UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

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

For the fiscal year ended December 31, 2017

or

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

For the transition period from _________ to _______

Commission File Number 001-38371

 

One Stop Systems, Inc.

(Exact name of Registrant as specified in its Charter)

 

 

Delaware

33-0885351

( State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer
Identification No.)

 

 

2235 Enterprise Street #110

Escondido, California 92029

(Address of principal executive offices, including Zip Code)

(877) 438-2724

(Registrant’s telephone number, including area code)

 

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

Title of each class:

Name of each exchange on which registered:

Common Stock, par value $0.0001 per share

The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  No 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes  No 

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

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).Yes  No 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 

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

 

Large accelerated filer

 

Accelerated filer

Non-accelerated filer

(Do not check if a smaller reporting company)

Smaller reporting company

 

Emerging growth company

 

 

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

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  No 

As of February 28, 2018, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was $37,711,082, based on the closing price of the registrant’s common stock on The Nasdaq Capital Market of $4.85 per share.  The registrant has elected to use February 28, 2018 as the calculation date, as on June 30, 2017 (the last business day of the registrant’s most recently completed second fiscal quarter) the registrant was a privately-held company.

As of February 28, 2018, the registrant had 12,476,923 shares of common stock (par value $0.0001) outstanding.

 

 

 

 

 


One Stop Systems, Inc.

FORM 10-K

For the Fiscal Year Ended December 31, 2017

Table of Contents

 

 

 

Page

PART I

 

 

Item 1.

Business

2

Item 1A.

Risk Factors

20

Item 1B.

Unresolved Staff Comments

36

Item 2.

Properties

36

Item 3.

Legal Proceedings

36

Item 4.

Mine Safety Disclosures

36

 

 

 

PART II

 

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

37

Item 6.

Selected Financial Data

38

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

40

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

55

Item 8.

Financial Statements and Supplementary Data

55

Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

56

Item 9A.

Controls and Procedures

56

Item 9B.

Other Information

57

 

 

 

PART III

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

58

Item 11.

Executive Compensation

63

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

76

Item 13.

Certain Relationships and Related Transactions, and Director Independence

78

Item 14.

Principal Accounting Fees and Services

80

 

 

 

PART IV

 

 

Item 15.

Exhibits, Financial Statement Schedules

81

 

 

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K (“Annual Report”) contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact contained in this Annual Report, including statements regarding our future operating results, financial position and cash flows, our business strategy and plans and our objectives for future operations, are forward-looking statements. These statements involve known and unknown risks, uncertainties and other important factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. This Annual Report also contains estimates and other statistical data made by independent parties and by us relating to market size and growth and other data about our industry. This data involves a number of assumptions and limitations, and you are cautioned not to give undue weight to such estimates. In addition, projections, assumptions and estimates of our future performance and the future performance of the markets in which we operate are necessarily subject to a high degree of uncertainty and risk. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “would,” “could,” “should,” “expect,” “plan,” “anticipate,” “could,” “intend,” “target,” “project,” “contemplate,” “believe,” “estimate,” “predict,” “potential” or “continue” or the negative of these terms or other similar expressions.  The forward-looking statements in this Annual Report are only predictions. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, operating results, business strategy, short-term and long-term business operations and objectives. These forward- looking statements speak only as of the date of this Annual Report and are subject to a number of risks, uncertainties and assumptions, including those described in Part I, Item 1A, “Risk Factors. The events and circumstances reflected in our forward-looking statements may not be achieved or occur and actual results could differ materially from those projected in the forward-looking statements. Moreover, we operate in a very competitive and rapidly changing environment. New risk factors and uncertainties may emerge from time to time, and it is not possible for management to predict all risk factors and uncertainties. Except as required by applicable law, we do not plan to publicly update or revise any forward-looking statements contained herein, whether as a result of any new information, future events, changed circumstances or otherwise.

One Stop Systems, the One Stop Systems logo, and other trademarks or service marks of One Stop Systems appearing in this Annual Report are the property of One Stop Systems, Inc. This Annual Report also includes trademarks, tradenames and service marks that are the property of other organizations. Solely for convenience, trademarks and tradenames referred to in this Annual Report appear without the ® and ™ symbols, but those references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights, or that the applicable owner will not assert its rights, to these trademarks and tradenames.

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PART I

ITEM 1. BUSINESS.

Overview

One Stop Systems (OSS) designs, manufactures and markets high-end systems for high performance computing (“HPC”) applications. We combine state-of-the art components from major technology providers to design and manufacture purpose-built systems that allow our customers to exploit Big Data opportunities faster and more efficiently. HPC applications require ultra-fast processing power and the ability to quickly access and store ever-growing data sets. We are uniquely positioned as a specialized provider for the high-end of this marketplace providing custom servers, compute accelerators, solid-state storage arrays and system expansion systems. We deliver this high-end technology to our customers through the sale of equipment and software for use on a customer’s premises or through remote cloud access to secure datacenters housing our technology.

The worldwide HPC market is expected to grow from $35.6 billion in 2016 to $43.9 billion by 2021, representing a compound annual growth rate (CAGR) of 4.3%. We are establishing a leading position as a provider of HPC servers, compute accelerators and flash storage arrays to the high-end of this growing marketplace. Today, we believe we are one of the largest providers of PCIe over cable adapters and expansion systems used worldwide. PCIe is the high performance communication protocol or bus between components which can also be used between boxes for the highest performance and lowest latency. We supply systems that attach to both existing servers through PCIe cables as well as all-in-one systems with the server, Graphic Processing Unit (GPU) computing and Solid State Devices (SSD) storage all included in a single product. OSS systems offer high performance in a physically dense packaging, enabling our customers to build massive compute and storage clusters that occupy less space and require less power and cooling than conventional systems. We also sell software used to operate flash-based storage systems for defense systems and commercial applications.

The more GPUs and flash-based storage devices available to a server, the faster it can process, store, and retrieve data. PCIe is increasingly the preferred technology for connecting system components together. We have built leading edge expertise in PCIe expansion technology and leveraged it to design and build systems that offer a higher quantity and density of GPUs and flash devices than competing suppliers.

A key element of our product strategy is technological market leadership. We believe a first-to-market strategy is key to our ability to continue to win significant OEM design wins. As a result, we are constantly developing new state-of-the-art products that are often based on components that do not yet exist. Our ability to drive the leading edge of technology is enabled by our strong relationships with strategic component manufactures, particularly Intel (for CPUs), NVIDIA (for GPUs), Western Digital (for SSD) and Broadcom (for PCIe switch components). In each of these cases, OSS has special access (under non-disclosure agreements) to product roadmaps and other technical information relating to future technology. Access to this information allows us to begin our design process well before the future components we are designing for even exist. This accelerates our time-to-market, and allows us to produce and release state-of-the-art designs well ahead of our competitors.

Today, HPC applications are moving beyond the traditional academic and scientific realms to broad application in enterprise applications across the spectrum of vertical markets. These applications include computationally intense areas like artificial intelligence (“AI”), deep learning, seismic exploration, predictive analytics, medical imaging, genomics, cyber security and defense. We are well positioned to leverage these market megatrends and capitalize on our unique core competencies in high speed system design. We have a proven track record of delivering first-to-market the latest and most advanced technologies and have continued to do so recently with high-end GPU accelerators and high-performance SSD arrays with light-weight removable high-capacity canisters. These products fit solidly into the emerging HPC market.

OSS sells its products worldwide to industry leading customers like Cisco, disguise (formerly d3), National Instruments, Northrop Grumman, Oracle and Raytheon. We are a strategic partner to technology leaders that include Intel, NVIDIA, Western Digital, and Broadcom, whose technology is integrated into our products. We are investing in new adjacent segments to our core product lines, including HPC storage management software and HPC cloud services. We anticipate continued market growth in our target markets and sustaining the ability to increase market share through leadership technology, engineering expertise, supply chain management and go-to-market innovation.

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We were originally organized as One Stop Systems, LLC, a California limited liability company in 1998 before converting into One Stop Systems, Inc., a California corporation in 1999. On July 6, 2016, we entered into a Merger Agreement and Plan of Reorganization with Mission Technology Group, Inc. (“Magma”) whereby Magma merged with and into OSS with OSS continuing as the surviving corporation. We reincorporated as a Delaware corporation on December 14, 2017. Our principal executive offices are located at 2235 Enterprise Street, Suite 110, Escondido, CA 92029 and our telephone number is (760) 745-9883. Our website address is www.onestopsystems.com. Information contained in, or accessible through, our website is for reference purposes only.

Industry Background

High Performance Computing (HPC) refers to computing solutions capable of processing large amounts of data and storing and retrieving that data at speeds 10-1,000 times faster than a typical personal computer. Increasingly, commercial companies, financial entities, governmental agencies, including the Department of Defense (DoD), and academic institutions are turning to HPC solutions to analyze vast amounts of data and to quickly obtain meaningful and actionable insights. Traditional computing systems using CPUs (Central Processing Units) are inefficient in quickly processing large data sets of information. Two technologies, GPU computing, and flash memory, enable systems to process and store data more efficiently than traditional systems. By harnessing large quantities of these components, companies can receive necessary data analysis much more quickly. Industry experts typically divide the HPC market into the following categories:

 

Servers – This market represents all HPC servers, which is composed of Supercomputers (>$500,000 per unit), Divisional Servers ($250,000-$500,000), Departmental Servers ($100,000-$250,000), and Workgroup Servers (<$100,000 per unit).

 

Storage – This includes both traditional hard disc drives and flash storage devices.

 

Middleware – A broad category encompassing programming environments, schedulers, and other tools outside the operating system.

 

Applications – Specific applications for high performance computing.

 

Services – All services associated with high performance computing.

Intersect360 Research categorizes and projects sales in the total HPC market.

High Performance Computing Market by Product Category — Total Market Forecast by Economic Sectors ($M)

 

 

 

2016

 

 

2017

 

 

2018

 

 

2019

 

 

2020

 

 

2021

 

 

CAGR

 

Servers

 

 

11,471

 

 

 

11,947

 

 

 

12,480

 

 

 

13,072

 

 

 

13,370

 

 

 

14,443

 

 

 

3.91

%

Storage

 

 

5,778

 

 

 

6,113

 

 

 

6,460

 

 

 

6,845

 

 

 

7,272

 

 

 

7,772

 

 

 

4.95

%

Services

 

 

3,824

 

 

 

3,877

 

 

 

3,939

 

 

 

4,010

 

 

 

4,090

 

 

 

4,174

 

 

 

1.47

%

Software

 

 

8,910

 

 

 

9,188

 

 

 

9,502

 

 

 

9,852

 

 

 

10,243

 

 

 

10,775

 

 

 

3.22

%

Networks

 

 

2,767

 

 

 

2,855

 

 

 

2,955

 

 

 

3,066

 

 

 

3,190

 

 

 

3,324

 

 

 

3.10

%

Cloud

 

 

784

 

 

 

854

 

 

 

930

 

 

 

1,015

 

 

 

1,108

 

 

 

1,210

 

 

 

7.50

%

Other

 

 

2,053

 

 

 

2,090

 

 

 

2,134

 

 

 

2,183

 

 

 

2,238

 

 

 

2,296

 

 

 

1.88

%

Total

 

 

35,587

 

 

 

36,923

 

 

 

38,400

 

 

 

40,042

 

 

 

41,871

 

 

 

43,944

 

 

 

4.3

%

 

Source: HPC Advisory Council Website, Market Report, HPC Market Update, Total HPC Market by Revenue, June 2017, Report by Intersect360 Research, authored by Addison Snell, Christopher Willard, Ph.D., and Laura Segervall. (Accessed on July 23, 2017)

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The markets for these products are large, and growing, albeit currently fragmented. The industry sectors that are currently or anticipated to require HPC systems are growing daily and include the following sectors at a minimum:

 

Bio-Sciences

 

Astrophysics

 

Quantum Chemistry

 

Aerodynamic Design and Modeling

 

Computer Aided Engineering

 

Chemical Engineering

 

Distribution

 

Economics/Financial – including econometrics, high frequency trading

 

Environmental Data Acquisition

 

Geosciences – including oil and gas exploration

 

Mechanical Design – including virtual design and prototyping

 

Defense

 

Government Laboratories

 

University/Academic

 

Weather Forecasting

These industry sectors expect to deploy increasingly faster computing environments to meet industry and competitive goals. GPU computer acceleration and high-density flash storage are key subsets of the HPC market.

GPU Compute Acceleration

The capabilities and speed of GPU accelerated computers are beginning to drive significant advances in AI and machine learning. Massive amounts of data, when analyzed by today’s sophisticated algorithms, able to reveal unique patterns and insights. AI and machine learning are poised to transform worldwide business, as advances in computing speed and storage come together to enable businesses to solve complex problems.

High Density Solid-State Storage

The market for solid-state drives is large and growing. According to a study by MarketsandMarkets, a market research firm, the flash drive market is growing at 9.5% per year and is expected to reach $25.3 billion by 2022. The proliferation of larger and larger databases, virtualized servers, virtual desktop servers, analytic application servers, and other server configurations are feeding the need for faster and faster ways to access the data being produced or mined.

Traditionally, companies have used hard disk drive technology that has proved more than adequate as the price for these drives have continued to drop as the associated capacities have risen. This was especially true when the amounts of data generated were relatively low, and users were satisfied with the comparatively slow data retrieval and processing that traditional hard disk drives offered. Today, the huge amount of data being generated requires categorization, storage and ready access. The advent of flash drives has given the industry a new device that has faster access time, greater reliability, lower power consumption, lower noise, smaller size and less heat generation.

4


These drives are especially useful in the field of high performance computing, where one is generally dealing with larger amounts of data and/or the need for complex calculations to be completed very rapidly. In either case, speed and efficiency are paramount. Military systems, for example, generate vast amounts of data using sensor systems, radar systems, cryptanalysis, targeting systems, microwave communications, and a myriad of other applications. This data needs to be collected, analyzed and acted upon in a real-time environment.

Key Components of Our Business

Product Development

Our systems are built using the latest GPU and flash storage technologies and draw upon years of expertise in designing and manufacturing semi-custom systems for OEMs. We have a history of being first to market with many solutions for emerging technologies. OSS first began designing and manufacturing custom systems for defense, manufacturing, and telecommunications customers. When PCIe (the interconnect used in most computers today) was first introduced by Intel Corporation in 2005, we were first to produce PCIe over cable adapters allowing system-to-system communication at incredible speeds. Today, we are one of the largest providers of PCIe adapters and expansion components used worldwide.

When GPU technology and solid-state flash were first introduced, we began designing systems that maximized the effectiveness of these technologies. We now produce compute systems with large numbers of GPUs and flash memory to allow faster processing and data storage and retrieval. The more GPUs and flash devices available to a server the faster that system can process and store/recover data, thus saving time and money for those applications. A readily recognized example is video imaging in defense applications when quickly knowing battlefield parameters is paramount.

We use leading edge, state-of-the art components from major technology providers to design purpose-built systems that solve customer problems in an efficient, cost-effective manner. We do not design silicon chips, but instead apply the technology provided by Intel, NVIDIA, Western Digital, Broadcom and others to deliver customer driven designs to provide true value to our customers.

Worldwide Sales

We provide our products on a worldwide basis and are supported through a network of reseller and distribution partners. Sales in North America are predominately driven by our direct sales force whereas European and Asian sales are driven through distributors.

In June 2015, we formed our wholly-owned subsidiary One Stop Systems, GmbH (“OSS GmbH”), located in Gröbenzell, Germany. It operates a regional facility formed to service customers in Europe, the Middle East and Africa. OSS GmbH was established to service OSS GmbH regional customers with faster product delivery, application engineering services and technical support. Our facility is centrally located outside of Munich, in a tech-rich region easily accessible to all of Europe and within just a few time zones of the Middle East and Africa. The office is staffed with knowledgeable technical personnel who can quickly resolve customer issues and facilitate quick delivery of their products. This facility also gives us the opportunity to provide an OEM warehousing location, as well as a service depot for equipment repair and rework that serves our growing customer base located outside of the United States.

New Business Initiatives

On April 6, 2017, OSS formed SkyScale, LLC (“SkyScale”), a HPC as a Service (HPCaaS) provider to offer customers world-class, ultra-fast, multi-GPU hardware platforms in the cloud. SkyScale is a 50/50 joint venture between OSS and Jacoma Investments, LLC, an entity affiliated with a member of our board of directors, which allows customers to lease state-of-the-art high performance computing hardware. SkyScale’s cloud services provide a compelling value proposition for customers who want the fastest computing performance available, but may not have the budget or infrastructure available to support a full-time HPC system. SkyScale provides that infrastructure, including common HPC applications at a fraction of the cost of the full-time system. The customer gets access to their own infrastructure in the cloud, which is available 7 days a week, 24 hours a day. This is our first foray into the

5


growing “Infrastructure as a Service” (IaaS) market, and is expected to produce strong growth for OSS in the future. The SkyScale datacenter utilizes OSS servers and GPU compute accelerators. These systems can be clustered and scaled in the cloud to provide companies with the desired computing power for their high performance application requirements. As a key part of our strategy, this creates demand for the systems we build (as they are used by SkyScale), revenues from the service itself, exposure to a potential customer for our products as they grow, and our increased involvement on the software front.

On May 9, 2017, OSS entered into an agreement to acquire the source code license to the Ion SSD software from Western Digital. We plan to continue to develop and sell Ion software with our high-density storage arrays, as well as servicing existing Western Digital software users. OSS Ion software works with our all-flash storage systems, and provides them with a critical point of differentiation with respect to speed and throughput. The OSS Ion software leverages flash storage and open server hardware to accelerate applications and storage-area network performance through sharing or clustering high-speed all-flash storage arrays. The software supports many major OEM servers and provides an intuitive interface for system users to manage its many features. Having the Ion software source code and engineering team on-board allows us to strategically grow our all-flash storage business in the many Big Data and HPC markets as well as increases our software content over time.

What Sets OSS Apart

Several factors differentiate OSS from other suppliers of HPC solutions:

 

Our expertise in PCIe expansion and building custom systems allows us to design reliable systems using this challenging highest performance technology with a greater quantity of GPUs and flash storage devices than other suppliers.

 

We design systems that both attach to existing servers through PCIe over cable leveraging our customer’s existing investments as well as all-in-one systems with the server, GPU computing and flash storage device all included in a single package.

 

Our systems can be clustered together to build massive compute engines that occupy less space and power than conventional systems driving performance up and costs down for our customers.

 

We produce the software required to operate high-capacity, low-latency storage systems used by defense systems and commercial applications and expect this will expand into other products in the future.

Our business model utilizes our products in two ways:

 

We sell systems to OEM customers who use them in their own data centers for their own applications.

 

We (via SkyScale) lease space on our own systems in our own data center for customers who prefer not to make the infrastructure investment require for owning their own systems.

Our niche is to provide reliable purpose-built platforms with the latest GPUs and flash storage devices that allow servers to access large numbers of these devices.

Business Strategy

We have traditionally followed a strategy of being first-to-market in leading edge technologies by designing and developing products that are delivered before our competitors. This market leader strategy is accomplished through what we term a “Catch the Wave” approach to the market. We currently have products and derivatives in the flash storage, GPU acceleration, and PCIe expansion markets. Within these three distinct market areas the OSS “Catch the Wave” approach implies that we:

 

anticipate trends in these markets;

 

consistently deploy resources in engineering and sales to bring innovative products to market before our competitors react;

6


 

work closely and leverage strategic component supplies to get early access to future products and technologies;

 

seek to procure early “design wins”, establishing the standard before our competitors can react; and

 

continually survey the market for complementary technologies for which a new “Wave” may be forming.

Growth Strategy

OSS intends to continue its rapid growth through three avenues:

 

Ramp-up of Existing OEM and Military Design-wins

Many of our design wins are in the early stages, and we anticipate significant revenue growth as they move into full production.

 

Winning New OEM and Military Program Designs

Our technology leadership provides the “in” to many potential OEM relationships. As we continue to grow the Company, our capabilities and market recognition also grow rapidly, providing even more opportunities for OEM and military program design-ins.

 

Acquisitions of strategic companies

OSS has an experienced team that has negotiated and managed numerous acquisitions of smaller companies. We have identified more than a dozen firms that we believe have potential to be acquired and provide significant, accretive value to OSS. Some of the proceeds from our initial public offering will assist in our acquisition activities by providing cash and stock which can be used selectively in future transactions.

OSS is using the following criteria for potential acquisition targets:

 

Target has a presence in our served or desired markets.

 

Target’s products can be easily integrated into our product portfolio and/or product roadmap resulting in an accretive benefit to our existing position.

 

Target should be profitable with positive cash flow at the outset or shortly following the acquisition.

 

Target’s products can provide $5-$15 million in incremental revenue.

 

Target is relatively proximate, geographically to OSS in Southern California.

 

Will consider companies that can extend our markets geographically.

 

Will consider companies that have an existing incremental services revenue stream.

Our acquisition strategy has the following benefits for OSS and our stockholders:

 

Immediate acquisition of new customers and products. Acquisition of new engineering, sales, administrative and operations personnel.

 

The increase in size and scale of OSS which can be leveraged to lower overall costs and drive up margins/profits.

 

Increased credibility with customers, vendors, and suppliers.

We plan to allocate some of the proceeds from our initial public offering to acquisitions of complementary businesses, products, services or technologies and working capital. At this time, however, we have not yet identified specific acquisition targets.

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Our Opportunity

The worldwide HPC market is expected to grow from $35.6 billion in 2016 to $43.9 billion by 2021. Within this market, OSS is positioned in the highest performance and fastest growing portion of the market including the server (custom and GPU accelerators), storage (flash arrays), PCIe expansion and adapters, and services sectors. The service sector is addressed with services being delivered over the cloud as Infrastructure as a Service, (IaaS). We will address each of these sectors below:

 

Custom Built Servers

 

GPU Compute Accelerators

 

All Flash Arrays

 

PCIe Expansion and Adaptors

 

Cloud Services (IaaS – Infrastructure as a Service)

Custom Built Servers

Within the server sector, OSS has secured a niche position of building purpose-built specialty servers, which the major server suppliers choose not to supply as they require custom tuning and special features that major OEMs cannot easily provide. Such flexibility is difficult to maintain for major suppliers because their systems are not designed to reflect specific customer specifications. OSS on the other hand has continued to find efficient ways service this market profitably.  For example, OSS designs and builds a custom server with custom connectors and 16 high definition video media outputs that are used in the entertainment industry to provide multimedia at a live performance.

These servers can be accelerated or not, but they are built generally to the latest release of PCIe. For HPC applications, these servers can be designed to support GPUs, either within the server itself or via PCIe-over-cable to an external GPU compute accelerator chassis designed and manufactured by OSS.

We believe the custom server segment is growing much faster than the standard server segment, which has contributed greatly to the growth of OSS. Intersect360 Research estimates that the market for HPC servers is expected to be approximately $14.4 billion by 2021, with the market share for HPC servers to be as follows:

 

Hewlett Packard

 

 

33.0

%

Dell

 

 

26.4

%

Lenovo

 

 

6.9

%

IBM

 

 

6.8

%

Cray

 

 

4.5

%

ATOS/Bull

 

 

2.6

%

Inspur

 

 

2.0

%

Fujitsu

 

 

1.8

%

Penguin

 

 

1.5

%

Huawei

 

 

1.2

%

Others

 

 

13.5

%

 

It is our experience that OSS is increasingly competitive in the “Others” category, where customers require their systems to meet specific operational specifications, power requirements, speed, latency, or other requirements not covered by traditional designs. We estimate that our addressable market for HPC computers is approximately 20% of the “Others” category in the above chart. This translates to an addressable market size of approximately $389 million with our current engineering capability and product set. Our strategy is to stay laser focused and be the best in this market segment. We plan to use some of the capital raised in our initial public offering to accelerate our growth to capitalize on this market segment.

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GPU Compute Accelerators

GPU computing uses hardware chips that are optimized to perform mathematical calculations in a rapid fashion. NVIDIA is the market leader in the design and manufacturing of these components. NVIDA has done extremely well in recent years as this part of the computing market is growing much faster by new applications compared to the traditional CPUs from companies like Intel.  OSS works closely with NVIDIA to design and build systems which use multiple GPUs to accelerate the applications being run by the computer.

The unique design of the GPU provides thousands of processing “cores” which act as individual coprocessors to speed up the calculations on large data sets. It is generally believed that traditional processor designs, which have been driven by “Moore’s Law,” are reaching the limits of what is physically possible in speed and throughput. GPU acceleration is driving many of the newest and fastest growing technology opportunities in this new age of computing. This is a relatively new phenomenon. Indeed, many of the applications that are gaining notoriety today have only become possible because of the ability of GPUs to optimize computational throughput, perform many tasks at once, and make sense of the massive amounts of data that is available to high performance algorithms.

Markets such as image rendering and processing, self-driving cars, deep learning, molecular modeling and genomics, advanced visualization, machine learning, and image processing, all benefit from the ability to use GPUs to accelerate the application. OSS builds compute accelerators, using the latest GPU technology, to attach to traditional servers used in these emerging growth markets. Because of the relative newness of these markets, little market data exists to precisely define these markets, but we estimate these markets to be very large and growing. While we are beginning from a small base, we expect these markets to be valued in the billions of dollars in the near future. Because our strategy has been to be first-to-market with the fastest and densest compute accelerator appliances, we anticipate our addressable market here to be in the hundreds of millions of dollars.

We also have a strong position in the government market which, according to Intersect360, constitutes 26% of the market that is growing to $43.9 billion by 2021. An emerging market, slightly different from traditional HPC markets, is the hyperscale market, which is a scalable, web-facing application infrastructure that is distinct from traditional IT infrastructure. OSS products can form a basis for companies who wish to participate in the hyperscale market, which includes deep learning and AI. This is a major technology trend that OSS is addressing through its product roadmap and investment in SkyScale, a company that provides HPC infrastructure as a service through a cloud-based interface. Intersect360 estimates the deep learning market was worth more than $2.0 billion in 2016, with nearly 100% growth projected from 2017 to 2018.

All Flash Arrays

We build flash storage arrays to customer specifications utilizing our unique know-how in packaging, cooling, and PCIe-over-cable. We deliver dense, high-performance systems that provide customers with extreme value and utility in the most demanding, data-intensive operations.

Through a strategic agreement with Western Digital, we have acquired a source code license to utilize their proprietary Ion flash array software, which provides OSS flash arrays with a high level of differentiation around management, latency and throughput. Although we maintain an offering of standard flash array products, our expertise and success has been in providing arrays with specialized packaging for demanding applications that are not suitable for standard offerings.

For example, we provide products to a large military/government contractor for integration into a military aircraft that required us to rethink packaging and data portability. This resulted in the development of a product that provides extreme data density with low weight, and a high degree of portability and security for the data. We developed this product, from concept to design and prototype, within a very short period and with outstanding results. We believe our experience and capability in high speed, low-latency, digital signaling via PCIe gives us an edge in providing these custom designs to OEMs, integrators, and other special purpose applications.

The overall market for flash arrays is growing rapidly. According to the Dell’Oro Group, the flash storage market totaled more than $1.3 billion in the first quarter of 2017, up 48% compared to the same year-ago quarter, and is expected to grow 40% in 2017. About 86% of the total in the first quarter was attributed to traditional large OEMs, like Dell EMC, NetApp, Hewlett Packard Enterprise, Pure Storage and IBM. The remaining 14%, or total revenue of about $182 million in the first quarter of 2017, is addressed by many smaller flash storage providers, including OSS. We believe that because our products are positively differentiated by speed, density, and management features, our offerings compete favorably in this market and provide a substantial growth opportunity.

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OSS participates in the broader market for dense, fast flash storage systems that may or may not be deployed into HPC environments. Since we develop custom flash storage arrays, we work closely with both OEMs and end users to insure they receive the product they want in the specific configuration, size and weight required for their application. We believe this gives OSS an advantageous position in a market that is growing rapidly and allows us to favorably compete in the market. We also believe our unique approach to building arrays and appliances based on leading-edge technology is one of the key factors driving our growth.

PCIe Expansion and Adaptors

PCIe (PCI Express) is a high-speed computer expansion standard. This standard defines the signals and connectors (i.e. slots) that are used for computer add-in cards (such as Ethernet or graphics). PCIe signaling can also be routed over a cable, allowing expansion input/output slots to be physically located in a separate chassis. This provides for the highest performance and lowest latency which is essential in this market.

Being able to route PCIe over a cable facilitates disaggregation of server functionality. That is, with PCIe, certain server functions no longer needed to be contained in the physical server chassis, but could instead be separated and continue to operate at full speed. From a practical perspective, servers could now be connected directly to larger storage arrays or other peripheral devices, with the resulting group of chassis operating as if they were all in the same physical chassis.

We began developing our first PCIe-over-cable adaptor in 2006, and were one of the early providers of PCIe adaptors. We recognized this as prime opportunity to utilize our core strengths, such as:

 

High-speed board design and layout

 

Hardware tuning to improve signal integrity

 

Design optimization for low cost

 

Rapid design capability

 

Manufacturing and supply chain management

This technology has now become a standard within the computer industry, and OSS customers have used our adaptors to connect their custom input/output chassis and achieve performance equivalence as if the input/output was integrated into the server box. This gives designers and integrators a degree of flexibility and utility in architecting computer systems that is unprecedented. For example, one of our customers has utilized PCIe-over-cable to connect its high performance video editing systems to a host computer, providing a system that is optimized for an application using standard servers. We have expanded our PCIe adaptor market in breadth and depth, including making adaptors for many OEM customers. To date, we have shipped more than 100,000 PCIe adaptor cards to customers globally.

With our expertise developed in designing adaptor cards, the logical extension of our capability led us to develop a method for expanding the PCIe bus into an external chassis containing one or many expansion slots. This allowed a customer to install multiple standard PCIe boards into a chassis and expand their system without having to add additional servers. A user could now connect a multiplicity of PCIe devices to a single server, and achieve performance and throughput that was not possible prior to the introduction of PCIe.

We have been a leader in PCIe expansion backplanes and chassis through generations 1, 2 and 3. As PCIe evolves through generations 4 and 5, we are uniquely positioned to continue our leadership role in this market. We currently offer what we believe to be the largest PCIe expansion product line breadth, with chassis and backplanes that offer expansion from one to 64 slots. Due to its greater data throughput and flexibility of design, we believe this is a growing market, and we intend to maintain our leadership role.

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Cloud Services (IaaS – Infrastructure as a Service)

One of the fastest growing areas of the HPC market is providing HPC services in the cloud. The cloud HPC market is estimated to grow to $10.8 billion by 2020 at an estimated compound annual growth rate of 19.9%, according to market research published by MarketsandMarkets. Cloud HPC makes it possible for enterprises to achieve rapid scalability for mission critical applications. Such services are fast and easy to deploy, and require less capital and operating overhead, which enables enterprises to focus on their core business activities.

We are ideally suited to participate in this market opportunity given our position in GPU acceleration and high-speed storage technology. In May 2017, we announced a partnership with SkyScale, LLC, a High-Performance Computing-as-a-Service (HPCaaS) provider to offer customers world-class, ultra-fast, multi-GPU hardware platforms in the cloud. This joint venture allows the leasing of state-of-the-art high-performance computing hardware at rates which provide a compelling value proposition to customers who want the fastest performance available, but are not interested in running their own HPC datacenter or committing to the significant capital investment. SkyScale provides this infrastructure, including common HPC applications, at a fraction of the cost of the full-time system.

SkyScale utilizes our equipment and hosts it in a state of the art, ultra-secure and highly reliable datacenter in San Diego. Through SkyScale, customers get access to their own infrastructure in the cloud which is available 24 hours a day, seven days a week. This is our first foray into the growing “Infrastructure as a Service” (IaaS) market, and is expected to become a cornerstone of growth for OSS. It also provides our sales teams with the ability to provide ‘try-to-buy’ programs, where customers considering purchase of on premise equipment can first test their compute environment via the SkyScale cloud infrastructure.

SkyScale addresses three classes of customers: First, it provides dedicated HPC GPU compute nodes to end-user customers on a weekly or monthly rental basis. These customers are typically either developers in deep learning and AI, or engineering teams doing complex simulation tasks in vertical industries, like automotive, aerospace, or oil and gas. Second, SkyScale provides the backend hardware cloud infrastructure that can be utilized by specialized cloud service providers that have a front-end customer portal. In this instance, SkyScale’s infrastructure is private-labeled by the front-end service provider and often as a HPC line extension of the AWS (Amazon Web Services) or Microsoft Azure hosted service. Lastly, SkyScale provides virtual private clouds for enterprises that want HPC hardware in the cloud, but also want a dedicated resource rather than using a public service like AWS.

SkyScale cloud offerings are based on today’s latest NVIDIA high end GPU called Pascal (P100). In keeping with our first-to-market strategy, SkyScale will be the first cloud provider to offer NVIDIA’s next generation GPU called Volta (V100) later this year.

Our Cloud Services business is still in its early stages. To date, we have not generated substantial revenues from this line of business.

Our Technology

We design and manufacture high performance computing systems that revolutionize the data center by increasing compute performance while reducing cost and impact to the infrastructure. Our high-density compute accelerators connect directly to a server’s PCIe bus, delivering substantial compute performance. Our flash storage arrays support hundreds of terabytes of high-speed storage that can also be accessed by multiple servers.

Technology Drivers for OSS HPC Business

OSS has developed expertise and core competencies in the three fundamental technology drivers of today’s HPC market. Namely, high-speed serial interconnect technology, massively parallel computing utilizing GPUs, and low latency flash storage. In combination, these technologies are fundamentally changing the economics of computing, bringing HPC within the grasp of a wide range of new industries and commercial applications. Simultaneously the explosion of massive data being generated in each of these industries is pushing the requirement for state-of-the-art HPC technology, AI, and machine learning to transform this data economically and efficiently to useful and actionable information.

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The opportunity is not only to provide competitive advantage for corporations, but also address some of the most fundamental challenges in life science, energy and security facing the world today. OSS is ideally situated to leverage these major industry forces. By exploiting its unique set of expertise in the underpinning technologies of HPC, OSS will continue to deliver world leading HPC solutions, with the opportunity to capture a growing market share of this rapidly expanding marketplace.

Switched Serial Interconnect

Switched serial interconnects are the data highways connecting all elements of today’s high-performance computing platforms. At ever increasing speeds, these pathways move data between system’s processing units, storage, networking, and peripheral elements. Bottlenecks in these data highways negatively impact the overall performance of the applications running on the system. Today for high performance computing the primary processing, direct attached storage and peripheral interconnect is PCIe Gen 3. PCIe Gen 3 has an ability to run up to 16 lanes in parallel, which allows up to 16 gigabytes per second theoretical bandwidth between system elements.

Serial switches incorporated in system design allow many system elements to be connected together in a non-blocking interconnect fabric at PCIe Gen 3 speeds. This allows systems to scale internally avoiding bottlenecks. The serial interconnect can be embedded directly in the computer printed circuit boards, across connectors board-to-board, or traverse across copper or optical cables for chassis-to-chassis connection. Due to the extremely high speeds, the design considerations around signal integrity are rigorous and with unforgiving tolerances. PCIe Gen 4 will begin deployment in early 2018, doubling the interconnect speed, and PCIe Gen 5 is expected early in the next decade.

Serial interconnects are also used to interconnect nodes into larger scale networks and clusters. In this case, the primary interconnects are Infiniband and Ethernet. These technologies have the advantage of scaling to very high numbers of network elements over potentially large distances. The tradeoff over PCIe is higher latency (transit time across the interconnect) and protocol complexity requiring processing cycles to manage. Many HPC deployments incorporate these interconnect technologies in order to deliver large scale solutions with optimized technology selections for each system aspect. In summary, PCIe is used at the local level for the ultimate performance/low latency and these other interconnects are used to expand the network.

GP-GPUs: Computational GPUs.

Over the last several years, GPUs have evolved from graphics display acceleration to becoming general-purpose processing workhorse of HPC systems. Today, the majority of the fastest supercomputers in the world utilize GPUs as their primary compute engines. GPUs are ideal for HPC workloads because of their ability to do massively parallel processing. While traditional CPUs today may have dozens of processing cores, GPUs have thousands of cores that are all able to execute calculations simultaneously.

For many HPC applications, fundamental pieces of the code can be optimized to run in parallel and therefore experience significant performance enhancements. NVIDIA, a key supplier of GPUs to the market, has done extensive benchmarking showing the ability of single GPU based machines to exceed the performance of dozens or even thousands of traditional CPU only computers. NVIDIA has worked extensively with the software development community, and hundreds of HPC applications have been tuned and developed to run on GPUs.

The current NVIDIA GPU Applications catalog lists more than 400 such applications across a broad set of market spaces including:

 

Computational Finance

 

Climate, Weather and Ocean Modeling

 

Computational Chemistry and Biology

 

Data Science and Analytics

 

Deep Learning and Machine Learning

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Federal Defense and Intelligence

 

Genomics

 

Manufacturing

 

Media and Entertainment

 

Medical Imaging

 

Oil and Gas

 

Safety and Security

Many of these applications also scale performance based on the number of GPUs utilized. OSS has designed multi-GPU systems including up to 16 GPUs in a single system. Current state-of-the art GP-GPUs includes Pascal 100 from NVIDIA, providing up to 4.7 teraflops of double precision performance, including 3,584 cores and up to 16 gigabytes of memory. NVIDIA’s next generation GPU, Volta, increases performance to 7.5 teraflops double precision, and includes extensive optimizations for AI algorithms.

Although GPUs provide tremendous application performance advantages, they pose significant system design challenges due to their power requirements. Today’s high-end GPUs can require up to 300 watts of power, which generates a tremendous amount of heat. Sophisticated power distribution and cooling designs are required, especially for large scale systems with multi-GPUs per chassis.

PCI Express Flash Storage

The use of flash memory technology for system storage has gained traction over the last several years, as the cost per gigabyte has continued to drop. Initially relegated to the ‘hot data’ tier in a layered storage architecture, flash memory is now becoming the ubiquitous storage technology in HPC systems across all performance and capacity tiers.

Combined with the move away from traditional rotating hard drive technology has been the trend toward eliminating traditional storage protocols in favor of low latency flash memory protocols. SSD drives using solid state memory connect directly to the system’s PCIe interconnect. This direct connection allows for very high bandwidth between the storage and the other system elements, and eliminates the need for protocol translation as data is moved from storage subsystems to and from the compute complex.

Today, SSD drives with capacities up to 8 terabytes and PCIe Gen 3 interfaces are available. OSS flash storage arrays with hundreds of terabytes of capacity are available, enabling the scaling of high-speed storage to meet the full range of HPC application requirements.

Core Technical Capabilities

For nearly 20 years, OSS has developed unique expertise and core competency across the fundamental technologies of today’s rapidly expanding HPC marketplace. These valuable assets are embedded in the leading-edge engineering capabilities of our engineers, the proprietary intellectual property residing in our vast library of designs, and our brand equity based on our reputation as a high-quality producer of state-of-the-art custom and standard solutions across a broad array of markets.

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High Speed System Interconnect Design

Our electrical engineers are experts in high speed digital signaling design. They have continually designed at the leading edge of the state-of-the-art signaling speeds, as semiconductor technology has driven up the clock rate of digital transmission. We have consistently been among a small handful of companies able to come to market first with the latest technology. In fact, we delivered the industry’s first PCIe link solutions for PCIe Gen 1, Gen 2 and Gen 3 and are currently on track to accomplish this again in Gen 4. The expertise required includes circuit design, PCB (printed circuit board) layout and routing optimizations all with a focus on achieving the highest levels of signal integrity. In our current systems, PCIe Gen 3 signals are propagated across multiple PCBs, connectors, and copper cabling while maintaining the ability to recognize digital signal transitions at 8 billion times per second.

In HPC systems the trajectory of ever increasing signaling speeds will not abate with next generations of PCIe, and nvlink pushing to 16 and 20 gigahertz (billions of transitions per second). An ever-shrinking set of companies have the capability to design robust, highly-reliable systems at these speeds. We believe our core competency in large-scale, high-speed design and layout will allow us to remain on the forefront of this growing industry.

Complex System Design

In addition to low-level signal integrity design expertise, we have amassed expertise and intellectual property in HPC system architecture design. This expertise allows us to develop extremely sophisticated systems with massive scaling, while meeting customer demands for reliability, cost, and flexibility. OSS HPC platforms integrate with server platforms from all major server OEMs, including Dell, HP, IBM, Oracle, and Cisco.

Often elements of the vendor’s servers need to be adapted to meet the scale required by HPC customers. We have developed the deep knowledge for basic input/output systems and operating system adjustments and configuration tuning required. Often, design enhancements are required for each successive generation of CPU technology. Our engineers are often called upon to consult with OEM designers to tune and enhance their systems.

For highly scalable systems, a deep understanding and experience with switching topologies and interconnect fabric design is required. We have worked with serial switching technology starting with the first generation of PCIe and have been an innovator in creating unique and flexible topologies to meet the specific needs of the customers. Creating custom solutions for unique customer solutions is a core competency and relies on this deep knowledge of switch capabilities and limitations.

For maximum system performance, design for optimizing data transfer speeds is also an important consideration. OSS has developed expertise in system design to leverage peer to peer data flows between GPUs and pioneering techniques for optimized data flows between SSD Storage and GPU compute engines. Our systems optimize switch and GPU configuration topologies to optimize GPU to GPU communication without requiring latency-inducing data transfer between host dual processors. Our platforms feature RDMA (remote direct memory access) across compute nodes, which support data transfer without burdening the host CPU.

We continue to be a leader in developing unique solutions leveraging PCIe. These system level design capabilities are uniquely part of our core engineering capabilities, and allow us to respond to specific customer custom requirements with high value, differentiated solutions.

OSS has pioneered the ability to extend the PCIe bus beyond the confines of a single enclosure, opening the possibility of flexible system expansion options. We believe we are one of the leading designers and suppliers of PCIe host bus adapters that extend PCIe signals from the host motherboard across copper or optical cables to expansion enclosures. OSS adapters provide both ends of the external cable connection. Our expertise in high-speed signal design in printed circuit boards, connectors and cables is essential to successful expansion designs. We also hold expertise in incorporating clustering and rack scale expansion into our system designs, including up to 100 gigabit Ethernet, 100 gigabit+ Infiniband, and emerging PCIe top-of-rack switch technology.

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Expertise in power, cooling and mechanical design are required to address the requirements of the HPC customers. We have developed leadership design capability in high-power design and distribution within large rack enclosures. High-end GPUs today require 300 watts or above, and in our high-end systems up to 16 of these can reside in a single chassis. Thousands of kilowatts of redundant power is required. Power stability and huge thermal loads are some of the critical design issues that must be addressed.

We have expertise in power distribution, redundant power and complex chassis cooling design, including materials selection, airflow simulation, fan technology, liquid cooling, and cable routing. We have also developed extensive intellectual property in regulatory compliance of complex HPC system design across emission, shock, vibration, thermal, humidity and other environmental requirements that are required for highly reliable and highly available solutions. OSS engineers are experts in design for regulatory testing for FCC (Federal Communications Commission), CE (European Conformity), UL (Underwriters Laboratories), and Mil-Spec (Military Standard). Additionally, we have expertise in rapid prototyping, design for manufacturability, and design for serviceability.

Storage Management Software

Given our hardware design and integration expertise, we see the next natural step is to add a robust software capability that will allow us to offer more optimized and customized systems. By licensing source code for the Ion software and hiring the members of the software design team from Western Digital, we now have the in-house expertise to deliver full server and storage solutions that produce the highest performance from today’s leading-edge flash storage, GPUs and processors.

The Ion software allows flash-based cards and drives to be put into a variety of storage and network configurations, which can then be accessed by multiple servers. The Ion software can do this cost-effectively, while preserving the low latency that is vital for many business and mission-critical enterprise applications, from database and transaction processing to massive data collection programs. Ion also has a full high-availability option to ensure complete data integrity.

In-house mature and established foundational storage software allows OSS to add new products and capabilities to its product portfolio. Possibilities range from increasing data efficiency with de-duplication and compression, to improving system manageability and adding software-defined storage to our server products.

Given the recent closing of the Ion transaction, we have yet to generate substantial revenues from this line of business.

Benefits of Technology and Core Capabilities to our Customers

Due to our core capabilities, we can provide our HPC customers with high-performance platforms possessing extreme reliability and cost effectiveness. Such performance allows our customers to solve bigger problems faster, and save the cost and time of highly-paid engineers, data scientists, and other human resources. Our technology enhances innovation by allowing more ‘what-if’ analysis in a finite amount of time. Our price/performance leadership enhances our customers’ competitiveness, and lowers capital expense and total cost of ownership.

Our Products

OSS has developed a complete line of products that have been customized for the benefit of its customers.

GPU Appliances – high-density, fully integrated computer clusters that are purpose-built for user applications. They provide thousands of cores and hundreds of teraflops of computing performance.

GPU Expansion – expansion units can add hundreds or thousands of computing cores with hundreds of teraflops of computing performance to virtually any OEM server.

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Flash Storage and Network Appliances – networked storage appliances optimized for the environment and system software of our customers. These offer flexible and powerful turnkey, customer-driven solutions for the HPC market.

Flash Storage Arrays – arrays that provide hundreds of terabytes of storage and millions of input/output operations per second with flash memory. They are flexible, powerful, and configurable for customers in the HPC market.

Servers – OSS designs servers optimized for PCIe-over-cable expansion. Available in various turn-key and custom configurations, they provide simple, reliable and cost-effective server solutions. These servers are optimized to work seamlessly with other OSS systems and appliances.

Desktop Computing Appliances – OSS designs and builds desktop expansion appliances in many configurations that add input/output flexibility to any user’s desktop system. These appliances come pre-configured with many combinations of flash memory, GPU, and coprocessors.

PCIe Expansion – PCIe is the standard for high speed connectivity from a server to a PCIe device. It provides vastly faster throughput compared to USB or Ethernet in a simple, cost-effective connection. It requires no special software, which adds no overhead to the system, and improves latency of throughput. OSS provides cables, kits, backplanes, enclosures, switches, and adaptor cards for this market.

Customers

We serve a global clientele consisting of multinational companies, governmental agencies, and leading technology providers. Some of our key customers are set forth below, including case studies illustrating how we provide custom solutions.

Epoch Concepts/Northrup Grumman/Missile Defense Agency – Epoch Concepts distributes enterprise virtualization and information technology solutions. The company offers system integration, implementation, disaster recovery, storage and desktop consolidation, network and server optimization, and application acceleration solutions. It caters to commercial, governmental, and public sectors. Epoch holds major defense and governmental contracting vehicles. OSS is working with Epoch and its customer, Northrup Grumman, to provide custom quad socket servers and 16 GPU compute accelerators to the Missile Defense Agency for radar simulation applications.

Raytheon/US Navy – OSS is working closely with Raytheon to build a customized flash storage array, with flash drives installed in removable canisters. Raytheon has installed these drives on a current military aircraft equipped with multiple sensors and data capture arrays. These devices are fully compliant with appropriate military specifications, include shock and vibration. Each canister has the capacity to save 50 terabytes of data and weighs only 6.5 pounds. This compares to a previous data storage device that weighed more than 155 pounds. Data is captured onto the OSS flash array canisters, which can be easily removed at the end of the mission for analysis. Our expertise in designing and manufacturing the highest-density flash arrays in the lightest, most compact package allow military aircraft to realize faster turn-arounds during critical missions. Not only will they use our products on new aircraft, the larger opportunity is retrofitting the fleet to this desired technology.

disguise (formerly d3) – disguise is the leading provider of hardware and software, including workflow that allows their customers to produce live events, television broadcasts, theater effects, and special effects for concert tours. OSS has worked with disguise to design purpose-built, custom servers that act as video controllers for special effects at these events. These servers work seamlessly with disguise software applications, providing up to 16 simultaneous video outputs that supports a rich array of special effects. Events like the Super Bowl halftime show and numerous musical concerts rely upon disguise controllers, designed and produced by OSS, to deliver a lasting impression on audiences. OSS and disguise entered into an Original Equipment Manufacturing and Supply Agreement (“OEM Agreement”), dated as of October 1, 2015. Per the terms of the OEM Agreement, disguise is not required to purchase a minimum amount of products from OSS but we continue to win the new designs. The OEM Agreement is for a five (5) year term, subject to extension upon mutual agreement of the parties.

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National Instruments – National Instruments is a market leader and multinational company that produces automated test equipment and virtual instrumentation software. OSS provides several PXI/PXIe/PCIe interface cards that are branded by National Instruments. OSS acts as an extension to National Instruments’ engineering group, allowing National to complete their product roadmap in a timely and cost-effective manner.

Sales and Marketing

Our sales and marketing efforts our focused on promoting sales and brand awareness.

Sales

Our sales efforts entail three main areas:

 

End-user Sales – OSS maintains a web site and direct sales team that sell directly to end-users. This includes e-commerce sales via typical web store functionality, and direct calling of end-user customers to provide unique solutions that fits their needs. The OSS direct sales team typically works in the OSS booth at tradeshows, directly interacting with potential customers and presenting solutions for their HPC needs.

 

OEM Sales – Our direct sales team also works to identify and develop potential OEM customers. This is the largest and fastest growing part of our business. For typical OEM customers, we design and build customer specified systems that are branded with the OEMs name and label. These companies then resell the products through their own channels. We actively seek this type of relationship, which is leveraged as a sales multiplier, allowing us to grow sales at a faster rate without adding more dedicated sales resources.

 

Channels – We have a dedicated sales resource that manages our worldwide network of resellers and distributors. We typically sell standard products through these channels, which allow us to achieve global customer touch without requiring a physical presence in all geographies.

Marketing

Our marketing department focuses on building cost effective brand awareness in several ways. We generate interest by utilizing traditional and non-traditional marketing to convey the uniqueness and compelling value of our products and services. The markets we target include machine learning, deep learning, finance, defense/government, oil and gas exploration, virtual desktop infrastructure (VDI), media and entertainment. Among the many channels utilized are:

 

Social Media – We regularly use Facebook and Twitter to instantly alert the followers of OSS to new events, products, services, and customer stories.

 

Publications – We periodically publish white papers, customer success stories, and other demand generation articles in periodicals and newsletters that include InsideHPC, Storage Newsletter, and HPC wire. We also purchase some print ads in many industry magazines.

 

Trade Shows – OSS participates in many tradeshow and events during the marketing year. Among these are AFCEA/USNI West, Rice University Oil and Gas Conference, National Association of Broadcasters (NAB), GPU Technology Conference (GTC), Gearfest, ISC (high performance computing show), HPC Summit, Cloud Expo (via SkyScale), AI World (via SkyScale), Supercomputing, and GTC Tokyo. OSS evaluates the value and costs of each show on an annual basis, and the number and themes of our participation may change from year to year.

As we grow, it is anticipated our marketing efforts will likewise continue to increase in size and diversity.

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Competition

In many cases, our primary competition is actually our potential customer. Our operational model lends itself to understanding technical and physical specifications, completing a rapid design based on our library of over 600 previous designs and prototypes, building a rapid prototype for customer approval, and an efficient design-to-manufacturing process.

Most of our OEM customers have sophisticated design capabilities in-house. They come to OSS for our particular expertise and experience, which allows us to work collaboratively with the customer to produce more advanced systems in a shorter timeframe. In most cases, the primary alternative to engaging OSS is for the customer to design the products themselves. We win when our customers realize that together we can produce better products faster and more cost-effectively than they can themselves. This has proven to be particularly evident when customers require state-of-the-art products that are constructed of parts available commercially. This has resulted in several design wins that demonstrate our flexibility and how we can work closely with large OEM and government customers.

We also compete with established competitors, third party competitive products and new entrants into the markets we serve. Established competitors include IBM, Lenovo, HP and Dell. Each offers a broad range of standard products and services for this market. In many cases, these companies are able to meet their customer needs thought their standard product offerings. In other cases, these companies work with us to help extend their product capabilities to meet customer-specific requirements.

Third party competitive products include cases where the manufacturers of the underlying chip or board-level products decide to also offer system-level products. This is the case with Intel, NVIDIA, Western Digital and others. These offerings tend to be tactical, short-term products that are intended to demonstrate a new technology, rather than long-term forays into the systems business. In addition these “technology demonstration systems” tend to be priced at high levels, making them less competitive once the newness factor wears off.

New market entrants continue to move into the rapidly evolving HPC space. Some, such as Pure Storage, Next IO and Violin Memory, raise tremendous amounts of capital and endure huge loses in an attempt to establish market share. Some of these companies come and go fairly quickly (note Next IO and Violin Memory are both out of business) as they ran out of capital to continue operations over the long term.

Manufacturing and Operations

OSS is certified under ISO 9001-2008 for “design, manufacture, and supply of industrial computers.” This means OSS has demonstrated its ability to consistently provide products that meet both customer requirements and applicable regulatory or statutory requirements. It also indicates that we have programs and processes in place to ensure a high level of customer satisfaction, as well as a continuous improvement program that ensures OSS gets better over time.

We utilize lean principles to drive our manufacturing and assembly process. One of the key aspects of this is our application of just-in-time principles that ensure effective ordering and utilization of inventory, and this helps optimize cash flow throughout the manufacturing cycle. Within the manufacturing process, our operations encompass three categories of “builds:”

 

Standard Builds – These are builds of standard products that are sold with little or no customization or non-standard features. These are products that are ready to be installed or integrated by the customer upon receipt.

 

Custom Builds – Custom builds involve a product built to a customer specification. Upon receipt, the customer has a unique product that performs all the functions and has the physical dimensions that match their specifications.

 

Engineering Project Builds – OSS supports the product development process by building models and prototypes of products. Developed by the OSS engineering group, the prototypes can be of standard or custom products.

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OSS is dedicated to quality and customer satisfaction. Within the manufacturing operations function at OSS, our processes begin with the end goal in mind. This means we start with the customer. All our business processes begin with the idea that the customer is the essence of why we exist. Our continuous improvement efforts require us to review products, services, and processes with the idea that minor changes can lead to greater outcomes for our customers.

While we are cognizant of the additive nature of small improvements, we believe a disciplined approach to improvement sometime leads to extraordinary, large, and positive advances in our products and services. This is extremely important to OSS, as our goal is to bring the most advanced leading-edge technologies to our customers before our competitors can. Our operations strategy supports our overall mission of being first to market with customized, leading-edge products that are best-in-market in terms of speed and overall performance.

Research and Development

Research and development at OSS is centered on the exploitation of key technologies as they evolve in the marketplace. Our product roadmap reflects new component technologies for CPUs, GPUs, flash storage, and advanced PCIe switches. We design first-to-market, custom implementations utilizing these component technologies. Accordingly, our focus lies not in the capital-intensive development of silicon implementations of technologies (i.e., chips, processors, GPUs, or storage devices), but rather in taking leading-edge technologies and building first-to-market products that fully exploit those technologies for solving customer problems.

The OSS research and development strategy can be summarized as follows: OSS drives design wins by utilizing key new technologies to develop products that are leading edge and first to market.

Some examples of OSS developments:

 

GPU compute accelerators with the most GPUs per rack unit.

 

Networking of GPUs.

 

Broad range of solutions, due to specific customer design.

 

Capability to expand existing servers from virtually any OEM.

 

First-to-market products as new GPUs are introduced by NVIDIA, Intel, Western Digital and Broadcom.

 

Complete customization per the needs of our OEM customers.

 

Integration of multiple new technologies (servers, GPUs, flash drives, and PCIe) into an optimized product for our OEM customers.

Intellectual Property

The primary intellectual property basis of OSS emanates from the more than 600 individual design projects we have undertaken over the decades since our founding. These designs are archived and cataloged, so we rarely begin a new design from scratch.

Over the years, our team has developed and maintained expertise in high-speed signal design and analysis, electronic and mechanical packaging, PCIe-over-cable, fiber optics transmission, high-speed/density flash arrays, and integration and deployment of GPUs in compute accelerators and servers. This extensive expertise positions us to expand and rationalize our product line to meet the growing and ever-changing HPC market.

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Employees

As of December 31, 2017, we had approximately 75 employees including several contracted personnel. Our employees are typically highly skilled as engineers, technicians, assemblers, and support staff. They are housed in four facilities, and are led by a management team that is supportive and helpful. We have experienced very little turnover of personnel in the past and endeavor to provide an environment that allows meaningful employee input to all functional areas of the Company. The management team provides transparency to its employees through monthly communication meetings designed to update all employees on current results and future expectations. None of our employees are covered by a collective bargaining agreement or represented by a labor union. We consider our relationship with our employees to be strong.

Facilities

Our corporate headquarters are in a leased space comprising approximately 17,911 square feet in Escondido, California under a lease that expires in August 2018. We occupy another facility in San Diego with approximately 13,588 square feet, which also expires in August 2018. SkyScale operates out of our San Diego facility and also leases data center space at a local data center. We also lease a small space near Munich, Germany for our German subsidiary, OSS GmbH and a 3,208 square foot facility in Salt Lake City, Utah that houses our Ion software development team. We are in the process of determining whether we want to extend our leases at the Escondido and San Diego locations or consolidate into a single, larger facility. We periodically review our lease arrangements at our Germany and Utah locations to determine whether they suit our needs.

Available Information

We file electronically with the Securities and Exchange Commission, or SEC, our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended. We make available on our website at www.onestopsystems.com, free of charge, copies of these reports, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. The public may read or copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street NE, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of that website is www.sec.gov. The information in or accessible through the SEC and our website are not incorporated into, and are not considered part of, this filing. Further, our references to the URLs for these websites are intended to be inactive textual references only.

Legal Proceedings

From time to time, we may be a party to legal proceedings and subject to claims incident in the ordinary course of business. Although the results of litigation and claims cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse effect on our financial condition or business. Regardless of outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources, and other factors.

ITEM 1A. RISK FACTORS

Investing in our common stock involves a high degree of risk. You should carefully consider the risks described below, as well as the other information in this Annual Report, including our financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” before deciding whether to invest in our common stock. The occurrence of any of the events or developments described below could harm our business, financial condition, operating results, and growth prospects. In such an event, the market price of our common stock could decline, and you may lose all or part of your investment. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations.

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Risks Related to Our Business and Industry

The market for our products is developing and may not develop as we expect.

The market for our high performance computing (“HPC”) products is developing and may not develop as we expect. The market for cutting-edge, high performance computing products is characterized by rapid advances in technologies. We believe our future success will depend in large part on our ability to develop products, new business initiatives and creating innovative and custom designs for our customers. The growth of server clusters, specialized or high performance applications, and hosted software solutions which require fast and efficient data processing, is crucial to our success. It is difficult to predict the development of the demand for high performance computing, supercomputers, and related hardware solutions, the size and growth rate for this market, the entry of competitive products, or the success of existing competitive products. Any expansion in our market depends on several factors, including the demand, cost, performance, and perceived value associated with our products. If our products are not adopted or there is a reduction in demand for our products caused by a lack of customer acceptance, a slowdown in demand for computational power, an overabundance of unused computational power, technological challenges, competing technologies and products, decreases in corporate spending, weakening economic conditions, or otherwise, it could result in reduced customer orders, early order cancellations, the loss of customers, or decreased sales, any of which would adversely affect our business, operating results, and financial condition.

Our operating results may fluctuate significantly, which makes our future operating results difficult to predict and could cause our operating results to fall below expectations or our guidance.

Our quarterly and annual operating results have fluctuated in the past and may fluctuate significantly in the future, which makes it difficult for us to predict our future operating results. The timing and size of sales of our products are variable and difficult to predict and can result in fluctuations in our net sales from period to period. In addition, our budgeted expense levels depend in part on our expectation of future sales. Any substantial adjustment to expenses to account for lower levels of sales is difficult and takes time, thus we may not be able to reduce our costs sufficiently to compensate for a shortfall in net sales, and even a small shortfall in net sales could disproportionately and adversely affect our operating margin and operating results for a given quarter.

Our operating results may also fluctuate due to a variety of other factors, many of which are outside our control, including the changing and volatile local, national, and international economic environments, any of which may cause our stock price to fluctuate. Besides the other risks in this “Risk Factors” section, factors that may affect our operations include:

 

fluctuations in demand for our products and services;

 

the inherent complexity, length, and associated unpredictability of product development windows and product lifecycles;

 

changes in customers’ budgets for technology purchases and delays in their purchasing cycles;

 

changing market conditions;

 

any significant changes in the competitive dynamics of our markets, including new entrants, or further consolidation;

 

our ability to continue to broaden our customer base beyond our traditional customers;

 

the timing of product releases or upgrades by us or our competitors; and

 

our ability to develop, introduce, and ship in a timely manner new products and product enhancements and anticipate future market demands that meet our customers’ requirements.

Each of these factors individually, or the cumulative effect of two or more of these factors, could result in large fluctuations in our quarterly and annual operating results. As a result, comparing our operating results on a period-to-period basis may not be meaningful. You should not rely on our past results as an indication of future performance.

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Our products are subject to competition, including competition from the customers to whom we sell.

Servers, computer accelerators, flash storage arrays, PCIe expansion products, and other products that we design, manufacture, and sell or license are subject to competition. The computer hardware and technology fields are well established with limited, and in many cases no, intellectual property and technological barriers to entry. The markets in which we operate are competitive and we expect competition to increase in the future from established competitors and new market entrants. The markets are influenced by, among others, brand awareness and reputation, price, strength and scale of sales and marketing efforts, professional services and customer support, product features, reliability and performance, scalability of products, and breadth of product offerings. Due to the nature of our products, competition occurs at the design, performance, and sales stages. A design or sales win by us does not limit further competition and our customers may purchase competitive products from third parties at any time. This competition could result in increased pricing pressure, reduced profit margins, increased sales and marketing expenses and failure to increase, or the loss of, market share, any of which would likely seriously harm our business, operating results or financial condition. From a cost and control perspective, our products are specialized and thus generally cost more than our competitors’ products. If our ability to design specialized solutions is deemed to be on par or of lesser value than competing solutions, we could lose our customers and prospects.

Many of our customers and competitors, often with substantially more resources or larger economies of scale, produce products that are competitive with our products. Many of these third parties mass-produce hardware solutions and have not heavily invested in or allocated resources to the smaller scale specialized products and solutions we design. A decrease in the cost of general mass-produced hardware solutions, which can serve as a substitute for our products, or the entrance of or additional allocation of resources by one of these customers or competitors into the production of specialized systems which compete with our products could create increased pricing pressure, reduced profit margins, increased sales and marketing expenses, or the loss of market share or expected market share, any of which may significantly harm our business, operating results and financial condition.

New entrants and the introduction of other distribution models in our markets may harm our competitive position.

The markets for development, distribution, and sale of our high performance computing solutions are rapidly evolving. New entrants seeking to gain market share by introducing new technology, new products and new server configurations may make it more difficult for us to sell our products and earn design wins which could create increased pricing pressure, reduced profit margins, increased sales and marketing expenses, or the loss of market share or expected market share, any of which may significantly harm our business, operating results and financial condition.

Large computer hardware and equipment manufacturers and suppliers have traditionally designed, produced, and sold general purpose servers, and storage arrays and related products and equipment. Our customers supplement these general purpose systems by purchasing our specialized or customized systems or supplemental products which improve the speed, efficiency, or performance of such systems. If the speed, efficiency, or computational power of such general purpose systems increases such that supplemental or specialized products become unnecessary, or the cost of such general purpose systems declines such that it is more cost effective for prospective customers to add general-purpose equipment rather than specialized or supplemental equipment, we could experience a significant decline in demand for the products which may significantly harm to our business, operating results and financial condition.

Our products compete with and supplement general purpose servers, storage systems and related equipment. If the producers of general purpose equipment implement proprietary standards, software, interfaces, or other interoperability restrictions, including controls which restrict the equipment’s compatibility with third party systems, we could experience a significant decline in sales because our products would not be interoperable with such systems, resulting in may significantly harm to our business, operating results and financial condition.

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In our marketplace, general-purpose equipment is traditionally mass-produced and available to order while specialized equipment and custom bulk-order equipment is subject to a bid-based purchase system. If one or more large manufacturers of general or standard servers storage arrays, or related products and equipment provide specialized, customized, or supplementary equipment on a made-to-order or generally available basis, we could be forced to reduce our prices or change our selling model to remain competitive which would significantly harm to our business, operating results and financial condition.

If we are unable to manage our growth and expand our operations successfully, our business and operating results will be harmed and our reputation may be damaged.

We have expanded our operations significantly since inception and anticipate that further significant expansion will be required to achieve our business objectives. The growth and expansion of our business and product offerings places a continuous and significant strain on our management, operational and financial resources. Any such future growth would also add complexity to and require effective coordination throughout our organization. To manage any future growth effectively, we must continue to improve and expand our information technology and financial infrastructure, our operating and administrative systems and controls, and our ability to manage headcount, capital and processes in an efficient manner. We may not be able to successfully implement improvements to these systems and processes in a timely or efficient manner, which could result in additional operating inefficiencies and could cause our costs to increase more than planned. If we do increase our operating expenses in anticipation of the growth of our business and this growth does not meet our expectations, our operating results may be negatively impacted. If we are unable to manage future expansion, our ability to provide high quality products and services could be harmed, which could damage our reputation and brand and may have a material adverse effect on our business, operating results and financial condition.

A limited number of customers and devices represent a significant portion of our sales. If we were to lose any of these customers or devices, our sales could decrease significantly.

In the fiscal years ended December 31, 2017 and December 31, 2016, one customer, disguise (formerly d3), accounted for approximately 37%, and 29% of net sales, respectively. As of December 31, 2017, three customers accounted for 68% of net trade accounts receivable and, as of December 31, 2016, three customers accounted for 56% of net trade accounts receivable. In addition, a few products comprise a significant amount of our sales, and the discontinuation, modification, or obsolescence of such products may materially and adversely affect our sales and results of operations. Any loss of, or a significant reduction in purchases by, these other significant customers or a decrease in the high performance applications that drive the use of our products, or the modification, discontinuation, or obsolescence of a device which constitutes a significant portion of our sales could have an adverse effect on our financial condition and operating results.

We rely on a limited number of parts suppliers to support our manufacturing and design processes.

We rely on a limited number suppliers to provide us with the necessary devices, parts and systems to allow us to build, design and manufacture our products, and the failure to manage our relationships with these parties successfully could adversely affect our ability to market and sell our products. In the fiscal years ended December 31, 2017 and December 31, 2016, two suppliers, Concisys, Inc. and Exact Computers, accounted for approximately 40%, and 46%, respectively, of materials purchased.

Although we do believe we could locate additional suppliers to fulfill our needs, any significant change in our relationship with these suppliers could have a material adverse effect on our business, operating results, and financial condition unless and until we are able to find suitable replacements. We make substantially all of our purchases from our contract suppliers on a purchase order basis. Our suppliers are not required to supply our raw materials for any specific period or in any specific quantity or price.

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Our future success depends on our ability to develop and successfully introduce new and enhanced products that meet the needs of our customers.

Our sales depend on our ability to anticipate our existing and prospective customers’ needs and develop products that address those needs. Our future success will depend on our ability to design new products, anticipate technological improvements and enhancements, and to develop products that are competitive in the rapidly changing computer hardware and software industry. Introduction of new products and product enhancements will require coordination of our efforts with those of our customers, suppliers, and manufacturers to develop products that offer performance features desired by our customers and performance and functionality superior or more cost effective than solutions offered by our competitors. If we fail to coordinate these efforts, develop product enhancements or introduce new products that meet the needs of our customers as scheduled, our operating results will be materially and adversely affected, and our business and prospects will be harmed. We cannot assure that product introductions will meet our anticipated release schedules or that our products will be competitive in the market. Furthermore, given the rapidly changing nature of the computer equipment market, there can be no assurance our products and technology will not be rendered obsolete by alternative or competing technologies.

Delays in our production cycle could result in outdated equipment or decreased purchases of our products.

The design and manufacture of our products can take several months to several years. The length of such process depends on the complexity and purpose of the system or equipment being designed, and may be affected by factors such as: the development and design of unique or specialized systems, the fabrication, availability, and supply of parts, the customization of parts as applicable, the manufacture and/or assembly of the units, quality control testing, and the development and incorporation of new technologies. If our products are outdated upon completion of this process our sales could materially decline and it may be necessary to sell products at a loss.

Unsuccessful government programs or OEM contracts could lead to reduced revenues.

We design and manufacture certain products to fit the specifications of government programs or OEM contracts. These programs may take months or years to complete and involve significant investment of our time, money and resources. We generally receive upfront fees for these programs but there is often no or little obligation on the part of our customer to purchase large volumes of products at the time of final product launch. Unsuccessful product launches could lead to reduced revenues, potential returns of products and have a material adverse effect on our financial condition and operating results. We may be forced to sell products at a loss or spend a significant amount of resources to find additional customers for these products if these programs do not fit the future needs of our intended customers.

Our inventory may rapidly become obsolete.

Sales cycles for some of our products can take several months. In addition, it can take time from the bid to the development and manufacture of the equipment. We maintain inventory based in large part on our forecasts of the volume and timing of orders. The varying length of the sales cycles makes accurate forecasting difficult. The delays inherent in our sales cycles raise the risk that the inventory we have on hand will become obsolete or impaired prior to its use or sale. If our forecasted demand does not materialize into purchase orders, we may be required to write off our inventory balances or reduce the value of our inventory, based on a reduced sales price. A write off of the inventory, or a reduction in the inventory value due to a sales price reduction, could have an adverse effect on our financial condition and operating results.

We offer an extended product warranty to cover defective products at no cost to the customer. An unexpected change in failure rates of our products could have a material adverse impact on our business.

We offer product warranties that generally extend for one year from date of sale that requires us to repair or replace defective products returned by the customer during the warranty period at no cost to the customer. Our product warranties are in addition to warranties we receive from our vendors. We record an estimate for anticipated warranty-related costs at the time of sale based on historical and estimated future product return rates and expected repair or replacement costs. While such costs have historically been within management’s expectations and the provisions established and we receive warranty coverage from our vendors, unexpected changes in failure rates could have a material adverse impact on our business requiring additional warranty reserves. These failures could adversely impact our operating results.

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If we fail to achieve design wins for our products, our business will be harmed.

Achieving design wins is an important success factor for our business. We work closely with OEM’s and end users to insure the customer gets the product they want in the specific configuration, size and weight required for the application. We have participated in many design wins based upon our ability to interpret technical specifications and proceed rapidly through prototyping, development, and delivery. This approach and expertise is one of the factors driving our growth. Failure to maintain our expertise and ability to deliver custom, specific design systems could harm our business. In order to achieve design wins, we must:

 

anticipate the features and functionality that OEMs, customers and consumers will demand;

 

incorporate those features and functionalities into products that meet the exacting design requirements of our customers; and

 

price our products competitively.

Unanticipated changes in industry standards could render our products incompatible with products developed by major hardware manufacturers and software developers. Further, if our products are not in compliance with prevailing industry standards, our customers may not incorporate our products into their design strategies.

If we cannot retain, attract and motivate key personnel, we may be unable to effectively implement our business plan.

Our success depends in large part upon our ability to retain, attract and motivate highly skilled management, development, marketing, sales and service personnel. The loss of and failure to replace key technical management and personnel could adversely affect multiple development efforts. Recruitment and retention of senior management and skilled technical, sales and other personnel is very competitive, and we may not be successful in either attracting or retaining such personnel. We have lost key personnel to other high technology companies, and many larger companies with significantly greater resources than us have aggressively recruited, and continue to aggressively recruit, key personnel. As part of our strategy to attract and retain key personnel, we may offer equity compensation through grants of stock options, restricted stock awards or restricted stock units. Potential employees, however, may not perceive our equity incentives as attractive enough. In addition, due to the intense competition for qualified employees, we may be required to, and have had to, increase the level of compensation paid to existing and new employees, which could materially increase our operating expenses.

We have made in the past, and may make in the future, acquisitions which could require significant management attention, disrupt our business, result in dilution to our stockholders, deplete our cash reserves and adversely affect our financial results.

Acquisitions involve numerous risks, including the following:

 

difficulties in successfully integrating the operations, systems, technologies, products, offerings and personnel of the acquired company or companies;

 

insufficient revenue to offset increased expenses associated with acquisitions;

 

diversion of management’s attention from normal daily operations of the business and the challenges of managing larger and more widespread operations resulting from acquisitions;

 

potential difficulties in completing projects associated with in-process research and development intangibles;

 

difficulties in entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions;

 

initial dependence on unfamiliar supply chains or relatively small supply partners; and

 

the potential loss of key employees, customers, distributors, vendors and other business partners of the companies we acquire following and continuing after announcement of acquisition plans.

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Acquisitions may also cause us to:

 

use a substantial portion of our cash reserves or incur debt;

 

issue equity securities or grant equity incentives to acquired employees that would dilute our current stockholders’ percentage ownership;

 

assume liabilities, including potentially unknown liabilities;

 

record goodwill and non-amortizable intangible assets that are subject to impairment testing on a regular basis and potential periodic impairment charges;

 

incur amortization expenses related to certain intangible assets;

 

incur large and immediate write-offs and restructuring and other related expenses; or

 

become subject to intellectual property litigation or other litigation.

Acquisitions of high-technology companies and assets are inherently risky and subject to many factors outside of our control and no assurance can be given that our recently completed or future acquisitions will be successful and will not materially adversely affect our business, operating results, or financial condition. Failure to manage and successfully integrate acquisitions could materially harm our business and operating results.

The continuing commoditization of HPC hardware and software has resulted in increased pricing pressure and may adversely affect our operating results.

The continuing commoditization of HPC hardware, such as processors, interconnects, flash storage and other infrastructure, and the growing commoditization of software, including plentiful building blocks and more capable open source software, as well as the potential for integration of differentiated technology into already-commoditized components, has resulted in, and may result in increased pricing pressure that may cause us to reduce our pricing in order to remain competitive, which can negatively impact our gross margins and adversely affect our operating results.

Our election to not opt out of the extended accounting transition period under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, may make our financial statements difficult to compare to other companies.

Under the JOBS Act, as an emerging growth company, we can elect to opt out of the extended transition period for any new or revised accounting standards that may be issued by the Financial Accounting Standards Board (“FASB”) or the U.S. Securities and Exchange Commission (the “SEC”). We have elected not to opt out of such extended transition period. This means that when a standard is issued or revised and it has different application dates for public or private companies, we, as an emerging growth company, are permitted to use any extended transition period for adoption that is provided in the new or revised accounting standard having different application dates for public and private companies. This may make the comparison of our financial statements with any other public company, which is not either an emerging growth company nor an emerging growth company which has opted out of using the extended transition period, difficult or impossible as possible different or revised standards may be used.

If we are unable to implement and maintain effective internal control over financial reporting in the future, the accuracy and timeliness of our financial reporting may be adversely affected. In addition, because of our status as an emerging growth company, you will not be able to depend on any attestation from our independent registered public accounting firm as to our internal control over financial reporting for the foreseeable future.

The Sarbanes-Oxley Act requires, among other things, that we assess disclosure controls and procedures and controls over financial reporting. In particular, we are required to perform system and process evaluations and testing of our internal control over financial reporting to allow management to report on the effectiveness of our internal controls over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act. We will be required to furnish a report by management on, among other things, the effectiveness of our internal control over financial

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reporting beginning with the fiscal year ended December 31, 2018. However, our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act until the later of the year following our first annual report required to be filed with the SEC or the date we are no longer an “emerging growth company” as defined in the JOBS Act. Accordingly, you will not be able to depend on any attestation concerning our internal control over financial reporting from our independent registered public accounting firm for the foreseeable future.

We have identified certain material weaknesses in our internal control over financial reporting. If we fail to remedy these material weaknesses and develop and maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results or prevent fraud. As a result, stockholders could lose confidence in our financial and other public reporting, which would harm our business and the trading price of our common shares.

We have identified material weaknesses in our internal control over financial reporting as of December 31, 2017. As defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended, or the Exchange Act, a “material weakness” is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. Specifically:

 

(i)

we did not have sufficient segregation of duties within our accounting functions; and

 

(ii)

we lacked appropriate controls to ensure the accuracy of labor and overhead inventory rates as well as excess and obsolescence inventory reserves.

Management is in the process of remediating the material weaknesses set forth above, as follows:

 

To address the identified weaknesses surrounding segregation of duties, supervision and expertise, in September 2017, we hired a chief financial officer with appropriate experience applying GAAP technical accounting guidance and have increased the number of hours worked by our contracted accounting personnel who are responsible for the closing process and external financial reporting. With the introduction of additional personnel, incompatible functions with respect to the segregation of duties and the recording of a transaction (including the review and approval processes) are being reassigned to different personnel to strengthen the control environment.

 

To strengthen the weaknesses in the control environment surrounding inventory and inventory valuation, we have and continue to evolve a new analytical process to identify slow-moving and obsolete inventory as well as formalizing the methodology for application of labor overhead to inventory. We are also strengthening the controls regarding physical verification of inventory on-hand.

Our remediation plan also includes relevant and appropriate training on technical GAAP topics, as well as SEC reporting requirements.

We intend to complete the implementation of our remediation plan during the first and second quarters of 2018. Except for additional personnel costs, we have not incurred any material costs on our remediation plan to date as we have been implementing the plan internally. As we continue to evaluate and take actions to improve our internal control over financial reporting, we may determine to take additional actions to address control deficiencies or determine to modify certain of the remediation measurements that we are anticipating to make which may include retaining a third party to assist with the implementation of our remediation plan. The retention of third party service providers for purposes of remediation may involve us incurring material costs in the future.

Effective internal control over financial reporting is necessary for us to provide reliable financial reports and, together with adequate disclosure controls and procedures, are designed to prevent fraud. Any failure to implement required new or improved controls, or difficulties encountered in their implementation could cause us to fail to meet our reporting obligations. In addition, any testing by us conducted in connection with Section 404 of the Sarbanes-Oxley Act or any subsequent testing by our independent registered public accounting firm may reveal additional deficiencies in our internal control over financial reporting that are deemed to be material weaknesses or significant deficiencies, or that may require prospective or retroactive changes to our financial statements or identify other areas

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for further attention or improvement. Inferior internal control over financial reporting could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock.

Risks Relating to Intellectual Property

If we are unable to protect our proprietary design and intellectual property rights, our competitive position could be harmed or we could be required to incur significant expenses to enforce our rights.

Our ability to compete effectively is dependent in part upon our ability to protect our proprietary technology. We rely on patents, trademarks, trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. There can be no assurance these protections will be available in all cases or will be adequate to prevent our competitors from copying, reverse engineering or otherwise obtaining and using our technology, proprietary rights or products. For example, the laws of certain countries in which our products are manufactured or licensed do not protect our proprietary rights to the same extent as the laws of the United States. In addition, third parties may seek to challenge, invalidate or circumvent our patents, trademarks, copyrights and trade secrets, or applications for any of the foregoing. There can be no assurance that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology or design around our proprietary rights. In each case, our ability to compete could be significantly impaired. To prevent substantial unauthorized use of our intellectual property rights, it may be necessary to prosecute actions for infringement and/or misappropriation of our trade secrets and/or proprietary rights against third parties. Any such action could result in significant costs and diversion of our resources and management’s attention, and there can be no assurance we will be successful in such action. Furthermore, many of our current and potential competitors have the ability to dedicate substantially greater resources to enforce their intellectual property rights than we do. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our trade secrets and/or intellectual property.

Many of our proprietary designs are in digital form and the breach of our computer systems could result in these designs being stolen.

If our cybersecurity measures are breached or unauthorized access to private or proprietary data is otherwise obtained, our proprietary designs could be stolen. Because we hold many of these designs in digital form on our servers, there exists an inherent risk that an unauthorized third party could conduct a cybersecurity breach resulting in the theft of our proprietary information. While we have taken cybersecurity steps to protect our proprietary information, because techniques used to obtain unauthorized access or sabotage systems change frequently and generally are not identified until they are launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. Any or all of these issues could negatively impact our competitive edge and our ability to obtain new customers thereby adversely affecting our financial results.

Our proprietary designs are susceptible to reverse engineering by our competitors.

Much of the value of our proprietary rights is derived from our vast library of design specifications. While we consider our design specifications to be protected by various proprietary, trade secret and intellectual property laws, such information is susceptible to reverse engineering by our competitors. We may not be able to prevent our competitors from developing competing design specifications and the cost of enforcing these rights may be significant. If we are unable to adequately protect our proprietary designs our financial condition and operating results could suffer.

If we are unable to protect the confidentiality of our trade secrets, our business and competitive position would be harmed.

We consider trade secrets, including confidential and unpatented know-how and designs important to the maintenance of our competitive position. We protect trade secrets and confidential and unpatented know-how, in part, by customarily entering into non-disclosure and confidentiality agreements with parties who have access to such knowledge, such as our employees, outside technical and commercial collaborators, consultants, advisors and other third parties. We also enter into confidentiality and invention or patent assignment agreements with our

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employees and consultants that obligate them to maintain confidentiality and assign their inventions to us. Despite these efforts, any of these parties may breach the agreements and disclose our proprietary information, including our trade secrets, and we may not be able to obtain adequate remedies for such breaches.

Claims by others that we infringe their intellectual property or trade secret rights could harm our business.

Our industry is characterized by vigorous protection and pursuit of intellectual property rights, which has resulted in protracted and expensive litigation for many companies. Third parties may in the future assert claims of infringement of intellectual property rights against us or against our customers or channel partners for which we may be liable. As the number of products and competitors in our market increases and overlaps occur, infringement claims may increase.

Intellectual property or trade secret claims against us, and any resulting lawsuits, may result in our incurring significant expenses and could subject us to significant liability for damages and invalidate what we currently believe are our proprietary rights. Our involvement in any patent dispute or other intellectual property dispute or action to protect trade secrets and know-how could have a material adverse effect on our business. Adverse determinations in any litigation could subject us to significant liabilities to third parties, require us to seek licenses from third parties and prevent us from manufacturing and selling our products. Any of these situations could have a material adverse effect on our business. These claims, regardless of their merits or outcome, would likely be time consuming and expensive to resolve and could divert management’s time and attention.

We are generally obligated to indemnify our channel partners and end-customers for certain expenses and liabilities resulting from intellectual property infringement claims regarding our products, which could force us to incur substantial costs.

We have agreed, and expect to continue to agree, to indemnify our channel partners and end-customers for certain intellectual property infringement claims regarding our products. As a result, in the case of infringement claims against these channel partners and end-customers, we could be required to indemnify them for losses resulting from such claims or to refund amounts they have paid to us. Our channel partners and other end-customers in the future may seek indemnification from us in connection with infringement claims brought.

Risks Related to Our International Operations

Our international sales and operations subject us to additional risks that can adversely affect our operating results and financial condition.

Our international operations subject us to a variety of risks and challenges, including: increased management, travel, infrastructure and legal compliance costs associated with having international operations; reliance on channel partners; increased financial accounting and reporting burdens and complexities; compliance with foreign laws and regulations; compliance with U.S. laws and regulations for foreign operations; and reduced protection for intellectual property rights in some countries and practical difficulties of enforcing rights abroad. Any of these risks could adversely affect our international operations, reduce our international sales or increase our operating costs, adversely affecting our business, operating results and financial condition and growth prospects.

We are subject to governmental export and import controls that could impair our ability to compete in international markets due to licensing requirements and subject us to liability if we are not in compliance with applicable laws.

Our products are subject to export control and import laws and regulations, including the U.S. Export Administration Regulations, U.S. Customs regulations and various economic and trade sanctions regulations administered by the U.S. Treasury Department’s Office of Foreign Assets Controls. Exports of our products must be made in compliance with these laws and regulations. If we violate these laws and regulations, we and certain of our employees could be subject to substantial civil or criminal penalties, including the possible loss of export or import privileges, fines, which may be imposed on us and responsible employees or managers and, in extreme cases, the incarceration of responsible employees or managers. In addition, if our channel partners, agents or consultants fail to obtain appropriate import, export or re-export licenses or authorizations, we may also be adversely affected through

29


reputational harm and penalties. Obtaining the necessary authorizations, including any required license, for a particular sale may be time-consuming, is not guaranteed and may result in the delay or loss of sales opportunities. Changes in our products or changes in applicable export or import laws and regulations may also create delays in the introduction and sale of our products in international markets, prevent our end-customers with international operations from deploying our products or, in some cases, prevent the export or import of our products to certain countries, governments or persons altogether. Any change in export or import laws and regulations, shift in the enforcement or scope of existing laws and regulations, or change in the countries, governments, persons or technologies targeted by such laws and regulations, could also result in decreased use of our products, or in our decreased ability to export or sell our products to existing or potential end-customers with international operations. Any decreased use of our products or limitation on our ability to export or sell our products would likely adversely affect our business, financial condition and operating results.

New regulations or standards or changes in existing regulations or standards in the United States or internationally related to our suppliers products may result in unanticipated costs or liabilities, which could have a material adverse effect on our business, operating results and future sales, and could place additional burdens on the operations of our business.

Our suppliers’ products are subject to governmental regulations in many jurisdictions. To achieve and maintain market acceptance, our suppliers’ products must continue to comply with these regulations and many industry standards. As these regulations and standards evolve, and if new regulations or standards are implemented, our suppliers may have to modify their products. The failure of their products to comply, or delays in compliance, with the existing and evolving industry regulations and standards could prevent or delay introduction of our products, which could harm our business. Supplier uncertainty regarding future policies may also affect demand for HPC products, including our products. Moreover, channel partners or customers may require us, or we may otherwise deem it necessary or advisable, to alter our products to address actual or anticipated changes in the regulatory environment. Our inability to alter our products to address these requirements and any regulatory changes may have a material adverse effect on our business, operating results and financial condition.

We could be adversely affected by violations of the U.S. Foreign Corrupt Practices Act and similar worldwide anti-bribery laws.

We have international operations. The U.S. Foreign Corrupt Practices Act and similar anti-bribery laws generally prohibit companies and their intermediaries from making improper payments to foreign government officials for the purpose of obtaining or retaining business. Practices in the local business communities of many countries outside the United States have a level of government corruption that is greater than that found in the developed world. Our policies mandate compliance with these anti-bribery laws and we have established policies and procedures designed to monitor compliance with these anti-bribery law requirements; however, we cannot assure that our policies and procedures will protect us from potential reckless or criminal acts committed by individual employees or agents. If we are found to be liable for anti-bribery law violations, we could suffer from criminal or civil penalties or other sanctions that could have a material adverse effect on our business.

Risks Related to Our Common Stock

The price of our common stock may be volatile, and you could lose all or part of your investment.

The trading price of our common stock following our initial public offering may fluctuate substantially and may be higher or lower than the initial public offering price. The trading price of our common stock will depend on several factors, including those described in this “Risk Factors” section, many of which are beyond our control and may not be related to our operating performance. These fluctuations could cause you to lose all or part of your investment in our common stock since you might be unable to sell your shares at or above the price you paid.  Factors that could cause fluctuations in the trading price of our common stock include:

 

price and volume fluctuations in the overall stock market from time to time;

 

volatility in the market prices and trading volumes of technology stocks;

30


 

changes in operating performance and stock market valuations of other technology companies generally, or those in our industry in particular;

 

sales of shares of our common stock by us or our stockholders;

 

failure of financial analysts to maintain coverage of us, changes in financial estimates by any analysts who follow our company, or our failure to meet these estimates or the expectations of investors;

 

the financial projections we may provide to the public, any changes in those projections or our failure to meet those projections;

 

announcements by us or our competitors of new products or new or terminated significant contracts, commercial relationships or capital commitments;

 

the public’s reaction to our press releases, other public announcements and filings with the SEC;

 

rumors and market speculation involving us or other companies in our industry;

 

actual or anticipated changes in our operating results or fluctuations in our operating results;

 

actual or anticipated developments in our business or our competitors’ businesses or the competitive landscape generally;

 

litigation involving us, our industry or both or investigations by regulators into our operations or those of our competitors;

 

developments or disputes concerning our intellectual property or other proprietary rights;

 

announced or completed acquisitions of businesses or technologies by us or our competitors;

 

new laws or regulations or new interpretations of existing laws or regulations applicable to our business;

 

changes in accounting standards, policies, guidelines, interpretations or principles;

 

any major change in our management;

 

general economic conditions and slow or negative growth of our markets; and

 

other events or factors, including those resulting from war, incidents of terrorism or responses to these events.

In addition, the stock market in general, and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Broad market and industry factors, as well as general economic, political and market conditions such as recessions or interest rate changes, may seriously affect the market price of our common stock, regardless of our actual operating performance. These fluctuations may be even more pronounced in the trading market for our stock shortly following our initial public offering. If the market price of our common stock after our initial public offering does not exceed the initial public offering price, you may not realize any return on your investment in us and may lose some or all of your investment.

In the past, following periods of volatility in the overall market and the market prices of particular companies’ securities, securities class action litigations have often been instituted against these companies. Litigation of this type, if instituted against us, could result in substantial costs and a diversion of our management’s attention and resources. Any adverse determination in any such litigation or any amounts paid to settle any such actual or threatened litigation could require that we make significant payments.

Our directors and principal stockholders own a significant percentage of our stock and will be able to exert significant control over matters subject to stockholder approval.

Our directors, executive officers and significant stockholders will have substantial control over the Company and could delay or prevent a change in corporate control. Our directors, executive officers and holders of more than 5% of our common stock, together with their affiliates, will beneficially own, in the aggregate, 44.9% of our

31


outstanding common stock, based on the number of shares outstanding as of February 28, 2018. As a result, these stockholders, acting together, would have the ability to control the outcome of matters submitted to our stockholders for approval, including the election of directors and any merger, consolidation or sale of all or substantially all of our assets. In addition, these stockholders, acting together, would have the ability to control the management and affairs of our company. Accordingly, this concentration of ownership might adversely affect the market price of our common stock by:

 

delaying, deferring or preventing a change in control of the Company;

 

impeding a merger, consolidation, takeover, or other business combination involving us; or

 

discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of the company.

If securities or industry analysts issue an adverse opinion regarding our stock or do not publish research or reports about our company, our stock price and trading volume could decline.

The trading market for our common stock will depend in part on the research and reports that equity research analysts publish about us and our business. We anticipate having limited analyst coverage and we may continue to have inadequate analyst coverage in the future. Even if we obtain adequate analyst coverage, we would have no control over such analysts or the content and opinions in their reports. Securities analysts may elect not to provide research coverage of our company and such lack of research coverage may adversely affect the market price of our common stock. The price of our common stock could also decline if one or more equity research analysts downgrade our common stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business. If one or more equity research analysts cease coverage of our company, we could lose visibility in the market, which in turn could cause our stock price to decline.

Substantial future sales of shares of our common stock could cause the market price of our common stock to decline.

The market price of shares of our common stock could decline as a result of substantial sales of our common stock, particularly sales by our directors, executive officers and significant stockholders, a large number of shares of our common stock becoming available for sale or the perception in the market that holders of a large number of shares intend to sell their shares. As of February 28, 2018, we have 12,476,923 shares of our common stock outstanding. This includes the shares issued in our initial public offering, which may be resold in the public market immediately without restriction, unless purchased by our affiliates or existing stockholders. The remaining 8,576,923 shares outstanding are currently restricted as a result of lock-up agreements but will be able to be sold in the near future as set forth below.

Moreover, certain holders of our common stock will have rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or our stockholders. Substantially all of these shares are subject to lock-up agreements restricting their sale for 180 days after the date of the effectiveness of our initial public offering which occurred on January 31, 2018. We also intend to register shares of common stock that we may issue under our employee equity incentive plans. Once we register these shares, they will be able to be sold freely in the public market upon issuance, subject to volume limitations applicable to affiliates and the lock-up agreements described in “Plan of Distribution.” Roth Capital Partners, LLC may, in its sole discretion, permit our officers, directors, employees, and current stockholders who are subject to the 180-day contractual lock-up to sell shares prior to the expiration of the lock-up agreements.

Our management will have discretion in the use of the net proceeds from our initial public offering and may not use them in a way which increases the value of your investment.

We currently intend to use the net proceeds from our initial public offering for retirement of debt, working capital and general corporate purposes, including sales and marketing activities, product development, and capital expenditures, and we may also use a portion of the net proceeds for the acquisition of, or investment in, technologies, solutions or businesses that complement our business, although we have no present commitments or agreements to enter into any acquisitions or investments. However, our management will have considerable discretion in the application of the net proceeds from our initial public offering and investors will be relying on the

32


judgment of our management regarding the application of those proceeds. Our management may spend the proceeds in ways that do not improve our operating results or enhance the value of our common stock, and you will not have the opportunity to influence management’s decisions on how to use the proceeds from our initial public offering. Our failure to apply these funds effectively could have a material adverse effect on our business and cause the price of our common stock to decline.

Anti-takeover provisions in our charter documents and under Delaware law could make an acquisition of us, which may be beneficial to our stockholders, more difficult and may prevent attempts by our stockholders to replace or remove our current management and limit the market price of our common stock.

Provisions in our certificate of incorporation and amended and restated bylaws may have the effect of delaying or preventing a change of control or changes in our management. Some of these provisions:

 

authorize our board of directors to issue, without further action by the stockholders, up to 10,000,000 shares of undesignated preferred stock and up to 50,000,000 shares of authorized common stock;

 

require that any action to be taken by our stockholders be effected at a duly called annual or special meeting and not by written consent;

 

specify that special meetings of our stockholders can be called only by our board of directors, the chairman of the board of directors, the chief executive officer or the president;

 

establish an advance notice procedure for stockholder approvals to be brought before an annual meeting of our stockholders, including proposed nominations of persons for election to our board of directors;

 

provide that our directors may be removed only for cause; and

 

provide that vacancies on our board of directors may, except as otherwise required by law, be filled only by a majority of directors then in office, even if less than a quorum.

In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which limits the ability of stockholders owning in excess of 15% of our outstanding voting stock to merge or combine with us. Furthermore, our certificate of incorporation specifies that, unless we consent in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware will be the sole and exclusive forum for most legal actions involving actions brought against us by stockholders. We believe this provision benefits us by providing increased consistency in the application of Delaware law by chancellors particularly experienced in resolving corporate disputes, efficient administration of cases on a more expedited schedule relative to other forums and protection against the burdens of multi-forum litigation. However, the provision may have the effect of discouraging lawsuits against our directors and officers. The enforceability of similar choice of forum provisions in other companies’ certificates of incorporation has been challenged in legal proceedings, and it is possible that, in connection with any applicable action brought against us, a court could find the choice of forum provisions contained in our certificate of incorporation to be inapplicable or unenforceable in such action.

These anti-takeover provisions and other provisions in our certificate of incorporation and amended and restated bylaws make it more difficult for stockholders or potential acquirers to obtain control of our board of directors or initiate actions that are opposed by the then-current board of directors and could also delay or impede a merger, tender offer or proxy contest involving our company. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing or cause us to take other corporate actions you desire. Any delay or prevention of a change of control transaction or changes in our board of directors could cause the market price of our common stock to decline.

We have never paid cash dividends on our capital stock, and we do not anticipate paying cash dividends in the foreseeable future.

We have never declared or paid any cash dividends on our common stock and do not intend to pay any cash dividends in the foreseeable future. In addition, our loan and security agreement with Bank of the West restricts our ability to pay cash dividends on our common stock without the prior written consent of Bank of the West, and we may also enter into credit agreements or other borrowing arrangements in the future that will restrict our ability to declare or pay cash dividends on our common stock. We currently intend to retain any future earnings to fund the growth of our business. Any determination to pay dividends in the future will be at the discretion of our board of

33


directors and will depend on our financial condition, operating results, capital requirements, general business conditions and other factors that our board of directors may deem relevant.

If an active, liquid trading market for our common stock does not develop, you may not be able to sell your shares quickly or at or above the initial offering price.

There has not been a public market for our common stock prior to our initial public offering. An active and liquid trading market for our common stock may not develop or be sustained following our initial public offering. Given the small size of our initial public offering, it may take some time for an active market to develop. The lack of an active market may impair your ability to sell your shares at the time you wish to sell them or at a price that you consider reasonable. The lack of an active market may also reduce the fair market value of your shares. An inactive market may also impair our ability to raise capital to continue to fund operations by selling shares and may impair our ability to acquire other companies or technologies by using our shares as consideration. You may not be able to sell your shares quickly or at or above the initial offering price. The initial public offering price was determined by negotiations with the representatives of the underwriters. This price may not be indicative of the price at which our common stock will continue to trade in the future, and our common stock could trade below the initial public offering price.

Our inability to raise additional capital on acceptable terms in the future may limit our ability to develop and commercialize new solutions and technologies and expand our operations.

If our available cash balances, net proceeds from our initial public offering and anticipated cash flow from operations are insufficient to satisfy our liquidity requirements, due to lower demand for our products as a result of other risks described in this “Risk Factors” section, we may seek to raise additional capital through equity offerings, debt financings, collaborations or licensing arrangements. We may also consider raising additional capital in the future to expand our business, pursue strategic investments, take advantage of financing opportunities, or other reasons.

Additional funding may not be available to us on acceptable terms, or at all. If we raise funds by issuing equity securities, dilution to our stockholders could result. Any equity securities issued also may provide for rights, preferences or privileges senior to those of holders of our common stock. The terms of debt securities issued or borrowings could impose significant restrictions on our operations. The incurrence of indebtedness or the issuance of certain equity securities could result in increased fixed payment obligations and could also result in restrictive covenants, such as limitations on our ability to incur additional debt or issue additional equity, limitations on our ability to acquire or license intellectual property rights, and other operating restrictions that could adversely affect our ability to conduct our business. In addition, the issuance of additional equity securities by us, or the possibility of such issuance, may cause the market price of our common stock to decline. If we do not have, or are not able to obtain, sufficient funds, we may have to delay development or commercialization of our products or license to third parties the rights to commercialize products or technologies that we would otherwise seek to commercialize. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish some rights to our technologies or our products, or to grant licenses on terms that are not favorable to us. If we are unable to raise adequate funds, we may have to liquidate some or all of our assets, or delay, reduce the scope of or eliminate some or all of our development programs. We also may have to reduce marketing, customer support or other resources devoted to our products or cease operations. Any of these actions could harm our business, operating results and financial condition.

34


We are an “emerging growth company” and we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.

We are an “emerging growth company” as defined in the JOBS Act. For as long as we continue to be an emerging growth company, we may choose to take advantage of certain exemptions from various reporting requirements applicable to other public companies but not to emerging growth companies, which includes, among other things:

 

exemption from the auditor attestation requirements under Section 404 of the Sarbanes-Oxley Act of 2002;

 

reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements; and

 

exemption from the requirements of holding non-binding stockholder votes on executive compensation arrangements.

We could be an emerging growth company until the last day of the fiscal year following the fifth anniversary after our initial public offering, or until the earliest of (i) the last day of the fiscal year in which we have annual gross revenue of $1.07 billion or more, (ii) the date on which we have, during the previous three year period, issued more than $1.07 billion in non-convertible debt or (iii) the date on which we are deemed to be a large accelerated filer under the federal securities laws. We will qualify as a large accelerated filer as of the first day of the first fiscal year after we have (i) more than $700 million in outstanding common equity held by our non-affiliates and (ii) been public for at least 12 months. The value of our outstanding common equity will be measured each year on the last day of our second fiscal quarter.

We cannot predict if investors will find our common stock less attractive if we rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile.

We will incur significant increased costs as a result of operating as a public company, and our management will be required to devote substantial time to comply with the laws and regulations affecting public companies, particularly after we are no longer an emerging growth company.

We have not previously operated as a public company. As a public company, particularly after we cease to qualify as an emerging growth company, we will incur significant legal, accounting and other expenses that we did not incur as a private company, including costs associated with public company reporting and corporate governance requirements, to comply with the rules and regulations imposed by the Sarbanes-Oxley Act and the Dodd-Frank Act, as well as rules implemented by the SEC and Nasdaq. Our management and other personnel will need to devote a substantial amount of time to these compliance initiatives and our legal and accounting compliance costs will increase. It is likely that we will need to hire additional staff or devote additional financial and other resources in the areas of investor relations, legal and accounting to operate as a public company. We also expect these new rules and regulations may make it more difficult and expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our board of directors or as executive officers. We are evaluating and monitoring developments regarding these rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.

35


For example, the Sarbanes-Oxley Act requires, among other things, that we assess the effectiveness of internal controls over financial reporting and disclosure controls and procedures. In particular, as a public company, we will be required to perform system and process evaluations and testing of our internal control over financial reporting to allow management to report on the effectiveness of our internal controls over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act. As described above, as an emerging growth company, we will not need to comply with the auditor attestation provisions of Section 404 for several years. Our testing, or the subsequent testing by our independent registered public accounting firm, may reveal deficiencies in our internal control over financial reporting that are deemed to be material weaknesses. Our compliance with Section 404 will require that we incur substantial accounting expense and management time on compliance-related issues. Moreover, if we are not able to comply with the requirements of Section 404 in a timely manner, or if we or our independent registered public accounting firm identify deficiencies in our internal control over financial reporting that are deemed to be material weaknesses, we could lose investor confidence in the accuracy and completeness of our financial reports, which could cause our stock price to decline.

ITEM 1B. UNRESOLVED STAFF COMMENTS.

Not applicable.

ITEM 2. PROPERTIES.

Our corporate headquarters are in a leased space of approximately 17,911 square feet in Escondido, California under a lease that expires in August 2018. We occupy another facility in San Diego with approximately 13,588 square feet, which also expires in August 2018. Our SkyScale joint venture operates out of our San Diego facility and also leases data center space at a local data center. We also lease a small space near Munich, Germany for our German subsidiary, OSS GmbH and a 3,208 square foot facility in Salt Lake City, Utah that houses our Ion software development team which expires in August 2020. We are in the process of determining whether we want to extend our leases at the Escondido and San Diego locations or consolidate into a single, larger facility. We periodically review our lease arrangements at our Germany and Utah locations to determine whether they suit our needs.

ITEM 3. LEGAL PROCEEDINGS.

We are subject to litigation, claims, investigations and audits arising from time to time in the ordinary course of our business. However, at this time, we are not aware on any material pending, threatened or unasserted claims.

ITEM 4. MINE SAFETY DISCLOSURES.

Not Applicable.

36


PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

Market Information

Our common stock par value $0.0001, has been publicly traded on The Nasdaq Capital Market under the symbol “OSS” since our initial public offering on February 1, 2018, which was completed at an offering price to the public of $5.00 per share.  Prior to our initial public offering, there was no public market for our common stock.  Due to the fact that our common stock has only been traded on a public market since February 1, 2018, we have not set forth quarterly information with respect to the high and low sale prices for our common stock for the two most recent fiscal years.

Holders

As of February 28, 2018, there were 996 beneficial holders of our common stock.

Dividend Policy

We have never declared or paid cash dividends on our common stock. We currently intend to retain all available funds and any future earnings for use in the operation of our business and do not anticipate paying any cash dividends on our common stock in the foreseeable future.  We may enter into credit agreements or other borrowing arrangements in the future that will restrict our ability to declare or pay cash dividends on our common stock. Any future determination to declare dividends will be made at the discretion of our board of directors and will depend on our financial condition, operating results, capital requirements, general business conditions and other factors that our board of directors may deem relevant.

Equity Compensation Plan Information

See Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” for information regarding securities authorized for issuance under equity compensation plans.

Unregistered Sales of Equity Securities

None.

Use of Proceeds

On January 31, 2018, our registration statement on Form S-1 (File No. 333-222121) was declared effective by the SEC for our initial public offering. At the closing of the offering on February 5, 2018, we sold 3,800,000 shares of common stock at an initial public offering price of $5.00 per share and received gross proceeds of $19,000,000, which resulted in net proceeds to us of $17,485,000, after deducting underwriting discounts and commissions of $1,330,000 and underwriter offering-related transaction costs of $185,000. None of the expenses associated with the initial public offering were paid to directors, officers, persons owning ten percent (10%) or more of any class of equity securities, or to their associates, or to our affiliates. Roth Capital Partners, LLC, acted as sole book-running managers for the offering and The Benchmark Company, LLC acted as co-manager.

On February 9, 2018, the underwriter partially exercised their over-allotment option to purchase an additional 200,000 shares of common stock of which 100,000 were newly issued by the Company and 100,000 were sold by our CEO Steve Cooper, at the public offering price of $5.00 per share. The Company received gross proceeds of $500,000 for its portion of the over-allotment, which resulted in net proceeds to us of $465,000, after deducting underwriting discounts and commissions of $35,000.

There has been no material change in the planned use of proceeds from our initial public offering as described in our final prospectus filed with the SEC on February 1, 2018, pursuant to Rule 424(b)(4).

37


Issuer Repurchases of Equity Securities

None.

ITEM 6. SELECTED FINANCIAL DATA.

The following tables set forth a summary of our historical financial data as of, and for the periods ended on, the dates indicated. We have derived the statements of operations and balance sheet data for the years ended December 31, 2017 and 2016 from our audited consolidated financial statements included elsewhere in this Annual Report. The following selected financial data should be read in conjunction with our financial statements and related notes included elsewhere in this Annual Report and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report. Our historical results for any prior period are not indicative of our future results.

 

 

 

For The Years Ended December 31,

 

Statement of Operations Data:

 

2017

 

 

2016

 

Net revenue

 

$

27,538,333

 

 

$

18,879,321

 

Cost of revenue

 

 

18,873,797

 

 

 

13,365,615

 

Gross margin

 

 

8,664,536

 

 

 

5,513,706

 

Operating expenses:

 

 

 

 

 

 

 

 

General and administrative

 

 

3,502,998

 

 

 

2,146,624

 

Marketing and selling

 

 

2,924,727

 

 

 

1,987,358

 

Research and development

 

 

2,687,249

 

 

 

1,599,585

 

Total operating expenses

 

 

9,114,974

 

 

 

5,733,567

 

Loss from operations

 

 

(450,438

)

 

 

(219,861

)

Other income (expense):

 

 

 

 

 

 

 

 

Interest expense

 

 

(199,257

)

 

 

(152,877

)

Other, net

 

 

30,440

 

 

 

5,364

 

Total other expense, net

 

 

(168,817

)

 

 

(147,513

)

Loss before benefit for income taxes

 

 

(619,255

)

 

 

(367,374

)

Benefit for income taxes

 

 

(402,717

)

 

 

(182,937

)

Net loss

 

$

(216,538

)

 

$

(184,437

)

Net loss attributable to noncontrolling interest

 

$

(313,158

)

 

$

-

 

Net income (loss) attributable to company

 

$

96,620

 

 

$

(184,437

)

Net income (loss) per share attributable to common stockholders:

 

 

 

 

 

 

 

 

Basic

 

$

0.02

 

 

$

(0.04

)

Diluted

 

$

0.01

 

 

$

(0.04

)

Weighted average common shares outstanding:

 

 

 

 

 

 

 

 

Basic

 

 

5,449,413

 

 

 

4,782,547

 

Diluted

 

 

10,689,047

 

 

 

4,782,547

 

 

38


 

Balance Sheet Data:

 

As of December 31,

 

 

 

2017

 

 

2016

 

Cash and cash equivalents

 

$

185,717

 

 

$

14,197

 

Other working capital accounts

 

 

(81,992

)

 

 

952,830

 

Total Working Capital

 

 

103,725

 

 

 

967,027

 

 

 

 

 

 

 

 

 

 

Long-term debt

 

$

347,963

 

 

$

1,124,386

 

Preferred stock

 

 

2,416,527

 

 

 

2,416,527

 

Common stock

 

 

551

 

 

 

537

 

Noncontrolling interest

 

 

436,842

 

 

 

-

 

Additional paid in capital

 

 

3,484,428

 

 

 

3,218,878

 

Retained earnings

 

 

281,423

 

 

 

184,803

 

Total Long-Term Debt and Stockholders' Equity

 

$

6,967,734

 

 

$

6,945,131

 

 

39


ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

You should read the following discussion and analysis of our financial condition and operating results together with our financial statements and related notes included elsewhere in this Annual Report. This discussion and analysis contains forward-looking statements based upon current beliefs, plans and expectations that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” or in other parts of this Annual Report.

Overview

OSS designs, manufactures and markets custom high speed computing systems for high performance computing (HPC) applications. These applications require ultra-fast processing power and the ability to quickly access and store ever-growing data sets.  Systems are built using the latest GPU (graphical processing unit) and solid-state flash (memory) technologies.  We are a niche provider of HPC custom servers, compute accelerators, and flash storage arrays.  We deliver this technology to customers through sale of equipment and software to customers or through remote cloud access to secure datacenters.

 

Business Developments

 

On July 15, 2016, we acquired 100% of the outstanding common shares of Mission Technology Group, Inc. (“Magma”). Magma designs, manufactures, and markets industrial grade computer systems and components and is located in Southern California.

 

On April 6, 2017, we formed SkyScale, LLC (“SkyScale”), a High-Performance Computing as a Service (HPCaaS) provider to offer customers world-class, ultra-fast, multi-GPU hardware platforms in the cloud.  SkyScale is jointly owned with Jacoma Investments, LLC, an entity controlled by our board member Jack Harrison.  In accordance with the terms of the operating agreement, Jacoma Investments, LLC agreed to contribute $750,000 in capital and we agreed to contribute $750,000 in the form of credits to purchase equipment, personnel or support services. Each of us received a 50% membership interest.

 

On May 9, 2017, we entered into an agreement to acquire the source code license to the Ion flash array software from Western Digital.  We plan to continue to develop and sell Ion software with our high-density storage arrays, as well as servicing existing Western Digital software users.  OSS Ion software works with our all-flash storage systems, and provides them with a critical point of differentiation with respect to speed and throughput.  The OSS Ion software leverages flash storage and open server hardware to accelerate applications and SAN performance through sharing or clustering high-speed all-flash storage arrays.  The software supports many major OEM servers and provides an intuitive interface for system users to manage its many features.  Having the Ion software source code and engineering team on-board allows us to strategically grow our all-flash storage business in the many Big Data and HPC markets going forward.

 

On July 1, 2017, we entered in to a Service Agreement with Western Digital to service their existing customer base that utilizes Ion flash storage software.  Additionally, we purchased certain equipment from Western Digital and hired selected employees to assist in the servicing of these existing customers.  

 

On August 1, 2017, we received a three month extension on our line of credit with no modification in terms.

 

On October 5, 2017, we received a renewal and modification on our line of credit that extends the line through August 31, 2018, and increases the borrowing capacity limit from $ 3.0 million to $3.5 million.

 

On November 9, 2017, we submitted a confidential draft registration statement on Form S-1 with the SEC in connection with a proposed initial public offering of our common stock.  

 

40


On December 14, 2017, the Company was reincorporated as a Delaware corporation in connection with our initial public offering.  

 

On December 18, 2017, the Company filed a Registration Statement on Form S-1 with the SEC related to a firm commitment underwritten initial public offering of the Company’s common stock, par value $0.0001 per share. The initial public offering was declared effective by the SEC on January 31, 2018.  The Company commenced trading on The Nasdaq Capital Market under the symbol “OSS” on February 1, 2018.  On February 5, 2018, the Company closed the initial public offering selling an aggregate of 3,800,000 shares of common stock at a price to the public of $5.00 for total gross proceeds to the Company of $19,000,000, after deducting underwriting discounts and commissions of approximately $1,330,000 and underwriter offering-related transaction costs of $185,000, the Company received net proceeds of $17,485,000.

On February 2, 2018, in connection with the completion of its initial public offering, the Company filed its amended and restated certificate incorporation with the Secretary of the State of Delaware whereby it increased its authorized common shares to 50,000,000 shares and authorized preferred stock to 10,000,000 shares.

On February 1, 2018, the Company issued warrants to purchase 380,000 shares of common stock at a price of $6.00 to Roth Capital Partners LLC.

On February 5, 2018, the Company paid down the outstanding balance of the line of credit which had an outstanding balance of $2,758,517.

On February 9, 2018, the underwriters exercised their over-allotment option to purchase an additional 200,000 shares of common stock at the public offering price of $5.00 per share of which 100,000 newly issued shares of common stock were purchased directly from the Company and 100,000 shares were sold by our CEO’s family trust.  The Company received gross proceeds of $500,000, which resulted in net proceeds of $465,000 to the Company, after deducting underwriting discounts and commissions of $35,000.

On February 15, 2018, the Company paid-off the remaining balances of the related party notes payable in the amount of $152,973.

On February 15, 2018, the Company paid-off the remaining balance of the “July 2016 Note” in the amount of $109,267.

On February 23, 2018, the Company paid of the remaining balance of the Bank of the West term loan in the amount of $834,103.

On March 2, 2018, the Company cancelled its line of credit with Bank of the West.

 

Our Business Model

 

OSS designs, manufactures and sells high performance computing (HPC) systems to customers world-wide.  We differentiate ourselves from other suppliers of HPC solutions by utilizing our expertise in custom systems design and PCIe expansion to build systems with a greater quantity of PCIe add-in slots, GPU-based compute cards and/or flash cards. Our systems offer industry leading capabilities that occupy less physical space and power consumption.

 

Components of Results of Operations

 

Revenue

We derive revenue from the sale of our hardware products and, to a lesser extent, support services. Provided that all other revenue recognition criteria has been met, we typically recognize revenue upon shipment, as title and risk of loss are transferred to customers and channel partners at that time. Products are typically shipped directly to our customers, or in some cases to our international distributors.  These international distributors assist with import regulations, currency conversions and local language, but do not stock our inventory.  Our product revenues vary

41


from period to period based on, among other things, the customer orders received and our ability to produce and deliver the ordered products. Customers often specify requested delivery dates that coincide with their need for our products.

 

Because these customers may use our products in connection with a variety of projects of different sizes and durations, a customer’s orders for one reporting period generally do not indicate a trend for future orders by that customer. Additionally, order patterns do not necessarily correlate amongst customers and, therefore, we generally cannot identify seasonal trends.  

 

In 2017, we have begun to offer support services which may involve providing customer phone support, system debug and software upgrades for a period of time. We recognize revenue from support services ratably over the contractual service period.

 

Cost of revenue

Cost of revenue primarily consists of costs of materials, costs paid to third-party contract manufacturers (which may include the costs of components), and personnel costs associated with manufacturing and support operations. Personnel costs consist of wages, bonuses, benefits, stock-based compensation expenses. Cost of revenue also includes freight, allocated overhead costs and inventory write-offs and changes to our inventory and warranty reserves. Allocated overhead costs consist of certain facilities and utility costs. We expect cost of revenue to increase in absolute dollars, as product revenue increases.

 

Operating expenses

Our operating expenses consist of general and administrative, sales and marketing and research and development expenses. Salaries and personnel-related costs, benefits, and stock-based compensation expense, are the most significant components of each category of operating expenses. Operating expenses also include allocated overhead costs for facilities and utility costs.

 

General and Administrative - General and administrative expense consists primarily of employee compensation and related expenses for administrative functions including finance, legal, human resources and fees for third-party professional services, as well as allocated overhead. We expect our general and administrative expense to increase in absolute dollars as we continue to invest in growing the business.

 

Sales and Marketing - Sales and marketing expense consists primarily of employee compensation and related expenses, sales commissions, marketing programs, travel and entertainment expenses as well as allocated overhead. Marketing programs consist of advertising, tradeshows, events, corporate communications and brand-building activities. We expect sales and marketing expenses to increase in absolute dollars as we expand our sales force, increase marketing resources, and further develop sales channels.

 

Research and Development - Research and development expense consists primarily of employee compensation and related expenses, prototype expenses, depreciation associated with assets acquired for research and development, third-party engineering and contractor support costs, as well as allocated overhead. We expect our research and development expenses to increase in absolute dollars as we continue to invest in new and existing products.

 

Other Income (Expense), net

Other income consists of income received for activities outside of our core business.  In 2017, this includes rental income received through the sub-leasing of certain facility space.  Other expense includes expenses for activities outside of our core business.  These expenses consist primarily of loan amortization and interest expense.

42


 

Provision for Income Taxes

Provision for income taxes consists of estimated income taxes due to the United States government and to the state tax authorities in jurisdictions in which we conduct business, as well as the change in our deferred income tax assets and liabilities.

 

Results of Operations

 

Results of operations for the years ended December 31, 2017 and 2016 include operating results for the acquired Magma business that was acquired on July 16, 2016, a newly formed 50% owned consolidated joint venture, SkyScale, LLC, which began operation in April 2017 and the purchase of the Ion business from Western Digital on July 1, 2017.

 

Accordingly, the periods presented below are not directly comparable.  After the completion of four quarters, these businesses for both revenue and expense reporting will be treated as organic operating activity for current and comparable historical periods.  The following tables set forth our results of operations for the years ended December 31, 2017 and 2016 respectively, presented in dollars and as percentage of net revenue.

 

The following tables set forth our results of operations for the years ended December 31, 2017 and 2016 respectively, presented in dollars and as a percentage of net revenue.

 

 

December 31,

 

 

2017

 

 

2016

 

Net revenue

$

27,538,333

 

 

$

18,879,321

 

Cost of revenue

 

18,873,797

 

 

 

13,365,615

 

Gross margin

 

8,664,536

 

 

 

5,513,706

 

Operating expenses:

 

 

 

 

 

 

 

General and administrative

 

3,502,998

 

 

 

2,146,624

 

Marketing and selling

 

2,924,727

 

 

 

1,987,358

 

Research and development

 

2,687,249

 

 

 

1,599,585

 

Total operating expenses

 

9,114,974

 

 

 

5,733,567

 

Loss from operations

 

(450,438

)

 

 

(219,861

)

Other income (expense):

 

 

 

 

 

 

 

Interest expense

 

(199,257

)

 

 

(152,877

)

Other, net

 

30,440

 

 

 

5,364

 

Total other expense, net

 

(168,817

)

 

 

(147,513

)

Loss before benefit for income taxes

 

(619,255

)

 

 

(367,374

)

Benefit from income taxes

 

(402,717

)

 

 

(182,937

)

Net loss

$

(216,538

)

 

$

(184,437

)

Net loss attributable to noncontrolling interest

$

(313,158

)

 

 

 

Net income (loss) attributable to company

$

96,620

 

 

$

(184,437

)

43


 

 

December 31,

 

 

2017

 

 

2016

 

Net revenue

 

100.00

%

 

 

100.00

%

Cost of revenue

 

68.54

%

 

 

70.79

%

Gross margin

 

31.46

%

 

 

29.21

%

Operating expenses:

 

 

 

 

 

 

 

General and administrative

 

12.72

%

 

 

11.37

%

Marketing and selling

 

10.62

%

 

 

10.53

%

Research and development

 

9.76

%

 

 

8.47

%

Total operating expenses

 

33.10

%

 

 

30.37

%

Loss from operations

 

-1.64

%

 

 

-1.16

%

Other income (expense):

 

 

 

 

 

 

 

Interest expense

 

-0.72

%

 

 

-0.81

%

Other, net

 

0.11

%

 

 

0.03

%

Total other expense, net

 

-0.61

%

 

 

-0.78

%

Loss before benefit for income taxes

 

-2.25

%

 

 

-1.95

%

Benefit from income taxes

 

-1.46

%

 

 

-0.97

%

Net loss

 

-0.79

%

 

 

-0.98

%

Net loss attributable to noncontrolling interest

 

-1.14

%

 

 

0.00

%

Net income (loss) attributable to company

 

0.35

%

 

 

-0.98

%

 

Non-GAAP Financial Measures

 

We believe that the use of Adjusted Earnings before Interest, Taxes, Depreciation and Amortization, or Adjusted EBITDA, is helpful for an investor to assess the performance of our Company.  Adjusted EBITDA is defined as income from continuing operations before interest income and expense, income taxes, depreciation, amortization of intangible assets, other charges, impairment of long-lived assets, acquisition and financing costs, fair value adjustments from purchase accounting, and stock-based compensation expense and certain non-recurring expenses.

 

Adjusted EBITDA is not a measurement of financial performance under generally accepted accounting principles in the United States, or GAAP. Because of varying available valuation methodologies, subjective assumptions and the variety of equity instruments that can impact a company’s non-cash operating expenses, we believe that providing a non-GAAP financial measure that excludes non-cash and non-recurring expenses allows for meaningful comparisons between our core business operating results and those of other companies, as well as providing us with an important tool for financial and operational decision making and for evaluating our own core business operating results over different periods of time.

 

44


Our Adjusted EBITDA measure may not provide information that is directly comparable to that provided by other companies in our industry, as other companies in our industry may calculate non-GAAP financial results differently, particularly related to non-recurring, unusual items. Our Adjusted EBITDA is not a measurement of financial performance under GAAP, and should not be considered as an alternative to operating income or as an indication of operating performance or any other measure of performance derived in accordance with GAAP. We do not consider Adjusted EBITDA to be a substitute for, or superior to, the information provided by GAAP financial results.

 

 

December 31,

 

 

2017

 

 

2016

 

Net income (loss) attributable to company

$

96,620

 

 

$

(184,437

)

Depreciation and amortization

 

836,274

 

 

 

437,036

 

Amortization of debt discount

 

23,837

 

 

 

10,925

 

Stock-based compensation expense

 

160,062

 

 

 

77,647

 

Interest expense

 

199,257

 

 

 

152,877

 

Benefit for income taxes

 

(402,717

)

 

 

(182,937

)

Non-recurring expense (1)

 

65,805

 

 

 

107,681

 

Adjusted EBITDA

$

979,138

 

 

$

418,792

 

 

(1)

Expenses incurred in the acquisition of Ion and Magma, respectively

 

Comparison of the Years Ended December 31, 2017 and 2016

 

Net revenue

 

 

Year Ended December 31,

 

 

Year Ended December 31,

 

Revenues:

2017

 

 

2016

 

 

2017

 

 

2016

 

Organic

$

21,593,319

 

 

$

15,693,331

 

 

 

78.4

%

 

 

83.1

%

Acquired

 

5,945,014

 

 

 

3,185,990

 

 

 

21.6

%

 

 

16.9

%

 

$

27,538,333

 

 

$

18,879,321

 

 

 

100.0

%

 

 

100.0

%

 

For the year ended December 31, 2017, total revenue increased $8,659,012 or 45.9%, as compared to the same period in 2016. The increase in revenue was primarily driven by OSS contributing $5,897,780 or 31.2 percentage points of the total increase in revenue with Magma contributing $2,162,670 or11.5 percentage points of the total increased revenue.  Ion contributed $567,675 or 3.0 percentage points for the period and SkyScale contributed $30,887 or .2 percentage points of revenue.  Total organic revenue grew in 2017 $5,899,988 or 37.6% as compared to the prior year.  This increase was attributable to increased purchases from existing customers and a growing number of new customers. Acquired revenues grew $2,759,024 or 86.6% for the same period.

 

Cost of revenue and gross margin

Cost of revenue increased by $5,508,182 or 41.2%, for the year ended December 31, 2017 as compared to the same period in 2016. The increase in cost of revenue for OSS was $3,698,234 or 27.7 percentage points of the total increase resulting from increased product sales and, to a lesser extent, by the increased costs in manufacturing operations.  Magma equipment sales contributed $1,436,176 or 10.7 percentage points of the total increase with Ion contributing $373,772 or 2.8 percentage points.  These costs are primarily driven by increased personnel costs associated with increased headcount and increases in part costs associated with higher-end product offerings.

 

Total gross margin percentage increased from 29.2% during the year ended December 31, 2016 to 31.5% during the year ended December 31, 2017, an increase of 230 basis points.  The increase in overall gross margin is predominately attributable to the inclusion of Magma which contributed margin at a rate of 37.6% and a shift in the mix of products sold to higher-end componentry and OSS provided content and a reduction in inventory reserves.  OSS contributed incremental revenue at a gross margin of 29.8% as compared to the year 2016 gross margin of

45


26.9%.  Such increase resulted from the sale of higher-end products to new and existing customers and better control over inventories which resulted in less obsolescence and slow moving inventory. Overall, incremental revenue for 2017 as compared to 2016 contributed gross margin at a rate of 36.4%.

 

Operating expenses

 

General and administrative expense

General and administrative expense increased $1,356,374, or 63.2%, for the year ended December 31, 2017, as compared to same period in 2016.  OSS contributed $191,752 or 14.1% of the total increase in these expenses of which Magma contributed $502,563 or 37.1% of the increase.  SkyScale contributed $580,064 or 42.8% and Ion contributed $81,995 or 6% of the increase.  General and administrative expense increased primarily due to increased headcount resulting in higher employee compensation related costs and administrative costs associated with the acquisition of Magma, Ion and the newly formed SkyScale joint venture. Overall general and administrative expenses increased as a percentage of revenue to 12.7% during the year ended December 31, 2017 as compared to 11.4% during the same period in 2016.

 

Marketing and selling expense

Marketing and selling expense increased by $937,369 or 47.2% during the year ended December 31, 2017, as compared to the same period in 2016.  OSS contributed $452,139 or 48.2% of the total increase with Magma contributing $369,741 or 39.5% of the increase.  SkyScale contributed $77,139 or 8.2% of the increase with Ion contributing $38,350 or 4.1%.   The increased expenses associated with marketing and selling expense is primarily attributable to increases in salary and related costs, commissions, tradeshows and advertising.   Overall total marketing and selling expense increased as a percentage of revenue to 10.6% during the year ended December 31, 2017 as compared to 10.5% during the same period in 2016.

 

Research and development expense

Research and development expense increased by $1,087,664, or 68%, during the year ended December 31, 2017 as compared to same period in 2016.  OSS contributed $400,592 or 36.8% with Magma contributing $376,348 or 34.6% of the total increase.  Ion software development contributed $310,724 or 28.6%.   These expenses are mainly compromised of salary and related costs, professional services and prototypes attributable to continued development of new and enhanced product offerings.  Overall total research and development expense increased as a percentage of revenue to 9.8% during the year ended December 31, 2017 as compared to 8.5% during the same period in 2016.

 

Interest expense

Interest expense increased $46,380 or 30.3% for the year ended December 31, 2017, as compared to same period in 2016 as a result of increased borrowings in July 2016 of approximately $600,000 at an annual percentage rate of 11% which was outstanding for 169 days in 2016 as compared to 365 days in 2017. Interest expense also includes non-cash amortization of warrant discounts issued in conjunction with debt offerings.

 

Other income (expense), net

Other income (expense), net increased $25,076 during the year ended December 31, 2017 as compared to the same period in 2016.  This increase is primarily attributable to miscellaneous refunds.

46


 

Provision for income taxes

We recorded an income tax benefit of $402,717 for the year ended December 31, 2017 as compared to a tax benefit of $182,937 for the same period in 2016.  The increase is attributable to the increase in pre-tax loss of $251,881 when comparing the two periods.  The effective tax rates for the year ended December 31, 2017 and 2016 were 65% and 49.8%, respectively.  For the year ended December 31, 2017, the increase in the effective tax rate is primarily attributable to permanent book/tax differences, the noncontrolling interest in SkyScale and non-deductible stock option compensation expense, and revaluation of the deferred tax assets and liabilities attributable to the change in federal tax rates attributable to the enactment of the Tax Act in 2017.

Liquidity and capital resources

During 2017, our primary sources of liquidity came from existing cash, a bank revolving line of credit and related party and third party term notes and the formation of SkyScale, LLC. Based on our current plans and business conditions, we believe that existing cash and cash generated from operations will be sufficient to satisfy our anticipated cash requirements for at least the next twelve months.

We have a credit agreement with a financial institution which provides for a revolving line of credit and a term note payable. Borrowings under the agreement are collateralized by substantially all of our assets and the personal guarantee of our CEO.  Borrowings under the revolving line of credit bear interest at a LIBOR-based rate, plus 2.5% (totaling 3.93% at December 31, 2017).  The outstanding balance on the line of credit as of December 31, 2017 was $3,334,508.  The credit agreement is subject to certain financial and non-financial covenants with which we were not in compliance as of December 31, 2017, but we have obtained a waiver. These covenants are as follows:

 

 

Debt to Effective Net Worth – We failed to maintain a ratio of Debt to Effective Tangible Net Worth of not more than 1.75 to 1, measured at each fiscal quarter-end. Our Debt to Effective Tangible Net Worth was 3.66 to 1, as of December 31, 2016 and 3.58 to 1, as of December 31, 2017.

 

Effective Tangible Net Worth – We failed to maintain a minimum Effective Tangible Net Worth of at least $2,500,000.00 through December 31, 2016 and $3,500,000 thereafter, measured at each fiscal quarter-end.  Our minimum Effective Tangible Net Worth was $2,169,000 as of December 31, 2016 and $2,836,000 as of December 31, 2017.

 

Cash Flow to Current Portion of Long Term Debt – We failed to maintain a ratio of Cash Flow to Current Portion of Long-Term Debt of not less than 1.25 to 1 for the year ended December 31, 2016.

 

Net Income – We failed to maintain a minimum Net Income after tax of at least $500,000.00 for the years ended December 31, 2016 and December 31, 2017. Our minimum Net income (loss) after tax was ($247,000) and $96,782 for the years ended December 31, 2016 and 2017, respectively.

 

Our lender has provided a waiver of the above compliance failures as of December 31, 2017. Any future breaches of the credit agreement are not waived.

The line of credit was to be due and payable in July 2017.  However, in August 2017, we received a three-month extension of our revolving line of credit while additional terms and conditions were agreed to for full extension of the revolving line of credit.  On October 5, 2017, we received that renewal and extension through August 31, 2018 and a modification in our borrowing capacity, which increased from $3.0 million to $3.5 million. On February 5, 2018, the Company paid down the outstanding balance of the line of credit with proceeds from the Company’s initial public offering.  On March 2, 2018, the line of credit with the Bank of the West was cancelled by the Company and the personal guarantee of our CEO was released.

As part of our credit agreement, in July 2016, we entered into a $1.6 million note payable.  Under the terms of the note, interest accrues on the outstanding balance at 3.80% per annum.  The note requires us to make monthly principal and interest payments totaling $47,219 through the maturity date of July 31, 2019.  The balance outstanding on this note payable as of December 31, 2017 was $868,918. On February 23, 2018, the Company paid off the remaining balance of the Bank of the West loan with proceeds from the Company’s initial public offering.

47


In July 2016, we issued a note payable totaling $250,000 to a third party. Under the terms of the note agreement, interest accrues on the outstanding balance at 11% per annum.  This note requires us to make monthly principal and interest payments totaling $9,570 with a maturity date on January 15, 2019.  The note is unsecured and personally guaranteed by our CEO and is subordinated to borrowings under the bank’s credit agreement. As of December 31, 2017, the outstanding balance was $116,774.  On February 15, 2018, the Company paid-off the remaining balance of the “July 2016 Note” with proceeds from the Company’s initial public offering.  Our CEO’s personal guarantee released as a result.

In July 2016, we issued notes payable totaling $350,000 to two stockholders.  Under the terms of the note agreements, interest accrues on the outstanding balance at 11% per annum.  This note requires us to make total monthly principal and interest payments of $13,395 with maturity on January 15, 2019.  The notes are unsecured and personally guaranteed by our CEO and are subordinated to borrowings under the bank’s credit agreement. As of December 31, 2017, the outstanding balance was $163,483. On February 15, 2018, the Company paid-off the remaining balances of the related party notes payable with proceeds from the Company’s initial public offering. Our CEO’s personal guarantee released as a result.

 

Our future capital requirements will depend on many factors including our growth rate, the timing and extent of spending to support development efforts, the expansion of our sales and marketing, the timing of new product introductions and the continuing market acceptance of our products and services.

We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise monies on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition would be adversely affected.

 

The following table summarizes our cash flows for the years ended December 31, 2017 and 2016:

 

Cash flows:

 

2017

 

 

2016

 

Net cash used in operating activities

 

$

(381,766

)

 

$

(273,224

)

Net cash used in investing activities

 

$

(425,482

)

 

$

(138,011

)

Net cash provided by financing activities

 

$

978,768

 

 

$

400,358

 

 

Operating Activities

During the year ended December 31, 2017, we used $381,766 in cash from operating activities, an increase in the use of cash of $108,542 when compared to the cash used in operating activities of $273,224 during the same period in 2016. The decrease in cash generated by operating activities was primarily a result of an increase in net income, offset by decreases in non-cash adjustments, comprised of the net loss attributable to non-controlling interests, deferred benefit for income taxes, amortization of deferred gain, and inventory reserves.  During the year ended December 31, 2017 and 2016 respectively, net income adjusted for non-cash expenditures was $929,438 in 2017 as compared to $857,107 in 2016, an increase of $72,331. Additionally, working capital requirements decreased overall by $180,873.  This net decrease was attributable to an increase in working capital for accounts receivable and accounts payable of $2,466,555 that was offset by $2,647,428 in decreases in working capital attributable to inventories, prepaid expenses and deposits and accrued expenses for the comparable period.

 

Our ability to generate cash from operations in future periods will depend in large part on our profitability, the rate and timing of collections of our accounts receivable, our inventory turns and our ability to manage other areas of working capital.

 

Investing Activities

During the year ended December 31, 2017, we used cash of $425,482 in investing activities as compared to $138,011used during the same period in 2016, an increase of $287,471. The net increase is primarily due to an increase in equipment purchases attributable to the Ion purchase and test equipment for a customer project. We do

48


not anticipate any significant purchases of equipment beyond that which is anticipated for use in the normal course of our core business activity.

 

Financing Activities

During the year ended December 31, 2017, we generated $978,768 from financing activities as compared to the cash generated of $400,358 during the same period in 2016.  Cash was generated through the receipt of cash from the 50% investor in the SkyScale joint venture, proceeds from the issuance of common stock and proceeds from the bank revolving line of credit. These receipts of cash of $1,731,833 were offset by payments on notes payable of $753,065.

 

Contractual obligations and commitments

 

The following table sets forth our non-cancellable contractual obligations as of December 31, 2017.

 

 

 

Total

 

 

Less than 1 year

 

 

1-3 years

 

 

3-5 years

 

 

More than 5 Years

 

Notes payable

 

$

1,149,175

 

 

$

163,483

 

 

$

985,692

 

 

$

-

 

 

$

-

 

Operating leases

 

 

575,253

 

 

 

402,721

 

 

 

172,532

 

 

 

-

 

 

 

-

 

Total

 

$

1,724,428

 

 

$

566,204

 

 

$

1,158,224

 

 

$

-

 

 

$

-

 

 

All notes payable were paid-off in February 2018, from proceeds from the Company’s initial public offering.  We have made certain indemnities, under which the Company may be required to make payments to an indemnified party, in relation to certain transactions.  We indemnify our directors, officers, employees and agents to the maximum extent permitted under the laws of the State of Delaware.  In connection with our facilities leases, we indemnify our lessors for certain claims arising from the use of our facilities.  Also, in connection with our bank credit agreement, we have agreed to indemnify our lender and others related to the use of the proceeds and other matters.  The duration of the indemnities varies, and in many cases is indefinite.  These indemnities do not provide for any limitation of the maximum potential future payments we could be obligated to make.  Historically, we have not been obligated to make any payments for these obligations and no liabilities have been recorded for these indemnities.

 

Off balance sheet arrangements

 

Other than lease commitments incurred in the normal course of business and certain indemnification provisions, we do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets, or any obligation arising out of a material variable interest in an unconsolidated entity.

We do not have any majority-owned subsidiaries that are not consolidated in the financial statements. Additionally, we do not have an interest in, or relationships with, any special purpose entities.  Prior to the 2018 pay-off of our outstanding notes payable and line of credit, our CEO provided a personal guarantee on much of our outstanding debt obligations.

 

Stockholder transactions

 

We issued notes payable to Series B preferred stockholders totaling $350,000 during the year ended December 31, 2016.  In connection with the issuance of the notes during the year ended December 31, 2016, we issued warrants to purchase 39,326 shares of common stock at $1.78 per share.  

 

Effective August 1, 2016, we entered into a management services agreement with a company owned by the former Chief Executive Officer of Magma.  The agreement calls for payments of $180,000 per year for the first two years paid in monthly installments.  In year three the amount is reduced to $37,500 for the year paid in monthly installments.  Additionally, we granted 30,000 options in conjunction with execution of this agreement.  Payments for the year ended December 31, 2017 were $180,000.

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Critical accounting policies and estimates

Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates.  The critical accounting estimates, assumptions and judgments that we believe have the most significant impact on our consolidated financial statements are described below.

 

Revenue Recognition

The Company recognizes revenue in accordance FASB ASC Topic 605.  Accordingly, revenue from the sale of products is recognized when there is evidence of an arrangement, the selling price is fixed or determinable, title and risk of loss has transferred to the customer, any installation or service obligations have been satisfied, and collection is reasonably assured. Net revenue includes deductions for customer discounts and actual and estimated returns. All amounts billed to customers related to shipping and handling are classified as net sales.

 

Customer agreements include one vendor managed inventory program.  Pursuant to Staff Accounting Bulletin Topic 13.A.3.a, the Company recognizes revenue under this arrangement when (i) risks of ownership have passed to the customer; (ii) the customer's  commitment to purchase the goods is fixed; (iii) there is a fixed schedule for delivery of the goods that is reasonable and consistent with the customer's  business purpose; (iv) the Company does not have any specific performance obligations such that the earning process is not complete; (v) the ordered goods must have been segregated from the Company's inventory and not be subject to being used to fill other orders; and (vi) the product must be complete and ready for shipment.  Also, such arrangement must be requested by the customer and the customer has explained a substantial business purpose for the arrangement.  Management also considers whether the customer's custodial risks are insured and whether modifications to the Company's normal billing and credit terms were required. Revenue from the sale of extended warranties is deferred and amortized on a straight-line basis over the applicable service period.

 

Stock-Based Compensation

We measure and recognize compensation expense for all stock-based awards granted to our employees and other service providers, including stock options granted under our 2015 Plan, based on the estimated fair value of the award. We use the Black-Scholes option pricing model to estimate the fair value of stock option awards granted under our 2015 Plan. We recognize the fair value of stock options granted under our 2015 Plan as stock-based compensation on a straight line basis over the requisite service period. We record expense net of anticipated forfeitures and adjust the annual expense based upon actual experience.  

 

Our use of the Black-Scholes option pricing model requires the input of highly subjective assumptions, including the fair value of the underlying common stock, expected term of the option, expected volatility of the price of our common stock, risk-free interest rates and the expected dividend yield of our common stock. The assumptions used in our option pricing model represent management’s best estimates. These estimates involve inherent uncertainties and the application of management’s judgment. If factors change and different assumptions are used, our stock-based compensation expense could be materially different in the future.  

 

These assumptions and estimates are as follows:  

 

Fair Value of Common Stock.    Our board of directors considered numerous objective and subjective factors to determine the fair value of our common stock at each grant date. These factors included, but were not limited to, (i) contemporaneous valuations of common stock performed by unrelated third-party specialists; (ii) the rights, preferences and privileges of our convertible preferred stock relative to those of our common stock; (iii) the lack of marketability of our common stock; (iv) developments in the business; (v) the likelihood of achieving a liquidity event, such as an IPO or a merger or acquisition of our business, given prevailing market conditions; and (vi) the market performance of comparable

50


 

publicly traded companies.  Now that we are a publicly-traded company, we will use the market value of our stock on the date of grant for future fair value determinations.

 

Expected Term.    The expected term represents the period that our stock-based awards are expected to be outstanding. The expected term assumptions were determined based on the vesting terms, exercise terms and contractual lives of the options.  

 

Expected Volatility.    Since we do not have sufficient trading history of our common stock, the expected volatility was determined based on the historical stock volatilities of comparable companies. Comparable companies consist of public companies in our industry that is similar in size, stage of life cycle and financial leverage. We intend to continue to apply this process using the same or similar public companies until a sufficient amount of historical information regarding the volatility of our own share price becomes available, or unless circumstances change such that the identified companies are no longer similar to us, in which case, more suitable companies whose share prices are publicly available would be used in the calculation.  

 

Risk-Free Interest Rate.    The risk-free interest rate is based on the implied yield available on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options.  

 

Dividend Rate.    We have never declared or paid any cash dividends and do not plan to pay cash dividends in the foreseeable future, and, therefore, use an expected dividend yield of zero.  

 

We will continue to use judgment in evaluating the assumptions related to our stock-based compensation on a prospective basis. As we continue to accumulate additional data related to our common stock, we may refine our estimation process, which could materially impact our future stock-based compensation expense.

 

Inventory Valuation

We value our inventory at the lower of cost or its current estimated market value.  We use the average cost method for purposes of determining cost, which approximates the first-in, first-out method. We write down inventory for excess and obsolescence based upon a review of historical usage and assumptions about future demand, product mix and possible alternative uses. Actual demand, product mix and alternative usage may be lower than those that we project and this difference could have a material adverse effect on our gross margin if inventory write-downs beyond those initially recorded become necessary.  Alternatively, if actual demand, product mix and alternative usage are more favorable than those we estimated at the time of such a write-down, our gross margin could be favorably impacted in future periods.

 

Goodwill, Intangible Assets and Long-lived Assets

We evaluate our goodwill for impairment annually and in any interim period in which events or circumstances arise that indicate our goodwill may be impaired. Indicators of impairment include, but are not limited to, a significant deterioration in overall economic conditions, a decline in our market capitalization, the loss of significant business, significant decreases in funding for our contracts, or other significant adverse changes in industry or market conditions.

 

We test goodwill for impairment at the reporting unit level. Goodwill impairment guidance provides entities an option to perform a qualitative assessment (commonly known as “step zero”) to determine whether further impairment testing is necessary before performing the two-step test. The qualitative assessment requires significant judgments by management about macro-economic conditions including the entity's operating environment, its industry and other market considerations, entity-specific events related to financial performance or loss of key personnel, and other events that could impact the reporting unit. If we conclude that further testing is required, the impairment test involves a two-step process. Step one compares the fair value of the reporting unit with its carrying value, including goodwill. If the carrying amount exceeds the fair value of the reporting unit, step two is required to determine if there is an impairment of the goodwill. Step two compares the implied fair value of the reporting unit's goodwill to the carrying amount of the goodwill. We estimate the fair value of our reporting unit using the income approach based upon a discounted cash flow model. The income approach requires the use of many assumptions and estimates including future revenues, expenses, capital expenditures, and working capital, as well as discount factors

51


and income tax rates. In addition, we use the market approach, which compares the reporting unit to publicly-traded companies and transactions involving similar businesses, to support the conclusions of the income approach.

 

As part of our annual goodwill impairment testing, we utilize a discount rate for our reporting unit, as defined by FASB ASC 350, Intangibles-Goodwill and Other , that we believe represents the risks that our business faces, considering our size, the current economic environment, and other industry data we believe is appropriate We also review finite-lived intangible assets and long-lived assets when indications of potential impairment exist, such as a significant reduction in undiscounted cash flows associated with the assets. Should the fair value of our long-lived assets decline because of reduced operating performance, market declines, or other indicators of impairment, a charge to operations for impairment may be necessary.

 

Income Taxes

The determination of income tax expense requires us to make certain estimates and judgments concerning the calculation of deferred tax assets and liabilities, as well as the deductions and credits that are available to reduce taxable income. We recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our consolidated financial statements. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates for the year in which the differences are expected to reverse.

 

In evaluating our ability to recover deferred tax assets, we consider all available positive and negative evidence, including our past operating results, our forecast of future earnings, future taxable income, and tax planning strategies. The assumptions utilized in determining future taxable income require significant judgment. We record a valuation allowance against deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. If it becomes more likely than not that a tax asset will be used for which a reserve has been provided, we reverse the related valuation allowance. If our actual future taxable income by tax jurisdiction differs from estimates, additional allowances or reversals of reserves may be necessary.

 

We use a two-step approach to recognize and measure uncertain tax positions. First, the tax position must be evaluated to determine the likelihood that it will be sustained upon external examination. If the tax position is deemed more-likely-than-not to be sustained, the tax position is then assessed to determine the amount of benefit to recognize in the financial statements. The amount of the benefit that may be recognized is the largest amount that has a greater than 50% likelihood of being realized upon ultimate settlement. We reevaluate our uncertain tax positions on a quarterly basis and any changes to these positions as a result of tax audits, tax laws or other facts and circumstances could result in additional charges to operations.

 

Business Combinations

We utilize the acquisition method of accounting for business combinations and allocate the purchase price of an acquisition to the various tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. We primarily establish fair value using the income approach based upon a discounted cash flow model. The income approach requires the use of many assumptions and estimates including future revenues and expenses, as well as discount factors and income tax rates. Other estimates include:

 

 

Estimated step-ups or write-downs for fixed assets and inventory;

 

Estimated fair values of intangible assets; and

 

Estimated income tax assets and liabilities assumed from the target

 

 

While we use our best estimates and assumptions as part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at the business acquisition date, our estimates and assumptions are inherently uncertain and subject to refinement. As a result, during the purchase price allocation period, which is generally one year from the business acquisition date, we record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill.

52


 

For changes in the valuation of intangible assets between preliminary and final purchase price allocation, the related amortization is adjusted in the period it occurs. Subsequent to the purchase price allocation period any adjustment to assets acquired or liabilities assumed is included in operating results in the period in which the adjustment is determined.  Should we issue shares of our common stock in an acquisition, we will be required to estimate the fair value of the shares issued.

 

Recent accounting pronouncements

 

In May 2014, the FASB issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”). ASU 2014-09 supersedes the revenue recognition requirements in FASB Topic 605, Revenue Recognition. ASU 2014-09 implements a five-step process for customer contract revenue recognition that focuses on transfer of control, as opposed to transfer of risk and rewards. The amendment also requires enhanced disclosures regarding the nature, amount, timing and uncertainty of revenues and cash flows from contracts with customers. Other major provisions include the capitalization and amortization of certain contract costs, ensuring the time value of money is considered in the transaction price, and allowing estimates of variable consideration to be recognized before contingencies are resolved in certain circumstances. Entities can transition to the standard either retrospectively or as a cumulative-effect adjustment as of the date of adoption.  On July 9, 2015, the FASB approved amendments deferring the effective date of the standard by one year. The new standard will be effective for the Company in the first quarter of 2019. The Company has not yet selected a transition method and is currently assessing the impact the adoption of ASU 2014-09 will have on its consolidated financial statements and disclosures.

 

In July 2015, the FASB issued ASU No. 2015-11, Inventory (Topic 330) ("ASU 2015-11"). The amendments in ASU 2015-11 require that an entity measure inventory within the scope of the standard at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transaction. The amendments in this update more closely align the measurement of inventory in U.S. GAAP with the measurement of inventory in International Financial Reporting Standards. ASU 2015-11 is effective for annual and interim periods beginning on or after December 15, 2017.  The Company will adopt this guidance in the first quarter of 2018 and does not expect a material impact on our consolidated financial statements or disclosures.

 

In February 2016, the FASB issued ASU No. 2016-02, Leases (“ASU 2016-02”).  Under ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term.  ASU 2016-02 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.  Early application is permitted.  Lessees must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements.  The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented.  Lessees may not apply a full retrospective transition approach.  The Company is currently evaluating the impact of adopting ASU 2016-02 on its consolidated financial statements and disclosures.

 

In March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic 718) (“ASU 2016-09”), which simplified certain aspects of the accounting for stock-based payment transactions, including income taxes, classification of awards and classification in the statement of cash flows. ASU 2016-09 will be effective for annual reporting periods beginning after December 15, 2017 and interim periods within those annual periods. The Company will adopt this guidance in the first quarter of 2018 and does not expect a material impact on its consolidated financial statements and disclosures.

 

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In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”), which is intended to reduce the existing diversity in practice in how certain cash receipts and cash payments are classified in the statement of cash flows. ASU 2016-15 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years with early adoption permitted, provided that all of the amendments are adopted in the same period. The Company is currently evaluating the impact of adopting ASU 2016-15 on its consolidated financial statements.

 

In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business (“ASU 2017-01”). The amendments in this update clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions or disposals of assets or businesses. ASU 2017-01 will be effective for the Company for the year ending December 31, 2019 and interim reporting periods within that year. Early adoption is permitted for transactions that have not been reported in financial statements that have been issued or made available for issuance. The Company is currently evaluating the effect of the adoption of this guidance on the Company’s consolidated financial statements.

 

In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). ASU 2017-04 simplifies the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment testing. An entity will no longer determine goodwill impairment by calculating the implied fair value of goodwill by assigning the fair value of a reporting unit to all of its assets and liabilities as if that reporting unit had been acquired in a business combination. Instead, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. ASU 2017-04 wi