CYNERGISTEK, INC.

FORM 10-Q

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PART I – FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS.

CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTSTATEMENTS OF STOCKHOLDERS’ EQUITY

NINETHREE MONTHS ENDED SEPTEMBER 30, 2017MARCH 31, 2021 and 2020

(UNAUDITED)

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CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NINETHREE MONTHS ENDED SEPTEMBER 30, 2017MARCH 31, 2021 AND 20162020

(UNAUDITED)

1.BASIS OF PRESENTATION 

The accompanying unaudited condensed consolidated financial statements of Cynergistek,CynergisTek, Inc. and its subsidiaries (the “Company”, “we”, “us”“Company,” “we,” “us,” or “Cynergistek”“CynergisTek”) have been prepared in accordance with generally accepted accounting principles of the United States of America (“GAAP”) for interim financial statements pursuant to the rules and regulations of the Securities and Exchange Commission.  Accordingly, these financial statements do not include all of the information and notes required by GAAP for complete financial statements.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016,2020, as filed with the Securities and Exchange Commission (“SEC”) on March 29, 2017.25, 2021.

The unaudited condensed consolidated financial statements included herein reflect all adjustments (which include only normal, recurring adjustments) that are, in the opinion of management, necessary to state fairly our financial position and results of operations as of and for the periods presented.  The results for such periods are not necessarily indicative of the results to be expected for the full year.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  As a result, actual results could differ from those estimates.

The accompanying unaudited condensed consolidated financial statements include the accounts of CynergistekCynergisTek and its wholly owned subsidiaries.  All intercompany balances and transactions have been eliminated.

Based on our integration strategies, and management strategies,an analysis of how our Chief Operating Decision Makers review, manage and are compensated, we operate in a single businesshave determined that the Company operates as one segment. For the periods presented, all revenues were derived from domestic operations.

As described in more detail in our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 8, 2017, Auxilio, Inc., a Nevada corporation (“Auxilio”) changed its name and state of incorporation from the State of Nevada to the State of Delaware by merging (the “Reincorporation”) with and into its wholly-owned subsidiary, CynergisTek, Inc., a Delaware corporation, which was established for the purpose of the Reincorporation.   As a result of the Reincorporation, Auxilio ceased to exist as a separate entity.  As of the date of the merger, each outstanding share of Auxilio’s common stock was deemed, by operation of law, to represent the same number of shares of our common stock.  In accordance with Rule 12g-3 under the Securities Exchange Act of 1934, as amended, the shares of our common stock were deemed to be registered under Section 12(b) of the Exchange Act as a successor to Auxilio.  Effective as of September 8, 2017, the Company’s trading symbol changed to “CTEK.”  

As part of the Reincorporation, two wholly owned subsidiaries of the Company also changed their corporate names, as follows: (i) Auxilio Solutions, Inc., a California corporation, has changed its name to CTEK Solutions, Inc.; and (ii) CynergisTek, Inc., a Texas corporation, has changed its name to CTEK Security, Inc. (“CTEK Security”).  

We have performed an evaluation of subsequent events through the date of filing these unaudited condensed consolidated financial statements with the SEC.

Effective

Liquidity and Capital Resources

As of March 31, 2021, our cash balance was $4.4 million, current assets minus current liabilities was positive $7.3 million and our non-current debt and lease obligations, excluding contingent earnout liability of $1.3 million, totaled $2.8 million. This $2.8 million of debt is related to the U.S. Small Business Administration (“SBA”) Paycheck Protection Program loan (the “PPP Loan”), received pursuant to the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”), that we anticipate will be fully forgiven as described in Note 9. The level of additional cash needed to fund operations and our ability to conduct business for the next twelve months will be influenced primarily by the following factors:

·our ability to manage our operating expenses and maintain gross margins while attracting, recruiting and retaining cybersecurity privacy professionals; 

·demand for our services from healthcare providers; the near-term impact of the COVID-19 on January 13, 2017,our customers allocation of time and resources to security and privacy, and their ability to pay for existing services as well as enter into new contractual arrangements during a period of crisis; 

·general economic conditions and changes in healthcare reimbursement and regulatory environment, including effects of the COVID-19 epidemic; and 

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·our ability to collect accounts receivable from health care customers whose operations and cash flow have been significantly impacted by COVID-19 pandemic. 

We have historically funded our operating costs, acquisition activities, working capital requirements and capital expenditures with cash from operations, proceeds from the issuances of our common stock and other financing arrangements. We are currently operating in a cash flow negative position while we seek to maintain and grow our cybersecurity business and cover our public company expenses during this uncertain time. In connection with our most recent results for the three months ended March 31, 2021, we reported a loss from operations of $1.2 million.  After excluding $0.6 million of non-cash items for depreciation, amortization of intangibles and stock-based compensation, our adjusted loss from operations was $0.6 million. Cash used in operating activities was $1.0 million for the three months ended March 31, 2021.

In late 2019, a novel strain of coronavirus (COVID-19) was first detected in Wuhan, China. Following the outbreak of this virus, governments throughout the world, including in the United States of America, have quarantined certain affected regions, restricted travel and imposed significant limitations on other economic activities. Our customer base is heavily concentrated in the healthcare provider space.  This part of the healthcare industry has indicated that they are seeing significant financial losses, have furloughed employees and are expressing uncertainty as to the short and long-term financial stability of their businesses.  Our operations team is closely monitoring the impact to the Company’s business, including its cash flows, customers and employees. We have heard and are working with a number of our active customers since the outbreak began providing relief in the form of extended payment terms and other contractual restructurings.  If the situation continues to impact our customers cash flow or resources available for cybersecurity and privacy projects, our cash flows, financial position and operating results for fiscal year 2021 and beyond will be negatively impacted.

We did experience a negative financial impact from March 2020 through March 2021 that management anticipates will continue to impact revenue and earnings for the foreseeable future due to COVID-19, primarily because many of the initial economic effects of the early stages of the COVID-19 pandemic resulting from the various shelter-in-place and other social distancing orders occurred towards the end of our first quarter of 2020. The severity and duration of the COVID-19 pandemic is uncertain, and such uncertainty will likely continue in the near term. We will continue to actively monitor the situation taking into account the impact to our employees, customers and partners.

At the end of 2019 and through the first quarter of 2021, we reduced staffing levels to reduce expenses that included permanent and temporary cost reductions, the precise extent of which will depend on the duration of the COVID-19 disruptions to our customers and our short-term financial performance. In addition, we received a $2.8 million PPP loan pursuant to the CARES Act, which we anticipate will be fully forgiven and we anticipate having approximately $0.7 million in quarterly employee retention tax credits in the first and second quarters of 2021.  With the proceeds from the PPP Loan and the employee retention tax credits, we have tried to minimize staff reductions in the areas of Sales and Delivery, our primary customer facing roles, to lessen the impact to our customers during this time of heightened security risks for the healthcare industry. If necessary, we could further reduce personnel and other variable and semi-variable costs to conserve cash and operate as a going concern. However, those actions if required, could negatively impact the long-term outlook of the business.

On November 12, 2020, we entered into the Equity Distribution Agreement with Craig-Hallum Capital Group LLC (the “Agent”), under which we may offer and sell, from time to time at our sole discretion, shares of our common stock having an aggregate offering price of up to $5.0 million in an “at-the-market” or ATM offering, to or through the Agent.  The Company agreed to pay the Agent a commission of three percent (3.0%) of the gross sales price per share of any common stock sold through the Agent under the Equity Distribution Agreement.

During November and December of 2020, the Company effected a reverse stock splitreceived gross proceeds under the Equity Distribution agreement of its$2,027,000 from the issuance of 1,315,000 shares of our common stock and paid an aggregate of $61,000 to the Agent in commissions and $123,000 in other offering-related expenses, yielding net proceeds of $1,843,000.

We believe that our existing sources of liquidity, including cash and cash equivalents, the proceeds from the PPP loan and employee retention tax credits, the ability to raise equity under our shelf registration (including via the Equity Distribution Agreement) and future operating cash flows, and other assets will be sufficient to meet our

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projected capital needs for at a ratioleast the next twelve months. As we execute our plans over the next twelve months, we intend to carefully monitor the impact on our operating expenses, working capital needs and cash balances relative to the availability of 1-for-3. No fractional shares of common stock were issued,cost-effective debt and no cash equity financing. In the event that capital is not available, we may then have to scale back operations, reduce expenses, and/or other consideration were paid as a resultcurtail future plans to manage our liquidity and capital resources.   However, we cannot provide assurance that we will be able to raise additional capital. The COVID-19 pandemic will likely continue to create uncertainty and volatility in the financial markets which may impact our operations and our ability to access capital and/or the terms under which we can do so.  

The impact of the reverse stock split. Instead,COVID-19 pandemic on the Company issued one whole shareeconomy and our operations is fluid and constantly evolving; we will continue to assess a variety of post-reverse stock split common stock in lieu of each fractional share of common stock. As a result of the reverse stock split, the Company’s common stock was reducedmeasures to 8,185,936 shares from 24,557,224 shares as of December 31, 2016. All per share amountsimprove our financial performance and number of shares in the unaudited condensedliquidity.

The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and related notes have been retroactively

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restatedrecorded asset amounts and classification of liabilities that might be necessary should the Company be unable to reflect the reverse stock split resulting in the reclassification of $15,749 from common stock to additional paid in capital at January 1, 2015.continue as a going concern.

Certain accounts have been reclassified to conform to current period presentation.

2.RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS 

Recently Issued Accounting Pronouncements Adopted

In November 2015,January 2020, the FASBFinancial Accounting Standards Board (the “FASB”) issued guidancean amendment clarifying the interaction between accounting standards related to the presentation of deferred income taxes.equity securities, equity method investments and certain derivatives. The guidance requires that deferred tax assets and liabilities be classified as non-current in the condensed consolidated balance sheet. This guidance was adopted early by us and resulted in the Company classifying its deferred tax assets as non-current assets.

In May 2014, the FASB issued guidance which provides a single, comprehensive accounting model for revenue arising from contracts with customers. This guidance supersedes most of the existing revenue recognition guidance, including industry-specific guidance. Under this model, revenue is recognized at an amount that a company expects to be entitled to upon transferring control of goods or services to a customer, as opposed to when risks and rewards transfer to a customer. The new guidance also requires additional disclosures about the nature, timing and uncertainty of revenue and cash flow arising from customer contracts, including significant judgments and changes in judgments. Considering the one-year delay in the required adoption date for the guidance as issued in July 2015, the new guidance is effective for us beginning in 2018 and may be applied retrospectively to all prior periods presented or through a cumulative adjustment to the opening retained earnings balance in the year of adoption. We will adopt this standard beginning January 1, 2018 and expect to use the modified retrospective method of adoption. Under the new guidance, based on the nature of our contracts, we expect to continue to recognize revenue in a similar manner as with the current guidance. Additionally, we expect the unit of accounting, that is, the identification of performance obligations, will be consistent with current revenue guidance. Accordingly, the adoption of this standard is not expected to have a material impact on our revenues.

In March 2016, the FASB issued a new accounting standard regarding stock compensation: improvements to employee share-based payment accounting, that simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The new standard was effective for fiscal years beginning after December 15, 2016, including interim periods within those annual years, and early adoption was permitted. We adopted the new standard prospectively in 2017.2020.  The adoption of the new standard did not have a material effect on our unaudited condensed consolidated financial statements for the three months and nine months ended September 30, 2017, and we do not expect that the adoption of the new standard will have a material effect on our consolidated financial statements for the year ended December 31, 2017.

In February 2016, the FASB issued a new accounting standard on leasing. The new standard will require companies to record most leased assets and liabilities on the balance sheet, and also proposes a dual model for recognizing expense. This guidance will be effective in the first quarter of 2019 with early adoption permitted. We have evaluated the impact of adopting this guidance and we are preparing for the changes to be made to our consolidated financial statements. We expect the adoption of these accounting changes will materially increase our assets and liabilities, but willdid not have a material impact on our net income or equity.consolidated financial statements.

In January 2017,December 2019, the FASB issued an amendment to the guidance on income taxes which is intended to simplify the accounting for income taxes.  The amendment eliminates certain exceptions related to the approach for intra-period tax allocation, the methodology for calculating income taxes in an interim period, and the recognition of the deferred tax liabilities for outside basis differences.  The amendment also clarifies existing guidance related to the recognition of franchise tax, the evaluation of a new accounting standard simplifyingstep up in the testtax basis of goodwill, and the effects of enacted changes in tax laws or rates in the effective tax rate computation, among other clarifications.  The guidance was effective for goodwill impairment. Currently,fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020.  The adoption of this guidance did not have a material impact on our consolidated financial statements.

Recently Issued Accounting Pronouncements Not Yet Adopted

In June 2016, the FASB issued an amendment to the guidance on the measurement of credit losses on financial instruments.  The amendment updates the guidance for measuring and recording credit losses on financial assets measured and amortized cost by replacing the “incurred loss” model with an “expected loss” model.  Accordingly, these financial assets will be presented at the net amount expected to be collected. The amendment also requires that credit losses related to available-for-sale debt securities be recorded as an allowance through net income rather than reducing the carrying amount under the current, other-than-temporary-impairment model.  The guidance is effective for smaller reporting companies for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.  Early adoption is permitted for annual periods after December 15, 2018. Management does not expect the impact from this guidance will have a material impact on our consolidated financial statements.

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3.ACCOUNTS RECEIVABLE

A summary of accounts receivable is as follows:

4.DEFERRED COMMISSIONS

Our incremental costs of obtaining a contract, which consist of sales commissions, are deferred and amortized over the period of contract performance. Deferred commissions are included in prepaid and other current assets in our consolidated balance sheets. We had $708,000 and $758,000 of unamortized deferred commissions as of March 31, 2021 and 2020, respectively. We had $183,000 and $165,000 of commissions expense for the three months ended March 31, 2021 and 2020, respectively.

5.PROPERTY AND EQUIPMENT

A summary of property and equipment follows:

6.LEASES

We previously leased approximately 9,600 square feet of office space in Austin, Texas. In March 2020, we amended this lease reducing the office space to 5,000 square feet and extended the lease term to May 31, 2022. We lease approximately 3,700 square feet of office space in Minneapolis, Minnesota. This lease terminates on July 31, 2021, and we expect to renew on a month-to-month or other short-term basis under one year. We leased approximately 18,000 square feet of office space in Mission Viejo, California. This lease terminated in April 2021. During the first quarter of 2019, we subleased this space to two subtenants. The terms of these subleases ended concurrently with the end of our lease obligation in April 2021.

We used a discount rate of 5.5% in determining our operating lease liabilities which represented our incremental borrowing rate. Short-term leases with initial terms of twelve months or less are not capitalized.

Right-of-use assets and liabilities are recognized based on the present value of future minimum lease payments over the expected lease term at commencement date. Certain lease agreements contain extension options; however, we have not included such options as part of right-of-use assets and lease liabilities because we originally did not expect to extend the leases. We measure and record a right-of-use asset and lease liability based on the discount rate implicit in the lease, if known. In cases where the discount rate implicit in the lease is not known, we measure the right-of-use assets and lease liabilities using a discount rate equal to our estimated incremental borrowing rate for loans with similar collateral and duration.

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Operating lease expense was comprised of the following:

Maturities of lease liabilities are as follows:

7.INTANGIBLE ASSETS

Intangible assets are amortized over expected useful lives ranging from 1.5 to 10 years and consist of the following:

8.DEFERRED REVENUE

We record deferred revenues when amounts are billed to customers, or cash is received from customers, in advance of our performance. During the three months ended March 31, 2021 and 2020, $738,000 and $884,000, respectively, of managed services revenues were recognized, that were included in deferred revenue at the beginning of the respective periods. During the three months ended March 31, 2021 and 2020, $225,000 and $142,000, respectively, of consulting and professional services revenues were recognized, that were included in deferred revenue at the beginning of the respective periods.

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9.PAYCHECK PROTECTION PROGRAM LOAN

On April 20, 2020, we received $2,825,500 in loan funding from the Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”), established pursuant to the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”).  The unsecured loan (the “PPP Loan”) is evidenced by a promissory note issued by the Company (the “Note”) in favor of BMO Harris Bank N.A.

The Company used the PPP Loan proceeds to cover payroll costs, rent and utilities in accordance with the relevant terms and conditions of the CARES Act.

Under the terms of the Note and the PPP Loan, interest accrues on the outstanding principal at the rate of 1.0% per annum. The term of the Note is two years, unless sooner provided in connection with an event of default under the Note. To the extent the Loan amount is not forgiven under the PPP, the Company is obligated to make equal monthly payments of principal and interest, beginning seven months from the date of the Note, until the maturity date. The Company has not started making interest payments as it awaits the forgiveness decision from the SBA. Details regarding the Note can be found in our 8-K filed on April 20, 2020.

The Company recognized interest charges associated with the PPP Loan of approximately $7,000 for the three months ended March 31, 2021. To the extent the principal balance is forgiven, the related interest would be forgiven as well. Management anticipates that the loan will be fully forgiven.

10.PROMISSORY NOTES

In connection with the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.), we issued a promissory note totaling $4.5 million to Michael McMillan (“Seller Note,”).In March, 2018, the Company repaid $2,250,000 plus accrued interest on the Seller Note and agreed to amend and restate the Seller Note in the remaining principal amount of $2,250,000.  The Seller Note bears interest at a rate of 8% per annum, provides for quarterly payments of principal and interest and matures on March 31, 2022.  As of March 31, 2021, and December 31, 2020, the outstanding principal balance due under the Seller Note was $562,500 and $703,125, respectively.

Interest charges associated with the Seller Note totaled approximately $13,000 and $24,000, for the three months ended March 31, 2021 and 2020, respectively.

11.REVENUES

Below is a summary of our revenues disaggregated by revenue source.

12.WARRANTS, OPTIONS AND RESTRICTED STOCK UNITS

Warrant Issued for Securities Purchase Agreement

On April 3, 2020, we entered into a Securities Purchase Agreement with Horton Capital Management, LLC (“Horton”) which provided that Horton was committed to purchase up to an aggregate of $2,500,000 of shares of the Company’s common stock over the term of the agreement, at the election of the Company, which terminated on March 31, 2021. Additionally, if and when the Company sold shares to Horton under the commitment, the Company agreed to grant to Horton a warrant, with the same number of shares of common stock purchased by Horton in the particular funding, with an exercise price equal to 125% of the purchase price of the shares of common stock sold in such funding, with a 10-year term. No purchases were made under the Securities Purchase Agreement.

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Upon signing the agreement, the Company issued Horton a warrant (the “Horton Warrant”) to purchase up to 500,000 shares of common stock in consideration of Horton’s obligation to purchase the shares, at an exercise price of $2.50 per share, subject to certain anti-dilution adjustments as set forth in the warrant. The fair value of this warrant of $390,000 was determined using the Black-Scholes option-pricing model and was expensed during the second quarter of 2020.

At the end of 2020 the Company issued common stock under an equity distribution agreement receiving net proceeds of $1,843,000 from the issuance of 1,315,000 shares of our common stock that resulted in a Q1 2021 anti-dilution adjustment increasing the number of shares under the Horton Warrant to 518,915 and reducing the exercise price to $2.41.  The resulting difference in fair value of the reporting unit is comparedHorton Warrant with the carrying valuenew exercise price was $6,000 and determined using the Black-Scholes option-pricing model and recorded as a deemed dividend in our consolidated statements of stockholders’ equity. As the Company has an accumulated deficit, the deemed dividend was recorded within additional paid-in capital.

The detailed terms and conditions of the reporting unit (identified as "Step 1"). IfHorton Securities Purchase Agreement and the fair valueHorton Warrant can be found in the documents themselves, which were filed with the SEC on April 7, 2020.

Below is a summary of warrant activities during the three-month period ended March 31, 2021:

2020 Equity Incentive Plan

The 2020 Equity Incentive Plan provides for a total number of shares available for issuance of 3,745,621 shares of our common stock, and it provides for the granting of stock options, stock appreciation rights, and restricted stock to our employees, members of the reporting unit is lower than its carrying amount, then the implied fair valueBoard of goodwill is calculated. If the implied fair value of goodwill is lower than the carrying value of goodwill an impairment is recognized (identified as "Step 2"). The new standard eliminates Step 2 from the impairment test; therefore, a goodwill impairment will be recognized as the difference of the fair valueDirectors and the carrying value. The new standard becomes effective on January 1, 2020 with early adoption permitted. We are currently evaluating the impact that the new standard will have on our financial position, results of operations and cash flows.

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3.OPTIONS, WARRANTS AND RESTRICTED STOCK UNITSservice providers.

Below is a summary of stock option warrant and restricted stock activityactivities during the nine-monththree-month period ended September 30, 2017:March 31, 2021:

During the ninethree months ended September 30, 2017,March 31, 2021, we granted a total of 25,000100,000 options to our employees and directorsan employee to purchase shares of our common stock at an exercise price of $3.06$2.75 per share. The exercise price equals the fair value of our stock on the grant date.  The options have graded vesting annually over three years.  The fair value of the options of approximately $135,000 was determined using the Black-Scholes option-pricing model.  The assumptions used to calculate

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Below is a summary of restricted stock unit activity during the fair market value are as follows: (i) risk-free interest rate of 0.38%; (ii) estimated volatility of 46.29%; (iii) dividend yield of 0.0%; and (iv) expected life of the options of three years.three-month period ended March 31, 2021:

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During the nine months ended September 30, 2017, we issued a total of 130,000There are 100,000 shares of restricted stock units to key employees and memberswhich have vested but had not yet been issued as of the Board of Directors. The shares vest after three years of continuous employment. The average price of the stock on the grant date was $4.78. The cost recognized for these restricted stock units totaled $54,163 and $98,347, respectively, for the three and nine months ended September 30, 2017, and is included in sales and marketing expense in the accompanying Condensed Consolidated Statement of Operations.March 31, 2021.

For the three and nine months ended September 30, 2017March 31, 2021 and 2016,2020, stock-based compensation expenseand other equity instrument related expenses recognized in the consolidated statements of operations were as follows:

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4.13.BASIC AND DILUTED NET INCOMELOSS PER SHARE 

Basic net incomeloss per share is calculated using the weighted average number of shares of our common stock issued and outstanding during a certain period and is calculated by dividing net loss by the weighted average number of shares of our common stock issued and outstanding during such period. Diluted net incomeloss per share is calculated using the weighted average number of common and potentially dilutive common shares outstanding during the period, using the as-if-converted method for secured convertible notes, and the treasury stock method for options and warrants. Diluted net incomeloss per share does not include potentially dilutive securities because such inclusion in the computation would be anti-dilutive.

For the three months ended September 30, 2017,March 31, 2021, potentially dilutive securities consisted of options and warrants to purchase 1,416,7471,724,700 shares of common stock at prices ranging from $0.90$1.08 to $6.45$4.86 per share. Of these potentially dilutive securities, 379,476none of the shares to purchase common stock from the options and warrants are included in the computation of diluted earnings per share, because the effect of including the remaining instruments would be anti-dilutive. Also excluded from potentially dilutive securities are 767,850 shares of non-vested restricted stock units and 100,000 shares of restricted stock units which vested but had not been issued as of March 31, 2021.

For the ninethree months ended September 30, 2017,March 31, 2020, potentially dilutive securities consisted of options and warrants to purchase 1,416,747797,325 shares of common stock at prices ranging from $0.90$2.28 to $6.45$4.86 per share. Of these potentially dilutive securities, 448,164none of the shares ofto purchase common stock underlyingfrom the options and warrants are included in the computation of diluted earnings per share because the effect of including the remainingthese instruments would be anti-dilutive.

For the three months ended September 30, 2016, Also excluded from potentially dilutive securities consisted of options and warrants to purchase 1,798,567are 1,088,000 shares of commonnon-vested restricted stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, 86,461 of theunits and 60,000 shares of commonrestricted stock underlying the options and warrants are included in the computationunits which vested but had not been issued as of diluted earnings per share because the effectMarch 31, 2020.

Table of including the remaining instruments would be anti-dilutive.

For the nine months ended September 30, 2016, potentially dilutive securities consisted of options and warrants to purchase 1,798,567 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, 118,686 of the shares of common stock underlying the options and warrants are included in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.Contents

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5.14.ACCOUNTS RECEIVABLEREMAINING PERFORMANCE OBLIGATIONS 

A summary of accounts receivable is as follows:

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6.INTANGIBLE ASSETS

Intangible assets are amortized over expected useful lives ranging from 1.5 to 10 years and consist of the following:

7.LINE OF CREDIT AND TERM LOAN

On May 4, 2012, we entered into a Loan and Security Agreement (the “Loan and Security Agreement”) with Avidbank Corporate Finance, a DivisionWe had remaining performance obligations of Avidbank (“Avidbank”).  On April 26, 2013, we amended the Loan and Security Agreement with Avidbank. On April 25, 2014, we again amended the Loan and Security Agreement with Avidbank (the “Second Avidbank Amendment”). This line of credit was further extended through June 25, 2015 under the third amendment to the Loan and Security Agreement. On June 19, 2015, we again amended the Loan and Security Agreement with Avidbank (the “Fourth Avidbank Amendment”). Under the Fourth Avidbank Amendment, the term of the revolving line-of-credit of up to $2.0approximately $17.4 million was extended through June 19, 2017, at an interest rate of prime plus 0.75% per annum.  On January 13, 2017, as part of the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.), we entered into an Amended and Restated Credit Agreement (the “A&R Credit Agreement”) with California Bank and Trust and Avidbank (collectively the “Lenders”). Under the A&R Credit Agreement, the term of the revolving line-of-credit is available through January 13, 2019 at an interest rate of prime plus 1.0% per annum. As of September 30, 2017, the interest rate was 5.25%.  There will be no minimum interest payable with respect to any calendar quarter. The amount available to us at any given time is the lesser of (a) $5.0 million, or (b) the amount available under our borrowing base (80% of our eligible accounts receivable, minus (1) accrued client lease payables, and minus (2) accrued equipment pool liability). As of September 30, 2017, and December 31, 2016, no amounts were outstanding under the line of credit.

The Fourth Avidbank Amendment provided for a term loan facility which allowed for advances up to $4,000,000 through June 19, 2016. Our initial draw was for $2,000,000 in 2015. As of December 31, 2016, outstanding borrowings under the term loan were $1,250,000 at an interest rate of 4.75%. On January 13, 2017, this loan was repaid in full. On that date, we entered into the A&R Credit Agreement which provided a term loan facility for $14,000,000. Term loan repayments are to be made 48 monthly principal installments of $198,333, plus accrued interest at an interest rate of prime plus 1.5% per annum, followed by 12 monthly principal installments of $373,333, plus accrued interest at an interest rate of prime plus 1.5%.  As of September 30, 2017, outstanding borrowings under the term loan are $13,008,333 at an interest rate of 5.75%.

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While there are outstanding credit extensions, we are to maintain an asset coverage ratio of cash plus accounts receivable divided by all obligations owing to the bank within one year of at least 1.50 to 1.00, measured monthly, and a fixed charge coverage ratio, whereby adjusted EBITDA for the most recent twelve months shall be no less than 1.15 to 1.00 of the sum of the following: (i) Non-Financed Capital Expenditures, (ii) taxes paid in cash during such period, (iii) Distributions paid in cash during such period, (iv) any Earnout Payment paid in cash during such period, and (v) Debt Service for such period, all as determined in accordance with GAAP. We were in compliance with all covenants as of September 30, 2017 and DecemberMarch 31, 2016.

In connection with the A&R Credit Agreement, the Company and its subsidiaries (collectively the “Borrowers”) entered into a security agreement (the “Security Agreement”), pursuant to which each of the Borrowers agreed to grant to Avidbank, in its capacity as contractual representative for itself and the other lender (the “Agent”), for the ratable benefit of itself, the Lenders and the other secured parties, a first priority security interest in certain collateral to secure prompt payment and2021. Our remaining performance of the secured obligations under the A&R Credit Agreement.  Pursuant to the Security Agreement, the “Collateral” was defined as including any and all (all such terms as defined in the Security Agreement) of the Accounts, Chattel Paper, Commercial Tort Claims, Deposit Accounts, Documents, Equipment, Instruments, Inventory, Investment Property, General Intangibles, Letter of Credit Rights, Negotiable Collateral, Supporting Obligations, Vehicles, Grantors’ Books, in each case whether now existing or hereafter acquired or created, any money or other assets of any Grantor that now or hereafter come into the possession, custody, or control of Agent and any Proceeds or products of any of the foregoing, or any portion thereof.  In connection with the grant of the security interest in the Collateral, each of the Borrowers made standard representations and warranties relating to ownership of the collateral, location and control of the collateral, and certain rights to payment.

Additionally, in connection with the A&R Credit Agreement and the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.) transaction, (see Note 11), Michael Mathews, (“Mathews”), Michael McMillan (“McMillan”), the Company, and Avidbank entered into a subordination agreement (the “Subordination Agreement”), pursuant to which Mathews and McMillan agreed that unless and until all of the Company’s obligations under the A&R Credit Agreement have been repaid in full, Mathews and McMillan would not, except as provided in the Subordination Agreement, ask, demand, sue for, take or receive, or retain, from the Company or any other person or entity, by setoff or in any other manner, payment of all or any part of the Subordinate Debt (as defined below), or take any other action with respect to the Subordinate Debt; forgive, cancel or discharge any of the Subordinate Debt; ask, demand or receive any security for the Subordinate Debt; amend any documents relating to the Subordinate Debt or any other agreement, instrument or document evidencing or executed in connection with the Subordinate Debt in a manner that could reasonably be expected to be adverse to Lenders or Agent (or any other holders of the obligations arising under the A&R Credit Agreement); or bring or join with any creditor in bringing any insolvency proceeding against the Company. Additionally, Mathews and McMillan each directed the Company to make, and the Company agreed to make, such prior payment of the Company’s obligations under the A&R Credit Agreement to Agent and the Lenders.  The Subordination Agreement defines “Subordinate Debt” to include all debt of the Company owing to Mathews and McMillan (or either of them) (a) under the promissory notes due to Mathews and McMillan (the “Seller Notes”) or (b) in respect of the Earn Out Payments (described in Note 11), in either case whether now existing or hereafter arising and including all principal, premium, interest, fees, attorneys’ fees, costs, charges, expenses, reimbursement obligations, any other indemnities or guarantees in each case with respect thereto, in each case whether direct or indirect, absolute or contingent, joint or several, due or not due, primary or secondary, liquidated or unliquidated, secured or unsecured.  So long as the Borrowers are not in default under the terms of the A&R Credit Agreement, the Company may make regular payments to Mathews and McMillan under the Seller Notes.

The foregoing description of the Fourth Amendment to the Loan and Security Agreement between Avidbank and the Company is qualified in its entirety by reference to the terms of the Fourth Amendment to the Loan and Security Agreement, which is found as Exhibit 10.1 of our Form 10-Q filed on August 14, 2015. The foregoing descriptions of the A&R Credit Agreement, Security Agreement and Subordination Agreement are qualified in their entirety by reference to the respective agreements.  These agreements are found in our Form 8-K filed on January 17, 2017 as Exhibits 99.7, 99.8, and 99.9, respectively.

Interest charges associated with borrowings on the line of credit for the three and nine months ended September 30, 2017 were $1,285 and $1,285, respectively. In addition, on January 13, 2017, we paid a $25,000 revolving loan

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commitment fee. There were no borrowings on the line of credit for the three and nine months ended September 30, 2016.

Interest charges associated with the term loans totaled $184,964 and $343,028 for the three and nine months ended September 30, 2017, respectively. In addition, on January 13, 2017, we paid a $70,000 term loan commitment fee. Interest charges associated with the term loans totaled $19,016 and $39,516 for the three and nine months ended September 30, 2016, respectively.

As additional consideration for the original Loan and Security Agreement, we issued Avidbank a 5-year warrant to purchase up to 24,033 shares of our common stock at an exercise price of $4.16 per share. On April 6, 2017 we entered into a warrant repurchase agreement with Avidbank whereby we paid Avidbank $4,743 to repurchase these warrants.

8.PROMISSORY NOTES

In connection with the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.) (Note 11) we issued two promissory notes totaling $9,000,000 to Dr. Michael G. Mathews and Michael McMillan (the “Seller Notes”), with each of the Seller Notes having an initial principal amount of $4,500,000.  These Seller Notes bear interest at 8% per annum, require quarterly interest-only payments during the first 12 months, quarterly payments of principal and interest during the last 24 months, using a 36-month amortization period commencing from that point, with a balloon payment due on the maturity date.  Amounts due and owing under the Seller Notes are subordinate to the right of payment due under the A&R Credit Agreement pursuant to the Subordination Agreement (Note 7).  The Company has the right to prepay all or any portion of the outstanding principal balance of the Seller Notes, provided that such prepayment is accompanied by accrued interest onrepresent the amount of principal prepaid, calculatedtransaction price for which work has not been performed and revenue has not been recognized. When applying Accounting Standards Codification (“ASC”) Topic 606, with only the non-cancelable portion of these contracts included in our performance obligations we had approximately $15.1 million as of March 31, 2021. We expect to the date of such prepayment.

The foregoing descriptionsrecognize revenue on approximately 81% of the Seller Notes and Subordination Agreement are qualified in their entirety by reference toremaining non-cancelable portion of these performance obligations over the respective agreements.  These agreements are found in our Form 8-K filed on January 17, 2017 as Exhibits 99.3, 99.4 and 99.9, respectively.

Interest charges associatednext 24 months, with the Seller Notes totaled $179,507 and $331,397, respectively for the three months and nine months ended September 30, 2017.

9.EMPLOYMENT AGREEMENTS

Effective January 1, 2016, we entered into an employment agreement with Joseph Flynn (the “2016 Flynn Agreement”). The 2016 Flynn Agreement provides that Mr. Flynn will continue his employment as our President and CEO.  The 2016 Flynn Agreement has a term of two years, provides for an annual base salary of $300,000, and will automatically renew for subsequent twelve (12) month terms unless either party provides advance written notice to the other that such party does not wish to renew the agreement for a subsequent twelve (12) months.  Mr. Flynn also receives the customary employee benefits available to our employees. Mr. Flynn is also entitled to receive a bonus of up to $180,000 per year, the achievement of which is based on Company performance metrics.  We may terminate Mr. Flynn’s employment under the 2016 Flynn Agreement without cause at any time on thirty (30) days advance written notice, at which time Mr. Flynn would receive severance pay for twelve months and be fully vested in all options and warrants granted to date.  In January 2017, Mr. Flynn resigned as President, and continued to serve as CEO until October 2, 2017.  The foregoing summary of the 2016 Flynn Agreement is qualified in its entirety by reference to the full context of the employment agreement, which is found as Exhibit 10.31 to our Annual Report on Form 10-K filed with the SEC on March 30, 2016.

As described in more detail in our Current Report on Form 8-K filed with the SEC on October 6, 2017, Joseph Flynn submitted his letter of resignation as Chief Executive Officer of the Company on October 2, 2017. The Board accepted Mr. Flynn’s resignation as Chief Executive Officer effective as of October 2, 2017 and as a director effective as of October 31, 2017. Mr. Flynn’s resignation was not due to any dispute or disagreement with the Company.

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January 1, 2016, we entered into an employment agreement with Paul Anthony (the “2016 Anthony Agreement”). The 2016 Anthony Agreement provides that Mr. Anthony will continue to serve as our Executive Vice President (“EVP”) and CFO. The 2016 Anthony Agreement has a term of two years, and provides for an annual base salary of $245,000. The 2016 Anthony Agreement will automatically renew for subsequent twelve (12) month terms unless either party provides advance written notice to the other that such party does not wish to renew the agreement for a subsequent twelve (12) months.  Mr. Anthony also receives the customary employee benefits available to our employees. Mr. Anthony is also entitled to receive a bonus of up to $132,000 per year, the achievement of which is based on Company performance metrics.  We may terminate Mr. Anthony’s employment under the 2016 Anthony Agreement without cause at any time on thirty (30) days advance written notice, at which time Mr. Anthony would receive severance pay for twelve months and be fully vested in all options and warrants granted to date.  The foregoing summary of the 2016 Anthony Agreement is qualified in its entirety by reference to the full context of the employment agreement, which is found as Exhibit 10.32 to our Annual Report on Form 10-K filed with the SEC on March 30, 2016. In March 2017, the Board of Directors authorized an increase in Mr. Anthony’s base salary to $250,000 and increased his potential annual bonus amount to $150,000.

The employment agreements of Dr. Michael G. Mathews and Michael McMillan are described in Note 11 as part of the acquisition of CTEK Security, Inc.

10.CONCENTRATIONS

Cash Concentrationsbalance thereafter.

15.CONCENTRATIONS

Cash Concentrations

At times, cash balances held in financial institutions are in excess of federally insured limits.  Management performs periodic evaluations of the relative credit standing of financial institutions and limits the amount of risk by selecting financial institutions with a strong credit standing.

Major Customers

Major Customers

Our two largest customerscustomer accounted for approximately 44%13% and 12% of our revenues for the ninethree months ended September 30, 2017March 31, 2021 and our two largest customers accounted for approximately 49% of our revenues for the nine months ended September 30, 2016.2020, respectively. Our largest customerscustomer had accounts receivable totaling approximately $5,200,000$195,000 and $4,000,000$74,000 as of September 30, 2017March 31, 2021, and December 31, 20162020, respectively.

11.16.STOCK PURCHASE AGREEMENTEARNOUT LIABILITY – CTEK SECURITY, INC.BACKBONE ENTERPRISES 

As previously disclosed in our Current Report on Form 8-K, filed with the SEC on January 17, 2017, on January 13, 2017, the Company (known at that time as Auxilio, Inc., a Nevada corporation, and subsequently renamed Cynergistek, Inc., a Delaware corporation, as part of the Reincorporation (the “Company”))

In 2019, we entered into a Stock Purchase Agreement (the “SPA”“Backbone Purchase Agreement”) with CTEK Security,Backbone Enterprises Inc., a TexasMinnesota corporation (formerly CynergisTek, Inc.) (“CTEK Security”Backbone”), Dr. Michael G. Mathews (“Mathews”) and Michael H. McMillan (“McMillan,” and together with Mathews, theits stockholders, (the “Stockholders”), pursuant to which we acquired 100% of the issued and outstanding shares of common stock (the “Shares”) of CTEK SecurityBackbone from the Stockholders (the “CTEK Security Transaction”).

Stockholders. Pursuant to the SPA,Backbone Purchase Agreement, the aggregate purchase price paid for the Shares consisted of four components: the Cash Consideration, the Securities Consideration, the Debt Consideration, and the Earn-out Consideration. The total purchase price was approximately $28.3 million.

·Cash Consideration.  We paid the Stockholders a cash payment of $15,000,000, less Closing Net Working Capital Deficit, Funded Indebtedness and Designated Transaction Expenses (defined as certain expenses of the Stockholders and certain expenses of CTEK Security). The net cash amount paid to the Stockholders was $14,202,645. We funded $14 million of the cash consideration through a term loan (Note 7).

·Securities Consideration.  We issued a total of 1,166,666 shares of our common stock, par value $0.001 per share to the Stockholders, with each of the Stockholders receiving 583,333 shares. The estimated fair value of the common stock issued was approximately $2.8 million at closing.

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·Debt Consideration.  We issued promissory notes totaling $9,000,000 to the Stockholders (the “Seller Notes”), with each of the Seller Notes havingincluded an initial principal amount of $4,500,000.  The Seller Notes bear interest at 8% per annum, with quarterly interest-only payments in the first year, and quarterly payments of principal and interest in the next 24 months, using a 36-month amortization period commencing from that point, with a balloon payment due on the maturity date.  Amounts due and owing under the Seller Notes are subordinate to the right of payment due under the AvidBank Loan (described below)earn-out, pursuant to which the Subordination Agreement.  The Company has the right to prepay all or any portion of the outstanding principal balance of the Seller Notes, provided that such prepayment is accompanied by accrued interest on the amount of principal prepaid, calculated to the date of such prepayment.

·Earn-out Consideration.   The Stockholders may be entitled to an additional $7,500,000$4,000,000 based upon the post-closing financial performance of CTEK Security after closing of the CTEK Security Transaction,Backbone, to be calculated based upon EBITDArevenue generated by the CTEK SecurityBackbone business during the three-year earn-out period, which began asperiod. There was no earnout earned for the first year of January 1, 2017, and ends on Decemberthe agreement.  As of March 31, 2021, (the “Earn-out Payments”). Thethe estimated fair value of the earn-out was approximately $2.3 million at closing.

Pursuant toearnout is $1,300,000 for the SPA, CTEK Security and the Stockholders agreed to deliver to us stock certificates representing the Shares; the corporate record books of CTEK Security; and the employment agreements (described below). We agreed to deliver the Cash Consideration, the Securities Consideration, the Debt Consideration and the signed employment agreements. By agreementremaining 2 years of the parties, the effective dateagreement.

Table of the CTEK Security Transaction for accounting purposes was January 1, 2017.

In connection with the SPA, the Company and the Stockholders also entered into a registration rights agreement (the “Registration Rights Agreement”) and employment agreements, each of which is discussed below.

Registration Rights Agreement

Pursuant to the Registration Rights Agreement between the Company and the Stockholders, we agreed to grant piggy-back registration rights under certain circumstances, and demand registration rights under other circumstances.  Briefly, for the piggy-back rights, if we propose to register the sale of any of our stock or other securities under the Securities Act of 1933, as amended (the “Securities Act”) in connection with the public offering of such securities solely for cash, or the resale of shares of our common stock by other selling stockholders, we agreed that prior to such filing, we would give written notice to the Stockholders of our intention to do so. Upon the written request of a Stockholder given within twenty (20) days after we provide such notice, we agreed to file a registration statement to register the resale of all such registrable securities which we have been requested by such Stockholder to register. With respect to the demand registration rights, we agreed that in the event that we fail to file timely public reports with the U.S. Securities and Exchange Commission if and as required by the Securities Exchange Act of 1934, as amended, then the Stockholders shall have the right, by delivering written notice to us (a “Demand Notice”), to require us to register the number of registrable securities requested to be so registered pursuant to the terms of the Registration Rights Agreement (a “Demand Registration”). Following the receipt of a Demand Notice for a Demand Registration, we agreed to file a registration statement not later than sixty (60) days after such Demand Notice, and we agreed to use our commercially reasonable efforts to cause such registration statement to be declared effective under the Securities Act as promptly as practicable after the filing thereof. Additionally, pursuant to the Registration Rights Agreement, the rights of the Stockholders to deliver a Demand Notice for a Demand Registration are not effective at any time when the registrable securities held by such Stockholder may be resold under Rule 144 of the Securities Act without regard to any volume limitation requirements under Rule 144 of the Securities Act.

Employment Agreements

In connection with the SPA, the Company and each of the Stockholders entered into an employment agreement, pursuant to which McMillan was appointed President and Chief Strategy Officer of the Company, and Mathews was appointed Executive Vice President of the Company.Contents

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McMillan Employment Agreement.

The Company and McMillan entered into an employment agreement (the “McMillan Employment Agreement”), pursuant to which we employ McMillan as President and Chief Strategy Officer of the Company. McMillan agreed that his duties for the Company and its subsidiaries would be substantially similar to those duties that McMillan had performed on behalf of CTEK Security, and would include, without limitation, responsibility for executive leadership and business development strategy.  McMillan also agreed to perform additional duties as reasonably assigned by our Chief Executive Officer, and/or Board of Directors in order to advance the interests of the Company and its subsidiaries. The initial term of the McMillan Employment Agreement is 36 months from January 13, 2017, and will automatically renew for subsequent 12-month terms unless either party provides written notice to the other party of a desire to not renew the agreement.

Pursuant to the McMillan Employment Agreement, McMillan’s base salary is $250,000, and he is entitled to incentive bonus compensation and equity compensation (consisting of stock options), as set forth in the McMillan Employment Agreement.  The Company has the right to terminate McMillan’s employment without cause at any time on thirty (30) days’ advance written notice to McMillan. Additionally, McMillan has the right to resign for “Good Reason” (as defined in the McMillan Employment Agreement) on thirty (30) days’ written notice.  In the event of (i) such termination without cause, or (ii) McMillan’s inability to perform the essential functions of his position due to a mental or physical disability or his death,  or (iii) McMillan’s resignation for Good Reason, McMillan is entitled to receive the base salary then in effect and full target annual bonus, prorated to the date of termination, and a “Severance Payment” equivalent to (a) payment of compensation for an additional twelve months, payable as a lump sum, and (b) the acceleration of all unvested stock options and warrants then held by McMillan, subject to certain conditions set forth in the McMillan Employment Agreement.  In addition, if McMillan is terminated by the Company without cause (as defined in the McMillan Employment Agreement), certain of the Earn-out Payments will accelerate and become immediately due and payable, as set forth in the SPA.  If McMillan resigns for other than Good Reason, he will be entitled to receive the base salary for the thirty (30) day written notice period, but no other amounts.  On October 2, 2017, the Board also appointed McMillan as Chief Executive Officer.  

Mathews Employment Agreement.

We entered into an employment agreement with Mathews (the “Mathews Employment Agreement”), pursuant to which we employ Mathews as Executive Vice President (Mathews was also appointed Chief Operation Officer on April 27, 2017). Mathews agreed that his duties for the Company and its subsidiaries would be substantially similar to those duties that Mathews had performed on behalf of CTEK Security, and would include, without limitation, day-to-day P&L responsibility for the cybersecurity service business line.  Mathews also agreed to perform additional duties as reasonably assigned by our President, Chief Executive Officer, and/or Board of Directors in order to advance the interests of the Company and its subsidiaries. The initial term of the Mathews Employment Agreement is 36 months from January 13, 2017, and will automatically renew for subsequent 12-month terms unless either party provides written notice to the other party of a desire to not renew the agreement.

Pursuant to the Mathews Employment Agreement, Mathews’ base salary is $250,000, and he is entitled to incentive bonus compensation and equity compensation (consisting of stock options), as set forth in the Mathews Employment Agreement.  We have the right to terminate Mathews’ employment without cause at any time on thirty (30) days’ advance written notice to Mathews. Additionally, Mathews has the right to resign for “Good Reason” (as defined in the Mathews Employment Agreement) on thirty (30) days’ written notice.  In the event of (i) such termination without cause, or (ii) Mathews’ inability to perform the essential functions of his position due to a mental or physical disability or his death,  or (iii) Mathews’ resignation for Good Reason, Mathews is entitled to receive the base salary then in effect and full target annual bonus, prorated to the date of termination, and a “Severance Payment” equivalent to (a) payment of compensation for an additional twelve months, payable as a lump sum, and (b) the acceleration of all unvested stock options and warrants then held by Mathews, subject to certain conditions set forth in the Mathews Employment Agreement.  In addition, if Mathews is terminated by the Company without cause (as defined in the Mathews Employment Agreement), certain of the Earn-out Payments will accelerate and become immediately due and payable, as set forth in the SPA.  If Mathews resigns for other than Good Reason, he will be entitled to receive the base salary for the thirty (30) day written notice period, but no other amounts.

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Amended and Restated Credit Agreement and Related Agreements

Also on January 13, 2017,  the Company and its subsidiaries (the “Borrowers”) entered into an Amended and Restated Credit Agreement (the “A&R Credit Agreement”) with ZB, N.A., dba California Bank and Trust (“CBT”), and Avidbank, a California banking corporation (“Avidbank,” and together with CBT, the “Lenders”), as well as Avidbank in its capacity as contractual representative for itself and the other lender (“Agent”).

By way of background, the Company on the one hand and Avidbank on the other hand previously entered into a Loan and Security Agreement, dated as of April 19, 2012 (as amended to date, the “Original Credit Agreement”), pursuant to which Avidbank extended to the Company a term loan and a revolving line of credit.  Subsequently, the Company advised Agent that the Company desired to acquire 100% of the ownership interests of CTEK Security pursuant to the SPA.  The CTEK Security Transaction is prohibited by Section 7.3 of the Original Credit Agreement.  

Borrowers requested that Lenders (1) consent to the CTEK Security Transaction, and (2) provide additional financing in order to finance, in part, the Company’s obligations under the SPA.  Agent and Lenders agreed with such request in accordance with and subject to the terms and conditions of the A&R Credit Agreement and other related documents defined in the A&R Credit Agreement (the “Loan Documents”).  In connection with the entry into the A&R Credit Agreement, the parties to the A&R Credit Agreement agreed that CTEK Security would automatically become a Borrower under the A&R Credit Agreement and under the Loan Documents on the closing date immediately upon consummation of the CTEK Security Transaction (and not prior thereto), without further action required by any party.

Accordingly, the parties to the A&R Credit Agreement agreed that the A&R Credit Agreement and the Loan Documents would amend and restate the Original Credit Agreement in its entirety, and continue the obligations incurred thereunder and evidenced thereby.  Additionally, any amounts outstanding under the Original Credit Agreement were repaid in full immediately prior to the execution of the A&R Credit Agreement.

Loan Facilities

Term Loans:  Pursuant to the A&R Credit Agreement, the Lenders agreed to provide term loans in the aggregate amount of $14,000,000 to the Company, which was paid to the Stockholders as part of the Cash Consideration in the CTEK Security Transaction (described above).  The term loans bear interest at a rate of Prime plus 1.5%, and the loans mature on January 12, 2022.  

Revolving Line of Credit: Additionally, pursuant to the A&R Credit Agreement, the Lenders agreed to provide revolving loans to the Borrowers in an aggregate amount of up to $5,000,000. At the closing of the CTEK Security Transaction, no draws were made on the revolving loans.

Security Agreement

In connection with the A&R Credit Agreement, the Borrowers and the Agent entered into a security agreement (the “Security Agreement”), pursuant to which each of the Borrowers agreed to grant to Agent, for the ratable benefit of itself, the Lenders and the other secured parties, a first priority security interest in certain collateral to secure prompt payment and performance of the secured obligations under the A&R Credit Agreement.  Pursuant to the Security Agreement, the “Collateral” was defined as including any and all (all such terms as defined in the Security Agreement) of the Accounts, Chattel Paper, Commercial Tort Claims, Deposit Accounts, Documents, Equipment, Instruments, Inventory, Investment Property, General Intangibles, Letter of Credit Rights, Negotiable Collateral, Supporting Obligations, Vehicles, Grantors’ Books, in each case whether now existing or hereafter acquired or created, any money or other assets of any Grantor that now or hereafter come into the possession, custody, or control of Agent and any Proceeds or products of any of the foregoing, or any portion thereof.  In connection with the grant of the security interest in the Collateral, each of the Borrowers made standard representations and warranties relating to ownership of the collateral, location and control of the collateral, and certain rights to payment.

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Seller Subordination Agreement

Additionally, in connection with the A&R Credit Agreement and the CTEK Security Transaction, Mathews, McMillan, the Company, and Avidbank entered into a subordination agreement (the “Subordination Agreement”), pursuant to which Mathews and McMillan agreed that unless and until all of the Company’s obligations under the A&R Credit Agreement have been repaid in full, Mathews and McMillan would not, except as provided in the Subordination Agreement, ask, demand, sue for, take or receive, or retain, from the Company or any other person or entity, by setoff or in any other manner, payment of all or any part of the Subordinate Debt (as defined below), or take any other action with respect to the Subordinate Debt; forgive, cancel or discharge any of the Subordinate Debt; ask, demand or receive any security for the Subordinate Debt; amend any documents relating to the Subordinate Debt or any other agreement, instrument or document evidencing or executed in connection with the Subordinate Debt in a manner that could reasonably be expected to be adverse to Lenders or Agent (or any other holders of the obligations arising under the A&R Credit Agreement); or bring or join with any creditor in bringing any insolvency proceeding against the Company. Additionally, Mathews and McMillan each directed the Company to make, and the Company agreed to make, such prior payment of the Company’s obligations under the A&R Credit Agreement to Agent and the Lenders.  The Subordination Agreement defines “Subordinate Debt” to include all debt of the Company owing to Mathews and McMillan (or either of them) (a) under the Seller Notes or (b) in respect of the Earn Out Payments (described above), in either case whether now existing or hereafter arising and including all principal, premium, interest, fees, attorneys’ fees, costs, charges, expenses, reimbursement obligations, any other indemnities or guarantees in each case with respect thereto, in each case whether direct or indirect, absolute or contingent, joint or several, due or not due, primary or secondary, liquidated or unliquidated, secured or unsecured.  So long as the Borrowers are not in default under the terms of the A&R Credit Agreement, the Company may make regular payments to the Stockholders under the Seller Notes.

The preliminary allocation of the purchase price of the assets acquired and liabilities assumed in the CTEK Security Transaction based on their fair values was as follows: 

Purchased identifiable intangible assets are amortized on a straight-line basis over the respective useful lives. Estimated useful lives of the identifiable intangible assets acquired ranges from three to ten years. We also recognized goodwill of $16,416,063. Goodwill is recognized as we expect to be able to realize synergies between the two companies, primarily our ability to provide market and reach for the Redspin products and services to our MDS customers.

The Company incurred approximately $330,000 in legal, accounting and other professional fees related to this acquisition, of which approximately $174,000 were expensed during the nine months ended September 30, 2017.

As of the date of this report, management is still in the process of determining the final accounting related to the CTEK Security transaction. Because management’s analysis has not yet been completed, the Company’s determination of the purchase price and the resulting purchase price allocation is preliminary.

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Pro Forma Information

The following supplemental unaudited pro forma information presents the combined operating results of the Company and the acquired business during the three and nine months ended September 30, 2017 and 2016, as if the acquisition had occurred at the beginning of each of the periods presented. The pro forma information is based on the historical financial statements of the Company and that of the acquired business. Amounts are not necessarily indicative of the results that may have been attained had the combinations been in effect at the beginning of the periods presented or that may be achieved in the future.

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q.  This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Section 27A of the Securities Act, and is subject to the safe harbors created by those sections.  Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “may,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements.  In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements.  These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict.  Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. We undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements.  

Due to possible uncertainties and risks, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Quarterly Report, which speak only as of the date of this Quarterly Report, or to make predictions about future performance based solely on historical financial performance.  We disclaim any obligation to update forward-looking statements contained in this Quarterly Report.

Readers should carefully review the risk factors described in other documents we file from time to time with the SEC, including our Form 10-K for the fiscal year ended December 31, 2016.  2020. You should interpret many of the risks identified in these reports as being heightened as a result of the ongoing and numerous adverse impacts of the COVID-19 pandemic. Our filings with the SEC, including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those filings, pursuant to Sections 13(a) and 15(d) of the Exchange Act, are available free of charge at www.cynergistek.com,www.CynergisTek.com, when such reports are available via the EDGAR system maintained by the SEC at www.sec.gov.www.sec.gov.

OVERVIEW

We are engaged in the business of providing IThelping U.S. based companies in highly regulated industries, including healthcare, be prepared to handle unforeseen cyber threats, comply with regulations, and relatedgain the confidence that their efforts are strengthening their security posture and building resilience. This is achieved through our cybersecurity, privacy and compliance services.  

CynergisTek was born in healthcare and is one of the few consulting services, including managed print services, cyberand advisory companies focused on converging security and IT security consulting servicesprivacy with a methodology to validate the healthcare industry.   Our business is operated throughout the United States.

We have been an industry leader in document solutions for the healthcare industry for many years, offering hospitalsrigor and health systems comprehensive services and solutions to support the document life cycle. We provide a vendor neutral program that enhances securityeffectiveness of printed, stored data and digital documents while driving out costs and inefficiencies within the patient information logistical chain. We also provide IT security consulting services through our proprietary Delphiis™ IT Risk Manager SaaS Solution and Redpsin.

In January 2017, we acquired CTEK Security, Inc. (formerly CynergisTek, Inc.) (“CTEK Security”), a top-ranked cybersecurity and privacy consulting firm, transforming and significantly expanding our cybersecurity and IT security consulting services capabilities. Our security experts perform technical assessments, penetration testing and remediation services, in addition to providing 24/7 advisory services to our Compliance Assist Partner Program customers. With our proven and prescriptive methodology, we help build the foundation needed to ensure the confidentiality, integrity and security of patient health information (PHI). Our proprietary RiskSonar IT Risk Manager SaaS Solution streamlines how covered entities perform annual and on-going risk assessments on their business associates, clinics, projects and hospitals.

Following the acquisition of CTEK Security, we have integrated our documents solutions, IT security and cybersecurity operations and are going to market as an integrated cybersecurity and document management solution company.programs. We believe that offering our current and prospective hospitalyears of experience of understanding our clients’ unique challenges allows us to provide our customers with services designed around industry best practices to improve security controls, policies and procedures and to protect sensitive information. Our team of subject matter experts and consultants are comprised of knowledgeable professionals who have learned their craft both in the classroom and through years of practical on-the-job experience, including as policy makers, attorneys and leaders in cybersecurity, privacy and compliance.

Our services are categorized into four service groups, which are: assess, build, manage, and validate.  These services are designed to meet the client where they are in their security journey as recurring managed services under long-term contracts structured to provide a sustainable and growing program, or under shorter duration consulting or professional services engagements.

·Assess – identify, measure, and test security and privacy risk of an organization’s readiness and verify and validate their programs meet compliance and business objectives through IT audits, technical testing, and risk and program assessments. 

·Build – develop policies and procedures and playbooks to help build out a fully comprehensive integrated offeringrisk management program and provide resources to help organizations prioritize, implement and execute initiatives to strengthen their security and privacy programs.  

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·Manage - provide on-going management and oversight of specific components of an organization’s security and privacy programs to address privacy, securityor give alerts when an issue arises and complianceto offer our expertise that they need to accelerate the effectiveness of their IT environmentprograms.  

·Validate – verify the processes, people, and technology are working effectively and provide insight to the ROI of an organization’s security investment through advanced services requiring highly experienced resources and/or technology to deliver.  

For sophisticated organizations our Managed Security Validation® program encompasses a bundle of services from the assess, build, manage, and validate categories to deliver clarity and guidance as a consistent partner helping maintain and grow their security infrastructure.

Impact of COVID-19 Pandemic

In December 2019, a novel strain of the coronavirus (COVID-19) surfaced, which spread globally and was declared a pandemic by the World Health Organization in March 2020. The challenges posed by the COVID-19 pandemic on the global economy increased significantly in the first several months of 2020. In response to COVID-19, national and local governments around the world instituted certain measures, including travel bans, prohibitions on group events and gatherings, shutdowns of certain businesses, curfews, shelter-in-place orders and recommendations to practice social distancing.  

In planning for the possible disruption of our business, we have taken steps to reduce expenses throughout the Company.  This included substantially reducing Company travel for a period of time, as well as our participation in trade shows and other business meetings and decreasing expenditures.  We also implemented workforce reductions during 2020 and the beginning of 2021, decreasing employment and related electronicexpenses.  Continued progression of the pandemic could result in a decline in customer orders, as our customers could shift purchases to lower-priced or other perceived value offerings or reduce their purchases of our services due to decreased budgets, reduced access to credit or various other factors, which could have a material adverse impact on our results of operations and physical records providescash flow.  While the current impacts of COVID-19 are reflected in our results of operations, we cannot at this time separate the direct COVID-19 impacts from other factors that cause our performance to vary from year to year. The ultimate duration and impact of the COVID-19 pandemic on our business, results of operations, financial condition and cash flows is dependent on future developments, including the duration and severity of the pandemic, and the related length of its impact on the global economy, which are uncertain and, given the daily evolution of the COVID-19 pandemic and the global responses to curb its spread, cannot be predicted at this time. Even after the COVID-19 pandemic has subsided, we may continue to experience an adverse impact to our business as a significant competitive advantageresult of its national and, to some extent, global economic impact, including any recession that has occurred or may occur in the Company.

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Tablefuture. Furthermore, the extent to which our mitigation efforts are successful, if at all, is not presently ascertainable.  However, we anticipate that our results of Contentsoperations in future periods may continue to be adversely impacted by the COVID-19 pandemic and its negative effects on global economic conditions.

Our common stock currently trades on the NYSE American exchange under the stock symbol “CTEK”.

As described in more detail in our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 8, 2017, Auxilio, Inc., a Nevada corporation (“Auxilio”) changed its name and state of incorporation from the State of Nevada to the State of Delaware by merging (the “Reincorporation”) with and into its wholly-owned subsidiary, CynergisTek, Inc., a Delaware corporation, which was established for the purpose of the Reincorporation.   As a result of the Reincorporation, Auxilio ceased to exist as a separate entity.  As of the date of the merger, each outstanding share of Auxilio’s common stock was deemed, by operation of law, to represent the same number of shares of our common stock.  In accordance with Rule 12g-3 under the Securities Exchange Act of 1934, as amended, the shares of our common stock were deemed to be registered under Section 12(b) of the Exchange Act as a successor to Auxilio.  Effective as of September 8, 2017, the Company’s trading symbol changed to “CTEK.”  

Where appropriate, references to “Cynergistek,“CynergisTek,” the “Company,” “Redspin,” “we,” “us”“us,” or “our” include Cynergistek,CynergisTek, Inc., a Delaware corporation and its wholly-owned subsidiaries, CTEK Solutions, Inc., a California corporation, CTEK Security, Inc., a Texas corporation, and Delphiis, Inc., a California corporation and, Backbone Enterprises, Inc., a Minnesota corporation.

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RESULTS OF OPERATIONS

APPLICATION OF CRITICAL ACCOUNTING POLICIESFor the Three Months Ended March31, 2021,Compared to the Three Months Ended March 31, 2020

Revenue

Revenue decreased $0.9 million to $4.2 million for the three months ended March 31, 2021, as compared to the same period in 2020. Managed Services revenue decreased $0.6 million due to the impact of some customers canceling contracts, delaying renewals and a slowdown in net new customers due to COVID-19 and customers holding off on purchasing or trying to reduce budgets. Consulting and professional services decreased $0.3 million due to lower revenue from two customers who completed contract work in the first half of 2020 and less business as a result of COVID-19 and our customers minimizing spend with third-party contractors.

Cost of Revenue

Cost of revenue consists primarily of salaries and related expenses of direct labor and indirect support staff.  Cost of revenue was $2.1 million for the three months ended March 31, 2021, as compared to $3.4 million for the same period in 2020. We reduced salary and related costs associated with our reduction in force by approximately $0.9 million due to the lower revenue from COVID-19 and $0.4 million benefit from the employee retention credit provided under the CARES Act.

Gross margin was 50% of revenue for the three months ended March 31, 2021.  After adjusting for the benefit from the employee retention tax credit, gross margin was 39%, compared to 33% for the same period in 2020. Margins improved as a result of targeted expense reductions we made over the last few quarters in reaction to the lower revenue due to COVID-19.

Sales and Marketing

Sales and marketing expenses include salaries, commissions and expenses for sales and marketing personnel, travel and entertainment, and other selling and marketing costs. Sales and marketing expenses decreased to $1.2 million for the three months ended March 31, 2021, as compared to $1.5 million for the same period in 2020.  This decrease was due to $0.2 million in lower marketing and sales support payroll and benefit costs from the headcount reductions due to COVID-19, $0.1 million less travel costs due to COVID-19 related travel restrictions and $0.1 million of employee retention tax credits provided under the CARES Act offset by $0.1 million in recruiting costs to bring on a new sales leader and additional direct sales leads.

General and Administrative

General and administrative expenses include personnel costs for finance, administration, information systems, general management, facilities expenses, professional fees, legal expenses and other administrative costs including those required to be a publicly traded company. General and administrative expenses decreased $0.4 million to $1.7 million for the three months ended March 31, 2021, compared to $2.1 million for the three months ended March 31, 2020. The decrease is due to $0.1 million in lower payroll and benefit related costs due to the expense reduction efforts taken in reaction to the lower revenue from COVID-19, $0.1 million less travel costs due to COVID-19 related travel restrictions, $0.1 million less in professional fees due to 2020 being higher due to strategic advisory and recruiting costs, and $0.1 million of employee retention tax credits provided under the CARES Act.

Depreciation

Depreciation expense was consistent at $48,000 for the three months ended March 31, 2021 and 2020.

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Amortization of Acquisition-Related Intangibles

Amortization of acquisition-related intangibles was $0.3 million for the three months ended March 31, 2021, compared to $0.4 million for the three months ended March 31, 2020. Amortization expense decreased over the comparable periods as a portion of the intangible assets became fully amortized and an impairment loss of $0.9 million that was recognized at the end of 2020.

Net Interest Expense

Net interest expense for the three months ended March 31, 2021 was $20,000, compared to net interest expense of $18,000 for the same period in 2020. The increase was due to lower interest income from a lower outstanding cash balance and lower interest rate earned on cash on hand partially offset by lower interest expense due to the lower outstanding debt balance from the paydown of the promissory note.

Income Tax Benefit

Income tax benefit for the three months ended March 31, 2021 was $0.3 million, compared to $0.5 million for the same period in 2020. These amounts were based on estimated annual income tax rates we anticipate for the year.

Liquidity and Capital Resources

As of March 31, 2021, our cash balance was $4.4 million, current assets minus current liabilities was positive $7.3 million and our non-current debt and lease obligations, excluding contingent earnout liability of $1.3 million, totaled $2.8 million. This $2.8 million of debt is related to the U.S. Small Business Administration (“SBA”) Paycheck Protection Program loan (the “PPP Loan”), received pursuant to the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”), that we anticipate will be fully forgiven as described in Note 9. The level of additional cash needed to fund operations and our ability to conduct business for the next twelve months will be influenced primarily by the following factors:

·our ability to manage our operating expenses and maintain gross margins while attracting, recruiting and retaining cybersecurity privacy professionals; 

·demand for our services from healthcare providers; the near-term impact of the COVID-19 on our customers allocation of time and resources to security and privacy, and their ability to pay for existing services as well as enter into new contractual arrangements during a period of crisis; 

·general economic conditions and changes in healthcare reimbursement and regulatory environment, including effects of the COVID-19 epidemic; and 

·our ability to collect accounts receivable from health care customers whose operations and cash flow have been significantly impacted by COVID-19 pandemic. 

We have historically funded our operating costs, acquisition activities, working capital requirements and capital expenditures with cash from operations, proceeds from the issuances of our common stock and other financing arrangements. We are currently operating in a cash flow negative position while we seek to maintain and grow our cybersecurity business and cover our public company expenses during this uncertain time. In connection with our most recent results for the most three months ended March 31, 2021, we reported a loss from operations of $1.2 million.  After excluding $0.6 million of non-cash items for depreciation, amortization of intangibles and stock-based compensation, our adjusted loss from operations was $0.6 million. Cash used in operating activities was $1.0 million for the three months ended March 31, 2021.

In late 2019, a novel strain of coronavirus (COVID-19) was first detected in Wuhan, China. Following the outbreak of this virus, governments throughout the world, including in the United States of America, have quarantined certain affected regions, restricted travel and imposed significant limitations on other economic activities. Our customer

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base is heavily concentrated in the healthcare provider space.  This part of the healthcare industry has indicated that they are seeing significant financial losses, have furloughed employees and are expressing uncertainty as to the short and long-term financial stability of their businesses.  Our operations team is closely monitoring the impact to the Company’s business, including its cash flows, customers and employees. We have heard and are working with a number of our active customers since the outbreak began providing relief in the form of extended payment terms and other contractual restructurings.  If the situation continues to impact our customers cash flow or resources available for cybersecurity and privacy projects, our cash flows, financial position and operating results for fiscal year 2021 and beyond will be negatively impacted.

We did experience a negative financial impact from March 2020 through March 2021 that management anticipates will continue to impact revenue and earnings for the foreseeable future due to COVID-19, primarily because many of the initial economic effects of the early stages of the COVID-19 pandemic resulting from the various shelter-in-place and other social distancing orders occurred towards the end of our first quarter of 2020. The severity and duration of the COVID-19 pandemic is uncertain, and such uncertainty will likely continue in the near term. We will continue to actively monitor the situation taking into account the impact to our employees, customers and partners.

At the end of 2019 and through the first quarter of 2021, we reduced staffing levels to reduce expenses that included permanent and temporary cost reductions, the precise extent of which will depend on the duration of the COVID-19 disruptions to our customers and our short-term financial performance. In addition, we received a $2.8 million PPP loan pursuant to the CARES Act, which we anticipate will be fully forgiven and we anticipate having approximately $0.7 million in quarterly employee retention tax credits in the first and second quarters of 2021.  With the proceeds from the PPP Loan and the employee retention tax credits, we have tried to minimize staff reductions in the areas of Sales and Delivery, our primary customer facing roles, to lessen the impact to our customers during this time of heightened security risks for the healthcare industry. If necessary, we could further reduce personnel and other variable and semi-variable costs to conserve cash and operate as a going concern. However, those actions if required, could negatively impact the long-term outlook of the business.

On November 12, 2020, we entered into the Equity Distribution Agreement with Craig-Hallum Capital Group LLC (the “Agent”), under which we may offer and sell, from time to time at our sole discretion, shares of our common stock having an aggregate offering price of up to $5.0 million in an “at-the-market” or ATM offering, to or through the Agent.  The Company agreed to pay the Agent a commission of three percent (3.0%) of the gross sales price per share of any common stock sold through the Agent under the Equity Distribution Agreement.

During November and December of 2020, the Company received gross proceeds under the Equity Distribution agreement of $2,027,000 from the issuance of 1,315,000 shares of our common stock and paid an aggregate of $61,000 to the Agent in commissions and $123,000 in other offering-related expenses, yielding net proceeds of $1,843,000.

We believe that our existing sources of liquidity, including cash and cash equivalents, the proceeds from the PPP loan and employee retention tax credits, the ability to raise equity under our shelf registration (including via the Equity Distribution Agreement) and future operating cash flows, and other assets will be sufficient to meet our projected capital needs for at least the next twelve months. As we execute our plans over the next twelve months, we intend to carefully monitor the impact on our operating expenses, working capital needs and cash balances relative to the availability of cost-effective debt and equity financing. In the event that capital is not available, we may then have to scale back operations, reduce expenses, and/or curtail future plans to manage our liquidity and capital resources.   However, we cannot provide assurance that we will be able to raise additional capital. The COVID-19 pandemic will likely continue to create uncertainty and volatility in the financial markets which may impact our operations and our ability to access capital and/or the terms under which we can do so.  

The impact of the COVID-19 pandemic on the economy and our operations is fluid and constantly evolving; we will continue to assess a variety of measures to improve our financial performance and liquidity.

Application of Critical Accounting Policies

The SEC defines critical accounting policies as those that are, in management’s view, most important to the portrayal of our financial condition and results of operations and most demanding of our judgment. The discussion

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and analysis of our financial condition and results of operations are based upon our financial statements, which have beenwere prepared in accordance with GAAP.accounting principles generally accepted in the U.S., which is referred to as “GAAP.”  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosuredisclosures of contingent assets and liabilities.  WeOn an on-going basis, we evaluate these estimates, on an on-going basis, including those estimates related to stock-based compensation, customer programs and incentives, product returns, bad debts, supplies, investments, intangible assets, income taxes, contingencies and litigation.  We base our estimates on historical experience and on various other assumptions that we believeare believed to be reasonable under the circumstances.  Thecircumstances, the results of these estimateswhich form the basis for ourmaking judgments about the carrying values of assets and liabilities whichthat are not readily apparent from other sources.  As a result, actualActual results may differ from these estimates under different assumptions or conditions.