Inventories are stated at the lower of cost or net realizable value, where cost is determined using the weighted average method.  Substantially all inventories consist of purchased off-the-shelf hardware and software, and component computer parts used in connection with system integration services that we perform.  An allowance for obsolete, slow-moving or nonsalable inventory is provided for all other inventory.  This allowance is based on our overall obsolescence experience and our assessment of future inventory requirements.  This charge is taken primarily due to the age of the specific inventory and the significant additional costs that would be necessary to upgrade to current standards as well as the lack of forecasted sales for such inventory in the near future.  Gross inventory was $3.62.7 million and $2.84.2 million as of March 31, 20202021 and December 31, 20192020, respectively. As of March 31, 2020,2021, it is management’s judgment that we have fully provided for any potential inventory obsolescence, which was $0.9 million as of March 31, 20202021 and December 31, 2019.2020.

Software Development Costs

Our policy on accounting for development costs of software to be sold is in accordance with ASC Topic 985-20, “Software – Costs of Software to be Sold, Leased, or Marketed” and ASC Topic 350-40 “Internal Use Software”, in so far as our Xacta products being available in various deployment modalities including on premises licenses and cloud-based Software as a Service (“SaaS”) as well as solutions developed within Telos ID.. Under both standards, software development costs are expensed as incurred until technological feasibility is reached, at which time additional costs are capitalized until the product is available for general release to customers or is ready for its intended use, as appropriate.  Technological feasibility is established when all planning, designing, coding and testing activities have been completed, and all risks have been identified. Beginning with the second quarter of 2017, softwareSoftware development costs are capitalized and amortized over the estimated product life of 2-32 years on a straight-line basis. As of March 31, 20202021 and December 31, 2019,2020, we capitalized $7.1$14.4 million and $5.6$12.3 million of software development costs, respectively, which are included as a part of property and equipment. Amortization expense was $0.5 million and $0.4 million for each of the three months ended March 31, 20202021 and 2019, respectively.2020. Accumulated amortization was $3.6$5.3 million and $3.1$4.8 million as of March 31, 20202021 and December 31, 2019,2020, respectively. The Company analyzes the net realizable value of capitalized software development costs on at least an annual basis and has determined that there is no indication of impairment of the capitalized software development costs as forecasted future sales are adequate to support amortization costs.

We account for income taxes in accordance with ASC 740, “Income Taxes.”  Under ASC 740, deferred tax assets and liabilities are recognized for the estimated future tax consequences of temporary differences and income tax credits.  Deferred tax assets and liabilities are measured by applying enacted statutory tax rates that are applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized for differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities.  Any change in tax rates on deferred tax assets and liabilities is recognized in net income in the period in which the tax rate change is enacted.  We record a valuation allowance that reduces deferred tax assets when it is "more likely than not" that deferred tax assets will not be realized.  We are required to establish a valuation allowance for deferred tax assets if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on available evidence, realization of deferred tax assets is dependent upon the generation of future taxable income.  We considered projected future taxable income, tax planning strategies, and reversal of taxable temporary differences in making this assessment. As such, we have determined that a full valuation allowance is required as of March 31, 20202021 and December 31, 2019.2020. As a result of a full valuation allowance against our deferred tax assets, a deferred tax liability related to goodwill remains on our condensed consolidated balance sheets at March 31, 20202021 and December 31, 2019.2020. Due to the tax reform enacted on December 22, 2017, net operating losses generated in taxable years beginning after December 31, 2017 will have an indefinite carryforward period, which will be available to offset future taxable income created by the reversal of temporary taxable differences related to goodwill. As a result, we have adjusted the valuation allowance on our deferred tax assets and liabilities at March 31, 20202021 and December 31, 2019.2020.

We follow the provisions of ASC 740 related to accounting for uncertainty in income taxes. The accounting estimates related to liabilities for uncertain tax positions require us to make judgments regarding the sustainability of each uncertain tax position based on its technical merits. If we determine it is more likely than not that a tax position will be sustained based on its technical merits, we record the impact of the position in our condensed consolidated financial statements at the largest amount that is greater than fifty percent likely of being realized upon ultimate settlement. These estimates are updated at each reporting date based on the facts, circumstances and information available. We are also required to assess at each reporting date whether it is reasonably possible that any significant increases or decreases to our unrecognized tax benefits will occur during the next 12 months.

The provision for income taxes in interim periods is computed by applying the estimated annual effective tax rate against earnings before income tax expense for the period. In addition, non-recurring or discrete items are recorded during the period in which they occur.

We evaluate the impairment of goodwill in accordance with ASC 350, “Intangibles - Goodwill and Other,” which requires goodwill and indefinite-lived intangible assets to be assessed on at least an annual basis for impairment using a fair value basis. Between annual evaluations, if events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount, then impairment must be evaluated. Such circumstances could include, but are not limited to: (1) a significant adverse change in legal factors or business climate, or (2) a loss of key contracts or customers.

As the result of an acquisition, we record any excess purchase price over the net tangible and identifiable intangible assets acquired as goodwill. An allocation of the purchase price to tangible and intangible net assets acquired is based upon our valuation of the acquired assets. Goodwill is not amortized, but is subject to annual impairment tests. We complete our goodwill impairment tests as of December 31st each year. Additionally, we make evaluations between annual tests if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The evaluation is based on the estimation of the fair values of our  three reporting units, CO&D (comprised of Information Assurance / Xacta and Secure Networks), Telos ID, Enterprise Solutions, and Secure Communications, Cyber and Enterprise Solutions, of which goodwill is housed in the CO&D reporting units,unit, in comparison to the reporting unit’s net asset carrying values. Our discounted cash flows required management’s judgment with respect to forecasted revenue streams and operating margins, capital expenditures and the selection and use of an appropriate discount rate. We utilized the weighted average cost of capital as derived by certain assumptions specific to our facts and circumstances as the discount rate. The net assets attributable to the reporting units are determined based upon the estimated assets and liabilities attributable to the reporting units in deriving its free cash flows. In addition, the estimate of the total fair value of our reporting units is compared to the market capitalization of the Company. The Company’s assessment resulted in a fair value that was greater than the Company’s carrying value, therefore the second step of the impairment test, as prescribed by the authoritative literature, was not required to be performed and no impairment of goodwill was recorded as of December 31, 2019.2020. Subsequent reviews may result in future periodic impairments that could have a material adverse effect on the results of operations in the period recognized. Recent operating results have reduced the projection of future cash flow growth potential, which indicates that certain negative potential events, such as a material loss or losses on contracts, or failure to achieve projected growth could result in impairment in the future. We estimate fair value of our reporting unit and compare the valuation with the respective carrying value for the reporting unit to determine whether any goodwill impairment exists. If we determine through the impairment review process that goodwill is impaired, we will record an impairment charge in our condensed consolidated statements of operations. Goodwill is amortized and deducted over a 15-year period for tax purposes.

We recognize these share-based payment transactions when services from the employees are received and recognize a corresponding increase in additional paid-in capital in our condensed consolidated balance sheets. The measurement objective for these equity awards is the estimated fair value at the date of grant of the equity instruments that we recorded immaterialare obligated to issue when employees have rendered the requisite service and satisfied any other conditions necessary to earn the right to benefit from the instruments. The compensation expense for an award is recognized ratably over the requisite service period for the entire award, which is the period during which an employee is required to provide service in exchange for an award. Compensation expense for awards with performance conditions is recognized over the requisite service period if it is probable that the performance condition will be satisfied.  If such performance conditions are not or are no longer considered probable, no compensation expense for these awards is recognized, and any previously recognized expense is reversed. Compensation expense for awards with performance conditions capable of being earned for satisfying the performance condition or as a result of completing a service requirement will be recognized ratably over the requisite service period for the entire award. If the performance condition is achieved prior to the completion of the issuancesrequisite service period, any unrecognized compensation expense will be recognized in the period the performance condition is achieved. Compensation expense for awards with market conditions is recognized over the derived service period, or sooner, if the market condition is achieved. Previously recognized expense for awards with market conditions will never be reversed even if the market conditions is never achieved. We recognize forfeitures of share-based compensation awards as they occur. Share-based compensation expense is recognized as part of cost of sales and general and administrative expenses in our condensed consolidated statements of operations.

On November 12, 2020, we amended our Articles of Amendment and Restatement to effect an approximate 0.794-for-1 reverse stock split with respect to our common stock was nominal, based onstock. The par value and the deductionauthorized shares of our outstanding debt, capital lease obligations, and preferred stock from an estimated enterprise value, which was estimated based on discounted cash flow analysis, comparable public company analysis, and comparable transaction analysis.  Additionally, we determined that a significant change in the valuation estimate for common stock wouldwere not haveadjusted as a significant effect onresult of the reverse stock split. The accompanying condensed consolidated financial statements and notes to the condensed consolidated financial statements.statements give retroactive effect to the reverse stock split for all periods presented.

Our functional currency is the U.S. Dollar. For one of our wholly owned subsidiaries, the functional currency is the local currency. For this subsidiary, the translation of its foreign currency into U.S. Dollars is performed for assets and liabilities using current foreign currency exchange rates in effect at the balance sheet date and for revenue and expense accounts using average foreign currency exchange rates during the period. Translation gains and losses are included in stockholders’ deficit as a component of accumulated other comprehensive income (loss).

Accumulated other comprehensive income included within stockholders’ deficitequity (deficit) consists of the following (in thousands):

On April 11, 2007, Telos ID was formed as a limited liability company under the Delaware Limited Liability Company Act. We contributed substantially all of the assets of our Identity ManagementTelos ID Enterprise business line and assigned our rights to perform under our U.S. Government contract with the Defense Manpower Data Center (“DMDC”) to Telos ID at their stated book values. The net book value of assets we contributed totaled $17,000.$17,000. Until April 19, 2007, we owned 99.999% of the membership interests of Telos ID and certain private equity investors (“Investors”)Hoya owned 0.001% of the membership interests of Telos ID. On April 20, 2007, we sold an additional 39.999% of the membership interests to the InvestorHoya in exchange for $6$6 million in cash consideration. In accordance with ASC 505, “Equity,” we recognized a gain of $5.8 million. As a result, we owned 60% of Telos ID, and therefore continued to account for the investment in Telos ID using the consolidation method.

On December 24, 2014 (the “Closing Date”), we entered into a Membership Interest Purchase Agreement (the “Purchase Agreement”) between the Company and the Investors, pursuant to which the InvestorsHoya acquired from the Company an additional ten percent (10%) membership interest in Telos ID in exchange for $5 million (the “Transaction”“2014 Transaction”). In connection with the 2014 Transaction, the Company and the InvestorsHoya entered into the Second Amended and Restated Operating Agreement (the “Operating Agreement”) governing the business, allocation of profits and losses and management of Telos ID. Under the Operating Agreement, Telos ID iswas managed by a board of directors comprised of  five (5) members (the “Telos ID Board”). The Operating Agreement provides for two classes of membership units, Class A (owned by the Company) and Class B (owned by the Investors). The Class A member (the Company) ownsCompany owned 50% of Telos ID, iswas entitled to receive 50% of the profits of Telos ID, and maycould appoint three (3) members of the Telos ID Board. The Class B member (the Investors) ownsHoya owned 50% of Telos ID, iswas entitled to receive 50% of the profits of Telos ID, and maycould appoint two (2) members of the Telos ID Board.

Distributions arewere made to the members only when and to the extent determined by Telos ID’s Board of Directors, in accordance with the Operating Agreement. Hoya received a final distribution of  $2.4 million in January 2021, which was accrued and presented in accounts payable and other accrued liabilities in the condensed consolidated balance sheets as of December 31, 2020. No distribution was made during the three months ended March 31, 2020. The Class B member received a total distribution of $716,000 for the three months ended March 31, 2019.

The goodwill balance was $14.9$14.9 million as of March 31, 20202021 and December 31, 2019.2020. Goodwill is subject to annual impairment tests and in the intereim if triggering events are present before the annual tests, we will assess impairment. As ofFor the three months ended March 31, 20202021 and December 31, 2019,2020, no impairment charges were taken.

The accounting standard for fair value measurements provides a framework for measuring fair value and expands disclosures about fair value measurements.  The framework requires the valuation of financial instruments using a three-tiered approach.  The statement requires fair value measurement to be classified and disclosed in one of the following categories:

As of March 31, 20202021 and December 31, 2019,2020, we did not have any financial instruments with significant Level 3 inputs and we did not have any financial instruments that are measured at fair value on a recurring basis.

For certain of our non-derivative financial instruments, including receivables, accounts payable and other accrued liabilities, the carrying amount approximates fair value due to the short-term maturities of these instruments. The estimated fair value of the Credit Agreement (as defined below) and long-term debt is based primarily on borrowing rates currently available to the Company for similar debt issues. The fair value approximates the carrying value of long-term debt.

As of March 31, 20202021 and December 31, 2019,2020, the accounts payable and other accrued liabilities consisted of $13.7$9.8 million and $13.5$14.7 million, respectively, in trade account payablesaccounts payable and $1.5$22.0 million and $6.2 million, respectively, in accrued liabilities.

The Credit Agreement also included an $825,000 exit fee, which was payable upon any repayment or prepayment of the loan. This amount had been included in the total principal due and treated as an unamortized discount on the debt, which would be amortized over the term of the loan, using the effective interest method at a rate of 15.0% at the time of the original loan. We incurred fees and transaction costs of approximately $374,000 related to the issuance of the Credit Agreement, which are beingwere amortized over the life of the Credit Agreement.

On March 30, 2018, the Credit Agreement was amended (the “Third Amendment”) to waive any actual or potential non-compliance with covenants in 2017 and to reset the covenants for 2018 measurement periods to more accurately reflect the Company’s projected performance for the year. The measurement against the covenants for consolidated leverage ratio and consolidated fixed charge coverage ratio were agreed to not be measured as of December 31, 2017 and were reset for 2018 measurement periods. Additionally, a minimum revenue covenant and a net working capital covenant were added. In consideration of these amendments, the interest rate on the loan was increased by 1%, which will revert back to the original rate upon achievement of two consecutive quarters of a specified fixed charge coverage ratio as defined in the agreement. The Company may elect to pay the increase in interest expense in cash or by payment-in-kind (by addition to the principal amount of the Loan). The increase in interest expense has been paid in cash.  Contemporaneously with the Third Amendment, Mr. John B. Wood agreed to transfer 50,000 shares of the Company’s Class A Common Stock owned by him to EnCap.

On July 19, 2019, we entered into the Fourth Amendment to Credit Agreement and Waiver; First Amendment to Fee Letter (“Fourth Amendment”) to amend the Credit Agreement.  As a result of the Fourth Amendment, several terms of the Credit Agreement were amended, including the following:

The exit fee hashad been included in the total principal due and treated as an unamortized discount on the debt, which is beingwas amortized over the term of the loan using the effective interest method at a rate of 17.3% over the remaining term of the loan.  For the measurement period ended March 31, 2020 we were in compliance with the Credit Agreement’s financial covenants, based on an agreement between the Company and EnCap on the definition of certain input factors that determine the measurement against the covenants.

On March 26, 2020, the Credit Agreement was amended (the “Fifth Amendment”) to modify the financial covenants for 2020 through the maturity of the Credit Agreement to establish that the covenants will remain at the December 31, 20192020 levels and to update the previously agreed-upon definition of certain financial covenants, specifically the amount of Capital Expenditures to be included in the measurement of the covenants.  The Fifth Amendment also provides for the right for the Company to elect to extend the maturity date of the Credit Agreement which is currently scheduled to mature on January 15, 2021. The Fifth Amendment provides for four quarterly maturity date extensions, which would increase the Exit Fee payable under the Credit Agreement by $250,000 for each quarterly maturity date extension elected, for a total of $1 million increase to the Exit Fee were all four of the maturity date extensions to be elected.  The Company paid EnCap an amendment fee of $100,000 and out-of-pocket costs and expenses in consideration for the Fifth Amendment.

Subordinated Debt

On April 18, 2017, we amended and restated the Porter Notes to reduce the interest rate from twelve percent (12%) to six percent (6%) per annum, to be accrued, and extended the maturity date from July 1, 2017 to July 25, 2022. Telos also entered into Intercreditor Agreements with Porter and EnCap, in which the Porter Notes arewere fully subordinated to the Credit Agreement and any subsequent senior lenders, and payments under the Porter Notes arewere permitted only if certain conditions arewere met. All other terms remainremained in full force and effect. We incurred interest expense in the amount of $87,000 and $80,000 for the three months ended March 31, 2020, and 2019, respectively, on the Porter Notes. As of March 31, 2020, approximately $1.1 million of accrued interest was payable according to the stated interest rate of the Porter Notes.

A maximum of 6,000,000 shares of the Public Preferred Stock, par value $.01$.01 per share, has been authorized for issuance. We initially issued 2,858,723 shares of the Public Preferred Stock pursuant to the acquisition of the Company during fiscal year 1990. The Public Preferred Stock was recorded at fair value on the date of original issue, November 21, 1989, and we made periodic accretions under the interest method of the excess of the redemption value over the recorded value. We adjusted our estimate of accrued accretion in the amount of $1.5$1.5 million in the second quarter of 2006. The Public Preferred Stock was fully accreted as of December 2008. We declared stock dividends totaling 736,863 shares in 1990 and 1991. Since 1991, no other dividends, in stock or cash, havehad been declared. In November 1998, we retired 410,000 shares of the Public Preferred Stock. The total number of shares issued and outstanding at March 31, 20202021 and December 31, 20192020 was 3,185,586. The Public Preferred Stock is quoted as "TLSRP" on the OTCQB marketplace and the OTC Bulletin Board.

The income tax provision for interim periods is determined using an estimated annual effective tax rate adjusted for discrete items, if any, which are taken into account in the quarterly period in which they occur.  We review and update our estimated annual effective tax rate each quarter. We recorded an approximately $146,000$34,000 income tax provision and $197,000$146,000 income tax benefit for the three months ended March 31, 20202021 and 2019,2020, respectively.  For the three months ended March 31, 20202021 and 2019,2020, our estimated annual effective tax rate was primarily impacted by the overall valuation allowance position which reduced the net tax impact from taxable income or loss for both periods.

In March 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was enacted. The CARES Act, among other things, includes certain changes to U.S. tax law that impact the Company, including deferment of employer social security payments, modifications to interest deduction limitation rules, a technical correction to tax depreciation methods for certain qualified improvement property, and alternative minimum tax credit refund. We will continue to assess the impact of the CARES Act as well as any ongoing government guidance related to COVID-19 that may be issued.

Under the provisions of ASC 740, we determined that there were approximately $502,000$835,000 and $673,000$763,000 of gross unrecognized tax benefits as of March 31, 2021 and December 31, 2020, respectively. Included in the balance of unrecognized tax benefits including $224,000 and $304,000 of related interest and penalties, required to be recorded in other liabilities in the condensed consolidated balance sheets as of March 31, 20202021 and December 31, 2019,2020 were $278,000 of tax benefits that, if recognized, would impact the effective tax rate. Also included in the balance of unrecognized tax benefits as of March 31, 2021 and December 31, 2020 were $556,000 and $485,000, respectively, of tax benefits that, if recognized, would not impact the effective tax rate due to the Company’s valuation allowance.  The Company had accrued interest and penalties related to the unrecognized tax benefits of $246,000 and $241,000, which were recorded in other liabilities as of March 31, 2021 and December 31, 2020, respectively.  We believe that the total amounts of unrecognized tax benefits will not significantly increase or decrease within the next 12 months.

As describedUpon the closing of the IPO, we issued 17.2 million shares of our common stock at a price of $17.00 per share, generating net proceeds of approximately $272.8 million. We used approximately $108.9 million of the net proceeds in connection with the ERPS Conversion (see Note 6 – Exchangeable Redeemable Preferred Stock Conversion), $30.0 million to fund our acquisition of the outstanding Class B Units of Telos ID (see Note 2 – Purchase of Telos ID/Non-controlling Interests), $21.0 million to repay our outstanding senior term loan and subordinated debt (see Note 5 – Current Liabilities and Debt Obligations, we maintainObligations).  We intend to use the remaining net proceeds for general corporate purposes. We also may use a Credit Agreement with EnCapportion of the net proceeds to acquire complementary businesses, products, services, or technologies. The amounts and a Purchase Agreement with RCA. The willingness of RCA to purchase our accounts receivable under the Purchase Agreement, and our ability to obtain additional financing, may be limited due to various factors, including the eligibilitytiming of our receivables,actual use of the statusnet proceeds will vary depending on numerous factors. Proceeds held by us is invested in short-term investments until needed for the uses described above. We currently anticipate that we will retain all available funds for use in the operation and expansion of our business, global credit market conditions, and perceptions of our business or industry by EnCap, RCA, or other potential sources of financing. If we are unable to maintain the Purchase Agreement, we would need to obtain additional credit to fund our future operations. If credit is available in that event, lenders may impose more restrictive terms and higher interest rates that may reduce our borrowing capacity, increase our costs, or reduce our operating flexibility. The failure to maintain, extend, renew or replace the Purchase Agreement with a comparable arrangement or arrangements that provide similar amounts of liquidity for the Company would have a material negative impactdo not anticipate paying any cash dividends on our overall liquidity, financial and operating results.

Our working capital was $(14.8)$102.2 million and $2.9$105.2 million as of March 31, 20202021 and December 31, 2019,2020, respectively. Our current working capital deficit is due to the classification of the EnCap Credit Agreement as a current liability as discussed in Note 5 to the financial statements, although the Fifth Amendment to the Credit Agreement provides us the option to extend the maturity of the agreement. We intend to consider exercising the option at the appropriate time.  Although no assurances can be given, we expect that our financing arrangements with EnCap and RCA, collectively, and funds generated from operations are sufficient to maintain the liquidity we require to meet our operating, investing and financing needs for the next 12 months.

Legal Proceedings

As previously disclosed in Note 13 of the Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2019, since2020, beginning on August 2, 2007, Messrs. Seth W. Hamot (“Hamot”) and Andrew R. Siegel (“Siegel”), principals of Costa Brava have beenPartnership III, L.P. (“Costa Brava”), were involved in litigation against the Company as Plaintiffs and Counter-defendants in the Circuit Court.Court for Baltimore City, Maryland (the “Circuit Court”). Mr. Siegel is a Class D Director of the Company and Mr. Hamot was a Class D Director of the Company until his resignation on March 9, 2018. The Plaintiffs initially alleged that certain documents and records had not been provided to them promptly and were necessary to fulfill their duties as directors of the Company. Subsequently, Hamot and Siegel further alleged that the Company had failed to follow certain provisions concerning the noticing of Board committee meetings and the recording of Board meeting minutes and, additionally, that Mr. John Wood’s service as both CEO and Chairman of the Board was improper and impermissible under the Company’s Bylaws. On April 23, 2008, the Company filed a counterclaim against Hamot and Siegel for money damages and preliminary and injunctive relief based upon Hamot and Siegel’s interference with, and improper influence of, the Company’s independent auditors regarding, among other things, a specific accounting treatment.  On June 27, 2008, the Circuit Court granted the Company’s motion for preliminary injunction and enjoined Hamot and Siegel from contacting the Company’s auditors until the completion of the Company’s Form 10-K for the preceding year, which injunction later expired by its own terms. As previously disclosed, trial on Hamot and Siegel’s claims and the Company’s counterclaims took place in July through September 2013, and the Court subsequently issued decisions on the various claims by way of memorandum opinions and orders dated September 11, 2017. Among other rulings, the Court found Hamot and Siegel liable for the intentional tort of tortious interference with the Company’s contractual relationship with one of its auditors and entered a monetary judgment in favor of the Company and against Hamot and Siegel for approximately $278,000. The Company’s subsequent appeal of the amount of damages awarded to it for Hamot and Siegel’s intentional interference with the relationships with its former auditor was ultimately dismissed by way of the Mandate issued by the Court of Appeals of Maryland on October 11, 2019.

Hamot (and later, his Estate) and Siegel at various times inon multiple occasions during this litigation have sought to be indemnified or to be awarded advancement of various attorney’s fees and expenses incurred by them in this litigation.  No claim for indemnification is pending as of the reporting date.

On May 5, 2021, the Company, Plaintiffs and Costa Brava entered into a settlement agreement, which included a mutual general release, fully and finally settling the indemnification claim in exchange for the payment of a specified amount on or before May 19, 2021.  This settlement concludes all open matters or disputes between the Company and Messrs. Hamot (or his estate) and Siegel, as well as Costa Brava. We recorded an accrual of $1.0 million in other expense on our condensed consolidated statements of operations related to vigorously defend the matter and oppose any claim for indemnification if it is pursued.this settlement.

In addition, the Company is a party to litigation arising in the ordinary course of business.  In the opinion of management, while the results of such litigation cannot be predicted with any reasonable degree of certainty, the final outcome of such known matters will not, based upon all available information, have a material adverse effect on the Company's condensed consolidated financial position, results of operations or cash flows.

Emmett J. Wood, the brother of our Chairman and CEO, has been an employee of the Company since 1996. The amounts paid to this individual as compensation were $173,000$218,000 and $158,000$173,000 for the three months ended March 31, 20202021 and 2019,2020, respectively. Additionally, Mr. Wood owned 682,502 shares of the Company’s common stock as of March 31, 20202021 and December 31, 2019, 2020Mr. Wood owned 810,000 shares of the Company’s Class A Common Stock and 50,000 shares of the Company’s Class B Common Stock..

On April 18, 2017, we amended and restated the Porter Notes to reduce the interest rate from twelve percent (12%) to six percent (6%) per annum, to be accrued, and extendsextended the maturity date from July 1, 2017 to July 25, 2022. Telos also entered into Intercreditor Agreements with Porter and EnCap, in which the Porter Notes arewere fully subordinated to the Credit Agreement and any subsequent senior lenders, and payments under the Porter Notes arewere permitted only if certain conditions arewere met. All other terms remainremained in full force and effect. We incurred interest expense in the amount of $87,000 and $80,000 for the three months ended March 31, 2020, respectively, on the Porter Notes. As of March 31, 2020, approximately $1.1 million of accrued interest was payable according to the stated interest rate of the Porter Notes.

Note 10 –10.  Leases

We account for leases in accordance with ASC Topic 842, “Leases,” which requires lessees to recognize a right-of-use (“ROU”) asset and lease liability on the balance sheet and expands disclosures about leasing arrangements for both lessees and lessors, among other items, for most lease arrangements.

As of March 31, 2020,2021, operating lease ROU assets were $1.9$1.3 million and operating lease liabilities were $2.1$1.4 million, of which $1.4$0.8 million were classified as noncurrent.

Future minimum lease commitments at March 31, 20202021 were as follows (in thousands):

The components of lease expense were as follows (in thousands):

Supplemental cash flow information related to leases was as follows (in thousands):

 

 This Quarterly Report on Form 10-Q contains forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the Company’s actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth in the risk factors section included in the Company’s Form 10-K for the year ended December 31, 2019,2020, as filed with the SEC.

Our mission is to protect our customers’ people, systems, and vital information assets with offerings for cybersecurity, cloud security, and enterprise security. In the current global environment, our mission is more critical than ever. The solutions we offer secure cyberspace, theemergence of each new ICT introduces new vulnerabilities, as security is still too often overlooked in solution development. Networks and applications meant to enhance productivity and profitability often jeopardize an organization due to poor planning, misconfiguration, or an unknown gap in security. Ransomware, insider threats, cybercrime, and advanced persistent threats continue to menace public and private enterprises across all industries.

Cybersecurity, cloud environment,security, and the people and operations of the enterprise. These three facetsenterprise security of the modern organization share much in common, butyet also requirecall for a diverse range of skills, capabilities, and experience in order to meet the important requirements of security-conscious customers. Telos’ decades-long resumeDecades of providing a broad spectrum of technologyexperience in developing, orchestrating, and securitydelivering solutions uniquely qualifies us to meet our customers’ needs inacross these three areas.domains gives us the vision and the confidence to provide solutions that empower and protect the enterprise at an integrated, holistic level. Our experience in addressing challenges in one operationarea of thean enterprise informs our work in meetinghelps us meet requirements in others. We understand that a range of complementary capabilities may be needed to solve a single challenge, and we also recognize when a single solution might address multiple challenges.

Our substantive expertisesecurity solutions span across the following domains:

ManyWe develop our annual budgeted revenue by estimating for the upcoming year our continuing business from existing customers and active contracts. We consider backlog, both funded and unfunded (as explained below), other expected annual renewals, and expansion planned by our current customers. In the context of our contracts with the U.S. Government are funded year to year by the procuring U.S. Government agencycurrent customer portfolio, we view “recurring revenue” as determined by the fiscal requirementsrevenue that occurs often and repeatedly. In each of the U.S. Governmentlast three years, recurring revenue has exceeded 85% of our annual revenue. Our total budgeted revenue is the combination of recurring revenue and the respective procuring agency. Such a contracting process results in two distinct categoriesforecast of backlog: funded and unfunded.  new business.

Total backlog, a component of recurring revenue, consists of the aggregate contract revenues remaining to be earned by us at a given time over the life of our contracts, whether funded or not.unfunded. Funded backlog consists of the aggregate contract revenues remaining to be earned by us at a given time, but only to the extent,which, in the case of U.S. Governmentgovernment contracts, whenmeans that they have been funded by the procuring U.S. Government agency and allotted to the specific contracts.agency. Unfunded backlog is the difference between total backlog and funded backlog.  Included in unfunded backlog areand includes potential revenues whichthat may be earned only when and if customers exercise delivery orders and/or renewal options to continue such existingthese contracts.

The accompanying condensed consolidated financial statements include the accounts of Telos Corporation and its subsidiaries including Ubiquity.com, Inc., Xacta Corporation, Telos Identity Management Solutions, LLC, Teloworks, Inc., and Telos APAC Pte. Ltd., all of whose issued and outstanding share capital is owned by Telos Corporation (collectively, the “Company” or “Telos” or “We”). We have also consolidated the results of operations of Telos ID (see Note 2 – Non-controlling Interests). All intercompany transactions have been eliminated in consolidation.

We provide different solutions and are party to contracts of varying revenue types under the NETCENTS (Network-Centric Solutions) and NETCENTS-2 contracts to the U.S. Air Force. NETCENTS and NETCENTS-2 are IDIQ and GWAC, therefore any government customer may utilize the NETCENTS and NETCENTS-2 vehicles to meet its purchasing needs. Consequently, revenue earned on the underlying NETCENTS and NETCENTS-2 delivery orders varies from period to period according to the customer and solution mix for the products and services delivered during a particular period, unlike a standalone contract with one separately identified customer. The contracts themselves do not fund any orders and they state that the contracts are for an indefinite delivery and indefinite quantity. The majority of our task/delivery orders have periods of performance of less than 12 months, which contributes to the variances between interim and annual reporting periods. We have also been awarded other IDIQ/GWACs, including the Department of Homeland Security’s EAGLE II, GSA Alliant 2, and blanket purchase agreements under our GSA schedule.

U.S. Government appropriations have been and continue to be affected by larger U.S. Government budgetary issues and related legislation. In 2011, Congress enacted the Budget Control Act of 2011 (the “BCA”), which established specific limits on annual appropriations for fiscal years 2012-2021. TheThese limits were subsequently amended several times. With the expiration of the BCA has been amended a numberat the end of times, most recently by the Bipartisan Budget Act of 2019 (the “BBA”), which was enacted on August 2, 2019. As a result, DoD funding levels have fluctuated over this period and have been difficult to predict. Most recently, while the two-year BBA allowed for modestly increased defense spending in FY 2020, unless and until it is again modified, the BBA also essentially will maintain defense spending in FY 2021, with only a minor increase (less than one percent) permitted above the currentthere are no statutory limits in place for FY 2020 appropriated funding level.2022 to guide federal spending negotiations and decisions.

According to the non-partisan Congressional Budget Office (CBO), since enactment of Management and Budget,the BCA, federal outlays devoted to defense programs have fallenfell from 4.5 percent to 3.2 percent as a share of Gross Domestic Product (GDP) since enactmentto as low as 3.1 percent of GDP in each of FYs 2016-18, before rising slightly the BCA.past two years to a level of 3.4 percent in FY 2020. Moreover, CBO reports that, as a result of the spending caps imposed by the BCA, annual DoD budget authoritynon-adjusted defense outlays subsequently shrank from $699.4 billion in FY 2020 is only 3.7 percent higher (in unadjusted dollars) than it was a decade ago2011 to as low as $583.4 billion in FY 2010.2016, and did not again exceed their FY 2011 level until FY 2020, when outlays were $713.8 billion, two percent above the FY 2011 level.

Since final enactment in December 2019 of appropriations legislation for FYIn fiscal years 2020 and 2021, the February 10, 2020 submission of the President’s proposed FY 2021 budget, the CoronavirusCOVID-19 pandemic and associated economic dislocation in the United States has resulted in the need for an overwhelming federal response. This has led to theresponse, including enactment of severalmultiple massive and comprehensive emergency appropriations and economic stimulus measures, as well as negotiations between Congress andmeasures. These were in addition to annual appropriations legislation for FY 2021, which was not enacted into law until late December 2020, nearly three months after the White House for additional massive initiatives forbeginning of the current year and into the next fiscal year, during which time the detailsgovernment once again operated under a series of Continuing Resolutions which are not yet finalized.strictly limited new spending initiatives. These substantial alterationsenormous emergency spending packages and their resulting increases in the budget deficit will necessarily factor into future federal budget planning and spending decisions, which will affect to FY 2020 spending baselines are also likely to further impact FY 2021 spending in ways that cannot now be predicted.  The impact of the health and economic crisis, and the resulting large increase in federal spending, onan unknown degree the government contracts that we hold and the federal procurements that we would otherwise compete for.

While a detailed FY 2022 budget proposal has not been released, on April 9, 2021, the White House released an outline of President Biden’s discretionary budget request, with topline numbers to help Congress begin the annual appropriations process. The President’s budget proposes $715 billion in base spending for cannotthe Department of Defense (“DoD”) in FY 2022, which the Office of Management and Budget described as an $11.3 billion (1.6 percent) increase above the FY 2021 enacted level of $703.7 billion. However, this requested base defense budget also now be known.includes wartime spending which was formerly provided in a separate account for Overseas Contingency Operations. Moreover, congressional support for the President’s proposed level of defense spending is uncertain, as there are some in Congress who are advocating large cuts to the defense budget, as well as others who are calling for much greater increases in military spending.

In addition to the ongoing need to respond to the crisis in the current fiscal year,Should Congress and the President must agreeWhite House be unable to make sufficient progress on the FY 20212022 budget and enact appropriations legislation prior to the beginning of the new fiscal year on October 1, 2020; failing to do so by then would likely mean2021, the DoD and other federal departments and agencies will likely again be funded for an unknown period of time under anothera Continuing Resolution, which would again restrict new spending initiatives.  This is consistent with the practice for a number of years where the U.S. Government has been unable to complete its appropriations process prior to the beginning of the next fiscal year, resulting in actual or threatened governmental shut-downs and repeated use for extended time periods each year of Continuing Resolutions to fund part of all of the government.  The impact of the substantial additional spending on the Coronavirus pandemic on the appropriations for FY 2021, and the appropriations process itself, is not now known.

The current healthDespite the pandemic’s resultant massive shift to teleworking by federal employees and economic crisis is highly fluid, and it is likely to continue to affect multiple federal departments and agencies for an unknown period of time and in ways that are difficult to predict. Nonetheless, we believe thatcontractors, the federal government will very likely endeavor to maintainhas successfully maintained continuity of services and, withas has Telos.  With much of the business of government now beingcontinuing to be conducted remotely through use of information technology systems, now and in many cases during the crisis remotely,future, we believe there will stillcontinue to be a need on the part of the government for the types of solutions and services provided by Telos.

The principal elements of the Company’s operating expenses as a percentage of sales for the three months ended March 31, 20202021 and 20192020 are as follows:

Revenue increased by 25.1%43.0% to $39.0$55.8 million for the first quarter of 2020,2021, from $31.2$39.0 million for the same period in 2019. Services2020. Security Solutions revenue increased to $34.6was $22.9 million and $27.3 million for the first quarter of 2021 and 2020, from $28.0respectively. This decrease of approximately 16.1% was driven primarily by a decrease of $5.3 million for the same period in 2019, primarily attributable to increases in sales of $3.6 million ofofferings in Telos ID Enterprise Solutions, $2.4 million ofon the contract with the U.S. Census Bureau as the contract ramps down, offset by various increases in Information Assurance and Secure Communications Cyberofferings. Secure Networks revenue was $32.9 million and Enterprise Solutions, $1.1 million of Secure Mobility and Network Management/Defense Enterprise Solutions, offset by a decrease in sales of $0.5 million of Cyber & Cloud Solutions. The change in product and services revenue varies from period to period depending on the mix of solutions sold and the nature of such solutions, as well as the timing of deliverables. Product revenue increased to $4.4$11.7 million for the first quarter of 2021 and 2020, respectively. This increase of approximately 181.2% resulted from $3.1 millionvarious contracts with the DoD, primarily in our Secure Mobility Solutions offerings. Due to the various solutions offerings within the business groups, sales may vary from period to period according to the solution mix and timing of deliverables for the same period in 2019, primarily attributable to an increase in sales of $1.4 million of Cyber & Cloud Solutions, offset by a decrease in resold products of $0.2 million of Telos ID Enterprise Solutions.particular period.

Cost of sales increased by 20.5%54.8% to $26.7$41.4 million for the first quarter of 2020,2021, from $22.2$26.7 million for the same period in 2019.2020 as a result of increases in revenue. Cost of sales for services increased by 23.2%Security Solutions decreased to $13.6 million (inclusive of $660,000 of stock-based compensation) for the first quarter of 2021 from $17.2 million for the same period in 2020 (which had no stock-based compensation), andwhich translates as a decrease in the cost of sales as a percentage of services revenue were consistent at 28%.to 59.4% from 63.0%, due to a change in the mix and nature of the programs. Cost of sales for productsSecure Networks increased by 42.4%to $27.8 million (inclusive of $77,000 of stock-based compensation) for the first quarter of 2021 from $9.5 million for the same period in 2020 (which had no stock-based compensation),  andwhich translates as an increase in the cost of sales as a percentage of product revenue decreased by 21.5% due primarily to an increase in proprietary software sales which carry lower cost of sales. The increase in cost of sales is not necessarily indicative of a trend as the mix of solutions sold and the nature of such solutions can vary84.5% from period to period, and further can be affected by the timing of deliverables.81.2%.

Gross profit increased by 17.3% to $12.2$14.4 million for the first quarter of 20202021 from $9.0$12.3 million for the same period in 2019.2020. Gross margin increasedprofit for Security Solutions decreased to 31.4% in$9.3 million for the first quarter of 2020,2021 from 28.8%$10.1 million for the same period in 2019. Services gross margin was 28.0% in both periods, and product gross margin2020. Gross profit for Secure Networks increased to 57.6%$5.1 million for the first quarter of 2021 from $2.2 million for the same period in 2020. Gross margin decreased to 25.7% for the first quarter of 2021 from 31.4% for the same period in 2020, due to stock-based compensation and various changes in the mix of contracts in all business lines as discussed above. Gross margin for Security Solutions increased to 40.6% for the first quarter of 2021 from 36.1%37.0% for the same period in 2019, due primarily2020. Gross margin for Secure Networks decreased to an increase15.5% for the first quarter of 2021 from 18.8% for the same period in proprietary software as noted above.2020.

Selling, general, and administrative (“SG&A”) expense increased by 14.3%135.2% to $11.8$27.9 million for the first quarter of 2020,2021, from $10.4$11.8 million for the same period in 2019,2020, primarily attributable to increases in outside servicesstock-based compensation of $1.3$12.9 million, labor costs of $2.2 million, outside services of $0.8 million, insurance costs of $0.3 million, legal costs of $0.2 million, and trade shows costs of $0.1$0.2 million, offset by the capitalization of software development costs of $0.9$0.7 million.

Operating incomeloss was $0.4$13.5 million for the first quarter of 2020,2021, compared to $0.4 million operating lossincome for the same period in 2020, due primarily to the stock-based compensation related to the RSUs granted in the first quarter of $1.42021.

Interest expense decreased by 90.3% to $0.2 million for the first quarter of 2021, from $2.0 million for the same period in 2019,2020, primarily due primarily to the increasepayoff of the EnCap senior term loan, subordinated debt, and redemption of public preferred stock upon the closing of our initial public offering (“IPO”) in gross profit as noted above.November 2020.

Interest expense increased by 14.6% to $2.0 millionIncome tax provision was $34,000 for the first quarter of 2020, from $1.8 million2021, compared to $146,000 income tax benefit for the same period in 2019, primarily due to an increase in interest on the EnCap senior term loan, offset by a decrease in interest on an equipment purchase arrangement.

Net loss attributable to Telos Corporation was $2.2$14.8 million for the first quarter of 2020,2021, compared to $3.4$2.2 million for the same period in 2019,2020, primarily attributable to the increasestock-based compensation recorded in operating income for the first quarter of 2021 as discussedmentioned above.

As describedUpon the closing of our IPO, we issued 17.2 million shares of our common stock at a price of $17.00 per share, generating net proceeds of approximately $272.8 million. We used approximately $108.9 million of the net proceeds in connection with the ERPS Conversion (see Note 6 – Exchangeable Redeemable Preferred Stock Conversion), $30.0 million to fund our acquisition of the outstanding Class B Units of Telos ID (see Note 2 – Purchase of Telos ID/Non-controlling Interests), $21.0 million to repay our outstanding senior term loan and subordinated debt (see Note 5 – Current Liabilities and Debt Obligations, we maintainObligations).  We intend to use the remaining net proceeds for general corporate purposes. We also may use a Credit Agreement with EnCapportion of the net proceeds to acquire complementary businesses, products, services, or technologies. The amounts and a Purchase Agreement with RCA. The willingness of RCA to purchase our accounts receivable under the Purchase Agreement, and our ability to obtain additional financing, may be limited due to various factors, including the eligibilitytiming of our receivables,actual use of the statusnet proceeds will vary depending on numerous factors. Proceeds held by us are invested in short-term investments until needed for the uses described above. We currently anticipate that we will retain all available funds for use in the operation and expansion of our business, global credit market conditions, and perceptionswe do not anticipate paying any cash dividends on our common stock in the foreseeable future.

On April 6, 2021, we completed our follow-on offering of 9.1 million shares of our business or industrycommon stock at a price of $33.00 per share, including a secondary public offering of 7.0 million shares of common stock by EnCap, RCA, or other potential sourcescertain existing stockholders of financing. IfTelos. The offering generated approximately $64.5 million of net proceeds to Telos. We did not receive any proceeds from the shares of common stock sold by the selling stockholders. On April 19, 2021, we are unable to maintain the Purchase Agreement, we would need to obtain additional credit to fund our future operations. If credit is available in that event, lenders may impose more restrictive terms and higher interest rates that may reduce our borrowing capacity, increase our costs, or reduce our operating flexibility. The failure to maintain, extend, renew or replace the Purchase Agreement with a comparable arrangement or arrangements that provide similar amounts of liquidity for the Company would have a material negative impact on our overall liquidity, financial and operating results.

Our working capital was $(14.8)$102.2 million and $2.9$105.2 million as of March 31, 20202021 and December 31, 2019,2020, respectively. Our current working capital deficit is due to the classification of the EnCap Credit Agreement as a current liability as discussed in Note 5 to the financial statements, although the Fifth Amendment to the Credit Agreement provides us the option to extend the maturity of the agreement. We intend to consider exercising the option at the appropriate time. Although no assurances can be given, we expect that our financing arrangements with EnCap and RCA, collectively, and funds generated from operations are sufficient to maintain the liquidity we require to meet our operating, investing and financing needs for the next 12 months.

Cash provided byused in operating activities was $1.7$9.3 million for the three months ended March 31, 2020,2021, compared to $4.0cash provided by operating activities of $1.7 million for the same period in 2019.2020. Cash provided by or used in operating activities is primarily driven by the Company’s operating income, the timing of receipt of customer payments, the timing of its payments to vendors and employees, and the timing of inventory turnover, adjusted for certain non-cash items that do not impact cash flows from operating activities. Additionally, net loss was $1.4$14.8 million for the three months ended March 31, 2020,2021, compared to $2.9$1.5 million for the three months ended March 31, 2019.2020.

Cash used in investing activities was approximately $1.7$2.6 million and $2.9$1.7 million for the three months ended March 31, 20202021 and 2019,2020, respectively, due primarily to the capitalization of software development costs of $1.5$2.2 million and $0.6$1.5 million for the three months ended March 31, 20202021 and 2019,2020, respectively, and the purchase of property and equipment.

Cash used in financing activities was $0.3 million and $0.4 million for the three months ended March 31, 2021 and 2020, was $0.4 million, compared to $1.0 million for the same period in 2019,respectively, primarily attributable to payments under finance leases for both periods and an amendment fee paid to lender for the three months ended March 31, 2020, compared to distribution of $0.7 million to the Telos ID Class B member and payments under finance leases for the three months ended March 31, 2019.

See Note 1 of the Condensed Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.

During the three months ended March 31, 2020,2021, there were no material changes to our critical accounting policies as reported in our Annual Report on Form 10-K for the year ended December 31, 20192020 as filed with the SEC on April 13, 2020.March 25, 2021.

 None.

Evaluation of Disclosure Controls and Procedures

An evaluation of the effectiveness of our disclosure controls and procedures as of March 31, 20202021 was performed under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in its reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that information required to be disclosed by the Company in the reports the Company files or submits under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Internal Control over Financial Reporting

There has been no change in our internal control over financial reporting during the quarter ended March 31, 20202021 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 Information regarding legal proceedings may be found in Note 8 – Commitments and Contingencies to the condensed consolidated financial statements.

There were no material changes in the period ended March 31, 20202021 in our risk factors as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2019.2020.

None.

Not applicable.