AUXO Auxilio, Inc. (delisted)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015

Business Activity

We are engaged in the business of providing fully-outsourced document solution services and IT security consulting data security services primarily to the healthcare industry, and also to financial institutions, gaming and other industries. Our business is operated throughout the United States.

Basis of Presentation and Reverse Stock Split

The accompanying consolidated financial statements were prepared in conformity with GAAP, and include the accounts of Auxilio and our wholly-owned subsidiaries. All intercompany balances and transactions were eliminated.

Effective on January 13, 2017, the Company effected a reverse stock split of its common stock at a ratio of 1-for-3. No fractional shares of common stock were issued, and no cash or other consideration were paid as a result of the reverse stock split. Instead, the Company issued one whole share of post-reverse stock split common stock in lieu of each fractional share of common stock. As a result of the reverse stock split, the Company’s common stock was reduced to 8,185,936 shares from 24,557,224 shares as of December 31, 2016. All per share amounts and number of shares in the consolidated financial statements and related notes have been retroactively restated to reflect the reverse stock split resulting in the reclassification of $15,749 from common stock to additional paid in capital at January 1, 2015.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Revenue Recognition and Deferred Revenue

Revenue is recognized pursuant to ASC Topic 605, “Revenue Recognition” (ASC 605).  Monthly service and supply revenue is earned monthly during the term of the contract, as services and supplies are provided. Revenues from equipment sales transactions are earned when there is persuasive evidence of an arrangement, delivery has occurred, the sales price has been determined and collectability has been reasonably assured. For equipment that is to be placed at a customer’s location at a future date, revenue is deferred until the placement of such equipment.

We enter into arrangements that include multiple deliverables, which typically consist of the sale of Multi-Function Device (“MFD”) equipment and a support services contract.  We account for each element within an arrangement with multiple deliverables as separate units of accounting.  Revenue is allocated to each unit of accounting under the guidance of ASC Topic 605-25, Multiple-Deliverable Revenue Arrangements, which provides criteria for separating consideration in multiple-deliverable arrangements by establishing a selling price hierarchy for determining the selling price of a deliverable.  The selling price used for each deliverable is based on vendor-specific objective evidence (“VSOE”) if available, third-party evidence if VSOE is not available, or estimated selling price if neither VSOE nor third-party evidence is available.  We are required to determine the best estimate of selling price in a manner that is consistent with that used to determine the price to sell the deliverable on a standalone basis.  We generally do not separately sell MFD equipment or service on a standalone basis.  Therefore, we do not have VSOE for the selling price of these units. As we purchase the equipment, we have third-party evidence of the cost of this element.  We estimate the proceeds from the arrangement to allocate to the service unit based on historical cost experiences.  Based on the relative costs of each unit to the overall cost of the arrangement, we utilize the same relative percentage to allocate the total arrangement proceeds.

The Company’s contracts with customers may include provisions that relate to guaranteed savings amounts and shared savings. Such provisions are considered by management during the Company’s initial proprietary client assessment and are charged and accrued when deemed by management to be probable. The Company’s historical settlement of such amounts has been within management’s estimates.     

   Software Subscriptions and Managed Services Revenue  

Software subscriptions and managed services revenues are recognized ratably over the contract terms beginning on the commencement date of each contract, which is the date the Company’s service is made available to customers.

Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met.

The Company’s software subscription service arrangements are non-cancelable and do not contain refund-type provisions.

   Cyber Security Professional Services Revenues  

The majority of the Company’s cyber security services contracts are on a time and material basis. When these services are not combined with subscription revenues as a single unit of accounting, these revenues are recognized as the services are rendered for time and material contracts, and when the milestones are achieved and accepted by the customer for fixed price contracts.

Cash and Cash Equivalents

For purposes of the statement of cash flows and balance sheet classification, cash equivalents include all highly liquid debt instruments with original maturities of three months or less which are not securing any corporate obligations.

Accounts Receivable

We provide an allowance for doubtful accounts equal to the estimated uncollectible amounts. Our estimate is based on historical collection experience and a review of the current status of trade accounts receivable. It is reasonably possible that our estimate of the allowance for doubtful accounts will change. Management believes that no accounts receivable were uncollectible at December 31, 2016 or 2015.

Supplies

Supplies consist of parts and supplies for the automated office equipment, including copiers, facsimile machines and printers. Supplies are valued at the lower of cost or market value on a first-in, first-out basis.

Property and Equipment

Property and equipment are carried at cost less accumulated depreciation. Depreciation of the property and equipment is provided using the straight-line method over the assets’ estimated economic lives, which range from two to seven years. Expenditures for maintenance and repairs are charged to expense as incurred.

The Company accounts for its business combinations in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) 805-10 through ASC 805-50, “Business Combinations” which requires that the purchase method of accounting be applied to all business combinations and addresses the criteria for initial recognition of intangible assets and goodwill. In accordance with FASB ASC 350-10 through ASC 350-30, goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment annually, or more frequently if circumstances indicate the possibility of impairment. If the carrying value of goodwill or an indefinite lived intangible asset exceeds its fair value, an impairment loss shall be recognized. Based on management’s tests and reviews, no impairment of its goodwill, intangible assets or other long-lived assets existed at December 31, 2015. However, during the year ended December 31, 2016, management determined that the goodwill associated with the Delphiis and Redspin acquisitions were impaired (Note 4).

To test for goodwill impairment, first we perform a qualitative assessment. If we determine, based on qualitative factors, that the fair value of goodwill is more likely than not greater than the carrying amount, a quantitative calculation would not be needed. Our methodology for a quantitative assessment of testing for goodwill impairment consists of one, and possibly two steps . In step one of the goodwill impairment test, management compares the carrying amount (including goodwill) of the reporting unit and the fair value. If the carrying value of the reporting unit exceeds the fair value of the reporting unit, then an impairment charge is recognized for the amount by which the goodwill carrying value exceeds the implied fair value of goodwill.

Long-Lived Assets

In accordance with ASC Topic 350, long-lived assets, such as definite lived intangible assets, to be held and used are analyzed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If there are indications of impairment, we use future undiscounted cash flows of the related asset or asset grouping over the remaining life in measuring whether the assets are recoverable. In the event such cash flows are not expected to be sufficient to recover the recorded asset values, the assets are written down to their estimated fair value. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value of asset less the cost to sell. During the year ended December 31, 2016, management determined there was impairment of certain definite lived intangible assets associated with the Delphiis and Redspin reporting units (Note 4).

Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial reporting requirements and those imposed under federal and state tax laws. Deferred taxes are provided for timing differences in the recognition of revenue and expenses for income tax and financial reporting purposes and are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred income tax expense represents the change during the period in the deferred tax assets and liabilities. Realization of the deferred tax asset is dependent on generating sufficient taxable income in future years. 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. The use of net operating loss deferred tax assets may be limited due to changes in the Company’s ownership structure.

Fair Value of Financial Instruments

ASC Topic 820, “Fair Value Measurements,” defines fair value, provides a framework for measuring fair value and expands the disclosures required for fair value measurements. The standard applies to other accounting pronouncements, but does not require any new fair value measurements.

The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, line of credit and capital lease obligations approximate fair value due to the short-term nature of these financial instruments. The carrying amount of our debt approximates its fair value as we believe the credit market has not materially changed since the original borrowing date.

Stock-Based Compensation

We account for stock options granted to employees and directors using the accounting guidance in ASC 718 “Stock Compensation” (“ASC 718”).  In accordance with ASC 718, we estimate the fair value of service based options and performance based options on the date of grant, using the Black-Scholes pricing model.  We recognize compensation expense for stock option awards over the requisite or implied service period of the grant.  With respect to performance-based awards, compensation expense is recognized when the performance target is deemed probable.  

For the years ended December 31, 2016 and 2015, stock-based compensation expense recognized in the consolidated statements of income is as follows:

The weighted average estimated fair value of stock options granted during 2016 and 2015 was $0.86 and $1.26 per share, respectively. These amounts were determined using the Black-Scholes option-pricing model, which values options based on the stock price at the grant date, the expected life of the option, the estimated volatility of the stock, the expected dividend payments, and the risk-free interest rate over the expected life of the option. The assumptions used in the Black-Scholes model were as follows for stock options granted in 2016 and 2015:

The Black-Scholes model was developed for estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Because option valuation models require the use of subjective assumptions, changes in these assumptions can materially affect the fair value of the options.

Compensation cost associated with grants of restricted stock units are also measured at fair value. We evaluate the assumptions used to value restricted stock units on a quarterly basis. When factors change, including the market price of the stock, share-based compensation expense may differ significantly from what was recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned share-based compensation expense. As of December 31, 2016, we have not granted any restricted stock units under the 2011 Stock Incentive Plan.

Basic and Diluted Net Income Per Share

In accordance with ASC Topic 260, “Earnings Per Share,” basic net income per share is calculated using the weighted average number of shares of our Common Stock issued and outstanding during a certain period, and is calculated by dividing net income by the weighted average number of shares of our Common Stock issued and outstanding during such period. Diluted net income per share is calculated using the weighted average number of common and potentially dilutive common shares outstanding during the period, using the as-if converted method for secured convertible notes, and the treasury stock method for options and warrants.

As of December 31, 2016, potentially dilutive securities consisted of options and warrants to purchase 1,713,154 shares of our Common Stock at prices ranging from $1.41 to $6.45 per share. Of these potentially dilutive securities, only 110,659 of the shares to purchase Common Stock from the options and warrants are included from the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.

As of December 31, 2015 potentially dilutive securities consisted of options and warrants to purchase 2,176,595 shares of our Common Stock at prices ranging from $0.90 to $6.45 per share. Of these potentially dilutive securities, only 276,121 of the shares to purchase Common Stock from the options and warrants are included from the computation of diluted earnings per share because the effect of including the remaining instruments would be anti-dilutive.

The following table sets forth the computation of basic and diluted net income per share:

Segment Reporting

Based on our integration and management strategies, we operate in a single business segment. For the years ended December 31, 2016 and 2015, all revenues were derived from domestic operations.

New Accounting Pronouncements

In April 2015, the FASB issued an update to a standard to simplify the presentation of debt issuance costs. This update requires debt issuance costs be presented on the balance sheet as a direct reduction from the carrying amount of the debt liability consistent with debt discounts or premiums. Adoption of this standard is required for interim and annual periods beginning after December 15, 2015 and is to be applied retrospectively. The adoption of this update on January 1, 2016 did not have a material impact on our consolidated financial statements.

A summary of accounts receivable follows:

(3)   Property and Equipment  

A summary of property and equipment follows:

Depreciation and amortization expense for property, equipment, and improvements amounted to $211,654 and $155,183 for the years ended December 31, 2016 and 2015, respectively.

(4)   Intangible Assets and Goodwill  

Intangible assets are amortized over expected useful lives ranging from 1.5 to 10 years and consist of the following as of December 31, 2015:

The Company performed its annual impairment testing for Delphiis and Redspin as of December 31, 2016, and concluded there were indicators of potential intangible asset and goodwill impairment based on the performance of these business units and changes in the Company’s short and long-term strategy and outlook for these units.

The Company first performed a quantitative impairment analysis of the intangible assets and then a quantitative impairment analysis of goodwill as of December 31, 2016. With respect to the intangible asset analysis, management estimated future undiscounted free cash flows associated with the intangibles assets and determined that they were less than the related carrying values. As a result, the Company recognized an aggregate impairment charge of $1,077,188. With respect to the goodwill analysis, management estimated the fair value of the reporting units and determined that such amounts were less than the carrying values. Management then determined that the implied fair value of goodwill of the reporting units was less than the carrying value of goodwill and an aggregate $1,556,513 impairment charge was recorded.

A summary of the Company’s intangible assets and goodwill carrying amounts and impairment charges as of December 31, 2016 follows:

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Our Board of Directors determined that the performance measures for 2014 were not met. As such the warrants for 2014 did not vest to the three executives. This tranche of warrants was cancelled. Our Board of Directors determined that the performance measures for 2015 and 2016 were met. As such the warrants for 2015 and 2016 vested to the three remaining executives. We have recorded stock compensation for the warrants totaling $122,569 for the year ended December 31, 2015 and $122,568 for the year ended December 31, 2016.

(8)   Stock Option and Stock Incentive Plans  

In October 2001, we approved the 2001 Stock Option Plan under which all employees may be granted options to purchase shares of our Common Stock . The maximum number of shares of the Common Stock available for issuance under the 2001 Plan was 1,800,000 shares. Under the 2001 Stock Option Plan (the “2001 Plan”), the option exercise price was equal to the fair market value of the Common Stock on the date of grant. Options expired no later than 10 years from the grant date and generally vested within five years. The Board approved the 2003 Stock Option Plan (the “2003 Plan ”) and it became effective immediately upon stockholder approval at the Annual Meeting on May 15, 2003. The maximum number of shares of Common Stock available for issuance under the 2003 Plan was 1,466,667 shares. On May 15, 2003, 299,833 shares were available to grant under the 2003 Plan, and 189,056 had been granted under our former 2000 Stock Option Plan (the “2000 Plan”) and the 2001 Plan. Although we no longer granted options under the 2000 Plan or the 2001 Plan, all outstanding stock options continue to be subject to the terms and conditions of the stock option agreement and the underlying plans, except to the extent the Board or the Compensation Committee elected to extend one or more features of the 2003 Plan to the outstanding stock options that were granted pursuant to the 2000 Plan or the 2001 Plan. Under the 2003 Plan, the option exercise price was equal to the fair market value of the Common Stock at the date of grant. Stock options expired no later than 10 years from the grant date and generally vested within five years.

In May of 2004, the Board and stockholders approved the 2004 Stock Incentive Plan (the “2004 Plan”). The maximum number of shares of the Common Stock available for issuance under the 2004 Plan was 2,133,333 shares. As of the date of stockholder approval, May 12, 2004, options to purchase 238,250 shares had been granted pursuant to the 2000 Plan, 2001 Plan and 2003 Plan. Under the terms and conditions of the 2004 Plan, the option exercise price is equal to the fair market value of the Common Stock at the date of grant. Options expired no later than 10 years from the grant date and generally vested within five years. The Board approved the 2007 Stock Option Plan , as amended (the “2007 Plan”), and it became effective on May 16, 2007 upon receipt of stockholder approval. On May 16, 2007, options to purchase 963,382 shares of Common Stock had been granted pursuant to the 2000 Plan, 2001 Plan, 2003 Plan and 2004 Plan. Under the 2007 Plan, the administrator could grant options to purchase 1,490,000 shares of Common Stock. The options granted pursuant to the 2004 Plan continue to be governed by the terms and conditions of the 2004 Plan, except to the extent the administrator elected to extend one or more features of the 2007 Plan to the outstanding stock options granted pursuant to the 2004 Plan. Under the 2007 Plan, the option exercise price was equal to the fair market value of the Common Stock at the date of grant. Options expired no later than 10 years from the grant date and generally vested within three years.

On March 17, 2011, the Board approved the 2011 Stock Incentive Plan (the “2011 Plan”), and it became effective on May 12, 2011 . The 2011 Plan authorizes the issuance of no more than 1,990,000 shares of our Common Stock and it provides for the granting of stock options, stock appreciation rights and restricted stock to our employees, members of the Board and service providers. As of December 31, 2016, there were 398,071 shares available for issuance under the 2011 Plan.  

Additional information with respect to these Plans’ stock option activity is as follows:

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Unamortized compensation expense associated with unvested options approximates $222,688 as of December 31, 2016. The weighted average period over which these costs are expected to be recognized is approximately 1.5 years.

Income tax benefit (expense) amounted to $5,074,439 and ($152,436) for the years ended December 31, 2016 and 2015, respectively (an effective rate of (7,851)% for 2016 and 10.4% for 2015).  A reconciliation of the provision for income taxes with amounts determined by applying the statutory U.S. federal income tax rate to income before income taxes is as follows:

F-21

Realization of deferred tax assets is dependent on future earnings, if any, the timing and amount of which is uncertain.  A valuation allowance, in an amount equal to the net deferred tax asset as of December 31, 2015 has been established to reflect these uncertainties.  As of December 31, 2016, following four consecutive years of pretax earnings and with the expectation of future earnings, management removed 100% of the valuation allowance against the net deferred tax assets and recognized a corresponding income tax benefit. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.  Significant components of our deferred tax assets and liabilities are as follows:

At December 31, 2016, we have available unused net operating loss carryforwards of approximately $9,497,000 for federal purposes and $7,079,000 for state purposes that may be applied against future taxable income and that, if unused, expire beginning in 2023 through 2032.

Utilization of the net operating loss carryforwards may be subject to a substantial annual limitation due to ownership change limitations provided by the Internal Revenue Code under section 382.  The annual limitation may result in the expiration of net operating loss carryforwards before utilization. Our federal and state net operating loss carryforwards will begin to expire in 2023 and 2020, respectively.

We evaluate our tax positions each reporting period to determine the uncertainty of such positions based upon one of the following conditions: (1) the tax position is not ‘‘more likely than not’’ to be sustained, (2) the tax position is ‘‘more likely than not’’ to be sustained, but for a lesser amount, or (3) the tax position is ‘‘more likely than not’’ to be sustained, but not in the financial period in which the tax position was originally taken. We have evaluated our tax positions for all jurisdictions and all years for which the statute of limitations remains open. We have determined that no additional liability for unrecognized tax benefits and interest was necessary.

(11)   Retirement Plan  

We sponsor a 401(k) plan (the “Plan”) for the benefit of employees who are at least 21 years of age. Our management determines, at its discretion, the annual and matching contribution. For the years ended December 31, 2016 and 2015, we made matching contributions totaling $117,762 and $94,042, respectively.

(12)   Commitments  

Leases

We lease our Mission Viejo, California facility under a non-cancellable operating lease effective December 2015 that expires in April 2021. Our Carpinteria, California office lease is currently on a month-to-month basis. Rent expense for the years ended December 31, 2016 and 2015 totaled $441,058 and $272,064 respectively. Future minimum lease payments under non-cancelable operating leases during subsequent years are as follows:

Employment Agreements

Effective January 1, 2016, we entered into an employment agreement with Mr. Flynn (the “2016 Flynn Agreement”). The 2016 Flynn Agreement provides that Mr. Flynn will continue his employment as our President and CEO. The 2016 Flynn Agreement has a term of two years, provides for an annual base salary of $300,000, and will automatically renew for subsequent twelve (12) month terms unless either party provides advance written notice to the other that such party does not wish to renew the agreement for a subsequent twelve (12) months.  Mr. Flynn also receives the customary employee benefits available to our employees. Mr. Flynn is also entitled to receive a bonus of up to $180,000 per year, the achievement of which is based on Company performance metrics.  We may terminate Mr. Flynn’s employment under the Flynn Agreement without cause at any time on thirty (30) days advance written notice, at which time Mr. Flynn would receive severance pay for twelve months and be fully vested in all options and warrants granted to date.  The foregoing summary of the 2016 Flynn Agreement is qualified in its entirety by reference to the full context of the employment agreement, which is found as Exhibit 10.31 to our Annual Report on Form 10-K filed with the SEC on March 30, 2016.

(13)   Concentrations  

Cash Concentrations

At times, cash and cash equivalent balances held in financial institutions are in excess of federally insured limits. Management performs periodic evaluations of the relative credit standing of financial institutions and limits the amount of risk by selecting financial institutions with a strong credit standing.

Major Customers

For the year ended December 31, 2016, there were two customers that each generated at least 10% of our revenues and these customers represented a total of 49% of revenues. As of December 31, 2016, net accounts receivable due from these customers totaled approximately $4,600,000.

For the year ended December 31, 2015, there were three customers that each generated at least 10% of our revenues and these customers represented a total of 50% of revenues. As of December 31, 2015, net accounts receivable due from these customers totaled approximately $3,100,000.

(14)   Asset Purchase Agreement – Redspin  

On March 31, 2015, Auxilio entered into an Asset Purchase Agreement (the “Purchase Agreement”) with Redspin, Inc., a California corporation (“Redspin”) and certain owners of Redspin, to acquire substantially all of the assets and certain liabilities of Redspin (the “Acquired Assets”).  A copy of the Purchase Agreement was filed as an exhibit to the Current Report on Form 8-K filed with the SEC on April 6, 2015.   On April 7, 2015, the Company completed its acquisition of the Acquired Assets in an asset purchase transaction (the “Transaction”) pursuant to the terms and conditions of the Purchase Agreement.

As a result of the consummation of the Purchase Agreement, on April 7, 2015, in consideration for the Acquired Assets, the Company paid Redspin $2,076,966 in cash, less a holdback of $200,000 to cover any indemnification claims made pursuant to the Transaction, and issued 150,761 shares of the Company’s restricted common stock, par value $0.001, which was the number of shares having an aggregate value of $500,000, with the price per share equal to the average of the closing price of Auxilio common stock on the OTC Markets for the 20 most recent trading days prior to the date of the Purchase Agreement, rounded up to the nearest whole number of shares. The Company also agreed to pay a cash Earn-out Payment, as defined in the Purchase Agreement, upon the achievement of certain earnings targets in the first year following the date of the Purchase Agreement. Management estimated the fair value of the contingent consideration to be approximately $623,000. Because the earnings targets were not met, this portion of the acquisition purchase price is recorded as other income on the consolidated statement of income for the year ended December 31, 2015.

The Purchase Agreement also provided for the Company to pay employee bonus shares of common stock upon the achievement of the same certain earnings targets and provided they remain with the Company for one year subsequent to the acquisition date. Management previously had considered the $124,000 of fair value of these employee bonus shares to be a component of the acquisition cost. After completing the analysis of the earn-out provisions, Management has determined that the employee bonus shares would be post-combination compensation. Because the minimum earnings targets were not be achieved, no related stock compensation expense has been recorded for the year ended December 31, 2015.

The allocation of the purchase price of the assets acquired and liabilities assumed based on their fair values was as follows: 

Purchased identifiable intangible assets are amortized on a straight-line basis over the respective useful lives. Our estimated useful life of the identifiable intangible assets acquired ranges from three to ten years. We recognized goodwill of $1,192,000. Goodwill is recognized as we expect to be able to realize synergies between the two companies, primarily our ability to provide market and reach for the Redspin products and services to Auxilio’s customers. During 2016, certain intangible assets and goodwill were deemed impaired (Note 4).

The Company incurred approximately $70,000 in legal, accounting and other professional fees related to this acquisition, all of which were expensed during the year ended December 31, 2015.

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Employment Agreement

In connection with the Purchase Agreement, Auxilio and Daniel Berger (“Berger”), CEO of Redspin, entered into an employment agreement (the “Berger Employment Agreement”), pursuant to which Berger was employed to serve as Executive Vice President of Auxilio.  The initial term of the Berger Employment Agreement was for two years (unless sooner terminated), and automatically renews for subsequent twelve-month periods unless either party determines to not renew.  Berger’s base annual salary was $250,000, and Berger was eligible to receive incentive compensation, consistent with that generally offered to executives of the Company.  In addition, Auxilio and John Abraham (“Abraham”), Founder of Redspin, entered into an independent contractor agreement (the “Abraham Agreement”), pursuant to which Abraham was retained to perform the work assigned by the Company.  The term of the Abraham Agreement was for two years (unless sooner terminated).  In consideration for such services, the Company agreed to pay Abraham $11,000 per month.

Pro Forma Information

The following supplemental unaudited pro forma information presents the combined operating results of the Company and the acquired business during the years ended December 31, 2016 and 2015, as if the acquisition had occurred at the beginning of each of the periods presented. The pro forma information is based on the historical financial statements of the Company and that of the acquired business. Amounts are not necessarily indicative of the results that may have been attained had the combinations been in effect at the beginning of the periods presented or that may be achieved in the future.

(15)   Subsequent events  

Stock Purchase Agreement – CynergisTek, Inc.; Amended and Restated Credit Agreement

As previously disclosed in our Current Report on Form 8-K, filed with the Commission on January 17, 2017, we entered into a Stock Purchase Agreement (the “SPA”) with CynergisTek, Inc., a Texas corporation (“CynergisTek”), Dr. Michael G. Mathews (“Mathews”) and Michael H. McMillan (“McMillan,” and together with Mathews, the “Stockholders”), pursuant to which Auxilio acquired 100% of the issued and outstanding shares of common stock (the “Shares”) of CynergisTek from the Stockholders (the “CynergisTek Transaction”).

Pursuant to the SPA, the purchase price paid for the Shares consisted of four components: the Cash Consideration, the Securities Consideration, the Debt Consideration, and the Earn-out Consideration.  

   Cash Consideration .  Auxilio paid the Stockholders a cash payment of $15,000,000, less Closing Net Working Capital Deficit, Funded Indebtedness and Designated Transaction Expenses (defined as certain expenses of the Stockholders and certain expenses of CynergisTek). The net cash amount paid to the Stockholders was $14,202,644.76.  

   Securities Consideration .  Auxilio issued a total of 1,166,666 shares of Auxilio common stock, par value $0.001 per share (the “Auxilio Stock”) to the Stockholders, with each of the Stockholders receiving 583,333 shares. 

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   Debt Consideration .  Auxilio issued promissory notes totaling $9,000,000 to the Stockholders (the “Seller Notes”), with each of the Seller Notes having an initial principal amount of $4,500,000.  The Seller Notes bear interest at 8% per annum, are quarterly interest-only payments due during the first 12 months, quarterly payments of principal and interest due during the last 24 months, using a 36-month amortization period commencing from that point, with a balloon payment due on the maturity date.  Amounts due and owing under the Seller Notes are subordinate to the right of payment due under the AvidBank Loan (described below) pursuant to the Subordination Agreement.  Auxilio has the right to prepay all or any portion of the outstanding principal balance of the Seller Notes, provided that such prepayment is accompanied by accrued interest on the amount of principal prepaid, calculated to the date of such prepayment. 

   Earn-out Consideration .   The Stockholders may be entitled to an additional $7,500,000 based upon the financial performance of CynergisTek after closing of the CynergisTek Transaction, to be calculated based upon EBITDA generated by the CynergisTek business during the earn-out period, which began as of January 1, 2017, and ends on December 31, 2021 (the “Earn-out Payments”).   

Pursuant to the SPA, CynergisTek and the Stockholders agreed to deliver to Auxilio certificates representing the Shares; the corporate record books of CynergisTek; and the employment agreements (described below). Auxilio agreed to deliver the Cash Consideration, the Securities Consideration, the Debt Consideration and the signed employment agreements.  

  In connection with the SPA, the Company and the Stockholders also entered into a registration rights agreement (the “Registration Rights Agreement”) and employment agreements, each of which is discussed below. 

Registration Rights Agreement

Pursuant to the Registration Rights Agreement between Auxilio and the Stockholders, Auxilio agreed to grant piggy-back registration rights under certain circumstances, and demand registration rights under other circumstances.  Briefly, for the piggy-back rights, if Auxilio proposes to register the sale of any of its stock or other securities under the Securities Act of 1933, as amended (the “Securities Act”) in connection with the public offering of such securities solely for cash, or the resale of shares of its common stock by other selling stockholders, Auxilio agreed that prior to such filing, it will give written notice to the Stockholders of its intention to do so. Upon the written request of a Stockholder given within twenty (20) days after Auxilio provides such notice (which request shall state the intended method of disposition of such registrable securities by the Stockholder), Auxilio will file a registration statement to register the resale of all such registrable securities which Auxilio has been requested by such Stockholder to register. With respect to the demand registration rights, Auxilio agreed that in the event that Auxilio fails to file timely public reports with the U.S. Securities and Exchange Commission if and as required by the Securities Exchange Act of 1934, as amended, then the Stockholders shall have the right, by delivering written notice to Auxilio (a “Demand Notice”), to require Auxilio to register the number of registrable securities requested to be so registered pursuant to the terms of the Registration Rights Agreement (a “Demand Registration”). Following the receipt of a Demand Notice for a Demand Registration, Auxilio agreed to file a registration statement not later than sixty (60) days after such Demand Notice, and will use its commercially reasonable efforts to cause such registration statement to be declared effective under the Securities Act as promptly as practicable after the filing thereof. Additionally, pursuant to the Registration Rights Agreement, the rights of the Stockholders to deliver a Demand Notice for a Demand Registration shall not be effective at any time when the registrable securities held by such Stockholder may be resold under Rule 144 of the Securities Act without regard to any volume limitation requirements under Rule 144 of the Securities Act.

Employment Agreements

In connection with the SPA, Auxilio and each of the Stockholders entered into an employment agreement, pursuant to which McMillan was appointed President and Chief Strategy Officer of Auxilio, and Mathews was appointed Executive Vice President of Auxilio.

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McMillan Employment Agreement.

Auxilio and McMillan entered into an employment agreement (the “McMillan Employment Agreement”), pursuant to which Auxilio employs McMillan as President and Chief Strategy Officer of Auxilio. McMillan agreed that his duties for Auxilio and its subsidiaries CynergisTek, Inc. and Delphiis, Inc. would be substantially similar to those duties that McMillan has performed on behalf of CynergisTek, and would include, without limitation, responsibility for executive leadership and business development strategy.  McMillan also agreed to perform additional duties as reasonably assigned by Auxilio’s Chief Executive Officer, and/or Board of Directors in order to advance the interests of Auxilio and its subsidiaries. The initial term of the McMillan Employment Agreement is 36 months from January 13, 2017, and will automatically renew for subsequent 12-month terms unless either party provides written notice to the other party of a desire to not renew the employment.

Pursuant to the McMillan Employment Agreement, McMillan’s base salary is $250,000, and he is entitled to incentive bonus compensation and equity compensation (consisting of stock options), as set forth in the McMillan Employment Agreement.  Auxilio has the right to terminate McMillan’s employment without cause at any time on thirty (30) days’ advance written notice to McMillan. Additionally, McMillan has the right to resign for “Good Reason” (as defined in the McMillan Employment Agreement) on thirty (30) days’ written notice.  In the event of (i) such termination without cause, or (ii) McMillan’s inability to perform the essential functions of his position due to a mental or physical disability or his death,  or (iii) McMillan’s resignation for Good Reason, McMillan is entitled to receive the base salary then in effect and full target annual bonus, prorated to the date of termination, and a “Severance Payment” equivalent to (a) payment of compensation for an additional twelve months, payable as a lump sum, and (b) the acceleration of all unvested stock options and warrants then held by McMillan, subject to certain conditions set forth in the McMillan Employment Agreement.  In addition, if McMillan is terminated by Auxilio without cause (as defined in the McMillan Employment Agreement), certain of the Earn-out Payments will accelerate and become immediately due and payable, as set forth in the SPA.  If McMillan resigns for other than Good Reason, he will be entitled to receive the base salary for the thirty (30) day written notice period, but no other amounts.

Mathews Employment Agreement.

Auxilio and Mathews entered into an employment agreement (the “Mathews Employment Agreement”), pursuant to which Auxilio employs Mathews as Executive Vice President of Auxilio. Mathews agreed that his duties for Auxilio and its subsidiaries CynergisTek, Inc. and Delphiis, Inc. would be substantially similar to those duties that Mathews has performed on behalf of CynergisTek, and would include, without limitation, day-to-day P&L responsibility for the cybersecurity service business line.  Mathews also agreed to perform additional duties as reasonably assigned by Auxilio’s President, Chief Executive Officer, and/or Board of Directors in order to advance the interests of Auxilio and its subsidiaries. The initial term of the Mathews Employment Agreement is 36 months from January 13, 2017, and will automatically renew for subsequent 12-month terms unless either party provides written notice to the other party of a desire to not renew the employment.

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Pursuant to the Mathews Employment Agreement, Mathew’s base salary is $250,000, and he is entitled to incentive bonus compensation and equity compensation (consisting of stock options), as set forth in the Mathews Employment Agreement.  Auxilio has the right to terminate Mathew’s employment without cause at any time on thirty (30) days’ advance written notice to Mathews. Additionally, Mathews has the right to resign for “Good Reason” (as defined in the Mathews Employment Agreement) on thirty (30) days’ written notice.  In the event of (i) such termination without cause, or (ii) Mathew’s inability to perform the essential functions of his position due to a mental or physical disability or his death,  or (iii) Mathew’s resignation for Good Reason, Mathews is entitled to receive the base salary then in effect and full target annual bonus, prorated to the date of termination, and a “Severance Payment” equivalent to (a) payment of compensation for an additional twelve months, payable as a lump sum, and (b) the acceleration of all unvested stock options and warrants then held by Mathews, subject to certain conditions set forth in the Mathews Employment Agreement.  In addition, if Mathews is terminated by Auxilio without cause (as defined in the Mathews Employment Agreement), certain of the Earn-out Payments will accelerate and become immediately due and payable, as set forth in the SPA.  If Mathews resigns for other than Good Reason, he will be entitled to receive the base salary for the thirty (30) day written notice period, but no other amounts.

Amended and Restated Credit Agreement and Related Agreements

Also on January 13, 2017,  Auxilio, and its subsidiaries Auxilio Solutions, Inc., a California corporation (“Solutions”), Delphiis, Inc., a California corporation (“Delphiis”), and immediately upon the consummation of the CynergisTek Transaction, CynergisTek (with Auxilio, Solutions, Delphiis, CynergisTek and such other subsidiaries collectively referred to as “Borrowers”), entered into an Amended and Restated Credit Agreement (the “A&R Credit Agreement”) with ZB, N.A., dba California Bank and Trust (“CBT”), and Avidbank, a California banking corporation (“Avidbank,” and together with CBT, the “Lenders”), as well as Avidbank in its capacity as contractual representative for itself and the other lender (“Agent”).

By way of background, Auxilio and Solutions on the one hand and Avidbank on the other hand previously entered into a Loan and Security Agreement, dated as of April 19, 2012 (as amended to date, the “Original Credit Agreement”), pursuant to which Avidbank extended to Auxilio and Solutions a term loan and a revolving line of credit.  Subsequently, Auxilio advised Agent that Auxilio desired to acquire 100% of the ownership interests of CynergisTek pursuant to the SPA.  The CynergisTek Transaction is prohibited by Section 7.3 of the Original Credit Agreement.  

Borrowers requested that Lenders (1) consent to the CynergisTek Transaction, and (2) provide additional financing in order to finance, in part, Auxilio’s obligations under the SPA.  Agent and Lenders agreed with such request in accordance with and subject to the terms and conditions of the A&R Credit Agreement and other related documents defined in the A&R Credit Agreement (the “Loan Documents”).  In connection with the entry into the A&R Credit Agreement, the parties to the A&R Credit Agreement agreed that CynergisTek automatically would become a Borrower under the A&R Credit Agreement and under the Loan Documents on the closing date immediately upon consummation of the CynergisTek Transaction (and not prior thereto), without further action required by any party.

Accordingly, the parties to the A&R Credit Agreement agreed that the A&R Credit Agreement and the Loan Documents would amend and restate the Original Credit Agreement in its entirety, and continue the obligations incurred thereunder and evidenced thereby.  Additionally, any amounts outstanding under the Original Credit Agreement were repaid in full immediately prior to the execution of the A&R Credit Agreement.

Loan Facilities

Term Loans:  Pursuant to the A&R Credit Agreement, the Lenders agreed to provide term loans in the aggregate amount of $14,000,000.00 to Auxilio, which was paid to the Stockholders as part of the Cash Consideration in the CynergisTek Transaction (described above).  The term loans bear interest at a rate of Prime plus 1.5%, and the loans mature on January 12, 2022.  

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Revolving Line of Credit: Additionally, pursuant to the A&R Credit Agreement, the Lenders agreed to provide revolving loans to the Borrowers in an aggregate amount of up to $5,000,000. At the closing of the CynergisTek Transaction, no draws were made on the revolving loans.

Security Agreement

In connection with the A&R Credit Agreement, the Borrowers and the Agent entered into a security agreement (the “Security Agreement”), pursuant to which each of the Borrowers agreed to grant to Agent, for the ratable benefit of itself, the Lenders and the other secured parties, a first priority security interest in certain collateral to secure prompt payment and performance of the secured obligations under the A&R Credit Agreement.  Pursuant to the Security Agreement, the “Collateral” was defined as including any and all (all such terms as defined in the Security Agreement) of the Accounts, Chattel Paper, Commercial Tort Claims, Deposit Accounts, Documents, Equipment, Instruments, Inventory, Investment Property, General Intangibles, Letter of Credit Rights, Negotiable Collateral, Supporting Obligations, Vehicles, Grantors’ Books, in each case whether now existing or hereafter acquired or created, any money or other assets of any Grantor that now or hereafter come into the possession, custody, or control of Agent and any Proceeds or products of any of the foregoing, or any portion thereof.  In connection with the grant of the security interest in the Collateral, each of the Borrowers made standard representations and warranties relating to ownership of the collateral, location and control of the collateral, and certain rights to payment.

Seller Subordination Agreement

Additionally, in connection with the A&R Credit Agreement and the CynergisTek transaction, Mathews, McMillan, Auxilio, and Avidbank entered into a subordination agreement (the “Subordination Agreement”), pursuant to which Mathews and McMillan agreed that unless and until all of Auxilio’s obligations under the A&R Credit Agreement has been repaid in full, Mathews and McMillan would not, except as provided in the Subordination Agreement, ask, demand, sue for, take or receive, or retain, from Auxilio or any other person or entity, by setoff or in any other manner, payment of all or any part of the Subordinate Debt (as defined below), or take any other action with respect to the Subordinate Debt; forgive, cancel or discharge any of the Subordinate Debt; ask, demand or receive any security for the Subordinate Debt; amend any documents relating to the Subordinate Debt or any other agreement, instrument or document evidencing or executed in connection with the Subordinate Debt in a manner that could reasonably be expected to be adverse to Lenders or Agent (or any other holders of the obligations arising under the A&R Credit Agreement); or bring or join with any creditor in bringing any insolvency proceeding against Auxilio. Additionally, Mathews and McMillan each directed Auxilio to make, and Auxilio agreed to make, such prior payment of Auxilio’s obligations under the A&R Credit Agreement to Agent and the Lenders.  The Subordination Agreement defines “Subordinate Debt” to include all debt of Auxilio owing to Mathews and McMillan (or either of them) (a) under the Seller Notes or (b) in respect of the Earn Out Payments (described above), in either case whether now existing or hereafter arising and including all principal, premium, interest, fees, attorneys’ fees, costs, charges, expenses, reimbursement obligations, any other indemnities or guarantees in each case with respect thereto, in each case whether direct or indirect, absolute or contingent, joint or several, due or not due, primary or secondary, liquidated or unliquidated, secured or unsecured.  So long as the Borrowers are not in default under the terms of the A&R Credit Agreement, Auxilio may make regular payments to the Stockholders under the Seller Notes.

Reverse Stock Split

On January 12, 2017, Auxilio, Inc. announced that it had received approval from the Financial Industry Regulatory Authority ("FINRA") of the Company's Company Related Action Notification Form relating to the implementation of a reverse split of its common stock, par value $0.001 per share  at a ratio of one-for-three, that is, one new share for each three old shares of the Company's common stock, whereby 24,557,224 outstanding shares of the Company’s common stock were exchanged for 8,185,936 newly issued shares of the Company's common stock. Under the terms of the reverse stock split, fractional shares issuable to stockholders were rounded up to the nearest whole share, resulting in a reverse split slightly less than one for three in the aggregate.

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On December 22, 2016, the Company filed a Certificate of Amendment to its Articles of Incorporation relating to the reverse split.  The Amendment provides that no fractional shares of Common Stock will be issued to the holders of record of Common Stock prior to the reverse split. Instead, all fractional shares will be rounded up to the next whole number of shares.

The reverse split was approved at the 2015 Annual Meeting of the Company's Shareholders.  At that meeting, the Company's shareholders voted to approve a reverse split at a ratio between 1-for-1.5 shares and 1-for-3 shares, to be determined by the Company's Board of Directors.  The Board determined to implement the reverse split at the ratio of one for three shares.

The reverse stock split became effective with FINRA and in the marketplace at the open of business on Friday, January 13, 2017, whereupon the shares of common stock began trading on a reverse-split-adjusted basis.

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PART IV

ITEM 15.     EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.  

*   Each of these Exhibits constitutes a management contract, compensatory plan or arrangement.