System1, Inc.: Form 10-Q for the period ended Sep 30, 2022

SYSTEM1 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Unless otherwise indicated or the context otherwise requires, references in this section to “the Company,” “System1,” “we,” “us,” “our” and other similar terms refer to System1 Inc. and its subsidiaries.

The following discussion and analysis of the financial condition and results of operations of System1 should be read together with our unaudited condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q, as well as our prospectus, dated April 13, 2022, filed with the Securities and Exchange Commission, or SEC. The following discussion and analysis should also be read together with the section entitled “Organization and description of business” as of September 30, 2022 (Successor) and for the period from January 1, 2022 through January 26, 2022 (Predecessor), the period from January 27, 2022 through September 30, 2022 (Successor) and for the year ended December 31, 2021 (Predecessor). In addition to historical information, the following discussion and analysis contains forward-looking statements. Our actual results may differ significantly from those projected in such forward-looking statements. Factors that might cause future results to differ materially from those projected in such forward-looking statements include, but are not limited to, those discussed in the sections entitled “Risk Factors,” Dollars, number of shares and number of units are presented in thousands, except percentages, per share and per unit information,unless otherwise noted.

References to “Notes” are notes included in our unaudited condensed consolidated financial statements appearing elsewhere in this Quarterly Report on Form 10-Q.

Company Overview

We operate an omnichannel customer acquisition platform, delivering high-intent customers to advertisers and sell antivirus software packages to end user customers.

We provide our omnichannel customer acquisition platform services through our proprietary responsive acquisition marketing platform (“RAMP”). Operating seamlessly across major advertising networks and advertising category verticals to acquire users on our behalf, RAMP allows us to monetize these acquired users through our relationships with third party advertisers and advertising networks (“Advertising Partners”). RAMP also allows third party advertising platforms and publishers (“Network Partners”), to send user traffic to, and monetize user traffic on, our owned and operated websites. RAMP operates across our network of owned and operated websites and related products, allowing us to monetize user traffic that we source from various acquisition marketing channels, including Google, Facebook, Taboola, Snapchat and TikTok.

Through RAMP, we process approximately 27 million daily advertising campaign optimizations and ingest 6 billion rows of data daily across 40 plus advertising verticals as of September 30, 2022. We are able to efficiently monetize user intent by linking data on consumer engagement, such as first party search data, with data on monetization and advertising spend. This context-enriched data, combined with our proprietary and data science driven algorithms, creates a closed-loop system that is not reliant on personally identifiable information or information obtained through third-party cookies, but which allows RAMP to efficiently match consumer demand with the appropriate advertiser or advertising experience across advertising verticals.

The business of S1 Holdco, LLC (“S1 Holdco”), one of the entities acquired in the Merger described below, was founded in 2013 with a focus on monetizing user traffic acquired by its network. Since launching, it has expanded to support additional advertising formats across numerous advertising platforms, and has acquired several leading websites, enabling it to control user acquisition and experience, and monetize user traffic on its behalf. Today S1 Holdco owns and operates over 40 websites, including leading search engines like info.com and Startpage.com, and publishing digital media sites and utilities, such as HowStuffWorks, Mapquest and ActiveBeat.

We, through Protected.net, also provide antivirus software solutions, offering our customers a single packaged solution that provides protection and reporting to the end user. We deliver our antivirus software solutions directly to end-user customers around the world. The antivirus software solutions product offering comprises a core security package with varying levels of extra protection based on a customer's specific needs. These products include antivirus software available on an unlimited number of devices, Adblock, ID Protect and are managed to ensure they provide a value-added service to the customer base. The software is sold in either a monthly or annual subscription predominantly through the flagship brand TotalAV. As of September 30, 2022, Protected.net had over 2.3 million active subscribers for its products.

Our primary operations are in the United States; and we also have operations in Canada, the United Kingdom and the Netherlands. Operations outside the United States are subject to risks inherent in operating under different legal systems and various political and economic environments. Among the risks are changes in existing tax laws, possible limitations on foreign investment and income repatriation, government foreign exchange controls, and exposure to currency exchange fluctuations. We do not engage in hedging activities to mitigate our exposure to fluctuations in foreign currency exchange rates.

The Merger

On June 28, 2021, the Company entered into a Business Combination Agreement (as amended on November 30, 2021, January 10, 2022 and January 25, 2022), (the “Business Combination Agreement”) by and among S1 Holdco, Trebia, and Protected (collectively, the “Companies”). On January 27, 2022 (the “Closing Date”), the Company consummated the business combination (the “Merger”) pursuant to the Business Combination Agreement. Following the consummation of the Merger, the combined company was organized via an “Up-C” structure, in which substantially all of the assets and business operations of System1 are held by S1 Holdco. The combined Companies’ business continues to operate through the subsidiaries of S1 Holdco and Protected. Additionally, Trebia’s ordinary shares, warrants and units ceased trading on the New York Stock Exchange (“NYSE”), and System1 Inc.s Class A common stock and the Public Warrants began trading on the NYSE on January 28, 2022 under the symbols “SST” and “SST.WS,” respectively.

The consideration paid to the existing equity holders of S1 Holdco and Protected in connection with the Merger was a combination of cash, Class A common stock and Class C common stock. The aggregate consideration under the Business Combination Agreement was $442,168 of cash and $421,047 of equity. Additionally, the aggregate Class B units in S1 Holdco retained by S1 Holdco equity holders at the Closing Date resulted in a non-controlling interest with an estimated value of $198,691.

The Company was deemed the accounting acquirer in the Merger, and S1 Holdco was deemed to be the predecessor entity. Accordingly, the historical financial statements of S1 Holdco became the historical financial statements of the Company, upon the consummation of the Merger. As a result, the financial statements included in this report reflect (i) the historical operating results of S1 Holdco prior to the Merger; and (ii) the consolidated results of the Company, including S1 Holdco and Protected following the closing of the Merger. The accompanying financial information include a Predecessor period, which include the periods through January 26, 2022 concurrent with the Merger, and a Successor period from January 27, 2022 through September 30, 2022. A black-line between the Successor and Predecessor periods has been placed in the condensed consolidated financial statements and in the tables within the notes to the condensed consolidated financial statements to highlight the lack of comparability between these two periods as the Merger resulted in a new basis of accounting for S1 Holdco.

Refer to Note 3—MERGER for additional information.

Components of Our Results of Operations

We have three reportable segments:

• Owned and Operated ("O&O");
• Partner Network; and
• Subscription.

Revenue

Revenue is earned from revenue-sharing arrangements with our Network Partners for the use of our RAMP platform and related services provided to them to direct advertising by the Advertising Partners to their advertising space. We have determined that we are the agent in these transactions and report this revenue on a net basis, because (a) we do not control the underlying advertising space, (b) we do not acquire the traffic and do not have risk of loss in connection therewith, and (c) the pricing is in the form of a substantively fixed-percentage revenue-sharing arrangement. We report this revenue on a net basis with respect to the amount retained under our revenue-sharing arrangements, which represents the difference between the amounts we receive from the Advertising Partners, less amounts remitted to the Network Partners based on underlying contracts.

We also earn revenue by directly acquiring traffic to our owned and operated websites and utilizing our RAMP platform and related services to connect our Advertising Partners to our owned and operated websites. For this revenue stream, we are the principal in the transaction and report revenue on a gross basis for the amounts received from our Advertising Partners. For this revenue, we have determined that we are the principal since we have the risk of loss on the traffic that it is acquired for monetization with our Advertising Partners, and, in the case of our owned and operated websites, we maintain the website, provide the content and bear the cost and risk of loss associated with our websites’ advertising space.

We use total advertising spend, number of Owned & Operated sessions, number of Partner Network sessions (“Network sessions”), O&O cost-per-session (“CPS”), O&O revenue-per-session (“RPS”) and Partner Network revenue-per-session (“Network RPS”) to track our operations. We define total advertising spend as the amount of advertising that is spent by us to acquire traffic to our websites. We define O&O sessions as the total number of monetizable user visits to our O&O websites. We define Network sessions as the number of monetizable user visits delivered by our Network Partners to RAMP. Monetizable visits exclude those visits identified by our Advertising Partners as spam, bot, or other invalid traffic. We define CPS as advertising spend divided by O&O sessions. We define O&O RPS as O&O Revenue divided by O&O sessions. We define Network RPS as Partner Network revenue divided by Network sessions.

We recognize revenue upon delivering traffic to our Advertising Partners based on a cost-per-click or cost-per-thousand impression basis. The payment term with our Advertising Partners is typically 30 days.

We, through Protected.net, are also engaged in selling security software subscriptions to customers. The subscription business provides real-time antivirus protection, a safe-browsing feature, adblocking, identity-theft protection, blocking of malicious websites and data breach monitoring. Subscription revenue is primarily derived from the (i) delivery of the antivirus software and (ii) delivery of the additional add-on service(s), which all are provided on a fixed-price basis. The performance obligations related to subscription, maintenance and support are satisfied over the length of the relevant customer contract term, and the associated subscription revenue is recognized over the term on a ratable basis, which is consistent with transfer of control. The fee for the services rendered to our customers are generally paid in advance and initially recorded as deferred revenue, which represents a liability under a noncancelable contract.

Revenue may fluctuate from period to period due to a number of factors including seasonality and the shift in mix of user acquisition sources from Advertising Partners, and renewal rates of customers for subscription services.

Operating Expenses

We classify our operating expenses into the following four categories:

Cost of Revenues. Cost of revenues primarily consists of traffic acquisition costs, which are the costs to place advertisements to acquire customers to our websites and services, as well as content, publishing, domain name registration costs, licensing costs to provide mapping services to Mapquest.com, credit card processing fees, and costs related to the utilization of antivirus engine licensing related to APIs for the antivirus product. We do not pay any up-front payments, incentive payments or bonuses and such costs are expensed as incurred.

Salaries, Commissions, and Benefits. Salaries, commissions and benefits expenses include salaries, bonuses, stock-based compensation, non-capitalized personnel costs incurred in the development of internal-use software, and employee benefits costs.

We expect to continue to invest in corporate infrastructure to support our growth. We expect salaries, commissions, and benefits to increase in absolute dollars in future periods.

Selling, General, and Administrative. Selling, general, and administrative expenses consist of fees for professional services, occupancy costs, travel and entertainment. These costs are expensed as incurred.

We expect to continue to invest in corporate infrastructure to support our growth. We expect selling, general and administrative expenses to increase in absolute dollars in future periods.

Depreciation and Amortization. Depreciation and amortization expenses are primarily attributable to the Company’s capital investment(s) and consist of fixed asset depreciation and amortization of intangible assets with finite lives.

Other Expenses

Other expenses consist of the following:

Interest Expense. Interest expense is primarily related to our debt, which carries a variable interest rate.

Change in Fair Value of Warrant Liabilities. Change in fair value of warrant liabilities relates to the mark to market of our liability-classified public and private warrants.

Income tax (benefit) provision

The Company is the managing member of S1 Holdco and, as a result, consolidates the financial results of S1 Holdco in its condensed consolidated financial statements. S1 Holdco is a pass-through entity for U.S. federal and most applicable state and local income tax purposes. As an entity classified as a partnership for tax purposes, S1 Holdco is not subject to U.S. federal and certain state and local income taxes. Any taxable income or loss generated by S1 Holdco is passed through to its members, including the Company. The Company is taxed as a corporation and pays corporate federal, state and local taxes with respect to income allocated from S1 Holdco based on the Company's economic interest in S1 Holdco. Various subsidiaries are subject to income tax in the United States and in other countries.

Results of Operations

The following tables set forth our consolidated results of operations and our consolidated results of operations as a percentage of revenue for the periods presented.

(in thousands)

51

* Percentages may not sum due to rounding

The comparability of our operating results for the nine months ended September 30, 2022 (Successor) compared to the nine months ended September 30, 2021 (Predecessor) was impacted by the Merger, as discussed above, and the acquisitions discussed in Note 4—ACQUISITIONS. Expense contributions from our recent acquisitions for each of the respective period comparisons generally were not separately identifiable due to the integration of these businesses into our existing operations.

Comparisons of Results of Operations for the three months ended September 30, 2022 (Successor) and September 30, 2021 (Predecessor), the period from January 1, 2022 through January 26, 2022 (Predecessor) and for the period from January 27, 2022 through September 30, 2022 (Successor) and the nine months ended September 30, 2021 (Predecessor)

Revenue

The following tables set forth our revenue by reportable segment.

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Refer to the Revenue discussions below.

Owned and Operated

The decrease in O&O revenues for the three months ended September 30, 2022, compared to the same prior year period was primarily due to an approximate $0.05 decrease in RPS, as well as a decrease in advertising spend to send traffic to this reportable segment. The increase in O&O revenues for the nine months ended September 30, 2022, compared to the same prior year period, was primarily due to increased traffic from international markets, revenues from our recent acquisitions and significant improvements in our RAMP technology. For the nine months ended September 30, 2022, compared to the same prior year period, sessions increased 699 million and RPS decreased approximately $0.04.

Partner Network

The increase in Partner Network revenue for the three and nine months ended September 30, 2022, compared to the same prior year periods, was due to our continued investment in this business and growth from partners signed in prior years. For the nine months ended September 30, 2022, compared to the same prior year period, sessions increased 79 million, with RPS increasing by approximately $0.01.

Subscription

In connection with the Merger, we acquired Protected.net and began recognizing subscription revenue.

Cost of revenues

The dollar increase in cost of revenues for the three months ended September 30, 2022, compared to the same prior year period, was due to the acquisition of Protected.net, which contributed $26 million of the increase in cost of revenues, partially offset by a decrease in user acquisition costs in our O&O segment.

The dollar increase in cost of revenues for the nine months ended September 30, 2022, compared to the same prior year period, was due to the acquisition of Protected.net, which contributed $68 million of the increase in cost of revenues, and an increase in user acquisition costs in the O&O segment. User acquisition costs for the nine months ended September 30, 2022, increased $9 million and drove 3.1 million sessions at approximately $0.12 CPS, compared to 2.4 million sessions at approximately $0.15 CPS for the same period in 2021 (Predecessor). User acquisition costs accounted for 81% and 98% of total cost of revenues for the nine months ended September 30, 2022 (Successor) and 2021 (Predecessor), respectively.

The following supplemental tables set forth our adjusted gross profit by reportable segment.

Refer to the Revenue and Cost of revenues discussions above. Additionally, refer to Note 16—SEGMENT REPORTING for additional information.

Refer to the Revenue and Cost of revenues discussions above. Additionally, refer to Note 16—SEGMENT REPORTING for additional information.

Salaries, commissions, and benefits

The increase in salaries, commissions, and benefits for the three months ended September 30, 2022, compared to the same prior year period, was primarily due to $31 million in stock-based compensation, which included $23 million related to the Protected.net Incentive Plan, and the fluctuations in the value of our common stock since the Merger; and $6 million in salaries and bonus related expenses due to increased headcount from the Merger and our recent acquisitions. For additional information on our stock-based compensation, refer to Note 18—SHARE-BASED COMPENSATION.

The increase in salaries, commissions, and benefits for the nine months ended September 30, 2022, compared to the same prior year period, was primarily due to $108 million in stock-based compensation, which included $41 million related to the Protected.net Incentive Plan, and $28 million recognized upon the close of the Merger; and $17 million in salaries and bonus related expenses due to increased headcount from the Merger and our recent acquisitions. For additional information on our stock-based compensation, refer to Note 18—SHARE-BASED COMPENSATION.

Selling, general, and administrative

The increase in selling, general, and administrative expense for the three months ended September 30, 2022, compared to the same prior year period, was primarily due to costs associated with our recent acquisitions and additional costs associated with being a public company.

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The increase in selling, general, and administrative expense for the nine months ended September 30, 2022, compared to the same prior year period, was primarily due to costs associated with the Merger, costs associated with our recent acquisitions and additional costs associated with becoming a public company.

Depreciation and amortization

The increases in depreciation and amortization expense for the three and nine months ended September 30, 2022, respectively, compared to the same prior year periods, was primarily due to additions of intangible assets as a result of the Merger, along with subsequent acquisitions.

Interest expense

The increases in interest expense for the three and nine months ended September 30, 2022, respectively, compared to the same prior year periods, was due to an increase in our outstanding loan balances as a result of the Term Loan and Revolving Facility, which we entered into as part of the Merger.

Change in fair value of warrant liabilities

The changes in fair value of warrant liabilities for the three and nine months ended September 30, 2022, respectively, compared to the same prior year periods, were driven by the fluctuations in the market value of our Class A common stock since the Merger.

Income tax (benefit) provision

The difference between the effective tax rates for the periods presented above and the federal statutory tax rate of 21% was primarily due to the exclusion of non-controlling income (loss), state taxes, foreign rate differential, non-deductible expenses, outside basis adjustments, and Global Intangible Low-taxed Income.

Liquidity and Capital Resources

As of September 30, 2022 (Successor), we had cash and cash equivalents of $31,933.

To date, our available liquidity and operations have been financed through the initial public offering of Trebia, the Merger, credit facilities, and cash flows from operations. We are subject to certain business risks, including dependence on key employees, dependence on key contracts, competition from alternative technologies, and dependence on growth to achieve its business and operational objectives.

Our revenues are dependent on two key Advertising Partners, which are Google and Microsoft. Refer to our concentration with customers discussion at Note 2— SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-Capital Resources, Liquidity, and Concentration for additional information.

We evaluate whether any conditions or events have occurred, individually and in the aggregate, that could raise substantial doubt about our ability to continue as a going concern for the twelve-month assessment period from the issuance of our financial statements. Our ability to continue as a going concern is dependent on our ability to generate sufficient cash flow from operations to meet our financial obligations including scheduled debt payments and maturities.

We believe that anticipated cash flows from operations, existing cash and investments balances and current financing arrangements will be sufficient to provide us with the liquidity necessary to fund our anticipated working capital and capital requirements for the next twelve months.

Credit Facilities

In connection with the Merger discussed above, Orchid Merger Sub II LLC (a subsidiary of S1 Holdco) entered into a new loan (“Term Loan”) and revolving facility (“Revolving Facility”) on January 27, 2022, providing for a 5.5 year Term Loan with a principal balance of $400,000 and with the net proceeds of $376,000, of which a portion of the proceeds were used by S1 Holdco, to settle the outstanding debt of $172,038 with Cerberus Business Finance, LLC. The Revolving Facility was for $50,000.

We have been able, and expect to continue to be able, to make payments on the principal and interest on a timely basis. As of September 30, 2022, we were in compliance with our borrowing covenants.

For additional information regarding our credit facilities, refer to Note 12—DEBT, NET.

Cash Flows

The following table summarizes our cash flows for the periods presented:

(in thousands)

Operating Activities

Our cash flows from operating activities are primarily influenced by growth in our operations, timing of collections from our clients and related payments to our suppliers for advertising inventory and data. We typically pay suppliers in advance of collections from our clients. Our collection and payment cycles can vary from period to period. In addition, seasonality may impact cash flows from operating activities on a sequential quarterly basis during the year.

During the period from January 1, 2022 to January 26, 2022 (Predecessor), cash used in operating activities of $10,490 resulted primarily from a net loss of $40,460, and a decrease in accounts payable of $67,600 due to the Merger. This was partially offset by an increase in accrued expenses of $57,170, stock-based compensation of $27,698 and a decrease in accounts receivable of $11,118 due to the Merger.

During the period from January 27, 2022 to September 30, 2022 (Successor), cash provided by operating activities of $521 resulted primarily from depreciation and amortization expense of $90,128, stock-based compensation of $79,802, change in fair value of warrants of $14,111, an increase in deferred revenue of $7,133, a decrease in accounts receivable of $6,670 due to the Merger, amortization of debt issuance cost of $3,540, and increase in the accounts payable of $1,981. This was partially offset by a net loss of $109,703, deferred tax benefit of $37,827, a decrease in other long-term liabilities of $26,549, a decrease in accrued expenses and other liabilities of $19,017 due to the Merger, and a decrease in the Protected.net Incentive Plan liability of $10,000 for a quarterly payment.

During the nine months ended September 30, 2021 (Predecessor), cash provided by operating activities of $39,369 resulted primarily from Owned and Operated advertising revenue, offset by user acquisition costs incurred to drive the growth and salaries, commissions and benefits costs. Contributing factors include net income of $29,883, an increase in depreciation and amortization expense of $10,260, and an increase in accounts payable of $12,535 due to increased user acquisition costs, partially offset by an increase in accounts receivable of $14,449.

Investing Activities

Our primary investing activities consist of acquisitions of businesses, such as the acquisition of S1 Holdco, Protected.net, Answers, CouponFollow and RoadWarrior in 2022, as well as costs capitalized for internally developed software.

During the period from January 1, 2022 to January 26, 2022 (Predecessor), cash used in investing activities of $441 resulted from costs capitalized for internally developed software.

During the period from January 27, 2022 to September 30, 2022 (Successor), cash used in investing activities of $453,425 resulted primarily from the acquisitions of S1 Holdco, Protected.net, Answers, CouponFollow and RoadWarrior.

During the nine months ended September 30, 2021 (Predecessor), cash used in investing activities of $4,901 resulted primarily from costs capitalized for internally developed software.

Financing Activities

Our financing activities consisted primarily of borrowings and repayments of our debt, distributions to members related to tax obligations, acquisition related contingent consideration and proceeds from the sale of assets.

During the period from January 27, 2022 to September 30, 2022 (Successor), cash used in financing activities of $22,552 resulted primarily from redemptions of Trebia Class A ordinary shares of $510,469, repayment of existing term loan of $182,488, and payment of debt financing costs related to the Term Loan of $24,845, partially offset by proceeds from the Term Loan and Revolving Facility of $449,000 and the Cannae Backstop of $246,484. In October 2022, the Company borrowed an additional $1,000 under its Revolving Facility.

During the nine months ended September 30, 2021 (Predecessor), cash used in financing activities of $27,635 resulted primarily from repayments of debt of $9,886, distributions to members of $9,793, and payment of acquisition related contingent consideration of $6,715 related to the acquisition of Startpage.

Share Repurchases

In August 2022, our Board of Directors authorized up to $25,000 for the repurchase of our Class A common stock and Public Warrants ("2022 Repurchase Program"). During October 2022 we repurchased 190 shares for an aggregate purchase price of $1,122 under the 2022 Repurchase Program.

Off-Balance Sheet Arrangements

We do not have any relationships with entities often referred to as structured finance or special purpose entities that have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We did not have any other off-balance sheet arrangements during the periods presented other than the indemnification agreements.

Contractual Obligations and Known Future Cash Requirements

Service Agreements

In June 2021, we entered into a multi-year agreement with a service provider whereby we are contractually obligated to spend $8,000 between July 2022 and June 2023. As of September 30, 2022 (Successor), we remain contractually obligated to spend $5,933 towards this commitment.

Acquisitions

For potential commitments associated with our acquisitions refer to Note 3—MERGER and Note 4—ACQUISITIONS.

Contingencies

From time to time, we are subject to contingencies that arise in the ordinary course of business. We record an accrual for a contingency when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. We do not currently believe the resolution of any such contingencies will have a material adverse effect upon our condensed consolidated financial statements.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with the accounting principles generally accepted in the United States of America (“U.S. GAAP”). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenues and expenses during the reporting period.

Significant estimates and assumptions reflected in these condensed consolidated financial statements include, but are not limited to: (1) valuation of goodwill, acquired intangible assets and long-lived assets, (2) valuation and recognition of the Company's share-based compensation awards, (3) income taxes, (4) contingent consideration and (5) determination of the fair value of the warrant liabilities. Significant estimates affecting the condensed consolidated financial statements have been prepared on the basis of the most current and best available information, including historical experience, known trends and other market-specific or other relevant factors that the Company believes to be reasonable. Management evaluates its estimates, as there are changes in circumstances, facts and experience. Changes in estimates are recorded in periods which they become known. However, actual results from the resolution of such estimates and assumptions may vary from those used in the preparation of the condensed consolidated financial statements.

Business combinations

The results of a business acquired in a business combination are included in our condensed consolidated financial statements from the date of acquisition. We allocate the purchase price, which is the sum of the consideration provided which may consist of cash, equity, or a combination of the two, paid in a business combination for the identifiable assets and liabilities of the acquired business at their acquisition-date fair values. Any excess amount paid over the identifiable net assets is recorded as goodwill. The process for estimating the fair values of the acquired business involves the use of significant estimates and assumptions, including estimating average industry purchase price multiples, customer and service attrition rate and estimating future cash flows. We estimate the fair value based on assumptions which we believe to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. During the measurement period, not to exceed one year from the date of acquisition, we may record adjustments to the assets acquired and liabilities assumed, with a corresponding offset to goodwill. At the conclusion of the measurement period, any subsequent adjustments are reflected in our condensed consolidated statements of operations.

Transaction costs associated with business combinations are expensed as incurred and are included in Selling, general and administrative expenses in our condensed consolidated statements of operations. When purchase consideration includes contingent consideration, we record the fair value of the contingent consideration as of the date of acquisition, and subsequently remeasure the contingent consideration at fair value each reporting period through our condensed consolidated statements of operations.

Goodwill

Goodwill represents the excess of the purchase price over the fair value of net assets acquired and identifiable intangibles in a business combination. We account for goodwill in accordance with ASC 350, Intangibles—Goodwill and Other, which requires us to test goodwill at the reporting unit level for impairment at least annually.

We have the option (i) to assess goodwill for possible impairment by performing a qualitative analysis to determine if it is more likely than not that the fair value of a reporting unit is less than its carrying amount or (ii) to perform the quantitative impairment test. The quantitative impairment test involves comparing the estimated fair value of a reporting unit with its respective book value, including goodwill. If the estimated fair value exceeds book value, goodwill is considered not to be impaired. If, however, the fair value of the reporting unit is less than book value, an impairment loss is recognized in an amount equal to the excess.

The determination of fair values requires us to make significant estimates and assumptions. These estimates include, but are not limited to, future expected cash flows from a market participant perspective, discount rates, industry data and management’s prior experience. Unanticipated events or circumstances may occur that could affect the accuracy or validity of such assumptions, estimates or actual results.

We test for goodwill impairment annually at December 31st. For the periods presented in this quarterly report, there were no triggering events identified, and therefore no goodwill impairment charges were recorded.

Share-based compensation

Compensation cost related to share-based payments is measured based on the fair value of the units issued and recognized within “Salaries, commissions, and benefits” in our condensed consolidated statement of operations. We have elected to treat share-based payment awards with time-based service condition(s) only as a single award and recognize share-based compensation expense on a straight-line basis over the vesting period, which is generally four years. The assumptions used in the Black-Scholes model to value equity in the Predecessor period are based upon the following:

• Fair Value of common stock: S1 Holdco’s equity was not publicly traded, therefore the fair value was determined by S1 Holdco’s board of directors, with input from management and contemporaneous valuation reports prepared by a third-party valuation specialist.
• Expected Term: The expected term of the option is estimated by considering the contractual term of the option, the vesting period of the option, the employees’ expected exercise behavior and the post-vesting employee turnover rate. For non-employees, the expected term equals the contractual term of the option.
• Risk-free Interest Rate: The risk-free interest rate is based on published U.S. Treasury Department interest rates for the expected terms of the underlying options.
• Volatility: The volatility was based on the expected unit price volatility of the underlying units over the expected term of the option, which is based upon historical share price data of an index of comparable publicly traded companies.

After the Merger, the fair value of our RSUs is derived from the market price of our Class A common stock, which is traded on the NYSE. We recognize compensation on a straight-line basis over the requisite service period for each award and recognize forfeitures as they occur.

In connection with the Merger and acquisition of Protected.net, we effected an incentive plan for eligible recipients (the “Protected.net Incentive Plan”). If the Protected.net business achieves certain financial metrics on or prior to December 31, 2023, recipients will be eligible to receive a pool of $50,000 payable in fully-vested shares of our Class A common stock (the “2023 Award”). On August 30, 2022, the Company modified the 2023 Award to remove the operational targets and reduce this award to $40,000 settled in four equal quarterly cash installments beginning upon the modification of this award. Further, if the Protected.net business achieves certain financial metrics on or prior to December 31, 2024, recipients will be eligible to receive a separate pool of $50,000 payable in fully-vested shares of our Class A common stock (the “2024 Award”). Shares under the 2024 Award will be issued to recipients within 30 days of December 31, 2024.

We account for each of these awards as liability-classified until the awards are settled in cash or stock, respectively, and accordingly, when the 2024 Award is probable of achievement, we record stock-based compensation for that liability award. Refer to Note 18—SHARE-BASED COMPENSATION for additional information regarding liability-classified awards.

Share-based compensation expense is included in the Salaries, commissions, and benefits expense in the condensed consolidated statements of operations.

Recently Issued Accounting Pronouncements

See Note 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES-Recent Accounting Pronouncement for a discussion of recently issued accounting pronouncements not yet adopted.

As a “smaller reporting company”, as defined by Rule 10(f)(1) of Regulation S-K, we are not required to provide this information.

Evaluation of Disclosure Controls and Procedures

Pursuant to Rules 13a-15(b) and 15d-15(b) under the Securities Exchange Act, we have evaluated, under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act as of the end of the period covered by this report. Based on that evaluation, our CEO and CFO concluded that, as of September 30, 2022, due to the material weaknesses in our internal control over financial reporting described below, our disclosure controls and procedures were not effective to ensure that the information required to be disclosed in the reports required to be filed or submitted under the Securities Exchange Act is (i) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and (ii) accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.

Material weaknesses in internal control over financial reporting

We have identified material weaknesses in our internal control over financial reporting, and these material weaknesses continued to exist as of September 30, 2022. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.

The material weaknesses we identified were as follows:

• We did not design and maintain an effective control environment commensurate with our financial reporting requirements. Specifically, we lacked a sufficient number of professionals with an appropriate level of accounting knowledge, training and experience to appropriately analyze, record and disclose accounting matters timely and accurately. Additionally, the limited personnel resulted in an inability to consistently establish appropriate authorities and responsibilities in pursuit of financial reporting objectives, as demonstrated by, among other things, insufficient segregation of duties in our finance and accounting functions.
• We did not design and maintain effective controls in response to the risks of material misstatement. Specifically, changes to existing controls or the implementation of new controls have not been sufficient to respond to changes to the risks of material misstatement to financial reporting.

These material weaknesses contributed to the following additional material weaknesses:

• We did not design and maintain effective controls to timely analyze and record the financial statement effects from acquisitions. Specifically, we did not design and maintain effective controls over the (i) application of U.S. GAAP to such transactions, including accounting for post-combination compensation arrangements, (ii) review of the inputs and assumptions used in the measurement of assets acquired and liabilities assumed, including discounted cash flow analysis to value acquired intangible assets at an appropriate level of precision, (iii) the tax impacts of acquisitions to the financial statements, and (iv) conforming of U.S. GAAP and accounting policies of acquired entities to that of the Company. In addition, we did not design and maintain effective controls relating to the oversight and ongoing recording of the financial statement results of the acquired businesses.
• We did not design and maintain formal accounting policies, procedures and controls to achieve complete, accurate and timely financial accounting, reporting and disclosures, including controls over the preparation and review of business performance reviews, account reconciliations and journal entries, and (ii) maintaining appropriate segregation of duties. Additionally, we did not design and maintain controls over the classification and presentation of accounts and disclosures in the financial statements.
• We did not design and maintain effective controls over the completeness and accuracy of accrued liabilities and stock-based compensation.

These material weaknesses resulted in immaterial misstatements to substantially all of the S1 Holdco, LLC accounts, which were recorded prior to the issuance of the consolidated financial statements:

• as of December 31, 2021, 2020, 2019 and 2018 and for the years then ended;
• as of March 31, 2021 and 2020 and for the three-month periods then ended;
• as of June 30, 2021 and 2020 and for the six-month periods then ended; and
• as of September 30, 2021 and 2020 and for the nine-month periods then ended.

Further, these material weaknesses resulted in material adjustments to share-based compensation expense, transaction expenses, and members’ capital accounts of the financial statements of S1 Holdco, LLC as of January 26, 2022 and for the period from January 1, 2022 through January 26, 2022, all of which were recorded prior to the issuance of the condensed consolidated financial statements.

These material weaknesses also resulted in material adjustments to share-based compensation expense, goodwill, additional paid-in-capital accounts and immaterial adjustments to substantially all accounts of the financial statements of System1, Inc. as of March 31, 2022 and for the period from January 27, 2022 through March 31, 2022, all of which were recorded prior to the issuance of the condensed consolidated financial statements.

Furthermore, these material weaknesses also resulted in material adjustments to share-based compensation expense and immaterial adjustments to the disclosure related to the business combinations as well as cash flows from operating, financing and investing activities, and non-controlling interest, goodwill, and accrued expenses and other current liabilities accounts of the financial statements of System1, Inc. as of June 30, 2022, and for the period from April 1, 2022 through June 30, 2022, all of which were recorded prior to the issuance of the condensed consolidated financial statements.

These material weaknesses also resulted in immaterial misstatements to deferred tax liability and comprehensive income (loss) accounts of the financial statements of System1, Inc. as of June 30, 2022 and for the period from April 1, 2022 through June 30, 2022.

These material weaknesses also resulted in immaterial adjustments to accrued expenses, deferred tax liability, share-based compensation expense, salaries expense, selling, general and administrative expenses, income tax expense, comprehensive income (loss) and non-controlling interest accounts of the financial statements of System1, Inc. as of September 30, 2022 and for the period from July 1, 2022 through September 30, 2022, and for the period from January 27, 2022 through September 30, 2022, all of which were recorded prior to the issuance of the condensed consolidated financial statements.

Additionally, these material weaknesses could result in a misstatement of substantially all of our accounts or disclosures that would result in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected.

• We did not design and maintain effective controls over information technology (“IT”) general controls for information systems that are relevant to the preparation of our financial statements. Specifically, we did not design and maintain:

i. program change management controls to ensure that IT program and data changes affecting financial IT applications and underlying accounting records are identified, tested, authorized, and implemented appropriately;

ii. user access controls to ensure appropriate segregation of duties and that adequately restrict user and privileged access to financial applications, programs, and data to appropriate Company personnel;

iii.computer operations controls to ensure that critical batch jobs are monitored and data backups are authorized and monitored; and

iv. testing and approval controls for program development to ensure that new software development is aligned with business and IT requirements.

These IT deficiencies did not result in a material misstatement to the financial statements; however, the deficiencies, when aggregated, could impact the effectiveness of IT-dependent controls (such as automated controls that address the risk of material misstatement to one or more assertions, along with the IT controls and underlying data that support the effectiveness of system-generated data and reports) that could result in misstatements potentially impacting all financial statement accounts and disclosures that would not be prevented or detected. Accordingly, we have determined these IT deficiencies in the aggregate constitute a material weakness.

Trebia Acquisition Corp. (“Trebia”) identified a material weakness in internal controls related to the accounting for complex financial instruments. This material weakness resulted in a material misstatement of the Trebia Warrant liabilities, change in the fair value of the Trebia Warrant liabilities, “Forward Purchase Agreement liabilities, change in the fair value of the Forward Purchase Agreement liabilities, classification of Redeemable Shares of Class A common stock issued in connection with Trebia’s initial public offering” additional paid-in-capital, accumulated deficit “Earnings Per Share”, and related financial disclosures:

• as of December 31, 2020 and for the period from February 11, 2020 (inception) through December 31, 2020;
• as of September 30, 2020 and for the three month period ended September 30, 2020 and for the period from February 11, 2020 (inception) through September 30, 2020;
• as of June 30, 2020 and for the three month period ended June 30, 2020 and for the period from February 11, 2020 (inception) through June 30, 2020; and
• as of March 31, 2021 and the for three month period ended March 31, 2021.

This material weakness also resulted in material adjustments to warrant liabilities of System1, Inc. as of March 31, 2022.

Remediation in progress for the previously identified material weaknesses

We commenced measures to remediate the identified material weaknesses. Those remediation measures are ongoing and include the following:

• Hiring additional senior level accounting personnel with appropriate technical accounting knowledge and public company experience in financial reporting, supplemented by third-party resources;
• Designing and implementing controls to formalize roles and review responsibilities to align with our team’s skills and experience and designing and implementing controls over segregation of duties;
• Engaging an accounting advisory firm to assist with the documentation, evaluation, remediation and testing of our internal control over financial reporting based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission;
• Designing and implementing controls related to accounting for acquisitions and other technical accounting and financial reporting matters, including controls over the preparation and review of accounting memoranda addressing these matters, valuations and key assumptions utilized in the valuations, tax impacts, and ongoing recording of the financial statement results of the acquired businesses;
• Designing and implementing formal accounting policies, procedures and controls supporting our period-end financial reporting process, including controls over the preparation and review of account reconciliations and journal entries, business performance reviews, foreign exchange gains/losses for intercompany transactions, and classification and presentation of accounts and disclosures;
• Designing and implementing controls over the completeness and accuracy of accrued liabilities and stock-based compensation;
• Designing and implementing controls related to accounting for complex financial instruments; and
• Designing and implementing IT general controls, including controls over change management, the review and update of user access rights and privileges, controls over batch jobs and data backups, and program development approvals and testing.

While we believe that these efforts have improved and will continue to improve our internal control over financial reporting, remediation of the material weaknesses will require validation and testing of the design and operating effectiveness of internal controls over a sustained period of financial reporting cycles. Therefore, these material weaknesses have not been remediated as of September 30, 2022.

Changes in Internal Control over Financial Reporting

We are taking actions to remediate the material weaknesses relating to our internal controls over financial reporting, as described above. Except as otherwise described herein, there have been no changes to our internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) that occurred during the fiscal quarter ended September 30, 2022 which have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

As of September 30, 2022, no material changes had occurred in our risk factors, compared with the disclosure in our Registration Statement on Form S-1, originally filed with the SEC on April 1, 2022, as subsequently amended (Reg. No. 333-262608).