Intellinetics(INLX) - 2019 Q4 - Annual Report

PART I ITEM 1. BUSINESS Intellinetics provides document solutions software, focusing on a cloud-based SaaS model and recent growth through acquisition and financing Company Overview - Intellinetics, Inc, a Nevada holding company, operates through its two wholly-owned subsidiaries, Intellinetics, Inc (Ohio) and Graphic Sciences, Inc (Michigan)[16] - The company provides document services and software solutions to small-to-medium businesses and governmental sectors[17] - Its software platform allows customers to capture and manage various documents, including scanned hard-copy and digital files like Microsoft Office 365, images, audio, and video[17] - The company offers both on-premise installation and a cloud-based (SaaS) model, viewing increasing SaaS adoption as a key strategic revenue growth opportunity[18] Recent Events - On March 2, 2020, Intellinetics acquired Graphic Sciences, Inc for approximately $3.5 million in cash, with potential earnout payments up to $2.5 million[20] - On March 2, 2020, the company completed a private offering, raising $5.5 million through sales of common stock and units for the acquisition and corporate purposes[21] - On March 2, 2020, all outstanding Convertible Promissory Notes were converted into 1,433,739 shares of Common Stock at a conversion price of $4.00 per share[22] - A one-for-fifty (1-for-50) reverse stock split was implemented on February 27, 2020, and authorized shares were subsequently increased to facilitate recent corporate actions[23][24] Software and Services - Intellinetics Ohio's flagship platform, IntelliCloud, focuses on cloud-based document services and includes professional services like installation, training, and maintenance[25] - The subsidiary Graphic Sciences offers digital scanning, microfilming, physical storage, and sales and repair of scanning equipment[26][28] Marketing and Sales - The company utilizes a multi-channel sales model, including direct sales and intermediaries like resellers and software developers[29] - Marketing programs with resellers and business solution templates for vertical markets aim to shorten sales cycles and expand sales[29] Competition and Market Position - The document solutions market is highly competitive, with primary competitors including DocuWare, Square 9, M-files, On Base, and Laserfiche[30][31] - Graphic Sciences competes with smaller shops and larger entities like Iron Mountain, based on reputation, quality, performance, and price[32] - The company believes its advantage lies in being a focused niche provider for the SMB market, particularly in regulated sectors[33] Customers - For Intellinetics Ohio, two customers each accounted for approximately 6% of 2019 revenues, while government contracts represented 41% of 2019 net revenues[35][37] - Graphic Sciences has significant customer concentration with the State of Michigan under a five-year contract extending to May 2023[38][40] Intellectual Property - The company relies on copyright, trademark laws, and contractual provisions to protect its intellectual property built on a MicrosoftNet framework[42] - Customers license software on a non-exclusive basis, and limited rights are granted to third parties for marketing[43] - While the overall intellectual property is valuable, the business is not materially dependent on any single trademark, license, or right[44] Government Regulation - The company is subject to various laws and regulations, particularly government procurement rules for its governmental customers[45] - Management believes it is in material compliance with applicable regulations, which do not entail significant cost or burden[45] Software Development - The company designs, develops, tests, and supports new software products and enhancements[46] - Software development costs are expensed before technological feasibility, resulting in immaterial capitalized costs for the reported periods[47] - No costs for internal-use software were capitalized during the reported periods[48] Employees - As of March 26, 2020, the company employed 77 individuals, with the vast majority being full-time employees[50] - Employee relations are considered good, and no employees are represented by a labor union or collective bargaining agreement[50] Executive Officers and Board of Directors Executive Officers and Directors (as of December 31, 2019) | Name | Age | Title | | :--- | :--- | :--- | | James F. DeSocio | 64 | President, Chief Executive Officer, and Director | | Matthew L. Chretien | 52 | Chief Strategy Officer, Chief Technology Officer, Secretary, and Director | | Joseph D. Spain | 52 | Chief Financial Officer, Treasurer | | Rye D'Orazio | 65 | Director | | Robert C. Schroeder | 53 | Director, Chairman of the Board | | Sophie Pibouin | 52 | Director | | Roger Kahn | 50 | Director | Available Information - The company's SEC filings are available free of charge on its website as soon as practicable after filing[58] ITEM 1A. RISK FACTORS The company faces significant risks from the COVID-19 pandemic, doubts about its ability to continue as a going concern, and various operational challenges Risks Relating to Our Business - The COVID-19 outbreak could negatively impact the company's business, customers, and vendors, with potential delayed effects on subscription revenue[62] - Management has expressed substantial doubt about the company's ability to continue as a going concern due to recurring net losses and capital needs[63] - Insufficient cash reserves and the inability to raise additional capital could lead to a curtailment of operations[67] - Adverse global economic conditions are likely to negatively affect operating results, leading to longer sales cycles and margin pressure[69] - The company's sales cycle can fluctuate significantly, leading to variations in revenue recognition[73] - Reliance on reseller partnerships for sales means any reduction in their efforts could materially impact revenues[74] - Failure to continuously develop technologically advanced products or achieve market acceptance could harm operating results[75][77] - Security breaches or disruptions at third-party data centers could lead to reputational damage, litigation, and significant liabilities[82][87] - The loss of major customers could negatively affect financial condition, especially given that government contracts were 41% of net revenues in 2019[93] - Investment in R&D is costly and speculative, with no assurance of sufficient returns[94] - The use of open-source software carries the risk of having to disclose proprietary source code[96] - Failure to protect intellectual property or facing infringement claims could increase costs and harm revenue[97][99] - Competition from larger, well-capitalized companies could significantly impact future revenues and profit margins[101][102] - Inability to attract and retain key employees could harm the company's ability to compete[105] - The recent GSI Acquisition may not be accretive and could be dilutive, while future acquisitions carry integration and financial risks[119][121][122] Risks Relating to Our Common Stock - As a former 'shell company,' its securities may have trading limitations, and shareholders cannot rely on Rule 144 if SEC filings are not current[124] - The common stock is quoted on the OTCQB, subjecting it to limited trading, high volatility, and liquidity risk[125] - Future sales of common stock by eligible stockholders under Rule 144 could adversely affect the market price[128] - The stock price may fluctuate significantly due to various factors, potentially leading to stockholder losses and litigation[129][130] - The common stock may be subject to SEC 'penny stock' rules, which could adversely affect trading liquidity[131] - Outstanding warrants with a 'cashless exercise' feature could dilute existing stockholders without a corresponding influx of capital[132] - FINRA sales practice requirements for low-priced securities may limit broker-dealer recommendations, affecting marketability[133][135] - The company does not anticipate paying cash dividends in the foreseeable future and is subject to restrictive loan covenants[136] ITEM 1B. UNRESOLVED STAFF COMMENTS This item is not applicable as the company has no unresolved staff comments ITEM 2. PROPERTIES The company leases office, operational, and storage facilities in Ohio and Michigan for its headquarters and subsidiary operations - Intellinetics Ohio leases a 6,000 sq ft office facility in Columbus, Ohio, for its headquarters, with a lease term until December 31, 2021[139] - Graphic Sciences leases a 36,000 sq ft main facility in Madison Heights, Michigan, until August 31, 2026[140] - Graphic Sciences also leases a separate 20,000 sq ft building for document storage in Highland Park, MI, until August 31, 2021[141] - The subsidiary owns specialized scanning equipment and operates a fleet of six leased vehicles for logistics[142] ITEM 3. LEGAL PROCEEDINGS The company is not currently involved in any material legal proceedings ITEM 4. MINE SAFETY DISCLOSURE This item is not applicable to the company's operations PART II ITEM 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The company's common stock trades on the OTCQB with 172 stockholders of record and no recent dividends or issuer purchases - The company's common stock is quoted on the OTCQB Venture Market under the symbol "INLX"[145] - As of March 26, 2020, there were 172 stockholders of record[146] - No dividends on common stock were paid in the last two fiscal years, and none are anticipated in the foreseeable future[147] - There were no unregistered securities issuances in Fiscal Year 2019 not previously disclosed[148] - There were no issuer purchases of securities[149] ITEM 6. SELECTED FINANCIAL DATA This item is not applicable as the company is a smaller reporting company ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The company's financial performance reflects a strategic shift to SaaS, recent acquisitions, and significant liquidity challenges Company Overview - Intellinetics is a document solutions software company serving both public and private sectors[155] - The company's software platform enables customers to capture and manage all types of scanned and digital documents[155] - The company offers on-premise and cloud-based (SaaS) models, anticipating SaaS to become its primary software business and a key growth driver[156] Cloud-based Revenue as % of Total Revenue | Year | Cloud-based Revenue (% of Total) | | :--- | :--- | | 2019 | 34% | | 2018 | 31% | How We Evaluate our Business Performance and Opportunities - The company's strategy focuses on cloud-based software delivery, assessing revenue growth from this source[163] - Performance is evaluated by sales channel, focus on vertical markets, and customer engagement profit margins[163] - The sales cycle averages 1-2 months, with large projects lasting 3-6 months[163] - R&D efforts for new software products are critical and evaluated for market success and profitability[163] - Costs and capital needs are monitored to ensure efficiency and support for the business plan[163] Recent Developments - On March 2, 2020, Intellinetics acquired Graphic Sciences for approximately $3.5 million cash, with potential earnouts up to $2.5 million[159] - On March 2, 2020, the company raised $5.5 million in a private offering to fund the acquisition and for general corporate purposes[160] - On March 2, 2020, all outstanding Convertible Promissory Notes were converted into 1,433,739 shares of Common Stock at $4.00 per share[161] - A one-for-fifty (1-for-50) reverse stock split was implemented effective February 27, 2020, followed by an increase in authorized shares[162][164] Executive Overview of Results - The COVID-19 pandemic is expected to materially adversely affect the company's business, financial condition, and results of operations[167] Key Financial Results (FY2019) | Metric | Amount | | :--- | :--- | | Revenues | $2,535,955 | | Revenue Growth (YoY) | 6% | | Cost of Revenues | $567,843 | | Operating Expenses (excl. Cost of Revenues) | $3,120,704 | | Losses from Operations | $(1,152,592) | | Net Loss | $(2,133,281) | | Basic and Diluted Net Loss per Share | $(0.12) | | Operating Cash Flow | $(982,169) | | Capital Expenditures | $5,489 | | Number of Employees (Dec 31, 2019) | 18 | Results of Operations - The net increase in total revenues was primarily due to growth in professional services and SaaS, offset by a decrease in third-party services[168] - Cost of revenues decreased by 24% year-over-year to $567,843 in 2019, driven by improved SaaS margins and a shift away from third-party services[175] Total Revenues (2019 vs. 2018) | Year | Total Revenues | Change (YoY) | % Change (YoY) | | :--- | :--- | :--- | :--- | | 2019 | $2,535,955 | $154,528 | 6% | | 2018 | $2,381,427 | - | - | Revenue Breakdown and Changes (2019 vs. 2018) | Revenue Category | 2019 Revenue | 2018 Revenue | Change (YoY) | % Change (YoY) | | :--- | :--- | :--- | :--- | :--- | | Sale of Software | $189,165 | $173,691 | $15,474 | 9% | | Software as a Service | $859,637 | $748,754 | $110,883 | 15% | | Software Maintenance Services | $1,011,278 | $995,170 | $16,108 | 2% | | Professional Services | $449,707 | $289,962 | $159,745 | 55% | | Third Party Services | $26,168 | $173,850 | $(147,682) | -85% | Gross Margins by Category (2019 vs. 2018) | Category | 2019 Gross Margin | 2018 Gross Margin | | :--- | :--- | :--- | | Overall Gross Margin | 78% | 69% | | Sale of Software | 95% | 60% | | Software as a Service | 70% | 60% | | Software Maintenance Services | 91% | 90% | | Professional Services | 57% | 58% | | Third Party Services | 5% | 13% | Operating Expenses - General and administrative expenses increased slightly due to professional fees related to the GSI Acquisition and Offering[187] - Sales and marketing expenses remained relatively flat[188] - Interest expense increased primarily from notes payable issued in September 2018[190] Operating Expenses (2019 vs. 2018) | Expense Category | 2019 Amount | 2018 Amount | Change (YoY) | % Change (YoY) | | :--- | :--- | :--- | :--- | :--- | | General and Administrative | $2,131,385 | $2,106,851 | $24,534 | 1% | | Sales and Marketing | $981,618 | $997,910 | $(16,292) | -2% | | Depreciation | $7,701 | $9,040 | $(1,339) | -15% | | Interest Expense, Net | $980,689 | $865,501 | $115,188 | 13% | Liquidity and Capital Resources - The significant net working capital deficit was due to notes payable becoming current, which were largely converted to equity in March 2020[191] - The company's ability to continue as a going concern is contingent upon managing cash requirements, as operating cash flows may be insufficient[193] - From 2012 through March 2, 2020, the company raised $18,533,494 through debt and equity issuances[194] - As of March 26, 2020, the company had 2,810,840 shares of common stock outstanding[195] - The recent Reverse Split is expected to improve the liquidity and marketability of the common stock[197] - In March 2020, substantially all outstanding promissory notes were converted to equity, and new 12% promissory notes totaling $2,000,000 were issued[199] Liquidity Snapshot (as of December 31, 2019) | Metric | Amount | | :--- | :--- | | Cash | $404,165 | | Net Working Capital Deficit | $(6,437,382) | Cash Flow from Operating Activities (2019 vs. 2018) | Year | Net Cash Used in Operating Activities | | :--- | :--- | | 2019 | $(982,169) | | 2018 | $(1,157,407) | Cash Flow from Investing Activities (2019 vs. 2018) | Year | Net Cash Used in Investing Activities | | :--- | :--- | | 2019 | $(5,489) | | 2018 | $(3,410) | Cash Flow from Financing Activities (2019 vs. 2018) | Year | Net Cash Provided by Financing Activities | | :--- | :--- | | 2019 | $303,193 | | 2018 | $1,123,526 | Critical Accounting Policies and Estimates - The preparation of financial statements requires management to make estimates and assumptions that could affect operating results[209][210] - Key accounting policies include liquidity, revenue recognition, deferred revenues, allowance for doubtful accounts, and stock-based compensation[211] - Revenue recognition follows ASC 606, using a five-step model to determine the timing of recognition[213] - Software development costs are expensed before technological feasibility is reached; no such costs were capitalized[221][222] - Stock-based compensation is recognized based on fair values estimated using the Black-Scholes-Merton option pricing model[223][224] - The company adopted ASC 842 (Leases) on January 1, 2019, recording a lease liability of $143,761 and a right-of-use asset of $138,549[297] - The company is currently evaluating the impact of new accounting pronouncements not yet effective[298][299][300] ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK This item is not applicable as the company is a smaller reporting company ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA This section presents audited consolidated financial statements for 2019 and 2018, with an auditor's report noting going concern doubts Report of Independent Registered Public Accounting Firm - GBQ Partners LLC audited the consolidated financial statements for 2019 and 2018, expressing a fair opinion in all material respects[231] - The report includes an explanatory paragraph noting substantial doubt about the company's ability to continue as a going concern[232] - The audit did not include an opinion on the effectiveness of internal control over financial reporting[234] - The auditor's opinion is not modified regarding the significant acquisition of Graphic Sciences, Inc, which is a subsequent event[236] Consolidated Balance Sheets Consolidated Balance Sheets (as of December 31) | ASSETS | 2019 | 2018 | | :--- | :--- | :--- | | Cash | $404,165 | $1,088,630 | | Accounts receivable, net | $329,571 | $135,739 | | Prepaid expenses and other current assets | $138,396 | $162,495 | | Total current assets | $872,132 | $1,386,864 | | Property and equipment, net | $6,919 | $9,131 | | Right of use asset | $97,239 | - | | Other assets | $10,284 | $10,284 | | Total assets | $986,574 | $1,406,279 | | LIABILITIES AND STOCKHOLDERS' DEFICIT | | | | Accounts payable and accrued expenses | $371,017 | $308,121 | | Lease liability - current | $47,397 | - | | Deferred revenues | $754,073 | $723,619 | | Deferred compensation | $117,166 | $165,166 | | Accrued interest payable | $1,212,498 | - | | Notes payable, net | $3,339,963 | - | | Notes payable - related party, net | $1,467,400 | $46,807 | | Total current liabilities | $7,309,514 | $1,243,713 | | Long-term liabilities: | | | | Notes payable | - | $3,144,926 | | Notes payable - related party | - | $1,045,937 | | Lease liability - net of current portion | $53,318 | - | | Accrued interest payable | - | $502,295 | | Total long-term liabilities | $53,318 | $4,693,158 | | Total liabilities | $7,362,832 | $5,936,871 | | Stockholders' deficit: | | | | Common stock | $31,528 | $30,733 | | Additional paid-in capital | $14,388,280 | $14,101,460 | | Accumulated deficit | $(20,796,066) | $(18,662,785) | | Total stockholders' deficit | $(6,376,258) | $(4,530,592) | | Total liabilities and stockholders' deficit | $986,574 | $1,406,279 | Consolidated Statements of Operations Consolidated Statements of Operations (for the Twelve Months Ended December 31) | Metric | 2019 | 2018 | | :--- | :--- | :--- | | Revenues: | | | | Sale of software | $189,165 | $173,691 | | Software as a service | $859,637 | $748,754 | | Software maintenance services | $1,011,278 | $995,170 | | Professional services | $449,707 | $289,962 | | Third party services | $26,168 | $173,850 | | Total revenues | $2,535,955 | $2,381,427 | | Cost of revenues: | | | | Sale of software | $8,633 | $69,754 | | Software as a service | $254,999 | $300,235 | | Software maintenance services | $87,280 | $100,205 | | Professional services | $192,129 | $120,421 | | Third party services | $24,802 | $151,790 | | Total cost of revenues | $567,843 | $742,405 | | Gross profit | $1,968,112 | $1,639,022 | | Operating expenses: | | | | General and administrative | $2,131,385 | $2,106,851 | | Sales and marketing | $981,618 | $997,910 | | Depreciation | $7,701 | $9,040 | | Total operating expenses | $3,120,704 | $3,113,801 | | Loss from operations | $(1,152,592) | $(1,474,779) | | Other income (expense): | | | | Interest expense, net | $(980,689) | $(865,501) | | Net loss | $(2,133,281) | $(2,340,280) | | Basic and diluted net loss per share | $(5.76) | $(6.60) | | Weighted average number of common shares outstanding - basic and diluted | 370,279 | 354,538 | Consolidated Statement of Stockholders' Deficit - The accumulated deficit increased from $(18,662,785) at year-end 2018 to $(20,796,066) at year-end 2019, primarily due to the net loss[243] Consolidated Statement of Stockholders' Deficit (for the Twelve Months Ended December 31) | Metric | 2019 | 2018 | | :--- | :--- | :--- | | Balance, December 31, 2017 | | $(2,643,555) | | Stock Issued to Directors | | $57,500 | | Stock Option Compensation | | $249,025 | | Note Offer Warrants | | $64,347 | | Beneficial Conversion of Convertible Notes | | $82,371 | | Net Loss | | $(2,340,280) | | Balance, December 31, 2018 | $(4,530,592) | | | Stock Issued to Directors and Employee | $87,500 | | | Stock Option Compensation | $200,115 | | | Net Loss | $(2,133,281) | | | Balance, December 31, 2019 | $(6,376,258) | | Consolidated Statements of Cash Flows - Net cash used in operating activities decreased in 2019 compared to 2018, due to non-cash expense adjustments and changes in operating assets and liabilities[203][245] - Financing activities provided cash through new borrowings, partially offset by repayments of notes payable to related parties[206][207][245] Consolidated Statements of Cash Flows (for the Twelve Months Ended December 31) | Cash Flow Activity | 2019 | 2018 | | :--- | :--- | :--- | | Net cash used in operating activities | $(982,169) | $(1,157,407) | | Net cash used in investing activities | $(5,489) | $(3,410) | | Net cash provided by financing activities | $303,193 | $1,123,526 | | Net decrease in cash | $(684,465) | $(37,291) | | Cash - beginning of period | $1,088,630 | $1,125,921 | | Cash - end of period | $404,165 | $1,088,630 | Notes to Consolidated Financial Statements PART III ITEM 10. Directors, Executive Officers and Corporate Governance Information on directors and governance is incorporated by reference from the company's upcoming 2020 Proxy Statement - Information regarding directors, executive officers, and corporate governance is incorporated by reference from the definitive Proxy Statement for the 2020 Annual Meeting of Stockholders[388] ITEM 11. Executive Compensation Information on executive compensation is incorporated by reference from the company's upcoming 2020 Proxy Statement - Information regarding executive compensation is incorporated by reference from the definitive Proxy Statement for the 2020 Annual Meeting of Stockholders[389] ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Information on security ownership is incorporated by reference from the company's upcoming 2020 Proxy Statement - Information regarding security ownership of certain beneficial owners and management and related stockholder matters is incorporated by reference from the definitive Proxy Statement for the 2020 Annual Meeting of Stockholders[390] ITEM 13. Certain Relationships and Related Transactions, and Director Independence Information on related transactions and director independence is incorporated by reference from the company's upcoming 2020 Proxy Statement - Information regarding certain relationships and related transactions, and director independence is incorporated by reference from the definitive Proxy Statement for the 2020 Annual Meeting of Stockholders[391] ITEM 14. Principal Accounting Fees and Services Information on accounting fees and services is incorporated by reference from the company's upcoming 2020 Proxy Statement - Information regarding principal accounting fees and services is incorporated by reference from the definitive Proxy Statement for the 2020 Annual Meeting of Stockholders[392] PART IV ITEM 15. Exhibits, Financial Statement Schedules This section lists the financial statements and exhibits filed with the report, omitting schedules as they are not applicable - Financial statements are referenced as beginning on Page F-1[393] - Financial Statement Schedules have been omitted because they are not required, not applicable, or the information is otherwise included[229][394] - An Exhibit Index lists all exhibits filed or incorporated by reference as part of this report[396] Signatures The report is duly signed by principal executive officers and directors as of March 30, 2020 - The report is signed by James F DeSocio (President, CEO, and Director), Joseph D Spain (CFO and Treasurer), Matthew L Chretien (CSO, CTO, Secretary, and Director), and other directors on March 30, 2020[399][400]