UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 20192020

[  ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _______ to _______

Commission file number 000-27507

CYNERGISTEK, INC.

(Exact name of registrant as specified in its charter)

11940 Jollyville Road, Suite 300-N

Austin, Texas 78759

(Address of principal executive offices, zip code)

(949) 614-0700

(Issuer’s telephone number)

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

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

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

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

Large accelerated fileroAccelerated filero 

Non-accelerated filerþSmaller reporting companyþ 

Emerging growth company  ¨

Indicate by check mark whether the registrant is a shell company (as defined by Section 12b-2 of the Exchange Act).  

YesoNoþ.

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

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

The number of shares of the issuer’s common stock, $0.001 par value, outstanding as of May 13, 2019,14, 2020, was 9,773,521.10,449,164.

CYNERGISTEK, INC.

FORM 10-Q

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Page

PART I – FINANCIAL INFORMATION4

ITEM 1.FINANCIAL STATEMENTS.34 

ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.2220 

ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.2629 

ITEM 4.CONTROLS AND PROCEDURES.29

26PART II - OTHER INFORMATION29 

ITEM 1A.RISK FACTORS.2629 

ITEM 6.EXHIBITS.2731 

SIGNATURES2832 

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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)

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

CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

THREE MONTHS ENDED MARCH 31, 2019 AND 2018

(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 FLOWSSTOCKHOLDERS’ EQUITY

THREE MONTHS ENDED MARCH 31, 2020 AND 2019

(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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CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(UNAUDITED)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 20192020 AND 20182019

(UNAUDITED)

1.BASIS OF PRESENTATION 

The accompanying unaudited condensed consolidated financial statements of CynergisTek, Inc. and its subsidiaries (the “Company”, “we”, “us” or “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, 2018,2019, as filed with the Securities and Exchange Commission (“SEC”) on March 27, 2019.30, 2020.

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 CynergisTek and its wholly owned subsidiaries.  All intercompany balances and transactions have been eliminated.

Based on our integration strategies, and an analysis of how our Chief Operating Decision Makers review, manage and are compensated, we have determined that the Company operates as one segment. As described in Note 17,18, we sold the MPSassets used in our managed print services business division (the “MPS Business”) on March 20, 2019. For the periods presented, all revenues were derived from domestic operations.

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

Certain prior year balances have been reclassified to conform to current period presentation.

2.RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

Recently Adopted Accounting Pronouncements

In February 2016, This includes adjusting our previously issued consolidated balance sheet for the Financial Accounting Standards Board (“FASB”) issued a new accounting standard on leasing. The new standard requires companiesyear ended December 31, 2019 to record most leasedreclassify Unbilled services as its own line item in current assets andfrom Deferred revenues in current liabilities on the balance sheet, andsheet.  The consolidated statement of cash flows for the three months ended March 31, 2019 was also proposed a dual model for recognizing expense.adjusted to reflect this change.  The reclassification did not have any impact on the consolidated statements of stockholders’ equity nor the consolidated statements of operations.  The Company adoptedanalyzed the standard as of January 1, 2019, with retroactive reporting for prior periods (the comparative option). Adoptionimpact of the reclassification and determined that the adjustment was not material to its previously issued financial statements. 

Liquidity and Capital Resources

As of March 31, 2020, our cash balance was $3.1 million, current assets minus current liabilities was positive $4.7 million and our debt and lease obligations totaled $1.0 million. 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; 

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demand for our services from healthcare providers; the near-term impact of the Coronavirus 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 standard resultedcontractual 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. 

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. Following the sale of the MPS business in 2019, we are now a much smaller cybersecurity and privacy focused business with significantly lower debt balances and debt service obligations. However, we also have less scale over which to leverage our operating expenses and public company expenses and are currently operating in a cash flow negative position while we seek to retain our cybersecurity business during this uncertain time. For the first quarter of 2020, we reported a loss from continuing operations of $1.9 million and cash used in operating activities from continuing operations was $2.1 million.

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 recordingUnited States of operating lease right-of-use ("ROU")  assetsAmerica, 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 started to furlough employees and are expressing uncertainty as to the short and long-term financial stability of their businesses.  Our operations team is closely monitoring the potential impact to the Company’s business, including its cash flows, customers and employees. We have heard from a number of our active customers since the outbreak began requesting relief in the form of extended payment terms, request for early termination and receivable forgiveness.  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 lease liabilitiesresults for fiscal year 2020 and beyond will be negatively impacted. Neither the length of $808,841 and $683,797, respectively, astime nor the magnitude of January 1, 2018, with the differencenegative impacts can be presently determined.

There was a small financial impact in the first quarter of 2020 due to deferred rent that were reclassifiedCOVID-19, primarily since 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. The severity and duration of the COVID-19 pandemic is uncertain and such uncertainty will likely continue in the near term and 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 during the first quarter of 2020 we reduced staffing levels to reduce expenses.  Our operating plan for the next twelve months includes additional permanent annualized cost reduction efforts totaling approximately $1.5 million and temporary cost reductions totaling approximately $1.0-$2.0 million 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 loan under the Coronavirus Aid, Relief, and Economic Security Act, and we received an equity funding commitment in the amount of $2.5 million from an existing investor.  We also have the ability to 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

As we execute our plans over the next 12 months, we intend to carefully monitor the impact on our operating expenses, working capital needs and cash balances relative to the ROUavailability 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 could 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.  

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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.

The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset value. The standard did not affect our consolidated net income or cash flows. See Note 6 for further details.amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

2.RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

Recently Adopted Accounting Pronouncements

In August 2016,2018, the FASB issued an amendment to the accounting guidance on cloud computing service arrangements.  The guidance aligns the requirements for capitalizing implementation costs incurred in a new accounting standard whichhosting arrangement that is intendeda service contract with the requirements for capitalizing implementation costs incurred to reducedevelop or obtain internal use software.  The guidance also requires an entity to expense the existing diversity in practice in how certain cash receipts and cash payments are classified incapitalized implementation costs of a hosting arrangement that is a service contract over the statementterm of cash flows. Thisthe hosting arrangement.  The guidance was effective for fiscal years beginning after December 15, 2018, including2019, and interim periods within those fiscal years

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with early adoption permitted, provided that all of the amendments are adopted in the same period. Adoption of these accounting changesthis guidance did not have a material impact on our consolidated financial statements.

In January 2017, the FASB issued a new accounting standard which clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions or disposals of assets or businesses. This guidance was effective for the Company beginning in 2019. Adoption of these accounting changes did not have a material impact on our consolidated financial statements.

In January 2017, the FASB issued a new accounting standard simplifying the test for goodwill impairment. Currently, the fair value of the reporting unit is compared with the carrying value of the reporting unit (identified as "Step 1"). If the fair value of the reporting unit is lower than its carrying amount, then the implied fair value 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 value and the carrying value. The new standard becomes effective on January 1, 2020, with early adoption permitted. We adopted this standard on January 1, 2019.This new standard has no impact on our financial position, results of operations and cash flows.

In May 2017, the FASB issued a new accounting standard which provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in ASC Topic 718. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. This guidance is effective for the Company beginning in 2019. Adoption of these accounting changes did not have a material impact on our consolidated financial statements.

In June 2018, the FASB issued a new accounting standard which provides guidance that expands the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. The new guidance is effective for the Company beginning in 2019, with early adoption permitted. Adoption of these accounting changes did not have a material impact on our consolidated financial statements.

Recently Issued Accounting Pronouncements Not Yet Adopted

In August 2018, the FASB issued a new accounting standard which modifies the disclosure requirements on fair value measurements. This guidance will bewas effective for fiscal years beginning after December 15, 2019. The amendments related to the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements, and the narrative description of measurement uncertainty should be applied prospectively. All other amendments should be applied retrospectively. An entity iswas permitted to early adopt any removed or modified disclosures upon issuance of this guidance and delay adoption of the additional disclosures until their effective date. We doThe adoption did not anticipate adoption to have a material impact on our consolidated financial statements.

Recently Issued Accounting Pronouncements Not Yet Adopted

In 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 intraperiod 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 step up in the tax 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 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020.  Management is currently evaluating the impact the guidance will have on our consolidated financial statements.

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.

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3.ACCOUNTS RECEIVABLE 

A summary of accounts receivable is as follows:

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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. Effective January 1, 2018, we adopted the modified retrospective method of the new revenue recognition pronouncement. Deferred commissions are included in prepaid and other current assets in our consolidated balance sheets. We had $991,766$757,602 and $849,975$764,607 of unamortized deferred commissions as of March 31, 20192020 and 2018,December 31, 2019, respectively. We had $256,553$165,010 and $47,030$256,553 of commissions expense for the three months ended March 31, 20192020 and 2018,2019, respectively.

5.PROPERTY AND EQUIPMENT 

A summary of property and equipment follows:

6.LEASES 

We lease approximately 17,000 square feet of office space at 27271 Las Ramblas, Suite 200,in Mission Viejo, California. This lease terminates in April of 2021. During the first quarter of 2019, we subleased this space to two subtenants. The terms of these subleases end concurrently with the end of our lease obligation in April 2021.We2021. We also leaseleased approximately 3,600 square feet of office space at 11410 Jollyville Road, Suite 2201,in Austin, Texas. This lease terminatesterminated in September 2019. During the first quarter of 2018, we subleased this space to a subtenant. The terms of this sublease endsended concurrently with the end of our lease obligation in September 2019. We also leaseleased approximately 9,600 square feet of office space at 11940 Jollyville Road,in Austin, Texas.Texas in March 2020. We amended this lease reducing the office space to 4,600 square feet and extended the lease term to May 31, 2022. We also lease approximately 3,700 square feet of office space in Minneapolis, Minnesota. This lease terminates in Mayon July 31, 2020. Operating lease expense totaled $158,642 and $184,482 for the three months ended March 31, 2019 and 2018, respectively.2021.

We used a discount rate of 5.5% as of January 1, 2018 in determining our operating lease liability. This rate represented our incremental borrowing rate at that time. Short-term leases with initial terms of twelve months or less are not capitalized.

We alsodetermine if a contract is or contains a lease certain office equipment underat inception or modification of a financecontract. A contract is or contains a lease arrangement.if the contract conveys the right to control the use of an identified asset for a period in exchange for consideration. Control over the use of the identified asset means the lessee has both (a) the right to obtain substantially all of the economic benefits from the use of the asset and (b) the right to direct the use of the asset.

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 contain extension options; however, we have not included

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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.

We elected the package of practical expedients in transition for leases that commenced prior to January 1, 2019, and therefore did not reassess (i) whether any expired or existing contracts are, or contain, leases, (ii) the lease classification for any expired or existing leases, and (iii) initial direct costs for any existing leases.  We did not elect to use hindsight for transition when considering judgments and estimates such as assessments of lease options to extend, or terminate, a lease, or to purchase the underlying asset.  We have no land easements.  For all asset classes, we elected to (i) not recognize a right-of-use asset and lease liability for leases with a term of 12 months or less and (ii) not separate non-lease components from lease components, and we have accounted for combined lease and non-lease components as a single lease component.

Operating lease expense is comprised of the following:

Maturities of lease liabilities are as follows:

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7.INTANGIBLE ASSETS 

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

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8.DEFERRED REVENUE 

We record deferred revenues when amounts are billed to customers, or cash is received from customers, in advance of our performanceperformance.. During the three months ended March 31, 2020 and 2019, $884,379 and 2018,  $335,569 and $307,780,$824,099, 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, 2020 and 2019, $141,666 and 2018, $290,045 and $214,970,$287,940, respectively, of consulting and professional services revenues were recognized, that were included in deferred revenue at the beginning of the respective periods.

9.LINE OF CREDIT AND TERM LOAN

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”).  The A&R Credit Agreement amended a loan and security agreement originally entered into on May 4, 2012, as amended by several amendments.  Under the A&R Credit Agreement, the term of the revolving line-of-credit was available through January 13, 2019, at an interest rate of prime plus 1.0% per annum.  The amount available to us at any given time was 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). The A&R Credit Agreement provided a term loan facility for $14,000,000.

There were no borrowings on the line of credit for the three months ended March 31, 2018.

Interest charges associated with this term loan totaled $133,914 for the three months ended March 31, 2018.

Debt Restructuring

On March 12, 2018, we entered into a Credit Agreement (together with the other related documents defined therein, the “Credit Agreement”) with BMO Harris Bank N.A., a national banking association (“Bank”), as lender (the “BMO Loan”).

The purposes of the BMO Loan were (1) to refinance and replace the facilities under the A&R Credit Agreement,prior credit agreement, thus terminating that agreement as of March 12, 2018, (2) to refinance $2,250,000 of a promissory note held by Michael McMillan (the “McMillan Seller Note”), (3) to finance payments to Michael Hernandez, including the full repayment of a promissory note held by Hernandez (the “Hernandez Seller Note”) in the original principal amount of $4,500,000, also issued as part of the Original SPA,acquisition of CTEK Security, Inc., (4) to finance working capital, (5) for general corporate purposes and (6) to fund certain fees and expenses associated with the closing of the BMO Loan.

Loan Facilities

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Term Loan:  Pursuant to the Credit Agreement, the Bank agreed to provide a term loan in the amount of $17,250,000 to the Company, which was paid in accordance with the purpose of the BMO Loan as described above.  Pursuant to the Credit Agreement, the Company could elect that the term loan be outstanding as Base Rate Loans or Eurodollar Loans. The term loan was payable in principal payment installments on the last day of each fiscal quarter, commencing on June 30, 2018. All principal and interest not sooner paid on the term loan was due and payable on September 12, 2022, the final maturity thereof.

Revolving Line of Credit: Additionally, pursuant to the Credit Agreement, the Bank agreed to provide a revolving loan or loans to the Company in an aggregate amount of up to $5,000,000 with a $500,000 sublimit for the issuance of letters of credit. Pursuant to the Credit Agreement, the Company could elect that each borrowing of revolving loans be either Base Rate Loans or Eurodollar Loans. Each revolving loan, both for principal and interest then outstanding, matured and was due and payable on March 12, 2020, or such earlier date on which the Revolving Credit Commitment (as defined in the Credit Agreement) was terminated in whole pursuant to the Credit Agreement. There were no borrowings on the line of credit for the three months ended March 31,in 2019 or 2018.

Beginning June 30, 2018, we were required to maintain certain financial covenants in connection with this credit agreement, including a total leverage ratio, a senior leverage ratio, and a fixed charge coverage ratio. These covenants contain ratios which changed over relevant periods of the credit agreement and could be found in Section 7.13 of the Credit Agreement.

Interest Rates

Base rate loans (“Base Rate Loans”) bear interest at an annual rate equal to the base rate (defined as the highest of (a) the rate of interest quoted in The Wall Street Journal, Money Rates Section as the prime rate in effect on such day, with any change in the Base Rate resulting from a change in such prime rate to be effective as of the date of the relevant change in such prime rate, (b) the sum of (i) the rate determined by the Bank to be the average of the rates per annum quoted to the Bank by two or more Federal funds brokers selected by the Bank for sale to the Bank at face value of Federal funds in the secondary market in an amount equal or comparable to the principal amount for which such rate is being determined, plus (ii) 1/2 of 1%, and (c) the overnight LIBOR rate plus 1.0%) plus an applicable margin of between 1.50% and 2.50%, depending upon the Company’s leverage ratio.

Eurodollar loans (“Eurodollar Loans”) bear interest at a rate per annum equal to the sum of the Adjusted LIBOR rate (defined as the quotient obtained by dividing (a) the LIBOR index rate by (b) the maximum reserve percentage, expressed as a decimal, at which reserves are imposed by the Board of Governors of the Federal Reserve System (or any successor) on “eurocurrency liabilities,” as defined in such Board’s Regulation D (or any successor thereto), subject to any amendments of such reserve requirement by such Board or its successor, taking into account any transitional adjustments thereto) plus an applicable margin of between 2.50% and 3.50%, depending upon the Company’s leverage ratio.

On March 12, 2018, we paid a $25,000 revolving loan commitment fee associated with the line of credit.

Interest charges associated with the BMO term loan totaled $207,903 and $50,217 for the three months ended March 31, 2019 and 2018, respectively. In addition, on March 12, 2018, we paid a $86,250 commitment fee associated with the term loan.

On March 20, 2019, we used a portion of the proceeds from the sale of the assets of CTEK Solutions businessthe MPS Business (Note 19) to fully repay the balance of the term loan in the amount of $15,456,984$15,401,786, plus interest of $52,760. At that time, the Revolving Line of Credit Commitment was terminated.

Interest charges associated with the BMO term loan totaled $207,903 for the three months ended March 31, 2019.

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10.PROMISSORY NOTES 

In connection with the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.), we issued two promissory notes totaling $9,000,000 to Michael Hernandez and Michael McMillan (the(respectively, the “Hernandez Seller Note” and the “McMillan Seller Note”; and together 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,

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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.  The Company had 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.

On March 12, 2018, the Company fully repaid the $4,500,000 plus accrued interest on the Hernandez Seller Note.

As part of the debt restructuring with BMO Harris Bank N.A., on March 12, 2018, the Company repaid $2,250,000 plus accrued interest on the McMillan Seller Note.  The Company and Mr. McMillan agreed to amend and restate the McMillan Seller Note pursuant to the Aan amended and restated promissory note (the “A&R McMillan Seller Note.Note”).  The A&R McMillan Seller Note is in the principal amount of $2,250,000, 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, 20192020 and December 31, 2018,2019, the outstanding principal balance due under the A&R McMillan Seller Note was $1,687,500$1,125,000 and $1,828,125,$1,265,625, respectively. Amounts due and owing under the A&R McMillan Seller Note arewere subordinate to the right of payment due under the BMO Loan pursuant to a Subordination Agreement among the Company, the Bank and Mr. McMillan.

Interest charges associated with the Seller Notes totaled $24,288 and $35,106, and $149,425respectively for the three months ended March 31, 20192020 and 2018, respectively.2019.

Pursuant to a separation agreement among the Separation Agreement,Company, CTEK Security, Inc. and Michael Hernandez (the “Separation Agreement”), in lieu of any earn-out payments (as described indue pursuant to the Original SPA (as defined below)purchase agreement related to the acquisition of CTEK Security, Inc. (the “Original SPA”) that could be earned by Hernandez under the Original SPA, the Company agreed to pay Hernandez the amount of $3,750,000 in the form of a promissory note (the “Earn-out Note”). The Earn-out Note provided for (i) a maturity date of March 12, 2023, at which all principal and accrued and unpaid interest was due, (ii) a simple interest rate of 5% per annum commencing on January 1, 2018, and compounding annually, and (iii) the right of the Company to prepay all or any portion of the Earn-out Note without premium or penalty. On March 26, 2019, we used a portion of the proceeds from the sale of the assets of CTEK Solutions businessMPS Business (Note 18) to fully repay the Earn-out Note with interest of $234,293.

Interest charges associated with the Earn-out Note totaled $45,858 and $45,813 for the three months ended March 31, 2019 and 2018, respectively.2019.

Pursuant to the Separation Agreement, the Company also issued a Severance Payment Note to Hernandez in the original principal amount of $343,750 (the “Severance Payment Note”). The Severance Payment Note bears interest at a rate of 5% per annum, compounded annually, allowed for prepayment by the Company and matured on January 10, 2019, at which time all principal and accrued and unpaid interest was due.  All principal and interest due under the Severance Payment Note was repaid on March 27, 2019.

Interest charges associated with the Severance Payment Note totaled $494 and $4,191 for the three months ended March 31, 2019 and 2018, respectively.

Amounts due and owing under the Earn-out Note and Severance Payment Note were subordinate to the right of payment due under the BMO Loan pursuant to a Subordination Agreement among the Company, the Bank and Hernandez.2019.

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11.REVENUES 

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

12.OPTIONS, WARRANTS AND RESTRICTED STOCK UNITS 

Below is a summary of stock option, warrant and restricted stock activity during the three-month period ended March 31, 2019:2020:

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For the three months ended March 31, 20192020 and 2018,2019, stock-based compensation expense recognized in the consolidated statements of operations as follows:

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13.NET INCOME (LOSS) PER SHARE 

Basic net income (loss) 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) income by the weighted average number of shares of our common stock issued and outstanding during such period. Diluted net income (loss) 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 income (loss) per share does not include potentially dilutive securities because such inclusion in the computation would be anti-dilutive.

For the three months ended March 31, 2020, potentially dilutive securities consisted of options and warrants to purchase 797,325 shares of common stock at prices ranging from $2.28 to $4.86 per share. Of these potentially dilutive securities, 11,683 of the shares of common stock underlying the options and warrants are excluded 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 60,000 shares of restricted stock units which vested in October 2019 but had not been issued by period end.

For the three months ended March 31, 2019, potentially dilutive securities consisted of options and warrants to purchase 583,865 shares of common stock at prices ranging from $2.28 to $4.05 per share and 780,850 shares of restricted stock units.share. Of these potentially dilutive securities, 209,904 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.share. Also included in potentially dilutive securities are 47,455 shares of restricted stock units which vested in March 2019 but had not been issued by period end.

For the three months ended March 31, 2018, potentially dilutive securities consisted of options and warrants to purchase 280,416 shares of common stock at prices ranging from $0.90 to $6.45 per share and 500,500 shares of restricted stock units. Of these potentially dilutive securities, none of the shares to purchase common stock from the options and warrants or shares related to the restricted stock units are included in the computation of diluted earnings per share because the effect of including these instruments would be anti-dilutive.

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14.REMAINING PERFORMANCE OBLIGATIONS 

RemainingWe had remaining performance obligations of approximately $22.6 million as of March 31, 2020. Our remaining performance obligations represent the amount of revenue from fixed-fee contracts, including those which have potential early cancellation provisions,transaction price for which work has not been performed. Asperformed and revenue has not been recognized. When applying Topic 606, with only the non-cancelable portion of these contracts included in our performance obligations we had approximately $13.5 million as of March 31, 2019, approximately $25,000,000 of revenue from fixed-fee contracts is expected to be recognized from these remaining performance obligations.2020. We expect to recognize revenue on approximately 87%92% of the remaining non-cancelable portion of these remaining performance obligations over the next 24 months, with the balance thereafter. We elected to utilize the practical expedient exemption to exclude from this disclosure, the amount of revenue from contracts which are not fixed-fee and where we do not have the right to invoice until the services have been performed.

15.EMPLOYMENT AGREEMENTS 

Michael H. McMillanCaleb Barlow

In January 2017,Effective August 1, 2019, we entered into an employment agreement with Michael H. McMillan (“McMillan”)Caleb Barlow (the “McMillan Employment“Barlow Agreement”), pursuant to which we employed McMillanhe will serve as President and Chief StrategyExecutive Officer ofand will have the Company.duties and responsibilities as are commensurate with such positions. The initial term of the McMillan EmploymentBarlow Agreement is 36 months and will automatically renew for subsequent 12-month terms unless either party provides written notice to the other party of a desire not to not renew the agreement.employment.

Pursuant to 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, McMillanMr. Barlow’s base salary is $350,000. He is entitled to receiveincentive bonus compensation that offers 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.    If McMillan resigns for other than Good Reason, he will be entitledpotential to receive the base salary for the thirty (30) day written notice period, but no other amounts.  On October 2, 2017, the Board appointed McMillan as Chief Executive Officer and his base salary was increased to $325,000.

In February 2018, the Company amended the McMillan Employment Agreement to extend the term thereof through December 31, 2020 and increased his base salary to $334,700 for 2018, $359,700 for 2019, and the 2020 base salary to be determined by the Board of Directors at the end of the 2019 calendar year. He will also be eligible for a discretionary bonus of up to $219,375 and $242,798 in 2018 and 2019, respectively, and his 2020 bonus will be up to 67.5%100% of his base salary. For 2019 there was no discretionary bonus paid. In addition, he receives a retention bonus totaling $500,000, with $200,000 being paid on August 1, 2019, $150,000 paid on January 1, 2020 and $150,000 payable on January 2021. Mr. Barlow also received equity compensation

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consisting of an option to purchase up to 500,000 shares of the Company’s Common Stock, subject to vesting, and 50,000 shares of restricted stock units. The options are nonqualified, and the grant was made outside of the Company's 2011 Stock Incentive Plan. The foregoing is a summary of the McMillan EmploymentBarlow Agreement, and the full context of whichentire agreement is foundincluded as Exhibit 99.610.1 to our Current Report on Form 8-K filed with the SEC on January 17, 2017, and the amendment to the McMillan Employment Agreement, which is found as Exhibit 10.44 to our Annual Report on Form 10-K filed with the SEC on March 28, 2018.July 16, 2019.

Paul T. Anthony

Effective January 1, 2016, we entered into an employment agreement with Paul T. Anthony (the “Anthony Agreement”). The Anthony Agreement provides that Mr. Anthony will continue to serve as our Executive Vice President, CFO and Corporate Secretary. The Anthony Agreement has a term of two years and provided for an annual base salary of $245,000. The 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 was 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 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 is a summary of the Anthony Agreement, the full context of 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

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authorized an increase in Mr. Anthony’s base salary to $250,000 and increased his potential annual bonus amount to $150,000.

In February 2018, the Company amended the Anthony Agreement to extend the term thereof through December 31, 2020 and increased his base salary to $284,700 for 2018, and $309,700 for 2019 with the 2020 base salary to be determined by the Board of Directors at the end of the 2019 calendar year. He will also be eligible forand 2020. Mr. Anthony was paid a bonus of up to $185,625 and $209,047 in 2018 and$41,841 for 2019, respectively, and his 2020 bonus will be up to 67.5% of his base salary. The foregoing is a summary of theentire Anthony Agreement the full context of which is found as Exhibit 10.32 to our Annual Report on Form 10-K filed with the SEC on March 30, 2016, and the amendment to the Anthony Agreement, which iscan be found as Exhibit 10.45 to our Annual Report on Form 10-K filed with the SEC on March 28, 2018.

Michael H. McMillan

On July 15, 2019, Mr. McMillan notified the Board of Directors of his decision to retire from the Company effective December 31, 2019.  In connection with his planned retirement, Mr. McMillan also submitted his resignation as President and Chief Executive Officer of the Company, effective July 31, 2019. Mr. McMillan will continue to serve as a director of the Company and remained employed by the Company through his retirement date in order to assist with the transition.  Mr. Mr. McMillan was given the honorary title of President and CEO Emeritus by the Board.

16.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

Our largest customer accounted for approximately 25%12% and 14%25% of our revenues for the three months ended March 31, 20192020 and 2018,2019, respectively. Our largest customer had accounts receivable totaling approximately $1,200,000$693,000 and $400,000$342,000 as of March 31, 20192020 and December 31, 2018,2019, respectively.

17.STOCK PURCHASE AGREEMENT – BACKBONE ENTERPRISES

On October 31, 2019, we entered into a Stock Purchase Agreement (the “Purchase Agreement”) with Backbone Enterprises Inc., a Minnesota corporation (“Backbone”), and its stockholders, (the “Stockholders”), pursuant to which we acquired 100% of the issued and outstanding shares of Common Stock (the “Shares”) of Backbone from the Stockholders (the “Backbone Transaction”).

Pursuant to the Purchase Agreement, the aggregate purchase price paid for the Shares consisted of (i) a cash payment of $5,500,000, less certain transaction expenses (the “Cash Consideration”), (ii) the issuance of 491,804 shares of our Common Stock to the Stockholders (the “Securities Consideration”), pro rata among the Stockholders in proportion to each Stockholder’s ownership of the Shares, and (iii) an earn-out, pursuant to which the Stockholders may be entitled to an additional $4,000,000 based upon the post-closing financial performance of Backbone, to be calculated based upon revenue generated by the Backbone business during the three-year earn-out

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period. As of March 31, 2020, the estimated fair value of the earnout is $2,400,000. The Cash Consideration was subject to adjustment based on closing working capital of Backbone, and $1,500,000 of the Cash Consideration was placed into a third-party escrow account by us, against a portion of which we may make claims for indemnification.

The Company performed a valuation analysis of the fair value of Backbone’s assets and liabilities. The following table summarizes the allocation of the purchase price as of the acquisition date:

Pro Forma Information (Unaudited)

The following supplemental unaudited pro forma information presents the combined operating results of the Company and the acquired business during the three months ended March 31, 2019, 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.

18.DISCONTINUED OPERATIONS 

On March 20, 2019, we, along with our wholly-owned subsidiary, CTEK Solutions, Inc., entered into an Asset Purchase Agreement (together with the other related documents defined therein, the “Purchase Agreement”) with Vereco, LLC, a Delaware limited liability company (“Buyer”). Pursuant to the Purchase Agreement, we sold our assets used in the provision of our managed print services business division (the “MPS Business”), which had been primarily conducted by CTEK Solutions, Inc. The Buyer also assumed certain liabilities relating to the MPS Business. The purchase price paid to us by Buyer pursuant to the Purchase Agreement was $30,000,000, $5,000,000 of which was placed in escrow by Buyer, the release of which iswas contingent upon certain events and conditions specified in the Purchase Agreement. On June 20, 2019, a contingent event had not occurred and per the terms of the Purchase Agreement, $1,500,000 of the $5,000,000 was removed. The purchase price iswas also subject to adjustment based on closing working capital results of the MPS Business.  The initialThis subsequent working capital adjustment, reducedtogether with the escrow amount, increased the cash received by $629,746.$1,933,247.

The following is the summary of the transaction selling the MPS Business:Business that was finalized in October 2019:

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The following are the carrying amounts of assets and liabilities included as part of discontinued operations:

The following is a composition of the line items constituting net income from discontinued operations:operations for the three months ended March 31, 2019:

The following is a composition of the capital expenditures, and any significant noncash operating and investing items, including depreciation, of the discontinued operations.operations for the three months ended March 31, 2019:

19.SUBSEQUENT EVENTS

Securities Purchase Agreement

On April 3, 2020, we entered into a Securities Purchase Agreement (the “Purchase Agreement”) with Horton Capital Management, LLC, a Delaware limited liability company (“Purchaser”), which provides that, upon the terms and subject to the conditions and limitations set forth therein, Purchaser is committed to purchase up to an aggregate of $2,500,000 of shares of the Company’s common stock (the “Purchase Shares”) over the term of the Purchase Agreement, which terminates on March 31, 2021. Upon signing the Purchase Agreement, the Company issued Purchaser a warrant to purchase up to 500,000 shares of common stock (the “Initial Warrant”) in consideration of Purchaser’s obligation to purchase the Purchase Shares, at an exercise price of $2.50 per share, subject to certain anti-dilution adjustments as set forth in the Initial Warrant.  Purchaser and its affiliates are current stockholders of the Company and, prior to the date of the Purchase Agreement, based solely on a Schedule 13D filing dated February 14, 2020, owned approximately 9.1% of the Company’s outstanding shares of common stock.

Details regarding the Purchase Agreement, the Registration Rights Agreement, the Initial Warrant and the Funding Warrant can be found in our 8-K filed on April 7, 2020.

Paycheck Protection Program

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

The Company plans to use the 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 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.  Details regarding the Note can be found in our 8-K filed on April 20, 2020.

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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, 2018.  2019.  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, when such reports are available via the EDGAR system maintained by the SEC at www.sec.gov.

OVERVIEW

We are engaged in the business of providing IT or cybersecurity services, privacy and compliance services to the healthcare and other industries.  Our business is operated throughout the United States.

We support the United States healthcare market to help organizations identify and protect against the ever-changing cyber threat factors, develop and mature their information security and privacy programs aligned to the NIST Cybersecurity Framework and comply with regulations and standards including the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”), Health Information Technology for Economic and Clinical Health Act (“HITECH”) Breach Notification Rule, Federal Trade Commission consumer protection guidelines and state privacy standards.

We are one of the few consulting and advisory companies focused in the healthcare industry, and our years of experience of understanding the industry’s unique challenges allows us to provide our customers with services designed around industry best practices and a top-rankedmethodology to evaluate the rigor and effectiveness of their programs to improve security controls, policies and procedures and to protect patient health 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 firm offering a suite of comprehensive services and solutions with an emphasis in healthcare and the challenges unique to the healthcare industry. Our service offerings help organizations identify ever-changing threat factors and security risks, provide resources to remediate or fill a gap in skilled and experienced talent, and offer a partner with experts in cybersecurity and privacy to manage and advise on their programs.compliance.

Our services include our Compliance Assist Partner Program (CAPP),are categorized into four groups which provides on-going risk assessmentsare: assessment and remediation tracking to ensure organizations are compliant with HIPAA. Our Virtual Chief Information Security Officer (CISO) helps organizations withaudit, technical testing, program development and prioritizes projects. The use of the CISO often reveals gaps in an organization’s security.  We can then provide additional resources through our Staffing service to execute a remediation, plan or work on other IT security projects. Our Vendor Security Management oversees third-party risk and our Incident Responsemonitoring and advisory services. These services help address the growing ransomware and malware attacks that plague organizations today.

To address growing market needs, we recently expanded our consulting andare delivered as recurring managed services offerings to include Medical Device Security Risk Assessment and Managed Security Services. The Medical Device Security Risk Assessment service helps hospitals and other organizations inventory the increasing number of medical devices connected to the network, identify hard to find vulnerabilities to overall security and the patient, and categorize these risks into a clearly defined remediation plan.  The Managed Security Services provide on-going monitoring and analysis of an organization’s security posture in regard to its network, endpoint devices, cloud infrastructure and SaaS applications.  

As of March 20, 2019, the Company is focused exclusively on cybersecurity and privacy. As reported in our prior public filings, beginning March 20, 2019, we no longer provide Managed Print Services (MPS) directly but willunder long-term contracts or under shorter duration consulting or professional services engagements.

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continue·Assessment and Audit Services - identify and measure security and privacy risk of an organization’s readiness and verify and validate their programs meet compliance and business objectives.  

·Technical Testing Services - test the effectiveness of controls in an organization’s environment. 

·Program Development and Remediation Services - develop policies and procedures and playbooks to referhelp build out a fully comprehensive risk management program and provide resources to help organizations prioritize, implement and execute initiatives to strengthen their security and privacy programs.  

·Monitoring and Advisory Services - provide on-going management and oversight of specific components of an organization’s security and privacy programs to address or give alerts when an issue arises and to offer our customersexpertise that they need to our partners for these services. MPS optimizes high-volume print environments while reducing costs, improving efficiency and securingaccelerate the print environment through industry best practices.effectiveness of their programs. 

Prior to March 20, 2019, we provided document solutions to the healthcare industry.  See Note 18 to the condensed consolidated financial statements regarding discontinued operations.

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

Where appropriate, references to “CynergisTek,” the “Company,” “we,” “us” or “our” include 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.corporation, Backbone Enterprises, Inc., a Minnesota corporation and Redspin.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

OurThe 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 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,supply inventories, 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.

We consider the following accounting policies to be those most important to the portrayal of our financial condition and those that require the most subjective judgment:

·Revenue recognitionRecognition and deferred revenueDeferred Revenue

We operate under a consolidated strategy and management structure, deriving revenue from the following sources:

oManaged services

oConsulting and professional services  

oHardware and software resales 

Revenue is recognized pursuant to ASC Topic 606, “Revenue from Contracts with Customers” (ASC 606).  Accordingly, revenue is recognized at an amount that reflects the consideration to which we expect to be entitled in exchange for transferring goods or services to a customer.  This principle is applied using the following 5-step process:

1.Identify the contract with the customer - A contract with a customer exists when (i) we enter into an enforceable contract with a customer that defines each party’s rights regarding the services to be transferred and identifies the payment terms related to these services, (ii) the contract has commercial substance and the parties are committed to perform, and (iii) we determine that collection of substantially  

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all consideration to which it will be entitled in exchange for services that will be transferred is probable based on the customer’s intent and ability to pay the promised consideration.

2.Identify the performance obligations in the contract - Performance obligations promised in a contract are identified based on the services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the service either on its own or together with other resources that are readily available from third parties or from us, and are distinct in the context of the contract, whereby the transfer of the services is separately identifiable from other promises in the contract. To the extent a contract includes multiple promised services, we apply judgment to determine whether promised services are capable of being distinct and distinct in the context of the contract. If these criteria are not met the promised services are accounted for as a combined performance obligation. 

3.Determine the transaction price - The transaction price is determined based on the consideration to which we will be entitled in exchange for transferring services to the customer. 

4.Allocate the transaction price to the performance obligations in the contract - If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price ("SSP") basis. Determination of SSP requires judgment. We determine standalone selling price taking into account available information such as historical selling prices of the performance obligation, overall strategic pricing objective, market conditions and internally approved pricing guidelines related to the performance obligations. 

5.Recognize revenue when (or as) each performance obligation is satisfied - We satisfy performance obligations over time. Revenue is recognized over the time the related performance obligation is satisfied by transferring a promised service to a customer. 

Managed Services

Managed services revenuecontracts are typically long-term contracts lasting three years.  Revenue is earned monthly during the term of the contract, as services and supplies are provided at a fixed fee and is recognized ratably over the contract term beginning on the commencement date of the contract. ManagedRevenue related to managed services provided is recognized based on the customer utilization of such resources, which management estimates to occur ratably over the customer contract term.

Prior to our sale of the MPS business in March 2019, our contracts are typically long-term contracts lasting 3with managed print service customers included provisions that related to 5 years.

guaranteed savings amounts and shared savings. Such provisions were considered by management during our initial proprietary client assessment. Our historical settlement of such amounts had been within management’s estimates.

Consulting and Professional Services

Consulting and professional services contracts are typically short-term, project-based services rendered on either a fixed fee or a time and materials basis. These contracts are normally for a duration of less than one year. For fixed

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fee arrangements, revenue is normally recognized ratably over the term of the project. For time and materials arrangements, revenues are recognized as the services are rendered.

Hardware and Software Resales

For hardware and software resales, we recognize revenue on a gross basis, as we are deemed to be the primary obligor in these arrangements. Revenue from the resale of hardware is recognized when delivered to the customer. For software resales, when we do not provide any services that are considered essential to the functionality of the software, revenue is recognized upon delivery of the software. All product warranties and upgrades or enhancements are provided exclusively by the manufacturer. We do not sell any internally-developed software.

For hardware and software maintenance arrangements, we recognize revenue at the time of sale on a net basis, as a third-party service provider is deemed to be the primary obligor. Under net sales recognition, the cost of the third-party service provider or vendor is recorded as a direct reduction to net revenues on the statements of operations.

Deferred and Unbilled Revenue

We receive payments from customers based on billing schedules established in our contracts.  Deferred revenue primarily consists of billings or payments received in advance of the amount of revenue recognized and such amounts are recognized as the revenue recognition criteria are met.  Unbilled revenue reflects our conditional right to receive payment from customers for our completed performance under contracts.  

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·Accounts receivable valuationReceivable Valuation and related reservesRelated Reserves

We estimate the losses that may result from that portion of our accounts receivable that may not be collectible as a result of the inability of our customers to make required payments.  Management specifically analyzes customer concentration, customer credit worthiness,creditworthiness, current economic trends, COVID-19 developments and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts.  We review past due accounts on a monthly basis and record an allowance for doubtful accounts where we deem appropriate.

·Impairment reviewReview of goodwillGoodwill and intangible assetsIntangible Assets

We periodically evaluate our intangible assets and goodwill relating to acquisitions for impairment. Goodwill is not amortized but is evaluated at least annually at year end for any impairment in the carrying value. We review our intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors we consider important which could trigger an impairment review include, but are not limited to, the following: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and a significant negative industry or economic trend for a sustained period. Goodwill and intangible asset impairment assessments are generally determined based on fair value techniques, including determining the estimated future discounted and undiscounted cash flows over the remaining useful life of the asset. Those models require estimates of future revenue, profits, capital expenditures and working capital for each reporting unit. We estimate these amounts by evaluating historical trends, the current state of the Company’s industries and the economy, current budgets, and operating plans. Determining the fair value of reporting units and goodwill includes significant judgment by management and different judgments could yield different results. Any resulting impairment loss could have a material impact on our financial condition and results of operations.

·Stock-based compensation

Stock-Based Compensation

Under the fair value recognition provisions of the authoritative guidance, stock-based compensation cost granted to employees is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service or performance period, which is the vesting period.  Stock options and warrants issued to consultants and other non-employees as compensation for services to be provided to us are accounted for based upon the fair value of the services provided or the estimated fair value of the option or warrant, whichever can be more clearly determined.  We currently use the Black-Scholes option pricing model to determine the fair value of stock options.  The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our

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stock price as well as assumptions regarding a number of complex and subjective variables.  These variables include our expected stock price volatility over the term of the awards, the expected term of the award, the risk-free interest rate and any expected dividends.  Compensation cost associated with grants of restricted stock units are also measured at fair value.value on the date of the grant.  We evaluate the assumptions used to value restricted stock units on a quarterly basis.  When factors change, including the market price of the stock, share-basedstock-based compensation expense may differ significantly from what has been recorded in the past.  If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned share-basedstock-based compensation expense.

·Income taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial reporting requirements and those imposed under federal and state tax laws.  Deferred taxes are provided for timing differences in the recognition of revenue and expenses for income tax and financial reporting purposes and are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  Deferred income tax expense represents the change during the period in the deferred tax assets and liabilities.  Realization of the deferred tax asset is dependent on generating sufficient taxable income in future years.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

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Reference is made to our Annual Report on Form 10-K for the fiscal year ended December 31, 20182019 filed with the SEC on March 27, 2019,30, 2020, for additional discussion of our critical accounting policies.

RESULTS OF OPERATIONS

For the Three Months Ended March 31, 2019,2020, Compared to the Three Months Ended March 31, 2018

Revenue2019

Revenue increased by

Revenue decreased approximately $1,400,000$0.7 million to $5,773,657$5.1 million for the three months ended March 31, 2019,2020, as compared to the same period in 2018 as we have intensified2019. Managed Services revenue increased 7% from sales of our sales efforts, expanded our service offerings and benefitted from our customers need for additional professional services. This increase is a result of  an approximately $500,000 increase in multi-yearnewer managed service revenues and approximately $900,000 in additional revenues from consultingservices offerings.  Consulting and professional services provideddecreased $0.8 million primarily due to new and existinglower revenue from two customers largelywho had large non-recurring remediation contracts that completed most of the work in Q1 last year.  This was offset by $1.1 million in revenues from professional staffing services contracts.the addition of the Backbone business.

Cost of Revenue

Cost of revenue consists primarily of salaries and related expenses of direct labor and indirect support staff.  Cost of revenue was $3,484,639comparable at $3.4 million for the three months ended March 31, 2019,2020, as compared to $2,408,780$3.5 million for the same period in 2018.2019. We incurred approximately $800,000 more$0.6 million less in salaries and related costs, approximately $100,000 more in stock compensation, and approximately $200,000 in contract labor. These increases were due to increased headcountthe lower revenue from consulting and professional services offset by the increase in order to provide services to a larger customer base, to support new services and our efforts to augment the employee salary and benefit offerings to attract and retain talent.labor costs associated with Backbone.

Gross margin was 40%33% of revenue for the three months ended March 31, 2019,2020, and 45%40% for the same period in 2018. The2019. Although we saw a reduction in gross margin is reflectivelabor costs due to the reduction in legacy CynergisTek consulting and professional services, we did see an increase in labor costs as a % of our investment inrevenue due to additional cost of attracting and retaining talented cyber security employees and costs associated with ramping up new managed services. OverThese increased expenses, coupled with continued lower revenue in legacy CynergisTek consulting and professional services revenue, negatively impacted gross margins.  We are taking actions to reduce expenses to restore margins and better position the next few quarters, we expect gross marginsCompany for the current challenging economic environment and uncertainties in the health care market related to improve as we look to grow our cyber security consulting services.COVID-19.

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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 were $1,481,383flat at $1.5 million for the three months ended March 31, 2019, as compared to $1,367,871 for the same period in 2018. The increase is primarily a result of increases in sales commissions earned as a result of an increase in bookings for the compared periods.2020 and 2019.

General and Administrative

General and administrative expenses include personnel costs for finance, administration, information systems, and general management, as well as facilities expenses, professional fees, legal expenses and other administrative costs. General and administrative expenses decreased by $515,658increased $0.4 million to $1,653,633$2.1 million for the three months ended March 31, 2019, as2020 compared to $2,169,291$1.7 million for the three months ended March 31, 2018.2019. The decreaseincrease is due to approximately $600,000$0.1 million in severance paidadditional stock-based compensation, $0.1 million in additional costs for Backbone and $0.2 million in additional costs related to a departed executive in 2018. This is partially offset by an increase in stock compensation expense of approximately $100,000 as a result of an increasestrategic advisory services and recruiting costs. We are taking actions to reduce expenses to restore operating margins and better position the Company for the current challenging economic environment and uncertainties in the issuance of restricted stock unitshealth care market related to key employees and board members.COVID-19

Depreciation

Depreciation remained steady at $38,985expense was $47,600 for the three months ended March 31, 2019,2020, as compared to $35,064$38,985 for the same period in 2018.2019.

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Amortization of Acquisition-Related Intangibles

Amortization of acquisition-related intangibles remained the same at $452,734was $0.4 million for each of the three months ended March 31, 2019 and 2018. The composition2020 compared to $0.5 million for the three months ended March 31, 2019. Amortization expense decreased over the comparable periods as a portion of identifiedthe intangible assets was consistent over the compared periods and there was no impairment affecting these assets.are now fully amortized.

Other Income (Expense)

InterestNet interest expense for the three months ended March 31, 20192020 was $295,905,$18,220, compared to $399,733$0.3 million for the same period in 2018.2019. The decrease was due to a lower average principaloutstanding debt balance onafter the bankpayoff of the term loan and certain sellerspaydown of the promissory notes forfrom the compared periods, due to scheduled quarterly principal payments. We expect interest expense to decrease substantially in future periods based since we repaidproceeds of the bank term loan and certain sellers promissory notes in March 2019.sale of the managed print services business.

Income Tax ExpenseBenefit

Income tax benefit for the three months ended March 31, 20192020 was $144,214,$0.5 million, compared to income tax benefit of $602,472$0.1 million for the same period in 2018.2019. These amounts were based on estimated annual income tax rates we anticipate for the year.

CARES Act

On March 27, 2020, the Coronavirus Aid, Relief and Economic Security (“CARES”) Act was enacted and signed into law. Provisions of the CARES Act were considered in computing the Company’s income tax provision for the first quarter of 2020, or the period of enactment. The CARES Act, among other things, permits NOL carryovers and carrybacks to offset 100% of taxable income for taxable years beginning before 2021. In addition, the CARES Act allows NOLs incurred in 2018, 2019, rateand 2020 to be carried back to each of the five preceding taxable years to generate a refund of previously paid income taxes. The Company is currently evaluating the impact of the CARES Act. The CARES Act also influenced by the tax ratecontains modifications on the gain onlimitation of business interest for tax years beginning in 2019 and 2020. The modifications to Section 163(j) increase the saleallowable business interest deduction from 30% of adjusted taxable income to 50% of adjusted taxable income. The change in the MPS company.interest expense limitation pursuant to the CARES Act is not expected to have a material impact to the Company during 2020.

Income from Discontinued Operations, Including Gain on Sale, Net of Tax

On March 20, 2019, we sold the net assets of our MPS business. The gain on the sale of this business together with the earnings from these discontinued operations totaled $19,304,463. This compares$19.0 million for the three months ending March 31, 2019. The final adjustment reflects the finalization of the working capital adjustment recognized subsequent to the earnings from these discontinued operations in the first quarter of 2018 totaling $1,149,069.

LIQUIDITY AND CAPITAL RESOURCES

At March 31, 2019 resulting in a final net gain from sale of discontinued operations of $19.5 million.

Liquidity and Capital Resources

As of March 31, 2020, our cash and cash equivalents were $12,386,637balance was $3.1 million, current assets minus current liabilities was positive $4.7 million and our working capital was $11,621,383.  Our principaldebt and lease obligations totaled $1.0 million. The level of additional cash requirements areneeded 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 including employee costs and capital expendituresmaintain gross margins while attracting, recruiting and retaining cybersecurity privacy professionals; 

demand for our services from healthcare providers; the near-term impact of the Coronavirus 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. 

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debt service toWe have historically funded our related party sellers noteoperating costs, acquisition activities, working capital requirements and income taxes. Our primary sources ofcapital expenditures with cash are revenues from operations, proceeds from the issuances of our common stock and other financing arrangements. Following the sale of the MPS business.business in 2019, we are now a much smaller cybersecurity and privacy focused business with significantly lower debt balances and debt service obligations. However, we also have less scale over which to leverage our operating expenses and public company expenses and are currently operating in a cash flow negative position while we seek to retain our cybersecurity business during this uncertain time. For the first quarter of 2020, we reported a loss from continuing operations of $1.9 million and cash used in operating activities from continuing operations was $2.1 million.

DuringIn late 2019, a novel strain of coronavirus (COVID-19) was first detected in Wuhan, China. Following the three months ended March 31, 2019,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 started to furlough employees and are expressing uncertainty as to the short and long-term financial stability of their businesses.  Our operations team is closely monitoring the potential impact to the Company’s business, including its cash flows, customers and employees. We have heard from a number of our active managed services customers since the outbreak began requesting relief in the form of extended payment terms, request for early termination and receivable forgiveness.  If the situation continues to impact our customers cash flow or resources available for cybersecurity and privacy projects, our cash provided byflows, financial position and operating activities amountedresults for fiscal year 2020 and beyond will be negatively impacted. Neither the length of time nor the magnitude of the negative impacts can be presently determined.

We experienced a small financial impact in the first quarter of 2020 due to $1,148,830, as comparedCOVID-19, primarily since 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. The severity and duration of the COVID-19 pandemic is uncertain and such uncertainty will likely continue in the near term and we will continue to $647,953 provided byactively monitor the situation taking into account the impact to our employees, customers and partners.

At the end of 2019 and during the first quarter of 2020 we reduced staffing levels to reduce expenses.  Our operating activitiesplan for the same periodnext twelve months includes additional permanent annualized cost reduction efforts totaling approximately $1.5 million and temporary cost reductions totaling approximately $1.0-$2.0 million 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 loan under the Coronavirus Aid, Relief, and Economic Security Act, and we received an equity funding commitment in 2018.the amount of $2.5 million from an existing investor.  We also have been ablethe ability to maintainfurther reduce personnel and other variable and semi-variable costs to conserve cash and operate as a positive position in providing cash from operations by staying current on collections and selling profitable service contracts.going concern. However, those actions if required, could negatively impact the long-term outlook of the business.

As discussed above, in March 2019, we soldexecute our plans over the MPS businessnext 12 months, we intend to carefully monitor the impact on our operating expenses, working capital needs and received initial cash of approximately $24,400,000 upon which we repaid approximately $15,400,000 remaining on a bank term loan. We also repaid approximately $4,200,000 in notes payablebalances relative to related parties. As a result of the repayment of the term loan to the bank, we terminated the availability of a $5,000,000 line of credit with them. Wecost-effective debt and equity financing. In the event that capital is not available, we may seek additional financing have to further scale back operations, reduce expenses, and/or equity raises; however, there can be nocurtail future plans to manage our liquidity and capital resources.   However, we cannot provide assurance that additional financingwe will be availableable to raise additional capital. The COVID-19 pandemic could 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 acceptable terms, if at all. Any financing or equity raises may result in dilutionthe economy and our operations is fluid and constantly evolving, we will continue to existing stockholdersassess a variety of measures to improve our financial performance and any debt financing may include restrictive covenants.  Management believes that cash generated from operations, together with existing cash reserves will be sufficient to sustain our business operations over at least the next twelve months.liquidity.

OFF-BALANCE SHEET ARRANGEMENTS

As of March 31, 2019,2020, we did not have any other relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

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CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS

As of March 31, 2019,2020, expected future cash payments related to contractual obligations and commercial commitments were as follows: