SYSTEM1, INC. SYSTEM1 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Unless otherwise indicated or the context otherwise requires, references in this section to "the Company," "System1 ," "we," "us," "our" and other similar terms refer toSystem1 Inc. and its subsidiaries. The following discussion and analysis of the financial condition and results of operations ofSystem1 should be read together with our condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q, as well as our audited consolidated financial statements and related notes included in our prospectus, datedApril 13, 2022 , filed with theSecurities and Exchange Commission , orSEC . The following discussion and analysis should also be read together with the section entitled "Organization and description of business" as ofMarch 31, 2022 (Successor) and for the period fromJanuary 1, 2022 throughJanuary 26, 2022 (Predecessor), the period fromJanuary 27, 2022 throughMarch 31, 2022 (Successor) and for the year endedDecember 31, 2021 . In addition to historical information, the following discussion and analysis contains forward-looking statements. Our actual results may differ significantly from those projected in such forward-looking statements. Factors that might cause future results to differ materially from those projected in such forward-looking statements include, but are not limited to, those discussed in the sections entitled "Risk Factors" and "Cautionary Statement Regarding Forward-Looking Statements." Certain amounts may not foot due to rounding, and all figures presented are in thousands with the exception of percentages and per share figures.
Company Overview
We operate an omnichannel customer acquisition platform, delivering high-intent customers to advertisers and selling antivirus software packages to end user customers. We provide these services through our proprietary responsive acquisition marketing platform, or RAMP. Operating seamlessly across major advertising networks and advertising category verticals to acquire users on our behalf, RAMP allows us to monetize these acquired users through its relationships with third party advertisers and advertising networks, which we refer to its "Advertising Partners". RAMP also allows third party advertising platforms and publishers, which we refer to as our "Network Partners ", to send user traffic to, and monetize user traffic on, our owned and operated websites. RAMP operates across our network of owned and operated websites and related products, allowing us to monetize user traffic that we source from various acquisition marketing channels, including Google, Facebook,Taboola ,Snapchat andTikTok . Through RAMP, we process approximately almost 19 million daily advertising campaign optimizations and ingest 6 billion rows of data daily across 40 advertising verticals. We are able to efficiently monetize user intent by linking data on consumer engagement, such as first party search data, with data on monetization and advertising spend. This context-enriched data, combined with our proprietary and data science driven algorithms, creates a closed-loop system that is not reliant on personally identifiable information or information obtained through third-party cookies, but which allows RAMP to efficiently match consumer demand with the appropriate advertiser or advertising experience across advertising verticals.S1 Holdco, LLC ("S1Holdco "), one of entities acquired in the merger described below, was founded in 2013 with a focus on monetizing user traffic acquired by its network. Since launching, it has expanded to support additional advertising formats across numerous advertising platforms, and have acquired several leading websites, enabling it to control user acquisition and experience, and monetize user traffic on its behalf. Today S1Holdco owns and operates over 40 websites, including leading search engines like info.com and Startpage.com, and publishing digital media sites and utilities such as HowStuffWorks,Mapquest and ActiveBeat.Protected.net Group Limited , another entity acquired in the Merger described below, provides a comprehensive antivirus product solution to its customers that provides robust and resilient protection against online threats. The product consists of a core antivirus software, with the ability to add additional products and services, to build up a security package based on a customer's needs. These products include unlimited devices, Adblock, ID Protect and 45 -------------------------------------------------------------------------------- are managed to ensure they provide a value-added service to the customer base. The software is sold in either a monthly or annual subscription predominantly through the flagship brand TotalAV. As ofMarch 31, 2022 , Protected had over 2.2 million active subscribers for its products. The Company's primary operations are inthe United States ; however, the Company also has operations inCanada , theUnited Kingdom andthe Netherlands . Operations outsidethe United States are subject to risks inherent in operating under different legal systems and various political and economic environments. Among the risks are changes in existing tax laws, possible limitations on foreign investment and income repatriation, government foreign exchange controls, and exposure to currency exchange fluctuations. The Company does not engage in hedging activities to mitigate its exposure to fluctuations in foreign currency exchange rates. The Company was deemed the accounting acquirer in the Merger based on an analysis of the criteria outlined in Accounting Standards Codification 805, Business Combinations. S1Holdco was deemed to be the predecessor entity based on an analysis of the criteria outlined in the Accounting Standards Codification 805, Business Combinations. Accordingly, the historical financial statements of S1Holdco became the historical financial statements of the combined company, upon the consummation of the Merger. As a result, the financial statements included in this report reflect (i) the historical operating results of S1Holdco prior to the Merger; and (ii) the combined results of the Company following the closing of the Merger. The accompanying financial information include a predecessor period, which include the periods throughJanuary 26, 2022 concurrent with the Merger discussed below, and the successor period fromJanuary 27, 2022 throughMarch 31, 2022 . A black-line between the Successor and Predecessor periods has been placed in the condensed consolidated financial statements and in the tables to the notes to the statements to highlight the lack of comparability between these two periods and differentiate the cut-off of these periods. The Merger OnJune 28, 2021 , the Company entered into a Business Combination Agreement (as amended onNovember 30, 2021 ,January 10, 2022 andJanuary 25, 2022 ), (the "Business Combination Agreement") by and among S1Holdco , Trebia, and Protected (collectively, the "Companies"). OnJanuary 26, 2022 (the "Closing Date"), the Company consummated the business combination (the "Merger") pursuant to the Business Combination Agreement. Following the consummation of the Merger, the combined company is organized via an "Up-C" structure, in which substantially all of the assets and business operations ofSystem1 are held by S1Holdco . The combined Companies' business continues to operate through the subsidiaries of S1Holdco and Protected. Additionally, Trebia's ordinary shares, warrants and units ceased trading on theNew York Stock Exchange ("NYSE"), andSystem1 Inc.'s Class A common stock and the Public Warrants began trading on the NYSE onJanuary 28, 2022 under the symbols "SST" and "SST.WS," respectively. The consideration paid to the existing equity holders of S1Holdco and Protected in connection with the Merger was a combination of cash, Class A common stock and Class C common stock.
The aggregate cash consideration under the Business Combination Agreement
("Closing Cash Consideration") was
The aggregate equity consideration paid under the Business Combination Agreement and/or retained S1 Holdco ClassB Units was$619,738 , consisting of (a) the aggregate equity consideration payable under the Business Combination Agreement, consisting of shares of Class A common stock (valued at$10.00 per share) and Replacement Awards, and (b) the aggregate ClassB Units in S1Holdco retained by S1Holdco equity holders at the Closing (valued at$10.00 per share). In connection with the Merger,System1 and Cannae Holdings, Inc. ("Cannae") entered into the Backstop Agreement (the "Backstop Agreement") whereby Cannae agreed, subject to the other terms and conditions, to subscribe forSystem1 Class A common stock in order to fund a certain amount of redemptions by shareholders ofSystem1 to be redeemed at the closing of the Merger. As a result of shareholder redemptions,System1 shareholders 46 -------------------------------------------------------------------------------- provided$7,031 of the cash used to fund the Closing Cash Consideration, and Cannae provided$246,484 of the cash used to fund the Closing Cash Consideration pursuant to its obligations under the Backstop Agreement. Concurrently with the consummation of the Merger,System1 entered into a tax receivable agreement with the minority holders of S1Holdco , (the "Tax Receivable Agreement"), pursuant to which, among other things, the parties to the Tax Receivable Agreement have agreed to the allocation and payment of 85% of the actual savings, if any, inU.S. federal, state and local income tax thatSystem1 may realize as a result of certain tax benefits (if any) related to the transactions contemplated by the Business Combination Agreement and future exchanges of ClassB Units in S1Holdco (together with the corresponding shares of the Company's shares of Class C common stock) in exchange for shares of the Company's Class A common stock. No amounts have been recorded as ofMarch 31, 2022 , related to the Tax Receivable Agreement as any tax savings are uncertain.
COVID-19
The worldwide spread of COVID-19 has resulted, and is expected to continue to result, in a global slowdown of economic activity which is likely to decrease demand for a broad variety of goods and services, including those provided by our clients, while also disrupting sales channels and advertising and marketing activities for an unknown period of time until the virus is contained or economic activity normalizes. Our revenue growth and results of operations have been resilient despite the headwinds created by the COVID-19 pandemic. The extent to which ongoing and future developments related to the global impact of the COVID-19 pandemic, including related vaccination measures and inoculation rates designed to curb its spread, continue to impact the business, financial condition and results of operations and cash flows, cannot be predicted with certainty. Many of these ongoing and future developments are beyond our control, including the speed of contagion or the spread of new variants, the development, distribution and implementation of effective preventative or treatment measures, including vaccines (and vaccination rates), the scope of governmental and other restrictions on travel, discretionary services and other activity, and the public reactions and receptiveness to these developments. See "Risk Factors" of the Amendment No. 3 to FORM S-1 filed with theU.S. Securities and Exchange Commission onApril 13, 2022 for further discussion of the adverse impacts of the COVID-19 pandemic on our business. 47 --------------------------------------------------------------------------------
Components of Our Results of Operations
Segment Results:
We have three reportable segments: Owned and Operated, Partner Network and Subscription.
Comparison of Results of Operations for the period fromJanuary 1, 2022 throughJanuary 26, 2022 (Predecessor) and for the period fromJanuary 27, 2022 throughMarch 31, 2022 (Successor) with the three months endedMarch 31, 2021 (Predecessor) Successor Predecessor Predecessor Period from Period from January January 1, 2022 27, 2022 through through January Three Months Ended March 31, 2022 26, 2022 March 31, 2021 Revenue: Owned and Operated $ 130,258$ 49,791 $ 139,426 Partner Network 7,976 2,921 8,135 Subscription 27,874 - - Total Revenue $ 166,108$ 52,712 $ 147,561 Successor Predecessor Predecessor Period from Period from January 27, 2022 January 1, 2022 through March through January Three Months Ended 31, 2022 26, 2022 March 31, 2021 Segment Adjusted Gross Profit: Owned and Operated$ 32,791 $ 9,310 $ 32,128 Partner Network 7,976 2,921 8,135 Subscription 12,647 - - Total Adjusted Gross Profit$ 53,414 $ 12,231 $ 40,263 Revenue Revenue is earned from revenue-sharing arrangements with the Company'sNetwork Partners for the use of the Company's RAMP platform and related services provided to them to direct advertising by theAdvertising Partners to their advertising space. The Company has determined it is the agent in these transactions and reports revenue on a net basis, because (a) the Company does not control the underlying advertising space, (b) the Company does not acquire the traffic and does not have risk of loss in connection therewith, and (c) the pricing is in the form of a substantively fixed-percentage revenue-sharing arrangement. The Company reports this revenue on a net basis for the amount retained from its revenue-sharing arrangements representing the difference between amounts received from theAdvertising Partners , less amounts remitted to theNetwork Partners based on underlying contracts. The Company also earns revenue by directly acquiring traffic to its owned and operated websites and utilizing its own RAMP platform and related services to connect itsAdvertising Partners to its owned and operated websites. For this revenue stream, the Company is the principal in the transaction and reports revenue on a gross basis for the amount received from theAdvertising Partners . For this revenue, the Company has determined that it is the principal since it has a risk of loss on the traffic that it is acquiring for monetization with itsAdvertising Partners , and, in the 48 --------------------------------------------------------------------------------
case of its owned and operated websites, the Company maintains the website, provides the content and bears the cost and risk of loss associated with its websites' advertising space.
The Company recognizes revenue upon delivering traffic to its
The Company, throughProtected.net , is also engaged in selling security software subscriptions to customers. The subscription business provides real-time antivirus protection, a safe-browsing feature, adblocking, identity-theft protection, blocking of malicious websites and data breach monitoring. Subscription revenue is primarily derived from the (i) delivery of the antivirus software and (ii) delivery of the additional add-on service(s), which all are provided on a fixed-price basis. The performance obligations related to subscription, maintenance and support are satisfied over the length of the contract, and the associated subscription revenue is recognized over the contract term on a ratable basis, which is consistent with transfer of control. The Company's services rendered to customers are generally paid for in advance with cash receipts recorded as deferred revenue and revenue recognized over time, generally the annual subscription period. The timing of customer billing and payment relative to the start of the service period varies from contract to contract; however, the Company bills many of its customers in advance of the provision of services under its contracts, resulting in contract liabilities consisting of deferred revenue ("contract liabilities"). Deferred revenue represents billings under noncancelable contracts before the related product or service is transferred to the customer. The portion of deferred revenue that is anticipated to be recognized as revenue during the succeeding twelve-month period is recorded as deferred revenue and the remaining portion is recorded as deferred revenue, noncurrent. Revenue may fluctuate from period to period due to a number of factors including seasonality and the shift in mix of user acquisition sources fromAdvertising Partners , and renewal rates of customers for subscription services.
Operating Expenses
We classify our operating expenses into the following four categories:
Cost of Revenues. Cost of revenues primarily consists of traffic acquisition costs, which are the costs to place advertisements to acquire customers to the Company's websites and services, as well as content, publishing, domain name registration costs, and licensing costs to provide mapping services to Mapquest.com, and licensing costs related to the utilization of antivirus engine licensing costs related to APIs for the antivirus product.. The Company does not pay any up-front payments, incentive payments or bonuses and such costs are expensed as incurred. Salaries, Commissions, and Benefits. Salaries, commissions and benefits expenses include salaries, bonuses, stock-based compensation, costs incurred in the preliminary project planning and post-implementation stages of internal use software development, employee benefits costs associated with our executive, finance, legal, human resources, compliance, and other administrative personnel, as well as accounting and legal professional services fees.
We expect to continue to invest in corporate infrastructure to support our growth. We expect salaries, commissions, and benefits to increase in absolute dollars in future periods.
Selling, General, and Administrative. Selling, general, and administrative expenses consist of fees for professional services, occupancy costs, travel and entertainment. These costs are expensed as incurred.
We expect to continue to invest in corporate infrastructure to support our growth. We expect general and administrative expenses to increase in absolute dollars in future periods.
Depreciation and Amortization. Depreciation and amortization expenses are
primarily attributable to the Company's capital investment(s) and consist of
fixed asset depreciation and amortization of intangible assets considered to
have finite lives.
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Other expenses consist of the following:
Interest Expense. Interest expense is primarily related to our debt, which carries a variable interest rate.
Loss on Warrant Fair Value. Loss on Warrant Fair Value relates to the mark to market of our liability-classified public and private warrants.
Provision for (Benefit from) Income Taxes
The Company is the managing member of S1Holdco and, as a result, consolidates the financial results of S1Holdco in its condensed consolidated financial statements. S1Holdco is a pass-through entity forU.S. federal and most applicable state and local income tax purposes. As an entity classified as a partnership for tax purposes, S1Holdco is not subject toU.S. federal and certain state and local income taxes. Any taxable income or loss generated by S1Holdco is passed through to its members, including the Company. The Company is taxed as a corporation and pays corporate federal, state and local taxes with respect to income allocated from S1Holdco based on the Company's economic interest in S1Holdco . Various subsidiaries of the Company are subject to income tax inthe United States and in other countries. 50 --------------------------------------------------------------------------------
Results of Operations
The following tables set forth our consolidated results of operations and our
consolidated results of operations as a percentage of revenue for the periods
presented.
Successor Predecessor Predecessor
Period from
Period from January January 1, 2022
27, 2022 through through January Three Months Ended
March 31, 2022 26, 2022 March 31, 2021
(in thousands)
Revenue $ 166,108 $ 52,712 $ 147,561
Operating expenses:
Cost of revenues 120,131 41,760 110,785
Salaries, commissions, and benefits 43,459 35,175 15,195
Selling, general, and administrative 14,981 14,817 6,950
Depreciation and amortization 23,311 1,000 3,689
Total operating expenses 201,882 92,752 136,619
Operating (loss) income (35,774) (40,040) 10,942
Interest expense 4,776 1,049 4,048
Loss on warrant fair value 13,761 - -
(Loss) income before income tax (54,311) (41,089) 6,894
Income tax expense (16,252) (629) 151
Net (loss) income $ (38,059) $ (40,460) $ 6,743
Net (loss) attributable to non-controlling
interest (8,068) - -
Net (loss) income attributable to System1,
Inc. $ (29,991) $ (40,460) $ 6,743
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Successor Predecessor Predecessor
Period from January 27, Period from January 1,
2022 through March 31, 2022 through January 26, Three Months Ended March
2022 2022 31, 2021
Revenue 100 % 100 % 100 %
Operating expenses:
Cost of revenues 72 % 79 % 75 %
Salaries, commissions, and benefits 26 % 67 % 10 %
Selling, general, and administrative 9 % 28 % 5 %
Depreciation and amortization 14 % 2 % 2 %
Total operating expenses 121 % 176 % 93 %
Operating (loss) income (21) % (76) % 7 %
Interest expense 3 % 2 % 3 %
Loss on warrant fair value 8 % - % - %
(Loss) income before income tax (32) % (78) % 5 %
Income tax expense 9% 1% -
Net (loss) income (23) % (77) % 5 %
Net (loss) attributable to non-controlling
interest 5 % - % - %
Net (loss) income attributable to System1,
Inc. (18) % (77) % 5 %
* Percentages may not sum due to rounding
The comparability of our operating results for the three months endedMarch 31, 2022 (Successor) compared to the three months endedMarch 31, 2021 (Predecessor) was impacted by the Merger, as discussed above, and the acquisitions of RoadWarrior and CouponFollow in the Successor period portion of the quarter endedMarch 31, 2022 . In the discussion of our results of operations for these periods we may quantitatively disclose the impact of our acquired businesses to the extent they remain ascertainable. Expense contributions from our recent acquisitions for each of the respective period comparisons generally were not separately identifiable due to the integration of these businesses into our existing operations. Revenue Successor Predecessor Predecessor Period from January 27, Period from January 1, 2022 Three Months Ended March 31, (in thousands) 2022 through March 31, 2022 through January 26, 2022 2021
Revenue $ 166,108 $ 52,712 $ 147,561 The increase in revenue in 2022 was primarily due to the acquisition of Protected which contributed to subscription revenue, and growth in the Owned and Operated segment. Revenue from Protected was$27,874 , and the Owned and Operated revenue segment increased$40,623 driven by an increase of 234 million sessions with Revenue Per Session ("RPS") flat. Partner Network segment revenue increased$2,762 as RPS increased by approximately$0.01 , offsetting a decrease of 31 million sessions. 52
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Cost of revenue
Successor Predecessor Predecessor
Period from January 27, Period from January 1,
2022 through March 31, 2022 through January 26, Three Months Ended
(in thousands, except percentages) 2022 2022 March 31, 2021
Cost of revenues $ 120,131 $ 41,760 $ 110,785
Percent of revenue 72 % 79 % 75 %
The increase in cost of revenues in 2022 was due to an increase in user
acquisition costs of $30,754 in the Owned and Operated segment and the
acquisition of Protected which contributed $18,414 to the cost of revenue. User
acquisition costs for the three months ended March 31, 2022 were $138,052 and
drove 975 million sessions at $0.14 Cost Per Session ("CPS"), compared to user
acquisition costs of $107,298 , driving 741 million sessions at $0.15 CPS for the
same period in 2021 (Predecessor). User acquisition costs accounted for 85% and
97% of total cost of revenue for the three months ended March 31, 2022
(Successor) and 2021 (Predecessor), respectively.
Salaries, commissions, and benefits
Successor Predecessor Predecessor
Period from January 27, Period from January 1,
2022 through March 31, 2022 through January 26, Three Months Ended
(in thousands, except percentages) 2022 2022 March 31, 2021
Salaries, commissions and benefits $ 43,459 $ 35,175 $ 15,195
Percent of revenue 26 % 67 % 10 %
The increase in salaries, commissions, and benefits was primarily due to an
increase in stock-based compensation of $54,865 driven by payments associated
with the Company's equity awards as a result of the Merger, of which $27,698 was
recognized upon the close of the Merger, an increase in salaries and bonus
related expenses of $5,013 due to increased headcount related to the Merger and
the acquisitions of Roadwarrior and CouponFollow, and an increase in expenses
related to the Merger transaction of $3,567 for taxes on equity payouts and
transaction bonuses.
Selling, general, and administrative
Successor Predecessor Predecessor
Period from January 27, Period from January
2022 through March 31, 1, 2022 through Three Months Ended
(in thousands, except percentages) 2022 January 26, 2022 March 31, 2021
Selling, general, and administrative $ 14,981 $ 14,817 $ 6,950
Percent of revenue 9 % 28 % 5 %
The increase in selling, general, and administrative expense was primarily due
to an increase of $24,653 in costs associated with the Merger, an increase in
audit and other professional fees of $2,281 to support increased compliance
requirements as a public company, an increase in business taxes of $1,551 , an
increase in network and bandwidth costs of $862 , and an increase in corporate
insurance costs of $770 as a result of becoming a public company.
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Depreciation and amortization
Successor Predecessor Predecessor
Period from January 27, Period from January 1,
2022 through March 31, 2022 through January 26, Three Months Ended
(in thousands, except percentages) 2022 2022 March 31, 2021
Depreciation and amortization $ 23,311 $ 1,000 $ 3,689
Percent of revenue 14 % 2 % 2 %
The increase in depreciation and amortization expense was primarily due to additions of intangible assets as a result of the Merger.
Interest expense
Successor Predecessor Predecessor
Period from January 27, Period from January 1,
2022 through March 31, 2022 through January 26, Three Months Ended
(in thousands, except percentages) 2022 2022 March 31, 2021
Interest expense $ 4,776 $ 1,049 $ 4,048
Percent of revenue 3 % 2 % 3 %
The increase in interest expense was due to an increase in our outstanding loan
balances as a result of the new facility which we entered into as part of the
Merger. Our outstanding loan balance, excluding loan origination fees, was
$449,000 and $181,924 at March 31, 2022 (Successor) and 2021 (Predecessor),
respectively.
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Loss on warrant fair value
Successor Predecessor Predecessor
Period from January 27, Period from January 1,
2022 through March 31, 2022 through January 26, Three Months Ended
(in thousands, except percentages) 2022 2022 March 31, 2021
Loss on warrant fair value $ 13,761 $ - $ -
Percent of revenue 8 % - % - %
The loss on warrant fair value in 2022 is due to a change in the fair value of the warrant liabilities driven by the increase in the market value of the Company's Class A common stock.
Provision for (Benefit from) Income Taxes
Successor Predecessor Predecessor
Period from January 27, Period from January
2022 through March 31, 1, 2022 through Three Months Ended
(in thousands, except percentages) 2022 January 26, 2022 March 31, 2021
Provision for (benefit from) income
taxes $ (16,252) $ (629) $ 151
Effective tax rate 29.92 % 1.53 % 2.19 %
The income tax expense varied from the expense calculated using the federal
statutory income tax rate for the period from January 1, 2022 through January
26, 2022 (Predecessor), the period from January 27, 2022 through March 31, 2022
(Successor), and for the three months ended March 31, 2021 (Predecessor),
primarily due to income (loss) from non-taxable pass-through entities related to
non-controlling interests, state taxes, foreign rate differential, change in
fair value of warrant liabilities, non-deductible expenses, outside basis
adjustments, and Global Intangible Low-taxed Income.
Liquidity and Capital Resources
As ofMarch 31, 2022 (Successor) andDecember 31, 2021 (Predecessor), we had cash and cash equivalents of$42,178 and$47,896 , respectively, which consists of amounts held as bank deposits. To date, the Company's available liquidity and operations have been financed through the initial public offering of Trebia, the backstop agreement, external loan facilities, and cash flows from operations. The Company is subject to certain business risks, including dependence on key employees, dependence on key contracts, competition from alternative technologies, and dependence on growth to achieve its business and operational objectives. The Company's revenue was dependent on two keyAdvertising Partners , which areJanuary 1, 2022 throughJanuary 26, 2022 (Predecessor), 73% and 3%, respectively, of the Company's revenue fromJanuary 27, 2022 throughMarch 31, 2022 (Successor), and 83% and 5%, respectively, of the Company's revenue for the three months endedMarch 31, 2021 (Predecessor).
The Company has (i) two paid search advertising partnership contracts with
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November 30, 2021 . However, the parties initially agreed to a three-month
extension through February 28, 2022 , and thereafter the contract continues to
automatically renew on a month to month basis as the parties work to finalize a
renewal or long-term extension of this arrangement. All three agreements may be
terminated by the respective Advertising Partner immediately or with minimal
notice under certain circumstances.
We evaluate whether any conditions or events have occurred, individually and in
the aggregate, that could raise substantial doubt about our ability to continue
as a going concern for the twelve-month assessment period from the date of this
filing. Our ability to continue as a going concern is dependent on our ability
to generate sufficient cash flow from operations to meet our financial
obligations including scheduled debt payments and maturities. In connection with
the Merger, the Company entered into a new loan ("Term Loan") and revolver
facility ("Revolver Facility") agreement on January 26, 2022 (Predecessor). See
discussion over the details of the New Facility below in the Debt section. The
Company has been able to and expects to continue to be able to make payments on
the principal and interest on a timely basis.
The coronavirus pandemic has adversely affected the Company's results of
operations and the Company has experienced unpredictable reductions in demand
for certain products and services. There is uncertainty around the duration and
breadth of the COVID-19 pandemic and, as a result, the ultimate impact on the
Company's business, financial condition, or operating results cannot be
reasonably estimated with certainty at this time. To the extent that existing
capital resources and sales growth are not sufficient to fund future activities,
the Company may need to raise capital resources through additional equity or
debt financings. Additional funds may not be available on terms favorable to the
Company or at all. Failure to raise additional capital, if and when needed,
could have a material adverse effect on the Company's consolidated financial
position, results of operations, and cash flows.
Debt
As ofDecember 31, 2021 (Predecessor), S1Holdco had principal of$172,038 outstanding under a term loan secured fromCerberus Business Finance, LLC . Amortization payments of$1,750 were due quarterly and, upon delivery of the prior year's audited consolidated financial statements, S1Holdco was required to make a payment of 50% of excess free cash flow, as defined. S1Holdco also had a$20,000 revolving line of credit. No amounts were outstanding as ofDecember 31, 2021 under the revolving line of credit. Interest payments on the secured financing were due monthly at London InterBank Offered Rate ("LIBOR"), plus 7% with a LIBOR floor of 1%. Maturity for the secured financing wasAugust 22, 2022 . The facility had certain financial and nonfinancial covenants, including a leverage ratio. In connection with the Merger disclosed in Note 3,Orchid Merger Sub II LLC (a subsidiary of S1Holdco ) entered into a new loan ("Term Loan") and revolving facility ("Revolving Facility") onJanuary 27, 2022 , providing for a 5.5 year term loan with a principal balance of$400,000 and with the net proceeds of$376,000 , of which a portion of the proceeds were used by S1Holdco , to settle the outstanding debt of$172,038 withCerberus Business Finance, LLC . In addition, the Company also obtained a Revolving Facility of$50,000 onJanuary 27, 2022 . For every interest period, the interest rate on the Term Loan is the adjusted Term Secured Overnight Financing Rate ("Term SOFR") plus 4.75% with an adjusted Term SOFR floor of 0.50%. The Term Loan will amortize in quarterly installments on each scheduled payment date (commencing with the scheduled payment date occurring onJune 30, 2022 ). The new loan comes with a springing covenant, which goes into effect if the utilization on the Revolving Facility exceeds 35% at each quarter-end starting from the first full quarter after the effective date of the Merger, such that the first lien leverage ratio (as defined in the credit agreement) should not exceed 5.40. For the period coveringJune 30, 2022 through and includingDecember 31, 2025 ,$5,000 of the amortization payment will be made quarterly. ForMarch 31, 2026 (scheduled payment date) and thereafter,$7,500 of the amortization payment will be made quarterly.
The Revolving Facility will mature five years after the closing date. The
interest rate on the Revolving Facility is the adjusted Term SOFR plus 2.75%
with an adjusted Term SOFR floor of 0%. In
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borrowed
As ofMarch 31, 2022 (Successor), future minimum principal payments on long-term debt are as follows: remainder for 2022$15,000 , 2023-$20,000, 2024-$20,000, 2025-$20,000, 2026-$30,000 and 2027-$344,000. Loan fees amounting to$1,265 have been offset against the loan balance. Interest expense was$2,492 ,$4,776 and$4,286 for the period fromJanuary 1, 2022 throughJanuary 26, 2022 (Predecessor), the period fromJanuary 27, 2022 throughMarch 31, 2022 (Successor), and for the three months endedMarch 31, 2021 (Predecessor), respectively.
Cash Flows
The following table summarizes our cash flows for the periods presented:
Successor Predecessor Predecessor
Period from
Period from January January 1, 2022
27, 2022 through through January Three Months Ended
(in thousands) March 31, 2022 26, 2022 March 31, 2021
Net cash provided by (used in) operating
activities $ (26,216) $ (10,490) $ 10,128
Net cash used in investing activities $ (428,850) $ (441) $ (1,440)
Net cash used in financing activities $ (12,143) $ - $ (6,603)
Operating Activities
Our cash flows from operating activities are primarily influenced by growth in our operations, increases or decreases in collections from our clients and related payments to our suppliers for advertising inventory and data. We typically pay suppliers in advance of collections from our clients. Our collection and payment cycles can vary from period to period. In addition, seasonality may impact cash flows from operating activities on a sequential quarterly basis during the year.
In the period fromJanuary 1, 2022 toJanuary 26, 2022 (Predecessor), cash used in operating activities of$10,490 resulted primarily from a net loss of$40,460 , and a decrease in accounts payable of$67,600 due to the Merger. This was partially offset by an increase in accrued expenses of$57,170 , non-cash expenses of$27,988 primarily due to stock-based compensation of$27,698 and a decrease in accounts receivable of$11,118 due to the Merger. In the period fromJanuary 27, 2022 toMarch 31, 2022 (Successor), cash used in operating activities of$26,216 resulted primarily from a net loss of$38,059 , a decrease in accrued expenses of$171,341 an increase in accounts receivable of$14,522 due to the Merger. This was partially offset by non-cash expenses of$48,969 primarily due to change in fair value of warrants of$13,761 , stock-based compensation of$27,167 , depreciation and amortization expense of$23,311 , non-cash tax benefit of$17,141 , increase in long term liabilities of$88,832 , increase in accounts payable of$66,170 , and a decrease in deferred revenue of$3,654 of due to the Merger.
In the three months ended
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Our primary investing activities consist of acquisitions of businesses, such as the acquisition of S1Holdco , Protected, RoadWarrior and CouponFollow in 2022 as well as costs capitalized for internally developed software.
In the period from
In the period fromJanuary 27, 2022 toMarch 31, 2022 (Successor), cash used in investing activities of$428,850 resulted primarily from the acquisitions of S1Holdco , Protected, RoadWarrior and CouponFollow, partially offset by purchases of property and equipment of$1,373 and expenditures related to internal-use software development costs of$922 . In the three months endedMarch 31, 2021 (Predecessor), cash used in investing activities of$1,440 resulted primarily from capitalized expenditures related to internal-use software development costs.
Financing Activities
Our financing activities consisted primarily of borrowings and repayments of our debt, distributions to members related to tax obligations, acquisition related contingent consideration and proceeds from the sale of assets.
In the period from
In the period fromJanuary 27, 2022 toMarch 31, 2022 (Successor), cash used in financing activities of$12,143 resulted primarily from redemptions of Trebia Class A ordinary shares of$510,469 , repayment of existing term loan of$172,488 , and payment of debt financing costs related to the New Facility of$24,423 , partially offset by proceeds from the new facility of$449,000 and the Cannae backstop of$246,484 . In the three months endedMarch 31, 2021 (Predecessor), cash used in financing activities of$6,603 resulted primarily from repayments of debt of$1,750 and payment of acquisition related contingent consideration of$5,000 .
Off-Balance Sheet Arrangements
We do not have any relationships with entities often referred to as structured finance or special purpose entities that have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We did not have any other off-balance sheet arrangements during the periods presented other than the indemnification agreements.
Contractual Obligations and Known Future Cash Requirements
Service Agreements
OnJune 18, 2021 the Company entered into an agreement with a service provider whereby the Company is contractually obligated to pay$6,900 and$8,000 in the first and second years of the contract, respectively. The contract commencement date wasJuly 1, 2021 . The Company has paid a total of$5,776 to this service provider as ofMarch 31, 2022 (Successor),$616 during the periodJanuary 1, 2022 toJanuary 26, 2022 (Predecessor) and$934 during the periodJanuary 27, 2022 toMarch 31, 2022 (Successor).
Executive Compensation
Ian Weingarten was hired as CEO of S1Holdco onApril 10, 2019 . He was entitled to a cash-settled profit interests of 5% of the value of S1Holdco , which was contingent upon (i) a participation threshold of$300 million 58 --------------------------------------------------------------------------------
(which was subject to adjustment as set forth in the S1
InFebruary 2021 ,Mr. Weingarten's employment with S1Holdco was terminated and the parties entered into a separation agreement. In connection with the separation agreement, S1Holdco agreed to payment of separation pay benefits consistent with the terms ofMr. Weingarten's employment agreement, including the payment of the liability accrued for the cash-settled profits interest of 5% of S1Holdco , which was deemed vested as to a 3.75% profits interest and forfeited as to the remaining 1.25% profits interest, in each case, above the applicable adjusted threshold amount (subject to further reduction to a 2.5% profits interest in the event that the Merger was not consummated). S1Holdco recorded a liability for this arrangement of$11,132 as ofDecember 31, 2021 (Predecessor). InJanuary 2022 , as part of the Merger, S1Holdco settled the profits interest liability pursuant to the separation agreement with the Mr. Weingarten. Contingencies From time to time,System1 is subject to contingencies that arise in the ordinary course of business.System1 records an accrual for a contingency when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated.System1 does not currently believe the resolution of any such contingencies will have a material adverse effect uponSystem1's consolidated balance sheets, statements of comprehensive loss, or statements of cash flows.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions reflected in these condensed consolidated financial statements include, but are not limited to, valuation of goodwill, acquired intangible assets and long-lived assets for impairment, inputs into the valuation of the Company's share-based compensation awards, income taxes, variable and contingent consideration and determination of the fair value of the warrant liabilities. Significant estimates affecting the condensed consolidated financial statements have been prepared on the basis of the most current and best available information, including historical experience, known trends and other market-specific or other relevant factors that the Company believes to be reasonable. On an ongoing basis, management evaluates its estimates, as there are changes in circumstances, facts and experience. Changes in estimates are recorded in periods which they become known. However, actual results from the resolution of such estimates and assumptions may vary from those used in the preparation of the condensed consolidated financial statements. The full extent to which the COVID-19 pandemic will directly or indirectly impact the Company's business, results of operations and financial condition will depend on future developments that are highly uncertain.
Business combinations
The results of a business acquired in a business combination are included in the
Company's condensed consolidated financial statements from the date of
acquisition. The Company allocates the purchase price, which is the sum of the
consideration provided which may consist of cash, equity, or a combination of
the two, in a business combination to the identifiable assets and liabilities of
the acquired business at their acquisition-date fair values. Any excess amount
paid over the identifiable net assets is recorded as goodwill. The goodwill is
non-deductible for tax purposes. The process for estimating the fair values of
the acquired business involves the use of significant estimates and assumptions,
including estimating average industry purchase price multiples, customer and
service attrition rate and estimating future cash flows. The Company estimates
the fair value based on assumptions believed to be reasonable, but which are
inherently uncertain and unpredictable and, as a result, actual results may
differ from estimates. During the measurement period, not to exceed one year
from the date of acquisition, the Company may
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record adjustments to the assets acquired and liabilities assumed, with a
corresponding offset to goodwill. At the conclusion of the measurement period,
any subsequent adjustments are reflected in the Company's Condensed Consolidated
Statements of Operations.
Transaction costs associated with business combinations are expensed as incurred
and are included in Selling, general and administrative expenses in the
Company's Condensed Consolidated Statements of Operations. When purchase
consideration includes contingent consideration, the Company records the fair
value of the contingent consideration as of the date of acquisition, and
subsequently remeasures the contingent consideration at fair value each
reporting period through earnings.
Goodwill represents the excess of the purchase price over the fair value of net assets acquired and identifiable intangibles in a business combination. The Company accounts for goodwill in accordance with Accounting Standards Codification ("ASC") 350, Intangibles-Goodwill and Other, which requires the Company to test goodwill at the reporting unit level for impairment at least annually. The Company has the option to assess goodwill for possible impairment by performing a qualitative analysis to determine if it is more likely than not that the fair value of a reporting unit is less than its carrying amount or to perform the quantitative impairment test. The quantitative impairment test involves comparing the estimated fair value of a reporting unit with its respective book value, including goodwill. If the estimated fair value exceeds book value, goodwill is considered not to be impaired. If, however, the fair value of the reporting unit is less than book value, an impairment loss is recognized in an amount equal to the excess. The determination of fair values requires us to make significant estimates and assumptions. These estimates include, but are not limited to, future expected cash flows from a market participant perspective, discount rates, industry data and management's prior experience. Unanticipated events or circumstances may occur that could affect the accuracy or validity of such assumptions, estimates or actual results. The Company tests for goodwill impairment annually atDecember 31st . During the period fromJanuary 1, 2022 throughJanuary 26, 2022 (Predecessor), the period fromJanuary 27, 2022 throughMarch 31, 2022 (Successor), and for the three months endedMarch 31, 2021 (Predecessor), there were no triggering events identified, and therefore no impairment charges recorded on goodwill.
Share-based compensation
Compensation cost related to share-based payment transactions is measured based on the fair value of the units issued and recognized within "Salaries, commissions, and benefits" in the Company's consolidated statement of operations. The Company has elected to treat share-based payment awards with graded vesting schedules and time-based service condition only as a single award and recognizes share-based compensation expense on a straight-line basis over the vesting period, which is generally four years. After the Merger, the Company's fair value of common stock is derived from the market price of the Class A common stock which is traded on the NYSE. The assumptions used in the Black-Scholes model to value equity in the Predecessor period are based upon the following:
•Fair Value of Common Stock: S1
•Expected Term: The expected life of the option is estimated by considering the contractual term of the option, the vesting period of the option, the employees' expected exercise behavior and the post-vesting employee turnover rate. For non-employees, the expected life equals the contractual term of the option.
•Risk-free Interest Rate: The risk-free interest rate is based on published
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•Volatility: The volatility was based on the expected unit price volatility of
the underlying units over the expected term of the option which is based upon
historical share price data of an index of comparable publicly traded companies.
The Company recorded total share-based compensation expense of $27,698 from
January 1, 2022 through January 26, 2022 (Predecessor), $27,167 from January 27,
2022 through March 31, 2022 (Successor), and $146 for the three months ended
March 31, 2021 (Predecessor). Share-based compensation expense is included in
the Salaries, commissions, and benefits expense in the Condensed Consolidated
Statements of Operations.
Recently Issued Accounting Pronouncements
See Note 2 to our unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for a discussion of recently adopted accounting pronouncements and recently issued accounting pronouncements not yet adopted.
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