UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

INTRUSION INC.

(Exact name of registrant as specified in its charter)

1101 East Arapaho Road, Suite 200, Richardson, Texas 75081

(Address of principal executive offices)

(Zip Code)

(972) 234-6400

(Registrant’s telephone number, including area code)

Not Applicable

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

* * * * * * * * * *

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes ☒ No ☐

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a)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)Act): Yes ☐ No ☒

The number of shares outstandingoutstanding of the Registrant’s Common Stock, $0.01 par value, on November 1, 2017July 31, 2020 was 12,797,836.13,792,030.

INTRUSION INC.

INDEX

We develop, market and support a family of entity identification, high speed data mining cybercrimeand cybersecurity solutions. Our products help detect, report and mitigate cybercrimes and advanced persistent threat detection products. threats.

Our product families include:

Our products in development include:

        We are in the process of developing a new product offering, Intrusion Shield, that is designed to be a next generation intrusion detection and protection solution.  After 20 years of providing research, analysis, and tools to the federal government and enterprise corporations, Intrusion possesses a comprehensive and proprietary database of Internet activity, including information about the activities of malicious online actors.  Intrusion’s Shield product will combine that comprehensive database with artificial intelligence (AI) and real-time process flow technology to provide businesses and government agencies with a unique and affordable tool to detect, identify, and prevent cyber-crimes. 

Shield is a combination of plug-and-play hardware, software, global data, and AI services providing organizations with aggressive protection against unaddressed information security threats and the most robust defense possible against cybercrime. Unlike traditional industry approaches that rely heavily on human resources, which malicious actors have learned to bypass, Intrusion Shield uses our extensive database together with real-time AI technology to prevent illicit behavior.  Shield's proprietary architecture isolates and neutralizes malicious traffic and network flows that existing solutions cannot identify or even characterize. Most breaches today are caused by malware free compromises that trigger no alarms in a firewall or endpoint solution. The common denominator is network communications, and Shield monitors and analyses all network traffic and communications allowing it to identify and stop malware-free attacks. Shield's capabilities will continuously evolve based on real-time updates originating from our worldwide installations and growing TraceCop database identifying new dangers.

Shield does not seek to displace existing solutions, instead providing a new, and additional layer of cybersecurity for enterprises.  According to SBA 2019, the U.S. enterprise market consists of 30.7 million businesses, of which 70% are characterized as small and medium sized businesses.  While the company believes that many large enterprises will recognize the need this product addresses and will be incentivized to purchase Shield, the enterprise market has many decision makers for new security product purchases; therefore, the sale cycle may be longer for this product than our current product offerings.  We have identified businesses with from 100 to 1,000 users as our initial target market, as we believe this market segment has the most pressing need for the enhanced protection that the Intrusion Shield will offer.  We intend to leverage existing and new channel partners, such as value added resellers and systems integrators, to market Shield to this target market.

Shield has experienced positive progress during Alpha testing and the Company has identified twelve companies for the Beta release anticipated to begin in September.  The configuration of hardware is a single Dell network appliance installed inline inside of the customer's firewall.  The size of the network appliance will vary depending on the number of workstations and the size of the customer's internet connection be that 1Gb, 10Gb, or 100 Gb.

Intrusion’s products help protect critical information assets by quickly detecting, protecting, analyzing and reporting attacks or misuse of classified, private and regulated information for government and enterprise networks.

We market and distribute our products through a direct sales force to:

Our end-user customers include:

Essentially, our end-users can be defined as any end-users requiring network security solutions for protecting their mission critical data.

We were organized in Texas in September 1983 and reincorporated in Delaware in October 1995. Our principal executive offices are located at 1101 East Arapaho Road, Suite 200, Richardson, Texas 75081, and our telephone number is (972) 234-6400.(972) 234-6400. Our website URL is www.intrusion.com. References to the “Company”, “we”, “us”, “our”, “Intrusion” or “Intrusion Inc.” refer to Intrusion Inc. and its subsidiaries. TraceCop and Savant are trademarksTrademarks of Intrusion Inc.include:

2.Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q10-Q and Item 10-0110-01 of Regulation S-X.S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The December 31, 2016 2019 balance sheet was derived from audited financial statements, but does not include all the disclosures required by accounting principles generally accepted in the United States. However, we believe that the disclosures are adequate to make the information presented not misleading. In our opinion, all the adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation have been included. The results of operations for the three and ninesix month periods ended SeptemberJune 30, 2017, 2020 are not necessarily indicative of the results that may be achieved for the full fiscal year or for any future period. The unaudited condensed consolidated financial statements included herein should be read in conjunction with the consolidated financial statements and notes thereto included in our annual report on Form 10-K10-K for the year ended December 31,2016, 2019, filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 29, 2017.27, 2020.

The Company calculates the fair value of its assets and liabilities which qualify as financial instruments and includes this additional information in the notes to consolidated financial statements when the fair value is different from the carrying value of these financial instruments. The estimated fair value of accounts receivable, accounts payable and accrued expenses, and dividends payable approximate their carrying amounts due to the relatively short maturity of these instruments. Loans payable to officer are with a related party and as a result do not bear market rates of interest (see Note 4).interest.  Management believes based on its current financial position that it could not obtain comparable amounts of third party financing, and as such cannot estimate the fair value of the loans payable to officer. None of these instruments are held for trading purposes.

In May2014, the FASB issued Accounting Standards Update No.2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes most current revenue recognition guidance under U.S. GAAP. The core principle ofOn January 1, 2019 we adopted ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The standard is effective for us beginning 2018. We will be using the following transition method:  a modified retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized atNo. 2016-02, Leases (topic 842). At the date of adoption (which includes additional footnote disclosures). We do not believethere was no impact on the adoptionstatement of this guidance willoperations, while the balance sheet reflects recording both assets and liabilities applicable to the operating right-of-use asset lease identified. ASU No. 2016-02 did not have a material impacteffect on our financial statements.the Company’s results of operations or cash flows for the three and six month periods ended June 30, 2020 and 2019.

3.Inventories (In thousands)

4.     Loan Payable to Officer

On February 9, 2017, 8, 2018, the Company entered into an unsecured revolving promissory note to borrow up to $3,400,000$3,700,000 from G. Ward Paxton, the Company’s Chief Executive Officer (the “CEO Note”).Paxton. Under the terms of the note,CEO Note, the Company may had the ability to borrow, repay and re-borrowreborrow on the loan as needed up to an outstanding principal balance due of $3,400,000$3,700,000 at any given time through March 2018.2020.

On March 2, 2017, February 7, 2019, the Company amended the unsecured revolving promissory note to borrow up to $2,700,000 from G. Ward Paxton, the Company’s former Chief Executive Officer. Amounts borrowed under the CEO Note described above on the same terms, with the Company being able to borrow, repay, and re-borrow on the note as needed up to an outstanding principal balance due of $3,700,000 at any given time through March 2019.

Amounts borrowed from this officer accrueaccrued interest at a floating rate per annum equal to Silicon Valley Bank’sBank’s (“SVB”) prime rate plus 1% (5.25%. Under the terms of the note, the Company had the ability to borrow, repay and reborrow on the loan as needed up to an outstanding principal balance due of $2,700,000 at September 30, 2017). All outstanding borrowings and accrued but unpaid interest is due on any given time through March 31,2021. We reduced our borrowing under this note to zero as of May 2019.

As of September 30, 2017, October 24, 2019, G. Ward Paxton passed away, terminating the CEO Note with the result that future borrowings outstanding totaled $2,865,000thereunder will no longer be available to the Company. Our management will be assessing whether to replace this borrowing capacity and accrued interest totaled $308,000.assessing what terms may be available to the Company, including whether any such terms are acceptable to the Company, if at all.

6.4.     Accounting for Stock-Based Compensation

During the three month periods ended SeptemberJune 30, 2017 2020 and 2016,2019, the Company did not grant anygranted 323,000 and 24,000, respectively, of stock options to employees or directors. The Company recognized $6,000$55,000 and $20,000,$10,000, respectively, of stock-based compensation expense for the three month periods ended SeptemberJune 30, 2017 2020 and 2016.2019. During the ninesix month periods ended SeptemberJune 30, 2017 2020 and 2016,2019, the Company granted 24,000323,000 and 24,000, respectively, of stock options to employees and directors. The Company recognized $16,000$74,000 and $82,000,$14,000, respectively, of stock-based compensation expense for the ninesix month periods ended SeptemberJune 30, 2017 2020 and 2016.2019.

During the three month periods ended SeptemberJune 30, 2017 2020 and 2016,no options2019, 14,000 and 14,000 were exercised under the 2005 Plan. Plan, respectively. During the ninesix month periods ended SeptemberJune 30, 2017 2020 and 2016,50,0002019, 186,600 and 136,000 options280,500 were exercised under the 2005 Plan, respectively.

Valuation Assumptions

The fair values of employee and director option awards were estimated at the date of grant using a Black-Scholes option-pricing model with the following assumptions:

Expected volatility is based on historical volatility and in part on implied volatility. The expected term considers the contractual term of the option as well as historical exercise and forfeiture behavior. The risk-free interest rate is based on the rates in effect on the grant date for U.S. Treasury instruments with maturities matching the relevant expected term of the award. Options granted to non-employees are valued using the fair market value on each measurement date of the option.

7.5.     Revenue Recognition

We generally recognize product revenue upon shipment or after meeting certain performance obligations. These products can include hardware, perpetual software licenses and data sets. Data set updates are the majority of our sales. We do not currently offer software on a subscription basis. Warranty costs and sales returns have not been material.

We recognize sales of our data sets in accordance with FASB ASC Topic 606 whereby revenue from contracts with

customers is not recognized until all five of the following have been met:

Data updates are typically done monthly and revenue will be matched accordingly. Product sales may include maintenance and customer support allocated revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy using the relative selling price method. All of our product offering and service offering market values are readily determined based on current and prior stand-alone sales. We may defer and recognize maintenance, updates and support revenue over the term of the contract period, which is generally one year.

Service revenue, primarily including maintenance, training and installation are recognized upon delivery of the service and typically are unrelated to product sales. To date, training and installation revenue has not been material. These revenues are included in net customer support and maintenance revenues in the statement of operations.

Our normal payment terms offered to customers, distributors and resellers are net 30 days domestically and net 45 days internationally. We do not offer payment terms that extend beyond one year and rarely do we extend payment terms beyond our normal terms. If certain customers do not meet our credit standards, we do require payment in advance to limit our credit exposure.

Shipping and handling costs are billed to the customer and included in product revenue. Shipping and handling expenses are included in cost of product revenue. We have elected to account for shipping and handling costs as fulfillment costs after the customer obtains control of the goods.

Contract assets represent contract billings for sales per contracts with customers and are classified as current. Our contract assets include our accounts receivables. At June 30, 2020, the Company had contract assets balance of $1,067,000. At December 31, 2019, the Company had contract assets balance of $1,566,000.

Contract liabilities consist of cash payments in advance of the Company satisfying performance obligations and recognizing revenue. The Company currently classifies deferred revenue as a contract liability. At June 30, 2020, the Company had contract liabilities balance of $164,000. At December 31, 2019, the Company had contract liabilities balance of $516,000.

6.     Net LossIncome (Loss) Per Share

Basic net lossincome (loss) per share is computed by dividing net lossincome attributable to common stockholders for the period by the weighted average number of common shares outstanding for the period. Diluted net lossincome (loss) per share is computed by dividing the net lossincome (loss) attributable to common stockholders by the weighted average number of common shares and dilutive common stock equivalents outstanding for the period. Our common stock equivalents include all common stock issuable upon conversion of preferred stock and the exercise of outstanding options and warrants.options. The aggregate number of common stock equivalents excluded from the diluted lossincome (loss) per share calculation for the three month periods ended SeptemberJune 30, 2017 2020 and 20162019 are 1,014,5001,942,990 and 3,532,943 as they are antidilutive.12,132, respectively. The aggregate number of common stock equivalents excluded from the diluted lossincome (loss) per share calculation for the ninesix month periods ended SeptemberJune 30, 2017 2020 and 20162019 are 1,675,6191,909,289 and 3,545,745 as they6,066, respectively. Since the Company is in a net loss position for the three and six month periods ending June 30, 2020, basic and dilutive net loss per share are antidilutive.the same.

8.7.     Concentrations

Our operations are concentrated in one area— area—security software/entity identification. Sales to the U.S. Government through direct and indirect channels totaled 90.6%91.0% of total revenues for the thirdsecond quarter of 20172020 compared to 78.4%91.3% of total revenues for the thirdsecond quarter of 2016.2019. During the thirdsecond quarter of 2017,2020, approximately 90.6%91.0% of total revenues were attributable to sixfour government customers compared to approximately 78.4%73.2% of total revenues attributable to fivethree government customers in the thirdsecond quarter of 2016. Sales to2019. In the second quarter of 2020, no individual commercial customers totaled 9.4%customer had revenues over 10.0% of total revenue compared to no individual commercial customer for the third quarter of 2017 compared to 21.6% of total revenue for the third quarter of 2016. During the third quarter of 2017, approximately 6.2% of total revenue was attributable to one commercial customer compared to approximately 18.9% to one commercial customersame period in the third quarter of 2016.2019. Our similar product and service offerings are not viewed as individual segments, as our management analyzes the business as a whole and expenses are not allocated to each product offering.

9.8.     Commitments and Contingencies

We are subject from time to time to various legal proceedings and claims that arise during the ordinary course of our business. We do not believe that the outcome of those "routine" legal matters should have a material adverse effect on our consolidated financial position, operating results or cash flows; however, we can provide no assurances that legal claims that may arise in the future will not have such a material impact on the Company.

10.9.     Dividends Payable

During the quarter ended September June 30,2017, 2020, we accrued $14,000$13,000 in dividends payable to the holders of our 5% Preferred Stock, $15,000$13,000 in dividends payable to the holders of our Series 25% Preferred Stock and $8,000$7,000 in dividends payable to the holders of our Series 35% Preferred Stock. As of SeptemberJune 30, 2017, 2020, we have $411,000had $19,000 in accrued and unpaid dividends.

Delaware law provides that we may only pay dividends, outall of our capital surplus or, if no surplus is available, out of our net profits for the fiscal year the dividend is declared and/or the preceding fiscal year. These dividends continue to accrue on all our outstanding shares of preferred stock, regardless of whether we are legally able to pay them. If we are unable to pay dividends on our preferred stock, we will be required to accrue an additional late fee penalty of 18% per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3 Preferred Stock. Our CEO, CFO and one outside board member who are holders of our Series 2 and Series 3 Preferred Stockwhich have waived any possible late fee penalties. In addition to this late penalty, the holders of our Series 2 Preferred Stock and Series 3 Preferred Stock could elect to present us with written notice of our failure to pay dividends as scheduled, in which case we would have 45 days to cure such a breach. In the event that we failed to cure the breach, the holders of these shares of preferred stock would then have the right to require us to redeem their shares of preferred stock for a cash amount calculated in accordance with their respective certificates of designation. If we were required to redeem all shares of Series 2 Preferred Stock and Series 3 Preferred Stockbeen paid as of November 1, 2017, the aggregate redemption price we would owe would be $2.2 million.date of this Quarterly Report.

11. Other Income10.   Right-of-use Asset and Leasing Liabilities

On July 7, 2017, Under the new lease accounting standard, we have determined that we have leases for right-of-use (ROU) assets. We have both finance right-of-use assets and operating right-of-use assets with a related lease liability. Our finance lease right-of-use assets consist of computer hardware and a copying machine. Our operating lease right-of-use assets include our rental agreements for our offices in Richardson and San Marcos, CA. Both types of lease liabilities are determined by the net present value of total payments and are amortized over the life of the lease. Both types of lease obligations are designed to terminate with the last scheduled payment. All of the finance lease right-of-use assets have a three year life and are in various stages of completion. The Richardson operating lease liability has a life of four years and five months as of June 30, 2020. The San Marcos operating lease liability has a life of nine months as of June 30, 2020. The adoption of the lease accounting standard resulted in the recognition of an operating ROU asset of $1,553 thousand and a related lease liability of $1,744 thousand during the first quarter of 2019.

Additional qualitative and quantitative disclosures regarding the Company's leasing arrangements are also required. The Company adopted ASC 842 prospectively and elected the package of transition practical expedients that does not require reassessment of: (1) whether any existing or expired contracts are or contain leases, (2) lease classification and (3) initial direct costs. In addition, the Company has elected other available practical expedients to not separate lease and non-lease components, which consist principally of common area maintenance charges, for all classes of underlying assets and to exclude leases with an initial term of 12 months or less.

As the implicit rate is not readily determinable for the Company's lease agreement, the Company uses an estimated incremental borrowing rate to determine the initial present value of lease payments. This discount rate for the lease approximates SVB's prime rate.

Supplemental cash flow information includes operating cash flows related to operating leases. For the six months ended June 30, 2020 and 2019, the Company had $179 thousand and $88 thousand, respectively, in operating cash flows related to operating leases.

Schedule of Items Appearing on the Statement of Operations:

Future minimum lease obligations consisted of the following at June 30, 2020 (in thousands):

*Interest is imputed for operating ROU leases and classified as lease expense and is included in operating expenses in the accompanying condensed consolidated statement of operations.

11.   PPP Loan

On March 27, 2020, the U.S. federal government enacted the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), which includes provision for a Paycheck Protection Program (“PPP”) administered by the U.S. Small Business Administration (“SBA”). The PPP allows qualifying businesses to borrow up to $10 million calculated based on qualifying payroll costs. The loan is guaranteed by the federal government, and does not require collateral. On April 30, 2020 we entered into a salePPP Loan with Silicon Valley Bank effective April 30, 2020, pursuant to the PPP under CARES for $629,000. The PPP Loan matures on April 30, 2022 and bears interest at a rate of 1.0% per annum. Monthly amortized principal and interest payments are deferred for six months after the date of disbursement. The PPP Loan funds were received on April 30, 2020. The PPP Loan contains events of default and other provisions customary for a loan of this type. The PPP provides that (1) the use of PPP Loan amount shall be limited to certain IP addressesqualifying expenses, (2) 100 percent of the principal amount of the loan is guaranteed by the SBA and (3) an amount up to the full principal amount may qualify for loan forgiveness in accordance with the terms of CARES. We are not yet able to determine the amount that were not currently being usedmight be forgiven. As of June 30, 2020, the Company was in full compliance with all covenants with respect to the PPP Loan. The Company expects to use the full proceeds of the PPP loan in accordance with the provisions of CARES. As of June 30, 2020, the balance of the PPP Loan was $630,000, which includes $1.0 thousand in accrued interest.

Future minimum loan obligations consisted of the following at June 30, 2020 (in thousands):

12.   Coronavirus Outbreak in the Company'sUnited States

Uncertainties surrounding the effects of the coronavirus, particularly potential diversion of time and resources of federal government entities which make up a significant concentration of our customer base, could cause a material adverse effect on our results of operations and financial results. The extent of the impact of COVID-19 on our operational and financial performance will depend on certain developments, including the duration and spread of the outbreak, impact on our customers, employees and vendors all of which are uncertain and cannot be predicted. A material disruption in our workplace as a result of the coronavirus could affect our ability to carry on our business operations in the ordinary course and were may require additional cost and effort should our employees not required for be able to be physically on-premises.

13.   Subsequent Events.

As of the Company's future business plans.date of this Quarterly Report, all current shares of issued and outstanding preferred stock have been voluntarily converted, resulting in the issuance of a total of 1,004,249 newly issued shares of the Company’s common stock. The net proceeds from the saleaddition of these intellectual property assets werenewly issued shares has resulted in the amountdilution of $872,000 whicheach share of issued and outstanding common stock by a factor of 7.28%.  While the Company received on August 9, 2017. In addition, $56,000 was received on August 3, 2017 from the sale of an investment. The receiptelimination of these transactions had an immediate positive impactthree classes of preferred stock removes a number of the Company’s obligations to the holders of preferred stock (such as the obligation to pay continuing dividends) as well as a number of restrictions on the Company's liquidity position.Company’s activities (such as restrictions on certain capital raising and funding transactions), the addition of these newly issued shares combined with the fact that the Company’s common stock is thinly traded on the OTCQB Marketplace could cause an increase in selling volume, and result in a decline in the market price of the Company’s common stock.

On August 6, 2020, Anthony J. LeVecchio was appointed to the board of directors and to serve on the Company’s audit and compensation committees.