AUDIOEYE INC (AEYE) FY 2021 MD&A

Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our audited financial statements and the related notes for the years ended December 31, 2021 and 2020 that appear elsewhere in this annual report on Form 10-K. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to such differences include but are not limited to those discussed below and elsewhere in this annual report on Form 10-K, particularly in “Risk Factors.” The forward-looking statements included in this annual report on Form 10-K are made only as of the date hereof.

Executive Overview

AudioEye is an industry-leading digital accessibility platform delivering website accessibility compliance at all price points to businesses of all sizes. Our solutions advance accessibility with patented technology that reduces barriers, expands access for individuals with disabilities, and enhances the user experience for a broader audience. In 2021 we focused on the continued expansion of revenue, product innovation, and building out of the AudioEye team.

We have two sales channels to deliver our product, the Partner and Marketplace channel and the Enterprise channel. AudioEye continues to focus on growth on both channels, with specific focus on growing recurring revenue in 2021, while still offering our Mobile App and PDF services. As of December 31, 2021, Monthly Recurring Revenue (“MRR”) was approximately $2.2 million, which represented an increase of 16% year-over-year. Refer to Other Key Operating Metrics below for details on how we calculate MRR.

As at December 31, 2021, AudioEye had approximately 82,000 customers, up from approximately 32,000 at December 31, 2020. This growth was primarily driven by additional customer implementations from Partner relationships and expanding engagement with customers via our Marketplace. Revenue from our Partners and Marketplace grew 40% from prior year. This channel represented about 57% of MRR contribution at the end of 2021.

Total Enterprise revenue grew by 1% from prior year. Enterprise revenue from recurring sources increased by 13% in 2021 over prior year, which helped offset the lower revenue from PDF remediation services due to decreased demand. This channel represented about 43% of MRR contribution at the end of 2021.

We had two major customers (including the customer’s affiliates reflecting multiple contracts and a partnership with the Company) which accounted for approximately 20% and 10%, respectively, of our revenue in the year ended December 31, 2021, and one major customer which generated approximately 16.7% of our revenue in the fiscal year ended December 31, 2020.

The Company continued to invest in Research and development. As a percent of revenue, Research and development cost was 27% of total revenue, an increase from 12% in prior year. With the increase in investment in research and development in 2021 we were able to continue to expand and improve our product offering, including issue reporting, an updated customer portal, and further advancements on automated fixes to accessibility, as well as provide hands-on manual remediation services.

We made additional sales and marketing investments in 2021 to reach a wider, growing, audience and bring further awareness to accessibility on the web. This included additional digital media spend and expanding our sales and marketing team.

We provide further commentary on our Results of Operation below.

Results of Operations

Our financial statements are stated in United States Dollars and are prepared in accordance with United States Generally Accepted Accounting Principles (“U.S. GAAP” or “GAAP”). The discussion of the results of our operations compares the year ended December 31, 2021 with the year ended December 31, 2020. Our results of operations in these periods are not necessarily indicative of

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the results which may be expected for any subsequent period. Due to rounding, numbers presented throughout this document may not add up precisely to the totals provided and percentages may not precisely reflect the absolute figures.

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Revenue

The following table presents our revenues disaggregated by sales channel:

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Partner and Marketplace channel consists of our CMS partners, platform & agency partners, authorized resellers and the Marketplace. This channel serves small & medium sized businesses that are on a partner or reseller’s web-hosting platform or that purchase our solutions from our Marketplace.

Enterprise channel consists of our larger customers and organizations, including those with non-platform custom websites, who generally engage directly with AudioEye sales personnel for custom pricing and solutions. This channel also includes federal, state and local government agencies.

For the year ended December 31, 2021, total revenue increased by 20% over the prior year. The increase in total revenues was primarily driven by higher Partner and Marketplace channel revenue as a result of our continued focus on highly transactional industry verticals to achieve higher penetration within our existing partnerships and expand into new partnerships. The Enterprise channel revenue remained consistent with prior year as a decrease in customer demand for our PDF remediation services was offset by an increase in recurring revenue sources. In 2021, Enterprise revenue from recurring sources increased 13% over the prior year.

Cost of Revenue and Gross Profit

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Cost of revenue consists primarily of compensation and related benefits costs for our customer experience team, as well as a portion of our technology operations team that supports the delivery of our services, fees paid to our managed hosting and other third-party service providers, amortization of capitalized software development costs and patent costs, and allocated overhead costs.

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For the year ended December 31, 2021, cost of revenue remained consistent with the prior year comparable periods as the increase in the cost of hosting fees and in the amortization of capitalized software development costs was offset by a reduction in delivery support costs from continued operating efficiencies.

For the year ended December 31, 2021, gross profit increased by 27% over the prior year. The increase in gross profit was a result of increased revenue and continued improvement in technology driven efficiencies and related support as we scale.

Selling and Marketing Expenses

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Selling and marketing expenses consist primarily of compensation and benefits related to our sales and marketing staff, as well as third-party advertising and marketing expenses.

For the year ended December 31, 2021, selling and marketing expenses increased by 73% over the prior year. The increase in selling and marketing expenses resulted primarily from higher online media and third-party marketing agency expenses, as well as higher personnel costs associated with the increase in headcount and in stock-based compensation expense as we continued to expand our business.

Research and Development

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Research and development (“R&D”) expenses consist primarily of compensation and related benefits, independent contractor costs, and an allocated portion of general overhead costs, including occupancy costs related to our employees involved in research and development activities. Total research and development cost includes the amount of research and development expense reported within operating expenses as well as development cost that was capitalized during the fiscal period.

For the year ended December 31, 2021, research and development expenses increased by 331% over the prior year. This was driven by higher personnel cost associated with the increase in headcount and in stock-based compensation expense. For the year ended December 31, 2021, capitalized research and development cost increased by 23% over the prior year, driven by increased investment in our platforms and products. Total research and development cost, which includes both R&D expenses and capitalized R&D costs, increased 182% from 2020 to 2021.

General and Administrative Expenses

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General and administrative expenses consist primarily of compensation and benefits related to our executives, corporate support functions and directors, general corporate expenses including legal fees, and occupancy costs.

For the year ended December 31, 2021, general and administrative expenses increased by 17% over the prior year. The increase in general and administrative expenses was due primarily to higher legal expenses towards patent litigation pursued by the Company, which in 2021 totaled $2.1 million, as well as higher stock-based compensation expense. Refer to Note 9 - Commitments and Contingencies to our financial statements for information on our litigation.

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Change in Fair Value of Warrant Liability

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Change in fair value of warrant liability consists of fair value adjustments associated with warrants to purchase 146,667 shares of the Company’s common stock, which were issued in consideration for the credit facility extended by Sero Capital in the third quarter of 2019. In the third quarter of 2020, the warrants were fully exercised and the related liability was extinguished.

Gain on loan forgiveness

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In the second quarter of 2021, we recorded a $1,316,000 gain on loan forgiveness in connection with the full forgiveness of the outstanding principal and interest on our PPP Loan, which was originated on April 15, 2020 with a principal amount of $1,302,000.

Interest Expense

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Interest expense consisted primarily of amortization of debt issuance costs from our line of credit, and interest on our PPP Loan and finance lease liabilities. The decrease in interest expense for the year ended December 31, 2021 was attributable to deferred issuance costs being fully amortized through August 2020, when the corresponding line of credit expired.

Other Key Operating Metrics

We consider monthly recurring revenue (“MRR”) as a key operating metric and a key indicator of our overall business. We also use MRR as (i) one of the primary methods for planning and forecasting overall expectations and for evaluating, on at least a quarterly and annual basis, actual results against such expectations; and (ii) as a performance metric for certain executive stock-based compensation awards.

We define MRR as the sum of (i) for our Enterprise channel, the total of the average monthly recurring fee amount under each active paid contract at the date of determination, plus (ii) for our Partner and Marketplace channel, the recognized monthly fee amount for all paying customers at the date of determination, in each case, assuming no changes to the subscription. This determination includes both annual and monthly contracts for recurring products. Some of our contracts are cancelable, which may impact future MRR. MRR excludes revenue from our PDF remediation services business and Mobile App report business. As of December 31, 2021, MRR was about $2.2 million, which represents a 16% increase year-over-year. MRR attributed to Enterprise and Partner and Marketplace channels increased by 14% and 17%, respectively, over prior year.

Use of Non-GAAP Financial Measures

From time to time, we review adjusted financial measures that assist us in comparing our operating performance consistently over time, as such measures remove the impact of certain items, as applicable, such as our capital structure (primarily interest charges), items outside the control of the management team (taxes), and expenses that do not relate to our core operations, including transaction-related expenses and other costs that are expected to be non-recurring, such as severance related to strategic shift. In order to provide investors with greater insight, and allow for a more comprehensive understanding of the information used in our financial and operational decision-making, the Company has supplemented the Financial Statements presented on a GAAP basis in this Annual Report on Form 10-K with the following non-GAAP financial measures: Non-GAAP earnings (loss) and Non-GAAP earnings (loss) per diluted share.

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These non-GAAP financial measures have limitations as analytical tools and should not be considered in isolation or as a substitute for analysis of Company results as reported under GAAP. The Company compensates for such limitations by relying primarily on our GAAP results and using non-GAAP financial measures only as supplemental data. We also provide a reconciliation of non-GAAP to GAAP measures used. Investors are encouraged to carefully review this reconciliation. In addition, because these non-GAAP measures are not measures of financial performance under GAAP and are susceptible to varying calculations, these measures, as defined by us, may differ from and may not be comparable to similarly titled measures used by other companies.

Non-GAAP Earnings (Loss) and Non-GAAP Earnings (Loss) per Diluted Share

We define: (i) Non-GAAP earnings (loss) as net income (loss), less non-cash valuation adjustments to liabilities, plus interest expense, plus stock-based compensation expense, plus certain litigation expense, plus certain severance expense, plus loss on impairment of long-lived assets, plus loss on disposal of property and equipment, and less gain on loan forgiveness; and (ii) Non-GAAP earnings (loss) per diluted share as net income (loss) per diluted common share, less non-cash valuation adjustments to liabilities, plus interest expense, plus stock-based compensation expense, plus certain litigation expense, plus certain severance expense, plus loss on impairment of long-lived assets, plus loss on disposal of property and equipment, and less gain on loan forgiveness, each on a per share basis. Non-GAAP earnings per diluted share would include incremental shares in the share count that are considered anti-dilutive in a GAAP net loss position. However, no incremental shares apply when there is a Non-GAAP loss per diluted share, as is the case for the periods presented in this Annual Report on Form 10-K.

Non-GAAP earnings (loss) and Non-GAAP earnings (loss) per diluted share are used to facilitate a comparison of our operating performance on a consistent basis from period to period and provide for a more complete understanding of factors and trends affecting our business than GAAP measures alone. All of the items adjusted in the Non-GAAP earnings (loss) to net loss and the related per share calculations are either recurring non-cash items, or items that management does not consider in assessing our on-going operating performance. In the case of the non-cash items, such as stock-based compensation expense and valuation adjustments to assets and liabilities, management believes that investors may find it useful to assess our comparative operating performance because the measures without such items are expected to be less susceptible to variances in actual performance resulting from expenses that do not relate to our core operations and are more reflective of other factors that affect operating performance. In the case of items that do not relate to our core operations, management believes that investors may find it useful to assess our operating performance if the measures are presented without these items because their financial impact does not reflect ongoing operating performance.

Non-GAAP earnings (loss) is not a measure of liquidity under GAAP, or otherwise, and is not an alternative to cash flow from continuing operating activities, despite the advantages regarding the use and analysis of these measures as mentioned above. Non-GAAP earnings (loss) and Non-GAAP earnings (loss) per diluted share, as disclosed in this Annual Report on Form 10-K, have limitations as analytical tools, and you should not consider these measures in isolation or as a substitute for analysis of our results as reported under GAAP; nor are these measures intended to be measures of liquidity or free cash flow for our discretionary use.

To properly and prudently evaluate our business, we encourage readers to review the GAAP financial statements included elsewhere in this Annual Report on Form 10-K, and not rely on any single financial measure to evaluate our business. The following

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table sets forth reconciliations of Non-GAAP loss to net loss, the most directly comparable GAAP-based measure, as well as Non-GAAP loss per diluted share to net loss per diluted share, the most directly comparable GAAP-based measure.

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Liquidity and Capital Resources

Working Capital

As of December 31, 2021, we had $19.0 million in cash and working capital of $13.6 million. The increase in working capital in 2021 was primarily a result of capital raised under the previously announced At The Market(“ATM”) offering initiated in the first quarter of 2021. Under the ATM Sales Agreement with B. Riley Securities, Inc. (“Agent”) entered into on February 11, 2021, the Company may offer and sell, from time to time at its sole discretion, shares of its common stock to or through the Agent as its sales agent, having an aggregate offering price of up to $30 million. In the twelve months ended December 31, 2021, the Company issued 471,970 shares of its common stock under the ATM offering and raised $16,534,000, net of transaction expenses.

We have no debt obligations or off-balance sheet arrangements and we believe that the Company has sufficient liquidity to continue as a going concern through the next twelve months.

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While the Company has been successful in raising capital, there is no assurance that it will be successful at raising additional capital in the future. Additionally, if the Company’s plans are not achieved and/or if significant unanticipated events occur, the Company may have to further modify its business plan, which may require us to raise additional capital or reduce expenses.

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Cash Flows

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For the year ended December 31, 2021, in relation to the prior year, cash used in operating activities increased primarily due to an increase in sales and marketing costs as a result of higher digital, consulting and third-party costs to support the Company’s growth, as well as increased product development headcount and legal fees associated with patent litigation pursued by the Company.

For the year ended December 31, 2021, in relation to the prior year, cash used in investing activities increased primarily due to higher investment to further enhance our product offerings.

For the year ended December 31, 2021, in relation to the prior year, cash provided by financing activities increased primarily due to capital raised under the ATM Offering initiated in the first quarter of 2021. In 2021, the Company issued 471,970 shares of its common stock under the ATM offering and raised $16,534,000, net of transaction expenses. In the third quarter of 2020, we received net proceeds of $7,824,000 from a public offering whereby we issued 473,239 shares of our common stock. In addition, in the second quarter of 2020, we obtained a $1,302,000 PPP loan, which was fully forgiven in the second quarter of 2021.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with the accounting principles generally accepted in the United States. The preparation of financial statements requires management to make estimates and assumptions that affect the amounts reported and disclosed in our financial statements and the accompanying notes. Actual results could differ materially from these estimates under different assumptions or conditions.

The critical accounting estimates discussed below are estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on the financial condition or results of operations.

Stock-Based Compensation

Awards with performance conditions

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Compensation expense related to performance-based options and RSUs is recognized on a straight-line basis over the requisite service period, provided that it is probable that performance conditions will be achieved. Management periodically assesses the probability of achievement of each performance condition. Expense recognition only starts when achievement is deemed probable, and the amount recognized in each reporting period varies based on the expected timing of performance completion. Changes in expectations and outcomes different from estimates (such as the achievement or non- achievement of performance conditions) may cause a significant adjustment to earnings in a reporting period as timing and amount of expense recognition is highly dependent on management’s estimate.

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Awards with market conditions

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We estimate the fair value and requisite service period of market-based restricted stock unit awards as of the grant date based on the Monte Carlo simulation model with the assistance of an independent third-party valuation specialist. The Monte Carlo simulation model is built on certain assumptions, including our stock volatility. We cannot predict the prices at which our common stock will trade in the future and achievement of market conditions may occur in period different that estimated. Compensation costs related to awards with market conditions are recognized on a straight-line basis over the requisite service period regardless of whether the market condition is satisfied and is not reversed provided that the requisite service period derived from the Monte-Carlo simulation has been completed.

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Refer to Note 2 - Significant Accounting Policies to our financial statements for a complete discussion of the significant accounting policies and methods used in the preparation of our financial statements, including our accounting policies related to stock-based compensation.

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