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FALCONSTOR SOFTWARE INC - Quarter Report: 2019 September (Form 10-Q)



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q
(Mark One)

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2019
or 
o 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:  000-23970
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
 
 
DELAWARE
77-0216135
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
701 Brazos Street, Suite 400, Austin, TX
78701
(Address of principal executive offices)
(Zip Code)
 
 
631-777-5188
(Registrant’s telephone number, including area code)
 
 
(Former name, former address and former fiscal year, if changed since last report)
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 ý  No ¨
 
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ý  No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.  (Check one):
Large accelerated filer o
Accelerated filer o
Non-accelerated filer x
Smaller reporting company x
Emerging growth company o
 

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No ý

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




 The number of shares of common stock outstanding as of October 31, 2019 was 5,918,733.
.



FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
FORM 10-Q
INDEX
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


3


PART I.  FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
 
 
September 30, 2019
 
December 31, 2018
 
 
(unaudited)
 
 
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
960,401

 
$
3,059,677

Accounts receivable, net of allowances of $33,483 and $162,112, respectively
 
1,959,885

 
3,605,411

Prepaid expenses and other current assets
 
2,085,377

 
1,909,846

Contract assets
 
805,699

 
637,179

Inventory
 
104,460

 
14,885

Total current assets
 
5,915,822

 
9,226,998

Property and equipment, net of accumulated depreciation of $18,297,400 and $18,194,827, respectively
 
418,167

 
433,935

Operating lease right-of-use assets
 
2,107,529

 
—

Deferred tax assets, net
 
553,673

 
545,044

Software development costs, net
 
34,571

 
88,769

Other assets
 
876,603

 
919,609

Goodwill
 
4,150,339

 
4,150,339

Other intangible assets, net
 
68,554

 
91,334

Contract assets, net of current portion
 
268,930

 
516,643

Total assets
 
$
14,394,188

 
$
15,972,671

Liabilities and Stockholders' Deficit
 
 

 
 

Current liabilities:
 
 

 
 

Accounts payable
 
$
1,066,567

 
$
551,389

Accrued expenses
 
2,429,388

 
2,879,473

Operating lease liabilities, net
 
1,704,858

 
—

Deferred revenue
 
4,990,047

 
6,859,592

Total current liabilities
 
10,190,860

 
10,290,454

Other long-term liabilities
 
689,089

 
1,549,692

Notes payable, net
 
2,852,842

 
3,124,827

Operating lease liabilities, net of current portion
 
917,563

 
—

Deferred tax liabilities, net of current portion
 
297,890

 
297,890

Deferred revenue, net
 
3,229,511

 
2,506,898

Total liabilities
 
18,177,755

 
17,769,761

Commitments and contingencies (Note 11)
 


 


Series A redeemable convertible preferred stock, $.001 par value, 2,000,000 shares authorized, 900,000 shares issued and outstanding, redemption value of $11,966,101 and $11,104,923, respectively
 
10,929,594

 
9,756,706

Stockholders' deficit:
 
 

 
 

Common stock - $.001 par value, 30,000,000 and 800,000,00 shares authorized, 5,918,733 shares and 5,872,552 shares issued and outstanding, respectively
 
5,919

 
5,873

Additional paid-in capital
 
112,098,875

 
113,243,227

Accumulated deficit
 
(124,761,338
)
 
(122,907,794
)
Accumulated other comprehensive loss, net
 
(2,056,617
)
 
(1,895,102
)
Total stockholders' deficit
 
(14,713,161
)
 
(11,553,796
)
Total liabilities and stockholders' deficit
 
$
14,394,188

 
$
15,972,671

See accompanying notes to unaudited condensed consolidated financial statements.

4


FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Revenue:
 
 
 
 
 
 
 
 
Product revenue
 
$
1,663,782

 
$
1,007,915

 
$
4,879,996

 
$
3,925,504

Support and services revenue
 
2,308,663

 
3,052,246

 
7,584,816

 
9,140,187

Total revenue
 
3,972,445

 
4,060,161

 
12,464,812

 
13,065,691

Cost of revenue:
 


 
 

 
 

 
 

Product
 
241,134

 
62,742

 
1,076,604

 
128,632

Support and service
 
531,709

 
645,700

 
1,639,299

 
1,964,897

Total cost of revenue
 
772,843

 
708,442

 
2,715,903

 
2,093,529

Gross profit
 
3,199,602

 
3,351,719

 
9,748,909

 
10,972,162

Operating expenses:
 
 

 
 

 
 

 
 

Research and development costs
 
782,161

 
1,065,031

 
2,503,008

 
2,997,826

Selling and marketing
 
1,067,436

 
1,144,271

 
3,436,783

 
3,209,930

General and administrative
 
1,454,103

 
1,068,754

 
4,280,188

 
4,175,578

Restructuring costs
 
384,829

 
315,283

 
745,201

 
951,265

Total operating expenses
 
3,688,529

 
3,593,339

 
10,965,180

 
11,334,599

Operating loss
 
(488,927
)
 
(241,620
)
 
(1,216,271
)
 
(362,437
)
Interest and other loss, net
 
(123,261
)
 
(187,667
)
 
(468,717
)
 
(501,087
)
Loss before income taxes
 
(612,188
)
 
(429,287
)
 
(1,684,988
)
 
(863,524
)
Income tax expense (benefit)
 
(55,274
)
 
(96,858
)
 
168,556

 
(33,868
)
Net loss
 
$
(556,914
)
 
$
(332,429
)
 
$
(1,853,544
)
 
$
(829,656
)
Less: Accrual of Series A redeemable convertible preferred stock dividends
 
266,447

 
229,022

 
770,027

 
687,152

Less: Deemed dividend on Series A redeemable convertible preferred stock
 
—

 
—

 
—

 
2,269,042

Less: Accretion to redemption value of Series A redeemable convertible preferred stock
 
139,399

 
124,993

 
402,861

 
240,743

Net loss attributable to common stockholders
 
$
(962,760
)
 
$
(686,444
)
 
$
(3,026,432
)
 
$
(4,026,593
)
Basic net loss per share attributable to common stockholders
 
$
(0.16
)
 
$
(0.70
)
 
$
(0.51
)
 
$
(5.31
)
Diluted net loss per share attributable to common stockholders
 
$
(0.16
)
 
$
(0.70
)
 
$
(0.51
)
 
$
(5.31
)
Weighted average basic shares outstanding
 
5,910,718

 
979,353

 
5,887,638

 
758,447

Weighted average diluted shares outstanding
 
5,910,718

 
979,353

 
5,887,638

 
758,447


See accompanying notes to unaudited condensed consolidated financial statements.


5


FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)

 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Net loss
 
$
(556,914
)
 
$
(332,429
)
 
$
(1,853,544
)
 
$
(829,656
)
Other comprehensive income (loss), net of applicable taxes:
 
 

 
 

 
 

 
 

Foreign currency translation
 
(131,497
)
 
70,061

 
(161,515
)
 
114,772

Total other comprehensive income (loss), net of applicable taxes:
 
(131,497
)
 
70,061

 
(161,515
)
 
114,772

Total comprehensive loss
 
$
(688,411
)
 
$
(262,368
)
 
$
(2,015,059
)
 
$
(714,884
)
Less: Accrual of Series A redeemable convertible preferred stock dividends
 
266,447

 
229,022

 
770,027

 
687,152

Less: Deemed dividend on Series A redeemable convertible preferred stock
 
—

 
—

 
—

 
2,269,042

Less: Accretion to redemption value of Series A redeemable convertible preferred stock
 
139,399

 
124,993

 
402,861

 
240,743

Total comprehensive loss attributable to common stockholders
 
$
(1,094,257
)
 
$
(616,383
)
 
$
(3,187,947
)
 
$
(3,911,821
)

See accompanying notes to unaudited condensed consolidated financial statements.


6


FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT
(UNAUDITED)


Common Stock

Additional Paid-In Capital

Accumulated Deficit

Accumulated Other Comprehensive Loss, Net

Total Stockholders' Deficit
Balance at January 1, 2019

$
5,873


$
113,243,227


$
(122,907,794
)

$
(1,895,102
)

$
(11,553,796
)
Net loss





(124,907
)



(124,907
)
Share-based compensation to employees



9,251






9,251

Accretion of Series A redeemable convertible preferred stock



(129,239
)





(129,239
)
Dividends on Series A redeemable convertible preferred stock



(247,027
)





(247,027
)
Foreign currency translation







19,392


19,392

Balance at March 31, 2019

5,873


112,876,212


(123,032,701
)

(1,875,710
)

(12,026,326
)
Net loss







(1,171,723
)




(1,171,723
)
Share-based compensation to employees




16,231








16,231

Warrants exercised
 
15


(15
)





—

Accretion of Series A redeemable convertible preferred stock




(134,223
)







(134,223
)
Dividends on Series A redeemable convertible preferred stock




(256,553
)







(256,553
)
Foreign currency translation










(49,410
)

(49,410
)
Balance at June 30, 2019

5,888


112,501,652


(124,204,424
)

(1,925,120
)

(13,622,004
)
Net loss
 




(556,914
)



(556,914
)
Share-based compensation to employees



3,100






3,100

Restricted stock issued

31


(31
)





—

Accretion of Series A redeemable convertible preferred stock



(139,399
)





(139,399
)
Dividends on Series A redeemable convertible preferred stock



(266,447
)





(266,447
)
Foreign currency translation







(131,497
)

(131,497
)
Balance at September 30, 2019

$
5,919


$
112,098,875


$
(124,761,338
)

$
(2,056,617
)

$
(14,713,161
)


See accompanying notes to unaudited condensed consolidated financial statements.

7


FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT
(UNAUDITED)


Common Stock

Additional Paid-In Capital

Accumulated Deficit

Treasury Stock

Accumulated Other Comprehensive Loss, Net

Total Stockholders' Deficit
Balance at January 1, 2018

$
601


$
112,234,058


$
(130,930,284
)

$
(570,329
)

$
(1,958,843
)

$
(21,224,797
)
Net income





506,877






506,877

Share-based compensation to employees



(22,895
)







(22,895
)
Accretion of Series A redeemable convertible preferred stock



(38,105
)







(38,105
)
Dividends on Series A redeemable convertible preferred stock



(243,167
)







(243,167
)
Deemed dividends on Series A redeemable convertible preferred stock



(2,269,042
)







(2,269,042
)
Purchase of shares











—

Foreign currency translation









(85,245
)

(85,245
)
Cumulative effect of adoption of ASC 606







8,930,633








8,930,633

Balance at March 31, 2018

601


109,660,849


(121,492,774
)

(570,329
)

(2,044,088
)

(14,445,741
)
Net loss





(1,004,104
)





(1,004,104
)
Warrants issued



4,143,000








4,143,000

Warrants exercised

378


(570,707
)



570,329




—

Share-based compensation to employees



29,519








29,519

Accretion of Series A redeemable convertible preferred stock



(77,645
)







(77,645
)
Dividends on Series A redeemable convertible preferred stock



(214,963
)







(214,963
)
Foreign currency translation









129,956


129,956

Balance at June 30, 2018

979


112,970,053


(122,496,878
)

—


(1,914,132
)

(11,439,978
)
Net loss
 




(332,429
)





(332,429
)
Share-based compensation to employees



29,024








29,024

Accretion of Series A redeemable convertible preferred stock



(124,993
)







(124,993
)
Dividends on Series A redeemable convertible preferred stock



(229,022
)







(229,022
)
Foreign currency translation









70,061


70,061

Balance at September 30, 2018

$
979


$
112,645,062


$
(122,829,307
)

$
—


$
(1,844,071
)

$
(12,027,337
)


8


FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
 
Nine Months Ended September 30,
 
 
2019
 
2018
Cash flows from operating activities:
 
 
 
 
Net loss
 
$
(1,853,544
)
 
$
(829,656
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 

 
 

Depreciation and amortization
 
320,388

 
511,232

Share-based payment compensation
 
28,582

 
35,648

Provision for (recovery of) returns and doubtful accounts
 
(128,628
)
 
(42,966
)
Changes in operating assets and liabilities:
 
 

 
 

Accounts receivable
 
1,778,241

 
2,581,079

Prepaid expenses and other current assets
 
(173,775
)
 
158,024

Contract assets
 
79,192

 
1,038,473

Inventory
 
(89,843
)
 
—

Other assets
 
1,402

 
7,539

Accounts payable
 
487,202

 
(219,868
)
Accrued expenses and other long-term liabilities
 
(718,562
)
 
(152,018
)
Deferred revenue
 
(1,163,169
)
 
(3,419,209
)
Net cash used in operating activities
 
(1,432,514
)
 
(331,722
)
Cash flows from investing activities:
 
 

 
 

Purchases of property and equipment
 
(175,139
)
 
(46,494
)
Capitalized software development costs
 
—

 
(32,919
)
Security deposits
 
33,815

 
3,625

Purchase of intangible assets
 
(46,674
)
 
(63,145
)
Net cash used in investing activities
 
(187,998
)
 
(138,933
)
Cash flows from financing activities:
 
 

 
 

Proceeds from issuance of long-term debt, net of issuance costs
 
—

 
2,328,019

Payments of long term-debt
 
(489,321
)
 
—

Net cash provided by (used in) financing activities
 
(489,321
)
 
2,328,019

Effect of exchange rate changes on cash and cash equivalents
 
10,557

 
(41,540
)
Net increase (decrease) in cash and cash equivalents
 
(2,099,276
)
 
1,815,824

Cash and cash equivalents, beginning of period
 
3,059,677

 
1,011,472

Cash and cash equivalents, end of period
 
$
960,401

 
$
2,827,296

Supplemental disclosures:
 
 

 
 

Cash paid for interest
 
$
176,008

 
$
64,817

Cash paid for income taxes, net
 
$
—

 
$
—

Non-cash investing and financing activities:
 
 

 
 

Undistributed Series A redeemable convertible preferred stock dividends
 
$
770,027

 
$
927,895

Warrants issued
 
$
—

 
$
4,143,000

Deemed dividend
 
$
—

 
$
2,269,042

Discount on preferred stock
 
$
—

 
$
1,602,428

Discount on notes payable
 
$
—

 
$
288,504

Accretion of Series A redeemable convertible preferred stock
 
$
402,861

 
$
240,743


See accompanying notes to unaudited condensed consolidated financial statements.

9


FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements 

(1) Basis of Presentation

(a)  The Company and Nature of Operations
 
FalconStor Software, Inc., a Delaware Corporation (the "Company" or "FalconStor"), is a leading storage software company offering a converged data services software platform that is hardware agnostic. The Company develops, manufactures and sells data migration, business continuity, disaster recovery, optimized backup and de-duplication solutions and provides the related maintenance, implementation and engineering services.

(b) Liquidity

As of September 30, 2019, the Company had a working capital deficiency of $4.3 million, which is inclusive of current deferred revenue of $5.0 million, and a stockholders' deficit of $14.7 million. During the three months ended September 30, 2019, we had a net loss of $0.6 million. During the nine months ended September 30, 2019, the Company had a net loss of $1.9 million and negative cash flow from operations of $1.4 million. The Company's total cash balance at September 30, 2019 was $1.0 million, a decrease of $2.1 million as compared to December 31, 2018.

The Company's ability to continue as a going concern, depends on its ability to execute its business plan, increase revenue and billings and reduce expenditures. In the third quarter of 2019, the Company adopted a plan to better align the Company’s cost structure with the skills and resources required to more effectively execute the Company’s long-term growth strategy and to support revenue levels the Company expected to achieve on a go forward basis (the "2019 Plan"). In connection with the 2019 Plan, the Company eliminated 23 positions worldwide, implemented tighter expense controls, ceased non-core activities and downsized several facilities. During the three months ended September 30, 2019, the Company incurred $0.2 million in severance expense as a result of this action. The 2019 Plan is anticipated to be substantially completed by December 31, 2019. The Company is also currently negotiating for additional borrowing facilities from investors, and management believes that the Company will be able to execute the terms for such borrowing facilities in the near future.

There is no assurance that the Company will be successful in generating sufficient bookings, billings, revenue or continue to reduce operating costs or that the Company will be able to obtain financing or that such financing will be on favorable terms. Any such financing would be dilutive to our shareholders. Failure to generate sufficient revenue, billings, control or further reduce expenditures and/or the inability to obtain financing will result in an inability of the Company to continue as a going concern. Subject to the foregoing, management believes that, based on projected cash flows and additional financing, the Company will have sufficient capital and liquidity to fund its operations for at least one year from the date of issuance of the accompanying interim condensed financial statements.
    
(c) Stock Split

On August 8, 2019, the Company effected a 100-for-1 reverse stock split of its issued and outstanding common stock. In connection with the reverse stock split, the Company also decreased its authorized capital to 32,000,000 shares, consisting of 30,000,000 shares of common stock and 2,000,000 shares of preferred stock. The par value of the Company's common stock was not adjusted as a result of the reverse stock split. All of the share and per share information presented in the accompanying financial statements have been adjusted to reflect, unless otherwise indicated, the reverse common stock split on a retroactive basis for all periods and as of all dates presented.

(d)  Principles of Consolidation
 
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
 
(e)  Use of Estimates
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company’s significant estimates include those related to revenue recognition, accounts receivable allowances, share-based payment compensation, valuation of derivatives, capitalizable software

10


development costs, valuation of goodwill and other intangible assets and income taxes. During the first quarter of 2018, the Company also had significant estimates in the determination of the fair value of Series A Preferred Stock, notes payable and warrants issued. Actual results could differ from those estimates.
 
The financial market volatility in many countries where the Company operates has impacted and may continue to impact the Company’s business. Such conditions could have a material impact on the Company’s significant accounting estimates discussed above.
 
(f)  Unaudited Interim Financial Information
 
The accompanying unaudited interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements.
 
In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company at September 30, 2019, and the results of its operations for the three and nine months ended September 30, 2019 and 2018. The results of operations of any interim period are not necessarily indicative of the results of operations to be expected for the full fiscal year. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes set forth in the Company's Annual Report on Form 10-K for the year ended December 31, 2018 ("2018 Form 10-K").

(g)  Recently Adopted Accounting Pronouncements

In February 2016, the Financial Accounting Standards Board (the "FASB") issued ASU No. 2016-02, which establishes a right-of-use (ROU) model that requires a lessee to record a right of use (ROU) asset and a lease liability on the balance sheet for most leases. In July 2018, the FASB issued ASU No. 2018-11, which amends the guidance to add a method of adoption whereby the issuer may elect to recognize a cumulative effect adjustment at the beginning of the period of adoption. ASU No. 2018-11 does not require comparative period financial information to be adjusted. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. ASU 2016-02 defines a lease as a contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration. To determine whether a contract conveys the right to control the use of the identified asset for a period of time, the customer has to have both (1) the right to obtain substantially all of the economic benefits from the use of the identified asset and (2) the right to direct the use of the identified asset, a contract does not contain an identified asset if the supplier has a substantive right to substitute such asset ("the leasing criteria"). We have determined that our real estate leases with terms in excess of one year and which do not include an option to purchase the underlying asset, meet the leasing criteria. On January 1, 2019, we adopted ASU No. 2016-02, applying the package of practical expedients to leases that commenced before the effective date whereby we elected to not reassess the following: (i) whether any expired or existing contracts contain leases; (ii) the lease classification for any expired or existing leases; and (iii) initial direct costs for any existing leases. We elected to apply the transition provisions as of January 1, 2019, the date of adoption, and we recorded lease ROU assets of $2.9 million and related liabilities of $3.6 million million on our balance sheet related to our operating leases. We have no financing leases. There was no change to our condensed consolidated statements of operations or cash flows.

In July 2018, the FASB issued ASU 2018-09, Codification Improvements. The amendments in ASU 2018-09 affect a wide variety of Topics in the FASB Codification and apply to all reporting entities within the scope of the affected accounting guidance. The Company has evaluated ASU 2018-09 in its entirety and determined that the amendments related to Topic 718-740, Compensation-Stock Compensation-Income Taxes, are the only provisions that currently apply to the Company. The amendments in ASU 2018-09 related to Topic 718-740, Compensation-Stock Compensation-Income Taxes, clarify that an entity should recognize excess tax benefits related to stock compensation transactions in the period in which the amount of the deduction is determined. On January 1, 2019, we adopted ASU 2018-09 and it did not have a material impact on the Company's Condensed Consolidated Financial Statements.

In June 2018, the FASB issued ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting, to expand the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees and supersedes the guidance in Subtopic 505-50, Equity - Equity-Based Payments to Non-Employees. Under ASU 2018-07, equity-classified nonemployee share-based payment awards are measured at the grant date fair value on the grant date. The probability of satisfying performance conditions must be considered for equity-

11


classified nonemployee share-based payment awards with such conditions. On January 1, 2019, we adopted ASU 2018-07 and it did not have a material impact on the Company's Condensed Consolidated Financial Statements.

In February 2018, the FASB issued ASU No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, which provides entities the option to reclassify tax effects stranded in accumulated other comprehensive income as a result of the 2017 Tax Cuts and Jobs Act (“the Tax Act”) to retained earnings. On January 1, 2019, we adopted ASU 2018-02 and it did not have a material impact on the Company's Condensed Consolidated Financial Statements.

(h)  Recently Issued Accounting Pronouncements

In August 2018, the FASB issued ASU 2018-14, Compensation—Retirement Benefits—Defined Benefit Plans—General: Disclosure Framework—Changes to the Disclosure Requirements for Defined Benefit Plans. The objective of the guidance is to improve the effectiveness of disclosure requirements on defined benefit pension plans and other postretirement plans. The guidance is effective for fiscal years beginning after December 15, 2020. The Company does not expect adoption of the new standard to have a material impact on its Condensed Consolidated Financial Statements.

(2) Summary of Significant Accounting Policies

The Company's significant accounting policies were described in Note (1) Summary of Significant Accounting Policies of the 2018 Form 10-K. There have been no significant changes in the Company's significant accounting policies since December 31, 2018, other than those noted below. For a description of the Company's other significant accounting policies refer to the 2018 Form 10-K.

Revenue from Contracts with Customers and Associated Balances

Nature of Products and Services

Licenses for on-premises software provide the customer with a right to use the software as it exists when made available to the customer. Customers may purchase perpetual licenses or subscribe to licenses, which provide customers with the same functionality and differ mainly in the duration over which the customer benefits from the software. Revenue from distinct on-premises licenses is recognized upfront at the point in time when the software is made available to the customer. Revenue allocated to software maintenance and support services is recognized ratably over the contractual support period.

Hardware products consist primarily of servers and associated components and function independently of the software products and as such are accounted for as separate performance obligations. Revenue allocated to hardware maintenance and support services is recognized ratably over the contractual support period.

Professional services are primarily related to software implementation services and associated revenue is recognized upon customer acceptance.

Contract Balances

Timing of revenue recognition may differ from the timing of invoicing to customers. The Company records a contract asset or receivable when revenue is recognized prior to invoicing, or unearned revenue when revenue is recognized subsequent to invoicing. For perpetual licenses with multi-year product maintenance agreements, the Company generally invoices customers at the beginning of the coverage period. For multi-year subscription licenses, the Company generally invoices customers annually at the beginning of each annual coverage period. The Company records a contract asset related to revenue recognized for multi-year on-premises licenses as its right to payment is conditioned upon providing product support and services in future years.

As of September 30, 2019 and December 31, 2018, accounts receivable, net of allowance for doubtful accounts, was $2.0 million and $3.6 million, respectively. As of September 30, 2019 and December 31, 2018, short and long-term contract assets, net of allowance for doubtful accounts, was $1.1 million and $1.2 million, respectively.
    
Deferred revenue is comprised mainly of unearned revenue related maintenance and technical support on term and perpetual licenses. Maintenance and technical support revenue is recognized ratably over the coverage period. Deferred revenue also includes contracts for professional services to be performed in the future which are recognized as revenue when the Company delivers the related service pursuant to the terms of the customer arrangement.


12


Changes in deferred revenue were as follows:
Nine Months Ended September 30, 2019
 
Balance at December 31, 2018
$
9,366,490

   Deferral of revenue
11,317,880

   Recognition of revenue
(12,464,812
)
Balance at September 30, 2019
$
8,219,558


Deferred revenue includes invoiced revenue allocated to remaining performance obligations that has not yet been recognized and will be recognized as revenue in future periods. Deferred revenue was $8.2 million as of September 30, 2019, of which the Company expects to recognize approximately 61% of the revenue over the next 12 months and the remainder thereafter.

Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 90 days. In instances where the timing of revenue recognition differs from the timing of invoicing, the Company has determined its contracts generally do not include a significant financing component. The primary purpose of the Company’s invoicing terms is to provide customers with simplified and predictable ways of purchasing its products and services, not to receive financing from our customers or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with maintenance and support revenue recognized ratably over the contract period, and multi-year on-premises licenses that are invoiced annually with product revenue recognized upon delivery.
Significant Judgments
The Company’s contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment.
Judgment is required to determine the standalone selling price (“SSP”) for each distinct performance obligation. For products and services aside from maintenance and support, the Company estimates SSP by adjusting the list price by historical discount percentages. SSP for software and hardware maintenance and support fees is based on the stated percentages of the fees charged for the respective products.
The Company’s perpetual and term software licenses have significant standalone functionality and therefore revenue allocated to these performance obligations are recognized at a point in time upon electronic delivery of the download link and the license keys.
Product maintenance and support services are satisfied over time as they are stand-ready obligations throughout the support period. As a result, revenues associated with maintenance services are deferred and recognized as revenue ratably over the term of the contract.
Revenues associated with professional services are recognized at a point in time upon customer acceptance.
Disaggregation of Revenue
Please refer to the condensed consolidated statements of operations and note 16, segment reporting and concentrations, for discussion on revenue disaggregation by product type and by geography. The Company believes this level of disaggregation sufficiently depicts how the nature, amount, timing and uncertainty of our revenue and cash flows are affected by economic factors.

Assets Recognized from Costs to Obtain a Contract with a Customer

The Company recognizes an asset for the incremental costs of obtaining a contract with a customer if it expects the benefit of those costs to be longer than one year. The Company has determined that its sales commission program meets the requirements for cost capitalization. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in other current and long-term assets on our consolidated balance sheets. The Company applies a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less.

Leases

We have entered into operating leases for our various facilities. We determine if an arrangement is a lease at inception. Operating leases are included in Right-of-Use ("ROU") assets, and lease liability obligations in our condensed consolidated balance

13


sheets. ROU assets represent our right to use an underlying asset for the lease term and lease liability obligations represent our obligation to make lease payments arising from the lease. ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. We have lease agreements with lease and non-lease components and account for such components as a single lease component. As most of our leases do not provide an implicit rate, we estimated our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. We use the implicit rate when readily determinable. The ROU asset also includes any lease payments made and excludes lease incentives and lease direct costs. Our lease terms may include options to extend or terminate the lease. Such extended terms have been considered in determining the ROU assets and lease liability obligations when it is reasonably certain that we will exercise that option. Lease expense is recognized on a straight-line basis over the lease term.

Right of Use Assets and Liabilities

We have various operating leases for office facilities that expire through 2021. Below is a summary of our right of use assets and liabilities as of September 30, 2019.

Right of use assets
$
2,107,529

Lease liability obligations, current
1,704,858

Lease liability obligations, less current portion
917,563

Total lease liability obligations
$
2,622,421

Weighted-average remaining lease term
1.61

Weighted-average discount rate
6.07
%

During the three months ended September 30, 2019 and September 30, 2018, we recognized approximately $0.3 million and $0.6 million, respectively, in total operating lease costs. During the nine months ended September 30, 2019 and September 30, 2018, we recognized approximately $1.2 million and $2.1 million, respectively, in total operating lease costs. During the three months ended September 30, 2019 and September 30, 2018, operating cash flows from operating leases was approximately $0.5 million and $0.5 million, respectively. During the nine months ended September 30, 2019 and September 30, 2018, operating cash flows from operating leases was approximately $1.5 million and $1.6 million, respectively. During the three and nine months ended September 30, 2019, we recognized sublease income of approximately $0.2 million and $0.5 million, respectively. We recorded $107,048 and $142,731 in sublease income during the three and nine months ended September 30, 2018, respectively.

Approximate future minimum lease payments for our right of use assets over the remaining lease periods as of September 30, 2019, are as follows:
Remainder of 2019
438,074

2020
1,714,436

2021
639,526

Thereafter
—

Total minimum lease payments
2,792,036

Less interest
(169,615
)
Present value of lease liabilities
2,622,421



(3) Earnings Per Share

Basic earnings per share ("EPS") is computed based on the weighted average number of shares of common stock outstanding. Diluted EPS is computed based on the weighted average number of common shares outstanding increased by dilutive common stock equivalents, attributable to stock option awards, restricted stock awards, warrants and the Series A Redeemable Convertible Preferred Stock ("Series A Preserved Stock") outstanding.


14


The following represents the common stock equivalents that were excluded from the computation of diluted shares outstanding because their effect would have been anti-dilutive for the three and nine months ended September 30, 2019 and 2018:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Stock options and restricted stock
 
1,157,537

 
3,701,178

 
1,263,009

 
3,701,178

Series A redeemable convertible preferred stock
 
87,815

 
87,815

 
87,815

 
87,815

Total anti-dilutive common stock equivalents
 
1,245,352

 
3,788,993

 
1,350,824

 
3,788,993


(4) Property and Equipment

The gross carrying amount and accumulated depreciation of property and equipment as of September 30, 2019 and December 31, 2018 are as follows:
 
 
September 30, 2019
 
December 31, 2018
Gross carrying amount
 
$
18,715,567

 
$
18,628,762

Accumulated depreciation
 
(18,297,400
)
 
(18,194,827
)
Property and Equipment, net
 
$
418,167

 
$
433,935


For the three months ended September 30, 2019 and 2018, depreciation expense was $62,910 and $77,697, respectively. For the nine months ended September 30, 2019 and 2018, depreciation expense was $196,736 and $236,007, respectively.

(5) Software Development Costs

The gross carrying amount and accumulated amortization of software development costs as of September 30, 2019 and December 31, 2018 are as follows:
 
 
September 30, 2019
 
December 31, 2018
Gross carrying amount
 
$
2,950,132

 
$
2,950,132

Accumulated amortization
 
(2,915,561
)
 
(2,861,363
)
Software development costs, net
 
$
34,571

 
$
88,769


During the three months ended September 30, 2019 and 2018, the Company recorded $11,565 and $58,608, respectively, of amortization expense related to capitalized software costs. During the nine months ended September 30, 2019 and 2018, the Company recorded $54,198 and $175,824, respectively, of amortization expense related to capitalized software costs.

(6) Goodwill and Other Intangible Assets

The gross carrying amount and accumulated amortization of goodwill and other intangible assets as of September 30, 2019 and December 31, 2018 are as follows: 
 
 
September 30, 2019
 
December 31, 2018
Goodwill
 
$
4,150,339

 
$
4,150,339

Other intangible assets:
 
 

 
 

Gross carrying amount
 
$
3,937,915

 
$
3,891,241

Accumulated amortization
 
(3,869,361
)
 
(3,799,907
)
Net carrying amount
 
$
68,554

 
$
91,334


For the three months ended September 30, 2019 and 2018, amortization expense was $22,130 and $28,581, respectively. For the nine months ended September 30, 2019 and 2018, amortization expense was $69,454 and 99,401, respectively.


15


(7) Share-Based Payment Arrangements

On June 22, 2018, the Company's stockholders adopted the FalconStor Software, Inc. 2018 Incentive Stock Plan (the "2018 Plan"). The 2018 Plan is administered by the Compensation Committee and provides for the issuance of up to 1,471,997 shares of the Company's common stock upon the grant of shares with such restrictions as determined by the Compensation Committee to the employees and directors of, and consultants providing services to, the Company or its affiliates. Exercise prices of the options will be determined by the Compensation Committee, subject to the consent of Hale Capital Partners, LP ("Hale Capital"). The vesting terms shall be performance based and determined by the Compensation Committee, subject to the consent of Hale Capital, based on various factors, including (i) the return of capital to the holders of the Series A Preferred Stock and the Company’s Common Stock in the event of a Change of Control, (ii) the repayment of the Company’s obligations under its senior secured debt, and (iii) the Company’s free cash flow.

The 2016 Incentive Stock Plan (the "2016 Plan") was terminated in April 2018.

The following table summarizes the 2018 Plan, which was the only plan under which the Company was able to grant equity compensation as of September 30, 2019: 
 
 
Shares
 
Shares Available
 
Shares
Name of Plan
 
Authorized
 
for Grant
 
Outstanding
FalconStor Software, Inc. 2018 Incentive Stock Plan
 
1,471,997
 
325,995
 
1,146,002

The following table summarizes the Company’s equity plans that have terminated or expired but that still have equity awards outstanding as of September 30, 2019: 
Name of Plan
 
Shares Available for Grant
 
Shares Outstanding
FalconStor Software, Inc., 2016 Incentive Stock Plan
 
—
 
3,850
FalconStor Software, Inc., 2006 Incentive Stock Plan
 
—
 
7,685
 
Related to the 2016 Plan, many share-based compensation awards were forfeited and the related expense reversed, resulting in negative expense for the six months ended June 30, 2018. The following table summarizes the share-based compensation expense for all awards issued under the Company’s stock equity plans in the following line items in the condensed consolidated statements of operations for the three and nine months ended September 30, 2019 and 2018:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Cost of revenue - support and service
 
104

 
6,314

 
2,146

 
19,889

Research and development costs
 
371

 
17,883

 
5,977

 
59,233

Selling and marketing
 
186

 
3,579

 
3,844

 
16,036

General and administrative
 
2,439

 
1,248

 
16,615

 
(59,510
)
 
 
$
3,100

 
$
29,024

 
$
28,582

 
$
35,648


(8) Income Taxes
 
The Company’s provision for income taxes consists principally of state and local, and foreign taxes, as applicable, in amounts necessary to align the Company’s year-to-date tax provision with the effective rate that it expects to achieve for the full year.

For the nine months ended September 30, 2019, the Company recorded an income tax provision of $168,556. The effective tax rate for the nine months ended September 30, 2019 was (10.0%). The effective tax rate differs from the statutory rate of 21% due to the mix of foreign and domestic earnings as no tax expense or benefit is being recognized on domestic earnings or losses. As of September 30, 2019, the Company’s conclusion did not change with respect to the realizability of its domestic deferred tax assets and therefore, the Company has not recorded any income tax benefit as such amounts are fully offset with a valuation allowance.


16


For the nine months ended September 30, 2018, the Company recorded an income tax provision of $(33,868). The effective tax rate for the nine months ended September 30, 2018 was 3.9%. The effective tax rate differs from the statutory rate of 21% due to the mix of foreign and domestic earnings as no tax expense or benefit is being recognized on domestic earnings or losses. As of September 30, 2018, the Company’s conclusion did not change with respect to the realizability of its domestic deferred tax assets and therefore, the Company has not recorded any income tax expense as such amounts are fully offset with a valuation allowance.

The Company’s total unrecognized tax benefits, excluding interest, at September 30, 2019 and December 31, 2018 were $87,039 and $134,246, respectively. As of September 30, 2019 and December 31, 2018, the Company had $32,447 and $57,860, respectively, of accrued interest reflected in accrued expenses. The Company recognized approximately $80,000 of tax benefits during the quarter due to expiring statute of limitations, which impacted the Company's effective tax rate.

    
(9) Notes Payable and Stock Warrants

The notes payable balance consists of the following:

Notes payable principal balance
$
3,000,000

Deferred issuance costs
(254,247
)
Discount
(288,504
)
Total notes payable, net at inception on February 23, 2018
2,457,249

Proceeds from issuance of long-term debt
1,000,000

Revaluation of long-term debt
(447,008
)
Accretion of discount
202,195

Deferred issuance costs
(87,609
)
Total notes payable, net at December 31, 2018
$
3,124,827

Repayment of long-term debt
(489,321
)
Accretion of discount
217,336

Total notes payable, net at September 30, 2019
$
2,852,842


The notes bear interest at prime plus 0.75% and mature on June 30, 2021. As of September 30, 2019, the Company was in compliance with the financial covenants contained in the Amended and Restated Term Loan Credit Agreement.

(10) Fair Value Measurements
 
The Company measures its cash equivalents and derivative instruments at fair value. Fair value is an exit price, representing the amount that would be received on the sale of an asset or that would be paid to transfer a liability in an orderly transaction between market participants. As a basis for considering such assumptions, the Company utilizes a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value.
 
The methodology for measuring fair value specifies a hierarchy of valuation techniques based upon whether the inputs to those valuation techniques reflect assumptions other market participants would use based upon market data obtained from independent sources (observable inputs) or reflect the Company’s own assumptions of market participant valuation (unobservable inputs). As a result, observable and unobservable inputs have created the following fair value hierarchy:
 
•
Level 1 – Quoted prices in active markets that are unadjusted and accessible at the measurement date for identical, unrestricted assets or liabilities. At September 30, 2019, the Company did not have any Level 1 category assets included in the condensed consolidated balance sheets.

•
Level 2 – Quoted prices for identical assets and liabilities in markets that are not active, quoted prices for similar assets and liabilities in active markets or financial instruments for which significant inputs are observable, either directly or indirectly. At September 30, 2019 and December 31, 2018, the Company did not have any Level 2 category assets included in the condensed consolidated balance sheets.


17


•
Level 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable. At September 30, 2019 and December 31, 2018, the Level 3 category included derivatives, which are included within other long-term liabilities in the condensed consolidated balance sheets. The Company did not hold any cash and cash equivalents categorized as Level 3 as of September 30, 2019 or December 31, 2018.

The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at September 30, 2019:
 
 
 
 
Fair Value Measurements at Reporting Date Using
 
 
Total
 
Quoted Prices in Active Markets for Identical Assets
(Level 1)
 
Significant other Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
Derivative liabilities:
 
 

 
 

 
 

 
 

Derivative Instruments
 
486,623

 
—

 
—

 
486,623

Total derivative liabilities
 
486,623

 
—

 
—

 
486,623

 
 
 
 
 
 
 
 
 
Total assets and liabilities measured at fair value
 
$
486,623

 
$
—

 
$
—

 
$
486,623


The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at December 31, 2018: 
 
 
 
 
Fair Value Measurements at Reporting Date Using
 
 
Total
 
Quoted Prices in Active Markets for Identical Assets
(Level 1)
 
Significant other Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
Derivative liabilities:
 
 
 
 
 
 
 
 
Derivative Instruments
 
498,086

 
—

 
—

 
498,086

Total derivative liabilities
 
498,086

 
—

 
—

 
498,086

 
 
 
 
 
 
 
 
 
Total assets and liabilities measured at fair value
 
$
498,086

 
$
—

 
$
—

 
$
498,086

 
The fair value of the Company’s derivatives were valued using the Black-Scholes pricing model adjusted for probability assumptions, with all significant inputs, except for the probability and volatility assumptions, derived from or corroborated by observable market data such as stock price and interest rates. The probability and volatility assumptions are both significant to the fair value measurement and unobservable. These embedded derivatives are included in Level 3 of the fair value hierarchy.

The fair value of the Company's Series A Preferred Stock is based on its future cash flows discounted at a 15% yield. The fair value of the Company's note payable is based on its future cash flows discounted at 12%. The fair value of the Company's previously outstanding warrants to purchase approximately 422 million shares of the Company's common stock, was based on the enterprise value of the Company calculated by a third party appraiser less the preferred stock and preferred stock accrued dividends that have a preference over common shares. These warrants were then valued based on a Black Scholes value using volatility of 60% and resulted in a fair value of approximately $0.01 per share (on a pre reverse stock split basis).

The following table presents a reconciliation of the beginning and ending balances of the Company's liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2019 and September 30, 2018:

18


 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Beginning Balance
 
$
489,489

 
$
482,871

 
$
498,086

 
$
445,838

Total income (loss) recognized in earnings
 
(2,866
)
 
15,215

 
(11,463
)
 
52,248

Ending Balance
 
$
486,623

 
$
498,086

 
$
486,623

 
$
498,086


(11) Commitments and Contingencies
 
The Company’s headquarters are located in Austin, Texas.  The Company has an operating lease covering its Melville, N.Y. office facility that expires in April 2021. The Company has sublet a portion of this lease. The Company also has several additional operating leases related to offices in foreign countries. The expiration dates for these leases range from 2020 through 2021. The following is a schedule of future minimum lease payments as well as sublease income for all operating leases as of September 30, 2019:
 
Payments
Sublease Income
Net Commitments
2019
$
438,074

$
(155,944
)
$
282,130

2020
1,714,436

(623,776
)
1,090,660

2021
639,526

(207,925
)
431,601

2022
—

—

—

Thereafter
—

—

—

 
$
2,792,036

$
(987,645
)
$
1,804,391



The Company typically provides its customers a warranty on its software products for a period of no more than 90 days. Such warranties are accounted for in accordance with the authoritative guidance issued by the FASB on contingencies. For the three and nine months ended September 30, 2019, the Company has not incurred any costs related to warranty obligations.
 
Under the terms of substantially all of its software license agreements, the Company indemnifies its customers for all costs and damages arising from claims against such customers based on, among other things, allegations that the Company’s software infringes on the intellectual property rights of a third party. In most cases, in the event of an infringement claim, the Company retains the right to (i) procure for the customer the right to continue using the software; (ii) replace or modify the software to eliminate the infringement while providing substantially equivalent functionality; or (iii) if neither (i) nor (ii) can be reasonably achieved, the Company may terminate the license agreement and refund to the customer a pro-rata portion of the license fee paid to the Company. Such indemnification provisions are accounted for in accordance with the authoritative guidance issued by the FASB on guarantees. From time to time, in the ordinary course of business, the Company receives claims for indemnification, typically from OEMs. The Company is not currently aware of any material claims for indemnification.
 
As described under Note 12, the holders of the Series A Preferred Stock have redemption rights upon certain triggering events. As of September 30, 2019, the Company did not fail any non-financial covenants related to the Company's Series A Preferred Stock.

In connection with the appointment of Todd Brooks as Chief Executive Officer, the Board approved an offer letter to Mr. Brooks (the “Brooks Agreement”), which was executed on August 14, 2017. The Brooks Offer Letter provides that Mr. Brooks is entitled to receive an annualized base salary of $350,000, payable in regular installments in accordance with the Company’s general payroll practices. Mr. Brooks will also be eligible for a cash bonus of $17,500 for any quarter that is free cash flow positive on an operating basis and additional incentive compensation of an annual bonus of up to $200,000, subject to attainment of performance objectives to be mutually agreed upon and established. Pursuant to the Brooks Agreement and the 2018 Plan, Mr. Brooks received 735,973 shares of restricted stock. If Mr. Brooks’ employment is terminated by the Company other than for cause he is entitled to receive severance equal to twelve (12) months of his base salary if (i) he has been employed by the Company for at least twelve (12) months at the time of termination or (ii) a change of control has occurred within six (6) months of Mr. Brooks’ employment. Except as set forth in the preceding sentence, Mr. Brooks is entitled to receive severance equal to six (6) months of his base salary if he has been employed by the Company for less than six (6) months and his employment was terminated by the Company without cause. Mr. Brooks is also entitled to vacation and other employee benefits in accordance with the Company’s policies as well as reimbursement for an apartment.


19


In connection with the appointment of Brad Wolfe as the Company's Chief Financial Officer, the Board approved an offer letter to Mr. Wolfe (the “Wolfe Offer Letter”), which was executed on April 4, 2018. The Wolfe Offer Letter provides that Mr. Wolfe is entitled to receive an annualized base salary of $240,000, payable in regular installments in accordance with the Company’s general payroll practices. Mr. Wolfe will also be eligible for a cash bonus of $10,000 for any quarter which has net working capital cash in excess of $27,500 and additional incentive compensation of an annual bonus of up to $70,000, subject to attainment of performance objectives to be mutually agreed upon and established.

As described under Note 17, the Company has incurred certain restructuring costs in connection with restructuring plans adopted in 2013, 2017 and 2019.

In addition, as of September 30, 2019, the Company's liability for uncertain tax positions totaled $119,486. At this time, the settlement period for this liability, including related accrued interest, cannot be determined.
 
(12) Series A Redeemable Convertible Preferred Stock
 
The Company has 900,000 shares of Series A Preferred Stock outstanding. Pursuant to the Amended and Restated  Certificate of Designations, Preferences and Rights  for the Series A Preferred Stock (the ”Certificate of Designations”), each share of Series A Preferred Stock can be converted into shares of the Company’s Common Stock, at current conversion price of $102.488 per share, subject to appropriate adjustments for any stock dividend, stock split, stock combination, reclassification or similar transaction, (i) at any time at the option of the holder or (ii) by the Company if, following the first anniversary of the issuance of the Series A Preferred Stock (subject to extension under certain circumstances), the volume weighted average trading price per share of the Company’s Common Stock for sixty (60) consecutive trading days exceeds 250% of the conversion price and continues to exceed 225% of the conversion price through the conversion date, subject at all times to the satisfaction of, and the limitations imposed by, the equity conditions set forth in the Certificate of Designations (including, without limitation, the volume limitations set forth therein).
Pursuant to the Certificate of Designations, the holders of the Series A Preferred Stock are entitled to receive quarterly dividends at the prime rate (provided in the Wall Street Journal Eastern Edition) plus 5% (up to a maximum dividend rate of 10%), payable in cash or in kind (i.e., through the issuance of additional shares of Series A Preferred Stock), except that the Company is not permitted to pay such dividends in cash while any indebtedness under the Company’s Amended and Restated Loan Agreement remains outstanding without the consent of the holders of the Series A Preferred Stock. In addition, the declaration and payment of dividends is subject to compliance with applicable law and unpaid dividends will accrue. A holder’s right to convert its shares of Series A Preferred Stock and receive dividends in the form of Common Stock is subject to certain limitations including, among other things, that the shares of Common Stock issuable upon conversion or as dividends will not, prior to receipt of stockholder approval, result in any holder beneficially owning greater than 19.99% of the Company’s currently outstanding shares of Common Stock.
The Series A Preferred stock dividends shall accrue whether or not the declaration or payment of such Series A Preferred Stock dividends are prohibited by applicable law, whether or not the Company has earnings, whether or not there are funds legally available for the payment of such dividends and whether or not such dividends are authorized or declared.
Upon certain triggering events, such as bankruptcy, insolvency or a material adverse effect or failure of the Company to issue shares of Common Stock upon conversion of the Series A Preferred Stock in accordance with its obligations, the holders may require the Company to redeem all or some of the Series A Preferred Stock at a price per share equal to the greater of (i) the sum of 100% of the stated value of a share of Series A Preferred Stock plus accrued and unpaid dividends with respect thereto, and (ii) the product of the number of shares of Common Stock underlying a share of Series A Preferred Stock and the closing price as of the occurrence of the triggering event. On or after July 30, 2021, each holder of Series A Preferred Stock can also require the Company to redeem its Series A Preferred Stock in cash at a per share price equal to 100% of the stated value of a share of Series A Preferred Stock plus accrued and unpaid dividends with respect thereto. Notwithstanding the forgoing, no holder of Series A Preferred Stock is permitted to exercise any rights or remedies upon a Breach Event or to exercise any redemption rights under the Certificate of Designations, unless approved by the holders of a majority of the then outstanding shares of Series A Preferred Stock.
Upon consummation of a fundamental sale transaction, the Series A Preferred Stock shall be redeemed at a per share redemption price equal to the greater of (y) 250% of the per share purchase price of the Series A Preferred Stock and (z) the price payable in respect of such share of Series A Preferred Stock if such share of Series A Preferred Stock had been converted into such number of shares of Common Stock in accordance with the Certificate of Designations (but without giving effect to any limitations or restrictions contained therein) immediately prior to such fundamental sale transaction;  provided however that the 250% threshold is changed to 100% if the fundamental sale transaction is approved by the two Series A Directors (as defined in the Certificate of

20


Designations). In addition, if the Company consummates an equity or debt financing that results in more than $5.0 million of net proceeds to the Company and/or its subsidiaries, the holders of Series A Preferred Stock will have the right, but not the obligation, to require the Company to use the net proceeds in excess of $5.0 million to repurchase all or a portion of the Series A Preferred Stock at a per share price equal to the greater of (i) the sum of 100% of the stated value of such share of Series A Preferred Stock plus accrued and unpaid dividends with respect thereto, and (ii) the number of shares of Common Stock into which such share of Series A Preferred Stock is then convertible multiplied by the greater of (y) the closing price of the Common Stock on the date of announcement of such financing or (z) the closing price of the Common Stock on the date of consummation of such financing.
Each holder of Series A Preferred Stock has a vote equal to the number of shares of Common Stock into which its Series A Preferred Stock would be convertible as of the record date. In addition, the holders of a majority of the Series A Preferred Stock must approve certain actions, including approving any amendments to the Company’s Restated Certificate of Incorporation as amended or Amended and Restated Bylaws that adversely affects the voting powers, preferences or other rights of the Series A Preferred Stock; payment of dividends or distributions; any liquidation, capitalization, reorganization or any other fundamental transaction of the Company; issuance of any equity security senior to or on parity with the Series A Preferred Stock as to dividend rights, redemption rights, liquidation preference and other rights; issuances of equity below the conversion price; any liens or borrowings other than non-convertible indebtedness from standard commercial lenders which does not exceed 80% of the Company’s accounts receivable; and the redemption or purchase of any of the capital stock of the Company.
 The Company has classified the Series A Preferred Stock as temporary equity in the financial statements as it is subject to redemption at the option of the holder under certain circumstances. As a result of the Company’s analysis of all the embedded conversion and put features within the Series A Preferred Stock, the contingent redemption put options in the Series A Preferred Stock were determined to not be clearly and closely related to the debt-type host and also did not meet any other scope exceptions for derivative accounting. Therefore, the contingent redemption put options are being accounted for as derivative instruments and the fair value of these derivative instruments was bifurcated from the Series A Preferred Stock and recorded as a liability. 

As of September 30, 2019 and December 31, 2018, the fair value of these derivative instruments was $486,623 and $498,086, respectively, and were included in "other long-term liabilities" within the consolidated balance sheets. The loss on the change in fair value of these derivative instruments for the nine months ended September 30, 2019 and September 30, 2018 of $(11,463) and $52,248, respectively, were included in “interest and other loss, net” within the consolidated statement of operations.

The fair value of these derivative instruments and the loss recorded on the change in the fair value of these derivative instruments, which was included in “Interest and other income, net” within the condensed consolidated statement of operations, for the three and nine months ended September 30, 2019 and 2018, were as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Beginning Balance
 
$
489,489

 
$
482,871

 
$
498,086

 
$
445,838

Total income (loss) recognized in earnings
 
(2,866
)
 
15,215

 
(11,463
)
 
52,248

Ending Balance
 
$
486,623

 
$
498,086

 
$
486,623

 
$
498,086



21


At the time of issuance, the Company recorded transaction costs, a beneficial conversion feature and the fair value allocated to the embedded derivatives as discounts to the Series A Preferred Stock. These costs were being accreted to the Series A Preferred Stock using the effective interest method through the stated redemption date of August 5, 2017, which represents the earliest redemption date of the instrument. This accretion was accelerated as of December 31, 2016 due to the failure of the financial covenants and the redemption right of the holders at that time. Hale Capital, which was the sole holder of the Series A Preferred Stock agreed to the Series A mandatory extension of the mandatory redemption right and waived prior breaches of the terms of the Series A Preferred Stock. The Company included deductions for accretion, deemed and accrued dividends on the Series A Preferred Stock as adjustments to net loss attributable to common stockholders on the statement of operations and in determining loss per share for the three and nine months ended September 30, 2019 and 2018, respectively. The following represents a reconciliation of net loss attributable to common stockholders for the three and nine months ended September 30, 2019 and 2018, respectively:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Net loss
 
$
(556,914
)
 
$
(332,429
)
 
$
(1,853,544
)
 
$
(829,656
)
Effects of Series A redeemable convertible preferred stock:
 
 

 
 

 
 

 
 

Less: Accrual of Series A redeemable convertible preferred stock dividends
 
266,447

 
229,022

 
770,027

 
687,152

Less: Deemed dividend on Series A redeemable convertible preferred stock
 
—

 
—

 
—

 
2,269,042

Less: Accretion to redemption value of Series A redeemable convertible preferred stock
 
139,399

 
124,993

 
402,861

 
240,743

Net loss attributable to common stockholders
 
$
(962,760
)
 
$
(686,444
)
 
$
(3,026,432
)
 
$
(4,026,593
)

The Series A Preferred Stock consists of the following:

Series A redeemable convertible preferred stock principal balance
$
9,000,000

Accrued dividends
1,312,112

Discount
(1,602,428
)
Total Series A redeemable convertible preferred stock, net at inception on February 23, 2018
8,709,684

Accrued dividends
683,742

Accretion of preferred stock
363,280

Total Series A redeemable convertible preferred stock, net at December 31, 2018
$
9,756,706

Accrued dividends
770,027

Accretion of preferred stock
402,861

Total Series A redeemable convertible preferred stock, net at September 30, 2019
$
10,929,594



22


(13) Accumulated Other Comprehensive Loss

The changes in Accumulated Other Comprehensive Loss, net of tax, for the three months ended September 30, 2019 are as follows:

 
 
Foreign Currency
Translation
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive income (loss) at June 30, 2019
 
$
(1,951,923
)
 
$
26,803

 
$
(1,925,120
)
Other comprehensive income (loss)
 
 

 
 

 
 

Other comprehensive loss before reclassifications
 
(131,497
)
 
—

 
(131,497
)
Total other comprehensive loss
 
(131,497
)
 
—

 
(131,497
)
Accumulated other comprehensive income (loss) at September 30, 2019
 
$
(2,083,420
)
 
$
26,803

 
$
(2,056,617
)


The changes in Accumulated Other Comprehensive Loss, net of tax, for the three months ended September 30, 2018 are as follows:

 
 
Foreign Currency
Translation
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive income (loss) at June 30, 2018
 
$
(1,936,229
)
 
$
22,097

 
$
(1,914,132
)
Other comprehensive income (loss)
 
 

 
 

 
 

Other comprehensive income before reclassifications
 
70,061

 
—

 
70,061

Total other comprehensive income
 
70,061

 
—

 
70,061

Accumulated other comprehensive income (loss) at September 30, 2018
 
$
(1,866,168
)
 
$
22,097

 
$
(1,844,071
)
 
The changes in Accumulated Other Comprehensive Loss, net of tax, for the nine months ended September 30, 2019 are as follows:

 
 
Foreign Currency
Translation
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive income (loss) at December 31, 2018
 
$
(1,921,905
)
 
$
26,803

 
$
(1,895,102
)
Other comprehensive income (loss)
 
 

 
 

 
 

Other comprehensive loss before reclassifications
 
(161,515
)
 
—

 
(161,515
)
Total other comprehensive loss
 
(161,515
)
 
—

 
(161,515
)
Accumulated other comprehensive income (loss) at September 30, 2019
 
$
(2,083,420
)
 
$
26,803

 
$
(2,056,617
)

The changes in Accumulated Other Comprehensive Loss, net of tax, for the nine months ended September 30, 2018 are as follows:


23


 
 
Foreign Currency
Translation
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive income (loss) at December 31, 2017
 
$
(1,980,940
)
 
$
22,097

 
$
(1,958,843
)
Other comprehensive income (loss)
 
 

 
 

 
 

Other comprehensive income before reclassifications
 
114,772

 
—

 
114,772

Total other comprehensive income (loss)
 
114,772

 
—

 
114,772

Accumulated other comprehensive income (loss) at September 30, 2018
 
$
(1,866,168
)
 
$
22,097

 
$
(1,844,071
)

 
(14) Stockholders' Equity

Amendments to Articles of Incorporation

On August 8, 2019, following stockholder approval, the Company filed a certificate of amendment to the Company’s Restated Certificate of Incorporation, as amended, with the Delaware Secretary of State to reduce the authorized shares of common stock, $.001 par value per share, to 30,000,000. In connection with this event, the Company effected a 100-for-1 reverse stock split of its issued and outstanding common stock. The par value of common stock was not adjusted as a result of the reverse stock split. Unless otherwise indicated, all of the share and per share information presented in the accompanying financial statements have been adjusted to reflect the reverse common stock split on a retroactive basis for all periods and as of all dates presented.

Stock Repurchase Activity
  
During the three and nine months ended September 30, 2019 and 2018, the Company did not repurchase any shares of its common stock. As of September 30, 2019, the Company had the authorization under previous Board approved stock repurchase plans to repurchase 4,907,839 shares of its common stock based upon its judgment and market conditions.

(15)  Litigation
 
In view of the inherent difficulty of predicting the outcome of litigation, particularly where the claimants seek very large or indeterminate damages, the Company generally cannot predict what the eventual outcome of the pending matters will be, what the timing of the ultimate resolution of these matters will be, or what the eventual loss, fines or penalties related to each pending matter may be.
 
In accordance with the authoritative guidance issued by the FASB on contingencies, the Company accrues anticipated costs of settlement, damages and losses for claims to the extent specific losses are probable and estimable. The Company records a receivable for insurance recoveries when such amounts are probable and collectable. In such cases, there may be an exposure to loss in excess of any amounts accrued. If, at the time of evaluation, the loss contingency related to a litigation is not both probable and estimable, the matter will continue to be monitored for further developments that would make such loss contingency both probable and estimable and, the Company will expense these costs as incurred. If the estimate of a probable loss is a range and no amount within the range is more likely, the Company will accrue the minimum amount of the range.

The Company is subject to various legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. While the outcome of any such matters cannot be predicted with certainty, such matters are not expected to have a material adverse effect on the Company’s financial condition or operating results.
 
(16) Segment Reporting and Concentrations
 
The Company is organized in a single operating segment for purposes of making operating decisions and assessing performance. Revenue from the United States to customers in the following geographical areas for the three and nine months ended September 30, 2019 and 2018, and the location of long-lived assets as of September 30, 2019 and December 31, 2018, are summarized as follows:

24


 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,

 
2019
 
2018
 
2019
 
2018
Revenue:
 
 
 
 
 
 
 
 
Americas
 
$
600,590

 
$
1,585,465

 
$
3,098,395

 
$
3,648,360

Asia Pacific
 
1,662,689

 
961,632

 
3,930,077

 
4,541,966

Europe, Middle East, Africa and Other
 
1,709,166

 
1,513,064

 
5,436,340

 
4,875,365

Total Revenue
 
$
3,972,445

 
$
4,060,161

 
$
12,464,812

 
$
13,065,691

 
 
 
September 30, 2019
 
December 31, 2018
Long-lived assets:
 
 
 
 
Americas
 
$
7,347,558

 
$
5,852,995

Asia Pacific
 
988,037

 
736,970

Europe, Middle East, Africa and Other
 
142,771

 
155,708

Total long-lived assets
 
$
8,478,366

 
$
6,745,673

 
For the three and nine months ended September 30, 2019, the Company had one and two customers that accounted for 10% or more of total revenue, respectively. For the three and nine months ended September 30, 2018, the Company had one customer that accounted for 10% of total revenue.

As of September 30, 2019, the Company had three customers that accounted for 10% or more of the gross accounts receivable balance. As of December 31, 2018, the Company had one customer that accounted for 10% or more of the gross accounts receivable balance.

(17) Restructuring Costs
 
In the third quarter of 2013, the Company adopted a plan to better align the Company’s cost structure with the skills and resources required to more effectively execute the Company’s long-term growth strategy and to support revenue levels the Company expected to achieve on a go forward basis (the "2013 Plan").  In connection with the 2013 Plan, the Company eliminated over 100 positions worldwide, implemented tighter expense controls, ceased non-core activities and closed or downsized several facilities. The 2013 Plan was substantially completed by December 31, 2014; however, we expect the majority of the remaining severance related costs to be paid once final settlement litigation is completed, which can be at various times over the next twelve months.

In June 2017, the Board approved a comprehensive plan to increase operating performance (the “2017 Plan”). The 2017 Plan resulted in a realignment and reduction in workforce. The 2017 Plan was substantially completed by the end of the Company’s fiscal year ended December 31, 2017, and when combined with previous workforce reductions in the second quarter of Fiscal 2017 reduced the Company’s workforce to approximately 86 employees at December 31, 2018. In connection with the 2017 Plan, the Company incurred severance expense of $1.2 million for the fiscal year ended December 31, 2017. In making these changes, the Company prioritized customer support and development while consolidating operations and streamlining direct sales resources, allowing the Company to focus on the install base and develop alternate channels to the market. As part of this consolidation effort the Company vacated a portion of the Mellville, NY office space during the three months ended June 30, 2018. In accordance with accounting standards governing costs associated with exit or disposal activities, expenses related to future rental payments for which the Company no longer intends to receive any economic benefit are accrued, net of any anticipated sublease income, when the Company ceases use of the leased space. During the nine months ended September 30, 2019, the Company incurred lease disposal-related costs for this property of $0.5 million.

In the third quarter of 2019, the Company adopted a plan to better align the Company’s cost structure with the skills and resources required to more effectively execute the Company’s long-term growth strategy and to support revenue levels the Company expected to achieve on a go forward basis (the "2019 Plan"). In connection with the 2019 Plan, the Company eliminated 23 positions worldwide, implemented tighter expense controls, ceased non-core activities and downsized several facilities. During the three months ended September 30, 2019, the Company incurred $0.2 million in severance expense as a result of this action. The 2019 Plan is anticipated to be substantially completed by December 31, 2019.


25


The following table summarizes the activity during 2018 and 2019 related to restructuring liabilities recorded in connection with the 2013, 2017 and 2019 Plans:
 
 
Severance Related Costs
 
Facility and Other Costs
 
Total
Balance at December 31, 2017
 
$
648,399

 
$
—

 
$
648,399

Additions (Reductions)
 
(173,263
)
 
—

 
(173,263
)
Utilized/Paid
 
(13,774
)
 
—

 
(13,774
)
Balance at March 31, 2018
 
$
461,362

 
$
—

 
$
461,362

Additions (Reductions)
 
—

 
809,245

 
809,245

Utilized/Paid
 
—

 
(312,507
)
 
(312,507
)
Balance at June 30, 2018
 
$
461,362

 
$
496,738

 
$
958,100

Additions (Reductions)
 
—

 
315,283

 
315,283

Utilized/Paid
 
—

 
(331,405
)
 
(331,405
)
Balance at September 30, 2018
 
$
461,362

 
$
480,616

 
$
941,978

Additions (Reductions)
 
—

 
310,314

 
310,314

Utilized/Paid
 
—

 
(337,484
)
 
(337,484
)
Balance at December 31, 2018
 
$
461,362

 
$
453,446

 
$
914,808

Additions (Reductions)
 
—

 
157,693

 
157,693

Utilized/Paid
 
—

 
(187,833
)
 
(187,833
)
Balance at March 31, 2019
 
$
461,362

 
$
423,306

 
$
884,668

Additions (Reductions)
 
—

 
202,679

 
202,679

Utilized/Paid
 
—

 
(238,090
)
 
(238,090
)
Balance at June 30, 2019
 
$
461,362

 
$
387,895

 
$
849,257

Additions (Reductions)
 
214,050

 
170,779

 
384,829

Utilized/Paid
 
(214,050
)
 
(257,453
)
 
(471,503
)
Balance at September 30, 2019
 
$
461,362

 
$
301,221

 
$
762,583


The severance and facility related liabilities are included within “accrued expenses” in the accompanying condensed consolidated balance sheets. The expenses under the 2013, 2017 and 2019 Plans are included within “restructuring costs” in the accompanying condensed consolidated statements of operations.


26


Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  These forward-looking statements can be identified by the use of predictive, future-tense or forward-looking terminology, such as “believes,” “anticipates,” “expects,” “estimates,” “plans,” “may,” “intends,” “will,” or similar terms.  Investors are cautioned that any forward-looking statements are not guarantees of future performance and involve significant risks and uncertainties, and that actual results may differ materially from those projected in the forward-looking statements. The following discussion should be read together with the consolidated financial statements and notes to those financial statements included elsewhere in this report.
 
On August 6, 2019, following stockholder approval, the Company filed a certificate of amendment (which was effective August 8, 2019) to the Company’s Restated Certificate of Incorporation, as amended, with the Delaware Secretary of State to reduce the authorized shares of common stock, $.001 par value per share, to 30,000,000. In connection with this event, the Company effected a 100-for-1 reverse stock split of its issued and outstanding common stock. The par value of common stock was not adjusted as a result of the reverse stock split. Unless otherwise indicated, all of the share and per share information presented in the accompanying financial statements have been adjusted to reflect the reverse common stock split on a retroactive basis for all periods and as of all dates presented.

OVERVIEW

We closed the three months ended September 30, 2019 with $3.2 million in billings, as compared to $2.9 million for the same period of the previous year. This 11% growth in billings, year over year, was driven by record sales in the Americas, where billings increased 40% as compared to the prior year. On a product specific basis, this growth also reflects progress with Virtual Tape Library (VTL), where Q3 billings grew by 65%, as compared to the previous year. Our software solutions play a key role in efficiently managing and protecting critical data for businesses around the world, and we are pleased with our recent sales success in key strategic markets, such as the Americas. Given our improved financial stability in the wake of our financing in 2018, our focus for the final stretch of the year will be to enhance our efficiency, seize upon strategic growth and foster continued product innovation.

During the three months ended September 30, 2019, we recorded a net loss of $0.6 million, as compared with a net loss of $0.3 million for the same period of the previous year. Despite our growth in sales, our results were constrained by product mix, as a result of higher than anticipated hardware and appliance sales during the current period, which yield significantly less profit margins, as compared to our key proprietary software license offerings. Our results also include $0.2 million of severance expense incurred in connection with our 2019 restructuring plan.

Deferred revenue as of September 30, 2019 totaled $8.2 million, compared with $9.4 million as of December 31, 2018.

During the three months ended September 30, 2019 we recognized revenue of $4.0 million, as compared with $4.1 million in the prior year period. Revenue recognition on sales is driven by several factors. First, the volume of new product licenses and maintenance sales, both for expansion of our existing installed base and the acquisition of new customers. Second, customer retention, which sustains maintenance renewal revenue over long term sales arrangements.
Total cost of revenue for the three months ended September 30, 2019 increased 9% to $0.8 million, compared with $0.7 million in the prior year period. Total gross profit decreased $0.2 million, or 5%, to $3.2 million for the three months ended September 30, 2019, compared with $3.4 million for the prior year period. Total gross margin decreased to 81% for the three months ended September 30, 2019, compared with 83% for the prior year period. The decrease in our total gross margin, and total gross profit in absolute dollars, was primarily due to a decline in revenue, and product mix, as a result of higher than anticipated hardware and appliance sales during the current period, which yield significant less profit margins, as compared to our key proprietary software license offerings. Generally, our total gross profits and total gross margins fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales.
Overall, our total operating expenses for the three months ended September 30, 2019 increased $0.1 million, or 3%, to $3.7 million, as compared to $3.6 million for the same period of the previous year.


27


RESULTS OF OPERATIONS – FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2019 COMPARED WITH THE THREE MONTHS ENDED SEPTEMBER 30, 2018.
 
The following table presents revenue and expense line items reported in our Consolidated Statements of Operations and their corresponding percentage of total revenue for the three months ended September 30, 2019 and 2018 and the period-over-period dollar and percentage changes for those line items. Our results of operations are reported as one business segment, represented by our single operating segment.
 
Three Months Ended September 30,
 
 Change
Period to Period
  
2019
 
2018
 
Revenue:
  
 
 
 
  
 
 
 
 
 
 
Product revenue
$
1,663,782

 
42
 %
 
$
1,007,915

 
25
 %
 
$
655,867

 
65
 %
Support and services revenue
2,308,663

 
58
 %
 
3,052,246

 
75
 %
 
(743,583
)
 
(24
)%
Total revenue
3,972,445

 
100
 %
 
4,060,161

 
100
 %
 
(87,716
)
 
(2
)%
Cost of revenue:
  

 
 
 
 

 
 
 
 
 
 
Product
241,134

 
6
 %
 
62,742

 
2
 %
 
178,392

 
284
 %
Support and service
531,709

 
13
 %
 
645,700

 
16
 %
 
(113,991
)
 
(18
)%
Total cost of revenue
772,843

 
19
 %
 
708,442

 
17
 %
 
64,401

 
9
 %
Gross profit
3,199,602

 
81
 %
 
3,351,719

 
83
 %
 
(152,117
)
 
(5
)%
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Research and development costs
782,161

 
20
 %
 
1,065,031

 
26
 %
 
(282,870
)
 
(27
)%
Selling and marketing
1,067,436

 
27
 %
 
1,144,271

 
28
 %
 
(76,835
)
 
(7
)%
General and administrative
1,454,103

 
37
 %
 
1,068,754

 
26
 %
 
385,349

 
36
 %
Restructuring costs
384,829

 
10
 %
 
315,283

 
8
 %
 
69,546

 
22
 %
Total operating expenses
3,688,529

 
93
 %
 
3,593,339

 
89
 %
 
95,190

 
3
 %
Operating loss
(488,927
)
 
(12
)%
 
(241,620
)
 
(6
)%
 
(247,307
)
 
102
 %
Interest and other loss
(123,261
)
 
(3
)%
 
(187,667
)
 
(5
)%
 
64,406

 
(34
)%
Loss before income taxes
(612,188
)
 
(15
)%
 
(429,287
)
 
(11
)%
 
(182,901
)
 
43
 %
Income tax benefit
(55,274
)
 
(1
)%
 
(96,858
)
 
(2
)%
 
41,584

 
(43
)%
Net loss
$
(556,914
)
 
(14
)%
 
$
(332,429
)
 
(8
)%
 
$
(224,485
)
 
68
 %
Less: Accrual of Series A redeemable convertible preferred stock dividends
266,447

 
7
 %
 
229,022

 
6
 %
 
37,425

 
16
 %
Less: Deemed dividend on Series A redeemable convertible preferred stock
—

 
—
 %
 
—

 
—
 %
 
—

 
—
 %
Less: Accretion to redemption value of Series A redeemable convertible preferred stock
139,399

 
4
 %
 
124,993

 
3
 %
 
14,406

 
12
 %
Net loss attributable to common stockholders
$
(962,760
)
 
(24
)%
 
$
(686,444
)
 
(17
)%
 
$
(276,316
)
 
40
 %

 Revenue

Our primary sales focus is on selling software solutions and platforms which includes stand-alone software applications, software integrated with industry standard hardware and sold as one complete integrated solution or sold on a subscription or consumption basis. As a result, our revenue is classified as either: (i) product revenue, or (ii) support and services revenue. During the three months ended September 30, 2019, we recognized revenue of $4.0 million, compared with $4.1 million in the prior year period.

Product revenue
 
Product revenue is comprised of sales of both licenses for our software solutions and sales of the platforms on which the software is installed. This includes stand-alone software applications and software integrated with industry standard hardware, sold as one complete integrated solution or sold on a subscription or consumption basis. Our products are sold through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users. These revenues are recognized when all the applicable criteria under accounting principles generally accepted in the United States are met.


28


For the three months ended September 30, 2019 and 2018, product revenue represented 42% and 25% of our total revenue, respectively. Product revenue of $1.7 million for the three months ended September 30, 2019 increased $0.7 million, or 65% from $1.0 million in the prior year period.

We continue to invest in our product portfolio by refreshing our existing product lines and developing our next generation of innovative product offerings to drive our sales volume in support of our long-term outlook.

Support and services revenue

Support and services revenue is comprised of revenue from (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) engineering services. Revenue derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Engineering services are recognized upon customer acceptance. 

Maintenance and technical support services revenue for the three months ended September 30, 2019 decreased to $2.3 million, as compared to $3.0 million in the prior year period. Our maintenance and technical support service revenue results primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. The decrease in revenue over the previous year reflects a decline in maintenance renewal revenue, as a result of customer attrition, a smaller volume of new customers, and a decline in new product license and maintenance sales.
 
Professional services revenue for the three months ended September 30, 2019 decreased to $0.0 million, as compared to $0.1 million for the prior year period. Professional services revenue can vary from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, (iii) the number of professional services contracts that are performed during the period, and (iv) the number of customers who elect to purchase engineering services.

Cost of Revenue, Gross Profit and Gross Margin

Total cost of revenue for the three months ended September 30, 2019 increased 9% to $0.8 million, compared with $0.7 million in the prior year period. Total gross profit decreased $0.2 million, or 5%, to $3.2 million for the three months ended September 30, 2019, compared with $3.4 million for the prior year period. Total gross margin decreased to 81% for the three months ended September 30, 2019, compared with 83% for the prior year period. The decrease in our total gross margin and total gross profit, in absolute dollars, was primarily due to product mix, as a result of higher than anticipated hardware and appliance sales during the current period, which yield significant less profit margins, as compared to our key proprietary software license offerings. Generally, our total gross profits and total gross margins fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales.

Cost of Product Revenue, Gross Profit and Gross Margin

Cost of product revenue consists primarily of industry standard hardware we purchase and integrate with our software for turn-key integrated solutions, personnel costs, amortization of capitalized software and shipping and logistics costs. Cost of product revenue for the three months ended September 30, 2019 increased to $0.2 million, compared with $0.1 million in the prior year period. Product gross margin for the three months ended September 30, 2019 declined, year over year, to 86% from 94% for the same period in 2018. The increase in cost of product revenue and decline in gross margin for the current year was primarily due to product mix, as the volume of our appliance and hardware sales, which deliver a lower margin, increased significantly, as compared to the prior year period.
 
Cost of Support and Service Revenue, Gross Profit and Gross Margin

Cost of support and service consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts and training. Cost of support and service revenue for the three months ended September 30, 2019 decreased 18% to $0.5 million, compared with $0.6 million in the prior year period. Support and service gross margin decreased to 77% for the three months ended September 30, 2019, compared with 79% for the prior year period, primarily attributable to a reduction in maintenance and support services revenue, year over year.


29


Operating Expenses

Our operating expenses for the three months ended September 30, 2019 increased $0.1 million to $3.7 million from $3.6 million, for the previous year period. Excluding restructuring charges, operating expenses remained constant, year over year.

Research and Development Costs
 
Research and development costs consist primarily of personnel costs for product development, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased $0.3 million, or 27%, to $0.8 million for the three months ended September 30, 2019, from $1.1 million in the prior year period. The decrease was primarily related to a decrease in personnel related costs resulting from our realignment and reduction in workforce and continued efforts to allocate the appropriate level of resources based upon the product development roadmap schedule. We continue to provide resources in support of our research and development activities to continue to enhance and to test our core products and in the development of new innovative products, features and options.
 
Selling and Marketing

Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, travel, public relations expense, marketing literature and promotions, commissions, trade show expenses, and the costs associated with our foreign sales offices. Selling and marketing expenses remained constant, year over year.

General and Administrative
 
General and administrative expenses consist primarily of personnel costs of general and administrative functions, public company related costs, directors’ and officers’ insurance, legal and professional fees, and other general corporate overhead costs. General and administrative expenses increased $0.4 million to $1.5 million for the three months ended September 30, 2019, as compared to $1.1 million for the prior year period. This increase, year over year, was primarily driven by professional fees incurred in connection with outsourcing efforts underway in our international subsidiaries.

Restructuring
 
In the third quarter of 2013, we adopted a restructuring plan intended to better align our cost structure with the skills and resources required to more effectively execute our long-term growth strategy and to support revenue levels we expect to achieve on a go forward basis (the "2013 Plan"). In connection with the 2013 Plan, we eliminated over 100 positions worldwide, implemented tighter expense controls, ceased non-core activities and closed or downsized several facilities. 

In June 2017, the Board approved a comprehensive plan to increase operating performance (the “2017 Plan”). The 2017 Plan resulted in a realignment and reduction in workforce. The 2017 Plan was substantially completed by the end of our fiscal year ended December 31, 2017 and when combined with previous workforce reductions in the second quarter of Fiscal 2017 reduced our workforce to approximately 81 employees at December 31, 2017. These actions are anticipated to result in an annualized cost savings of approximately $10.0 million. As part of this consolidation effort, the Company vacated a portion of the Mellville, NY office space during the three months ended June 30, 2018. In accordance with accounting standards governing costs associated with exit or disposal activities, expenses related to future rental payments for which the Company no longer intends to receive any economic benefit are accrued, net of any anticipated sublease income, when the Company ceases use of the leased space. During the three months ended September 30, 2019, the Company incurred lease disposal-related costs for this property of $0.4 million.

During the three months ended September 30, 2019, the Company adopted a plan to better align the Company’s cost structure with the skills and resources required to more effectively execute the Company’s long-term growth strategy and to support revenue levels the Company expected to achieve on a go forward basis (the "2019 Plan"), implemented tighter expense controls, ceased non-core activities and downsized several facilities. During the three months ended September 30, 2019, the Company incurred $0.2 million in severance expense as a result of this action. The 2019 Plan is anticipated to be substantially completed by December 31, 2019.

Restructuring expense increased $0.1 million for the three months ended September 30, 2019 to $0.4 million, as compared to a restructuring expense of $0.3 million in the prior year period. For further information, refer to Note (17) Restructuring Costs, to our unaudited condensed consolidated financial statements.


30


Interest and other (loss) income, net
 
Interest and other income (loss), net, increased $0.1 million to a loss of $0.1 million for the three months ended September 30, 2019, compared with a loss of $0.2 million in the prior year period. The fluctuation in interest and other income (loss) from quarter to quarter relates to interest expense, foreign currency gains and losses, interest income, sublease income and the change in fair value of our embedded derivatives.

Income Taxes
 
Our provision for income taxes consists of state and local, and foreign taxes. For the three months ended September 30, 2019 and 2018, the Company recorded an income tax benefit of $0.1 million and $0.1 million, respectively, consisting primarily of state and local, and foreign taxes. 

As of September 30, 2019, our conclusion regarding the realizability of our US deferred tax assets did not change and we have recorded a full valuation allowance against them.


31


RESULTS OF OPERATIONS – FOR THE NINE MONTHS SEPTEMBER 30, 2019 COMPARED WITH THE NINE MONTHS ENDED SEPTEMBER 30, 2018.
 
The following table presents revenue and expense line items reported in our Consolidated Statements of Operations and their corresponding percentage of total revenue for the nine months ended September 30, 2019 and 2018 and the period-over-period dollar and percentage changes for those line items. Our results of operations are reported as one business segment, represented by our single operating segment.
 
Nine Months Ended September 30,
 
 Change
Period to Period
(amounts in dollars)
2019
 
2018
 
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Product revenue
$
4,879,996

 
39
 %
 
$
3,925,504

 
30
 %
 
$
954,492

 
24
 %
Support and services revenue
7,584,816

 
61
 %
 
9,140,187

 
70
 %
 
(1,555,371
)
 
(17
)%
Total revenue
12,464,812

 
100
 %
 
13,065,691

 
100
 %
 
(600,879
)
 
(5
)%
Cost of revenue:
 

 
 
 
 

 
 
 
 
 
 
Product
1,076,604

 
9
 %
 
128,632

 
1
 %
 
947,972

 
737
 %
Support and service
1,639,299

 
13
 %
 
1,964,897

 
15
 %
 
(325,598
)
 
(17
)%
Total cost of revenue
2,715,903

 
22
 %
 
2,093,529

 
16
 %
 
622,374

 
30
 %
Gross profit
9,748,909

 
78
 %
 
10,972,162

 
84
 %
 
(1,223,253
)
 
(11
)%
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Research and development costs
2,503,008

 
20
 %
 
2,997,826

 
23
 %
 
(494,818
)
 
(17
)%
Selling and marketing
3,436,783

 
28
 %
 
3,209,930

 
25
 %
 
226,853

 
7
 %
General and administrative
4,280,188

 
34
 %
 
4,175,578

 
32
 %
 
104,610

 
3
 %
Restructuring costs
745,201

 
6
 %
 
951,265

 
7
 %
 
(206,064
)
 
(22
)%
Total operating expenses
10,965,180

 
88
 %
 
11,334,599

 
87
 %
 
(369,419
)
 
(3
)%
Operating loss
(1,216,271
)
 
(10
)%
 
(362,437
)
 
(3
)%
 
(853,834
)
 
236
 %
Interest and other loss, net
(468,717
)
 
(4
)%
 
(501,087
)
 
(4
)%
 
32,370

 
(6
)%
Loss before income taxes
(1,684,988
)
 
(14
)%
 
(863,524
)
 
(7
)%
 
(821,464
)
 
95
 %
Income tax expense (benefit)
168,556

 
1
 %
 
(33,868
)
 
—
 %
 
202,424

 
*

Net loss
$
(1,853,544
)
 
(15
)%
 
$
(829,656
)
 
(6
)%
 
$
(1,023,888
)
 
123
 %
Less: Accrual of Series A redeemable convertible preferred stock dividends
770,027

 
6
 %
 
687,152

 
5
 %
 
82,875

 
12
 %
Less: Deemed dividend on Series A redeemable convertible preferred stock
—

 
—
 %
 
2,269,042

 
17
 %
 
(2,269,042
)
 
(100
)%
Less: Accretion to redemption value of Series A redeemable convertible preferred stock
402,861

 
3
 %
 
240,743

 
2
 %
 
162,118

 
67
 %
Net loss attributable to common stockholders
$
(3,026,432
)
 
(24
)%
 
$
(4,026,593
)
 
(31
)%
 
$
1,000,161

 
(25
)%

 Revenue

Our primary sales focus is on selling software solutions and platforms which includes stand-alone software applications, software integrated with industry standard hardware and sold as one complete integrated solution or sold on a subscription or consumption basis. As a result, our revenue is classified as either: (i) product revenue, or (ii) support and services revenue. Total revenue for the nine months ended September 30, 2019 decreased 5% to $12.5 million, compared with $13.1 million in the prior year period.

32



Product revenue
 
Product revenue is comprised of sales of both licenses for our software solutions and sales of the platforms on which the software is installed. This includes stand-alone software applications and software integrated with industry standard hardware, sold as one complete integrated solution or sold on a subscription or consumption basis. Our products are sold through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users. These revenues are recognized when all the applicable criteria under accounting principles generally accepted in the United States are met.

For the nine months ended September 30, 2019 and 2018, product revenue represented 39% and 30% of our total revenue, respectively. Product revenue of $4.9 million for the nine months ended September 30, 2019 increased $1.0 million, or 24%, from $3.9 million in the prior year period.

We continue to invest in our product portfolio by refreshing our existing product lines and developing our next generation of innovative product offerings to drive our sales volume in support of our long-term outlook.

Support and services revenue

Support and services revenue is comprised of revenue from (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) engineering services. Revenue derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Engineering services are recognized upon customer acceptance. 

Maintenance and technical support services revenue for the nine months ended September 30, 2019 decreased to $7.3 million, as compared to $8.9 million in the prior year period. Our maintenance and technical support service revenue results primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. The decrease in revenue over the previous year reflects a decline in maintenance renewal revenue, as a result of customer attrition, a smaller volume of new customers, and a decline in new product license and maintenance sales.
 
Professional services revenue for the nine months ended September 30, 2019 increased to $293 thousand, as compared to $256 thousand in the prior year period. Professional services revenue can vary from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, (iii) the number of professional services contracts that are performed during the period, and (iv) the number of customers who elect to purchase engineering services.

Cost of Revenue, Gross Profit and Gross Margin

Total cost of revenue for the nine months ended September 30, 2019 increased 30% to $2.7 million, compared with $2.1 million in the prior year period. Total gross profit decreased $1.2 million, or 11%, to $9.7 million for the nine months ended September 30, 2019, compared with $11.0 million for the prior year period. Total gross margin decreased to 78% for the nine months ended September 30, 2019, compared with 84% for the prior year period. The decrease in our total gross profit was primarily due to product mix, as a result of higher than anticipated hardware and appliance sales during the current period, which yield significant less profit margins, as compared to our key proprietary software license offerings. Generally, our total gross profits and total gross margins fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales.

Cost of Product Revenue, Gross Profit and Gross Margin

Cost of product revenue consists primarily of industry standard hardware we purchase and integrate with our software for turn-key integrated solutions, personnel costs, amortization of capitalized software and shipping and logistics costs. Cost of product revenue for the nine months ended September 30, 2019 increased to $1.1 million, as compared with $0.1 million in the prior year period. Product gross margin for the nine months ended September 30, 2019 declined to 78% from 97% for the same period in 2018. The increase in cost of product revenue and decline in gross margin for the current year was primarily due to product mix, as the volume of our appliance and hardware sales, which deliver a lower margin, increased significantly, as compared to the prior year period.
 

33


Cost of Support and Service Revenue, Gross Profit and Gross Margin

Cost of support and service consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts and training. Cost of support and service revenue for the nine months ended September 30, 2019 decreased 17% to $1.6 million, compared with $2.0 million in the prior year period. Support and service gross margin decreased to 78% for the nine months ended September 30, 2019, compared with 79% for the prior year period, primarily attributable to a reduction in personnel related costs.

Operating Expenses

Our operating expenses for the nine months ended September 30, 2019 declined $0.4 million to $11.0 million from $11.3 million, for the previous year period. Operating expenses include $0.7 million of restructuring costs incurred in connection with our cost reduction efforts during the current period. Excluding restructuring charges, operating expenses declined $0.2 million, as compared to the same period of the previous year. This decline was primarily attributable to tighter expense controls and overall operational efficiencies which better align our current business plan on a run-rate basis. These efficiencies include among other items, stream-lined personnel related costs and global overhead costs and efficiencies realized on our redesigned go-to-market coverage models. We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook and to take actions in areas of the Company that are not performing.

Research and Development Costs
 
Research and development costs consist primarily of personnel costs for product development, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased $0.5 million, or 17%, to $2.5 million for the nine months ended September 30, 2019, from $3.0 million in the prior year period. The decrease was primarily related to a decrease in personnel related costs resulting from our realignment and reduction in workforce and continued efforts to allocate the appropriate level of resources based upon the product development roadmap schedule. We continue to provide resources in support of our research and development activities to continue to enhance and to test our core products and in the development of new innovative products, features and options.
 
Selling and Marketing

Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, travel, public relations expense, marketing literature and promotions, commissions, trade show expenses, and the costs associated with our foreign sales offices. Selling and marketing expenses increased $0.2 million to $3.4 million from $3.2 million for the previous year period. The increase was driven primarily by an increase in promotional expenses, and the expansion of our marketing efforts.
 
General and Administrative
 
General and administrative expenses consist primarily of personnel costs of general and administrative functions, public company related costs, directors’ and officers’ insurance, legal and professional fees, and other general corporate overhead costs. General and administrative expenses increased $0.1 million to $4.3 million for the nine months ended September 30, 2019, as compared to $4.2 million for the prior year period. This increase, year over year, was primarily driven by professional fees incurred in connection with outsourcing efforts underway in our international subsidiaries.

Restructuring
 
In the third quarter of 2013, we adopted the "2013 Plan". In connection with the 2013 Plan, we eliminated over 100 positions worldwide, implemented tighter expense controls, ceased non-core activities and closed or downsized several facilities. 

In June 2017, the Board approved the “2017 Plan”. The 2017 Plan resulted in a realignment and reduction in workforce. The 2017 Plan was substantially completed by the end of our fiscal year ended December 31, 2017 and when combined with previous workforce reductions in the second quarter of Fiscal 2017 reduced our workforce to approximately 81 employees at December 31, 2017. These actions are anticipated to result in an annualized cost savings of approximately $10.0 million. As part of this consolidation effort, the Company vacated a portion of the Mellville, NY office space during the three months ended June 30, 2018. In accordance with accounting standards governing costs associated with exit or disposal activities, expenses related to future rental payments for which the Company no longer intends to receive any economic benefit are accrued, net of any anticipated sublease income, when the Company ceases use of the leased space. During the nine months ended September 30, 2019, the Company incurred lease disposal-related costs for this property of $0.5 million.


34


During the three months ended September 30, 2019, the Company adopted the "2019 Plan". In connection with the 2019 Plan, the Company eliminated 23 positions worldwide, implemented tighter expense controls, ceased non-core activities and downsized several facilities. During the three months ended September 30, 2019, the Company incurred $0.2 million in severance expense as a result of this action. The 2019 Plan is anticipated to be substantially completed by December 31, 2019.

Restructuring expense decreased $0.2 million for the nine months ended September 30, 2019 to $0.7 million, as compared to a restructuring expense of $1.0 million in the prior year period. For further information, refer to Note (17) Restructuring Costs, to our unaudited condensed consolidated financial statements.

Interest and other (loss) income, net
 
Interest and other income (loss), net, resulted in a loss of $0.5 million for the nine months ended September 30, 2019, as compared with a loss of $0.5 million in the prior year period. The fluctuation in interest and other income (loss) from quarter to quarter relates to interest expense, foreign currency gains and losses, interest income, sublease income and the change in fair value of our embedded derivatives.

Income Taxes
 
Our provision for income taxes consists of state and local, and foreign taxes. For the nine months ended September 30, 2019 and 2018, the Company recorded an income tax provision of $0.2 million and $0.0 million, respectively, consisting primarily of state and local, and foreign taxes. 

As of September 30, 2019, our conclusion regarding the realizability of our US deferred tax assets did not change and we have recorded a full valuation allowance against them.

LIQUIDITY AND CAPITAL RESOURCES 

Principal Sources of Liquidity

Our principal sources of liquidity are our cash and cash equivalents balances generated from operating, investing and financing activities. Our cash and cash equivalents balance as of September 30, 2019 and December 31, 2018 totaled $1.0 million and $3.1 million, respectively. Such decrease includes a $0.5 million prepayment during the nine months ended September 30, 2019 of outstanding principle owed under the Amended and Restated Loan Agreement we entered into on February 23, 2018 ("Amended and Restated Loan Agreement").

The Amended and Restated Loan Agreement has customary representations, warranties and affirmative and negative covenants. The negative covenants include financial covenants by the Company to maintain minimum cash denominated in U.S. dollars plus accounts receivable outstanding for less than 90 days of $2 million. The Amended and Restated Loan Agreement also contains customary events of default, including but not limited to payment defaults, cross defaults with certain other indebtedness, breaches of covenants, bankruptcy events and a change of control. In the case of an event of default, as administrative agent under the Amended Restated Loan Agreement, HCP-FVA, an affiliate of Hale Capital  may (and upon the written request of lenders holding in excess of 50% of the Term Loan, which must include HCP-FVA, is required to) accelerate payment of all obligations under the Amended and Restated Loan Agreement, and seek other available remedies.

The restrictions in the Amended and Restated Loan Agreement may prevent us from taking actions that we believe would be in the best interests of our business, and may make it difficult for us to successfully execute our business strategy or effectively compete with companies that are not similarly restricted. In addition, our ability to comply with the financial and other covenants and restrictions in the Amended and Restated Loan Agreement will largely depend on the pricing of our products and services, and our ability to successfully implement our overall business strategy. We cannot assure you that we will be granted waivers or amendments to the Amended and Restated Loan Agreement if for any reason we are unable to comply with these covenants and restrictions. The breach of any of these covenants and restrictions could result in a default under the Amended and Restated Loan Agreement, which could result in an acceleration of our indebtedness.

Liquidity
    
We have incurred operating losses in nine of the previous ten years and negative cash flow from operations in seven of the previous ten years. We currently have a working capital deficiency of $4.3 million, which is inclusive of current deferred revenue of $5.0 million and a stockholders' deficit of $14.7 million. During the nine months ended September 30, 2019, we incurred

35


a net loss of $1.9 million and cash flow used in operations of $1.4 million. Our total cash balance at September 30, 2019 was $1.0 million, a decrease of $2.1 million as compared to December 31, 2018.

Our ability to continue as a going concern, depends on our ability to execute our business plan, increase revenue and billings and reduce expenditures. In the third quarter of 2019, we adopted a plan to better align our cost structure with the skills and resources required to more effectively execute our long-term growth strategy and to support revenue levels we expected to achieve on a go forward basis (the "2019 Plan"). In connection with the 2019 Plan, we eliminated 23 positions worldwide, implemented tighter expense controls, ceased non-core activities and downsized several facilities. During the three months ended September 30, 2019, we incurred $0.2 million in severance expense as a result of this action. The 2019 Plan is anticipated to be substantially completed by December 31, 2019. We are also currently negotiating for additional borrowing facilities from investors, and management believes that we will be able to execute the terms for such borrowing facilities in the near future.

There is no assurance that we will be successful in generating sufficient bookings, billings, revenue or continue to reduce operating costs or that we will be able to obtain financing or that such financing will be on favorable terms. Any such financing would be dilutive to our shareholders. Failure to generate sufficient revenue, billings, control or further reduce expenditures and/or the inability to obtain financing will result in an inability of the Company to continue as a going concern. Subject to the foregoing, management believes that, based on projected cash flows and additional financing, we will have sufficient capital and liquidity to fund the Company's operations for at least one year from the date of issuance of the accompanying interim condensed financial statements.

Cash Flow Analysis

Cash flow information is as follows:
 
 
Nine Months Ended September 30,
 
 
2019
 
2018
Cash (used in) provided by:
 
 
 
 
Operating activities
 
(1,432,514
)
 
(331,722
)
Investing activities
 
(187,998
)
 
(138,933
)
Financing activities
 
(489,321
)
 
2,328,019

Effect of exchange rate changes
 
10,557

 
(41,540
)
Net increase (decrease) in cash and cash equivalents
 
$
(2,099,276
)
 
$
1,815,824


Net cash used in operating activities totaled $1.4 million for the nine months ended September 30, 2019, compared with $0.3 million of net cash used in operating activities in the prior year period. The changes in net cash used in operating activities for the nine months ended September 30, 2019, was primarily due to our net income (loss) and adjustments for net changes in operating assets and liabilities, primarily changes in our accounts receivable, deferred revenue, prepaid expenses, inventory, other assets, accounts payable, accrued expenses and other long-term liabilities contributed to the decrease.

Net cash used in investing activities totaled $0.2 million for the nine months ended September 30, 2019, compared with net cash used in investing activities of $0.1 million in the prior year period. Included in investing activities are purchases of property and equipment, capitalized software development costs, cash received from security deposits and purchases of intangible assets.
. 
Net cash used in financing activities totaled $0.5 million for the nine months ended September 30, 2019, compared with net cash provided by financing activities of $2.3 million in the prior year period. The nine months ended September 30, 2019 reflects the partial repayment of $0.5 million of principle under our Term Loan in January 2019. Included in the nine months ended September 30, 2018 are proceeds from the issuance of long-term debt received in connection with an initial commitment during the prior year.
 
Total cash and cash equivalents decreased $2.1 million to $1.0 million at September 30, 2019 compared to December 31, 2018.


36


Contractual Obligations

As of September 30, 2019, our significant commitments are related to (i) the Amended Restated Loan Agreement, (ii) our operating leases for our office facilities, (iii) dividends (including accrued dividends) on our Series A Preferred Stock, and (iv) the potential redemption of the Series A Preferred Stock as discussed above.

The following is a schedule summarizing our significant obligations to make future payments under contractual obligations as of September 30, 2019:

 
Operating Leases
Note Payable (c)
Interest Payments (a) (c)
Long-Term Income Tax Payable (b)
Series A Preferred Stock Mandatory Redemption
Dividends on Series A Preferred Stock
2019
$
438,074

$
—

$
62,500

$
—

$
—

$
—

2020
1,714,436

—

250,000

—

—

—

2021
639,526

3,510,679

125,000

—

—

—

2022
—

—

—

—

—

—

Other
—

—

—

119,486

9,000,000

5,244,240

Total contractual obligations
$
2,792,036

$
3,510,679

$
437,500

$
119,486

$
9,000,000

$
5,244,240

Sublease income
$
(987,645
)
$
—

$
—

$
—

$
—

$
—

Net contractual obligations
$
1,804,391

$
3,510,679

$
437,500

$
119,486

$
9,000,000

$
5,244,240


(a) The cash obligations for interest requirements reflect floating rate debt obligations on the balance of our Note Payable at September 30, 2019 using interest rate in effect at such time.

(b) Represents our liability for uncertain tax positions. We are unable to make a reasonably reliable estimate of the timing of payments due to uncertainties in the timing of tax audit outcomes.

(c) See Note (9) Notes Payable and Stock Warrants to our unaudited condensed consolidated financial statements for further information and for a detailed description of the Amended and Restated Loan Agreement.
 
Critical Accounting Policies and Estimates
 
We describe our significant accounting policies in Note (1), "Summary of Significant Accounting Policies" of our 2018 Form 10-K. We discuss our critical accounting estimates in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our 2018 Form 10-K. There have been no significant changes in our significant accounting policies or critical accounting estimates since December 31, 2018, other than those noted below.

Revenue Recognition
Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment.
Judgment is required to determine the standalone selling price (“SSP”) for each distinct performance obligation. For products and services aside from maintenance and support, we estimate SSP by adjusting the list price by historical discount percentages. SSP for software and hardware maintenance and support fees is based on the stated percentages of the fees charged for the respective products.
Our perpetual and term software licenses have significant standalone functionality and therefore revenue allocated to these performance obligations are recognized at a point in time upon electronic delivery of the download link and the license keys.
Product maintenance and support services are satisfied over time as they are stand-ready obligations throughout the support period. As a result, revenues associated with maintenance services are deferred and recognized as revenue ratably over the term of the contract.

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Revenues associated with professional services are recognized at a point in time upon customer acceptance.

Impact of Recently Issued Accounting Pronouncements

See Item 1 of Part 1, Condensed Consolidated Financial Statements – Note (1) Basis of Presentation.
 
Off-Balance Sheet Arrangements
 
As of September 30, 2019 and December 31, 2018, we had no off-balance sheet arrangements.

Item 3.     Quantitative and Qualitative Disclosures About Market Risk
 
Foreign Currency Risk.

We have several offices outside the United States. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. For the nine months ended September 30, 2019 and 2018, approximately 75% and 77% of our sales were from outside North America. Not all of these transactions were made in foreign currencies. Our primary exposure is to fluctuations in exchange rates for the U.S. Dollar versus the Euro and Japanese Yen, and to a lesser extent the Canadian Dollar, the Korean Won and the British Pound. Changes in exchange rates in the functional currency for each geographic area’s revenues are primarily offset by the related expenses associated with such revenues. However, changes in exchange rates of a particular currency could impact the re-measurement of such balances on our balance sheets.

If foreign currency exchange rates were to change adversely by 10% from the levels at September 30, 2019, the effect on our results before taxes from foreign currency fluctuations on our balance sheet would be approximately $1.6 million. The above analysis disregards the possibility that rates for different foreign currencies can move in opposite directions and that losses from one currency may be offset by gains from another currency.
 
Item 4.     Controls and Procedures
 
Disclosure Controls and Procedures

Disclosure controls and procedures are procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report, and, based on their evaluation, our principal executive officer and principal financial officer have concluded that these controls and procedures are not effective as of the end of the period covered by this report. We describe this deficiency and the steps we have taken to remedy such deficiency in our discussion of internal control over financial reporting below.

Internal Control Over Financial Reporting

Management’s Report on Internal Control Over Financial Reporting

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company; as such term is defined in Rules 13a-15(f) under the Securities and Exchange Act of 1934, as amended. To evaluate the effectiveness of the Company’s internal control over financial reporting, the Company’s management uses the Integrated Framework (2013) adopted by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

The Company’s management has assessed the effectiveness of the Company’s internal control over financial reporting as of September 30, 2019, using the COSO framework (2013). The Company’s management has determined that the Company’s internal control over financial reporting is not effective as of that date because of the following material weakness:


38


During the three months ended September 30, 2019, the Company did not fully document all the COSO framework (2013) mandated system controls in place nor did the Company have an independent party complete testing of the controls as of September 30, 2019. The Company has implemented certain mitigating controls such as secondary reviews by senior management, variance analysis reporting and cash-flow monitoring, which insured that both internal and external financial reporting included all the information and disclosures required by generally accepted accounting principles in the United States of America.

Notwithstanding the above, the Principal Executive Officer and the Principal Financial Officer believe that the consolidated financial statements and other information contained in this Annual Report present fairly, in all material respects, our business, financial condition and results of operations.

Remediation

 The Company is implementing the appropriate system controls mandated by the COSO framework (2013) for 2019 and plans to conduct independent audit testing of these controls which are implemented. 




 

39


PART II.     OTHER INFORMATION
 
Item 1.     Legal Proceedings
 
See the discussion of the Company’s material litigation in Note (15) Litigation, to the unaudited condensed consolidated financial statements, which is incorporated by reference in Item 1.
 
Item 1A.  Risk Factors
 
We are affected by risks specific to us as well as factors that affect all businesses operating in a global market. The significant factors known to us that could materially adversely affect our business, financial condition, or operating results are set forth in Item 1A to our 2018 Form 10-K.

Unknown Factors

Additional risks and uncertainties of which we are unaware or which currently we deem immaterial also may become important factors that affect us. 


40




Item 6.     Exhibits
 
 
31.1
 
 
31.2
 
 
32.1
 
 
32.2
 
 
101.1
The following financial statements from FalconStor Software, Inc’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2019, formatted in XBRL (eXtensible Business Reporting Language):
 
(i)
unaudited Condensed Consolidated Balance Sheets – September 30, 2019 and December 31, 2018.
 
 
 
 
(ii)
unaudited Condensed Consolidated Statement of Operations – Three and Nine Months Ended September 30, 2019 and 2018.
 
 
 
 
(iii)
unaudited Condensed Consolidated Statement of Comprehensive Income (Loss) – Three and Nine Months Ended September 30, 2019 and 2018.
 
 
 
 
(iv)
unaudited Condensed Consolidated Statements of Stockholder's Deficit - Three and Nine Months Ended September 30, 2019 and 2018.
 
 
 
 
(v)
unaudited Condensed Consolidated Statement of Cash Flows – Nine Months Ended September 30, 2019 and 2018.
 
 
 
 
(vi)
Notes to unaudited Condensed Consolidated Financial Statements – September 30, 2019.
.

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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
FALCONSTOR SOFTWARE, INC.
 
(Registrant)
 
 
 
/s/ Brad Wolfe
 
Brad Wolfe
 
Executive Vice President, Chief Financial Officer and Treasurer
 
(principal financial and accounting officer)
 

 
/s/ Todd Brooks
 
Todd Brooks
 
President & Chief Executive Officer
November 19, 2019
(principal executive officer)


42