CYNERGISTEK, INC.

FORM 10-Q

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PART I – FINANCIAL INFORMATION

ITEM 1.   FINANCIAL STATEMENTS.

CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

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

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CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

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

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CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

NINETHREE MONTHS ENDED SEPTEMBER 30, 2017MARCH 31, 2018

(UNAUDITED)

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

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CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

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

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CYNERGISTEK, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(UNAUDITED)

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NINETHREE MONTHS ENDED SEPTEMBER 30,MARCH 31, 2018 AND 2017 AND 2016

(UNAUDITED)

1.BASIS OF PRESENTATION 

The accompanying unaudited condensed consolidated financial statements of Cynergistek, Inc. and its subsidiaries (the “Company”, “we”, “us” or “Cynergistek”) have been prepared in accordance with generally accepted accounting principles of the United States of America (“GAAP”) for interim financial statements pursuant to the rules and regulations of the Securities and Exchange Commission.  Accordingly, these financial statements do not include all of the information and notes required by GAAP for complete financial statements.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016,2017, as filed with the Securities and Exchange Commission (“SEC”) on March 29, 2017.28, 2018.

The unaudited condensed consolidated financial statements included herein reflect all adjustments (which include only normal, recurring adjustments) that are, in the opinion of management, necessary to state fairly our financial position and results of operations as of and for the periods presented.  The results for such periods are not necessarily indicative of the results to be expected for the full year.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  As a result, actual results could differ from those estimates.

The accompanying unaudited condensed consolidated financial statements include the accounts of Cynergistek and its wholly owned subsidiaries.  All intercompany balances and transactions have been eliminated.

Based on the Company’s recent integration with CTEK Security and an analysis of how our integrationChief Operating Decision Makers review, manage and management strategies,are compensated, we operatehave determined that the Company operates in a single business segment.two segments, services and equipment & software resale.  The equipment & software resale operating segment is not reported separately in the accompanying condensed consolidated financial statements, as this segment did not meet the quantitative thresholds established in ASC 280-10-50-12, For the periods presented, all revenues were derived from domestic operations.

As described in more detail in our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 8, 2017, Auxilio, Inc., a Nevada corporation (“Auxilio”) changed its name and state of incorporation from the State of Nevada to the State of Delaware by merging (the “Reincorporation”) with and into its wholly-owned subsidiary, CynergisTek, Inc., a Delaware corporation, which was established for the purpose of the Reincorporation.   As a result of the Reincorporation, Auxilio ceased to exist as a separate entity.  As of the date of the merger, each outstanding share of Auxilio’s common stock was deemed, by operation of law, to represent the same number of shares of our common stock.  In accordance with Rule 12g-3 under the Securities Exchange Act of 1934, as amended, the shares of our common stock were deemed to be registered under Section 12(b) of the Exchange Act as a successor to Auxilio.  Effective as of September 8, 2017, the Company’s trading symbol changed to “CTEK.”  

As part of the Reincorporation, two wholly owned subsidiaries of the Company also changed their corporate names, as follows: (i) Auxilio Solutions, Inc., a California corporation, has changed its name to CTEK Solutions, Inc.; and (ii) CynergisTek, Inc., a Texas corporation, has changed its name to CTEK Security, Inc. (“CTEK Security”).  

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

Effective on January 13, 2017, the Company effected a reverse stock split of its common stock at a ratio of 1-for-3. No fractional shares of common stock were issued, and no cash or other consideration were paid as a result of the reverse stock split. Instead, the Company issued one whole share of post-reverse stock split common stock in lieu of each fractional share of common stock. As a result of the reverse stock split, the Company’s common stock was reduced to 8,185,936 shares from 24,557,224 shares as of December 31, 2016. All per share amounts and number of shares in the unaudited condensed consolidated financial statements and related notes have been retroactively

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restated to reflect the reverse stock split resulting in the reclassification of $15,749 from common stock to additional paid in capital at January 1, 2015.

Certain accounts have been reclassified to conform to current period presentation.

2.RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS 

In November 2015, the FASB issued guidance related to the presentation of deferred income taxes. The guidance requires that deferred tax assets and liabilities be classified as non-current in the condensed consolidated balance sheet. This guidance was adopted early by us and resulted in the Company classifying its deferred tax assets as non-current assets.

In May 2014, the FASB issued guidance which provides a single, comprehensive accounting model for revenue arising from contracts with customers.customers (“Topic 606”). This guidance supersedes most of the existing revenue recognition guidance, including industry-specific guidance. Under this model, revenue is recognized at an amount that a company expects to be entitled to upon transferring control of goods or services to a customer, as opposed to when risks and rewards transfer to a customer. The new guidance also requires additional disclosures about the nature, timing and uncertainty of revenue and cash flow arising from customer contracts, including significant judgments and changes in judgments. Considering the one-year delay in the required adoption date for the guidance as issued in July 2015, the new guidance is effective for us beginning in 2018 and may be applied retrospectively to all prior periods presented or through a cumulative adjustment to the opening retained earnings balance in the year of adoption. We will adoptadopted this standard beginning January 1, 2018 and expect to useare using the modified retrospective method of adoption. Under the new guidance, based on the nature of our contracts, we expect towill continue to recognize revenue in a similar manner as with the current guidance. Additionally, we expect the unit of accounting, that is, the identification of performance obligations, will beis consistent with current revenue guidance. Accordingly, the adoption of this standard is not expected to have a material impact on our revenues.

In March 2016, the FASB issued a new accounting standard regarding stock compensation: improvements to employee share-based payment accounting, that simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The new standard was effective for fiscal years beginning after December 15, 2016, including interim periods within those annual years, and early adoption was permitted. We adopted the new standard prospectively in 2017. The adoption of the new standard did not have a material effect onsignificantly impact our unaudited condensed consolidated financial statements for the three months and nine months ended September 30, 2017, and we do not expect that the adoption of the new standard will have a material effect on our consolidated financial statements for the year ended December 31, 2017.revenues.

In February 2016, the FASB issued a new accounting standard on leasing. The new standard will require companies to record most leased assets and liabilities on the balance sheet, and also proposes a dual model for recognizing expense. This guidance will be effective in the first quarter of 2019 with early adoption permitted. We have evaluated the impact of adopting this guidance and we are preparing for the changes to be made to our consolidated financial statements. We expect the adoption of these accounting changes will materially increase our assets and liabilities but will not have a material impact on our net income or equity.

In January 2017, the FASB issued a new accounting standard simplifying the test for goodwill impairment. Currently, the fair value of the reporting unit is compared with the carrying value of the reporting unit (identified as "Step 1"). If the fair value of the reporting unit is lower than its carrying amount, then the implied fair value of goodwill is calculated. If the implied fair value of goodwill is lower than the carrying value of goodwill an impairment is recognized (identified as "Step 2"). The new standard eliminates Step 2 from the impairment test; therefore, a goodwill impairment will be recognized as the difference of the fair value and the carrying value. The new standard becomes effective on January 1, 2020 with early adoption permitted. We are currently evaluating the impact that the new standard will have on our financial position, results of operations and cash flows.

In August 2016, the FASB issued new accounting standard which is intended to reduce the existing diversity in practice in how certain cash receipts and cash payments are classified in the statement of cash flows. This guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years with early adoption permitted, provided that all of the amendments are adopted in the same period. We are currently evaluating the impact of adopting this standard on our consolidated financial statements.

In January 2017, the FASB issued new accounting standard which clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions or disposals of assets or businesses. This guidance will be effective for the Company for the year ending December 31, 2019 and interim reporting periods within that year. Early adoption is permitted for transactions that have not been reported in financial statements that have been issued or made available for issuance. We are currently evaluating the effect of the adoption of this guidance on our consolidated financial statements.

In May 2017, the FASB issued new accounting standard which provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in ASC Topic 718. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. This guidance will be effective for the year ending December 31, 2019 and interim reporting periods within that year. Early adoption is permitted. We expect the adoption of this guidance will not have a material effect on our consolidated financial statements or footnotes.

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Table3.REVENUES

On January 1, 2018, we adopted Topic 606 using a modified retrospective method applied to those customer contracts which were not completed as of ContentsJanuary 1, 2018. There was no change in revenues reported using this method as compared to the previous guidance. Below is a summary of our revenues disaggregated by revenue source.

3.4.OPTIONS, WARRANTS AND RESTRICTED STOCK UNITS 

Below is a summary of stock option, warrant and restricted stock activity during the nine-monththree-month period ended September 30, 2017:March 31, 2018:

During the nine months ended September 30, 2017, we granted a total of 25,000 options to our employees and directors to purchase shares of our common stock at an exercise price of $3.06 per share. The exercise price equals the fair value of our stock on the grant date.  The options have graded vesting annually over three years.  The fair value of the options was determined using the Black-Scholes option-pricing model.  The assumptions used to calculate the fair market value are as follows: (i) risk-free interest rate of 0.38%; (ii) estimated volatility of 46.29%; (iii) dividend yield of 0.0%; and (iv) expected life of the options of three years.

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During the nine months ended September 30, 2017, we issued a total of 130,000 shares of restricted stock units to key employees and members of the Board of Directors. The shares vest after three years of continuous employment. The average price of the stock on the grant date was $4.78. The cost recognized for these restricted stock units totaled $54,163 and $98,347, respectively, for the three and nine months ended September 30, 2017, and is included in sales and marketing expense in the accompanying Condensed Consolidated Statement of Operations.

For the three and nine months ended September 30,March 31, 2018 and 2017, and 2016, stock-based compensation expense recognized in the consolidated statements of operations as follows:

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4.5.NET (LOSS) INCOME PER SHARE 

Basic net (loss) income per share is calculated using the weighted average number of shares of our common stock issued and outstanding during a certain period and is calculated by dividing net loss(loss) income by the weighted average number of shares of our common stock issued and outstanding during such period. Diluted net (loss) income per share is calculated using the weighted average number of common and potentially dilutive common shares outstanding during the period, using the as-if-converted method for secured convertible notes, and the treasury stock method for options and warrants. Diluted net (loss) income per share does not include potentially dilutive securities because such inclusion in the computation would be anti-dilutive.

For the three months ended September 30,March 31, 2018, potentially dilutive securities consisted of options and warrants to purchase 280,416 shares of common stock at prices ranging from $0.90 to $6.45 per share and 500,500 shares of restricted stock units. Of these potentially dilutive securities, none of the shares to purchase common stock from the options and warrants or shares related to the restricted stock units are included in the computation of diluted earnings per share because the effect of including these instruments would be anti-dilutive.

For the three months ended March 31, 2017, potentially dilutive securities consisted of options and warrants to purchase 1,416,7471,454,051 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, 379,476 of the shares to purchase common stock from the options and warrants are included in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.

For the nine months ended September 30, 2017, potentially dilutive securities consisted of options and warrants to purchase 1,416,747 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, 448,164398,566 of the shares of common stock underlying the options and warrants are included in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.

For the three months ended September 30, 2016, potentially dilutive securities consisted of options and warrants to purchase 1,798,567 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, 86,461 of the shares of common stock underlying the options and warrants are included in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.

For the nine months ended September 30, 2016, potentially dilutive securities consisted of options and warrants to purchase 1,798,567 shares of common stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, 118,686 of the shares of common stock underlying the options and warrants are included in the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.

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5.6.ACCOUNTS RECEIVABLE 

A summary of accounts receivable is as follows:

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7.DEFERRED COMMISSIONS

Our incremental costs of obtaining a contract, which consist of sales commissions, are deferred and amortized over the period of contract performance. Effective January 1, 2018, when we adopted the modified retrospective method of the new revenue recognition pronouncement, we increased deferred commissions by $879,666 with a corresponding increase in beginning retained earnings. Deferred commissions are included in prepaid and other current assets in our consolidated balance sheets. As of March 31, 2018, we had $849,975 related to unamortized deferred commissions. We had $151,308 and $154,642 of commissions expense for the three months ended March 31, 2018 and 2017, respectively. If we had recognized commissions expense under the full retrospective approach, commission expense would have been $164,419 for the three months ended March 31, 2017.

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6.8.INTANGIBLE ASSETS 

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

7.9.DEFERRED REVENUE

We record deferred revenues when amounts are billed to customers in advance of our performance. $307,780 and $640,962 of managed services revenues were recognized during the three months ended March 31, 2018 and 2017, respectively, that was included in deferred revenue at the beginning of the respective periods. $214,970 and $327,236 of consulting and professional services revenues were recognized during the three months ended March 31, 2018 and 2017, respectively, that was included in deferred revenue at the beginning of the respective periods.

10.REMAINING PERFORMANCE OBLIGATIONS

Remaining performance obligations represent the amount of revenue from fixed-fee contracts, including those which have potential early cancellation provisions, for which work has not been performed. As of March 31, 2018, approximately $21,000,000 of revenue from fixed-fee contracts is expected to be recognized from these remaining performance obligations. We expect to recognize revenue on approximately 85% of these remaining performance obligations over the next 24 months, with the balance thereafter. We elected to utilize the practical expedience exemption to exclude from this disclosure, the amount of revenue from contracts which are not fixed-fee and where we do not have the right to invoice until the services have been performed.

11.LINE OF CREDIT AND TERM LOAN

On May 4, 2012, we entered into a Loan and Security Agreement (the “Loan and Security Agreement”) with Avidbank Corporate Finance, a Division of Avidbank (“Avidbank”).  On April 26, 2013, we amended the Loan and Security Agreement with Avidbank. On April 25, 2014, we again amended the Loan and Security Agreement with Avidbank (the “Second Avidbank Amendment”). This line of credit was further extended through June 25, 2015 under the third amendment to the Loan and Security Agreement. On June 19, 2015, we again amended the Loan and Security Agreement with Avidbank (the “Fourth Avidbank Amendment”). Under the Fourth Avidbank Amendment, the term of the revolving line-of-credit of up to $2.0 million was extended through June 19, 2017, at an interest rate of prime plus 0.75% per annum.  On January 13, 2017, as part of the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.), we entered into an Amended and Restated Credit Agreement (the “A&R Credit Agreement”) with California Bank and Trust and

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Avidbank Corporate Finance, a Division of Avidbank (collectively the “Lenders”).  The A&R Credit Agreement amended a loan and security agreement originally entered into on May 4, 2012, as amended by several amendments, between the Company and AvidBank Corporate Finance.  Under the A&R Credit Agreement, the term of the revolving line-of-credit iswas available through January 13, 2019 at an interest rate of prime plus 1.0% per annum. As of September 30, 2017, the interest rate was 5.25%.  There will be no minimum interest payable with respect to any calendar quarter. The amount available to us at any given time iswas the lesser of (a) $5.0 million, or (b) the amount available under our borrowing base (80% of our eligible accounts receivable, minus (1) accrued client lease payables, and minus (2) accrued equipment pool liability). As of September 30, 2017, and December 31, 2016,2017, no amounts were outstanding under the line of credit.

The Fourth Avidbank Amendment provided for a term loan facility which allowed for advances up to $4,000,000 through June 19, 2016. Our initial draw was for $2,000,000 in 2015. As of December 31, 2016, outstanding borrowings under the term loan were $1,250,000 at an interest rate of 4.75%. On January 13, 2017, this loan was repaid in full. On that date, we entered into the A&R Credit Agreement which provided a term loan facility for $14,000,000. Term loan repayments arewere to be made in 48 monthly principal installments of $198,333, plus accrued interest at an interest rate of prime plus 1.5% per annum, followed by 12 monthly principal installments of $373,333, plus accrued interest at an interest rate of prime plus 1.5%.  As of September 30,December 31, 2017, outstanding borrowings under the term loan are $13,008,333were $11,818,333 at an interest rate of 5.75%6.0%.

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While there are outstanding credit extensions, we are to maintain an asset coverage ratio of cash plus accounts receivable divided by all obligations owing to the bank within one year of at least 1.50 to 1.00, measured monthly, and a fixed charge coverage ratio, whereby adjusted EBITDA for the most recent twelve months shall be no less than 1.15 to 1.00 of the sum of the following: (i) Non-Financed Capital Expenditures, (ii) taxes paid in cash during such period, (iii) Distributions paid in cash during such period, (iv) any Earnout Payment paid in cash during such period, and (v) Debt Service for such period, all as determined in accordance with GAAP.  We were in compliance with all covenants set forth in the A&R Credit Agreement as of September 30, 2017 and December 31, 2016.2017.

In connection with the A&R Credit Agreement, the Company and its subsidiaries (collectively the “Borrowers”) entered into a security agreement (the “Security Agreement”), pursuant to which each of the Borrowers agreed to grant to Avidbank, in its capacity as contractual representative for itself and the other lender (the “Agent”), for the ratable benefit of itself, the Lenders and the other secured parties, a first priority security interest in certain collateral to secure prompt payment and performance of the secured obligations under the A&R Credit Agreement.  Pursuant to the Security Agreement, the “Collateral” was defined as including any and all (all such terms as defined in the Security Agreement) of the Accounts, Chattel Paper, Commercial Tort Claims, Deposit Accounts, Documents, Equipment, Instruments, Inventory, Investment Property, General Intangibles, Letter of Credit Rights, Negotiable Collateral, Supporting Obligations, Vehicles, Grantors’ Books, in each case whether now existing or hereafter acquired or created, any money or other assets of any Grantor that now or hereafter come into the possession, custody, or control of Agent and any Proceeds or products of any of the foregoing, or any portion thereof.  In connection with the grant of the security interest in the Collateral, each of the Borrowers made standard representations and warranties relating to ownership of the collateral, location and control of the collateral, and certain rights to payment.

Additionally, in connection with the A&R Credit Agreement and the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.) transaction, (see Note 11), Michael Mathews, Hernandez, (f/k/a Dr Michael G. Mathews)(“Mathews”Hernandez”), Michael McMillan (“McMillan”), the Company, and Avidbank entered into a subordination agreement (the “Subordination Agreement”), pursuant to which MathewsHernandez and McMillan agreed that unless and until all of the Company’s obligations under the A&R Credit Agreement have been repaid in full, MathewsHernandez and McMillan would not, except as provided in the Subordination Agreement, ask, demand, sue for, take or receive, or retain, from the Company or any other person or entity, by setoff or in any other manner, payment of all or any part of the Subordinate Debt (as defined below), or take any other action with respect to the Subordinate Debt; forgive, cancel or discharge any of the Subordinate Debt; ask, demand or receive any security for the Subordinate Debt; amend any documents relating to the Subordinate Debt or any other agreement, instrument or document evidencing or executed in connection with the Subordinate Debt in a manner that could reasonably be expected to be adverse to Lenders or Agent (or any other holders of the obligations arising under the A&R Credit Agreement); or bring or join with any creditor in bringing any insolvency proceeding against the Company. Additionally, MathewsHernandez and McMillan each directed the Company to make, and the Company agreed to make, such prior payment of the Company’s obligations under the A&R Credit Agreement to Agent and the Lenders.  The Subordination Agreement defines “Subordinate Debt” to include all debt of the Company owing to MathewsHernandez and McMillan (or either of them) (a) under the promissory notes due to MathewsHernandez and McMillan (the “Seller Notes”) or (b) in respect of the Earn Out Payments, (described in Note 11), in either case whether now existing or hereafter arising and including all principal, premium, interest, fees, attorneys’ fees, costs, charges, expenses, reimbursement obligations, any other indemnities or guarantees in each case with respect thereto, in each case whether direct or indirect, absolute or contingent, joint or several, due or not due, primary or secondary, liquidated or unliquidated, secured or unsecured.  So long as the Borrowers are not in default under the terms of the A&R Credit Agreement, the Company may make regular payments to MathewsHernandez and McMillan under the Seller Notes.

The foregoing description of the Fourth Amendment to the Loan and Security Agreement between Avidbank and the Company is qualified in its entirety by reference to the terms of the Fourth Amendment to the Loan and Security Agreement, which is found as Exhibit 10.1 of our Form 10-Q filed on August 14, 2015. The foregoing descriptions of the A&R Credit Agreement, Security Agreement and Subordination Agreement are qualified in their entirety by reference to the respective agreements.  These agreements are found in our Form 8-K filed on January 17, 2017 as Exhibits 99.7, 99.8, and 99.9, respectively.

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On January 13, 2017, we paid a $25,000 revolving loan commitment fee. There were no borrowings on the line of credit for the three and nine months ended September 30, 2017 were $1,285 and $1,285, respectively. In addition, on January 13, 2017, we paid a $25,000 revolving loan

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commitment fee. There were no borrowings on the line of credit for the three and nine months ended September 30, 2016.

Interest charges associated with thethese term loans totaled $184,964$133,914 and $343,028$119,272 for the three and nine months ended September 30,March 31, 2018 and 2017, respectively. In addition, on January 13, 2017, we paid a $70,000 term loan commitment fee.

Debt Restructuring

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

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

Loan Facilities

Term Loan:  Pursuant to the Credit Agreement, the Bank agreed to provide a term loan in the amount of $17,250,000 to the Company, which was paid in accordance with the purpose of the BMO Loan as described above.  Pursuant to the Credit Agreement, the Company may elect that the term loan be outstanding as Base Rate Loans or Eurodollar Loans. The term loan is payable in principal payment installments on the last day of each fiscal quarter, commencing on June 30, 2018. All principal and interest not sooner paid on the term loan shall be due and payable on September 12, 2022, the final maturity thereof. As of March 31, 2018, outstanding borrowings under the term loan were $17,250,000 at an interest rate of 5.24%.

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

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

Interest Rates

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

Eurodollar loans (“Eurodollar Loans”) bear interest at a rate per annum equal to the sum of the Adjusted LIBOR rate (defined as the quotient obtained by dividing (a) the LIBOR index rate by (b) the maximum reserve percentage,

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expressed as a decimal, at which reserves are imposed by the Board of Governors of the Federal Reserve System (or any successor) on “eurocurrency liabilities,” as defined in such Board’s Regulation D (or any successor thereto), subject to any amendments of such reserve requirement by such Board or its successor, taking into account any transitional adjustments thereto) plus an applicable margin of between 2.50% and 3.50%, depending upon the Company’s leverage ratio.

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

Interest charges associated with the BMO term loansloan totaled $19,016 and $39,516$50,217 for the three and nine months ended SeptemberMarch 31, 2018. In addition, on March 12, 2018, we paid a $86,250 commitment fee associated with the term loan.

Acceleration

Pursuant to the Credit Agreement, the Bank may, by written notice to the Company, declare the principal of and the accrued interest on all outstanding loans to be forthwith due and payable upon the occurrence of certain Events of Default. The Credit Agreement defines Events of Default to include, inter alia, (i) a default in payment when due of all or any part of any obligation payable by the Company under the BMO Loan, (ii) a default in the observance or performance of certain of the covenants set forth in the BMO Loan, (iii) any representation or warranty made in connection with the BMO Loan proves untrue in any respect (or in any material respect if such representation, warranty, certification or statement is not by its terms already qualified as to materiality), (iv) default on any subordinated debt, (v) any judgment or judgments, writ or writs or warrant or warrants of attachment shall be entered or filed against the Company or any of its subsidiaries, or against any of its Property, in an aggregate amount in excess of $250,000 (except to the extent fully covered by insurance as to which the insurer has been notified of such judgment and has not denied coverage) which remains undischarged, unvacated, unbonded or unstayed for a period of 30 2016, respectively.days, (vi) any change of control of the Company shall occur, and (vii) any other specified event of default.

As additional consideration forSecurity Agreement

In connection with the original LoanCredit Agreement, the Company, including its subsidiaries as guarantors (“Guarantors”), and the Bank entered into a Pledge and Security Agreement we issued Avidbank(the “Security Agreement”), pursuant to which each of the Company and the Guarantors agreed to grant to the Bank a 5-year warrantlien on and security interest in certain collateral to purchase upsecure prompt payment and performance of the secured obligations under the Credit Agreement.  Pursuant to 24,033 sharesthe Security Agreement, the “Collateral” was defined as including, inter alia, any and all (all such terms as defined in the Security Agreement) of the Accounts, Chattel Paper, Instruments (including Promissory Notes), Documents, General Intangibles, Letter-of-Credit Rights, Supporting Obligations, Deposit Accounts, Pledged Collateral and other Investment Property (including all certificated and uncertificated Securities, Securities Accounts, Security Entitlements, Commodity Accounts, and Commodity Contracts), Goods, Fixtures, Inventory and Equipment, Commercial Tort Claims, and Rights to merchandise and other Goods, any Monies, personal property, and interests in personal property, in each case whether now existing or hereafter acquired or created, any money or other assets of any grantor that now or hereafter come into the possession, custody, or control of Bank and any Proceeds or products of any of the foregoing, or any portion thereof.  In connection with the grant of the security interest in the Collateral, each of the Company and the Guarantors made standard representations and warranties relating to ownership of the collateral, location and control of the collateral, and certain rights to payment.

The foregoing summary of the BMO Harris Bank N.A. Credit Agreement and related agreements is qualified in its entirety by reference to the full context of the agreement, which is found in our common stock at an exercise price of $4.16 per share. Current Report on Form 8-K filed with the SEC on March 12, 2018.

Separation Agreement and Mutual Release with Hernandez

On April 6, 2017 weMarch 12, 2018, the Company, CTEK Security and Hernandez entered into a warrant repurchase agreementSeparation Agreement and Mutual Release (the “Separation Agreement”).

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Pursuant to the Separation Agreement, Hernandez’s employment with Avidbank whereby wethe Company as the Company’s Chief Operating Officer was terminated and the Company and Hernandez mutually agreed to release the other from any and all claims, disputes, demands, actions, liabilities, damages, suits (whether at law or in equity), promises, accounts, costs, expenses, setoffs, contributions, attorneys’ fees and/or causes of action of whatever kind or character, whether past, present, future, known or unknown, liquidated or unliquidated, accrued or unaccrued, from the beginning of time, or which may hereinafter accrue as a result of the discovery of new and/or additional facts, which such party has had, may now have, or might claim to have, arising out of the agreements between the parties or any transaction contemplated thereby, based upon the acts or omissions of the other party prior to the date of the Separation Agreement.

Further, pursuant to the Separation Agreement, in lieu of any earn-out payments (as described in the Original SPA (as defined below)) that could be earned by Hernandez under the Original SPA, the Company agreed to pay Hernandez the amount of $3,750,000 in the form of a promissory note (the “Earn-out Note”). The Earn-out Note provides for (i) a maturity date of March 12, 2023, at which all principal and accrued and unpaid interest is due, (ii) a simple interest rate of 5% per annum commencing on January 1, 2018, and compounding annually, and (iii) the right of the Company to prepay all or any portion of the Earn-out Note without premium or penalty. As a result, the Company recorded an additional accrual of $1,394,000 at December 31, 2017 related to the earn-out contingent liability.

Also pursuant to the Separation Agreement, the Company paid Avidbank $4,743off the outstanding amount due under the Hernandez Seller Note and paid Hernandez a severance payment consisting of a $250,000 payment upon execution of the Separation Agreement and the delivery of a promissory note in the original principal amount of $343,750 (the “Severance Payment Note”). The Severance Payment Note bears interest at a rate of 5% per annum, compounds annually, allows for prepayment by the Company and matures on January 10, 2019, at which time all principal and accrued and unpaid interest is due.

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

Amendment to CTEK Security, Inc. (formerly CynergisTek, Inc.) Stock Purchase Agreement; Amended and Restated Promissory Note

On March 12, 2018, the Company, CTEK Security and McMillan entered into an Amendment to Stock Purchase Agreement (“Amendment”). Pursuant to the Amendment, certain provisions of the Stock Purchase Agreement dated as of January 13, 2017 which memorialized the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.) (the “Original SPA”) related to the Earn-Out (as defined in the Original SPA and described in the Company’s Form 8-K dated January 13, 2017) were amended. The earn-out provisions were amended to remove all obligations to make earn-out payments to Hernandez. As to McMillan, the Amendment modified the maximum earn-out payment which could be earned by McMillan to $1,200,000, with a maximum of $400,000 per year based on revised performance metrics (rather than the benchmarks described in the Original SPA) during the 2018, 2019 and 2020 calendar years, as determined by the Company’s board of directors and/or a committee thereof.  

On March 12, 2018, the Company repaid $2,250,000 plus accrued interest on the McMillan Seller Note.  The Company and Mr. McMillan agreed to amend and restate the McMillan Seller Note pursuant to an Amended and Restated Promissory Note (the “A&R McMillan Seller Note”).  The A&R McMillan Seller Note is in the principal amount of $2,250,000, bears interest at a rate of 8% per annum, provides for quarterly payments of principal and interest and matures on March 31, 2022.  Amounts due and owing under the A&R McMillan Seller Note are subordinate to the right of payment due under the BMO Loan pursuant to a Subordination Agreement among the Company, the Bank and Mr. McMillan.  Mr. McMillan is a director and the President and Chief Executive of the Company.

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8.12.PROMISSORY NOTES 

In connection with the acquisition of CTEK Security, Inc. (formerly CynergisTek, Inc.) (Note 11) we issued two promissory notes totaling $9,000,000 to Dr. Michael G. MathewsHernandez and Michael McMillan (the “Seller Notes”), with each of the Seller Notes having an initial principal amount of $4,500,000.  These Seller Notes bear interest at 8% per annum, require quarterly interest-only payments during the first 12 months, quarterly payments of principal and interest during the last 24 months, using a 36-month amortization period commencing from that point, with a balloon payment due on the maturity date.  Amounts due and owing under the Seller Notes are subordinate to the right of payment due under the A&R Credit Agreement pursuant to the Subordination Agreement (Note 7)11).  The Company hashad the right to prepay all or any portion of the outstanding principal balance of the Seller Notes, provided that such prepayment is accompanied by accrued interest on the amount of principal prepaid, calculated to the date of such prepayment.

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

As part of the debt restructuring with BMO Harris Bank N.A. (Note 10), on March 12, 2018, the Company repaid $2,250,000 plus accrued interest on the McMillan Seller Note.  The Company and Mr. McMillan agreed to amend and restate the McMillan Seller Note pursuant to the A&R McMillan Seller Note.  The A&R McMillan Seller Note is in the principal amount of $2,250,000, bears interest at a rate of 8% per annum, provides for quarterly payments of principal and interest and matures on March 31, 2022.  Amounts due and owing under the A&R McMillan Seller Note are subordinate to the right of payment due under the BMO Loan pursuant to a Subordination Agreement among the Company, the Bank and Mr. McMillan.

The foregoing descriptions of the Seller Notes and Subordination Agreementare qualified in their entirety by reference to the respective agreements.  These agreements are found in our Form 8-K filed on January 17, 2017 as Exhibits 99.3, 99.4 and 99.9, respectively. The foregoing descriptions of the A&R McMillan Seller Note are qualified in their entirety by reference to the agreement which is found in our Form 8-K filed on March 13, 2018 as Exhibit 10.5.

Interest charges associated with the Seller Notes totaled $179,507$149,425 and $331,397, respectively$151,890 for the three months ended March 31, 2018 and nine2017, respectively.

Pursuant to the Separation Agreement (see Note 11), in lieu of any earn-out payments (as described in the Original SPA (as defined below)) that could be earned by Hernandez under the Original SPA, the Company agreed to pay Hernandez the amount of $3,750,000 in the form of a promissory note (the “Earn-out Note”). The Earn-out Note provides for (i) a maturity date of March 12, 2023, at which all principal and accrued and unpaid interest is due, (ii) a simple interest rate of 5% per annum commencing on January 1, 2018, and compounding annually, and (iii) the right of the Company to prepay all or any portion of the Earn-out Note without premium or penalty.

Interest charges associated with the Earn-out Note totaled $45,813 for the three months ended September 30, 2017.March 31, 2018.

9.EMPLOYMENT AGREEMENTS

Effective January 1, 2016, we entered into an employment agreement with Joseph FlynnPursuant to the Separation Agreement, the Company also issued a Severance Payment Note to Hernandez in the original principal amount of $343,750 (the “2016 Flynn Agreement”“Severance Payment Note”). The 2016 Flynn Agreement provides that Mr. Flynn will continue his employment as our PresidentSeverance Payment Note bears interest at a rate of 5% per annum, compounds annually, allows for prepayment by the Company and CEO.  The 2016 Flynn Agreement has a term of two years, provides for an annual base salary of $300,000, and will automatically renew for subsequent twelve (12) month terms unless either party provides advance written notice to the other that such party does not wish to renew the agreement for a subsequent twelve (12) months.  Mr. Flynn also receives the customary employee benefits available to our employees. Mr. Flynn is also entitled to receive a bonus of up to $180,000 per year, the achievement of which is basedmatures on Company performance metrics.  We may terminate Mr. Flynn’s employment under the 2016 Flynn Agreement without cause at any time on thirty (30) days advance written notice,January 10, 2019, at which time Mr. Flynn would receive severance pay for twelve monthsall principal and be fully vested in all optionsaccrued and warrants granted to date.  In January 2017, Mr. Flynn resigned as President, and continued to serve as CEO until October 2, 2017.  The foregoing summary of the 2016 Flynn Agreementunpaid interest is qualified in its entirety by reference to the full context of the employment agreement, which is found as Exhibit 10.31 to our Annual Report on Form 10-K fileddue.

Interest charges associated with the SEC on March 30, 2016.

As described in more detail in our Current Report on Form 8-K filed with the SEC on October 6, 2017, Joseph Flynn submitted his letter of resignation as Chief Executive Officer of the Company on October 2, 2017. The Board accepted Mr. Flynn’s resignation as Chief Executive Officer effective as of October 2, 2017 and as a director effective as of October 31, 2017. Mr. Flynn’s resignation was not due to any dispute or disagreement with the Company.

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January 1, 2016, we entered into an employment agreement with Paul Anthony (the “2016 Anthony Agreement”). The 2016 Anthony Agreement provides that Mr. Anthony will continue to serve as our Executive Vice President (“EVP”) and CFO. The 2016 Anthony Agreement has a term of two years, and provides for an annual base salary of $245,000. The 2016 Anthony Agreement will automatically renew for subsequent twelve (12) month terms unless either party provides advance written notice to the other that such party does not wish to renew the agreement for a subsequent twelve (12) months.  Mr. Anthony also receives the customary employee benefits available to our employees. Mr. Anthony is also entitled to receive a bonus of up to $132,000 per year, the achievement of which is based on Company performance metrics.  We may terminate Mr. Anthony’s employment under the 2016 Anthony Agreement without cause at any time on thirty (30) days advance written notice, at which time Mr. Anthony would receive severance pay for twelve months and be fully vested in all options and warrants granted to date.  The foregoing summary of the 2016 Anthony Agreement is qualified in its entirety by reference to the full context of the employment agreement, which is found as Exhibit 10.32 to our Annual Report on Form 10-K filed with the SEC on March 30, 2016. In March 2017, the Board of Directors authorized an increase in Mr. Anthony’s base salary to $250,000 and increased his potential annual bonus amount to $150,000.

The employment agreements of Dr. Michael G. Mathews and Michael McMillan are described inSeverance Payment Note 11 as part of the acquisition of CTEK Security, Inc.

10.CONCENTRATIONS

Cash Concentrations

At times, cash balances held in financial institutions are in excess of federally insured limits.  Management performs periodic evaluations of the relative credit standing of financial institutions and limits the amount of risk by selecting financial institutions with a strong credit standing.

Major Customers

Our two largest customers accounted for approximately 44% of our revenuestotaled $4,191 for the ninethree months ended September 30, 2017 and our two largest customers accounted for approximately 49% of our revenues for the nine months ended September 30, 2016. Our largest customers had accounts receivable totaling approximately $5,200,000 and $4,000,000 as of September 30, 2017 and DecemberMarch 31, 2016 respectively.2018.

11.STOCK PURCHASE AGREEMENT – CTEK SECURITY, INC.

As previously disclosed in our Current Report on Form 8-K, filed with the SEC on January 17, 2017, on January 13, 2017, the Company (known at that time as Auxilio, Inc., a Nevada corporation, and subsequently renamed Cynergistek, Inc., a Delaware corporation, as part of the Reincorporation (the “Company”)) entered into a Stock Purchase Agreement (the “SPA”) with CTEK Security, Inc., a Texas corporation (formerly CynergisTek, Inc.) (“CTEK Security”), Dr. Michael G. Mathews (“Mathews”) and Michael H. McMillan (“McMillan,” and together with Mathews, the “Stockholders”), pursuant to which we acquired 100% of the issued and outstanding shares of common stock (the “Shares”) of CTEK Security from the Stockholders (the “CTEK Security Transaction”).

Pursuant to the SPA, the purchase price paid for the Shares consisted of four components: the Cash Consideration, the Securities Consideration, the Debt Consideration, and the Earn-out Consideration. The total purchase price was approximately $28.3 million.

·Cash Consideration.  We paid the Stockholders a cash payment of $15,000,000, less Closing Net Working Capital Deficit, Funded Indebtedness and Designated Transaction Expenses (defined as certain expenses of the Stockholders and certain expenses of CTEK Security). The net cash amount paid to the Stockholders was $14,202,645. We funded $14 million of the cash consideration through a term loan (Note 7).

·Securities Consideration.  We issued a total of 1,166,666 shares of our common stock, par value $0.001 per share to the Stockholders, with each of the Stockholders receiving 583,333 shares. The estimated fair value of the common stock issued was approximately $2.8 million at closing.

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·Debt Consideration.  We issued promissory notes totaling $9,000,000 to the Stockholders (the “Seller Notes”), with each of the Seller Notes having an initial principal amount of $4,500,000.  The Seller Notes bear interest at 8% per annum, with quarterly interest-only payments in the first year, and quarterly payments of principal and interest in the next 24 months, using a 36-month amortization period commencing from that point, with a balloon payment due on the maturity date.  Amounts due and owing under the Seller NotesEarn-out Note and Severance Payment Note are subordinate to the right of payment due under the AvidBankBMO Loan (described below) pursuant to thea Subordination Agreement.  The Company has the right to prepay all or any portion of the outstanding principal balance of the Seller Notes, provided that such prepayment is accompanied by accrued interest on the amount of principal prepaid, calculated to the date of such prepayment.

·Earn-out Consideration.   The Stockholders may be entitled to an additional $7,500,000 based upon the financial performance of CTEK Security after closing of the CTEK Security Transaction, to be calculated based upon EBITDA generated by the CTEK Security business during the earn-out period, which began as of January 1, 2017, and ends on December 31, 2021 (the “Earn-out Payments”). The estimated fair value of the earn-out was approximately $2.3 million at closing.

Pursuant to the SPA, CTEK Security and the Stockholders agreed to deliver to us stock certificates representing the Shares; the corporate record books of CTEK Security; and the employment agreements (described below). We agreed to deliver the Cash Consideration, the Securities Consideration, the Debt Consideration and the signed employment agreements. By agreement of the parties, the effective date of the CTEK Security Transaction for accounting purposes was January 1, 2017.

In connection with the SPA,Agreement among the Company, the Bank and the Stockholders also entered into a registration rights agreement (the “Registration Rights Agreement”) and employment agreements, each of which is discussed below.Hernandez.

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13.EMPLOYMENT AGREEMENTS

Michael H. McMillan

Registration Rights Agreement

Pursuant to the Registration Rights Agreement between the Company and the Stockholders,In January 2017, we agreed to grant piggy-back registration rights under certain circumstances, and demand registration rights under other circumstances.  Briefly, for the piggy-back rights, if we propose to register the sale of any of our stock or other securities under the Securities Act of 1933, as amended (the “Securities Act”) in connection with the public offering of such securities solely for cash, or the resale of shares of our common stock by other selling stockholders, we agreed that prior to such filing, we would give written notice to the Stockholders of our intention to do so. Upon the written request of a Stockholder given within twenty (20) days after we provide such notice, we agreed to file a registration statement to register the resale of all such registrable securities which we have been requested by such Stockholder to register. With respect to the demand registration rights, we agreed that in the event that we fail to file timely public reports with the U.S. Securities and Exchange Commission if and as required by the Securities Exchange Act of 1934, as amended, then the Stockholders shall have the right, by delivering written notice to us (a “Demand Notice”), to require us to register the number of registrable securities requested to be so registered pursuant to the terms of the Registration Rights Agreement (a “Demand Registration”). Following the receipt of a Demand Notice for a Demand Registration, we agreed to file a registration statement not later than sixty (60) days after such Demand Notice, and we agreed to use our commercially reasonable efforts to cause such registration statement to be declared effective under the Securities Act as promptly as practicable after the filing thereof. Additionally, pursuant to the Registration Rights Agreement, the rights of the Stockholders to deliver a Demand Notice for a Demand Registration are not effective at any time when the registrable securities held by such Stockholder may be resold under Rule 144 of the Securities Act without regard to any volume limitation requirements under Rule 144 of the Securities Act.

Employment Agreements

In connection with the SPA, the Company and each of the Stockholders entered into an employment agreement pursuant to whichwith Michael H. McMillan was appointed President and Chief Strategy Officer of the Company, and Mathews was appointed Executive Vice President of the Company.

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McMillan Employment Agreement.

The Company and McMillan entered into an employment agreement(“McMillan”) (the “McMillan Employment Agreement”), pursuant to which we employemployed McMillan as President and Chief Strategy Officer of the Company. McMillan agreed that his duties for the Company and its subsidiaries would be substantially similar to those duties that McMillan had performed on behalf of CTEK Security, and would include, without limitation, responsibility for executive leadership and business development strategy.  McMillan also agreed to perform additional duties as reasonably assigned by our Chief Executive Officer, and/or Board of Directors in order to advance the interests of the Company and its subsidiaries. The initial term of the McMillan Employment Agreement is 36 months from January 13, 2017, and will automatically renew for subsequent 12-month terms unless either party provides written notice to the other party of a desire to not renew the agreement.

Pursuant to the McMillan Employment Agreement, McMillan’s base salary is $250,000, and he is entitled to incentive bonus compensation and equity compensation (consisting of stock options), as set forth in the McMillan Employment Agreement.  The Company has the right to terminate McMillan’s employment without cause at any time on thirty (30) days’ advance written notice to McMillan. Additionally, McMillan has the right to resign for “Good Reason” (as defined in the McMillan Employment Agreement) on thirty (30) days’ written notice.  In the event of (i) such termination without cause, or (ii) McMillan’s inability to perform the essential functions of his position due to a mental or physical disability or his death,  or (iii) McMillan’s resignation for Good Reason, McMillan is entitled to receive the base salary then in effect and full target annual bonus, prorated to the date of termination, and a “Severance Payment” equivalent to (a) payment of compensation for an additional twelve months, payable as a lump sum, and (b) the acceleration of all unvested stock options and warrants then held by McMillan, subject to certain conditions set forth in the McMillan Employment Agreement.    In addition, if McMillan is terminated by the Company without cause (as defined in the McMillan Employment Agreement), certain of the Earn-out Payments will accelerate and become immediately due and payable, as set forth in the SPA.  If McMillan resigns for other than Good Reason, he will be entitled to receive the base salary for the thirty (30) day written notice period, but no other amounts.  On October 2, 2017, the Board also appointed McMillan as Chief Executive Officer.  Officer and his base salary was increased to $325,000.

MathewsIn February 2018, the Company amended the McMillan Employment Agreement.agreement to extend the term thereof through December 31, 2020 and increased his base salary to $334,700 for 2018, $359,700 for 2019, and the 2020 base salary to be determined by the Board of Directors at the end of the 2019 calendar year. He will also be eligible for a bonus of up to $219,375 and $242,798 in 2018 and 2019, respectively, and his 2020 bonus will be up to 67.5% of his base salary.  The foregoing summary of the McMillan Employment Agreement is qualified in its entirety by reference to the full context of the agreement, which is found as Exhibit 99.6 to our Current Report on Form 8-K filed with the SEC on January 17, 2017, and the amendment to the McMillan Employment Agreement, which is found as Exhibit 10.44 to our Annual Report on Form 10-K filed with the SEC on March 28, 2018.

Paul T. Anthony

Effective January 1, 2016, we entered into an employment agreement with Paul T. Anthony (the “2016 Anthony Agreement”). The 2016 Anthony Agreement provides that Mr. Anthony will continue to serve as our Executive Vice President and CFO. The 2016 Anthony Agreement has a term of two years and provided for an annual base salary of $245,000. The 2016 Anthony Agreement will automatically renew for subsequent twelve (12) month terms unless either party provides advance written notice to the other that such party does not wish to renew the agreement for a subsequent twelve (12) months.  Mr. Anthony also receives the customary employee benefits available to our employees. Mr. Anthony was also entitled to receive a bonus of up to $132,000 per year, the achievement of which is based on Company performance metrics.  We may terminate Mr. Anthony’s employment under the 2016 Anthony Agreement without cause at any time on thirty (30) days advance written notice, at which time Mr. Anthony would receive severance pay for twelve months and be fully vested in all options and warrants granted to date.  The foregoing summary of the 2016 Anthony Agreement is qualified in its entirety by reference to the full context of the employment agreement, which is found as Exhibit 10.32 to our Annual Report on Form 10-K filed with the SEC on March 30, 2016. In March 2017, the Board of Directors authorized an increase in Mr. Anthony’s base salary to $250,000 and increased his potential annual bonus amount to $150,000. In February 2018, the Company extended the Anthony Employment agreement through December 31, 2020 and increased his base salary to $284,700 for 2018, and $309,700 for 2019, with the 2020 base salary to be determined by the Board of Directors at the end of the 2019 calendar year. He will also be eligible for a bonus of up to $185,625 and $209,047 in 2018 and 2019, respectively, and his 2020 bonus will be up to 67.5% of his base salary.

Michael G. Mathews

We entered into an employment agreement with Michael G. Mathews (“Mathews”), (the “Mathews Employment

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Agreement”), pursuant to which we employemployed Mathews as Executive Vice President (Mathews was also appointed Chief OperationOperations Officer on April 27, 2017). Mathews agreed that his duties for the Company and its subsidiaries would be substantially similar to those duties that Mathews had performed on behalf of CTEK Security, and would include, without limitation, day-to-day P&L responsibility for the cybersecurity service business line.  Mathews also agreed to perform additional duties as reasonably assigned by our President, Chief Executive Officer, and/or Board of Directors in order to advance the interests of the Company and its subsidiaries. The initial term of the Mathews Employment Agreement iswas 36 months from January 13, 2017, and willwould automatically renew for subsequent 12-month terms unless either party providesprovided written notice to the other party of a desire to not renew the agreement.

Pursuant to the Mathews Employment Agreement, Mathews’ base salary iswas $250,000, and he iswas entitled to incentive bonus compensation and equity compensation (consisting of stock options), as set forth in the Mathews Employment Agreement.  We

Effective March 12, 2018, Michael G. Hernandez (formerly Michael G. Mathews) (“Hernandez”) resigned as a Director of the Company and as the Company’s Chief Operating Officer. At that time, the Company, CTEK Security and Hernandez entered into a Separation Agreement and Mutual Release (the “Separation Agreement”). Pursuant to the Separation Agreement, Hernandez’ employment with the Company as the Company’s Chief Operating Officer was terminated and the Company and Hernandez mutually agreed to release the other from any and all claims, disputes, demands, actions, liabilities, damages, suits (whether at law or in equity), promises, accounts, costs, expenses, setoffs, contributions, attorneys’ fees and/or causes of action of whatever kind or character, whether past, present, future, known or unknown, liquidated or unliquidated, accrued or unaccrued, from the beginning of time, or which may hereinafter accrue as a result of the discovery of new and/or additional facts, which such party has had, may now have, or might claim to have, arising out of the right to terminate Mathews’ employment without cause atagreements between the parties or any time on thirty (30) days’ advance written notice to Mathews. Additionally, Mathews hastransaction contemplated thereby, based upon the right to resign for “Good Reason” (as defined inacts or omissions of the Mathews Employment Agreement) on thirty (30) days’ written notice.  In the event of (i) such termination without cause, or (ii) Mathews’ inability to perform the essential functions of his position due to a mental or physical disability or his death,  or (iii) Mathews’ resignation for Good Reason, Mathews is entitled to receive the base salary then in effect and full target annual bonus, proratedother party prior to the date of termination, and a “Severance Payment” equivalentthe Separation Agreement.

Pursuant to (a) payment of compensation for an additional twelve months, payable as a lump sum, and (b) the acceleration of all unvested stock options and warrants then held by Mathews, subject to certain conditions set forth in the Mathews Employment Agreement.  In addition, if Mathews is terminated bySeparation Agreement, the Company without cause (as defined in the Mathews Employment Agreement), certainpaid Hernandez a severance payment consisting of the Earn-out Payments will accelerate and become immediately due and payable, as set forth in the SPA.  If Mathews resigns for other than Good Reason, he will be entitled to receive the base salary for the thirty (30) day written notice period, but no other amounts.

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Amended and Restated Credit Agreement and Related Agreements

Also on January 13, 2017,  the Company and its subsidiaries (the “Borrowers”) entered into an Amended and Restated Credit Agreement (the “A&R Credit Agreement”) with ZB, N.A., dba California Bank and Trust (“CBT”), and Avidbank, a California banking corporation (“Avidbank,” and together with CBT, the “Lenders”), as well as Avidbank in its capacity as contractual representative for itself and the other lender (“Agent”).

By way of background, the Company on the one hand and Avidbank on the other hand previously entered into a Loan and Security Agreement, dated as of April 19, 2012 (as amended to date, the “Original Credit Agreement”), pursuant to which Avidbank extended to the Company a term loan and a revolving line of credit.  Subsequently, the Company advised Agent that the Company desired to acquire 100% of the ownership interests of CTEK Security pursuant to the SPA.  The CTEK Security Transaction is prohibited by Section 7.3 of the Original Credit Agreement.  

Borrowers requested that Lenders (1) consent to the CTEK Security Transaction, and (2) provide additional financing in order to finance, in part, the Company’s obligations under the SPA.  Agent and Lenders agreed with such request in accordance with and subject to the terms and conditions of the A&R Credit Agreement and other related documents defined in the A&R Credit Agreement (the “Loan Documents”).  In connection with the entry into the A&R Credit Agreement, the parties to the A&R Credit Agreement agreed that CTEK Security would automatically become a Borrower under the A&R Credit Agreement and under the Loan Documents on the closing date immediately$250,000 payment upon consummation of the CTEK Security Transaction (and not prior thereto), without further action required by any party.

Accordingly, the parties to the A&R Credit Agreement agreed that the A&R Credit Agreement and the Loan Documents would amend and restate the Original Credit Agreement in its entirety, and continue the obligations incurred thereunder and evidenced thereby.  Additionally, any amounts outstanding under the Original Credit Agreement were repaid in full immediately prior to the execution of the A&R Credit Agreement.

Loan Facilities

Term Loans:  PursuantSeparation Agreement and also issued a Severance Payment Note to the A&R Credit Agreement, the Lenders agreed to provide term loansHernandez in the aggregateoriginal principal amount of $14,000,000 to the Company, which was paid to the Stockholders as part of the Cash Consideration in the CTEK Security Transaction (described above)$343,750 (See Note 11). The term loans bearSeverance Payment Note bears interest at a rate of Prime plus 1.5%, and the loans mature on January 12, 2022.  

Revolving Line of Credit: Additionally, pursuant to the A&R Credit Agreement, the Lenders agreed to provide revolving loans to the Borrowers in an aggregate amount of up to $5,000,000. At the closing of the CTEK Security Transaction, no draws were made on the revolving loans.

Security Agreement

In connection with the A&R Credit Agreement, the Borrowers and the Agent entered into a security agreement (the “Security Agreement”), pursuant to which each of the Borrowers agreed to grant to Agent,5% per annum, compounds annually, allows for the ratable benefit of itself, the Lenders and the other secured parties, a first priority security interest in certain collateral to secure prompt payment and performance of the secured obligations under the A&R Credit Agreement.  Pursuant to the Security Agreement, the “Collateral” was defined as including any and all (all such terms as defined in the Security Agreement) of the Accounts, Chattel Paper, Commercial Tort Claims, Deposit Accounts, Documents, Equipment, Instruments, Inventory, Investment Property, General Intangibles, Letter of Credit Rights, Negotiable Collateral, Supporting Obligations, Vehicles, Grantors’ Books, in each case whether now existing or hereafter acquired or created, any money or other assets of any Grantor that now or hereafter come into the possession, custody, or control of Agent and any Proceeds or products of any of the foregoing, or any portion thereof.  In connection with the grant of the security interest in the Collateral, each of the Borrowers made standard representations and warranties relating to ownership of the collateral, location and control of the collateral, and certain rights to payment.

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Seller Subordination Agreement

Additionally, in connection with the A&R Credit Agreement and the CTEK Security Transaction, Mathews, McMillan,prepayment by the Company and Avidbank entered into a subordination agreement (the “Subordination Agreement”), pursuant tomatures on January 10, 2019, at which Mathewstime all principal and McMillan agreed that unlessaccrued and until allunpaid interest is due. The foregoing summary of the Company’s obligations underSeparation Agreement is qualified in its entirety by reference to the A&R Credit Agreement have been repaid in full Mathews and McMillan would not, except as provided in the Subordination Agreement, ask, demand, sue for, take or receive, or retain, from the Company or any other person or entity, by setoff or in any other manner, payment of all or any partcontext of the Subordinate Debt (as defined below), or take any other actionagreement, which is found as Exhibit 10.3 to our Current Report on Form 8-K filed with respect to the Subordinate Debt; forgive, cancel or discharge anySEC on March 13, 2018.

14.CONCENTRATIONS

Cash Concentrations

At times, cash balances held in financial institutions are in excess of federally insured limits.  Management performs periodic evaluations of the Subordinate Debt; ask, demand or receive any securityrelative credit standing of financial institutions and limits the amount of risk by selecting financial institutions with a strong credit standing.

Major Customers

Our two largest customers accounted for approximately 51% of our revenues for the Subordinate Debt; amend any documents relating to the Subordinate Debt or any other agreement, instrument or document evidencing or executed in connection with the Subordinate Debt in a manner that could reasonably be expected to be adverse to Lenders or Agent (or any other holdersthree months ended March 31, 2018 and our two largest customers accounted for approximately 41% of the obligations arising under the A&R Credit Agreement); or bring or join with any creditor in bringing any insolvency proceeding against the Company. Additionally, Mathews and McMillan each directed the Company to make, and the Company agreed to make, such prior payment of the Company’s obligations under the A&R Credit Agreement to Agent and the Lenders.  The Subordination Agreement defines “Subordinate Debt” to include all debt of the Company owing to Mathews and McMillan (or either of them) (a) under the Seller Notes or (b) in respect of the Earn Out Payments (described above), in either case whether now existing or hereafter arising and including all principal, premium, interest, fees, attorneys’ fees, costs, charges, expenses, reimbursement obligations, any other indemnities or guarantees in each case with respect thereto, in each case whether direct or indirect, absolute or contingent, joint or several, due or not due, primary or secondary, liquidated or unliquidated, secured or unsecured.  So long as the Borrowers are not in default under the terms of the A&R Credit Agreement, the Company may make regular payments to the Stockholders under the Seller Notes.

The preliminary allocation of the purchase price of the assets acquired and liabilities assumed in the CTEK Security Transaction based on their fair values was as follows: 

Purchased identifiable intangible assets are amortized on a straight-line basis over the respective useful lives. Estimated useful lives of the identifiable intangible assets acquired ranges from three to ten years. We also recognized goodwill of $16,416,063. Goodwill is recognized as we expect to be able to realize synergies between the two companies, primarily our ability to provide market and reachrevenues for the Redspin products and services to our MDS customers.

The Company incurred approximately $330,000 in legal, accounting and other professional fees related to this acquisition, of which approximately $174,000 were expensed during the ninethree months ended September 30,March 31, 2017.

As Our two largest customers had accounts receivable totaling approximately $5,300,000 and $5,600,000 as of the date of this report, management is still in the process of determining the final accounting related to the CTEK Security transaction. Because management’s analysis has not yet been completed, the Company’s determination of the purchase priceMarch 31, 2018 and the resulting purchase price allocation is preliminary.

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Pro Forma Information

The following supplemental unaudited pro forma information presents the combined operating results of the Company and the acquired business during the three and nine months ended September 30,December 31, 2017, and 2016, as if the acquisition had occurred at the beginning of each of the periods presented. The pro forma information is based on the historical financial statements of the Company and that of the acquired business. Amounts are not necessarily indicative of the results that may have been attained had the combinations been in effect at the beginning of the periods presented or that may be achieved in the future.respectively.