Note 1. Basis of Consolidation and Presentation

We harness proprietary big data predictive analytics, artificial intelligence and telehealth, combined with human intervention, to deliver improved member health and cost savings to health plans through integrated technology enabled treatment solutions. It is our mission to provide access to affordable and effective care, thereby improving health and reducing cost of care for people who suffer from the medical consequences of behavioral health conditions; helping these people and their families achieve and maintain better lives

The accompanying unaudited condensed consolidated financial statements for Catasys, Inc. and its subsidiaries have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and instructions to Form 10-Q and, therefore, do not include all disclosures necessary for a complete presentation of financial position, results of operations, and cash flows in conformity with U.S. GAAP. In our opinion, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included.  Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying financial information should be read in conjunction with the financial statements and the notes thereto included in our most recent Annual Report on Form 10-K for the year-ended December 31, 2017, from which the balance sheet, as of December 31, 2017, have been derived.

Our ability to fund our ongoing operations is dependent on increasing the number of members that are eligible for our solutions by signing new contracts, identifying more eligible members in existing contracts, and generating fees from existing and new contracts and the success of management’s plan to increase revenue and continue to control expenses. We currently operate our OnTrak solutions in twenty states. We provide services to commercial (employer funded), managed Medicare Advantage, and managed Medicaid and duel eligible (Medicare and Medicaid) populations. We have generated fees from our launched programs and expect to increase enrollment and fees throughout 2018.

Management’s Plans

In June 2018 we entered into a venture loan and security agreement (the “Loan Agreement”) with Horizon Technology Finance Corporation (the “Lender”), which provides for up to $7.5 million in loans to the Company, including initial loans in the amount of $5.0 million funded upon signing of the Loan Agreement.  An additional $2.5 million loan is subject to the Company’s achievement of billings of not less than $5.0 million during any three consecutive month period on or prior to November 30, 2018.  Also, in June 2018, we entered into a loan and security agreement in connection with a $2.5 million receivables financing facility with Corporate Finance, a division of Heritage Bank of Commerce (the “A/R Facility”). The A/R Facility provides for the borrower entities to borrow up to 85% of the Company’s eligible accounts receivable, as defined in the A/R Facility.

Historically we have seen and continue to see net losses, net loss from operations, negative cash flow from operating activities, and historical working capital deficits as we continue through a period of rapid growth. These conditions raise substantial doubt about our ability to continue as a going concern.  The accompanying financial statements do not reflect any adjustments that might result if we were unable to continue as a going concern. We entered into contracts for additional revenue-generating health plan customers and expanding our OnTrak program within existing health plan customers.  To support this increased demand for services, we invested in the additional headcount needed to support these customers launching during the first half of 2018.  We have had a growing customer base and are able to fully scale our operations to service the contracts and future enrollment providing leverage in these investments that is expected to result in positive cash flow during the second quarter of 2019. Based upon this expected positive cash flow, we believe we will have enough capital to cover expenses through at least the next twelve months. We will continue to monitor liquidity carefully and in the event we do not have enough capital to cover expense we will make the necessary and appropriate reductions in spending to remain cash flow positive.  However, if we were to add more health plans than budgeted, increase the size of the outreach pool by more than we anticipate, decide to invest in new products or seek out additional growth opportunities, we would look to finance these options via a debt financing rather than an equity financing, subject to complying with certain restrictions on the incurrence of indebtedness in our current lending facilities.

All inter-company transactions have been eliminated in consolidation.

 Note 2. Summary of Significant Accounting Policies

Revenue Recognition

      Revenue from contracts with customers is recognized when, or as, we satisfy our performance obligations by transferring the promised goods or services to the customers. A good or service is transferred to a customer when, or as, the customer obtains control of that good or service. A performance obligation may be satisfied over time or at a point in time. Revenue from a performance obligation satisfied over time is recognized by measuring our progress in satisfying the performance obligation in a manner that depicts the transfer of the goods or services to the customer. Revenue from a performance obligation satisfied at a point in time is recognized at the point in time that we determine the customer obtains control over the promised good or service. The amount of revenue recognized reflects the consideration we expect to be entitled to in exchange for those promised goods or services (i.e., the “transaction price”). In determining the transaction price, we consider multiple factors, including the effects of variable consideration. Variable consideration is included in the transaction price only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainties with respect to the amount are resolved. In determining when to include variable consideration in the transaction price, we consider the range of possible outcomes, the predictive value of our past experiences, the time period of when uncertainties expect to be resolved and the amount of consideration that is susceptible to factors outside of our influence, such as the judgment and actions of third parties.

The following table disaggregates our revenue by contract (in thousands):

Because the Company’s contracts have an expected duration of one year or less, the Company has elected the practical expedient in Accounting Standards Codification (“ASC”) 606-10-50-14(a) to not disclose information about its remaining performance obligations.

Our Catasys contracts are generally designed to provide cash fees to us on a monthly basis, an upfront case rate, or fee for service based on enrolled members. The Company’s performance obligation is satisfied over time as the OnTrak service is provided continuously throughout the service period. The Company recognizes revenue evenly over the service period using a time-based measure because the Company is providing a continuous service to the customer. Contracts with minimum performance guarantees or price concessions include variable consideration and are subject to the revenue constraint. The Company uses an expected value method to estimate variable consideration for minimum performance guarantees and price concessions. The Company has constrained revenue for expected price concessions during the period ending June 30, 2018.

Cost of Services

Cost of healthcare services consists primarily of salaries related to our care coaches, outreach specialists and other staff directly involved in member care, healthcare provider claims payments, and fees charged by our third party administrators for processing these claims. Salaries and fees charged by our third party administrators for processing claims are expensed when incurred and healthcare provider claims payments are recognized in the period in which an eligible member receives services. We contract with doctors and licensed behavioral healthcare professionals, on a fee-for-service basis. We determine that a member has received services when we receive a claim or in the absence of a claim, by utilizing member data recorded in the OnTrak^TM database within the contracted timeframe, with all required billing elements correctly completed by the service provider. 

Cash Equivalents and Concentration of Credit Risk 

We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents. Financial instruments that potentially subject us to a concentration of credit risk consist of cash and cash equivalents. Cash is deposited with what we believe are highly credited, quality financial institutions. The deposited cash may exceed Federal Deposit Insurance Corporation (“FDIC”) insured limits. As of June 30, 2018, we had $5.4 million in cash and cash equivalents exceeding federally insured limits.

For the six months ended June 30, 2018, five customers accounted for approximately 93% of revenues (26%, 25%, 16%, 15%, and 11%) and three customers accounted for approximately 71% of accounts receivable (42%, 17%, and 12%).

For the three months ended June 30, 2018, two customers accounted for approximately 36% of revenues (19% and 17%).

Basic and Diluted Income (Loss) per Share

Basic income (loss) per share is computed by dividing the net loss to common stockholders for the period by the weighted average number of common stock outstanding during the period. Diluted loss per share is computed by dividing the net loss for the period by the weighted average number of common stock and dilutive common equivalent shares outstanding during the period.

Common equivalent shares, consisting of 4,571,912 and 2,255,381 common shares for the six months ended June 30, 2018 and 2017, issuable upon the exercise of stock options and warrants have been excluded from the diluted earnings per share calculation as their effect is anti-dilutive.

Common equivalent shares, consisting of 413,701 incremental common shares for the three months ended June 30, 2017, issuable upon the exercise of warrants have been included in the diluted earnings per share calculation.

Share-Based Compensation

Our 2017 Stock Incentive Plan (the “2017 Plan”), provides for the issuance of up to 2,333,334 shares of our common stock and an additional 243,853 shares of our common stock that are represented by awards granted under our 2010 Stock Incentive Plan (the “2010 Plan”). Incentive stock options (ISOs) under Section 422A of the Internal Revenue Code and non-qualified options (NSOs) are authorized under the 2017 Plan. We have granted stock options to executive officers, employees, members of our board of directors, and certain outside consultants. The terms and conditions upon which options become exercisable vary among grants, but option rights expire no later than ten years from the date of grant and employee and board of director awards generally vest over three to five years. As of June 30, 2018, we had 2,526,664 shares outstanding, of which 368,609 shares are vested and 50,523 shares are available for future awards under the 2017 Plan.

Share-based compensation expense attributable to operations were approximately $425,000 and $753,000 for the three and six months ended June 30, 2018, respectively compared with approximately $32,000 and $159,000 for the same periods in 2017, respectively.

Stock Options – Employees and Directors

We measure and recognize compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the date of grant. We estimate the fair value of share-based payment awards using the Black-Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statements of operations.

For share-based awards issued to employees and directors, share-based compensation is attributed to expense using the straight-line single option method. Share-based compensation expense recognized in our consolidated statements of operations for the three and six months ended June 30, 2018 and 2017 is based on awards ultimately expected to vest, reduced for estimated forfeitures. Accounting rules for stock options require forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

There were 642,307 options granted to employees and directors during the three and six months ended June 30, 2018 compared with no options granted during the same periods in 2017. Employee and director stock option activity for the six months ended June 30, 2018 are as follows:

The expected volatility assumptions have been based on the historical and expected volatility of our stock, measured over a period generally commensurate with the expected term. The weighted average expected option term for the three and six months ended June 30, 2018 and 2017, reflects the application of the simplified method prescribed in Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 107 (as amended by SAB 110), which defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches.

As of June 30, 2018, there was $6.7 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 2017 Plan. That cost is expected to be recognized over a weighted-average period of approximately 3.5 years.          

Stock Options and Warrants – Non-employees

We account for the issuance of options and warrants for services from non-employees by estimating the fair value of warrants issued using the Black-Scholes pricing model. This model’s calculations include the option or warrant exercise price, the market price of shares on grant date, the weighted average risk-free interest rate, the expected life of the option or warrant, and the expected volatility of our stock and the expected dividends.

For options and warrants issued as compensation to non-employees for services that are fully vested and non-forfeitable at the time of issuance, the estimated value is recorded in equity and expensed when the services are performed and benefit is received. For unvested shares, the change in fair value during the period is recognized in expense using the graded vesting method.

There were no options issued to non-employees for the three and six months ended June 30, 2018 or in the same periods in 2017.

There was no share-based compensation expense relating to stock options and warrants recognized for non-employees for the three and six months ended June 30, 2018 or in the same periods in 2017.

There were 0 and 24,000 warrants issued in exchange for services during the three months and six months ended June 30, 2018, compared with 90,000 options issued in exchange for services during the same periods in 2017. Generally, the costs associated with warrants issued for services are amortized to the related expense on a straight-line basis over the related service periods.

There were 9,720 warrants issued in connection with the June 2018 A/R Facility financing (see Footnote 4).

There were 2,045,248 and 2,011,528 warrants outstanding as of June 30, 2018 and 2017, respectively.

Common Stock

There were 0 and 24,000 shares of common stock issued in exchange for investor relations services during the three and six months ended June 30, 2018, respectively, compared with 14,493 and 28,985 for the same periods in 2017. Generally, the costs associated with shares issued for services are amortized to the related expense on a straight-line basis over the related service periods.

In April 2017, we entered into an underwriting agreement with Joseph Gunnar & Co., LLC (“Joseph Gunnar”), as underwriter in connection with a public offering of the Company’s securities. Pursuant to the underwriting agreement, we agreed to issue and sell an aggregate 3,125,000 shares of common stock at a public offering price of $4.80 per share, and the purchase price to the underwriter after discounts and commission was $4.464 per share. The closing of the offering occurred on April 28, 2017. We received $15.0 million in gross proceeds in connection with the offering.

Pursuant to the underwriting agreement with Joseph Gunnar, we granted the underwriters a 45 day over-allotment option to purchase up to 468,750 additional shares of common stock at the public offering price less the applicable underwriter discount. In May, the underwriter acquired an additional 303,750 shares pursuant to such over-allotment option. We received $1.5 million in gross proceeds in connection with the over-allotment option.

In connection with the public offering, our common stock began trading on the NASDAQ Capital Market (“NASDAQ”) under the symbol “CATS” beginning on April 26, 2017.

In April 2017, several investors, including Acuitas Group Holdings, LLC (“Acuitas”), one hundred percent (100%) of which is owned by Terren S. Peizer, Chairman and Chief Executive Officer of the Company, and Shamus, LLC (“Shamus”), a Company owned by David E. Smith, a member of our board of directors, exercised their option to convert their convertible debentures and received 2,982,994 shares of common stock. There was a loss on the conversion of the convertible debentures of $1.4 million for the six months ended June 30, 2017.

In April 2017, Terren S. Peizer agreed to settle his deferred salary balance of $1.1 million for 233,734 shares of common stock. As a result, the Company recognized a loss on settlement of liability totaling $83,807 which is recorded to loss on issuance of common stock.

In April 2017, we filed a certificate of amendment to our Certificate of Incorporation, as amended and in effect, with the Secretary of State of the State of Delaware, implementing a 1-for-6 reverse stock split of the Company's common stock, pursuant to which each six shares of issued and outstanding common stock converted into one share of common stock. Proportionate voting rights and other rights of common stock holders were not affected by the reverse stock split.  No fractional shares of common stock were issued as a result of the reverse stock split; stockholders were paid cash in lieu of any such fractional shares.

All stock options and warrants to purchase common stock outstanding and our Common Stock reserved for issuance under the Company's equity incentive plans immediately prior to the reverse stock split were appropriately adjusted by dividing the number of affected shares of common stock by six and, as applicable, multiplying the exercise price by six as a result of the reverse stock split.

Income Taxes

We have recorded a full valuation allowance against our otherwise recognizable deferred tax assets as of June 30, 2018.  As such, we have not recorded a provision for income tax for the period ended June 30, 2018.  We utilize the liability method of accounting for income taxes as set forth in ASC 740, Income Taxes. Under the liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. 

We assess our income tax positions and record tax benefits for all years subject to examination based upon our evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where there is greater than 50% likelihood that a tax benefit will be sustained, we have recorded the largest amount of tax benefit that may potentially be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where there is less than 50% likelihood that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements.  Based on management's assessment of the facts, circumstances and information available, management has determined that all of the tax benefits for the period ended June 30, 2018 should be realized.   

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Assets and liabilities recorded at fair value in the consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure fair value. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level I) and the lowest priority to unobservable inputs (Level III). The three levels of the fair value hierarchy are described below:

The following table summarizes fair value measurements by level at June 30, 2018 for assets and liabilities measured at fair value:

Financial instruments classified as Level III in the fair value hierarchy as of June 30, 2018, represent our liabilities measured at market value on a recurring basis which include warrant liabilities resulting from recent debt financings. In accordance with current accounting rules, the warrant liabilities with anti-dilution protection are being marked-to-market each quarter-end until they are completely settled or expire. The warrants are valued using the Black-Scholes option-pricing model, using both observable and unobservable inputs and assumptions consistent with those used in our estimate of fair value of employee stock options. See Warrant Liabilities below.

The following table summarizes our fair value measurements using significant Level III inputs, and changes therein, for the six months ended June 30, 2018:

Property and Equipment

Property and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Expenditures for maintenance and repairs are charged to expense as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, which range from two to seven years for furniture and equipment. Leasehold improvements are amortized over the lesser of the estimated useful lives of the assets or the related lease term, which is typically five to seven years.

Variable Interest Entities

Generally, an entity is defined as a Variable Interest Entity (“VIE”) under current accounting rules if it has (a) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (b) equity investors that cannot make significant decisions about the entity’s operations, or that do not absorb the expected losses or receive the expected returns of the entity. When determining whether an entity that is a business qualifies as a VIE, we also consider whether (i) we participated significantly in the design of the entity, (ii) we provided more than half of the total financial support to the entity, and (iii) substantially all of the activities of the VIE either involve us or are conducted on our behalf. A VIE is consolidated by its primary beneficiary, which is the party that absorbs or receives a majority of the entity’s expected losses or expected residual returns.

As discussed under the heading Management Services Agreement (“MSA”) below, we have an MSA with a Texas nonprofit health organization (“TIH”). Under this MSA, the equity owner of TIH has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We participate significantly in the design of this MSA. We also agree to provide working capital loans to allow for TIH to pay for its obligations. Substantially all of the activities of TIH either involve us or are conducted for our benefit, as evidenced by the facts that (i) the operations of the TIH are conducted primarily using our licensed network of providers and (ii) under the MSA, we agree to provide and perform all non-medical management and administrative services for the medical group. Payment of our management fee is subordinate to payments of the obligations of TIH, and repayment of the working capital loans is not guaranteed by the equity owner of the affiliated medical group or other third party. Creditors of TIH do not have recourse to our general credit.

Based on the design and provisions of this MSA and the working capital loans provided to the medical group, we have determined that TIH is a VIE, and that we are the primary beneficiary as defined in the current accounting rules. Accordingly, we are required to consolidate the revenues and expenses of the managed medical corporation.

Management Services Agreement

In April 2018, we executed an MSA with TIH. Under the MSA, we license to TIH the right to use our proprietary treatment programs and related trademarks and provide all required day-to-day business management services, including, but not limited to:

All clinical matters relating to the operation of TIH and the performance of clinical services through the network of providers shall be the sole and exclusive responsibility of the TIH Board free of any control or direction by Catasys.

TIH pays us a monthly fee equal to the aggregate amount of (a) our costs of providing management services (including reasonable overhead allocable to the delivery of our services and including salaries, rent, equipment, and tenant improvements incurred for the benefit of the medical group, provided that any capitalized costs will be amortized over a five-year period), (b) 10%-15% of the foregoing costs, and (c) any performance bonus amount, as determined by the treatment center at its sole discretion. The treatment center’s payment of our fee is subordinate to payment of the treatment center's obligations, including physician fees and medical group employee compensation.

Under the MSA, the equity owner of the affiliated treatment center has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We also agree to provide working capital loans to allow for TIH to pay for its obligations. Substantially all of the activities of TIH either involves us or are conducted for our benefit, as evidenced by the facts that (i) the operations of TIH is conducted primarily using our licensed protocols and (ii) under the MSA, we agree to provide and perform all non-medical management and administrative services for the treatment center. Payment of our management fee is subordinate to payments of the obligations of TIH, and repayment of the working capital loans is not guaranteed by the equity owner of TIH or other third party. Creditors of TIH do not have recourse to our general credit. Based on these facts, we have determined that TIH is a VIE and that we are the primary beneficiary as defined in current accounting rules.  Accordingly, we are required to consolidate the assets, liabilities, revenues and expenses of the managed treatment center.

The amounts and classification of assets and liabilities of the VIE included in our consolidated balance sheets at June 30, 2018 are as follows:

Warrant Liabilities

The warrant liabilities were calculated using the Black-Scholes model based upon the following assumptions:

We issued 11,049 warrants to purchase common stock in April 2015 which are being accounted for as liabilities in accordance with Financial Accounting Standards Board (“FASB”) accounting rules, due to anti-dilution provisions in the warrants that protect the holders from declines in our stock price, which is considered outside our control.  These warrants are marked-to-market each reporting period, using the Black-Scholes pricing model, until they are completely settled or expire.

For the three and six months ended June 30, 2018, we recognized a loss of $19,000 and $29,000, respectively, compared with a gain of $7.0 million and $1.8 million for the same periods in 2017, respectively, related to the revaluation of our warrant liabilities.

Recently Issued or Newly Adopted Accounting Standards

In June 2018, the FASB issued Accounting Standard Update (“ASU”) 2018-07, Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”), which supersedes ASC 505-50 and expands the scope of ASC 718 to include all share-based payments arrangements related to the acquisition of goods and services from both employees and nonemployees. For public companies, the amendments are effective for annual reporting periods beginning after December 15, 2018, including interim periods within those annual periods. Early adoption is permitted, but no earlier than a company's adoption date of ASC 606. The Company is currently assessing the impact that adopting this new accounting guidance will have on its financial statements and footnote disclosures.

In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606) (“ASU 2016-10”), which amends certain aspects of the Board’s new revenue standard, ASU 2014-09, Revenue from Contracts with Customers. The standard should be adopted concurrently with adoption of ASU 2014-09, which is effective for annual and interim periods beginning after December 15, 2017. Early adoption is permitted. We have selected the modified retrospective approach as our transition method under ASU 2016-10 and the financial impact to the financial statements was to decrease retained earnings and deferred revenue by $1.9 million effective January 1, 2018 (Please see footnote 3).

In February 2016, the FASB ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the lease 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. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The new lease guidance simplified the accounting for sale and leaseback transactions primarily because lessees must recognize lease assets and lease liabilities. Lessees will no longer be provided with a source of off-balance sheet financing. Public business entities should apply the amendments in ASU 2016-02 for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019, for a calendar year entity). Early application is permitted.  Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) 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 and lessors may not apply a full retrospective transition approach. We are currently evaluating the expected impact that the standard could have on our condensed consolidated financial statements and related disclosures.  We plan on having this analysis completed during the fourth quarter of 2018.

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (“ASU 2016-13”). The amendment revises the impairment model to utilize an expected loss methodology in place of the currently used incurred loss methodology, which will result in more timely recognition of losses on financial instruments, including, but not limited to, available for sale debt securities and accounts receivable. The Company is required to adopt this standard starting in the first quarter of fiscal year 2021. Early adoption is permitted. We are currently evaluating the impact of the adoption of this standard on our condensed consolidated financial statements and related disclosures.

In July 2017, the FASB issued ASU 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception (“ASU 2017-11”). The amendments in this update are intended to simplify the accounting for certain equity linked financial instruments and embedded features with down round features that result in the strike price being reduced on the basis of the pricing of future equity offerings. Under the new guidance, a down round feature will no longer need to be considered when determining whether certain financial instruments or embedded features should be classified as liabilities or equity instruments. That is, a down round feature will no longer preclude equity classification when assessing whether an instrument or embedded feature is indexed to an entity's own stock. In addition, the amendments clarify existing disclosure requirements for equity-classified instruments. These amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted. The adoption of ASU 2017-11 should not have a material impact on our condensed consolidated financial statements.

Note 3. ASC 606

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), (“ASU 2014-09”). ASU 2014-09 supersedes the revenue recognition requirements in ASC 605 - Revenue Recognition (“ASC 605”) and most industry-specific guidance throughout ASC 605. The FASB has issued numerous updates that provide clarification on a number of specific issues as well as requiring additional disclosures. The core principle of ASC 606 requires that an entity recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services.

We adopted ASC 606 effective January 1, 2018 using the modified retrospective method. We recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The cumulative effect of the changes made to our consolidated January 1, 2018 balance sheet for the adoption of ASU 2014-09 were as follows (in thousands): 

In accordance with the new revenue standard requirements, the disclosure of the impact of adoption on our consolidated income statement and balance sheet for the three and six months ended June 30, 2018 was as follows (in thousands): 

Note 4. Long-Term Debt

In June 2018 we entered into a venture loan and security agreement (the “Loan Agreement”) with Horizon Technology Finance Corporation (the “Lender”), which provides for up to $7.5 million in loans to the Company, including initial loans in the amount of $5.0 million funded upon signing of the Loan Agreement.  An additional $2.5 million loan is subject to the Company’s achievement of billings of not less than $5.0 million during any three consecutive month period on or prior to November 30, 2018.

Repayment of the loans is on an interest-only basis through September 1, 2019, followed by monthly payments of principal and accrued interest for the balance of the term, subject to extension in the event the billings of the Company exceed $20.0 million during the six months period ended June 30, 2019. The loans bear interest at a floating coupon rate of 8.75% plus the amount by which one-month LIBOR exceeds 2.0%.  We have also agreed to make quarterly revenue based payments to the Lender in the amount of 0.2% of their consolidated revenue in accordance with GAAP, in any quarter in which the Company’s EBITDA is negative, or 0.4% of such consolidated revenue if the Company’s EBITDA is positive. A final payment equal to 6.0% of each loan tranche will be due on the scheduled maturity date of March 1, 2022 for each loan. In addition, if we repay all or a portion of the loan prior to the applicable maturity date, we will pay the Lender a prepayment penalty fee, based on a percentage of the then outstanding principal balance, equal to 3% if the prepayment occurs during the interest-only payment period, 2% thereafter, plus the amount by which the Revenue Based Payments received prior to such prepayment did not exceed certain minimum thresholds.  We paid $23,000 in interest for the three and six months ended June 30, 2018.

Obligations under the Loan Agreement are secured by a first priority security interest in all of our respective assets, with the exception of intellectual property. We have agreed not to pledge or otherwise encumber our intellectual property assets, subject to certain exceptions.

The Loan Agreement includes customary affirmative and restrictive covenants, excluding any covenants to attain or maintain certain financial metrics, and also includes customary events of default, including for payment failures, breaches of covenants, change of control and material adverse changes.  Upon the occurrence of an event of default and following any applicable cure periods, a default interest rate of an additional 5% may be applied to the outstanding loan balances (and a late payment fee of 6% of the amount due incurred), and the Lender may declare all outstanding obligations immediately due and payable and take such other actions as set forth in the Loan Agreement.

In connection with the Loan Agreement, the Company obligated to pay the Lender a $75,000 commitment fee.

We recognized approximately $438,000 of debt discount associated with this Loan Agreement, which is being amortized to interest expense using the effective interest method over the term of the Loan Agreement.  Amortization of the debt discount associated with the Loan Agreement was approximately $4,000 for the three and six months ended June 30, 2018 and is included in interest expense in the accompanying condensed consolidated statements of operations.  

Also in June 2018, we entered into a loan and security agreement in connection with a $2.5 million receivables financing facility with Corporate Finance, a division of Heritage Bank of Commerce (the “A/R Facility”). The A/R Facility provides for us to borrow up to 85% of the Company’s eligible accounts receivable, as defined in the A/R Facility. Interest on such borrowings accrues at the rate of the Wall Street Journal Prime Rate plus 3.0%. The lender under the A/R Facility is entitled to an annual facility fee of 1% and the initial term of the A/R Facility is two years.  Obligations under the A/R Facility are secured by a first priority security interest in all of the personal property of the Company, with the exception of intellectual property, and are senior to all borrowings under the Loan Agreement pursuant to an intercreditor agreement.

In connection with the A/R Facility agreement, we issued Heritage Bank of Commerce warrants to purchase an aggregate of 9,720 shares of common stock (the “Heritage Warrants”), subject to a reduction in the event of early termination of the AR Facility agreement.  These warrants were recorded as debt issuance costs as well as all fees associated with securing the A/R Facility and are being amortized to interest expense over the two-years term of the A/R Facility using the straight-line method.  We recognized approximately $248,000 of debt issuance costs associated with the A/R Facility, and the amortization of the debt issuance costs associated with the A/R Facility was approximately $6,000 for the three and six months ended June 30, 2018 and is included in interest expense in the accompanying condensed consolidated statements of operations.

Note 5. Subsequent Events

In August 2018, at our Annual Stockholders Meeting, Stockholders approved an amendment to the Company's 2017 Stock Incentive Plan, among other things, to provide for an additional 1,400,000 shares to be issued in connection with awards granted thereunder.