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 is 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.
As of December 31, 2022,
we had cash and cash equivalents of $3.0 million and negative working capital of $7.8 million. Our primary source of cash for funding
operations and growth in 2022 has come from net proceeds received from the issuance of notes payable, net proceeds received from our registered
direct offering and from our at-the-market program in an aggregate amount of approximately $15.6 million. 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 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 with to Streeterville Capital, LLC and related issuance of two promissory
notes, 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. 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 24, 2023, our public
float calculated in accordance with General Instruction I.B.6 of Form S-3 was $28.7 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 our indebtedness.
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. The notes mature on September
10, 2023, and December 29, 2023. 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 convertible
notes is dependent upon the market value of our common stock, which could result in significant dilution to our existing stockholders.
The noteholder has the right
to redeem up to $0.5 million of the outstanding balance of each note per month. In January 2023, we amended the note agreements whereby
the noteholder agreed to waive their redemption rights through March 31, 2023, in exchange for a fee equal to 3.75% of the outstanding
principal balance. 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 stock 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, 2022, we had a net loss of $16.2 million and had an accumulated deficit of approximately $96.3 million as of December 31, 2022. We
need to increase current revenue levels from the sales of our solutions if we are to regain profitability, and our new INTRUSION Shield
suite of products may take time to achieve market penetration which could negatively impact future revenues and results of operations.
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 be able to implement our business plan, fund our liquidity needs, or continue our operations.
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 80.9% of our
existing revenues result from sales of TraceCop a cybersecurity solution. TraceCop revenues were $6.1 million
for the year ended December 31, 2022, compared to $6.3 million for the year ended December 31, 2021. We can offer no assurances that
our new INTRUSION Shield solution will reduce our dependence on this single solution 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 not be successful in our
efforts to broaden the marketing and sale of the INTRUSION Shield.
We believe that we must expand
our sales and marketing efforts 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. If we are unsuccessful in our efforts to leverage channel and strategic partners, 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.
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.
Continuing 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.
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 substantial 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, 2022, and 2021, we derived 31.5% and 37.5% 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 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 product and solutions through these
indirect sales channels, which could result in lower prices and reduced profit margins for the 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 President, and
Chief Executive Officer; T. Joe Head, our Chief Technology Officer; Kimberly Pinson, 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 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 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 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 changing circumstances and customer needs
such as the creation and introduction of 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 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 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.
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 has been forced to allocate scarce and competing resources and balance budgetary
demands placed upon them because of the effects of the coronavirus, scarcity of commodities, and similar economic and operational effects
of the virus upon their own constituencies. 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 considering 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.
Investment Risks
We experience volatility in the market
for our common stock, particularly with respect to swings in the market price as well as volatility in the trading of our common stock.
We experience significant
shifts in the market value of our common stock as it trades on the Nasdaq Capital Market as well as volatility in the trading volume of
our shares on that market. For example, the market price of our common stock fluctuated between $1.74 and $5.77 during the year
ended December 31, 2022. 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 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 U.S. 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. We also have engineers
and other employees working remotely in Texas as well as several other states.
We believe that the existing
facility will be adequate to meet our operational requirements through the expiration of the lease. We are currently evaluating the office
rental market in proximity to our existing lease to identify and secure space or our future needs. We believe that our property insurance
provides adequate coverage for our leased facilities. See Note 5 – Right-of-use Asset and Leasing Liabilities to our Consolidated
Financial Statements for additional information regarding our obligations under leases.
Item 3. Legal Proceedings.
Class Action Litigation
On April 16, 2021, a 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 us, our now-former 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 our business, operations,
and prospects in violation of Section 10(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rule
10b-5 promulgated thereunder, as well as Section 20(a) of the Exchange Act. The Celeste lawsuit claimed compensatory damages and legal
fees.
On May 14, 2021, a related
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 us, our now-former chief financial officer, and now-former chief executive officer.
The Neely lawsuit alleged the same violations under the federal securities laws as those alleged in the Celeste lawsuit. The Neely lawsuit
also sought 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. The amended complaint named the following additional parties as named defendants: Mr.
Michael Paxton, a former director and executive officer; Mr. Gary Davis, a former officer; Mr. Joe Head, the current chief technology
officer, and a former director; and Mr. James Gero, a current director and chair of the compensation committee.
The parties to the
consolidated class action held a mediation on April 5, 2022, at the conclusion of which the parties executed a settlement term sheet
setting forth the material terms associated with the resolution of the action, subject to the preparation of formal documents and a
plan of distribution approved by the Court. The settlement agreement was subject to certain terms and conditions and received final
approval by the Court on December 16, 2022. At that time, a final judgement was entered dismissing the case, with the Court
retaining jurisdiction over the action for purposes of enforcing the terms of the class settlement agreement. The $3.3 million
settlement was paid by our insurance provider under our insurance policy as our retention had previously been exhausted.
The lead plaintiff in the
class action filed a motion for distribution of settlement funds on February 21, 2023. The Court approved the parties’ class action
settlement and plan of allocation on March 22, 2023, and cancelled the previously-rescheduled March 31, 2023, hearing on the motion for
distribution, all remaining matters in the class action then-pending have been fully and finally adjudicated.
Securities Investigation
On August 8, 2021, we 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 we produce certain documents and information. On November 9, 2021, the Securities and Exchange
Commission served a subpoena to us in connection with this investigation which formally requested substantially similar information as
in the prior request. We are continuing to comply with the requests and is cooperating in the investigation. We can offer no assurances
as to the outcome of this investigation or its potential effect on us or our results of operations.
Stockholder Derivative Claim
On June 3, 2022, a stockholder
derivative complaint was filed in U.S. District Court, District of Delaware by plaintiff Nathan Prawitt (the “Plaintiff Stockholder”)
on behalf of Intrusion against certain of our current and former officers and directors (the “Defendants”). Plaintiff alleges
that Defendants through various actions breached their fiduciary duties, wasted corporate assets, and unjustly enriched Defendants by
(a) incurring costs and expenses in connection with the ongoing SEC investigation, (b) incurring costs and expenses to defend us with
respect to the consolidated class action, (c) settling class-wide liability with respect to the consolidated class action, as well as
ancillary claims regarding sales of our common stock by certain of the Defendants. The Plaintiff is seeking remedial actions including
improvements in our corporate governance and internal control policies and reimbursement of legal costs. While we are not a named defendant,
but a nominal plaintiff in the stockholder derivative claim, we will be providing the financial and other assistance for each of the Defendants
that we are obligated to provide under our Articles of Incorporation, our Bylaws, as well as individual indemnifications agreements that
are in effect between, us and each of the Defendants.
In addition to these legal
proceedings, we are subject to various other 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 condensed consolidated financial position, operating
results, or cash flows. However, there can be no assurance such legal proceedings will not have a material impact on our future results.
PART II
Item 5. Market for Common Equity and Related Stockholder Matters
and Business Issuer Purchases of Equity Securities.
Our common stock trades on
the Nasdaq Capital Market, where it is currently listed under the symbol “INTZ.” As of March 24, 2023, there were approximately
89 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, 2022, for all our equity compensation plans (in thousands, except per share data). See Note 9 –
Stock-Based Compensation to our consolidated financial statements for additional discussion.
Equity compensation plans not approved by security holders – – – – –
On November 21, 2022, we
sold 31,746 shares of common stock in a private placement under Section 4(a)(2) of the Securities Act to our Chief Executive Officer,
Anthony Scott, at the then current market price, resulting in gross proceeds of $0.1 million, which we used for general corporate purposes.
Item 7. Management’s Discussion and Analysis of Financial
Condition and Results of Operations.
General
The following discussion
and analysis include 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.
During 2022 we spent significant
time and resources on:
· Developing Shield Cloud and Shield End-Point; both released in September 2022;
· Building out our management team.
We feel that these efforts
provide the resources needed to implement our business plan.
In 2022, we raised $15.6
million through the combined issuance of notes payable pursuant to the Securities Purchase Agreement with Streeterville Capital, LLC dated
March 10, 2022, the sale of common stock through our at-the-market-program and a registered direct offering. On December 31, 2022, we
had $3.0 million in cash. If we are not able to obtain additional debt or equity financing on terms and conditions acceptable to us, we
may be unable to implement our business plan or even continue our operations.
Results of Operations
The following table set forth, the results
of operations for the fiscal years ended December 31, 2022, and 2021. Certain historical amounts have been reclassified
to be presented on a comparable basis. For additional details, see Note 14 Correction of Immaterial Errors to the consolidated
financial statements (Part II, Item 8 of this Form 10-K).
Comparison of the years ended December 31, 2022, and December 31,
2021
Year Ended December 31, Year Ended December 31,
Operating expenses:
Gain on lease termination 385 – 5.1% –
Income tax provision – – – –
Net Revenue
Total revenue increased 3.5%
to $7.5 million in 2022 from $7.3 million in 2021. Shield revenues increased $0.7 million year-over-year as a result of the full year
impact of sales from prior year, the expanded use of Shield from existing customers and new customers signed in 2022. The increase in
Shield revenues was partially offset by a decline in consulting revenues of $0.4 million. The decline in consulting revenues resulted
primarily from the loss of a contract in the fourth quarter in which Intrusion’s prime sponsor chose not to renew the final option
year of a contract that had been in place since 2018. This contract represented annual revenue totaling $2.6 million. While the loss of
this contract significantly impacts Intrusion’s top-line revenue, the gross margin on this contract was 14% and, as a result, has
a marginal impact on profitability. We will continue to pursue new consulting opportunities and expect to see an increase in consulting
revenues in 2023.
Concentration of Revenues.
Revenues from sales to various U.S. government entities totaled $5.0 million, or 65.8% of revenues, for the year ended December 31, 2022,
compared to $5.2 million, or 71.3% of revenues, for the same period in 2021. In both 2022 and 2021, sales to three government entities
individually accounted for over 10% of total revenues. Sales to commercial customers totaled $2.6 million or 34.2% of total revenue for
year ended December 31, 2022, compared to $2.1 million or 28.7% of total revenue for the same period in 2021. Two commercial customers
individually accounted for over 10% of total revenues in 2022 compared to one commercial customer in 2021. We have increased our Shield
sales and marketing efforts by expanding our reseller channels. On December 31, 2022, our Shield opportunities comprised a large percentage
of our sales pipeline. We anticipate our concentration of revenues will vary among customers in future periods depending upon the timing
of certain sales, we anticipate that sales to government customers, while comprising a significant portion of our revenues in future periods,
will represent a lower percentage of our revenue base as we gain traction selling our Shield products into commercial markets.
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 which could have a material adverse effect on our financial results. Currently, we are not aware of
any additional 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.
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 for the 12-months
ended December 31, 2022, and 2021 totaled $4.2 million or 55% compared to $3.7 million or 50%. The improved gross profit in 2022 is mostly
due to Shield revenues representing a larger percentage of revenues, 16% compared to 7% in 2021. To the extent Shield revenues become
a larger percentage of revenues, we anticipate we will continue to see favorable growth in gross profit margins.
Sales
and Marketing
Sales and marketing expenses
decreased to $6.5 million in 2022, compared to $10.9 million in 2021. In 2021, with the launch of the INTRUSION Shield commercial
product, we aggressively ramped up selling and marketing costs in anticipation of driving revenue growth from Shield sales. As a result
of our inability to successfully market and gain traction with sales of the Shield On-Premise solution, we implemented cost saving measures
which included changing our go-to-market strategy. We changed from primarily a direct sales effort to a fully indirect channel program
including value added resellers, managed service providers, managed security service providers and strategic partners. This change contributed
to significantly lowering year-over-year spend with reductions in sales and marketing headcount from a high of 40 in mid-2021 to 9 employees
on December 31, 2021, and 2022. Other cost saving measures implemented in late 2021 that carried forward into 2022 included reduced spend
on web marketing, trade shows and other forms of business development and advertising costs. Sales and marketing expenses may vary in
the future.
Research and Development
Research and development
expenses increased to $6.5 million in 2022 compared to $6.3 million in 2021. In 2022, we implemented the Agile methodology of software
development to manage and track our development costs. As a result, we are now able to accurately quantify and capture the cost associated
with each stage of the development life cycle. As required under ASC Topic 350-40 Internal Use Software Accounting-Capitalization, we
began capitalization of costs incurred during the application development stage. In 2022, we recorded $1.4 million of research and development
costs to internal use software. The net increased spend year-over-year, when including amounts capitalized, of $1.6 million related to
costs to design, develop and launch the new Shield Cloud and End-Point solutions as well as costs to support and enhance Shield On-Premise.
General
and Administrative
General and administrative
expenses increased to $7.5 million from $5.9 million in 2021. The increase in general and administrative costs relates primarily to increased
legal defense costs associated with the various legal proceedings as described in more detail in Item 3. Legal Proceedings of this report.
In late 2022 we hired an in-house General Counsel which we believe will help to reduce any remaining expense for the Legal Proceedings
described herein and expense for legal matters going forward. Also, in late 2021 and early 2022, we experienced significant turnover in
our finance department which resulted in higher contract labor and recruiting costs. Insurance expense for our Directors’ and Officers’
insurance policy increased in 2022 when compared to 2021 as a result of the Class Action lawsuits and related claims activity and, increasing
coverage limits for our new policy year.
Interest
Expense
Interest expense increased
to $2.4 million in 2022 compared to $21 thousand for the year ended December 31, 2021. The increase relates to the Streeterville notes
payable entered into in March and June of 2022 and related debt issuance cost amortization as well as interest expense from finance leases.
Interest expense will vary in the future based on our cash flow and borrowing needs.
Interest and Other Income
Other income totaled $2.0
million for the year ended December 31, 2022, compared to $0.7 million for the year ended December 31, 2021. In 2022 we recorded a $2.0
million to Other Income related to an Employee Retention Credit refund due from the federal government as a result of amending 941 returns
for the 2020 and 2021 tax periods. Other income in 2021 related to the forgiveness of our U.S. Small Business Administration (“SBA”) Payroll Protection
Program (“PPP”) loan principal and accrued interest.
Gain on Lease Termination
In 2022 we recorded a gain of $0.4 million relating
to the settlement of our lease abandonment lawsuit.
Income
Taxes
Our effective income tax
rate was 0% in 2022 and 2021 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,
2022, and 2021 were:
Year Ended
Net cash used in operating activities $ (13,190 ) $ (16,557 )
Net cash used in investing activities (1,479 ) (1,148 )
Net cash provided by financing activities 13,584 5,101
Change in cash and cash equivalents $ (1,085 ) $ (12,604 )
Operating Activities
Net cash used in operations
for the year ended December 31, 2022, was ($13.2) million due to a net loss of ($16.2) million offset by adjustments for non-cash
items of $5.0 million which are mostly comprised of depreciation, stock-based compensation and interest related to Streeterville notes,
and changes in working capital consisting primarily of a reduction in trade receivables $0.5 million; an increase in other receivables
relating principally to the remaining Employee Retention Credits (“ERC”) refund outstanding ($1.5) million; an increase in
accounts payable and accrued expenses $0.2 million; and a decrease in operating lease liabilities ($1.0) million.
Net cash used in operations for the year
ended December 31, 2021 was ($16.6) million due primarily to a net loss of ($18.8) million partially offset by the following sources of
cash and non-cash items: $0.4 million 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 $0.2 million decrease in accounts receivable, primarily caused by timing in receipt of receivables
from our customers, a ($0.6) million in gain on the extinguishment of the PPP Loan, $1.3 million in stock-based compensation, $0.8 million
in depreciation and amortization expense and $0.2 in noncash lease costs.
Investing Activities
Net cash used in investing
activities for the year ended December 31, 2022, totaled ($1.5) million and was primarily related to capitalized internal use software
of ($1.2) million for the new Shield Cloud and End Point solutions as well as enhancements to the Shield On-Premise solution and, the
purchase of equipment for use with the Shield On-Premise solution, in the data center and by employees of ($0.3) million.
Net cash used in investing
activities for the year ended December 31, 2022, was ($1.1) million which consisted of the purchases of property and equipment and a domain
name.
Financing Activities
Net cash provided by financing
activities was $13.6 million for the year ended December 31, 2022. Primary sources of cash from financing activities included proceeds
from the issuance of the two Streeterville notes payable, net of issuance costs, equal to $9.3 million (see Note 6 Notes Payable
to the consolidated financial statements in Part II, Item 8 of this Form 10-K), net proceeds received from our registered direct offering
of $4.3 million, net proceeds from issuance of shares from our at-the-market program of $2.0 million, and proceeds received from a private
placement sale of common stock equal to $0.1 million. Funds used in financing activities included ($1.5) million in principal repayments
on the Streeterville notes payable and ($0.6) million payments on equipment financing leases.
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.
Liquidity and Capital Resources
As of December 31, 2022,
we had cash and cash equivalents of $3.0 million, down from $4.1 million as of December 31, 2021; and a working capital deficit of ($7.8)
million on December 31, 2022, compared to $2.1 million in working capital on December 31, 2021. As discussed above in Financing Activities,
our principal sources of cash for funding operations in 2022 was through the issuance of the two Streeterville notes which contributed
$9.3 million, net of issuance costs, and $6.4 million from the sale and issuance of common stock and warrants. On February 23, 2023 we sold a secured promissory note to Streeterville in the aggregate principal amount of
$1.4 million plus certain reimbursed expenses in exchange for $1.3 million. The note provided for weekly principal payments of $50 thousand
until its maturity on March 31, 2023. The note was secured by all employee retention credits (“ERC”), or other funds still
owed or otherwise payable to the Company under the Cares Act. We received payment for the ERC owed to Intrusion on March 13, 2023 and
on March 14, 2023 we repaid in full the secured promissory note with Streeterville.
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. As of December 31,
2022, we have received proceeds of approximately $7.5 million net of fees from the sale of 1,843 thousand shares of our common stock
pursuant to the program.
For so long as our public
float is less than $75 million, we will be subject to the restrictions set forth in General Instruction I.B.6 to Form S-3, which limit
our ability to conduct primary offerings under a Form S-3 registration statement, including with respect to 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 24, 2023, our public float calculated in accordance with General Instruction
I.B.6 of Form S-3 was $28.7 million.
2022 Convertible Notes
Issuance.
We entered into a securities
purchase agreement (the “SPA”) with Streeterville Capital, LLC (“Streeterville”) on March 10, 2022, pursuant to
which Streeterville purchased two unsecured promissory notes with substantively identical terms. Streeterville purchased the first note
on March 10th and the second note on June 29th, each note with an aggregate principal amount of $5.4 million in exchange for
$5.0 million less certain expenses. We received approximately $9.3 million, net of transaction expenses, in connection with these issuances.
The notes mature in September
and December 2023 and, as a result, are reflected as a current liability on our consolidated balance sheet. Beginning six months following
the issuance of each note, Streeterville has the right to redeem up to $0.5 million of the outstanding balance of each note per month.
Payments may be made by the Company, generally at the Company’s option, (a) in cash, (b) by paying the redemption amount in the
form of shares of common stock or (c) a combination of cash and shares of common stock. If paid in common stock, the number of redemption
shares to be issued is based on a 15% discount to market, as further defined in the note agreements. Through December 2022, Streeterville
made three separate redemption requests totaling $1.5 million, we made the redemption payments in cash. In January 2023, the note agreements
were amended whereby Streeterville waived their right to redemptions through March 31, 2023, in exchange for a fee equal to 3.75% of
the outstanding note balance. This fee was added to the outstanding principal balance to be paid at maturity. As of March 24, 2023, our
total outstanding indebtedness to Streeterville including principal, accrued interest and fees was $10.2 million.
We need to raise additional
funds in the near term to continue operations. We intend to obtain these funds from sales of our common stock through registered direct
offerings and the use of our aftermarket program. While we can provide no assurances that we will be able to raise additional funds through
any future equity or debt financings, 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.
Critical Accounting Policies and Estimates
Management’s discussion
and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared
in accordance with accounting principles generally accepted in the U. S. The preparation of these financial statements requires us to
make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to product returns, bad debts,
income taxes, warranty obligations, maintenance contracts and contingencies. 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.
We believe the following
critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial
statements.
Capitalized Software Development
We capitalize internally developed software using
the Agile software development methodology which allows us to accurately track, and record costs associated with new software development
and enhancements.
Pursuant to ASC Topic 250-40
Internal Use Software Accounting Capitalization, certain development costs related to our products during the application development
stage are capitalized as part of property and equipment. Costs incurred in the preliminary stages of development are expensed as incurred.
The preliminary stage includes such activities as conceptual formulation of alternatives, evaluation of alternatives, determination of
existence of needed technology, and the final selection of alternatives. Once the application development stage is reached, internal and
external costs are capitalized until the software is complete and ready for its intended use. Capitalized internal use software is amortized
on a straight-line basis over its estimated useful life, which is generally three years.
Revenue Recognition
We recognize product revenue
upon shipment or after meeting certain performance obligations. These products can include hardware, software subscriptions and consulting
services. Most of our sales are from consulting services. We also offer software on a subscription basis subject to software as a service
(”SaaS”). Warranty costs and sales returns have not been material.
We recognize sales of its
consulting services in accordance with FASB ASC Topic 606 whereby revenue from contracts with customers are recognized once the criteria
under the five steps below are met:
i) identification of the contract with a customer;
ii) identification of the performance obligations in the contract;
iii) determination of the transaction price;
v) Recognition of revenue upon satisfaction of a performance obligation.
Consulting services include
reporting are typically done monthly, and revenue is matched accordingly. Product sales may include maintenance and customer support allocated
revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy using
the relative selling price method. All product offering and service offering market values are readily determined based on current and
prior stand-alone sales. We defer and recognize maintenance, updates, and support revenue over the term of the contract period, which
is generally one year.