ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the information contained in our consolidated financial statements and the notes thereto. The following discussion and analysis includes forward-looking statements that involve certain risks and uncertainties, including, but not limited to, those described in Item 1A. Risk Factors in our most recent Annual Report on Form 10-K (the “2018 Annual Report”). Our actual results may differ materially from those discussed below. See “Special Note Regarding Forward-Looking Statements” below.

Overview

Purpose built for the cloud, Cyren is an early pioneer and leading innovator of SaaS security solutions that protect businesses and their employees and customers from threats on the web, in email and on mobile devices. Our mission is to protect people and organizations from cyber threats when they use the internet.

Cyren’s cloud-first approach to security sets us apart from other vendors in the market. Cyren is an internet security company that is delivering security results that are disrupting legacy vendors and appliance-based solutions. Our security solutions are architected around the fundamental belief that internet security is a race against time – and the cloud best enables the speed, sophistication and advanced automation needed to detect and block threats as they emerge on the internet.

Cyren’s security cloud delivers faster detection and protection, with SaaS security solutions that inspect web and email traffic before it reaches a user’s browser or inbox – often identifying and blocking threats in just seconds. Our SaaS solutions are easy to deploy and manage, delivering critical security and faster innovation, for a low total cost of ownership.

Cyren’s cloud security services are sold into two markets:

Key Opportunities and Challenges

Threat Landscape

Over the last several years, possibly the greatest magnitude of significant incidents directly related to malware and cyber threats have occurred since the advent of the internet. From election hacks to global ransomware attacks and cyber breaches, malware threats are at an all-time high. Today, no item or user connected to the internet is immune to attack. While many businesses are still exploring effective security measures, cybercriminals are “all in”, creating dangerous new tools to target companies, governments, and private citizens. We need to be mindful that the world has changed; hyper-evasive malware and threat distribution via HTTPS are growing rapidly, mobile devices are increasingly targets, and Internet of Things (IoT) devices, from refrigerators to televisions, are an inviting new vector for criminal attacks. 

Cloud and Mobility

Businesses are going through a massive change in their IT strategies as they look to drive more business value, agility, and better customer experiences, while cloud and mobility are becoming increasingly important, as evidenced by the following trends:

These are some of the reasons why we believe Cyren’s vision for 100% cloud security is compelling to IT security teams looking to protect their businesses in today’s cloud-centric mobile-first world.  

Investments in Operations, Research and Development and Sales and Marketing

Our cost of revenues, research and development (“R&D”) expenses, and sales and marketing expenses are all significant contributing factors to our operating losses. Nonetheless, we expect to increase our investments in all three areas in order to grow our revenues. Over time, we expect that our utilization of our cloud infrastructure will increase and provide the opportunity for improved gross margins. Our investments in R&D are required in order to enhance and improve our solutions. In the future, we expect to lower the rate of R&D investment as a percentage of revenue, and we will be able to drive more revenue from existing solutions rather than by adding new solutions. The return on our sales and marketing investment is tied to attracting new customers and enhancing our business with existing customers, thereby lowering the overall sales and marketing costs as a percent of revenues. Finally, we continue to increase our headcount to support the growth of the business, but we expect that reducing the historical rate of headcount growth will be key in improving our gross and operating margins over time.

Growing Our Enterprise SaaS Business

Although all of our services are subscription services, our Enterprise Security-as-a-Service offerings on the CCS platform are typically invoiced up front for an annual contract amount, or the full multi-year contract amount, at the start of the term. As a result, this business is expected to provide a larger immediate contribution to cash flow and better return on investment. As this enterprise business grows as a portion of our overall revenues, we expect to increase deferred revenue and our operating results and cash flow to improve, which will make us less reliant on other sources of capital in the future.

  Components of our Operating Results

Revenue

We derive revenues from the sale of real-time cloud-based services for each of Cyren’s email security, web security, antimalware and advanced threat protection offerings.

We sell all of our solutions as subscription services, either through OEMs and service providers, which are considered Cyren customers, or as complete security services directly, or indirectly via our partners, to enterprises.

Cost of Revenues

Personnel costs, which consist of salaries, benefits, bonuses and stock-based compensation for employees that operate our network and provide support services to our customers, as well as data center costs, are the most significant components of our cost of revenues. Other costs include third party contractors, royalties for use of third party technologies, amortization of intangibles and depreciation of data center equipment. We expect these costs to continue to increase in absolute dollars as we continue to invest in enhancing our cloud infrastructure and our support services.

Operating Expenses

Our operating expenses consist of R&D, sales and marketing, and general and administrative expenses. Personnel costs, which consist of salaries, benefits, bonuses, and stock-based compensation, are the most significant component of our operating expenses. Operating expenses also include allocated overhead costs for facilities, IT and depreciation. We expect operating expenses to increase in absolute dollars as we continue to grow.

Research and Development . R&D expense consists primarily of personnel costs, outsourced engineering and threat analysis services. We believe these investments are crucial for our ability to continue to enhance the functionality of our services, as well as to develop and introduce new services to the market. We expect R&D expenses to continue increasing in absolute dollars as we continue to invest in our service offerings. Development costs related to internal use technology that supports our security services are capitalized on the balance sheet, while other development costs are expensed as they are incurred.

Sales and Marketing . Sales and marketing expenses primarily include personnel costs, sales commissions, marketing activities, and travel associated with sales and marketing. We market and sell our services worldwide through our sales organization and distribution channels. We capitalize sales commissions paid to internal sales personnel and amortize these expenses over an estimated period of benefit that reflects the expected future revenue streams. We expect our sales and marketing expenses to continue to increase in absolute dollars as we continue to enhance our sales and marketing teams to support our further growth. Our sales personnel are typically not immediately productive, and therefore the increase in expenses we incur when adding personnel is not immediately accompanied by increased revenue and in some cases may not result in increased revenue if these new sales personnel are unsuccessful in becoming productive.

General and Administrative . General and administrative expenses consist primarily of personnel costs, audit fees, legal expenses, recruiting expenses and other general operating costs. We expect our general and administrative expenses to continue to grow in absolute dollars as we continue our operational growth.

Other Income (Expense), net

Other income (expense), net consists primarily of capital gain or loss from the sale of assets.

Financial Expenses, net

Financial expenses, net consist mainly of foreign exchange gains and losses, interest expense on our outstanding debt and interest income earned on our cash and cash equivalents.

Tax Benefit

Our tax benefit is derived primarily from income taxes in foreign jurisdictions in which we conduct business. We estimate income taxes in each of the jurisdictions in which we operate. This process involves determining income tax expense together with calculating the deferred income tax expense related to temporary differences resulting from the differing treatment of items for tax and accounting purposes. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. These temporary differences result in deferred tax assets and liabilities, which are included net as applicable within our balance sheets. For most of our recent years, we have incurred operating losses in Israel and the U.S., where we have recorded a full valuation allowance against our deferred tax assets in those jurisdictions.

Three Months Ended March 31, 2019 Compared to Three Months Ended March 31, 2018

Revenues . Revenues increased by $2.0 million from $7.7 million for the three months ended March 31, 2018 to $9.7 million for the three months ended March 31, 2019, which represents a 26% year-over-year increase. The increase was primarily driven by contract expansions with two large Threat Intelligence customers which were signed during the second quarter of 2018, as well as new and upsell contracts in the enterprise business during the second half of 2018. These increases were offset by a small number of customer terminations in the Threat Intelligence and enterprise businesses, but overall contract renewal rates were consistent with prior periods.

Cost of Revenues. Cost of revenues increased by $0.6 million from $3.4 million for the three months ended March 31, 2018 to $4.0 million for the three months ended March 31, 2019, which represents an 18% year-over-year increase. For the three months ended March 31, 2019 cost of revenues represented 41% of revenue, compared to 44% during the prior year, and accordingly gross margins for the period were 59% for the three months ended March 31, 2019 compared to 56% for the same period in the prior year. The increase in cost of revenues is the result of continued investment in our global network and data centers, as well as additional payroll expense in our Support and Operations groups compared to the prior year. During the period, there was a slight decrease in amortization of capitalized development expenses for the three months ended March 31, 2019 to $0.8 million from $0.9 million during the prior year.

Operating Expenses. Overall operating expenses increased by $1.0 million from $9.5 million for the three months ended March 31, 2018 to $10.5 million for the three months ended March 31, 2019, which represents an increase of 10% year-over-year. Operating expenses for the quarter totaled 108% of quarterly revenue, compared to 125% of quarterly revenue a year ago. The increase in operating expenses was primarily due to an increase in employee headcount, captured in cost of revenues and operating expenses, which totaled 272 employees at the end of March 31, 2019, compared to 247 employees at the end of March 31, 2018.

Research and Development, Net. R&D expense increased by $0.8 million from $3.4 million for the three months ended March 31, 2018 to $4.2 million for the three months ended March 31, 2019, which represents an increase of 25%. R&D expense for the quarter represented 43% of revenue, compared to 44% a year ago. The increase in R&D expense is primarily driven by increased employee headcount, higher payroll and an increase in outsourced development compared to the same period in 2018. Approximately $0.2 million of the increase was the result of capitalization of technology development, which reduces overall R&D expenses. Capitalization of technology development decreased from $0.9 million for the period ended March 31, 2018 to $0.7 million for the three months ended March 31, 2019.

Sales and Marketing . Sales and marketing expenses decreased by $0.3 million (rounded) from $4.1 million for the three months ended March 31, 2018, to $3.9 million for the three months ended March 31, 2019, which represents a decrease of 7%. Sales and marketing expense represented 40% of revenue during the three month period ending March 31, 2019 compared to 54% of revenue for the period ending March 31, 2018. The decrease in sales and marketing expense was primarily due to a reduction of overall sales and marketing headcount from 65 employees to 59 employees at the end of the first quarter 2019, as well as a reduction in overall marketing spend related to advertising and industry trade shows.

General and Administrative . General and administrative (“G&A”) expense increased by $0.4 million from $2.0 million for the three months ended March 31, 2018 to $2.4 million for the three months ended March 31, 2019, which represents an increase of 19%. G&A expense represented 25% of revenue for the first quarter of 2019, compared to 27% of revenue during the first quarter of 2018. The increase in G&A expense is mainly due to an increase in recruiting costs, legal costs, and board-related expenses compared to the first quarter of 2018.

Other Income (Expense), Net . Other income, net for the three months ended March 31, 2019 was $0.2 million, compared to an expense of $0.0 million for the three months ended March 31, 2018. During the first quarter, we reached a financial settlement with the former shareholders of eleven related to the legal dispute regarding the amount and timing of the earn-out payments related to the acquisition of eleven (the “eleven settlement”). Since the financial settlement was less than the accrued interest and the unpaid earn-out consideration on the Company’s balance sheet, the difference was reflected as other income during the period. For additional information, please refer to “Earn-Out Consideration” below and Note 3 of the consolidated financial statements included elsewhere in this quarterly report on Form 10-Q (the “Quarterly Report”).

Financial Expense, Net . Financial expenses, net, increased by $57 thousand for the three months ended March 31, 2019, to $53 thousand from an income of $4 thousand as compared to the prior year, due mainly to an increase in interest expenses associated with the convertible notes issued in December 2018. For additional information, please refer to Note 4 of the consolidated financial statements included elsewhere in this Quarterly Report. In addition, during the three months ended March 31, 2019 we also recorded a decrease of $53 thousand in the expenses resulting from the effect of foreign currency exchange rate fluctuation.

Effective Corporate Tax Rates

Corporate tax rates and real capital gains tax in Israel were 23% for the three months ended March 31, 2019 and 2018.

Our German subsidiary is subject to German tax at a consolidated rate of approximately 30%.

Other non-Israeli subsidiaries are taxed according to the tax laws in their respective countries of residence.

We do not provide deferred tax liabilities when we intend to reinvest earnings of foreign subsidiaries indefinitely. As of March 31, 2019, there are no undistributed earnings of foreign subsidiaries. 

We may currently qualify as an “industrial company” within the definition of the Law for the Encouragement of Industry (Taxation) and, as such, we may be eligible for certain tax benefits, including, inter alia, special depreciation rates for machinery, equipment and buildings, amortization of patents, certain other intangible property rights and deduction of share issuance expenses.

Net Operating Loss Carry-Forwards

As of December 31, 2018, Cyren’s net operating loss carryforwards for tax purposes amounted to $80.1 million and capital loss carryforwards of $17.8 million which may be carried forward and offset against taxable income in the future, for an indefinite period.

As of December 31, 2018, the U.S. subsidiary had net operating loss carryforwards of $40.3 million for federal tax purposes and $8.8 million for state tax purposes. These losses may offset any future U.S. taxable income of the U.S. subsidiary and will expire in the years 2019 through 2038.

On December 24, 2017, a “change in the respective ownership” event occurred upon the completion of a tender offer of our ordinary shares by an entity controlled by funds affiliated with Warburg Pincus LLC (“Warburg Pincus”), and in accordance with the relevant provisions of the Internal Revenue Code 382 of 1986 and similar state provisions. Therefore, our utilization of U.S. net operating losses are subject to substantial annual limitations. Management believes that the annual limitations will result in the partial expiration of net operating losses before utilization.

Management currently believes that based upon its estimations for future taxable income, it is more likely than not that the deferred tax assets regarding the loss carryforwards will not be utilized in the foreseeable future. Thus, a valuation allowance was provided to reduce deferred tax assets to their realizable value.

LIQUIDITY AND CAPITAL RESOURCES

We finance our operations primarily from our cash and cash equivalents and cash from operations. As of March 31, 2019 and December 31, 2018, we had approximately $12.4 million and $17.6 million of cash and cash equivalents, respectively.

Our future capital requirements will depend on many factors, including, but not limited to our growth, market acceptance of our offerings, the timing and extent of spending to support our efforts to develop our platform and the expansion of sales and marketing activities. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, financial condition and results of operations could be adversely affected.

Outlook

During 2019, we expect to continue to incur capital expenditures associated with R&D and data center infrastructure.  We generated a loss of $4.6 million and negative cash flow of $1.3 million from operating activities in the three month period ended March 31, 2019, and have an accumulated deficit of $217.8 million as of March 31, 2019. We are planning to finance our operations from our existing and future working capital resources and to continue to evaluate additional sources of capital and financing. However, there is no assurance that additional capital and/or financing will be available to us, and even if available, whether it will be on terms acceptable to us or in amounts required. Accordingly, our Board approved a contingency plan, to be effected if needed, in whole or in part, at its discretion, to allow us to continue our operations and meet our cash obligations. The contingency plan consists of cost reduction, which include mainly the following steps: reduction in consultants’ expenses, headcount, compensation paid to key management personnel and capital expenditures. We and the Board believe that our existing capital resources and other future measures that may be implemented, if so required, will be adequate to satisfy our expected liquidity requirements for at least twelve months from the filing date. 

Cash Flows from Operating Activities

Cash used in operating activities was $1.3 million for the three months ended March 31, 2019 as compared to $4.3 million for the three months ended March 31, 2018. The decrease in cash usage of $3.0 million was primarily due to a multi-year prepayment for services to be provided related to a customer contract renewal during the first quarter of 2019. The prepayment is reflected on the balance sheet as an increase in short-term and long-term deferred revenue.

Cash Flows from Investing Activities

Cash used in investing activities was $1.2 million for the three months ended March 31, 2019 as compared to $1.5 million for the three months ended March 31, 2018. The decrease of $0.3 million was primarily due to a decrease in capital expenditures compared to the same period a year ago.

Cash Flows from Financing Activities

Cash used in financing activities was $2.5 million for the three months ended March 31, 2019 as compared to $0.0 million for the three months ended March 31, 2018. The increase of $2.5 million was primarily due to a payment of $2.7 million in conjunction with the eleven settlement. The eleven settlement was offset by $0.2 million generated from the exercise of stock options in the period.

Working Capital

As of March 31, 2019 and 2018, we had positive working capital of $5.1 million and $7.7 million, respectively. The decrease in working capital during the three months ended March 31, 2019 as compared to the prior year is primarily due to our negative cash flow from operations and lower amounts of capital raised during the fourth quarter of 2018 compared to amounts of capital raised during the fourth quarter of 2017.

Convertible Notes

On December 5, 2018, we issued an aggregate $10.0 million principal amount of convertible notes in a private placement (the “Notes”) to affiliates of an existing minority institutional shareholder. The Notes are unsecured, unsubordinated obligations of Cyren and carry a 5.75% interest rate, payable semi-annually in (i) 50% cash and (ii) 50% cash or ordinary shares at Cyren’s election. The Notes have a 3-year term and mature in December 2021, unless converted in accordance with their terms prior to maturity. The Notes have a conversion price of $3.90 per share, which may be subject to adjustment using a weighted average ratchet mechanism based on the size and price of future capital raises and the total shares outstanding. In addition, the Notes would be subject to immediate conversion upon any change in control in the Company.

Earn-Out Consideration

In conjunction with the 2012 acquisition of eleven, we entered into an earn-out agreement with the former shareholders that would pay additional consideration based on the revenue performance for the years ending 2012-2015. Subsequently in 2014, we had a legal dispute regarding the amount and timing of the earn-out payments and had entered into arbitral proceedings with the former shareholders of eleven. On March 9, 2017, we received the arbitral judgement. Pursuant to the judgement, the earn-out consideration balance was increased to reflect additional legal expenses and interest expenses covering the period up to December 31, 2016. During 2017 and 2018, we continued to accrue interest on the unpaid earn-out consideration balance. Such interest is reflected in the consolidated statements of operations under financial expenses, net. In May 2018, we made a partial payment of the earn-out consideration to five of the six former shareholders, in an amount of $0.6 million. The earn-out consideration balance presented on our balance sheet as of December 31, 2018 reflected the complete remaining liability relating to the earn-out, including accrued interest. In February 2019, the parties agreed to resolve all pending claims, and on February 28, 2019, we paid approximately $2.7 million to settle the earn-out consideration in full. For additional information, please refer to Note 3 of the consolidated financial statements included elsewhere in this Quarterly Report.

 Registration Statements

In connection with a previously disclosed private placement in November 2017 in which we issued approximately 10.6 million ordinary shares to an entity controlled by funds affiliated with Warburg Pincus, we and Warburg Pincus entered into a registration rights agreement which, among other things, provides Warburg Pincus with three demand registration rights, piggyback and shelf registration rights. The demand registration rights may be exercised starting August 6, 2018, subject to certain customary blackout periods. In addition, as of November 6, 2019, at the request of Warburg Pincus, we will be required to file a shelf registration statement covering the sale of Warburg Pincus’s shares.

On September 21, 2018 we filed a shelf registration statement on Form F-3 with the Securities and Exchange Commission (“SEC”), which we intend to convert to a Form S-3 during the second quarter of 2019. This registration statement enabled us to issue debt securities, ordinary shares, warrants or subscription rights up to an aggregate amount of $50 million. Under the rules governing shelf registration statements, once we convert the registration statement on Form F-3 to a registration statement on Form S-3, we will thereafter be able to file a prospectus supplement with the SEC which describes the amount and type of securities being offered each time we issue securities under the registration statement. No securities were issued under the registration statement on Form F-3 from September 21, 2018 through the date of the filing of this Quarterly Report.

Off-Balance Sheet Arrangements

As of March 31, 2019, we did not have any off-balance sheet arrangements. 

Critical Accounting Policies and Estimates

Our significant accounting policies are discussed in Note 2. Significant Accounting Policies to our consolidated financial statements included in the Company’s Form 10-K filed with the Securities and Exchange Commission on March 29, 2019. There have been no significant changes to these policies for the three months ended March 31, 2019, except as described in Note 2. Significant Accounting Policies to our condensed consolidated financial statements are included elsewhere in this Quarterly Report. The critical accounting policies requiring estimates, assumptions, and judgements that we believe have the most significant impact on our consolidated financial statements are described in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our 2018 Annual Report.

Recent Accounting Pronouncements

Please refer to Note 2. Significant Accounting Policies to our condensed consolidated financial statements included elsewhere in this Quarterly Report for a full description of recent accounting pronouncements.