects, our cash flows, financial position and operating results for fiscal year 2022 and beyond could be negatively impacted.

During 2020 and 2021, we took actions to reduce expenses, conserve cash, and raise additional capital. During 2021, we raised $1.4 million in additional capital through an “at-the-market” or ATM offering. In addition, we received a $2.8 million PPP Loan (as described in Note 9 to the condensed consolidated financial statements above) which was fully forgiven in August 2021. We also received approximately $0.7 million per quarter in employee retention tax credits in the first three quarters of 2021 and a $1.4 million tax refund in April 2022. With the proceeds from the tax refund, PPP Loan and the employee retention tax credits, we were able to minimize staff reductions in the areas of Sales and Delivery, our primary customer facing roles, to lessen the impact to our customers during this time of heightened security risks for the healthcare industry. If necessary, we could further reduce personnel and other variable and semi-variable costs to conserve cash and operate as a going concern. However, those actions if required, could negatively impact our ability to grow the business as well as the overall long-term outlook of the business.

We recently signed a $750,000 revolving loan with Clearwater related to the Merger. We issued a revolving promissory note in a principal amount of up to $750,000 to Clearwater (the “Clearwater Note”). The Clearwater Note bears interest at a rate of 10.0% per annum and provides for quarterly payments of principal and interest. CynergisTek may make advances under the Clearwater Note in such amounts and at such times as we request from time to time in increments of at least $50,000, but not more than $750,000 in the aggregate (the “Clearwater Revolving Loan”).

We believe that our existing sources of liquidity, including cash and cash equivalents, the ability to raise equity under our effective Registration Statement on Form S-3, Clearwater Revolving Loan as well as our ability to manage the business to decrease expenses, if necessary, will be sufficient to meet our projected capital needs for at least the next twelve months. If the Merger does not consummate in the short-term, as we execute our plans over the next twelve months, we intend to carefully monitor the impact of growth initiatives on our operating expenses, working capital needs and cash balances relative to the availability of cost-effective debt and equity financing. Based on the Company’s current liquidity, and its potential merger-related costs, including payments which would be accelerated under the revolving promissory note if the merger were not consummated, it is anticipated that the Company would be required to raise additional capital to meet its obligations and such capital may not be available, or may not be available on acceptable terms at that time. In the event that capital is not available, we may then have to scale back operations, reduce expenses, and/or curtail future plans to manage our liquidity and capital resources. However, we cannot provide assurance that we will be able to raise additional capital. The lingering impact of the COVID-19 pandemic, the conflict in Ukraine and related sanctions against Russia and Belarus, and inflationary pressures (including specifically, but not limited to, human capital costs which are essential to CynergisTek’s business), as well as the impact that such uncertainty has had, and could continue to have, on CynergisTek’s customers and industry and business and operating results create uncertainty and volatility in the financial markets which may impact our operations and our ability to access capital and/or the terms under which we can do so.

The accompanying condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

Application of Critical Accounting Policies and Estimates

The SEC defines critical accounting policies as those that are, in management’s view, most important to the portrayal of our financial condition and results of operations and most demanding of our judgment. The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which were prepared in accordance with accounting principles generally accepted in the U.S., which is referred to as “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 related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate these estimates, including those related to stock-based compensation, customer programs and incentives, bad debts, intangible assets, income taxes, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

Revenue Recognition and Deferred Revenue

We operate under a consolidated strategy and management structure, deriving revenue from the following sources:

Revenue is recognized pursuant to Accounting Standard Codification (“ASC”) Topic 606, “Revenue from Contracts with Customers”. Accordingly, revenue is recognized at an amount that reflects the consideration to which we expect to be entitled in exchange for transferring goods or services to a customer. This principle is applied using the following 5-step process:

Managed Services

Managed services contracts are typically long-term contracts lasting three years. Revenue is earned monthly during the term of the contract, as services are provided at a fixed fee and is recognized ratably over the contract term beginning on the commencement date of the contract. Revenue related to managed services provided is recognized based on the customer utilization of such resources, which management estimates to occur ratably over the customer contract term.

Consulting and Professional Services

Consulting and professional services contracts are typically short-term, project-based services rendered on either a fixed fee or a time and materials basis. These contracts are normally for a duration of less than one year. For fixed fee arrangements, revenue is normally recognized ratably over the term of the project. For time and materials arrangements, revenues are recognized as the services are rendered.

Deferred and Unbilled Revenue

We receive payments from customers based on billing schedules established in our contracts. 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. Unbilled revenue reflects our conditional right to receive payment from customers for our completed performance under 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 creditworthiness, current economic trends, COVID-19 developments 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.

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 at least annually at year end for any impairment in the carrying value. We review our intangible assets for impairment 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 and warrants. 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 on the date of the grant. 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 largely 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.

The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP, with no need for management’s judgment in its application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. Please see our audited consolidated financial statements and notes thereto which begin on page F-1 of our Annual Report on Form 10-K, which contain accounting policies and other disclosures required by GAAP and please refer to the disclosures in Note 1 of our consolidated financial statements for a summary of our significant accounting policies.

Reference is made to our Annual Report on Form 10-K for the fiscal year ended December 31, 2021, filed with the SEC on March 28, 2022, for additional discussion of our critical accounting policies and estimates.

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 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 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 (principal executive officer) and Chief Financial Officer (principal 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.

No change in our internal control over financial reporting occurred during our last fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting. The Company is continually monitoring and assessing the impact of COVID-19 on its internal controls in an effort to ensure that its internal controls respond to any changes in its operating environment.

PART II - OTHER INFORMATION

ITEM 1A. RISK FACTORS.

As of the date of this filing, except as set forth herein, 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, 2021, filed with the Commission on March 28, 2022 (the “2021 Form 10-K”).

We are subject to a number of risks and uncertainties in connection with our Merger Agreement. These risks and uncertainties include the following:

The Risk Factors set forth herein and in the 2021 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 herein and in the 2021 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.

ITEM 5. OTHER INFORMATION.

Clearwater Revolving Loan.

CynergisTek and Clearwater have entered into a Guaranty and Security Agreement (the “Security Agreement”) and Revolving Promissory Note (the “Clearwater Note”), each dated August 12, 2022, whereby Clearwater will provide a secured revolving loan of up to $750,000.00 to CynergisTek (the “Clearwater Revolving Loan”). The Security Agreement and Clearwater Note may be referred to collectively as the “Loan Documents”. The Loan Documents provide for a fixed 10.0% annual interest on sums advanced, five-year maturity date for unpaid sums loaned and unpaid interest accrued thereon, and calendar quarterly payments of accrued interest on any sums advanced under the Clearwater Revolving Loan (interest payments commencing on September 30, 2022). CynergisTek may elect to pay all of the interest that is due on any interest payment due date in-kind (which portion, if applicable, shall be added to the outstanding principal amount under the Clearwater Note) upon prior written notice of such election at least five business days prior to such interest payment due date.  Principal of the Clearwater Revolving Loan may be used for any lawful purpose, including CynergisTek’s working capital needs. CynergisTek’s obligations under the Clearwater Note are secured by a first, senior lien on all of CynergisTek’s assets and accounts receivable, as set forth in the Security Agreement.

There is no premium or penalty for pre-payment of sums owed under the Loan Documents. In the event of a default under the Loan Documents, the default interest rate is a fixed rate of 12% annual interest.

The Clearwater Note provides for certain customary events of default, including (i) CynergisTek’s failure to pay any principal amount outstanding under the Clearwater Note; any outstanding interest under the Clearwater Note; or any other amount due under the Clearwater Note, in each case, whether such amount is due by scheduled maturity, required prepayment, acceleration, demand or otherwise, subject to a five-day grace period (except in limited circumstances); (ii) CynergisTek’s breach in any material respect any representation or warranty made by CynergisTek in the Loan Documents; (iii) a proceeding under any bankruptcy, reorganization, arrangement of debt, insolvency, readjustment of debt or receivership law or statute is filed (A) against CynergisTek or any of its subsidiaries, and an adjudication or appointment is made or order for relief is entered, or such proceeding remains undismissed for a period in excess of 60 days, or (B) by CynergisTek or any of its subsidiaries; CynergisTek or any of its subsidiaries makes an assignment for the benefit of creditors; CynergisTek or any of its subsidiaries takes any action to authorize any of the foregoing; or CynergisTek or any of its subsidiaries becomes insolvent or fails generally to pay its debts as they become due; (iv) CynergisTek fails to notify Clearwater of an event of default under the Clearwater Note; or (v) CynergisTek shall, or shall attempt or purport to, revoke any of its obligations under the Clearwater Note, or CynergisTek or any of its subsidiaries shall challenge or contest, in any action, suit or proceeding, the validity or enforceability of any of the Clearwater Note or the perfection or priority of any lien granted to Clearwater. Upon and at any time following the occurrence of any of the foregoing events of default, Clearwater may, at its option, terminate CynergisTek’s right to request and receive advances under the Clearwater Note and/or declare the entire principal, interest and other amounts then outstanding under the Clearwater Note due and payable immediately without notice to CynergisTek, and Clearwater may proceed to enforce payment of the same, except that upon the occurrence of an event of default described in subparagraph (iii) above, the entire principal, interest and other amounts then outstanding under the Clearwater Note shall be due and payable immediately without notice to CynergisTek. In addition, Clearwater may exercise and pursue any and all rights and remedies available to it under the Loan Documents, and all rights and remedies available to Clearwater under applicable law.

The Clearwater Note matures and any remaining outstanding principal balance and all accrued and unpaid interest shall become due and payable upon the earliest to occur of (i) the five-year anniversary of the date thereof, (ii) the termination of the Merger Agreement, or (iii) the incurrence by CynergisTek or any of its subsidiaries of any debt of any kind whatsoever from a third party, other than payables incurred in the ordinary course of business; provided that (x) if the Merger Agreement is terminated pursuant to Sections 7.1(a), 7.1(b), 7.1(c), 7.1(d), or 7.1(g) of the Merger Agreement, then all outstanding principal and interest under the Clearwater Note shall be due and payable by the 60th day following such termination; and (y) if the Merger Agreement is terminated in connection with the entry into an Acquisition Transaction (as such term is defined in the Merger Agreement), then CynergisTek shall be required to repay all outstanding interest and principal then due under the Clearwater Note as a condition to, and prior to or concurrently with, the termination of the Merger Agreement by CynergisTek.

The above summary of the Security Agreement and Clearwater Note is qualified in its entirety by reference to the Security Agreement, which is attached to this Quarterly Report on Form 10-Q as Exhibit 10.1, and the Clearwater Note, which is attached to this Quarterly Report on Form 10-Q as Exhibit 10.2.

ITEM 6. EXHIBITS.

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.