10-K 1 rtnb2014_10k.htm 10-K rtnb2014_10k.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K
 
 [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2014
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: 000-50502
 
ROOT9B TECHNOLOGIES, INC.
(Exact Name of registrant as Specified in Its Charter)
 
Delaware
20-0443575
(State of other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)

4521 Sharon Road
Suite 300
Charlotte, North Carolina 28211
(Address of principal executive offices)

(704) 521-8077
(Registrant’s telephone number)

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

Title of Each Class
Name of Each Exchange On Which Registered
N/A
N/A

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

Common stock, par value $0.001 per share

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

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

Note – Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Exchange Act from their obligations under those Sections.
 

 
 

 

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 past 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.
 
[X] Yes [ ] No
 
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
[ ]

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

Large accelerated filer [ ]                                                                Accelerated filer [ ]
 
Non-accelerated filer   [ ]                                                                Smaller reporting company [X]
 

 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

[ ] Yes [X] No

State issuer’s revenues for its most recent fiscal year (ended December 31, 2014): $20,175,488

The aggregate market value of voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity as of the last day of the registrant’s most recently completed second fiscal quarter was $17,374,155.

The total number of shares of Common Stock of the Registrant outstanding as of the latest practicable date, March 16, 2015 is 72,076,243.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
 
Certain sections of the Company’s definitive proxy statement to be filed with the Securities and Exchange Commission (SEC) within 120 days of the end of the Company’s fiscal year ended December 31, 2014, are incorporated by reference into Part III hereof. Except for those portions specifically incorporated by reference herein, such document shall not be deemed to be filed with the SEC as part of this annual report on Form 10-K.
 
 
 

 
 
 

 
 

ROOT9B TECHNOLOGIES, INC.
 
FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2014
 
TABLE OF CONTENTS
 
 
PART I
Page
Item 1.
BUSINESS
 1
Item 2.
PROPERTIES
13
Item 3.
LEGAL PROCEEDINGS
13
Item 4.
MINE SAFETY DISCLOSURES
13
 
PART II
 
Item 5.
MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND REGISTRANT’S ISSUER PURCHASES OF EQUITY SECURITIES
14
Item 6.
SELECTED FINANCIAL DATA
15
Item 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
16
Item 8.
FINANCIAL STATEMENTS & SUPPLEMENTARY DATA
31
Item 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
32
Item 9A.
CONTROLS AND PROCEDURES
32
Item 9B.
OTHER INFORMATION
33
 
PART III
 
Item 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
34
Item 11.
EXECUTIVE C0MPENSATION
34
Item 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
34
Item 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
34
Item 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
34
Item 15.
EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES
35
SIGNATURES
 
37
FINANCIAL STATEMENTS
F-1
EXHIBIT 31.1
SECTION 302 CEO CERTIFICATION
 
EXHIBIT 31.2
SECTION 302 CFO CERTIFICATION
 
EXHIBIT 32.1
SECTION 906 CEO CERTIFICATION
 
EXHIBIT 32.2
SECTION 906 CFO CERTIFICATION
 

 
 

 

 
DISCLOSURES REGARDING FORWARD-LOOKING STATEMENTS
 
Statements in this Annual Report on Form 10-K, including the information incorporated by reference herein, that are not historical in nature, including those concerning the Company’s current expectations about its future requirements and needs, are “forward-looking” statements as defined in Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and the Private Securities Litigation Reform Act of 1995. Forward-looking statements are identified by words such as “may,” “should,” “expects,” “provides,” “anticipates,” “assumes,” “can,” “meets,” “could,” “intends,” “might,” “predicts,” “seeks,” “would,” “believes,” “estimates,” “plans” or “continues.” Although we believe that the expectations reflected in such forward-looking statements are reasonable at the time they are made, you are cautioned that forward-looking information and statements are subject to various risks and uncertainties, many of which are difficult to predict and generally beyond our control. Risks and uncertainties could cause actual results and developments to differ materially from those expressed in, or implied or projected by, forward-looking information and statements provided here or in other disclosures and presentations. Those risks and uncertainties include, but are not limited to, the risks discussed or identified below in a section titled "Risk Factors." As we may update those Risk Factors from time to time, please consult our public filings at www.sec.gov or www.root9btechnologies.com. We do not undertake any obligation to update or revise any forward-looking information or statements.
 
In this Annual Report on Form 10-K, references to "we," "our," "us," "the Company," or "root9B" refer to root9B Technologies, Inc. All references to years, unless otherwise noted, refer to our fiscal year, which ends on December 31.
 
 
 PART I
 
ITEM 1.                      BUSINESS.
 
OVERVIEW
 
We are a provider of cybersecurity, regulatory risk mitigation, and energy and controls solutions.  We help clients in diverse industries to provide full scale cyber operations and solutions, mitigate risk, comply with complex regulations, improve performance and productivity, and leverage and integrate technology.  We work with our customers to assess, design, and provide customized solutions and advisory services that are tailored to address each client’s particular requirements and needs. Our clients range in size from Fortune 100 companies to mid-sized and owner-managed businesses across a broad range of industries including local, state, and federal agencies.
 
We (sometimes referred to as the “Company”) were incorporated on January 5, 2000 as Continuum Group C Inc. under the laws of the State of Nevada, and did not conduct business as such.  On November 5, 2004, we consummated a share exchange agreement dated as of October 12, 2004, among us, Premier Alliance Group, Inc., a North Carolina corporation (‘‘North Carolina Premier’’), and the shareholders of North Carolina Premier. As a result, North Carolina Premier merged into us and our name was changed to Premier Alliance Group, Inc. North Carolina Premier had commenced operations in 1995 and was founded by a group of experienced consultants that specialized in technology and financial services.  In November 2004, and as a result of the merger of North Carolina Premier into the Company, it became part of a publicly traded company.  In 2011, we re-domiciled under the laws of the state of Delaware. We have grown significantly both organically and through strategic acquisitions of complementary businesses.  Significant acquisitions we have completed include Greenhouse Holdings, Inc. (“GHH”) in March 2012, Ecological, LLC in December 2012, root9B, LLC in November 2013 and IPSA International, Inc. in February 2015.
 
In September 2014, the Company announced a shift in strategy to accelerate the differentiated capabilities of its wholly-owned cybersecurity subsidiary root9B, and to focus primarily on cybersecurity and regulatory risk mitigation.  In connection with this strategic shift, the Company changed its name and OTCQB ticker symbol as part of a rebranding effort, to root9B Technologies, Inc. and RTNB.

 
 
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Our team is made up of individuals that have deep experience and training as cyber security experts, analysts, technology and engineer specialists, business and project consultants.  We have hired our experienced professionals from a wide variety of organizations and key industries, which include financial services, utilities, life science, technology, government and healthcare.
 

OUR SERVICES
 

We are a provider of cyber security, regulatory risk mitigation, and energy solutions.  Our services and solutions target mitigating risk, assisting with compliance, and maximizing profits by addressing these core areas for businesses, primarily cyber security, regulatory compliance, risk mitigation and energy management related initiatives.
 
During 2014 we provided our services through three operating segments: Cyber Solutions, Business Advisory Solutions and Energy Solutions.  For the year ended December 31, 2014, 20% of our revenue was generated from Cyber Solutions, 64% from Business Advisory Solutions and 16% from Energy Solutions.
 
For further financial information on our segment results, see “Part II—Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 19 “Segment Information” under “Part II—Item 8. Financial Statements and Supplementary Data.”

 
Cyber Solutions
 
We are a provider of cyber security and advanced technology training capabilities, operational support and consulting services.  From our offices in Colorado Springs, Colorado, Honolulu, Hawaii, New York, NY, and San Antonio, Texas, we provide services to the US Government and commercial organizations in the United States and overseas.  Our services range from cyber operations assessments, analysis and testing, to cyber training, forensics, exploitation, and strategic defense planning. Our cybersecurity personnel are recognized providers of cyber services across the defense, civil, intelligence and commercial communities.  Our capabilities include but are not limited to:
 

· Vulnerability Assessment & Penetration Testing
· Network Defense Operations
· Computer Forensics
· Malware Analysis & Reverse Engineering
· Forensic Data Analysis
· Mobile Forensics
· Tool Development
· Mobile Cyber Protection
· SCADA Security Operations
· Wireless Technology Support
· Compliance Testing
· Data Breach Prevention & Remediation
· Cyber Policy Assessment & Design
· Curriculum Development
 

Business Advisory Solutions
 
Our Business Advisory Solutions team focuses on delivering solutions in both regulatory compliance and risk mitigation.  The group works to assist our customers with compliance by applying our expertise in various regulations and deploying processes and automation.  Similarly, we have deep expertise in risk assessment and work with our customers to develop solutions and structures to evaluate and mitigate risk.  A typical customer is an organization that has complex business processes, large amounts of data to manage, and faces change driven by regulatory or market environments, or strategic, growth and profitability initiatives.  Key areas of focus continue to be large, mandated regulatory efforts including complying with the Sarbanes-Oxley Act of 2002 (SOX), BASEL ACCORDS (for financial institutions), the Dodd-Frank Wall Street Reform and Consumer Protection Act and cybersecurity initiatives, where the team partners with the Cyber Solutions group.

 
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Energy Solutions
 
The Energy Solutions group works with our customers to assess, design and install processes and automation to address energy regulation, strategy, cost, and usage initiatives.    Examples of solutions and areas of expertise include automated control systems and energy management systems. These systems apply technology to respond to events, scenarios or data patterns automatically adjusting for more efficient processes.    Our customers include companies in the commercial sector, not for profit entities and local municipalities.
 

OUR ACQUISITION STRATEGY
 
We are focused on balanced growth with a priority on driving growth in revenue and profitability in our existing businesses along with the acquisition of complementary businesses.  In 2013, we made the acquisition of root9B, LLC which expanded our scope of solutions offerings into the cybersecurity business.  We viewed this acquisition as a way to strategically broaden our business capability while also being complementary to our existing businesses, which set up an opportunity for cross-selling and providing our customers key solutions.  In February 2015, we acquired IPSA International, which is discussed further below.  In 2014, we operated three business segments, 1) Cyber Security Solutions 2) Business Advisory Solutions and 3) Energy Solutions.  After our acquisitions of root9B and IPSA we believe we are positioned in the highest areas of concern and activity for our target customers and will allow for future growth.  These segments and our solutions are complementary and give us the opportunity to cross sell across the business lines and provide our customers with core solutions and greater value.  We will continue to assess complementary acquisition opportunities.
 
On February 6, 2015, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with IPSA International, Inc. (“IPSA”). On February 9, 2015, the Company and IPSA consummated and closed the Merger.  Pursuant to the terms of the Merger Agreement, upon the closing of the Merger, the Corporation issued ten million shares of the Corporation’s common stock to the stockholders of IPSA (the “Stock Consideration”), as well as paid $2,500,000 to such stockholders. Twenty five percent of the Stock Consideration (the “Indemnity Shares”) are subject to a pledge agreement executed by and between the Company and the stockholders of IPSA, whereby such Indemnity Shares shall secure the obligations of IPSA to indemnify the Company pursuant to the terms of the Merger Agreement.  In conjunction with the closing of the Merger, the Corporation entered into a registration rights agreement with the stockholders of IPSA whereby the Corporation agreed to provide piggyback registration rights to the holders of the Stock Consideration.  The Company entered into an employment agreement with Dan Wachtler, the CEO of IPSA.
 
IPSA specializes in Anti-Money Laundering (AML) operational, investigative and remedial services, AML risk advisory and consulting services, conducting high-end investigations with expertise in services ranging from complex financial crime and intellectual property issues to conducting anti-bribery investigations or due diligence on a potential partner or customer.   Additionally IPSA provides investigative services related to passport issuances by foreign countries.  IPSA has offices in the U.S., Canada, U.K., U.A.E. and Hong Kong, vetted resources in over 75 countries worldwide and a talent base that is focused on assisting clients in making better-informed decisions to protect their investments and assets.
 
FINANCINGS
 
The Company has recently closed on three financing transactions as follows:
 
1)  
On February 9, 2015, the Company entered into a securities purchase agreement with an accredited investor, an investment advisory client of Wellington Management Company LLP, pursuant to which the Company issued 5,586,450 shares of common stock at a purchase price of $1.10 per share. In addition, the Company issued warrants to purchase up to 5,135,018 shares of the Company’s common stock in the aggregate, at an exercise price of $0.80 per share (the “Warrants”). The Warrants have a term of three years and may be exercised at any time from or after the date of issuance, may be exercised on a cashless basis and contain customary, structural anti-dilution protection (i.e., stock splits, dividends, etc).  Upon closing of this equity financing, the Company received proceeds of $6,145,095.
 
 
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2)  
On February 17, 2015, the Company entered into a securities purchase agreement with the same accredited investor, pursuant to which the Company issued 1,162,321 shares of common stock at a purchase price of $1.10 per share. In addition, the Company issued warrants to purchase up to 1,068,390 shares of the Corporation’s common stock in the aggregate, at an exercise price of $0.80 per share (the “Warrants”). The Warrants have a term of three years and may be exercised at any time from or after the date of issuance, may be exercised on a cashless basis and contain customary, structural anti-dilution protection (i.e., stock splits, dividends, etc).  Upon closing of this equity financing, the Company received proceeds of $1,278,553.
 
 
3)  
On March 12, 2015, the Company entered into securities purchase agreements with a group of accredited investors, pursuant to which the Company issued 3,686,818 shares of common stock at a purchase price of $1.10 per share. In addition, the Company issued warrants to purchase up to 1,843,413 shares of the Corporation’s common stock in the aggregate, at an exercise price of $1.50 per share (the “Warrants”). The Warrants have a term of three years and may be exercised at any time from or after the date of issuance and contain customary, structural anti-dilution protection (i.e., stock splits, dividends, etc).  Upon closing of this equity financing, the Company received proceeds of $4,055,498.
 
The Company incurred fees of $184,697 in connection with these three financing transactions and this amount is not reflected in the proceeds above.
 

OUR STRATEGY

Our business focus is to work with the top levels of corporations to address major initiatives that fall under governance, risk and compliance (GRC) areas.  Within GRC, the key emphasis today is around risk related to cybersecurity.  With our cyber group, root9B, we take a new approach to combatting cyber activity, using a full solution encompassing active adversarial pursuit (HUNT), cybersecurity and intelligence training, operational support, and associated technology and tools.  In 2015, we are building a HUNT operations center where we will be able to conduct and provide remote HUNT services to our customers, which, we believe, offers a competitive advantage.  We believe a full spectrum solution is needed to mitigate risk associated with cyber threats.  Our Business Advisory capabilities focus on aspects related to the ongoing emerging regulatory environment that corporations must address (AML, SOX, FCP, etc). We utilize talent with specific expertise that allow us to effectively assist corporations to assess compliance, design programs, remediate problems, and provide ongoing operational support.
 
Our customers include Fortune 500 companies (including Cisco, Duke Power, Bank of America, and PNC Bank). With the acquisition of root9B, we are also providing services to the mid-market arena and governmental entities.  The acquisition of IPSA has added a number of large financial institutions to our customer base.


OUR COMPETITION

The market for professional services and solutions is highly competitive. It is also highly fragmented, with many providers and no single competitor maintaining clear market leadership. Our competition varies by segment, type of service provided, and the customer to whom services are provided.  Our competitors in cyber security include Fireeye, IBM, and Symantec; and in the risk regulatory arena include Deloitte, Price Waterhouse Coopers, and Accenture.  Many of our competitors are larger and better financed than we are and have substantial marketplace reputations.
 
 
CONTRACTS
When servicing customers, we typically sign master contracts for a one to three year period. The contracts typically set rules of engagement and can include pricing guidelines. The contracts manage the relationship and are not indicators of guaranteed work. Individual contracts, Purchase Orders, or Statements of Work, are put in place (under the master agreement) for each engineer, consultant or team assigned to the client site and cover logistics of length of contract, billing information and deliverables for the particular assignment. In most cases, contracts can be terminated by either party by providing ten to thirty days’ advance notice.
 
 
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To date, we have received a significant portion of revenues from large sales to a small number of customers. During 2014 and 2013, our five largest customers, together comprised approximately 34% and 47% of our total revenues, respectively. Our operating results may be harmed if we are not able to complete one or more substantial sales to any large customers or are unable to collect accounts receivable from any of the large customers in any future period.
 

 
EMPLOYEES
 

As of March 1, 2015, we employed a total of 215 persons on a full time basis.  We believe our employee relations are good.
 

 
ITEM 1A.                      RISK FACTORS
 
We are subject to various risks that may materially harm our financial condition and results of operations. If any of these risks or uncertainties actually occurs, the trading price of our common stock could decline.
 
Risks Related to Our Business and Industry
 
WE HAVE CONTINUED TO EXPERIENCE SIGNIFICANT LOSSES FROM OPERATIONS
 
We have experienced substantial and continuing losses from operations.  These are the result of declining revenues and increases in selling, general and administrative expenses incurred in preparation for growth. We expect that our cyber security operations and the operations of IPSA, which we acquired in February 2015, will increase revenues and help move the Company to profitability from operations, of which there can be no assurance.
 
A DECLINE IN THE PRICE OF, OR DEMAND FOR, ANY OF OUR BUSINESS ADVISORY SOLUTIONS AND SERVICES, WOULD HARM OUR REVENUES AND OPERATING MARGINS.
 
Our Business Advisory Solutions services accounted for the majority of our revenues in 2013 (approximately 55%), and 2014 (approximately 64%). We anticipate that revenue from the Business Advisory Solutions services, particularly in view of the acquisition of IPSA International, which will be combined with the Business Advisory group, will continue to constitute the majority of our revenues for the near term and anticipate that revenue in the Cybersecurity segment could, in the future, exceed the revenues of our Business Advisory Solutions group, of which there can be no assurance. A decline in the price of, or demand for, Business Advisory Solutions services or the failure to achieve substantial growth in cyber security revenue would harm our business.  
 
A SIGNIFICANT PORTION OF OUR BUSINESS REVENUES DEPEND ON A RELATIVELY SMALL NUMBER OF LARGE CUSTOMERS.  IF ANY OF THESE CUSTOMERS DECIDE THEY WILL NO LONGER USE OUR SERVICES, REVENUES WILL DECREASE AND FINANCIAL PERFORMANCE WILL BE SEVERELY IMPACTED.
 
To date, we have received a significant portion of our revenues from large sales to a small number of customers. During 2014 and 2013, our five largest customers, together comprised approximately 34% and 47% of our total revenues, respectively. Our operating results may be harmed if we are not able to complete one or more substantial sales to any large customers or are unable to collect accounts receivable from any of the large customers in any future period.
 
INTENSE COMPETITION IN OUR TARGET MARKETS COULD IMPAIR OUR ABILITY TO GROW AND TO ACHIEVE PROFITABILITY.  IF WE DO NOT GROW, OUR COMPETITIVE ABILITY WILL BE SEVERELY RESTRICTED, WHICH WOULD DECREASE PROFITABILITY.
 
Our competitors vary in size and in the scope and breadth of the products and services they offer. Our competitors include Deloitte, Accenture, Fireeye and SAI Global as well as other national firms and a number of smaller regional firms. Many of our competitors have longer operating histories, substantially greater financial, technical, marketing, or other resources, or greater name recognition than us. Our
 
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competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements. Increased competition is likely to result in price reductions, reduced gross margins, and loss of market share, any one of which could seriously harm our business.
 
OUR LENGTHY SALES CYCLE COULD MAKE IT MORE DIFFICULT TO ACHIEVE OUR GROWTH OBJECTIVES.
 
The period between initial contact with a potential customer and that customer’s purchase of services is often long.  A customer’s decision to purchase services involves a significant allocation of resources on our part, is influenced by a customer’s budgetary cycles, and in many instances involves a preferred-vendor process. To successfully sell our services, generally we must educate the potential customers regarding the uses and benefits of our services, which can require significant time and resources. Many potential customers are large enterprises that generally take longer to designate preferred vendors; the typical sales cycle in connection with becoming an approved vendor has been approximately six to 12 months. Delay or failure to complete sales in a particular quarter could reduce revenues in that quarter, as well as subsequent quarters over which revenues for the sale would likely be recognized. If the sales cycle unexpectedly lengthens in general, or for one or more large orders, it would adversely affect the timing of revenues and revenue growth. If we were to experience a delay of several weeks on a large order, it could harm our ability to meet forecasts for a given quarter.
 
WE MAY NOT BE ABLE TO SECURE NECESSARY FUNDING IN THE FUTURE WHICH WOULD ADVERSELY AFFECT OUR ABILITY TO GROW, INCREASE REVENUES, AND ACHIEVE PROFITABILITY.
 
Unless we achieve positive cash flow, substantial working capital will be required for continued operations. We believe that if capital requirements increase materially from those currently planned, additional financing may be required sooner than anticipated. If we raise additional funds by issuing equity securities, the percentage of our capital stock owned by our current shareholders would be reduced, and those equity securities may have rights that are senior to those of the holders of our currently outstanding securities. Additional financing may not be available when needed on commercially acceptable terms, or at all. If adequate funds are not available or are not available on acceptable terms, we may be forced to curtail planned growth, and we may be unable to develop or enhance planned products and services, take advantage of future opportunities, or respond to competitive pressures.
 
THERE ARE SUBSTANTIAL RISKS ASSOCIATED WITH ACQUISITIONS.
 
An integral part of our growth strategy has been evaluating and, from time to time, consummating acquisitions. These transactions involve a number of risks and present financial, managerial and operational challenges, including: diversion of management’s attention from running the existing business; increased expenses, including legal, administrative and compensation expenses resulting from newly hired employees; increased costs to integrate personnel, customer base and business practices of the acquired company; adverse effects on reported operating results due to possible impairment of intangible assets including goodwill associated with acquisitions; and dilution to stockholders to the extent of issuance of securities in the transaction.  .
 
OUR EXECUTIVE OFFICERS AND DIRECTORS, AND MAJOR STOCKHOLDERS WILL BE ABLE TO EXERT SIGNIFICANT INFLUENCE OVER US,WHICH WILL LIMIT OUR STOCKHOLDERS’ ABILITY TO INFLUENCE THE OUTCOME OF KEY DECISIONS.
 
Our executive officers and directors collectively control approximately 23.5% of our current outstanding capital stock and approximately 27.0% on a fully diluted basis. As a result, if they act together they will be able to influence management and affairs and all matters requiring stockholder approval, including significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing any change in control of our Company and might affect the market price of the common stock.
 
Miriam Blech currently controls approximately 7.0% of our outstanding voting capital stock, including 60% of our Series C preferred stock.  Isaac Blech currently controls approximately 4.6% of our outstanding voting capital stock (which is included in the above figures concerning officers and directors), including 40% of our Series C preferred stock.  Together, Mr. and Mrs. Blech currently control approximately 11.6% of our outstanding voting capital stock, including 100% of our Series C preferred stock.  The interests of Mr. and Mrs. Blech may differ from the interests of other stockholders. Third parties may be discouraged from making a tender offer or bid or it may make it easier for them to acquire root9B because of this concentration of ownership.
 
 
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Ithan Creek Master Investors (Cayman), L.P. currently controls approximately 9.0% of our outstanding voting capital stock, In addition they can increase their ownership thru exercise of warrants up to approximately 17.0%.  
 
A FAILURE TO ATTRACT AND RETAIN QUALIFIED PERSONNEL COULD HAVE AN ADVERSE EFFECT ON US.
 
Our ability to attract and retain qualified professional and/or skilled personnel in accordance with our needs, either through direct hiring or acquisition of other firms employing such professionals, is an important factor in determining our future success. The market for these professionals is competitive, and there can be no assurance that we will be successful in our efforts to attract and retain needed personnel. Our success is also highly dependent upon the continued services of our key officers, and we do not maintain key employee insurance on any of our executive officers.
 
If we are unable to retain qualified personnel, the roles and responsibilities of those employees will need to be filled, which may require that we devote time and resources to identifying, hiring and integrating new employees. In addition, the failure to attract and retain key employees, including officers, could impair our ability to provide services to our clients and conduct our business effectively.
 
Risks Related to root9B
 

OUR FAILURE TO ATTRACT AND RETAIN HIGHLY SKILLED CYBER EXPERTS WOULD HAVE AN ADVERSE EFFECT ON US.

Our ability to attract and retain qualified professional and/or skilled cyber personnel, either through direct hiring or acquisition of other firms employing such professionals, is an important factor in determining our future success. The market for these professionals is very competitive as well as limited for senior level operators with the Department of Defense experience we seek.  There can be no assurance that we will be successful in our efforts to attract and retain the needed personnel.  The failure to attract and retain skilled personnel could impair our ability to sell, provide services to our clients, and conduct our business effectively by limiting the number of engagements we can handle concurrently and could limit our ability to work on large scale projects.

INTENSE COMPETITION IN OUR TARGET MARKETS COULD IMPAIR OUR ABILITY TO GROW AND TO ACHIEVE PROFITABILITY.

The market for cyber solutions work has been developing rapidly over the past several years and continues to change as new entrants enter the market and as legislation moves forward in this area.  As competition increases, there could be impact on the markets and pricing which will present a risk to the revenue growth for root9B.

 OUR SALES CYCLES CAN BE LONG AND UNPREDICTABLE, AND OUR SALES EFFORTS REQUIRE CONSIDERABLE TIME AND EXPENSE. AS A RESULT, OUR SALES AND REVENUE ARE DIFFICULT TO PREDICT AND MAY VARY SUBSTANTIALLY FROM PERIOD TO PERIOD, WHICH MAY CAUSE OUR RESULTS OF OPERATIONS TO FLUCTUATE SIGNIFICANTLY.
 
Our results of operations may fluctuate, in part, because of the resource intensive nature of our sales efforts, the length and variability of our sales cycle and the short-term difficulty in adjusting our operating expenses. Our results of operations depend in part on sales to large organizations. The length of our sales cycle, from proof of concept to delivery of and payment for our products, is typically four to twelve months but can be more than a year. To the extent our competitors develop products that our prospective customers view as equivalent to ours, our average sales cycle may increase. Because the length of time required to close a sale varies substantially from customer to customer, it is difficult to predict exactly when, or even if, we will make a sale with a potential customer. As a result, large individual sales have, in some cases, occurred in quarters subsequent to those we anticipated, or have not occurred at all. The loss or delay of one or more large transactions in a quarter could impact our results of operations for that quarter and any future quarters for which revenue from that transaction is delayed.
 
 
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As a result of these factors, it is difficult for us to forecast our revenue accurately in any quarter. Because a substantial portion of our expenses are relatively fixed in the short term, our results of operations will suffer if our revenue falls below our or analysts’ expectations in a particular quarter, which could cause the price of our common stock to decline.
 
IF WE ARE UNABLE TO SELL OUR PROPRIETARY PRODUCTS, SUBSCRIPTIONS AND SERVICES, AS WELL AS RENEWALS OF OUR SUBSCRIPTIONS AND SERVICES, TO OUR CUSTOMERS, OUR FUTURE REVENUE AND OPERATING RESULTS WILL BE HARMED.
 
 Our future success depends, in part, on our ability to expand the deployment of our products with new and existing customers, including solutions delivered through the new Adversarial Pursuit Center,.  This may require increasingly sophisticated and costly sales efforts and may not result in additional sales. In addition, the rate at which our customers purchase additional products, subscriptions and services depends on a number of factors, including the perceived need for additional IT security as well as general economic conditions. If our efforts to sell additional products, subscriptions and services to our customers are not successful, our business would suffer.
 
Further, existing customers that purchase our products have no contractual obligation to renew their subscriptions and support and maintenance services beyond the initial contract period, and given our limited operating history, we may not be able to accurately predict our renewal rates. Our customers’ renewal rates may decline or fluctuate as a result of a number of factors, including the level of their satisfaction with our products, our customer support, customer budgets and the pricing of our products compared with the products and services offered by our competitors. We cannot assure that our customers will renew their subscriptions, and if our customers do not renew their subscriptions or renew on less favorable terms, our revenue may grow more slowly than expected, if at all.
 
We also depend on our installed customer base for future support and maintenance revenue. We offer our support and maintenance agreements for terms that generally range between one and five years. If customers choose not to renew their support and maintenance agreements or seek to renegotiate the terms of their support and maintenance agreements prior to renewing such agreements, our revenue may decline.
 
IF WE ARE UNABLE TO INCREASE SALES OF OUR SOLUTIONS TO LARGE ORGANIZATIONS WHILE MITIGATING THE RISKS ASSOCIATED WITH SERVING SUCH CUSTOMERS, OUR BUSINESS, FINANCIAL POSITION AND RESULTS OF OPERATIONS MAY SUFFER.
 
Our growth strategy is dependent, in part, upon increasing sales of our solution to large enterprises and governments. Sales to large customers involve risks that may not be present (or that are present to a lesser extent) with sales to smaller entities. These risks include:
 
· 
Increased purchasing power and leverage held by large customers in negotiating contractual arrangements with us;
· 
More stringent or costly requirements imposed upon us in our support service contracts with such customers;
· 
More complicated implementation processes;
· 
Longer sales cycles and the associated risk that substantial time and resources may be spent on a potential customer that ultimately does not purchase our platform or solutions
· 
More pressure for discounts and write-offs

In addition, because security breaches with respect to larger, high-profile enterprises are likely to be heavily publicized, there is increased reputational risk associated with serving such customers. If we are unable to increase sales of our platform to large enterprise and government customers while mitigating the risks associated with serving such customers, our business, financial position and results of operations may suffer.
 

IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, THE VALUE OF OUR CYBER SECURITY BUSINESS MAY BE DIMINISHED, AND OUR CYBER SECURITY BUSINESS MAY BE ADVERSELY AFFECTED.
 
We rely and expect to continue to rely on a combination of confidentiality and license agreements with our employees, consultants, and third parties with whom we have relationships, as well as trademark, copyright, trade secret, and domain name protection laws, to protect our cyber security proprietary rights. We presently do not intend to rely on the filing and prosecution of patent applications. Third parties may knowingly or unknowingly infringe our
 
 
8

 
 
proprietary rights, third parties may challenge proprietary rights held by us, and future trademark and patent applications may not be approved. In any or all of these cases, we may be required to expend significant time and expense in order to prevent infringement or to enforce our rights. Although we have taken measures to protect our proprietary rights, there can be no assurance that others will not offer products or concepts that are substantially similar to ours and compete with our business. If the protection of our proprietary rights is inadequate to prevent unauthorized use or appropriation by third parties, the value of our cyber security business and other intangible assets may be diminished and competitors may be able to more effectively mimic our service and methods of operations. Any of these events would have an adverse effect on our cyber security business and financial results.
 
WE MAY, IN THE FUTURE, BE A PARTY DEFENDANT TO PATENT LAWSUITS AND OTHER INTELLECTUAL PROPERTY RIGHTS CLAIMS THAT ARE EXPENSIVE AND TIME CONSUMING, AND, IF RESOLVED ADVERSELY, WOULD HAVE A SIGNIFICANT IMPACT ON OUR CYBER SECURITY BUSINESS, FINANCIAL CONDITION, AND RESULTS OF OPERATIONS.
 
Companies in the cyber security business often own large numbers of patents, copyrights, trademarks, and trade secrets, and frequently enter into litigation based on allegations of infringement, misappropriation, or other violations of intellectual property or other rights. In addition, various "non-practicing entities" that own patents and other intellectual property rights often attempt to aggressively assert their rights in order to extract value from technology companies. Furthermore, from time to time we may introduce new products, including in areas where we currently do not operate, which could increase our exposure to patent and other intellectual property claims from competitors and non-practicing entities. Defending patent and other intellectual property litigation is costly and can impose a significant burden on management and employees, and there can be no assurances that favorable final outcomes will be obtained in all cases. In addition, plaintiffs may seek, and we may become subject to, preliminary or provisional rulings in the course of any such litigation, including potential preliminary injunctions requiring us to cease some or all of our operations. We may decide to settle such lawsuits and disputes on terms that are unfavorable to us. Similarly, if any litigation to which we are a party is resolved adversely, we may be subject to an unfavorable judgment that may not be reversed upon appeal. The terms of such a settlement or judgment may require us to cease some or all of our operations or pay substantial amounts to the other party. In addition, we may have to seek a license to continue practices found to be in violation of a third party's rights, which may not be available on reasonable terms, or at all, and may significantly increase our operating costs and expenses. As a result, we may also be required to develop alternative non-infringing technology or practices or discontinue the practices. The development of alternative non-infringing technology or practices could require significant effort and expense or may not be feasible. Our business, financial condition, and results of operations would be adversely affected as a result of an unfavorable resolution of the disputes and litigation referred to above.
 
A DATA SECURITY BREACH WITH OUR CUSTOMERS AS A RESULT OF OUR CYBERSECURITY PROCESSES COULD CAUSE SUBSTANTIAL NEGATIVE IMPACT ON US FINANCIALLY, LEGALLY AS WELL AS IMPACT OUR REPUTATION IN THE MARKETPLACE
 
As a part of our services we access customers environments, if this access led to the opportunity for a data breach by others, although remote, and if this happened and it was determined we were liable this could cause significant damage to our reputation, have an adverse impact on our results of operations as well as lead to the possibility of litigation and other financial liabilities.
 
 
Risks related to IPSA
 
AN INABILITY TO RETAIN IPSA’S SENIOR MANAGEMENT TEAM AND OTHER MANAGING DIRECTORS WOULD BE DETRIMENTAL TO THE SUCCESS OF IPSA’S BUSINESS.
 
We will rely heavily on IPSA senior management team, its practice leaders, and other staff; our ability to retain them is particularly important to IPSA’s future success. Given the highly specialized nature of IPSA’s services, the senior management team must have a thorough understanding of IPSA’s service offerings as well as the skills and experience necessary to manage an organization consisting of a diverse group of professionals. In addition, we rely on IPSA’s senior management team and other managing directors to generate and market IPSA’s business. Further, IPSA’s senior management’s and other managing directors’ personal reputations and relationships with IPSA’s clients are a critical element in obtaining and maintaining client engagements.
 
 
9

 
 
IPSA’S INABILITY TO HIRE AND RETAIN TALENTED PEOPLE IN AN INDUSTRY WHERE THERE IS GREAT COMPETITION FOR TALENT COULD HAVE A SERIOUS NEGATIVE EFFECT ON OUR PROSPECTS AND RESULTS OF OPERATIONS.
 
IPSA’s business involves the delivery of professional services and is highly labor-intensive. Its success depends largely on its ability to attract, develop, motivate, and retain highly skilled professionals. Further, IPSA must successfully maintain the right mix of professionals with relevant experience and skill sets if IPSA is to continue to grow, as it expands into new service offerings, and as the market evolves. The loss of a significant number of its professionals, the inability to attract, hire, develop, train, and retain additional skilled personnel, or failure to maintain the right mix of professionals could have a serious negative effect on IPSA, including its ability to manage, staff, and successfully complete its existing engagements and obtain new engagements.
 
CHANGES IN CAPITAL MARKETS, LEGAL OR REGULATORY REQUIREMENTS, AND GENERAL ECONOMIC OR OTHER FACTORS BEYOND IPSA’S CONTROL COULD REDUCE DEMAND FOR IPSA’S SERVICES, IN WHICH CASE IPSA’S REVENUES AND PROFITABILITY COULD DECLINE.
 
A number of factors outside of its control affect demand for IPSA’s services. These include:
·  
Fluctuations in U.S. and global economies;
·  
The U.S. or global financial markets and the availability, costs, and terms of credit;
·  
Changes in laws and regulations; and
·  
Other economic factors and general business conditions.
 
We are not able to predict the positive or negative effects that future events or changes to the U.S. or global economy, financial markets, regulatory and business environment could have on IPSA’s operations.
 
IPSA’S REPUTATION COULD BE DAMAGED AND IT COULD INCUR ADDITIONAL LIABILITIES IF IT FAILS TO PROTECT CLIENT AND EMPLOYEE DATA.
 
IPSA relies on information technology systems to process, transmit, and store electronic information and to communicate among its locations around the world and with its clients, partners, and employees. The breadth and complexity of this infrastructure increases the potential risk of security breaches which could lead to potential unauthorized disclosure of confidential information.
 
In providing services to clients, IPSA may manage, utilize, and store sensitive or confidential client or employee data, including personal data. As a result, IPSA is subject to numerous laws and regulations designed to protect this information, such as the U.S. federal and state laws governing the protection of health or other personally identifiable information and international laws such as the European Union Directive on Data Protection.
 
These laws and regulations are increasing in complexity and number. If any person, including any of IPSA’s employees, negligently disregards or intentionally breaches its established controls with respect to client or employee data, or otherwise mismanages or misappropriates that data, IPSA could be subject to significant monetary damages, regulatory enforcement actions, fines, and/or criminal prosecution. In addition, unauthorized disclosure of sensitive or confidential client or employee data, whether through systems failure, employee negligence, fraud, or misappropriation, could damage IPSA’s reputation and cause it to lose clients and their related revenue in the future.
 
INTERNATIONAL OPERATIONS COULD RESULT IN ADDITIONAL RISKS.
 
IPSA operates both domestically and internationally, including in the Middle East, Europe and Asia. IPSA intends to continue to expand internationally. These operations result in additional risks that are not present domestically and which could adversely affect IPSA’s business:
·  
compliance with additional U.S. regulations and those of other nations applicable to international operations;
·  
cultural and language differences;
·  
employment laws and rules and related social and cultural factors;
·  
losses related to start-up costs, lack of revenue, higher costs due to low utilization, and delays in purchase decisions by prospective clients;
 
 
10

 
 
·  
currency fluctuations between the U.S. dollar and foreign currencies, which are harder to predict in the current adverse global economic climate;
·  
restrictions on the repatriation of earnings;
·  
potentially adverse tax consequences and limitations on our ability to utilize losses generated in IPSA’s foreign operations;
·  
different regulatory requirements and other barriers to conducting business; 
·  
different or less stable political and economic environments;
·  
greater personal security risks for employees traveling to or located in unstable locations; and
·  
civil disturbances or other catastrophic events.
 
Further, conducting business abroad subjects IPSA to increased regulatory compliance and oversight. For example, in connection with its international operations, it is subject to laws prohibiting certain payments to governmental officials, such as the Foreign Corrupt Practices Act and the U.K. Bribery Act. The provisions of the U.K. Bribery Act may apply outside of the U.K. and due to its U.K. based subsidiaries, IPSA and its employees could be subject to liability for alleged activities involving bribery even if such activities were to take place outside of the U.K. A failure to comply with applicable regulations could result in regulatory enforcement actions as well as substantial civil and criminal penalties assessed against us and our employees.
 
IPSA’S FINANCIAL RESULTS COULD SUFFER IF IT IS UNABLE TO ACHIEVE OR MAINTAIN ADEQUATE UTILIZATION AND SUITABLE BILLING RATES FOR ITS CONSULTANTS.
 
IPSA’s profitability depends to a large extent on the utilization and billing rates of its professionals. Utilization of its professionals is affected by a number of factors, including:
·  
the number and size of client engagements;
·  
the timing of the commencement, completion and termination of engagements, which in many cases is unpredictable;
·  
IPSA’s ability to transition its consultants efficiently from completed engagements to new engagements;
·  
the hiring of additional consultants because there is generally a transition period for new consultants that results in a temporary drop in our utilization rate;
·  
unanticipated changes in the scope of client engagements;
·  
IPSA’s ability to forecast demand for its services and thereby maintain an appropriate level of consultants; and
·  
conditions affecting the industries in which IPSA practices as well as general economic conditions.
 
The billing rates of IPSA’s consultants that it is able to charge are also affected by a number of factors, including:
·  
clients’ perception of our ability to add value through IPSA’s services;
·  
the market demand for the services IPSA provides;
·  
an increase in the number of clients in the government sector;
·  
introduction of new services by IPSA or its competitors;
·  
competition and the pricing policies of its competitors; and
·  
current economic conditions.
 
A SIGNIFICANT PORTION OF IPSA’S REVENUES IS DERIVED FROM A LIMITED NUMBER OF CLIENTS, AND ITS ENGAGEMENT AGREEMENTS, INCLUDING THOSE RELATED TO ITS LARGEST CLIENTS, CAN BE TERMINATED BY CLIENTS WITH LITTLE OR NO NOTICE AND WITHOUT PENALTY, WHICH MAY CAUSE ITS  OPERATING RESULTS TO BE UNPREDICTABLE.
 
IPSA has derived, and expect to continue to derive, a significant portion of its revenues from a limited number of clients. Its five largest clients accounted for approximately 94%, 94%, and 93% of its revenues for the years ended December 31, 2014, 2013, and 2012, respectively. IPSA’s clients typically retain it on an engagement-by-engagement basis, rather than under fixed-term contracts; the volume of work performed for any particular client is likely to vary from year to year, and a major client in one fiscal period may not require or may decide not to use our services in any subsequent fiscal period. Moreover, a large portion of new engagements comes from existing clients. Accordingly,
 
 
11

 
the failure to obtain new large engagements or multiple engagements from existing or new clients could have a material adverse effect on the amount of revenues IPSA generates. In addition, almost all engagement agreements can be terminated by its clients with little or no notice and without penalty.
 
IPSA’S ENGAGEMENTS COULD RESULT IN PROFESSIONAL LIABILITY, WHICH COULD BE VERY COSTLY AND HURT OUR REPUTATION.
 
IPSA’s engagements typically involve complex analyses and the exercise of professional judgment. As a result, IPSA is subject to the risk of professional liability. Litigation alleging that IPSA performed negligently or breached any other obligations could expose it to significant legal liabilities and, regardless of outcome, is often very costly, could distract management, could damage its reputation, and could harm its financial condition and operating results.
 
CONFLICTS OF INTEREST COULD PRECLUDE IPSA FROM ACCEPTING ENGAGEMENTS, THEREBY CAUSING DECREASED UTILIZATION AND REVENUES.
 
IPSA provides services that usually involve sensitive client information. IPSA’s engagement agreement with a client or other business reasons may preclude it from accepting engagements from time to time with its clients’ competitors or adversaries. As IPSA grows its operations and the complement of consulting services, the number of conflict situations may continue to increase. Moreover, in industries in which IPSA provides services, there has been a continuing trend toward business consolidations and strategic alliances. These consolidations and alliances reduce the number of companies that may seek IPSA’s services and increase the chances that IPSA will be unable to accept new engagements as a result of conflicts of interest. If IPSA is unable to accept new engagements for any reason, its consultants may become underutilized, which would adversely affect IPSA’s revenues and results of operations in future periods.
 
Risks Related to Our Stock
 
THE MARKET FOR OUR COMMON STOCK IS LIMITED.
 
Our common stock is thinly-traded and any recently reported sales price may not be a true market-based valuation of our common stock. There can be no assurance that an active market for our common stock will develop.  In addition, the stock market in general has experienced extreme price and volume fluctuations that have often been unrelated or
 
disproportionate to operating performance.  Consequently, holders of shares of our common stock may not be able to liquidate their investment in our shares at prices that they may deem appropriate.
 
OUR EXISTING PREFERRED STOCK HAS LIQUIDATION PREFERENCES THAT COULD ADVERSELY AFFECT OUR COMMON STOCK HOLDERS.
 
In the event of our dissolution, liquidation or change of control, the holders of our Series B and Series C preferred stock will receive a liquidation preference in priority to the holders of our common stock.  A consolidation or merger, a sale of all or substantially all of our assets, or a sale of 50% or more of our common stock would be treated as a change of control for this purpose.  Therefore, it is possible that holders of common stock will not obtain any proceeds upon any such event.
 
THE ISSUANCE OF SHARES UPON CONVERSION OF THE PREFERRED STOCK AND EXERCISE OF OUTSTANDING WARRANTS COULD CAUSE IMMEDIATE AND SUBSTANTIAL DILUTION TO EXISTING STOCKHOLDERS.
 
The issuance of shares upon conversion of our outstanding preferred stock and exercise of warrants could result in substantial dilution to the interests of other stockholders since the selling stockholders may ultimately convert and sell the full amount issuable on conversion.
 
OUR COMMON STOCK IS CONSIDERED A “PENNY STOCK."
 
The SEC has adopted regulations that generally define "penny stock" to be an equity security that has a market price of less than $5.00 per share, subject to specific exemptions.  This designation requires any broker or dealer selling these securities to disclose certain information concerning the transaction, obtain a written agreement from the purchaser and determine that the purchaser is reasonably suitable to purchase the securities. These rules may restrict the
 
 
12

 
 
ability of brokers or dealers to sell our common stock and may affect the ability of investors hereunder to sell their shares. Additionally, previously we were considered a “shell company” (as defined in Rule 12b-2 of the Exchange Act).  As a result, the Company will be required to continue to file current information in order for the holders of our securities to rely on Rule 144 in order to sell their restricted securities.    In addition, since our common stock is traded on the OTCQB, investors may find it difficult to obtain accurate quotations of the stock and may experience a lack of buyers to purchase such stock or a lack of market makers to support the stock price.
 
THERE ARE RISKS ASSOCIATED WITH OUR STOCK TRADING ON THE OTCQB RATHER THAN A NATIONAL SECURITIES EXCHANGE.
There are significant consequences associated with our stock trading on the OTCQB rather than a national securities exchange. The effects of not being able to list our securities on a national securities exchange include:
 
· 
Limited release of the market prices of our securities;
· 
Limited news coverage of our Company;
· 
Limited interest by investors in our securities;
· 
Volatility of our stock price due to low trading volume;
· 
Increased difficulty in selling our securities in certain states due to “blue sky” restrictions;
· 
Limited ability to issue additional securities or to secure financing.

WE DO NOT INTEND TO PAY CASH DIVIDENDS ON OUR COMMON STOCK. AS A RESULT, STOCKHOLDERS WILL BENEFIT FROM AN INVESTMENT IN THE COMMON STOCK ONLY IF IT APPRECIATES IN VALUE.
 
We have never paid a cash dividend on our common stock, and do not plan to pay any cash dividends in the foreseeable future. We currently intend to retain any future earnings to finance operations and further expand and grow the business, including growth through acquisitions. As a result, the success of an investment in our common stock will depend upon any future appreciation in its value. We cannot assure you that our common stock will appreciate in value or even maintain the price at which stockholders have purchased their shares. 
 
ITEM 2.                      PROPERTIES.
 
We lease commercial office space for all of our offices. Our headquarters are in New York, NY and our operations office is located in Charlotte, North Carolina. Currently we lease approximately 41,500 square feet of space at all of our 16 locations, under leases that will expire between August 2015 and May 2020.
 
 Most of these facilities serve as sales and support offices or training facilities and vary in size, depending on the number of people employed at that office. The lease terms vary from periods of less than a year to five years and generally have flexible renewal options. We believe that our existing facilities are adequate to meet our current needs.
 
ITEM 3.                      LEGAL PROCEEDINGS.
 
As of December 31, 2014, and as of the date of this filing, the Company is not a party to any pending or threatened legal proceeding that management believes could have a material impact to the Company.
 
ITEM 4.                      MINE SAFETY DISCLOSURES.
 
Not applicable.
 
 
13

 

 
PART II
 
ITEM 5.
MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND REGISTRANT’S ISSUER PURCHASES OF EQUITY SECURITIES
 

 
(a)  Market information.    Our common stock is traded on the OTCQB under the symbol “RTNB” And was traded on such market prior to December 1, 2014 under the symbol “PIMO”. The following table sets forth the range of high and low bid prices for the common stock for each of the periods indicated as reported by the OTCQB.  These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.
 

 
Year Ended December 31, 2014:
High $
 
Low $
 
Quarter Ended
       
      March 31, 2014
  0.68     0.51  
      June 30, 2014
  0.86     0.51  
      September 30, 2014
  1.16     0.83  
      December 31, 2014
  1.59     0.85  
             
Year Ended December 31, 2013:
High $
 
Low $
 
Quarter Ended
           
     March 31, 2013
  0.88     0.60  
     June 30, 2013
  0.74     0.51  
     September 30, 2013
  0.72     0.53  
     December 31, 2013
  0.70     0.45  

We consider our common stock to be thinly traded and, accordingly, reported sales prices or quotations may not be a true market-based valuation of our common stock.

(b)  Holders.   As of March 16, 2015, there were 505 record holders of our common stock. We believe there are more owners of our common stock whose shares are held by nominees or in street name.

(c)  Dividends.   Holders of our common stock are entitled to receive dividends, as and when declared by our Board of Directors, out of funds legally available therefor, subject to the dividend and liquidation rights of preferred stock issued and outstanding. We have never declared or paid any dividends on common stock, nor do we anticipate paying any cash dividends on common stock in the foreseeable future.

 
14

 


 
The following table provides information regarding the status of our existing equity compensation plan at December 31, 2014:
 
 
Equity Compensation Plan
 
 
Plan Category
A
Number of securities to be issued upon exercise of outstanding options, warrants and rights
B
Weighted-average exercise price of outstanding options, warrants and rights
C
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (A))
Equity compensation plans approved by security holders
11,309,864 (1)
$.81
8,690,136
Equity compensation plans not approved by security holders
0
0
0
Total
11,309,864
$.81
8,690,136

 
 
(1)
The Board of Directors approved the 2008 Stock Incentive Plan in May 2008 and the stockholders approved the Plan in 2009. On August 13, 2014, the Company’s stockholders approved an amendment to the Company’s 2008 Stock Incentive Plan increasing the number of shares of Common Stock available for issuance under the Plan to 20,000,000 from 10,000,000.  The Plan reserves 20,000,000 shares of common stock for issuance, and allows the board to issue Incentive Stock Options, non-statutory Stock Options, and Restricted Stock Awards, whichever the Board or the Compensation Committee shall determine, subject to the terms and conditions contained in the Plan document.  The purpose of the Plan is to provide a method whereby selected key employees, selected key consultants, professionals and non-employee directors may have the opportunity to invest in our common stock, thereby giving them a proprietary and vested interest in our growth and performance, generating an increased incentive to contribute to our future success and prosperity, thus enhancing our value for the benefit of shareholders.  Further, the Plan is designed to enhance our ability to attract and retain individuals of exceptional managerial talent upon whom, in large measure, our sustained progress, growth, and profitability depends.
 

 
ITEM 6.                      SELECTED FINANCIAL DATA
 
As a Smaller Reporting Company as defined Rule 12b-2 of the Exchange Act and in Item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting obligations and therefore are not required to provide the information requested by this Item 6.
 
 
 
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ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and related Notes included elsewhere in this Annual Report on Form 10-K. This discussion and analysis also contains forward-looking statements and should be read in conjunction with the disclosures and information contained in "Disclosures Regarding Forward-Looking Statements" and "Risk Factors" in this Annual Report on Form 10-K. References to "we," "our," "us," "the Company," or "root9B Technologies" in this Annual Report on Form 10-K refer to root9B Technologies, Inc.  “SEC” refers to the Securities and Exchange Commission.  All references to years, unless otherwise noted, refer to our fiscal year, which ends on December 31.


Results of Operations

Our results of operations for 2014, 2013, and 2012 are highlighted in the table below and discussed in the following paragraphs:
   
Years Ended December 31
   
   
2014
   
% of Net Revenue
   
2013
   
% of Net Revenue
   
2012
     % of Net Revenue
 
Net Revenue
  $ 20,175,488           $ 26,399,916           $ 19,472,015      
Operating Expenses:
                                       
   Cost of revenues
    14,982,996       74.3 %     20,845,516       79.0 %     14,673,811       75.4 %
   Selling, general & administrative
    11,184,909       55.4 %     9,214,410       34.9 %     8,186,511       42.0 %
   Depreciation and amortization
    386,282       1.9 %     380,951       1.4 %     242,650       1.2 %
   Energy repositioning and subcontract obligation
    1,162,089       5.8 %     -       0.0 %     -       0.0 %
Total operating expenses
    27,716,276       137.4 %     30,440,877       115.3 %     23,102,972       118.6 %
Loss from Operations
    (7,540,788 )     -37.4 %     (4,040,961 )     -15.3 %     (3,630,957 )     -18.6 %
Other Income (Expense):
                                                 
   Derivative (expense) income
    (10,344,753 )     -51.3 %     2,149,951       8.1 %     (894,512 )     -4.6 %
   Adjustment to estimates recorded at acquisition
    -       0.0 %     431,919       1.6 %     -       0.0 %
   Interest expense, net
    (59,066 )     -0.3 %     (44,270 )     -0.2 %     (86,040 )     -0.4 %
   Interest expense – debt discount
    -       0.0 %     -       0.0 %     (353,656 )     -1.8 %
   Goodwill impairment
    (6,363,630 )     -31.5 %     (4,472,089 )     -16.9 %     (4,378,182 )     -22.5 %
   Intangibles impairment
    (429,394 )     -2.1 %     (238,803 )     -0.9 %     -       0.0 %
   Other income (expense)
    301,065       1.5 %     87,799       0.3 %     45,698       0.2 %
Total other (expense) income
    (16,895,778 )     -83.7 %     (2,085,493 )     -7.9 %     (5,666,692 )     -29.1 %
Loss Before Income Taxes
    (24,436,566 )     -121.1 %     (6,126,454 )     -23.2 %     (9,297,649 )     -47.7 %
Income Tax Benefit (Expense)
    -       0.0 %     -       0.0 %     (396,000 )     -2.0 %
Net Income (Loss)
    (24,436,566 )     -121.1 %     (6,126,454 )     -23.2 %     (9,693,649 )     -49.8 %
Preferred Stock Dividends
    (1,597,356 )     -7.9 %     (1,280,408 )     -4.9 %     (321,218 )     -1.6 %
Deemed Dividend On Preferred Stock
    -       0.0 %     (509,184 )     -1.9 %     (1,160,278 )     -6.0 %
Net Loss Available to Common
 Stockholders
  $ (26,033,922 )     -129.0 %   $ (7,916,046 )     -30.0 %   $ (11,175,145 )     -57.4 %

 
 
16

 


 
Comparison of 2014 to 2013

The result of operations described below includes the Business Advisory Solutions (“BAS”) segment and the Energy Solutions (“ES”) segment for the entire years of 2014 and 2013.  We acquired root9B, LLC on November 22, 2013, and the results of operations for the Cyber Solutions (“CS”) segment are for the full year of 2014 and only the period from November 22, 2013 to December 31, 2013 is included in 2013.


Net Revenue

Total revenue for the year ended December 31, 2014 was $20,175,488 as compared to $26,399,916 for the year ended December 31, 2013, a net decrease of $6,224,428, or 23.6%.  Revenue by segment was as follows:

   
Year Ended December 31st
       
   
2014
   
2013
   
% growth
 
                   
Business Advisory Solutions Revenue
  $ 12,964,920     $ 14,482,476       -10.5 %
                         
Energy Solutions Revenue
  $ 3,134,518     $ 11,908,690       -73.7 %
                         
Cyber Solutions Revenue
  $ 4,076,050     $ 8,750    
nm
 
                         
Total Revenue
  $ 20,175,488     $ 26,399,916       -23.6 %


Business Advisory Solutions Segment

Revenue for the BAS segment for the year ended December 31, 2014 decreased 10.5% as compared to the year ended December 31, 2013.  Revenue for the BAS segment was below the Company’s plans for mid-to-high single digit revenue growth and was mainly due to a significant decline in revenue from two large customers as well as the impact of three projects that were completed during 2013 and the related revenue was not fully offset by revenue from new customers in 2014.

Energy Solutions Segment

Revenue for the ES segment for the year ended December 31, 2014 decreased 73.7% as compared to the year ended December 31, 2013.  There are two key reasons for the decline in revenue.  First, the Company had two significant contracts during 2013 that generated approximately $7.6 million of revenue and did not have similar large sized projects during 2014.  Second, the ES segment had a significant amount of revenue in 2013 related to the implementation of auto demand response (ADR) systems in California.  During 2013, the state of California altered the ADR program and incentives to corporations for implementing these type of energy saving systems and as a result the demand for this business has dropped significantly.  During 2014, the Company had no revenue from ADR systems work.  In light of the Company’s repositioning effort and strategy adjustment as well as lower than planned revenue growth in the ES segment, the energy business has changed its deliverables based on current capabilities and opportunities and will have a more narrow focus going forward on controls and automation.  Future revenue opportunities and opportunities to reduce costs are being evaluated under the Company’s new strategy.
 
Cyber Solutions Segment

Revenue for the CS segment for the year ended December 31, 2014, which is generated from cyber security advisory and technical services, was approximately $4,076,000, and was almost entirely incremental as compared to the year ended December 31, 2013, and is attributable to the acquisition of root9B, LLC.  The CS segment was formed upon the acquisition of root9B, LLC in November 2013, and therefore the revenue during 2013 was not significant.  During 2014, the Company invested in building up the CS segment, primarily by hiring new resources with specialized
 
 
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cyber security skills and extending the infrastructure.  The segment continues to ramp up and is planned to be a key revenue growth driver for the Company in 2015 and future years.
 
Gross Margin
 
Gross margin (revenue less cost of revenues, defined as all costs for billable staff for the BAS segment and cost of goods for the ES and CS segments) decreased to approximately $5,192,000 for 2014 from approximately $5,554,000 for 2013, a reduction of $362,000. The decline in gross margin was due to decreases in both the BAS and ES segments, which totaled approximately $1,550,000 and was a result of the lower revenue in both segments in 2014 as compared to 2013.  This reduction was partially offset by an increase in gross margin of $1,188,000 in the CS segment, which business was incremental in 2014 as compared to 2013.
 
Gross margin, as a percentage of revenue, increased to 25.7% in 2014 from 21.0% in 2013.  On a segment basis, the gross margin percentage increased in the BAS segment to 27.0% in 2014 from 25.7% in 2013 and increased in the ES segment to 18.3% in 2014 from 16.0% in 2013.  The increase in the gross margin rate was due to the impact in 2013 of low gross margin on a significant solar contract, and, in 2014 there was not a similar contract.  The gross margin rate in the ES segment was lower than planned in 2014 due to the decrease in revenue and that resulting lower revenue not covering the production related fixed overhead costs in the segment.  The gross margin rate in the CS segment was 27.6% for 2014 and was lower than planned due to the ramp up of headcount as the CS segment builds its infrastructure in anticipation of future growth.  As a result of this ramp up, all of the production resources being assembled were not deployed to projects and therefore reduced the gross margin rate.

 
Selling, General and Administrative Expenses
 
Selling, general and administrative (“SG&A”) expenses increased to $11,185,000 in 2014 from $9,214,000 in 2013, an increase of 21.4%.  As a percentage of revenue, SG&A expenses increased to 55.4% in 2014 as compared to 34.9% in 2013.  The increase in SG&A expenses as a percentage of revenue was due primarily to the reduced revenue in the ES segment, additional expenses related to the CS segment, as well as increased corporate overhead expenses.  SG&A expenses increased approximately $1,971,000 during 2014 as compared to 2013 and break out as follows: the BAS segment increased $250,000, the ES segment decreased $991,000, the CS segment increased $776,000 (primarily incremental for 2014 as compared to 2013) and Corporate Overhead increased $1,936,000.  The Company accounts and manages expenses as those directly related to a business segment and corporate overhead expenses which includes executive compensation, back office functions, such as finance and human resources, and other administrative costs.  Expenses related to these groups are discussed below.

BAS Segment

SG&A expenses in the BAS segment increased to approximately $2,085,000 in 2014 as compared to approximately $1,835,000 in 2013, an increase of $250,000 or 13.6%.  The increase is mainly attributable to increased labor costs of $247,000.  This increase in labor expenses for the BAS segment is due to a change in the classification of certain individuals from overhead to direct expenses for the BAS segment.  During the first quarter of 2014, the Company determined that the labor costs related to some BAS leadership positions, which had previously been charged to Corporate Overhead, would now be charged directly to the BAS segment.  As a result of this change, labor costs increased for the BAS segment in 2014 as compared to 2013 and were reduced for Corporate Overhead.  BAS expenses as a percentage of segment revenue increased to 16.2% in 2014 from 12.7% in 2013.

ES Segment

SG&A expenses in the ES segment decreased to approximately $1,894,000 in 2014 as compared to approximately $2,885,000 in 2013, a decrease of $991,000 or 34.3%.  The decrease is primarily attributable to reduced labor costs of $806,000.  The decrease in labor costs is due to planned reductions in the labor force due to declining revenues as well as reduced commission expense, also due to lower revenues as compared to the prior year.

 
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CS Segment

SG&A expenses in the CS segment were approximately $1,131,000 in 2014 as compared to $355,000 in 2013.  The CS segment began operations in November 2013 when the Company acquired root9B, LLC, and therefore a majority of the expenses in 2014 are incremental as compared to 2013.  SG&A expenses during 2014 were slightly higher than planned as the Company invested in additional headcount, with specialized cyber security skill sets, as the Company prepares for anticipated growth in this segment.

Corporate Overhead
 
Corporate Overhead SG&A expenses increased to $6,075,000 in 2014 from $4,139,000 in 2013 (exclusive of CS segment startup expenses), an increase of $1,936,000 or 46.8%.  The main drivers of the increase were an increase in labor costs of $1,278,000 and an increase in stock option expense for employees and directors in the amount of $579,000.  The increase in labor costs was primarily due to the addition of two senior executive positions.  During January of 2014, the Company hired a senior team member who was leading the Energy Solutions group and is no longer with the Company.  Additionally, in May of 2014 a new CEO was named.  The compensation and bonus related to these two positions is incremental to 2014 as compared to 2013.  The increase in stock option expense was due to the issuance of 6,585,000 stock options to new hires, key employees and directors during 2014 as compared to 525,000 stock option issuances during 2013.  The buildup in corporate overhead has been undertaken in planning for substantial revenue growth, of which there can be no assurance.

Energy repositioning and subcontract obligation
 
During 2014, the Company incurred one-time charges of approximately $1,162,000 related to two items: 1) the repositioning of the Company to accentuate an increased focus and commitment to cybersecurity and regulatory risk mitigation and 2) recording a liability where the Company is a co-indemnitor with Prime Solutions, Inc. which is a subcontractor to Honeywell on a solar project, which items are explained below.
 
On October 17, 2014, the Company announced it would reposition the business to focus on cyber security and regulatory risk mitigation, rename the Company “root9B Technologies, Inc.”, and de-emphasize the ES segment by adjusting its focus to operate in support of the Cyber and Business Advisory segments.  As a part of this repositioning the Company has reduced headcount in the ES segment and incurred one-time expenses of $412,000 related to the headcount adjustments.
 
The Company is a co-indemnitor in support of surety bonds issued by Platte River Insurance on behalf of Prime Solutions for the benefit of Honeywell pursuant to Prime Solutions, Inc.’s (“Prime”) solar project located in Worcester Massachusetts (the “Prime Contract”).  The Company’s maximum liability exposure under the bond is limited to $1,412,544, if Prime were to fail to meet its contracted obligations.  On October 15, 2014, the Company determined it was probable that Prime would not be able to meet its contracted obligations under the Prime Contract and therefore the Company may have an obligation to Platte River to meet outstanding Prime Contract obligations.  The Company has recorded a one-time accrual of $650,000, which is the Company’s estimate of the most likely amount of its obligation under the co-indemnity agreement.
 
Other Income (Expense)

Other Income (Expense) for 2014 resulted in an expense of $16,896,000 as compared to an expense of $2,085,000 in 2013.  The components of the net expense are discussed below.

Derivative (expense) income

From May 2010 through the first quarter of 2013, the Company issued Series B Preferred Stock, Debentures, Series C Preferred Stock, 7% Convertible Redeemable Promissory Notes, and Series D Preferred Stock, all with detachable common stock purchase warrants deemed to be derivative instruments. These warrants are recorded as a derivative liability and “marked-to-market” based on fair value estimates at each reporting date.  Collectively, these derivatives were valued at an estimated fair value of $10,651,000 at December 31, 2014, with the change (increase) in value since December 31, 2013 of $10,344,000, being recognized as derivative (non-cash) expense on the statement of operations for 2014.  For the year ended December 31, 2013, the change in derivative valuation for the like period was non-cash income of $2,150,000.

 
19

 
Adjustment to estimates recorded at acquisition

An “adjustment to estimates recorded at acquisition” of $432,000 (a non-cash income item) related to the GHH acquisition was recorded in 2013.  The income was to record the retirement of certain escrow shares issued as part of the consideration given in the initial purchase price allocation and to remove certain liabilities assumed at the time of acquisition.  There was no similar income in 2014.

Goodwill impairment

An annual goodwill impairment evaluation for 2014 was performed by applying both the Step 1 and Step 2 tests as prescribed by FASB ASC 350. The results of the Step 1 test for the BAS segment indicated no impairment to goodwill related to this segment and Step 2 was not required.  The results for the Step 1 test for the ES segment did indicate impairment of goodwill and Step 2 was completed to determine the amount of impairment.  The Company engaged an outside firm that specializes in valuation assessments to perform the Step 1 and Step 2 tests and valuation work.  Of the $10,716,000 in goodwill that was recorded as of December 31, 2013, $6,364,000 was attributable to the ES segment.  After completion of the valuation work of the segment it was determined that the fair value of the goodwill for the ES segment was $0, resulting in a non-cash impairment charge of $6,364,000.  The impairment was due primarily to the slower than planned growth in revenue, earnings and cash flow as well as the repositioning of the Company to focus on cyber security and regulatory risk mitigation while deemphasizing the energy business.  A similar process was performed for 2013 and resulted in a goodwill impairment charge for the ES segment of $4,472,000.  This impairment was related to the timing and amounts of expected revenue, earnings and cash flow results.  See further discussion on goodwill and goodwill impairment in Note 7 to the Financial Statements.

Intangibles Impairment

As a part of the acquisitions of GHH and Ecological, both in 2012, the Company recorded intangible assets for the acquired customer lists and trade names of both companies.  The value at acquisition of these assets was $1,118,000 and they were being amortized over 5 to 7 years.  The balance at December 31, 2014 prior to impairment was $429,000.  The estimates of future revenue, income and cash flow have been reduced from prior estimates and the Company has shifted its strategy to focus on cyber security and regulatory risk mitigation while deemphasizing the energy segment.  Based on the revised strategy and estimates, we have measured the fair value of the intangible assets as of December 31, 2014 and determined the fair value for each of these intangible assets to be $0, resulting in a non-cash impairment charge of $429,000.  A similar process was performed for 2013 and resulted in an intangible asset impairment charge for the ES segment of $238,000.

Other income

Other income increased to approximately $301,000 in 2014 as compared to approximately $88,000 in 2013.  During the first quarter of 2014 the Company entered into an agreement with the landlord for the New York office under which we vacated the office space at the end of 2014, which is earlier than the lease term, and in exchange we incurred no rent expense during 2014.  As a result of this agreement, the Company recorded a gain related to the early termination of the contract of $239,248 which is included in other income in 2014.

Income Tax Benefit (Expense)

There was no income tax expense for 2014 or 2013.  The effective tax rate was 0% in 2014 and 2013.  We have deferred tax assets and liabilities attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis.  We have determined, at both December 31, 2014 and 2013, that it is not more likely than not that our deferred tax assets would be recoverable and, accordingly have set up a full valuation allowance for the deferred tax assets at December 31, 2014 and 2013.
 

 
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Preferred Stock Dividends

The Company has three series of Convertible Preferred Stock which pay dividends at annual specified rates.  The three series are: 7% Series B Convertible Preferred Stock, Series C Convertible Preferred Stock, which has a 7% dividend rate, and the Series D Convertible Preferred Stock, which has a 8% dividend rate.  See further discussion on the Convertible Preferred Stock in Note 11 to the Financial Statements. Dividends paid during 2014, which were paid in common stock, were valued at issuance as follows: to Series B, 98,003 shares valued at $56,372, to Series C, 603,448 shares valued at $350,000 and to Series D, 1,592,748 shares valued at $1,190,984.
 
Deemed Dividend on Preferred Stock
 
The deemed dividend on preferred stock is an amount calculated, at the time of issuance of the convertible preferred stock, by comparing the effective conversion price of the preferred stock to the market price of the Company stock.  The difference in these two amounts yields a deemed dividend on the Convertible Preferred Stock, a non-cash charge.  During 2013, the Company recorded a deemed dividend upon the issuance of Series D Preferred Convertible Stock during the first quarter in the amount of $509,000.  During 2014, there was no deemed dividend recorded.


Comparison of 2013 to 2012

The result of operations described below includes the Business Advisory Solutions (“BAS”) segment for the entire years of 2013 and 2012.  The Energy Solutions (“ES”) segment began with the acquisition of Greenhouse Holdings, Inc. (“GHH”) on March 5, 2012; hence, operating results related to this acquisition are included for the full 2013 period and are only included from March 5, 2012 through December 31, 2012 for the 2012 period.  We acquired Ecological, LLC, also part of our ES segment, on December 31, 2012; and accordingly, their results of operations are only included for 2013.

Net Revenue

Total revenue for the year ended December 31, 2013 was $26,399,916 as compared to $19,472,015 for the year ended December 31, 2012, a net increase of $6,927,901, or 35.6%.  Revenue by segment was as follows:


   
Year Ended December 31st
       
   
2013
   
2012
   
% growth
 
                   
Business Advisory Solutions Revenue
  $ 14,482,476     $ 16,524,648       -12.4 %
                         
Energy Solutions Revenue
  $ 11,908,690     $ 2,947,367       304.0 %
                         
Cyber Solutions Revenue
  $ 8,750       -    
nm
 
                         
Total Revenue
  $ 26,399,916     $ 19,472,015       35.6 %


Business Advisory Solutions Segment

Revenue for the BAS segment for the year ended December 31, 2013 decreased 12.3% as compared to the year ended December 31, 2012.  The primary reasons for the decrease in revenue was the closing of the Kansas City office in September 2012 due to poor ongoing prospects as well as the unanticipated loss of revenue related to two projects that were cancelled with financial institutions, which revenue was partially offset by new engagements.  In closing the Kansas City office we had a negative variance of approximately $1.3 million in revenue from 2012 to 2013.  One cancelled project was a compliance project that was cancelled due to a change in the customer’s business environment which eliminated the need for the compliance work and the other project was significantly reduced in scope due to the customer’s need to eliminate costs in its business.  After accounting for the closed office in Kansas City, the revenue decline was approximately 4% from the segment.

 
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Energy Solutions Segment

Revenue for the ES segment for the year ended December 31, 2013 increased 304.0% as compared to the year ended December 31, 2012.  There are two key reasons for the significant increase.  First, the ES segment was in full operation during 2013 and was only operating for part of the year in 2012.  The portion of the business related to the GHH acquisition began operations on March 5, 2012 and only operated from then until December 31st during 2012.  The Ecological portion of the business began operations on January 1, 2013 and therefore had no operations in 2012.  Also, the ES segment had a significant contract and related project during 2013.  The Company engaged in a Subcontract Agreement and Contract (the “Subcontract Agreement”) with Prime Solutions, Inc. (“Prime”), whereby the Company provided senior project management consulting, oversight and advisory services as well as responsibility for materials management, procurement, and delivery for a large solar project. The revenue from the Subcontract Agreement in 2013 was approximately $6.1 million.  As we grow our business in the ES segment, we will continue to target comparable sized projects to be a part of our portfolio of efforts, although we can make no assurance that this will be successful.
 
Excluding the Subcontract Agreement, revenues related to the GHH portion of the ES segment would have been $4,542,000 for 2013 compared to revenue of $2,947,000 during 2012 (of which GHH was only operating for 10 months of the year), or an increase of $1,595,000.
 
Revenue related to the Ecological portion of the business, which is generated from benchmarking services, audit and retro-commissioning services and LEED certification services, was $1,271,000 for 2013 and was therefore incremental as compared to 2012.

 
Gross Margin
 
Gross margin (revenue less cost of revenues, defined as all costs for billable staff for the BAS segment and cost of goods for the ES segment) increased to $5,554,400 for 2013 from $4,798,204 for 2012, increasing $756,196. The main reason for the increase in gross margin was due to the ES segment operating for the full year in 2013 and only part of the year in 2012 (the GHH business operated for 10 months in 2012 and Ecological did not operate at all in 2012).  This was partially offset by a reduction in gross margin in the BAS segment due to lower revenue in 2013 as compared to 2012.
 
Gross margin, as a percentage of revenue, declined to 21.0% in 2013 from 24.6% in 2012.  On a segment basis, the gross margin percentage increased in the BAS segment to 25.2% in 2013 from 24.9% in 2012 and decreased in the ES segment to 16.0% in 2013 from 23.3% in 2012.  The significant decline in the ES gross margin % is due to the low margin associated with the Prime Subcontract Agreement described in the net revenue section above.  The gross margin associated with the subcontract agreement was 5%.  The gross margin % for the ES segment if the Prime subcontract was excluded would have been 27.5%, which compares favorably to the 2012 gross margin.

 
Selling, General and Administrative Expenses
 
Selling, general and administrative (“SG&A”) expenses increased to $9,214,000 in 2013 from $8,186,000 in 2012, an increase of 12.6%.  As a percentage of revenue, SG&A expenses decreased to 34.9% in 2013 as compared to 42.0% in 2012.  The leverage improvement in SG&A expenses as a percentage of revenue was due primarily to the tight control of expenses in the BAS segment and the high rate of growth in revenue in the ES segment.  SG&A expenses increased $1,028,000 in 2013 as compared to 2012 and break out as follows: BAS segment decreased $39,000, the ES segment increased $790,000 and Corporate Overhead increased $278,000. The Company accounts and manages expenses as those directly related to a business segment and corporate overhead expenses which includes executive compensation, back office functions, such as finance and human resources, and other administrative costs.  Expenses related to these groups are discussed below.

 
22

 

 
BAS Segment

SG&A expenses in the BAS segment decreased to $1,835,000 in 2013 as compared to $1,874,000, a decrease of $39,000 or 2.1%.  Expenses in this segment were tightly managed in an environment of reduced revenue.  BAS expenses as a percentage of segment revenue increased to 12.7% in 2013 from 11.3% in 2012.  The primary reason for the deleverage of segment expenses was the decrease in revenues.

ES Segment

SG&A expenses in the ES segment increased to $2,885,000 in 2013 as compared to $2,096,000, an increase of $790,000 or 2.1%.  The ES segment is made up of the operations from the GHH acquisition (completed in March 2012) and operations from the Ecological acquisition (completed in December 2012).  Ecological had no operations in 2012 and was operating for the full year in 2013 and, as such, the associated SG&A expenses of $929,000 in 2013 was completely incremental as compared to 2012.  SG&A expenses for the ES segment, absent the impact from Ecological, were $1,957,000 in 2013 as compared to $2,096,000, a decrease of $139,000.  The decrease is attributable to reduced professional fees of $531,000, which were offset by increases to labor costs of approximately $146,000, travel expenses in the amount of $26,000 and an increase in bad debt expense of $198,000.  The decrease in professional fees is due to a significant amount of expense in 2012 related to the acquisition and integration of GHH that was not repeated in 2013.  The increases in labor and travel were planned and a part of the growth strategy for GHH.  The increase in bad debt expense is due to a reserve set up against amounts due from a customer related to a single contract, the Subcontract Agreement mentioned in the net revenue discussion above.  The work related to the Subcontract Agreement was completed in 2013 and resulted in a receivable of $945,378 as of December 31, 2013 which was past due.  We have been in contact with the customer, who has liquidity issues, and have arrived at an agreement regarding payment of the open account over time.  At December 31, 2013 we expected that we would ultimately be paid in full, due to the risk posed by our customer’s weak financial position, we reserved $198,000 against the receivable as bad debt expense.

Corporate Overhead
 
Corporate Overhead SG&A expenses increased to $4,494,000 in 2013 from $4,216,000 in 2012, an increase of $278,000 or 6.6%.  Corporate Overhead SG&A expenses were well controlled in 2013 as the integration of the GHH and Ecological acquisitions was completed, and resulted in modest expense growth.  The Corporate Overhead expenses include expenses incurred by root9B from the time of acquisition, November 22, 2013 through the end of the year in the amount of $355,000.  The main component of the short period root9B expenses was $300,000 of bonus expense related to sign on bonuses, after the acquisition date, for key root9B employees.  Absent the impact of root9B, Corporate Overhead expenses would have been $4,139,000 in 2013 compared to $4,216,000 in 2012, a decrease of $77,000 or 1.8%.  The main driver of the decrease was a reduction in stock option expense for employees and directors in the amount of $568,000 and a reduction in professional fees related to marketing and branding of $197,000.  These decreases were offset by increases in Directors fees of $157,000, fees authorized by the board for outside services of $150,000, legal and accounting fees of $191,000, and bad debt expense of $87,000.  Stock option expense declined as significantly fewer stock options were issued in 2013 as compared to 2012.  Professional fees related to marketing and branding declined as we completed a significant branding effort in 2012.  Director’s fees and expenses grew as the full non-management 10 member Board was in place for the full year of 2013 and only partially in 2012.  The increase in legal and accounting fees was primarily due to the additional efforts required in connection with the restatement of 2012 financial results and the root9B acquisition.   Bad debt expense increased as a result of the write off of open receivables from three customers.  Included in the SG&A expenses are non-recurring charges related to the restatements and acquisitions of approximately $350,000.  We have invested in the infrastructure of the company for the future, as evident in the SG&A expenses, and expect that SG&A expense growth will be slower compared to revenue growth as we move forward.

Other Income (Expense)

Other Income (Expense) for 2013 resulted in an expense of $2,085,000 as compared to an expense of $5,667,000 in 2012.  The components of the net expense are discussed below.

 
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Derivative (expense) income

From May 2010 through the first quarter of 2013, the Company issued Series B Preferred Stock, Debentures, Series C Preferred Stock, 7% Convertible Redeemable Promissory Notes, and Series D Preferred Stock, all with detachable common stock purchase warrants deemed to be derivative instruments. These warrants are recorded as a derivative liability and “marked-to-market” based on fair value estimates at each reporting date.  Collectively, these derivatives were valued at an estimated fair value of $727,000 at December 31, 2013, with the change (decline) in value since December 31, 2012 of $2,150,000, being recognized as derivative (non-cash) income on the statement of operations for 2013.  For the year ended December 31, 2012, the change in derivative valuation for the like period was a non-cash expense of $895,000.

Adjustment to estimates recorded at acquisition

An “adjustment to estimates recorded at acquisition” of $432,000 (a non-cash income item) related to the GHH acquisition was recorded in 2013.  The income, which was not present in the same period in the prior year, was to record the retirement of certain escrow shares issued as part of the consideration given in the initial purchase price allocation and to remove certain liabilities assumed at the time of acquisition.

Goodwill impairment

An annual goodwill impairment evaluation for 2013 was performed by applying both the Step 1 and Step 2 tests as prescribed by FASB ASC 350. The results of the Step 1 test for the BAS segment indicated no impairment to goodwill related to this segment and Step 2 was not required.  The results for the Step 1 test for the ES segment did indicate impairment of goodwill and Step 2 was completed to determine the amount of impairment.  The Company engages an outside firm that specializes in valuation assessments to perform the Step 1 and Step 2 tests and valuation work.  Of the $13,153,000 in goodwill that was recorded as of December 31, 2012, $10,836,000 was attributable to the ES segment.  After completion of the valuation work of the segment it was determined that the fair value of the goodwill for the ES segment was $6,364,000, resulting in a non-cash impairment charge of $4,472,000.  The impairment is due primarily to the slower than planned growth in revenue, earnings and cash flow.  The Company had built a strategy for the ES segment and worked to integrate the acquisitions of GHH and Ecological and believed it was well positioned to deliver strong growth and returns from the segment.  However, the growth to date had been slower than planned, partially due to integration and development of the segment and partially due to some delays in the effectiveness of certain regulatory requirements which had delayed anticipated revenue (specifically, related to Local Law 87 in New York which required energy related retrofit work on buildings based on energy audits has been pushed out from the dates we had originally planned).  These factors were considered in the valuation work and resulted in the impairment amount.  A similar process was performed for 2012 and resulted in a goodwill impairment charge for the ES segment of $4,378,000.  This impairment was related to the GHH acquisition and timing and amounts of expected revenue, earnings and cash flow results.  See further discussion on goodwill and goodwill impairment in Note 7 to the Financial Statements.

Intangibles Impairment

As a part of the acquisition of Ecological in December 2012, the Company recorded an intangible asset for the acquired customer list from Ecological.  The value at acquisition was determined based on estimates that included customer retention rates and future revenue from these customers.  The value at acquisition $527,000 and is being amortized over 5 years.  The balance at December 31, 2013 prior to impairment was $421,000.  Customer retention rates had been as planned and remained very high.  However, the estimates of revenue from these customers had come in lower than planned as of December 31, 2013.  We have measured the fair value of the intangible asset, with lower revenue assumptions, and as of December 31, 2013 determined the fair value to be $182,000, resulting in a non-cash impairment charge of $239,000.  We engaged an outside firm that specializes in valuation work to perform the valuation assessment.


Income Tax Benefit (Expense)

There was no income tax expense for 2013, compared to $396,000 of income tax expense for 2012.  The effective tax rate was 0% in 2013 and 4.3% in 2012.  We have deferred tax assets and liabilities attributable to
 
 
24

 
differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis.  We have determined, at both December 31, 2013 and 2012, that it is not more likely than not that our deferred tax assets would be recoverable and, accordingly have set up a full valuation allowance for the deferred tax assets at December 31, 2013 and 2012.

 
Preferred Stock Dividends

The Company has three series of Convertible Preferred Stock which pay dividends at annual specified rates.  The three series are: 7% Series B Convertible Preferred Stock, Series C Convertible Preferred Stock, which has a 7% dividend rate, and the Series D Convertible Preferred Stock, which has a 8% dividend rate.  See further discussion on the Convertible Preferred Stock in Note 11 to the Financial Statements. Dividends paid during 2013, which were paid in common stock, were valued at issuance as follows: to Series B, 71,050 shares valued at $56,840, to Series C, 437,500 shares valued at $350,000 and to Series D, 1,341,902 shares valued at $873,568.
 
Deemed Dividend on Preferred Stock
 
The deemed dividend on preferred stock is an amount calculated, at the time of issuance of the convertible preferred stock, by comparing the effective conversion price of the preferred stock to the market price of the Company stock.  The difference in these two amounts yields a deemed dividend on the Convertible Preferred Stock, a non-cash charge.  During 2013 the Company recorded a deemed dividend upon the issuance of Series D Preferred Convertible Stock during the first quarter in the amount of $509,000.  During 2012, the Company recorded deemed dividends upon the issuance of Series D Preferred Convertible Stock during the fourth quarter in the amount of $1,160,000.
 

Critical Accounting Policies
 
Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with the U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make significant estimates and judgments that affect the reported amount of assets, liabilities, revenues, and expenses and related disclosures of contingent assets and liabilities. We evaluate our estimates, including those related to bad debts, intangible assets and contingencies on an ongoing basis. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
 
While our significant accounting policies are more fully described in our consolidated financial statements appearing at the end of the Annual Report on Form 10-K, we believe that the following critical accounting policies involve the more significant judgments and estimates used in the preparation of our consolidated financial statements and are the most critical to aid you in fully understanding and evaluating our reported financial results.
 
Revenue Recognition

We follow the guidance of the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104 for revenue recognition.  In general, we record revenue when persuasive evidence of any agreement exists, services have been rendered, and collectability is reasonably assured, therefore, revenue is recognized when we invoice customers for completed services at contracted rates and terms.  Therefore, revenue recognition may differ from the timing of cash receipts.
 
Goodwill and Intangible Assets
 
Our intangible assets include goodwill, trademarks, non-compete agreements, patents and purchased customer relationships, all of which are accounted for based on Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 350 Intangibles-Goodwill and Other. As described below, goodwill and intangible assets that have indefinite useful lives are not amortized but are tested at least annually for impairment or more
 
 
25

 
frequently if events or changes in circumstances indicate that the asset might be impaired. Intangible assets with limited useful lives are amortized using the straight-line method over their estimated period of benefit, ranging from two to eight years.  Goodwill is tested for impairment by comparing the carrying value to the estimated fair value, in accordance with GAAP.
 
Impairment Testing
 
Our goodwill impairment testing is calculated at the reporting or segment unit level. Our annual impairment test has two steps. The first identifies potential impairments by comparing the fair value of the reporting or segment unit with its carrying value.  If the fair value exceeds the carrying amount, goodwill is not impaired and the second step is not necessary. If the carrying value exceeds the fair value, the second step calculates the possible impairment loss by comparing the implied fair value of goodwill with the carrying amount. If the implied fair value of goodwill is less than the carrying amount, a write-down is recorded.
 
The impairment test for the other intangible assets is performed by comparing the carrying amount of the intangible assets to the sum of the undiscounted expected future cash flows. In accordance with GAAP, which relates to impairment of long-lived assets other than goodwill, impairment exists if the sum of the future undiscounted cash flows is less than the carrying amount of the intangible asset or to its related group of assets.
 
We predominately use discounted cash flow models derived from internal budgets in assessing fair values for our impairment testing.  Factors that could change the result of our impairment test include, but are not limited to, different assumptions used to forecast future net sales, expenses, capital expenditures, and working capital requirements used in our cash flow models. In addition, selection of a risk-adjusted discount rate on the estimated undiscounted cash flows is susceptible to future changes in market conditions, and when unfavorable, can adversely affect our original estimates of fair values. In the event that our management determines that the value of intangible assets have become impaired using this approach, we will record an accounting charge for the amount of the impairment.  We have engaged an independent valuation expert to assist us in performing the valuation and analysis of fair values of goodwill and intangibles.
 
Derivative Warrant Liability
 
The Company evaluates warrants issued in connection with debt and preferred stock issuances to determine if those contracts or any potential embedded components of those contracts qualify as derivatives to be separately accounted for.  This accounting treatment requires that the carrying amount of any embedded derivatives be marked-to-market at each balance sheet date and carried at fair value.  In the event that the fair value is recorded as a liability, the change in the fair value during the period is recorded in the Statement of Operations as either income or expense. Upon conversion or exercise, the derivative liability is marked to fair value at the conversion date and then the related fair value is reclassified to equity.  The fair value at each balance sheet date and the change in value for each class of warrant derivative is disclosed in detail in Note 11 to the Financial Statements.
 
Share-Based Compensation
 
We account for stock-based compensation based on ASC Topic 718 – Stock Compensation which requires expensing of stock options and other share-based payments (ie, stock warrant issuances) based on the fair value of each stock option/warrant awarded. The fair value of each stock option/warrant is estimated on the date of grant using the Black-Scholes valuation model. This model requires management to estimate the expected volatility, expected dividends, and expected term as inputs to the valuation model.
 
Fair Value of Financial Assets and Liabilities – Derivative Instruments
 
We measure the fair value of financial assets and liabilities in accordance with GAAP, which defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements.
 
GAAP defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. GAAP also establishes a fair value hierarchy, which requires an entity
 
 
26

 
to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. GAAP describes three levels of inputs that may be used to measure fair value:
 
Level 1 – quoted prices in active markets for identical assets or liabilities.
 
Level 2 – quoted prices for similar assets and liabilities in active markets or inputs that are observable.
 
Level 3 – inputs that are unobservable (for example the probability of a capital raise in a “binomial” methodology for valuation of a derivative liability directly related to the issuance of common stock warrants).
 
We do not use derivative financial instruments to hedge exposures to cash-flow, market or foreign-currency risks. However, we have entered into certain financial instruments and contracts, such as debt financing arrangements, the issuance of preferred stock with detachable common stock warrants features that are either i) not afforded equity classification, ii) embody risks not clearly and closely related to host contracts, or iii) may be net-cash settled by the counterparty. These instruments are required to be carried as derivative liabilities, at fair value.
 
Our only derivative instruments are detachable (or “free-standing”) common stock purchase warrants issued in conjunction with debt or preferred stock. We estimate fair values of these derivatives (and related embedded beneficial conversion features) utilizing Level 2 inputs for all classes of warrants issued, other than one class, Series C Preferred Stock. Other than the Series C Preferred Stock warrants, we use the Black-Scholes option valuation technique as it embodies all of the requisite assumptions (including trading volatility, remaining term to maturity, market price, strike price, and risk free rates) necessary to fair value these instruments, for they do not contain material “down round protection” (otherwise referred to as “anti-dilution” and “full ratchet” provisions). For the warrants directly related to the Series C Preferred Stock, the warrant contracts contain “Down Round Protections” and the “Black-Scholes” option valuation technique does not, in its valuation calculation, give effect for the additional value inherently attributable to the warrant having the “Down Round Protection” mechanisms in its contractual arrangement.
 
However, additional valuation models and techniques have been developed and are widely accepted that take into account the additional value inherent in “Down Round Protection.” These techniques include “Modified Binomial”, “Monte Carlo Simulation” and the “Lattice Model.” The “core” assumptions and inputs to the “Binomial” model are the same as for “Black-Scholes”, such as trading volatility, remaining term to maturity, market price, strike price, and risk free rates; all Level 2 inputs.  Fair value measurements are classified according to the lowest level input or value-driver that is significant to the valuation. A measurement may therefore be classified within Level 3 even though there may be significant inputs that are readily observable. However, a key input to a “Binomial” model (in our case, the “Monte Carlo Simulation”, for which we engage an independent valuation firm to perform) is the probability of a future capital raise.  By definition, this input assumption does not meet the requirements for Level 1 or Level 2 outlined above; therefore, the entire fair value calculation is deemed to be Level 3 under accounting requirements due to this single Level 3 assumption. This input to the Monte Carlo Simulation model, was developed with significant input from management based on its knowledge of the business, current financial position and the strategic business plan with its best efforts.
 
As discussed above, financial liabilities are considered Level 3 when their fair values are determined using pricing models or similar techniques and at least one significant model assumption or input is unobservable.  For the Company, the only Level 3 financial liability is the derivative liability related to the common stock purchase warrants directly related to the Series C Preferred Stock for the warrant contract includes “Down Round Protection” and they were valued using the “Monte Carlo Simulation” technique.
 
Income Taxes
 
The Company accounts for income taxes under FASB ASC Topic 740 Income Taxes.  Under FASB ASC Topic 740, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be removed or settled. The Company regularly assesses the likelihood that its deferred tax assets will be realized from recoverable income taxes or recovered from future taxable income.  To the extent that the Company believes any amounts are not more likely than not to be realized through the reversal of the deferred tax liabilities and future income, the Company records a valuation allowance to
 
 
27

 
reduce its deferred tax assets.  In the event the Company determines that all or part of the net deferred tax assets are not realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. Similarly, if the Company subsequently realizes deferred tax assets that were previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in an adjustment to earnings in the period such determination is made.
 
Recent Accounting Pronouncements
 
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606).  This guidance requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  This guidance is effective for annual reporting periods beginning after December 15, 2016 and early adoption is not permitted.  The Company has not yet determined the effect, if any, that the adoption of this standard will have on the Company’s financial position or results of operations.

In August 2014, the FASB issued Accounting Standards Update No. 2014-15, Going Concern (“ASU 2014-15”). ASU 2014-15 provides GAAP guidance on management’s responsibility in evaluating whether there is substantial doubt about a company’s ability to continue as a going concern and about related footnote disclosures. For each reporting period, management will be required to evaluate whether there are conditions or events that raise substantial doubt about a company’s ability to continue as a going concern within one year from the date the financial statements are issued. The standard will be effective for annual periods ending after December 15, 2016, and interim periods within annual periods beginning after December 15, 2016. Early application is permitted for annual or interim reporting periods for which the financial statements have not previously been issued. Upon adoption the Company will use the guidance in ASU 2014-15 to assess going concern.
 
Since January 1, 2013, there have been several new accounting pronouncements and updates to the Accounting Standards Codification.  Each of these updates has been reviewed by Management who does not believe their adoption has had or will have a material impact on the Company’s financial position or operating results.
 
Executive Compensation Agreements
 
We have executive compensation agreements with 2 original executives. We own two separate life insurance policies (Flexible Premium Multifunded Life), each with a face amount of $3,000,000. We pay all scheduled monthly premiums and retain all interests in each policy. If an insured employee were to die, we would pay the employee’s designated beneficiary an annual survivor’s benefit of $300,000 per year for 10 consecutive years after the employee’s death.
 
Employee Benefit Plan
 
We have a 401(k) plan that covers substantially all employees. Plan participants can make voluntary contributions of up to 15% of compensation, subject to certain limitations, and we match a portion of employee contributions. Total contributions to the plan for the years ended December 31, 2014 and 2013 were approximately $51,292 and $62,007 respectively, not including forfeitures that are applied to the contributions by the Company.
 
Financial Condition and Liquidity
 
As of December 31, 2014, we had cash and cash equivalents of $765,000, compared to $7,004,000 at December 31, 2013, a decrease of $6,239,000.  The decrease is primarily attributable to the net use of cash in operations for the year ended December 31, 2014 of $5,534,000 and reduction of the outstanding balance on the line of credit in the amount of $2,721,000, which were offset by the proceeds of $1,800,000 from the issuance of the 10% convertible notes.  The Company decided not to renew the line of credit when it came due in July 2014 and paid off the outstanding balance on July 3, 2014.  After financings in the first quarter of 2015 (see below), our cash position has increased and outstanding cash and cash equivalents at March 16, 2015 was approximately $6.2 million.
 
Overall, our revenues were down during 2014, compared to revenues for the same period a year ago, by $6,224,000, or 23.5%.  The primary cause of this reduction in our revenues was a significant reduction in activity experienced in our Energy Services segment, and a reduction in revenues of our Business Advisory Solutions group also contributed
 
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to a decrease in overall revenues. We have evaluated all of our lines of business both from a historical performance perspective as well as looking at opportunities for future growth.  As a result of this evaluation we have launched the repositioning of the Company and adjustment of the Company’s strategy.  The repositioning effort included a change of the business to focus on cyber security and regulatory risk mitigation, renaming the Company “root9B Technologies, Inc.”, and de-emphasizing the Energy Solutions segment by adjusting its focus to operate in support of the Cyber Solutions and Business Advisory Solutions segments.  In addition, our SG&A expenses have substantially increased although our revenues have been declining, as we invest in infrastructure and support for future growth.
 
The consequence of the downturn in our revenues and increase in our expenses is significant liquidity pressures.
 
The goal of the Company from a liquidity perspective is to use operating cash flows to fund day to day operations.  In both 2014 and 2013, we have not met this goal as cash flow from operations has been a net use of $5.5 million and $3.2 million, respectively.  The Company is taking steps to try to improve its liquidity going forward by executing on its repositioning and strategy adjustment, focusing on the areas of the business with the most opportunity for revenue growth and continuing to manage costs.  In addition, the Company expects the acquisition of IPSA International will enhance operations, of which there can be no assurance.  Additionally, we continue to explore various financing alternatives to provide additional liquidity.  In February and March of 2015, we closed on approximately $7,400,000 and $4,000,000, respectively, of additional financing, which proceeds were partially used for the acquisition of IPSA International and will also provide relief for near term liquidity pressures.  We will need significant additional financing to carry out our repositioning plan and assure future operations and there can be no assurance that we will be able to obtain the same, or if obtained, on terms favorable to the Company.
 
Working capital was $(1,607,000) and $4,177,000, at December 31, 2014 and 2013, respectively, a decrease of $5,784,000.  The decrease results primarily from the decrease in cash from operations of $5,534,000.  The recent closing of additional financing in the amount of $11,400,000 has provided additional liquidity and improved our working capital position from that at December 31, 2014.
 
 Non-current liabilities at December 31, 2014 are $10,740,000, and primarily consist of a derivative liability related to the current valuation of outstanding common stock purchase warrants, of $10,651,000, which is a non-cash liability. Stockholders’ Equity (Deficit) was $(5,548,000) at December 31, 2014, compared to a balance at December 31, 2013 of $16,922,000 (representing 68.9% of total assets).
 

Line of Credit
 
The Company closed on an asset based revolving line of credit on July 5, 2013 with a financial institution, increasing the borrowing base to 80% of eligible receivables or $3,000,000. In accordance with this facility, the Company was required to maintain a compensating balance of $3 million on account at this financial institution.  However, the loan terms included a release provision on the compensating balance, reducing it as the Company met net operating income thresholds set forth in the loan agreement. As the line of credit required a compensating balance for the full amount of the line, effectively providing the Company with no additional liquidity, the Company decided not to renew the facility when it came due in July 2014 and paid off the outstanding balance on July 3, 2014.

Cash Flows from Operating Activities
 
During the year ended December 31, 2014, net cash used in operating activities was $5,534,000 as compared to net cash used in operating activities of $3,160,000 during the year ended December 31, 2013, an increase of $2,374,000.  The net cash used during 2014 was computed based on: i) the net loss of $24,437,000, ii) decreased by the non-cash charges for derivative expense, stock option expense and impairment of goodwill and intangible assets of $10,345,000, $795,000, and $6,793,000, respectively, iii) the increase in accounts payable and accrued expenses of $402,000, iv) the increase in accounts receivable of $290,000 and v) the increase in billings in excess of costs and estimated earnings of $435,000.

 
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Cash Flows from Investing Activities
 
Cash used in investing activities during the 2014 was $244,000 from net purchases of property and equipment.  During 2014, the Company acquired 3 cyber security software products in exchange for the issuance of 900,000 stock options.  The stock options vest immediately and were valued at approximately $217,000.  The acquisition of the software was a non-cash transaction and addition to Property and Equipment on the Consolidated Balance Sheet as of December 31, 2014.
 

Cash Flows from Financing Activities
 
Cash used from financing activities of $461,000 for 2014 was due to the net payments made to reduce the balance outstanding on the line of credit of $2,721,000 offset by proceeds from the exercise of warrants of $462,000 and proceeds of $1,800,000 from the issuance of 10% convertible notes.
 
The following table represents the Company’s most liquid assets:
 
   
2014
   
2013
 
Cash and cash equivalents
  $ 765,099     $ 7,003,773  
Marketable securities
    38,863       36,510  
Investment in cost method investee
    100,000       100,000  
    $ 903,962     $ 7,140,283  

We are actively exploring additional sources of financing as we expect we will need to raise additional funds in order to fund operations.  Without substantial additional financing, the Company will not be able to continue operating in the manner that is presently in place, and would have to reduce operations and/or restructure selling, general and administrative expenses.  A financing for approximately $11,400,000 of net proceeds has been completed subsequent to December 31, 2014 and those proceeds were partially used to fund the acquisition of IPSA International, Inc. as well as to relieve short term liquidity pressures.
 
Financing transactions may include the issuance of equity or debt securities, and obtaining credit facilities, or other financing mechanisms.  The trading price of our common stock, or if the Company continues to incur losses could make it more difficult to obtain financing through the issuance of equity or debt securities.  If we issue additional equity or debt securities, stockholders will likely experience additional dilution or the new equity securities may have rights, preferences or privileges senior to those of existing holders of our common stock.
 
Outlook

In the latter half of 2014, the Company launched and announced the repositioning of the Company’s business and adjustment to its strategy to focus on cybersecurity and regulatory risk mitigation.  Effort on the strategic and structural changes to the Company continue.  In support of this strategy, in February 2015, the Company acquired IPSA International and expanded capabilities related to regulatory risk mitigation as discussed previously in “Other Developments”. This strategic change in focus is driven by several factors: 1) our expertise, capabilities and proprietary solutions in the cyber security sector, 2) the growing opportunity related to cyber security, regulation and risk as indicated above, and 3) our overall ineffectiveness related to our targeted energy solutions.  We believe the demand for cyber security expertise and solutions will grow substantially and that this will continue to cause change related to solutions and regulation.  root9B, our cyber security segment is differentiated in four ways.  First, we have attracted many of the country’s most highly recognized subject matter experts, most of whom have served within the National Security Agency.  Second, root9B has proprietary hardware and software designed to combat the new methodologies being utilized by state-sponsored and sophisticated individual hackers.  Third, root9B utilizes an advanced integrated strategy known as active adversarial pursuit that employs HUNT capabilities, in which cyber threats are identified before or during an attack rather than discovering the attack after it has taken place.  We believe this approach represents a game changer in cyber defense.  During 2015 we are building an Adversarial Pursuit Operations Center to expand our ability to deliver these services as well as continuing to develop our proprietary products.  Fourth, root9B is known for its training curriculum and capabilities regarding cyber security.  The ongoing trend regarding cyber security is also moving into the regulatory/compliance arena beyond what it has traditionally been.  We see these trends being a good fit for our business model although we cannot assure that we can fully take advantage of the same.

 
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Contractual Obligations
 
As of December 31, 2014, our contractual obligations consisted of the following lease and other contractual obligations:
 
2015
$ 758,579
2016
$ 598,314
2017
$ 555,867
2018
$ 247,169
2019
$ 188,275
The leases cover office premises and leased vehicles.  Of these leases, a total of $9,701 is allocated for vehicle leases and $2,292,711 is for office premises. Non-cancellable contracts with talent acquisition search engines account for $56,110 of the obligations.  The above schedule of contractual obligations does not include dividends on preferred stock as they have not been declared and, further, at the Company’s option may be paid in shares of the Company’s common stock.  We have several employment agreements in place with key management which are in the normal course and have not been included in the above table.
 
 
Off-Balance-Sheet Arrangements
 
The 7% Series B Convertible Preferred Stock accrues 7 percent per annum dividends. Dividends are payable annually in arrears.  At December 31, 2014, $56,372 of dividends has accrued on these shares, respectively.  However, they are unrecorded on the Company’s books until declared. On January 16, 2015, we declared dividends on our Convertible Series B Preferred Stock and we paid the dividends in shares of our common stock.  On January 16, 2015, we issued 36,369 shares of our common stock to the 7% Series B Convertible Preferred Stockholders.
 
The 7% Series C Convertible Preferred Stock accrues 7 percent per annum dividends. Dividends are payable annually in arrears. At December 31, 2014, $350,000 of dividends has accrued on these shares. However, they are unrecorded on our books until declared. On January 16, 2015, we declared dividends on our 7% Series C Convertible Preferred Stock and we paid the dividends in shares of our common stock.  On January 16, 2015, we issued 225,807 shares of our common stock to the 7% Series C Convertible Preferred Stockholders.
 
As of December 31, 2014, and during the prior year then ended, there were no transactions, agreements or other contractual arrangements to which an unconsolidated entity was a party under which we (1) had any direct or contingent obligation under a guarantee contract, derivative instrument, or variable interest in the unconsolidated entity, or (2) had a retained or contingent interest in assets transferred to the unconsolidated entity.
 

            ITEM 8.                      FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
Our financial statements, including notes and the report of our independent accountants, can be found at page F-1 of this annual report.
 

 
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ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
None.
 
ITEM 9A(T).                                CONTROLS AND PROCEDURES
 
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
 
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to this Company’s management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
 
As required by Securities and Exchange Commission Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls were effective at December 31, 2014.
 
MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
 
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States, and includes those policies and procedures that:
 
1.
Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;
 
2.
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and,
 
3.
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the Company’s financial statements.
 
We have in place controls for financial process and reporting that encompass the following: (a) use of an automated financial system with built in controls and balance points, (b) fully documented compliance and audit processes for the operations team, (c) segregation of duties, (d) daily and monthly reconciliation/balance and audit points, (e) established review points with external accounting / auditors and SEC counsel, (f) review points by management for all unique or key financial transactions/activity, and (g) a Code of Ethics guiding activity of all employees.
 
Despite these controls, because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance of achieving their control objectives. Furthermore, smaller reporting companies, like us, face additional limitations. Smaller reporting companies employ fewer individuals and can find it difficult to properly segregate all duties. Often, one or two individuals control every aspect of the Company's operation and are in a position to override any system of internal control. Additionally, smaller reporting companies tend to utilize general accounting software packages that lack a rigorous set of software controls.
 
 
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Management, with the participation of the CEO, evaluated the effectiveness of the Company's internal control over financial reporting as of December 31, 2014.  In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – 2013 Integrated Framework. Based on the above, our management, with the participation of the CEO, concluded that as of December 31, 2014, our internal control over financial reporting was effective.
 
 

 LIMITATIONS ON CONTROLS
 
Disclosure controls and procedures, no matter how well designed and implemented, can provide only reasonable assurance of achieving the Company's disclosure objectives. The likelihood of achieving such objectives is affected by limitations inherent in such controls and procedures, including the fact that human judgment in decision making can be faulty and that breakdown in internal controls can occur because of human failures such as simple errors or mistakes or intentional circumvention of the established process.
 
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting.  Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
 

 
ITEM 9B.                      OTHER INFORMATION
 
None.
 

 
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PART III
 
ITEM 10.                      DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
The information required by Item 10 is incorporated by reference to our definitive proxy statement relating to our 2015 annual meeting of shareholders. In accordance with Regulation 14A, we will be filing that proxy statement no later than 120 days after the end of the last fiscal year.
 
ITEM 11.                      EXECUTIVE COMPENSATION
 
The information required by Item 11 is incorporated by reference to our definitive proxy statement relating to our 2015 annual meeting of shareholders. In accordance with Regulation 14A, we will be filing that proxy statement no later than 120 days after the end of the last fiscal year.
 
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
The information required by Item 12 is incorporated by reference to our definitive proxy statement relating to our 2015 annual meeting of shareholders. In accordance with Regulation 14A, we will be filing that proxy statement no later than 120 days after the end of the last fiscal year.
 
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
The information required by Item 13 is incorporated by reference to our definitive proxy statement relating to our 2015 annual meeting of shareholders. In accordance with Regulation 14A, we will be filing that proxy statement no later than 120 days after the end of the last fiscal year.
 
ITEM 14.                      PRINCIPAL ACCOUNTANT FEES AND SERVICES
 
The information required by Item 14 is incorporated by reference to our definitive proxy statement relating to our 2015 annual meeting of shareholders. In accordance with Regulation 14A, we will be filing that proxy statement no later than 120 days after the end of the last fiscal year.
 

 
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ITEM 15.                      EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES
 
The following exhibits are filed as a part of, or incorporated by reference into, this report.
 
No.
Description
 
2.1
Agreement and Plan of Merger dated February 6, 2015, between the Registrant, IPSA International Services Inc, a Delaware corporation and IPSA International Inc a Nevada corporation (incorporated by reference to Exhibit 2.1 of the Current Report on Form 8-K of the Registrant filed with the Commission on February 10, 2015).
 
3.1
Certificate of Incorporation filed with the state of Delaware on June 21, 2011. (incorporated by reference to exhibit 3.1 to Form 10-K of the Registrant filed with the Commission on March 30, 2012).
 
3.2
Restated and amended bylaws (incorporated by reference to exhibit 3.1 to Form 8-K of the registrant filed with the Commission on February 1, 2011).
 
3.3
Amended Certificate of Incorporation filed with the state of Delaware on April 30, 2012. (incorporated by reference to exhibit 3.1 to Form 8-K of the Registrant filed with the Commission on April 30, 2012).
 
3.3
Amended Certificate of Incorporation filed with the state of Delaware on August 28, 2014. (incorporated by reference to exhibit 3.1 to Form 8-K of the Registrant filed with the Commission on August 28, 2014).
 
3.4
Amended Certificate of Incorporation filed with the state of Delaware on November 24, 2014. (incorporated by reference to exhibit 3.1 to Form 8-K of the Registrant filed with the Commission on December 1, 2014).
 
4.1
Amended and Restated Certificate of Designations, Powers, Preferences and other Rights and Qualifications of the Series B Convertible Preferred Stock (incorporated by reference to Exhibit 4.1 to Current Report on Form 8-K of the Registrant filed with the Commission on March 11, 2011).
 
4.2
Amended and Restated Certificate of Designations, Powers, Preferences and other Rights and Qualifications of the Series C Convertible Preferred Stock (incorporated by reference to Exhibit 4.1 to Current Report on Form 8-K of the Registrant filed with the Commission on March 7, 2011).
 
4.3
Certificate of Designations, Powers, Preferences a Preferences and other Rights and Qualifications of the Series D Redeemable Convertible Preferred Stock (incorporated by reference to Exhibit 4.1 to Current Report on Form 8-K/A of the Registrant filed with the Commission on January 31, 2013)
 
10.1
Form of Subscription Agreement by and between the Registrant and the Series D Redeemable Convertible Preferred Stock holders (incorporated by reference to Exhibit 10.1 to Current Report on Form 8- K of the Registrant filed with the Commission on January 2, 2013).
 
10.2
Form of Warrant issued to the Series D Redeemable Convertible Preferred Stock holders (incorporated by reference to Exhibit 10.2 to Current Report on Form 8-K of the Registrant filed with the Commission on January 2, 2013).
 
10.3
Employment Agreement between the Registrant and Mark Elliott dated August 9, 2013 (incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K of the Registrant filed with the Commission on August 14, 2013).
 
10.4
Agreement and Plan of Merger dated November 13, 2013, between the Registrant, root9B Partners, LLC, a North Carolina limited liability company and root9B LLC, a Colorado limited liability company (incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K of the Registrant filed with the Commission on November 19, 2013).
 
10.5
Form of Warrant, Subscription Agreement, and Promissory Note by and between the Registrant and the Convertible Note holders (incorporated by reference to Exhibit 4.1, 10.1 and 10.2 to Current Report on Form 8-K of the Registrant filed with the Commission on October 23, 2014).
 
 
35

 
 
10.6
Employment Agreement between the Registrant and Joseph Grano dated May 20, 2014 (incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K of the Registrant filed with the Commission on May 22, 2014).
 
10.7
Employment Agreement between Registrants subsidiary IPSA International and Dan Wachtler dated February 9, 2015 (incorporated by reference to Exhibit 10.2 of the Current Report on Form 8-K of the Registrant filed with the Commission on February 10, 2015).
 
10.8
Form of Warrant, Securities Purchase Agreement, and Pledge Agreement by and between the Registrant and the accredited investor (incorporated by reference to Exhibit 4.1, 10.4 and 10.5 to Current Report on Form 8-K of the Registrant filed with the Commission on February 10, 2015).
 
10.9
Form of Warrant, Securities Purchase Agreement, and Pledge Agreement by and between the Registrant and the accredited investor (incorporated by reference to Exhibit 4.1, 10.4 and 10.5 to Current Report on Form 8-K of the Registrant filed with the Commission on February 17, 2015).
 
10.10
Form of Warrant and Securities Purchase Agreement by and between the Registrant and the accredited investors (incorporated by reference to Exhibit 4.1, and 10.4 to Current Report on Form 8-K of the Registrant filed with the Commission on March 16, 2015).
 
14.1
Code of ethics (incorporated by reference to exhibit 14.1 to Form 10-KSB of the registrant filed with the Commission on March 31, 2005).
 
21
Subsidiaries of the Registrant (filed herewith).
 
31.1
Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Sec. 1350).  (filed herewith).
 
31.2
Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Sec. 1350).  (filed herewith).
 
32.1
Written Statement of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350). (filed herewith).
 
32.2
Written Statement of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350). (filed herewith).
 
101.INS *
 
XBRL Instance Document.
101.SCH *
 
XBRL Taxonomy Extension Schema Document.
101.CAL *
 
XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF *
 
XBRL Taxonomy Extension Definition Linkbase Document.
101.LAB *
 
XBRL Taxonomy Extension Label Linkbase Document.
101.PRE *
 
XBRL Taxonomy Extension Presentation Linkbase Document.
*
 
Furnished herewith. XBRL (Extensible Business Reporting Language) information is furnished and not filed or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.


 
36

 
 
                                                                                  SIGNATURES
 
In accordance with the requirements of Section 13 or 15(d) of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
PREMIER ALLIANCE GROUP, INC.
 
Date: March 30, 2015
By:
/s/ Joseph J. Grano, Jr.               .
 
   
Joseph J. Grano, Jr.,
Chief Executive Officer
 
Date: March 30, 2015
By:
/s/ Kenneth T. Smith       .
 
   
Kenneth T. Smith,
Chief Financial Officer and
Principal Accounting Officer
 

In accordance with the requirements of the Exchange Act, this report is signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated.

 
Signature
 
 
Signature
 
         
 /s/ Joseph J. Grano Jr       /s/ Gregory C Morris 
 
Joseph J. Grano, Jr. – Director, Chairman
   
Gregory C. Morris – Director
 
March 30, 2015
   
March 30, 2015
 
         
 /s/ Isaac Blech 
 
 
   
Isaac Blech – Director
 
 
Harvey Pitt – Director
 
March 30, 2015
   
March 30, 2015
 
         
 /s/ Kevin Carnahan       /s/ Anthony Sartor   
Kevin Carnahan – Director
   
Anthony Sartor – Director
 
March 30, 2015
   
March 30, 2015
 
         
 /s/ John Catsimatidis       /s/ Cary W Sucoff   
John Catsimatidis – Director
   
Cary W. Sucoff - Director
 
March 30, 2015
   
March 30, 2015
 
         
 /s/ Wesley Clark       /s/ Seymour Siegel   
Wesley Clark – Director
   
Seymour Siegel - Director
 
March 30, 2015
   
March 30, 2015
 
 
 
 
   
 /s/ Patrick Kolenik       /s/ Daniel Wachtler   
Patrick Kolenik – Director
 
 
Daniel Wachtler – Director
 
March 30, 2015
   
March 30, 2015
 

 
37

 


 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 

 
To the Board of Directors and Stockholders of root9B Technologies, Inc. and subsidiaries
Charlotte, North Carolina
 

 
 
We have audited the accompanying consolidated balance sheets of root9B Technologies, Inc. and subsidiaries (the “Company”) as of December 31, 2014 and 2013, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended.  The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2014 and 2013, and the consolidated results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
 
 

 

 
/s/ Cherry Bekaert LLP
 

 

 
Charlotte, North Carolina
March xx, 2015
 








 
 
(F-1)
See Notes to Financial Statements

 



ROOT9B TECHNOLOGIES, INC.
BALANCE SHEETS
DECEMBER 31, 2014 AND 2013
 
 
   
December 31,
   
December 31,
 
   
2014
   
2013
 
ASSETS
           
             
CURRENT ASSETS:
           
Cash
  $ 765,099     $ 7,003,773  
Accounts receivable, net
    3,078,604       2,788,209  
Marketable securities
    38,863       36,510  
Cost and estimated earnings in excess of billings
    731,709       1,018,141  
Prepaid expenses and other current assets
    384,223       160,480  
                 
Total current assets
    4,998,498       11,007,113  
                 
Construction in Progress - at cost
    -       859,161  
                 
Property and Equipment - at cost less accumulated depreciation
    1,748,631       593,025  
                 
OTHER ASSETS:
               
                 
Goodwill
    4,352,177       10,715,807  
Intangible assets - net
    151,623       803,493  
Investment in cost-method investee
    100,000       100,000  
Cash surrender value of officers' life insurance
    338,214       416,265  
Deposits and other assets
    175,497       74,045  
                 
Total other assets
    5,117,511       12,109,610  
                 
TOTAL ASSETS
  $ 11,864,640     $ 24,568,909  

 

 

 

 

 

 
 
(F-2)
See Notes to Financial Statements

 

 
 
   
December 31,
   
December 31,
 
   
2014
   
2013
 
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
           
             
CURRENT LIABILITIES:
           
Notes payable
  $ 1,670,765     $ 2,721,239  
Current portion of long-term debt
    1,500       3,846  
Accounts payable
    1,306,578       2,227,840  
Billings in excess of costs and estimated earnings
    991,254       556,545  
Accrued expenses and other current liabilities
    2,634,903       1,320,448  
                 
Total current liabilities
    6,605,000       6,829,918  
                 
NONCURRENT LIABILITIES:
               
                 
Long term debt - net of current portion
    3,926       5,426  
Derivative liability
    10,651,239       726,993  
Deferred tax liability
    85,000       85,000  
                 
Total noncurrent liabilities
    10,740,165       817,419  
                 
STOCKHOLDERS' EQUITY (DEFICIT):
               
                 
Preferred stock, $.001 par value, 4,985,000 authorized, no shares issued or outstanding at December 31, 2014 and December 31, 2013.
    -       -  
Class B convertible preferred stock, no liquidation preference $.001 par value, 2,000,000 shares authorized, 1,080,000 and 1,160,000 shares issued and outstanding at 
December 31, 2014 and December 31, 2013, respectively.
    1,080       1,160  
Class C convertible preferred stock, $.001 par value, 2,500,000 shares authorized, 2,380,952 shares issued and outstanding at December 31, 2014 and 2013, respectively.
    2,381       2,381  
Class D convertible preferred stock, $.001 par value, 15,000 shares authorized, 0 and 13,376 shares issued and outstanding at December 31, 2014 and December 31, 2013,
respectively.
    -       13  
Common stock, $.001 par value, 125,000,000 shares authorized, 48,670,144 and 27,465,836 shares issued and outstanding at December 31, 2014 and December 31, 2013,
respectively.
    48,670       27,466  
Additional paid-in capital
    42,803,888       39,193,174  
Accumulated deficit
    (48,336,544 )     (22,302,622 )
Total stockholders' equity (deficit)
    (5,480,525 )     16,921,572  
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
  $ 11,864,640     $ 24,568,909  

 
 
(F-3)
See Notes to Financial Statements

 

ROOT9B TECHNOLOGIES, INC.
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2014 AND 2013

   
December 31, 2014
   
December 31, 2013
 
NET REVENUE
  $ 20,175,488     $ 26,399,916  
                 
OPERATING EXPENSES:
               
Cost of revenues
    14,982,996       20,845,516  
Selling, general and administrative
    11,184,909       9,214,410  
Depreciation and amortization
    386,282       380,951  
Energy repositioning and subcontract obligation
    1,162,089       -  
                 
Total operating expenses
    27,716,276       30,440,877  
                 
LOSS FROM OPERATIONS
    (7,540,788 )     (4,040,961 )
                 
OTHER INCOME (EXPENSE):
               
Derivative (expense) income
    (10,344,753 )     2,149,951  
Goodwill impairment
    (6,363,630 )     (4,472,089 )
Intangibles impairment
    (429,394 )     (238,803 )
Adjustment to estimates recorded at acquisition
    -       431,919  
Interest expense, net
    (59,066 )     (44,270 )
Other income (expense)
    301,065       87,799  
                 
Total other (expense) income
    (16,895,778 )     (2,085,493 )
                 
LOSS BEFORE INCOME TAXES
    (24,436,566 )     (6,126,454 )
                 
INCOME TAX BENEFIT (EXPENSE)
    -       -  
                 
NET LOSS
    (24,436,566 )     (6,126,454 )
                 
PREFERRED STOCK DIVIDENDS
    (1,597,356 )     (1,280,408 )
DEEMED DIVIDEND ON PREFERRED STOCK
    -       (509,184 )
                 
NET LOSS ATTRIBUTABLE TO COMMON STOCKHOLDERS
  $ (26,033,922 )   $ (7,916,046 )
 
               
Net loss  per share:
               
Basic
    (0.86 )     (0.33 )
Diluted
    (0.86 )     (0.33 )
Weighted average number of shares:
               
Basic
    30,345,422       24,052,686  
Diluted
    30,345,422       24,052,686  
 
 

 
 
(F-4)
See Notes to Financial Statements

 

ROOT9B TECHNOLOGIES, INC.
STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
FOR THE YEARS ENDED DECEMBER 31, 2014 AND 2013
 
 
Class B
Class C
Class D
 
Additional
Retained Earnings
Total
 
Preferred Stock
Preferred Stock
Preferred Stock
Common Stock
Paid -In
(Accumulated
Stockholders’
 
Shares
Amount
Shares
Amount
Shares
Amount
Shares
Amount
Capital
Deficit)
Equity
Balance at December 31, 2012
1,160,000
 $1,160
2,380,952
 $2,381
 7,796
$ 8
22,331,687
$22,332
     $30,805,827
  $(14,386,539)
       $16,445,169
Issuance of preferred stock, net of issuance costs
       
6,080
6
   
5,452,144
 
5,452,150
Record the derivative liability associated with the issuance of the preferred stock
               
(401,785)
 
(401,785)
Deemed dividend on preferred stock
               
509,184
(509,184)
--
Issuance of common stock as dividends on Preferred B, C and D stock
           
1,850,452
1,850
1,278,558
(1,280,408)
--
Stock warrants issued for services
               
5,786
 
 
5,786
Stock options issued for services rendered
               
 
        188,016
 
 
           188,016
Conversion of 925 shares of Preferred D stock to common stock
       
(500)
     (1)
1,000,000
1,000
(1,000)
   
Issuance of Common Stock
           
308,000
308
208,032
 
208,340
Retirement of escrowed Common Stock related to GHH acquisition
           
(266,238)
(266)
(239,348)
 
 (239,614)
Issuance of Common Stock in Root9B Acquisition
           
2,241,935
2,242
1,387,758
 
1,390,000
Net Loss
                 
    (6,126,454)
         (6,126,454)
Rounding
               
2
(37)
(36)
Balance at December 31, 2013
1,160,000
 $1,160
2,380,952
 $2,381
 13,376
$13
27,465,836
$27,466
     $39,193,174
  $(22,302,622)
        $16,921,572

 
 
(F-5)
See Notes to Financial Statements

 

ROOT9B TECHNOLOGIES, INC.
STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
FOR THE YEARS ENDED DECEMBER 31, 2014 AND 2013
(Continued)

 
Class B
Class C
Class D
 
Additional
Retained Earnings
Total
 
Preferred Stock
Preferred Stock
Preferred Stock
Common Stock
Paid -In
(Accumulated
Stockholders’
 
Shares
Amount
Shares
Amount
Shares
Amount
Shares
Amount
Capital
Deficit)
Equity (Deficit)
Balance at December 31, 2013
1,160,000
 $1,160
2,380,952
 $2,381
 13,376
$ 13
27,465,836
$27,466
     $39,193,174
  $(22,302,622)
        $ 16,921,572
Deemed dividend on preferred stock
                     
Issuance of common stock as dividends on Preferred B, C and D stock
           
2,294,487
2,294
1,595,062
(1,597,356)
--
Stock warrants issued for services
               
28,259
 
 
28,259
Stock options issued for assets and services rendered
               
 
        983,305
 
 
           983,305
Conversion of Preferred D stock to common stock
       
(13,376)
(13)
18,001,392
18,001
(17,988)
 
--
Conversion of Preferred B stock to common stock
(80,000)
(80)
       
80,000
80
   
--
Exercise of stock warrants
           
795,095
795
437,755
 
 438,550
Exercise of stock options
           
33,334
34
23,301
 
23,335
Reclassification of derivative warrant liability to equity
               
420,507
 
420,507
Issuance of stock warrants in connection with 10% Convertible Notes
               
140,513
 
140,513
Net Loss
                 
    (24,436,566)
         (24,436,566)
Balance at December 31, 2014
1,080,000
 $1,080
2,380,952
 $2,381
 --
--
48,670,144
$48,670
     $42,803,888
  $(48,336,544)
        $  (5,480,525)
 

 
 
(F-6)
See Notes to Financial Statements

 


ROOT9B TECHNOLOGIES, INC.
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2014 AND 2013

   
December 31, 2014
   
December 31, 2013
 
Cash flows from operating activities:
           
Net Income (loss)
  $ (24,436,566 )   $ (6,126,454 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    386,282       380,951  
Amortization of debt discount
    11,278          
Decrease (increase) in cash surrender value of officers' life insurance
    78,051       (50,435 )
(Income) loss from change in value of derivatives
    10,344,753       (2,149,951 )
Stock option / warrant compensation expense
    794,901       193,802  
Adjustment to estimates recorded at acquisition
    -       (431,919 )
Impairment of goodwill and intangible assets
    6,793,024       4,710,892  
Changes in operating assets and liabilities:
               
Decrease (increase) in accounts receivable
    (290,395 )     126,918  
Increase in marketable securities
    (2,353 )     (5,403 )
Decrease (increase) in costs and estimated earnings in excess of billings
    286,432       (656,283 )
Increase in prepaid expenses
    (223,743 )     (3,586 )
Increase in deposits and other assets
    (101,452 )     (18,616 )
Increase in accounts payable and accrued expenses
    390,847       914,073  
Increase (decrease) in billings in excess of costs and estimated earnings
    434,709       (43,726 )
Net cash used in operating activities
    (5,534,232 )     (3,159,737 )
                 
Cash flows from investing activities:
               
Cash paid for construction in progress
    -       (859,161 )
Cash paid in acquisitions
    -       (347,886 )
Cash acquired in acquisitions
    -       82,352  
Purchases of property and equipment, net
    (243,587 )     (41,703 )
Net cash used in investing activities
    (243,587 )     (1,166,398 )
                 
Cash flows from financing activities:
               
Issuance of Class D preferred stock
    -       5,452,150  
Warrants and Options Exercised
    461,884       -  
Net payments on long-term debt
    (1,500 )     -  
Issuance of Convertible Notes and Warrants
    1,800,000       -  
Net proceeds (payments) of Notes Payable
    (2,721,239 )     1,406,656  
Net cash (used) provided by financing activities
    (460,855 )     6,858,806  
                 
Net (decrease) increase in cash
    (6,238,674 )     2,532,671  
                 
Cash - beginning of period
    7,003,773       4,471,102  
                 
Cash - end of period
  $ 765,099     $ 7,003,773  


 
 
(F-7)
See Notes to Financial Statements

 

ROOT9B TECHNOLOGIES, INC.
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2014 AND 2013
(continued)
 

             
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
           
             
   
2014
   
2013
 
             
Cash payments for:
           
Interest
  $ 44,066     $ 44,270  
                 
Income taxes
  $ 0     $ 0  
                 
Summary of non-cash investing and financing activities:
 
               
Reclassification of Derivative warrant liability to equity
  $ 420,507     $ 0  
                 
Stock options issued for assets purchased
  $ 216,663     $ 0  
                 
Issuance of 2,241,935 shares of common stock in Root9B
   Acquisition
  $ 0     $ 1,390,000  
                 
Issuance of 308,000 shares of common stock
  $ 0     $ 208,340  

 
  
 

 
 
(F-8)
See Notes to Financial Statements

 
ROOT9B TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2014 AND 2013
 
Note 1 - Description of Business and Summary of Significant Accounting Policies:
 
Description of Business
 
We are a provider of Cyber Security, Regulatory Risk Mitigation and Energy Solutions delivering technology and advisory services. We help clients in diverse industries improve performance, comply with complex regulations, reduce costs, leverage and integrate technology, and stimulate growth. We team with our clients to deliver sustainable and measurable results. Our primary focus is using our expertise on issues related to three key areas for customers; (i) cyber security, (ii) regulatory risk mitigation, and (iii) energy usage and strategy initiatives.  We work with our customers to assess, design, and provide customized advice and solutions that are tailored to address each client’s particular needs. We provide solutions and services to a wide variety of organizations including Fortune 500 companies, medium-sized businesses and governmental entities.
 
Principles of Consolidation
 
The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly owned.  All significant intercompany balances and transactions have been eliminated.
 
Use of Estimates
 
The preparation of the Company’s consolidated financial statements, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions.  These estimates and assumptions affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from these estimates.
 
Cash and cash equivalents
 
The Company considers all highly liquid investments having an original maturity of three months or less to be cash equivalents.  Amounts invested may exceed federally insured limits at any given time.  Financial instruments that potentially expose the Company to concentrations of credit risk consist primarily of cash and cash equivalents.  The Company places its cash and cash equivalents on deposit with financial institutions in the United States.  The Company from time to time may have amounts on deposit in excess of the insured limits (FDIC limits are $250,000).  The Company periodically assesses the financial condition of the institutions and believes that the risk of loss is remote.
 
      Accounts receivable:
 
Accounts receivable are recorded at the invoiced amount, net of an allowance for doubtful accounts. The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company determines the allowance based on historical write-off experience, customer specific facts and economic conditions. Bad debt expense is included in general and administrative expenses, if any.  At December 31, 2014 and 2013, the allowance for doubtful accounts was $356,597 and $252,864, respectively.
 
Marketable securities:
 
Marketable equity securities are accounted for as trading securities and are stated at market value with unrealized gains and losses accounted for in other income (expense).
 
Property and equipment:
 
Property and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets ranging from three to seven years.  Maintenance and repair costs are expensed as incurred.  Gains or losses on dispositions are reflected in income.
 
       Valuation of goodwill and intangible assets:
 
Our intangible assets include goodwill, trademarks, non-compete agreements, patents and purchased customer relationships, all of which are accounted for based on Financial Accounting Standards Board (FASB) Accounting Standards Codification (“ASC”) Topic 350 Intangibles-Goodwill and Other. As described below, goodwill and intangible assets that have indefinite useful lives are not amortized but are tested at least annually for impairment or more frequently if events or changes in circumstances indicate that
 
 
(F-9)

 
the asset might be impaired. Intangible assets with limited useful lives are amortized using the straight-line method over their estimated period of benefit, ranging from two to eight years.
 
        Intangible asset impairment testing:
 
Our goodwill impairment testing is calculated at the reporting unit level. Our annual impairment test has two steps. The first identifies potential impairments by comparing the fair value of the reporting unit with its carrying value.  If the fair value exceeds the carrying amount, goodwill is not impaired and the second step is not necessary. If the carrying value exceeds the fair value, the second step calculates the possible impairment loss by comparing the implied fair value of goodwill with the carrying amount. If the implied fair value of goodwill is less than the carrying amount, a write-down is recorded.
 
The impairment test for the other intangible assets is performed by comparing the carrying amount of the intangible assets to the sum of the undiscounted expected future cash flows whenever events or circumstances indicate that an impairment may have occurred. If the sum of the future undiscounted cash flows is less than the carrying amount of the intangible asset or to its related group of assets, an impairment charge is recorded to the extent that the carrying amount of the intangible asset exceeds its fair value.
 
We predominately use a discounted cash flow model derived from internal budgets and forecasts in assessing fair values for our impairment testing.  Factors that could change the result of our impairment test include, but are not limited to, different assumptions used to forecast future net sales, expenses, capital expenditures, and working capital requirements used in our cash flow models. In addition, selection of a risk-adjusted discount rate on the estimated undiscounted cash flows is susceptible to future changes in market conditions, and when unfavorable, can adversely affect our original estimates of fair values. In the event that management determines that the value of intangible assets have become impaired using this approach, we will record an accounting charge for the amount of the impairment.  The Company also engages an independent valuation expert to assist it in performing the valuation and analysis of fair values of goodwill and intangibles.
 
The Company’s annual goodwill impairment testing date is October 1 of each year.  The Company recorded the results of the impairment testing for 2014 and 2013 as of September 30, 2014 and December 31, 2013, respectively.  In determining impairment charges, the Company uses various valuation techniques using both the income approach and market approach at each reporting unit in accordance with FASB ASC 350. During 2014, the Company recorded a goodwill impairment write-down of $6,363,630 related to the Energy Solutions segment which is reflected in the Statement of Operations.  During 2013, the Company recorded a goodwill impairment write-down of $4,472,089 related to its Energy Solutions business segment which is reflected in the Statement of Operations.  The balance recorded as goodwill as of December 31, 2014 and 2013 is $4,352,177 and $10,715,807, respectively, net of accumulated impairment of $16,969,662 and $10,606,032, respectively.
 
Intangible assets, other than goodwill, consist of customer relationships, non-competition agreements and trademarks/trade names.  The fair market value of the customer relationships were determined by discounting the expected future cash flows from the acquired customers.  The value of the non-competition agreements were estimated from the percentage of discounted cash flows expected to be lost if the agreement was not in place.  At September 30, 2014 and December 31, 2013, the Company performed an impairment analysis. Based on the analysis at September 30, 2014, it was determined that a full impairment of the trade name and customer list intangible assets related to the Energy Solutions segment was required.  As a result, the Company recorded an impairment charge of $429,394 at September 30, 2014.  Based on the analysis at December 31, 2013, it was determined that an impairment was required for the intangible asset related to the customer lists for the Energy Solutions segment.  As a result, the Company recorded an impairment charge of $238,803 to the ES segment at December 31, 2013.  Customer relationships acquired are being amortized over the estimated useful life of four or five years. Non-competition agreements are being amortized over the life of the agreement. Acquired trademarks/trade names are being amortized over seven years.  Total intangibles balances, prior to accumulated amortization, were $664,648 and $1,561,404 at December 31, 2014 and 2013, respectively. At December 31, 2014 and 2013, accumulated amortization of intangible assets totaled $513,025 and $757,911, respectively.  Amortization expense on these intangible assets of $222,476 and $295,459 for the years ended December 31, 2014 and 2013, respectively, is included as depreciation and amortization on the Statement of Operations.
 
Amortization expense related to intangible assets for the next five years is expected to be as follows for the years ended:
 
December 31, 2015
$     59,301
December 31, 2016
       42,951
December 31, 2017
       39,371
December 31, 2018
       10,000
December 31, 2019
                -
 
$   151,623

 
 
(F-10)

 
 
Revenue recognition:
 
The Company follows the guidance of the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104 for revenue recognition.  In general, the Company records revenue when persuasive evidence of any agreement exists, services have been rendered, and collectability is reasonably assured; therefore, revenue is recognized when the Company invoices customers for completed services at contracted rates and terms. Therefore, revenue recognition may differ from the timing of cash receipts.
 
Income taxes:
 
The Company accounts for income taxes under FASB ASC Topic 740 Income Taxes.  Under FASB ASC Topic 740, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be removed or settled (see Note 13). The Company regularly assesses the likelihood that its deferred tax assets will be realized from recoverable income taxes or recovered from future taxable income.  To the extent that the Company believes any amounts are not more likely than not to be realized through the reversal of the deferred tax liabilities and future income, the Company records a valuation allowance to reduce its deferred tax assets.  In the event the Company determines that all or part of the net deferred tax assets are not realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. Similarly, if the Company subsequently realizes deferred tax assets that were previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in an adjustment to earnings in the period such determination is made.
 
FASB ASC Topic 740-10 clarifies the accounting for income taxes, by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the balance sheet. It also provides guidance on de-recognition, measurement and classification of amounts related to uncertain tax positions, accounting for and disclosure of interest and penalties, accounting in interim period disclosures and transition relating to the adoption of new accounting standards. Under FASB ASC Topic 740-10, the recognition for uncertain tax positions should be based on a more-likely-than-not threshold that the tax position will be sustained upon audit. The tax position is measured as the largest amount of benefit that has a greater than fifty percent probability of being realized upon settlement.
 
Derivative Warrant Liability
 
The Company evaluates warrants issued in connection with debt and preferred stock issuances to determine if those contracts, or any potential embedded components of those contracts, qualify as derivatives to be separately accounted for.  This accounting treatment requires that the carrying amount of any embedded derivatives be marked-to-market at each balance sheet date and carried at fair value.  In the event that the fair value is recorded as a liability, the change in the fair value during the period is recorded in the Statement of Operations as either income or expense. Upon expiration or exercise, the derivative liability is marked to fair value at the conversion date and then the related fair value is reclassified to equity.  The fair value at each balance sheet date and the change in value for each class of warrant derivative is disclosed in detail in Note 2 to the Financial Statements.
 
Share-based compensation:
 
The Company accounts for stock based compensation in accordance with FASB ASC 718 – Compensation-Stock Compensation. For employee stock options issued under the Company’s stock-based compensation plans, the fair value of each option grant is estimated on the date of the grant using the Black-Scholes pricing model, and an estimated forfeiture rate is used when calculating stock-based compensation expense for the period. For employee restricted stock awards and units issued under the Company’s stock-based compensation plans, the fair value of each grant is calculated based on the Company’s stock price on the date of the grant and an estimated forfeiture rate when calculating stock-based compensation expense for the period. The Company recognizes the compensation cost of stock-based awards according to the vesting schedule of the award.
 
The Company accounts for stock-based compensation awards to non-employees in accordance with FASB ASC 505-50 Equity-Based Payments to Non-Employees (“ASC 505-50”). Under ASC 505-50, the Company determines the fair value of the warrants or stock-based compensation awards granted as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable. Any stock options issued to non-employees are recorded in expense and additional paid-in capital in stockholders’ equity (deficit) over the applicable service periods.
 
Recent accounting pronouncements:
 
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606).  This guidance requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  This guidance is effective for annual reporting periods beginning after December 15, 2016 and early adoption is not permitted.  The Company has not yet determined the effect, if any, that the adoption of this standard will have on the Company’s financial position or results of operations.

 
(F-11)

 

In August 2014, the FASB issued Accounting Standards Update No. 2014-15, Going Concern (“ASU 2014-15”). ASU 2014-15 provides GAAP guidance on management’s responsibility in evaluating whether there is substantial doubt about a company’s ability to continue as a going concern and about related footnote disclosures. For each reporting period, management will be required to evaluate whether there are conditions or events that raise substantial doubt about a company’s ability to continue as a going concern within one year from the date the financial statements are issued. The standard will be effective for annual periods ending after December 15, 2016, and interim periods within annual periods beginning after December 15, 2016. Early application is permitted for annual or interim reporting periods for which the financial statements have not previously been issued. Upon adoption the Company will use the guidance in ASU 2014-15 to assess going concern.
 
                 Since January 1, 2013, there have been several new accounting pronouncements and updates to the Accounting Standards Codification.  Each of these updates has been reviewed by Management who does not believe their adoption has had or will have a material impact on the Company’s financial position or operating results.


Note 2 – Fair Value Measurements:
 
We measure the fair value of financial assets and liabilities in accordance with GAAP, which defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements.
 
GAAP defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. GAAP also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. GAAP describes three levels of inputs that may be used to measure fair value:
 
Level 1 – quoted prices in active markets for identical assets or liabilities.
 
Level 2 – quoted prices for similar assets and liabilities in active markets or inputs that are observable.
 
Level 3 – inputs that are unobservable (for example the probability of a capital raise in a “binomial” methodology for valuation of a derivative liability directly related to the issuance of common stock warrants).
 
Derivative Instruments:
 
We do not use derivative financial instruments to hedge exposures to cash-flow, market or foreign-currency risks. However, we have entered into certain financial instruments and contracts, such as debt financing arrangements and the issuance of preferred stock with detachable common stock warrants features that are either i) not afforded equity classification, ii) embody risks not clearly and closely related to host contracts, or iii) may be net-cash settled by the counterparty. These instruments are required to be carried as derivative liabilities, at fair value.
 
Our only derivative instruments are detachable (or “free-standing”) common stock purchase warrants issued in conjunction with debt or preferred stock. We estimate fair values of these derivatives (and related embedded beneficial conversion features) utilizing Level 2 inputs for all classes of warrants issued, other than one class, Series C Preferred Stock. Other than the Series C Preferred Stock warrants, we use the Black-Scholes option valuation technique as it embodies all of the requisite assumptions (including trading volatility, remaining term to maturity, market price, strike price, and risk free rates) necessary to fair value these instruments, for they do not contain material “down round protection” (otherwise referred to as “anti-dilution” and full ratchet provisions). For the warrants directly related to the Series C Preferred Stock, the warrant contracts do contain “Down Round Protections” and the “Black-Scholes” option valuation technique does not, in its valuation calculation, give effect for the additional value inherently attributable to the warrant having the “Down Round Protection” mechanisms in its contractual arrangement.  Valuation models and techniques have been developed and are widely accepted that take into account the additional value inherent in “Down Round Protection.” These techniques include “Modified Binomial”, “Monte Carlo Simulation” and the “Lattice Model.” The “core” assumptions and inputs to the “Binomial” model are the same as for “Black-Scholes”, such as trading volatility, remaining term to maturity, market price, strike price, and risk free rates; all Level 2 inputs.  However, a key input to the “Binomial” model (in our case, the “Monte Carlo Simulation”, for which we engage an independent valuation firm to perform) is the probability of a future capital raise.  By definition, this input assumption does not meet the requirements for Level 1 or Level 2 outlined above; therefore, the entire fair value calculation for the Series C Common Stock Warrants is deemed to be Level 3. This input to the Monte Carlo Simulation model, was developed with significant input from management based on its knowledge of the business, current financial position and the strategic business plan with its best efforts.

 
(F-12)

 

Estimating fair values of these derivative financial instruments require the use of significant and subjective inputs that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors. In addition, option-based techniques are volatile and sensitive to changes in our trading market price, the trading market price of various peer companies and other key assumptions such as the probability of a capital raise for the Monte Carlo Simulation described above. Since derivative financial instruments are initially and subsequently carried at fair value, our operating results will reflect this sensitivity of internal and external factors.

The key quantitative assumptions related to the Series C Common Stock Warrants, issued March 3, 2011 and expiring March 3, 2016, are as follows:
 
 
 
December 31, 2014
December 31, 2013
Expected Life (Years)
1.2
2.2
Risk Free Rate
0.32%
0.45%
Volatility
26.78%
29.31%
Probability of a Capital Raise
8-95%
4-8%

 
Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis
 
Financial assets and liabilities measured at fair value on a recurring basis (for the Company, only derivative liabilities related to common stock purchase warrants, issued in conjunction with debt and preferred stock issuances) are summarized below and disclosed on the balance sheet under Derivative liability:
 
   
December 31, 2014
 
   
Fair Value
 
Level 1
 
Level 2
   
Level 3
 
Derivative Liability – Common Stock Purchase Warrants:
                   
  Debentures
  $ -       $ -        
  Series B Preferred Stock
    794,633         794,633        
  Promissory Notes
    225,897         225,897        
  Series D Preferred Stock
    3,325,449         3,325,449        
  Series C Preferred Stock
    6,305,260                 6,305,260  
Total
  $ 10,651,239       $ 4,345,979     $ 6,305,260  
                           
   
December 31, 2013
 
   
Fair Value
 
Level 1
 
Level 2
   
Level 3
 
Derivative Liability – Common Stock Purchase Warrants:
                         
  Debentures
  $ 10,207       $ 10,207          
  Series B Preferred Stock
    24,277         24,277          
  Promissory Notes
    85,824         85,824          
  Series D Preferred Stock
    224,075         224,075          
  Series C Preferred Stock
    382,610                 382,610  
Total
  $ 726,993       $ 344,383     $ 382,610  
                           

 
 
 
(F-13)

 

The table below provides a summary of the changes in fair value of financial assets and liabilities (for the Company, only derivative liabilities related to common stock purchase warrants, issued in conjunction with certain debt and preferred stock issuances) measured at fair value on a recurring basis for all derivatives, both level 2 and those using significant unobservable inputs (Level 3 – or only the common stock purchase warrants directly related to Series C Preferred Stock) for the years ended December 31, 2014 and 2013.:

 

   
Fair Value Measurements Using
 
   
Level 2 Inputs
   
Level 3 Inputs
       
   
Derivative liability - Common Stock Purchase Warrants -