FALCONSTOR SOFTWARE, INC. 26
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The following 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 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements can be identified by the use of predictive, future-tense or forward-looking terminology, such as "believes," "anticipates," "expects," "estimates," "plans," "may," "intends," "will," or similar terms. Investors are cautioned that any forward-looking statements are not guarantees of future performance and involve significant risks and uncertainties, and that actual results may differ materially from those projected in the forward-looking statements. The following discussion should be read together with the consolidated financial statements and notes to those financial statements included elsewhere in this report.
OVERVIEW
FalconStor Software, Inc. , aDelaware corporation ("we", the "Company" or "FalconStor") is a trusted data protection software leader modernizing disaster recovery and backup operations for the hybrid cloud world. The Company enables enterprise customers and managed service providers to secure, migrate, and protect their data while reducing data storage and long-term retention costs by up to 95%. More than 1,000 organizations and managed service providers worldwide standardize on FalconStor as the foundation for their cloud first data protection future. Our products are offered through and supported by a worldwide network of leading managed service providers ("MSPs"), systems integrators, resellers, and original equipment manufacturers ("OEMs"). Our products address a demand for enterprise data protection driven by the manner in which consumers and businesses are increasingly interacting in a digital space through multiple devices, networks and platforms. The onset of the coronavirus pandemic accelerated this shift, as ongoing remote work and work from home arrangements introduced novel challenges to maintaining enterprise data security. The adoption of increased employee mobility and flexible remote work arrangements, such as a broader incorporation of cloud technology and the option for employees to use their own devices, has introduced additional vulnerabilities that businesses must monitor and protect through solutions like ours in order to maintain enterprise data integrity. Our products are utilized by enterprises and MSPs to address two key areas of enterprise data protection: (i) long-term data retention and recovery, and (ii) data replication to preserve business continuity. Our integration with modern cloud-based data storage environments, such as IBM PowerVS Cloud, AWS and Microsoft Azure, enables our enterprise customers to significantly reduce costs and improve the portability, security and accessibility of their enterprise data. We believe this accessibility is key in our modern world, where data must be protected and intelligently leveraged to facilitate learning, improve product design and drive competitive advantage. Our products can be used regardless of the underlying hardware, cloud and source-data, which enables our enterprise customers to leverage their existing hardware and software investments. Since the beginning of 2020, we have focused our go-to-market efforts on long-term data retention and recovery data protection segments, building on the momentum we generated since 2019. In 2021, we increased our go-to-market investment within our core regions of theAmericas , EMEA,Japan ,Korea , andSoutheast Asia , and released StorSafeTM, the next generation of ourVirtual Tape Library ("VTL") product family built for MSPs. During the third quarter of 2022, we continued to deliver innovation and to enhance each of our products. Our StorSafeTM solution is a vital backup long-term archive retention tool in enterprise IT departments' data protection arsenal and for MSPs that provide data protection as a service to enterprise companies. It enables them to modernize their backup and archive environments, leverage efficient hybrid- and public-cloud storage environments, such as those provided by IBM PowerVS Cloud, AWS and Microsoft Azure, save operational costs, and improve restore performance for rapid remote disaster recovery. Through StorSafeTM, we are making progress expanding our technology to deliver an enterprise-class, highly flexible and efficient backup and long-term data storage optimization solution for the hybrid cloud world. 27 -------------------------------------------------------------------------------- Beyond our long-term retention and reinstatement products, our StorGuardTM business continuity driven data replication solution gives our customers the ability to move workloads to the right destination, on-premises or in the cloud, with advanced insight. This solution is designed for MSPs and enterprise organizations with complex, heterogeneous IT environments and the full spectrum of data management use cases, including but not limited to large enterprises, universities, health care entities and governmental institutions. StorGuardTM is a modern, comprehensive and easy-to-use software solution that enables IT professionals to have complete insight into and control over their organization's data. To provide for greater ease of use for all our products, we also made significant enhancements to our central data management console, now called StorSightTM, to interface with each of our products to provide a holistic view of an enterprise's entire data protection environment - whether on-premises in data centers, in the public cloud, or a hybrid - as well as the key analytics, reports and dashboards our customers need to continuously optimize their operations. FalconStor continues to focus on MSPs, enterprise customers, and OEM partners. These markets offer the most significant opportunity and are best suited to realize the value of FalconStor products, and provide an efficient and effective access to broad, worldwide markets. Most of our revenue comes from sales to MSPs and to enterprise customers through resellers. Our "Business Partner" program for our MSPs and resellers provides financial incentives for those partners that are willing to make a commitment to FalconStor through training, marketing and revenue. As part of our review of all of our operations to maximize savings without sacrificing sales, and in connection with our Business Partner program, we continually review our relationship with each of our partners in all regions. We decided to focus on only those partnerswho have the expertise, personnel and networks to identify potential customers and to service our end users. Historically, the majority of our software licenses have been sold on a capacity basis and have included a perpetual right to use the licensed capacity. However, we have shifted our focus to an annual recurring revenue model through subscription or term-based licenses, which gives a customer the right to utilize our solutions over a designated period of time. We expect revenue from subscription-based licensing to increase over the next several years. Fluctuation in our revenue is driven by the volume and mix of sales from period to period. Revenue allocated to perpetual and term software licenses are recognized at a point in time upon electronic delivery of the download link and the license keys, as these products have significant standalone functionality. Product maintenance and support services are satisfied over time as they are stand-ready obligations throughout the support period. As a result, revenues associated with maintenance services are deferred and recognized as revenue ratably over the term of the contract. Revenues associated with professional services are recognized at a point in time upon customer acceptance. During the third quarter of 2022, our shift to recurring revenue based revenue took a material step forward as we continued to expand our strategic reseller relationship with IBM. Through this strategic reseller relationship, IBM and FalconStor co-market joint solutions consisting of FalconStor's VTL/StorSafe software, IBM Cloud Object Storage ("COS"), and IBM Power Virtual Servers ("PowerVS") for efficient application and data migration from on-premises environments to IBM PowerVS Cloud, and on-going SaaS-based backup and restore within IBM PowerVS Cloud. While we expect this relationship to provide healthy recurring revenue growth in the future as our joint solutions will be sold on a monthly consumption basis (MRR), our accelerated focus in these types of hybrid cloud relationships, and associated realignment of our sales teams, will continue to contribute to total GAAP revenue fluctuations in the short-term. In fact, GAAP total revenue in the third quarter of 2022 declined 6.8% year-over-year. Given the reduction in GAAP Q3 2022 revenues, we delivered a net income of$221,372 , compared to a net income of$348,640 in the third quarter of 2021, even though we managed operating costs to$2,296,464 in the quarter compared to$2,391,966 in Q3 2021. Despite our year-over-year GAAP total revenue decline, we believe GAAP total revenue will continue to increase each quarter during 2022. In fact, GAAP total revenue increased to$3,059,141 in the third quarter of 2022 compared to$2,394,335 and$2,049,107 in the second and first quarters of 2022, respectively, and we expect sequential quarter-over-quarter GAAP total revenue to continue increasing throughout the balance of 2022. 28 --------------------------------------------------------------------------------
COVID-19
We are closely monitoring the impact of the 2019 novel coronavirus, or COVID-19, on all aspects of our business. InMarch 2020 , theWorld Health Organization characterized COVID-19 as a pandemic and the President ofthe United States declared the COVID-19 outbreak a national emergency. Since then, the COVID-19 pandemic has rapidly spread across the globe and has already resulted in significant volatility, uncertainty and economic disruption. The outbreak of COVID-19 has caused and may continue to cause travel bans or disruptions, and in some cases, prohibitions of non-essential activities, disruption and shutdown of businesses and greater uncertainty in global financial markets. The impact of COVID-19 is fluid and uncertain, but it has caused and may continue to cause various negative effects, including an inability to meet with actual or potential customers, our end customers deciding to delay or abandon their planned purchases or failing to make payments, and delays or disruptions in our or our partners' supply chains.
RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED
The following table presents revenue and expense line items reported in our condensed consolidated statements of operations and their corresponding percentage of total revenue for the three months endedSeptember 30, 2022 and 2021 and the period-over-period dollar and percentage changes for those line items. Our results of operations are reported as one business segment, represented by our single operating segment. Three Months Ended September 30, Change (amounts in dollars) 2022 2021 Period to Period Revenue: Product revenue$ 1,568,110 51 %$ 1,547,013 47 %$ 21,097 1 % Support and services revenue 1,491,031 49 % 1,736,456
53 % (245,425 ) (14 )% Total revenue 3,059,141 100 % 3,283,469 100 % (224,328 ) (7 )% Cost of revenue: Product 19,711 1 % 41,351 1 % (21,640 ) (52 )% Support and service 360,393 12 % 400,934 12 % (40,541 ) (10 )% Total cost of revenue 380,104 12 % 442,285 13 % (62,181 ) (14 )% Gross profit 2,679,037 88 % 2,841,184 87 % (162,147 ) (6 )% Operating expenses: Research and development costs 581,941 19 % 711,273 22 % (129,332 ) (18 )% Selling and marketing 887,967 29 % 1,610,635 49 % (722,668 ) (45 )% General and administrative 826,556 27 % 633,954 19 % 192,602 30 % Gain on litigation settlement - - % (632,600 ) (19 )% 632,600 (100 )% Restructuring costs - - % 68,704 2 % (68,704 ) (100 )% Total operating expenses 2,296,464 75 % 2,391,966 73 % (95,502 ) (4 )% Operating income (loss) 382,573 13 % 449,218 14 % (66,645 ) (15 )% Gain on debt extinguishment - - % - - % - - %
Interest and other expense (111,399 ) (4 )% (84,049 )
(3 )% (27,350 ) (33 )% Income (loss) before income taxes 271,174 9 % 365,169 11 % (93,995 ) (26 )% Income tax expense (benefit) 49,802 2 % 16,529 1 % 33,273 201 % Net income (loss)$ 221,372 7 %$ 348,640 11 %$ (127,268 ) (37 )% Less: Accrual of Series A redeemable convertible preferred stock dividends 391,016 13 % 288,802 9 % 102,214 35 % Less: Accretion to redemption value of Series A redeemable convertible preferred stock 40,023 1 % 13,517 0 % 26,506 196 % Net income (loss) attributable to common stockholders$ (209,667 ) (7 )%$ 46,321 1 %$ (255,988 ) (553 )% 29
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Revenue
Our primary sales focus is on selling software solutions and platforms which includes stand-alone software applications, software integrated with industry standard hardware and sold as one complete integrated solution or sold on a subscription or consumption basis. As a result, our revenue is classified as either: (i) product revenue, or (ii) support and services revenue. During the three months endedSeptember 30, 2022 , we recognized revenue of$3,059,141 , compared with$3,283,469 in the prior year period.
Product Revenue
Product revenue is comprised of sales of both licenses for our software solutions and sales of the platforms on which the software is installed. This includes stand-alone software applications and, on occasion, software integrated with industry standard hardware. We no longer primarily source or sell hardware, rather we facilitate our customers in buying their own hardware. Our products are sold through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users. These revenues are recognized when all the applicable criteria under accounting principles generally accepted inthe United States are met. For the three months endedSeptember 30, 2022 and 2021, product revenue represented 51% and 47% of our total revenue, respectively. Product revenue of$1,568,110 for the three months endedSeptember 30, 2022 increased slightly by$21,097 , or 1%, from$1,547,013 in the prior year period. Product revenue during the three months endedSeptember 30, 2022 was comparable to product revenue for the same quarter in the prior year period. We continue to invest in our product portfolio by refreshing and updating our existing product lines and developing our next generation of innovative product offerings to drive our sales volume in support of our long-term outlook.
Support and Services Revenue
Support and services revenue is comprised of revenue from (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) engineering services. Revenue derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Revenues associated with professional and engineering services are recognized at a point in time upon customer acceptance. Maintenance and technical support services revenue for the three months endedSeptember 30, 2022 decreased by$152,278 to$1,489,635 , compared to$1,641,913 in the prior year period. Our maintenance and technical support service revenue results primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. The decrease in maintenance and technical support service revenue from the previous year reflects a decline in new contracts and renewals. We received$1,396 in professional services revenue for the three months endedSeptember 30, 2022 as compared to$94,543 in the prior year period. Professional services revenue will vary depending on the number of solutions for which customers elect to purchase engineering or professional services to assist with their implementations or other projects. We expect professional services revenue to continue to vary from period to period based upon the number of customerswho elect to utilize our professional services upon purchasing any of our solutions.
Cost of Revenue, Gross Profit and Gross Margin
Total cost of revenue for the three months endedSeptember 30, 2022 decreased 14% to$380,104 , compared with$442,285 in the prior year period. Total gross profit decreased$162,147 , or 6%, to$2,679,037 for the three months endedSeptember 30, 2022 , compared with$2,841,184 for the prior year period. Total gross margin decreased to 88% for the three months endedSeptember 30, 2022 , compared with 87% for the prior year period. The decrease in our total gross profit, in absolute dollars, was due to decreased revenue. 30 -------------------------------------------------------------------------------- Generally, our total gross profits and total gross margins fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales.
Cost of Product Revenue, Gross Profit and Gross Margin
Cost of product revenue consists primarily of hardware and warranty expenses. Cost of product revenue for the three months endedSeptember 30, 2022 decreased to$19,711 , compared with$41,351 in the prior year period. This decrease in cost of product revenue for the three months endedSeptember 30, 2022 was primarily due to a continued intentional shift away from hardware sales in the current period, compared to the prior year period.
Cost of Support and Service Revenue, Gross Profit and Gross Margin
Cost of support and service revenue consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts and training. Cost of support and service revenue for the three months endedSeptember 30, 2022 decreased 10% to$360,393 , compared with$400,934 in the prior year period. Support and service gross margin decreased slightly to 76 % for the three months endedSeptember 30, 2022 , compared with 77 % for the prior year period. The decrease in the cost of support and service revenue was primarily related to decreased contractors and consulting fees. Operating Expenses
Our operating expenses for the three months ended
Research and Development Costs
Research and development costs consist primarily of personnel costs for product development, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased by$129,332 , or 18%, to$581,941 for the three months endedSeptember 30, 2022 , from$711,273 in the prior year period. The decrease in research and development costs was primarily related to a decrease in personnel costs.
Selling and Marketing
Selling and marketing expenses consist primarily of sales and marketing
personnel and related costs, travel, public relations expense, marketing
literature and promotions, commissions, trade show expenses, and the costs
associated with our foreign sales offices. Selling and marketing expenses
declined
General and Administrative
General and administrative expenses consist primarily of personnel costs of general and administrative functions, public company related costs, directors' and officers' insurance, legal and professional fees, and other general corporate overhead costs. General and administrative expenses increased slightly by$192,602 to$826,556 for the three months endedSeptember 30, 2022 , compared to$0.6 million for the prior year period. The increase in general and administrative expenses was due primarily to an increase in professional fees and contractors which were partially offset by a reduction in personnel costs. 31 --------------------------------------------------------------------------------
Gain on Litigation Settlement
During the three months endedSeptember 30, 2021 , we recorded a gain of$632,600 million for a legal settlement of a contractual dispute with a marketing/sales firm. Restructuring InJune 2017 , the Board of Directors of the Company (the "Board") approved a comprehensive plan to increase operating performance ("the 2017 Plan"). The 2017 Plan resulted in a realignment and reduction in workforce. The 2017 Plan was substantially completed by the end of our fiscal year endedDecember 31, 2017 and when combined with previous workforce reductions in the second quarter of Fiscal 2017 reduced our workforce to approximately 81 employees atDecember 31, 2017 . As part of this consolidation effort, the Company vacated a portion of its formerMelville, NY office space during the three months endedJune 30, 2018 . As the lease has terminated inApril 2021 , there are no further restructuring costs associated with this lease.
There was no restructuring expense in the three months ended
Interest and Other (Loss) Income, Net
Interest and other expense, net, increased$27,350 to a loss of$111,399 for the three months endedSeptember 30, 2022 , compared with a loss of$84,049 in the prior year period. The increase in interest and other expense primarily relates to an increase in currency translation loss. The fluctuation in interest and other expense from quarter to quarter also relates to interest expense, foreign currency gains and losses, interest income, sublease income and the change in fair value of our embedded derivatives. For more information on our derivative instruments, see Note (10) Fair Value Measurements to our unaudited condensed consolidated financial statements.
Income Taxes
Our provision for income taxes consists of state and local, and foreign taxes. For the three months endedSeptember 30, 2022 and 2021, the Company recorded income tax provision of$49,802 and provision of$16,529 , respectively, consisting primarily of state and local, and foreign taxes.
As of
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RESULTS OF OPERATIONS - FOR THE NINE MONTHS ENDED
The following table presents revenue and expense line items reported in our condensed consolidated statements of operations and their corresponding percentage of total revenue for the nine months endedSeptember 30, 2022 and 2021 and the period-over-period dollar and percentage changes for those line items. Our results of operations are reported as one business segment, represented by our single operating segment. Change Nine Months Ended September 30, Period to Period (amounts in dollars) 2022 2021 Revenue: Product revenue$ 3,125,936 42 %$ 5,288,747 51 %$ (2,162,811 ) (41 )% Support and services revenue 4,376,647 58 % 5,081,795 49 % (705,148 ) (14 )% Total revenue 7,502,583 100 % 10,370,542 100 % (2,867,959 ) (28 )% Cost of revenue: Product 65,018 1 % 298,966 3 % (233,948 ) (78 )% Support and service 1,128,764 15 % 1,233,067 12 % (104,303 ) (8 )% Total cost of revenue 1,193,782 16 % 1,532,033 15 % (338,251 ) (22 )% Gross profit 6,308,801 84 % 8,838,509 85 % (2,529,708 ) (29 )% Operating expenses: Research and development costs 1,943,446 26 % 2,032,360 20 % (88,914 ) (4 )% Selling and marketing 3,202,311 43 % 4,267,010 41 % (1,064,699 ) (25 )% General and administrative 2,400,561 32 % 2,129,921 21 % 270,640 13 % Gain on litigation settlement - - % (632,600 ) (6 )% 632,600 (100 )% Restructuring costs 744 0 % 792,754 8 % (792,010 ) (100 )% Total operating expenses 7,547,062 101 % 8,589,445 83 % (1,042,383 ) (12 )% Operating income (loss) (1,238,261 ) (17 )% 249,064 2 % (1,487,325 ) (597 )% Gain on debt extinguishment - - % 754,000 7 % (754,000 ) (100 )% Interest and other expense (430,630 ) (6 )% (544,625 ) (5 )% 113,995 21 % Income (loss) before income taxes (1,668,891 ) (22 )% 458,439 4 % (2,127,330 ) (464 )% Income tax expense (benefit) 150,369 2 % 63,804 1 % 86,565 136 % Net income (loss)$ (1,819,260 ) (24 )%$ 394,635 4 %$ (2,213,895 ) (561 )% Less: Accrual of Series A redeemable convertible preferred stock dividends 1,030,365 14 % 848,898 8 % 181,467 21 % Less: Accretion to redemption value of Series A redeemable convertible preferred stock 90,420 1 % 285,814 3 % (195,394 ) (68 )% Net income (loss) attributable to common stockholders$ (2,940,045 ) (39 )%$ (740,077 ) (7 )%$ (2,199,968 ) (297 )% Revenue Our primary sales focus is on selling software solutions and platforms which includes stand-alone software applications, software integrated with industry standard hardware and sold as one complete integrated solution or sold on a subscription or consumption basis. As a result, our revenue is classified as either: (i) product revenue, or (ii) support and services revenue. During the nine months endedSeptember 30, 2022 , we recognized revenue of$7.5 million , compared with$10.4 million in the prior year period.
Product Revenue
Product revenue is comprised of sales of both licenses for our software solutions and sales of the platforms on which the software is installed. This includes stand-alone software applications and, on occasion, software integrated with industry standard hardware. We no longer primarily source or sell hardware, rather we facilitate our customers in buying their own hardware. Our products are sold through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users. These revenues are recognized when all the applicable criteria under accounting principles generally accepted inthe United States are met. 33
-------------------------------------------------------------------------------- For the nine months endedSeptember 30, 2022 and 2021, product revenue represented 42% and 51% of our total revenue, respectively. Product revenue of$3,125,936 for the nine months endedSeptember 30, 2022 decreased$2,162,811 , or 41%, from$5,288,747 in the prior year period. The decrease in product revenue is due to order delays as well as entering into several large multi-year contracts in the first nine months of 2021 that did not repeat in the first half of 2022. We continue to invest in our product portfolio by refreshing and updating our existing product lines and developing our next generation of innovative product offerings to drive our sales volume in support of our long-term outlook.
Support and Services Revenue
Support and services revenue is comprised of revenue from (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) engineering services. Revenue derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Revenues associated with professional and engineering services are recognized at a point in time upon customer acceptance. Maintenance and technical support services revenue for the nine months endedSeptember 30, 2022 decreased$456,857 to$4,369,416 , compared to$4,826,273 in the prior year period. Our maintenance and technical support service revenue results primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. The decrease in maintenance and technical support service revenue from the previous year reflects a decline in new contracts and renewals. Professional services revenue for the nine months endedSeptember 30, 2022 decreased to$7,231 , compared to$255,522 in the prior year period. Professional services revenue will vary depending on the number of solutions for which customers elect to purchase engineering or professional services to assist with their implementations or other projects. We expect professional services revenue to continue to vary from period to period based upon the number of customerswho elect to utilize our professional services upon purchasing any of our solutions.
Cost of Revenue, Gross Profit and Gross Margin
Total cost of revenue for the nine months endedSeptember 30, 2022 decreased 22% to$1,193,782 , compared with$1,532,033 in the prior year period. Total gross profit decreased$2.5 million , or 28.6%, to$6.3 million for the nine months endedSeptember 30, 2022 , compared with$8.8 million for the prior year period. Total gross margin decreased slightly to 84% for the nine months endedSeptember 30, 2022 , compared with 85% for the prior year period. The decrease in our total gross profit was due to decreased revenue. Generally, our total gross profits and total gross margins fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales.
Cost of Product Revenue, Gross Profit and Gross Margin
Cost of product revenue consists primarily of hardware and warranty expenses. Cost of product revenue for the nine months endedSeptember 30, 2022 decreased to$65,018 , compared with$298,966 in the prior year period. Product gross margin for the nine months endedSeptember 30, 2022 increased, year over year, to 98 % from 94 % for the same period in 2021. This decrease in cost of product revenue for the nine months endedSeptember 30, 2022 was primarily due to a continued intentional shift away from hardware sales in the current period, compared to the prior year period.
Cost of Support and Service Revenue, Gross Profit and Gross Margin
Cost of support and service revenue consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts and training. Cost of support and service revenue for the nine months endedSeptember 30, 2022 decreased 8% to$1,128,764 , compared with$1,233,067 in the prior year period. Support and service gross 34 -------------------------------------------------------------------------------- margin decreased slightly to 74% for the nine months endedSeptember 30, 2022 , compared with 76% for the prior year period. The decrease in the cost of support and service revenue, in absolute dollars, was primarily related to decreased personnel cost and employee bonuses.
Operating Expenses
Our operating expenses for the nine months ended
Research and Development Costs
Research and development costs consist primarily of personnel costs for product development, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased$88,914 , or 4%, to$1,943,446 for the nine months endedSeptember 30, 2022 , from$2,032,360 in the prior year period. The decrease in research and development costs was primarily related to a decrease in personnel costs and bonuses.
Selling and Marketing
Selling and marketing expenses consist primarily of sales and marketing
personnel and related costs, travel, public relations expense, marketing
literature and promotions, commissions, trade show expenses, and the costs
associated with our foreign sales offices. Selling and marketing expenses
declined
General and Administrative
General and administrative expenses consist primarily of personnel costs of general and administrative functions, public company related costs, directors' and officers' insurance, legal and professional fees, and other general corporate overhead costs. General and administrative expenses increased by$270,640 to$2,400,561 for the nine months endedSeptember 30, 2022 , compared to$2,129,921 for the prior year period. The increase in general and administrative expenses was due primarily to an increase in professional fees and contractors which were partially offset by a reduction in personnel costs.
Gain on Litigation Settlement
During the nine months endedSeptember 30, 2021 , we recorded a gain of$632,600 million for a legal settlement of a contractual dispute with a marketing/sales firm. Restructuring InJune 2017 , the Board of Directors of the Company (the "Board") approved a comprehensive plan to increase operating performance ("the 2017 Plan"). The 2017 Plan resulted in a realignment and reduction in workforce. The 2017 Plan was substantially completed by the end of our fiscal year endedDecember 31, 2017 and when combined with previous workforce reductions in the second quarter of Fiscal 2017 reduced our workforce to approximately 81 employees atDecember 31, 2017 . As part of this consolidation effort, the Company vacated a portion of its formerMelville, NY office space during the three months endedJune 30, 2018 . As the lease has terminated inApril 2021 , there are no further restructuring costs associated with this lease. Restructuring expense decreased$792,010 for the nine months endedSeptember 30, 2022 to$744 , compared to a restructuring expense of$792,754 in the prior year period. 35
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Gain on Debt Extinguishment
Gain on debt extinguishment decreased$754,000 for the nine months endedSeptember 30, 2022 , from$754,000 for the nine months endedSeptember 30, 2021 . The debt extinguishment during such nine months endedSeptember 30, 2021 reflected the forgiveness of the Company's PPP Paycheck Protection Program loan, which was issued byPeapack Gladstone Bank in an aggregate principal amount of$754,000 , and forgiven in full onMarch 30, 2021 .
Interest and Other (Loss) Income, Net
Interest and other expense, net, decreased$113,995 to a loss of$430,630 for the nine months endedSeptember 30, 2022 , compared with a loss of$544,625 in the prior year period. The decreased interest and other expense primarily relates to a decrease interest expense as a result of payments made on outstanding debt, which has been partially offset by an increase in currency translation loss. The fluctuation in interest and other expense from quarter to quarter also relates to interest expense, foreign currency gains and losses, interest income, sublease income and the change in fair value of our embedded derivatives. For more information on our derivative instruments, see Note (10) Fair Value Measurements to our unaudited condensed consolidated financial statements.
Income Taxes
Our provision for income taxes consists of state and local, and foreign taxes. For the nine months endedSeptember 30, 2022 and 2021, the Company recorded income tax provision of$150,369 and$63,804 , respectively, consisting primarily of state and local, and foreign taxes.
As of
LIQUIDITY AND CAPITAL RESOURCES
Principal Sources of Liquidity and Company Obligations
Our principal sources of liquidity are our cash and cash equivalents balances generated from operating, investing and financing activities. Our cash and cash equivalents balance as ofSeptember 30, 2022 andDecember 31, 2021 totaled$1.7 million and$3.2 million , respectively. We are currently a party to the Amended and Restated Term Loan Credit Agreement, dated as ofFebruary 23, 2018 , as amendedDecember 27, 2019 , by and between the Company andHCP-FVA, LLC ("HCP-FVA"), (the "Amended and Restated Loan Agreement"). In connection with the then-proposed public offering of the Company as described in the Company's Registration Statement on Form S-1, as amended, originally filed onJune 3, 2021 , we entered into the Loan Extension Letter Agreement, which provided for an extension of the maturity date on the portion of the outstanding indebtedness owed toHale Capital Partners, LP ("Hale Capital ") under the Amended and Restated Loan Agreement toJune 30, 2023 . The remaining principal amount outstanding, which was owed to other lenders, was repaid in full. OnJuly 19, 2022 , we entered into a letter agreement withHale Capital (the "Second Loan Extension Letter Agreement"), that provided for a subsequent extension of the maturity date on the outstanding indebtedness owed under the Amended and Restated Loan Agreement fromJune 30, 2023 toDecember 31, 2023 . See Note (9) Notes Payable to our unaudited condensed consolidated financial statements for more information. Also, as described further in Note (12) Series A Redeemable Convertible Preferred Stock to our unaudited condensed consolidated financial statements, the effective date of the mandatory redemption right of the Company's Series A Redeemable Convertible Preferred Stock (the "Series A Preferred Stock") held byHCP-FVA and Hale Capital was extended fromJuly 30, 2021 toJuly 30, 2023 pursuant to that certain Amendment No. 1 to the Company's Amended and Restated Certificate of Designations, Preferences and Rights of the Series A Preferred Stock, dated as ofJune 24, 2021 (as amended, the "Certificate of Designations"). OnJuly 19, 2022 , the Company andHale Capital entered into a letter agreement pursuant to whichHale Capital agreed not to exercise or to permit the exercise of the mandatory redemption right of the Series A Preferred Stock on or prior toDecember 31, 2023 unless the redemption is in accordance with Section 8(e)(z) of the Certificate of Designations or in accordance with 36 -------------------------------------------------------------------------------- a Breach Event (as defined in the Certificate of Designations). If such Series A Preferred Stock was redeemed atSeptember 30, 2022 , the Company would have been required to pay the holders of the Series A Preferred Stock$15.5 million . The Amended and Restated Loan Agreement has customary representations, warranties and affirmative and negative covenants. The negative covenants include financial covenants relating to in-force annual contract value. The Amended and Restated Loan Agreement also contains customary events of default, including but not limited to payment defaults, cross defaults with certain other indebtedness, breaches of covenants, bankruptcy events and a change of control. In the case of an event of default, as administrative agent under the Amended and Restated Loan Agreement, HCP-FVA, an affiliate ofHale Capital may (and upon the written request of lenders holding in excess of 50% of the term loans, which must include HCP-FVA, is required to) accelerate payment of all obligations under the Amended and Restated Loan Agreement, and seek other available remedies. As discussed in Note (17) Restructuring Costs to our unaudited condensed consolidated financial statements, theMelville, NY lease which ended onApril 30, 2021 with a gross annualized rental cost of$1.5 million , will not be replaced. FalconStor is primarily a virtual company and expects to redeploy this savings to more productive uses.
Liquidity
As ofSeptember 30, 2022 , we had a working capital deficiency of$0.2 million , which is inclusive of current deferred revenue of$3.5 million , and a stockholders' deficit of$15.7 million . During the nine months endedSeptember 30, 2022 , the Company had a net loss of$1.8 million and negative cash flow from operations of$1.4 million . The Company's total cash balance atSeptember 30, 2022 was$1.7 million , a decrease of$1.5 million compared toDecember 31, 2021 . OnJune 30, 2021 , the Company repaid in full$1.3 million of the$3.5 million principal amount that was outstanding as ofJune 2, 2021 under the Amended and Restated Loan Agreement. Although there can be no assurance, based on its projected cash flows from operations, recently completed financing activities, cost cutting measures in place and existing cash on hand, the Company is projecting to have sufficient liquidity and to be cash flow positive through the next 12 months.
Cash Flow Analysis
Cash flow information is as follows:
Nine Months Ended September 30,
2022 2021
Cash provided by (used in):
Operating activities $ (1,417,959 ) $ (707,889 )
Investing activities (38,078 ) (108,928 )
Financing activities - 2,371,707
Effect of exchange rate changes (59,118 ) (762 )
Net increase (decrease) in cash and cash equivalents
Net cash used in operating activities totaled$1.4 million for the nine months endedSeptember 30, 2022 , compared with$0.7 million of net cash used in operating activities in the prior year period. The change in net cash used in operating activities for the nine months endedSeptember 30, 2022 versus the prior year was primarily due to our net loss, a larger decrease in deferred revenue, partially offset with a gain on debt extinguishment and a larger decrease in accounts receivable. Net cash used in investing activities totaled$38,078 for the nine months endedSeptember 30, 2022 , compared with$108,928 of net cash used in investing activities in the prior year period. The change in net cash used in investing activities versus the prior year was primarily due to a decrease in security deposits refunds. 37
-------------------------------------------------------------------------------- There was no cash used in or provided by financing activities for the nine months endedSeptember 30, 2022 , compared with net cash provided by financing activities of$2,371,707 in the prior year period. The net cash provided by financing activities in the prior year period included net proceeds from a public offering of our common stock, less offering costs, and payments on our long-term debt.
Total cash and cash equivalents decreased
Contractual Obligations
As ofSeptember 30, 2022 , our significant commitments are related to (i) the Amended and Restated Loan Agreement, (ii) our operating leases for our office facilities, (iii) dividends (including accrued dividends) on our Series A Preferred Stock, and (iv) the potential redemption of the Series A Preferred Stock as discussed above.
The following is a schedule summarizing our significant obligations to make
future payments under contractual obligations as of
Series A Dividends on
Interest Long-Term Preferred Stock Series A
Operating Note Payable Payments Income Tax Mandatory Preferred Stock
Leases (a) (a) Payable (b) Redemption (c) (d)
2022 $ 19,249 $ - $ 21,766 $ - $ - $ -
2023 38,498 2,176,621 87,065 - - -
Other - - - 113,788 9,000,000 8,852,447
Total contractual
obligations $ 57,747 $ 2,176,621 $ 108,831 $ 113,788 $ 9,000,000 $ 8,852,447
(a) See Note (9) Notes Payable to our unaudited condensed consolidated financial
statements for further information and for a detailed description of the Amended
and Restated Term Loan Credit Agreement.
(b) Represents our liability for uncertain tax positions. We are unable to make
a reasonably reliable estimate of the timing of payments due to uncertainties in
the timing of tax audit outcomes.
(c) Represents our potential liability if the holders of our Series A Preferred
Stock redeem their shares for cash. The earliest date in which a redemption
could occur as of September 30, 2022 was July 30, 2023 . However, on July 19,
2022 , the Company and Hale Capital entered into a letter agreement pursuant to
which Hale Capital agreed not to exercise or to permit the exercise of the
mandatory redemption right of the Series A Preferred Stock on or prior to
December 31, 2023 unless the redemption is in accordance with Section 8(e)(z) of
the Certificate of Designations or in accordance with a Breach Event (as defined
in the Certificate of Designations). For further information, see Note (12)
Series A Redeemable Convertible Preferred Stock to our unaudited condensed
consolidated financial statements.
(d) Our agreements with the holders of the Series A Preferred Stock provide that
such holders will receive quarterly dividends on the Series A Preferred Stock at
prime rate plus 5%, subject to a maximum dividend rate of 10%. We also have the
ability to accrue and roll over dividends. Due to the lack of sufficient surplus
to pay dividends as required by the Delaware General Corporation Law, the
Company was not permitted to pay the fourth quarter 2016 dividend in cash or
common stock and has been accruing its quarterly dividends since then. This
amount represents our potential liability to pay preferred stock dividends in
cash on July 30, 2023 , which was the earliest date in which the holders of our
Series A Preferred Stock could redeem their shares for cash as of September 30,
2022 . However, on July 19, 2022 , the Company and Hale Capital entered into a
letter agreement pursuant to which Hale Capital agreed not to exercise or to
permit the exercise of the mandatory redemption right of the Series A Preferred
Stock on or prior to December 31, 2023 unless the redemption is in accordance
with Section 8(e)(z) of the Certificate of Designations or in accordance with a
Breach Event (as defined in the Certificate of Designations). For further
information, see Note (12) Series A Redeemable Convertible Preferred Stock to
our unaudited condensed consolidated financial statements.
38
--------------------------------------------------------------------------------Critical Accounting Policies and Estimates
We describe our significant accounting policies in Note (1) Summary of Significant Accounting Policies of our 2021 Form 10-K. We discuss our critical accounting estimates in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our 2021 Form 10-K. There have been no significant changes in our significant accounting policies or critical accounting estimates sinceDecember 31, 2021 .
Impact of Recently Issued Accounting Pronouncements
See Note (1) Basis of Presentation to our unaudited condensed consolidated financial statements.
Off-Balance Sheet Arrangements
As of
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