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.
Overview
We are an artificial intelligence (“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 device that has previously received
FDA breakthrough device designation status for an earlier version. 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 2025. 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 has been on the burn indication which is supported by the BARDA PBS contract.
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. 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 patients undergoing both surgical and non-surgical treatment. In December
2023, we initiated a pivotal clinical study seeking enrollment of 240 patients, including 180 adult and 60 pediatric patients through
multiple sites across the United States in both burn center and emergency departments. By the end of 2024, the Company had completed
the enrollment of the pivotal clinical study with 267 patients, including 146 at burn centers, 121 at emergency departments across 22
sites across the United States. As part of the total 267 patients enrolled, 42 pediatric patients were included from burn centers and
another 42 pediatric patients were included from emergency departments.
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 $281.9 million in funding awards 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 contract funding is non-dilutive to our shareholders, and we believe it validates
the important nature of our mission and technology.
In addition to our PBS 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 version
of the DeepView® System (the “MTEC Agreement”). In August 2024, the MTEC award was increased to $4.9 million
and is currently intended to run through December 2025 with funding dependent on various milestones. In March 2024, we received an additional
$0.5 million award from the DHA to further this development, for a total contract value of approximately $2.8 million.
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.
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Business Combination
On September 12, 2023, following
completion of the Business Combination, 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.
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)
In 2024, other income (expense) consists of fees incurred in connection
with the Yorkville transaction and B. Riley purchase agreement, net interest income, borrowing related costs related to the Yorkville
convertible notes, including the 8% original issue discount and 7% repayment premium as may be applicable per each Pre-Paid Advance, change
in fair value of notes payable, change in fair value of warrant liabilities, changes in fair value of derivatives, and foreign exchange
transaction gains/losses. In 2023, other income (expense) consists of transaction costs related to the Business Combination, net interest
income, change in fair value of warrant liabilities and foreign exchange transaction gain/losses. Historic foreign exchange transaction
loss primarily relates to changes in the exchange rate between the U.S. dollar and the British pound sterling for our deposit accounts
that are denominated in British pound sterling. In addition, this amount includes costs associated with currency translation costs associated
with purchasing British pound sterling for payment of our employees and vendors in the UK.
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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, 2024 and 2023
The following table summarizes
these metrics for the years ended December 31, 2024 and 2023 (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,
identify 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.
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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 our results of operations for the years
ended December 31, 2024 and 2023 (in thousands):
Year Ended December 31,
Operating costs and expenses:
Other income (expense):
Borrowing related costs (2,965 ) - (2,965 )
Change in fair value of warrant liability (4,633 ) 335 (4,968 )
Change in fair value of notes payable (220 ) - (220 )
Foreign exchange transaction loss (43 ) (24 ) (19 )
Research and development revenue
Year Ended December 31, Change in
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Research and development revenue was $29,581 for the year ended December
31, 2024, an increase of 63.8% compared to the comparable period in 2023, reflecting more activity as we completed work under the PBS
BARDA Contract and in the awards and work performed under the Company’s other U.S. governmental contracts.
For the year ended December
31, 2024 and 2023, the Company’s revenues disaggregated by the major sources was as follows:
Year Ended December 31, Change in
Cost of Revenues and Gross Profit
Year Ended December 31, Change in
Cost of revenue for the
year ended December 31, 2024 was $16.3 million, an increase of 60.2% compared to the comparable period in 2023, due to increased development
activity to fulfill our U.S. governmental contracts, consistent with increased research and development revenue.
Gross margin for the year
ended December 31, 2024 was 44.9%, an increase from 43.6% as compared to the comparable period in 2023, due to more direct labor attributed
to the PBS BARDA Contract as a component of the overall development activity and the higher reimbursement rate under the PBS BARDA Contract,
executed in September 2023, than the rate in the BARDA Burn II contact.
General and Administrative Expense
Year Ended December 31, Change in
General and administrative expense was $19.9 million, for the year
ended December 31, 2024, a decrease of 4.8% as compared to the comparable period in 2023. Non-revenue generating research and development
activities have decreased by approximately $2.1 million for the year ended December 31, 2024 compared to the comparable period in 2023
due to an overall increase in the percentage of work performed on the PBS BARDA Contract in 2024. The reduction was offset by an increase
of approximately $1.1 million related to other administrative expenses for the year ended December 31, 2024, compared to the comparable
period in 2023. This expense also reflects the consistent headcount at the Company from the prior year.
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Other income (expense)
Year Ended December 31, Change in
Borrowing related costs (2,965 ) — (2,965 )
Change in fair value of warrant liabilities (4,633 ) 335 (4,968 )
Change in fair value of notes payable (220 ) — (220 )
Foreign exchange transaction loss, net (43 ) (24 ) (19 )
Other income (expenses), including transaction costs (615 ) (8,342 ) 7,727
Total other income (expense), net $ (8,462 ) $ (7,859 ) $ (603 )
Net interest income for
the year ended December 31, 2024 primarily relates to cash interest received or (paid) by us from our deposit accounts.
Borrowing related costs increased
$3.0 million for the year ended December 31, 2024, as compared to the comparable period in 2023 due to debt issuance costs and payments
of the discount and premium related to the Yorkville Convertible Notes that were expensed during fiscal year 2024.
Change in fair value of
warrant liabilities decreased by approximately $5.0 million for the year ended December 31, 2024 as compared to the comparable period
in 2023. The decrease reflects changes in the fair value of the Public Warrants, which were issued in September 2023 and repriced in
December 2024.
Change in fair value of
notes payable decreased by approximately $0.2 million for the year ended December 31, 2024, as compared to the comparable period in 2023,
which reflects the total change in the fair value of the Yorkville notes issued in 2024.
Foreign exchange transaction
loss for the year ended December 31, 2024 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, 2023 relates to the decreased exchange rate between the U.S. dollar and the British
pound sterling during 2023 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.
Other income (expenses),
including transaction costs for the year ended December 31, 2024 primarily relate to legal, professional, and service fees incurred in
connection with the Yorkville transaction and B. Riley purchase agreement. Other income (expenses), including transaction costs for the
year ended December 31, 2023 primarily relate to non-recurring legal, accounting, and consulting costs expended for the Business Combination.
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.
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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, 2024 and 2023 (in thousands):
Year Ended December 31,
Adjust:
Depreciation expense 10 9
Provision for income taxes 271 11
Net interest expense (14 ) (172 )
Additional adjustments:
Borrowing related costs 2,965 -
Change in fair value of warrant liability 4,633 (335 )
Change in fair value of notes payable 220 -
Foreign exchange transaction (gain) loss 43 24
Other (income) expenses, including transaction costs 615 8,342
Liquidity and Capital Resources
Sources of Liquidity
As of December 31, 2024, we had approximately $5.2 million in cash,
notes payable of $2.8 million, and no long-term debt. We had an accumulated deficit of approximately $48.1 million. The Company incurred
a net loss of $15.3 million during the year ended December 31, 2024 and had working capital (current assets less current liabilities)
of approximately ($7.5) million as of December 31, 2024. Net cash used in operating activities was $9.1 million for the year ended December
31, 2024.
In November and December 2024, the Company issued 3,896,781 shares
for gross proceeds of approximately $4.5 million to certain institutional investors through at-the market equity issuances, stock option
exercises and the conversion of the Company’s wholly-owned subsidiary, Spectral IP, Inc. (“Spectral IP”), convertible
promissory note into shares of the Company’s common stock.
On December 26, 2023, we
entered into a Common Stock Purchase Agreement and related Registration Rights Agreement with B. Riley Principal Capital II, LLC (“B.
Riley”). 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 up to $10.0 million in aggregate gross purchase price of newly issued
shares of the Company’s Common Stock (the “ELOC”). The Company maintained the right to raise up to $3,000,000 of shares
of its Common Stock from the B. Riley transaction upon execution of the SEPA with Yorkville, which is described in more detail below.
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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 Company received $4.6 million in cash, net of the 8% original issue discount. On May 14, 2024, the
shareholders voted to approve the reservation and issuance of shares to Yorkville to exceed the 19.99% of the shares of Common stock outstanding
immediately prior to the execution of the SEPA (the “Exchange Cap”) and the second Pre-Paid Advance was disbursed on May 16,
2024 in the amount of $4.6 million, which is the $5.0 million second Pre-Paid Advance net of $0.4 million of the 8% original issue discount,
with a fixed conversion price of $2.03. The third Pre-Paid Advance was disbursed on July 17, 2024 in the principal amount of $2.3 million,
which is the $2.5 million third Pre-Paid Advance net of the $0.2 million of the 8% original issue discount. As of December 31, 2024, $7.8
million of the outstanding balance of the Pre-Paid Advances was paid in cash and $2.4 million was paid in shares of the Company issued
under the SEPA. The Company still has access to the remaining funds under the SEPA. The sales of the shares of Common Stock to Yorkville
under the SEPA, and the timing of any such sales, are at the Company’s option.
We have historically funded
our operations through the issuance of notes and the sale of common stock, along with payments under governmental contracts for research
and development activity.
In September 2023, the Company executed its third contract with BARDA
for a multi-year PBS BARDA Contract, valued at up to approximately $150.0 million. 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 development and distribution purposes.
The Company completed the second contract with BARDA, referred to as BARDA Burn II, which was signed in July 2019 and completed in November
2023. Under this contract, the Company furthered the DeepView System design, developed the AI algorithm, and took steps to obtain FDA
approval.
In April 2023, the Company
received a $4.0 million grant under the MTEC Agreement, which was increased to $4.9 million in August 2024 and is currently intended
to run through December 2025. The MTEC Agreement is for the development of a handheld version of the DeepView® System which is to
be used to support military battlefield burn evaluation. The project has three phases, beginning with planning, design and testing; followed
by development, design modification and buildout of the handheld device; and then the manufacturing of the handheld device.
Based on our current operating
plan, we believe that our cash and cash equivalents, together with the PBS BARDA Contract, the MTEC Agreement, the B. Riley ELOC, and
the Yorkville Transaction, will be sufficient to fund operations for at least one year beyond the release date of these consolidated
financial statements. We have based this determination on assumptions that may prove to be wrong, and we could utilize our available
capital resources sooner than we currently expect. The Company may continue to conserve our working capital and to focus our efforts
primarily on the burn indication. Changing circumstances could also cause us to consume capital significantly faster than we currently
anticipate, and we may need to raise capital sooner or in greater amounts than currently expected because of circumstances beyond our
control. Changes in the current equity markets may also limit our ability to utilize the B. Riley ELOC and Yorkville SEPA as currently
structured. To the extent additional capital is necessary, there are no assurances that we will be able to raise additional capital on
favorable terms or at all, and therefore we may not be able to execute our business plans and the continued work on indications beyond
expanding our burn indication.
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. 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 years ended December 31, 2024 and 2023 (in thousands):
Year Ended December 31,
Net cash used in operating activities $ (9,199 ) $ (13,240 )
Net cash provided by financing activities 9,575 3,844
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Cash Flows Used in
Operating Activities
Net
cash used in operating activities decreased by approximately $4.0 million for the year ended December 31, 2024, as compared to the year
ended December 31, 2023 primarily driven by changes in operating liabilities including accrued expenses and deferred revenue, partially
offset by a decrease in net loss. The lower net loss is a result of higher research and development revenue due to increased BARDA activity
and lower non-operating transaction costs in the year ended December 31, 2024 compared to the year ended December 31, 2023.
Cash Flows Provided
by Financing Activities
Net
cash provided by financing activities increased approximately $5.7 million for the year ended December 31, 2024 compared to the year ended
December 31, 2023. This was primarily attributable to the proceeds of $2.7 million from the ELOC, proceeds of $13.1 received from the
sale of the Company’s Common Stock and the principal amount of the notes payable from the Pre-Paid Advances under the SEPA, partially
offset by $7.8 million of repayments of notes payable as compared to proceeds of $3.4 million from the issuance of Common Stock and operating
cash received upon closing of the Business Combination of $0.7 million during the year ended December 31, 2023.
Current Indebtedness
On
March 20, 2024, the Company entered into the SEPA with Yorkville pursuant to which the Company has the right to sell to Yorkville up
to $30.0 million of its shares of Company Common Stock, subject to certain limitations and conditions set forth in the SEPA, from time
to time during the term of the SEPA (such transaction, the “Yorkville Transaction”). 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 (the
“Convertible 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 Company received $4.6 million in cash, net of the 8% original issue discount. On May 14, 2024, the shareholders voted
to approve the reservation and issuance of shares to Yorkville to exceed the Exchange Cap and the second Pre-Paid Advance was disbursed
on May 16, 2024 in the amount of $4.6 million, which is the $5.0 million second Pre-Paid Advance net of $0.4 million of the 8% original
issue discount, with a fixed conversion price of $2.03. The third Pre-Paid Advance was disbursed on July 17, 2024 in the principal amount
of $2.3 million, which is the $2.5 million third Pre-Paid Advance net of the $0.2 million of the 8% original issue discount, with a fixed
conversion price equal to 120% of the average VWAP during the three trading days immediately prior to the issuance of the note. The purchase
price for the Pre-Paid Advance is 92.0% of the principal amount of the Pre-Paid Advance. Interest shall accrue on the outstanding balance
of any Pre-Paid Advance at an annual rate equal to 0%, subject to an increase to 18% upon an event of default as described in the Convertible
Notes.
Beginning on the forty-fifth (45th) day following the issuance date
of the Convertible Note issued in connection with the first Pre-Paid Advance, and continuing on the same day of each successive month
thereafter, (each, an “Installment Date”), the Company shall repay a portion of the outstanding balance of the Pre-Paid Advance
in an amount equal to (i) $1,750,000, plus (ii) the a payment premium of 7% of such Installment Principal Amount, and (iii) accrued and
unpaid interest hereunder as of each Installment Date. The maturity date of the Convertible Notes issue in connection with each Pre-Paid
Advance will be 12 months after the issuance date of such Convertible Notes. In October 2024, the Company and Yorkville agreed to amend
the dates and the allocation of installment amounts to be paid pursuant to the Pre-Paid Advances, such that the outstanding balance of
the Pre-Paid Advances is to be paid by February 2025. As of December 31, 2024, the Company has made aggregate installment payments on
the Pre-Paid Advances in the amount of $10.2 million, of which $7.8 million was settled in cash and $2.4 million was settled in shares.
Of the aggregate installment payments, $9.4 million relates to the repayment of the principal, $0.8 million relates to the 8% original
issue discount and $0.6 million relates to the 7% payment premium. As of December 31, 2024, $7.8 million of the outstanding balance of
the Pre-Paid Advances was paid in cash and $2.4 million has been paid in shares of the Company issued under the SEPA. The Company still
has access to the remaining funds under the SEPA. The sales of the shares of Common Stock to Yorkville under the SEPA, and the timing
of any such sales, are at the Company’s option.
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Related Party Transactions
On
March 7, 2024, the Company formed a new wholly-owned subsidiary, Spectral IP, to be utilized to acquire artificial intelligent intellectual
property with a specific emphasis on healthcare. On March 19, 2024, the Company announced that Spectral IP received a $1.0 million investment
from an affiliate of its largest shareholder for the development of its artificial intelligence intellectual property portfolio. The
investment is structured as a note payable with a one-year maturity, an interest rate of 8%, and requiring earlier prepayment if the
Company spins off Spectral IP to the Company’s shareholders or if Spectral IP is sold to a third party.
On October 1, 2024, the
note was amended to (i) reduce the annual interest rate from 8% to 4%, (ii) extend the term of the Note through the second
anniversary of the issuance date, March 18, 2026, (iii) include a conversion feature at the option of either the holder or Spectral IP
to convert the then outstanding principal and accrued but unpaid interest into shares of the Company at any time (into such number of
shares calculated by taking a five percent (5.00%) discount to the closing price of the Company’s common stock on the day prior
to the date of notice to the Company of the exercise of the conversion right) and at maturity, respectively, and (iv) provide for registration
rights of any shares of the Company issued in satisfaction of the outstanding obligations.
On
October 1, 2024, Spectral IP amended its existing $1,000,000 promissory note to extend the term from one to two years, reduce the interest
rate from 8.00% to 4.00% per annum and to provide a conversion feature for shares of the Company’s common stock in satisfaction
of the outstanding principal and accrued but unpaid interest. The holder of the Spectral IP Note exercised a number of conversion rights
throughout the fourth quarter of 2024 for the full conversion of the Spectral IP Note in exchange for a total of 540,996 shares of the
Company’s common stock, which represents a 5.00% discount to the closing price of the Company’s shares of Common Stock on
the day prior to the date of notice of the holder’s exercise of its conversion right.
For
the year ended December 31, 2023, 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
Our
significant accounting policies are described 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.
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.
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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 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 have also issued
restricted stock units that vest upon the achievement of certain market conditions. We determine the fair value of time-based
vesting 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 risk-free interest rate and expected dividends, and the
contractual term as the expected term of the award. We determine the fair value of restricted stock units that vest upon the
achievement of certain market conditions using a Monte Carlo simulation 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, the relevant accounting literature
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, 2024 and 2023.
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:
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We
may take advantage of these provisions until the last day of the fiscal year ending after the fifth anniversary of our 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.
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 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, 2024, our Chief Financial Officer has concluded that we successfully
remediated the material weaknesses related to (i) our lack of communication within management and internal departments regarding complex
and unusual arrangements and (ii) that 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. However, our remediation and testing continue for the material
weakness (iii) that 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. As a result of the material weakness 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, 2024. As a result, certain control activities in 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. This control
deficiency 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.
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Notwithstanding the identified
material weaknesses, our management believes the 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.
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 weakness, we implemented, and are continuing to implement, measures
designed to improve our internal control over financial reporting. These efforts include:
● engaging consultants to provide additional technical accounting expertise; and
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 weakness. 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 weakness 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, 2024. 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, 2024, our internal control over financial reporting was not effective at the reasonable assurance level, due to the material weakness
outlined above.
We believe progress was made in 2024 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 this material weakness. 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, 2024 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.
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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 2025 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 2025 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 2024” in our Definitive Proxy Statement with respect to our 2025 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 2025 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 2025 Annual Meeting of Stockholders and is incorporated
herein by reference.
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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