TELOS CORP (TLS) FY 2024 MD&A

Item 7. 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 our consolidated financial statements and the related notes to consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K ("10-K"). In addition to historical financial information, the following discussion and analysis contain forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and timing of selected events in future periods may differ materially from those anticipated or implied in these forward-looking statements as a result of many factors, including those discussed under Item 1A, "Risk Factors," and elsewhere in this 10-K. See also "Special Note Regarding Forward-Looking Statements" at the beginning of this 10-K.

In this section, we discuss our financial condition, changes in financial condition and results of operations for the year ended December 31, 2024, compared to the year ended December 31, 2023.

Overview

For an overview of our business, including our business segments and a discussion of the services and products we provide, see Item 1, "Business" of this 10-K. Additional information regarding our segments is also presented in Note 18 – Segment Information to the consolidated financial statements at Item 8 of this 10-K.

As discussed under Item 1A, "Risk Factors," we derive a substantial portion of our revenues from contracts and subcontracts with the U.S. government. Our revenues are generated from a number of contract vehicles and task orders. The U.S. government has increasingly relied on contracts that are subject to a competitive bidding process (including IDIQ, GSA schedules, OTA, and other multi-award contracts), resulting in greater competition and increased pricing pressure. We expect that a majority of the business that we seek in the foreseeable future will be awarded through a competitive bidding process.

Over the past several years we have sought to diversify and improve our operating margins through the evolution of our business from an emphasis on product reselling to that of an advanced solutions technologies provider. Although we continue to offer resold products through our contract vehicles or our prime partners' contracts, we focused on the transformation and growth on selling our software and service solutions, as well as designing and delivering Telos manufactured and branded technologies. We believe our contract portfolio is characterized as having low to moderate financial risk due to the limited number of long-term fixed-price development contracts. Our firm-fixed-price activities consist primarily of contracts for products and services at established contract prices. For 2024 and 2023, the Company's revenue derived from firm-fixed-price contracts was 75% and 79%, respectively; time-and-material contracts was 15% and 9%, respectively; and cost-plus contracts revenue was 10% and 12%, respectively.

Our business performance is affected by the overall level of U.S. government spending and the alignment of our offerings and capabilities with the budget priorities of the U.S. government. Approximately 88% of our revenues were generated from U.S. government agencies in fiscal year 2024. In addition, our overall performance depends, in part, on global economic and geopolitical conditions. Adverse changes in fiscal and economic conditions could materially impact our business. Some changes that could adversely impact our business include the implementation of future spending reductions, government shutdown and supply chain challenges. Despite the budget and competitive pressure affecting the industry, we believe we are well-positioned to expand existing customer relationships and benefit from opportunities that we have not previously pursued.

Business Environment

U.S. Budget

In March 2024, the U.S. President proposed the annual appropriations for Fiscal Year ("FY") 2025 to fit within the tight caps set as part of the prior year's debt ceiling agreements. The FY2025 budget request included $850 billion for the DoD base budget, in alignment with levels agreed to in the Fiscal Responsibility Act ("FRA") of 2023. This proposed budget will enable the DoD to make the investments necessary to execute the Administrations' 2022 National Security Strategy and 2022 National Defense Strategy. The President's FY2025 budget also proposed several increases for new, key cyber programs and initiatives. For FY2025, the White House had directed agencies to prioritize cyber investments in "secure by design" technologies and the modernization of legacy technology. In the wake of the President's Executive Order ("EO") on artificial intelligence last fall, the 2025 budget proposal includes plenty of AI-related spending, much of which intersects with cybersecurity and AI safety.

Congress was unable to enact any of its annual appropriations bills before the start of FY2025, which began on October 1, 2024. Instead, on December 20, 2024, the U.S. House and Senate passed a second Continuing Resolution ("CR") to extend federal spending and avert a government shutdown through March 14, 2025. The CR keeps the government operating at FY2024 funding levels, and ensures the federal government can receive adequate funding to operate for the duration of the CR. The current CR provides $888 billion in base defense funding for 2025, an amount exceeding the $850 billion cap on such funding established under the FRA. As of January 6, 2025, $12 billion in Defense funding was designated as an emergency requirement, and is not constrained by the caps established by the FRA.

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Appropriators in both chambers had been hoping to at least reach a topline spending agreement, but the momentum for a deal was derailed after the new Administration issued a slew of EOs since inauguration, including an order to freeze funding on several federal programs. While the Cybersecurity and Infrastructure Security Agency ("CISA") is viewed as vital for national security purposes and its programs will still continue, the new Administration has sworn to reduce the size and scope of CISA.

Of note, the CR did not address the federal debt ceiling, which is the limit that Congress imposes on the federal budget for authorized spending. In January 2025, the federal debt limit was reinstated at $36.1 trillion to accommodate borrowing since its suspension through FRA. Until Congress acts to modify the limit, the Treasury Department relies on the available cash on hand and invoked authorities to use extraordinary measures to continue paying its debt obligations, without jeopardizing the "full faith and credit" of the U.S. government.

While there is no clear path to approval of the FY2025 budget, failure to do so poses uncertainty about actual funding and will impact federal customers' ability to move forward on their planned expenditures in FY2025.

Cybersecurity Landscape

The scope of cybersecurity is on the cusp of transformative changes. Cyber threats are not just escalating in frequency but are also becoming more sophisticated, thus challenging traditional security standards. In this rapidly evolving cybersecurity landscape, the need for vigilant defense is vital, and cybersecurity is a priority for organizations to mitigate their risk and keep safe from threats and exploitation. Understanding the threat environment and the impending trends (both current and future) is a matter of foresight and is crucial in designing effective security strategies. The DoD continues to invest in cybersecurity programs to protect the nation from malicious cyber actors and cyber campaigns. These investments strengthen cyber protection standards for the defense industrial base and cybersecurity of DoD networks. With this growing threat, below are some trends to consider when looking at the cybersecurity landscape:

Emerging Cyber and Counterintelligence Threats: The proposed FY2025 budget expands the Department of Justice’s ("DOJ") ability to pursue threats through investments in the FBI’s cyber and counterintelligence investigative capabilities. These investments sustain the FBI’s cyber intelligence, counterintelligence, and analysis capabilities and include funding to enhance those cyber response and counterintelligence capabilities. The budget also includes funding to expand a new section within the DOJ’s National Security Division to focus on cyber threats. These investments align with the National Cybersecurity Strategy that emphasizes a whole-of-nation approach to addressing ongoing cyber threats. Finally, the budget also provides for the DOJ to support the implementation of Executive Order 14110, “Safe, Secure, and Trustworthy Development and Use of Artificial Intelligence.”

Rising Threats, Rising Liability: Ransomware remains arguably the most severe cyber threat to enterprises in the commercial, state, and local government and education sectors. Phishing is one of the top distribution channels for ransomware. Modern phishing attacks have become adept at bypassing traditional security measures, using more personalized and technically advanced tactics to deceive users. One reason for the rise of ransomware attacks is that it is exceedingly profitable for cybercriminals, and ransomware victims generally settle the ransom rather than restoring the system from backups or dealing with the fallout from a data breach. Aside from the financial costs of paying the ransom and restoring the system, the consequences of a successful ransomware attack can include damage to the organization's reputation, stolen sensitive data being used for malicious purposes, and loss of business.

The Nation's Critical Systems Are Still at Risk: Critical infrastructure and industrial IoT are among the categories at greatest risk of cyberattacks. The IoT continues its rapid growth, interconnecting an increasing number of devices. However, this expansion brings with it a host of security challenges. The wide range of IoT devices make them attractive targets for cyberattacks, and their interrelated nature can lead to pervasive vulnerabilities.

Navigating a Changing Regulatory Landscape and Compliance: The regulatory landscape governing cybersecurity is developing swiftly. Over time, the government mandates stronger security in highly regulated industries. These government initiatives and audit fatigue continue to burden highly regulated organizations, with automation solutions recognized as the most effective remedy for the many repetitive and redundant tasks that security compliance requires.

Additionally, the SEC adopted new rules on cybersecurity risk management, strategy, governance and incident disclosure by public companies. The required reporting of this information leads many companies to proactively establish policies that will improve their cyber risk management posture and enable them to better withstand heightened public and regulatory scrutiny.

Identity Assurance and Privacy Protection are Essential for Today's Enterprises: Identity and access management continue to be a major cybersecurity concern for organizations and individuals that need to ensure their security and protect their privacy. Trusted identities are essential to confidence in IT and physical security strategies and to the success of Zero Trust security models and architectures. The shift to a Zero Trust framework represents a fundamental change in approach to cybersecurity, focusing on identity and access management, continuous monitoring and robust authentication mechanisms to establish a secure digital environment.

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Enhancing Identity Security: The shift towards biometric authentication methods is redesigning identity verification in the digital domain. Integrating biometrics with multi-factor authentication can provide a robust defense against unauthorized access.

Artificial Intelligence: AI is set to play a critical role in cybersecurity. Cybercriminals are using AI to launch more sophisticated attacks that can quickly adapt to changing environments, making detection harder. AI's advanced data analysis capabilities are increasingly used for defensive measures over time. To protect against AI-powered cyberattacks, organizations must stay vigilant and adopt advanced cybersecurity tools and techniques that can detect and respond to these threats in a timely manner before they cause damage. The proposed FY2025 budget provides $455 million to extend the frontiers of AI for science and technology and to increase AI’s safety, security, and resilience. These investments enhance the DoD’s computing capabilities and support the development of AI testbeds to build foundation models for energy security, national security, and climate resilience as well as tools to evaluate AI capabilities to generate outputs that may represent nuclear, nonproliferation, biological, chemical, critical-infrastructure, and energy security threats or hazards.

Key Performance Measures

The primary financial performance measures we use to manage our business and monitor results of operations are revenue, gross profit, and Adjusted EBITDA. We evaluate our results of operations by considering the drivers causing changes in these measures. We evaluate significant trends and fluctuations in our contract portfolio over time due to contract awards and completions, changes in customer requirements and changes in the volume of product and software sales.

Backlog

Backlog is also a useful measure in developing our annual budgeted revenue by estimating for the upcoming year our continuing business from existing customers and active contracts. We consider backlog, both funded and unfunded (as explained below), other expected annual renewals, and expansion planned by our current customers.

Total backlog consists of the aggregate contract revenues remaining to be earned by us at a given time over the life of our contracts, whether funded or unfunded. Funded backlog consists of the aggregate contract revenues remaining to be earned at a given time, which, in the case of U.S. government contracts, means that they have been funded by the procuring agency. Unfunded backlog is the difference between total backlog and funded backlog and includes potential revenues that may be earned if customers exercise delivery orders and/or renewal options to continue these contracts.

Based on historical experience, we generally assume option year renewals to be exercised. Most of our customers fund contracts on the basis of one year or less, and, as a result, funded backlog is generally expected to be earned within one year from any point in time, whereas unfunded backlog is expected to be earned over a longer period.

Increases in backlog is a result of the award of new contracts and the renewal or extension of existing contracts. Reductions in backlog arise from the completion or the early termination of contracts. See the relevant industry, legal and regulatory risks under Item 1A, "Risk Factors," of this 10-K. We believe that comparisons of backlog period-to-period are difficult. We also believe that it is difficult to predict future revenue solely based on analysis of backlog. The actual timing of revenue from projects included in backlog will vary.

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Financial Highlights

A number of factors have affected our fiscal year 2024 results, the most significant of which we have listed below. More details on these changes are presented below within our "Results of Operations" section.

•The decline in year-over-year revenue was primarily driven by the successful completion of certain programs and ramp-down of programs in Secure Networks without corresponding new business wins to backfill completed programs.

•Growth in TSA PreCheck revenue partially offset the year-over-year revenue decline and was driven by the increase in our enrollment locations and a full year of renewal operations as compared to only a partial year in fiscal year 2023.

•The reduction in gross margin was mainly driven by the impact of an impairment loss on intangible assets of $5.3 million and higher amortization of software development costs. This was partially offset by a more favorable program mix.

•The assessment of our cost structure and investment priorities in fiscal year 2024 led to restructuring actions and the discontinued development and/or sale of selected solutions or parts of solutions that were not generating acceptable returns. These initiatives resulted in a $1.3 million restructuring charge and a $11.7 million of non-cash impairment of software development costs.

•Lower year-over-year gross profit was partially offset by reduced operating expenses.

Results of Operations

Consolidated Results

Our business segments have different factors driving revenue fluctuations and profitability. The discussion of the changes in our net revenue and profitability is covered in greater detail under the section that follows: "Segment Results." We generate revenue from the delivery of products and services to our customers. Cost of sales, for both products and services, consists of labor, materials, subcontracting costs and an allocation of indirect costs.

Operating Expenses: Operating expenses decreased by 3% in 2024, compared to 2023. Research and development expenses decreased by $3.3 million in 2024, compared to 2023, primarily due to the discontinued development of selected solutions or parts of solutions associated with the restructuring plan and lower stock-based compensation expenses. Selling, general and administrative expenses decreased by $5.5 million in 2024, compared to 2023, primarily due to decreased cash incentive compensation expenses. These reductions were partially offset by an increase in impairment loss on intangible assets of $5.9 million.

Other income: Other income decreased by 40% in 2024, compared to 2023, primarily due to the gain on early extinguishment of other financing obligation of $1.4 million in 2023, without a similar gain in 2024. The remaining variance is attributable to decreased dividend income from money market placements.

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Segment Results

The accounting policies of each business segment are the same as those followed by the Company as a whole. Management evaluates business segment performance based on gross profit.

Security Solutions segment revenue decreased by 1% in 2024, compared to 2023, primarily due to the reduction in revenue from a long-term program, the completion of a short-term program in the prior year and the sale of a non-recurring perpetual license in the prior year, partially offset by the growth in the TSA PreCheck program.

Security Solutions segment gross profit decreased by 30% in 2024, compared to 2023, and gross margin decreased from 51.2% in 2023 to 36.1% in 2024, primarily due to the impairment loss on intangible assets in 2024, higher amortization of software development costs, and program mix within the portfolio.

Secure Networks segment revenue decreased by 54% in 2024, compared to 2023, primarily due to the successful completion of certain programs and ramp-down of certain programs without corresponding new business wins to backfill completed programs.

Secure Networks segment gross profit decreased by 49% in 2024, compared to 2023, primarily due to lower revenues. By contrast, the segment gross margin increased from 19.6% in 2023 to 21.4% in 2024, primarily due to a favorable program mix and strong program management.

Non-GAAP Measures

In addition to our results determined in accordance with U.S. GAAP, we believe the non-GAAP financial measures of EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net Loss, Adjusted Earnings Per Share ("EPS"), Adjusted Gross Profit, Adjusted Gross Margin, Cash Gross Profit, Cash Gross Margin and Free Cash Flow are useful in evaluating our operating and cash flow performance. We believe that this non-GAAP financial information, when taken collectively with our GAAP results, may be helpful to readers of our financial statements because it provides consistency and comparability with past financial performance and assists in comparisons with other companies, some of which use similar non-GAAP financial information to supplement their GAAP results. The non-GAAP financial information is presented for supplemental informational purposes only, should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly-titled non-GAAP measures used by other companies. A reconciliation is provided below for each of these non-GAAP financial measures to the most directly comparable financial measure stated in accordance with GAAP.

We believe these non-GAAP financial measures facilitate comparison of our operating and cash performance on a consistent basis between periods by excluding certain items that may, or could, have a disproportionately positive or negative impact on our results of operations in any particular period. When viewed in combination with our results prepared in accordance with GAAP, these non-GAAP financial measures help provide a broader picture of factors and trends affecting our results of operations.

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EBITDA, Adjusted EBITDA, EBITDA Margin and Adjusted EBITDA Margin

EBITDA, Adjusted EBITDA, EBITDA Margin and Adjusted EBITDA Margin are supplemental measures of operating and cash flow performance that are not made under GAAP and do not represent, and should not be considered as an alternative to net (loss) income as determined by GAAP. We define EBITDA as net (loss) income, adjusted for non-operating (income) expense, interest expense, provision for (benefit from) income taxes, and depreciation and amortization. We define Adjusted EBITDA as EBITDA, adjusted for stock-based compensation expense, impairment loss on intangible assets, and restructuring expenses (adjustments). We define EBITDA Margin as EBITDA as a percentage of total revenue. We define Adjusted EBITDA Margin as Adjusted EBITDA as a percentage of total revenue.

We believe that EBITDA, EBITDA Margin, Adjusted EBITDA and Adjusted EBITDA Margin provide the Board of Directors, management and investors with clear representation of our core operating performance and trends, provide greater visibility into the long-term financial performance of the Company, and eliminate the impact of items that do not relate to the ongoing operating performance of the business. Further, Adjusted EBITDA is used by the Board of Directors and management to prepare and approve our annual budget, and from time to time, to evaluate the performance of certain management personnel when determining incentive compensation.

(1) The stock-based compensation adjustment to EBITDA is made up of stock-based compensation expense for the awarded service-based restricted stock units ("RSUs"), performance-based restricted stock units ("PSUs"), stock options, and other sources. Stock-based compensation expense for the awarded RSUs, PSUs and stock options was $19.4 million and $22.9 million for fiscal years 2024 and 2023, respectively. Stock-based compensation expense from other sources was $2.1 million and $1.5 million for the fiscal years 2024 and 2023, respectively. The other source of stock-based compensation consists of accrued compensation, which the Company intends to settle in shares of the Company's common stock. However, it is the Company's discretion whether this compensation will ultimately be paid in stock or cash. The Company has the right to dictate the form of these payments up until the date at which they are paid. Any change to the expected payment form would result in a change in estimate that would add back to Adjusted EBITDA.

(2) Due to its immaterial amount, the impairment loss on intangible assets of $0.5 million for fiscal year 2023 was reported as part of depreciation and amortization in 2023.

(3) The restructuring expenses include severance and other related benefit costs (including outplacement services and continuing health insurance coverage), external consulting and advisory fees related to implementing the restructuring plan.

Adjusted Net Loss and Adjusted EPS

Adjusted Net (Loss) Income and Adjusted EPS are supplemental measures of operating and cash flow performance that are not made under GAAP and do not represent, and should not be considered as alternatives to, net (loss) income and earnings per share as determined by GAAP. We define Adjusted Net (Loss) Income as net (loss) income, adjusted for non-operating (income) expense, stock-based compensation expense, impairment loss on intangible assets, and restructuring expenses (adjustments). We define Adjusted EPS as Adjusted Net (Loss) Income divided by the weighted-average number of common shares outstanding for the period.

Adjusted Net (Loss) Income and Adjusted EPS provide the Board of Directors, management and investors with clear representation of our core operating performance and trends, provide greater visibility into the long-term financial performance of the Company, and eliminate the impact of items that do not relate to the ongoing operating performance of the business.

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(1) The stock-based compensation adjustment to EBITDA is made up of stock-based compensation expense for the awarded service-based RSUs, PSUs, stock options, and other sources. Stock-based compensation expense for the awarded RSUs, PSUs and stock options was $19.4 million and $22.9 million for fiscal years 2024 and 2023, respectively. Stock-based compensation expense from other sources was $2.1 million and $1.5 million for the fiscal years 2024 and 2023, respectively. The other source of stock-based compensation consists of accrued compensation, which the Company intends to settle in shares of the Company's common stock. However, it is the Company's discretion whether this compensation will ultimately be paid in stock or cash. The Company has the right to dictate the form of these payments up until the date at which they are paid. Any change to the expected payment form would result in a change in estimate that would add back to Adjusted Net Loss.

(2) Due to its immaterial amount, the impairment loss on intangible assets of $0.5 million for fiscal year 2023 was reported as part of depreciation and amortization in 2023.

(3) The restructuring expenses include severance and other related benefit costs (including outplacement services and continuing health insurance coverage), external consulting and advisory fees related to implementing the restructuring plan.

Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin and Cash Gross Margin

Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin and Cash Gross Margin are supplemental measures of operating and cash flow performance that are not made under GAAP and do not represent, and should not be considered as alternatives to gross profit and gross margin as determined by GAAP. We define Adjusted Gross Profit as gross profit, plus stock-based compensation expense, impairment loss on intangible assets, and restructuring expenses charged under cost of sales. We define Adjusted Gross Margin as Adjusted Gross Profit as a percentage of total revenue. We define Cash Gross Profit as Adjusted Gross Profit, plus depreciation and amortization. We define Cash Gross Margin as Cash Gross Profit as a percentage of total revenue.

Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin and Cash Gross Margin provide management and investors with a clear representation of the core economics of gross profit and gross margin without the impact of non-cash expenses and sunk costs expended.

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Free Cash Flow

Free Cash Flow is a supplemental measure of operating and cash flow performance that is not made under GAAP and does not represent, and should not be considered as an alternative to, net cash flow (used in) provided by operating activities, as determined by GAAP. We define Free Cash Flow as net cash (used in) provided by operating activities, less net purchases of property and equipment, and capitalized software development costs.

We use Free Cash Flow to understand the cash flows that directly correspond with our operations and the investments we must make in those operations, using a methodology that combines operating cash flows and capital expenditures. Further, Free Cash Flow may be useful to management and investors in evaluating the Company's operating and cash flow performance and liquidity, and to evaluate the performance of certain management personnel when determining incentive compensation.

EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net Loss, Adjusted EPS, Adjusted Gross Profit, Adjusted Gross Margin, Cash Gross Profit, Cash Gross Margin and Free Cash Flow each have limitations as an analytical tool, and you should not consider any of them in isolation, or as a substitute for analysis of our results as reported under GAAP. Among other limitations, each of EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net Loss, Adjusted EPS, Adjusted Gross Profit, Adjusted Gross Margin, Cash Gross Profit, Cash Gross Margin and Free Cash Flow does not reflect our cash expenditures, or future requirements, for capital expenditures or contractual commitments, does not reflect the impact of certain cash and non-cash charges resulting from matters we consider not to be indicative of our ongoing operations, and does not reflect income tax expense or benefit. Other companies in our industry may calculate Adjusted EBITDA, Adjusted EBITDA Margin, Adjusted Net Loss, Adjusted EPS, Adjusted Gross Profit, Adjusted Gross Margin, Cash Gross Profit, Cash Gross Margin and Free Cash Flow differently than we do, which limits their usefulness as comparative measures. Because of these limitations, neither EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net Loss, Adjusted EPS, Adjusted Gross Profit, Adjusted Gross Margin, Cash Gross Profit, Cash Gross Margin nor Free Cash Flow should be considered as a replacement for gross profit, gross margin, net (loss) income, earnings per share or net cash flows (used in) provided by operating activities, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes.

Liquidity and Capital Resources

Our primary sources of liquidity are cash on hand, future operating cash flows, and, if needed, borrowings under our $30.0 million senior secured revolving credit facility, with an expansion feature of up to $30.0 million of additional revolver capacity. While a variety of factors related to sources and uses of cash, such as timeliness of accounts receivable collections, vendor credit terms, or significant collateral requirements, ultimately impact our liquidity, such factors may or may not have a direct impact on our liquidity.

As of December 31, 2024, we had cash and cash equivalents of $54.6 million and our working capital was $69.3 million.

We place a strong emphasis on liquidity management. This focus gives us the flexibility for capital deployment while preserving a strong balance sheet to position us for future opportunities. We believe we have adequate funds on hand to execute our financial and operating strategy. Our overall financial position and liquidity are strong. Although no assurances can be given, we believe the available cash balances and access to our revolving credit facility are sufficient to maintain the liquidity we require to meet our operating, investing and financing needs for the next 12 months.

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For the year ended December 31, 2024, net cash used in operating activities was $25.9 million, compared with net cash provided by operating activities of $1.6 million in 2023, an increase in cash outflow of $27.5 million compared year over year. The change in cash flow from operating activities is primarily driven by the Company's operating losses, the timing of receipts of customer payments, and the timing of payments to vendors and employees, adjusted for certain non-cash items that do not impact cash flows from operating activities.

Net cash used in investing activities for the years ended December 31, 2024, increased by $1.3 million in cash outflow compared to the same period in 2023, primarily due to the cash outflow from the purchase of an investment of $3.0 million in 2024, with no similar transaction in 2023. This is partially offset by a decrease of $1.7 million in capital expenditures in 2024.

For the year ended December 31, 2024, net cash used in financing activities was $2.0 million, compared to $6.2 million in 2023. This is primarily attributable to decreases in payments of tax withholding related to the net share settlement of equity awards of $0.5 million in 2024, compared with $3.7 million in 2023, and a $0.6 million payment for the Diamond Fortress Technologies ("DFT") holdback in February 2023, with no similar payment in 2024.

Commitments from Contractual Obligations

The Company does not have any other material cash requirements from contractual obligations. As of December 31, 2024, we had contractual commitments to make payments under existing lease obligations on various office space and equipment under non-cancelable operating and finance leases, and an obligation under a service agreement. We reported current and long-term lease liabilities; see Note 13 - Leases in the consolidated financial statements within this 10-K.

There were no outstanding commitments that were considered material for capital expenditures on December 31, 2024.

From time to time, we may be subject to various audits, reviews, investigations, lawsuits and claims related to our business. See Note 19 - Commitments and Contingencies to the consolidated financial statements within this Annual Report for further discussion of other commitments and contingencies.

Revolving Credit Facility

On December 30, 2022, we entered into a senior secured credit facility with JPMorgan Chase Bank, N.A. ("Credit Agreement") that provides for a $30.0 million senior secured revolving credit facility, with the option of issuing letters of credits thereunder and with an uncommitted expansion feature of up to $30.0 million of additional revolver capacity, maturing on December 30, 2025. On April 12, 2023, we amended our Credit Agreement and revised certain provisions on the terms of the covered collateral. See Note 10 - Debt and Other Obligations to the consolidated financial statements contained within this Annual Report for additional information.

The Credit Agreement contains customary terms and conditions, including certain covenant requirements. As of December 31, 2024, there were no outstanding balances under the revolving credit facility and we were in compliance with all covenants contained in the Credit Agreement.

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Other Financing Obligations

In November 2022, we entered into a Master Purchase Agreement ("MPA") with a third party for $9.1 million relating to software licenses under a specific delivery order with a customer, resulting in proceeds from other financing obligations. On February 9, 2023, when the third-party buyer notified us that it would not exercise the option period, we transferred all the rights, title and interest in the underlying licenses in exchange for the extinguishment of the outstanding financing obligations. The extinguishment of the other financing obligations resulted in a gain of $1.4 million in 2023. See Note 10 – Debt and Other Obligations to the consolidated financial statements combined within this Annual Report for a detailed discussion of our debt financing arrangements.

Under the MPA, if the customer terminates the delivery order for non-renewal and the buyer reasonably concludes that the customer's actions constitute grounds for filing a claim, the buyer and Telos will cooperate in preparing such a claim. During the third quarter of 2024, the buyer, through Telos, filed a claim against the customer.

Critical Accounting Policies and Estimates

The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported. In preparing these financial statements, management has made its best estimates and judgments of certain amounts included in the consolidated financial statements, giving due consideration to materiality. Management evaluates these estimates and assumptions on an ongoing basis. Our estimates and assumptions have been prepared on the basis of the most current reasonably available information, and may change in the future as more current information is available.

Management believes that our critical accounting policies are those that are both material to the presentation of our financial condition and results of operations and require management's most difficult, subjective and complex judgments. Typically, the circumstances that make these judgments difficult, subjective and complex have to do with making estimates about the effect of matters that are inherently uncertain; as a result, actual results could differ from those estimates.

The critical accounting policies requiring estimates, assumptions, and judgments that we believe have the most significant impact on our consolidated financial statements in fiscal year 2024 are described below. This is not intended to be a comprehensive list of all significant accounting policies that are more fully described in the notes to consolidated financial statements contained within this report.

Revenue Recognition

Although most of our revenue is recognized concurrently with billing or with the passage of time, some of our revenue requires us to make estimates. The timing of the satisfaction of performance obligations varies across our businesses due to our diverse product and service mix, customer base, and contractual terms. Significant judgment can be required in determining certain performance obligations, and these determinations could change the amount of revenue and profit recorded in a given period. Our contracts may have a single performance obligation or multiple performance obligations. When there are multiple performance obligations within a contract, we allocate the transaction price, net of any discounts, to each performance obligation based on the standalone selling price of the product or service underlying each performance obligation. The standalone selling price is either based on estimated or actual costs plus a reasonable profit margin or the observable price of a good or service when Telos sells that good or service separately in similar circumstances and to similar customers. The transaction price for our contracts represents our best estimate of the consideration we will receive and includes assumptions regarding variable consideration, as applicable. The transaction price is allocated to each distinct performance obligation within the contract and recognized as revenue when, or as, the performance obligation is satisfied.

Our contracts may also include various types of variable considerations such as claims (i.e., indirect rate or other equitable adjustments) or incentive fees and we include estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur. The estimated amounts are based on an assessment of our anticipated performance and all other information that is reasonably available to us.

For contracts where revenue is recognized over time, we recognize revenue based on progress towards completion of the performance obligation, using costs incurred to date relative to the total estimated cost at completion to measure progress on a proportional performance basis for our contracts. Due to the nature of the work required to be performed on certain contracts, the estimation of total revenue and cost at completion is complex, subject to many variables and requires significant judgment. Contract estimates are based on various assumptions, including labor and subcontractor costs, materials and other direct costs and the complexity of the work to be performed. A significant change in one or more of these estimates could affect the profitability of our contracts. We review and update our contract-related estimates regularly and recognize adjustments in estimated profit on contracts on a cumulative catch-up basis, which may result in an adjustment increasing or decreasing revenue to date on a contract in a particular period that the adjustment is identified. Revenue and profit in future periods of contract performance are recognized using the adjusted estimate. As a result of the changes in contract estimates, we recorded immaterial catch-up revenue adjustments during the year ended December 31, 2024, and 2023.

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Goodwill and Other Long-Lived Assets

We evaluate the impairment of goodwill and other long-lived assets in accordance with Accounting Standards Codification ("ASC") 350, "Intangibles – Goodwill and Other." Management annually reviews goodwill and other long-lived assets for impairment or whenever events or changes in circumstances indicate the carrying amount may not be recoverable. If we determine that the carrying value of the goodwill and other long-lived assets may not be recoverable, we will record an impairment charge for the amount by which the carrying value of the goodwill and other long-lived assets exceeds its fair value.

Goodwill is not amortized, but rather tested for potential impairment as of December 31 each year. The goodwill impairment test is performed at the reporting unit level. Accounting requirements provide that a reporting entity may perform an optional qualitative assessment on an annual basis to determine whether events occurred or circumstances changed that would more likely than not reduce the fair value of a reporting unit below its carrying amount. If an initial qualitative assessment identifies that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, or the optional qualitative assessment is not performed, a quantitative analysis is performed.

In testing goodwill for impairment, we first assess the qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying value. If, after the assessment, we determine that an impairment indicator exists, we perform the quantitative goodwill impairment test. The Company performs the quantitative goodwill impairment test by calculating the fair value of the reporting unit and comparing it to its respective carrying value including goodwill. If the fair value is less than the carrying value, the amount of impairment expense is equal to the difference between the reporting unit's fair value and the reporting unit's carrying value.

Determining the fair value of a reporting unit requires management's judgment and involves the use of significant estimates and assumptions, including forecasted revenue, operating margins, capital expenditures, and selection and use of an appropriate discount rate commensurate with the risk inherent in each of our reporting units' current business models. We utilize the weighted average cost of capital as derived by certain assumptions specific to our facts and circumstances as the discount rate. Our estimate of cash flows and discount rate are subject to change due to the economic environment. A relatively small change in the underlying assumptions, including if the financial performance of the reporting unit does not meet expectations in future years, may cause a change in the results of the impairment assessment in future periods and, as such, could result in goodwill impairment.

For fiscal year 2024, we performed a qualitative assessment of our reporting units and determined that it is more likely than not that the estimated fair value of the reporting units exceeds their carrying value and thus, we did not proceed to the two-step goodwill impairment test.

Due to the nature of our business and other factors described in Item 1A, "Risk Factors," of this Annual Report on Form 10-K, the profitability of our individual reporting units may periodically be affected by downturns in customer demand, operational challenges, and other factors. If material adverse conditions occur that impact one or all of our reporting units, our determination of future fair value might not support the carrying amount of our reporting units, and the related goodwill may be impaired. We will continue to monitor any changes to our assumptions and will evaluate goodwill as deemed warranted during future periods.

We amortize intangible assets over their respective estimated useful lives, and review them for impairment whenever events or changes in business circumstances indicate the carrying value may not be recoverable.

We evaluated our intangible assets for potential impairment. As a result of the assessment, we identified conditions demonstrating an impairment of certain software development costs. An impairment charge of $11.7 million and $0.5 million was recorded in the consolidated statements of operations for the years ended December 31, 2024, and 2023, respectively.

For further discussion of the methods used and factors considered in our estimates as part of the impairment testing for goodwill and intangible assets, see Note 2 - Significant Accounting Policies on Goodwill and Intangible Assets, Note 7 - Goodwill and Note 8 - Intangible Assets, Net to the consolidated financial statements contained within this Annual Report.

Income Taxes

We account for income taxes in accordance with ASC 740, "Income Taxes." Our income tax expense, deferred tax assets and liabilities, and liabilities for unrecognized tax benefits reflect our best estimate of current and future taxes to be paid. We record net deferred assets to the extent we believe these assets will more likely than not be realized. The realizability of net deferred tax assets is based on all available evidence, including future taxable income projections, tax planning strategies, and reversal of taxable temporary differences. We regularly review our deferred tax assets for recoverability and establish a valuation allowance when management believes it is more likely than not that such asset will not be recovered, taking into consideration historical operating results, expectations of future earnings, tax planning strategies and the expected timing of the reversals of existing temporary differences.

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Recent Accounting Pronouncements

See Note 2 - Significant Accounting Policies of the consolidated financial statements contained within this Annual Report for a discussion of recently issued accounting pronouncements.