Firefly Neuroscience, Inc.: Form 10-Q for the period ended Sep 30, 2021

Cautionary Statement Regarding Forward-Looking Statements

This Form 10-Q contains forward-looking statements regarding our business, customer prospects, or other factors that may affect future earnings or financial results that are subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. Such statements involve risks and uncertainties which could cause actual results to vary materially from those expressed in the forward-looking statements. Investors should read and understand the risk factors detailed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 (“2020 10-K”) and in other filings with the Securities and Exchange Commission.

We operate in a rapidly changing environment that involves a number of risks, some of which are beyond our control. This list highlights some of the risks which may affect future operating results. These are the risks and uncertainties we believe are most important for you to consider. Additional risks and uncertainties, not presently known to us, which we currently deem immaterial, or which are similar to those faced by other companies in our industry or business in general, may also impair our business operations. If any of the following risks or uncertainties actually occurs, our business, financial condition and operating results would likely suffer. These risks include, among others, the following:

• our failure to generate a sufficient level of professional fees;
• the loss of one or more material subcontracts under which a material portion of our revenue and income is concentrated;
• our inability to integrate businesses, products, or technologies we may acquire;
• the limited public market for our common stock;
• inaccuracy in our estimates of the cost of services and the timeline for completion of contracts;
• our inability to hire, retain, and utilize qualified personnel;
• our failure to protect our information technology from disruptions, failures, and security breaches;
• changes in the funding priorities of the U.S. federal government;
• intense competition from other companies;
• our inability to raise additional capital when needed;
• fluctuations in our results of operations and the resulting impact on our stock price;
• efforts to gain entry into new markets may be unsuccessful;
• investments in developing new services offerings may take time to recover;
• health epidemics, pandemics, and other natural disasters and national emergencies;
• our inability to reach investors and gain shareholder approval when needed; and
• our forward-looking statements and projections may prove to be inaccurate.

In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “intends,” “potential” and similar expressions intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We discuss many of these risks in greater detail under the heading “Risk Factors” in Item 1A of our 2020 10-K. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this report. Except as required by law, we assume no obligation to update any forward-looking statements after the date of this report.

Our Business

Information Analysis Incorporated, which we refer to as IAI, the Company, we or our, is an information technology, or IT, provider primarily for the benefit of federal government agencies. Our focus is on enterprise IT solutions primarily relating to system modernization, cloud-based solutions and cyber security protection. Modernization has been a core competency of IAI for over 20 years. We have modernized over 100 million lines of COBOL code for over 35 governmental and commercial customers. We maintain a pool of skilled COBOL programmers. This provides us with competitive advantage as the labor pool of such programmers is shrinking as aging software professionals retire. Our business has also historically relied upon the reselling of applications, primarily for forms development.

Through our recent acquisition of Tellenger, Inc., we acquired competencies in web-based solutions and cyber security. We believe combining web-based solutions with system modernization will provide us with the skill sets that are needed to migrate legacy systems to the cloud. We foresee this as a key component of our growth since there are billions of lines of code, in both the governmental and commercial sectors, that eventually must be modernized. We see this as an expanding market since users eventually will need to substantially update their systems.

Our acquisition of Tellenger was also premised upon gaining access to its professionals and service engagements in cyber security. Cyber security opportunities continue to grow. Given recent hacking incidents, it is increasingly clear, that every enterprise and governmental agency must devote resources to protect themselves. It is our intention to better leverage our resources to take advantage of the growth in this market.

Our Strategy

Our strategy is to grow our business organically and through acquisitions. Over the last two decades, IAI had been resistant to investing in business development activities. Instead, it was inclined to rely upon a limited number of professional service engagements to sustain itself and not risk capital to grow the business. With changes in our executive management team and in the composition of our board of directors, we are now focused on growing our business. As a public company, we are positioned to raise capital to support our growth. We have also made our initial hires in business development personnel to help grow our business. We also intend to become more proactive in bidding as a prime contractor on government proposals and expanding our outreach to larger prime contractors for subcontract and teaming opportunities.

As for acquisitions, we believe there are numerous small government contractors, such as IAI and Tellenger, who recognize that unless they undertake fundamental changes in their business and invest the necessary capital, their business prospects stall. The founders of these companies who are resistant to change and investment are often inclined to sell their businesses, but given their modest size, their ability to attract suitable buyers is limited. We believe we can be a potential buyer for these companies. As in the Tellenger transaction, the currency of our publicly traded shares allows us to provide sellers with a means of participating in the anticipated future growth of the combined companies. These acquisitions can also serve as a talent acquisition vehicle to better enable us to compete for engagements in our focus areas.

We have been taking steps to make it easier for investors to trade in our stock. In January, we upgraded IAI’s listing from the OTC pink sheets to the OTCQB. We currently have a pending application to list our shars on the NASDAQ Capital Market.

Concentration of Risk

Our greatest concentration of risk for us is that a material portion of our gross profits and our income is derived from a few material subcontracts for professional services. For the three months ended September 30, 2021, three subcontracts under government procurements represented 54.4% of our revenue and 87.9% of our gross profit, respectively. For the nine months ended September 30, 2021, these same subcontracts represented 50.4% of our revenue and 78.7% of our gross profit, respectively.

Fluctuations in our revenue and concentrations of prime U.S. government contracts have ceased to be a material risk compared to our gross profits on professional fees contracts, as a large percentage of our sales under prime U.S. government contracts are software sales. The amount of such revenue does not have a material effect on gross profit.

At September 30, 2021, accounts receivable balances related to two professional services subcontracts under one prime contractor for projects at one federal agency collectively represented 63% of our outstanding accounts receivable. One other subcontract under federal procurements represented 12.3% outstanding accounts receivable.

We sold third-party software and maintenance contracts under multiple agreements with one major supplier. These sales accounted for 34.8% and 55.6% of total revenue in the three months ended September 30, 2021 and 2020, respectively, and 30.8% and 67.3% of revenue in the nine months ended September 30, 2021 and 2020, respectively.

Results of Operations

Three Months Ended September 30, 2021 versus Three Months Ended September 30, 2020

Revenue

Total revenue was $4,299,925 for the three months ended September 30, 2021, compared with $3,922,746 in the prior year quarter, an increase of $377,179, or 9.6%. Professional fees increased $1,217,421, or 77.0%, while software sales revenue decreased by $840,242, or 35.9%. Our acquisition of Tellenger represents approximately two-thirds of the increase in professional fees. The decrease in software revenue in 2021 versus the same period in 2020 is due to the non-recurring nature of software sales transactions, as well as the timing of recurring orders.

Gross Profit

Gross profit increased by $364,548, or 59.3%, to $978,875, in the third quarter of 2021 over the third quarter of 2020, due to the increase in the revenue generated from professional fees. Overall gross profit margin was 22.8% in 2021, up from 15.7% in 2020, due to the increase in professional fees revenue relative to software sales revenue. Gross profit percentage for professional fees in the third quarter of 2021 was 34.5%, while software sales generated a gross profit percentage of 0.9%. In 2021, we have added several new partnerships for software product lines that are expected to improve our gross profit margin.

Selling, General and Administrative Expenses

Selling, general and administrative expenses (SG&A) increased by $658,102 in the third quarter of 2021 over the prior year. Incorporating Tellenger’s administrative structure added $66,062 to our SG&A, and amortization of intangible assets (a non-cash expense) related to the Tellenger acquisition added another $44,061. Our efforts to attract and retain quality new members of our board of directors, the addition of an additional independent director, the increased use of share-based compensation (a non-cash expense) to attract and retain key employees and directors, management changes and administrative salaries, investor relations, a post-employment transition agreement with a retiring executive, increased legal expenses, and investment in our business resources, including our business development program and our accounting department, contributed to the increase in SG&A. Much of the increase in SG&A is associated with putting the resources in place necessary to position the Company for growth.

Acquisition Costs

We incurred legal, accounting, and other acquisition related expenses totaling $39,245 in the third quarter of 2021.

Income (Loss) from Operations

Loss from operations was $84,267 in the third quarter of 2021 compared to income from operations of $214,906 in 2020, a difference of $299,173. The decrease in income from operations is the net effect of increased gross profit of $364,548 being more than offset by increased SG&A costs of $658,102, as discussed above.

Nine Months Ended September 30, 2021 versus Nine Months Ended September 30, 2020

Revenue

Total revenue was $12,451,467 for the nine months ended September 30, 2021, compared with $10,803,897 in the prior year period, an increase of $1,647,570, or 15.2%. Professional fees increased $5,212,131, or 155.4%, while software sales revenue decreased by $3,564,561, or 47.8%. Our acquisition of Tellenger represents approximately one-third of the increase in professional fees. The decrease in our software revenue in the first nine months of 2021 versus the same period in 2020 is due to the non-recurring nature of many of our software sales transactions, including one software sales contract that expired after 2020 that contributed $1,931,692 to revenue each year, as well as the timing of recurring orders. Software sales are subject to considerable fluctuation from period to period, based on the product mix sold and referral fees earned.

Gross Profit

Gross profit increased by $1,672,282, or 130.4%, to $2,954,453, for the nine months ended September 30, 2021 over the comparable period of 2020, due to the increase in the revenue generated from professional fees. Maintaining a certain level of professional fees revenue is necessary to generate sufficient gross profit to cover the cost of our operations. Overall gross profit margin was 23.7% in 2021, up from 11.9% in 2020, due to the increase in professional fees revenue relative to software sales revenue. Gross profit percentage for professional fees for the nine months ended September 30, 2021 was 33.5%, while software sales generated a gross profit percentage of 2.2%. In 2021, we have added several new partnerships for software product lines that are expected to improve our gross profit margin. Our first sale under one of these new product lines, while a modest sale, produced a gross profit percentage of 19.3%.

Selling, General and Administrative Expenses

SG&A increased by $1,296,919 for the nine months ended September 30, 2021 over the prior year. Incorporating Tellenger’s administrative structure added $146,807 to our SG&A, and amortization of intangible assets (a non-cash expense) related to the Tellenger acquisition added another $87,912. Our efforts to attract and retain quality new members of our board of directors, the addition of an additional independent director, the increased use of share-based compensation (a non-cash expense) to attract and retain key employees and directors, management changes and administrative salaries, investor relations, a post-employment transition agreement with a retiring executive, increased legal expenses, and investment in our business resources, including our business development program and our accounting department, contributed to the increase in SG&A. Much of the increase in SG&A is associated with putting the resources in place necessary to position the Company for growth.

Acquisition Costs

We incurred legal, accounting, and other expenses totaling $192,530 for the nine months ended September30, 2021, primarily related to the acquisition of Tellenger.

Income (Loss) from Operations

Income from operations was $238,583 for the nine months ended September 30, 2021 as compared to $52,850 for the comparable period of 2020, an increase of $185,733, or 351.4%. The increase in income from operations is the net effect of increased gross profit of $1,672,282 being partially offset by increased SG&A expenses of $1,296,919, as discussed above.

Liquidity and Capital Resources

Our beginning cash and cash equivalents balance, when combined with our cash flow from operations and proceeds from sales of common stock and exercise of stock options, was sufficient to provide financing for our operations. Our cash balance at September 30, 2021, was $3,682,613.

On August 26, 2021 we completed a private offering of 1,400,000 units at a price of $2.00 per unit, each unit consisting of one share of common stock and one warrant exercisable at $3.00 for one share of common stock. The warrants expire on August 31, 2026.

On April 16, 2021, we secured financing for a $1 million 24-month term loan and a $1 million revolving line of credit as joint borrowings of IAI and our subsidiary, Tellenger, Inc. The purpose of the term loan was to provide financing for the Tellenger acquisition, and the balance at September 30, 2021, was $791,667. The line of credit has a current balance of $402,306 and is limited to a borrowing base calculated based on our accounts receivable and expires on April 16, 2022. As of September 30, 2021, we had borrowing availability of $597,694 under this line of credit. In addition, we borrowed $150,000 from the sellers of Tellenger to provide additional net working capital support for the first ninety days following the transaction. The seller loan was repaid in July 2021.

In March 2021 we raised $495,999 in a private placement, and payments received from exercised stock options have added an additional $95,145 in 2021 through September 30.

Due to the coronavirus uncertainty, and pending staffing and payroll cuts due to liquidity constraints, the Company applied for a Paycheck Protection Program loan, guaranteed by the SBA. The Company was funded by its lender on April 20, 2020, in the amount of $450,000. The loan accrues interest at a fixed rate of 1% and has a term of two years. The first payment is deferred until the date the SBA remits the Company’s loan forgiveness amount to the lender, though interest accrues during the deferral period. The loan has been used exclusively to support maintaining employee payroll and benefits. We began making principal and interest payments in August 2021 while also continuing to pursue our application for loan forgiveness. On, October 6, 2021, we were notified that the bank had approved the full amount of $450,000 for forgiveness, and the forgiveness package had been submitted to the SBA for final approval. The SBA may take up to 90 days to complete their review of the submission. The Company expects its application for loan forgiveness to be fully resolved during the fourth quarter of 2021.

There was a financing component to one of our subcontracts under which we had accrued $545,152 through July 31, 2021. The full amount of the accrual was invoiced on September 8, 2021.

Based on our current cash position and operating plan, we anticipate that we will be able to meet our cash requirements for at least one year from the filing date of this Quarterly Report on Form 10-Q.

We have no material commitments for capital expenditures.

Disclosure Controls and Procedures

Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, and people performing similar functions, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as of September 30, 2021 (the “Evaluation Date”). Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (ii) is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

Changes in Internal Controls over Financial Reporting

In September 2021 the Company created the position of Senior Vice President & Corporate Controller which created an additional level of review for the Company's financial reporting. There were no other changes in the Company’s internal control over financial reporting during the quarter ended September 30, 2021, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Tellenger, Inc. had been privately held and utilized non-U.S.-GAAP financial reporting prior to being acquired. It had written procedures but insufficient and limited controls. The IAI accounting department reconstructed Tellenger’s prior years’ financial statements and assumed full control of Tellenger’s books. As such, Tellenger has now been fully integrated into the IAI systems of internal controls over financial reporting. Tellenger’s will be migrated into IAI’s primary accounting system by the start of the 2022 calendar year.

Inherent Limitations on Effectiveness of Controls

Because of the inherent limitations in all control systems, no control system can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of a person, by collusion of two or more people or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected. Notwithstanding these limitations, we believe that our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives.

“Item 1A. Risk Factors” of our annual report on Form 10-K for the year ended December 31, 2020, as amended, includes a discussion of our risk factors. There have been no material changes from the risk factors described in our annual report on Form 10-K for the year ended December 31, 2020.