Item 1A. Risk Factors
The following are the significant factors that could materially adversely
affect our business, financial condition, or operating results, as well as adversely affect the value of an investment in our common stock.
The risks described below are not the only risks facing our Company. Risks and uncertainties not currently known to us or that we currently
deem to be immaterial also may materially adversely affect our business, financial condition and operating results.
Risks Related to Our Financial Position and Liquidity
The Company’s ability to
implement its current business plan will be dependent on our ability to raise additional funds through additional public or private financings,
which raises the possibility that the Company may not be able to continue as a going concern.
The significant expense of the product launch
combined with minimal sales of the INTRUSION Shield in 2021 has strained the Company’s capital resources and caused
significant doubt about our ability to continue our current operations as a going concern. In order to finance our operations and to continue
as a going concern, we believe it will be necessary for us to raise additional funds through public or private financings, including through
the utilization of our at-the-market program. We can provide no assurances that we will be able to raise additional funds through any
future equity or debt financings, and the terms of those financings, if available at all, may be on terms, which are not favorable to
us and, in the case of equity financings, will result in dilution to our stockholders.
We are subject to certain contractual and regulatory limitations on our ability to consummate future financings.
Pursuant to that certain securities purchase agreement
we entered into in March 2022 in connection with the issuance of a promissory note to Streeterville Capital, LLC, we agreed to be subject
to certain restrictions on our ability to issue securities during the term of the notes issued under the agreement. Specifically, we
agreed to obtain Streeterville Capital’s consent prior to issuing any debt securities or certain equity securities where the pricing
of such equity securities is tied to the public trading price of our common stock. Furthermore, we also must offer Streeterville with
the right to purchase up to 10% of future equity and debt securities offerings, subject to certain exceptions and limitations, in each
case during the term of any note issued to Streeterville.
Furthermore, unless our public float exceeds $75
million, we will be subject to the restrictions set forth in General Instruction I.B.6 to Form S-3 that limit our ability to conduct
primary offerings under a Form S-3 registration statement, like issuances under our at-the-market program. Under such limitations, we
may not sell, during any 12-month period, securities on Form S-3 having an aggregate market value of more than one-third of our public
float. As of March 9, 2022, our public float calculated in accordance with General Instruction I.B.6 of Form S-3 was $69.1 million. These
restrictions may delay or prevent us from entering into funding arrangements or being able to access the capital markets, including under
our at-the-market program, on favorable terms or at all.
We may be unable to generate sufficient cash to service the cash
portion of our indebtedness under the March 2022 convertible notes.
Our ability to make scheduled payments on or
to refinance our indebtedness and financial commitments to the noteholder under the convertible notes issued under our March 2022 securities
purchase agreement depends on our financial condition and operating performance, which are subject to prevailing economic and competitive
conditions including financial, business and other factors beyond our control. We may be unable to generate sufficient cash flow to permit
us to pay the principal, premium, if any, and interest on that indebtedness which would have a material adverse effect on our financial
condition and results of operations.
The terms of our March 2022 securities purchase agreement contain
significant obligations and limitations that could restrict our right to enter into transactions that would otherwise be favorable to
our stockholders.
Our debt agreements contain a number of significant
covenants, including the obligations to not issue debt securities or certain equity securities where the pricing of such equity securities
is tied to the public trading price of the Common Stock, in each case, without the noteholder’s prior consent, and offer the noteholder
the right to purchase up to 10% of future equity and debt securities offerings, subject to certain exceptions and limitations. These obligations
and limitations may limit our ability to enter into certain, corporate, financing, operational or capital raising transactions.
If we fail to comply with the restrictions
and covenants in our March 2022 securities purchase agreement, there could be an event of default under the convertible notes issued thereunder,
which could result in an acceleration of payments due under those notes and other consequences.
Failure to meet the restrictions, obligations,
and limitations under the March 2022 securities purchase agreement may result in an event of default in accordance with the terms of the
convertible notes issued thereunder. An event of default would, among other things, provide the noteholder with the right to increase
the outstanding balance by 15% for certain major events of default and 5% for others. Additionally, upon an event of default, the noteholder
may consider the convertible note immediately due and payable. Furthermore, upon an event of default, the interest rate may also be increased
to the lesser of 18% per annum or the maximum rate permitted under applicable law.
The redemption feature under our March 2022
convertible notes is dependent upon the market value of our common stock, which could result in significant dilution to our existing stockholders.
The noteholder will have the right to redeem up
to $500,000 of the outstanding balance of such note per month after the notes have been issued for six months. While we have the option
to make such payments in either (a) cash, (b) by paying the redemption amount in the form of shares of common ctock with the number of
redemption shares being equal to the portion of the applicable redemption amount divided by the redemption conversion price or (c) a combination
of cash and shares of common stock. Since the redemption conversion price will be equal 85% multiplied by the average of the two lowest
daily volume weighted average prices per share of the common stock during the 15 trading days immediately preceding the date that the
noteholder delivers notice electing to redeem a portion of the note, the number of shares to be issued by us in satisfaction of this redemption
will vary, perhaps considerably. A reduction in our trading value could cause us to issue a greater number of shares under a redemption
notice and therefore increase the dilutive effect to other stockholders.
We must increase revenue levels in order to finance
our current operations and to implement our business strategies.
For the year ended December
31, 2021, we had a net loss of $18.8 million and had an accumulated deficit of approximately $80.1 million as of December 31, 2021, compared
to a net loss of $6.5 million for the year ended December 31, 2020, and an accumulated deficit of approximately $61.3 million at December
31, 2020. We need to increase current revenue levels from the sales of our solutions if we are to regain profitability. If we are unable
to increase revenue levels, losses could continue for the near term and possibly longer, and we may not regain profitability or generate
positive cash flow from operations in the future.
Risks Related to Ongoing and Potential Litigation.
We are currently a defendant in
class action lawsuits alleging violations of the federal securities laws, which will potentially divert the attention of our management
and board of directors, require significant legal expenditures in the defense of such suit, as well as possibly result in financial liability
should we be unsuccessful in the defense of these claims.
We are in the preliminary stages of defending
class action lawsuits alleging that we have committed violations of federal securities laws and regulations. While the exact nature
of these claims is not capable of being determined at this time, we will be expending time, personnel, and financial
resources in our defense of these suits. Even if successful, these suits may not be resolved for a considerable period of time,
during which these limited resources will be deployed and lingering uncertainty may persist in the ultimate culpability, if any, of
the Company in connection with these allegations. The effect of these lawsuits during their pendency will have a negative effect on
our cash flow, contribute to our liquidity challenges over the near term, and may ultimately affect our ability to operate our
business.
Business and Operational Risks
Most of our current revenues are generated
from one family of solutions with a limited number of customers, and the decrease of revenue from sales of this family of solutions could
materially harm our business and prospects.
Approximately 86.9% of our
existing revenues result from sales of TraceCop a cybersecurity solution. TraceCop revenues were $6.3 million
for the year ended December 31, 2021, compared to $6.2 million for the year ended December 31, 2020. While we anticipate the continued
introduction of our new INTRUSION Shield solution will reduce our dependence on this single solution, we can offer no assurances
as such, and in the absence of a shift in solution mix, we may continue to face risks in the event that sales of this key solution to
these limited customers were to decrease.
We may be unable to successfully market, promote,
and sell our new commercial solution, INTRUSION Shield, and market it through new sales channels to a new set of prospective customers.
We have expended significant resources and anticipate
continuing to expend significant resources launching our new INTRUSION Shield solution, including the time, attention,
and focus of our senior management and our research and development team, coordination of new marketing strategies highlighting this
new offering and promoting it through new and expanded sales channels to a wider audience of prospective customers than we have historically
marketed and sold our solutions and services. Even if we have sufficient capital to expend on these initiatives, supporting our INTRUSION
Shield products may divert resources from other critical operational areas and further strain our liquidity.
We may not be successful in our current efforts to
broaden the marketing and sale of the INTRUSION Shield.
We believe that we must expand our sales and marketing
efforts in order for INTRUSION Shield to achieve marketplace acceptance and to generate revenue for the Company. However,
these efforts depend, in large part, on the success of our channel partners as they market and sell INTRUSION Shield, which
may not be successful. Further, our new efforts in forging meaningful relationships with seasoned and well positioned strategic partners
may not yield meaningful results, and any and all such efforts will need to be accomplished despite certain public remarks and comments
that have been made on social media and web-based platforms as well as statements and allegations that have been, and will continue to
be, advanced in the various pleadings that are publicly filed with the courts. If we are unsuccessful in our efforts to leverage channel
and strategic partners and to counter negative public statements, we may not be able to generate sufficient revenue from INTRUSION
Shield to improve the Company’s financial position, results of operations, and cash flow position.
Our efforts to provide a cloud-based delivery system
for INTRUSION Shield may not be successful or attractive to our current and potential clients.
We are expending significant research and development
resources in order to be able to provide the INTRUSION Shield to customers in a cloud-based environment without the requirement
for complementary hardware to be deployed and installed on a customer’s information platforms. If this alternate product deployment
is not achieved, achieved at too great an expense, or does not provide the added incentive to retain and to attract INTRUSION Shield
customers, we may not be able to generate sufficient revenue to justify the expense or to significantly contribute to our revenues, which
could in turn have a negative effect on our financial position, results of operations, and our cash flow position.
The current geo-political climate may add uncertainty
in the dealings of our customers and could cause them to delay indefinitely certain cyber-security initiatives or to determine not to
introduce or implement any new or innovative cyber-solution products into their information networks.
Current events in Eastern Europe and Russia have introduced
a significant level of uncertainty in the dealings of our current and potential customers that could cause them to be hesitant to implement
new cyber-security initiatives regardless of the efficacy of our INTRUSION Shield product. Further, these entities may also
determine not to deploy their cash reserves in the face of such uncertainty. These uncertainties could depress the interest or the ability
of companies and governmental entities to test, evaluate, and deploy our INTRUSION Shield in their network environments.
The effect of the coronavirus, particularly in the
diversion of time and resources of the federal, state, and local governmental entities which make up a significant concentration of our
customer base have caused, and may continue to cause, material adverse effects on our operations and our financial results.
A significant concentration of our federal, state,
and local governmental customers have been forced to allocate scarce and competing resources and balance budgetary demands placed upon
them as a result of the effects of the coronavirus, mandatory quarantines, decreased travel, interruptions in workforce populations,
scarcity of commodities, and similar economic and operational effects of the virus upon their own constituencies. Considerable uncertainties
continue with respect to the spread and containment of the pandemic, including, without limitation, the effects of mutations in the virus
and the efficacy of vaccination efforts throughout the country and the world. These adverse effects have resulted in decreased demand
by some of our customers for our current product offerings and cybersecurity solutions, negatively affecting historic revenue levels
for the Company. A continued decrease in orders for our solutions by our government customers and losses of efficiency or diversions
of resources in our own operations may continue to cause material adverse effect on our operations and financial results.
Scarcity of products and materials in the supply
chain could hinder or prevent the deployment of our INTRUSION Shield for our customers who elect to use the wired version of our
solution.
Supply chain interruptions have become frequent
in light of the lingering commercial effects of COVID and its related variants. Should any of the component parts required for the hardware
interface our customers use to access and to utilize the INTRUSION Shield product, we may have to delay or cancel our fulfillment
of orders that could defer potential revenues or even result in customer cancellations, which would have a negative effect on our financial
position and results of operations.
A large percentage of our current revenues are received
from U.S. government entities, and the loss of these customers or our failure to widen the scope of our customer base to include general
commercial enterprises could negatively affect our revenues.
A large percentage of our current revenues result
from sales to U.S. government entities. If we were to lose one or more of these customers, our revenues could decline and our business
and prospects may be materially harmed. Further, sales to the government present risks in addition to those involved in sales to commercial
customers, including potential disruption due to appropriation and spending patterns, delays in approving a federal budget and the government’s
right to cancel contracts and purchase orders for its convenience. While we expect that developing relationships with non-governmental
customers will mitigate or eliminate this dependence on, and risk from, serving governmental entities, we can offer no assurances that
we will be able to sufficiently diversify our customer portfolio in a time and manner to adequately mitigate this risk.
We are highly dependent on sales of our current solutions
through indirect channels, the loss of which would materially adversely affect our operations.
For the years ended December 31, 2021 and 2020,
we derived 37.5% and 49.3% of our revenues from sales through indirect sales channels, such as distributors, value-added resellers, system
integrators, original equipment manufacturers and managed service providers. We must expand sales of our current solutions as well as
any new solutions, such as INTRUSION Shield, through these indirect channels in order to increase our revenues. We cannot
assure you that our current solutions or future solutions will gain market acceptance in these indirect sales channels or that sales through
these indirect sales channels will increase our revenues. Further, many of our competitors are also trying to sell their products and
solutions through these indirect sales channels, which could result in lower prices and reduced profit margins for sales of our solutions.
Our business depends on the continued
service of our key management and technical personnel.
Our success depends upon the continued contributions
of our key management, sales, marketing, research and development and operational personnel, including Anthony Scott, our recently appointed
President and Chief Executive Officer; T. Joe Head, our Chief Technology Officer; Franklin Byrd, our Chief Financial Officer; and other
key technical personnel. The loss of the services of one or more of our key employees in the future could have a material adverse effect
on our operating results. We also believe our future success will depend upon our ability to attract and retain additional highly skilled
management, technical, marketing, research and development, and operational personnel with experience in managing large and rapidly changing
companies, as well as training, motivating and supervising employees. The market for hiring and retaining certain technical personnel,
including software engineers, has become more competitive and intense in recent years. Failure to attract and retain a sufficient number
of qualified technical personnel, including software engineers, or retain our key personnel could have a material adverse effect on our
operating results.
We may experience volatility in
our workforce and be unable to attract employees in the future as a result of our recent reduction in force.
On July 29, 2021, the Company executed a planned
reduction in force resulting in the termination of approximately 20% of its employees. Following this reduction in force, a number of
additional employees resigned, were terminated, or had their positions eliminated. As a result of these recent events, we may be unable
to retain our current employees and be unable to attract new employees in the future, which would have a negative effect on the implementation
of our operations.
We could experience damage to our reputation in the cybersecurity
industry in the event that our INTRUSION Shield solution fails to meet our customers’ needs or to achieve market acceptance.
Our reputation in the industry may be harmed,
perhaps significantly, in the event that INTRUSION Shield fails to perform as we expect it to. If INTRUSION Shield
does not perform as we expect, if we experience delivery delays, or if our customers do not perceive the benefits of purchasing and using
INTRUSION Shield as part of their comprehensive cybersecurity solution, our position as a leader in this technology space
may be damaged and could affect the willingness of our customers, as well as potential customers, to purchase our other solutions that
function separately from INTRUSION Shield. Any reputational damage could result in a decrease in orders for all of our solutions,
the loss of current customers, and a decrease in our overall revenues which could in turn have a material adverse effect on our results
of operations.
If we fail to respond to rapid technological changes in
the network security industry, we may lose customers or our solutions may become obsolete.
The network security industry is characterized
by frequent product and service introductions, rapidly changing technology and continued evolution of new industry standards. We have
and must continue to introduce upgrades to our current solutions rapidly in response to customer needs such as new computer viruses or
other novel external attacks on computer networks. Further, our new INTRUSION Shield solution represents our efforts to
continue to provide state-of-the art first-in-time innovation for our customer’s cybersecurity solutions. As a result, our success
depends upon our ability to develop and introduce timely upgrades, enhancements, and new solutions to meet evolving customer requirements
and industry standards. The development of technologically advanced network security products and solutions is a complex and uncertain
process requiring high levels of innovation, rapid response, and accurate anticipation of technological and market trends. We cannot assure
you that we will be able to identify, develop, manufacture, market or support new or enhanced solutions successfully in a timely manner.
Further, we or our competitors may introduce new solutions or enhancements that shorten the life cycle of our existing solutions or cause
our existing solutions to become obsolete.
We must expend time and resources addressing potential cybersecurity
risk, and any breach of our information security safeguards could have a material adverse effect on the Company.
The threat of cyber-attacks requires additional
time and money to be expended in efforts to prevent any breaches of our information security protocols. However, we can provide no assurances
that we can prevent all such attempts from being successful, which could result in expenses to address and remediate such breaches as
well as potentially losing the confidence of our customers who depend upon our services to prevent and mitigate such attacks on their
respective business. Should a material breach of our information security systems occur, it would likely have a material adverse impact
on our business operations, our customer relations, and our current and future sales prospects, resulting in a significant loss of revenue.
A breach of network security could harm public perception
of our cybersecurity solutions, which could cause us to lose revenues.
If an actual or perceived breach of network security
occurs in the network of a customer of our cybersecurity solutions, regardless of whether the breach is attributable to our solutions,
the market perception of the effectiveness of our solutions could be harmed. This could cause us to lose current and potential end customers
or cause us to lose current and potential value-added resellers and distributors. Because the techniques used by computer hackers to
access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate
these techniques.
If our solutions do not interoperate with our customers’
networks, installations will be delayed or cancelled and could harm our business.
Our solutions are designed to interface with our customers’ existing
networks, each of which have different specifications and utilize multiple protocol standards and products or solutions from other vendors.
Many of our customers’ networks contain multiple generations of products that have been added over time as these networks have grown
and evolved. Our solutions will be required to interoperate with many products and solutions within these networks as well as future products
or solutions in order to meet our customers’ requirements. If we find errors in the existing software or defects in the hardware
used in our customers’ networks, we may have to modify our software or hardware to fix or overcome these errors so that our solutions
will interoperate and scale with the existing software and hardware, which could be costly and negatively impact our operating results.
In addition, if our solutions do not interoperate with those of our customers’ networks, demand for our solutions could be adversely
affected, orders for our solutions could be cancelled, or our solutions could be returned. This could hurt our operating results, damage
our reputation and seriously harm our business and prospects.
We face intense competition from both start-up and
established companies that may have significant advantages over us and our solutions.
The market for our solutions is intensely competitive.
There are numerous companies competing with us in various segments of the data security markets, and their products or solutions may have
advantages over our solutions in areas such as conformity to existing and emerging industry standards, interoperability with networking
and other cybersecurity products, management and security capabilities, performance, price, ease of use, scalability, reliability, flexibility,
features, and technical support.
Our principal competitors in the data mining and
advanced persistent threat market include Niksun, NetScout, FireEye, and Darktrace. Our current and potential competitors may have one
or more of the following significant advantages over us:
· greater financial, technical and marketing resources;
· better name recognition;
· more comprehensive security solutions;
· better or more extensive cooperative relationships; and
· larger customer base.
We cannot assure you that we will be able to compete
successfully with our existing or new competitors. Some of our competitors may have, in relation to us, one or more of the following:
· longer operating histories;
· longer-standing relationships with OEM and end-user customers; and
· greater customer service, public relations and other resources.
As a result, these competitors may be able to
more quickly develop or adapt to new or emerging technologies and changes in customer requirements, or devote greater resources to the
development, promotion and sale of their products or solutions. Additionally, it is likely that new competitors or alliances among existing
competitors could emerge and rapidly acquire significant market share.
Investment Risks
Our management and larger stockholders currently exercise
significant control over our Company and such influence may be in conflict to your interests.
As of March 9, 2022, our executive
officers and directors beneficially own approximately 8.7% of our voting power. In addition, other related affiliate parties control
approximately 5.3% of voting power. As a result, these stockholders have been able to exercise significant control over all matters
requiring stockholder approval, including the election of directors and approval of significant corporate transactions. Although we
follow our policies regarding related party transactions, we cannot entirely eliminate the influence of these stockholders as long
as they hold such a concentration of the voting power of our common stock.
We have experienced recent volatility
in the market for our common stock, particularly with respect to significant swings in the market price as well as significant volume
in the trading of our common stock.
We have experienced extreme shifts in the market
value of our common stock as it trades on the Nasdaq Capital Market as well significant increases in the trading volume of our shares
on that market. For example, the market price of our common stock fluctuated between $3.05 and $29.90 during the twelve months ended
December 31, 2021. These fluctuations may result in a hesitancy for investors to purchase and hold shares of our common stock, continued
depression of the market value of our stock, and ultimately negatively affect our ability to raise capital through the issuance and sale
of our common stock, particularly through our at-the-market program or otherwise.
Risks Related to our Intellectual Property
We must adequately protect our intellectual property
in order to prevent loss of valuable proprietary information.
We rely primarily on a combination of patent,
copyright, trademark and trade secret laws, confidentiality procedures, and non-disclosure agreements to protect our proprietary technology.
However, unauthorized parties may attempt to copy or reverse engineer aspects of our solutions or to obtain and use information that
we regard as proprietary. Policing unauthorized use of our solutions is difficult, and we cannot be certain that the steps we have taken
will prevent misappropriation of our intellectual property. This is particularly true in foreign countries whose laws may not protect
proprietary rights to the same extent as the laws of the United States and may not provide us with an effective remedy against unauthorized
use. If protection of our intellectual property proves to be inadequate or unenforceable, others may be able to use our proprietary developments
without compensation to us, resulting in potential cost advantages to our competitors.
We may incur substantial expenses defending ourselves against
claims of infringement.
There are numerous patents held by many companies
relating to the design and manufacture of network security systems. Third parties may claim that our solutions infringe on their intellectual
property rights. Any claim, with or without merit, could consume our management’s time, result in costly litigation, cause delays
in sales or implementations of our solutions or require us to enter into royalty or licensing agreements. Royalty and licensing agreements,
if required and available, may be on terms unacceptable to us or detrimental to our business. Moreover, a successful claim of product
infringement against us or our failure or inability to license the infringed or similar technology on commercially reasonable terms could
seriously harm our business.
Our solutions are highly technical and if they contain
undetected errors, our business could be adversely affected, and we might have to defend lawsuits or pay damages in connection with any
alleged or actual failure of our solutions and services.
Our solutions are highly technical and complex,
are critical to the operation of many networks and, in the case of ours, provide and monitor network security and may protect valuable
information. Our solutions have contained and may contain one or more undetected errors, defects or security vulnerabilities. Some errors
in our solutions may only be discovered after a solution has been installed and used by end customers. Any errors or security vulnerabilities
discovered in our solutions after commercial release could result in loss of revenues or delay in revenue recognition, loss of customers
and increased service and warranty cost, any of which could adversely affect our business and results of operations. In addition, we could
face claims for product liability, tort, or breach of warranty. Defending a lawsuit, regardless of its merit, is costly and may divert
management’s attention. In addition, if our business liability insurance coverage is inadequate or future coverage is unavailable
on acceptable terms or at all, our financial condition could be harmed.
Item 2. Properties
Our corporate headquarters are currently located
in 17,250 square feet of space at 101 East Park Blvd, Suite 1200, Plano Texas. This facility houses our corporate administration, engineering,
sales, and marketing operations. The lease for this facility extends until November 2023. The Company vacated its previous space in Richardson,
Texas beginning in the fourth quarter of 2020. The lease for the 23,000 square foot Richardson facility initially extended through November
2024 and is the subject of a lawsuit the Company filed against the landlord on February 16, 2021. We have charged this landlord with breach
of contract, constructive eviction, and we have requested a declaratory judgment relieving us of any further payment obligations under
this lease. The landlord has denied our claims and responded with a counterclaim seeking alleged past due rent. (See Item 3 – Legal
Proceedings)
For a variety of reasons, the Company began encouraging
its engineers and analysts to work remotely beginning in fourth quarter 2020, and we currently have engineers and other employees working
remotely in Texas as well as several other US States.
We believe that the existing facilities will be
adequate to meet our operational requirements through 2022, although we periodically review our leased space to in order to ensure such
space is secure and suitable for our current and future needs. We believe that all such facilities are adequately covered by appropriate
property insurance. See Note 8 – Right-of-use Asset and Leasing Liabilities to our Consolidated Financial Statements for
additional information regarding our obligations under leases.
Item 3. Legal Proceedings.
On February 16, 2021, Intrusion Inc. instituted
legal proceedings in the District Court of Dallas County, Texas, 14th Judicial District against Purple Plaza LLC, the landlord for the
facilities we previously occupied in Richardson, Texas. This lawsuit claims damages for breach of contract for, among other things, failure
to maintain and repair the leased facilities and to provide adequate heating, air conditioning and ventilation on the premises, resulting
in a constructive eviction. Intrusion is seeking damages in excess of $1,000,000 together with a declaratory judgment that any of Intrusion’s
remaining obligations under the lease have terminated. Purple Plaza, LLC has answered by filing a general denial, and recently
added a counterclaim seeking alleged past due rent in the amount of approximately $229,000 and future rent allegedly exceeding $2,000,000
without offsetting its duty to mitigate its damages. Discovery is underway in the matter. The case is set for jury trial on June 7, 2022.
On April 16, 2021, a purported class action lawsuit
was filed in the United States District Court, Eastern District of Texas, Sherman Division, captioned Celeste v. Intrusion Inc. et al.,
Case No. 4:21-cv-00307 (E.D.Tex) against the Company, the Company’s chief financial officer, and now-former chief executive officer
alleging, among other things, that the defendants made false and/or misleading statements or omissions about the Company’s business,
operations, and prospects in violation of Section 10(b) of the Exchange Act ,
and Rule 10b-5 promulgated thereunder, as well as Section 20(a) of the Exchange Act. The Celeste lawsuit claims compensatory damages and
legal fees.
On May 14, 2021, a related purported class action
lawsuit was filed in the United States District Court, Eastern District of Texas, Sherman Division, captioned Neely v. Intrusion Inc.,
et al., Case No. 4:12-cv-00374 (E.D. Tex.) against the Company, the Company’s chief financial officer, and now-former chief executive
officer. The Neely lawsuit alleges the same violations under the federal securities laws as those alleged in the Celeste lawsuit. The
Neely lawsuit also seeks compensatory damages and legal fees.
On
November 23, 2021, the Court consolidated the Celeste and Neely actions, and appointed a lead plaintiff and lead plaintiff’s counsel.
The lead plaintiff filed his amended complaint on February 7, 2022, which named as additional defendants current and former officers and
directors of the Company James Gero, T. Joe Head, Gary Davis, and Michael Paxton. The Company’s current deadline to respond to the
amended complaint is June 9, 2022. Our management believes the claims in the lawsuit are without merit and intends to defend our
position vigorously.
On August 8, 2021, the Company received a notification
from the Securities and Exchange Commission, Division of Enforcement, that it was conducting an investigation captioned In the Matter
of Intrusion Inc. and requesting the Company produce certain documents and information. On November 9, 2021, the Securities and Exchange
Commission served a subpoena on the Company in connection with this investigation which formally requested substantially similar information
as in the prior request. The Company is continuing to comply with the requests and is cooperating in the investigation. The Company can
offer no assurances as to the outcome of this investigation or its potential effect on the Company or its results of operations.
In addition to this pending litigation, we are
subject to various other legal proceedings and claims that may arise in the ordinary course of business. We do not believe that any claims
exist where the outcome of such matters would have a material adverse effect on our consolidated financial position, operating results
or cash flows. However, there can be no assurance such legal proceedings will not have a material impact on future results.
PART II
Item 5. Market for Common Equity and Related
Stockholder Matters and Business Issuer Purchases of Equity Securities. – Intrusion Equity Accounting
Our common stock trades on the Nasdaq Capital
Market, where it is currently listed under the symbol “INTZ.” As of March 9, 2022, there were approximately 86 registered
holders of record of our common stock. The Company does not have a history of paying dividends on its common stock and has no present
intention to declare any dividends in the foreseeable future.
All equity compensation plans under which our
common stock is reserved for issuance have previously been approved by our stockholders. The following table provides summary information
as of December 31, 2021, for all of our equity compensation plans (in thousands, except per share data). See Note 10 – Employee
Incentive Plans to our consolidated financial statements for additional discussion.
Equity compensation plans not approved by security holders – – – – –
__________________
Item 7.Management’s Discussion
and Analysis of Financial Condition and Results of Operations.
General
The following discussion and analysis includes
information management believes is relevant to understand and assess our consolidated financial condition and results of operations. This
section should be read in conjunction with our consolidated financial statements, accompanying notes and the risk factors contained in
this report.
Overview
Intrusion Inc. offers businesses of all sizes
and industries products and services that leverage across our exclusive threat intelligence database which contains the historical data,
known associations, and reputational behavior of over 8.5 billion IP addresses. After many years of gathering intelligence and providing
our INTRUSION TraceCop and Savant solutions exclusively to government entities, we released our first commercial
product in 2021, the INTRUSION Shield. INTRUSION Shield was designed to allow businesses to incorporate a
Zero Trust, reputation-based security solution into their existing infrastructure and to observe traffic flow and instantly block known
malicious or unknown connections from both entering or exiting a network, making it an ideal solution for protecting from Zero Day and
ransomware attacks.
We spent considerable financial resources and
energy in 2021 completing beta testing and launching the INTRUSION Shield product, and these efforts included an aggressive
ramp up in our expenditures, particularly in the areas of sales and marketing and other general and administrative expenses. Unfortunately,
these efforts at promoting the launch of INTRUSION Shield were not as successful as the Company had anticipated. The significant
expense of the product launch combined with minimal sales of INTRUSION Shield in 2021 has strained the Company’s capital
resources and caused significant doubt about our ability to continue our current operations as a going concern.
We believe that we must expand our sales and marketing
efforts in order for the INTRUSION Shield to achieve marketplace acceptance and to generate revenue for the Company. However,
these efforts depend, in large part, on the success of our channel partners as they market and sell the INTRUSION Shield,
which may not be successful. Further, our new efforts in forging meaningful relationships with seasoned and well positioned strategic
partners may not yield meaningful results, and any and all such efforts will need to be accomplished despite certain public remarks and
comments that have been made on social media and web-based platforms as well as statements and allegations that have, and will continue
to be, that have and will continue to be advanced in the various pleadings that are publicly filed with the courts. We are also expending
significant research and development resources in order to be able to provide INTRUSION Shield to customers in a cloud-based
environment without the requirement for complementary hardware to be deployed and installed on a customer’s information platforms.
If this alternate product deployment is not achieved, achieved at too great an expense, or does not provide the added incentive to retain
and to attract INTRUSION Shield customers, we may not be able to generate sufficient revenue to justify the expense or to
significantly contribute to our revenues.
In order to finance our operations and to continue
as a going concern, it has been necessary for us to raise additional funds through public and private financings. We engaged B. Riley
Securities Inc. to act as sales agent under an at-the-market stock issuance program that begin in August of 2021 and has generated approximately
$5.5 million net of fees from those stock sales. We also engaged in certain cost-cutting measures in the latter portion of 2021, including
measures to reduce head count in our non-performing segments and negotiating with certain contractors and vendors to appropriately align
our expenses with our revenue trends.
And in March of 2022, we generated $4,682,500
in net proceeds from the issuance of the first of two convertible promissory notes that are issuable under a Securities Purchase
Agreement we entered into with Streeterville Capital, LLC with the ability to receive an additional $4,682,500 in net proceeds from
the issuance of the subsequent note upon the satisfaction of certain conditions, including, without limitation, obtaining certain
stockholder approvals at our upcoming annual meeting of stockholders. (For additional details, see Liquidity and Capital Resources:
2022 Convertible Notes Issuance, below)
We have also streamlined and added focused talent
to our sales and marketing departments and recruited and engaged a new President and Chief Executive Officer to spearhead these and other
initiatives to better align expenses with revenue, provide valuable and meaningful cybersecurity offerings to both governmental and commercial
clients, and to attract the needed capital resources for the Company to execute on these initiatives in 2022.
Results of Operations
The following table set forth, the consolidated
statements of operations in dollar amounts and as a percentage of our total revenue for the periods indicated. The period-to-period comparison
of results is not necessarily indicative of results for future periods.
Comparison of the years ended December 31, 2021 and December 31,
2020
Year Ended December 31, Year Ended December 31,
Operating expenses:
Interest and other income 87 11 1.2% 0.1%
Interest expense (21 ) (6 ) -0.3% -0.1%
Gain on the extinguishment of debt 635 – 8.7% –
Income tax provision – – – –
Preferred stock dividends accrued – (79 ) – -1.2%
Net Revenue
Total revenue increased 9.9% to $7.3 million in
2021 from $6.6 million in 2020. The increases in product revenues were primarily due to $0.6 million in revenues from our INTRUSION
Shield product line which was introduced to the market in the first quarter of 2021 and a $0.1 million increase in TraceCop
revenues between the periods. TraceCop revenues were $6.3 million and $6.2 million for the years ended December
31, 2021 and 2020, respectively. No revenue related to INTRUSION Shield was recognized during the same periods in 2020,
as INTRUSION Shield was introduced in 2021. The increases in revenues during these periods were offset by a de minimus decrease
in revenues related to Savant. We expect our product revenues to increase in the future if we can increase sales to existing
customers and add new customers.
There were no export sales in 2021 and 2020 primarily
due to our focus on domestic revenue sales. Sales of our products internationally may be subject to currency exchange risk, which may
cause our products to effectively increase in price, if the exchange rate moves significantly and the dollar gains value over the foreign
currency.
Historically, due to the timing of our sales cycle,
a significant portion of our monthly sales occurs in the second half of the month. Accordingly, our receivables increase at the end of
each month, which causes a higher accounts receivable balance at month end. This monthly trend also causes an inflated comparative relationship
between revenue and accounts receivable. We believe that this monthly trend will continue because monthly sales forecast and planning
meetings are held in the first week of every month, the middle of the month is focused on sales calls to customers and the latter half
of the month on closing sales.
Concentration of
Revenues. Revenues from sales to various U.S. government entities totaled $5.2 million, or 71.3% of revenues, for the year ended December
31, 2021, compared to $5.7 million, or 86.3% of revenues, for the same period in 2020. Sales to commercial customers totaled $2.1 million
or 28.7% of total revenue for year ended December 31, 2021, compared to $0.9 million or 13.7% of total revenue for the same period in
2020. Although we expect our concentration of revenues to vary among customers in future periods depending upon the timing of certain
sales, we anticipate that sales to government customers will continue to account for a significant portion of our revenues in future periods.
Sales to the government present risks in addition to those involved in sales to commercial customers which could adversely affect our
revenues, including, without limitation, potential disruption to appropriation and spending patterns and the government’s reservation
of the right to cancel contracts and purchase orders for its convenience. Although we do not anticipate that any of our revenues with
government customers will be renegotiated, any cancelled or renegotiated government orders could have a material adverse effect on our
financial results. Currently, we are not aware of any proposed cancellation or renegotiation of any of our existing arrangements with
government entities and, historically, cancellations or renegotiated orders by government entities have not resulted in a material adverse
effect on our business. One individual commercial customer during the year ended December 31, 2021, individually accounted for over 10.0%
of total revenues. During the year ended December 31, 2020, no individual commercial customer accounted for revenues that were over 10.0%
of total revenues. The Company’s similar product and service offerings are not viewed as individual segments, as its management
analyzes the business as a whole and expenses are not allocated to each product offering.
Gross Profit
Gross profit increased 19.0% to $4.7 million in
2021 from $3.9 million in 2020. As a percentage of revenue, gross profit increased from 59.1% in 2020 to 63.9% in 2021. Gross profit as
a percentage of revenue is impacted by several factors, including shifts in product mix, changes in channels of distribution, sales volume,
fluctuations in manufacturing costs, labor costs, pricing strategies, and fluctuations in sales of integrated third-party products. The
increase in gross profit in 2021 was attributable to the introduction of the new INTRUSION Shield product, which has lower
direct labor costs than our legacy products.
Sales and Marketing
Sales and marketing expenses
increased to $11.9 million or 164.0% of net revenue in 2021, compared to $3.8 million or 57.7% of net revenue in 2020. The increase is
primarily related to an aggressive ramp up in selling and marketing costs in anticipation of increased revenues from sales of our new
INTRUSION Shield commercial product which failed to materialize in 2021. Some of the more significant increases include:
an increase of $3.6 million in labor costs including share-based compensation expense, an increase of $1.6 million in web marketing, trade
shows and other forms of business development advertising costs, an increase of $1.3 million in contract labor and consulting costs and
a $1.3 million increase in general and administrative costs allocated to the sales and marketing departments. These increases were offset
by certain other minor increases and decreases between both periods. In light of our inability to generate significant revenues from sales
of our INTRUSION Shield products in 2021, we determined that these sales costs should be significantly reduced. During the
third and fourth quarter of 2021, we started implementing certain cost saving measures such as a reduction in force as well as negotiations
with certain contractors and vendors to appropriately align our expenses with our revenue trends. Sales and marketing expenses may vary
in the future.
Research and Development
Research and development expenses
increased to $6.3 million or 87.0% of net revenue in 2021 compared to $3.8 million or 57.4% of net revenue in 2020. The increase in research
and development expense was due to increases in direct labor expenses and increases in costs associated with the development and testing
of our legacy and INTRUSION Shield products. As discussed above, during the third quarter of 2021, we started implementing
certain cost saving measures such as a reduction in force as well as negotiations with certain contractors and vendors to appropriately
align our expenses with our revenue trends. Research and development costs are expensed in the period in which they are incurred. Research
and development expenses may vary in the future; mainly dependent on levels of research and development labor expense charged to direct
labor.
General and Administrative
General and administrative expenses increased
to $5.9 million, or 81.0% of revenue in 2021 compared to $2.8 million or 42.5% of revenue in 2020. The increase in general and administrative
costs was also related to an aggressive ramp up in general and administrative costs in anticipation of increased revenues from sales of
our new INTRUSION Shield commercial product which failed to materialize in 2021. Some of the more significant increases
include: Employee related expenses such as direct labor, benefits and recruitment agency fees increased by $2.4 million during the year
ended December 31, 2021, when compared to 2020. Legal costs increased by $1.3 million specifically related to non-recurring projects during
the year ended December 31, 2021, when compared to 2020. Stock compensation expense increased by $0.6 million during 2021, when compared
to 2020. The increase during 2021, was related to options granted to new employees as well as compensation expense recognized during this
period, related to the accelerated vesting of stock options granted to certain members of our Board upon retirement during 2021, when
compared to 2020. These increases were offset by the $1.1 million loss incurred in 2021 related to the abandonment of our old office lease,
as well as a $2.3 million increase related to costs allocated to other departments within the research and development group and the sales
and marketing group during year ended 2021, when compared with 2020. During the year 2021, the Company executed a series of reduction
as part of a larger effort on the Company’s part to reduce expenses and overhead as a result of the challenges the Company anticipates
in meeting its liquidity and cash-flow needs in the near term, as a result of lower-than-expected 2021 revenues from its newly introduced
INTRUSION Shield service offering.
Interest Expense
Interest expense increased to $21,000 or 0.3%
of revenues for the year ended December 31, 2021, compared to $6,000 or 0.1% of revenues for the year ended December 31, 2020. Our
interest expense consists primarily of interest related to finance leases and in 2020 interest specifically related to the SBA PPP
Loan entered in April of 2020. During 2021, we entered multiple finance lease arrangements in the amount of $1.9 million, $1.5
million of which related to new sever systems replacing our old and outdated sever systems and $0.4 million related to equipment
necessary for our INTRUSION Shield commercial product. The PPP Loan along with accrued interest amounts was forgiven
in April 2021 and a gain in the extinguishment of debt was recognized on the consolidated statements of operations. The increase in
Interest Expense for the periods presented above is primarily related to the increase in finance leases between the periods and the
extinguishment of the PPP Loan. Interest expense will vary in the future based on our cash flow and borrowing needs.
Interest and Other Income
Interest and other income were
$87,000 for the year ended December 31, 2021, compared to $11,000 for the year ended December 31, 2020.
Gain on Extinguishment of Debt
Gain on extinguishment of debt increased $0.6
million for the year ended December 31, 2021, compared to no gains or losses on the extinguishment of debt incurred for the year ended
December 31, 2020. This increase due to the forgiveness of our SBA PPP Loan principal and accrued interest entered in April 2020 and forgiven
in April 2021. There were no other gains or losses on the extinguishment of debt incurred for the year ended December 31, 2021.
Income Taxes
Our effective income tax rate was 0% in 2021 and
2020 as valuation allowances have been recorded for the entire amount of the net deferred tax assets due to uncertainty of realization.
Consolidated Statements of Cash Flows
Our cash flows for the years ended December 31,
2021 and 2020 were:
Year Ended
Net cash used in operating activities $ (16,557 ) $ (5,177 )
Net cash used in investing activities (1,148 ) (320 )
Net cash provided by financing activities 5,101 18,867
Change in cash and cash equivalents $ (12,604 ) $ 13,370
Operating Activities
Net cash used in operations for the twelve months
ended December 31, 2021, was $16.6 million due primarily to a net loss of $18.8 million offset by the following sources of cash and non-cash
items: a $383 thousand increase in deferred revenue, primarily due to increases in cash advances from certain customers shifting to making
upfront payments for our services for their contract term of one year and an increased customer base related to our INTRUSION Shield
product, a $172 thousand decrease in accounts receivable, primarily caused by timing in receipt of receivables from our customers, a $25
thousand increase in accounts payable and accrued expense, a $0.6 million in gain on the extinguishment of the PPP Loan, $1.3 million
in stock-based compensation, $780 thousand in depreciation expense and amortization expense, $243 thousand in noncash lease costs and
$17 thousand in other operating activities.
Net cash used in operations for the twelve months
ended December 31, 2020, was $5.2 million due primarily to a net loss of $6.5 million and the following uses of cash: a $339 thousand
decrease in deferred revenue, due to shorter term upfront fee payments received from our customers, a $258 thousand increase in prepaid
expenses and other assets, driven by increases in prepaid software and insurance costs, and a $334 thousand decrease in accounts payable
and accrued expenses. This was partially offset by these sources of cash and non-cash items: a $1.1 million non-cash write-off for an
abandoned operating lease asset, a $333 thousand decrease in accounts receivable, primarily related to the timing in receipt of receivables
from our customers, $322 thousand in stock-based compensation, $231 thousand in depreciation expense and amortization expense, and $294
thousand in noncash lease costs.
Investing Activities
Net cash used in investing activities for the
year ended December 31, 2021 was $1.1 million, which was primarily the result of additions to property and equipment specifically related
to $0.4 million related to hardware utilized to administer our INTRUSION Shield product, $0.3 million of hardware and software
equipment utilized in our data center, $0.1 million of in-house software and computer systems for employees, $0.2 million of AI related
computer systems and $0.1 million related to website design and intangible assets – domain name (“www.Cyberwarfare.com”).
Net cash used in investing activities for the
year ended December 31, 2020, was $320 thousand for purchases of property and equipment.
Financing Activities
Net cash provided by financing activities was
$5.1 million for the year ended December 31, 2021, which was primarily the result of net proceeds from our at-the-market program public
offering of $5.6 million, proceeds from exercise of stock options of $0.2 million offset by the payment on principal of finance right-of-use
leases of $0.7 million.
Net cash provided by financing activities was
$18.9 million for the year ended December 31, 2020, with proceeds of $18.2 million from a stock offering, $629 thousand from a PPP loan,
and proceeds from exercise of stock options of $209 thousand. This was directly offset by the following uses of cash: payments for preferred
stock dividends of $99 thousand and payment on principal of finance right-of-use leases of $43 thousand.
Liquidity and Capital Resources
As of December 31, 2021, we had cash and cash
equivalents of $4.1 million, down from approximately $16.7 million as of December 31, 2020, and working capital of $2.1 million as of
December 31, 2021, compared to $16.2 million as of December 31, 2020. Our principal source of cash for funding operations and growth had
been through cash flows generated from operating activities together with the approximately $5.6 million in net proceeds received from
our at-the-market program during 2021 and the approximately $18.0 million in net proceeds received from our secondary public offering
in 2020.
Current At-The Market Offering.
In August of 2021, we engaged
B. Riley Securities, Inc. to act as sales agent under our at-the-market program, which allows us to potentially sell up to $50.0 million
of our common stock on a delayed or continuous basis through the use of a shelf-registration statement on Form S-3, which we initially