10-K 1 bsqr-10k_20191231.htm 10-K bsqr-10k_20191231.htm

 

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2019

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from           to           

Commission file number: 000-27687

BSQUARE CORPORATION

(Exact name of registrant as specified in its charter)

 

Washington

91-1650880

(State or other jurisdiction of
incorporation or organization)

(I.R.S. Employer
Identification Number)

110 110th Avenue NE, Suite 300, Bellevue, Washington 98004

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code: (425) 519-5900

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(b) of the Exchange Act:

 

Title of each class

 

Trading Symbol(s)

 

Name of each exchange on which registered

Common stock, no par value

 

BSQR

 

The NASDAQ Stock Market LLC

 

Securities registered pursuant to Section 12(g) of the Act: NONE

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  No 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes  No 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  No 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes  No 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer 

Accelerated filer 

Non-accelerated filer 

Smaller reporting company 

Emerging growth company 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  No 

The aggregate market value of common stock held by non-affiliates of the registrant on June 30, 2019 was approximately $11.8 million and was determined using the closing price of our common stock on that same date per the NASDAQ Stock Market ($1.16). The number of shares of common stock outstanding as of January 31, 2020: 13,042,293

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement to be delivered to shareholders in connection with the 2020 annual meeting of shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

 

 



 

BSQUARE CORPORATION

FORM 10-K

TABLE OF CONTENTS

 

 

 

Page

 

PART I

 

 

 

 

Item 1

Business

2

 

 

 

Item 1A

Risk Factors

8

 

 

 

Item 1B

Unresolved Staff Comments

17

 

 

 

Item 2

Properties

17

 

 

 

Item 3

Legal Proceedings

17

 

 

 

Item 4

Mine Safety Disclosures

17

 

 

 

 

PART II

 

 

 

 

Item 5

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

18

 

 

 

Item 6

Selected Financial Data

18

 

 

 

Item 7

Management’s Discussion and Analysis of Financial Condition and Results of Operations

19

 

 

 

Item 7A

Quantitative and Qualitative Disclosures About Market Risk

25

 

 

 

Item 8

Financial Statements and Supplementary Data

26

 

 

 

Item 9

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

51

 

 

 

Item 9A

Controls and Procedures

51

 

 

 

Item 9B

Other Information

51

 

 

 

 

PART III

 

 

 

 

Item 10

Directors, Executive Officers and Corporate Governance

52

 

 

 

Item 11

Executive Compensation

52

 

 

 

Item 12

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

52

 

 

 

Item 13

Certain Relationships and Related Transactions, and Director Independence

52

 

 

 

Item 14

Principal Accounting Fees and Services

52

 

 

 

 

PART IV

 

 

 

 

Item 15

Exhibits, Financial Statement Schedules

53

 

 

 

Item 16

Form 10-K Summary

55

 

 

 

 

Signatures

56

 

 

 

 


 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements contained in this Annual Report on this Form 10-K (“Form 10-K”) are not purely historical statements, discuss future expectations, contain projections of results of operations or financial condition, or state other forward-looking information. Those statements are subject to known and unknown risks, uncertainties, and other factors that could cause the actual results to differ materially from those contemplated by the statements. The “forward-looking” information is based on various factors and was derived using numerous assumptions. In some cases, you can identify these so-called forward-looking statements by words like “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “seeks” or “continue” or the negative of those words and other comparable words. You should be aware that those statements only reflect our predictions and are subject to risks and uncertainties. Actual events or results may differ substantially. Important factors that could cause our actual results to be materially different from the forward-looking statements include (but are not limited to) the following:

 

1)

risks associated with the operation of our business generally, including:

 

a)

customer demand for our services and solutions;

 

b)

maintaining a balance of our supply of skills and resources with customer demand;

 

c)

effectively competing in a highly competitive market;

 

d)

protecting our customers’ and our data and information;

 

e)

risks from international operations including fluctuations in exchange rates;

 

f)

obtaining favorable pricing to reflect services provided;

 

g)

adapting to changes in technologies and offerings;

 

h)

risk of loss of one or more significant software vendors;

 

i)

making appropriate estimates and assumptions in connection with preparing our consolidated financial statements;

 

j)

maintaining effective internal controls; and

 

k)

changes to tax levels, audits, investigations, tax laws or their interpretation;

 

2)

the impact of the general economy and economic and political uncertainty on our business;

 

3)

risks associated with potential changes to federal, state, local and foreign laws, regulations, and policies;

 

4)

risks associated with managing growth organically and through acquisitions;

 

5)

risks associated with servicing our debt, the potential impact on the value of our common stock from the conditional conversion features of our debt and the associated convertible note hedge transactions;

 

6)

legal liabilities, including intellectual property protection and infringement or the disclosure of personally identifiable information; and

 

7)

the risks detailed from time to time within our filings with the Securities and Exchange Commission (the “SEC”).

This discussion is not exhaustive but is designed to highlight important factors that may impact our forward-looking statements. Because the factors referred to above, as well as the statements included under the heading “Risk Factors” in this Form 10-K, including documents incorporated by reference therein and herein, could cause actual results or outcomes to differ materially from those expressed in any forward-looking statement made by us or on our behalf, you should not place undue reliance on any forward-looking statements.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. We are under no duty to update any of the forward-looking statements after the date of this Form 10-K to conform such statements to actual results.

All forward-looking statements, express or implied, included in this report and the documents we incorporate by reference and that are attributable to Bsquare Corporation and its subsidiaries (collectively, “we,” “us,” “Bsquare,” or the “Company”) are expressly qualified in their entirety by this cautionary statement. This cautionary statement should also be considered in connection with any subsequent written or oral forward-looking statements that the Company or any persons acting on our behalf may issue.

1

 


 

PART I

Item 1.

Business.

Overview

We believe the promise of Internet of Things (“IoT”) will be realized through the development of intelligent devices and systems that are cloud-enabled, contribute critical data, facilitate distributed control and decision making, and operate securely at scale. The opportunity to help companies transform their businesses and operations through these intelligent systems is enormous, and Bsquare offers a unique combination of expertise in device-level solutions, embedded operating systems, and IoT software and services. Since our founding in 1994, Bsquare has been at the intersection of hardware and software. Today that intersection is the “edge” where cloud-enabled devices connect to create intelligent systems that share data, facilitate distributed control and machine learning, and operate securely at scale. From device hardware, to the operating system, to IoT software solutions, and cloud services that make intelligent systems possible, Bsquare’s expertise, products and services are at the center of digital transformation.

While 2019 was a year of transition for Bsquare, we expect 2020 to be a year of focus and discipline as we seek to accelerate the recovery we started in 2019. With an entrepreneurial leadership team in place we anticipate a return to revenue growth and predictability. In 2019 we established a foundation that will allow Bsquare to more readily take advantage of growth opportunities as they become apparent.

Our Partner Solutions business segment is a strong source of both cash and important partner and customer relationships. We are uniquely positioned as a software-only Microsoft distributor. Because we sell operating system (“OS”) software decoupled from hardware, we can partner with a wide range of customers, especially those who are concerned about procuring their software from a potential hardware competitor. Nearly every customer that has been buying OS software is now contemplating their IoT strategy and our longstanding relationship allows us to cross sell our Edge to Cloud products and services.

The distribution market is also changing dramatically. Our customers’ products, essentially hardware and associated software, cannot be sold, installed, and then forgotten. Today, our customers constantly seek to maintain and optimize the operating system, firmware, and software in their products. Further, these devices are increasingly becoming a part of complex networks, what is often referred to as IoT, and what we call intelligent systems. This evolution is creating new opportunities for our business. Our software and edge expertise combined with our position as a supply chain partner makes us uniquely suited to address these complex requirements.

In our Edge to Cloud business segment, we plan to expand on the valuable experience we gained serving our large customers in 2019 building and operating their IoT solutions at scale. Our B2IQ software and consulting suite and our improved engineering methodologies create a foundation upon which we can build and grow this business segment. We plan to continue to invest in creating an agile and quality-oriented customer service function that will become an integral part of our customers’ IoT operations, allowing our customers to rely on Bsquare to ensure that their products are well designed and can operate in a fully connected IoT-enabled world.

In pursuing revenue growth in both segments, we seek to exploit what we believe to be the obvious synergy between our two core businesses.

We were incorporated in the State of Washington in July 1994. Our principal office is located at 110 110th Avenue NE, Suite 300, Bellevue, Washington 98004, and our telephone number is (425) 519-5900. Our website address is www.bsquare.com. Information contained on or that can be accessed through our website is not a part of this Form 10-K.

Partner Solutions Business Segment

Customers engage us because of our long history as a Microsoft OS distribution and technology partner and our industry leading technical expertise in OS image development, device software development and testing, and embedded and mobile operating systems design. We believe that engaging us on a new device design typically results in shorter development cycles and reduced time-to-market, lower overall costs to complete projects, and enhanced product robustness and features, which a customer may otherwise have been unable to achieve.

Market

Our target market includes makers of connected, intelligent computing devices such as point-of-sale terminals, kiosks, tablets and handheld data collection devices, smart vending machines, ATM machines, essential equipment in buildings and facilities environments, digital signs and in-vehicle telematics and entertainment devices. These devices utilize various operating system software including Microsoft Windows IoT, Android, Linux, or QNX, and are typically connected to a network via a wired or wireless connection. Our customers, for these smart devices, include world-class original equipment manufacturers (“OEMs”), original design manufacturers (“ODMs”), corporate enterprises (“Enterprises”), silicon vendors (“SVs”) and peripheral vendors.

2

 


 

Software Distribution

We have distribution agreements with multiple third-party software vendors. Our ability to resell these third-party software products, whether as stand-alone products or in conjunction with our own proprietary software and engineering service offerings, provides our customers with a comprehensive solution source for their device project needs. Our primary third-party software offerings include the following:

 

For over 20 years, we have been a Microsoft authorized Value-Added Provider (“VAP”) of Windows IoT operating systems and toolkits for the complete line of Windows IoT products, including major product families such as Windows IoT Compact, Windows IoT Standard and Windows IoT Server. Effective March 1, 2019, pursuant to a Global Partnership Agreement with Microsoft, we are authorized to sell Windows IoT operating systems in Canada, the United States, Argentina, Brazil, Chile, Mexico, Peru, Venezuela, Puerto Rico, Columbia, and several Caribbean countries. Of our total revenue, 79% in 2019 and 75% in 2018 resulted from the sale of Windows IoT operating systems. Our existing distribution agreement for sales of Windows IoT operating systems in the European Union (“E.U.”), the European Free Trade Association, Turkey and Africa, expired on June 30, 2019 and was not renewed thereafter. We generated approximately 3% of our Partner Solutions software sales under this agreement in 2019.

 

We have been a Microsoft authorized VAP of Windows Mobile operating systems since November 2009. Along with Windows Mobile operating systems, we also sell Microsoft’s Office Mobile product. We are currently authorized to sell Windows Mobile operating systems and related products in North America, South America, Central America (excluding Cuba), Japan, Taiwan, and the region comprised of Europe, the Middle East, and Africa (“EMEA”). Of our total revenue in 2019, 5% was generated through the sale of Windows Mobile operating systems, compared to 6% in 2018. Our current distribution agreements related to Windows Mobile operating systems expire on April 30, 2022;

 

We are an authorized distributor for Adobe Flash technologies and Adobe Reader. We have the right to distribute Adobe Flash Lite licenses on a worldwide basis; and

 

We are an authorized distributor of McAfee security software in North America.

The majority of our revenue continues to be derived from reselling Microsoft Windows operating system software to device makers. The sale of Microsoft operating systems has accounted for substantially all of our third-party software revenue historically, including approximately 98% of third-party software revenue in 2019 and 97% in 2018.

Software Products

We offer the following software products (B2IQ OS Utilities) and anticipate developing additional products during the year to compliment the offerings of our partners and address the evolving needs of our customers:

 

B2IQ Imaging and Recovery Tool. A turnkey utility for managing the operating system image of a Windows-based device. The graphic user interface facilitates capturing an operating system image, including the Windows operating system and any applications, and simplifies deploying images from external media. It offers a recovery mode that stores an image in a hidden partition, allowing the system to be restored to a working state by a non-technical end user in the field.

 

B2IQ Field Upgrade Tool. A streamlined utility for remote, cloud-based upgrades of Windows OEM appliances and devices in the field.

Service Products

Bsquare offers a full suite of professional services to assist our customers with the design, development, and deployment of devices and systems that make use of the software we resell. Typically, our professional services are provided on a time and materials consulting basis, although the Jumpstart service is offered as a package. Our professional services include the following:

 

Windows 10 IoT Enterprise Jumpstart. Bsquare plans to build a production-ready system software image for a customer device, including retrieving and installing latest Windows updates. We also offer live Windows 10 IoT Enterprise training.

 

Image build. Bsquare plans to build a production-ready Linux or Android system software image with the latest OS updates. We develop the image, configure it on the target device, and install customers’ OEM drivers and software.

 

OS upgrade and porting services. Bsquare helps modernize our customers’ operating systems by upgrading within an operating system family or porting to alternate operating system platforms.

3

 


 

 

Embedded OS Support Services. Bsquare provides support for embedded operating systems and we have direct access to premium Microsoft Embedded Operating System support.

 

Field upgrade consulting. Bsquare provides support for customers upgrading their devices and systems reducing the cost and complexity of field upgrades.

 

OS lockdown services. Bsquare helps customers configure their operating system software, especially older non-supported operating systems such as Windows 7, to disable access points that could corrupt the system or lead to intrusion.

 

Microsoft Azure Sphere engineering – Bsquare is one of the first ten technical engineering partners approved in the new Azure Sphere ecosystem. We speed integration of Azure Sphere with new devices being developed or as a bolt-on to existing deployed assets.

Relationship with Microsoft

We have a long-standing relationship with Microsoft and this relationship is important to the continuing success of our business. Our credentials as a Microsoft partner include:

 

We have been one of Microsoft’s largest distributors of Windows IoT operating systems for over 20 years;

 

We have been a distributor of Microsoft’s Windows Mobile operating systems since November 2009;

 

We were the OED Americas Channel Sales & Marketing Award recipient for Distributor Sales Excellence in 2013;

 

We are a Silver Data Analytics partner;

 

We are a Silver Data Platform partner;

 

We are a Co-Sell Ready ISV Partner for Microsoft; and

 

Microsoft has engaged us from time to time on various engineering service engagements.

 

We work closely with Microsoft executives, developers, product managers and sales personnel. We leverage these relationships in a variety of ways, including:

 

We gain early access to new Microsoft embedded software and other technologies;

 

We leverage co-marketing resources, content and strategies from Microsoft, including market development funds, to support our own marketing and sales efforts;

 

We participate in Microsoft-sponsored trade shows, seminars, and other events;

 

We receive sales leads from Microsoft; and

 

We receive rebates from Microsoft based upon the achievement of predefined sales objectives.

See Item 1A, “Risk Factors,” for more information regarding our relationship with Microsoft.

Competition

Microsoft controls who can distribute its OS software. Authorized distributors that we complete with include the following:

 

Arrow Electronics, Inc.

 

Avnet, Inc.

 

Advantech, Inc.

 

Dell Computer, Inc.

Our competition is not limited to the Microsoft-authorized distributors. We compete with other consulting firms for services related to device design and development, system software development, and engineering firms that offer similar services.

4

 


 

Edge to Cloud Business Segment

Customers engage us because of our extensive experience in the areas of device software development and testing, our experience with Microsoft Azure and Amazon Web Service cloud development and operation, our modular suite of IoT development components (B2IQ Suite), our experience serving large IoT customers at scale, and our focus on understanding the return on investment (“ROI”) for their IoT projects. We believe that engaging us typically results in shorter development cycles and reduced time-to-market, lower overall costs to complete projects, and enhanced product robustness and features, and a clear ROI for their system.

Market

The IoT market continues to emerge and evolve. This market includes business and industrial segments. It encompasses services, software, hardware, connectivity and cloud providers as well as systems integrators. The IoT marketplace is currently being influenced by the following factors:

 

Development of machine learning and data analytics software that advances the understanding of complex systems but lacks the capability to effectively process the proliferation of resulting data.

 

Nearly ubiquitous wireless connectivity, including near-field communications (or NFC), Bluetooth, Wi-Fi and cellular, allowing connectivity and data exchange with large populations of small, remote, and frequently mobile devices;

 

Increasing competitive pressures that are forcing a wide array of businesses to invest in automation as a way to improve productivity, reduce costs, and enhance the value of their own offerings;

 

The increasing availability of inexpensive cloud computing and storage capabilities that are scalable to the extent likely to be demanded by IoT, and;

 

The ROI for IoT systems and capabilities. Early customer activity was dominated by “Proof of Concept” or “Prototypes” with unrealistic implementation and operating costs. As the market matures and clear ROI models emerge, such as cost reduction and/or new revenue, we expect the market adoption rate to increase.

Software Products

We offer the following software products and anticipate developing additional products during the year to compliment the offerings of our partners and address the evolving needs of our customers:

 

B2IQ Edge and Cloud Suite. The B2IQ Edge to Cloud Suite is a collection of software components that securely connects edge devices and non-connected assets to the cloud, accelerating development of application-specific solutions forming the basis for almost any IoT use case.

 

B2IQ Cloud Base. The B2IQ Cloud Base runs on Microsoft Azure and Amazon Web Services (”AWS”) and offers automatic registration of B2IQ Edge devices with the cloud.

 

B2IQ Edge. The B2IQ Edge is a compact and efficient edge client that supports bi-directional communication between devices, sensors, and cloud components. B2IQ Edge runs on Linux, FreeRTOS devices and Azure Sphere.

 

B2IQ Gateway, The B2IQ Gateway supports bi-directional communication between constrained devices and the cloud. B2IQ Gateway runs on Linux devices.

 

B2IQ Edge Modules. The B2IQ Edge Modules accelerate connecting B2IQ Edge to the systems and standards our customers’ teams have already adopted. We offer the B2IQ Modbus connector for industrial assets, the B2IQ Canbus connector for automotive assets, and the B2IQ SAE 1939 Canbus connector for diesel assets.

Service Products

Bsquare offers a full suite of professional services to assist our customers with the design, development, deployment and operation of their IoT system.

Typically, our professional services are provided on a time and materials consulting basis.

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We have developed, deployed, and operated IoT systems for businesses of all sizes, from global Fortune 500 companies to small private organizations. Our professional services include the following:

 

Requirements gathering. Working with our customers’ stakeholders to identify pain points and understand solutions requirements.

 

Architecture. Bsquare structures solutions based on open standards and device industry standard protocols as well as appropriate cloud provider technologies.

 

Design. We offer technical design of software and creative design of user interactions.

 

Development. Our solutions are built to efficiently connect the edge to the cloud and follow ISO 9001 quality standards.

 

Quality Assurance. We provide quality assurance services during all aspects of development, from design to implementation.

 

Data science. Bsquare data scientists use machine learning to provide valuable insights such as forecasting breakdowns, detecting anomalies, and predicting demand.

 

24 hours a day / 7 days a week (“24/7”) Operations Services. Bsquare provides cloud asset management, system status monitoring, DevOps automation, support, and software maintenance, to ensure our customers’ vital systems are secure and meeting business objectives.

Competition

Our competitors in the Edge to Cloud segment, or companies against which we anticipate vying for opportunities, include:

 

Large, established enterprise software and solution providers such as IBM, SAS, Oracle and SAP;

 

Cloud IoT providers such as AWS and Microsoft Azure. Although we are closely partnered with AWS and Microsoft, there are elements of their solutions with which we compete directly;

 

Mid-sized companies engaged in business transitions similar to our own, including PTC ThingWorx; and

 

Startups funded to enter the IoT market, including C3IOT and others.

The market for device software and engineering services is competitive. We face competition from the following:

 

Our current and potential customers’ internal engineering and research and development departments, which may seek to provide their own IoT-related services and/or develop their own software solutions which could compete with our own service offerings and products;

 

Engineering service firms, including offshore development companies, such as Adeneo, SymphonyTeleca and Wipro;

 

ODMs, particularly those in Taiwan and China, with their own software development capabilities;

 

Contract manufacturers with their own software development capabilities;

 

Microsoft Windows IoT and Windows Mobile operating system distributors such as Arrow Electronics, Inc. Avnet, Inc. and Synnex Corporation.

Some of our competitors have greater financial and other resources than we do. They may also focus on only one aspect of our business or offer complementary products that can be integrated with our products. As we develop and bring to market new software products and service offerings, we may begin competing with companies with which we have not previously competed. Further, as we expand the geographic markets into which we sell our services and software solutions, or increase our penetration therein, we may expect to increasingly compete with companies with which we have not previously competed. It is also likely that new competitors will enter the market or that our competitors will form alliances, including alliances with AWS or Microsoft, that may enable them to rapidly increase their market share. New competitors may have lower overhead than we do and may be able to undercut our pricing. We expect that competition will increase as other established and emerging companies enter the connected device market, and as new products and technologies are introduced.

6

 


 

Neither AWS nor Microsoft has agreed to an exclusive arrangement with us, nor has either agreed not to compete against us. Amazon may decide to focus on providing products or services that compete directly with our products and services or partnering with other solution providers that compete with us. Microsoft may decide to bring in-house more of the core-embedded development services and expertise that we currently provide, possibly resulting in reduced software and service revenue opportunities for us. The barrier to entering the market as a provider of Microsoft-based smart connected systems software and services is relatively low. In addition, Microsoft has created marketing programs to encourage systems integrators to work on Windows operating system software and services, including in the evolving IoT market. These systems integrators may be given substantially the same access by Microsoft to Microsoft technology as we are.

Sales and Marketing

We market our products and professional engineering services utilizing a direct sales model. We have sales personnel in the United States and in the United Kingdom. Historically, we have not made significant use of resellers, channel partners, representative agents or other indirect channels. Key elements of our sales and marketing strategy include direct marketing, digital marketing, content marketing, trade shows, event marketing, public relations, analyst relations, social media properties, customer and strategic alliance partner co-marketing programs and a comprehensive website.

International Operations

Our international operations outside of North America are conducted through our offices in Trowbridge, England. In the fourth quarter of 2019 we made the decision to close our operation in Taipei, Taiwan. Because our OEM Distribution Agreement with Microsoft for the sale of Microsoft Windows IoT operating systems was previously restricted to North America, the majority of our revenue continues to be generated from North America. Revenue generated from customers located outside of North America was approximately 15% and 6% of total revenue in 2019 and 2018 respectively. Our distribution rights for Microsoft Windows IoT products in the E.U., the European Free Trade Association, Turkey and Africa expired on June 30, 2019.

See Item 1A, “Risk Factors,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for more information regarding our international operations.

Personnel

We had total headcount of 75 at December 31, 2019; including 48 located in North America, 26 in the United Kingdom, and 1 in Taiwan. As conditions necessitate, professional engineering service employees may perform research and development activities and vice versa.

Intellectual Property and Other Proprietary Rights

We strive to protect our intellectual property rights through patent, copyright, trademark and trade secret laws and through contractual arrangements. While we cannot be certain that our efforts will be effective to prevent the misappropriation of our intellectual property, or to prevent the development and design by others of products or technologies similar to, or competitive with, those developed by us, we plan to continue to pursue appropriate protections for our intellectual property.

Additionally, because a significant portion of our revenue relates to the sale of third-party software products, we also rely on our partners, particularly Microsoft, to appropriately protect their own intellectual property.

See Item 1A, “Risk Factors,” for more information regarding our intellectual property and other proprietary rights.

Available Information

We electronically file with or furnish to the Securities and Exchange Commission (“SEC”) our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. We make available on our website at www.bsquare.com, free of charge, copies of these reports, as soon as reasonably practicable after electronically filing such reports with, or furnishing them to the SEC.

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Item 1A.

Risk Factors.

As discussed under Item 1 of Part I, “Business—Cautionary Note Regarding Forward-Looking Statements,” our actual results could differ materially from those expressed in our forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed below. Additional risks and uncertainties not presently known to us, or that we currently deem immaterial but later emerge as material, may also impair our business operations. If any of the following risks occur, our business, financial condition, operating results, cash flows and the trading price of our common stock could be materially adversely affected.

Risks Related to General Business Conditions

If we are not successful in developing and delivering competitive product and services offerings that keep pace with technological changes and needs, or if our engineering services fail to gain or maintain traction with potential customers, our business would be negatively impacted.

In the third quarter of 2019, we initiated an updated go to market product strategy and pragmatic edge-to-cloud sales and marketing message that we believe builds on our history of helping our customers build intelligent devices. We now offer a complete solution that allows our customers to build and operate the next generation of intelligent devices and systems. While we will continue to support our existing DataV solution customer commitments, we have stopped marketing DataV as a specific product offering. Our ability to grow our higher-margin Edge to Cloud segment is contingent on the success of IoT solution components, solution accelerators and engineering services in certain market segments. If the sales cycle in these segments is longer than expected, or if the solutions we offer to these segments fail to gain or maintain traction with potential customers, or if we are not otherwise successful in developing competitive product offerings that keep pace with market requirements, our business would be negatively impacted.

Expected operating efficiencies from our restructuring plans may not be realized as anticipated.

In the second quarter of 2019, we initiated a workforce reduction program intended to reduce expenses and better align our organizational structure with our strategic focus. The program was implemented in stages throughout the remainder of 2019. Factors which may affect the potential operating efficiencies we realize from our restructuring plans include the adverse impact of job eliminations, uncertainties associated with loss of customer and vendor confidence, potential negative impact on sales and customer service as well as factors outside of our control such as changes in the economic environment. We may not realize the anticipated benefits under our restructuring plans, which could result in additional restructuring efforts. If our restructuring plans are not successful, our business and results of operations may be negatively impacted.

If our IoT-related service offerings fail to gain or maintain traction with potential customers our business would be negatively impacted.

Our strategy to focus on expanding our IoT-related service offerings is subject to a number of risks, including those relating to:

 

The significant investment of time and financial and other corporate resources required;

 

Customer acceptance of our IoT-related service offerings;

 

Our ability to cross sell customers;

 

The ROI model for IoT, which has proven to be elusive and could further delay adoption of IoT solutions by the market;

 

Because IoT services are a relatively new offering, the sales cycle may be longer than we anticipate, and;

 

We may be unable to grow our IoT-related services business rapidly enough to contribute to profitability in 2020.

Our marketplace is highly competitive, which may result in price reductions, lower gross profit margins and loss of market share.

The IoT market is still emerging but is already becoming increasingly competitive. Our competitors in this space include, or we anticipate could include, the following:

 

Large, established enterprise software and solution providers such as IBM, SAS, Oracle and SAP;

 

Cloud IoT providers such as AWS and Microsoft Azure. Although we are closely partnered with AWS and Microsoft, there are elements of their solutions with which we compete directly;

 

Mid-sized companies engaged in business transitions similar to our own, including PTC ThingWorx; and

 

Startups funded to enter the IoT market, including C3IoT and others.

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In addition, we anticipate that we will encounter increasing competition in the growing IoT market from a number of additional software and service providers as we continue to focus on this market in 2019 and beyond, and as we expand our focus on providing IoT-related service offerings.

The market for device software and engineering services is extremely competitive. We face competition from the following:

 

Our current and potential customers’ internal engineering and research and development departments, which may seek to provide their own IoT services and/or develop their own software solutions which could compete with our IoT-related service offerings and products;

 

Engineering service firms, including offshore development companies, such as Adeneo, SymphonyTeleca and Wipro;

 

ODMs, particularly those in Taiwan and China, with their own software development capabilities;

 

Contract manufacturers with their own software development capabilities;

 

Microsoft Windows IoT and Windows Mobile operating system distributors such as Arrow Electronics, Inc. Avnet, Inc. and Synnex Corporation; and

Some of our competitors have greater financial and other resources than we do. They may also focus on only one aspect of our business or offer complementary products that can be integrated with our products. As we develop and bring to market new software products and service offerings, we may begin competing with companies with which we have not previously competed. Further, as we expand the geographic markets into which we sell our services and related software solutions, or increase our penetration therein, we may expect to increasingly compete with companies with which we have not previously competed. It is also likely that new competitors will enter the market or that our competitors will form alliances, including alliances with AWS or Microsoft, that may enable them to rapidly increase their market share. New competitors may have lower overhead than we do and may be able to undercut our pricing. We expect that competition will increase as other established and emerging companies enter the connected device market, and as new products and technologies are introduced.

Neither AWS nor Microsoft has agreed to any exclusive arrangement with us, nor has either agreed not to compete with us. Amazon may decide to focus on providing products or services that compete directly with our products and services or partnering with other solution providers that compete with us. Microsoft may decide to bring more of the core embedded development services and expertise that we provide in-house, possibly resulting in reduced software and service revenue opportunities for us. The barrier to entering the market as a provider of Microsoft-based smart connected system software and services is relatively low. In addition, Microsoft has created marketing programs to encourage systems integrators to work on Windows IoT and Windows Mobile operating system software and services, including in the evolving IoT market. These systems integrators may be given substantially the same access by Microsoft to Microsoft technology as we are.

Our operating results may be adversely affected by changing economic and market conditions and the uncertain geopolitical environment.

Uncertain economic and political conditions in the U.S. and worldwide have from time to time contributed, and may in the future contribute, to volatility in the technology industries at large, particularly in an emerging market such as IoT. These factors could potentially result in reduced demand for our products and services as a result of constraints on IT-related capital spending by our customers; purchasing delays; payment delays adversely affecting our cash flow and revenue; and difficulty in accurate budgeting and planning. If global economic and market conditions, or economic conditions in key markets, remain uncertain or deteriorate, we may experience material impacts on our business, operating results and financial condition.

We may be subject to product liability, infringement or other legal claims that could result in significant costs.

Our software license and service agreements with our customers typically contain provisions designed to limit our exposure to potential product liability, infringement and other legal claims. It is possible, however, that these provisions may be ineffective under the laws of certain jurisdictions or that our customers may not agree to these limitations. Although we have not experienced any product liability or infringement claims to date, as our business focus continues to transition to the sale of our own proprietary products, the sale and support of our products and services may be subject to such claims in the future. There is a risk that any such claims or liabilities may exceed, or fall outside, the scope of our insurance coverage, and we may be unable to obtain adequate liability insurance in the future. A product liability, infringement or other legal claim brought against us, whether successful or not, could negatively impact our business and operating results.

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Our common stock has experienced and may continue to experience price and volume fluctuations, which could lead to costly litigation for us and make an investment in us less appealing.

Stock markets are subject to significant price and volume fluctuations that may be unrelated to the operating performance of particular companies and the market price of our common stock may therefore frequently change as a result. In addition, the market price of our common stock has fluctuated and may continue to fluctuate substantially due to a variety of other factors, including quarterly fluctuations in our results of operations (including as a result of fluctuations in our revenue recognition), our ability to execute on our current growth strategy in a timely fashion, announcements about technological innovations or new products or services by us or our competitors, market acceptance of new products and services offered by us, developments in the IoT market, changes in our relationships with our suppliers or customers, our ability to meet analysts’ expectations, changes in the information technology environment, changes in earnings estimates by analysts, sales of our common stock by existing holders and the loss of key personnel. In the past, following periods of volatility in the market price of a company’s stock, class action securities litigation has often been instituted against such companies. Such litigation, if instituted against us, could result in substantial costs and diversion of management’s attention and resources, which would materially adversely affect our business, financial condition and operating results.

Past acquisitions have proven difficult to integrate, and future acquisitions, if any, could disrupt our business, dilute shareholder value and negatively affect our operating results and may not accrete to our revenue or other operating results or to our business generally.

We have acquired the technologies, assets and/or operations of other companies in the past and may acquire or make investments in companies, products, services and technologies in the future as part of our growth strategy. If we fail to properly evaluate, integrate and execute on our acquisitions and investments, our business and prospects may be seriously harmed. In addition, acquisitions may not be as accretive to our revenue or other operating results as expected. To successfully complete an acquisition, we must properly evaluate the business, technology, market and management team of the acquisition target, accurately forecast the financial impact of the transaction, including accounting charges and transaction expenses, integrate and retain personnel, combine potentially different corporate cultures and effectively integrate products, research and development, sales, marketing and support operations. If we fail to do any of these, we may suffer losses and impair relationships with our employees, customers and strategic partners. Additionally, acquisition activities may distract management from day-to-day operations. We also may be unable to maintain consistently uniform standards, controls, procedures and policies across our entire business as a result, and significant additional demands may be placed on our management and our operations, information services and financial, legal and marketing resources. Finally, acquired businesses may result in unexpected liabilities and contingencies, which may involve compliance with foreign laws, payment of taxes, labor negotiations or other unknown costs and expenses, which could be significant.

Changing growth strategies, negative business conditions, changes in useful lives, and other factors may negatively affect the carrying value of the intangible assets and goodwill we have acquired.

We evaluate goodwill and intangible assets for impairment on an annual basis or more frequently when an event occurs, or circumstances change that indicate that the carrying value may not be recoverable. Reductions in operating cash flows or projected cash flows of our reporting units could result in an impairment charge that would negatively impact our operating results. For example, we performed our annual goodwill assessment for 2018 in the fourth quarter of 2018 and determined that the carrying value of goodwill was impaired. As a result, an impairment charge of $3.7 million was recorded. Further, business conditions and other factors may also require us to reassess the useful lives associated with intangible assets.

Risks Related to Technology

Our software or hardware products or the third-party hardware or software integrated with our products or delivered as part of our service offerings may suffer from defects or errors that could impair our ability to sell our products and services.

Software and hardware components as complex as those needed for dedicated purpose intelligent systems frequently contain errors or defects, especially when first introduced or when new versions are released. We have had to delay commercial release of certain versions of our products until problems were corrected and, in some cases, have provided product enhancements to correct errors in released products. Some of our contracts require us to repair or replace products that fail to work. To the extent that we repair or replace products, our expenses may increase. In addition, it is possible that by the time defects are fixed, the market opportunity may decline which may result in lost revenue. Moreover, to the extent that we provide increasingly complex and comprehensive products and services, particularly those focused on IoT hardware, and rely on third-party manufacturers and suppliers to manufacture these products, we will be dependent on the ability of such third-party manufacturers and suppliers to correct, identify and prevent manufacturing errors or defects. Errors or defects that are discovered after commercial release could result in loss of revenue or delay in market acceptance, diversion of development resources, damage to our reputation and increased service and warranty costs, all of which could negatively impact our business and operating results.

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Our business and operations would be adversely impacted in the event of a failure or interruption of our IT infrastructure.

The proper functioning of our own IT infrastructure is critical to the efficient operation and management of our business. Our IT is vulnerable to cyberattacks, computer viruses, worms and other malicious software programs, physical and electronic break-ins, sabotage and similar disruptions from unauthorized tampering with our computer systems. We believe that we have adopted appropriate measures to mitigate potential risks to our technology infrastructure and our operations from these IT-related and other potential disruptions. However, given the unpredictability of the timing, nature and scope of such disruptions, we could potentially be subject to downtimes, operational delays, other detrimental impacts on our operations or ability to provide products and services to our customers, the compromising of confidential or personal information, destruction or corruption of data, security breaches, other manipulation or improper use of our systems and networks, financial losses from remedial actions, loss of business or potential liability, and/or damage to our reputation, any of which could have a material adverse effect on our cash flows, competitive position, financial condition or results of operations.

Interruptions or delays in services from third-party data center hosting facilities or cloud computing platform providers could impair the delivery and availability of our products and services and harm our business.

We currently serve certain customers through third-party data center hosting facilities and cloud computing platform providers located in the United States and other countries. Any damage to, or failure of, these systems generally could result in interruptions in the availability of our products and services. We have from time to time experienced, and may continue to experience, such interruptions, which could cause us to issue credits or pay penalties, cause customers to terminate their subscriptions, and adversely affect our customer attrition rates and our ability to attract new customers, all of which would reduce our revenue. Our business would also be harmed if our customers and potential customers believe our product and services offerings are unreliable. Despite contract provisions to protect us, customers may look to us to support and provide warranties for these third-party systems, which may expose us to potential claims, liabilities and obligations for technology or services we did not develop or sell, all of which could harm our business. Further, third-party software and cloud platforms that we currently or may in the future utilize may not continue to be available at reasonable prices, on commercially reasonable terms, or may become unavailable. Any of these outcomes could significantly increase our expenses and result in delays in the provisioning of our products and services until we are able to procure alternative solutions, either by developing equivalent technology or, if available, obtaining such technology through purchase or license from other third parties.

We do not control the operation or security of any of these hosting facilities or cloud computing platforms, and they may be vulnerable to damage or interruption from earthquakes, floods, fires, power loss, telecommunications failures and similar events. They may also be subject to break-ins, sabotage, intentional acts of vandalism and similar misconduct, as well as local administrative actions, changes to legal or permitting requirements and litigation to stop, limit or delay operation. Despite precautions taken by providers of these facilities and platforms, the occurrence of a natural disaster or an act of terrorism, a decision to close the facilities or platforms without adequate notice or other unanticipated problems at these facilities or platforms could result in lengthy interruptions in or cessation of our services.

Breaches in data security or incidents of cybercrime could damage our customers’ business and our reputation, which may harm our ability to gain new customers or cause our existing customer to look to our competitors for products and services.

Our products and services involve the storage and transmission of customers’ proprietary data and personal information, and security breaches could result in a risk of loss of this data or information, litigation and possible liability. While we have security measures in place, they may be breached as a result of third-party action, including intentional misconduct by computer hackers, employee error, malfeasance or otherwise and result in someone obtaining unauthorized access to our IT systems, our customers’ data or our data, including our intellectual property and other confidential business information. Additionally, third parties may attempt to fraudulently induce employees or customers into disclosing sensitive personal information such as usernames, passwords or other information in order to gain access to our customers’ data, our data or our IT systems. Because the techniques used to obtain unauthorized access, or to sabotage systems, change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. In addition, our customers may authorize third-party technology providers to access their customer data, and some of our customers may not have adequate security measures in place to protect their data. Because we do not control the IT security of our customers or third-party technology providers, or of the processing of such data by third-party technology providers, we cannot ensure the integrity or security of such transmissions or processing. Malicious third parties may also conduct attacks designed to temporarily deny customers access to our products and services. Any security breach could result in a loss of confidence in the security of our products and services, damage our reputation, negatively impact our future sales, disrupt our business and lead to legal liability.

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Privacy concerns and laws, evolving regulation of cloud computing, cross-border data transfer restrictions and other domestic or foreign regulations may limit the use and adoption of our products and services and adversely affect our business.

Regulation related to the provision of services on the internet is evolving and increasing, as federal, state and foreign governments continue to adopt new laws and regulations addressing data privacy and the collection, processing, storage and use of personal information, such as the E.U.’s Data Protection Directive and General Data Protection Regulation (“GDPR”) and the California Consumer Privacy Act (“CCPA”). Further, laws and regulations are increasingly aimed at the use of personal information for marketing purposes, such as the E.U.’s ePrivacy Directive and ePrivacy Regulation. Country-specific laws and regulations are subject to new and differing interpretations and may be inconsistent among jurisdictions. Existing laws and regulations, as well as future requirements, could reduce demand for our products and services or restrict our ability to store and process data or, in some cases, impact our ability to offer our products and services in certain locations or our customers' ability to deploy our solutions globally. The costs of compliance with and other burdens imposed by laws, regulations and standards such as GDPR and CCPA may also limit the use and adoption of our products and services, reduce overall demand for our products and services, lead to significant fines, penalties or liabilities for noncompliance, or slow the pace at which we close sales transactions, any of which could harm our business. Furthermore, concerns regarding data privacy may cause our customers’ customers to resist providing the data necessary to allow our customers to use our products and services effectively. Even the perception that the privacy of personal information is not satisfactorily protected or does not meet regulatory requirements could inhibit sales of our products and services and could limit adoption of our cloud-based solutions.

Risks Related to Our Partnership with Microsoft

Because we provide software and services to customers building devices utilizing Microsoft’s Windows IoT and Windows Mobile operating systems, as well as the fact that a significant portion of our revenue is derived from the sale of Microsoft Windows IoT and Windows Mobile operating systems, Microsoft has a significant direct and indirect influence on our business. The following Microsoft-related risks may negatively impact our business and operating results.

If we do not maintain our distribution relationship with Microsoft, our revenue would decrease, and our business would be adversely affected.

Effective March 1, 2019, pursuant to a Global Partnership Agreement with Microsoft, we are authorized to sell Windows IoT operating systems in Canada, the United States, Argentina, Brazil, Chile, Mexico, Peru, Venezuela, Puerto Rico, Columbia, and several Caribbean countries. Of our total revenue, 79% in 2019 and 75% in 2018 resulted from the sale of Windows IoT operating systems. Our existing distribution agreement for sales of Windows IoT operating systems in the European Union (“E.U.”), the European Free Trade Association, Turkey and Africa, expired on June 30, 2019 and was not renewed thereafter. We generated approximately 3% of our Partner Solutions software sales under this agreement in 2019.

We have also entered into OEM distributor agreements (“ODAs”) with Microsoft pursuant to which we are licensed to sell Microsoft Windows Mobile operating systems to customers in North America, South America, Central America (excluding Cuba), Japan, Taiwan, Europe, the Middle East, and Africa. The ODAs to sell Windows Mobile operating systems are effective through April 30, 2022.

We generated $49.8 million and $59.5 million of revenue in 2019 and 2018, respectively, through our sales of Microsoft operating systems and expect this revenue stream to continue, although potentially at a declining rate. If the new GPA or any of our other ODAs are terminated by Microsoft (which Microsoft can do unilaterally) or not renewed, third-party software revenue and resulting gross profit could decrease significantly and our operating results would be negatively impacted. Future renewals by Microsoft, if any, could be on less favorable terms, which could also negatively impact our business and operating results.

Microsoft can change its product pricing at any time, and unless we are able to pass through price increases to our customers, our revenue, gross profit and operating results would be negatively impacted. Further, Microsoft currently offers a rebate program in conjunction with our resale activities in which we earn money for achieving certain predefined objectives. If Microsoft changes the way that rebates are earned by eliminating or negatively modifying the rebate program, our gross profit and operating results would be adversely impacted. We qualified for rebate credits from Microsoft of $2.4 million and $1.7 million in 2019 and 2018, respectively, of which 20% and 30%, respectively, was credited against product invoices and accounted for as a reduction in cost of sales, with the remaining portion as a reduction in marketing expense if and when qualified expenditures are made and claimed.

In January 2019, Microsoft changed the way a portion of its earned rebate may be claimed. The process previously in place under its 2018 program for claiming 30% of the rebates against product invoices was changed; these earned rebate amounts are now credited to the Microsoft Azure Sponsorship program and claimed upon delivery of approved Azure programs. We joined this sponsorship program in January 2019; if we are unable to complete enough qualified Azure programs during each qualification period, we may not be able to claim all or a portion of this rebate.

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Our business and results of operations could be negatively impacted by changes Microsoft implements in its pricing of its operating systems.

Microsoft implemented significant pricing changes for its operating systems products, including ending its design registration pricing discounts, terminating its OEM Volume Royalty Program and changing the aggregate volume price structure and product royalties for existing Windows IoT products effective January 1, 2016, and Microsoft could make further pricing changes in the future. These changes have altered the competitive dynamics because the same pricing discounts are available to all distributors of these Microsoft products. As a distributor of Microsoft products, this may impact both the sales prices we charge our customers and the cost of goods sold we incur for many of the Microsoft products we sell. The amount and impact of these changes to our revenue and gross profit are not determinable; however, they may negatively impact our operating results in future reporting periods. The sale of Microsoft operating systems represented approximately 84% and 81% of our total revenue and approximately 70% and 57% of our total gross margin for the years ended December 31, 2019 and 2018, respectively.

In recent years, the markets for Windows IoT and Windows Mobile operating systems have declined; if the markets for these operating systems continue to decline or decline more rapidly than anticipated, our business and operating results would be materially harmed.

A significant portion of our revenue to date has been generated by software and services targeted at customers and devices running various Microsoft Windows IoT and Windows Mobile operating systems. In recent years, the markets for these systems have declined. If the markets for these operating systems continue to decline or decline more rapidly than anticipated, our business and operating results would be negatively impacted. Continued market acceptance of Microsoft Windows IoT and Windows Mobile operating systems will depend on many factors, including:

 

Microsoft’s development and support of various Windows IoT and Windows Mobile markets. As the developer and primary promoter of Windows IoT and Windows Mobile operating systems, if Microsoft were to decide to discontinue or lessen its support of these operating systems, potential customers could select competing operating systems, which could reduce the demand for our Microsoft Windows IoT and Windows Mobile software products and engineering services, from which a significant portion of our revenue continues to be generated;

 

The ability of the Microsoft Windows IoT and Windows Mobile operating systems to compete against existing and emerging operating systems for the smart connected systems market, including iOS from Apple, Inc.; VxWorks and Linux from WindRiver Systems Inc.; Android from Google Inc.; QNX from BlackBerry Limited; and other proprietary operating systems. Microsoft Windows IoT and Windows Mobile operating systems may be unsuccessful in capturing or retaining a significant share of the smart connected systems market in the future;

 

The acceptance by customers of the mix of features and functions offered by Microsoft Windows IoT and Windows Mobile operating systems; and

The willingness of software developers to continue to develop and expand the applications running on Microsoft Windows IoT and Windows Mobile operating systems. To the extent that software developers write applications for competing operating systems that are more attractive to users than those available on Microsoft Windows IoT and Windows Mobile operating systems, this could cause potential customers to select competing operating systems.

Our business and results of operations would be adversely impacted if Microsoft decided to provide Windows IoT or Windows Mobile operating systems free of charge to customers.

Microsoft offers certain consumer Windows phone and tablet-based operating systems to customers free of charge, subject to certain limitations. While we do not distribute these operating systems today under our ODAs with Microsoft, if Microsoft were to offer, free of charge, operating systems that we do distribute, our business and results of operations would be adversely impacted.

Microsoft has audited our records under the ODAs in the past and may audit our records again in the future, and any negative audit results could result in additional charges and/or the termination of our distributor relationship with Microsoft.

There are provisions in the ODAs that require us to maintain certain internal records and processes for auditing purposes. Non-compliance with these or other contractual requirements could result in the termination of our distributor relationship with Microsoft. Microsoft concluded audits of our records pertaining to the ODAs in 2009 and 2006, neither of which had material findings. It is possible that future audits could result in charges due to any material findings that are found. We may also be contractually liable for payment of royalties to Microsoft in the event that certificates of authenticity are lost, damaged or stolen.

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Risks Related to Operating Internationally

Our international operations expose us to greater intellectual property, management, collections, regulatory and other risks.

Customers outside of North America generated 15% and 6% of our total revenue in 2019 and 2018, respectively. We currently have sizable operations outside of North America and in the United Kingdom (“U.K.”). Our international activities and operations expose us to a number of risks, including the following:

 

Greater difficulty in protecting intellectual property due to less stringent foreign intellectual property laws and enforcement policies;

 

Longer collection cycles than we typically experience in North America;

 

Unfavorable changes in regulatory practices and tariffs;

 

Compliance with complex regulatory regimes or restrictions on import and export of our goods and services;

 

Complex and/or adverse tax laws and/or changes thereto. Additionally, we may be subject to income, withholding and other taxes for which we may realize no current benefit despite the existence of significant net operating loss and tax credit carryforwards in the U.S.;

 

Loss or reduction of withholding tax exemptions;

 

The impact of fluctuating exchange rates between the U.S. dollar and foreign currencies;

 

General economic and political conditions in international markets which may differ from those in the U.S.;

 

Increased exposure to potential liability under the Foreign Corrupt Practices Act;

 

Added cost and administrative burden associated with creating and operating business structures in other jurisdictions;

 

Potential labor costs and risks associated with employees and labor laws in other geographies; and

 

The inherent risks of working in a certain highly regulated and/or controlled economies where relationships between company management and government officials is critical to timely processing of approvals required to conduct business.

 

On January 31, 2020, the U.K. exited the E.U., commonly referred to as “Brexit”. As the long-term implications of Brexit become clear, it is possible that there will be greater restrictions on imports and exports between the U.K. and E.U. countries and increased regulatory complexities, which could adversely impact our operations and business in both the U.K. and the E.U.

These risks could have a material adverse effect on the financial and managerial resources required to operate our foreign offices, as well as on our future international revenue, which could negatively impact our business and operating results.

As our customers seek more cost-effective locations to develop and manufacture their products, particularly overseas locations, our ability to continue to sell our software products and services to these customers could be adversely affected, which could negatively impact our revenue and operating results.

Due to competitive and other pressures, some of our customers have moved, and others may seek to move, the development and manufacturing of their smart, connected systems to overseas locations, which may limit our ability to sell our software and services to these customers. As an example, under our ODAs with Microsoft, we are currently only able to sell Microsoft Windows IoT operating systems to our customers in the United States, Canada, the Caribbean (excluding Cuba), Mexico, and the European Free Trade Association. If our customers, or potential customers, move their manufacturing overseas to locations in which our business may be limited, we may be less able to remain competitive, which could negatively impact our revenue and operating results.

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Risks Related to Intellectual Property

Our software and service offerings could infringe the intellectual property rights of third parties, which could expose us to additional costs and litigation and could adversely affect our ability to sell our products and services or cause shipment delays or stoppages.

It is difficult to determine whether our software products and engineering services infringe third-party intellectual property rights, particularly in a rapidly evolving technological environment in which technologies often overlap and where there may be numerous patent applications pending, many of which are confidential when filed. If we were to discover that one of our software products or service offerings, or a product based on one of our reference designs, violated a third party’s proprietary rights, we may not be able to obtain a license on commercially reasonable terms, or at all, to continue offering that product or service. Similarly, third parties may claim that our software products and services infringe their proprietary rights, regardless of whether such claims have merit. Any such claims could increase our costs and negatively impact our business and operating results. In certain cases, we have been unable to obtain indemnification against claims that third-party technology incorporated into our software products and services infringe the proprietary rights of others. However, any indemnification we do obtain may be limited in scope or amount. Even if we receive broad third-party indemnification, these entities may not have the financial capability to indemnify us in the event of infringement.

In addition, in some circumstances we are required to indemnify our customers for claims made against them that are based on our software products or services. We may face claims of infringement or invalidity related to the software products and services we provide or arising from the incorporation by us of third-party technology and claims for indemnification from our customers resulting from such claims. Some of our competitors have, or are affiliated with companies with, substantially greater resources than we have, and these competitors may be able to sustain the costs of complex intellectual property litigation to a greater degree and for longer periods of time than we could. In addition, we expect that software developers will be increasingly subject to infringement claims as the number of products and competitors in the software industry grows, and as the functionality of products in different industry segments increasingly overlap. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources in addition to potential product redevelopment costs and delays. Furthermore, if we were unsuccessful in resolving a patent or other intellectual property infringement action claim against us, we may be prohibited from developing or commercializing certain of our technologies and products, or delivering services based on the infringing technology, unless we obtain a license from the holder of the patent or other intellectual property rights. We may not be able to obtain any such license on commercially favorable terms, or at all. If such license were not obtained, we would be required to cease these related business operations, which could negatively impact our business, revenue and operating results.

If we are unable to license key software from third parties, our business could be harmed.

We sometimes integrate third-party software with our proprietary software and engineering service offerings or sell such third-party software offerings on a standalone basis, such as we do with Microsoft Windows IoT and Mobile operating systems under our ODAs with Microsoft. If our relationships with these third-party software vendors were to deteriorate, or be eliminated in their entirety, we might be unable to obtain licenses on commercially reasonable terms, if at all. In the event that we are unable to obtain these third-party software offerings, we would be unable to continue to generate revenue from our reseller relationships or, with respect to our proprietary software and engineering services offerings, we would be required to develop this technology internally, assuming it was economically or technically feasible, or seek similar software offerings from other third parties assuming there were competing offerings in the marketplace, which could delay or limit our ability to introduce enhancements or new products, or to continue to sell existing products and engineering services, thereby negatively impacting our revenue and operating results.

If we fail to adequately protect our intellectual property rights, competitors may be able to use our technology or trademarks, which could weaken our competitive position, reduce our revenue and increase our costs.

If we fail to adequately protect our intellectual property, our competitive position could be weakened, and our revenue and operating results adversely affected. We rely primarily on confidentiality policies and procedures and contractual provisions as well as a combination of patent, copyright, trade secret and trademark laws, to protect our intellectual property. These laws, policies and procedures provide only limited protection. It is possible that another party could obtain patents that block our use of some, or all, of our software products and services. If that occurred, we would need to obtain a license from the patent holder or design around those patents. The patent holder may or may not choose to make a license available to us on acceptable terms, or at all. Similarly, it may not be possible to design around a blocking patent. Our efforts to protect our intellectual property rights through patent, copyright, trade secret and trademark laws may not be effective to prevent misappropriation of our technology, or to prevent the development and design by others of products or technologies similar to or competitive with those developed by us.

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We license our computer source code to customers. Customers with access to our source code may not comply with the license terms. We may not discover any violations of the license terms and, in the event of discovery of violations, we may not be able to successfully enforce the license terms or recover the economic value lost from such violations. To license some of our software products, we rely in part on “shrink-wrap” and “click wrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. As with other software, our software products are susceptible to unauthorized copying and uses that may go undetected, and policing such unauthorized use is difficult.

A significant portion of our marks include the word “BSQUARE.” Other companies use forms of “BSQUARE” in their marks alone, or in combination with other words, and we cannot prevent all such third-party uses. We license certain trademark rights to third parties. Such licensees may not abide by our compliance and quality control guidelines with respect to such trademark rights. Any of these outcomes could negatively impact our brand, dilute its recognition in the marketplace, or confuse potential customers, all of which could harm our business.

The computer software market is characterized by frequent and substantial intellectual property litigation, which is often complex and expensive, and involves a significant diversion of resources and uncertainty of outcome. Litigation may be necessary in the future to enforce our intellectual property or to defend against a claim of infringement or invalidity. Litigation could result in substantial costs and the diversion of resources and could negatively impact our business and operating results.

Risks Related to Taxes

We could become subject to taxation in jurisdictions in which we do not believe we currently have tax nexus, which could expose us to additional tax liability that we have not been subject to in the past.

We make sales in many jurisdictions across the United States. We believe we do not have nexus in most of these jurisdictions and, therefore, we believe we are not subject to sales, franchise, income and other state and local taxes in such jurisdictions. However, if we are determined to have tax nexus in other jurisdictions (as a result of more aggressive interpretations of nexus by taxing jurisdictions or otherwise) and we are unable to pass through this cost to our customers, our tax expense will increase which will negatively affect our results of operations. Further, because state and local tax laws are becoming increasingly complex, we anticipate that our cost to monitor our state and local tax compliance will increase which will negatively affect our results of operations. Additionally, we may have unknown tax exposure in a state or local tax jurisdiction because of recent tax law changes of which we are unaware, and the resulting liability could be significant and would negatively affect our results of operations.

Changes in our effective tax rate may impact our results of operations.

We are subject to taxes in the U.S. and other jurisdictions. Tax rates in these jurisdictions may be subject to significant change due to economic and/or political conditions. A number of other factors may also impact our future effective tax rate including:

 

the jurisdictions in which profits are determined to be earned and taxed;

 

the resolution of issues arising from tax audits with various tax authorities;

 

changes in valuation of our deferred tax assets and liabilities;

 

increases in expenses not deductible for tax purposes, including write-offs of acquired intangibles and impairment of goodwill in connection with acquisitions;

 

changes in availability of tax credits, tax holidays, and tax deductions;

 

changes in share-based compensation; and

 

changes in tax laws or the interpretation of such tax laws and changes in generally accepted accounting principles.

There may be restrictions on the use of our net operating loss and tax credit carryforwards due to a tax law “ownership change.”

We did not generate taxable income in 2019 or 2018 and, as a result, we were unable to use our net operating loss and tax credit carryforwards with respect to such tax years. In addition, Sections 382 and 383 of the Internal Revenue Code restrict the ability of a corporation that undergoes an ownership change to use net operating loss and tax credit carryforwards. At December 31, 2019, we had approximately $79.7 million of federal and $12.4 million of state net operating loss carryforwards and $3.6 million of tax credit carryforwards. Of the federal net operating loss carryforwards, an aggregate of $45.7 million will expire by 2024 and we may not generate sufficient taxable income prior to such time in order to fully utilize our net operating loss and tax credit carryforwards before they expire. Moreover, under the applicable

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tax rules, an ownership change occurs if greater than five percent shareholders of an issuer’s outstanding common stock collectively increase their ownership percentage by more than 50 percentage points over a rolling three-year period. As of December 31, 2017, we performed analyses of possible ownership changes which included consideration of a third-party study, and do not believe that an ownership change, as defined by Section 382, has occurred. However, if a tax law ownership change has occurred of which we are not aware, or if a tax law ownership change occurs in the future, we may have to adjust the valuation of our deferred tax assets and could be at risk of having to pay income taxes notwithstanding the existence of our sizable carryforwards. Further, to the extent that we have utilized our carryforwards from prior years, the existence of a previous tax law ownership change that we did not account for could result in liability for back taxes, interest, and penalties. If we are unable to utilize our carryforwards and/or if we previously utilized carryforwards to which we were not entitled, it would negatively impact our business, financial condition and operating results.

Risks Related to Governance

It might be difficult for a third party to acquire us even if doing so would be beneficial to our shareholders.

Certain provisions of our articles of incorporation, bylaws and Washington law may discourage, delay or prevent a change in the control of us or a change in our management, even if doing so would be beneficial to our shareholders. Our Board of Directors has the authority under our articles of incorporation to issue preferred stock with rights superior to the rights of the holders of common stock. As a result, preferred stock could be issued quickly and easily with terms calculated to delay or prevent a change in control of our company or make removal of our management more difficult. In addition, our Board of Directors is divided into three classes. The directors in each class serve for three-year terms, one class being elected each year by our shareholders. This system of electing and removing directors may discourage a third party from making a tender offer or otherwise attempting to obtain control of our company because it generally makes it more difficult for shareholders to replace a majority of our directors. In addition, Chapter 19 of the Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with a defined “acquiring person” for a period of five years after the acquisition, unless the transaction or acquisition of shares is approved by a majority of the members of the target corporation’s Board of Directors prior to the time of acquisition. This provision may have the effect of delaying, deterring or preventing a change in control of our company. The existence of these anti-takeover provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock.

Item 1B.

Unresolved Staff Comments.

None.

Item 2.

Properties.

As of December 31, 2019, our corporate headquarters had 24,061 square feet of leased space in a single location in Bellevue, Washington. The lease term ends in May 2020. We have entered into a lease agreement for corporate headquarters in Seattle, Washington and expect to move in prior to the end of our current lease.

We lease office space overseas in Trowbridge, England, U.K. In the fourth quarter of 2019, we made the decision to close our office in Taipei, Taiwan.

We believe that our facilities meet our current operational needs now and in the near-term future.

Item 3.

Legal Proceedings.

None.

Item 4.

Mine Safety Disclosures.

Not applicable.

 

 

17

 


 

PART II

Item 5.

Market for Registrant’s Common Equity Related Stockholder Matters and Issuer Purchases of Equity Securities.

Market Information

Our common stock is traded on The NASDAQ Stock Market, LLC under the symbol “BSQR.”

Holders

As of January 31, 2020, there were 112 holders of record of our common stock. Because many shares of our common stock are held by brokers and other institutions on behalf of shareholders, we are unable to determine the total number of shareholders represented by these holders of record.

Item 6.

Selected Financial Data.

Not applicable.

 

 

18

 


 

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes. This Management’s Discussion and Analysis of Financial Condition and Results of Operations may contain some statements and information that are not historical facts but are forward-looking statements. For a discussion of these forward-looking statements, and of important factors that could cause results to differ materially from the forward-looking statements contained in this report, see Item 1 of Part I, “Business—Cautionary Note Regarding Forward-Looking Statements,” and Item 1A of Part I, “Risk Factors.”

Overview

Bsquare builds technology that is powering the next generation of intelligent systems. We help companies realize the promise of IoT through the development of devices and systems that are cloud-enabled, share data seamlessly, facilitate distributed learning and control, and operate securely at scale. We believe that IoT-enabled systems can not only deliver value to our customers, but also can help people make better use of the resources of our planet and work more effectively to improve quality of life. Bsquare's suite of services and software components create for our customers new revenue streams and operating models while providing opportunities for lowering costs and improving operations.

2019 was a year of transition for Bsquare. In March 2019, Ralph C. Derrickson joined as our President and Chief Executive Officer. Upon his arrival we initiated an assessment of our product and service offering including DataV, our Industrial Internet of Things (IIoT) software platform and associated business model, the market landscape, our experience with IoT and device customers, our historical software distribution business and our leadership team. In May 2019 we announced a series of business rebuilding initiatives called “One Bsquare” that included:

 

revising our go to market strategy;

 

strengthening our strategic partnerships;

 

offering customers an edge-to-cloud product and service suite;

 

retooling sales and marketing; and

 

focusing on operating excellence.

We also announced that we would be reducing headcount in our Bellevue location, reorganizing and eliminating positions on our senior leadership team, and no longer marketing DataV as a platform and that it would be replaced by suite of software components harvested from DataV.

We called this suite of software and services Bsquare IQ (or “B2IQ”).

The software components of the B2IQ suite were harvested from our prior DataV efforts and were substantially re-tooled to exploit the capabilities of cloud services that weren’t available when DataV was first conceived. We observed that customers who were buying OS software for their devices were now contemplating their approach to IoT and it was logical for them to consider Bsquare as a software partner. Our B2IQ software and B2IQ OS utilities allowed us to capitalize on our relationships and long history with OS software. Further, where DataV was contemplated as a “one-size-fits-all” platform, our B2IQ software strategy recognized that the requirements for IoT vary widely and we could create more opportunities to win consulting contracts for custom IoT solutions if we switched to a “building blocks” approach to IoT. We expect these components will be licensed on a per-device basis when deployed as part of a customer-specific solution.

In addition to the system design and software engineering services included in the B2IQ suite, we have expanded our services to include 24/7 support, dev/ops, and cloud management – the services that are critical when a customer puts an edge-to-cloud solution into production. Experience with our early IoT customers showed that Bsquare’s role could last well beyond the design and development phase and continue into their on-going operations. This role as an operating partner for our customers represents an opportunity for future collaboration and on-going business in the form of monthly support and services fees to Bsquare.

During the transition of our product strategy we were in close communication with our DataV customers to ensure we were meeting our operating commitments while re-tooling our software. At the end of 2019 we were in active discussions to revise the commercial terms of our relationships to match our B2IQ software and professional services approach.

In September 2019 we relaunched our sales and marketing with new branding, messaging, Bsquare website and full suite of products. The new website emphasized our full offering including software from our partners (Microsoft, Adobe, and MacAfee), our B2IQ software and our suite of software development and operating services. Prior versions of our website focused almost exclusively on DataV with little emphasis on our other products and services, which we believe contributed to the erosion of their related revenue.

19

 


 

We invested heavily in our longstanding partnership with Microsoft and reaffirmed our new partnership with AWS.  Our move away from DataV paved the way for collaboration at the cloud that was not possible with our DataV platform product strategy. We added new partnerships with Synnex and Arrow that allow us to offer Azure CSP products and services. We also expanded our collaboration with Microsoft to include its Sphere product.

Coinciding with the announcement of our Q3 2019 results, we announced a change in the way we manage and report about our business. The Partner Solutions business segment, formerly Third-Party Software, generates revenue from the re-sale of partners’ software and the consulting services we provide to support them. The Edge to Cloud business segment, formerly and separately reported as Professional Engineering Services and Proprietary Software, generates revenue from the sale and delivery of professional services as well as licensed proprietary software components. We also announced that we were closing our Taiwan offices effective at the end of 2019.

During the year we made a number of changes to our leadership team, Mary Haggard joined in May as VP of Strategic Partnerships, Chris Wheaton joined as CFO and Steven Gottlieb joined as VP of Marketing. In November 2019 we promoted Matthew Inglis to VP of Engineering and John Luethe to VP of Product Management. Also, in November 2019, we announced that we would be adopting the ISO-compliant engineering and project management processes developed in our UK operation.

By year end our results showed that the One Bsquare Initiatives were working and our concerted focus on operational excellence was having a sustained impact. The fourth quarter of 2019 saw our third sequential quarter of continued improvement in the business. Revenue was up in the Partner Solutions segment, margins were steady as a result of continued strength in the Edge to Cloud segment, and operating losses, net of restructuring were at their lowest levels since the fourth quarter of 2016. While we have not yet returned to profitability, we have stabilized the business and are reversing the trends. We are actively setting a foundation that will allow Bsquare to more readily take advantage of growth opportunities as they become apparent.

Critical Accounting Judgments

Revenue recognition

We recognize revenue when control of the promised goods or services is transferred to our customers, in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. We generate all of our revenue from contracts with customers.

Embedded operating system software

We sell embedded operating system software licenses based upon a customer purchase order, shipping a certificate of authenticity (“COA”) to satisfy this single performance obligation. These shipments are also subject to limited return rights; historically, returns have averaged less than one-quarter of one percent. We recognize revenue from third-party products at the time of shipment when the customer accepts control of the COA.

Proprietary software

We sell our proprietary software products to customers under a contract or by purchase order. Our Edge to Cloud software contracts generally include professional services, a perpetual or term license and support and maintenance. In contracts with multiple performance obligations, we identify each performance obligation and evaluate whether the performance obligations are distinct within the context of the contract at contract inception. Performance obligations that are not distinct at contract inception are combined. Contracts that include software customization may result in the combination of the customization services with the software license as one distinct performance obligation. The transaction price is generally in the form of a fixed fee at contract inception. Certain Edge to Cloud contracts also include variable consideration in the form of royalties earned when customers meet contractual volume thresholds. We allocate the transaction price to each distinct performance obligation based on the estimated standalone selling price for each performance obligation. We then look to how control of the software transfers to the customer in order to determine the timing of revenue recognition. In contracts that include customer acceptance, we recognize revenue when we have delivered the software and received customer acceptance. We recognize revenue from support and maintenance over the service delivery period. We recognize revenue from royalties in the period of usage.

Our software products generally do not include customization or modification services and are sold in the form of term licenses. These software licenses represent one distinct performance obligation. Revenue is recognized when the software is delivered to the customer.

20

 


 

Professional services

 

We enter into contracts for professional services, including for our IoT-related service offerings, that include software development and customization. We identify each performance obligation in our professional services contracts at contract inception. The contracts generally include project deliverables specified by each customer. The performance obligations in the contracts are generally combined into one deliverable. The contract pricing is either at stated billing rates per service hour and material costs or at a fixed amount. Services provided under professional engineering contracts generally result in the transfer of control of the applicable deliverable over time. We recognize revenue on service contracts based on time and materials as we have the right to invoice. We recognize revenue on fixed fee contracts on the proportion of labor hours expended to the total hours expected to complete the contract performance obligation. Certain professional service contracts include substantive customer acceptance provisions, in which case, we recognize revenue upon customer acceptance.

 

The determination of the total labor hours expected to complete the performance obligations on fixed fee contracts involves significant judgment. We incorporate revisions to hour and cost estimates when the causal facts become known. In certain situations, when it is impractical for us to reasonably measure the outcome of a performance obligation, and where we anticipate that we will not incur a loss, an adjusted cost-based input method is used for revenue recognition. Equal amounts of revenue and cost are recognized during the contract period, and profit is recognized when the project is completed and accepted.

 

We measure our estimate of completion on fixed-price contracts, which in turn determines the amount of revenue we recognize, based primarily on actual hours incurred to date and our estimate of remaining hours necessary to complete the contract. These estimates factor in such variables as the remaining tasks, the complexity of the tasks, the contracted quality of the software to be provided, the customer’s estimated delivery date, integration of third-party software and quality thereof and other factors. Every fixed-price contract requires various approvals within our company, including by our Chief Executive Officer if significant. This approval process takes into consideration several factors, including the complexity of engineering required. Historically, our estimation processes related to fixed-price contracts have been accurate based on the information known at the time of the reporting of our results. However, percentage-of-completion estimates require significant judgment. During the year ended December 31, 2019, we delivered professional engineering services under three fixed-price service contracts. The estimated remaining labor hours and costs to complete these contracts represent management’s best estimates based on the facts and circumstances as of the filing of this report. If there are changes to the underlying facts and circumstances, we record the revisions to our calculations in the period the changes are noted.

Leases

We lease office facilities, primarily under operating leases, which expire at various dates through 2027. These leases generally contain renewal options for a defined number of years at the then-fair market rental rate or rate stipulated in the lease agreement; which the Company has an option to exercise at the end of the initial lease term.

We determine if an arrangement is a lease at inception. On our balance sheet, our office facility leases, with a lease term greater than 12-months, are included in Right-of-Use (“ROU”) assets and related lease liabilities are included in the Operating leases and Operating leases, long-term statement line items. ROU assets represent our right to use the underlying assets for the lease term and operating lease liabilities represent our obligation to make lease payments arising from the lease agreements. Operating lease ROU assets and liabilities are recognized at the lease commencement date based on the present value of lease payments over the term of the lease. For leases that do not provide an implicit rate, we use an incremental borrowing rate based on information available at the commencement date to determine the present value of lease payments. We will use the implicit rate in the lease when readily determinable. The Company accounts for its lease expense with free rent periods and step-rent provisions on a straight-line basis over the original term of the lease and any extension options that the Company more likely than not expects to exercise, from the date the Company has control of the property. Certain leases provide for periodic rental increases based on price indices. Lease expense for lease payments is recognized on a straight-line basis over the lease term.

Intangible assets and goodwill

We evaluate our intangible assets for indications of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Our intangible assets consist of customer relationships arising from business acquisitions. We periodically assess the value of our intangible assets. Factors that could trigger an impairment analysis include significant under-performance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business or significant negative industry or economic trends. If this evaluation indicates that the value of the intangible asset may be impaired, we assess the likelihood of recoverability of the net carrying value of the asset over its remaining useful life. If this assessment indicates that the intangible asset is not recoverable, based on the estimated undiscounted future cash flows of the technology over the remaining useful life, we reduce the net carrying value of the related intangible asset to fair value.

21

 


 

We evaluate goodwill for impairment annually during the fourth quarter or more frequently when an event occurs, or circumstances change that indicate that the carrying value may not be recoverable. We have three reporting units for the purpose of evaluating goodwill for impairment—third-party software, proprietary software and professional engineering services. See Note. 15, Information about Operating Segments and Geographic Areas in the Notes to our Consolidated Financial Statements in Item 8.

For reporting units that carry goodwill, we test for impairment by performing an optional qualitative assessment to determine whether the fair value of the reporting unit is more likely than not less than the carrying amount. Alternatively, at our option, we can forego performing the qualitative assessment and proceed directly to perform the quantitative impairment test by comparing the fair value of the reporting unit with its carrying amount, including goodwill, and recording a goodwill impairment charge for the excess. Any such impairment charges could be significant and have a material adverse effect on our reported financial results.

Taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate income taxes in each of the countries and other jurisdictions in which we operate. This process involves estimating our current tax expense together with assessing temporary differences resulting from the differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. Net operating losses and tax credits, to the extent not already utilized to offset taxable income or income taxes, also give rise to deferred tax assets. We must then assess the likelihood that any deferred tax assets will be realized from future taxable income, and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. We are required to use judgment as to the appropriate weighting of all available evidence when assessing the need for the establishment or the release of valuation allowances. As part of this analysis, we examine all available evidence on a jurisdiction-by-jurisdiction basis and weigh the positive and negative information when determining the need for full or partial valuation allowances. The evidence considered for each jurisdiction includes, among other items, (i) the historical levels of income or loss over a range of time periods that extends beyond the two years presented, (ii) the historical sources of income and losses, (iii) the expectations and risk associated with underlying estimates of future taxable income, (iv) the expectations and risk associated with new product offerings and uncertainties with the timing of future taxable income, and (v) prudent and feasible tax planning strategies. Significant judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our deferred tax assets. We estimate the valuation allowance related to our deferred tax assets on a quarterly basis.

Our sales may be subject to other taxes, particularly withholding taxes, due to our sales to customers in countries other than the United States. The tax regulations governing withholding taxes are complex, causing us to have to make assumptions about the appropriate tax treatment. Further, we make sales in many jurisdictions across the United States, where tax regulations are varied and complex. We must therefore continue to analyze our state tax exposure and determine what the appropriate tax treatments are, and make estimates for sales, franchise, income and other state taxes.

Results of Operations

The following table presents our summarized results of operations for the periods indicated. Our historical operating results are not necessarily indicative of the results for any future period.

 

 

 

Year Ended December 31,

 

(In thousands, except percentages)

 

2019

 

 

2018

 

 

$ Change

 

 

% Change

 

Revenue

 

$

59,283

 

 

$

73,414

 

 

$

(14,131

)

 

 

(19

)%

Cost of revenue

 

 

49,187

 

 

 

57,904

 

 

 

(8,717

)

 

 

(15

)%

Gross profit

 

 

10,096

 

 

 

15,510

 

 

 

(5,414

)

 

 

(35

)%

Operating expenses

 

 

19,410

 

 

 

29,441

 

 

 

(10,031

)

 

 

(34

)%

Loss from operations

 

 

(9,314

)

 

 

(13,931

)

 

 

4,617

 

 

 

(33

)%

Other income, net

 

 

149

 

 

 

207

 

 

 

(58

)

 

 

(28

)%

Loss before income taxes

 

 

(9,165

)

 

 

(13,724

)

 

 

4,559

 

 

 

(33

)%

Income tax expense

 

 

(16

)

 

 

(13

)

 

 

(3

)

 

 

23

%

Net loss

 

$

(9,181

)

 

$

(13,737

)

 

$

4,556

 

 

 

(33

)%

 

22

 


 

Revenue

We generate revenue from the sale of software, both embedded operating system software that we resell and our own proprietary software, and the sale of professional services. Total revenue decreased in 2019 compared to 2018, primarily due to lower sales of Microsoft Windows IoT and Mobile operating systems and lower Edge to Cloud service revenue, predominantly in North America.

One customer, Honeywell International, Inc., accounted for 10% of total revenue in 2018. No other customers accounted for 10% or more of total revenue in 2019 or 2018.

Additional revenue details were as follows:

 

 

 

Year Ended December 31,

 

(In thousands, except percentages)

 

2019

 

 

2018

 

 

$ Change

 

 

% Change

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Partner Solutions

 

$

50,628

 

 

$

61,159

 

 

$

(10,531

)

 

 

(17

)%

Edge to Cloud

 

 

8,655

 

 

 

12,255

 

 

 

(3,600

)

 

 

(29

)%

Total revenue

 

$

59,283

 

 

$

73,414

 

 

$

(14,131

)

 

 

(19

)%

As a percentage of total revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Partner Solutions

 

 

85

%

 

 

83

%

 

 

 

 

 

 

 

 

Edge to Cloud

 

 

15

%

 

 

17

%

 

 

 

 

 

 

 

 

 

Total revenue consists of sales of embedded operating system software and revenue realized from sales of our own proprietary software products, which include software license sales and support and maintenance revenue, and professional services that support DataV software and service customers.

Partner solutions revenue decreased in 2019 compared to 2018, driven primarily by lower sales of Microsoft Windows IoT operating systems. Sales of Microsoft operating systems represented approximately 84% and 81% of our total revenue and 70% and 57% of our total gross profit for 2019 and 2018, respectively.

Edge to Cloud revenue decreased in 2019 compared to 2018, due to declines in service revenue generated in North America, Asia and Europe with the completion in 2018 of several DataV software projects. We expect Edge to Cloud service revenue to grow over time as we focus our strategic focus toward cloud-based and other IoT-related service offerings. We expect Edge to Cloud revenue will continue to vary in timing and amounts.

Gross profit and gross margin Cost of Partner Solutions revenue consists primarily of the cost of embedded operating system software product costs payable to third-party vendors and support costs associated with our proprietary software products. Cost of Edge to Cloud revenue consists primarily of salaries and benefits, contractor costs and re-billable expenses, related facilities and depreciation costs, and amortization of certain intangible assets related to acquisitions.

Gross profit and gross margin were as follows:  

 

 

 

Year Ended December 31,

 

(In thousands, except percentages)

 

2019

 

 

2018

 

 

$ Change

 

 

% Change (1)

 

Partner Solutions gross profit

 

$

7,430

 

 

$

9,751

 

 

$

(2,321

)

 

 

(24

)%

Partner Solutions gross margin

 

 

15

%

 

 

16

%

 

 

-

 

 

 

(1

)%

Edge to Cloud gross profit

 

$

2,666

 

 

$

5,759

 

 

$

(3,093

)

 

 

(54

)%

Edge to Cloud gross margin

 

 

31

%

 

 

47

%

 

 

-

 

 

 

(16

)%

Total gross profit

 

$

10,096

 

 

$

15,510

 

 

$

(5,414

)

 

 

(35

)%

Total gross margin

 

 

17

%

 

 

21

%

 

 

-

 

 

 

(4

)%

(1) For gross margin, amounts represent percentage point change.

 

 

Partner Solutions gross profit declined in 2019 compared to 2018, primarily as a result of lower third-party software sales and from a decrease in the amount of rebate credits we received from Microsoft in the current year period compared to the prior year period, but gross margins were relatively stable. We experienced increased competition with respect to a number of larger Partner Solutions software accounts during 2019 as price protections under the Microsoft volume pricing arrangement, which ended in 2016, reduced per account revenue. Gross profit on Partner Solutions software was positively impacted in 2019 and 2018 by rebate credits we received from Microsoft for the sale of Windows IoT operating systems earned through the achievement of defined objectives. In accordance with Microsoft rebate program rules, we allocate 20% and 30% of rebates in 2019 and 2018, respectively, to reduce cost of revenue, with the remaining 80% in 2019, and 70% in 2018, used to offset qualified marketing expenses in the period the expenditures are incurred. Under the Microsoft rebate program, we recorded $0.3 million and $0.7 million of rebates in 2019 and 2018, respectively, which

23

 


 

were accounted for as reductions in cost of revenue. Additionally, we recorded $1.2 million and $0.7 million in rebates in 2019 and 2018 respectively, which were accounted for as reductions in marketing expenses. There was a balance of approximately $1.0 million in outstanding rebates for which we qualified as of December 31, 2019. If qualified program expenditures are subsequently made, these will be accounted for as reductions in marketing expenses in the period in which such expenditures are made.

Edge to Cloud gross profit and gross margin decreased in 2019 compared to 2018, primarily due to decreased sales of DataV software and services in 2019 compared to 2018.

Operating expenses

Operating expenses were as follows:

 

 

 

Year Ended December 31,

 

(In thousands, except percentages)

 

2019

 

 

2018

 

 

$ Change

 

 

% Change

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

$

11,316

 

 

$

17,074

 

 

$

(5,758

)

 

 

(34

)%

Research and development

 

 

5,751

 

 

 

8,629

 

 

 

(2,878

)

 

 

(33

)%

Restructuring costs

 

 

2,343

 

 

 

-

 

 

 

2,343

 

 

 

100

%

Goodwill impairment

 

 

-

 

 

 

3,738

 

 

 

(3,738

)

 

 

(100

)%

Total operating expenses

 

$

19,410

 

 

$

29,441

 

 

$

(10,031

)

 

 

(34

)%

As a percentage of total revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

 

19

%

 

 

23

%

 

 

 

 

 

 

 

 

Research and development

 

 

10

%

 

 

12

%

 

 

 

 

 

 

 

 

Restructuring costs

 

 

4

%

 

 

0

%

 

 

 

 

 

 

 

 

Goodwill impairment

 

 

0

%

 

 

5

%

 

 

 

 

 

 

 

 

 

Selling, general and administrative

Selling, general and administrative (“SG&A”) expenses consist primarily of salaries and related benefits, commissions and bonuses for our sales, marketing and administrative personnel and related facilities and depreciation costs, as well as professional services fees (e.g., consulting, legal, audit and tax). SG&A expenses decreased in 2019 compared to 2018, due to lower salaries and related benefits and across the board spending reduction efforts that started in the second half of 2018 and continued during 2019.

Research and development

Research and development (“R&D”) expenses consist primarily of salaries and benefits for software development and quality assurance personnel, contractor and consultant costs and related facilities and depreciation costs. R&D expenses decreased in 2019 compared to 2018, primarily due to lower salaries and related benefits resulting from our spending reduction efforts.

Restructuring costs

Restructuring costs include $1.9 million in severance and benefits related to a workforce reduction plan announced by management in the second quarter of 2019 and a non-cash impairment charge in the second quarter of 2019 of $0.4 million related to certain software development cost assets.

Goodwill impairment

Goodwill impairment expense resulted from our annual goodwill assessment in the fourth quarter of 2018, where the carrying value of goodwill was determined to be fully impaired, resulting in an impairment charge of $3.7 million.

Other income and loss

Other income and loss consist primarily of interest income on our cash and investments, gains and losses we may recognize on our investments, gains and losses on foreign exchange transactions and other items. The decrease in 2019 compared to 2018 was primarily due to lower total interest earned on our cash and investments and foreign exchange rate fluctuations.

Income taxes

Income tax expense for 2019 and 2018 related to state and local income taxes.

24

 


 

Liquidity and Capital Resources

As of December 31, 2019, we had $10.6 million of cash, cash equivalents and investments (including $0.6 million in restricted cash), compared to $16.9 million at December 31, 2018, reflecting a net use of approximately $6.4 million in cash, cash equivalents and investments. We generally invest our excess cash in high quality marketable investments. These investments generally include corporate notes and bonds, commercial paper and money market funds, although specific holdings can vary from period to period depending upon our cash requirements. Our investments held at December 31, 2019 had minimal default risk and short-term maturities.

Operating activities used cash of approximately $6.0 million in 2019, which included a net loss of $9.2 million, partially offset by non-cash adjustments of $1.8 million and a change in working capital of approximately $1.4 million. Cash used in operating activities in 2019 included one-time payment of $1.5 million in restructuring costs. Operating activities used cash of approximately $7.4 million in 2018, which included a net loss of approximately $13.7 million, partially offset by non-cash adjustments of approximately $5.1 million and a working capital usage of approximately $1.3 million.

Investing activities provided cash of approximately $3.9 million in 2019, primarily due to net cash inflows on short-term investments of $4.3 million, partially offset by capital expenditures of $0.4 million. Investing activities provided cash of approximately $5.1 million in 2018, primarily due to net cash inflows on short-term investments of $5.5 million, partially offset by capital expenditures of $0.5 million.

Financing activities provided no cash in 2019 and negligible cash in 2018 resulting from the exercise of stock options.

We believe that our existing cash, cash equivalents and investments will be sufficient to meet our needs for working capital and capital expenditures for at least the next 12 months.

Contractual commitments

Future operating lease commitments were as follows as of December 31, 2019 (in thousands):

 

As of December 31, 2019, maturities of lease liabilities were as follows:

 

Operating leases

 

Years Ended December 31,

 

 

 

 

2020

 

$

727

 

2021

 

 

304

 

2022

 

 

249

 

2023

 

 

255

 

2024

 

 

262

 

Thereafter

 

 

709

 

Total minimum lease payments

 

 

2,506

 

Less: amount representing interest

 

 

(548

)

Present value of lease liabilities

 

$

1,958

 

 

Recently Issued Accounting Standards

See Note 1, “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements in Item 8.

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk.

Not applicable.

 

25

 


 

Item 8.

Financial Statements and Supplementary Data.

 

BSQUARE CORPORATION

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

 

 

 

 

26

 


 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Shareholders

BSQUARE Corporation

Opinion on the Financial Statements

We have audited the accompanying consolidated balance sheets of BSQUARE Corporation (the Company) as of December 31, 2019 and 2018, the related consolidated statements of operations and comprehensive loss, shareholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2019 and 2018, and the consolidated results of its operations and its cash flows for the years then ended, in accordance with accounting principles generally accepted in the United States of America.

 

Change in Accounting Principle

As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for leases in 2019.

Basis for Opinion

These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.

Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.

 

/s/ Moss Adams LLP

 

Seattle, Washington

February 24, 2020

 

We have served as the Company’s auditor since 2006.

 

 

 

27

 


 

BSQUARE CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

 

 

 

December 31,

 

 

 

2019

 

 

2018

 

ASSETS

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

7,712

 

 

$

10,005

 

Restricted cash

 

 

600

 

 

 

263

 

Short-term investments

 

 

2,249

 

 

 

6,409

 

Accounts receivable, net of allowance for doubtful accounts of $31 at December 31, 2019 and $40 at December 31, 2018

 

 

9,216

 

 

 

11,581

 

Prepaid expenses and other current assets

 

 

244

 

 

 

685

 

Contract assets

 

 

494

 

 

 

1,053

 

Total current assets

 

 

20,515

 

 

 

29,996

 

Restricted cash, long-term

 

 

 

 

 

263

 

Equipment, furniture and leasehold improvements, net

 

 

252

 

 

 

911

 

Deferred tax assets

 

 

7

 

 

 

7

 

Intangible assets, net

 

 

169

 

 

 

267

 

Right-of-use lease assets, net

 

 

1,828

 

 

 

 

Other non-current assets including contract assets

 

 

284

 

 

 

550

 

Total assets

 

$

23,055

 

 

$

31,994

 

LIABILITIES AND SHAREHOLDERS' EQUITY

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

Third-party software fees payable

 

$

7,224

 

 

$

7,620

 

Accounts payable

 

 

408

 

 

 

565

 

Accrued compensation

 

 

1,001

 

 

 

1,629

 

Other accrued expenses

 

 

306

 

 

 

653

 

Deferred rent, current portion

 

 

 

 

 

347

 

Deferred revenue, current portion

 

 

1,559

 

 

 

1,652

 

Operating leases

 

 

702

 

 

 

 

Total current liabilities

 

 

11,200

 

 

 

12,466

 

Deferred rent

 

 

 

 

 

150

 

Deferred revenue

 

 

903

 

 

 

1,037

 

Operating leases, long-term

 

 

1,256

 

 

 

 

 

Commitments and contingencies (Note 10)

 

 

 

 

 

 

 

 

Shareholders' equity:

 

 

 

 

 

 

 

 

Preferred stock, no par: 10,000,000 shares authorized; no shares issued and outstanding

 

 

 

 

 

 

Common stock, no par: 37,500,000 shares authorized; 13,042,293 issued and outstanding at December 31, 2019 and 12,777,573 issued and outstanding at December 31, 2018

 

 

138,877

 

 

 

138,280

 

Accumulated other comprehensive loss

 

 

(987

)

 

 

(926

)

Accumulated deficit

 

 

(128,194

)

 

 

(119,013

)

Total shareholders' equity

 

 

9,696

 

 

 

18,341

 

Total liabilities and shareholders' equity

 

$

23,055

 

 

$

31,994

 

 

 

 

 

See notes to consolidated financial statements.

 

 

28

 


 

BSQUARE CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(In thousands, except per share amounts)

 

 

 

Year Ended December 31,

 

 

 

2019

 

 

2018

 

Revenue:

 

 

 

 

 

 

 

 

Partner Solutions

 

$

50,628

 

 

$

61,159

 

Edge to Cloud

 

 

8,655

 

 

 

12,255

 

Total revenue

 

 

59,283

 

 

 

73,414

 

Cost of revenue:

 

 

 

 

 

 

 

 

Partner Solutions

 

 

43,198

 

 

 

51,408

 

Edge to Cloud

 

 

5,989

 

 

 

6,496

 

Total cost of revenue

 

 

49,187

 

 

 

57,904

 

Gross profit

 

 

10,096

 

 

 

15,510

 

Operating expenses:

 

 

 

 

 

 

 

 

Selling, general and administrative

 

 

11,316

 

 

 

17,074

 

Research and development

 

 

5,751

 

 

 

8,629

 

Restructuring costs

 

 

2,343

 

 

 

 

Goodwill impairment

 

 

 

 

 

3,738

 

Total operating expenses

 

 

19,410

 

 

 

29,441

 

Loss from operations

 

 

(9,314

)

 

 

(13,931

)

Other income, net

 

 

149

 

 

 

207

 

Loss before income taxes

 

 

(9,165

)

 

 

(13,724

)

Income tax expense

 

 

(16

)

 

 

(13

)

Net loss

 

$

(9,181

)

 

$

(13,737

)

Basic loss per share

 

$

(0.71

)

 

$

(1.08

)

Diluted loss per share

 

$

(0.71

)

 

$

(1.08

)

Shares used in per share calculations:

 

 

 

 

 

 

 

 

Basic

 

 

12,896

 

 

 

12,712

 

Diluted

 

 

12,896

 

 

 

12,712

 

Comprehensive loss:

 

 

 

 

 

 

 

 

Net loss

 

$

(9,181

)

 

$

(13,737

)

Other comprehensive loss:

 

 

 

 

 

 

 

 

Foreign currency translation, net of tax

 

 

(63

)

 

 

(17

)

Unrealized gain on investments, net of tax

 

 

2

 

 

 

7

 

Total other comprehensive loss

 

 

(61

)

 

 

(10

)

Comprehensive loss

 

$

(9,242

)

 

$

(13,747

)

 

 

 

 

 

 

 

 

 

 

 

 

See notes to consolidated financial statements.

 

 

29

 


 

BSQUARE CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(In thousands, except share amounts)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other

 

 

 

 

 

 

Total

 

 

 

Preferred Stock

 

 

Common Stock

 

 

Comprehensive

 

 

Accumulated

 

 

Shareholders'

 

 

 

Shares

 

 

Amount

 

 

Shares

 

 

Amount

 

 

Income (Loss)

 

 

Deficit

 

 

Equity

 

Balance as of December 31, 2017

 

 

-

 

 

$

-

 

 

 

12,664,489

 

 

$

137,622

 

 

$

(916

)

 

$

(105,276

)

 

$

31,430

 

Exercise of stock options

 

 

-

 

 

 

-

 

 

 

2,422

 

 

 

9

 

 

 

-

 

 

 

-

 

 

 

9

 

Share-based compensation, including issuance of restricted stock

 

 

-

 

 

 

-

 

 

 

113,535

 

 

 

678

 

 

 

-

 

 

 

-

 

 

 

678

 

Shares of restricted stock withheld for taxes

 

 

 

 

 

 

 

 

 

 

(2,873

)

 

 

(10

)

 

 

-

 

 

 

-

 

 

 

(10

)

Net loss

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

(13,737

)

 

 

(13,737

)

Foreign currency translation adjustment, net of tax

 

 

-

 

 

 

-

 

 

 

-

 

 

 

(19

)

 

 

(17

)

 

 

-

 

 

 

(36

)

Unrealized gain on investments, net of tax

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

7

 

 

 

-

 

 

 

7

 

Balance as of December 31, 2018

 

 

-

 

 

 

-

 

 

 

12,777,573

 

 

 

138,280

 

 

 

(926

)

 

 

(119,013

)

 

 

18,341

 

Exercise of stock options

 

 

-

 

 

 

-

 

 

 

264,720

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

Share-based compensation, including issuance of restricted stock

 

 

-

 

 

 

-

 

 

 

-

 

 

 

519