Stem, Inc.: Form 10-Q for the period ended Jun 30, 2021

You should read the following management’s discussion and analysis of our financial condition and results of operations together with our unaudited condensed consolidated financial statements and related notes included under Part I, Item 1 of this Quarterly Report on Form 10-Q. This discussion and analysis should also be read together with our audited consolidated financial statements as of December 31, 2020 and 2019 and for the years ended December 31, 2020 and 2019 (“Annual Financial Statements”) and the section entitled “Stem’s Management’s Discussion and Analysis of Financial Condition and Results or Operations” contained in our Form S-1 filed with the SEC on July 19, 2021.You should carefully read the sections entitled “Special Note Regarding Forward-Looking Statements” and “Risk Factors” to gain an understanding of the important factors that could cause actual results to differ materially from our forward-looking statements. Throughout this section, unless otherwise noted “we”, “us”, “our” and the “Company” refer to Stem and its consolidated subsidiaries.

Star Peak Acquisition Corp. Merger

On April 28, 2021, Star Peak Energy Transition Corp. (“STPK”), an entity listed on the New York Stock Exchange under the trade symbol “STPK”, acquired Stem, Inc. (“Legacy Stem”), by the merger of STPK Merger Sub Corp., a Delaware corporation and wholly-owned subsidiary of STPK (“Merger Sub”), with and into Legacy Stem, with Legacy Stem continuing as the surviving entity and a wholly-owned subsidiary of STPK (the “Merger”). The public company resulting from the Merger was renamed Stem, Inc., which we refer to as “Stem”, “we”, “us”, “our”, or the Company, and is listed on the New York Stock Exchange under the trade symbol “STEM”. Upon the consummation of the Merger, Stem received approximately $550.3 million, net of fees and expenses. See Note 1 in the accompanying condensed consolidated financial statements for additional details regarding this transaction. For financial reporting purposes, Legacy Stem is treated as the accounting acquirer.

Overview

Our mission is to build and operate the largest, digitally connected, intelligent energy storage network for our customers. In order to fulfill our mission, (i) we provide our customers, which include commercial and industrial (“C&I”) enterprises as well as independent power producers, renewable project developers, utilities and grid operators, with an energy storage system, sourced from leading, global battery original equipment manufacturers (“OEMs”), that we deliver through our partners, including solar project developers and engineering, procurement and construction firms and (ii) through our Athena artificial intelligence (“AI”) platform (“Athena”), we provide our customers with on-going software-enabled services to operate the energy storage systems for 10 to 20 years. In addition, in all the markets where we operate our customers’ systems, we have agreements to manage the energy storage systems using the Athena platform to participate in energy markets and to share the revenue from such market participation.

We operate in two key areas within the energy storage landscape: Behind-the-Meter (“BTM”) and Front-of-the-Meter (“FTM”). An energy system’s position in relation to a customer’s electric meter determines whether it is designated a BTM or FTM system. BTM systems provide power that can be used on-site without interacting with the electric grid and passing through an electric meter. Our BTM systems reduce C&I customer energy bills and help our customers facilitate the achievement of their corporate environmental, social, and corporate governance (“ESG”) objectives. FTM, grid-connected systems provide power to off-site locations and must pass through an electric meter prior to reaching an end-user. Our FTM systems decrease risk for project developers, lead asset professionals, independent power producers and investors by adapting to dynamic energy market conditions in connection with the deployment of electricity and improving the value of energy storage over the course of their FTM system’s lifetime.

Since our inception in 2009, we have engaged in developing and marketing Athena’s software enabled services, raising capital, and recruiting personnel. We have incurred net operating losses and negative cash flows from operations each year since our inception. We have financed our operations primarily through the issuance of convertible preferred stock, debt financing, and cash flows from customers.

Our total revenue grew from $4.4 million for the three months ended June 30, 2020 to $19.3 million for the three months ended June 30, 2021. For the three months ended June 30, 2021 and 2020, we incurred net losses of $100.2 million and $19.0 million, respectively. Our total revenue grew from $8.5 million for the six months ended June 30, 2020 to $34.8 million for the six months ended June 30, 2021. For the six months ended June 30, 2021 and 2020, we incurred net losses of $182.8 million and $36.5 million, respectively. As of June 30, 2021, we had an accumulated deficit of $590.6 million.

We expect that our sales and marketing, research and development, regulatory and other expenses will continue to increase as we expand our marketing efforts to increase sales of our solutions, expand existing relationships with our customers, and obtain regulatory clearances or approvals for future product enhancements. In addition, we expect our general and administrative costs and expenses to increase due to the additional costs associated with scaling our business operations as well as being a public company, including legal, accounting, insurance, exchange listing and SEC compliance, investor relations and other costs and expenses.

Some Key Factors, Trends and Risks Affecting our Business

We believe that our performance and future success depend on several factors that present significant opportunities for us but also pose risks and challenges, including but not limited to:

Decline in Lithium-Ion Battery Costs

Our revenue growth is directly tied to the continued adoption of energy storage systems by our customers. The cost of lithium ion energy storage hardware has declined significantly in the last decade and has resulted in a large addressable market today. The market for energy storage is rapidly evolving, and while we believe costs will continue to decline, there is no guarantee. If costs do not continue to decline, or do not decline as quickly as we anticipate, this could adversely affect our ability to increase our revenue and grow our business.

Increase in Deployment of Renewables

Deployment of intermittent resources has accelerated over the last decade, and today, wind and solar have become a low cost fuel source. We expect the cost of generating renewable energy to continue to decline and deployments of energy storage systems to increase. As renewable energy sources of energy production are expected to represent a larger proportion of energy generation, grid instability rises due to their intermittency, which can be addressed by energy storage solutions.

Competition

We are currently a market leader in terms of capacity of energy storage under management. We intend to expand our market share over time by leveraging the network effect of Athena’s AI infrastructure. Existing competitors may expand their product offerings and sales strategies, and new competitors may enter the market. Furthermore, our competitors include other types of software providers and some hardware manufacturers that offer software solutions. If our market share declines due to increased competition, our revenue and ability to generate profits in the future may be adversely affected.

Government Regulation and Compliance

Although we are not regulated as a utility, the market for our product and services is heavily influenced by federal, state, and local government statutes and regulations concerning electricity. These statutes and regulations affect electricity pricing, net metering, incentives, taxation, competition with utilities, and the interconnection of customer-owned electricity generation. In the United States and internationally, governments continuously modify these statutes and regulations and acting through state utility or public service commissions, regularly change and adopt different rates for commercial customers. These changes can positively or negatively affect our ability to deliver cost savings to customers.

Impact of COVID-19

In March 2020, the World Health Organization declared the outbreak of the novel coronavirus disease (“COVID-19”) as a pandemic, adversely impacting global commercial activity and greatly disrupting supply chains and the manufacturing, delivery and installation of energy storage systems worldwide. As a result, we adjusted certain aspects of our operations to protect our employees and customers while still meeting customers’ needs for vital technology. Government and business responses to COVID-19, along with the rise of the COVID-19 Delta variant and resurgence of related disruptions, could have a continued material adverse impact on economic and market conditions and trigger a period of continued global economic slowdown. The continued uncertainty and fluidity of this situation precludes any predication as to the extent and duration of the economic impact of COVID-19. Government and business responses to COVID-19 and the Delta variant therefore present material uncertainty and risk with respect to the Company and its performance and could materially and adversely affect our business, financial condition, and results of operations.

In particular, we cannot predict the full impact the pandemic will have on the demand for our services, our sales cycles or installation timelines, the collections of accounts receivable, or spending by new customers. Furthermore, we cannot predict whether the pandemic will cause further customers to go out of business or continue to limit the ability of our direct sales force to travel to existing or potential customers, all of which could adversely affect our business, financial condition and results of operations. In addition, if supply chains become significantly disrupted due to additional outbreaks of the COVID-19 virus and the Delta variant or otherwise, or government and business responses including implementation of stringent health and safety guidelines, our ability to install and service energy systems could become adversely impacted.

Non-GAAP Financial Measures

In addition to our results determined in accordance with GAAP, we use Adjusted EBITDA and non-GAAP gross margin, which are non-GAAP financial measures, for financial and operational decision making and as a means to evaluate our operating performance and future prospects, develop internal budgets and financial goals, and to facilitate period-to-period comparisons. Our management believes that these non-GAAP financial measures provide meaningful supplemental information regarding our performance and liquidity by excluding certain expenses and expenditures that may not be indicative of our operating performance, such as stock-based compensation and other non-cash charges, as well as discrete cash charges that are infrequent in nature. We believe that both management and investors benefit from referring to these non-GAAP financial measures in assessing our performance and when planning, forecasting, and analyzing future periods. These non-GAAP financial measures also facilitate management’s internal comparisons to our historical performance and liquidity as well as comparisons to our competitors’ operating results. We believe these non-GAAP financial measures are useful to investors both because they (1) allow for greater transparency with respect to key metrics used by management in its financial and operational decision making and (2) are used by our institutional investors and the analyst community to help them analyze the health of our business.

Non-GAAP gross margin

We define non-GAAP gross margin as gross margin excluding amortization of capitalized software, impairments related to decommissioning of end-of-life systems, and certain operating expenses including communication and cloud services expenditures reclassified to cost of revenue.

The following table provides a reconciliation of gross margin (GAAP) to non-GAAP gross margin ($ in millions):

26

Adjusted EBITDA

We believe that Adjusted EBITDA is useful for investors to use in comparing our financial performance with the performance of other companies for the following reasons:

• Adjusted EBITDA is widely used by investors and securities analysts to measure a company’s operating performance without regard to items such as stock-based compensation expense, depreciation and interest expense, which can vary substantially from company to company depending upon their financing and capital structures, and the method by which assets were acquired; and
• Adjusted EBITDA provides consistency and comparability with our past financial performance, and facilitates comparisons with other companies, many of which use similar non-GAAP financial measures to supplement their GAAP results.

Our use of Adjusted EBITDA has limitations as an analytical tool, and you should not consider this measure in isolation or as a substitute for analysis of our financial results as reported under GAAP. Some of these limitations are as follows:

• Although depreciation expense is a non-cash charge, the assets being depreciated may have to be replaced in the future. Adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements or for new capital expenditure requirements;
• Adjusted EBITDA excludes stock-based compensation expense, which has been, and will continue to be for the foreseeable future, a significant recurring expense for our business and an important part of our compensation strategy;
• Adjusted EBITDA does not reflect: (1) changes in, or cash requirements for, our working capital needs; (2) interest expense, or the cash requirements necessary to service interest or principal payments on our debt, which reduces cash available to us; or (3) tax payments that may represent a reduction in cash available to us; and
• The expenses and other items that we exclude in our calculation of Adjusted EBITDA may differ from the expenses and other items, if any, that other companies may exclude from Adjusted EBITDA when they report their operating results.

Because of these limitations, Adjusted EBITDA should be considered along with other operating and financial performance measures presented in accordance with GAAP.

We define Adjusted EBITDA as net loss before depreciation and amortization, including amortization of internally developed software, net interest expense, further adjusted to exclude stock-based compensation and other income and expense items, including the change in fair value of warrants and embedded derivatives, vesting of warrants and loss on extinguishment of debt.

The following table provides a reconciliation of net loss to Adjusted EBITDA:

(in thousands)

(in thousands)

Key Metrics

The following table presents our key metrics:

(in thousands)

(in thousands)

Bookings

Due to the long-term nature of our contracts, bookings are a key metric that allows us to understand and evaluate the growth of our Company and our estimated future revenue related to customer contracts for our energy optimization services and transfer of energy storage systems. Bookings represents the accumulated value at a point in time of contracts that have been executed under both our host customer and partnership sales models.

For host customer sales, bookings represent the expected consideration from energy optimization services contracts, including estimated incentive payments that are earned by the host customer from utility companies in relation to the services provided by us and assigned by the host customer to us. For host customer sales, there are no differences between bookings and remaining performance obligations at any point in time.

For partnership sales, bookings are the sum of the expected consideration to be received from the transfer of hardware and energy optimization services (excluding any potential revenues from market participation). For partnership sales, even though we have secured an executed contract with estimated timing of project delivery and installation from the customer, we do not consider it a contract in accordance with ASC 606 or a remaining performance obligation until the customer has placed a binding purchase order. A signed customer contract is considered a booking as this indicates the customer has agreed to place a purchase order in the foreseeable future, which typically occurs within three (3) months of contract execution. However, executed customer contracts, without binding purchase orders, are cancellable without penalty by either party.

For partnership sales, once a purchase order has been executed, the booking is considered to be a contract in accordance with ASC 606, and therefore, gives rise to a remaining performance obligation as we have an obligation to transfer hardware and energy optimization services in our partnership agreements. We also have the contractual right to receive consideration for our performance obligations.

The accounting policy and timing of revenue recognition for host customer contracts and partnership arrangements that qualify as contracts with customers under ASC 606, are described within Note 3 of the notes to our annual Financial Statements.

Adjusted EBITDA

We calculate Adjusted EBITDA as net loss before net interest expense, income tax provision and depreciation and amortization, including amortization of internally developed software, further adjusted to exclude stock-based compensation and other income and expense items, including the change in fair value of warrants and embedded derivatives, vesting of warrants and loss on extinguishment of debt. See description of Adjusted EBITDA in Non-GAAP Financial Measures above.

Components of Our Results of Operations

Revenue

We generate service revenue and hardware revenue. Service revenue is generated through arrangements with host customers to provide energy optimization services using our proprietary cloud-based software platform coupled with a dedicated energy storage system owned and controlled by us throughout the term of the contract. Fees charged to customers for energy optimization services generally consist of recurring fixed monthly payments throughout the term of the contract and in some arrangements, an installation and/or upfront fee component. We may also receive incentives from utility companies in relation to the sale of our services.

We generate hardware revenue through partnership arrangements consisting of promises to sell an energy storage system to a solar plus storage project developers. Performance obligations are satisfied when the energy storage system along with all ancillary hardware components are delivered. The milestone payments received before the delivery of hardware is treated as deferred revenue. We separately generate services revenue through partnership arrangements by providing energy optimization services after the developer completes the installation of the project.

Cost of Revenue

Cost of hardware revenue includes the cost of the hardware, which generally includes the cost of the hardware purchased from a manufacturer, shipping, delivery, and other costs required to fulfill our obligation to deliver the energy storage system to the customer location. Cost of revenue may also include any impairment of energy storage systems held in our inventory for sale to our customer. Cost of hardware revenue related to the sale of energy storage systems is recognized when the delivery of the product is completed.

Cost of service revenue includes depreciation of the cost of energy storage systems we own under long-term customer contracts, which includes capitalized fulfillment costs, such as installation services, permitting and other related costs. Cost of revenue may also include any impairment of inventory and energy storage systems, along with system maintenance costs associated with the ongoing services provided to customers. Costs of revenue are recognized as energy optimization and other supporting services are provided to our customers throughout the term of the contract.

Gross Margin

Our gross margin fluctuates significantly from quarter to quarter. Gross margin, calculated as revenue less costs of revenue, has been, and will continue to be, affected by various factors, including fluctuations in the amount and mix of revenue and the amount and timing of investments to expand our customer base. We hope to increase both our gross margin in absolute dollars and as a percentage of revenue through enhanced operational efficiency and economies of scale.

Operating Expenses

Sales and Marketing

Sales and marketing expense consists of payroll and other related personnel costs, including salaries, stock-based compensation, employee benefits, and travel for our sales and marketing personnel. In addition, sales and marketing expense includes trade show costs, amortization of intangibles and others expenses. We expect to increase selling and marketing expense to support the overall growth in our business.

Research and development

Research and development expense consists primarily of payroll and other related personnel costs for engineers and third parties engaged in the design and development of products, third-party software and technologies, including salaries, bonus and stock-based compensation expense, project material costs, services and depreciation. We expect research and development expense to increase in future periods to support our growth, including continuing to invest in optimization, accuracy and reliability of our platform and other technology improvements to support and drive efficiency in our operations. These expenses may vary from period to period as a percentage of revenue, depending primarily upon when we choose to make more significant investments.

General and Administrative Expense

General and administrative expense consists of payroll and other related personnel costs, including salaries, stock-based compensation, employee benefits and expenses for executive management, legal, finance and other costs. In addition, general and administrative expense includes fees for professional services and occupancy costs. We expect our general and administrative expense to increase as we scale up headcount with the growth of our business, and as a result of operating as a public company, including compliance with the rules and regulations of the SEC, legal, audit, additional insurance expenses, investor relations activities, and other administrative and professional services.

Other Income (Expense), Net

Interest Expense

Interest expense consists primarily of interest on our outstanding borrowings under our outstanding notes payable, convertible promissory notes, and financing obligations and accretion on our asset retirement obligations.

Loss on Extinguishment of Debt

Loss on extinguishment of debt consists of penalties incurred in relation to the prepayment of our outstanding borrowings under our outstanding notes payable and the write-off of any unamortized debt issuance costs associated with such notes.

Change in Fair Value of Warrants and Embedded Derivatives

Change in fair value of warrants and embedded derivatives is related to the revaluation of our outstanding convertible preferred stock warrant liabilities and embedded derivatives related to the redemption features associated with our convertible notes at each reporting date.

Other Expenses, Net

Other expenses, net consists primarily of income from equity investments and foreign exchange gains or losses.

Results of Operations for the Three Months Ended June 30, 2021 and 2020

(In thousands, except percentage)

*Not meaningful

Revenue

Revenue increased by $15.0 million, or 342%, for the three months ended June 30, 2021, as compared to the three months ended June 30, 2020. The increase was primarily driven by a $13.5 million increase in hardware revenue due to increase in demand for systems related to FTM partnership agreements. Services revenue increased by $1.5 million primarily due to continued growth in host customers arrangements and partnership revenue related to services provided.

Cost of Revenue

Cost of revenue increased by $13.3 million, or 218%, for the three months ended June 30, 2021, as compared to the three months ended June 30, 2020. The increase was primarily driven by an increase of cost of hardware sales of $13.0 million in line with the increase in hardware revenue and an increase of $0.3 million in cost of service revenue associated with growth in service revenue.

Operating Expenses

Sales and Marketing

Sales and marketing expense decreased by $0.3 million, or 8%, for the three months ended June 30, 2021, as compared to the three months ended June 30, 2020. The decrease was primarily due to lower marketing expense by $0.2 million compared to to 2020 during which educational material to sell, model and deploy energy storage systems was created, An increase in capitalized commissions in 2021 by $0.1 million due to higher volume of sales in 2021 added to the variance..

Research and Development

Research and development expense increased by $1.2 million, or 33%, for the three months ended June 30, 2021, as compared to the three months ended June 30, 2020. The increase was primarily due to higher personnel related costs as a result of higher headcount to support the growth of our operations.

General and Administrative

General and administrative expense increased by $12.6, or 525% for the three months ended June 30, 2021 compared to the three months ended June 30, 2020. The increase was primarily driven by an increase of $10.1 million in professional and legal services, an increase of $1.1 million in insurance and office related expenses, an increase of $0.9 million in personnel related costs due to increase in headcount and an increase of $0.5 million in stock-based compensation as a result of additional options to purchase our common stock granted to certain executives and other key employees.

Other Income (Expense), Net

Interest Expense

Interest expense increased by $1.3 million, or 24%, for the three months ended June 30, 2021 compared to the three months ended June 30, 2020. an The increase was partially offset by a decrease of $1.3 million in interest expense due to the repayment of notes payable in 2021.

Loss on Extinguishment of Debt

Loss on extinguishment of debt increased by $5.1 million for the three months ended June 30, 2021 compared to the three months ended June 30, 2020. The increase was driven by payment of a $4.0 million penalty on debt extinguishment and the write-off of $1.1 million of unamortized debt issuance costs upon the conversion of our Series D convertible notes in relation to the Merger.

Change in Fair Value of Warrants and Embedded Derivative

Change in fair value of warrants and embedded derivative increased by a $65.3 million for the three months ended June 30, 2021 compared to the three months ended June 30, 2020. This increase was due to the increase in the fair value of warrant liabilities in 2021.

Other Expenses, Net

Other expenses, net increased by $0.3 million, or 217%, for the three months ended June 30, 2021 compared to the three months ended June 30, 2020. The net increase was primarily driven by foreign exchange losses realized in the period related to operations in Canada.

Results of Operations for the Six Months Ended June 30, 2021 and 2020

(In thousands, except percentage)

*Not meaningful

Revenue

Revenue increased by $26.3 million, or 309%, for the six months ended June 30, 2021, as compared to the six months ended June 30, 2020. The increase was primarily driven by a $23.3 million increase in hardware revenue as our sales of standalone systems related to FTM partnership agreements continue to grow. Services revenue increased by $3.0 million primarily due to continued growth in host customers arrangements and partnership revenue related to services provided.

Cost of Revenue

Cost of revenue increased by $23.4 million, or 201%, for the six months ended June 30, 2021, as compared to the six months ended June 30, 2020. The increase was primarily driven by an increase of cost of hardware sales of $20.9 million in line with the increase in hardware revenue and an increase of $2.5 million in cost of service revenue associated with growth in service revenue.

Operating Expenses

Sales and Marketing

Sales and marketing expense decreased by $2.1 million, or 24%, for the six months ended June 30, 2021, as compared to the six months ended June 30, 2020. The decrease was primarily due to a decrease of $0.8 million in personnel related costs as a result of turnover in the period, a decrease of $0.6 million in commission expenses as a result of a change in our commission plan structure, and a $0.2 million increase in capitalized commissions. Higher costs in marketing consulting expense by $0.5 million in 2020 compared to 2021.

Research and Development

Research and development expense increased by $2.2 million, or 31%, for the six months ended June 30, 2021, as compared to the six months ended June 30, 2020. The increase was primarily due to an increase of $3.6 million in personnel related costs as a result of increased headcount, which was partially offset by an increase of $1.4 million in capitalized software development costs.

General and Administrative

General and administrative expense increased by $12.3 million, or 229%, for the six months ended June 30, 2021, as compared to the six months ended June 30, 2020. The increase was primarily driven by $9.1 million of warrants issued for services in April 2021, an increase of $1.5 million in professional and legal services, an increase of $1.0 million in insurance related expenses, and an increase of $0.7 million in personnel-related costs due to higher headcount.

Other Income (Expense), Net

Interest Expense

Interest expense increased by $0.6 million, or 6%, for the six months ended June 30, 2021, as compared to the six months ended June 30, 2020. An increase of $0.6 million in interest expense mainly from the issuance of Series D convertible notes from October 2020 through January 2021.

Loss on Extinguishment of Debt

Loss on extinguishment of debt increased by $5.1 million for the six months ended June 30, 2021 compared to the six months ended June 30, 2020. The increase was driven by payment of a $4.0 million penalty on debt extinguishment and the write-off of $1.1 million of unamortized debt issuance costs upon the conversion of our Series D convertible notes in relation to the Merger.

Change in Fair Value of Warrants and Embedded Derivative

Change in fair value of warrants and embedded derivative increased by $132.7 million for the six months ended June 30, 2021, as compared to the six months ended June 30, 2020. This increase was due to the increase in the fair value of warrant liabilities in 2021.

Other Expenses, Net

Other expenses, net decreased by $1.6 million, or 89%, for the six months ended June 30, 2021, as compared to the six months ended June 30, 2020. The net decrease was primarily driven by $1.2 million in legal settlement and late fees incurred in the six months ended June 30, 2021 and a $0.4 million decrease in foreign exchange losses realized in the period related to operations in Canada.

Liquidity and Capital Resources

Sources of liquidity

Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of its business operations, including working capital needs, debt service, acquisitions, contractual obligations and other commitments. We assess liquidity in terms of our cash flows from operations and their sufficiency to fund our operating and investing activities. To meet our payment service obligations we must have sufficient liquid assets and be able to move funds on a timely basis.

As of June 30, 2021, our principal source of liquidity is cash generated from financing activities. Cash generated from financing activities through June 30, 2021 primarily includes proceeds from the Merger that provided us with approximately $550.3 million, net of fees and expenses, sales of convertible preferred stock, proceeds from convertible notes, and proceeds from our various borrowings. In connection with the Merger, the convertible notes and related accrued interest converted to equity and we paid in full all other outstanding debt except the 2021 Credit Agreement described below. We believe that our cash position is sufficient to meet our capital and liquidity requirements for at least the next 12 months after the date that the condensed consolidated financial statements are available to be issued and thereafter for the foreseeable future; therefore, there is not substantial doubt about the Company’s ability to continue as a going concern.

Our business prospects are subject to risks, expenses and uncertainties frequently encountered by companies in the early stages of commercial operations. The attainment of profitable operations is dependent upon future events, including obtaining adequate financing to complete our development activities, obtaining adequate supplier relationships, building our customer base, successfully executing our business and marketing strategy and hiring appropriate personnel. Failure to generate sufficient revenues, achieve planned gross margins and operating profitability, control operating costs, or secure additional funding may require us to modify, delay, or abandon some of our planned future expansion or development, or to otherwise enact operating cost reductions available to management, which could have a material adverse effect on our business, operating results, financial condition and ability to achieve our intended business objectives.

In the future, we may be required to obtain additional equity or debt financing in order to support our continued capital expenditures and operations. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital or generate cash flows necessary to expand our operations and invest in new technologies, this could reduce our ability to compete successfully and harm our business, growth and results of operations.

The Company’s long-term liquidity requirements primarily are linked to the continued extension of the Athena platform and the use of our balance sheet to improve the terms and conditions associated with the purchase of energy storage systems from our hardware vendors. While we have plans to potentially expand our geographical footprint beyond our current partnerships and enter into joint ventures, those are not required initiatives to achieve our plan.

In addition to the foregoing, based on our current assessment, we do not expect any material adverse effect on our long-term liquidity due to the COVID-19 pandemic or government responses thereto. However, we will continue to assess these effects to our operations. The extent to which the COVID-19 pandemic and government and business responses thereto will affect our business and operations will continue to depend on future developments that are highly uncertain and cannot be predicted with confidence, such as the ultimate geographic spread of the disease, the duration of the pandemic, any restrictions on the ability of hospitals and trial sites to conduct trials that are not designed to address the COVID-19 pandemic and the perceived effectiveness of actions taken in the United States and other countries to contain and treat the disease. While the potential economic impact brought by COVID-19 and government and business responses may be difficult to assess or predict, a widespread pandemic and government and business responses could result in significant disruption of global financial markets, reducing our ability to access capital in the future. In addition, a recession or long-term market correction resulting from the spread of COVID-19 or government and business responses could materially affect our business and the value of our common stock.

Financing Obligations

We have entered into arrangements wherein we finance the cost of energy storage systems via special purpose entities (“SPE”) we establish with outside investors. These SPEs are not consolidated into our financial statements, but are accounted for as equity method investments. Through the SPEs, the investors provide us upfront payments. Under these arrangements, the payment by the SPE to us is accounted for as a borrowing by recording the proceeds received as a financing obligation. The financing obligation is repaid with the future customer payments and incentives received. A portion of the amounts paid to the SPE is allocated to interest expense using the effective interest rate method.

Furthermore, we continue to account for the revenues from customer arrangements and incentives and all associated costs despite such systems being legally sold to the SPEs due to our significant continuing involvement in the operations of the energy storage systems.

The total financing obligation as of June 30, 2021 was $89.8 million, of which $15.3 million was classified as a current liability.

Notes Payable

Revolving Loan Due to SPE Member

In April 2017, we entered into a revolving loan agreement with an affiliate of a member of certain SPEs in which we have an ownership interest. The purpose of this revolving loan agreement is to finance the Company’s purchase of hardware for its various energy storage system projects. We have amended the loan from time to time as our business has grown, and as of the beginning of 2020, the agreement had a total revolving loan capacity of $45.0 million that bore fixed interest at 10% with a maturity date of June 2020.

In May 2020, concurrent with the 2020 Credit Agreement discussed below, we amended the facility to reduce the loan capacity to $35.0 million and extend the maturity date to May 2021. The amendment increased the fixed interest rate for any borrowings outstanding more than nine (9) months to 14% thereafter.

Additionally, under the original terms of the revolving loan agreement, we were able to finance 100% of the value of the hardware purchased up to the total loan capacity. The amendment reduced the advance rate to 85%, with an additional reduction to 70% in August 2020. We had $9.6 million outstanding under this revolving loan agreement as of March 31, 2021. In April 2021, we repaid the remaining outstanding balance in full.

Term Loan Due to SPE Member

In December 2018, we entered into a term loan in the amount of $13.3 million with an affiliate of a member of certain SPEs in which we have an ownership interest. As of the beginning of 2020, this term loan bore fixed interest of 12.5% on the outstanding principal balance with a final balloon payment of $3.0 million due at the maturity date of June 30, 2020. In May 2020, we repaid the remaining outstanding balance of $5.9 million with the proceeds received through the 2020 Credit Agreement discussed below.

Term Loan Due to Former Non-Controlling Interest Holder

In June 2018, we acquired the outstanding member interests of an entity we controlled for $8.1 million. We financed this acquisition by entering into a term loan agreement with the noncontrolling member bearing fixed interest of 18% (4.5% quarterly) on the outstanding principal balance. This loan requires fixed quarterly payments throughout the term of the loan, which will be paid in full by April 1, 2026. In May 2020, we amended the term loan and, using the proceeds from the 2020 Credit Agreement discussed below, prepaid $1.5 million of principal and interest on the note, of which $1.0 million was towards the outstanding principal balance, thereby reducing the fixed quarterly payment due to the lender. In relation to this amendment, we were required to issue warrants for 400,000 shares of common stock resulting in a discount to the term loan of $0.2 million. Such debt discount is amortized to earnings through interest expense over the expected life of the debt. In April 2021, we repaid the remaining outstanding balance in full.

2020 Credit Agreement

In May 2020, we entered into a credit agreement (“2020 Credit Agreement”) with a new lender that provided us with proceeds of $25.0 million that increased our access to working capital. The 2020 Credit Agreement has a maturity date of the earlier of (1) May 14, 2021, (2) the maturity date of the revolving loan agreement, or (3) the maturity date of the convertible promissory notes discussed below. The loan bears interest of 12% per annum, of which 8% is paid in cash and 4% is added back to principal of the loan balance every quarter. We used a portion of the proceeds towards payments associated with existing debt as previously discussed. In April 2021, we repaid the remaining outstanding balance in full.

2021 Credit Agreement

In January 2021, we entered into a non-recourse credit agreement to provide a total of $2.7 million towards the financing of certain energy storage systems that we own and operate. The credit agreement has a stated interest of 5.45% and a maturity date of June 2031. We received an advance under the credit agreement of $1.8 million in January 2021. The repayment of advances received under this credit agreement is determined by the lender based on the proceeds generated by us through the operation of the underlying energy storage systems. We have $1.8 million of outstanding borrowings under this credit agreement as of June 30, 2021.

Cash Flows

The following table summarizes our cash flows for the periods indicated (in thousands):

Operating Activities

During the six months ended June 30, 2021, net cash used in operating activities was $41.8 million, primarily resulting from our operating loss of $182.8 million, adjusted for non-cash charges of $163.7 million and net cash outflows of $22.8 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of depreciation and amortization of $10.3 million, non-cash interest expense of $7.1 million, which includes interest expenses associated with debt issuance costs, stock-based compensation expense of $1.8 million, change in the fair value of warrant liability and embedded derivative of $133.6 million, impairment of energy storage systems of $1.3 million, and issuance of warrants for services of $9.2 million. The net cash inflow from changes in operating assets and liabilities was primarily driven by an increase in deferred revenue of $3.3 million and an increase in accounts payable and accrued expenses of $3.3 million, partially offset by an increase in inventory of $6.3 million, an increase in other assets of $16.9 million, an increase in accounts receivable of $4.2 million, and an increase in contract origination costs of $1.7 million.

During the six months ended June 30, 2020, net cash used in operating activities was $16.5 million, primarily resulting from our operating loss of $36.5 million, offset by non-cash charges of $15.8 million and net cash inflows of $4.2 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of depreciation and amortization of $7.9 million, non-cash interest expense of $4.6 million, which includes interest expenses associated with debt issuance costs, stock-based compensation expense of $0.9 million, change in the fair value of warrant liability and embedded derivative of $0.9 million, and impairment of energy storage systems of $0.9 million. The net cash inflow from changes in operating assets and liabilities was primarily driven by an increase in deferred revenue of $12.3 million, an increase in accounts payable and accrued expenses of $0.4 million, and a decrease in accounts receivable of $2.2 million, partially offset by increase in inventory of $6.3 million, an increase in contract origination costs of $1.4 million, and an increase in other assets of $2.7 million.

Investing Activities

During the six months ended June 30, 2021, net cash used for investing activities was $8.6 million, primarily consisting of $5.6 million in purchase of energy systems and $2.7 million in capital expenditures on internally-developed software.

During the six months ended June 30, 2020, net cash used for investing activities was $10.2 million, consisting of $7.6 million in purchase of energy systems and $2.6 million in capital expenditures on internally-developed software.

Financing Activities

During the six months ended June 30, 2021, net cash provided by financing activities was $517.2 million, primarily consisting of net proceeds from the Merger and PIPE financing of $550.3 million, proceeds from issuance of notes payable of $3.9 million, proceeds from financing obligations of $4.9 million, proceeds from exercise of stock options and warrants of $2.9 million, net proceeds from issuance of convertible promissory notes of $1.1 million, partially offset by repayment of notes payable and financing obligations of $41.4 million and $4.6 million, respectively.

During the six months ended June 30, 2020, net cash provided by financing activities was $22.1 million, primarily resulting from net proceeds from issuance of convertible notes of $14.1 million, net proceeds from issuance of notes payable of $23.5 million, proceeds from financing obligations of $8.4 million, partially offset by repayment of notes payable of $19.7 million and repayment of financing obligations of $4.3 million.

Contractual Obligations and Commitments

There have been no material changes to our contractual obligations described in our registration statement on Form S-1 as filed with the SEC on July 19, 2021.

Off-Balance Sheet Arrangements

We are not a party to any off-balance sheet arrangements, including guarantee contracts, retained or contingent interests, or unconsolidated variable interest entities that either have, or are reasonably likely to have, a current or future material effect on our consolidated financial statements.

Critical Accounting Policies and Estimates

A summary of our critical accounting policies and estimates is presented in our registration statement on Form S-1 filed with the SEC on July 19, 2021. Information with respect to changes in our critical accounting policies can be found in Note 2 of the Notes to the unaudited condensed consolidated financial statements in this report, which information is incorporated herein by reference..

Recent Accounting Pronouncements

Information with respect to recent accounting pronouncements may be found in Note 2 of the Notes to the unaudited condensed consolidated financial statements in this report, which information is incorporated herein by reference.

Special Note Regarding Forward-Looking Statements

This second-quarter 2021 Form 10-Q, as well as other statements we make, contains “forward-looking statements” within the meaning of the federal securities laws, which include any statements that are not historical facts. Such statements often contain words such as “expect,” “may,” “can,” “believe,” “predict,” “plan,” “potential,” “projected,” “projections,” “forecast,” “estimate,” “intend,” “anticipate,” “ambition,” “goal,” “target,” “think,” “should,” “could,” “would,” “will,” “hope” “see,” “likely,” and other similar words.

Forward-looking statements address matters that are, to varying degrees, uncertain, such as statements about the reduction of greenhouse gas (“GHG”) emissions; the integration and optimization of energy resources; the business strategies of Stem and those of its customers; the global commitment to decarbonization; our ability to retain or upgrade current customers, further penetrate existing markets or expand into new markets; our ability to manage our supply chains and distribution channels and the impact of natural disasters and other events beyond our control, such as the COVID-19 pandemic and the Delta variant, and government and business responses thereto; and future results of operations. Such forward-looking statements are subject to risks, uncertainties, and other factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These forward-looking statements are based upon assumptions and estimates that, while considered reasonable by Stem and its management, depend upon inherently uncertain factors and risks that may cause actual results to differ materially from current expectations, including our inability to help reduce GHG emissions; our inability to seamlessly integrate and optimize energy resources; our inability to achieve our financial and performance targets and other forecasts and expectations; our inability to recognize the anticipated benefits of our recent business combination with Star Peak Energy Transition Corp. (“Star Peak”); our ability to grow and manage growth profitably; risks relating to the development and performance of our energy storage systems and software-enabled services; the risk that the global commitment to decarbonization may not materialize as we predict, or even if it does, that we might not be able to benefit therefrom; our inability to retain or upgrade current customers, further penetrate existing markets or expand into new markets; our inability to secure sufficient inventory from our suppliers to meet customer demand, and provide us with contracted quantities of equipment; supply chain interruptions and manufacturing or delivery delays; disruptions in sales, production, service or other business activities; our inability to attract and retain qualified personnel; the risk that our business, financial condition and results of operations may be adversely affected by other political, economic, business and competitive factors; and other risks and uncertainties set forth in this Form 10-Q, the section entitled “Risk Factors” in the definitive proxy statement relating to the business combination filed by Star Peak on March 30, 2021, the Form 10-K/A filed by Star Peak with the SEC on April 26, 2021, and our Forms 8-K filed with or furnished to the SEC. If one or more of these or other risks or uncertainties materialize (or the consequences of any such development changes), or should our underlying assumptions prove incorrect, actual outcomes may vary materially from those reflected in our forward-looking statements. Statements in this second-quarter 2021 Form 10-Q are made as of August 11, 2021, and Stem disclaims any intention or obligation to update publicly or revise such statements, whether as a result of new information, future events or otherwise.

1. Disclosure Controls and Procedures

We maintain disclosure controls and procedures (Disclosure Controls) within the meaning of Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Our Disclosure Controls are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act, such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Our Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our Disclosure Controls, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily applied its judgment in evaluating and implementing possible controls and procedures.

As of the end of the period covered by this Quarterly Report on Form 10-Q, we evaluated the effectiveness of the design and operation of our Disclosure Controls, which was done under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer. Based on the evaluation of our Disclosure Controls, our Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2021, our Disclosure Controls were not effective due to a material weakness in the Company’s internal control over financial reporting as disclosed below.

2. Material Weaknesses in Internal Control Over Financial Reporting

During the course of preparing our financial statements as of and for the year ended December 31, 2020, management identified certain deficiencies in our internal controls over financial reporting that management believes to be a material weaknesses. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that a reasonable possibility exists that a material misstatement of our annual or interim financial statements would not be prevented or detected on a timely basis.

Specifically, the material weaknesses identified relate to (i) ineffective internal controls over accounting for complex and significant transactions, (ii) accounting for energy storage systems, deferred cost of goods sold and inventory, (iii) ineffective internal controls over review of the Company’s consolidated financial statements and related disclosures, (iv) a lack of formality in our internal control activities, especially related to management review-type controls, (v) ineffective internal controls over the review of certain revenue recognition calculations, and (vi) ineffective internal controls over the review of internal-use capitalized software calculations. With respect to accounting for complex and significant transactions, deficiencies exist in our process for ensuring the completeness of information utilized in various technical accounting analyses and, in certain instances, the proper application of the relevant accounting literature, including the determination of the appropriate valuation methodology. These deficiencies could result in material adjustments for certain transactions, including interest capitalization and accounting for convertible notes, and accounting and valuation of embedded derivatives and warrant liabilities. With respect to energy storage systems, inventory and deferred cost of goods sold, we did not properly track inflows and outflows, including the valuation of energy storage systems, due in part to the systems that the Company used to track and value energy storage systems and inventory. With respect to a lack of formality in our control activities, we did not sufficiently establish formal policies and procedures to design effective controls, establish responsibilities to execute these policies and procedures and hold individuals accountable for performance of these responsibilities, including over review over revenue recognition and internal-use capitalized software calculations. We had multiple control deficiencies aggregating to a material weakness over ineffective control activities.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements or prevent or detect all error and fraud. Any control system, no matter how well designed and operated, is based upon certain assumptions, and can provide only reasonable, not absolute, assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

3. Plan to Remediate Material Weaknesses in Internal Control Over Financial Reporting

The Company, with oversight of the Audit Committee of the Board, is devoting significant time, attention, and resources to remediating the above material weaknesses in our internal control over financing reporting. As of June 30, 2021, the Company had initiated the following steps intended to remediate the material weakness described above and strengthen our internal control over financial reporting:

• Develop and deliver internal controls training to executives, other management and finance/accounting resources. The training includes a review of management’s and individual roles and responsibilities related to internal controls;
• Hire, train and develop experienced accounting executives and personnel with a level of public accounting knowledge and experience in the application of US GAAP commensurate with our financial reporting requirements and the complexity of our operations and transactions. A portion of their job responsibilities is to perform reviews, reconciliations and other financial reporting monitoring controls.
• Establish and implement policies and practices for the attraction, development and retention of competent public accounting personnel in alignment with objectives.

We plan to continue to devote significant time and attention to remediate the above material weaknesses as soon as reasonably practicable. As we continue to evaluate our controls, we will make the necessary changes to improve our demonstration of commitment to attract, develop and retain competent individuals in alignment with objectives. We believe these actions will be sufficient to remediate the identified material weaknesses and strengthen our internal control over financial reporting; however, there can be no guarantee that such remediation will be sufficient. We will continue to evaluate the effectiveness of our controls and will make any further changes management determines appropriate.

There have been no material changes to the risk factors disclosed in Part 1, Item 1A, of our registration statement on Form S-1 filed with the SEC on July 19, 2021.