UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

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

 

For the Quarterly Period Ended September 30, 2020

 

[  ] 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: 000-31671

 

INTELLINETICS, INC.

(Exact name of registrant as specified in its charter)

 

Nevada   87-0613716

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

 

2190 Dividend Drive    
Columbus, Ohio   43228
(Address of Principal Executive Offices)   (Zip Code)

 

(614) 921-8170

(Registrant’s telephone number, including area code)

 

 

(Former name and former address, if changed since last report)

 

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

 

Title of each class   Trading Symbol(s)   Name of each exchange on which registered
None.   N/A   N/A

 

Securities registered pursuant to Section 12(g) of the Act: Common stock, $0.001 par value.

 

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 [X] No [  ]

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes [X] No [  ]

 

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

 

Large accelerated filer [  ] (Do not check if a smaller reporting company) Accelerated filer [  ]
Non-accelerated filer [  ]   Smaller reporting company [X]
Emerging growth company [  ]      

 

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

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): Yes [  ] No [X]

 

As of November 12, 2020 there were 2,810,865 shares of the issuer’s common stock outstanding with par value of $0.001 per share.

 

 

 

 

 

 

INTELLINETICS, INC.

Form 10-Q

September 30, 2020

TABLE OF CONTENTS

 

   

Page

No.

PART I    
     
FINANCIAL INFORMATION 4
     
ITEM 1. Financial Statements. 4
     
  Condensed Consolidated Balance Sheets as of September 30, 2020 (Unaudited) and December 31, 2019 4
     
  Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2020 and 2019 (Unaudited) 5
     
  Condensed Consolidated Statement of Stockholders’ Equity (Deficit) for the three and nine months ended September 30, 2020 and 2019 (Unaudited) 6
     
  Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2020 and 2019 (Unaudited) 7
     
  Notes to Condensed Consolidated Financial Statements (Unaudited) 8
     
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. 31
     
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk. 42
     
ITEM 4. Controls and Procedures. 42
     
PART II    
     
OTHER INFORMATION 43
     
ITEM 1. Legal Proceedings. 43
     
ITEM 1A. Risk Factors. 43
     
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds. 44
     
ITEM 3. Defaults Upon Senior Securities. 44
     
ITEM 4. Mine Safety Disclosures. 44
     
ITEM 5. Other Information. 44
     
ITEM 6. Exhibits. 44
     
SIGNATURES 45

 

2

 

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q and the documents incorporated into this report by reference contain, and we may from time to time make, forward-looking statements. From time to time in the future, we may make additional forward-looking statements in presentations, at conferences, in press releases, in other reports and filings and otherwise. Forward-looking statements are all statements other than statements of historical fact, including statements that refer to plans, intentions, objectives, goals, targets, strategies, hopes, beliefs, projections, prospects, expectations or other characterizations of future events or performance, and assumptions underlying the foregoing. The words “may,” “could,” “should,” “would,” “will,” “project,” “intend,” “continue,” “believe,” “anticipate,” “estimate,” “forecast,” “expect,” “plan,” “potential,” “opportunity,” “scheduled,” “goal,” “target,” and “future,” variations of such words, and other comparable terminology and similar expressions and references to future periods are often, but not always, used to identify forward-looking statements. Examples of forward-looking statements include, but are not limited to, statements about the following:

 

  our prospects, including our future business, revenues, expenses, net income, earnings per share, margins, profitability, cash flow, cash position, liquidity, financial condition and results of operations, backlog of orders and revenue, our targeted growth rate, our goals for future revenues and earnings, and our expectations about realizing the revenues in our backlog and in our sales pipeline;
     
  the effects on our business, financial condition and results of operations of current and future economic, business, market and regulatory conditions, including the current economic and market conditions and their effects on our customers and their capital spending and ability to finance purchases of our products, services, technologies and systems;
     
  the effects of fluctuations in sales on our business, revenues, expenses, net income, earnings per share, margins, profitability, cash flow, capital expenditures, liquidity, financial condition and results of operations;
     
  our products, services, technologies and systems, including their quality and performance in absolute terms and as compared to competitive alternatives, their benefits to our customers and their ability to meet our customers’ requirements, and our ability to successfully develop and market new products, services, technologies and systems;
     
  our markets, including our market position and our market share;
     
  our ability to successfully develop, operate, grow and diversify our operations and businesses;
     
  our business plans, strategies, goals and objectives, and our ability to successfully achieve them;
     
  the sufficiency of our capital resources, including our cash and cash equivalents, funds generated from operations, availability of borrowings under our credit and financing arrangements and other capital resources, to meet our future working capital, capital expenditure, lease and debt service and business growth needs;
     
  the value of our assets and businesses, including the revenues, profits and cash flow they are capable of delivering in the future;
     
  industry trends and customer preferences and the demand for our products, services, technologies and systems; and
     
  the nature and intensity of our competition, and our ability to successfully compete in our markets.

 

Any forward-looking statements we make are based on our current plans, intentions, objectives, goals, targets, strategies, hopes, beliefs, projections and expectations, as well as assumptions made by and information currently available to management. Forward-looking statements are not guarantees of future performance or events, but are subject to and qualified by substantial risks, uncertainties and other factors, which are difficult to predict and are often beyond our control. Forward-looking statements will be affected by assumptions and expectations we might make that do not materialize or that prove to be incorrect and by known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from those expressed, anticipated or implied by such forward-looking statements. These risks, uncertainties and other factors include, but are not limited to, those described in “Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2019, filed on March 30, 2020, those items described in Part II, Item 1A “Risk Factors” of our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2020 and June 30, 2020, filed on May 15, 2020 and August 14, 2020, respectively, as well as other risks, uncertainties and factors discussed elsewhere in this report, in documents that we include as exhibits to or incorporate by reference in this report, and in other reports and documents we from time to time file with or furnish to the SEC. In light of these risks and uncertainties, you are cautioned not to place undue reliance on any forward-looking statements that we make.

 

Any forward-looking statements contained in this report speak only as of the date of this report, and any other forward-looking statements we make from time to time in the future speak only as of the date they are made. We undertake no duty or obligation to update or revise any forward-looking statement or to publicly disclose any update or revision for any reason, whether as a result of changes in our expectations or the underlying assumptions, the receipt of new information, the occurrence of future or unanticipated events, circumstances or conditions or otherwise.

 

3

 

 

Part I Financial Information

Item 1. Financial Statements

 

INTELLINETICS, INC. and SUBSIDIARIES

Condensed Consolidated Balance Sheets

 

   (Unaudited)     
   September 30,   December 31, 
   2020   2019 
         
ASSETS          
Current assets:          
Cash  $1,511,990   $404,165 
Accounts receivable, net   1,078,862    329,571 
Accounts receivable, unbilled   503,642    23,371 
Parts and supplies, net   79,975    4,184 
Prepaid expenses and other current assets   207,201    110,841 
Total current assets   3,381,670    872,132 
           
Property and equipment, net   716,000    6,919 
Right of use assets   2,703,978    97,239 
Intangible assets, net   1,239,090    - 
Goodwill   2,322,887    - 
Other assets   18,784    10,284 
Total assets  $10,382,409   $986,574 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY(DEFICIT)          
           
Current liabilities:          
Accounts payable  $183,327   $160,911 
Accrued compensation   261,638    70,027 
Accrued expenses, other   156,567    140,079 
Lease liabilities - current   516,206    47,397 
Deferred revenues   1,022,252    754,073 
Deferred compensation   100,828    117,166 
Earnout liabilities - current   287,390    - 
Accrued interest payable - current   4,505    1,212,498 
Notes payable - current   612,539    3,339,963 
Notes payable - related party - current   -    1,467,400 
Total current liabilities   3,145,252    7,309,514 
           
Long-term liabilities:          
Notes payable   1,817,681    - 
Lease liabilities - net of current portion   2,262,445    53,318 
Earnout liabilities - net of current portion   601,810    - 
Total long-term liabilities   4,681,936    53,318 
Total liabilities   7,827,188    7,362,832 
           
Stockholders’ equity (deficit):          
Common stock, $0.001 par value, 25,000,000 shares authorized; 2,810,865 and 370,497 shares issued and outstanding at September 30, 2020 and December 31, 2019, respectively   2,811    371 
Additional paid-in capital   24,121,370    14,419,437 
Accumulated deficit   (21,568,960)   (20,796,066)
Total stockholders’ equity (deficit)   2,555,221    (6,376,258)
Total liabilities and stockholders’ equity (deficit)  $10,382,409   $986,574 

 

See Notes to these condensed consolidated financial statements

 

4

 

 

INTELLINETICS, INC. and SUBSIDIARIES

Condensed Consolidated Statements of Operations

(Unaudited)

 

    For the Three Months Ended September 30,     For the Nine Months Ended September 30,  
    2020     2019     2020     2019  
                         
Revenues:                                
Sale of software   $ 53,767     $ 170,738     $ 153,999     $ 179,590  
Software as a service     281,810       214,237       756,497       643,402  
Software maintenance services     340,129       248,343       915,483       753,692  
Professional services     1,615,445       122,250       3,221,154       334,877  
Storage and retrieval services     220,131       -       510,453       -  
Total revenues     2,511,282       755,568       5,557,586       1,911,561  
                                 
Cost of revenues:                                
Sale of software     -       1,469       40,117       4,479  
Software as a service     65,712       67,643       209,508       195,911  
Software maintenance services     49,354       17,894       127,439       67,813  
Professional services     841,016       60,684       1,637,308       152,056  
Storage and retrieval services     64,906       -       136,283       -  
Total cost of revenues     1,020,988       147,690       2,150,655       420,259  
                                 
Gross profit     1,490,294       607,878       3,406,931       1,491,302  
                                 
Operating expenses:                                
General and administrative     844,186       510,817       2,533,046       1,570,835  
Significant transaction costs     -       -       636,440       -  
Sales and marketing     285,462       248,757       759,024       739,177  
Depreciation and amortization     89,475       1,901       204,317       5,908  
                                 
Total operating expenses     1,219,123       761,475       4,132,827       2,315,920  
                                 
Income (loss) from operations     271,171       (153,597 )     (725,896 )     (824,618 )
                                 
Other income (expense)                                
Gain on extinguishment of debt     -       -       287,426       -  
Income tax benefit     -       -       188,300       -  
Interest expense, net     (115,498 )     (245,156 )     (522,724 )     (717,650 )
                                 
Total other expense     (115,498 )     (245,156 )     (46,998 )     (717,650 )
                                 
Net income (loss)   $ 155,673     $ (398,753 )   $ (772,894 )   $ (1,542,268 )
                                 
Basic and diluted net income (loss) per share:   $ 0.06     $ (1.08 )   $ (0.34 )   $ (4.17 )
                                 

Weighted average number of common shares outstanding – basic and diluted

    2,810,865       370,497       2,271,169       370,205  

 

See Notes to these condensed consolidated financial statements

 

5

 

 

INTELLINETICS, INC. and SUBSIDIARIES

Condensed Consolidated Statement of Stockholders’ Equity (Deficit)

For the Three and Nine Months Ended September, 2020 and 2019

(Unaudited)

 

   Common Stock   Additional Paid-in   Accumulated     
   Shares   Amount   Capital   Deficit   Total 
                     
Balance, June 30, 2019     370,497   $371   $14,374,320   $(19,806,300)  $(5,431,609)
                          
Stock Option Compensation     -    -    58,863    -    58,863 
                          
Net Loss     -    -    -    (398,753)   (398,753)
                          
Balance, September 30, 2019     370,497   $371   $14,433,183   $(20,205,053)  $(5,771,499)
                          
Balance, June 30, 2020     2,810,865    2,811    24,107,401    (21,724,633)   2,385,579 
                          
Stock Option Compensation     -    -    13,969    -    13,969 
                          
Net Income   -    -    -    155,673    155,673 
                          
Balance, September 30, 2020     2,810,865   $2,811   $24,121,370   $(21,568,960)  $2,555,221 

 

   Common Stock   Additional Paid-in   Accumulated     
   Shares   Amount   Capital   Deficit   Total 
                     
Balance, December 31, 2018     354,588   $355   $14,162,216   $(18,662,785)  $(4,500,214)
                          
Stock Issued to Directors and Employee     15,909    16    87,484    -    87,500 
                          
Stock Option Compensation     -    -    183,483    -    183,483 
                          
Net Loss     -    -    -    (1,542,268)   (1,542,268)
                          
Balance, September 30, 2019     370,497   $371   $14,433,183   $(20,205,053)  $(5,771,499)
                          
Balance, December 31, 2019     370,497    371    14,419,437    (20,796,066)   (6,376,258)
                          
Stock Issued to Directors     16,429    16    57,484    -    57,500 
                          
Stock Option Compensation     -    -    32,652    -    32,652 
                          
Stock Issued     955,000    955    3,819,045    -    3,820,000 
                          
Stock Issued for Convertible Notes     1,468,939    1,469    5,728,566    -    5,730,035 
                          
Equity Issuance Costs     -    -    (307,867)   -    (307,867)
                          
Note Offer Warrants      -    -    372,053    -    372,053 
                          
Net Loss     -    -    -    (772,894)   (772,894)
                          
Balance, September 30, 2020     2,810,865   $2,811   $24,121,370   $(21,568,960)  $2,555,221 

 

See Notes to these condensed consolidated financial statements

 

6

 

 

INTELLINETICS, INC. and SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

   For the Nine Months Ended September 30, 
   2020   2019 
         
Cash flows from operating activities:          
Net loss  $(772,894)  $(1,542,268)
Adjustments to reconcile net loss to net cash used in operating activities:          
Depreciation and amortization   204,317    5,908 
Bad debt expense   40,325    14,340 
Parts and supplies reserve change   10,500    - 
Amortization of deferred financing costs   91,156    137,888 
Amortization of beneficial conversion option   11,786    53,038 
Amortization of debt discount   62,222    - 
Amortization of right of use asset   278,879    30,982 
Stock issued for services   57,500    87,500 
Stock options compensation   32,652    183,483 
Note conversion stock issue expense   141,000    - 
Warrant issue expense   236,761    - 
Interest on converted debt   176,106    - 
Gain on extinguishment of debt   (287,426)   - 
Amortization of original issue discount on notes   18,296    - 
Changes in operating assets and liabilities:          
Accounts receivable   333,121    (227,594)
Accounts receivable, unbilled   (204,248)   29,766 
Parts and supplies   5,105    1,533 
Prepaid expenses and other current assets   (25,790)   4,155 
Right of use assets   0    (138,549)
Accounts payable and accrued expenses   (589,461)   65,798 
Lease liabilities, current and long-term   (269,748)   111,476 
Deferred compensation   (16,338)   (35,077)
Accrued interest, current and long-term   4,504    523,085 
Deferred revenues   69,520    (50,903)
Total adjustments   380,739    796,829 

Net cash used in operating activities

   (392,155)   (745,439)
           
Cash flows from investing activities:          
Cash paid to acquire business, net of cash acquired   (4,019,098)   - 
Purchases of property and equipment   (55,603)   (5,489)
Net cash used in investing activities   (4,074,701)   (5,489)
           
Cash flows from financing activities:          
Proceeds from issuance of common stock   3,167,500    - 
Offering costs paid on issuance of common stock   (307,867)   - 
Payment of deferred financing costs   (175,924)   - 
Proceeds from notes payable   3,008,700    - 
Repayment of notes payable   (70,000)   - 
Repayment of notes payable - related parties   (47,728)   (34,622)
Net cash provided by/(used in) financing activities   5,574,681    (34,622)
           
Net increase (decrease) in cash   1,107,825    (785,550)
Cash - beginning of period   404,165    1,088,630 
Cash - end of period  $1,511,990   $303,080 
           
Supplemental disclosure of cash flow information:          
Cash paid during the period for interest  $

142,018

   $

6,241

Cash paid during the period for taxes

  $

112,954

   $- 
           
Supplemental disclosure of non-cash financing activities:          
Accrued interest notes payable converted to equity  $796,074   $- 
Accrued interest notes payable related parties converted to equity   238,883    - 
Discount on notes payable for beneficial conversion feature   320,000    - 
Discount on notes payable for warrants   135,292    - 
Notes payable converted to equity   3,421,063    - 
Notes payable converted to equity - related parties   1,465,515    - 
           
Supplemental disclosure of non-cash investing activities relating to business acquisitions:          
Cash  $17,269   $- 
Accounts receivable   1,122,737    - 
Accounts receivable, unbilled   276,023    - 
Parts and supplies   91,396    - 
Prepaid expenses   73,116    - 
Other current assets   5,954    - 
Right of use assets   2,885,618    - 
Property and equipment   735,885    - 
Intangible assets   1,361,000    - 
Accounts payable   (168,749)   - 
Accrued expenses   (162,426)   - 
Lease liabilities   (2,947,684)   - 
Federal and state taxes payable   (168,900)   - 
Deferred revenues   (198,659)   - 
Deferred tax liabilities, net   (149,900)   - 
Net assets acquired in acquisition   2,772,680    - 
Total goodwill acquired in acquisition   2,322,887    - 
Total purchase price of acquisition   5,095,567    - 
Purchase price of business acquisition financed with earnout liability   (889,200)   - 
Purchase price of business acquisition financed with installment payments   (170,000)   - 
Cash used in business acquisition  $4,036,367   $- 

 

See Notes to these condensed consolidated financial statements

 

7

 

 

INTELLINETICS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

 

1. Business Organization and Nature of Operations

 

Intellinetics, Inc., formerly known as GlobalWise Investments, Inc., (“Intellinetics”), is a Nevada corporation incorporated in 1997, with two subsidiaries: (i) Intellinetics, Inc., an Ohio corporation that is wholly-owned by the Company (“Intellinetics Ohio), and (ii) Graphic Sciences, Inc., a Michigan corporation that is also wholly-owned by the Company (“Graphic Sciences”). Intellinetics Ohio was incorporated in 1996, and on February 10, 2012, Intellinetics Ohio became the sole operating subsidiary of the Company as a result of a reverse merger and recapitalization. On March 2, 2020, the Company purchased all the outstanding capital stock of Graphic Sciences.

 

The Company is a document management company, providing comprehensive document solutions, software, and services to its customers in both the public and private sectors. The Company’s software platform allows customers to capture and manage all documents across operations such as scanned hard-copy documents and all digital documents including those from Microsoft Office 365, digital images, audio, video and emails. The Company’s suite of document services includes indexing, conversion, and physical document storage and retrieval. The Company’s comprehensive solutions create value for customers by making it easy to connect business-critical documents to the processes they drive by making them easy to find, secure and compliant with its customers’ audit requirements.

 

2. Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (“U.S. GAAP”). The Company has evaluated subsequent events through the issuance of this Form 10-Q.

 

The financial statements presented in this Quarterly Report on Form 10-Q are unaudited. However, in the opinion of management, such Financial Statements include all adjustments, consisting solely of normal recurring adjustments, necessary to present fairly the financial position, results of operations and cash flows for the periods presented in conformity with U.S. GAAP applicable to interim periods.

 

Operating results for the interim periods presented are not necessarily indicative of the results that may be expected for the current fiscal year ending December 31, 2020.

 

3. Liquidity and Management’s Plans

 

Through September 30, 2020, the Company had incurred an accumulated deficit since its inception of $21,568,960. At September 30, 2020, the Company had a cash balance of $1,511,990. Since inception, the Company’s operations have primarily been funded through a combination of gross profits, government-sponsored loans, and the sale of both equity and debt securities.

 

As part of its overall strategic plan to increase the Company’s revenues, improve liquidity, and move the Company towards profitability, the Company acquired Graphic Sciences on March 2, 2020, and CEO Imaging Systems, Inc. (“CEO Image”) on April 21, 2020. Additionally, proceeds from issuance of shares, including conversion of convertible debt, and issuance of new debt on March 2, 2020 enabled the company to restructure its balance sheet and reduce its overall debt burden by approximately $3 million.

 

The Company’s business plan is to increase our sales and market share by focusing on a targeted marketing approach to select vertical markets, maximizing cross selling opportunities within the newly expanded customer base of the consolidated company, enhancing our direct selling results, and continuing to develop a network of select resellers through which we expect to sell our expanded document management solutions. We expect that these initiatives will require us to continue our efforts towards direct marketing campaigns and leads management, reseller on-boarding, and to develop additional software integration and customization capabilities, all of which may require additional capital. We also plan to continually monitor opportunities to make strategic acquisitions that will strengthen or complement our product and services offerings, bring more solutions to our customers, and increase revenues and liquidity. Since the COVID-19 crisis began, the Company has been working proactively to preserve cash, including a temporary furlough at Graphic Sciences until the Michigan stay-at-home order was lifted, a reduction in management compensation through June 2020, and the receipt of a loan through the Paycheck Protection Program (“PPP”) in April 2020 amounting to $838,700. Currently, we believe that we comply with the program requirements and that the entire amount will be forgiven, but will not have assurance on the amount forgiven until our forgiveness application is accepted by the Small Business Administration.

 

Our ability to meet our capital needs in the future will depend on many factors, including maintaining and enhancing our operating cash flow, successfully managing the transition of our recent acquisitions of Graphic Sciences and CEO Image, successfully retaining and growing our client base in the midst of general economic uncertainty, managing the effects of the COVID-19 pandemic on our business, and obtaining forgiveness of our PPP loan. We will need to successfully manage our revenues to support potential future earnout commitments for previous transactions and current debt service commitments, and our future cash resources and capital requirements may vary materially from those now planned. Our ability to obtain additional capital or debt financing on favorable terms, if needed, would likely be adversely affected by our history of operating losses. Prior to this quarter, management has historically assessed that there was substantial doubt regarding our ability to continue as a going concern. These conditions raise substantial doubt over the Company’s ability to meet all of its obligations over the twelve months following the date of this Report. However, management has evaluated these conditions and believes, based on its current plans and expectations, that we will be able to meet those obligations, although there is no assurance.

 

Based on our plans and assumptions as of the date of this report, we believe our capital resources, including our cash and cash equivalents, along with funds expected to be generated from our operations, will be sufficient to meet our anticipated cash needs, including for working capital, earnout liability payments for previous transactions, capital spending, and debt service commitments, for at least the next 12 months. However, any projections of future cash needs and cash flows are subject to substantial risks and uncertainties, such as our history of operating losses, the current COVID-19 pandemic, as well as general overall economic conditions. See “Cautionary Note Regarding Forward-Looking Statements” above in this report and the risk factors included in Part II, Item IA of this Report, Part II, Item 1A of our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2020, and June 30, 2020, and filed on May 15, 2020, and August 14, 2020, respectively, and the risk factors that are included in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2019, filed on March 30, 2020.

 

8

 

 

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

 

4. Corporate Actions

 

On March 20, 2020, the Company effected a one-for-fifty (1-for-50) reverse stock split of the Company’s common stock. All share and per share amounts herein have been adjusted to reflect the reverse stock split.

 

5. Summary of Significant Accounting Policies

 

Principles of Consolidation

 

The financial statements include the accounts of Intellinetics and the accounts of all the subsidiaries in which a controlling interest is held by the Company. Under U.S. GAAP, consolidation is generally required for investments of more than 50% of the outstanding voting stock of an investee, except when control is not held by the majority owner. The Company’s subsidiaries include: Intellinetics Ohio and Graphic Sciences. The Company considers the criteria established under Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) Topic 810, “Consolidations” in its consolidation process. All significant intercompany balances and transactions have been eliminated in consolidation.

 

Use of Estimates

 

The preparation of condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions. Such estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses. Actual results could differ from estimated amounts.

 

Significant estimates and assumptions include valuation allowances related to receivables, accounts receivable -unbilled, allowance for obsolescence or slow-moving parts and supplies inventory, the recoverability of long-term assets, depreciable lives of property and equipment, purchase price allocations for acquisitions, fair value for goodwill and intangibles, the lease liabilities, estimates of fair value deferred taxes and related valuation allowances. The Company’s management monitors these risks and assesses its business and financial risks on a quarterly basis.

 

Revenue Recognition

 

In accordance with ASC 606, the Company follows a five-step model to assess each contract of a sale or service to a customer: identify the legally binding contract, identify the performance obligations, determine the transaction price, allocate the transaction price, and determine whether revenue will be recognized at a point in time or over time. Revenue is recognized when a performance obligation is satisfied and the customer obtains control of promised goods and services. The amount of revenue recognized reflects the consideration to which we expect to be entitled to receive in exchange for these goods and services. In addition, ASC 606 requires disclosures of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.

 

9

 

 

We categorize revenue as software, software as a service, software maintenance services, professional services, and storage and retrieval services. We earn the majority of our revenue from the sale of professional services, followed by the sale of software maintenance services and software as a service. Specific revenue recognition policies apply to each category of revenue.

 

a) Sale of software

 

Revenues included in this classification typically include sales of licenses with professional services to new customers, additional software licenses to existing customers, and sales of software with or without services to the Company’s resellers (See section j) - Reseller Agreements, below. Our software licenses are functional intellectual property and typically provide customers with the right to use our software in perpetuity as it exists when made available to the customer. We recognize revenue from software licenses at a point in time upon delivery, provided all other revenue recognition criteria are met.

 

b) Sale of software as a service

 

Sale of software as a service (“SaaS”) consists of revenues from arrangements that provide customers the use of the Company’s software applications, as a service, typically billed on a monthly or annual basis. Advance billings of these services are not recorded to the extent that the term of the arrangement has not commenced and payment has not been received. Revenue on these services is recognized over the contract period.

 

c) Sale of software maintenance services

 

Software maintenance services revenues consist of revenues derived from arrangements that provide post-contract support (“PCS”), including software support and bug fixes, to the Company’s software license holders. Advance billings of PCS are not recorded to the extent that the term of the PCS has not commenced and payment has not been received. PCS are considered distinct services. However, these distinct services are considered a single performance obligation consisting of a series of services that are substantially the same and have the same pattern of transfer to the customer. These revenues are recognized over the term of the maintenance contract.

 

d) Sale of professional services

 

Professional services revenues consist of revenues from document scanning and conversion services, consulting, discovery, training, and advisory services to assist customers with document management needs, as well as repair and maintenance services for customer equipment. We recognize professional services revenue over time as the services are delivered using an input or output method (e.g., labor hours incurred as a percentage of total labor hours budgeted, images scanned, or similar milestones), as appropriate for the contract, provided all other revenue recognition criteria are met.

 

e) Sale of storage and retrieval services

 

Sale of document storage and retrieval services consist principally of secured warehouse storage of customer documents, as well as retrieval per agreement terms and certified destruction if desired. We recognize revenue from document storage and retrieval services over the term of the contract for storage and for the retrieval and destructions components, as the services are delivered.

 

f) Arrangements with multiple performance obligations

 

In addition to selling software licenses, software as a service, software maintenance services, professional services, and storage and retrieval services on a stand-alone basis, a portion of our contracts include multiple performance obligations. For contracts with multiple performance obligations, the Company allocates the transaction price of the contract to each distinct performance obligation, on a relative basis using its standalone selling price. The Company determines the standalone selling price based on the price charged for the deliverable when sold separately.

 

10

 

 

g) Contract balances

 

When the timing of our delivery of goods or services is different from the timing of payments made by customers, we recognize either a contract asset (performance precedes contractual due date) or a contract liability (customer payment precedes performance). Customers that prepay are represented by deferred revenue until the performance obligation is satisfied. Contract assets represent arrangements in which the good or service has been delivered but payment is not yet due. Our contract assets consisted of accounts receivable, unbilled, which are disclosed on the condensed consolidated balance sheets. Our contract liabilities consisted of deferred (unearned) revenue, which is generally related to software as a service or software maintenance contracts. We classify deferred revenue as current based on the timing of when we expect to recognize revenue, which are disclosed on the condensed consolidated balance sheets.

 

The following table present changes in our contract assets and liabilities during the nine months ended September 30, 2020 and 2019:

 

   Balance at
Beginning of Period
   Addition
from
acquisition
(Note 6)
   Revenue
Recognized in
Advance of
Billings
   Billings   Balance at
End of
Period
 
Nine months ended September 30, 2020                         
Contract assets: Accounts receivable, unbilled  $23,371   $276,023   $602,692   $(398,444)  $503,642 
                          
Nine months ended September 30, 2019                         
Contract assets: Accounts receivable, unbilled  $65,118   $-   $133,505   $(163,271)  $35,352 

 

h) Deferred revenue

 

Amounts that have been invoiced are recognized in accounts receivable, deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. Deferred revenue represents amounts billed for which revenue has not yet be recognized. Deferred revenues typically relate to maintenance and software-as-a-service agreements which have been paid for by customers prior to the performance of those services, and payments received for professional services and license arrangements and software-as-a-service performance obligations that have been deferred until fulfilled under our revenue recognition policy.

 

Remaining performance obligations represent the transaction price from contracts for which work has not been performed or goods and services have not been delivered. We expect to recognize revenue on approximately 96% of the remaining performance obligations over the next 12 months, with the remainder recognized thereafter. As of September 30, 2020, the aggregate amount of the transaction price allocated to remaining performance obligations for software as a service and software maintenance contracts with a duration greater than one year was $43,337. As of December 31, 2019, the aggregate amount of the transaction price allocated to remaining performance obligations for software as a service and software maintenance contracts with a duration greater than one year was $69,381. This does not include revenue related to performance obligations that are part of a contract whose original expected duration is one year or less.

 

   Balance at
Beginning
of Period
   Addition
from
acquisition
(Note 6)
   Billings   Recognized
Revenue
   Balance at
End of
Period
 
Nine months ended September 30, 2020                         
Contract liabilities: Deferred revenue  $754,073   $198,659   $2,215,742   $(2,146,222)  $1,022,252 
                          
Nine months ended September 30, 2019                         
Contract liabilities: Deferred revenue  $723,619   $-   $2,010,090   $(2,060,993)  $672,716 

 

11

 

 

i) Rights of return and customer acceptance

 

The Company does not generally offer variable consideration, financing components, rights of return or any other incentives such as concessions, product rotation, or price protection and, therefore, does not provide for or make estimates of rights of return and similar incentives. Our contracts with customers generally do not include customer acceptance clauses.

 

j) Reseller agreements

 

The Company executes certain sales contracts through resellers. The Company recognizes revenues relating to sales through resellers when all the recognition criteria have been met including passing of control. In addition, the Company assesses the credit-worthiness of each reseller, and if the reseller is undercapitalized or in financial difficulty, any revenues expected to emanate from such resellers are deferred and recognized only when cash is received and all other revenue recognition criteria are met.

 

k) Contract costs

 

The Company capitalizes the incremental costs of obtaining a contract with a customer. We have determined that certain sales commissions meet the requirement to be capitalized, and we amortize these costs on a consistent basis with the pattern of transfer of the goods and services in the contract. Total capitalized costs to obtain contracts were immaterial during the periods presented and are included in other current and long-term assets on our consolidated balance sheets.

 

l) Sales taxes

 

Sales taxes charged to and collected from customers as part of the Company’s sales transactions are excluded from revenues, as well as the determination of transaction price for contracts with multiple performance obligations, and recorded as a liability to the applicable governmental taxing authority.

 

m) Disaggregation of revenue

 

The Company provides disaggregation of revenue based on product groupings in our consolidated statements of operations as it believes this best depicts how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors. Revenues from contracts are primarily within the United States. International revenues were not material to the condensed consolidated financial statements for the nine months ended September 30, 2020 and 2019.

 

n) Significant financing component

 

The Company’s customers typically do not pay in advance for goods or services to be transferred in excess of one year. As such, it is not necessary to determine if the Company benefits from the time value of money and should record a component of interest income related to the upfront payment due to the practical expedient of ASC 606-10-32-18.

 

Concentrations of Credit Risk

 

The Company maintains its cash with high credit quality financial institutions. At times, the Company’s cash and cash equivalents may be uninsured or in deposit accounts that exceed the Federal Deposit Insurance Corporation insurance limit.

 

The number of customers that comprise the Company’s customer base, along with the different industries, governmental entities and geographic regions, in which the Company’s customers operate, limits concentrations of credit risk with respect to accounts receivable, with the exception of the State of Michigan. In the nine months ended September 30, 2020, the Company’s sales to the State of Michigan totaled approximately 43% of revenues. The Company expects revenues from the State of Michigan to be a slightly higher percentage of total revenues in future periods. The Company is not aware of any losses by Graphic Sciences resulting from nonpayment by the State of Michigan.

 

12

 

 

The Company does not generally require collateral or other security to support customer receivables; however, the Company may require its customers to provide retainers, up-front deposits or irrevocable letters-of-credit when considered necessary to mitigate credit risks. The Company has established an allowance for doubtful accounts based upon facts surrounding the credit risk of specific customers and past collections history. Credit losses have been within management’s expectations. At September 30, 2020 and December 31, 2019, the Company’s allowance for doubtful accounts was $59,706 and $35,733, respectively.

 

Parts and Supplies

 

Parts and supplies are valued at the lower of cost or net realizable value. Costs are determined using the first-in, first-out method. Parts and supplies are used for scanning and document conversion services. A provision for potentially obsolete or slow-moving parts and supplies inventory is made based on parts and supplies levels, future sales forecasted and management’s judgment of potentially obsolete parts and supplies. The Company recorded an allowance of $10,500 at September 30, 2020 and there was no allowance recorded as of September 30, 2019.

 

Property and Equipment

 

Property, equipment and leasehold improvements are stated at cost less accumulated depreciation and amortization. Depreciation and amortization is computed over the estimated useful lives of the related assets on a straight-line basis. Furniture and fixtures, computer hardware and purchased software are depreciated over three to seven years. Leasehold improvements are amortized over the life of the lease or the asset, whichever is shorter, generally seven to ten years. Upon retirement or other disposition of these assets, the cost and related accumulated depreciation and amortization of these assets are removed from the accounts and the resulting gains and losses are reflected in the results of operations.

 

Intangible

 

All intangible assets have finite lives and are stated at cost, net of amortization. Amortization is computed over the useful life of the related assets on a straight-line method.

 

Goodwill

 

The carrying value of goodwill is not amortized, but is tested for impairment annually as of December 31, as well as on an interim basis whenever events or changes in circumstances indicate that the carrying amount of a reporting unity may not be recoverable. An impairment charge is recognized for the amount by which the carrying amount exceeds the recorded fair value.

 

Impairment of Long-Lived Assets

 

The Company accounts for the impairment and disposition of long-lived assets in accordance with ASC 360, “Property, Plant, and Equipment.” The Company tests long-lived assets or asset groups, such as property and equipment, for recoverability when events or changes in circumstances indicate that their carrying amount may not be recoverable.

 

Circumstances which could trigger a review include, but are not limited to: significant adverse changes in the business climate or legal factors; current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the asset; and a current expectation that the asset will more likely than not be sold or disposed of before the end of its estimated useful life.

 

Recoverability is assessed based on comparing the carrying amount of the asset to the aggregate pre-tax undiscounted cash flows expected to result from the use and eventual disposal of the asset or asset group. Impairment is recognized when the carrying amount is not recoverable and exceeds the fair value of the asset or asset group. The impairment loss, if any, is measured as the amount by which the carrying amount exceeds fair value, which for this purpose is based upon the discounted projected future cash flows of the asset or asset group. There were no impairment of long lived assets in the periods ended September 30, 2020 or 2019.

 

Stock-Based Compensation

 

The Company accounts for stock-based payments to employees in accordance with ASC 718, “Compensation - Stock Compensation.” Stock-based payments to employees include grants of stock that are recognized in the consolidated statement of operations based on their fair values at the date of grant.

 

The Company accounts for stock-based payments to non-employees in accordance with ASC 718, “Compensation - Stock Compensation,” which requires that such equity instruments are recorded at their fair values on the grant date.

 

The grant date fair value of stock option awards is recognized in earnings as stock-based compensation cost over the requisite service period of the award using the straight-line attribution method. The Company estimates the fair value of the stock option awards using the Black-Scholes-Merton option pricing model. The exercise price of options is specified in the stock option agreements. The expected volatility is based on the historical volatility of the Company’s stock for the previous period equal to the expected term of the options. The expected term of options granted is based on the midpoint between the vesting date and the end of the contractual term. The risk-free interest rate is based upon a U.S. Treasury instrument with a life that is similar to the expected term of the options. The expected dividend yield is based upon the yield expected on date of grant to occur over the term of the option.

 

13

 

 

Software Development Costs

 

The Company designs, develops, tests, markets, licenses, and supports new software products and enhancements of current products. The Company continuously monitors its software products and enhancements to remain compatible with standard platforms and file formats. In accordance with ASC 985-20, “Costs of Software to be Sold, Leased or Otherwise Marketed,” the Company expenses software development costs, including costs to develop software products or the software component of products to be sold, leased, or marketed to external users, before technological feasibility is reached. Once technological feasibility has been established, certain software development costs incurred during the application development stage are eligible for capitalization. Based on the Company’s software development process, technical feasibility is established upon completion of a working model. Technological feasibility is typically reached shortly before the release of such products. No such costs were capitalized during the periods presented in this report.

 

In accordance with ASC 350-40, “Internal-Use Software,” the Company capitalizes purchase and implementation costs of internal use software. Once an application has reached development stage, internal and external costs, if direct and incremental, are capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon complete of all substantial testing. The Company also capitalize costs related to specific upgrades and enhancements when it is probable that the expenditure will result in additional functionality. No such costs were capitalized during the periods presented in this report.

 

For the three and nine months ended September 30, 2020 and 2019, our expensed software development costs were $60,085 and $228,834, respectively, and $101,885 and $349,111, respectively.

 

Recent Accounting Pronouncements

 

Intangibles – Goodwill and Other – Internal-Use Software

 

In August 2018, the FASB issued ASU 2018-15, which addresses a customer’s accounting for implementation costs incurred in a cloud computing arrangement that is a service contract. Under the new guidance, customers will apply the same criteria for capitalizing implementation costs as they would for an arrangement that has a software license. ASC 2018-15 was effective for the Company beginning in its first quarter of 2020. The Company has concluded that the impact on its condensed consolidated financial statements and related disclosures is not material.

 

Fair Value

 

In August 2018, the FASB issued ASU 2018-13, which is guidance that changes the fair value measurement disclosure requirements of ASC 820. ASU 2018-13 was effective for the Company beginning in its first quarter of 2020. The Company has concluded that the impact on its condensed consolidated financial statements and related disclosures is not material.

 

Leases

 

In February 2016, the FASB issued ASU No. 2016-02, Leases (“ASC 842”) (“ASU 2016-02”), which modified lease accounting for both lessees and lessors to increase transparency and comparability by recognizing lease assets and lease liabilities by lessees for those leases classified as operating leases under previous accounting standards and disclosing key information about leasing arrangements. ASU 2016-02 was effective for the Company beginning in its first quarter of 2019. On January 1, 2019, the Company recorded a lease liability of $143,761 and a net right-of-use asset of $138,549 using the required modified retrospective approach. On March 2, 2020, the Company recorded a lease liability of $2,947,684 and a net right-of-use asset of $2,885,619 using the required modified retrospective approach for the newly acquired subsidiary, Graphic Sciences. In adopting ASC 842, the Company elected to utilize the available package of practical expedients permitted under the transition guidance within the new standard, which does not require the reassessment of the following: i) whether existing or expired arrangements are or contain a lease, ii) the lease classification of existing or expired leases, and iii) whether previous initial costs would qualify as capitalization under the new lease standard.

 

14

 

 

Recently Issued Accounting Pronouncements Not Yet Effective

 

Financial Instruments – Credit Losses

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326), which requires entities to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. This replaces the existing incurred loss model and is applicable to the measurement of credit losses on financial assets measured at amortized cost. ASC 2016-16 is effective for annual reporting periods beginning after December 15, 2023, including interim reporting periods within those annual reporting periods. Early adoption is permitted. The Company is currently evaluating the impact of the new guidance on its condensed consolidated financial statements and related disclosures.

 

Reference Rate Reform

 

In March 2020, the FASB issued ASU 2020-04, “Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting” which provides optional relief through specific exceptions and practical expedients for transitioning away from reference rates that are expected to be discontinued. The relief generally applies to eligible modifications of contractual terms that change (or have the potential to change) the amount or timing of contractual cash flows related to replacement of a reference rate. The relief allows such modifications to be accounted for as continuations of existing contracts without additional analysis. The optional relief is available from March 2020 through December 31, 2022. The Company is currently evaluating the impact of this ASU.

 

Income Taxes

 

In December 2019, the FASB issued ASU 2019-12, “Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes” which removes certain exceptions related to intra-period tax allocations and deferred tax accounting on outside basis differences in foreign subsidiaries and equity method investments. Additionally, it provides other simplifying measures for the accounting for income taxes. The new standard is effective for fiscal years beginning after December 15, 2021 with early adoption permitted. The Company is currently evaluating the impact of this ASU.

 

Equity Securities, Equity Method Investments and Certain Derivatives

 

In January 2020, the FASB issued ASU 2020-01, “Clarifying the Interactions Between Topic 321, Topic 323, and Topic 815.” This ASU clarifies the interaction between accounting standards related to equity securities, equity method investments and certain derivatives. The effective date of the standard will be for annual periods beginning after December 15, 2020, and interim periods within those fiscal years. The Company is currently evaluating the impact of the adoption of the new standard on its condensed consolidated financial statements and related disclosures.

 

Lease Accounting and COVID-19

 

In April 2020, the FASB issued a question-and-answer document to address stakeholder questions on the application of the lease accounting guidance for lease concessions related to the effects of the COVID-19 pandemic. The guidance will allow concessions related to the timing of payments, where the total consideration has not changed, to not be accounted for as lease modifications. Instead, any such concessions can be accounted for as if no change was made to the contract or as variable lease payments. The Company is currently assessing the impact of the question-and-answer document on its condensed consolidated financial statements.

 

All other Accounting Standards Updates issued but not yet effective are not expected to have a material effect on the Company’s future condensed consolidated financial statements.

 

Advertising

 

The Company expenses the cost of advertising as incurred. Advertising expense for the three and nine months ended September 30, 2020 and 2019 amounted to $1,651 and 5,331, respectively, $1,028 and $3,084, respectively.

 

Earnings (Loss) Per Share

 

Basic income or loss per share is computed by dividing net income or loss by the weighted average number of shares of common stock outstanding during the period. Diluted income or loss per share is computed by dividing net income or loss by the diluted weighted average number of shares of common stock outstanding during the period. The diluted weighted average number of shares gives effect to all dilutive potential common shares outstanding during the period using the treasure stock method. Diluted earnings per share exclude all diluted potential shares if their effect is anti-dilutive, including warrants or options which are out-of-the-money and for those periods with a net loss. For the three months ended September 30, 2020, all applicable options and warrants were out-of-the-money. The nine months ended September 30, 2020 and the three and nine months ended September 30, 2019 reported a net loss.

 

Income Taxes

 

The Company and its subsidiaries file a consolidated federal income tax return. The provision for income taxes is computed by applying statutory rates to income before taxes.

 

Deferred income taxes are recognized for the tax consequences in future years of temporary differences between the financial reporting and tax bases of assets and liabilities as of each period-end based on enacted tax laws and statutory rates. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. A 100% valuation allowance has been established on deferred tax assets at September 30, 2020 and December 31, 2019, due to the uncertainty of our ability to realize future taxable income. For the nine months ended September 30, 2020 the Company recovered a net $179,400 of its valuation allowance in conjunction with the consolidation of the net deferred tax liability of its wholly owned subsidiary, Graphic Sciences.

 

The Company accounts for uncertainty in income taxes in its financial statements as required under ASC 740, “Income Taxes.” The standard prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The standard also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition accounting. Management determined there were no material uncertain positions taken by the Company in its tax returns.

 

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Segment Information

 

Operating segments are defined in the criteria established under ASC 280, “Segment Reporting,” as components of public entities that engage in business activities from which they may earn revenues and incur expenses for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker (“CODM”) in deciding how to assess performance and allocate resources. The Company’s CODM assesses performance and allocates resources based on two operating segments: Document Management and Document Conversion. These segments contain individual business components that have been combined on the basis of common management, customers, solutions offered, service processes and other economic characteristics. The Company currently has no intersegment sales. The Company evaluates the segments’ performance based on gross profits.

 

The Document Management Segment provides cloud-based content services software. Its modular suite of solutions complements existing operating and accounting systems to serve a mission-critical role for organizations to make content secure, compliant, and process-ready. This segment conducts its primary operations in the United States. Markets served include highly regulated, risk and compliance-intensive markets in healthcare, K-12 education, public safety, other public sector, risk management, financial services, and others. Solutions are sold both directly to end-users and through resellers.

 

The Document Conversion Segment provides services for scanning and indexing, converting images from paper to digital, paper to microfilm, and microfiche to microfilm, as well as long-term physical document storage and retrieval. This segment conducts its primary operations in the United States. Markets served include business and federal, county, and municipal governments. Solutions are sold both directly to end-users and through a reseller distributor.

 

Information by operating segment is as follows:

 

   Three months ended
September 30, 2020
   Three months ended
September 30, 2019
 
Revenues          
Document Management  $780,834   $738,957 
Document Conversion   1,730,448    16,611 
Total revenues  $2,511,282   $755,568 
           
Gross profit          
Document Management  $605,451   $610,998 
Document Conversion   884,843    (3,120)
Total gross profit  $1,490,294   $607,878 
           
Capital additions, net          
Document Management  $-   $- 
Document Conversion   33,676    - 
Total capital additions, net  $33,676   $- 

 

   Nine months ended
September 30, 2020
   Nine months ended
September 30, 2019
 
Revenues          
Document Management  $2,018,208   $1,879,187 
Document Conversion   3,539,378    32,374 
Total revenues  $5,557,586   $1,911,561 
           
Gross profit          
Document Management  $1,526,283   $1,506,071 
Document Conversion   1,880,648    (14,769)
Total gross profit  $3,406,931   $1,491,302 
           
Capital additions, net          
Document Management  $7,911   $- 
Document Conversion   51,205    5,489 
Total capital additions, net  $59,116   $5,489 

 

   September 30, 2020   December 31, 2019 
Total assets          
Document Management  $1,825,343   $986,574 
Document Conversion   4,995,089    - 
Corporate   3,561,977    - 
Total assets  $10,382,409   $986,574 

 

16

 

 

Statement of Cash Flows

 

For purposes of reporting cash flows, cash includes cash on hand and demand deposits held by banks.

 

Reclassifications

 

Certain amounts reported in prior filings of the condensed consolidated financial statements have been reclassified to conform to current presentation.

 

6. Business Acquisitions

 

On March 2, 2020, the Company entered into a stock purchase agreement to acquire all of the issued and outstanding stock of Graphic Sciences. The acquisition was accounted for in accordance with GAAP and was made to expand the Company’s market share in the document management industry and due to synergies of product lines and services between the Companies.

 

On April 21, 2020, the Company entered into an asset purchase agreement to acquire substantially all of the assets of CEO Image. The acquisition was accounted for in accordance with GAAP and was made to expand the Company’s market share in the document management industry and due to synergies of product lines and services between the Companies.

 

The purchase price has been preliminarily allocated to assets acquired and liabilities assumed based on the estimated fair value of such assets and liabilities at the date of acquisitions as follows:

 

   Total   March 2, 2020   April 21, 2020 
Assets acquired:               
Cash  $17,269   $17,269   $- 
Accounts receivable   1,122,737    1,071,770    50,967 
Accounts receivable, unbilled   276,023    276,023    - 
Parts and supplies   91,396    91,396    - 
Prepaid expenses   73,116    73,116    - 
Other current assets   5,954    5,954    - 
Right of use assets   2,885,618    2,885,618    - 
Property and equipment   735,885    732,372    3,513 
Intangible assets (see Note 7)   1,361,000    1,230,000    131,000 
    6,568,998    6,383,518    185,480 
Liabilities assumed:               
Accounts payable   168,749    129,622    39,127 
Accrued expenses   162,426    155,949    6,477 
Lease liabilities   2,947,684    2,947,684    - 
Federal and state taxes payable   168,900    168,900    - 
Deferred revenue   198,659    39,186    159,473 
Deferred tax liabilities - Net   149,900    149,900    - 
    3,796,318    3,591,241    205,077 
                
Total identifiable net assets/(liabilities)   2,772,680    2,792,277    (19,597)
                
Purchase price   5,095,567    4,592,453    503,114 
                
Goodwill - Excess of purchase price over fair value of net assets acquired  $2,322,887   $1,800,176   $522,711 

 

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The purchase price of Graphic Sciences was financed with a $686,200 seller earnout liability and $3,906,253 was paid in cash. Goodwill in the amount of $1,800,176 was recognized in the acquisition of Graphic Sciences and is attributable to the cash flows of the business derived from the potential of the Company to outperform the market due to its existing relationship and other synergies created within the Company.

 

The purchase price of CEO Image was partially financed with a $203,000 seller earnout liability and $170,000 in installment payments. $128,832 was paid in cash at the closing. On August 3, 2020, $1,282 was paid for a net working capital adjustment and $70,000 was paid, along with accrued interest, in installment payments. The remaining Seller note of $100,000 is included in notes payable – current. Goodwill in the amount of $522,711 was recognized in the acquisition of CEO Image and is attributable to the cash flows of the business derived from the potential of the Company to outperform the market due to its existing relationship and other synergies created within the Company.

 

Acquisition costs which include legal and other professional fees of approximately $636,440 were expensed as nonrecurring transaction costs and are included in Significant transaction costs in the accompanying condensed consolidated statement of operations.

 

The earnout arrangement for Graphic Sciences requires the Company to pay the seller up to $833,000 annually for a three year period based on a gross profit level achieved by Graphic Sciences on an annual basis, resulting in a max payout to the seller over a three year period of $2,500,000, as defined. Management estimated a fair value of the earnout liability of $686,200 which would be owed to the seller based on the terms of the earnout, and accordingly, recorded this liability at the acquisition date in accordance with GAAP. The fair value was based on projections of future gross profit over a three year period and valuation techniques that utilized expected volatility, threshold probability, and discounting of future payments.

 

The earnout arrangement for CEO Image requires the Company to pay the seller up to $185,000 annually for a two year period based on a sales revenue level achieved by certain customers of CEO Image on an annual basis, resulting in a max payout to the seller over a two year period of $370,000, as defined. Management estimated a fair value of the earnout of $203,000 which would be owed to the seller based on the terms of the earnout, and accordingly, recorded this liability at the acquisition date in accordance with GAAP. The fair value was based on projections of future revenue over a two year period and valuation techniques that utilized expected volatility, threshold probability, and discounting of future payments.

 

As the Company finalizes the fair value of assets acquired and liabilities assumed, additional purchase price adjustments may be recorded. The finalization of the purchase accounting assessment may result in changes in the valuation of assets acquired and liabilities assumed and may have an impact on the Company’s results of operations and financial position.

 

The following unaudited pro forma information presents a summary of the consolidated results of operations for the Company as if the acquisitions of Graphic Sciences and CEO Image had occurred on January 1, 2019.

 

    For the Three months ended  
    (unaudited)     (unaudited)  
    September 30, 2020     September 30, 2019  
Total revenues   $ 2,511,282     $ 2,931,250  
                 
Net income (loss)   $ 155,673     $ (324,174 )
                 
Basic and diluted net income (loss) per share   $ 0.06     $ (0.12 )

 

   For the Nine months ended 
   (unaudited)   (unaudited) 
   September 30, 2020   September 30, 2019 
Total revenues  $6,990,549   $7,716,421 
           
Net loss  $(566,082)  $(1,031,326)
           
Basic and diluted net loss per share  $(0.20)  $(0.37)

 

The unaudited pro forma consolidated results are based on the Company’s historical financial statements and those of Graphic Sciences and CEO Image and do not necessarily indicate the results of operations that would have resulted had the acquisition actually been completed at the beginning of the applicable period presented. The pro forma financial information assumes that the companies were combined as of January 1, 2019.

 

The following table presents the amounts of revenue and earnings of the acquirees since the acquisition date included in the condensed consolidated income statement for the reporting period.

 

For the three months ended September 30, 2020  Graphic Sciences   CEO Image 
Total revenues  $1,660,775   $155,414 
           
Net income  $239,555   $(a) 

 

For the nine months ended September 30, 2020  Graphic Sciences   CEO Image 
Total revenues  $3,409,193   $219,934 
           
Net income  $380,881   $(a) 

 

  (a) Total earnings from the CEO Image acquisition is impracticable to disclose as the operations were merged with existing operations and not accounted for separately.

 

7. Intangible Assets, Net

 

At September 30, 2020, intangible assets consisted of the following:

 

   Estimated      Accumulated     
   Useful Life  Costs   Amortization   Net 
Trade names  10 years  $119,000   $(6,942)  $112,058 
Customer contracts  5-8 years   1,242,000    (114,968)   1,127,032 
      $1,361,000   $(121,910)  $1,239,090 

 

Amortization expense for the three and nine months ended September 30, 2020, amounted to $54,119 and $121,910, respectively. The following table represents future amortization expense for intangible assets subject to amortization.

 

For the Nine Months Ending September 30,  Amount 
2021  $216,475 
2022   216,475 
2023   216,475 
2024   216,475 
2025   205,558 
Thereafter   167,632 
   $1,239,090 

 

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8. Fair Value Measurements

 

Under U.S. GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy included in U.S. GAAP gives the highest priority to Level 1 inputs, which consist of unadjusted quoted prices for identical instruments in active markets. Level 2 inputs consist of quoted prices for similar instruments. Level 3 valuations are derived from inputs that are significant and unobservable, and these valuations have the lowest priority.

 

Management believes that the carrying values of cash and equivalents, accounts receivable, accounts payable, accrued expenses, and the 2019 Related Notes approximate fair value because of their short maturity. Management believes that the carrying value of the 2020 Notes approximates fair value given the March 2, 2020 transaction proximity to September 30, 2020.

 

The table below reflects all other notes payable at December 31, 2019.

 

      December 31, 2019 
      Fair Value 
2016 Unrelated Notes  (a)  $942,256 
2017 Unrelated Notes  (a)   2,011,859 
2018 Unrelated Notes  (a)   1,028,792 
Total     $3,982,907 

 

      December 31, 2019 
      Fair Value 
2016 Related Notes  (a)  $405,784 
2017 Related Notes  (a)   445,810 
2018 Related Notes  (a)   457,241 
Total     $1,308,835 

 

  (a) The fair value was based upon Level 2 inputs. See Note 10 for additional information about the Company’s 2016, 2017, and 2018 Unrelated Notes. See Note 11 for additional information about the Company’s 2016, 2017, and 2018 Related Notes.

 

Management believes that the carrying value of the earnout liabilities approximates fair value given the March 2, 2020 and April 21, 2020 transactions proximity to September 30, 2020. Fair value of the earnout liabilities is based upon Level 3 inputs, using significant unobservable inputs for the period ended.

 

9. Property and Equipment

 

Property and equipment are comprised of the following:

 

   September 30, 2020   December 31, 2019 
Computer hardware and purchased software  $998,007   $259,959 
Leasehold improvements   275,106    221,666 
Furniture and fixtures   82,056    82,056 
    1,355,169    563,681 
Less: accumulated depreciation and amortization   (639,169)   (556,762)
Property and equipment, net  $716,000   $6,919 

 

Total depreciation expense on the Company’s property and equipment for the three and nine months ended September 30, 2020 and 2019 amounted to $35,357 and $82,407, respectively, and $1,901 and $5,908, respectively.

 

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10. Notes Payable

 

Summary of Notes Payable

 

The table below reflects all notes payable at September 30, 2020 and December 31, 2019, respectively, with the exception of related party notes disclosed in Note 11 - Notes Payable - Related Parties.

 

   September 30, 2020   December 31, 2019 
Seller Notes Payable  $100,000   $- 
PPP Note Payable   838,700    - 
2020 Notes   2,000,000    - 
2018 Unrelated Notes   -    900,000 
2017 Unrelated Notes   -    1,760,000 
2016 Unrelated Notes, net of beneficial conversion feature of $50,703   -    824,297 
Total notes payable  $2,938,700   $3,484,297 
Less unamortized debt issuance costs   (250,702)   (144,334)
Less unamortized debt discount   (257,778)   - 
Less current portion   (612,539)   3,339,963 
Long-term portion of notes payable  $1,817,681   $- 

 

Future minimum principal payments of these notes payable as described in this Note 10 are as follows:

 

As of September 30,  Amount 
2021  $612,539 
2022   326,161 
2023   2,000,000 
Total  $2,938,700 

 

As of September 30, 2020 and December 31, 2019, accrued interest for these notes payable with the exception of the related party notes in Note 11 - Notes Payable - Related Parties, was $4,505 and $918,307, respectively. As of September 30, 2020, unamortized deferred financing costs and unamortized debt discount were reflected within long term liabilities on the condensed consolidated balance sheets. As of December 31, 2019, unamortized deferred financing costs were $144,334, and was reflected within current liabilities on the consolidated balance sheets.

 

With respect to all notes outstanding (other than the notes to related parties), for the three and nine months ended September 30, 2020 and 2019, interest expense, including the amortization of deferred financing costs, accrued loan participation fees, original issue discounts, deferred interest and related fees, interest expense related to warrants issued for the conversion of convertible notes, and the embedded conversion feature was $115,498 and $433,783, respectively, and $186,198 and $544,639, respectively.

 

Seller Notes Payable

 

On April 21, 2020, the Company entered into an asset purchase agreement under which the Company agreed to pay a principal amount of $170,000 (“Seller Notes Payable”) as further discussed in Note 6. The terms of the Seller Notes Payable are approximately three and six months, with $70,000 plus accrued interest paid August 3, 2020 and $100,000 plus accrued interest due November 1, 2020. The Seller Notes Payable bear an interest rate of 1.5% per annum.

 

Paycheck Protection Program Note Payable

 

On April 15, 2020, the Company entered into an unsecured promissory note (“PPP Note Payable”) under the Paycheck Protection Program (the “PPP”), through PNC Bank with a principal amount of $838,700. The term of the PPP Note Payable is two years, with an interest rate of 1.0% per annum, which shall be deferred for the first six months of the term of the loan. PPP loan recipients can be granted forgiveness for all or a portion of loans granted under the PPP, based on the use of loan proceeds for payroll costs and mortgage interest, rent or utility costs and the maintenance of employee and compensation levels. No assurance is provided that the Company will obtain forgiveness of the PPP Note Payable in whole or in part.

 

2020 Note Issuance

 

On March 2, 2020, the Company issued and sold 2,000 units (“Units”) to certain accredited investors in a private offering, with each Unit consisting of $1,000 in 12% Subordinated Notes (“2020 Notes”) and 40 shares of common stock, for aggregate gross proceeds of $2,000,000 in Units. The entire outstanding principal and accrued interest of the 2020 Notes are due and payable on February 28, 2023. Interest on the 2020 Notes accrues at the rate of 12% per annum, payable quarterly in cash, beginning on June 30, 2020. Any accrued but unpaid quarterly installment of interest shall accrue interest at the rate of 14.0% per annum. Any overdue principal and accrued and unpaid interest at the maturity date shall accrue a mandatory default penalty of 20% of the outstanding principal balance and an interest rate of 14% per annum from the maturity date until paid in full. The Company used a portion of the net proceeds of the offering to finance the acquisition of Graphic Sciences and CEO Image and using the remaining net proceeds for working capital and general corporate purposes. The Company recognized a debt discount of $320,000 for the 80,000 shares issued in conjunction with the Units. The amortization of the debt discount will be recognized over the life of the 2020 Notes as interest expense, and was $26,667 and $62,222, respectively, for the three and nine months ended September 30, 2020.

 

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2020 Note Conversion

 

On March 2, 2020, the Company entered into amendments to all of its then-outstanding convertible promissory notes, which were issued by the Company to various related and unrelated investors in 2016, 2017, and 2018. The Note Amendments permitted the Company to convert all of the then-outstanding principal and accrued and unpaid interest payable with respect to the 2016-2018 Notes into shares of Common Stock upon the same terms as such private placement. Pursuant to the Note Amendments, on March 2, 2020, the Company converted all of the then-outstanding principal and accrued and unpaid interest payable with respect to the 2016-2018 Notes into the aggregate amount of 1,433,689 shares of Common Stock at a conversion price of $4.00 per share. Taglich Brothers, Inc. acted as the exclusive placement agent for the Note Conversion, and earned fees in the form of 35,250 shares of Common Stock at a price of $4.00 per share (with such fees relating to the conversion of both the related and unrelated notes).

 

2018 Notes

 

On September 20 and September 26, 2018, the Company issued convertible promissory notes in an aggregate amount of $900,000 (“2018 Unrelated Notes”) to unrelated accredited investors (the “2018 Note Investors”). Placement agent and escrow agent fees of $106,740 were paid out of the cash proceeds. The 2018 Unrelated Notes matured on December 31, 2020, and bore interest at an annual rate of interest of 8% until maturity, with interest of 8% payable quarterly beginning January 2, 2019. The 2018 Note Investors had the right, in their sole discretion, to convert the 2018 Unrelated Notes into shares of Company common stock under certain circumstances at a conversion rate of $6.50 per share. These notes were further amended and converted into equity on March 2, 2020, as described further below in this note, see “2020 Note Conversion.”

 

2017 Notes

 

On November 17 and November 30, 2017, the Company issued convertible promissory notes in an aggregate amount of $1,760,000 (“2017 Unrelated Notes”) to unrelated accredited investors (the “2017 Note Investors”). Placement agent and escrow agent fees of $174,810 were paid out of the cash proceeds. The 2017 Unrelated Notes had an original maturity date of November 30, 2019. On September 14, 2018, the 2017 Unrelated Notes were amended to mature on December 31, 2020. The amendment was accounted for as a troubled debt restructuring with the future undiscounted cash flows being greater than the carrying value of the debt prior to extension. No gain was recorded on the amendment, and a new effective interest rate on the 2017 Unrelated Notes was established based on the carrying value of the debt and the revised future cash flows. The 2017 Unrelated Notes bore interest at an annual rate of interest of 8% until maturity, with interest of 8% payable quarterly beginning July 1, 2018. The 2017 Note Investors had the right, in their sole discretion, to convert the 2017 Unrelated Notes into shares of Company common stock under certain circumstances at a conversion rate of $10.00 per share. These notes were further amended and converted into equity on March 2, 2020, as described further below in this note, see “2020 Note Conversion.”

 

2016 Notes

 

The Company issued convertible promissory notes on December 30, 2016 in an aggregate amount of $315,000, and on January 6, 2017 and January 31, 2017 in an aggregate amount of $560,000 (collectively, the “2016 Unrelated Notes”), to unrelated accredited investors (the “2016 Note Investors”). Placement agent and escrow agent fees of $100,255 in the aggregate for those issuances, were paid out of the cash proceeds of those issuances. The 2016 Unrelated Notes bore interest at an annual rate of interest of 12% until maturity, with partial interest of 6% payable quarterly, and an original maturity date of December 31, 2018. The 2016 Note Investors had the right, in their sole discretion, to convert the 2016 Unrelated Notes into shares of Company common stock at a conversion rate of $32.50 per share. On September 17, 2018, the 2016 Unrelated Notes were amended to mature on December 31, 2020, and bore interest at an annual rate of interest of 10% until maturity, with partial interest of 5% payable quarterly. With the amendment, the 2016 Note Investors had the right, in their sole discretion, to convert the 2016 Unrelated Notes into shares of Company common stock at a conversion rate of $20.00 per share. The amendment was accounted for as a troubled debt restructuring with the future undiscounted cash flows being greater than the carrying value of the debt prior to extension. No gain was recorded on the amendment, and a new effective interest rate on the 2016 Unrelated Notes was established based on the carrying value of the debt and the revised future cash flows. The Company recognized an initial beneficial conversion feature in the amount of $369,677, plus a fair value adjustment of $56,661 under the troubled debt restructuring accounting. Interest expense recognized on the amortization of the beneficial conversion feature of the 2016 Unrelated Notes was $0 and $50,703, and $12,675 and $38,027, for the three and nine months ended September 30, 2020 and 2019, respectively. These notes were further amended and converted into equity on March 2, 2020, as described further below in this note, see “2020 Note Conversion.”

 

The Company has evaluated the terms of its convertible notes payable in accordance with ASC 815 – 40, “Derivatives and Hedging - Contracts in Entity’s Own Stock” and determined that the underlying common stock is indexed to the Company’s common stock. The Company determined that the conversion feature did not meet the definition of a derivative and therefore did not bifurcate the conversion feature and account for it as a separate derivative liability. The Company evaluated the conversion feature for a beneficial conversion feature. The effective conversion price was compared with the market price on the date of each note. If the conversion price was deemed to be less than the market value of the underlying common stock at the inception of the note, then the Company recognized a beneficial conversion feature resulting in a discount on the note payable, upon satisfaction of the contingency. The beneficial conversion features were amortized to interest expense over the life of the respective notes, starting from the date of recognition.

 

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11. Notes Payable - Related Parties

 

Summary of Related Notes

 

The table below reflects the notes payable to related parties at September 30, 2020 and December 31, 2019, respectively:

 

   September 30, 2020   December 31, 2019 
2019 Related Notes  $-   $397,728 
2018 Related Notes   -    400,000 
2017 Related Notes   -    390,000 
2016 Related Notes, net of beneficial conversion feature of $20,015   -    354,985 
Total notes payable - related party  $-   $1,542,713 
Unamortized original issue discount and debt issuance costs   -    (75,313)
Less current portion   -    (1,467,400)
Long-term portion of notes payable-related party  $-   $- 

 

As of December 31, 2019, accrued interest for these notes payable – related parties amounted to $294,191, and on the condensed consolidated balance sheets was reflected within current liabilities as of December 31, 2019.

 

For the three and nine months ended September 30, 2020 and 2019, interest expense in connection with notes payable – related parties was $0 and $88,941, respectively, and $58,958 and $173,011, respectively.

 

2020 Note Conversion

 

On March 2, 2020, the Company entered into amendments to all of its currently outstanding Convertible Promissory Notes, which were issued by the Company to various related and unrelated investors in 2016, 2017, and 2018. The Note Amendments permitted the Company to convert all of the then-outstanding principal and accrued and unpaid interest payable with respect to the 2016-2018 Notes into shares of Common Stock upon the same terms as such private placement. Pursuant to the Note Amendments, on March 2, 2020, the Company converted all of the then-outstanding principal and accrued and unpaid interest payable with respect to the 2016-2018 Notes into the aggregate amount of 1,433,689 shares of Common Stock at a conversion price of $4.00 per share. Taglich Brothers, Inc. acted as the exclusive placement agent for the Note Conversion, and earned fees in the form of 35,250 shares of Common Stock at a price of $4.00 per share (with such fees relating to the conversion of both the related and unrelated notes).

 

2019 Notes

 

On November 15, 2019, the Company issued promissory notes in an aggregate principal amount of $397,728 (the “2019 Related Notes”) to Robert Taglich and Michael Taglich (each holding more than 5% beneficial interest in the Company’s Shares). The notes included an original issue discount of $47,728. Interest expense recognized on the amortization of the original discount was $11,932, for the twelve months ended December 31, 2019. The notes bore no interest in addition to the original issue discount, which was 12%, and matured on May 15, 2020. If the 2019 Related Notes had not been either fully repaid by the Company or converted into Company shares or other securities by the maturity date, then the 2019 Related Notes would have accrued interest at the annual rate of 12% from the maturity date until the date of repayment. The Company used the proceeds of the 2019 Related Notes for working capital, general corporate purposes, and debt repayment. On March 2, 2020, $350,000 of such notes were converted into equity in connection with a private placement of common stock at a conversion price of $4.00 per share. On May 15, 2020, the remaining balance of $47,728 was repaid by the Company in cash.

 

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2018 Notes

 

On September 26, 2018, the Company issued convertible promissory notes in an aggregate amount of $400,000 (the “2018 Related Notes”) to accredited investors, including Robert Taglich and Michael Taglich (each holding more than a 5% beneficial interest in the Company’s shares). The 2018 Related Notes matured on December 31, 2020, and bore interest at an annual rate of 8% until maturity, with interest payable quarterly beginning January 2, 2019. The 2018 Related Note investors had the right, in their sole discretion, to convert the 2018 Related Notes into shares of Company common stock under certain circumstances at a conversion rate of $6.50 per share. These notes were further amended and converted into equity on March 2, 2020, as described further below in this note, see “2020 Note Conversion.”

 

2017 Notes

 

On September 21, 2017, the Company issued convertible promissory notes in an aggregate principal amount of $154,640 (the “2017 Bridge Notes”) to Robert Taglich and Michael Taglich (each holding more than a 5% beneficial interest in the Company’s shares). The 2017 Bridge Notes included an original issue discount of $4,640. Interest expense recognized on the amortization of the original discount was $889 for the twelve months ended December 31, 2017. The 2017 Bridge Notes bore interest at an annual rate of 8% beginning March 21, 2018 until maturity on September 21, 2018. The effective interest rate was 7% for the term of the 2017 Bridge Notes. The 2017 Bridge Note investors had the right, in their sole discretion, to convert the 2017 Bridge Notes into securities to be issued by the Company in a private placement of equity, equity equivalents, convertible debt or debt financing. In conjunction with the issue of the 2016 Bridge Notes, 3,000 warrants were issued to the 2017 Bridge Note investors. The warrants have an exercise price equal to $15.00 per share and contain a cashless exercise provision. All warrants are immediately exercisable and are exercisable for five years from issuance. The Company recognized debt issuance costs, recorded as a debt discount, on the issue of the warrants in the amount of $38,836. Interest expense recognized on the amortization of the debt discount was $38,836 for the twelve months ended December 31, 2017. On November 30, 2017, principal in the amount of $150,000 of the 2017 Bridge Notes was converted by the 2017 Bridge Note investors into the 2017 Related Notes, described below.

 

On November 17, 2017, the Company issued convertible promissory notes in an aggregate amount of $390,000 (the “2017 Related Notes”) to accredited investors, including Robert Taglich and Michael Taglich (each holding more than a 5% beneficial interest in the Company’s shares) and James DeSocio (President, Chief Executive Officer and Director), in exchange for the conversion of $150,000 principal amount under the 2017 Bridge Notes and the receipt of $240,000 cash. The 2017 Related Notes were initially scheduled to mature on November 30, 2019. On September 14, 2018, the 2017 Related Notes were amended to mature on December 31, 2020. The amendment was accounted for as a troubled debt restructuring with the future undiscounted cash flows being greater than the carrying value of the debt prior to extension. No gain was recorded, and a new effective interest rate was established based on the carrying value of the debt and the revised future cash flows. The 2017 Related Notes bore interest at an annual rate of 8% until maturity, with interest payable quarterly beginning July 1, 2018. The 2017 Related Note investors had the right, in their sole discretion, to convert the 2017 Related Notes into shares of Company common stock under certain circumstances at a conversion rate of $10.00 per share. These notes were further amended and converted into equity on March 2, 2020, as described further below in this note, see “2020 Note Conversion.”

 

2016 Notes

 

On December 30, 2016, the Company issued convertible promissory notes in an aggregate amount of $375,000 (the “2016 Related Notes”) to accredited investors (the “2016 Related Note Investors”), including Robert Taglich and Michael Taglich (each holding more than 5% beneficial interest in the Company’s shares) and Robert Schroeder (a director of the Company). The 2016 Related Notes bore interest at an annual rate of interest of 12% until maturity, with partial interest of 6% payable quarterly, and an initial maturity date of December 31, 2018. The 2016 Related Note Investors had a right, in their sole discretion, to convert the 2016 Related Notes into shares of Company common stock at a conversion rate of $32.50 per share. On September 17, 2018, the 2016 Related Notes were amended to mature on December 31, 2020, and to bear interest at an annual rate of interest of 10% until maturity, with partial interest of 5% payable quarterly. With the amendment, the 2016 Related Note Investors had the right, in their sole discretion, to convert the 2016 Related Notes into shares at a conversion rate of $20.00 per share. The amendment was accounted for as a troubled debt restructuring with the future undiscounted cash flows being greater than the carrying value of the debt prior to extension. No gain was recorded on the amendment, and a new effective interest rate on the 2016 Related Notes was established based on the carrying value of the debt and the revised future cash flows. The Company recognized an initial beneficial conversion feature in the amount of $144,231, plus a fair value adjustment of $24,710 under the troubled debt restructuring accounting. Interest expense recognized on the amortization of the beneficial conversion feature of the 2016 Related Notes was $0 and $20,015, and $5,004 and $15,011, for the three and nine months ended September 30, 2020 and 2019, respectively. These notes were further amended and converted into equity on March 2, 2020, as described further below in this note, see “2020 Note Conversion.”

 

12. Deferred Compensation

 

Pursuant to the Company’s employment agreements with the founders, the founders have earned incentive compensation totaling $100,828 and $117,166 in cash, as of September 30, 2020 and December 31, 2019, respectively, which payment obligation has been deferred by the Company until it reasonably believes it has sufficient cash to make the payment. Following the retirement of founder A. Michael Chretien on December 8, 2017, the Company made bi-weekly payments of $1,846 until his portion of the deferred compensation had been paid, which occurred in May, 2020. For the three and nine months ended September 30, 2020 and 2019, the Company paid $0 and $16,338, respectively, and $11,077 and $35,077, respectively, which is reflected as a reduction in the deferred compensation liability.

 

23

 

 

13. Commitments and Contingencies

 

Employment Agreements

 

The Company has entered into employment agreements with three of its key executives. Under their respective agreements, the executives serve at will and are bound by typical confidentiality, non-solicitation and non-competition provisions. Deferred compensation for a founder of the Company, as disclosed in Note 12 above, is still outstanding as of December 31, 2019.

 

Operating Leases

 

On January 1, 2010, the Company entered into an agreement to lease 6,000 rentable square feet of office space in Columbus, Ohio. The lease commenced on January 1, 2010 and, pursuant to a lease extension dated August 9, 2016, the lease expires on December 31, 2021.

 

Our subsidiary, Graphic Sciences, uses 36,000 square feet of leased space in Madison Heights as its main facility. Graphic Sciences uses about 20,000 square feet for its records storage services, with the remainder of the space used for production, sales, and administration. The monthly rental payment is $40,694, with increases annually in September up to $45,828 for the final year, with a lease term continuing until August 31, 2026.

 

Graphic Sciences also leases and uses a separate 20,000 square foot building for document storage in Highland Park, MI, a satellite office in Traverse City, MI for production, and additional temporary storage space in Madison Heights, MI. The monthly Highland Park rental payment is $10,417, with increases annually in September up to $11,250 for the final year, with a lease term continuing until September 30, 2021. The monthly Traverse City rental payment is $4,500, with a lease term continuing until January 31, 2024. The monthly additional Madison Heights rental payment is $6,348, with an initial lease term until July 31, 2020 and a month-to-month arrangement thereafter.

 

Graphic Sciences also leases and uses four leased vehicles for logistics. The monthly rental payments for these vehicles total $2,618, with lease terms continuing until October 31, 2024.

 

Future minimum lease payments under these operating leases are as follows:

 

For the Twelve Months Ending September 30,  Amount 
2021  $774,230 
2022   607,808 
2023   593,781 
2024   564,589 
2025   541,481 
Thereafter   504,111 
   $3,586,000 

 

Lease costs charged to operations for the three and nine months ended September 30, 2020 and 2019 amounted to $216,561 and $505,072, respectively, and $12,814 and $38,441, respectively. Additional information pertaining to the Company’s lease are as follows:

 

For the Nine Months Ending September 30, 2020:    
Operating cash flows from operating leases  $315,377 
Weighted average remaining lease term – operating leases   5.4 years 
Weighted average discount rate – operating leases   8.0%

 

14. Stockholders’ Equity

 

Description of Authorized Capital

 

The Company is authorized to issue up to 25,000,000 shares of common stock with $0.001 par value. The holders of the Company’s common stock are entitled to one vote per share. The holders of common stock are entitled to receive ratably such dividends, if any, as may be declared by the Board of Directors out of legally available funds. However, the current policy of the Board of Directors is to retain earnings, if any, for the operation and expansion of the business. Upon liquidation, dissolution or winding-up of the Company, the holders of common stock are entitled to share ratably in all assets of the Company that are legally available for distribution.

 

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Reverse Stock Split

 

Effective February 27, 2020, upon recommendation and authorization by the Board of Directors, stockholders holding a majority in interest of the issued and outstanding shares of Common Stock, acting by written consent, adopted an amendment to the Company’s Articles of Incorporation to (i) effectuate the Reverse Split at a ratio of one-for-fifty (1-for-50) and (ii) reduce the number of authorized shares of Common Stock of the Company as of the effective date of such amendment to 25,000,000 shares. On March 3, 2020, the Company filed the Reverse Split Amendment, which became effective on March 20, 2020. On March 1, 2020, upon recommendation and authorization by the Board of Directors, stockholders holding a majority in interest of the issued and outstanding shares of Common Stock of the Company, acting by written consent, adopted an amendment to the Company’s Articles of Incorporation to increase the authorized number of shares of Common Stock to 160,000,000 shares (representing 3,200,000 on a post-split basis) from 75,000,000 shares (representing 1,500,000 on a post-split basis), in order to facilitate the acquisition of Graphic Sciences, the 2020 private placement of equity and debt, and the 2020 Note Conversion. On March 2, 2020, the Company filed the Shares Increase Amendment, which was effective immediately upon filing.

 

The reverse stock split did not cause an adjustment to par value of the common stock. As a result of the reverse stock split, the Company also adjusted the share amounts for shares reserved for issuance upon the exercise of outstanding warrants, outstanding stock options, and shares reserved for the 2015 Plan. All disclosures of common shares and per share data in the accompanying financial statements related notes have been adjusted to reflect the reverse stock split for all periods presented. The September 30, 2019 balances of common stock and additional paid in capital were adjusted to $371 and $14,433,183, from previously reported amounts of $31,528 and $14,371,648, respectively. The December 31, 2019 balances of common stock and additional paid in capital were adjusted to $371 and $12,419,437, from previously reported amounts of $31,528 and $14,388,280, respectively.

 

Issuance of Restricted Common Stock to Directors

 

On January 2, 2020 and January 7, 2019, the Company issued 16,429 and 10,454 shares, respectively, of restricted common stock to directors of the Company as part of an annual compensation plan for directors. The grant of shares was not subject to vesting. Stock compensation of $57,500 was recorded on the issuance of the common stock for the nine months ended September 30, 2020 and 2019.

 

Issuance of Warrants

 

Between December 30, 2016 and January 31, 2017, the Company issued convertible promissory notes, the 2016 Unrelated Notes and the 2016 Related Notes (collectively, the “2016 Notes”), in an aggregate amount of $1,250,000 to certain accredited investors, including related parties, in private placements. The Company retained Taglich Brothers, Inc. as the exclusive placement agent for the private placement offering of the 2016 Notes. In January 2017, in compensation for the placement agent’s services in the private placement offering of the 2016 Notes, the Company paid the placement agent a cash payment of $100,000, equal to 8% of the gross proceeds of the offering, along with warrants to purchase 3,077 shares of Company common stock, and the reimbursement for the placement agent’s reasonable out of pocket expenses, FINRA filing fees and related legal fees. The warrants issued to the placement agent contained an exercise price at $37.50 per share, are exercisable for a period of five years after issuance, contain customary cashless exercise provisions and anti-dilution protection and, pursuant to piggyback registration rights, the underlying shares were registered in the Company’s a Registration Statement on Form S-1 declared effective in February 2018. Of the warrants issued to the placement agent, 1,699 warrants were issued in conjunction with proceeds raised in December 2016, and underwriting expense of $65,243 was recorded for the issuance of these warrants, utilizing the Black-Scholes valuation model to value the warrants issued. The remaining 1,378 warrants were issued in conjunction with proceeds raised in January 2017, and underwriting expense of $52,951 was recorded for the issuance of these warrants, utilizing the Black-Scholes valuation model. The fair value of warrants issued was determined to be $38.50.

 

On September 21, 2017, the Company issued warrants to purchase 3,000 shares of Company common stock to Robert Taglich and Michael Taglich (each holding more than a 5% beneficial interest in the Company’s shares) in connection with the 2017 Bridge Notes. The warrants are exercisable at an exercise price of $15.00 per share, contain a cashless exercise provision, antidilution protection and are exercisable for five years after issuance. A debt discount of $38,837 was recorded for the issuance of these warrants, utilizing the Black-Scholes valuation model. The 2017 Bridge Notes were converted into the 2017 Related Notes in November 2017. The fair value of warrants issued was determined to be $13.00 utilizing the Black-Scholes valuation model.

 

25

 

 

Between November 17 and November 30, 2017, the Company issued convertible promissory notes, the 2017 Unrelated Notes and the 2017 Related Notes (collectively, the “2017 Notes”), in an aggregate amount of $2,150,000 to certain accredited investors, including related parties, in private placements. The Company retained Taglich Brothers, Inc. as the exclusive placement agent for the private placement offering of the 2017 Notes. In compensation for the placement agent’s services in the private placement offering of the 2017 Notes, the Company paid the placement agent a cash payment of 8% of the gross proceeds of the offering, along with warrants to purchase shares of Company common stock, and the reimbursement for the placement agent’s reasonable out of pocket expenses, FINRA filing fees and related legal fees. On November 17, 2017, the Company paid the placement agent cash in the amount of $172,000 and issued the placement agent warrants to purchase 7,080 shares at an exercise price at $12.50 per share, which are exercisable for a period of five years after issuance, contain customary cashless exercise provisions and anti-dilution protection and were entitled to piggyback registration rights that were exercised in connection with the Company’s Registration Statement on Form S-1 declared effective in February 2018. On November 30, 2017, the Company issued the placement agent warrants to purchase 10,120 shares at an exercise price at $12.50 per share, which are exercisable for a period of five years after issuance, contain customary cashless exercise provisions and anti-dilution protection and are entitled to registration rights that were exercised in connection with the Company’s Registration Statement on Form S-1 declared effective in February 2018. Debt issuance costs of $126,603 was recorded for the issuance of the November 17 and November 30, 2017 warrants, utilizing the Black-Scholes valuation model. The fair value of warrants issued was determined to be $8.50 and $6.50 for the November 17 and November 30 warrants, respectively. For the three and nine months ended September 30, 2020 and 2019, interest expense of $0 and $14,726, respectively, and $22,089 and $66,267, respectively, was recorded as amortization of the debt issuance costs.

 

Between September 20 and September 26, 2018, the Company issued convertible promissory notes, the 2018 Unrelated Notes and the 2018 Related Notes (collectively, the “2018 Notes”), in an aggregate amount of $1,300,000 to certain accredited investors, including related parties, in private placements. The Company retained Taglich Brothers, Inc. as the exclusive placement agent for the private placement offering of the 2018 Notes. In compensation, the Company paid the placement agent a cash payment of 8% of the gross proceeds of the offering, along with warrants to purchase shares of Company common stock, and reimbursement for the placement agent’s reasonable out of pocket expenses, FINRA filing fees and related legal fees. On September 20, 2018, the Company paid the placement agent cash in the amount of $40,000 and issued the placement agent warrants to purchase 6,153 shares at an exercise price at $9.00 per share, which are exercisable for a period of five years after issuance, contain customary cashless exercise provisions and anti-dilution protection and are entitled to limited piggyback registration rights. On September 26, 2018, the Company paid the placement agent cash in the amount of $64,000 and issued the placement agent warrants to purchase 9,846 shares at an exercise price at $9.00 per share, which are exercisable for a period of five years after issuance, contain customary cashless exercise provisions and anti-dilution protection and are entitled to limited piggyback registration rights. Debt issuance costs of $64,348 was recorded for the issuance of the September 20 and September 26, 2018 warrants, utilizing the Black-Scholes valuation model. The fair value of warrants issued was determined to be $5.00 and $3.50 for the September 20 and September 26 warrants, respectively. For the nine months ended September 30, 2020 and 2019, interest expense of $0 and $14,458, respectively, and $21,688 and $65,063, respectively, was recorded as amortization of the debt issuance costs.

 

On March 2, 2020, the Company entered into a Securities Purchase Agreement (the “Securities Purchase Agreement”) with certain accredited investors, pursuant to which the Company issued and sold (i) 875,000 shares of the Company’s Common Stock, at a price of $4.00 per share, for aggregate gross proceeds of $3,500,000 and (ii) 2,000 units (“Units”), with each Unit consisting of $1,000 in 12% Subordinated Notes and 40 shares, for aggregate gross proceeds of $2,000,000 in Units and $5,500,000 for the combined private placement pursuant to the Securities Purchase Agreement. The Company issued 955,000 new shares of Common Stock for the Offering. The Company retained Taglich Brothers, Inc. as the exclusive placement agent for the private placement offering of the Securities Purchase Agreement. In compensation, the Company paid the placement agent a cash payment of 8% of the gross proceeds of the offering, along with warrants to purchase shares of Company common stock, and reimbursement for the placement agent’s reasonable out of pocket expenses, FINRA filing fees and related legal fees. On March 2, 2020, the Company paid the placement agent cash in the amount of $440,000 and issued the placement agent warrants to purchase 95,500 shares at an exercise price at $4.00 per share, which are exercisable for a period of five years after issuance, contain customary cashless exercise provisions and anti-dilution protection and are entitled to limited piggyback registration rights. Underwriting expense of $236,761 and debt issuance costs of $135,291 was recorded for the issuance of the March 2, 2020 warrants, utilizing the Black-Scholes valuation model. The fair value of warrants issued was determined to be $3.90. Underwriting expense of $307,867 and debt issuance costs of $175,924 was recorded for the placement agent cash fee and other related legal fees. For the three and nine months ended September 30, 2020, interest expense of $25,935 and $60,514, respectively, was recorded as amortization of the debt issuance costs.

 

26

 

 

The estimated values of warrants, as well as the assumptions that were used in calculating such values were based on estimates at the issuance date as follows:

 

   Placement
Agent
December 30,
2016
   Bridge
Noteholders
September 21,
2017
 
Risk-free interest rate   1.93%   1.89%
Weighted average expected term   5 years    5 years 
Expected volatility   123.07%   130.80%
Expected dividend yield   0.00%   0.00%

 

   Placement
Agent
November 17,
2017
   Placement
Agent
November 30,
2017
 
Risk-free interest rate   2.06%   2.14%
Weighted average expected term   5 years    5 years 
Expected volatility   129.87%   129.34%
Expected dividend yield   0.00%   0.00%

 

   Placement
Agent
September 20,
2018
   Placement
Agent
September 26,
2018
 
Risk-free interest rate   2.96%   2.96%
Weighted average expected term   5 years    5 years 
Expected volatility   122.52%   122.92%
Expected dividend yield   0.00%   0.00%

 

   Placement
Agent
March 2, 2020
 
Risk-free interest rate   0.88%
Weighted average expected term   5 years 
Expected volatility   130.12%
Expected dividend yield   0.00%

 

Shares Issued and Outstanding and Shares Reserved for Exercise of Warrants, Convertible Notes, and the 2015 Plan

 

The Company had 2,810,865 Shares issued and outstanding, 230,032 Shares reserved for issuance upon the exercise of outstanding warrants, and 197,330 Shares reserved for issuance under the 2015 Plan, as of September 30, 2020.

 

15. Stock-Based Compensation

 

On April 30, 2015, the Company entered into a Non-qualified Stock Option Agreement with Sophie Pibouin, a director of the Company, in accordance with the 2015 Plan. The agreement granted options to purchase 2,560 shares prior to the expiration date of April 29, 2025 at an exercise price of $37.50. The options granted vested on a graded scale over a period of time through October 31, 2015.

 

27

 

 

On January 1, 2016, the Company granted employees stock options to purchase 5,000 shares at an exercise price of $45.00 per share in accordance with the 2015 Plan. The options were fully vested as of January 1, 2019. The total fair value of $196,250 for these stock options was recognized by the Company over the requisite service period.

 

On February 10, 2016, the Company granted employees stock options to purchase 4,200 shares at an exercise price of $48.00 per share in accordance with the 2015 Plan. The options were fully vested as of February 10, 2020. The total fair value of $174,748 for these stock options is being recognized by the Company over the requisite service period.

 

On December 6, 2016, the Company granted one employee stock options to purchase 2,000 shares at an exercise price of $38.00 per share in accordance with the 2015 Plan, with vesting continuing until December 2020. The total fair value of $63,937 for these stock options is being recognized by the Company over the requisite service period.

 

On September 25, 2017, the Company granted an employee stock options to purchase 15,000 shares at an exercise price of $15.00 per share and 10,000 shares at an exercise price of $19.00 per share, in accordance with the 2015 Plan. The options were fully vested as of September 25, 2019. The total fair value of $321,011 for these stock options was recognized by the Company over the requisite service period.

 

On January 30, 2019, the Company entered into a Non-qualified Stock Option Agreement with an individual consultant to the Company, in accordance with the 2015 Plan. The agreement granted options to purchase 250 shares prior to the expiration date of December 31, 2025 at an exercise price of $45.00. The options granted were 100% vested as of the grant date.

 

On March 11, 2019, the Company canceled previously granted stock options to employees in the following amounts: 3,000 shares at an exercise price of $45.00 per share; 3,200 shares at an exercise price of $48.00 per share; 2,000 shares at an exercise price of $38.00 per share; 15,000 shares at an exercise price of $15.00 per share; and 10,000 shares at an exercise price of $19.00 per share. On March 11, 2019, the Company replaced those canceled stock options exercisable for a total of 33,200 shares with virtually identical stock options at an exercise price of $6.50 per share in accordance with the 2015 Plan. The incremental fair value of $24,898 for these stock options is being recognized by the Company over the requisite service periods, which range by tranche from fully vested at issuance through vesting by December 2020.

 

On March 11, 2019, the Company granted employees stock options to purchase 10,100 shares at an exercise price of $6.50 per share in accordance with the 2015 Plan, with vesting continuing until 2023. The total fair value of $44,591 for these stock options is being recognized by the Company over the requisite service period.

 

On September 2, 2020, the Company granted employees stock options to purchase 99,000 shares, including 37,500 shares of performance-based options, at an exercise price of $4.00 per share in accordance with the 2015 Plan, with vesting continuing until 2024. The total fair value of $327,181 for these stock options is being recognized by the Company over the requisite service period.

 

The weighted average estimated values of director and employee stock option grants, as well as the weighted average assumptions that were used in calculating such values during the nine months ended September 30, 2020 and 2019, were based on estimates at the date of grant as follows:

 

   April 30,   January 1,   February 10, 
   2015 Grant   2016 Grant   2016 Grant 
Risk-free interest rate   1.43%   1.76%   1.15%
Weighted average expected term   5 years    5 years    5 years 
Expected volatility   143.10%   134.18%   132.97%
Expected dividend yield   0.00%   0.00%   0.00%

 

   December 6,   September 25,   January 30, 
   2016 Grant   2017 Grant   2019 Grant 
Risk-free interest rate   1.84%   1.85%   2.54%
Weighted average expected term   5 years    5 years    5 years 
Expected volatility   123.82%   130.79%   115.80%
Expected dividend yield   0.00%   0.00%   0.00%

 

28

 

 

   March 11,   September 2, 
   2019 Grant   2020 Grant 
Risk-free interest rate   2.44%   0.26%
Weighted average expected term   5 years    5 years 
Expected volatility   116.46%   121.33%
Expected dividend yield   0.00%   0.00%

 

A summary of stock option activity during the nine months ended September 30, 2020 and 2019 is as follows:

 

           Weighted-    
       Weighted-   Average    
   Shares   Average   Remaining  Aggregate 
   Under   Exercise   Contractual  Intrinsic 
   Option   Price   Life  Value 
Outstanding at January 1, 2020   46,860   $9.02   9 years   19,200 
Granted   99,000    4.00         
Outstanding at September 30, 2020   145,860   $5.61   9 years  $19,200 
                   
Exercisable at September 30, 2020   38,785   $9.54   8 years  $19,200 

 

           Weighted-    
       Weighted-