UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
(Mark One)
 
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2018
 
    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: 001-32421
 
FUSION CONNECT, INC.
(Exact name of registrant as specified in its charter)
 
Delaware
 
58-2342021
(State or other jurisdiction of incorporation or organization)
 
(IRS Employer Identification No.)
 
420 Lexington Avenue, Suite 1718, New York, New York   10170
   (Address of principal executive offices)    (Zip Code)
 
(212) 201-2400
 (Registrants telephone number, including area code)
 
Fusion Telecommunications International, Inc.
(Former name, former address and former fiscal year, if changed since last report)
 
Indicate by check mark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “non-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
Smaller reporting company
(do not check if a smaller reporting company)
Emerging growth company 
☐ 
 
If an emerging growth company that prepares its financial statements in accordance with U.S. GAAP, 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  
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: May 7, 2018.
 
Title of Each Class
Number of Shares Outstanding
Common Stock, $0.01 par value
76,583,701
 

 
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
TABLE OF CONTENTS
 
Part 1 Financial Information.
 3
Item 1. Financial Statements.
 3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 25
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 32
Item 4. Controls and Procedures.
 32
Part II Other Information.
 33
Item 1. Legal Proceedings.
 33
Item 1A. Risk Factors.
 33
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
 33
Item 3. Defaults Upon Senior Securities.
 33
Item 4. Mine Safety Disclosures.
 33
Item 5. Other Information.
 33
Item 6. Exhibits.
 33
Signatures.
 34
Index to Exhibits
 35
 
 
2
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
PART I FINANCIAL INFORMATION
 
Item 1. Financial Statements.
Condensed Consolidated Balance
Sheets
 
 
 
March 31,
2018
 
 
December 31,
2017
 
ASSETS
 
(unaudited)
 
 
 
 
Current assets:
 
 
 
 
 
 
Cash and cash equivalents
 $30,999,732 
 $2,472,836 
Accounts receivable, net of allowance for doubtful accounts of
    
    
approximately $435,000 and $668,000, respectively
  9,174,993 
  10,634,393 
Prepaid expenses and other current assets
  1,871,183 
  1,609,518 
Deferred installation costs - current portion
  798,166 
  - 
Current assets of discontinued operations
  4,269,653 
  2,867,953 
Total current assets
  47,113,727 
  17,584,700 
Property and equipment, net
  11,115,107 
  12,838,840 
Security deposits
  612,299 
  612,299 
Restricted cash
  27,153 
  27,153 
Goodwill
  35,181,698 
  34,773,629 
Intangible assets, net
  55,687,545 
  56,156,023 
Deferred installation costs - net of current portion
  1,102,648 
  - 
Other assets
  35,632 
  43,937 
Non-current assets of discontinued operations
  19,780 
  20,980 
TOTAL ASSETS
 $150,895,589 
 $122,057,561 
 
    
    
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
    
    
Current liabilities:
    
    
Term loan - current portion
 $6,500,000 
 $6,500,000 
Obligations under asset purchase agreements - current portion
  723,297 
  227,760 
Equipment financing obligations - current portion
  1,075,252 
  1,206,773 
Deferred installation revenue - current portion
  797,332 
  - 
Accounts payable and accrued expenses
  20,165,445 
  21,995,443 
Current liabilities from discontinued operations
  4,660,278 
  3,093,602 
Total current liabilities
  33,921,604 
  33,023,578 
Long-term liabilities:
    
    
Notes payable - non-related parties, net of discount
  32,083,554 
  31,953,163 
Notes payable - related parties
  928,081 
  928,081 
Term loan
  47,663,242 
  54,222,668 
Indebtedness under revolving credit facility
  - 
  1,500,000 
Obligations under asset purchase agreements
  477,162 
  222,240 
Equipment financing obligations - net of current obligations
  407,345 
  590,602 
Deferred installation revenue - net of current portion
  1,029,445 
  - 
Derivative liabilities
  586,197 
  872,900 
Total liabilities
  117,096,630 
  123,313,232 
Stockholders' equity (deficit):
    
    
Preferred stock, $0.01 par value, 10,000,000 shares authorized,
    
    
13,466 and 14,216 shares issued and outstanding
  134 
  142 
Common stock, $0.01 par value, 150,000,000 shares authorized,
    
    
23,847,140 and 14,980,756 shares issued and outstanding
 238,471
 149,807
Capital in excess of par value
 235,027,397
 195,940,320
Accumulated deficit
  (201,318,706)
  (197,264,083)
Total Fusion Connect, Inc. stockholders' equity (deficit)
  33,947,296 
  (1,173,804)
Noncontrolling interest
  (148,337)
  (81,867)
Total stockholders' equity (deficit)
  33,798,959 
  (1,255,671)
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
 $150,895,589 
 $122,057,561 
 
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
 
 
3
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Condensed Consolidated Statements of Operations 
(unaudited)
 
 
 
For the Three Months Ended March 31,
 
 
 
2018
 
 
2017
 
Revenues
 $29,038,043 
 $28,481,039 
Cost of revenues, exclusive of depreciation and
    
    
amortization, shown separately below
  12,918,895 
  12,140,707 
Gross profit
  16,119,148 
  16,340,332 
Depreciation and amortization
  3,135,779 
  3,835,948 
Selling, general and administrative expenses
  13,947,995 
  13,613,661 
Impairment charge
  1,195,837 
  - 
Total operating expenses
  18,279,611 
  17,449,609 
Operating loss
  (2,160,463)
  (1,109,277)
Other (expenses) income:
    
    
Interest expense
  (2,147,775)
  (2,092,312)
Change in fair value of derivative liabilities
  194,312 
  (40,445)
Loss on disposal of property and equipment
  (3,184)
  (26,800)
Other income, net
  89,558 
  116,520 
Total other expenses
  (1,867,089)
  (2,043,037)
Loss before income taxes
  (4,027,552)
  (3,152,314)
Provision for income taxes
  (14,050)
  (7,811)
Net loss from continuing operations
  (4,041,602)
  (3,160,125)
Net loss from discontinued operations
  (166,175)
  (321,823)
Net loss
  (4,207,777)
  (3,481,948)
Less: Net loss attributable to non-controlling interest
  66,470 
  - 
Net loss attributable to Fusion Connect, Inc.
  (4,141,307)
  (3,481,948)
Preferred stock dividends
  (243,582)
  (1,254,109)
Net loss attributable to common stockholders
  (4,384,889)
  (4,736,057)
 
    
    
Basic and diluted loss per common share from continuing operations:
 $(0.20)
 $(0.32)
Basic and diluted loss per common share from discontinued operations:
 $(0.01)
 $(0.02)
Weighted average common shares outstanding:
    
    
Basic and diluted
  20,682,262 
  13,805,133 
 
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
 
 
4
FUSION CONNECT, INC. AND SUBSIDIARIES
 
Condensed Consolidated Statement of Stockholders’ (Deficit) Equity
(unaudited)
 
 
 
Preferred Stock
 
 
Common Stock
 
 
Capital in Excess of Par
 
 
Accumulated
 
 
Total Fusion Connect, Inc. (Deficit)
 
 
Non-controlling
 
 
Stockholders' (Deficit)
 
 
 
Shares
 
 
$
 
 
Shares
 
 
$
 
 
 Value
 
 
 Deficit
 
 
 Equity
 
 
 interest
 
 
  Equity
 
Balance at December 31, 2017
  14,216 
 $142 
  14,980,756 
  149,807 
 $195,940,330 
 $(197,264,083)
 $(1,173,804)
 $(81,867)
 $(1,255,671)
Cumulative effect of change in accounting principle
  - 
  - 
  - 
  - 
  - 
  86,684 
  86,684 
    
  86,684 
Balance at January 1, 2018
  14,216 
  142 
  14,980,756 
  149,807 
  195,940,330 
  (197,177,399)
  (1,087,120)
  (81,867)
  (1,168,987)
Conversion of preferred stock into common stock
  (750)
  (8)
  100,000 
  1,000 
  (992)
  - 
  - 
  - 
  - 
Dividends on preferred stock
  - 
  - 
  3,985 
  40 
  (40)
  - 
  - 
  - 
  - 
Exercise of common stock purchase warrants
  - 
  - 
  5,120 
  51 
  11,931 
  - 
  11,982 
  - 
  11,982 
Cashless exercise of warrants
  - 
  - 
  22,155 
  222 
  (222)
  - 
  - 
  - 
  - 
Reclassification of derivative liability
  - 
  - 
  - 
  - 
  92,391 
  - 
  92,391 
  - 
  92,391 
Common stock issued in acquisition
  - 
  - 
  110,124 
  1,101 
  498,899 
  - 
  500,000 
  - 
  500,000 
Proceeds from the sale of common stock, less expenses of $2,843,000
  - 
  - 
  8,625,000 
  86,250 
  38,119,846 
  - 
  38,206,096 
  - 
  38,206,096 
Net loss
  - 
  - 
  - 
  - 
  - 
  (4,141,307)
  (4,141,307)
  (66,470)
  (4,207,777)
Stock-based compensation
  - 
  - 
  - 
  - 
  365,254 
  - 
  365,254 
  - 
  365,254 
Balance at March 31, 2018
  13,466 
 $134 
  23,847,140 
 $238,471 
 $235,027,397 
 $(201,318,706)
 $33,947,296 
 $(148,337)
 $33,798,959 
 
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
 
 
5
FUSION CONNECT, INC. AND SUBSIDIARIES
 
Condensed Consolidated Statements of Cash Flows
(unaudited)
 
 
 
Three Months Ended March 31,
 
 
 
2018
 
 
2017
 
Cash flows from operating activities:
 
 
 
 
 
 
Net loss from continuing operations
 $(4,041,602)
 $(3,160,125)
Net loss from discontinued operations
  (166,175)
  (321,823)
Net loss
  (4,207,777)
  (3,481,948)
 
    
    
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
    
    
Depreciation and amortization
  3,135,779 
  3,835,948 
Loss on disposal of property and equipment
  3,184 
  26,800 
Stock-based compensation
  365,254 
  224,647 
Impairment charge
  1,195,837 
  - 
Stock issued for services rendered or in settlement of liabilities
  - 
  164,450 
Amortization of debt discount and deferred financing fees
  195,963 
  209,628 
(Gain) loss on the change in fair value of derivative liability
  (194,312)
  40,445 
Changes in operating assets and liabilities:
    
    
Accounts receivable
  1,459,401 
  179,518 
Prepaid expenses and other current assets
  (304,442)
  (873,401)
Other assets and liabilities
  20,952 
  8,295 
Accounts payable and accrued expenses
  (1,949,917)
  690,812 
Cash (used in) provided by operating activities - continuing operations
  (113,903)
  1,385,070 
Cash provided by (used in) operating activities - discontinued operations
  107,612 
  (15,826)
Net cash (used in) provided by operating activities
  (6,291)
  1,369,244 
 
    
    
Cash flows from investing activities:
    
    
Purchase of property and equipment
  (976,877)
  (984,642)
Proceeds from the sale of property and equipment
  31,533 
  40,680 
(Payment) for acquisitions, net of cash acquired
  - 
  (558,329)
Cash used in investing activities - continuing operations
  (945,344)
  (1,502,291)
Cash used in investing activities - discontinued operations
  - 
  - 
Net cash used in investing activities
  (945,344)
  (1,502,291)
 
    
    
Cash flows from financing activities:
    
    
Proceeds from the exercise of common stock purchase warrants
  11,982 
  780,951 
Repayments of term loan
  (6,625,000)
  (812,500)
Repayments of revolving debt, net
  (1,500,000)
  - 
Payments for obligations under asset purchase agreements
  (192,157)
  (191,668)
Proceeds from the sale of common stock, net of offering expenses
  38,206,096 
  - 
Payments on equipment financing obligations
  (314,777)
  (223,493)
Cash provided by (used in) financing activities - continuing operations
  29,586,144 
  (446,710)
Cash provided by (used in) financing activities - discontinued operations
  - 
  - 
Net cash provided by (used in) financing activities
  29,586,144 
  (446,710)
Net change in cash and cash equivalents
  28,634,509 
  (579,757)
Cash and cash equivalents, including restricted cash, beginning of period
  2,557,541 
  7,249,063 
Cash and cash equivalents, including restricted cash, end of period
 $31,192,050 
 $6,669,306 
Less cash and cash equivalents of discontinued operations, end of period
  165,165 
  15,038 
Cash and cash equivalents, including restricted cash of continuing operations, end of period
  31,026,885 
  6,654,268 
 
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
 
 
6
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Note 1. Organization and Business
 
Fusion Connect, Inc. (f/k/a Fusion Telecommunications International, Inc.) is a Delaware corporation incorporated in September 1997 (“Fusion” and together with its subsidiaries, the “Company,” “we,” “us” and “our”). Fusion changed its name to Fusion Connect, Inc. on May 4, 2018. The Company is a provider of integrated cloud solutions, including cloud voice, cloud connectivity, cloud infrastructure, cloud computing, and managed cloud-based applications to businesses of all sizes.
 
Note 2. Basis of Presentation and Summary of Significant Accounting Policies
 
Basis of Presentation
 
The accompanying unaudited condensed consolidated financial statements have been prepared in all material respects in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information. Pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”), certain information and footnote disclosures normally included in annual consolidated financial statements prepared in accordance with U.S. GAAP have been condensed or omitted.
 
Because certain information and footnote disclosures have been condensed or omitted, these unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2017 (the “2017 Form 10-K”) as filed with the SEC. In management’s opinion, all normal and recurring adjustments considered necessary for a fair presentation of the financial position, results of operations and cash flows for the periods presented have been included. Management believes that the disclosures made in these unaudited condensed consolidated interim financial statements are adequate to make the information not misleading. The results of operations for the interim periods presented are not necessarily indicative of the results for the entire year.
 
On May 4, 2018 (the “Closing Date”), Fusion completed the various transactions contemplated by the Agreement and Plan of Merger, dated August 26, 2017, as amended (the “Birch Merger Agreement”), by and among Fusion, Fusion BCHI Acquisition LLC, a wholly-owned subsidiary of Fusion (“BCHI Merger Sub”), and Birch Communications Holdings, Inc. (“Birch”). As contemplated by the Birch Merger Agreement, on the Closing Date, Birch merged with and into BCHI Merger Sub (the “Birch Merger”), with BCHI Merger Sub surviving the Birch Merger as a wholly-owned subsidiary of Fusion. See “Note 19 – Subsequent Events”.
 
The Company determined that the acquisition of Birch qualified as a reverse acquisition where Fusion was identified as a legal acquirer and Birch was identified as an accounting acquirer. All periodic reports for periods that end on or after the date the reverse acquisition is completed will be filed within the time periods specified by the SEC's rules and forms. The financial statements included in periodic reports filed for periods that end on or after the date the reverse acquisition is completed will be the accounting acquirer's financial statements for all periods presented (reflecting the combined company beginning with the date of the reverse acquisition) since the accounting acquirer is considered to be the successor to the legal issuer's reporting obligation.
 
In the quarter ended March 31, 2018, the Company determined that the assets and liabilities of its Carrier Services reportable segment met the discontinued operations criteria in ASC 205-20-45. Accordingly, all assets, liabilities and results of operations have been classified as discontinued operations for all periods presented in the accompanying Consolidated Balance Sheet, Consolidated Statements of Operations and Consolidated Statements of Cash Flows. See “Note 3 - Discontinued Operations”.
 
During the three months ended March 31, 2018 and 2017, comprehensive loss was equal to the net loss amounts presented for the respective periods in the accompanying condensed consolidated interim statements of operations.
 
Reverse Stock Split
 
Fusion filed a Certificate of Amendment (the “Charter Amendment”) to its Certificate of Incorporation with the Secretary of State of the State of Delaware, to effect a reverse split of the Fusion common stock at an exchange ratio of 1-for-1.5 (the “Reverse Split”), which became effective on May 4, 2018. The number of authorized shares of Fusion common stock was not affected by the Reverse Split. Any fractional shares of Fusion common stock resulting from the Reverse Split were rounded up to the nearest whole share.
 
As a result of the Reverse Stock Split, all share and per share amounts as of December 31, 2017 as well as for the three months ended March 31, 2018 and March 31, 2017, have been restated at the Reverse Split Ratio to give effect to the Reverse Stock Split.
 
 
7
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Principles of Consolidation
 
The condensed consolidated interim financial statements include the accounts of Fusion and each of its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Effective September 1, 2017, Fusion transferred 40% of its membership interests in Fusion Global Services LLC (“FGS”) to XcomIP, LLC (“XcomIP”), in exchange for which XcomIP contributed assets of its carrier business to FGS. In connection with this transaction, Fusion and XcomIP also executed a shareholder agreement under which Fusion agreed to provide up to $750,000 in working capital to FGS. The Company has determined that, based on the terms of the shareholders agreement, it has a controlling financial interest in FGS under the guidance set forth in Accounting Standards Codification (“ASC”) 810, Consolidation and, therefore, the accounts of FGS are consolidated into Fusion’s consolidated financial statements as of and for the year ended December 31, 2017. Prior to the transfer of membership interests to XcomIP, Fusion transferred its Carrier Services business to FGS. Effective March 31, 2018, the Carrier Business is recorded as discontinued operations for all periods presented. See “Note 19 – Subsequent Events”.
 
Use of Estimates
 
The preparation of condensed consolidated interim financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated interim financial statements and the reported amounts of revenues and expenses during the reporting periods. On an on-going basis, the Company evaluates its estimates, including, but not limited to, those related to recognition of revenue; allowance for doubtful accounts; fair value measurements of its financial instruments; useful lives of its long-lived assets used in computing depreciation and amortization; impairment assessment of goodwill and intangible assets; accounting for stock options and other equity awards, particularly related to fair value estimates; and accounting for income taxes, contingencies and litigation. Changes in the facts or circumstances underlying these estimates could result in material changes and actual results could differ from those estimates.
 
Cash Equivalents
 
Cash and cash equivalents include cash on deposit and short-term, highly-liquid investments with maturities of three months or less on the date of purchase. As of March 31, 2018 and December 31, 2017, the carrying value of cash and cash equivalents approximates fair value due to the short period to maturity.
 
Fair Value of Financial Instruments
 
At March 31, 2018 and December 31, 2017, the carrying value of the Company’s accounts receivable, accounts payable and accrued expenses approximates their fair value due to the short-term nature of these financial instruments.
 
Impairment of Long-Lived Assets
 
The Company periodically reviews long-lived assets, including intangible assets, for possible impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If an impairment indicator is present, the Company evaluates recoverability by a comparison of the carrying amount of the assets to future undiscounted net cash flows expected to be generated by the assets.  If the carrying value of the asset exceeds the projected undiscounted cash flows, the Company is required to estimate the fair value of the asset and recognize an impairment charge to the extent that the carrying value of the asset exceeds its estimated fair value. During the three-month period ended March 31, 2018, the Company recorded an impairment charge of $1.2 million. The Company did not record any impairment charges during the three months ended March 31, 2017.
 
Goodwill
 
Goodwill is the excess of the acquisition cost of a business combination over the fair value of the identifiable net assets acquired. Goodwill at March 31, 2018 and December 31, 2017 was $35.2 million and $34.8 million, respectively.  All of the Company’s goodwill is attributable to its Business Services segment.  
 
The following table presents the changes in the carrying amounts of goodwill during the three months ended March 31, 2018:
 
Balance at December 31, 2017
 $34,773,629 
Increase in goodwill associated with a business acquisition
  408,069 
Balance at March 31, 2018
 $35,181,698 
 
 
8
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Goodwill is not amortized and is tested for impairment on an annual basis in the fourth quarter of each fiscal year and whenever events or circumstances indicate that it is more likely than not that fair value of a reporting unit is below its carrying amount.
The Company has the option to perform a qualitative assessment of goodwill to determine whether it is more likely than not that the fair value of its reporting unit is less than its carrying amount, including goodwill and other intangible assets. The Company also may elect not to perform the qualitative assessment and, instead, proceed directly to the quantitative impairment test by comparing the fair value of the reporting unit to its carrying value. An impairment charge is recorded to the extent the reporting unit’s carrying value exceeds its fair value, however, the impairment loss recognized would not exceed the total amount of goodwill allocated to that reporting unit. The Company did not record any impairment charges related to goodwill during the three months ended March 31, 2018 and 2017.
 
Advertising and Marketing Costs
 
Advertising and marketing expenses includes cost for promotional materials and trade show expenses for the marketing of the Company’s products and services.  Advertising and marketing expenses were $0.1 million for each of the three months ended March 31, 2018 and 2017. Advertising and marketing expenses are reflected in selling, general and administrative expenses in the Company’s condensed consolidated statements of operations.
 
Income Taxes
 
The accounting and reporting requirements with respect to accounting for income taxes require an asset and liability approach. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred income tax assets to the amount expected to be realized.
 
In accordance with U.S. GAAP, the Company is required to determine whether a tax position of the Company is more likely than not to be sustained upon examination by the applicable taxing authority, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The tax benefit to be recognized is measured as the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Derecognition of a tax benefit previously recognized could result in the Company recording a tax liability that would reduce net assets. Based on its analysis, the Company has determined that it has not incurred any liability for unrecognized tax benefits as of March 31, 2018 and December 31, 2017. The Company is subject to income tax examinations by major taxing authorities for all tax years since 2013 and its tax returns may be subject to review and adjustment at a later date based on factors including, but not limited to, on-going analyses of and changes to tax laws, regulations and interpretations thereof. No interest expense or penalties have been recognized as of March 31, 2018 and December 31, 2017. During the three months ended March 31, 2018 and 2017, the Company recognized no adjustments for uncertain tax positions.
 
Stock-Based Compensation
 
The Company recognizes expense for its employee stock-based compensation based on the fair value of the awards on the date of grant. The fair values of stock options are estimated on the date of grant using the Black-Scholes option valuation model. The use of the Black-Scholes option valuation model requires the input of subjective assumptions. Compensation cost, net of estimated forfeitures, is recognized ratably over the vesting period of the related stock-based compensation award. For transactions in which goods or services are received from non-employees in return for the issuance of equity instruments, the expense is recognized in the period when the goods and services are received at the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more readily determinable.
 
New and Recently Adopted Accounting Pronouncements
 
In July 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No. 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480), Derivatives and Hedging (Topic 815). The amendments in Part I of this update change the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features. When determining whether certain financial instruments should be classified as liabilities or equity instruments, a down round feature no longer precludes equity classification when assessing whether the instrument is indexed to an entity’s own stock. The amendments also clarify existing disclosure requirements for equity-classified instruments. As a result, a freestanding equity-linked financial instrument (or embedded conversion option) no longer would be accounted for as a derivative liability at fair value as a result of the existence of a down round feature. This standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted. The Company is currently evaluating the effect that the new guidance will have on its financial statements and related disclosures.
 
 
9
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
In February 2016, the FASB issued ASU No. 2016-02, Leases, which is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018 with early adoption permitted. Under ASU 2016-02, lessees will be required to recognize for all 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 to-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. The Company is currently evaluating the effect that the new guidance will have on its financial statements and related disclosures.
  
Note 3: Discontinued Operations
 
On August 26, 2017, the Company and its wholly owned subsidiary, Fusion BCHI Acquisition LLC, a Delaware limited liability company (“Merger Sub”), entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Birch Communications Holdings, Inc., a Georgia corporation (“Birch”). As part of this Merger Agreement, the Company is required to spin-off or otherwise exit its Carrier Services business segment prior to the closing of the Merger. See "Note 19 - Subsequent Events." Accordingly, the Company determined that the assets and liabilities of its Carrier Services reportable segment met the discontinued operations criteria in ASC 205-20-45 in the quarter ended March 31, 2018. As such, assets, liabilities and results of operations have been classified as discontinued operations for all periods presented in the accompanying Consolidated Balance Sheet, Consolidated Statements of Operations and Consolidated Statements of Cash Flows.
 
Summarized operating results for discontinued operations, for the periods ended March 31, 2018 and 2017, respectively, are as follows:
 
 
 
For the Three Months Ended March 31,
 
 
 
2018
 
 
2017
 
Revenues
 $9,955,558 
 $7,330,836 
Cost of revenues, exclusive of depreciation and
    
    
amortization, shown separately below
  9,659,011 
  7,130,207 
Gross profit
  296,547 
  200,629 
Depreciation and amortization
  1,201 
  1,200 
Selling, general and administrative expenses
  461,521 
  521,213 
Total operating expenses
  462,722 
  522,413 
Operating loss
  (166,175)
  (321,784)
Other (expenses) income:
    
    
Other (expenses) income, net
  - 
  (39)
Total other expenses
  - 
  (39)
Loss before income taxes
  (166,175)
  (321,823)
Provision for income taxes
  - 
  - 
Net loss
  (166,175)
  (321,823)
 
 
10
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
The carrying amounts of assets and liabilities for discontinued operations for the periods ended March 31, 2018 and December 31, 2017 are as follows:
 
 
 
March 31,
2018
 
 
December 31,
2017
 
 
   
 
 
 
Cash and cash equivalents
 $165,165 
 $57,552 
Accounts receivable, net of allowance for doubtful accounts of
    
    
approximately $42,000 and $32,000, respectively
  4,099,748 
  2,328,674 
Prepaid expenses and other current assets
  4,740 
  481,727 
Total current assets of discontinued operations
  4,269,653 
  2,867,953 
 
    
    
Property and equipment, net
  16,494 
  17,695 
Security deposits
  3,286 
  3,285 
Total non-current assets of discontinued operations
  19,780 
  20,980 
 
    
    
Accounts payable and accrued expenses
  3,991,463 
  2,303,122 
Related party payable
  668,815 
  790,480 
Total current liabilities of discontinued operations
  4,660,278 
  3,093,602 
 
    
    
Non-current liabilities
  - 
  - 
Total non-current liabilities of discontinued operations
  - 
  - 
 
Operating segments are defined under U.S. GAAP as components of an enterprise for which discrete financial information is available and evaluated regularly by a company's chief operating decision maker in deciding how to allocate resources and assess performance. Prior to the spin-off, the Company had two reportable segments – Business Services and Carrier Services. These segments were organized by the products and services that were sold and the customers that were served. The Company measured and evaluated its reportable segments based on revenues and gross profit margins. Because of a spin-off, Carrier Services are reported as Discontinued Operations and Business Services is the only remaining segment. As a result, segment information is no longer presented in a separate footnote.
 
Note 4. Acquisitions
 
In January 2018, the Company acquired substantially all of the assets of IQMax, a Charlotte, N.C.-based provider of secure messaging, enterprise data integration and advanced cloud communications solutions. The total consideration for this transaction was $1.0 million, $0.5 million of which was paid with 110,124 shares of Fusion common stock, with the remaining portion of the purchase price, also payable in shares of common stock, due six months from the closing date of the transaction. These shares will remain in escrow until 12 months following the closing of the transaction. The Company also agreed to pay a royalty fee to the seller based on the net revenue in excess of $1.75 million from the annual sales of acquired assets. The estimated present value of the contingent royalty fee of $0.4 million was recognized as a non-current liability in the condensed consolidated balance sheet as of March 31, 2018.
 
 
11
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
The allocation of the purchase price as of the acquisition date is as follows:
 
 
 
 
 
 
Useful life
 
 
 
 
 
 
(in years)
 
Covenant not to compete
 $125,000 
  3 
Trademark
  16,125 
  10 
Intellectual property
  1,017,805 
  17 
Goodwill
  408,069 
    
Deferred revenue
  (119,921)
    
Total purchase price
 $1,447,078 
    
 
Note 5. Loss per share
 
Basic and diluted loss per share is computed by dividing the loss attributable to common stockholders by the weighted-average number of common shares outstanding during the period. The following table sets forth the computation of basic and diluted net loss per share for the three months ended March 31, 2018 and 2017:
 
 
 
Three Months Ended March 31,
 
 
 
2018
 
 
2017
 
Numerator
 
 
 
 
 
 
Net loss from continuing operations
 $(4,041,602)
 $(3,160,125)
Net loss from discontinued operations
  (166,175)
  (321,823)
Net loss
  (4,207,777)
  (3,481,948)
   Less Net loss attributable to non-controlling interest
  66,470 
  - 
Net loss attributable to Fusion Connect, Inc.
  (4,141,307)
  (3,481,948)
Undeclared dividends on Series A-1, A-2 and A-4 Convertible Preferred Stock
  (99,518)
  (99,518)
Conversion price reduction on Series B-2 Preferred Stock (see note 14)
  - 
  (623,574)
Series B-2 warrant exchange (see note 14)
  - 
  (347,190)
Dividends declared on Series B-2 Convertible Preferred Stock
  (144,064)
  (183,827)
Net loss attributable to common stockholders
 $(4,384,889)
 $(4,736,057)
 
    
    
Denominator
    
    
Basic and diluted weighted average common shares outstanding
  20,682,262 
  13,805,133 
 
    
    
Loss per share basic and diluted
    
    
From continuing operatins
 $(0.20)
 $(0.32)
From discontinued operations
 $(0.01)
 $(0.02)
 
For the three months ended March 31, 2018 and 2017, the following dilutive securities were excluded from the calculation of diluted earnings per common share because of their anti-dilutive effects:
 
 
 
For the Three Months Ended March 31,
 
 
 
2018
 
 
2017
 
Warrants
  1,274,126 
  1,798,453 
Convertible preferred stock
  1,265,398 
  1,375,417 
Stock options
  1,997,288 
  1,434,049 
 
  4,536,812 
  4,607,919 
 
 
12
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
The net loss per common share calculation includes a provision for preferred stock dividends on Fusion’s outstanding Series A-1, A-2 and A-4 preferred stock (collectively, the “Series A Preferred Stock”) for the three months ended March 31, 2018 and 2017 of $0.1 million in each period. Through March 31, 2018, the Board of Directors of Fusion has never declared a dividend on any Series A Preferred Stock, resulting in approximately $5.2 million of accumulated preferred stock dividends. See “Note 19 – Subsequent Events”.
 
The Fusion Board declared dividends on Fusion Series B-2 Cumulative Convertible Preferred Stock (the “Series B-2 Preferred Stock”) of $0.1 million and $0.2 million for the three months ended March 31, 2018 and 2017, respectively. As permitted by the terms of the Series B-2 Preferred Stock, dividends were paid in the form of 3,985 and 71,251 shares of Fusion’s common stock for the three months ended March 31, 2018 and 2017, respectively. See “Note 19 – Subsequent Events”.
 
Note 6. Intangible Assets
 
Intangible assets as of March 31, 2018 and December 31, 2017 are as follows:
 
 
 
March 31, 2018
 
 
December 31, 2017
 
 
 
Gross Carrying Amount
 
 
Accumulated Amortization
 
 
Total
 
 
Gross Carrying Amount
 
 
Accumulated Amortization
 
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Trademarks and tradename
 $1,109,525 
 $(715,166)
 $394,359 
 $1,093,400 
 $(672,314)
 $421,086 
Proprietary technology
  6,798,805 
  (5,209,277)
  1,589,528 
  5,781,000 
  (5,005,400)
  775,600 
Non-compete agreement
  12,245,043 
  (11,758,563)
  486,480 
  12,120,043 
  (11,701,307)
  418,736 
Customer relationships
  67,614,181 
  (14,397,003)
  53,217,178 
  67,614,181 
  (13,073,580)
  54,540,601 
Favorable lease intangible
  - 
  - 
  - 
  218,000 
  (218,000)
  - 
Total acquired intangibles
 $87,767,554 
 $(32,080,009)
 $55,687,545 
 $86,826,624 
 $(30,670,601)
 $56,156,023 
 
Amortization expense was $1.6 million and $2.2 million for the three months ended March 31, 2018 and 2017, respectively. Estimated future aggregate amortization expense is expected to be as follows:
 
Year
 
Amortization Expense
 
remainder of 2018
 $4,751,306 
2019
  5,469,042 
2020
  5,458,742 
2021
  5,284,375 
2022
  4,612,642 
 
Note 7. Supplemental Disclosure of Cash Flow Information
 
Supplemental cash flow information for the three months ended March 31, 2018 and 2017 is as follows:
 
 
 
Three Months Ended March 31,
 
Supplemental Cash Flow Information
 
2018
 
 
2017
 
   Cash paid for interest
 $1,961,727 
 $2,186,314 
 
    
    
Supplemental Non-Cash Investing and Financing Activities
    
    
Conversion of preferred stock into common stock
 $750,000 
 $2,958,000 
   Dividend on Series B-2 preferred stock paid with the issuance of Fusion common stock
 $19,479 
 $183,827 
   Obligations under acquisition
 $500,000 
 $1,350,000 
Common stock issued in acquisition
 $500,000 
 $- 
Contingent royalty fee
 $447,079
 
  -
 
Reconciliation of Cash, Cash Equivalents and Restricted Cash
    
    
Cash and cash equivalents of continuing operations
 $30,999,732
 
 $6,627,115
 
Restricted cash of continuing operations
  27,153 
  27,153 
Total cash, cash equivalents and restricted cash of continuing operations
 $31,026,885
 
 $6,654,268
 
Cash and cash equivalents of discontinued operations
  165,165
 
  15,038
 
Total cash, cash equivalants and restricted cash
  31,192,050
 
  6,669,306
 
 
 
13
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Note 8. Prepaid Expenses and Other Current Assets
 
Prepaid expenses and other current assets at March 31, 2018 and December 31, 2017 are as follows:
 
 
 
March 31,
2018
 
 
December 31,
2017
 
Insurance
 $69,355 
 $18,639 
Rent
  16,326 
  16,326 
Marketing
  157,162 
  55,801 
Software subscriptions
  646,495 
  610,191 
Comisssions
  58,833 
  46,755 
Line costs
  391,211 
  335,978 
Other
  531,801 
  525,828 
Total
 $1,871,183 
 $1,609,518 
 
Note 9. Accounts Payable and Accrued Expenses
 
Accounts payable and accrued expenses at March 31 2018 and December 31, 2017 are as follows:
 
 
 
March 31,
2018
 
 
December 31,
2017
 
Trade accounts payable
 $6,060,192 
 $7,434,257 
Accrued license fees
  2,673,648 
  2,881,331 
Accrued sales and federal excise taxes
  3,598,141 
  3,496,697 
Deferred revenue
  1,517,100 
  1,283,969 
Accrued network costs
  1,808,853 
  1,796,302 
Accrued sales commissions
  956,150 
  911,192 
Property and other taxes
  746,309 
  759,770 
Accrued payroll and vacation
  487,711 
  422,097 
Customer deposits
  393,868 
  383,032 
Interest payable
  7,263 
  7,263 
Credit card payable
  135,433 
  114,209 
Accrued USF fees
  1,195,512 
  728,826 
Accrued bonus
  131,593 
  333,337 
Professional and consulting fees
  204,081 
  171,163 
Rent
  217,036 
  163,030 
Other
  32,555 
  1,108,968 
Total
 $20,165,445 
 $21,995,443 
 
 
14
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Note 10. Equipment Financing Obligations
 
From time to time, the Company enters into equipment financing or capital lease arrangements to finance the purchase of network hardware and software utilized in its operations. These arrangements require monthly payments over a period of 24 to 48 months with interest rates ranging between 5.3% and 6.6% per annum. The Company’s equipment financing obligations are as follows:
 
 
 
March 31,
 
 
December 31,
 
 
 
2018
 
 
2017
 
Equipment financing obligations
 $1,482,597 
 $1,797,374 
Less current portion
  (1,075,252)
  (1,206,773)
Long-term portion
 $407,345 
 $590,601 
 
The Company’s payment obligations under its capital leases are as follows:
 
Year ending December 31:
 
Principal
 
remainder of 2018
 $891,996 
2019
  502,589 
2020
  88,012 
 
 $1,482,597 
 
Note 11. Long-Term Debt
 
Secured Credit Facilities
 
As of March 31, 2018 and December 31, 2017, secured credit facilities consists of the following:
 
 
 
March 31,
 
 
December 31,
 
 
 
2018
 
 
2017
 
Term loan
 $55,125,000 
 $61,750,000 
Less:
    
    
Deferred financing fees
  (961,758)
  (1,027,332)
Current portion
  (6,500,000)
  (6,500,000)
Term loan - long-term portion
 $47,663,242 
 $54,222,668 
 
    
    
Indebtedness under revolving credit facility
 $- 
 $1,500,000 
 
On November 14, 2016, Fusion NBS Acquisition Corp. (“FNAC”), a wholly-owned subsidiary of Fusion, entered into a credit agreement (the “East West Credit Agreement”) with East West Bank (“EWB”), as administrative agent and the lenders identified therein (collectively the “East West Lenders”). Under the East West Credit Agreement, the East West Lenders extended FNAC (i) a $65.0 million term loan and (ii) a $5.0 million revolving credit facility (which includes up to $4 million in “swingline” loans that may be accessed on a short-term basis).
 
Borrowings under the East West Credit Agreement are evidenced by notes bearing interest at rates computed based upon either the then current “prime” rate of interest or “LIBOR” rate of interest, as selected by FNAC. Interest on borrowings that FNAC designates as “base rate” loans bear interest at the greater of the prime rate published by the Wall Street Journal or 3.25% per annum, in each case plus 2% per annum. Interest on borrowings that FNAC designates as “LIBOR rate” loans bear interest at the LIBOR rate of interest published by the Wall Street Journal, plus 5% per annum. The current interest rate is 6.75% per annum.
 
Effective January 1, 2018, the Company is required to make monthly principal payments in the amount of $541,667 until the November 12, 2021 maturity date of the term loan, when the remaining $36.8 million of principal is due. Borrowings under the revolving credit facility are also payable on the November 12, 2021 maturity date of the facility. At March 31, 2018 and December 31, 2017, $0 and $1.5 million, respectively, was outstanding under the revolving credit facility.
 
 
15
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Under the East West Credit Agreement: 
 
● 
The Company is subject to a number of affirmative and negative covenants, including but not limited to, restrictions on paying indebtedness subordinate to its obligations to the East West Lenders, incurring additional indebtedness, making capital expenditures, dividend payments and cash distributions by subsidiaries.
 
● 
The Company is required to comply with various financial covenants, including leverage ratio, fixed charge coverage ratio and minimum levels of earnings before interest, taxes, depreciation and amortization; and its failure to comply with any of the restrictive or financial covenants could result in an event of default and accelerated demand for repayment of amounts outstanding.
 
● 
The Company granted the lenders security interests on all of its assets, as well as its membership interest in FGS and the capital stock of FNAC and each of its subsidiaries.
 
● 
Fusion and its subsidiaries (and future subsidiaries of both) other than FNAC and FGS have guaranteed FNAC’s obligations, including FNAC’s repayment obligations thereunder.
 
At March 31, 2018 and December 31, 2017, the Company was in compliance with all of the financial covenants contained in the East West Credit Agreement. See “Note 19 – Subsequent Events”.
 
Notes Payable – Non-Related Parties
 
At March 31, 2018 and December 31, 2017, notes payable – non-related parties consists of the following: 
 
 
 
March 31,
 
 
December 31,
 
 
 
2018
 
 
2017
 
Subordinated notes
 $33,588,717 
 $33,588,717 
Discount on subordinated notes
  (958,052)
  (1,040,167)
Deferred financing fees
  (547,111)
  (595,387)
Total notes payable - non-related parties
  32,083,554
  31,953,163 
Less: current portion
  - 
  - 
Long-term portion
 $32,083,554
 $31,953,163 
 
On November 14, 2016, FNAC, Fusion and Fusion’s other subsidiaries entered into the Fifth Amended and Restated Securities Purchase Agreement (the “Praesidian Facility”) with Praesidian Capital Opportunity Fund III, L.P., Praesidian Capital Opportunity Fund III-A, LP and United Insurance Company of America (collectively, the “Praesidian Lenders”). The Praesidian Facility amends and restates a prior facility, pursuant to which FNAC previously sold its Series A, Series B, Series C, Series D, Series E and Series F senior notes in an aggregate principal amount of $33.6 million (the “SPA Notes”). These notes require interest payments in the amount of $0.3 million per month. The current interest rate is 10.8% per annum.
 
Under the terms of the Praesidian Facility, the maturity date of the SPA Notes is May 12, 2022, no payments of principal are due until the maturity date, and the financial covenants contained in the Praesidian Facility are substantially similar to those contained in the East West Credit Agreement. In connection with the execution of the Praesidian Facility, the Praesidian Lenders entered into a subordination agreement with the East West Lenders pursuant to which the Praesidian Lenders have subordinated their right to payment under the Praesidian Facility and the SPA Notes to repayment of the Company’s obligations under the East West Credit Agreement. At March 31, 2018 and December 31, 2017, the Company was in compliance with all of the financial covenants contained in the Praesidian Facility. See “Note 19 – Subsequent Events”.
 
 
16
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Notes Payable – Related Parties
 
At March 31, 2018 and December 31, 2017, the Company had $0.9 million of outstanding notes payable due to Marvin Rosen, the Chairman of Fusion’s Board of Directors. These notes are subordinated to borrowings under the East West Credit Agreement and the Praesidian Facility. The notes are unsecured, pay interest monthly at an annual rate of 7%, and mature 120 days after the Company’s obligations under the East West Credit Agreement and the Praesidian Facility are paid in full. See “Note 19 – Subsequent Events”.
 
Note 12. Obligations Under Asset Purchase Agreements
 
In connection with certain acquisitions and asset purchases completed by the Company during 2016, 2017 and 2018, the Company has various obligations to the sellers, mainly for payments of portions of the purchase price that have been deferred under the terms of the respective asset purchase agreements. Such obligations to sellers or other parties associated with these transactions as of March 31, 2018 and December 31, 2017 are as follows:
 
 
March 31,
 
 
December 31,
 
 
 
2018
 
 
2017
 
Customer base acquisitions
 $253,380 
 $450,000 
IQMax
  947,079 
  - 
 
  1,200,459 
  450,000 
Less current portion
  (723,297)
  (227,760)
Long-term portion
 $477,162 
 $222,240 
 
Note 13. Derivative Liability
 
Fusion has issued warrants to purchase shares of its common stock in connection with certain debt and equity financing transactions. These warrants are accounted for in accordance with the guidance contained in ASC Topic 815, Derivatives and Hedging. For warrant instruments that are not deemed to be indexed to Fusion’s common stock, the Company classifies such instruments as a liability at its fair value and adjusts the instrument to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until the warrant is exercised or expires, and any change in fair value is recognized in the Company’s statement of operations. At March 31, 2018, Fusion had 203,647 warrants outstanding which provide for a downward adjustment of the exercise price if Fusion were to issue common stock at an issuance price, or issue convertible debt or warrants with a conversion or exercise price, that is less than the exercise price of these warrants. During the three months ended March 31, 2018, 37,120 warrants were exercised, resulting in a reclassification to equity in the amount of $0.1 million. During the three months ended March 31, 2017, 12,800 of these warrants were exercised, and $13,000 was reclassified from the Company’s derivative liability into equity.
 
The fair values of these warrants have been estimated using option pricing and other valuation models, and the quoted market price of Fusion common stock. The following weighted average assumptions were used to determine the fair value of the warrants for the three months ended March 31, 2018 and 2017:
 
 
Three months ended March 31,
 
 
 
2018
 
 
2017
 
Stock price ($)
  4.85 
  2.37 
Adjusted Exercise price ($)
  2.34 
  2.34 
Risk-free interest rate (%)
  2.09 
  2.23 
Expected volatility (%)
  86.90 
  74.40 
Time to maturity (years)
  1.00 
  1.75 
 
At March 31, 2018 and December 31, 2017, the fair value of the derivative was $0.6 million and $0.9 million, respectively. For the three months ended March 31, 2018, the Company recognized a gain on the change in fair value of the derivative of $0.2 million, and for the three months ended March 31, 2017, the Company recognized a loss on the change in fair value of the derivative in the amount of $40,000.
 
Note 14. Revenues from Contracts with Customers
 
In May 2014, the FASB issued ASU 2014-09, Revenues from Contracts with Customers (Topic 606) (“ASU 2014-09”), as subsequently amended, that outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most recent revenue recognition guidance, including industry-specific guidance. The core principle of the revenue model is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This standard is effective for public companies for years ending after December 15, 2017, with early adoption permitted. In March 2016, April 2016 and December 2016, the FASB issued ASU No. 2016-08, Revenue From Contracts with Customers (ASC 606): Principal Versus Agent Considerations, ASU No. 2016-10, Revenue From Contracts with Customers: Identifying Performance Obligations and Licensing, and ASU No. 2016-20, Technical Corrections and Improvements to Topic 606, Revenue From Contracts with Customers, respectively, which further clarify the implementation guidance on principal versus agent considerations contained in ASU No. 2014-09. In May 2016, the FASB issued ASU 2016-12, Revenue from Contracts with Customers, narrow-scope improvements and practical expedients which provides clarification on assessing the collectability criterion, presentation of sales taxes, measurement date for non-cash consideration and completed contracts at transition. These standards became effective for the Company beginning with the first quarter of 2018.
 
 
17
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
The Company adopted ASC 606 using the modified retrospective method by recognizing the cumulative effect of initially applying ASC 606 as an adjustment to the opening balance of shareholders’ equity at January 1, 2018. The historical periods have not been adjusted and continue to be reported under ASC 605 “Revenue Recognition”.
 
The following table includes information for the transition adjustment recorded as of January 1, 2018 to record the cumulative impact of adoption of ASC 606:
 
 
 
Balance as of
 
 
ASC 606
 
 
Balance as of
 
 
 
December 31, 2017
 
 
Transition Adjustment
 
 
January 1, 2018
 
Assets
 
 
 
 
 
 
 
 
 
Deferred installation costs, current
 $- 
 $783,667 
 $783,667 
Deferred installation costs, non-current
  - 
  1,125,414 
  1,125,414 
 
  - 
  1,909,081 
  1,909,081 
Liabilities
    
    
    
Deferred installation revenue, current
  - 
  (785,740)
  (785,740)
Deferred installation revenue, non-current
  - 
  (1,036,657)
  (1,036,657)
 
  - 
  (1,822,397)
  (1,822,397)
Stockholders' Equity
    
    
    
Accumulated deficit
 $- 
 $86,684
 $86,684
 
Under this new guidance, the Company recognizes revenue when its customer obtains control of promised services, in an amount that reflects the consideration which the Company expects to receive in exchange for those services. To determine whether arrangements are within the scope of this new guidance, the Company performs the following five steps: (i) identifies the contract with a customer; (ii) identifies the performance obligations in the contract; (iii) determines the transaction price; (iv) allocates the transaction price to the performance obligations in the contract; and (v) recognizes revenue when (or as) the Company satisfies its performance obligation. The details of changes under the new guidance are as follow:
 
Contract Acquisition Costs
Under ASC 606, certain costs to acquire customers must be deferred and amortized over the related contract period of expected customer life. For the Company, this includes certain commissions paid to acquire new customers. Beginning January 1, 2018, commissions attributable to new customer contracts are being deferred and amortized into expense. Historically, these acquisition costs were expensed as incurred. The Company determined that incremental commissions paid as a result of acquiring customers are recoverable and, therefore, as part of the transition adjustment above, current deferred installation costs of $784,000 and non-current deferred installation costs of $1,125,000 were capitalized. For the three months ended March 31, 2018, the Company capitalized a total of $209,000 and amortized $217,000 of commissions. As of March 31, 2018, the Company recorded a total of $798,000 of current deferred installation costs and $1,103,000 of non-current deferred installation costs in its consolidated balance sheet.
 
Installation Revenues
Under ASC 606, certain installation fees charged to the customers did not represent separate performance obligations and, as a result, these fees must be deferred and recognized over the related contract period of expected customer life. Beginning January 1, 2018, installation revenues attributable to the customer contracts are being deferred and amortized into revenue. Historically, these revenues were recognized when completed. As part of the transition adjustment above, the Company recorded a total of $786,000 of current deferred installation revenue and $1,036,000 of non-current deferred installation revenue at January 1, 2018. For the three months ended March 31, 2018, the Company deferred a total of $225,000 and recognized $221,000 of installation revenue. As of March 31, 2018, the Company recorded a total of $797,000 of current deferred installation revenue and $1,029,000 of non-current deferred installation revenue on our consolidated balance sheet.
 
The following table summarize the impacts of adopting ASC 606 on Company’s consolidated balance sheet and statement of operations as of and for the three months ended March 31, 2018:
 
 
18
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
 
 
 
March 31, 2018        
 
 
 
 
 
 
 
 
 
Impact of
 
 
 
As reported
 
 
Previous guidance
 
 
Adoption of ASC 606
 
Assets
 
 
 
 
 
 
 
 
 
Deferred installation costs, current
 $798,166 
 $- 
 $798,166 
Deferred installation costs, non-current
  1,102,648 
  - 
  1,102,648 
 
  1,900,814 
  - 
  1,900,814 
Liabilities
    
    
    
Deferred installation revenue, current
  (797,332)
  - 
 $(797,332)
Deferred installation revenue, non-current
  (1,029,445)
  - 
  (1,029,445)
 
  (1,826,777)
  - 
  (1,826,777)
Stockholders' Equity
    
    
    
Accumulated deficit
 $(201,318,706)
 $(201,244,669)
 $(74,037)
 
 
 
For the three months ended March 31, 2018
 
 
 
 
 
 
 
 
 
Impact of
 
 
 
As reported
 
 
Previous guidance
 
 
Adoption of ASC 606
 
 
 
 
 
 
 
 
 
 
 
Revenues
 $29,038,043 
 $29,042,422 
 $(4,379)
Selling, general and administrative
  (13,947,995)
  (13,939,728)
  (8,267)
Net Impact
 $15,090,048 
 $15,102,694 
 $(12,646)
 
The impact of adoption of ASC 606 on net income, basic and diluted net loss per share, consolidated statement of operations and the consolidated statement of cash flows were not material for the three months ended March 31, 2018.
 
The following table includes estimated revenue expected to be recognized in the future related to performance obligations that are unsatisfied (or partially unsatisfied) at the end of the reporting period:
 
 
 
Deferred installation
 
 
Deferred installation
 
 
Net
 
 
 
revenue
 
 
costs
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2018 (remaining nine months)
 $616,688 
 $(614,571)
 $2,117 
2019
  634,105 
  (663,614)
  (29,509)
2020
  405,576 
  (459,859)
  (54,283)
2021 and thereafter
  170,408 
  (162,770)
  7,638 
 
 $1,826,777 
 $(1,900,814)
 $(74,037)
 
Summary of disaggregated revenue for the three months periods ended March 31, 2018 and 2017 is as follows:
 
Revenue category
 
For the three months ended March 31, 2018
 
 
For ther three
 
 
 
 
 
 
 
 
 
Impact of
 
 
months ended
 

 
As
reported
 
 
Previous
guidance
 
 
Adoption of
ASC 606
 
 
March 31,
2017
 
Monthly recurring
 $24,313,686 
 $24,313,686 
 $- 
  24,721,490 
Usage and other
  4,473,467 
  4,473,467 
  - 
  3,444,654 
Installation
  250,890 
  255,269 
  (4,379)
  314,895
Total revenue
 $29,038,043 
 $29,042,422 
 $(4,379)
 $28,481,039
 
Note 15. Equity Transactions
 
Common Stock
 
Fusion is authorized to issue 150,000,000 shares of common stock. As of March 31, 2018 and December 31, 2017, 23,847,140 and 14,980,756 shares of its common stock, respectively, were issued and outstanding. See “Note 19 – Subsequent Events”.
 
In February 2018, the Company completed an underwritten public offering whereby Fusion issued 8,625,000 shares of its common stock and received net proceeds of $38.2 million. The proceeds from this offering are being used to pay down certain indebtedness and for general corporate purposes.
 
 
 
19
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
During the three months ended March 31, 2018, Fusion issued 27,275 shares of common stock upon the exercise of outstanding warrants, and declared dividends of $144,000 on the Series B-2 Preferred Stock, which was paid in the form of 3,985 shares of Fusion common stock.
 
In March 2017, the Company entered into exchange agreements with certain holders of its outstanding warrants whereby the outstanding warrants were exchanged for new warrants (the “2017 Warrants”), which warrants permitted the holders to exercise and purchase, for a limited period of 60 days, unregistered shares of Fusion common stock at a discount of up to 10% below the closing bid price of the common stock at the time of exercise but in no event at a price of less than $1.95 per share. In connection with these exchange agreements, the warrant holders exercised warrants to purchase 374,556 shares of common stock on March 31, 2017 at an exercise price of $2.09 per share. The Company received proceeds from the exercise of the 2017 Warrants in the amount of $0.8 million, which will be used for general corporate purposes. All of the 2017 Warrants were immediately exercised and none remained outstanding as of March 31, 2017. As a result of the exchange, the Company recorded a preferred stock dividend in the amount of $0.3 million for the difference in fair value of the warrants that were exchanged (see note 5).
 
Preferred Stock
 
Fusion is authorized to issue up to 10,000,000 shares of preferred stock. As of March 31, 2018 and December 31, 2017, there were 5,045 shares of Series A Preferred Stock issued and outstanding. In addition, there were 8,421 and 9,171 shares of Series B-2 Preferred Stock issued and outstanding as of March 31, 2018 and December 31, 2017, respectively. See “Note 19 – Subsequent Events”.
 
During the three months ended March 31, 2018, 750 shares of Series B-2 Preferred stock were converted into 100,000 shares of Fusion common stock.
 
On March 31, 2017, the Company agreed with certain holders of its Series B-2 Preferred Stock to convert their shares of Series B-2 Preferred Stock into shares of Fusion common stock at a conversion price of $4.50 per share (a three dollar reduction from the specified conversion price). As a result, 2,958 shares of Series B-2 Preferred Stock were converted into a total of 657,777 shares of Fusion common stock, and the Company recorded a preferred stock dividend of $0.6 million for the value of the incremental number of common shares issued in connection with the reduction in the conversion price of the Series B-2 Preferred Stock (see note 5).
 
The holders of the Series A Preferred Stock are entitled to receive cumulative dividends of 8% per annum payable in arrears, when and if declared by Fusion’s Board, on January 1 of each year. As of March 31, 2018, no dividends have been declared with respect to the Series A Preferred Stock (see note 5). The holders of the Series B-2 Preferred Stock are entitled to receive cumulative dividend of 6% per annum payable quarterly in arrears when and if declared by Fusion’s Board, in cash or shares of Fusion common stock, at the option of the Company (see note 5).
 
Stock Options
 
Fusion's 2016 equity incentive plan reserves a number of shares of common stock equal to 10% of Fusion common stock outstanding from time to time on a fully diluted basis, adjusted upward for the number of shares available for grant under Fusion’s 2009 stock option plan plus the number of shares covered by options granted under the 2009 plan that expire without being exercised. The 2016 equity incentive plan provides for the grant of incentive stock options, stock appreciation rights, restricted stock, restricted stock units, stock grants, stock units, performance shares and performance share units to employees, officers, non-employee directors of, and consultants to the Company. Options issued under the various Fusion plans typically vest in annual increments over a three or four year period, expire ten years from the date of grant and are issued at exercise prices no less than 100% of the fair market value at the time of grant.
 
The following assumptions were used to determine the fair value of the stock options granted under Fusion’s stock-based compensation plans using the Black-Scholes option-pricing model:
 
 
 
Three Months Ended March 31,
 
 
 
2018
 
 
2017
 
Dividend yield
  0.0%
  0.0%
Expected volatility
  92.40%
  92.40%
Average Risk-free interest rate
  2.56%
  2.27%
Expected life of stock option term (years)
  8.00 
  8.00 
 
 
20
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
The Company recognized compensation expense of $0.4 million and $0.2 million for the three months ended March 31, 2018 and 2017, respectively. These amounts are included in selling, general and administrative expenses in the condensed consolidated interim statements of operations.
 
The following table summarizes stock option activity for the three months ended March 31, 2018:
 
 
 
Number of Options
 
 
Weighted Average Exercise Price
 
 
Weighted Average Remaining Contract Term
 
Outstanding at December 31, 2017
  2,011,952 
 $3.57 
 
 
 
Granted
  4,800 
  5.48 
 
 
 
Exercised
  - 
  - 
 
 
 
Forfeited
  (1,500)
  2.55 
 
 
 
Expired
  (17,964)
  14.57 
 
 
 
Outstanding at March 31, 2018
  1,997,288 
  3.48 
  8.09 
Exercisable at March 31, 2018
  1,416,765 
  4.04 
  7.92 
 
As of March 31, 2018, the Company had approximately $0.9 million of unrecognized compensation expense related to stock options granted under the Company’s stock-based compensation plans, which is expected to be recognized over a weighted-average period of 1.7 years.
 
Note 16. Commitments and Contingencies
 
From time to time, the Company may be involved in a variety of claims, lawsuits, investigations and proceedings relating to contractual disputes, employment matters, regulatory and compliance matters, intellectual property rights and other litigation arising in the ordinary course of business. Defending such proceedings can be costly and can impose a significant burden on management and employees. As of March 31, 2018, the Company does not expect that the outcome of any such claims or actions will have a material adverse effect on the Company’s liquidity, results of operations or financial condition.
 
The Company underwent a compliance audit for the use of certain software licenses by one of the Company’s recently acquired businesses. The Company is negotiating with the software vendor with regard to a settlement and based upon correspondence and conversations with the vendor, the Company has recorded an accrual in accounts payable and accrued expenses in the accompanying consolidated balance sheet. There can be no assurances that this matter will be settled and, if settled, the amount that we would pay in any such settlement.
 
Note 17. Related Party Transactions
 
Since March 6, 2014, the Company has engaged a tax advisor to prepare its tax returns and to provide related tax advisory services. The Company was billed $0 and $0.1 million for the three months ended March 31, 2018 and 2017, respectively, by this firm. Larry Blum, a member of Fusion’s Board of Directors, is a Senior Advisor to, and a former partner of, this firm.
 
The Company has also issued notes payable to Marvin Rosen (see note 10). See “Note 19 – Subsequent Events”.
 
Note 18. Fair Value Disclosures
 
Fair value of financial and non-financial assets and liabilities is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The three-tier hierarchy for inputs used in measuring fair value, which prioritizes the inputs used in the methodologies of measuring fair value for assets and liabilities, is as follows:
 
 
21
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Level 1—Quoted prices in active markets for identical assets or liabilities
Level 2—Observable inputs other than quoted prices in active markets for identical assets and liabilities
Level 3—No observable pricing inputs in the market
 
The following table represents the liabilities measured at fair value on a recurring basis:
 
 
 
Level 1
 
 
Level 2
 
 
Level 3
 
 
Total
 
As of March 31, 2018
 
 
 
 
 
 
 
 
 
 
 
 
Current liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
Contingent purchase price liability
  - 
  - 
 $223,297 
 $223,297 
Non-current liabilities:
    
    
    
    
Contingent purchase price liability
  - 
  - 
 $477,162
 $477,162
Derivative liability (see note 13)
  - 
  - 
 $586,197 
 $586,197 
As of December 31, 2017
    
    
    
    
Current liabilities:
    
    
    
    
Contingent purchase price liability
  - 
  - 
 $227,760 
 $227,760 
Non-current liabilities:
    
    
    
    
Contingent purchase price liability
  - 
  - 
 $222,240 
 $222,240 
Derivative liability (see note 13)
  - 
  - 
 $872,900 
 $872,900 
 
Changes in the derivative warrant liability for the three months ended March 31, 2018 are as follows:
 
Balance at December 31, 2017
 $872,900 
Change for the period:
    
Change in fair value included in net loss
  (194,312)
Warrant exercises (see note 13)
  (92,391)
Balance at March 31, 2018
 $586,197 
 
Note 19. Subsequent Events
 
Completion of the Acquisition of Birch Communications
 
On May 4, 2018 (the “Closing Date”), Fusion completed the various transactions contemplated by the Merger Agreement. As contemplated by the Merger Agreement, on the Closing Date, Birch merged with and into Merger Sub, with Merger Sub surviving the merger as a wholly-owned subsidiary of Fusion.
 
On the Closing Date, all of the outstanding shares of common stock, par value $0.01 per share, of Birch (other than treasury shares or shares owned of record by any Birch subsidiary) were cancelled and converted into the right to receive, in the aggregate, 49,896,310 shares (the “Merger Shares”) of Fusion Common Stock. Pursuant to subscription agreements executed by each of the shareholders of Birch, the Merger Shares were issued in the name of, and are now held by, BCHI Holdings, LLC, a Georgia limited liability company owned by the former shareholders of Birch.
 
Carrier Spin-Off
 
On the Closing Date, Fusion entered into a Membership Interest Purchase and Sale Agreement (the “Membership Sale Agreement”) with XComIP pursuant to which Fusion transferred its sixty percent (60%) membership interest in FGS to XComIP in exchange for a right to receive: (i) sixty percent (60%) of the Net Profits (as defined in the Membership Sale Agreement) of FGS; (ii) sixty percent (60%) of any distributions being made by FGS to its members only to the extent such amounts are not distributed as part of the distribution of Net Profits; and (iii) sixty percent (60%) of the net proceeds received by the members from a sale of FGS to a third party.
 
22
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Senior Secured Credit Facilities
 
On the Closing Date, Fusion entered into a First Lien Credit and Guaranty Agreement (the “First Lien Credit Agreement”) with Wilmington Trust, National Association, as Administrative Agent and Collateral Agent (in such capacities, the “First Lien Agent”), the lenders party thereto (the “First Lien Lenders”), and all of the U.S.-based subsidiaries of Fusion, as guarantors thereunder (the “Guarantors”), pursuant to which the First Lien Lenders extended (a) term loans to Fusion in an aggregate principal amount of $555,000,000, consisting of the “Tranche A Term Loan” and “Tranche B Term Loan,” in an aggregate principal amount of $45,000,000 and $510,000,000, respectively (collectively, the “First Lien Term Loan”), and (b) a revolving facility in an aggregate principal amount of $40,000,000 (the “Revolving Facility”, and together with the First Lien Term Loan, the “First Lien Facility”). Borrowings under the First Lien Credit Agreement are computed based upon either the then current “base rate” of interest or “LIBOR” rate of interest, as selected by Fusion at the time of its borrowings. The Tranche A Term Loan has an original issue discount of 0.5%. The Tranche B Term Loan has an original issue discount of 4%, except for the $170 million portion of the Tranche B Term Loan made by one lender and certain of its affiliates, which has an original issue discount of 9%, for a blended original issue discount of approximately 5.67%. The Tranche A Term Loan and the Revolving Facility mature on the fourth anniversary of the Closing Date and the Tranche B Term Loan matures on the fifth anniversary of the Closing Date. The Guarantors guaranty the obligations of Fusion under the First Lien Credit Agreement.
 
In addition, Fusion simultaneously entered into a Second Lien Credit and Guaranty Agreement (the “Second Lien Credit Agreement”, and with the First Lien Credit Agreement, the “Credit Agreements”), by and among Fusion, the Guarantors, Wilmington Trust, National Association, as Administrative Agent and Collateral Agent (in such capacities, the “Second Lien Agent”, and together with the First Lien Agent, collectively the “Agents”), and the lenders party thereto (the “Second Lien Lenders”, and together with the First Lien Lenders, the “Lenders”), pursuant to which the Second Lien Lenders extended a term loan in the aggregate principal amount of $85,000,000 (the “Second Lien Term Loan”, and collectively with the First Lien Term Loan, the “Term Loans”, and collectively with the First Lien Facility, the “Credit Facilities”). Borrowings under the Second Lien Credit Agreement are computed based upon either the then current “base” rate of interest or “LIBOR” rate of interest, as selected by Fusion at the time of its borrowings. The Second Lien Term Loan has an original issue discount of 4.00%, and it matures 5.5 years from the Closing Date. The Guarantors guaranty the obligations of Fusion under the Second Lien Credit Agreement. The Credit Facilities may be prepaid, in whole or in part, subject to specified prepayment premiums.
 
Under the Credit Agreements, Fusion is subject to a number of affirmative and negative covenants, including but not limited to, restrictions on paying indebtedness subordinate to its obligations to the Lenders, incurring additional indebtedness, making capital expenditures, dividend payments and cash distributions by subsidiaries. Furthermore, Fusion is required to comply with various financial covenants, including net leverage ratio, fixed charge coverage ratio and maximum levels of consolidated capital expenditures; and its failure to comply with any of the restrictive or financial covenants could result in an event of default and accelerated demand for repayment of its indebtedness.
 
The proceeds of the Term Loans have been used, in part, to refinance all of the existing indebtedness of Fusion and its subsidiaries (including Birch), under (i) the East West Bank Credit Agreement; (ii) the Praesidian Facility; and (iii) the Credit Agreement, dated as of July 18, 2014, among Birch Communications Holdings, Inc., Birch Communications, Inc., Cbeyond, Inc., the other guarantors party thereto, the lenders party thereto and PNC Bank, National Association, as Administrative Agent. In addition, the Term Loans were used to repay, in full, approximately $929,000 of indebtedness under that certain Second Amended and Restated Unsecured Promissory Note, dated November 14, 2016, payable by Fusion to Marvin Rosen. The proceeds were also be used to pay the fees and expenses associated with the Birch Merger and related transactions, including in connection with the Credit Facilities.
 
The Term Loans were also used to make a prepayment of an aggregate of approximately $3.0 million of indebtedness of Birch under the subordinated notes each dated October 28, 2016, in favor of Holcombe T. Green, Jr., R. Kirby Godsey and the Holcombe T. Green, Jr. 2013 Five-Year Annuity Trust. The remaining indebtedness thereunder is evidenced after the closing of the Birch Merger by Amended and Restated Subordinated Notes, dated as of the Closing Date, made by BCHI Merger Sub (as successor in interest to Birch pursuant to the Birch Merger) with an aggregate principal amount of $3.3 million (the “Bircan Notes”). The Bircan Notes each have an interest rate of 12% per annum, and are amortized in three equal installments, to be paid off completely in March 2019, with interest due in quarterly installments. The indebtedness under the Bircan Notes is unsecured, and obligations thereunder are subordinated to the Credit Facilities.
 
In addition, $62,000,000 of the Tranche B Term Loan under the First Lien Credit Agreement has been deposited in a deposit account with EWB, which account is subject to the terms of a deposit account control agreement by and among Fusion, EWB, and the First Lien Agent. The amounts deposited in this account will be used by Fusion to pay the Purchase Price (as defined below) for MegaPath Holdings Corporation (“MegaPath”). If the MegaPath Merger (as defined below) is not completed by August 4, 2018, such funds must be used to prepay the Tranche B Term Loan under the First Lien Credit Agreement.
 
23
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Green Subordinated Note
 
At Closing, Holcombe T. Green, Jr. made an additional loan to Fusion in the principal amount of $10,000,000, which is evidenced by a Subordinated Promissory Note, dated the Closing Date (the “Green Note”), that Fusion delivered to Mr. Green. The Green Note has an interest rate of 13% per annum and an original issue discount of 4%, and it matures on the date which is 91 days after the maturity date of the Second Lien Term Loan. Until the maturity date of the Green Note, only interest is due thereunder, in quarterly payments. The indebtedness under the Green Note is unsecured, and obligations thereunder are subordinated to the Credit Facilities.
 
Vector Subordinated Note
 
In connection with its participation in the Tranche B Term Loan under the First Lien Credit Agreement, Vector Fusion Holdings (Cayman), Ltd. (“Vector”) entered into a separate credit agreement (the “Vector Credit Agreement”) with Goldman Sachs & Co., as administrative agent and lender, and U.S. Bank National Association, as collateral agent and collateral custodian, pursuant to which Vector borrowed funds from Goldman Sachs, the proceeds of which were used to purchase Tranche B Term Loans under the First Lien Credit Agreement. In connection therewith, Vector issued to Fusion, and Fusion bought from Vector using proceeds of the various financing transactions consummated on the Closing Date, a $25,000,000 unsecured subordinated note (the “Vector Note”). The Vector Note bears interest at the rate earned by the bank account in which the proceeds of the Vector Note will be deposited and matures on May 3, 2024. The Vector Note is subordinate in right of payment to Vector’s loan from Goldman Sachs& Co. Other than payments permitted under certain limited circumstances set forth in the Vector Credit Agreement, Fusion is not entitled to any distribution on account of the principal, premium or interest or any other amount in respect of the Vector Note until all amounts owed by Vector under the Vector Credit Agreement are paid in full. Similarly, while Fusion has the right to declare obligations due under the Vector Note to be immediately due and payable upon the occurrence of an event of default (including, without limitation, in the event of any insolvency, bankruptcy or liquidation or Vector), Fusion will not be entitled to receive any payment on account of the Vector Note until Vector’s obligations under the Senior Credit Agreement are paid in full. Fusion pledged the Vector Note as security for its obligations under the Credit Agreements.
 
Private Placements of Common Stock
 
On the Closing Date, Fusion entered into and consummated the sale of shares of Fusion common stock under three separate common stock purchase agreements. Specifically, Fusion issued and sold (i) 952,382 shares of Fusion common stock, for an aggregate purchase price of approximately $5,000,000, to North Haven Credit Partners II L.P., one of the First Lien Lenders under the Tranche B Term Loan, which is managed by Morgan Stanley Credit Partners; (ii) 380,953 shares of Fusion common stock, for an aggregate purchase price of approximately $2,000,000, to Aetna Life Insurance Company; and (iii) 190,477 shares of Fusion common stock, for an aggregate purchase price of approximately $1,000,000, to Backcast Credit Opportunities Fund I, L.P. These shares of common stock were sold in reliance upon the exemption from the registration requirements under the Securities Act of 1933, as amended (“Securities Act”) pursuant to Section 4(a)(2) thereunder.
 
Private Placement of Series D Preferred Stock
 
On the Closing Date, Fusion entered into a preferred stock purchase agreement with Holcombe T. Green, Jr. pursuant to which it issued and sold to Mr. Green 15,000 shares of Series D Cumulative Preferred Stock, par value $0.01 per share (the “Series D Preferred Stock”) of Fusion, for an aggregate purchase price of $14,700,000. The Series D Preferred Stock has a stated value of $15,000,000. The Series D Preferred Shares were sold in reliance upon the exemptions from the registration requirements under the Securities Act pursuant to Section 4(a)(2) thereunder. The Series D Preferred Stock accrues dividends when, as and if declared by the Fusion Board at an annual rate of twelve percent (12%) per annum, payable monthly in arrears on a cumulative basis.
 
MegaPath Merger Agreement
 
On May 4, 2018, Fusion, and its wholly owned subsidiary, Fusion MPHC Acquisition Corp., a Delaware corporation (“MPHC Merger Sub”), entered into an Agreement and Plan of Merger (the “MegaPath Merger Agreement”), with MegaPath and Shareholder Representative Services LLC, a Colorado limited liability company, solely in its capacity as the representative of the stockholders and optionholders of MegaPath. The MegaPath Merger Agreement, provides, among other things, that upon the terms and conditions set forth therein, MPHC Merger Sub will merge with and into MPHC Merger Sub, with MegaPath surviving the MegaPath Merger and continuing as a wholly-owned subsidiary of Fusion. The purchase price for MegaPath is $71,500,000 (the “Purchase Price”), up to $10,000,000 of which may be paid by Fusion, at its option, in shares of Fusion’s common stock. The Purchase Price is subject to a working capital adjustment as well as a reduction for certain transaction expenses and any outstanding indebtedness of MegaPath as of the closing of the MegaPath Merger, in each case, as provided in the MegaPath Merger Agreement. At closing, $2,500,000 of the Purchase Price will be deposited in an escrow account held by Citibank, N.A., as escrow agent, for one (1) year, to secure indemnification obligations in favor of Fusion under the MegaPath Merger Agreement.
 
A full description of each of the foregoing events is contained in our Current Report on Form 8-K which was filed with the Securities and Exchange Commission on May 10, 2018.
 
 
24
FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion should be read in conjunction with the information contained in our unaudited consolidated financial statements and the notes thereto appearing elsewhere herein and in conjunction with the Management’s Discussion and Analysis set forth in the Company’s 2017 Form 10-K.
 
Certain statements and the discussion contained herein regarding the Company’s business and operations may include “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements consist of any statement other than a recitation of historical fact and can be identified by the use of forward-looking terminology such as “may,” “plans,” “expect,” “anticipate,” “intend,” “estimate” or “continue” or the negative thereof or other variations thereof or comparable terminology. The reader is cautioned that all forward-looking statements are speculative, and there are certain risks and uncertainties that could cause actual events or results to differ from those referred to in such forward-looking statements. The primary risk of the Company is its ability to attract new capital to execute its comprehensive business strategy. There may be additional risks associated with the integration of businesses following an acquisition, the Company’s ability to comply with the terms of its credit facilities, competitors with broader product lines and greater resources, emergence into new markets, natural disasters, acts of war, terrorism or other events beyond the Company’s control and the other factors identified by the Company from time to time in its filings with the SEC. However, the risks included should not be assumed to be the only risks that could affect future performance. All forward-looking statements included are made as of the date hereof, based on information available to the Company as of the date thereof, and the Company assumes no obligation to update any forward-looking statements.
 
OVERVIEW
 
Our Business
 
We offer a comprehensive suite of cloud communications, cloud connectivity, cloud computing and managed cloud-based applications to small, medium and large businesses.  Our advanced, proprietary cloud services platforms, as well as our state-of-the art switching systems, enable the integration of leading edge solutions in the cloud, increasing customer collaboration and productivity by seamlessly connecting employees, partners, customers and vendors.
 
We are focused on becoming our business customers’ single source for leveraging the increasing power of the cloud, providing a robust package of what we believe to be the essential services that form the foundation for their successful migration to, and efficient use of, the cloud.  Our core Business Services products and services include cloud voice and Unified Communications as a Service, improving communication and collaboration on virtually any device, virtually anywhere, cloud connectivity services, securely and reliably connecting customers to the cloud with managed network solutions that are designed to increase quality and optimize network efficiency and contact center solutions.  Our cloud computing and Infrastructure as a Service solutions are designed to provide our larger enterprise customers with a platform on which additional cloud services can be layered.  Complemented by our Software as a Service solutions, such as security and business continuity, our advanced cloud offerings include private and hybrid cloud, storage, backup and recovery and secure file sharing that allow our customers to experience the increased efficiencies and agility delivered by the cloud. The Company’s cloud-based services are flexible, scalable and rapidly deployed, reducing our customers’ cost of ownership while increasing their productivity.
 
We continue to focus our sales and marketing efforts on developing vertically oriented solutions for targeted markets that require the kind of specialized solutions made possible by our state-of-the-art network and advanced services platforms.  Our vertically oriented solutions, which are currently focused on healthcare, legal, hospitality and real estate, offer a substantial opportunity to gain additional market share.   We intend to accelerate the growth of our business with the goal of increasing the portion of our total revenue derived from this higher margin.
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”).  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent liabilities.  We base these estimates on our historical experience and on various other assumptions that we believe to be reasonable under the circumstances, and these estimates form the basis for our judgments concerning the carrying values of assets and liabilities that are not readily apparent from other sources.  We periodically evaluate these estimates and judgments based on available information and experience. Actual results could differ from our estimates under different assumptions and conditions.  If actual results significantly differ from our estimates, our financial condition and results of operations could be materially impacted.
 
 
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FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
We have identified the policies and significant estimation processes discussed below as critical to our operations and to an understanding of our results of operations.  For a detailed discussion on the application of these and other accounting policies, see Note 2 to the Consolidated Financial Statements included in the 2017 Form 10-K.
 
Revenue Recognition
 
We recognize revenue upon transfer of goods or services to a customer at an amount that reflects the expected consideration to be received in exchange for those goods or services. We use a five-step approach for recognizing revenue: (i) identification of the contract, (ii) identification of the performance obligations, (iii) determination of the transaction price, (iv) allocation of the transaction price to the performance obligations, and (v) recognition of revenue as the entity satisfies the performance obligations. These criteria for revenue recognition may require a company to use more judgment and make more estimates. We record provisions against revenue for billing adjustments, which are based upon estimates derived from factors that include, but are not limited to, historical results, analysis of credits issued and current economic trends.  The provisions for revenue adjustments are recorded as a reduction of revenue at the time revenue is recognized.
 
As a result of the adoption of ASC 606 effective January 1, 2018, we now defer certain installation revenues and installation costs and recognize these revenues and costs ratable over 48-month period. The implementation impact of ASC 606 is not material to the Company’s financial statements.
 
Our revenue includes monthly recurring charges (“MRC”) to customers for whom services are contracted over a specified period of time, and variable usage fees charged to customers that purchase our business products and services.  Revenue recognition commences after the provisioning, testing and acceptance of the service by the customer.  MRC continues until the expiration of the contract, or until cancellation of the service by the customer.  To the extent that payments received from a customer are related to a future period, the payment is recorded as deferred revenue until the service is provided or the usage occurs.
 
Cost of Revenues
 
Our cost of revenues include the MRC associated with certain platform services purchased from other service providers, the MRC associated with private line services and the cost of broadband Internet access used to provide service to these business customers.
 
Fair Value of Financial Instruments
 
The carrying value of certain financial instruments such as accounts receivable, accounts payable and accrued expenses, approximates their fair values due to their short term nature.  Some of the warrants issued in conjunction with the issuance of our debt and equity securities are accounted for in accordance with the guidance contained in Accounting Standards Codification (“ASC”) Topic 815, Derivatives and Hedging.  For these warrant instruments that are not deemed to be indexed to Fusion’s stock, we classify the warrant instrument as a liability at its fair value and adjust the instrument to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until the underlying warrants are exercised or as they expire, and any change in fair value is recognized in our statement of operations.  The fair values of these warrants have been estimated using option pricing and other valuation models, and the quoted market price of Fusion common stock.
 
Accounts Receivable
 
Accounts receivable is recorded net of an allowance for doubtful accounts.  On a periodic basis, we evaluate our accounts receivable and adjust the allowance for doubtful accounts based on our history of past write-offs and collections and current credit conditions.  Specific customer accounts are written off as uncollectible if the probability of a future loss has been established, collection efforts have been exhausted and payment is not expected to be received.
 
Impairment of Long-Lived Assets
 
We periodically review long-lived assets, including intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable.  If an impairment indicator is present, we evaluate recoverability by a comparison of the carrying amount of the asset to future undiscounted net cash flows expected to be generated by the asset.  If the carrying value of the asset exceeds the projected undiscounted cash flows, we are required to estimate the fair value of the asset and recognize an impairment charge to the extent that the carrying value of the asset exceeds its estimated fair value.  
 
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FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
Impairment testing for goodwill is performed in the fourth fiscal quarter of each year.  The impairment test for goodwill uses a two-step approach, which is performed at the reporting unit level.  We have determined that our reporting units are our operating segments since that is the lowest level at which discrete, reliable financial and cash flow information is available.  The authoritative guidance provides entities with an option to perform a qualitative assessment to determine whether a quantitative analysis is necessary. We recorded an impairment charge of $1.2 million in the three months ended March 31, 2018. The Company did not record any impairment charges during the three months ended March 31, 2017.
 
Income Taxes
 
We account for income taxes in accordance with U.S. GAAP, which requires the recognition of deferred tax liabilities and assets for the expected future income tax consequences of events that have been recognized in our financial statements.  Deferred income tax assets and liabilities are computed for temporary differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income.  Valuation allowances are established to reduce deferred income tax assets when we determine that it is more likely than not that we will fail to generate sufficient taxable income to be able to utilize the deferred tax assets.
 
Recently Issued Accounting Pronouncements
 
In July 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480), Derivatives and Hedging (Topic 815). The amendments in Part I of this update change the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features. When determining whether certain financial instruments should be classified as liabilities or equity instruments, a down round feature no longer precludes equity classification when assessing whether the instrument is indexed to an entity’s own stock. The amendments also clarify existing disclosure requirements for equity-classified instruments. As a result, a freestanding equity-linked financial instrument (or embedded conversion option) no longer would be accounted for as a derivative liability at fair value as a result of the existence of a down round feature. This standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted. The Company is currently evaluating the effect that the new guidance will have on its financial statements and related disclosures.
 
In February 2016, the FASB issued ASU No. 2016-02, Leases, which is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018 with early adoption permitted. Under ASU 2016-02, lessees will be required to recognize for all 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 to-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. The Company is currently evaluating the effect that the new guidance will have on its financial statements and related disclosures.
 
In May 2014, the FASB issued new guidance related to revenue recognition, ASU 2014-09, Revenue from Contracts with Customers (“ASC 606”), which outlines a comprehensive revenue recognition model and supersedes most current revenue recognition guidance. The new guidance requires a company to recognize revenue upon transfer of goods or services to a customer at an amount that reflects the expected consideration to be received in exchange for those goods or services. ASC 606 defines a five-step approach for recognizing revenue: (i) identification of the contract, (ii) identification of the performance obligations, (iii) determination of the transaction price, (iv) allocation of the transaction price to the performance obligations, and (v) recognition of revenue as the entity satisfies the performance obligations. The new criteria for revenue recognition may require a company to use more judgment and make more estimates than under the current guidance. The new guidance became effective in calendar year 2018. Two methods of adoption are permitted: (a) full retrospective adoption, meaning the standard is applied to all periods presented; or (b) modified retrospective adoption, meaning the cumulative effect of applying the new guidance is recognized at the date of initial application as an adjustment to the opening retained earnings balance.
 
In March 2016, April 2016 and December 2016, the FASB issued ASU No. 2016-08, Revenue From Contracts with Customers (ASC 606): Principal Versus Agent Considerations, ASU No. 2016-10, Revenue From Contracts with Customers (ASC 606): Identifying Performance Obligations and Licensing, and ASU No. 2016-20, Technical Corrections and Improvements to Topic 606, Revenue From Contracts with Customers, respectively, which further clarify the implementation guidance on principal versus agent considerations contained in ASU No. 2014-09. In May 2016, the FASB issued ASU 2016-12, Revenue from Contracts with Customers, narrow-scope improvements and practical expedients which provides clarification on assessing the collectability criterion, presentation of sales taxes, measurement date for non-cash consideration and completed contracts at transition. These standards became effective for the Company beginning with the first quarter of 2018.
 
 
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FUSION CONNECT, INC. AND SUBSIDIARIES
 
 
We adopted the new standard and related updates effective January 1, 2018, using the modified retrospective method of adoption. Adoption of this standard resulted in an adjustment to our accumulated deficit in the amount of $0.1 million.
 
 RESULTS OF OPERATIONS
 
Three Months Ended March 31, 2018 Compared with Three Months Ended March 31, 2017
 
The following table summarizes the results of our consolidated operations for the three months ended March 31, 2018 and 2017:
 
 
 
2018
 
 
2017
 
 
 
$
 
 
%
 
 
$
 
 
%
 
Revenues
 $29,038,043 
  100.0 
 $28,481,039 
  100.0 
Cost of revenues *
  12,918,895 
  44.5 
  12,140,707 
  42.6 
Gross profit
  16,119,148 
  55.5 
  16,340,332 
  57.4 
Depreciation and amortization
  3,135,779 
  10.8 
  3,835,948 
  13.5 
Selling, general and administrative expenses
  13,947,995 
  48.0 
  13,613,661 
  47.8 
Impariment charge
  1,195,837 
  4.1 
  - 
  - 
Total operating expenses
  18,279,611 
  63.0 
  17,449,609 
  61.3 
Operating loss
  (2,160,463)
  (7.4)
  (1,109,277)
  (3.9)
Other (expenses) income:
    
    
    
    
Interest expense
  (2,147,775)
  (7.4)
  (2,092,312)
  (7.3)
Gain (loss) on change in fair value of derivative liability
  194,312 
  0.7 
  (40,445)
  (0.1)
Loss on disposal of property and equipment
  (3,184)
  (0.0)
  (26,800)