Datasea(DTSS) - 2020 Q4 - Annual Report

PART I Item 1. Description of Business Datasea is a Beijing-based technology company specializing in smart security systems and education-related technologies for the Chinese market Overview and Impact of COVID-19 - The company focuses on smart security solutions, smart hardware, and education-related technologies, commercializing its products for schools, public communities, and governmental authorities in China[14] - Revenue is generated from selling smart security systems and hardware, with product design handled in-house and manufacturing outsourced[15] - The COVID-19 pandemic negatively impacted operations from January to March 2020, but the company developed a new smart epidemic system deployed in 22 schools and 62 communities[19][20] Recent Developments - Completed an IPO on NASDAQ in December 2018, raising net proceeds of approximately $5.7 million[21] - Expanded operations by incorporating new subsidiaries and acquiring three entities from management for no consideration to enhance marketing, 5G partnerships, and hardware development[22][23][24] - Filed a shelf registration on Form S-3 to offer up to $100 million in securities and is addressing a Nasdaq compliance issue for a delayed annual shareholder meeting[27][28] History and Corporate Structure - The company operates in the PRC through a Variable Interest Entity (VIE), Shuhai Beijing, controlled via contractual agreements with its wholly-owned subsidiary, Tianjin Information[36][37] - Key VIE agreements include an Operation and IP Service Agreement, a Voting Rights Entrustment Agreement, an Equity Option Agreement, and an Equity Pledge Agreement[39][40][41] Business and Products - Core platforms include a big data security analysis system and a smart 3D security platform using advanced computer visual and perception algorithms[45][46] - Key products are the Safe Campus Security System, Public Community Security System, and Scenic Area Security System[49][51][52] - Developed a Datasea epidemic system with specific versions for campuses and public communities to address COVID-19 needs[54][55][56] - The business model is expanding to include recurring service fees, such as for epidemic systems and big data services charging 0.38% of transaction value[57][58] Fiscal Year 2020 Revenue Breakdown | Revenue Source | Amount (USD) | Notes | | :--- | :--- | :--- | | Safe Campus Security Systems | $1.29 million | Revenue from 20 schools sold via agents | | Epidemic Related Systems | ~$120,000 | Revenue from 62 contracts | | Total Revenue | $1.41 million | | Competitive Strengths and Growth Strategy - Competitive Strengths include a talented R&D team, 30 software copyrights and 3 patents, quality certifications, and a customer base across 40% of China's provinces[61][62][63] - Growth Strategy is driven by new technology, market needs, sales system enhancement, talent acquisition, and data analytics, with global expansion initiated in Africa[67][68][75] Research and Development - The company has obtained 30 software copyrights and 3 independent patents in China, with 13 additional patent applications under review[82][84] - Plans to invest approximately $10 million in R&D over the next three years, with 60% allocated to personnel salaries[86][87] R&D Expenditure | Fiscal Year | R&D Spending (USD) | | :--- | :--- | | 2019 | $168,248 | | 2020 | $1,114,486 | Manufacturing, Market Operation, and Competition - The company uses an outsourced manufacturing model, partnering with companies like Hangzhou Tuya Technology Co, Ltd, while conducting design and quality control in-house[89][91][92] - Market presence has expanded to 13 provinces, covering about 40% of China's provincial administrative regions[95][96] - The company's competitive edge lies in its fusion of visual and non-visual perception algorithms, claimed to be superior to competitors[105][106][107] FY2020 Financial Snapshot | Metric | Amount (USD) | | :--- | :--- | | Operating Revenue | $1,414,780 | | Operating Cost | $146,380 | | Gross Profit | $1,268,400 | | Gross Margin | 90% | Government Regulation and Employees - Operations are subject to PRC laws, including the Cybersecurity Law and specific regulations for its Safe Campus, Scenic Area, and Smart Community systems[110][111][112] - The company's VIE, Shuhai Beijing, holds key licenses such as the National High Tech Enterprises Certificate and Value-Added Telecommunications Business Operating License[114] Employees by Function | Function | Number of Employees | | :--- | :--- | | Research & Development | 26 | | Marketing and Sales | 11 | | Management | 7 | | Finance & Accounting | 4 | | Other | 10 | | Total | 58 | Item 1A. Risk Factors The company faces significant risks related to its going concern status, VIE structure, reliance on the PRC market, and concentrated stock ownership Risks Relating to Our Business and Industry - The independent auditor's report expresses substantial doubt about the company's ability to continue as a going concern, citing a deficit of approximately $7.4 million[121] - The company relies on third-party contractors for manufacturing, exposing it to supply chain risks such as delays, cost increases, and quality control issues[124] - The business requires significant capital for R&D and growth, and an inability to obtain additional financing could impair operations[131] - The company faces heightened competition from mature companies with more resources and new entrants in the PRC security industry[135] - Control deficiencies in internal control over financial reporting may cause errors in financial statements or untimely SEC filings[140] Risks Relating to Our Corporate Structure - The company depends on VIE agreements to conduct business in the PRC, which may not be as effective as direct ownership and are subject to interpretation under PRC law[155][156] - If PRC authorities determine the VIE contractual arrangements violate regulations, the company could face severe penalties, including the revocation of business licenses[163][165] - The shareholders of the VIE are also the company's majority shareholders and executives, creating potential conflicts of interest[167][168] - The company is a 'controlled company' under NASDAQ rules because majority shareholders hold over 50% of the voting power, exempting it from certain governance requirements[171] Risks Associated With Doing Business in China - Changes in PRC government policies, a slowdown in the PRC economy, or worsening U.S.-China relations could adversely affect the business[173][174][175] - Fluctuations in the Renminbi exchange rate and PRC restrictions on currency conversion may limit the ability to use revenue effectively and distribute dividends[178][179] - The PRC legal system's uncertainties could limit legal protections and make it difficult to enforce U.S. court judgments in the PRC[182][184][185] - Failure by PRC resident shareholders to comply with SAFE foreign exchange regulations could restrict profit distribution and cross-border investment[192][193] - The PCAOB is currently unable to inspect the audit documentation of the company's auditor located in China, which may deprive investors of such benefits[202][203] Risks Relating to Our an Investment in Our Common Stock - Officers and directors collectively hold approximately 71.6% of the company, giving them control over shareholder votes and corporate actions[207][208] - The common stock is thinly traded, which may limit market visibility and make it difficult for investors to buy or sell shares[209][212][213] - The stock may be considered a 'penny stock' if it trades below $5.00 per share, subjecting it to stricter sales regulations[215][216] - The company is not likely to pay cash dividends in the foreseeable future, as it intends to retain earnings for business operation and expansion[222] Item 1B. Unresolved Staff Comments This item is not applicable to the company - The company reports no unresolved staff comments[223] Item 2. Description of Property The company leases all its office spaces and does not own any real estate, with recent expansion into Shenzhen and Hangzhou - The company leases its headquarters in Beijing, with a monthly rent of approximately $33,100, under a lease expiring in October 2022[224] - New leases were signed in August 2020 for office space in Shenzhen (monthly rent ~$29,851) and Hangzhou to support expansion[225][226] Item 3. Legal Proceedings The company and its subsidiaries are not party to any material pending legal proceedings - The company reports that neither it nor its subsidiaries are a party to any material pending legal proceedings[227] Item 4. Mine Safety Disclosures This item is not applicable to the company - The company reports that mine safety disclosures are not applicable[227] PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The company's stock trades on NASDAQ under 'DTSS', with no dividends anticipated and an unused equity incentive plan in place - Common stock began trading on the NASDAQ Capital Market under the symbol 'DTSS' on December 18, 2018[230] - The company does not anticipate paying dividends in the foreseeable future and plans to retain earnings for business development[232] - The 2018 Equity Incentive Plan authorizes up to 4,000,000 shares of common stock, but no awards have been granted under this plan as of the report date[234] Item 6. Selected Financial Data This item is not applicable to the company - The company reports that Selected Financial Data is not applicable[235] Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The company generated its first significant revenue in FY2020 but saw an increased net loss due to sharply higher operating and R&D expenses Results of Operations - Revenue of $1.41 million in FY2020 was generated from Safe Campus security systems ($1.29 million) and customized hardware/software solutions for epidemic control ($124,000)[245][247] - R&D expenses increased by 562% to $1.11 million, mainly due to increased staff and project-specific expenses[250] - Selling expenses increased by 120% to $438,621, primarily due to a payment to a service provider to develop and market an education platform[249] Comparison of Operations (Years ended June 30) | Metric | 2020 | 2019 | | :--- | :--- | :--- | | Revenue | $1,414,780 | $0 | | Gross Profit | $1,268,400 | $0 | | Operating Expenses | $3,173,453 | $1,499,308 | | - R&D Expenses | $1,114,486 | $168,248 | | - Selling Expenses | $438,621 | $199,485 | | - G&A Expenses | $1,620,346 | $1,131,575 | | Loss from Operations | ($1,905,053) | ($1,499,308) | | Net Loss | ($1,863,253) | ($1,425,181) | Liquidity and Capital Resources - Working capital was $2.6 million as of June 30, 2020, down from $4.6 million as of June 30, 2019 (excluding restricted cash)[255] - The increase in cash used in operations was mainly due to a higher net loss, increased prepaid expenses for R&D projects, and decreased advances from customers[260] - Financing activities in FY2019 were primarily driven by net proceeds from the IPO, while in FY2020 they consisted of a shareholder loan repayment[262] Summary of Cash Flows (Years ended June 30) | Activity | 2020 | 2019 | | :--- | :--- | :--- | | Net cash used in operating activities | ($4,573,352) | ($424,048) | | Net cash used in investing activities | ($306,813) | ($66,385) | | Net cash (used in) provided by financing activities | ($84,842) | $5,609,222 | Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure The company changed its independent registered public accounting firm in January 2020 without any disagreements on accounting principles - Wei, Wei & Co, LLP resigned as the company's auditor effective January 10, 2020[266] - There were no disagreements with the former auditor on accounting principles, financial disclosure, or auditing scope[266] - Morison Cogen LLP was appointed as the new independent registered public accounting firm on January 14, 2020[267] Item 9A. Controls and Procedures Management concluded that disclosure controls and internal controls over financial reporting were not effective as of June 30, 2020 - Disclosure controls and procedures were deemed not effective as of the end of the reporting period[269] - A material weakness was identified due to the incorrect capitalization of R&D costs, requiring restatement of quarterly reports for FY2020[269] - Management's report on internal control over financial reporting concluded it was not effective as of June 30, 2020, due to weaknesses including poor segregation of duties and lack of US GAAP expertise[274] - Remediation steps are underway with a target completion date of June 30, 2021[271][272] Item 9B. Other Information There is no other information to report under this item - None[277] PART III Item 10. Directors, Executive Officers and Corporate Governance The company's board includes family members and three independent directors who comprise the Audit, Compensation, and Nomination committees - Director Fu Liu is the father of Chairman and CEO Zhixin Liu[290] - The Board has three independent directors: Stephen Wong, Tongjun Si, and Ling Wang[298] - The Audit, Compensation, and Nomination Committees are each composed entirely of independent directors, with Stephen Wong serving as the audit committee financial expert[291][295][296] Directors and Executive Officers | Name | Age | Position | | :--- | :--- | :--- | | Zhixin Liu | 34 | Chairman of the Board, CEO | | Jijin Zhang | 51 | Chief Financial Officer | | Fu Liu | 55 | Director | | Tongjun Si | 79 | Independent Director | | Stephen (Chun Kwok) Wong | 38 | Independent Director | | Ling Wang | 64 | Independent Director | | Chunqi Jiao | 48 | Chief Technology Officer | Item 11. Executive Compensation Executive compensation consists of salaries, with no equity awards granted in the last fiscal year despite an existing incentive plan - The company has an employment agreement with CEO Zhixin Liu with an annual compensation package of RMB 600,000 (approx $90,340)[307] - No stock or option awards were granted to executive officers in the last fiscal year from the 2018 Equity Incentive Plan[307][309] Summary Compensation Table (Fiscal Year 2020) | Name and Principal Position | Salary ($) | Total ($) | | :--- | :--- | :--- | | Ms. Zhixin Liu, Chairman, CEO | 43,174 | 43,174 | | Jijin Zhang, CFO | 4,397 | 4,397 | | Chunqi Jiao, CTO | 19,924 | 19,924 | Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Company ownership is highly concentrated, with officers and directors as a group beneficially owning 71.6% of the common stock - Ownership is based on 20,943,846 shares of common stock outstanding as of September 16, 2020[318] Beneficial Ownership (as of Sep 16, 2020) | Name of Beneficial Owner | Number of Common Stock Beneficially Owned | Percent of Class Beneficially Owned | | :--- | :--- | :--- | | Zhixin Liu (CEO) | 9,583,335 | 45.75% | | Fu Liu (Director) | 5,416,668 | 25.86% | | All officers and directors as a group (seven persons) | 15,000,003 | 71.6% | Item 13. Certain Relationships and Related Transactions, and Director Independence The company has engaged in several related party transactions, primarily loans and rental agreements with CEO Zhixin Liu - CEO Zhixin Liu provided loans for operating expenses, which were fully settled by June 30, 2020[320] - The company leases multiple vehicles from Ms. Liu under various rental agreements[320][321] - The company rents an apartment and office space from Ms. Liu for its branch and subsidiary operations[321][322][324] Item 14. Principal Accountant Fees and Services Total accountant fees were $67,000 in FY2020, an increase from $58,000 in FY2019, with all services pre-approved by the Board - All audit and non-audit services were reviewed and approved by the Board, which determined that the provision of these services did not impair the auditors' independence[327] Accountant Fees | Fee Type | 2020 | 2019 | | :--- | :--- | :--- | | Audit Fees | $50,000 | $58,000 | | Audit-Related Fees | $17,000 | $0 | | Tax Fees | $0 | $0 | | All Other Fees | $0 | $0 | | TOTAL | $67,000 | $58,000 | PART IV Item 15. Exhibits, Financial Statement Schedules This section lists all filed exhibits, including financial statements, corporate governance documents, VIE agreements, and executive certifications - The financial statements and report of the independent registered public accounting firm are included[329] - A list of exhibits is provided, including corporate governance documents, material contracts such as VIE agreements, and executive certifications[331][333][334] Financial Statements Reports of Independent Registered Public Accounting Firms The auditor's report for FY2020 includes a 'Going Concern' paragraph, highlighting substantial doubt about the company's ability to continue - The auditor's report for FY2020 includes a 'Going Concern' paragraph, citing net losses and negative cash flows as factors that raise substantial doubt[343] - Morison Cogen LLP (FY2020) and Wei, Wei & Co, LLP (FY2019) both opined that the respective financial statements were presented fairly in conformity with U.S. GAAP[342][349] Consolidated Financial Statements Financials show a decrease in assets and stockholders' equity, with an increased net loss of $1.86 million for FY2020 Consolidated Balance Sheet Data (as of June 30) | | 2020 | 2019 | | :--- | :--- | :--- | | Total Assets | $4,913,200 | $7,448,790 | | Cash | $1,065,936 | $6,072,637 | | Total Liabilities | $1,030,764 | $1,683,402 | | Advances from customers | $20,953 | $1,318,897 | | Total Stockholders' Equity | $3,882,436 | $5,765,388 | Consolidated Statement of Operations Data (for the year ended June 30) | | 2020 | 2019 | | :--- | :--- | :--- | | Revenues | $1,414,780 | $0 | | Gross Profit | $1,268,400 | $0 | | Net Loss | ($1,863,253) | ($1,425,181) | | Net Loss Per Share | ($0.09) | ($0.07) | Notes to Consolidated Financial Statements Key notes detail the 'Going Concern' uncertainty, VIE structure, revenue recognition, related party transactions, and a full valuation allowance on NOLs - Going Concern (Note 2): The financial statements were prepared assuming the company will continue as a going concern, but net losses ($1.86M), an accumulated deficit ($7.41M), and negative operating cash flow ($4.57M) raise substantial doubt[373][374] - VIE Structure (Note 2): The company consolidates its operating entity, Shuhai Beijing, as a VIE and details the contractual agreements that provide control[377][380][381] - Revenue Recognition (Note 2 & 7): The company adopted ASC 606 and recognized $1.29 million in revenue in June 2020 from two sales agent contracts for its Safe Campus system[407][443] - Related Party Transactions (Note 8): The company engaged in several transactions with its President, Zhixin Liu, including interest-free loans (repaid in FY2020), car rentals, and an apartment lease[446][447][448] - Income Taxes (Note 10): The company has significant Net Operating Loss (NOL) carryforwards of approximately $5.68 million and has established a full valuation allowance against deferred tax assets[459][464] - Subsequent Events (Note 13): In August 2020, the company formed a new subsidiary and entered into new office lease agreements in Shenzhen and Hangzhou[481]