Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
This Quarterly Report on Form 10-Q, including, without limitation, the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Such forward-looking statements are generally accompanied by words such as “estimate,” “expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may” or other words that convey uncertainty of future events or outcomes. These statements relate to future events or to our future financial performance, and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Factors that may cause actual results to differ materially from current expectations, which we describe in more detail elsewhere in this Quarterly Report on Form 10-Q, as well as in our Quarterly Reports filed on Form 10-Q on May 11, and August 14, 2018, in Part II Item 1A ”Risk Factors”, and in our 2017 Annual Report on Form 10-K, filed March 29, 2018, in Item 1A “Risk Factors” include, but are not limited to:
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insufficient cash to operate our business and inability to meet our liquidity requirements;
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loss of revenues due to the failure of our newer products to achieve market acceptance;
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our need to increase current revenue levels in order to achieve sustainable profitability;
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concentration of our revenues from U.S. government entities or commercial customers and the possibility of loss of one of these customers and the unique risks associated with government customers;
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our dependence on sales made through indirect channels;
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our dependence on equity or debt financing provided primarily by our Chief Executive Officer under the CEO Note in order to meet our cash flow requirements;
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the adverse effect that payment of accrued dividends on our preferred stock would have on our cash resources and the substantial dilution upon the conversion or redemption of our preferred stock;
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the consequences of our inability to pay scheduled dividends on shares of our preferred stock;
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the potentially detrimental impact that the conversion of preferred stock would have on the price of our common stock;
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the ability of our preferred stockholders to hinder additional financing; and
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the influence that our management and larger stockholders have over actions taken by the Company.
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If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary significantly from what we projected. These forward-looking statements and other statements made elsewhere in this report are made in reliance on the Private Securities Litigation Reform Act of 1995. Any forward-looking statement you read in this Quarterly Report on Form 10-Q or our Annual Report on Form 10-K reflects our current views with respect to future events and is subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. We assume no obligation to publicly update or revise these forward-looking statements for any reason, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future. The section below entitled “Factors That May Affect Future Results of Operations” sets forth and incorporates by reference certain factors that could cause actual future results of the Company to differ materially from these statements.
Results of Operations
The following table sets forth, for the periods indicated, certain financial data as a percentage of net revenues. The period-to-period comparison of financial results is not necessarily indicative of future results.
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Three Months Ended
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Nine
Months Ended
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September
30,
201
8
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September
30,
201
7
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September
30,
2018
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September
30,
201
7
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Total revenue
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100.0
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%
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100.0
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%
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100.0
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%
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100.0
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%
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Total cost of revenue
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36.3
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43.9
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37.6
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40.8
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Gross profit
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63.7
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56.1
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62.4
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59.2
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Operating expenses:
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Sales and marketing
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17.5
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23.5
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18.0
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24.4
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Research and development
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12.3
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36.7
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11.4
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37.6
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General and administrative
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9.1
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14.4
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11.3
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17.9
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Operating income (loss)
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24.8
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(18.5
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)
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21.7
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(20.7
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)
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Other income
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—
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55.3
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—
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19.4
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Interest expense, net
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(1.6
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)
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(2.9
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)
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(2.0
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)
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(3.3
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Income (loss) before income tax provision
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23.2
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33.9
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19.7
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(4.6
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)
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Income tax provision
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—
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—
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—
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—
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Net income (loss)
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23.2
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%
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33.9
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%
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19.7
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%
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(4.6
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)%
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Preferred stock dividends accrued
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(1.4
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)
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(2.1
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)
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(1.4
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)
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(2.2
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)
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Net income (loss) attributable to common stockholders
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21.8
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%
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31.8
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%
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18.3
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%
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(6.8
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)%
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Three Months Ended
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Nine
Months Ended
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September
30,
201
8
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September
30,
201
7
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September
30,
201
8
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September
30,
201
7
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Domestic revenues
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100.0
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%
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100.0
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%
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100.0
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%
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100.0
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%
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Export revenues
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—
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—
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—
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—
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Net revenues
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100.0
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%
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100.0
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%
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100.0
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%
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100.0
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%
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Net Revenues
. Net revenues for the quarter and nine months ended September 30, 2018 were $2.7 million and $7.3 million, respectively, compared to $1.7 million and $4.8 million for the same periods in 2017. Product revenues increased $1.0 million for the quarter ended September 30, 2018, and $2.5 million for the nine months ended September 30, 2018 compared to the same periods in 2017. Increased product revenues were primarily due to an increase in sales of our TraceCop product line. TraceCop sales for the quarters ended September 30, 2018 and 2017 were $2.7 million and $1.7 million, respectively. Savant sales were $29 thousand for the quarter ended September 30, 2018 and remained the same as the quarter ended September 30, 2017.
Concentration of Revenues
. Revenues from sales to various U.S. government entities totaled $2.3 million, or 84.5% of revenues, for the quarter ended September 30, 2018 compared to $1.5 million, or 90.6% of revenues, for the same period in 2017. Revenues from sales to various U.S. government entities totaled $6.1 million, or 84.2% of revenues, for the nine months ended September 30, 2018, compared to $3.8 million, or 80.2% of revenues, for the same period in 2017. Sales to commercial customers totaled 15.5% of total revenue for the third quarter of 2018 compared to 9.4% of total revenue for the third quarter of 2017. During the third quarter of 2018, approximately 14.5% of total revenue was attributable to one commercial customer compared to approximately 6.2% to one commercial customer in the third quarter of 2017. Although we expect our concentration of revenues to vary among customers in future periods depending upon the timing of certain sales, we anticipate that sales to government customers will continue to account for a significant portion of our revenues in future periods. Sales to the government present risks in addition to those involved in sales to commercial customers which could adversely affect our revenues, including, without limitation, potential disruption to appropriation and spending patterns and the government’s reservation of the right to cancel contracts and purchase orders for its convenience. Although we do not anticipate that any of our revenues with government customers will be renegotiated, a large number of cancelled or renegotiated government orders could have a material adverse effect on our financial results. Currently, we are not aware of any proposed cancellation or renegotiation of any of our existing arrangements with government entities and, historically, government entities have not cancelled or renegotiated orders which had a material adverse effect on our business.
Gross Profit
. Gross profit was $1.7 million or 63.7% of net revenues for the quarter ended September 30, 2018, compared to $0.9 million or 56.1% of net revenues for the quarter ended September 30, 2017. Gross profit was $4.6 million or 62.4% of net revenues for the nine months ended September 30, 2018 compared to $2.8 million or 59.2% of net revenues for the nine months ended September 30, 2017. Gross profit on product revenues for the quarter and nine months ended September 30, trended from 56.1% and 59.2%, respectively, in 2017 to 63.7% and 62.4%, respectively, in 2018 mainly due to a change in product mix. Gross profit increases can be attributed to such variables as labor hour rates and department overhead. Gross profit as a percentage of net revenues is impacted by several factors, including shifts in product mix, changes in channels of distribution, revenue volume, pricing strategies, and fluctuations in revenues of integrated third-party products.
Sales and Marketing
. Sales and marketing expenses increased to $0.5 million for the quarter ended September 30, 2018, compared to $0.4 million for same period in 2017. Sales and marketing expenses increased to $1.3 million for the nine months ended September 30, 2018, compared to $1.2 million for the same period in 2017. Sales and marketing expenses may vary in the future. We believe that these costs will increase through the end of 2018, with increases in revenue.
Research and Development
. Research and development expenses decreased to $0.3 million for the quarter ended September 30, 2018, compared to $0.6 million for the same period in 2017. Research and development decreased to $0.8 million for the nine months ended September 30, 2018, compared $1.8 million in 2017. Decreases in research and development costs were due to lower payroll expense as payroll was allocated to cost of sales. Research and development costs are expensed in the period incurred. Research and development expenses may vary in the future; however, we believe that these costs will remain relatively constant through the end of 2018, although expenses may be increased relative to increases in revenue.
General and Administrative
. General and administrative expenses remained constant at $0.2 million for the quarters ended September 30, 2018 and 2017. General and administrative expenses decreased to $0.8 million compared to $0.9 million for the nine months ended for September 30, 2018 and 2017. It is expected that general and administrative expenses will remain relatively constant throughout the remainder of 2018, although expenses may be increased relative to increases in revenue.
Other Income.
On July 7, 2017, the Company entered into a sale of certain IP addresses that were not currently being used in the Company's business operations and were not required for the Company's future business plans. The net proceeds from the sale of these intellectual property assets were in the amount of $872,000 which the Company received on August 9, 2017. In addition, $56,000 was received on August 3, 2017 from the sale of an investment.
Interest
. Net interest expense decreased to $43 thousand for the quarter ended September 30, 2018, compared to $49 thousand for the same period in 2017. Net interest expense decreased to $144 thousand for the nine months ended September 30, 2018 compared to $157 thousand for the same period in 2017. The decrease in interest expense was primarily due to a reduction in the principal balance of the CEO Note. Net interest expense may vary in the future based on our level of borrowing, which will be affected by our cash flow, operating income and capital expenditures.
Liquidity and Capital Resources
Our principal source of liquidity at September 30, 2018, was approximately $853 thousand of cash and cash equivalents. At September 30, 2018, we had a working capital deficiency of $0.4 million compared to a $1.0 million deficiency at September 30, 2017.
Net cash provided by operations for the nine months ended September 30, 2018 was $1.8 million due primarily to a net income of $1.437 million and to the following sources of cash and non-cash items: $213 thousand increase in deferred revenue, $191 thousand increase in accounts payable and accrued expenses, $15 thousand decrease in Inventories, $34 thousand in penalties and waived penalties on dividends, $50 thousand in amortization expense of capital leases, $46 thousand in depreciation expense, $16 thousand in stock-based compensation, and a $65 thousand write-off of the United Kingdom’s cumulative translation adjustment. This was partially offset by a $120 thousand increase in prepaid expenses and other assets and a $155 thousand increase in accounts receivable. Net cash provided by operations for the nine months ended September 30, 2017, was $274 thousand due to the following sources of cash and non-cash items: $263 thousand increase in deferred revenue, $168 thousand increase in accounts payable and accrued expenses, $40 thousand decrease in prepaid expenses and other assets, $15 thousand decrease in Inventories, $106 thousand in amortization expense of capital leases, $53 thousand in depreciation expense, $24 thousand in penalties and waived penalties on dividends, and $16 thousand in stock-based compensation. This was partially offset by a net operating loss of $221 thousand, $56 thousand gain on sale of investment and a $134 thousand increase in accounts receivable. Future fluctuations in inventory balances, accounts receivable and accounts payable will be dependent upon several factors, including, but not limited to, quarterly sales volumes and timing of invoicing, and the accuracy of our forecasts of product demand and component requirements.
Net cash used by investing activities for the nine months ended September 30, 2018, was $173 thousand for net purchases of property and equipment, compared to net cash provided by investing activities for the nine months ended September 30, 2017, was $43 thousand due to $56 thousand in proceeds from sale of investment offset by $13 thousand for net purchases of property and equipment.
Net cash used by financing activities in 2018 was $1.0 million due to payments to the CEO Note of $1.2 million and $51 thousand payment on principal on capital leases. This was directly offset by the following provisions of cash: proceeds from a loan by an officer of $150 thousand and $111 thousand from the exercise of stock options. Net cash used by financing activities for the nine months ended September 30, 2017, was $118 thousand due to $1.6 million in payments to the loan by an officer, and $109 thousand payment on the principal of capital leases. This was offset by: proceeds from a loan by an officer of $1.58 million and $11 thousand in proceeds from the exercise of stock options.
At September 30, 2018, the Company did not have any material commitments for capital expenditures.
During the nine months ended September 30, 2018, the Company funded its operations through the use of cash and cash equivalents and advances on the loan from our Chief Executive Officer.
As of September 30, 2018, we had cash and cash equivalents of approximately $853,000, up from approximately $224,000 as of December 31, 2017. We generated net income of $617,000 for the quarter ended September 30, 2018 compared to a net income of $568,000 for the quarter ended September 30, 2017. As of September 30, 2018, in addition to cash and cash equivalents of $853,000, we had $1.9 million of funding available from a promissory note to borrow up to $3.7 million from G. Ward Paxton, the Company’s Chief Executive Officer. We are obligated to make payments of accrued dividends on all our outstanding shares of preferred stock that will reduce our available cash resources. Based on projections of growth in revenue and net income in the coming quarters, and the borrowings available previously mentioned, we believe that we will have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months. We expect to fund our operations through anticipated Company profits and borrowings from the Company’s CEO, and possibly additional investments of private equity and debt, which, if we are able to obtain, will have the effect of diluting our existing common stockholders, perhaps significantly. Any equity or debt financings, if available at all, may be on terms which are not favorable to us and, in the case of equity financings, may result in dilution to our stockholders. If our operations do not generate positive cash flow in the upcoming year, or if we are not able to obtain additional debt or equity financing on terms and conditions acceptable to us, if at all, we may be unable to implement our business plan, fund our liquidity needs or even continue our operations.
We may explore the possible acquisitions of businesses, products and technologies that are complementary to our existing business. We are continuing to identify and prioritize additional security technologies, which we may wish to develop, either internally or through the licensing, or acquisition of products from third parties. While we may engage from time to time in discussions with respect to potential acquisitions, there can be no assurances that any such acquisitions will be made or that we will be able to successfully integrate any acquired business. In order to finance such acquisitions and working capital it may be necessary for us to raise additional funds through public or private financings. Any equity or debt financings, if available at all, may be on terms, which are not favorable to us and, in the case of equity financings, may result in dilution to our stockholders.