Firefly Neuroscience, Inc.: Form 10-Q for the period ended Jun 30, 2022

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, 2021 (“Annual Report”) 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 ability to successfully execute our business plan and necessary transition activities following the acquisition of Gray Matters, Inc.
• Recent, past and future acquisitions and investments could disrupt our business and harm our financial condition and operating results.
• Our business is subject to risks related to the COVID-19 pandemic and the conflict in Ukraine.
• Our operating history and recent and proposed changes to our business model make it difficult to evaluate our current business and prospects and may increase the risk that we will not be successful.
• We have had operating losses in three of each of the last four years and may not achieve or maintain profitability in the future.
• If the cybersecurity, Internet of Things (“IoT”), enterprise resource planning (“ERP”), command and control (“C2”), or supply chain management (“SCM”) markets are not receptive to our solutions, our sales will not grow as quickly as anticipated, or at all, and our business, results of operations and financial condition would be harmed.
• A portion of our revenue is expected to be generated by sales to government entities, which are subject to a number of challenges and risks.
• We face intense competition and could lose market share to our competitors, which could adversely affect our business, financial condition, and results of operations.
• We rely on our management team and other key employees and will need additional personnel to grow our business, and the loss of one or more key employees or our inability to hire, integrate, train and retain qualified personnel, including members for our board of directors, could harm our business.
• Our business is subject to risks related to the use of blockchain and distributed ledger technology.
• We are dependent on a few key customer contracts for a significant portion of our future revenue, and a significant reduction in services to one or more of these contracts would reduce our future revenue and harm our anticipated operating results.
• Our Gray Matters business currently has one key customer and since our acquisition of GMI in December 2022, there have been delays in the timing of revenue recognition vs our initial expectations. Continued delays in recognizing revenue for GMI could have an adverse impact on the carrying value of the intangible assets and goodwill that was recorded in connection with the acquisition of GMI.
• Our proprietary rights may be difficult to enforce or protect, which could enable others to copy or use aspects of our products or subscriptions without compensating us.
• Our use of open-source software in our products and subscriptions could negatively affect our ability to sell our products and subscriptions and subject us to possible litigation.
• We are dependent on information technology, and disruptions, failures or security breaches of our information technology infrastructure could have a material adverse effect on our operations.
• We depend on computing infrastructure operated by Amazon Web Services (“AWS”), Microsoft, and other third parties to support some of our solutions and customers, and any errors, disruption, performance problems, or failure in their or our operational infrastructure could adversely affect our business, financial condition, and results of operations.
• Failure to comply with governmental laws and regulations could harm our business.
• We are subject to risks associated with our strategic investments, and impairments in the value of our investments could negatively impact our financial results.

20

WaveDancer, Inc. Form 10-Q June 30, 2022

• Our failure to raise additional capital or generate the significant capital necessary to expand our operations and invest in new products and subscriptions could reduce our ability to compete and could harm our business.
• The requirements of being a public company may strain our resources, divert management’s attention, and affect our ability to attract and retain qualified board members.
• If we are not able to maintain and enhance our brand and our reputation as a provider of high-quality security solutions and services, our business and results of operations may be adversely affected.

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 2021 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

Founded in 1979 as Information Analysis Incorporated, the Company changed its name to WaveDancer, Inc. and converted from a Virginia corporation to a Delaware corporation in December 2021. The Company is in the business of developing and maintaining information technology (“IT”) systems, modernizing client information systems, and performing other IT-related professional services to government and commercial organizations.

The Company is an IT provider primarily for the benefit of federal government agencies. At present, we primarily apply our technology, services and experience to legacy software migration and modernization, developing web-based and mobile device solutions, including dynamic electronic forms development and conversion, data analytics, and we are in the process of acquiring talent and expertise in developing cybersecurity and cloud services practices. Our focus is on enterprise IT solutions primarily relating to system modernization, cloud-based solutions and cybersecurity protection.

Since the Company’s inception, we have performed software development and conversion projects for over 100 commercial and government customers including, but not limited to, the Department of Agriculture, Department of Defense, Department of Education, Department of Homeland Security, Department of the Treasury, U.S. Small Business Administration, U.S. Army, U.S. Air Force, Department of Veterans Affairs, and General Dynamics Information Technology (formerly Computer Sciences Corporation, CSRA).

Modernization has been a core competency of the Company 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 acquisition in April 2021 of Tellenger, Inc. (“Tellenger”), which is now a wholly-owned subsidiary of the Company, we acquired competencies in web-based solutions and cybersecurity. Tellenger is a boutique IT consulting and software development firm specializing in modernization, software development, cybersecurity, cloud solutions, and data analytics. 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 modernization growth since there are billions of lines of code, in both the governmental and commercial sectors, that eventually must be modernized. It is also our intention to better leverage our resources, largely gained through the acquisition of Tellenger, to take advantage of the growth in the cybersecurity market.

In December 2021, we announced the reorganization of our entire professional services practice into Tellenger, and as a result, our professional services are contained in a single entity. Through Tellenger, we perform services such as business process re-engineering, cloud migrations, and Software-as-a-Service (“SaaS”) implementations on behalf of clients in the private and public sector with an aim to increase productivity, gain efficiencies, and achieve key performance indicators. Tellenger is appraised at Capability Maturity Model Integration (CMMI) Level 3.

Through our acquisition of Gray Matters, Inc. and in connection with our business transformation strategy which we discuss below, in December 2021 we gained access to blockchain and encryption algorithm technology. Gray Matters specializes in the supply chain management (“SCM”) industry and in United States intelligence, national security and diplomatic organizations. Gray Matters uses a “Zero Trust” product and is designed to secure and monitor the lifecycle of manufacturing through destruction and recycling.

We refer to the products and services offered by Tellenger and WaveDancer prior to the acquisition of GMI as “Legacy IAI”.

Our Strategy

Our strategy is to grow our business organically as well as through acquisitions.

Through the acquisitions of Tellenger and Gray Matters in 2021, we began to reposition our legacy professional services business by allocating resources away from third-party product reselling and toward professional services, which management viewed as higher margin, including within the SCM sector. In assessing the Company’s repositioning, management observed cybersecurity practices as evolving toward a zero-trust approach, the integration of blockchain as enhancing SCM, and the proliferation of Internet of Things (“IoT”) devices that were taking organizational networks to the edge. Additionally, we have been seeking to purchase other technology companies whose businesses complement the Company’s existing business and whose personnel would better enable us to compete for engagements in our focus areas.

To grow organically, we have hired and plan to continue to hire, business development personnel and intend to become more proactive in bidding as a prime contractor on government proposals and in expanding our outreach to larger prime contractors for subcontract and teaming opportunities.

Results of Operations – Three Months Ended June 30, 2022 and 2021

Revenue

Total revenue was $4,317,382 for the three months ended June 30, 2022, compared with $4,731,961 in the prior year quarter, a decrease of $414,579, or 8.8%. The decrease consists of: 1) professional services fees decrease of $483,580 including a decrease of $1,050,442 from our core professional services business, partially offset by $566,862 of revenue generated by the contracts from the Gray Matters acquisition; and 2) third-party software sales increase of $69,001. The decline in services revenue from our core professional services business has two major declining items: 1) one contract for which the 2021 first quarter included significant levels of overtime in connection with meeting an accelerated milestone, while in the 2022 quarter we did not devote overtime resources to the project ($397 thousand); and 2) one contract that ended in 2021($336 thousand).

Gross Profit

Gross profit decreased by $26,147 or 2.7%, to $929,781 for the three months ended June 30, 2022 as compared to $955,928 in the prior year quarter. The decrease in gross profit includes the following: 1) a decrease in professional services business from our core professional services business ($106 thousand); 2) an increase in margin on third-party software sales ($25 thousand); and 3) increased margin from our Gray Matters acquisition ($54 thousand). The decrease from our core professional services business of $106 thousand represents approximately 10% of the $1,050,442 revenue decline, reflecting the relatively higher margins on the business we retained in 2022 vs. 2021.

Selling, General and Administrative Expenses

Selling, general and administrative ("SG&A") expenses have increased significantly since the second half of 2021 when we began to implement our transformative strategy described in the Our Strategy section above and in our Annual Report. The following table shows the major elements of SG&A expenses for the three months ended June 30, 2022 and 2021 and the increases between periods:

Acquisition Costs

We incurred acquisition expenses totaling $356,159 in 2022 as compared to $82,756 in 2021. The current quarter expenses were incurred in connection with the terminated acquisition of Knowmadics. These expenses include fees for legal, tax and audit professional services as well as other costs to conduct due diligence and finalize a transaction.

Change in Fair Value of Contingent Consideration

Under the terms of the Gray Matters purchase agreement, the Seller is eligible to receive up to $4,000,000 of additional consideration, payable in cash, based on the amounts of revenue and gross profit achieved by GMI during the period from the acquisition date through December 31, 2022. In the purchase accounting for GMI, we recorded a contingent liability of $930 thousand based on our estimate for GMI’s performance in 2022. Since that initial estimate, there have been delays in the timing of revenue recognition that have pushed a material amount of the projected revenue and related gross profit outside of the one-year measurement period of the Seller's earnout provision. We do not believe that these delays adversely affect the longer-term prospects for the GMI business. The result of writing down the contingent liability has been the recognition of non-cash operating income of $942,609, as noted in Note 4. The additional $12,609 is additional expense recorded in the first quarter of 2021 driven by the impact of discounting the estimated gross liability to its present value as of March 31, 2022 versus December 31, 2021.

(Loss) Income from Operations

Loss from operations was $1,724,157 in the second quarter of 2022 compared to income from operations of $53,979 in 2021, a decrease of $1,778,135. The decrease in income from operations is the result of the decrease in gross profit of $26,147 and the increase in SG&A expenses and acquisition costs totaling $694,598, partially offset by the income from the change in fair value of contingent consideration recorded in connection with the Gray Matters acquisition of $942,609, all as discussed above.

Results of Operations – Six Months Ended June 30, 2022 and 2021

Revenue

Total revenue was $7,312,984 for the six months ended June 30, 2022, as compared to $8,151,541 in the comparable period in 2021, a decrease of $838,647, or 10.3%. The decrease includes 1) professional services fees net decrease of $856,149 including a net decrease of $1,423,011 from our core professional services business, partially offset by $566,862 of revenue generated from the Gray Matters acquisition; and 2) third-party software sales increase of $17,502. The decline in services revenue from our core professional services business has three major declining items: 1) one contract for which the 2021 first quarter included significant levels of overtime in connection with meeting an accelerated milestone, while in the 2022 quarter we did not devote overtime resources to the project ($953 thousand); 2) one contract that has transitioned to a maintenance phase where in 2021 we had revenues associated with systems conversion ($332 thousand); and 3) one contract that ended in 2021 ($563 thousand). These declining items were partially offset by increased revenues from having a full six months of the Tellenger acquisition in 2022 versus just over 3 months in 2021 ($421 thousand).

Gross Profit

Gross profit was $1,305,846 for the six months ended June 30, 2022, as compared to $1,975,578 in the comparable period in 2021, a decrease of $669,732 or 33.9%. Of this $669,732 decrease, $643,585 was generated in the first quarter and $26,147 in the second quarter. The decrease includes 1) professional services net gross profit decrease of $668,180 including a net decrease of $374,801 from our core professional services business and an additional negative gross profit of by $293,380 attributable to the Gray Matters acquisition; and 2) third-party software sales decrease of $1,551. The decline in services revenue from our core professional services business includes two major declining items: 1) one contract for which the 2021 first quarter included significant levels of overtime in connection with meeting an accelerated milestone, while in the 2022 quarter we did not devote overtime resources to the project ($414 thousand); and 2) one contract that has transitioned to a maintenance phase where in 2021 we had revenues associated with systems conversion ($220 thousand). These declining items were partially offset by increased gross profit from having a full six months of the Tellenger acquisition in 2022 versus just over three months in 2021 ($269 thousand).

Selling, General and Administrative Expenses

SG&A expenses have increased significantly since the second half of 2021 when we began to implement our transformative strategy described in the Our Strategy section above and in our Annual Report. The following table shows the major elements of SG&A expenses for the six months ended June 30, 2022 and 2021 and the increases between periods:

Acquisition Costs

We incurred acquisition expenses totaling $790,861 for the six months ended June 30, 2022 as compared to $153,286 for the six months ended June 30, 2021. The current year expenses were incurred in connection with the terminated acquisition of Knowmadics. These expenses include fees for legal, tax and audit professional services as well as other costs to conduct due diligence and finalize a transaction.

Change in Fair Value of Contingent Consideration

Under the terms of the Gray Matters purchase agreement, the Seller is eligible to receive up to $4,000,000 of additional consideration, payable in cash, based on the amounts of revenue and gross profit achieved by GMI during the period from the acquisition date through December 31, 2022. In the purchase accounting for GMI we recorded a contingent liability of $930,000 based on our estimate for GMI’s performance in 2022. Since that initial estimate there have been delays in the timing of revenue recognition that have pushed a material amount of the projected revenue and related gross profit outside of the one-year measurement period of the Seller's earnout provision. We do not believe that these delays adversely affect the longer-term prospects for the GMI business. The result of writing down the contingent liability has been the recognition of non-cash operating income of $930,000 as noted in Note 4.

(Loss) Income from Operations

Loss from operations was $4,509,745 for the six months ended June 30, 2022 compared to income from operations of $322,849 for the six months ended June 30, 2021, a decrease of $4,832,594. The decrease in income from operations is the result of the decrease in gross profit of $669,732 and the increase in SG&A expenses and acquisition costs totaling $5,032,862, partially offset by the income from the change in fair value of contingent consideration recorded in connection with the Gray Matters acquisition of $930,000, all as discussed above.

Liquidity and Capital Resources

On June 30, 2022, the Company had working capital of approximately $1.0 million, including cash and cash equivalents of $0.6 million, generated operating losses in 2022 and at June 30, 2022 had an accumulated deficit of $17.0 million. The Company intends to continue to pursue growth in revenue and profitability, at least in the near term, via acquisition. To implement this strategy, we have hired staff and implemented processes that are needed to identify, execute, and integrate acquisitions, and manage the Company post-acquisition. In addition, Gray Matters is an early-stage company that has required investments in sales, marketing, and engineering. While we intend to prioritize acquisition targets that are immediately accretive to operating cash flow, the Company will require additional capital to support its strategy. During August, 2022 the Company sold 1,562,506 unregistered shares of its common stock in a private offering at a price of $1.20 per share from which it raised aggregate gross proceeds of $1,875,000 and on July 8, 2022 the Company entered into a Common Stock Purchase Agreement with B. Riley Principal Capital II, LLC, by which it intends to raise additional capital through an equity line of credit. Based on our current cash position and operating plan, along with our capital raising efforts, 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 off-balance-sheet arrangements that have or are likely to have a material current or future effect on our financial condition, or changes in financial condition, liquidity or capital resources or 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 June 30, 2022 (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

There were no changes in the Company’s internal control over financial reporting during the quarter ended June 30, 2022, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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, 2021, 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, 2021.