Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
You should
read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial
statements and related notes included elsewhere in this Annual Report on Form 10-K (the “Annual Report”). Some of the information
contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans
and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors,
including those factors set forth in the section titled “Risk Factors,” our actual results could differ materially from the
results described in or implied by the forward-looking statements contained in the following discussion and analysis.
51
Overview
We are an AI
company focused on predictive medical diagnostics. We operate in one segment. Currently, we are devoting substantially all of our efforts
towards research and development of our DeepView System, an internally developed multi-spectral imaging (“MSI”) device that
has FDA breakthrough device designation (“BDD”) status. Given our recent receipt of the UKCA mark for burn indication on our
DeepView System, we expect to begin commercialization activities in the United Kingdom in the second half of 2024. Our DeepView System
uses proprietary algorithms to distinguish between damaged and healthy human tissue invisible to the naked eye, providing “Day One”
healing assessments. DeepView’s output is specifically engineered to allow the physician to make a more accurate, timely and informed
decision regarding the treatment of the patient’s wound. Our focus from 2013 through 2021 was on the burn indication, which we expanded
to also include the diabetic foot ulcer (“DFU”) indication in 2022.
In the case of
DFUs, our DeepView System provides an assessment in seconds as to the non-healing portions of a DFU. The non-healing assessment would
provide the physician with an objective assessment to use an advanced wound care therapy on “Day One” as opposed to the current
approach that involves waiting up to 30 days to see how the wound develops before making such clinical assessment.
For burn wounds,
a non-healing assessment could aid the clinician in making an immediate and objective determination for appropriate candidates for
surgery, as well as determining what specific areas of the burn wound will require excision and skin grafting. DeepView’s current
accuracy for burn wounds is 92% for adults and 88% for pediatrics, compared with current physician accuracy in evaluation of all burn
wounds of 50% to 75%, respectively, at best, according to industry literature.1 In
addition, in head-to-head clinical trial evaluations, our DeepView System provided higher accuracy to “ground truth”
on burn wound analysis than the accuracy of burn specialists, who reported 70-80% accuracy, or non-burn specialist physicians, who
reported 50-60% accuracy.2 We have conducted three large
clinical studies with multiple sites across the United States, enrolling 413 burn patients, including 329 adult and 84 pediatric patients.
Through these studies, we were able to quantify the burn assessment accuracy in both surgical and non-surgical treatment. Beginning
in 2023, we have initiated a pivotal clinical study seeking enrollment of 240 patients, including 180 adult and 60 pediatric patients
through multiple sites across the United States.
We have not generated
any product revenue to date. We have received substantial support from the U.S. government for our DeepView System’s application
for burn wounds, particularly from the Biomedical Advanced Research and Development Authority (“BARDA”),
which is part of the HHS Office of the Assistant Secretary for Preparedness and Response in the United States, established to aid
in securing the United States from chemical, biological, radiological, and nuclear threats, as well as from pandemic influenza and
emerging infectious diseases. We have also received funding from the National Science Foundation (the “NSF”), the National
Institute of Health (the “NIH”) and the Defense Health Agency (the “DHA”). Since 2013, we have received approximately
$279.6 million in funding commitments from government contracts, primarily from BARDA, which accounts for $272.9 million. This has allowed
us to develop our technology and further our clinical trials.
In September 2023, we executed our third contract with BARDA for a
multi-year Project BioShield (“PBS”) agreement, valued at up to approximately $150.0 million (the “PBS BARDA Contract”).
This multi-year contract includes an initial award of nearly $54.9 million to support the clinical validation and FDA clearance of DeepView® for
commercial marketing and distribution purposes, which we expect to continue through the first quarter of 2026. This grant funding is non-dilutive to
our shareholders, and we believe it validates the important nature of our mission and technology.
In addition to our BARDA contract, we received a $4.0 million
grant award from the Medical Technology Enterprise Consortium (“MTEC”) in April 2023, which, building on prior awards from
DHA, is to be used to support military battlefield burn evaluation via a handheld DeepView device (the “MTEC Agreement”).
The MTEC Agreement is currently intended to run through April 2025 with funding dependent on various milestones.
Once commercialized,
we anticipate that the DeepView System will have two revenue streams, a SaMD (software as a medical device) model, and an imaging device
component. The SaMD model applies a SaaS (software as a service) treatment for the DeepView System which will feature a software licensing
fee that includes maintenance, image hosting, and access to algorithm updates. The proprietary imaging device accesses artificial intelligence
algorithms and is a universal platform to house multiple clinical applications. Pricing for these components will be evaluated and strategically
set per country and site-of-service for heightened customer adoption.
Business Combination
On September 11, 2023, we consummated a business combination, pursuant
to the business combination agreement dated April 11, 2023 (the “Business Combination Agreement”)
by and among the Company (previously, Rosecliff Acquisition Corp I (“Rosecliff”)), Ghost Merger Sub I (a wholly owned subsidiary
of Rosecliff), Ghost Merger Sub II (a wholly owned subsidiary of Rosecliff) and Spectral MD Holdings, Ltd. (“Legacy Spectral”).
Upon the closing of the Business Combination (the “Closing”), in sequential order: (a) Ghost Merger Sub I merged with and
into Legacy Spectral, with Legacy Spectral continuing as the surviving company as our wholly owned subsidiary (the “Spectral Merger”)
and then, (b) Legacy Spectral merged with and into Ghost Merger Sub II (the “SPAC Merger”, together with the Spectral Merger
(the “Business Combination”)), with Ghost Merger Sub II (renamed Spectral MD Holdings LLC) surviving the SPAC Merger as our
direct wholly-owned subsidiary. Upon the Closing, we changed our name from Rosecliff Acquisition Corp I to Spectral AI, Inc.
In addition to our Common Stock, we currently have 8,433,333 redeemable warrants (the “Public Warrants”) and 73,978 warrants
(“Angel Warrants”) to SP Angel Corporate Finance LLP (“SP Angel”) remaining outstanding.
52
On
September 12, 2023, the Company began trading its shares of the Company Common Stock and the Public Warrants on the Nasdaq Global Market
(the “Nasdaq”) under the symbols “MDAI” and “MDAIW”, respectively.
The Business
Combination was accounted for as a reverse recapitalization in accordance with GAAP. Under the guidance in Accounting Standards Codification
(“ASC”) 805, Business Combinations, Rosecliff, which is the legal acquirer, has been treated as the “acquired”
company for financial reporting purposes and the Company has been treated as the accounting acquirer. This determination was primarily
based on the following:
Accordingly, for accounting purposes,
the Business Combination was treated as the equivalent of a capital transaction in which Legacy Spectral issued stock for the net assets
of Rosecliff prior to the Closing. Upon the Closing, the net assets of Rosecliff are stated at fair value, with no goodwill or other
intangible assets recorded. All historical financial information presented in the consolidated financial
statements represents the accounts of Legacy Spectral at their historical cost as if Legacy Spectral is the predecessor to the Company.
Upon consummation of the Business Combination, Spectral AI has continued as an SEC-registered and Nasdaq-listed company.
The consolidated financial statements following the Closing reflect the results of the Combined
Company’s operations.
Financial Operations Overview
Research and Development
Revenue
To
date we have not generated any revenues from the sale or license of our products. Our primary source of revenue is research and development
revenue. Currently, we are highly dependent upon the reimbursements from BARDA for the burn diagnostic testing of our DeepView System
and other U.S. government awards. Our research and development revenue is affected by the amount of research and development that is expended
each month with respect to our contract with BARDA and other U.S. governmental contract awards, such as our grant under the MTEC Agreement
which we earn based on the achievement of milestones. Our revenue growth is dependent upon a number of factors including expanding the
research and development activities under the BARDA contract, research and development reimbursed expenses relating to other contract
awards from U.S. governmental agencies and the intended future commercial sales of our DeepView System. See “Liquidity and Capital
Resources” for additional information.
Cost of Revenue
Our cost of revenues consists primarily of direct and indirect costs
associated with the research and development activities relating to the BARDA and MTEC contracts. Our cost of revenue is affected by the
extent of research and development activities as well as expansion of work on other U.S. governmental projects and the expanded applications
for our DeepView System.
Gross Profit
Gross profit may vary from period-to-period and is primarily affected
by the current reimbursement rates under the BARDA contract and other U.S. governmental contract awards. These reimbursement rates are
fixed under the BARDA contract. Under the BARDA contract our gross profit represents this reimbursement rate plus a fixed fee component
relating to non-reimbursed expenses incurred in connection with the work completed. Under the other fixed fee U.S. governmental contract
awards our gross profit corresponds to the achievement of pre-determined milestones.
Operating Expenses
Operating costs
and expenses consist of general and administrative expenses. These expenses primarily relate to salaries and related costs of our organization’s
support and operations staff, consulting fees, rent, insurance and office expenses, and our non-revenue generating research and development
expenses, primarily related to salaries and related costs and consulting fees.
Other Income
(Expense)
Other income (expense) primarily consists of transaction costs, primarily
related to the Business Combination, net interest income, change in fair value of warrant liabilities and foreign exchange transaction
gains/losses. Historic foreign exchange transaction loss primarily relates to changes in the exchange rate between the U.S. dollar, the
Euro and the British pound sterling for our deposit accounts that are denominated in British pound sterling. In addition, this amount
includes costs associated with buying British pound sterling for payment of our employees and vendors in the UK.
53
Key Operating and Financial Metrics
We regularly
review a number of metrics, including the following key operating and financial metrics, to evaluate our business, measure our performance,
identify trends in our business, prepare financial projections and make strategic decisions. We believe the operating and financial metrics
presented are useful in evaluating our operating performance, as they are similar to measures by our public competitors and are regularly
used by security analysts, institutional investors, and other interested parties in analyzing operating performance and prospects. Adjusted
EBITDA is a non-GAAP measure, as it is not a financial measure calculated in accordance with GAAP and should not be considered as
a substitute for net (loss) income, calculated in accordance with GAAP. See “Non-GAAP Financial Measures” for additional
information on adopted non-GAAP financial measures and a reconciliation of these non-GAAP measures to the most comparable GAAP
measures.
Comparison
of Years Ended December 31, 2023 and 2022
The following
table summarizes these metrics for the years ended December 31, 2023 and 2022 (in thousands):
Year Ended December 31,
See “Non-GAAP
Financial Measures” below for a reconciliation of net loss to Adjusted EBITDA.
Research and Development Revenue
We define research
and development revenue as revenue generated from the research, testing and development of our DeepView System as utilized in connection
with our burn indication. This research and development revenue reflects applied research and experimental development costs relating
to our burn application as developed in connection with our BARDA, MTEC and DHA contracts.
Gross Profit and Gross Margin
We define gross profit as research and development revenue, less cost
of revenue, and define gross margin, expressed as a percentage, as the ratio of gross profit to revenue. Gross profit and gross margin
can be used to understand our financial performance and efficiency and as we begin commercialization, it will allow investors to evaluate
our pricing strategy and compare against our competitors. Our management uses these metrics to make strategic decisions, pricing decisions,
identifying areas for improvement, set targets for future performance and make informed decisions about how to allocate resources going
forward.
Adjusted EBITDA
We define adjusted
earnings before interest, tax, depreciation and amortization (“Adjusted EBITDA”) as net loss excluding income taxes, depreciation
of property and equipment, net interest income, stock compensation, transaction costs and any non-operating financial income and expense.
See “Non-GAAP Financial Measures” for a reconciliation of GAAP net loss to Adjusted EBITDA.
Key Factors that May Influence
Future Results of Operations
Our financial
results of operations may not be comparable from period to period due to several factors. Key factors affecting our results of operations
are summarized below.
Revenue Sources. As
a pre-commercialization company, we currently generate revenue almost exclusively from two U.S. governmental agencies. We are
highly dependent upon the continuation of the existing U.S. governmental contract awards, as well as future governmental procurement
or other awards. Our operating results may not be comparable between periods as the timing and amount of awards or procurements from the
U.S. government may be inconsistent with the timing of prior awards and the phasing of the development study schedules may be different.
Our revenues may continue to be almost exclusively dependent upon the terms of those awards.
54
Gross Margin. When we begin commercial sales of the DeepView System, we may need
to determine lower pricing and incentives to accelerate adoption and implementation of the DeepView System, which may negatively impact
future revenue and gross margin percentages.
Managing our
Supply Chain. We are reliant on contract manufacturers and suppliers to produce our
components. While we have not been subject to any disruptions in our current limited production, we may be subject to component shortages,
which may cause delays in critical components and inventory, longer lead times, increased costs and delays in product shipments. Our ability
to grow depends, in part, on the ability of our contract manufacturers and suppliers to provide high quality services and deliver components
and finished products on time and at reasonable costs. While we do not maintain sole-source suppliers, there is a concentration of
suppliers which could lead to supply shortages, long lead times for components and supply changes. In the event we are unable to mitigate
the impact of delays and/or price increases in raw materials, electronic components and freight, it could delay the manufacturing and
installation of our products, which would adversely impact our cash flows and results of operations, including revenue and gross margin.
Results of Operations
The following
table summarizes of our results of operations for the years ended December 31, 2023 and 2022 (in thousands):
Year Ended December 31,
Operating costs and expenses:
Other income (expense):
Change in fair value of warrant liability 335 57 278
Foreign exchange transaction loss (24 ) (237 ) 213
Income tax provision (11 ) (106 ) 95
Research and development revenue
Year Ended December 31, Change in
Research and
development revenue was $18.1 million, for the year ended December 31, 2023, a decrease of 28.8% compared to the comparable period in
2022, reflecting less activity as we completed work under the BARDA Burn II contact. Additionally, we initiated work on the BARDA PBS
contract in the fourth quarter of 2023.
For the year
ended December 31, 2023 and 2022, the Company’s revenues disaggregated by the major sources was as follows:
Year Ended December 31, Change in
55
Cost of Revenues and Gross Profit
Year Ended December 31, Change in
Cost of revenue
for the year ended December 31, 2023 was $10.2 million, a decrease of 30.0% compared to the comparable period in 2022, due to decreased
activity to fulfill our U.S. governmental contracts, consistent with decreased research and development revenue.
Gross margin
for the year ended December 31, 2023 was 43.6%, an increase of 0.9% as compared to the comparable period in 2022. The reimbursement rate
under the BARDA PBS Contract, executed in September 2023, is higher than the rate in the BARDA Burn II contact.
General and Administrative Expense
Year Ended December 31, Change in
General and administrative expense was $20.9 million, for the year
ended December 31, 2023, an increase of 54.7% as compared to the comparable period in 2022. The increase reflects. our headcount growth
from 71 employees as of December 31, 2022 to 78 full-time employees as of December 31, 2023. Increased personnel cost in general
and administrative expense was approximately $3.8 million for the year ended December 31, 2023. Additionally, non-revenue generating research
and development activities, primarily related to salaries and related costs and consulting fees, have increased by approximately $3.3
million for the year ended December 31, 2023 compared to the comparable period in 2022.
Other income (expense)
Year Ended December 31, Change in
Change in fair value of warrant liability 335 57 278
Foreign exchange transaction loss (24 ) (237 ) 213
Net interest
income for the year ended December 31, 2023 primarily relates to cash interest received by us from our deposit accounts.
Change in fair value of warrant liability increased by approximately
$0.3 million for the year ended December 31, 2023 as compared to the comparable period in 2022. The decrease reflects changes in the fair
value of the Public Warrants from the closing of the Business Combination in September 2023.
Foreign exchange
transaction loss for year ended December 31, 2023 is immaterial due to lower balances in our deposit accounts and accounts payable denominated
in British pound sterling and less fluctuation in the exchange rate between the U.S. dollar and the British pound sterling. Foreign exchange
transaction loss for the year ended December 31, 2022 relates to the decreased exchange rate between the U.S. dollar and the British
pound sterling during 2022 for our deposit accounts that are denominated in British pound sterling. In addition, this amount includes
costs associated with buying British pound sterling for payment of our employees and vendors in the UK.
Transaction costs
for the year ended December 31, 2023 primarily relate to non-recurring legal, accounting, and consulting costs expended for the Business
Combination.
56
Non-GAAP Financial Measures
We use Adjusted
EBITDA as a non-GAAP metric when measuring performance, including when measuring current period results against prior periods’ Adjusted
EBITDA. This non-GAAP financial measure should be considered in addition to results prepared in accordance with GAAP and should not
be considered as a substitute for, or superior to, GAAP results. In addition, Adjusted EBITDA should not be construed as an indicator
of our operating performance, liquidity or cash flows generated by operating, investing and financing activities, as there may be significant
factors or trends that it fails to address.
Because of their
non-standardized definitions, non-GAAP measures (unlike GAAP measures) may not be comparable to the calculation of similar measures of
other companies. We caution investors that non-GAAP financial information, by its nature, departs from traditional accounting conventions.
Supplemental non-GAAP measures are presented solely to permit investors to more fully understand how Spectral AI’s management assesses
underlying performance.
Adjusted EBITDA
We define Adjusted
EBITDA as net loss excluding income taxes, depreciation of property and equipment, net interest income, stock compensation, transaction
costs and any non-operating financial income and expense.
The following
table presents our Adjusted EBITDA for the years ended December 31, 2023 and 2022 (in thousands):
Year Ended December 31,
Adjust:
Depreciation expense 9 11
Provision for income taxes 13 106
Net interest income (172 ) (21 )
Additional adjustments:
Change in fair value of warrant liability (335 ) (57 )
Foreign exchange transaction loss 24 237
Transaction costs 8,342 -
Liquidity and Capital Resources
Sources of Liquidity
As of December 31, 2023 we had approximately $4.8 million in cash,
notes payable of $0.4 million and no long-term debt. We had an accumulated deficit of approximately $32.8 million. Additionally, on December
26, 2023, we entered into a Common Stock Purchase Agreement and related Registration Rights Agreement with B. Riley Principal Capital
II, LLC. Upon the terms and subject to the satisfaction of the conditions set forth in the Common Stock Purchase Agreement, the Company
has the right, in our sole discretion, to sell to B. Riley Capital II up to $10.0 million in aggregate gross purchase price of newly issued
shares of the Company’s Common Stock (the “ELOC”). On March 20, 2024, the Company also entered into a Standby Equity
Purchase Agreement (“SEPA”) with YA II PN, LTD, a Cayman Islands exempt limited partnership (“Yorkville”) pursuant
to which the Company has the right to sell to Yorkville up to $30.0 million of its shares of Common Stock, subject to certain limitations
and conditions set forth in the SEPA. In connection with the SEPA, and subject to the conditions set forth therein, Yorkville has agreed
to advance to the Company in the form of convertible promissory notes an aggregate principal amount of up to $12.5 million (the “Pre-Paid
Advance”), which will be paid in three tranches. The first Pre-Paid Advance was disbursed on March 20, 2024 in the amount of $5.0
million with a fixed conversion price of $3.16, the second Pre-Paid Advance shall be in a principal amount of $5.0 million and advanced
after the earlier of the registration statement registering the resale of the shares of Common Stock issuable under the SEPA being declared
effective and or shareholder approval to exceed the 19.99% threshold of the aggregate number of shares of Common Stock issued pursuant
to the SEPA (the “Exchange Cap”) (the “Second Pre-Advance Closing”), and the third Pre-Paid Advance shall be in
a principal amount of $2.5 million and advanced sixty days following the Second Pre-Advance Closing. The Company is authorized to drawdown
an additional $3.0 million from the ELOC prior to utilizing the SEPA.
We
have historically funded our operations through the issuance of notes and the sale of preferred stock and common stock, along with payments
under governmental contracts for research and development activity.
57
The new PBS BARDA Contract, executed in September 2023, has a total
value of up to approximately $150.0 million if all future options are executed. The base phase of the PBS BARDA Contract, valued at $54.9
million, was exercised concurrently with the contract award in September 2023. To date, our total potential support from BARDA is nearly
$251.0 million for our 2013, 2019, and 2023 awards. In April 2023, we received a $4.0 million
grant under the MTEC Agreement. See “Research and Development Revenue” above. With
the PBS BARDA Contract, the ELOC and funding available through the SEPA, the Company believes it will have sufficient working capital
to fund operations for at least one year beyond the release date of the consolidated financial statements.
Our future capital requirements will depend
on many factors, including the revenue growth rate, the success of future product development and capital investment required, and the
timing and extent of spending to support further sales and marketing and research and development efforts. In addition, we expect to incur
additional costs as a result of operating as a U.S. public company. There can be no assurance that we will be successful in raising
any additional capital. If additional financing is required from outside sources, we cannot be sure that any additional financing will
be available to us on acceptable terms, if at all. If we are unable to raise additional capital when desired, our business, operating
results, and financial condition could be adversely affected.
Cash Flows
The following
table summarizes our cash flows for the year ended December 31, 2023 and 2022 (in thousands):
Year Ended December 31,
Net cash used in operating activities $ (13,240 ) $ (1,162 )
Net cash provided by (used in) financing activities 3,844 (785 )
Cash Flows
Used in Operating Activities
Net cash used in operating activities increased by approximately $12.1 million
for the year ended December 31, 2023, as compared to the year ended December 31, 2022 primarily driven by (a) increased spending on general
and administrative expenses of approximately $3.6 million for our increased staff and approximately $3.3 million for our higher non-revenue
generating research and development costs, (b) decreased gross profit of approximately $2.7 million from less research and development
work performed pursuant to the BARDA Burn II contract as clinical trials under this contract were nearing completion, partially offset
by cash receipts in excess of cash payments, and (c) cash paid for transaction costs for the Business Combination of $0.8 million.
Cash Flows
Provided by (Used in) Financing Activities
Net cash provided by financing activities increased approximately $4.6 million
for the year ended December 31, 2023 compared to the year ended December 31, 2022. This was primarily attributable to the proceeds of
$3.4 million from the Equity Raise and operating cash received upon the Closing of the Business Combination of $0.7 million.
Current
Indebtedness
In September 2023,
we entered into a financing arrangement for a portion of our insurance premium for approximately $0.6 million (the “Note”).
The Note bears interest at 8.6% per annum and is payable in equal monthly payments of principal and interest, maturing in June 2024. As
of December 31, 2023, we owed $0.4 million for the Note.
Related Party
Transactions
For the years
ended December 31, 2023 and 2022, we did not have any transactions with related parties.
Off-Balance
Sheet Arrangements
During the periods
presented, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Critical Accounting
Policies
There have been
no material changes to the Company’s critical accounting policies and estimates discussed in Legacy Spectral’s Management’s
Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies for the years ended December 31,
2022 and 2021 included in the Prospectus.
Our significant accounting policies are described in more detail in
Note 2 to our audited consolidated financial statements included elsewhere in this Annual Report. We believe that the following accounting
policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements.
58
Accrued Research and Development
Expenses
As part of the
process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses
as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our applicable personnel
to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred
for the service when we have not yet been invoiced or otherwise notified of actual costs. The majority of our service providers invoice
us in arrears for services performed, on a pre-determined schedule or when contractual milestones are met; however, some require advance
payments. We make estimates of our accrued expenses as of each balance sheet date in the consolidated financial statements based on facts
and circumstances known to us at that time. We periodically confirm the accuracy of the estimates with the service providers and make
adjustments if necessary.
Determination of the Fair Value
of Equity-Based Awards
We measure stock options and other stock-based awards granted to directors,
employees, and non-employees based on their fair value on the date of the grant and recognize the corresponding compensation expense of
those awards over the requisite service period, which is generally the vesting period of the respective award. We have only issued stock
options, restricted stock awards and restricted stock units with time-based vesting conditions and record the expense for these awards
using the ratable method. We determine the fair value of restricted stock awards granted based on the fair value of our common stock.
We estimate the fair value of stock option awards granted using the Black-Scholes option-pricing model, which uses as inputs the fair
value of our common stock and subjective assumptions we make, including the expected stock price volatility, the expected term of the
award, the risk-free interest rate and expected dividends.
Due
to insufficient trade history of our common stock, we are unable to estimate the future volatility of our share price and instead estimate
our expected volatility from the historical volatility of a representative group of publicly traded companies for which historical information
is available. The historical volatility is generally calculated based on a period of time commensurate with the expected term assumption.
We use the simplified method to calculate the expected term for options granted to employees and directors, which is based on the average
of the time-to-vesting and the contractual life of the options. We utilize this method as we do not have sufficient historical exercise
data to provide a reasonable basis upon which to estimate the expected term. For grants to non-employees, ASU 2018-07 allows entities
to use the expected term to measure non-employee options or elect to use the contractual term as the expected term, on an award-by-award
basis. The risk-free interest rate is based on a U.S. treasury instrument whose term is consistent with the expected term of the stock
options. The expected dividend yield is assumed to be zero as we have never paid dividends and do not have current plans to pay any dividends
on our common stock.
See
Note 11 to our audited consolidated financial statements included elsewhere in this Annual Report for information concerning certain
of the specific assumptions we used in applying the Black-Scholes option pricing model to determine the estimated fair value of our stock
options granted in the years ended December 31, 2023 and 2022.
Recent
Accounting Pronouncements
See Note 2, Summary
of Significant Accounting Policies, of the notes to our consolidated financial statements included elsewhere in this Form 10-K for recently
adopted accounting standards and recently issued accounting standards as of the dates of the statement of financial position included
in this Form 10-K.
Emerging Growth
Company and Smaller Reporting Company Status
We are an emerging growth company, as defined in the Jumpstart Our
Business Startups Act of 2012 (the “JOBS Act”). The JOBS Act provides that an emerging growth company can take advantage of
an extended transition period for complying with new or revised accounting standards. This provision allows an emerging growth company
to delay the adoption of some accounting standards until those standards would otherwise apply to private companies. We have elected to
use the extended transition period under the JOBS Act for the adoption of certain accounting standards until the earlier of the date we
(i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period
provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply more promptly with new
or revised accounting pronouncements as of public company effective dates.
In addition,
as an emerging growth company, we may take advantage of specified reduced disclosure and other requirements that are otherwise applicable
generally to public companies. These provisions include:
59
We may take advantage of these provisions until the last day of the
fiscal year ending after the fifth anniversary of Rosecliff’s initial public offering or such earlier time that we no longer qualify
as an emerging growth company. We will cease to qualify as an emerging growth company on the date that is the earliest of: (i) December
31, 2026; (ii) the last day of the fiscal year in which we have more than $1.235 billion in total annual gross revenues; (iii) the date
on which we are deemed to be a “large accelerated filer” under the rules of the SEC, which means the market value of our common
stock that is held by non-affiliates exceeds $700.0 million as of the prior June 30th and we have been a public company for at least 12
months and have filed one annual report on Form 10-K; or (iv) the date on which we have issued more than $1.0 billion of non-convertible
debt over the prior three-year period. We may choose to take advantage of some but not all of these reduced reporting burdens. Accordingly,
the information contained herein may be different than you might obtain from other public companies in which you hold equity interests.
We are also a “smaller reporting company.” If we are a
smaller reporting company at the time we cease to be an emerging growth company, we may continue to rely on exemptions from certain disclosure
requirements that are available to smaller reporting companies. Specifically, as a smaller reporting company, we may choose to present
only the two most recent fiscal years of audited consolidated financial statements in our Annual Report and, similar to emerging growth
companies, smaller reporting companies have reduced disclosure obligations regarding executive compensation.
Item 7.A. Quantitative and Qualitative Disclosures about Market Risk
Not required for smaller reporting companies.
Item 8. Financial Statements and Supplementary Data
The financial
statements required to be filed pursuant to this Item 8 are appended to this Annual Report on Form 10-K. An index of those financial statements
is found in Item 15, Exhibits and Financial Statement Schedules, of this Annual Report on Form 10-K.
Item 9. Changes in and Disagreements
with Accountants on Accounting and Financial Disclosure
None.
Item 9.A. Controls and Procedures.
Evaluation of Disclosure Controls
and Procedures
Our management, including our Chief Executive Officer and Chief Financial
Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under
the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this Annual Report
on Form 10-K. Based on management’s evaluation as of the year ended December 31, 2023, our Chief Executive Officer and Chief Financial
Officer have concluded that, as a result of the material weaknesses in our internal control over financial reporting as described below
and in Part II, Item 1A. Risk Factors, our disclosure controls and procedures were not effective as of December 31, 2023. In connection
with the preparation of our consolidated financial statements for the year ended December 31, 2023, we identified material weaknesses
in: (i) lack of communication within management and internal departments regarding complex and unusual arrangements. This resulted in
communication failures of relevant facts necessary for the accounting group to properly conclude and apply the required accounting treatment
of certain stock transactions; (ii) the Company did not maintain adequately designed controls to ensure the proper recording of operating
expenses, related accruals and unbilled revenue in the correct period. As a result, certain control activities in the accrual and unbilled
revenue processes were not designed and implemented effectively; and (iii) our financial statement close process controls which relate
to all financial statement accounts, did not consistently operate effectively or lacked appropriate evidence, to ensure account reconciliations,
transactions, and journal entries were performed or reviewed at the appropriate level of precision and on a timely basis. These control
deficiencies could result in a material misstatement of our accounts or disclosures that would not be prevented or detected on a timely
basis, and accordingly, we determined that these control deficiencies in aggregate constitute a material weakness.
Notwithstanding
the identified material weaknesses, our management believes that the condensed consolidated financial statements included in this
Annual Report on Form 10-K fairly present, in all material respects, our financial condition, results of operations and cash flows as
of and for the periods presented in accordance with U.S. GAAP.
60
Remediation Plan for Material Weaknesses
Remediation
generally requires making changes to how controls are designed and implemented and then adhering to those changes for a sufficient period
of time such that the effectiveness of those changes is demonstrated with an appropriate amount of consistency. In response to the material
weaknesses, we implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting.
These efforts include:
The
measures we are implementing are subject to continued management review supported by confirmation and testing, as well as audit committee
oversight. Management and the Audit Committee remain committed to the implementation of remediation efforts to address the material weaknesses.
We will continue to implement measures to remedy our internal control deficiencies, though there can be no assurance that our efforts
will be successful or avoid potential future material weaknesses. In addition, until remediation steps have been completed and are operated
for a sufficient period of time, and subsequent evaluation of their effectiveness is completed, the material weaknesses previously disclosed,
and as described above, will continue to exist.
Management’s
Annual Report on Internal Control over Financial Reporting
Our
management assessed the effectiveness of our internal control over financial reporting as of December 31, 2023. In making this assessment,
our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, in Internal
Control-Integrated 2013 Framework.
Based
on this assessment, our management concluded that, as of December 31, 2023, our internal control over financial reporting was not effective
at the reasonable assurance level, due to the material weaknesses outlined above.
We believe progress was made in 2023 to enhance and strengthen our
internal control over financial reporting. The measures we are implementing are subject to continued management review supported by confirmation
and testing, as well as audit committee oversight. Management remains committed to remediating these material weaknesses. We will continue
to implement measures to remedy our internal control deficiencies, though there can be no assurance that our efforts will be successful
or avoid potential future material weaknesses.
This
Annual Report on Form 10-K does not include an attestation report of our independent registered public accounting firm on internal control
over financial reporting due to an exemption established by the JOBS Act for “emerging growth companies.”
Changes in Internal Control over Financial
Reporting
Except for the remediation efforts in connection with the material
weaknesses described above, there were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) of the
Exchange Act) that occurred during the fourth quarter of the year ended December 31, 2023 that has materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting.
Item 9.B. Other Information.
None.
Item 9.C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspection.
Not Applicable.
61
PART III.
Item 10. Directors, Executive Officers and Corporate Governance.
The information required
by this Item 10 is set forth under the captions “Executive Officers of the Registrant”, “Proposal No. 1 – Election
of Directors” and “Board of Directors and Committees” in our Definitive Proxy Statement with respect to our 2024 Annual
Meeting of Stockholders and is incorporated herein by reference.
Item 11. Executive Compensation.
As an “emerging growth
company” as defined in the JOBS Act, we are not required to include a Compensation Discussion and Analysis section and have opted
to comply with the scaled disclosure requirements applicable to emerging growth companies.
The information required by
this Item 11 is set forth under the caption “Executive Officer and Director Compensation” in our Definitive Proxy Statement
with respect to our 2024 Annual Meeting of Stockholders and is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The
information required by this Item 12 is set forth under the captions “Share Ownership” and “Outstanding Equity Awards
at Fiscal Year End 2023” in our Definitive Proxy Statement with respect to our 2024 Annual Meeting of Stockholders and is incorporated
by reference.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The
information required by this Item 13 is set forth under the captions “Certain Relationships and Related Transactions” and
“Board of Directors and Committees” in our Definitive Proxy Statement with respect to our 2024 Annual Meeting of Stockholders
and is incorporated herein by reference.
Item 14. Principal Accountant Fees and Services.
The information required
by this Item 14 will be set forth under the caption “Proposal No. 3: Ratification of Independent Registered Public Accounting Firm”
in our Definitive Proxy Statement with respect to our 2024 Annual Meeting of Stockholders and is incorporated herein by reference.
62
PART IV.
Item 15. Exhibits, Financial Statement Schedules.
SPECTRAL AI, INC.
INDEX TO FINANCIAL
STATEMENTS
Report of Independent Registered Public Accounting Firm (PCAOB ID: 185) F-2
Consolidated Balance Sheets F-3
Consolidated Statements of Operations and Comprehensive Loss F-4
Consolidated Statements of Changes in Stockholders’ Equity (Deficit) F-5
Consolidated Statements of Cash Flows F-6
Notes to Consolidated Financial Statements F-7
F-1
Report of Independent Registered Public Accounting
Firm
To the Stockholders and Board of Directors
Spectral AI, Inc.:
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Spectral
AI, Inc. and subsidiaries (the Company) as of December 31, 2023 and 2022, the related consolidated statements of operations
and comprehensive loss, changes in stockholders’ equity (deficit), and cash flows for each of the years in the two-year period ended
December 31, 2023, and the related notes (collectively, the consolidated financial statements). In our opinion, the consolidated
financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2023
and 2022, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2023,
in conformity with U.S. generally accepted accounting principles.
Basis for Opinion
These consolidated financial statements are the responsibility of the
Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required
to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations
of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB.
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements
are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform,
an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal
control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal
control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material
misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those
risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial
statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as
evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for
our opinion.
We have served as the Company’s auditor since 2021.
Dallas, Texas
March 29, 2024
F-2
SPECTRAL AI, INC.
CONSOLIDATED BALANCE
SHEETS
(in thousands, except
share and per share data)
December 31, December 31,
Assets
Current assets:
Unbilled revenue - 618
Deferred offering costs 283 -
Non-current assets:
Property and equipment, net 12 21
Commitments and contingencies (Note 8)
Liabilities and Stockholders’ Equity (Deficit)
Current liabilities:
Deferred revenue 2,311 -
Lease liabilities, short-term 853 680
Lease liabilities, long-term - 346
Stockholders’ Equity (Deficit)
Accumulated other comprehensive income 12 -
Total Stockholders’ Equity (Deficit) (1,709 ) 11,996
Total Liabilities and Stockholders’ Equity (Deficit) $ 10,692 $ 18,716
The accompanying notes
are an integral part of these consolidated financial statements
F-3
SPECTRAL AI, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(in thousands, except share and per share data)
Year Ended December 31,
Operating costs and expenses:
Other income (expense):
Net interest income 172 21
Change in fair value of warrant liability 335 57
Foreign exchange transaction loss, net (24 ) (237 )
Transaction costs (8,342 ) -
Total other expense, net (7,859 ) (159 )
Income tax provision (11 ) (106 )
Net loss per share of common stock
Basic and Diluted $ (1.48 ) $ (0.22 )