Quarterly Report (10-q)

Date : 11/14/2019 @ 2:32PM
Source : Edgar (US Regulatory)
Stock : Digital Ally Inc (DGLY)
Quote : 0.9024  0.004205 (0.47%) @ 6:42PM
Digital Ally share price Chart

Quarterly Report (10-q)

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2019.

 

or

 

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

 

For the transition period from ___________ to __________.

 

Commission File Number: 001-33899

 

Digital Ally, Inc.

(Exact name of registrant as specified in its charter)

 

Nevada 20-0064269
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)

 

9705 Loiret Blvd, Lenexa, KS 66219

(Address of principal executive offices) (Zip Code)

 

(913) 814-7774

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class   Trading Symbol(s)   Name of exchange on which registered
Common stock, $0.001 par value   DGLY   the Nasdaq Capital Market, LLC

 

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

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).

 

Yes [X] No [  ]

 

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

 

Large accelerated filer [  ] Accelerated filer [  ]
Non-accelerated filer [  ] (Do not check if a smaller reporting company) Smaller reporting company [X]
Emerging growth company [  ]  

 

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

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes [  ] No [X]

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

 

Class   Outstanding at November 13, 2019
Common Stock, $0.001 par value   12,079,095

 

 

 

     
     

 

FORM 10-Q

DIGITAL ALLY, INC.

SEPTEMBER 30, 2019

 

TABLE OF CONTENTS   Page(s)
PART I – FINANCIAL INFORMATION    
     
Item 1. Financial Statements.    
     
Condensed Consolidated Balance Sheets – September 30, 2019 (Unaudited) and December 31, 2018   3
     
Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2019 and 2018 (Unaudited)   4
     
Condensed Consolidated Statements of Stockholders’ Deficit for the Three and Nine Months Ended September 30, 2019 and 2018 (Unaudited)   5
     
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2019 and 2018 (Unaudited)   6
     
Notes to the Condensed Consolidated Financial Statements (Unaudited)   7-24
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.   25-48
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk.   48
     
Item 4. Controls and Procedures.   48
     
PART II - OTHER INFORMATION    
     
Item 1. Legal Proceedings.   48-50
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.   50
     
Item 3. Defaults Upon Senior Securities   50
     
Item 4. Mine Safety Disclosures   50
     
Item 5. Other Information.   50
     
Item 6. Exhibits.   50
     
SIGNATURES   51
     
EXHIBITS   52 
     
CERTIFICATIONS    

 

  2  
     

 

PART I – FINANCIAL INFORMATION

 

Item 1 – Financial Statements.

 

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

SEPTEMBER 30, 2019 AND DECEMBER 31, 2018

 

    (Unaudited)        
   

September 30,

2019

   

December 31,

2018

 
Assets                
Current assets:                
Cash and cash equivalents   $ 1,272,935     $ 3,598,807  
Accounts receivable-trade, less allowance for doubtful accounts of $123,224 – 2019 and $70,000-2018     1,762,169       1,847,886  
Accounts receivable-other     468,629       382,412  
Inventories, net     6,381,713       6,999,060  
Income tax refund receivable, current     44,603       44,603  
Prepaid expenses     477,023       429,403  
Total current assets     10,407,072       13,302,171  
                 
Furniture, fixtures and equipment, net     141,987       247,541  
Intangible assets, net     434,933       486,797  
Operating lease right of use assets     167,443        
Income tax refund receivable     45,397       45,397  
Other assets     404,253       256,749  
Total assets   $ 11,601,085     $ 14,338,655  
                 
Liabilities and Stockholders’ Deficit                
Current liabilities:                
Accounts payable   $ 2,075,213     $ 784,599  
Accrued expenses     1,077,482       2,080,667  
Secured convertible notes, at fair value-current portion     1,606,305        
Current portion of operating lease obligations     248,603        
Contract liabilities-current     1,698,560       1,748,789  
Income taxes payable     5,833       3,689  
Total current liabilities     6,711,996       4,617,744  
                 
Long-term liabilities:                
Proceeds investment agreement, at fair value- less current portion     6,417,000       9,142,000  
Contract liabilities-long term     1,830,471       1,991,091  
Total liabilities     14,959,467       15,750,835  
                 
Commitments and contingencies                
                 
Stockholder’s Deficit:                
Common stock, $0.001 par value; 50,000,000 shares authorized; shares issued: 12,079,095 – 2019 and 10,445,445 – 2018     12,079       10,445  
Additional paid in capital     82,748,400       78,117,507  
Treasury stock, at cost (63,518 shares)     (2,157,226 )     (2,157,226 )
Accumulated deficit     (83,961,635 )     (77,382,906 )
Total stockholders’ deficit     (3,358,382 )     (1,412,180 )
Total liabilities and stockholders’ deficit   $ 11,601,085     $ 14,338,655  

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

  3  
     

 

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND NINE MONTHS ENDED

SEPTEMBER 30, 2019 AND 2018

(Unaudited)

 

   

Three months ended
September 30,

   

Nine months ended
September 30,

 
    2019     2018     2019     2018  
                         
Revenue:                                
Product   $ 2,173,257     $ 2,334,863     $ 6,039,445     $ 7,319,676  
Service and other     749,891       543,196       1,981,482       1,593,446  
Total revenue     2,923,148       2,878,059       8,020,927       8,913,122  
                                 
Cost of revenue:                                
Product   1,601,913     1,592,072     4,333,812     4,672,432  
Service and other     132,973       108,698       366,301       335,540  
Total cost of revenue     1,734,886       1,700,770       4,700,113       5,007,972  
                                 
Gross profit     1,188,262       1,177,289       3,320,814       3,905,150  
Selling, general and administrative expenses:                                
Research and development expense     517,010       323,981       1,562,086       1,097,861  
Selling, advertising and promotional expense     877,218       711,506       2,871,154       2,097,919  
Stock-based compensation expense     405,579       669,480       1,715,972       1,757,227  
General and administrative expense     1,668,902       1,382,038       5,970,565       4,272,484  
Patent litigation settlement                 (6,000,000 )      
Total selling, general and administrative expenses     3,468,709       3,087,005       6,119,777       9,225,491  
Operating loss     (2,280,447 )     (1,909,716 )     (2,798,963 )     (5,320,341 )
                                 

Other income (expense)

                               
Interest income     6,667       2,206       30,279       4,507  
Interest expense     (37,037 )     (1,083,317 )     (37,037 )     (1,366,520 )
Change in warrant derivative liabilities           (9,799 )           (319,105 )
Secured convertible notes issuance expense     (89,148 )           (89,148 )     (220,312 )
Loss on the extinguishment of secured convertible debentures           (100,000 )           (600,000 )
Change in fair value of proceeds investment agreement     (177,000 )     (98,487 )     (3,275,000 )     (98,487 )
Change in fair value of secured convertible notes     (408,860 )            (408,860 )      
Change in fair value of secured convertible debentures           (1,466,467 )           (2,296,444 )
Loss before income tax benefit     (2,985,825 )     (4,665,580 )     (6,578,729 )     (10,216,702 )
Income tax benefit                        
Net loss   $ (2,985,825 )   $ (4,665,580 )   $ (6,578,729 )   $ (10,216,702 )
Net loss per share information:                                
Basic   $ (0.26 )   $ (0.60 )   $ (0.58 )   $ (1.40 )
Diluted   $ (0.26 )   $ (0.60 )   $ (0.58 )   $ (1.40 )
                                 
Weighted average shares outstanding:                                
Basic     11,637,289       7,725,877       11,296,999       7,295,098  
Diluted     11,637,289       7,725,877       11,296,999       7,295,098  

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

  4  
     

 

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018
(Unaudited)

 

    Common Stock     Additional Paid in     Treasury     Accumulated        
    Shares     Amount     Capital     stock     deficit     Total  
Balance, December 31, 2018     10,445,445     $ 10,445     $ 78,117,507     $ (2,157,226 )   $ (77,382,906 )   $ (1,412,180 )
                                                 
Stock-based compensation                 725,198                   725,198  
Restricted common stock grant     522,110       522       (522 )                  
Restricted common stock forfeitures     (2,500 )     (2 )     2                    
Issuance of common stock upon exercise of common stock purchase warrants     161,000       161       515,839                   516,000  
Net loss                             (3,205,174 )     (3,205,174 )
Balance, March 31, 2019     11,126,055     11,126       79,358,024       (2,157,226 )     (80,588,080 )     (3,376,156 )
                                                 
Stock-based compensation                 585,195                   585,195  
Issuance of common stock upon exercise of common stock purchase warrants     368,000       368       1,047,632                   1,048,000  
Net loss                             (387,730 )     (387,730 )
                                                 
Balance, June 30, 2019     11,494,055       11,494       80,990,851       (2,157,226 )     (80,975,810 )     (2,130,691 )
                                                 
Stock-based compensation                 405,579                   405,579  
Restricted common stock forfeitures     (2,870 )     (3 )     3                    
Issuance of common stock purchase warrants related to secured convertible notes                 535,739                   535,739  
Issuance of common stock upon conversion of secured convertible notes and interest     498,625       499       697,568                   698,067  
Issuance of common stock related to the issuance of secured convertible notes     89,285       89       118,660                   118,749  
Net loss                             (2,985,825 )     (2,985,825 )
Balance, September 30, 2019     12,079,095     $ 12,079     $ 82,748,400     $ (2,157,226 )   $ (83,961,635 )   $ (3,358,382 )
                                                 
Balance, December 31, 2017     7,037,799     $ 7,038     $ 64,923,735     $ (2,157,226 )   $ (61,909,799 )   $ 863,748  
                                                 
Cumulative effects of adjustment for adoption of ASC 606                             71,444       71,444  
Stock-based compensation                 493,519                   493,519  
Restricted common stock grant     84,500       84       (84 )                    
Restricted common stock forfeitures     (26,450 )     (26 )     26                    
Issuance of common purchase warrants in connection with the issuance of subordinated notes payable                 47,657                   47,657  
Net loss                             (2,588,232 )     (2,588,232 )
                                                 
Balance, March 31, 2018     7,095,849       7,096       65,464,853       (2,157,226 )     (64,426,587 )     (1,111,864 )
                                                 
Stock-based compensation                 594,227                   594,227  
Restricted common stock grant     100,000       100       (100 )                  
Restricted common stock forfeitures     (3,950 )     (4 )     4                    
Issuance of common purchase warrants in connection with the issuance of secured convertible debentures                 1,684,251                   1,684,251  
Issuance of stock upon conversion of secured convertible debentures and accrued interest     74,276       74       185,614                   185,688  
Issuance of common stock upon exercise of common stock purchase warrants     20,000       20       48,980                   49,000  
Net loss                             (2,962,890 )     (2,962,890 )
                                                 
Balance, June 30, 2018     7,286,175       7,286       67,977,829       (2,157,226 )     (67,389,477 )     (1,561,588 )
                                                 
Stock-based compensation                 669,481                   669,481  
Restricted common stock grant     300,000       301       (301 )                  
Restricted common stock forfeitures     (3,500 )     (4 )     4                    
Issuance of common stock through underwritten public offering (net of offering expenses and underwriters’ discount)     2,600,000       2,600       7,322,300                   7,324,900  
Issuance of common stock purchase warrants in connection with issuance of proceeds investment agreement                 932,487                   932,487  
Issuance of stock upon conversion of secured convertible debentures and accrued interest     43,200       43       107,957                   108,000  
Issuance of common stock upon conversion of secured notes payable and accrued interest     47,139       47       153,153                   153,200  
Issuance of common stock upon exercise of common stock purchase warrants     151,738       152       376,073                   376,225  
Net loss                             (4,665,580 )     (4,665,580 )
                                                 
Balance, September 30, 2018     10,424,752     $ 10,425     $ 77,538,983     $ (2,157,226 )   $ (72,055,057 )   $ 3,337,125  

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

  5  
     

 

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018
(Unaudited)

 

    2019     2018  
             
Cash Flows from Operating Activities:                
Net loss   $ (6,578,729 )   $ (10,216,702 )
Adjustments to reconcile net loss to net cash flows used in operating activities:                
Depreciation and amortization     287,184       395,819  
Gain on disposal of equipment           (28,218 )
Change in fair value of warrant derivative liabilities           319,105  
Loss on extinguishment of secured convertible debentures           600,000  
Secured convertible notes issuance expense     89,148       220,312  
Change in fair value of secured convertible notes     408,860       2,296,444  
Change in fair value of proceeds investment agreement     3,275,000       98,487  
Interest on secured convertible notes paid through issuance of common stock     50,000        
Interest expense added to convertible debenture           995,368  
Amortization of discount on subordinated note payable           47,657  
Operating lease right of use asset     333,308        
Stock-based compensation     1,715,972       1,757,227  
Provision for inventory obsolescence     47,637       (300,729 )
Provision for doubtful accounts receivable     53,224        
Change in assets and liabilities:                
(Increase) decrease in:                
Accounts receivable - trade     32,493       (27,180 )
Accounts receivable - other     (86,217 )     (40,336 )
Inventories     569,710       1,680,765  
Prepaid expenses     (47,620 )     (208,099 )
Other assets     (147,504 )     (129,009 )
Increase (decrease) in:                
Accounts payable     1,290,614       (1,691,458 )
Accrued expenses     (1,003,185 )     (68,294 )
Lease obligation with right of use asset     (252,148 )      
Income taxes payable     2,144       (6,437 )
Contract liabilities     (210,849 )     227,786  
Net cash used in operating activities     (170,958 )     (4,077,492 )
Cash Flows from Investing Activities:                
Purchases of furniture, fixtures and equipment     (78,584 )     (34,448 )
Proceeds from the sale of equipment           76,268  
Additions to intangible assets     (51,182 )     (72,721 )
Release of cash in accordance with secured convertible note           500,000  
Net cash provided by (used) in investing activities     (129,766 )     469,099  
Cash Flows from Financing Activities:                
Proceeds from subordinated notes payable           250,000  
Proceeds from sale of common stock in underwritten public offering           7,324,900  
Proceeds from proceeds investment agreement and detachable common stock purchase warrants           10,000,000  
Proceeds from exercise of common stock purchase warrants     1,564,000        
Proceeds from secured convertible notes and detachable common stock purchase warrants     2,500,000       6,250,000  
Principal payment on secured convertible debentures           (10,834,169 )
Principal payment on subordinated notes payable           (1,108,500 )
Payment on proceeds investment agreement     (6,000,000 )      
Proceeds from issuance of common stock and warrants           89,304  
Loss on extinguishment of secured convertible debentures           (600,000 )
Secured convertible notes issuance expense     (89,148 )     (220,312 )
Principal payments on capital lease obligation           (8,492 )
Net cash provided by (used in) financing activities     (2,025,148 )     11,142,731  
Net increase (decrease) in cash and cash equivalents     (2,325,872 )     7,534,338  
Cash and cash equivalents, beginning of period     3,598,807       54,712  
Cash and cash equivalents, end of period   $ 1,272,935     $ 7,589,050  
Supplemental disclosures of cash flow information:                
Cash payments for interest   $     $ 1,367,561  
Cash payments for income taxes   $ 3,856     $ 6,437  
Supplemental disclosures of non-cash investing and financing activities:                
Restricted common stock grant   $ 522     $ 485  
Restricted common stock forfeitures   $ 5     $ 34  
                 
Obtaining right of use asset for lease liability   $ 500,751     $  
                 
Amounts allocated to common stock purchase warrants in connection with proceeds from secured convertible notes   $ 535,739     $ 1,684,251  
                 
Issuance of common stock upon conversion of secured convertible notes and interest   $ 698,067     $ 293,688  
                 
Issuance of common stock related to the issuance of secured convertible notes   $ 118,749     $  
                 
Amounts allocated to common stock purchase warrants in connection with proceeds investment agreement   $     $ 932,487  
                 
Issuance of common stock upon conversion of secured convertible notes payable and accrued interest   $     $ 153,200  
                 
Issuance of common stock upon exercise of common stock purchase warrants accounted for as warrant liabilities   $     $ 335,921  
                 
Amounts allocated to common stock purchase warrants in connection with proceeds from subordinated notes payable   $     $ 47,657  

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

  6  
     

 

DIGITAL ALLY, INC.
NOTES TO Unaudited CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Nature of Business:

 

Digital Ally, Inc. and subsidiary (collectively, “Digital Ally,” “Digital,” the “Company”) produces digital video imaging and storage products for use in law enforcement, security and commercial applications. Its products are an in-car digital video/audio recorder contained in a rear-view mirror for use in law enforcement and commercial fleets; a system that provides its law enforcement customers with audio/video surveillance from multiple vantage points and hands-free automatic activation of body-worn cameras and in-car video systems; a miniature digital video system designed to be worn on an individual’s body; and cloud storage solutions. The Company has active research and development programs to adapt its technologies to other applications. It can integrate electronic, radio, computer, mechanical, and multi-media technologies to create unique solutions to address needs in a variety of other industries and markets, including mass transit, school bus, taxicab and the military. The Company sells its products to law enforcement agencies, private security customers and organizations and consumer and commercial fleet operators through direct sales domestically and third-party distributors internationally.

 

The Company was originally incorporated in Nevada on December 13, 2000 as Vegas Petra, Inc. and had no operations until 2004. On November 30, 2004, Vegas Petra, Inc. entered into a Plan of Merger with Digital Ally, Inc., at which time the merged entity was renamed Digital Ally, Inc.

 

Recently Adopted Accounting Standards

 

In February 2016, the FASB issued Accounting Standard Update (“ASU”) 2016-02, Leases (“Topic 842”). The guidance requires lessees to put most leases on their balance sheets but recognize expenses on their income statements in a manner similar to today’s accounting. Lessees initially recognize a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. The lease liability is measured at the present value of the lease payments over the lease term. The right-of-use asset is measured at the lease liability amount, adjusted for lease prepayments, lease incentives received and the lessee’s initial direct costs. The standard is effective for public business entities for annual reporting periods beginning after December 15, 2018, and interim periods within that reporting period, which is the first quarter of 2019 for the Company.

 

The Company adopted the new guidance on January 1, 2019 using the optional transitional method and elected to use the package of three practical expedients which allows the Company not to reassess whether contracts are or contain leases, lease classification and whether initial direct costs qualify for capitalization. The Company has completed its assessment of the impact of the standard and determined that the only lease that the Company held was an operating lease for its office and warehouse space. Upon adoption of the standard, the Company recorded Right of Use (ROU) assets of approximately $501,000 and lease liabilities of approximately $582,000 related to it office and warehouse space operating leases. The Company also removed deferred rent of approximately $81,000 when adopting the new guidance.

 

For financial liabilities measured using the fair value option in ASC 825, ASU 2016-01, Financial Instruments — Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, issued in January 2016, requires entities to recognize the changes in fair value of liabilities caused by a change in instrument specific credit risk (own credit risk) in other comprehensive income. The ASU is effective for calendar-year public business entities beginning in 2018. For all other calendar-year entities, it is effective for annual periods beginning in 2019 and interim periods beginning in 2020. Entities can early adopt certain provisions of the new standard, including this provision related to financial liabilities measured under the fair value option. We have considered this guidance and its impact on this debt accounted for at fair value. Based on discussions with our valuation expert and knowledge of the Company there was no change in valuation caused by a change in the Company’s credit risk during the period from August 5, 2019 to September 30, 2019.

 

ASU 2018-09, Codification improvements, clarifies the accounting for a debt extinguishment when the fair value option is elected. Upon extinguishment an entity shall include in net income the cumulative amount of the gain or loss previously recorded in other comprehensive income for the extinguished debt that resulted from changes in instrument-specific credit risk. The ASU is effective for calendar-year public business entities beginning in 2019. For all other calendar-year entities, it is effective for annual periods beginning in 2020 and interim periods beginning in 2021. Early adoption is permitted for any fiscal year or interim period for which an entity’s financial statements have not yet been issued or have not been made available to be issued. We have considered this guidance and its impact on this debt accounted for at fair value. Based on discussions with our valuation expert and knowledge of the Company there was no change in valuation caused by a change in the Company’s credit risk during the period from August 5, 2019 to September 30, 2019. Since there is no change accounted for as a change in Credit Risk (included in other comprehensive income/loss) there is no impact to the Company’s financial statements from this new guidance.

 

Management’s Liquidity Plan

 

The Company incurred operating losses in the nine months ended September 30, 2019 and substantial operating losses for the year ended December 31, 2018 primarily due to reduced revenues and gross margins caused by competitors’ willful infringement of its patents, specifically the auto-activation of body-worn and in-car video systems, and by competitors’ introduction of newer products with more advanced features together with significant price cutting of their products. The Company incurred net losses of approximately $6.6 million for the nine months ended September 30, 2019 and $15.5 million during the year ended December 31, 2018 and it had an accumulated deficit of $84.0 million as of September 30, 2019. During the nine months ended September 30, 2019, the Company settled one of its patent infringement cases and received a lump sum payment of $6.0 million which was used to pay its obligations under its Proceeds Investment Agreement as more fully described in Note 11. In recent years the Company has accessed the public and private capital markets to raise funding through the issuance of debt and equity. In that regard, the Company raised $1,564,000 in the nine months ended September 30, 2019 from the exercise of warrants and on August 5, 2019, the Company raised funds from the issuance of $2.78 million principal balance of secured convertible notes with detachable warrants to purchase 571,248 shares of common stock with the net proceeds being used for working capital purposes as more fully described in Note 6. Additionally, the Company raised funding in the form of subordinated debt, secured debt and Proceeds Investment Agreement totaling $16,500,000 and net proceeds of $7,324,900 from an underwritten public offering of common stock during the year ended December 31, 2018. The Company issued common stock with detachable common stock purchase warrants for $2,776,332 and raised funding from subordinated and secured debt totaling $1,608,500 during the year ended December 31, 2017. During 2016, the Company raised $4.0 million of funding in the form of convertible debentures and common stock purchase warrants. These debt and equity raises were utilized to fund its operations and management expects to continue this pattern until it achieves positive cash flows from operations, although it can offer no assurance in this regard.

 

  7  
     

 

The Company settled its lawsuit with the PGA Tour and the case was dismissed by the Plaintiff with prejudice on April 17, 2019. See Note 11, “Contingencies” for the details respecting the settlement. Additionally, the Company settled its lawsuit with WatchGuard on May 13, 2019 and the case was dismissed. See Note 11, “Contingencies” for the details respecting the settlement.

 

The Company will have to restore positive operating cash flows and profitability over the next year and/or raise additional capital to fund its operational plans, meet its customary payment obligations and otherwise execute its business plan. There can be no assurance that it will be successful in restoring positive cash flows and profitability, or that it can raise additional financing when needed, and obtain it on terms acceptable or favorable to the Company.

 

The Company has implemented an enhanced quality control program to detect and correct product issues before they result in significant rework expenditures affecting its gross margins and has seen progress in that regard. The Company has increased its addressable market to non-law enforcement customers and obtained new non-law enforcement contracts in 2018, which contracts include recurring revenue during the period 2019 to 2020. The Company believes that its quality control and cost cutting initiatives, expansion to non-law enforcement sales channels and new product introduction will eventually restore positive operating cash flows and profitability, although it can offer no assurances in this regard.

 

In addition to the initiatives described above, the Board of Directors is conducting a review of a full range of strategic alternatives to best position the Company for the future including, but not limited to, monetizing its patent portfolio and related patent infringement litigation against Axon Enterprise, Inc. (“Axon” formerly Taser International, Inc.), the sale of all or certain assets, properties or groups of properties or individual businesses or merger or combination with another company. The result of this review may also include the continued implementation of the Company’s business plan. The Company’s August 5, 2019 issuance of $2.78 million principal balance of convertible notes was part of this strategic alternatives review. While such funding addressed the Company’s near-term liquidity needs, it continues to consider strategic alternatives to address longer-term liquidity needs and operational issues. There can be no assurance that any additional transactions or financings will result from this process.

 

Based on the uncertainties described above, the Company believes its business plan does not alleviate the existence of substantial doubt about its ability to continue as a going concern within one year from the date of the issuance of these unaudited condensed consolidated interim financial statements.

 

The following is a summary of the Company’s Significant Accounting Policies:

 

Basis of Consolidation:

 

The accompanying financial statements include the consolidated accounts of Digital Ally and its wholly-owned subsidiary, Digital Ally International, Inc. All intercompany balances and transactions have been eliminated during consolidation.

 

The Company formed Digital Ally International, Inc. during August 2009 to facilitate the export sales of its products.

 

Fair Value of Financial Instruments:

 

The carrying amounts of financial instruments, including cash and cash equivalents, accounts receivable and accounts payable approximate fair value because of the short-term nature of these items. The Company accounts for its proceeds investment agreement and convertible debt on a fair value basis.

 

Revenue Recognition:

 

The Company applies the provisions of Accounting Standards Codification (ASC) 606-10, Revenue from Contracts with Customers, and all related appropriate guidance. The Company recognizes revenue under the core principle to depict the transfer of control to its customers in an amount reflecting the consideration to which it expects to be entitled. In order to achieve that core principle, the Company applies the following five-step approach: (1) identify the contract with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when a performance obligation is satisfied.

 

  8  
     

 

The Company considers customer purchase orders, which in some cases are governed by master sales agreements, to be the contracts with the customer. In situation where sales are to a distributor, the Company had concluded its contracts are with the distributor as the Company holds a contract bearing enforceable rights and obligations only with the distributor. As part of part of its consideration for the contract, the Company evaluates certain factors including the customers’ ability to pay (or credit risk). For each contract, the Company considers the promise to transfer products, each of which is distinct, to be the identified performance obligations. In determining the transaction price, the Company evaluates whether the price is subject to refund or adjustment to determine the net consideration to which it expects to be entitled. As the Company’s standard payment terms are less than one year, it has elected the practical expedient under ASC 606-10-32-18 to not assess whether a contract has a significant financing component. The Company allocates the transaction price to each distinct product based on its relative standalone selling price. The product price as specified on the purchase order is considered the standalone selling price as it is an observable input which depicts the price as if sold to a similar customer in similar circumstances. Revenue is recognized when control of the product is transferred to the customer (i.e. when the Company’s performance obligations is satisfied), which typically occurs at shipment. Further in determining whether control has been transferred, the Company considers if there is a present right to payment and legal title, along with risks and rewards of ownership having transferred to the customer. Customers do not have a right to return the product other than for warranty reasons for which they would only receive repair services or replacement product. The Company has also elected the practical expedient under ASC 340-40-25-4 to expense commissions for product sales when incurred as the amortization period of the commission asset the Company would have otherwise recognized is less than one year.

 

The Company sells its products and services to law enforcement and commercial customers in the following manner:

 

Sales to domestic customers are made direct to the end customer (typically a law enforcement agency or a commercial customer) through its sales force, which is composed of its employees. Revenue is recorded when the product is shipped to the end customer.
     
Sales to international customers are made through independent distributors who purchase products from the Company at a wholesale price and sell to the end user (typically law enforcement agencies or a commercial customer) at a retail price. The distributor retains the margin as its compensation for its role in the transaction. The distributor generally maintains product inventory, customer receivables and all related risks and rewards of ownership. Accordingly, upon application of steps one through five above, revenue is recorded when the product is shipped to the distributor consistent with the terms of the distribution agreement.
     
Repair parts and services for domestic and international customers are generally handled by its inside customer service employees. Revenue is recognized upon shipment of the repair parts and acceptance of the service or materials by the end customer.

 

Sales taxes collected on products sold are excluded from revenues and are reported as accrued expenses in the accompanying balance sheets until payments are remitted.

 

Service and other revenue is comprised of revenues from extended warranties, repair services, cloud revenue and software revenue. Revenue is recognized upon shipment of the product and acceptance of the service or materials by the end customer for repair services. Revenue for extended warranty, cloud service or other software-based products is over the term of the contract warranty or service period. A time-elapsed method is used to measure progress because the Company transfers control evenly over the contractual period. Accordingly, the fixed consideration related to these revenues is generally recognized on a straight-line basis over the contract term, as long as the other revenue recognition criteria have been met.

 

Contracts with some of the Company’s customers contain multiple performance obligations that are distinct and accounted for separately. The transaction price is allocated to the separate performance obligations on a relative standalone selling price (“SSP”). The Company determined SSP for all the performance obligations using observable inputs, such as standalone sales and historical pricing. SSP is consistent with the Company’s overall pricing objectives, taking into consideration the type of service being provided. SSP also reflects the amount the Company would charge for the performance obligation if it were sold separately in a standalone sale. Multiple performance obligations consist of product, software, cloud subscriptions and extended warranties.

 

The Company’s multiple performance obligations may include future in-car or body-worn camera devices to be delivered at defined points within a multi-year contract, and in those arrangements, the Company allocates total arrangement consideration over the life of the multi-year contract to future deliverables using management’s best estimate of selling price.

 

Contract liabilities consist of deferred revenue and include payments received in advance of performance under the contract and are reported separately as current liabilities and non-current liabilities in the Condensed Consolidated Balance Sheets. Such amounts consist of extended warranty contracts, prepaid cloud services and prepaid installation services and are generally recognized as the respective performance obligations are satisfied. Total contract liabilities consist of the following:

 

   

September 30,

2019

   

December 31,

2018

 
Contract liabilities, current   $ 1,698,560     $ 1,748,789  
Contract liabilities, non-current     1,830,471       1,991,091  
Total contract liabilities   $ 3,529,031     $ 3,739,880  

 

  9  
     

 

Sales returns and allowances aggregated $19,356 and $72,127 for the three months ended September 30, 2019 and 2018, respectively, and $127,114 and $126,373 for the nine months ended September 30, 2019 and 2018, respectively. Obligations for estimated sales returns and allowances are recognized at the time of sales on an accrual basis. The accrual is determined based upon historical return rates adjusted for known changes in key variables affecting these return rates

 

Revenues for nine month ended September 30, 2019 and 2018 were derived from the following sources

 

    Nine months ended September 30,  
    2019     2018  
DVM-800   $ 2,964,862     $ 3,956,816  
DVM-250 Plus     844,140       617,705  
FirstVu HD     1,019,287       1,070,245  
EVO     186,369        
DVM-100 & DVM-400     7,140       69,496  
DVM-750     115,589       378,660  
VuLink     113,894       146,896  
Repair and service     386,806       288,073  
Cloud service revenue     543,999       500,305  
Other service revenue     1,050,677       805,068  
Laser Ally     19,130       79,155  
Accessories and other revenues     769,034       1,000,703  
    $ 8,020,927     $ 8,913,122  

 

Use of Estimates:

 

The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Cash and cash equivalents:

 

Cash and cash equivalents include funds on hand, in bank and short-term investments with original maturities of ninety (90) days or less.

 

Accounts Receivable:

 

Accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a weekly basis. The Company determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customer’s financial condition, credit history, and current economic conditions. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received.

 

A trade receivable is considered to be past due if any portion of the receivable balance is outstanding for more than thirty (30) days beyond terms. No interest is charged on overdue trade receivables.

 

Inventories:

 

Inventories consist of electronic parts, circuitry boards, camera parts and ancillary parts (collectively, “components”), work-in-process and finished goods, and are carried at the lower of cost (First-in, First-out Method) or market value. The Company determines the estimate for the reserve for slow moving or obsolete inventories by regularly evaluating individual inventory levels, projected sales and current economic conditions.

 

  10  
     

 

Furniture, fixtures and equipment:

 

Furniture, fixtures and equipment is stated at cost net of accumulated depreciation. Additions and improvements are capitalized while ordinary maintenance and repair expenditures are charged to expense as incurred. Depreciation is recorded by the straight-line method over the estimated useful life of the asset, which ranges from three to ten years. Amortization expense on capitalized leases is included with depreciation expense.

 

Intangible assets:

 

Intangible assets include deferred patent costs and license agreements. Legal expenses incurred in preparation of patent application have been deferred and will be amortized over the useful life of granted patents. Costs incurred in preparation of applications that are not granted will be charged to expense at that time. The Company has entered into several sublicense agreements under which it has been assigned the exclusive rights to certain licensed materials used in its products. These sublicense agreements generally require upfront payments to obtain the exclusive rights to such material. The Company capitalizes the upfront payments as intangible assets and amortizes such costs over their estimated useful life on a straight-line method.

 

Leases:

 

The Company determines if an arrangement contains a lease at inception. For arrangements where the Company is the lessee, the Company will evaluate whether to account for the lease as an operating or finance lease. Operating leases are included in the right of use assets (ROU) and operating lease liabilities on the condensed consolidated balance sheet as of September 30, 2019. Finance leases would be included in furniture, fixtures and equipment, net and long-term debt and finance lease obligations on the condensed balance sheet. The Company had an operating lease for office and warehouse space at September 30, 2019 but no financing leases.

 

ROU assets and lease liabilities are recognized based on the present value of the future minimum lease payments over the lease term at commencement date. The Company uses its incremental borrowing rate based on the information available at the commencement date in determining the operating lease liabilities if the operating lease does not provide an implicit rate. Lease terms may include the option to extend when Company is reasonably certain that the option will be exercised. Lease expense for operating leases is recognized on a straight-line basis over the lease term.

 

The Company elected to apply the short-term lease measurement and recognition exemption in which ROU assets and lease liabilities are not recognized for short term leases.

 

Proceeds investment agreement:

 

The Company has elected to record its proceeds investment agreement at its fair value. Accordingly, the proceeds investment agreement will be marked-to-market at each reporting date with the change in fair value reported as a gain (loss) in the Condensed Consolidated Statement of Operations. All issuance costs related to the proceeds investment agreement were expensed as incurred in the Condensed Consolidated Statement of Operations.

 

Senior Convertible Notes:

 

The Company has elected to record its senior convertible notes at its fair value. Accordingly, the new debt agreement will be marked-to-market at each reporting date with the change in fair value reported as a gain (loss) in the Condensed Consolidated Statement of Operations. All issuance costs related to the proceeds investment agreement were expensed as incurred in the Condensed Consolidated Statement of Operations.

 

Long-Lived Assets:

 

Long-lived assets such as furniture, fixtures and equipment and purchased intangible assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by that asset or asset group to its carrying value. If the carrying value of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, an impairment is recognized to the extent that the carrying value exceeds its fair value. Fair value is determined through various valuation techniques, including discounted cash flow models, quoted market values and third-party appraisals, as considered necessary.

 

  11  
     

 

Warranties:

 

The Company’s products carry explicit product warranties that extend up to two years from the date of shipment. The Company records a provision for estimated warranty costs based upon historical warranty loss experience and periodically adjusts these provisions to reflect actual experience. Accrued warranty costs are included in accrued expenses. Extended warranties are offered on selected products and when a customer purchases an extended warranty the associated proceeds are treated as contract liabilities and recognized over the term of the extended warranty.

 

Shipping and Handling Costs:

 

Shipping and handling costs for outbound sales orders totaled $16,208 and $12,378 for the three months ended September 30, 2019 and 2018, respectively, and $47,842 and $46,662 for the nine months ended September 30, 2019 and 2018, respectively. Such costs are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations.

 

Advertising Costs:

 

Advertising expense includes costs related to trade shows and conventions, promotional material and supplies, and media costs. Advertising costs are expensed in the period in which they are incurred. The Company incurred total advertising expense of approximately $249,377 and $104,395 for the three months ended September 30, 2019 and 2018, respectively, and $884,184 and $295,641 for the nine months ended September 30, 2019 and 2018, respectively. Such costs are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations.

 

Income Taxes:

 

Deferred taxes are provided for by the liability method in which deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

 

The Company applies the provisions of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) No. 740 - Income Taxes that provides a framework for accounting for uncertainty in income taxes and provided a comprehensive model to recognize, measure, present, and disclose in its financial statements uncertain tax positions taken or expected to be taken on a tax return. It initially recognizes tax positions in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. Application requires numerous estimates based on available information. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, and it recognized tax positions and tax benefits may not accurately anticipate actual outcomes. As it obtains additional information, the Company may need to periodically adjust its recognized tax positions and tax benefits. These periodic adjustments may have a material impact on its Condensed consolidated Statements of Operations.

 

The Company’s policy is to record estimated interest and penalties related to the underpayment of income taxes as income tax expense in the condensed consolidated statements of operations. There was no interest expense related to the underpayment of estimated taxes during the nine months ended September 30, 2019 and 2018. There have been no penalties in the nine months ended September 30, 2019 and 2018.

 

The Company is subject to taxation in the United States and various states. As of September 30, 2019, the Company’s tax returns filed for 2016, 2017 and 2018 are subject to examination by the relevant taxing authorities. With few exceptions, as of September 30, 2019, the Company is no longer subject to Federal, state, or local examinations by tax authorities for years before 2016.

 

Research and Development Expenses:

 

The Company expenses all research and development costs as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been established. Costs incurred subsequent to achievement of technological feasibility were not significant, and software development costs were expensed as incurred during the nine months ended September 30, 2019 and 2018.

 

  12  
     

 

Common Stock Purchase Warrants:

 

The Company has common stock purchase warrants that are accounted for as equity based on their relative fair value and are not subject to re-measurement.

 

Stock-Based Compensation:

 

The Company grants stock-based compensation to its employees, board of directors and certain third-party contractors. Share-based compensation arrangements may include the issuance of options to purchase common stock in the future or the issuance of restricted stock, which generally are subject to vesting requirements. The Company records stock-based compensation expense for all stock-based compensation granted based on the grant-date fair value. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award.

 

The Company estimates the grant-date fair value of stock-based compensation using the Black-Scholes valuation model. Assumptions used to estimate compensation expense are determined as follows:

 

Expected term is determined using the contractual term and vesting period of the award;
     
Expected volatility of award grants made in the Company’s plan is measured using the weighted average of historical daily changes in the market price of the Company’s common stock over the period equal to the expected term of the award;
     
Expected dividend rate is determined based on expected dividends to be declared;
     
Risk-free interest rate is equivalent to the implied yield on zero-coupon U.S. Treasury bonds with a maturity equal to the expected term of the awards; and
     
Forfeitures are accounted for as they occur.

 

Segments of Business:

 

Management has determined that its operations are comprised of one reportable segment: the sale of digital audio and video recording and speed detection devices. For the three and nine months ended September 30, 2019 and 2018, sales by geographic area were as follows:

 

    Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
   

2019 

   

2018 

   

2019 

   

2018 

 
Sales by geographic area:                                
United States of America   $ 2,854,501     $ 2,787,618     $ 7,846,560     $ 8,612,552  
Foreign     68,647       90,441       174,367       300,570  
    $ 2,923,148     $ 2,878,059     $ 8,020,927     $ 8,913,122  

 

Sales to customers outside of the United States are denominated in U.S. dollars. All Company assets are physically located within the United States.

 

NOTE 2. BASIS OF PRESENTATION

 

The condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine-month period ended September 30, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.

 

The balance sheet at December 31, 2018 has been derived from the audited financial statements at that date but does not include all the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements.

 

For further information, refer to the financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2018.

 

  13  
     

 

NOTE 3. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist of accounts receivable. Sales to domestic customers are typically made on credit and the Company generally does not require collateral while sales to international customers require payment before shipment or backing by an irrevocable letter or credit. The Company performs ongoing credit evaluations of its customers’ financial condition and maintains an allowance for estimated losses. Accounts are written off when deemed uncollectible and accounts receivable are presented net of an allowance for doubtful accounts. The allowance for doubtful accounts totaled $123,224 as of September 30, 2019 and $70,000 as of December 31, 2018.

 

The Company uses primarily a network of unaffiliated distributors for international sales and employee-based direct sales force for domestic sales. No international distributor individually exceeded 10% of total revenues for the nine months ended September 30, 2019 and 2018. No individual customer receivable balance exceeded 10% of total accounts receivable as of September 30, 2019. One individual customer exceeded 10% of total accounts receivable as of September 30, 2018 and totaled $205,259, or 10% of total accounts receivable.

 

The Company purchases finished circuit boards and other proprietary component parts from suppliers located in the United States and on a limited basis from Asia. Although the Company obtains certain of these components from single source suppliers, it generally owns all tooling and management has located alternative suppliers to reduce the risk in most cases to supplier problems that could result in significant production delays. The Company has not historically experienced significant supply disruptions from any of its principal vendors and does not anticipate future supply disruptions. The Company acquires most of its components on a purchase order basis and does not have long-term contracts with its suppliers.

 

NOTE 4. INVENTORIES

 

Inventories consisted of the following at September 30, 2019 and December 31, 2018:

 

   

September 30, 2019

   

December 31, 2018

 
Raw material and component parts   $ 4,220,724     $ 4,969,786  
Work-in-process     334,967       351,451  
Finished goods     5,161,430       4,965,594  
                 
Subtotal     9,717,121       10,286,831  
Reserve for excess and obsolete inventory     (3,335,408 )     (3,287,771 )
                 
Total   $ 6,381,713     $ 6,990,060  

 

Finished goods inventory includes units held by potential customers and sales agents for test and evaluation purposes. The cost of such units totaled $162,202 and $115,456 as of September 30, 2019 and December 31, 2018, respectively.

 

NOTE 5. FURNITURE, FIXTURES AND EQUIPMENT

 

Furniture, fixtures and equipment consisted of the following at September 30, 2019 and December 31, 2018:

 

   

Estimated

Useful Life

  September 30, 2019    

December 31,

2018

 
Office furniture, fixtures and equipment   3-10 years   $ 825,526     $ 802,681  
Warehouse and production equipment   3-5 years     537,471       526,932  
Demonstration and tradeshow equipment   2-5 years     466,394       426,582  
Leasehold improvements   2-5 years     163,171       160,198  
Rental equipment   1-3 years     126,968       124,553  
                     
Total cost         2,119,530       2,040,946  
Less: accumulated depreciation and amortization         (1,977,543 )     (1,793,405 )
                     
Net furniture, fixtures and equipment       $ 141,987     $ 247,541  

 

Depreciation and amortization of furniture, fixtures and equipment aggregated $45,866 and $92,192 for the three months ended September 30, 2019 and 2018, respectively and $184,138 and $309,993 for the nine months ended September 30, 2019 and 2018, respectively.

 

  14  
     

 

NOTE 6. DEBT OBLIGATIONS

 

Proceeds investment agreement is comprised of the following:

 

   

September 30, 2019

   

December 31, 2018

 
2018 Proceeds investment agreement, at fair value   $ 6,417,000     $ 9,142,000  
Less: Current portion     -       -  
2018 Proceeds investment agreement at fair value-less current portion   $ 6,417,000     $ 9,142,000  

 

2018 Proceeds Investment Agreement.

 

On July 31, 2018, the Company entered into a Proceeds Investment Agreement (the “PIA”) with Brickell Key Investments LP (“BKI”), pursuant to which BKI funded an aggregate of $500,000 (the “First Tranche”) to be used (i) to fund the Company’s litigation proceedings relating to the infringement of certain patent assets listed in the PIA and (ii) to repay the Company’s existing debt obligations and for certain working capital purposes set forth in the PIA. Pursuant to the PIA, BKI was granted an option to provide the Company with an additional $9.5 million, at BKI’s sole discretion (the “Second Tranche”). On August 21, 2018, BKI exercised its option on the Second Tranche for $9.5 million which completed the $10 million funding.

 

Pursuant to the PIA and in consideration for the $10.0 million in funding, the Company agreed to assign to BKI (i) 100% of all gross, pre-tax monetary recoveries paid by any defendant(s) to the Company or its affiliates agreed to in a settlement or awarded in judgment in connection with the patent assets, plus any interest paid in connection therewith by such defendant(s) (the “Patent Assets Proceeds”), up to the minimum return (as defined in the PIA) and (ii) if BKI has not received its minimum return by the earlier of a liquidity event (as defined in the PIA) and July 31, 2020, then the Company agreed to assign to BKI 100% of the Patent Asset Proceeds until BKI has received an amount equal to the minimum return on $4.0 million.

 

Pursuant to the PIA, the Company granted BKI (i) a senior security interest in the Patent Assets, the claims (as defined in the PIA) and the Patent Assets Proceeds until such time as the minimum return is paid, in which case, the security interest on the patent assets, the claims and the Patent Assets Proceeds will be released, and (ii) a senior security interest in all other assets of the Company until such time as the minimum return is paid on $4.0 million, in which case, the security interest on such other assets will be released.

 

The security interest is enforceable by BKI if the Company is in default under the PIA which would occur if (i) the Company fails, after five (5) days’ written notice, to pay any due amount payable to BKI under the PIA Agreement, (ii) the Company fails to comply with any provision of the PIA or any other agreement or document contemplated under the PIA, (iii) the Company becomes insolvent or insolvency proceedings are commenced (and not subsequently discharged) with respect to the Company, (iv) the Company’s creditors commence actions against the Company (which are not subsequently discharged) that affect material assets of the Company, (v) the Company, without BKI’s consent, incurs indebtedness other than immaterial ordinary course indebtedness up to $500,000, (vi) the Company fails, within five (5) business days following the closing of the second tranche, to fully satisfy its obligations to certain holders of the Company’s senior secured convertible promissory notes listed in the PIA Agreement and fails to obtain unconditional releases from such holders as to the Company’s obligations to such holders and the security interests in the Company held by such holders or (vii) there is an uncured non-compliance of the Company’s obligations or misrepresentations by the Company under the PIA.

 

Under the PIA, the Company issued BKI a warrant to purchase up to 465,712 shares of the Company’s common stock, par value $0.001 per share (the “PIA Warrant”), at an exercise price of $2.60 per share provided that the holder of the PIA Warrant will be prohibited from exercising the PIA Warrant if, as a result of such exercise, such holder, together with its affiliates, would own more than 4.99% of the total number of shares of the Company’s common stock outstanding immediately after giving effect to such exercise. However, such holder may increase or decrease such percentage to any other percentage not in excess of 9.99%, provided that any increase in such percentage shall not be effective until 61 days after such notice to the Company. The PIA Warrant is exercisable for five years from the date of issuance and is exercisable on a cashless exercise basis if there is no effective registration statement. No contractual registration rights were given.

 

  15  
     

 

The Company elected to account for the PIA on the fair value basis. Therefore, the Company determined the fair value of the PIA and PIA Warrants which yielded estimated fair values of the PIA including their embedded derivatives and the detachable PIA Warrants as follows:

 

Proceeds investment agreement   $ 9,067,513  
Common stock purchase warrants     932,487  
         
Gross cash proceeds   $ 10,000,000  

 

During the nine months ended September 30, 2019, the Company settled its patent infringement litigation with WatchGuard whereby it received a lump-sum payment of $6.0 million as further described in Note 11. In accordance with the terms of the PIA, the Company remitted the $6.0 as a principal payment toward its minimum return payment obligations under the PIA. The Company recorded the receipt of the $6,000,000 settlement as Patent litigation settlement income in the accompanying condensed consolidated statement of operations.

 

The following represents activity in the PIA during the nine months ended September 30, 2019:

 

Beginning balance as of January 1, 2019   $ 9,142,000  
Repayment of obligation     (6,000,000 )
         
Change in the fair value during the period     3,275,000  
Ending balance as of September 30, 2019   $ 6,417,000  

 

2019 Secured Convertible Notes.

 

On August 5, 2019, the Company, entered into a securities purchase agreement with several accredited investors providing for the issuance of (i) the Company’s 8% secured convertible notes due August 4, 2020 with a principal face amount of $2,777,777.78, which convertible notes are, subject to certain conditions, convertible into 1,984,126 shares of the Company’s common stock, at a price per share of $1.40; (ii) five-year warrants to purchase an aggregate of 571,428 shares of Common Stock at an exercise price of $1.8125, which warrants are immediately exercisable upon issuance and on a cashless basis if the Warrants have not been registered 180 days after the date of issuance; and (iii) the issuance of shares of common stock equal to 5% of the aggregate purchase price of the convertible notes, with an aggregate value of $125,000 (the “Commitment Shares”). The accredited investors purchased the foregoing securities for an aggregate cash purchase price of $2,500,000.

 

Pursuant to the purchase agreement, an aggregate of $1,153,320 in principal amount of convertible notes (the “Registered Notes”), the conversion shares underlying the Registered Notes and all of the Commitment Shares were issued to the accredited investors in a registered direct offering pursuant to a prospectus supplement to the Company’s currently effective shelf registration statement on Form S-3. Accordingly, $1,153,320 in original principal amount of our convertible notes were issued as Registered Notes pursuant to the shelf registration statement and therefore freely tradable.

 

In a related transaction and in accordance with the purchase agreement, the Company issued to the accredited investors in a concurrent private placement pursuant to an exemption from the registration requirements of the Securities Act provided in Section 4(a)(2) of the Securities Act and/or Regulation D promulgated thereunder, (1) the remaining aggregate of $1,624,457.78 in principal amount of convertible notes, (2) the shares of common stock issuable from time to time upon conversion of such convertible notes, and (3) the common shares underlying the common stock purchase warrants. On September 5, 2019, the Company filed a Registration Statement on Form S-1 covering the securities issued in the concurrent private placement including an aggregate of $1,624,457.78 in principal amount of previously non-registered convertible notes, the shares of common stock issuable from time to time upon conversion of such non-registered convertible notes and the common stock underlying the common stock purchase warrants. Such Registration Statement on Form S-1 was declared effective by the Securities and Exchange Commission on September 12, 2019.

 

In connection with the purchase agreement, the Company and its subsidiary entered into a security agreement, dated as of August 5, 2019, with the investors, pursuant to which the Company and its subsidiary granted a security interest in, among other items, the Company and its subsidiary’s accounts, chattel paper, documents, equipment, general intangibles, instruments and inventory, and all proceeds, as set forth in the security agreement. In addition, pursuant to an intellectual property security agreement, dated as of August 5, 2019, the Company granted a continuing security interest in all of the Company’s right, title and interest in, to and under certain of the Company’s trademarks, copyrights and patents. In addition, the Company’s subsidiary jointly and severally agreed to guarantee and act as surety for the Company’s obligation to repay the convertible notes pursuant to a subsidiary guarantee.

 

Under the purchase agreement, the convertible notes and warrants contain provisions whereby the accredited investors are prohibited from exercising their rights to convert the notes or exercise the warrants if, as a result of such conversion or exercise, such holder, together with its affiliates, would own more than 4.99% of the total number of shares of the Company’s common stock outstanding immediately after giving effect to such exercise. However, the investors may increase or decrease such percentage to any other percentage not in excess of 9.99%, provided that any increase in such percentage shall not be effective until 61 days after such notice to the Company.

 

  16  
     

 

The Company elected to account for the secured convertible notes on the fair value basis. Therefore, the Company determined the fair value of the (1) secured convertible notes, (2) the Commitment Shares and (3) the common stock purchase warrants which yielded estimated fair values of the secured convertible notes including their embedded derivatives, the Commitment Shares and the detachable common stock purchase warrants. The following represents the resulting fair value as determined on August 5, 2019, the date of origination:

 

Secured convertible notes   $ 1,845,512  

Common stock issued as Commitment Shares

    118,749  
Common stock purchase warrants     535,739  
         
Gross cash proceeds   $ 2,500,000  

 

Under the fair value basis, the Company determines the fair value of the secured convertible notes and adjusts the carrying value of the secured convertible notes at each reporting date with the resulting charge or credit being reflected in the consolidated statement of operations. Following is an analysis of the activity in the secured convertible notes during the nine months ended September 30, 2019:

 

    Amount  
Balance at December 31, 2018   $  
Issuance of convertible notes on August 5, 2019, at fair value     1,845,512  
Principal repaid during the period by issuance of common stock     (648,067 )
Principal repaid during the period by payment of cash      
Change in fair value of secured convertible note during the period     408,860   
         
Balance at September 30, 2019   $ 1,606,305  

 

Under the fair value basis, legal, accounting and miscellaneous costs directly related to the issuance of the secured convertible notes are charged to expense as incurred. A total of $89,148 of such issuance costs were charged to operations during the three and nine months ended September 30, 2019.

 

NOTE 7. FAIR VALUE MEASUREMENT

 

In accordance with ASC Topic 820 — Fair Value Measurements and Disclosures (“ASC 820”), the Company utilizes the market approach to measure fair value for its financial assets and liabilities. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or a group of assets or liabilities, such as a business.

 

ASC 820 utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

 

Level 1 — Quoted prices in active markets for identical assets and liabilities
   
Level 2 — Other significant observable inputs (including quoted prices in active markets for similar assets or liabilities)
   
Level 3 — Significant unobservable inputs (including the Company’s own assumptions in determining the fair value)

 

  17  
     

 

The following table represents the Company’s hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2019 and December 31, 2018.

 

    September 30, 2019  
    Level 1     Level 2     Level 3     Total  
Liabilities:                                
Proceeds investment agreement   $     $     $ 6,417,000     $ 6,417,000  
Secured convertible notes   $     $     1,606,305     1,606,305  
    $     $     $ 8,023,305     $ 8,023,305  

 

    December 31, 2018  
    Level 1     Level 2     Level 3     Total  
Liabilities:                                
Proceeds investment agreement   $     $     $ 9,142,000     $ 9,142,000  

 

The following table represents the change in Level 3 tier value measurements:

 

    Proceeds Investment Agreement     Secured Convertible Notes     Total  
December 31, 2018   $ 9,142,000     $     $ 9,142,000  
Repayment of obligation     (6,000,000 )           (6,000,000 )
Issuance of secured convertible notes           1,845,512       1,845,512  
Conversion of principal to equity           (648,067 )     (648,067 )
Change in fair value     3,275,000      

408,860

      3,683,860  
                         
September 30, 2019   $ 6,417,000     $ 1,606,305     $ 8,023,305  

 

NOTE 8. ACCRUED EXPENSES

 

Accrued expenses consisted of the following at September 30, 2019 and December 31, 2018:

 

   

September 30,

2019

   

December 31,

2018

 
Accrued warranty expense   $ 61,640     $ 195,135  
Accrued litigation costs     265,000       1,119,445  
Accrued sales commissions     33,583       25,750  
Accrued payroll and related fringes     385,101       186,456  
Accrued insurance     136,345       71,053  
Accrued sales returns and allowances     30,124       13,674  
Other     165,689       469,154  
                 
    $ 1,077,482     $ 2,080,667  

 

Accrued warranty expense was comprised of the following for the nine months ended September 30, 2019:

 

    2019  
Beginning balance   $ 195,135  
Provision for warranty expense     37,648  
Charges applied to warranty reserve     (171,143 )
         
Ending balance   $ 61,640  

 

NOTE 9. INCOME TAXES

 

The effective tax rate for the nine months ended September 30, 2019 and 2018 varied from the expected statutory rate due to the Company continuing to provide a 100% valuation allowance on net deferred tax assets. The Company determined that it was appropriate to continue the full valuation allowance on net deferred tax assets as of September 30, 2019 primarily because of the Company’s history of operating losses.

 

  18  
     

 

The Company has incurred operating losses in recent years and it continues to be in a three-year cumulative loss position at September 30, 2019. Accordingly, the Company determined there was not sufficient positive evidence regarding its potential for future profits to outweigh the negative evidence of our three-year cumulative loss position under the guidance provided in ASC 740. Therefore, it determined to continue to provide a 100% valuation allowance on its net deferred tax assets. The Company expects to continue to maintain a full valuation allowance until it determines that it can sustain a level of profitability that demonstrates its ability to realize these assets. To the extent the Company determines that the realization of some or all of these benefits is more likely than not based upon expected future taxable income, a portion or all of the valuation allowance will be reversed.

 

NOTE 10. OPERATING LEASE

 

The Company entered into an operating lease with a third party in September 2012 for office and warehouse space in Lenexa, Kansas. The terms of the lease include monthly payments ranging from $38,026 to $38,533 with a maturity date of April 2020. The Company has the option to renew for an additional three years beyond the original expiration date, which may be exercised at the Company’s sole discretion. The Company evaluated the renewal option at the lease commencement date to determine if it is reasonably certain the exercise the option and concluded that it is not reasonably certain that any options will be exercised. The weighted average remaining lease term for the Company’s operating lease as of September 30, 2019 was .58 years.

 

Expense related to the office space operating lease was recorded on a straight-line basis over the lease term. Lease expense under the operating lease was approximately $298,292 for the nine months ended September 30, 2019.

 

The discount rate implicit within the Company’s operating lease was not generally determinable and therefore the Company determined the discount rate based on its incremental borrowing rate on the information available at commencement date. As of September 30, 2019, the operating lease liabilities reflect a weighted average discount rate of 8%.

 

The following sets forth the operating lease right of use assets and liabilities as of September 30, 2019:

 

Assets:      
Operating lease right of use assets   $ 167,443  
         
Liabilities:        
Operating lease obligations-current portion   $ 248,603  
Operating lease obligations-less current portion   $  
Total operating lease obligations   $ 248,603  

 

Following are the minimum lease payments for each year and in total.

 

Year ending December 31:      
2019 (period from October 1, 2019 to December 31, 2019)   $ 115,092  
2020     154,131  
    $ 269,223  

 

NOTE 11. CONTINGENCIES

 

Litigation.

 

From time to time, the Company is notified that it may be a party to a lawsuit or that a claim is being made against us. It is the Company’s policy to not disclose the specifics of any claim or threatened lawsuit until the summons and complaint are actually served on it. After carefully assessing the claim, and assuming the Company determines that it is not at fault or it disagrees with the damages or relief demanded, it vigorously defends any lawsuit filed against us. It records a liability when losses are deemed probable and reasonably estimable. When losses are deemed reasonably possible but not probable, the Company determines whether it is possible to provide an estimate of the amount of the loss or range of possible losses for the claim, if material for disclosure. In evaluating matters for accrual and disclosure purposes, it takes into consideration factors such as its historical experience with matters of a similar nature, the specific facts and circumstances asserted, the likelihood of prevailing, the availability of insurance, and the severity of any potential loss. It reevaluates and updates accruals as matters progress over time.

 

While the ultimate resolution is unknown, the Company does not expect that these lawsuits will individually, or in the aggregate, have a material adverse effect to our results of operations, financial condition or cash flows. However, the outcome of any litigation is inherently uncertain and there can be no assurance that any expense, liability or damages that may ultimately result from the resolution of these matters will be covered by its insurance or will not be in excess of amounts recognized or provided by insurance coverage and will not have a material adverse effect on its operating results, financial condition or cash flows.

 

  19  
     

 

Axon

 

The Company owns U.S. Patent No. 9,253,452 (the “ ‘452 Patent”), which generally covers the automatic activation and coordination of multiple recording devices in response to a triggering event, such as a law enforcement officer activating the light bar on the vehicle.

 

The Company filed suit on January 15, 2016 in the U.S. District Court for the District of Kansas (Case No: 2:16-cv-02032) against Axon, alleging willful patent infringement against Axon’s body camera product line and Signal auto-activation product. The Company is seeking both monetary damages and a permanent injunction against Axon for infringement of the ‘452 Patent.

 

In addition to the infringement claims, the Company brought claims alleging that Axon conspired to keep the Company out of the marketplace by engaging in improper, unethical, and unfair competition. The amended lawsuit alleges Axon bribed officials and otherwise conspired to secure no-bid contracts for its products in violation of both state law and federal antitrust law. The Company’s lawsuit also seeks monetary and injunctive relief, including treble damages, for these alleged violations.

 

Axon filed an answer, which denied the patent infringement allegations on April 1, 2016. In addition, Axon filed a motion to dismiss all allegations in the complaint on March 4, 2016 for which the Company filed an amended complaint on March 18, 2016 to address certain technical deficiencies in the pleadings. Digital amended its complaint and Axon renewed its motion to seek dismissal of the allegations that it had bribed officials and otherwise conspired to secure no-bid contracts for its products in violation of both state law and federal antitrust law on April 1, 2016. Formal discovery commenced on April 12, 2016 with respect to the patent related claims. In January 2017, the Court granted Axon’s motion to dismiss the portion of the lawsuit regarding claims that it had bribed officials and otherwise conspired to secure no-bid contracts for its products in violation of both state law and federal antitrust law. On May 2, 2018, the Federal Circuit affirmed the District Court’s ruling and on October 1, 2018 the Supreme Court denied Digital Ally’s petition for review.

 

In December 2016 and January 2017, Axon filed two petitions for Inter Partes Review (“IPR”) against the ‘452 Patent. The United States Patent and Trademark Office (“USPTO”) rejected both of Axon’s petitions. Axon is now statutorily precluded from filing any more IPR petitions against the ‘452 Patent.

 

The District Court litigation in Kansas was temporarily stayed following the filing of the petitions for IPR. However, on November 17, 2017, the Federal District Court of Kansas rejected Axon’s request to maintain the stay. With this significant ruling, the parties will now proceed towards trial. Since litigation has resumed, the Court has issued a claim construction order (also called a Markman Order) where it sided with the Company on all disputes and denied Axon’s attempts to limit the scope of the claims. Following the Markman Order, the Court set all remaining deadlines in the case. Fact discovery closed on October 8, 2018, and a Final Pretrial Conference took place on January 16, 2019. The parties filed motions for summary judgment on January 31, 2019.

 

On June 17, 2019, the Court granted Axon’s motion for summary judgment that Axon did not infringe on the Company’s patent and dismissed the case. Importantly, the Court’s ruling did not find that Digital’s ‘452 Patent was invalid. It also did not address any other issue, such as whether Digital’s requested damages were appropriate, and it did not impact the Company’s ability to file additional lawsuits to hold other competitors accountable for patent infringement. This ruling solely related to an interpretation of the claims as they relate to Axon and was unrelated to the supplemental briefing Digital recently filed on its damages claim and the WatchGuard settlement. Those issues are separate and the judge’s ruling on summary judgment had nothing to do with Digital’s damages request. The Company has filed an appeal to this ruling and has asked the appellate court to reverse this decision.

 

The Company filed its Opening Appeal Brief on August 26, 2019 and Axon filed its Responsive Brief on November 6, 2019. The Company will file its Reply Brief responding to Axon no later than November 27, 2019.

 

WatchGuard

 

On May 27, 2016, the Company filed suit against WatchGuard, (Case No. 2:16-cv-02349-JTM-JPO) alleging patent infringement based on WatchGuard’s VISTA Wifi and 4RE In-Car product lines.

 

On May 13, 2019, the parties resolved the dispute and executed a settlement agreement in the form of a Release and License Agreement. The litigation has been dismissed as a result of this settlement.

 

The Release and License Agreement encompasses the following key terms:

 

  WatchGuard paid Digital Ally a one-time, lump settlement payment of $6,000,000.
     
 

Digital Ally granted WatchGuard a perpetual covenant not to sue if WatchGuard’s products incorporate agreed-upon modified recording functionality. Digital Ally also granted WatchGuard a license to the ‘292 Patent and the ‘452 Patent (and related patents, now existing and yet-to-issue) through December 31, 2023. The parties agreed to negotiate in good faith to attempt to resolve any alleged infringement that occurs after the license period expires.

     
  The parties further agreed to release each other from all claims or liabilities pre-existing the settlement.
     
 

As part of the settlement, the parties agreed that WatchGuard made no admission that it infringed any of Digital Ally’s patents.

 

Upon receipt of the $6,000,000 the parties filed a joint motion to dismiss the lawsuit which the Judge granted.

 

  20  
     

 

PGA Tour, Inc.

 

On January 22, 2019 the PGA Tour, Inc. (the “PGA”) filed suit against the Company in the Federal District Court for the District of Kansas (Case No. 2:19-cv-0033-CM-KGG) alleging breach of contract and breach of implied covenant of good faith and fair dealing relative to the Web.com Tour Title Sponsor Agreement (the “Agreement”). The contract was executed on April 16, 2015 by and between the parties. Under the Agreement, Digital Ally would be a title sponsor of and receive certain naming and other rights and benefits associated with the Web.com Tour for 2015 through 2019 in exchange for Digital Ally’s payment to Tour of annual sponsorship fees.

 

The suit has been resolved and the case has been dismissed by Plaintiff with prejudice on April 17, 2019.

 

401 (k) Plan. The Company sponsors a 401(k) retirement savings plan for the benefit of its employees. The plan, as amended, requires it to provide 100% matching contributions for employees, who elect to contribute up to 3% of their compensation to the plan and 50% matching contributions for employee’s elective deferrals on the next 2% of their contributions. The Company has made matching contributions totaling $27,235 and $26,680 for the three months ended September 30, 2019 and 2018, respectively, and $80,645 and $85,028 for the nine months ended September 30, 2019 and 2018, respectively. Each participant is 100% vested at all times in employee and employer matching contributions.

 

Consulting and Distributor Agreements. The Company entered into an agreement that required it to make monthly payments that will be applied to future commissions and/or consulting fees to be earned by the provider. The agreement is with a limited liability company (“LLC”) that is minority owned by a relative of the Company’s chief financial officer. Under the agreement, dated January 15, 2016 and as amended on February 13, 2017, the LLC provides consulting services for developing a new distribution channel outside of law enforcement for its body-worn camera and related cloud storage products to customers in the United States. The Company advanced amounts to the LLC against commissions ranging from $5,000 to $6,000 per month plus necessary and reasonable expenses for the period through June 30, 2017, which can be automatically extended based on the LLC achieving minimum sales quotas. The agreement was renewed in January 2017 for a period of three years, subject to yearly minimum sales thresholds that would allow the Company to terminate the contract if such minimums are not met. As of September 30, 2019, the Company had advanced a total of $276,150 pursuant to this agreement and established an allowance reserve of $164,140 for a net advance of $112,010. The minimum sales threshold has not been met and the Company has discontinued all advances, although the contract has not been formally terminated. However, the exclusivity provisions of the agreement have been terminated.

 

On June 1, 2018 the Company entered into an agreement with an individual that required it to make monthly payments that will be applied to future commissions and/or consulting fees to be earned by the provider. Under the agreement, the individual provides consulting services for developing new distribution channels both inside and outside of law enforcement for its in-car and body-worn camera systems and related cloud storage products to customers within and outside the United States. The Company was required to advance amounts to the individual as an advance against commissions of $7,000 per month plus necessary and reasonable expenses for the period through August 31, 2018, which was extended to December 31, 2018 by mutual agreement of the parties at $6,000 per month. The parties have mutually agreed to further extend the arrangement on a monthly basis at $5,000 per month. As of September 30, 2019, the Company had advanced a total of $53,332 pursuant to this agreement.

 

NOTE 12. STOCK-BASED COMPENSATION

 

The Company recorded pretax compensation expense related to the grant of stock options and restricted stock issued of $405,579 and $669,480 for the three months ended September 30, 2019 and 2018, respectively, and $1,715,972 and $1,757,227 for the nine months ended September 30, 2019 and 2018, respectively.

 

As of September 30, 2019, the Company had seven separate stock option and restricted stock plans: (i) the 2005 Stock Option and Restricted Stock Plan (the “2005 Plan”), (ii) the 2006 Stock Option and Restricted Stock Plan (the “2006 Plan”), (iii) the 2007 Stock Option and Restricted Stock Plan (the “2007 Plan”), (iv) the 2008 Stock Option and Restricted Stock Plan (the “2008 Plan”), (v) the 2011 Stock Option and Restricted Stock Plan (the “2011 Plan”), (vi) the 2013 Stock Option and Restricted Stock Plan (the “2013 Plan”), (vii) the 2015 Stock Option and Restricted Stock Plan (the “2015 Plan”) and (vii) the 2018 Stock Option and Restricted Stock Plan (the “2018 Plan”). The 2005 Plan, 2006 Plan, 2007 Plan, 2008 Plan, 2011 Plan, 2013 Plan, 2015 Plan and 2018 Plan are referred to as the “Plans.”

 

  21  
     

 

These Plans permit the grant of stock options or restricted stock to its employees, non-employee directors and others for up to a total of 4,175,000 shares of common stock. The 2005 Plan terminated during 2015 with 19,678 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2005 Plan that remain unexercised and outstanding as of September 30, 2019 total 8,063. The 2006 Plan terminated during 2016 with 24,662 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2006 Plan that remain unexercised and outstanding as of September 30, 2019 total 42,812. The 2007 Plan terminated during 2017 with 88,401 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2007 Plan that remain unexercised and outstanding as of September 30, 2019 total 6,250. The 2008 Plan terminated during 2018 with 8,249 shares not awarded or underlying options, which shares are now unavailable for issuance. Stock options granted under the 2008 Plan that remain unexercised and outstanding as of September 30, 2019 total 32,250.

 

The Company believes that such awards better align the interests of our employees with those of its stockholders. Option awards have been granted with an exercise price equal to the market price of its stock at the date of grant with such option awards generally vesting based on the completion of continuous service and having ten-year contractual terms. These option awards typically provide for accelerated vesting if there is a change in control (as defined in the Plans). The Company has registered all shares of common stock that are issuable under its Plans with the SEC. A total of 629,186 shares remained available for awards under the various Plans as of September 30, 2019.

 

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model.

 

Activity in the various Plans during the nine months ended September 30, 2019 is reflected in the following table:

 

Options   Number of
Shares
    Weighted
Average
Exercise Price
 
Outstanding at January 1, 2019     434,012     $ 4.62  
Granted     180,000       3.01  
Exercised            
Forfeited     (24,887 )     (13.78 )
Outstanding at September 30, 2019     589,125     $ 3.74  
Exercisable at September 30, 2019     454,125     $ 3.96  

 

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model. The total estimated grant date fair value stock options issued during the nine months ended September 30, 2019 was $436,217.

 

The Company has utilized the following assumptions in its Black-Scholes option valuation model to calculate the estimated grant date fair value of the options during the nine months ended September 30, 2019.

 

    Assumptions  
Volatility – range     107.6 %
Risk-free rate     2.23 %
Expected term     5.5 years  
Exercise price   $ 3.01  

 

The Plans allow for the cashless exercise of stock options. This provision allows the option holder to surrender/cancel options with an intrinsic value equivalent to the purchase/exercise price of other options exercised. There were no shares surrendered pursuant to cashless exercises during the nine months ended September 30, 2019.

 

At September 30, 2019, the aggregate intrinsic value of options outstanding was approximately $-0- and the aggregate intrinsic value of options exercisable was approximately $-0-. No options were exercised in the nine months ended September 30, 2019.

 

As of September 30, 2019, the unrecognized portion of stock compensation expense on all existing stock options was $290,811.

 

The following table summarizes the range of exercise prices and weighted average remaining contractual life for outstanding and exercisable options under the Company’s option plans as of September 30, 2019:

 

      Outstanding options   Exercisable options  
Exercise price
range
    Number of
options
    Weighted average
remaining
contractual life
  Number of
options
    Weighted average
remaining
contractual life
 
                         
$ 0.01 to $3.49       470,313     8.6 years     335,313       8.2 years  
$ 3.50 to $4.99       66,875     4.5 years     66,875       4.5 years  
$ 5.00 to $6.49           — years           — years  
$ 6.50 to $7.99       8,437     2.1 years     8,437       2.1 years  
$ 8.00 to $9.99       2,500     1.7 years     2,500       1.7 years  
$ 10.00 to $19.99       39,750     1.3 years     39,750       1.3 years  
$ 20.00 to $24.99       1,250     0.3 years     1,250       0.3 years  
                                 
          589,125     7.5 years     454,125       6.9 years  

 

  22  
     

 

Restricted stock grants. The Board of Directors has granted restricted stock awards under the Plans. Restricted stock awards are valued on the date of grant and have no purchase price for the recipient. Restricted stock awards typically vest over nine months to four years corresponding to anniversaries of the grant date. Under the Plans, unvested shares of restricted stock awards may be forfeited upon the termination of service to or employment with the Company, depending upon the circumstances of termination. Except for restrictions placed on the transferability of restricted stock, holders of unvested restricted stock have full stockholder’s rights, including voting rights and the right to receive cash dividends.

 

A summary of all restricted stock activity under the equity compensation plans for the nine months ended September 30, 2019 is as follows:

 

    Number of
Restricted
shares
    Weighted
average
grant date
fair
value
 
Non-vested balance, January 1, 2019     772,150     $ 3.40  
Granted     522,110       2.91  
Vested     (397,790 )     (3.84 )
Forfeited     (5,370 )     (3.46 )
Non-vested balance, September 30, 2019     891,100     $ 2.91  

 

The Company estimated the fair market value of these restricted stock grants based on the closing market price on the date of grant. As of September 30, 2019, there were $666,687 of total unrecognized compensation costs related to all remaining non-vested restricted stock grants, which will be amortized over the next 15 months in accordance with the respective vesting scale.

 

The non-vested balance of restricted stock vests as follows:

 

Years ended   Number of
shares
 
       
2019 (October 1, 2019 to December 31, 2019)     376,225  
2020     264,750  
2021     250,125  

 

NOTE 13. COMMON STOCK PURCHASE WARRANTS

 

The Company has issued common stock purchase warrants in conjunction with various debt and equity issuances. The warrants are either immediately exercisable, or have a delayed initial exercise date, no more than nine months from issue date, and allow the holders to purchase up to 4,717,573 shares of common stock at $2.60 to $16.50 per share as of September 30, 2019. The warrants expire from July 15, 2020 through July 31, 2023 and allow for cashless exercise.

 

    Warrants     Weighted
average
exercise price
 
Vested Balance, January 1, 2019     4,693,145     $ 5.40  
Granted     571,428       1.81  
Exercised     (529,000 )     (2.96 )
Cancelled     (18,000 )     (3.50 )
Vested Balance, September 30, 2019     4,717,573     $ 5.23  

 

The total intrinsic value of all outstanding warrants aggregated $-0- as of September 30, 2019 and the weighted average remaining term is 40.3 months.

 

  23  
     

 

The following table summarizes the range of exercise prices and weighted average remaining contractual life for outstanding and exercisable warrants to purchase common shares as of September 30, 2019:

 

      Outstanding and exercisable warrants
Exercise price     Number of warrants     Weighted average
remaining
contractual life
$ 1.81       571,428     4.9 years
$ 2.60       465,712     3.8 years
$ 3.00       701,667     3.5 years
$ 3.25       120,000     3.2 years
$ 3.36       880,000     3.2 years
$ 3.65       200,000     2.8 years
$ 3.75       94,000     2.9 years
$ 5.00       800,000     2.3 years
$ 13.43       879,766     1.3 years
$ 16.50       5,000     0.8 years
                 
          4,717,573     3.0 years

 

NOTE 14. NET LOSS PER SHARE

 

The calculations of the weighted average number of shares outstanding and loss per share outstanding for the three and nine months ended September 30, 2019 and 2018 are as follows:

 

   

Three Months Ended

September 30,

   

Nine Months Ended

September 30,

 
    2019     2018     2019     2018  
Numerator for basic and diluted income per share – Net loss   $ (2,985,825 )   $ (4,665,580 )   $ (6,578,729 )   $ (10,216,702 )
                                 
Denominator for basic loss per share – weighted average shares outstanding     11,637,289       7,725,877       11,296,999       7,295,098  
                                 
Dilutive effect of shares issuable under stock options and warrants outstanding                        
                                 
Denominator for diluted loss per share – adjusted weighted average shares outstanding     11,637,289       7,725,877       11,296,999       7,295,098  
                                 
Net loss per share:                                
Basic   $ (0.26 )   $ (0.60 )   $ (0.58 )   $ (1.40 )
Diluted   $ (0.26 )   $ (0.60 )   $ (0.58 )   $ (1.40 )

 

Basic loss per share is based upon the weighted average number of common shares outstanding during the period. For the three and nine months ended September 30, 2019 and 2018, all outstanding stock options to purchase common stock were antidilutive, and, therefore, not included in the computation of diluted net loss per share.

 

Note 15 – Subsequent Events

 

Management evaluated all activities of the Company through the issuance date of the Company’s unaudited condensed consolidated financial statements and concluded that no subsequent events have occurred that would require adjustments or disclosure into the unaudited condensed consolidated financial statements.

 

*************************************

 

  24  
     

 

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

 

This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “may,” “should,” “could,” “will,” “plan,” “future,” “continue,” and other expressions that are predictions of or indicate future events and trends and that do not relate to historical matters identify forward-looking statements. These forward-looking statements are based largely on our expectations or forecasts of future events, can be affected by inaccurate assumptions, and are subject to various business risks and known and unknown uncertainties, a number of which are beyond our control. Therefore, actual results could differ materially from the forward-looking statements contained in this document, and readers are cautioned not to place undue reliance on such forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. A wide variety of factors could cause or contribute to such differences and could adversely impact revenues, profitability, cash flows and capital needs. There can be no assurance that the forward-looking statements contained in this document will, in fact, transpire or prove to be accurate.

 

Factors that could cause or contribute to our actual results differing materially from those discussed herein or for our stock price to be adversely affected include, but are not limited to: (1) our losses in recent years, including the nine months ended September 30, 2019 and fiscal 2018; (2) macro-economic risks from the effects of the decrease in budgets for the law-enforcement community; (3) our ability to increase revenues, increase our margins and return to consistent profitability in the current economic and competitive environment; (4) our operation in developing markets and uncertainty as to market acceptance of our technology and new products; (5) the availability of funding from federal, state and local governments to facilitate the budgets of law enforcement agencies, including the timing, amount and restrictions on such funding; (6) our ability to deliver our new product offerings scheduled in 2019, such as the EVO-HD, have them perform as planned or advertised and whether they will help increase our revenues; (7) whether we will be able to increase the sales, domestically and internationally, for our products in the future; (8) our ability to maintain or expand our share of the market for our products in the domestic and international markets in which we compete, including increasing our international revenues; (9) our ability to produce our products in a cost-effective manner; (10) competition from larger, more established companies with far greater economic and human resources; (11) our ability to attract and retain quality employees; (12) risks related to dealing with governmental entities as customers; (13) our expenditure of significant resources in anticipation of sales due to our lengthy sales cycle and the potential to receive no revenue in return; (14) characterization of our market by new products and rapid technological change; (15) our dependence on sales of our DVM-800, FirstVU HD and DVM-250 products and cloud and service revenue; (16) potential that stockholders may lose all or part of their investment if we are unable to compete in our markets and return to profitability; (17) defects in our products that could impair our ability to sell our products or could result in litigation and other significant costs; (18) our dependence on key personnel; (19) our reliance on third-party distributors and sales representatives for part of our marketing capability; (20) our dependence on a few manufacturers and suppliers for components of our products and our dependence on domestic and foreign manufacturers for certain of our products; (21) our ability to protect technology through patents and to protect our proprietary technology and information as trade secrets and through other similar means; (22) our ability to generate more recurring cloud and service revenues; (23) risks related to our license arrangements; (24) our revenues and operating results may fluctuate unexpectedly from quarter to quarter; (25) sufficient voting power by coalitions of a few of our larger stockholders, including directors and officers, to make corporate governance decisions that could have significant effect on us and the other stockholders; (26) sale of substantial amounts of our common stock that may have a depressive effect on the market price of the outstanding shares of our common stock; (27) possible issuance of common stock subject to options and warrants that may dilute the interest of stockholders; (28) our nonpayment of dividends and lack of plans to pay dividends in the future; (29) future sale of a substantial number of shares of our common stock that could depress the trading price of our common stock, lower our value and make it more difficult for us to raise capital; (30) our additional securities available for issuance, which, if issued, could adversely affect the rights of the holders of our common stock; (31) our stock price is likely to be highly volatile due to a number of factors, including a relatively limited public float; (32) whether the litigation against Axon will achieve its intended objectives and result in monetary recoveries for us; (33) whether the USPTO rulings will curtail, eliminate or otherwise have an effect on the actions of Axon respecting us, our products and customers; (34) whether the remaining two claims under the ‘556 Patent have applicability to us or our products; and (35) whether our patented VuLink technology is becoming the de-facto “standard” for agencies engaged in deploying state-of-the-art body-worn and in-car camera systems and will increase our revenues; (36) whether such technology will have a significant impact on our revenues in the long-term; and (37) indemnification of our officers and directors.

 

Current Trends and Recent Developments for the Company

 

Overview

 

We supply technology-based products utilizing our portable digital video and audio recording capabilities, for the law enforcement and security industries and for the commercial fleet and mass transit markets. We have the ability to integrate electronic, radio, computer, mechanical, and multi-media technologies to create unique solutions to our customers’ requests. Our products include the DVM-800 and DVM-800 Lite, in-car digital video mirror systems for law enforcement; the FirstVU and the FirstVU HD, body-worn cameras, our patented and revolutionary VuLink product, which integrates our body-worn cameras with our in-car systems by providing hands-free automatic activation, for both law enforcement and commercial markets; the DVM-250 and DVM-250 Plus, a commercial line of digital video mirrors that serve as “event recorders” for the commercial fleet and mass transit markets; and FleetVU and VuLink, our cloud-based evidence management systems. We introduced the EVO-HD product in late June 2019 and began full-scale deployments in the third quarter 2019. It is designed and built on a new and highly advanced technology platform that will become the platform for a new family of our in-car video solution products for the law enforcement and commercial markets. We believe that the launch of these new products will help to reinvigorate our in-car and body-worn systems revenues while diversifying and broadening the market for our product offerings, although we can offer no assurance in this regard.

 

  25  
     

 

We experienced operating losses for all quarters during 2019 and 2018 except for the second quarter 2019, which was aided by a patent litigation settlement. The following is a summary of our recent operating results on a quarterly basis:

 

   

September 30,

2019

   

June 30,

2019

   

March 31,

2019

   

December 31,

2018

   

September 30,

2018

   

June 30,

2018

   

March 31,

2018

 
Total revenue   $ 2,923,148     $ 2,546,983     $ 2,550,796     $ 2,378,287     $ 2,878,059     $ 3,563,550     $ 2,471,513  
Gross profit     1,188,262       980,812       1,181,740       56,658       1,177,289       1,618,467       1,109,394  
Gross profit margin percentage     40.7 %     37.3 %     46.3 %     2.3 %     40.9 %     45.4 %     44.9 %
Total selling, general and administrative expenses     3,468,709       (1,616,830 )     4,267,898       5,292,374       3,087,005       3,055,776       3,082,710  
Operating loss     (2,280,447 )     2,567,642       (3,086,158 )     (5,235,716 )     (1,909,716 )     (1,437,309 )     (1,973,316 )
Operating loss percentage     (78.0 )%     100.8 %     (121.0 )%     (220.1 )%     (66.4 )%     (40.3 )%     (79.8 )%
Net loss   $ (2,985,825 )   $ (387,730 )   $ (3,205,174 )   $ (5,327,849 )   $ (4,665,580 )   $ (2,962,890 )   $ (2,588,232 )

 

Our business is subject to substantial fluctuations on a quarterly basis as reflected in the significant variations in revenues and operating results in the above table. These variations result from various factors, including but not limited to: (1) the timing of large individual orders; (2) the traction gained by newer products, such as the recently released EVO-HD; (3) production, quality and other supply chain issues affecting our cost of goods sold; (4) unusual increases in operating expenses, such as the timing of trade shows and bonus compensation; (5) the timing of patent infringement litigation settlements, such as the $6.0 settlement we obtained from WatchGuard during the second quarter 2019 and (5) ongoing patent and other litigation and related expenses respecting outstanding lawsuits. We reported an operating loss of $2,280,447 on revenues of $2,923,148 for the three months ended September 30, 2019 compared to operating income of $2,567,642 on revenues of $2,546,983 for the three months ended June 30, 2019 primarily as a result of the $6.0 million settlement of the WatchGuard patent litigation. The income recognized in the second quarter 2019 ended a series of quarterly losses resulting from competitive pressures, supply chain problems, increases in inventory reserves as our current product suite ages, product quality control issues, product warranty issues, infringement of our patents by direct competitors such as Axon that reduced our revenues, and litigation expenses relating to the patent infringement.

 

A number of factors and trends affected our recent performance, which include:

 

 

On May 13, 2019 we reached a resolution of the pending patent infringement litigation with WatchGuard and executed a settlement agreement that resulted in the dismissal of this case. As part of the settlement agreement, we received a one-time $6.0 million payment and granted WatchGuard a perpetual covenant to not sue WatchGuard if its products incorporate agreed-upon modified recording functionality. Additionally, we granted it a license to the ‘292 Patent and ‘452 Patent through December 31, 2023. As part of the settlement, the parties agreed that WatchGuard made no admission that it infringed any of our patents. See Note 11, “Contingencies” for the details respecting the settlement.

     
 

Revenues increased in third quarter 2019 to $2,923,148 from $2,546,983 in second quarter 2019. The primary reason for the revenue increases in the third quarter 2019 is the 38% increase in service and other revenues. We continue to face increased challenges for our in-car and body-worn systems because our competitors have released new products with advanced features and have maintained their product price cuts. We introduced a new product platform, the EVO-HD, specifically for in-car systems late in June 2019 to address our competitors’ new product features. We expect potential customers to review and test the EVO-HD prior to adopting the new platform for deployment. This new product platform utilizes advanced chipsets that will generate new and highly advanced products for our law enforcement and commercial customers and we believe will improve product revenues in future quarters as customers become aware of and commit to the new EVO-HD, although we can make no assurances in this regard. Our law enforcement revenues declined over the prior period due to price-cutting, willful infringement of our patents and other actions by our competitors and adverse marketplace effects related to the patent litigation. For example, one of our competitors introduced a body-camera including cloud storage free for one year that disrupted the market beginning in 2017 to date in 2019. This has continued to pressure our revenues in 2019.

 

  26  
     

 

  Our objective is to expand our recurring service revenue to help stabilize our revenues on a quarterly basis. Revenues from extended warranties have been increasing and were approximately $379,989 for Q-3 2019, an increase of $101,054 (36%) over the comparable quarter in 2018. Additionally, revenues from cloud storages have been increasing in recent quarters and reached $194,661 in Q-3 2019, an increase of $21,097 (12%) over Q-3 2018. We are pursuing several new market channels that do not involve our traditional law enforcement and private security customers, such as our NASCAR affiliation, which we believe will help expand the appeal of our products and service capabilities to new commercial markets. If successful, we believe that these new market channels could yield recurring service revenues in the future.
     
  Recognizing a critical limitation in law enforcement camera technology, during 2014 we pioneered the development of our VuLink ecosystem that provided intuitive auto-activation functionality as well as coordination between multiple recording devices. The USPTO granted us multiple patents with claims covering numerous features, such as automatically activating an officer’s cameras when the light bar is activated or when a data-recording device such as a smart weapon is activated. Additionally, our patent claims cover automatic coordination between multiple recording devices. Prior to this innovation, officers were forced to manually activate each device while responding to emergency scenarios - a requirement that both decreased the usefulness of the existing camera systems and diverted officers’ attention during critical moments. We believe law enforcement agencies have recognized the value of our VuLink technology and agencies are seeking information on “auto-activation” features in requests for bids and requests for information involving the procurement process of body-worn cameras and in-car systems. We believe this may result in our patented VuLink technology becoming the de-facto “standard” for agencies engaged in deploying state-of-the-art body-worn and in-car camera systems. However, the willful infringement of our VuLink patent by Axon and others has substantially and negatively impacted revenues that otherwise would have been generated by our VuLink system and indirectly our body-worn and in-car systems. We believe that the results of the current patent litigation will largely set the competitive landscape for body-worn and in-car systems for the foreseeable future. We are seeking other ways to monetize our VuLink patents, which may include entering into license agreements or supply and distribution agreements with competitors. We expect that this technology will have a significant positive impact on our revenues in the long-term, particularly if we are successful in our prosecution of the patent infringement litigation pending with Axon and we can successfully monetize the underlying patents, although we can make no assurances in this regard.
     
 

We have asserted two significant patent infringement lawsuits involving Axon and WatchGuard that has had significant impacts on our quarterly results primarily due to the timing and amounts of legal fees expended on such lawsuits. We settled the WatchGuard lawsuit in May 2019 for $6.0 million (see Note 11 for details) and in June 2019 the Court granted Axon’s Motion for Summary Judgment and accepted Axon’s position that it did not infringe on our patents and dismissed the Axon lawsuit in its entirety. We have appealed the Court’s ruling. Future quarterly results during 2019 and possibly beyond will continue to be impacted as this appeal is heard and, if the case moves to trial. If we win the appeal and the case moves to trial, the jury will then determine whether Axon infringed on our patents. If the jury decides that Axon infringes our patents, it would determine the amount of compensatory damages owed to us by the defendants and whether such damage awards should be trebled due to willful infringement by the defendants. In addition, there may be attempts by the defendant to settle such lawsuit prior to a trial. Such jury award and/or potential settlement prior to trial would likely have a significant impact on our quarterly operating results if and when it occurs.

     
 

We announced a multi-year official partnership with NASCAR, naming us “A Preferred Technology Provider of NASCAR.” As part of the relationship, we will provide cameras that will be mounted in the Monster Energy NASCAR Cup Series garage throughout the season, bolstering both NASCAR’s commitment to safety at every racetrack, as well as enhancing its officiating process through technology. We believe this new partnership with NASCAR will demonstrate the flexibility of our product offerings and help expand the appeal of our products and service capabilities to new commercial markets.

     
  Our international revenues decreased to $68,647 (2% of total revenues) during third quarter 2019, compared to $90,441 (3% of total revenues) during third quarter 2018. Our third quarter 2019 international revenues were disappointing; however, the international sales cycle generally takes longer than domestic business and we have provided bids to a number of international customers.

 

  27  
     

 

Off-Balance Sheet Arrangements

 

We do not have any off-balance sheet debt nor did we have any transactions, arrangements, obligations (including contingent obligations) or other relationships with any unconsolidated entities or other persons that may have material current or future effect on financial conditions, changes in the financial conditions, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenue or expenses.

 

For the Three Months Ended September 30, 2019 and 2018

 

Results of Operations

 

Summarized immediately below and discussed in more detail in the subsequent sub-sections is an analysis of our operating results for the three months ended September 30, 2019 and 2018, represented as a percentage of total revenues for each respective year:

 

   

Three Months Ended

September 30,

 
    2019     2018  
Revenue     100 %     100 %
Cost of revenue     59 %     59