10-Q

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

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

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

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

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

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ☒ No ☐

As of May 8, 2023, the registrant had 7,122,199 shares of common stock, $0.001 par value per share, outstanding.

See accompanying notes to unaudited condensed consolidated financial statements.

(1) Basis of Presentation

(a) The Company and Nature of Operations

FalconStor Software, Inc., a Delaware corporation ("we", the "Company" or "FalconStor"), is a trusted data protection software leader modernizing disaster recovery and backup operations for the hybrid cloud world. The Company enables enterprise customers and managed service providers to secure, migrate, and protect their data while reducing data storage and long-term retention costs by up to 95%. More than 1,000 organizations and managed service providers worldwide standardize on FalconStor as the foundation for their cloud first data protection future.

(b) Liquidity

As of March 31, 2023, the Company had a working capital deficiency of $0.5 million, which is inclusive of current deferred revenue of $3.6 million, and a stockholders' deficit of $17.2 million. During the three months ended March 31, 2023, the Company had net loss of $0.4 million and negative cash flow from operations of $0.1 million. The Company's total cash balance as of March 31, 2023 was $1.8 million, a decrease of $0.2 million compared to $2.0 million on December 31, 2022.

The Company’s principal sources of liquidity as of March 31, 2023 consisted of cash and future cash anticipated to be generated from operations. The Company generated negative net income and negative cash flows from operations during the three months ended March 31, 2023, and it reported negative working capital as of March 31, 2023.

The Company is currently a party to an Amended and Restated Term Loan Credit Agreement, dated as of February 23, 2018, as amended December 27, 2019, by and between the Company and HCP-FVA, LLC (“HCP-FVA”), (the “Amended and Restated Loan Agreement”). In connection with the then-proposed public offering of the Company as described in the Company's Registration Statement on Form S-1, as amended, originally filed on June 3, 2021 (the "June Offering"), we entered into a letter agreement with Hale Capital Partners, LP (“Hale Capital”), dated June 2, 2021 (the “Loan Extension Letter Agreement”), that provided for an extension of the maturity date on Hale Capital’s portion of the outstanding indebtedness owed under the Amended and Restated Loan Agreement to June 30, 2023. The remaining principal amount outstanding, which was owed to other lenders, was repaid in full. On July 19, 2022, we entered into a letter agreement with Hale Capital (the "Second Loan Extension Letter Agreement"), that provided for a subsequent extension of the maturity date on the outstanding indebtedness owed under the Amended and Restated Loan Agreement from June 30, 2023 to December 31, 2023. On February 10, 2023, the Company entered into a letter agreement with Hale Capital to further extend the maturity date of the senior secured debt to June 30, 2024 (the "Third Loan Extension Letter Agreement"). See Note (9) Notes Payable for more information.

Also, as described further in Note (12) Series A Redeemable Convertible Preferred Stock, the effective date of the mandatory redemption right of the Company's Series A Redeemable Convertible Preferred Stock (the “Series A Preferred Stock”) held by HCP-FVA and Hale Capital was extended from July 30, 2021 to July 30, 2023 pursuant to that certain Amendment No. 1 to the Amended and Restated Certificate of Designations, Preferences and Rights of Series A Convertible Preferred Stock of the Company, dated as of June 24, 2021 (as amended, the “Certificate of Designations”). On July 19, 2022, the Company and Hale Capital entered into a letter agreement pursuant to which Hale Capital agreed not to exercise or permit the exercise of the mandatory redemption right of the Series A Preferred Stock on or prior to December 31, 2023 unless the redemption is in accordance with Section 8(e)(z) of the Certificate of Designations or in accordance with a Breach Event (as defined in the Certificate of Designations). If such Series A Preferred Stock was redeemed on March 31, 2023, the Company would have been required to pay the holders of the Series A Preferred Stock $16.3 million. On February 10, 2023, the Company entered into a letter agreement with Hale Capital to further extend the redemption date of the Series A Preferred Stock to June 30, 2024.

The Company believes its current cash balances together with anticipated cash flows from operating activities will be sufficient to meet its working capital requirements for at least one year from the date the consolidated financial statements were issued.

We are subject to risks and uncertainties arising from macroeconomic and geopolitical conditions, including, but not limited to, inflation, rising interest rates, foreign currency fluctuations, lower consumer spending, geopolitical conflicts, including the conflict in the Ukraine, and continuing effects of the COVID-19 pandemic. We continuously monitor the direct and indirect impacts of these macroeconomic and geopolitical events and trends on our business and financial results.

The full extent to which these macroeconomic and geopolitical conditions impact our business is difficult to predict. Such impacts include, but are not limited to, supply chain and logistical challenges, reduced consumer demand for our products, and an industry-wide slowdown in advertising spending. The impact of COVID-19, for example, is fluid and uncertain, but it has caused and may continue to cause various negative effects, including an inability to meet with actual or potential customers, our end customers deciding to delay or abandon their planned purchases or failing to make payments, and delays or disruptions in our or our partners’ supply chains. As a result, we may experience extended sales cycles, our ability to close transactions with new and existing customers and partners may be negatively impacted, our ability to recognize revenue from software transactions we do close may be negatively impacted, our demand generation activities, and the efficiency and effect of those activities, may be negatively affected, and it has been and, until the COVID-19 outbreak is contained, will continue to be more difficult for us to forecast our operating results. These uncertainties have, and may continue to, put pressure on global economic conditions and overall IT spending and may cause our end customers to modify spending priorities or delay or abandon purchasing decisions, thereby lengthening sales cycles and potentially lowering prices for our solutions, and may make it difficult for us to forecast our sales and operating results and to make decisions about future investments, any of which could materially harm our business, operating results and financial condition.

(d) Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

(e) Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company’s significant estimates include those related to revenue recognition, accounts receivable allowances, valuation of derivatives, valuation of goodwill and income taxes. Actual results could differ from those estimates.

The financial market volatility in many countries where the Company operates has impacted and may continue to impact the Company’s business. Such conditions could have a material impact on the Company’s significant accounting estimates discussed above.

(f) Unaudited Interim Financial Information

The accompanying unaudited interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements.

In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to fairly state the financial position of the Company at March 31, 2023, and the results of its operations for the three months ended March 31, 2023 and 2022. The results of operations of any interim period are not necessarily indicative of the results of operations to be expected for the full fiscal year. These condensed consolidated

financial statements should be read in conjunction with the consolidated financial statements and notes set forth in the Company's Annual Report on Form 10-K for the year ended December 31, 2022 ("2022 Form 10-K").

(g) Recently Issued Accounting Pronouncements

In August 2020, the Financial Accounting Standards Board, or FASB, issued ASU 2020-06, regarding ASC Topic 470 “Debt” and ASC Topic 815 “Derivatives and Hedging,” which reduces the number of accounting models for convertible instruments and amends the calculation of diluted earnings per share for convertible instruments, among other changes. The guidance is effective for smaller reporting companies as defined by the SEC, for annual reporting periods beginning after December 15, 2023, including interim periods within that reporting period. Early adoption is permitted. We are currently evaluating the impact of the adoption of this standard on our consolidated financial statements.

In June 2016, the FASB issued ASU 2016-13, "Financial Instruments – Credit Losses (together with all subsequent amendments, ("Topic 326"))", which replaced the previous U.S. GAAP that required an incurred loss methodology for recognizing credit losses and delayed recognition until it was probable a loss had been incurred. Topic 326 replaced the incurred loss methodology with a methodology that reflects expected credit losses and requires consideration of reasonable and supportable information to estimate credit losses. This provision was effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years, with early adoption permitted. In February 2020, the FASB issued ASU 2020-02, "Financial Instruments—Credit Losses (Topic 326) and Leases (Topic 842)", which delayed the effective date of Topic 326 for smaller reporting companies until fiscal years beginning after December 15, 2022. The Company adopted Topic 326 effective January 1, 2023. The impact of adoption of this standard was not material on the Company’s consolidated financial statements.

(2) Summary of Significant Accounting Policies

The Company's significant accounting policies were described in Note (1) Summary of Significant Accounting Policies of the 2022 Form 10-K. There have been no significant changes in the Company's significant accounting policies since December 31, 2022. For a description of the Company's significant accounting policies refer to the 2022 Form 10-K.

Revenue from Contracts with Customers and Associated Balances

Nature of Products and Services

Licenses for on-premises software provide the customer with a right to use the software as it exists when made available to the customer. Customers may purchase perpetual licenses or subscribe to licenses, which provide customers with the same functionality and differ mainly in the duration over which the customer benefits from the software. Revenue from distinct on-premises licenses is recognized upfront at the point in time when the software is made available to the customer. Revenue allocated to software maintenance and support services is recognized ratably over the contractual support period.

Hardware products consist primarily of servers and associated components and function independently of the software products and as such are accounted for as separate performance obligations. Revenue allocated to hardware maintenance and support services is recognized ratably over the contractual support period.

Professional services are primarily related to software implementation services and associated revenue is recognized upon customer acceptance.

Contract Balances

The timing of revenue recognition may differ from the timing of invoicing to customers. The Company records a contract asset when revenue is recognized prior to invoicing, or unearned revenue when revenue is recognized subsequent to invoicing. For perpetual licenses with multi-year maintenance agreements, the Company invoices the license and generally one year of maintenance with future maintenance generally invoiced annually. For multi-year subscription licenses, the Company generally invoices customers annually at

the beginning of each annual coverage period. The Company records a contract asset related to revenue recognized for multi-year on-premises licenses as its right to payment is conditioned upon providing product support and services in future years.

As of March 31, 2023 and December 31, 2022, accounts receivable, net of allowance for doubtful accounts, was $1.8 million and $2.3 million, respectively. A provision for expected credit losses for accounts receivables and contract assets that share similar risk characteristics is recorded based on an evaluation of historical loss experience, current conditions, and reasonable and supportable forecasts. Accounts are written off when it becomes apparent that such amounts will not be collected, generally when amounts are past due by greater than nine months. Our provision for credit loss on accounts receivable was $54,869 as of March 31, 2023 and $25,720 as of December 31, 2022, respectively. As of March 31, 2023 and December 31, 2022, short and long-term contract assets, net of provision for credit loss, was $0.5 million and $0.5 million, respectively. Our provision for credit loss on contract assets was $5,112 and zero as of March 31, 2023 and December 31, 2022 , respectively.

Deferred revenue is comprised mainly of unearned revenue related maintenance and technical support on term and perpetual licenses. Maintenance and technical support revenue is recognized ratably over the coverage period. Deferred revenue also includes contracts for professional services to be performed in the future which are recognized as revenue when the Company delivers the related service pursuant to the terms of the customer arrangement.

Changes in deferred revenue were as follows:


Three Months Ended March 31, 2023
Balance at January 1, 2023	$	4,965,849
Deferral of revenue		2,293,933
Recognition of revenue		(2,268,396	)
Change in reserves		567
Balance at March 31, 2023	$	4,991,953

During the three months ended March 31, 2023 and 2022, revenue of $1.3 million and $1.4 million respectively, was recognized from the deferred revenue balance at the beginning of each period.

Deferred revenue includes invoiced revenue allocated to remaining performance obligations that has not yet been recognized and will be recognized as revenue in future periods. Deferred revenue was $5.0 million as of March 31, 2023, of which the Company expects to recognize approximately 72% of such amount as revenue over the next 12 months and the remainder thereafter.

Approximately $1.6 million of revenue is expected to be recognized from remaining performance obligations for unbilled support and services as of March 31, 2023. We expect to recognize revenue on approximately 39% of these remaining performance obligations over the next twelve months, with the balance recognized thereafter.

Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 90 days. In instances where the timing of revenue recognition differs from the timing of invoicing, the Company has determined that its contracts generally do not include a significant financing component. The primary purpose of the Company’s invoicing terms is to provide customers with simplified and predictable ways of purchasing its products and services, and not to receive financing from our customers or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with maintenance and support revenue recognized ratably over the contract period, and multi-year, on-premises licenses that are invoiced annually with product revenue recognized upon delivery.

Significant Judgments

The Company’s contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment.

Judgment is required to determine the standalone selling price (“SSP”) for each distinct performance obligation. For products and services aside from maintenance and support, the Company estimates SSP by adjusting the list price by historical discount percentages.

SSP for software and hardware maintenance and support fees is based on the stated percentages of the fees charged for the respective products.

The Company’s perpetual and term software licenses have significant standalone functionality and therefore revenue allocated to these performance obligations are recognized at a point in time upon electronic delivery of the download link and the license keys.

Product maintenance and support services are satisfied over time as they are stand-ready obligations throughout the support period. As a result, revenues associated with maintenance services are deferred and recognized as revenue ratably over the term of the contract.

Revenues associated with professional services are recognized at a point in time upon customer acceptance.

Disaggregation of Revenue

Please refer to the condensed consolidated statements of operations and Note (16) Segment Reporting and Concentrations for discussion on revenue disaggregation by product type and by geography. The Company believes this level of disaggregation sufficiently depicts how the nature, amount, timing and uncertainty of our revenue and cash flows are affected by economic factors.

Assets Recognized from Costs to Obtain a Contract with a Customer

The Company recognizes an asset for the incremental costs of obtaining a contract with a customer if it expects the benefit of those costs to be longer than one year. The Company has determined that its sales commission program meets the requirements for cost capitalization. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in other current and long-term assets on our consolidated balance sheets. The Company applies a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less.

Leases

We have entered into operating leases for our various facilities. We determine if an arrangement is a lease at inception. Operating leases are included in Right-of-Use ("ROU") assets, and lease liability obligations in our condensed consolidated balance sheets. ROU assets represent our right to use an underlying asset for the lease term and lease liability obligations represent our obligation to make lease payments arising from the lease. ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. We have lease agreements with lease and non-lease components and account for such components as a single lease component. As most of our leases do not provide an implicit rate, we estimated our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. We use the implicit rate when readily determinable. The ROU asset also includes any lease payments made and excludes lease incentives and lease direct costs. Our lease terms may include options to extend or terminate the lease. Such extended terms have been considered in determining the ROU assets and lease liability obligations when it is reasonably certain that we will exercise that option. Lease expense is recognized on a straight-line basis over the lease term.

Right of Use Assets and Liabilities

We have various operating leases for office facilities that are expected to continue through 2023. Below is a summary of our ROU assets and liabilities as of March 31, 2023.


Right of use assets	$	17,370
Lease liability obligations, current		17,370
Lease liability obligations, less current portion		—
Total lease liability obligations	$	17,370
Weighted-average remaining lease term	0.25
Weighted-average discount rate		3.35	%


	Three Months Ended March 31,
	2023		2022
Components of lease expense:
Operating lease cost	$	33,118	$	32,094
Sublease income		—		—
Net lease cost	$	33,118	$	32,094

During the three months ended March 31, 2023, operating cash flows from operating leases were approximately $17,467.

Approximate future minimum lease payments for our ROU assets over the remaining lease periods as of March 31, 2023, are as follows:


2023 (remaining)	$	17,467
2024		—
Total minimum lease payments	$	17,467
Less interest


Delaware	77-0216135
( State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
501 Congress Avenue, Suite 150
Austin, TX	78701
(Address of principal executive offices)	(Zip Code)


Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common stock, $0.001 Par Value	FALC	OTCQB


		Page
PART I.	Financial Information	3

Item 1.	Financial Statements	3

	Condensed Consolidated Balance Sheets at March 31, 2023 (unaudited) and December 31, 2022	3

	Unaudited Condensed Consolidated Statements of Operations for the three months ended March 31, 2023 and 2022	4

	Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss) for the three months ended March 31, 2023 and 2022	5

	Unaudited Condensed Consolidated Statements of Stockholders' Deficit for the three months ended March 31, 2023 and 2022	6

	Unaudited Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2023 and 2022	8

	Notes to the Unaudited Condensed Consolidated Financial Statements	9

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	33

Item 4.	Controls and Procedures	33

PART II.	Other Information	34

Item 1.	Legal Proceedings	34

Item 1A.	Risk Factors	34

Item 2	Unregistered Sales of Equity Securities and use of Proceeds	35

Item 3	Defaults Upon Senior Securities	35

Item 4	Mine Safety Disclosures	35

Item 5	Other Information	35

Item 6.	Exhibits	36

SIGNATURES		37


	March 31, 2023			December 31, 2022
	(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	1,839,227		$	2,011,062
Accounts receivable, net		1,790,174			2,278,802
Prepaid expenses and other current assets		1,033,747			897,493
Contract assets, net		247,451			181,933
Total current assets		4,910,599			5,369,290
Property and equipment, net		78,126			86,263
Operating lease right-of-use assets, net		17,370			34,416
Software development costs, net		46,001			53,057
Other assets		37,741			98,747
Goodwill		4,150,339			4,150,339
Other intangible assets, net		13,285			20,086
Long-term contract assets, net		263,768			357,914
Total assets	$	9,517,229		$	10,170,112
Liabilities and Stockholders' Deficit
Current liabilities:
Accounts payable	$	436,711		$	387,379
Accrued expenses		1,220,138			1,427,979
Current portion of lease liabilities		17,370			34,416
Short-term note payable		101,227			177,149
Deferred revenue		3,589,822			3,684,742
Total current liabilities		5,365,268			5,711,665
Other long-term liabilities		956,267			956,023
Notes payable, net of debt issuance costs and discounts		2,165,874			2,163,090
Deferred tax liabilities		537,766			537,651
Deferred revenue, net of current portion		1,402,131			1,281,107
Total liabilities		10,427,306			10,649,536
Commitments and contingencies (Note 11)
Series A redeemable convertible preferred stock, $.001 par value, 2,000,000 shares authorized, 900,000 shares issued and outstanding, redemption value of $16,299,546 and $15,984,331, respectively		16,253,084			15,928,018
Stockholders' deficit:
Common stock, $.001 par value, 30,000,000 shares authorized, 7,122,199 shares and 7,118,609 shares issued and outstanding, respectively		7,122			7,119
Additional paid-in capital		110,524,978			110,844,716
Accumulated deficit		(125,954,948	)		(125,507,178	)
Accumulated other comprehensive loss		(1,740,313	)		(1,752,099	)
Total stockholders' deficit		(17,163,161	)		(16,407,442	)
Total liabilities and stockholders' deficit	$	9,517,229		$	10,170,112


	Three Months Ended March 31,
	2023			2022
Revenue:
Product revenue	$	1,022,186		$	594,928
Support and services revenue		1,246,210			1,454,179
Total revenue		2,268,396			2,049,107
Cost of revenue:
Product		34,129			20,719
Support and service		341,188			394,549
Total cost of revenue		375,317			415,268
Gross profit	$	1,893,079		$	1,633,839
Operating expenses:
Research and development costs		618,527			705,981
Selling and marketing		802,566			1,189,846
General and administrative		892,654			849,939
Restructuring costs		—			744
Total operating expenses		2,313,747			2,746,510
Operating income (loss)		(420,668	)		(1,112,671	)
Interest and other expense		(79,863	)		(117,995	)
Income (loss) before income taxes		(500,531	)		(1,230,666	)
Income tax expense (benefit)		(52,761	)		(121,260	)
Net income (loss)	$	(447,770	)	$	(1,109,406	)
Less: Accrual of Series A redeemable convertible preferred stock dividends		315,215			300,921
Less: Accretion to redemption value of Series A redeemable convertible preferred stock		9,851			14,815
Net income (loss) attributable to common stockholders	$	(772,836	)	$	(1,425,142	)
Basic net income (loss) per share attributable to common stockholders	$	(0.11	)	$	(0.20	)
Diluted net income (loss) per share attributable to common stockholders	$	(0.11	)	$	(0.20	)
Weighted average basic shares outstanding		7,119,735			7,082,276
Weighted average diluted shares outstanding		7,119,735			7,082,276


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


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


Large accelerated filer	☐	Accelerated filer	☐
Non-accelerated filer	☒	Smaller reporting company	☒
Emerging growth company	☐


	Common Stock Outstanding		Common Stock		Additional Paid-In Capital			Accumulated Deficit			Accumulated Other Comprehensive Loss, Net			Total Stockholders' Deficit
Balance at January 1, 2023		7,118,609	$	7,119	$	110,844,716		$	(125,507,178	)	$	(1,752,099	)	$	(16,407,442	)
Net income (loss)									(447,770	)					(447,770	)
Share-based compensation to employees						5,331									5,331
Shares issued in connection with vesting of restricted stock		3,590		3		(3	)								—
Accretion of Series A redeemable convertible preferred stock						(9,851	)								(9,851	)
Dividends on Series A redeemable convertible preferred stock						(315,215	)								(315,215	)
Foreign currency translation												11,786			11,786
Balance at March 31, 2023		7,122,199		7,122		110,524,978			(125,954,948	)		(1,740,313	)		(17,163,161	)