Net Revenues. Net revenues for the quarter and nine months ended September 30, 20192020 were $1.6 million and $5.0 million, respectively, compared to $3.9 million and $11.1 million, respectively, compared to $2.7 million and $7.3 million for the same periods in 2018.2019. Product revenues increased $1.2decreased $2.3 million for the quarter ended September 30, 2019,2020, and $3.8$6.1 million for the nine months ended September 30, 20192020 compared to the same periods in 2018. Increased2019. Decreased product revenues were primarily due to an increasea decrease in sales of our TraceCop product line. TraceCop sales for the quarters ended September 30, 2020 and 2019 were $1.5 million and 2018 were $3.9 million, and $2.7 million, respectively. TraceCop sales continue to be negatively affected due to Covid-19. Savant sales remainedincreased to $106 thousand for the same atquarter ended September 30, 2020 compared to $29 thousand for the quartersquarter ended September 30, 2019 and 2018.2019. We expect the launch of our INTRUSION Shield solution to begin to have positive effects on our net revenue in fiscal year 2021.

Concentration of Revenues. Revenues from sales to various U.S. government entities totaled $1.5 million, or 92.3% of revenues, for the quarter ended September 30, 2020 compared to $3.5 million, or 90.9% of revenues, for the quarter ended September 30, 2019 compared to $2.3 million, or 84.5% of revenues, for the same period in 2018.2019. Revenues from sales to various U.S. government entities totaled $9.9$4.3 million, or 89.8%84.4% of revenues, for the nine months ended September 30, 2019,2020, compared to $6.1$9.9 million, or 84.2%89.8% of revenues, for the same period in 2018.2019. Sales to commercial customers totaled 7.7% of total revenue for the third quarter of 2020 compared to 9.1% of total revenue for the third quarter of 2019 compared to 15.5% of total revenue for2019. During the third quarter of 2018. During the third quarter of2020 and 2019, no individual commercial customer had revenues over 10.0% of total revenue approximately compared to approximately 14.5% to one commercial customer in the third quarter of 2018. Although we expect our concentration of revenues to vary among customers in future periods depending upon the timing of certain sales, we anticipate that sales to government customers will continue to account for a significant portion of our revenues in future periods.revenue. Sales to the government present risks in addition to those involved in sales to commercial customers which could adversely affect our revenues, including, without limitation, potential disruption to appropriation and spending patterns and the government’s reservation of the right to cancel contracts and purchase orders for its convenience. Although we do not anticipate that any of our revenues with government customers will be renegotiated, a large number of cancelled or renegotiated government orders could have a material adverse effect on our financial results. Currently, we are not aware of any proposed cancellation or renegotiation of any of our existing arrangements with government entities and, historically, government entities have not cancelled or renegotiated orders which had a material adverse effect on our business. Although we expect our concentration of revenues to vary among customers in future periods depending upon the timing of certain sales, we anticipate that sales to government customers will decrease as a percentage of revenues to the extent our INTRUSION Shield solution and its follow-on solutions appeal to a wider customer base comprised of commercial customers who are distinct from and our historical customer base of governmental and regulatory customers.

Gross Profit. Gross profit was $0.9 million or 58.9% of net revenues for the quarter ended September 30, 2020, compared to $2.4 million or 62.0% of net revenues for the quarter ended September 30, 2019, compared to $1.72019. Gross profit was $3.0 million or 63.7%59.3% of net revenues for the quarternine months ended September 30, 2018. Gross profit was2020 compared to $6.7 million or 60.8% of net revenues for the nine months ended September 30, 2019 compared to $4.6 million or 62.4% of net revenues for the nine months ended September 30, 2018.2019. Gross profit on product revenues for the quarter and nine months ended September 30, trended from 63.7% and 62.4%, respectively, in 2018 to 62.0% and 60.8%, respectively, in 2019 to 58.9% and 59.3%, respectively, in 2020 mainly due to a change in product mix. Gross profit increasesdecreases can be attributed to such variables as labor hour rates and department overhead. Gross profit as a percentage of net revenues is impacted by several factors, including shifts in product mix, changes in channels of distribution, revenue volume, pricing strategies, and fluctuations in revenues of integrated third-party products. We expect our gross profit will be affected by the introduction, marketing, and sales of our new INTRUSION Shield solution and its follow on solutions to the extent that such products receive market acceptance.

Sales and Marketing. Sales and marketing expenses decreasedincreased to $0.4$0.9 million for the quarter ended September 30, 2019,2020, compared to $0.5$0.4 million for same period in 2018.2019. Sales and marketing expenses decreasedincreased to $0.8$1.9 million for the nine months ended September 30, 2019,2020, compared to $1.3$0.8 million for the same period in 2018.2019. For the nine months ended September 30, 2019,2020, sales and marketing expenses decreasedincreased due to shiftingincreased expense due to costplanned investment in the marketing of sales for various projects during the second quarter 2019 and the Company was able to collect payment of $200 thousand from a customer related expense that occurred during the year 2018.INTRUSION Shield. Sales and marketing expenses may vary in the future. We believe that these costs maywill increase through the end of 2019.2020 as we continue to invest in the marketing of INTRUSION Shield.

Research and Development. Research and development expenses remained constant at $0.3increased to $1.1 million for the quarter ended September 30, 2019,2020 compared to $0.3 million for the same period in 2018.2019. Research and development remained constant at $0.8expenses increased to $2.7 million for the nine months ended September 30, 2019,2020 compared to $0.8 million for the same period in 2018. Research2019. The increase in research and development expense was due partly to increased costs remained constantrelated to the development of our INTRUSION Shield solution as well as an increase in labor expense due to increasedless direct labor expense being allocated to cost of sales.required on existing projects. Research and development costs are expensed in the period in which they are incurred. Research and development expenses may vary in the future; however, we believe that these costs will mainly be dependent on the amountlevels of research and development labor expense allocatedcharged to costprojects. We expect research and development expenses to increase through the end of2020 due to product development of sales.INTRUSION Shield as well as its follow-on product solutions.

General and Administrative. General and administrative expenses increased to $0.3$0.4 million for the quarter ended September 30, 2019,2020, compared to $0.2$0.3 million for the same period in 2018.2019. General and administrative expenses increased to $0.9$1.0 million for the nine months ended September 30, 2019,2020, compared to $0.8$0.9 million for the same period in 2018.2019. It is expected that general and administrative expenses will remain relatively constantincrease throughout the remainder of 2019.2020 due to increases in administrative expenses related to the implementation of INTRUSION Shield.

Interest. Net interestInterest expense decreasedincreased to $1$2 thousand for the quarter ended September 30, 2019,2020 compared to $43$1 thousand for the same period in 2018. Net interest2019. Interest expense decreased to $45$4 thousand for the nine months ended September 30, 20192020 compared to $144$45 thousand for the same period in 2018. The decrease in interest2019. Interest expense wasdecreased due to eliminationdecreased amount of Loan Payable to Officer culminating in our repayment of the loan payable to an officer. Net interestbalance in May 2019. Interest expense maywill vary in the future based on our level of borrowing, which will be affected by our cash flow operatingand borrowing needs. Interest income increased to $3 hundred for the quarter ended September 30, 2020 compared to none for the same period in 2019. Interest income increased to $8 thousand for the nine months ended September 30, 2020 compared to none for the same period in 2019. This is attributable to investing extra cash in money market accounts and capital expenditures.

getting better interest rates.

Liquidity and Capital Resources

Our principal source of liquidity at September 30, 2019,2020, was approximately $2.1$1.5 million of cash and cash equivalents. At September 30, 2019,2020, we had working capital deficiency of $2.9$1.0 million compared to a $0.4$2.9 million working capital deficiency at September 30, 2018.2019.

Net cash used by operations for the nine months ended September 30, 2020 was $2.4 million due primarily to a net loss of $2.6 million, a $514 thousand increase in prepaid expenses and other assets, and a $457 thousand decrease in deferred revenue. This was partially offset by the following sources of cash and non-cash items: a $536 thousand decrease in accounts receivable, $186 thousand expense in noncash lease costs, a $134 thousand decrease in accounts payable and accrued expenses, $164 thousand in depreciation and amortization expense and $174 thousand in stock-based compensation. Net cash provided by operations for the nine months ended September 30, 2019 was $2.9 million due primarily to a net income of $4.2 million and the following sources of cash and non-cash items: a $364 thousand decrease in operatingnoncash lease right-of-use assets,costs, $136 thousand in depreciation and amortization expense, $24 thousand in stock-based compensation, and $6 thousand in penalties and waived penalties on dividends. This was partially offset by a $737 thousand increase in accounts receivable, a $621 thousand decrease in accounts payable and accrued expenses, a $361 thousand decrease in deferred revenue, and a $45 thousand increase in prepaid expenses and other assets. Net cash provided by operations for the nine months ended September 30, 2018 was $1.8 million due primarily to a net income of $1.437 million and to the following sources of cash and non-cash items: $213 thousand increase in deferred revenue, $191 thousand increase in accounts payable and accrued expenses, $15 thousand decrease in Inventories, $34 thousand in penalties and waived penalties on dividends, $50 thousand in amortization expense of capital leases, $46 thousand in depreciation expense, $16 thousand in stock-based compensation, and a $65 thousand write-off of the United Kingdom’s cumulative translation adjustment. This was partially offset by a $120 thousand increase in prepaid expenses and other assets and a $155 thousand increase in accounts receivable. Future fluctuations in inventory balances, accounts receivable and accounts payable will be dependent upon several factors, including, but not limited to, quarterly sales volumes and timing of invoicing, and the accuracy of our forecasts of product demand and component requirements.

Net cash used in investing activities for the nine months ended September 30, 2019,2020, was $183$153 thousand for net purchases of property and equipment, compared to net cash used by investing activities for the nine months ended September 30, 2018,2019, was $173$183 thousand for net purchases of property and equipment.

Net cash provided by financing activities in 2020 was $691 thousand with proceeds of $629 thousand from a PPP loan and proceeds from exercise of stock options of $193 thousand. This was directly offset by the following uses of cash: payments for preferred stock dividends of $99 thousand and payment on principal of finance right-of-use leases of $32 thousand. Net cash used by financing activities in 2019 was $2.3 million with payments on the loan from an officer of $1.8 million, payments for preferred stock dividends of $667 thousand, and payment on principal of finance right-of-use leases of $47 thousand. This was directly offset by the following provisions of cash: proceeds from exercise of stock options of $236 thousand. Net cash used by financing activities in 2018 was $1.0 million due to payments to the CEO Note of $1.2 million and $51 thousand payment on principal on capital leases. This was directly offset by the following provisions of cash: proceeds from a loan by an officer of $150 thousand and $111 thousand from the exercise of stock options.

At September 30, 2019,2020, the Company did not have any material commitments for capital expenditures.

During the nine months ended September 30, 2019,2020, the Company funded its operations through the use of cash and cash equivalents.

As of September 30, 2019,2020, we had cash and cash equivalents of approximately $2,111,000,$1,505,000, down from approximately $1,652,000$3,334,000 as of December 31, 2018.2019. We generated a net loss of $1,409,000 for the quarter ended September 30, 2020 compared to net income of $1,464,000 for the quarter ended September 30, 2019 compared to a net income of $617,000 for the quarter ended September 30, 2018. As of September 30, 2019, in addition to cash and cash equivalents of $2,111,000, we had $2.7 million of funding available2019. Based on funds received from a promissory note to borrow up to $2.7 million from G. Ward Paxton, the Company’s Chief Executive Officer (the “CEO Note”). We are obligated to make payments of accrued dividends on all our outstanding shares of preferredcommon stock that will reduce our available cash resources.

Based on projections of growth in revenue and net income in the coming quarters,offering, we believe that we will have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months. However, asAs of October 24, 2019, our funding available from the CEO Note terminated. Our management will be assessing whether to replace this borrowing base and assessing what terms may be available to the Company, including whether any such terms are available on terms acceptable to the Company, if at all (the “Potential Replacement Funding Facility”).

We expect to fund our operations through anticipated Company profits possibletogether with the approximately $18 million in net proceeds we received from our Secondary Public Offering, which we believe will be sufficient to finance our operations, the additional investmentsexpenses of private equitymarketing, promoting, and debt, ,selling our new INTRUSION Shield solution and the Potential Replacement Facility. Any equity or debt financings, if available at all, may be on terms which are not favorable to us and, indevelopment of its follow-on solutions, as well as other expected capital expenditures for the case of equity financings, may result in dilution to our stockholders. If our operations do not generate positive cash flow in the upcoming year, or if we are not able to obtain additional debt or equity financing on terms and conditions acceptable to us, if at all, we may be unable to implement our business plan, fund our liquidity needs or even continue our operations.

We may explore the possible acquisitions of businesses, products and technologies that are complementary to our existing business. We are continuing to identify and prioritize additional security technologies, which we may wish to develop, either internally or through the licensing, or acquisition of products from third parties. While we may engage from time to time in discussions with respect to potential acquisitions, there can be no assurances that any such acquisitions will be made or that we will be able to successfully integrate any acquired business. In order to finance such acquisitions and working capital it may be necessary for us to raise additional funds through public or private financings. Any equity or debt financings, if available at all, may be on terms, which are not favorable to us and, in the case of equity financings, may result in dilution to our stockholders.next twelve months.

We maintain “disclosure controls and procedures,” as defined in Rule 13a-15(e) under the Exchange Act, that are designed to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable assurance of achieving the desired control objectives, and we necessarily are required to apply our judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures.

Our management, including our principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2019,2020, and concluded that the disclosure controls and procedures were effective.

Our management, with the participation of our principal executive officer and principal financial officer, evaluated our “internal control over financial reporting” (as defined in Rule 13a-15(f) under the Exchange Act) as of December 31, 2018,2019, and concluded that there have not been any changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2019,2020, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

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 will not have such a material impact in the future.

Factors That May Affect Future Results of Operations

We are providing the following information regarding changes that have occurred to previously disclosed risk factors from our Annual Report on Form 10-K for the year ended December 31, 2018.2019. In addition to the other information set forth below and elsewhere in this report, you should consider the factors discussed under the heading “Risk Factors” in our Form 10-K for the year ended December 31, 20182019 filed on March 28, 2019.27, 2020 and in our Form 10-Q for the quarters ended March 31, 2020 filed on May 15, 2020 and June 30, 2020 filed on August 13, 2020. The risks described in our Annual Report on Form 10-K and our Quarterly Reports on Form 10-Q are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

We may be unsuccessful in the transition of responsibilities of our co-founder, G. Ward Paxton upon his unexpected passing on October 24, 2019, which may havehad a material adverse effect on our results of operations.

Mr. G. Ward Paxton co-founded the Company in 1983, and he served as President, Chief Executive Officer, Director, and Chairman of the Board for most of his 36 year tenure. He demonstrated dedication and leadership, and provided a unique insight and understanding of the Company’s operations and business strategy for decades. Thenet loss of that leadership and experience may cause the expenditure of Company’s and its managements time and attention as it works through this transition with the Company’s management, staff, vendors, suppliers and customers, any or all of whom may be apprehensive regarding the loss of Ward’s leadership. We can provide no assurance of the smoothness, the diversion of the Company’s resources, or the successfulness of this transition.

The appointment of our current CFO, Mr. Michael L. Paxton, to the positions of Director and Chairman of the Board, as well as his service as Interim President and Interim CEO, may take significant time, attention, and focus from our day to day operations and the Company’s goals and objectives, perhaps in a material way.

Mr. Michael Paxton has been an integral part of our management team for many years, and our Board has expressed confidence that he will provide a smooth transition going forward. However, Mr. Paxton will be tasked with continuing his current obligations of our Chief Financial Officer as well as taking on these additional roles and responsibilities. While we believe that Mike’s long tenure with and understanding of the Company’s operations will be an asset to his ability to quickly adapt to these additional duties, we can provide no assurances of such.

As of October 24, 2019, we have lost the ability to borrow, up to $2.7$1.4 million under the CEO Note, the loss of which may have a material adverse effect on our business, our results of operation, or even out ability to continue as a going concern.

With the passing of our former CEO, Mr. G. Ward Paxton, the CEO Note terminated, with the result that future borrowings thereunder will no longer be available to the Company. Our ability to draw funds under the CEO Note has been a major strength behind the Company’s liquidity for a number of years, the loss of which is unable to be measured at this time. However, the lack of this financial backstop could, in the future, have a material adverse effect on our business, our results of our operations, our ability to continue as a going concern, or to continue operations at all. Our management will be assessing whether to replace this borrowing base and assessing what terms may be available to the Company, including whether any such terms are acceptable to the Company, if at all; however we can make no such assurances as to the replacement of this borrowing facility.

We may not have sufficient cash to operate our business and may not be able to maintain future liquidity requirements. Additional debt and equity offerings to fund future operations may not be available and, if available, may significantly dilute the value of our currently outstanding common stock.

As of September 30, 2019, we had cash and cash equivalents of approximately $2,111,000, down from approximately $1,652,000 as of December 31, 2018. We generated net income of $1,464,000 for the quarter ended September 30, 2019 compared to a net income2020, and we have an accumulated deficit of $617,000 for the quarter ended September 30, 2018. As$57.4 million as of September 30, 2019, in addition to cash and cash equivalents of $2,111,000, we had $2.7 million of funding available from a promissory note to borrow up to $2.7 million from G. Ward Paxton, the Company’s Chief Executive Officer (the "CEO Note). We are obligated to make payments of accrued dividends on all our outstanding shares of preferred stock that will reduce our available cash resources. However, as of October 24, 2019, our funding available from the CEO Note terminated. Our management will be assessing whether to replace this borrowing base and assessing what terms may be available to the Company, including whether any such terms are available on terms acceptable to the Company, if at all (the “Potential Replacement Funding Facility”). We expect to fund our operations through anticipated Company profits, possibly additional investments of private equity and debt, which, if we are able to obtain, will have the effect of diluting our existing common stockholders, perhaps significantly, and a possible Potential Replacement Facility. Any equity or debt financings, if available at all, may be on terms which are not favorable to us and, in the case of equity financings, may result in dilution to our stockholders. If our operations do not generate positive cash flow in the upcoming year, or if we are not able to obtain additional debt or equity financing on terms and conditions acceptable to us, if at all, we may be unable to implement our business plan, fund our liquidity needs or even2020. To continue our operations.

We had a net incomeof $1.5million for the quarter ended September 30, 2019, and we have an accumulated deficit of $55.1 million as of September 30, 2019. To continuecurrent financial performance,, we must sustain or increaseincrease revenue levels.

For the quarter ended September 30, 2019,2020, we generatedhad a net incomeloss of $1.5$1.4 million and had an accumulated deficit of approximately $55.1$57.4 million as of September 30, 2019,2020, compared to a net income of $617 thousand$1.5 million for the quarter ended September 30, 20182019 and an accumulated deficit of approximately $60.1$54.8 million at September 30, 2018.December 31, 2019. We need to maintainincrease current revenue levels from the sales of our productssolutions if we are to continueregain profitability. If we are unable to achieve these revenue levels, losses could happencontinue for the near term and possibly longer, and we may not maintainregain profitability or generate positive cash flow from operations in the future.

We do not anticipate significant changes in net revenue for the fourth quarter of fiscal year 2020 as compared with the third quarter, which was lower than previous quarters. Lack of increased revenue could adversely affect our results of operation, our liquidity position, and result in a decline in the price of our common stock.

The Company anticipates that we will not see significant changes in our net revenue for the quarterly period ending on December 31, 2020 as compared with the third quarter, which was lower than previous quarters. While it is premature to determine whether this depressed revenue is a trend or merely a reflection of our customers’ varying ordering patterns, our inability to increase our net revenue could result in lower operating results for the fiscal year 2020, have a negative effect on our cash flow and our overall liquidity position, and potentially affect the perception of the Company’s value in the marketplace and result in a decline in the price of our common stock.

Further, our expense levels are based, in part, upon our expectations as to future revenues and are largely fixed in the short term. Therefore, we may not be able to timely adjust our expenditures in order to compensate for an unanticipated shortfall in revenue in any given quarter. Any significant, unanticipated shortfall in revenues could have an immediate and significant effect on our operating results for that quarter and might lead to a reduced market price for our stock.

We may be unable to successfully market, promote, and sell our new commercial solution, INTRUSION Shield, and market it through new sales channels to a new set of prospective customers.

We anticipate significant resources will be required in order to succeed in launching our new INTRUSION Shield solution, including the time, attention, and focus of our senior management and our research and development team, coordination of new marketing strategies highlighting this new offering and promoting it through new and expanded sales channels to a wider audience of prospective customers than we have historically marketed and sold our solutions and services. In addition, significant financial resources will be required to successfully manage the implementation of this new solution. This could result in diversion of those resources from critical areas of our company operations and a potential strain on our liquidity and ability to meet our current and these anticipated increases in our cash-flow needs.

We could experience damage to our reputation in the cybersecurity industry in the event that our INTRUSION Shield solution fails to perform as expected, to meet our customers’ needs, or to achieve market acceptance.

Our reputation in the industry as a leading provider of entity identification, data mining, and advanced persistent threat detection solutions may be harmed, perhaps significantly, in the event that our new INTRUSION Shield fails to perform as we expect it to. If Shield does not perform as we expect, if we experience delivery delays, or if our customers do not perceive the benefits of purchasing and using Shield as part of their comprehensive cybersecurity solution, our position as a leader in this technology space may be damaged and could affect the willingness of our customers, as well as potential customers, to purchase our other solutions that function separately from our INTRUSION Shield. Any reputational damage could result in a decrease in orders for all of our solutions, the loss of current customers, and a decrease in our overall revenues which could in turn have a material adverse effect on our results of operation.

Uncertainties surrounding the effects of the coronavirus, particularly potential diversion of time and resources of the federal, state, and local governmental 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.

We have a concentration of customers that are federal, state, and local governmental entities. Such entities have had to allocate resources and adjust budgets to accommodate real and potential contingencies related to the effects of the coronavirus and measures required to be put in place to prevent and contain contamination of the virus. These uncertainties have resulted in decreased demand by some of our customers for our current solutions. A continued decrease in orders for our solutions by government customers could cause a material adverse effect on our operations and financial results. While we anticipate that widening the scope of our customer base through the introduction of our INTRUSION Shield solution will minimize the effect of this decrease in demand by our government customers, we can offer no assurances as to the effects the Coronavirus may continue to have on our current or future customers.

Our common stock may experience volatility in trading or loss in value as a result of the effects of the coronavirus on the US and global economies.

Uncertainties surrounding the effects of the coronavirus on the US and global economies has resulted in an increase in volatility and violent drops in the value of publicly traded securities. While the price of our common stock has not experienced such volatility or loss in value, we can offer no assurances that the long-term effects on the overall US economy will not negatively affect us in the future.

We must expend time and resources addressing potential cybersecurity risk, and any breach of our information security safeguards could have a material adverse effect on the Company.

The threat of cyber-attacks requires additional time and money to be expended in efforts to prevent any breaches of our information security protocols. However, we can provide no assurances that we can prevent all such attempts from being successful, which could result in expenses to address and remediate such breaches as well as potentially losing the confidence of our customers who depend upon our services to prevent and mitigate such attacks on their respective business. Should a material breach of our information security systems occur, it would likely have a material adverse impact on our business operations, our customer relations, and our current and future sales prospects, resulting in a significant loss of revenue.