System1 Inc

3. Goodwill, Internal-Use Software Development Costs, Net, and Intangible Assets, Net

Goodwill

Goodwill was $82.4 million as of September 30, 2024 and December 31, 2023, all of which is attributable to the Partner Network reporting unit. No impairment of goodwill was recognized in any of the periods presented for our continuing operations.

Internal-use Software Development Costs, Net and Intangible Assets, Net

Internal-use software development costs and intangible assets consisted of the following (in thousands):

The internal-use software development costs include construction in progress (which amounts are not subject to amortization until placed in service) of $4.5 million and $3.5 million as of September 30, 2024 and December 31, 2023, respectively.

Amortization expense for internal-use software development costs and intangible assets were as follows (in thousands):

No impairment of internal-use software development cost or intangible assets was recognized for any of the periods presented.

4. Accrued Expenses and Other Current Liabilities

Accrued expenses and other current liabilities consisted of the following items as of the periods presented (in thousands):

CouponFollow Incentive Plan

As of September 30, 2024, we determined that it is probable the CouponFollow business would achieve all performance conditions during the Performance Periods, and accordingly, has recognized a short-term liability within accrued expenses and other current liabilities of $9.4 million and a non-current liability of $6.7 million within other non-current liabilities in our condensed consolidated balance sheets for all Tier amounts set forth in the CouponFollow Incentive Plan. The total amount to be earned under the CouponFollow Incentive Plan is $21.3 million The carrying amount of the share-based liabilities approximates its fair value.

For the nine months ended September 30, 2024, we issued 1.0 million shares of Class A common stock with an aggregate fair value of $1.7 million, net of shares withheld for taxes, on the date of the settlement to settle the second $3.3 million installment of the Fixed Amount. We recognized a gain of$0.5 million for the difference between the fair value of the Class A common stock issued and the carrying value of the liability. For thethree and nine months ended September 30, 2024, we recognized $0.8 million and $2.5 million for the third installment of the Fixed Amount within salaries and benefits expenses on the condensed consolidated statements of operations, respectively.

5. Debt, Net

We entered into a term loan ("Term Loan") and revolving facility ("2022 Revolving Facility") with Bank of America, N.A., on January 27, 2022, providing for a 5.5-year term loan with a principal balance of$400.0 million and with the net proceeds of$376.0 million. The 2022 Revolving Facility provided for borrowing availability of up to$50.0 million. As of September 30, 2024, there wasno balance outstanding on the 2022 Revolving Facility, and principal of $285.1 million was outstanding on the Term Loan. Through December 31, 2025, the outstanding Term Loan is subject to quarterly amortization payments of $5.0 million. From March 31, 2026, the Term Loan is subject to quarterly amortization payments of $7.5 million. The Term Loan matures in 2027.

For every interest period, the interest rate on the Term Loan is the adjusted Secured Overnight Financing Rate ("SOFR") plus 4.75%. The Term Loan is amortized in quarterly installments on each scheduled payment date. The Term Loan comes with a leverage covenant, which goes into effect only if the utilization on the 2022 Revolving Facility exceeds 35% of the $50.0 million 2022 Revolving Facility at each quarter-end starting the second quarter 2022, such that the first lien leverage ratio (as defined in the credit agreement) should not exceed 5.40. The facility has certain financial and nonfinancial covenants, including a leverage ratio. The facility also requires that we deliver our audited consolidated financial statements toour lender within 120 days of our fiscal year end, December 31. Should we fail to distribute the financial statements toour lender within 120 days, we are allowed an additional 30 days to cure. We were in compliance with our financial covenants as of September 30, 2024.

The interest rate on the 2022 Revolving Facility is the adjusted SOFR plus 2.5% with an adjusted SOFR floor of 0%. As of September 30, 2024, we had $50.0 million available on the 2022 Revolving Facility.

During nine months ended September 30, 2024 we completed the repurchase of $64.9 million in principal amount of our Term Loan for an aggregate purchase price of $41.6 million (at an average discount of 64.12% of its par value). Following the repurchases on January 17, 2024 and April 30, 2024, the outstanding principal amount of the Term Loan was $301.3 million and $295.0 million, respectively. We used available cash on hand to fund the repurchases. Our gain on the repurchases were $20.1 million before fees and expenses incurred to negotiate, document and consummate the repurchase.

The carrying values of our debt, net of discounts, deferred financing and debt issuance costs were as follows (in thousands):

6. Income Taxes

We are the sole managing member of System1 Holdingsand, as a result, consolidate the financial results of System1 Holdings. System1 Holdings is treated as a partnership for U.S. federal and most applicable state and local income tax purposes. As a partnership, System1 Holdings is not subject to U.S. federal and certain state and local income taxes. Any taxable income or loss generated by System1 Holdings is passed through to and included in the taxable income or loss of its members, including us, on a pro rata basis. We are subject to U.S. federal income taxes, in addition to state and local income taxes with respect to its allocable share of any taxable income or loss of System1 Holdings, as well as any stand-alone income or loss generated by us.

We recorded an income tax expense of $0.6 million and $0.4 million for the three and nine months ended September 30, 2024 and a benefit from income taxes of $1.1 million and $11.6 million for thethree and nine months ended September 30, 2023, respectively. The effective tax rate was (2.0)% and (0.5)% for thethree and nine months ended September 30, 2024, respectively and 4.1% and 11.9% for thethree and nine months ended September 30, 2023, respectively. The provision for income taxes differs from the amount of income tax computed by applying the U.S. statutory federal tax rate of 21% to the loss before income taxes due to the exclusion of non-controlling loss, state taxes, foreign rate differential, non-deductible expenses, changes to tax reserves, return to provision true-ups, increase to the valuation allowance related to unrealizable deferred tax assets, and outside basis adjustments. As of September 30, 2024, we had a full valuation allowance on our U.S. federal and state net deferred tax assets as it was more likely than not that those deferred tax assets would not be realized.

During thethree and nine months ended September 30, 2024 and 2023, inclusive of interest, no payments were made to the parties to the Tax Receivable Agreement. The total amount of Tax Receivable Agreement Payments due under the Tax Receivable Agreement was $0.9 million and $0.8 million as of September 30, 2024 and December 31, 2023, respectively.

7. Commitments and Contingencies

In June 2023, we entered into a multi-year agreement with a service provider whereby we are contractually obligated to spend $5.0 million in each annual period between July 2023 and June 2026. As of September 30, 2024, we remain contractually obligated to spend$8.0 million towards this commitment.

As of September 30, 2024, we had various non-cancelable operating lease commitments for office space which have been recorded as Operating lease liabilities.

Litigation

We are subject to various legal proceedings and claims that arise in the ordinary course of business. We believe the ultimate liability, if any, with respect to these actions will not materially affect the consolidated financial position, results of operations, or cash flows reflected in the condensed consolidated financial statements. There can be no assurance, however, that the ultimate resolution of such actions will not materially or adversely affect our consolidated financial position, results of operations, or cash flows. We accrued for losses when the loss is deemed probable and the liability can reasonably be estimated.

In October 2023, a putative California class action complaint (the "Complaint") was filed against us and our Protected business regarding alleged violations of California’s Auto Renewal Law requirements related to the marketing and sale of its subscription service offerings for anti-virus and ad-blocking software (the "Protected Software") to consumers. The Complaint alleges claims under California’s false advertising and unfair competition laws and primarily alleges that the marketing and sales checkout flows for the Protected Software did not clearly and conspicuously disclose that the named plaintiffs set forth in the Complaint were purchasing the Protected Software for a promotional period which would auto-renew after the applicable promotional period. While we dispute the claims alleged, we reached a tentative settlement during June 2024. During September 2024 we entered into a Settlement Agreement, that still remains subject to court approval. The amount of such settlement has been accrued accordingly in accrued expenses and other current liabilities in our condensed consolidated balance sheet as of September 30, 2024.

Indemnifications

In the ordinary course of business, we may provide indemnifications of varying scope and terms to customers, vendors, lessors, investors, directors, officers, employees, and other parties with respect to certain matters, including, but not limited to, losses arising out of our breach of such agreements, services to be provided by us, or from intellectual property infringement claims made by third parties. These indemnifications may survive termination of the underlying agreement and the maximum potential amount of future payments we could be required to make under these indemnification provisions may not be subject to claims related to these indemnifications. As a result, we believe the estimated fair value of these agreements was immaterial. Accordingly, we have no liabilities recorded for these agreements as of September 30, 2024.

8. Fair Value Measurement

Financial Liabilities Measured at Fair Value on a Recurring Basis

The following tables present our fair value hierarchy for liabilities measured at fair value on a recurring basis (in thousands):

The fair value of the Public Warrants has been estimated using the Public Warrants’ quoted market price. There were no transfers in or out of levels during the periods presented.

9. Net Loss Per Share

Basic net loss per share was calculated by dividing net loss attributable to common stockholders by the weighted average number of shares of common stock outstanding. Basic and diluted net loss per share was calculated as follows(in thousands, except per share):

For the periods presented in the table above, a total of 16.8 million Public Warrants were excluded from the computation of net loss per share as the impact was anti-dilutive. In addition, for the three and nine months ended September 30, 2024, we excluded stock appreciation rights ("SARs") of 22.3 million as they are contingently issuable based on certain performance conditions, which were not achieved as of September 30, 2024 . Refer to Note 11, Stock-Based Compensation for further details.

During 2022, we replaced certain unvested profits interests awards, value creation units and Class F units that were outstanding, with a combination of a restricted stock unit and cash awards (collectively, "Replacement Awards"). We do not consider unvested Class A common stock related to the Replacement Awards as outstanding for accounting purposes as they are subject to continued service requirements or contingencies. These shares are not included in the denominator of the net loss per share calculation until the employee provides the requisite service resulting in the vesting of the award or the contingency is removed, or upon termination of an employee at which point the common stock underlying the award becomes issuable to the previous investors. Shares associated with the vested or forfeited Replacement Awards are deemed to be issued and outstanding for accounting purposes on the day of vest or forfeiture.

10. Segment Reporting

We havetwo operating and reportable segments: Owned and Operated Advertising and Partner Network. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker ("CODM"), in deciding how to allocate resources and assess performance. Our Chief Executive Officer, who is considered to be our CODM, reviews financial information presented on an operating segment basis for purposes of making operating decisions and assessing financial performance.

The CODM measures and evaluates reportable segments based on segment operating revenue as well as adjusted gross profit. The tables below include the following operating expenses that are not allocated to the reporting segments presented to our CODM: depreciation and amortization of property, equipment and leasehold improvements, amortization of intangible assets and, at times, certain other transactions or adjustments. The CODM does not consider these expenses for the purposes of making decisions to allocate resources among segments or to assess segment performance, however these costs are included in reported condensed consolidated net loss from continuing operations before income tax and are included in the reconciliation that follows.

The following table summarizes revenue by reportable segments (in thousands):

The following table summarizes Adjusted gross profit by reportable segments (in thousands):

The following table summarizes revenue by geographic region (in thousands):

11. Stock-Based Compensation

We recorded the following total stock-based compensation expense(in thousands):

Stock Appreciation Rights Plan

During the quarter ended June 30, 2024, we adopted the 2024 Stock Appreciation Rights Plan (the "2024 Plan"), to enhance our ability to attract, retain, and motivate individuals who are expected to make significant contributions to our future financial and operating performance. The maximum number of Class A common stock that may be issued pursuant to awards of Stock Appreciation Rights ("SARs") granted under the 2024 Plan ("Awards") is 23.8 million shares.

Financial performance in the Plan is determined by the achievement of Adjusted EBITDA. The Plan defines Adjusted EBITDA as, with respect to any particular period, the Company’s net income (loss) before interest expense, income taxes, depreciation and amortization expense, stock-based compensation expenses, dividends or other distributions to equity holders, expense associated with revaluation of any warrants, costs associated with acquisitions or dispositions, deferred compensation, management fees, minority interest expense, restructuring charges, impairment and certain segment-specific adjustments, and such other adjustments as may be appropriate to accurately reflect performance, in each case, as determined by the Plan administrator.

In July 2024, we granted 22.4 million SARs in accordance with the Plan. Each Award is subject to the employee's continued service through the applicable Vesting Date (as defined in the Plan) and the term of any Stock Appreciation Right shall not exceed seven years. The SARs will vest in four equal tranches upon achieving trailing twelve month Adjusted EBITDA targets of $50.0 million, $60.0 million, $70.0 million, and $80.0 million.

Upon exercise, the SARs will be settled in shares of our Class A common stock or in cash at our election. We will assess whether it is probable that the award will vest for each of the four tranches at the end of every reporting period. If and when the award is deemed probable of vesting, we will recognize stock-based compensation expense for the award on a graded basis through the date of vesting. Unvested SARs are forfeited upon termination of service.

We use the Black-Scholes option pricing model to estimate the grant date fair value of each SARs award granted under the Plan. The expected term is estimated using the simplified method, which is the midpoint between the vesting date and the contractual term. Volatility is based on a blend of the historical volatility of our common stock and the peer-leveraged volatility. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The following table sets forth the key assumptions used to determine the fair value:

The weighted-average grant date fair value of SARs granted during the three months ended September 30, 2024 was $0.94.

A summary of our SARs activity is as follows:

As of September 30, 2024, we determined that none of the performance conditions related to the SARs are probable of being achieved. Accordingly, no stock-based compensation expense for thethree and nine months ended September 30, 2024 was recognized. As of September 30, 2024, the total unrecognized compensation cost related to unvested SARs was $21.0 million.

12. Discontinued Operations

Sale of Protected

On November 30, 2023, we completed the sale of our Protected business, our subscription reporting unit. Total consideration comprised of: (a) $240.0 million in cash, subject to certain adjustments, (b) the return and subsequent cancellation of approximately 29.1 million shares of our Class A common stock, par value $0.0001 per share, owned by Just Develop It ("JDI") and other entities and individuals affiliated with the Purchasing Parties and (c) confirmation from JDI, Protected and the Protected CEO that the financial performance benchmarks related to the financial benchmarks included in the Protected Incentive Plan (as defined below), will, as a result of the Protected sale, no longer be achievable.

Impairment of Protected

Upon classifying our Protected business as held for sale as of September 30, 2023, we performed a goodwill impairment test on the Subscription reporting unit, resulting in a goodwill impairment charge of $115.5 million. This impairment was the result of decreases in long-term forecasts due to adverse customer trends and other macroeconomic outcomes. We recorded a further impairment loss of $3.3 million upon the classification of the disposal group as held for sale, for a total impairment charge of $118.8 million that was recorded in the results of discontinued operations for the three and nine months ended September 30, 2023. There was no tax benefit of this charge for the three and nine months ended September 30, 2023.

The financial results of Protected are presented as a loss from discontinued operations, net of taxes in the condensed consolidated statements of operations. The following table presents the summarized discontinued operations condensed consolidated statements of operations(in thousands):

The following table presents the significant non-cash items and capital expenditures for the discontinued operations with respect to the subscription business that are included in thecondensed consolidated statements of cash flows (in thousands):

Transition Service Agreement

In connection with a transition service agreement entered into with the sale of our Protected business, we agreed to provide certain services for which full reimbursement of cost will be provided through the earlier of November 30, 2024 or the date Protected is able to independently participate in Google's advertising purchasing programs.

Discontinued Operations Related-Party Transactions

Payment Processing Agreement

Protected utilizes multiple credit card payment processors, including Paysafe Financial Services Limited ("Paysafe"). In March 2021, Paysafe completed a merger with Foley Trasimene Acquisition Corp. II, a special purpose acquisition company sponsored by entities affiliated with a sponsor of Trebia who was also a member of our Board of Directors. We incurred credit card processing fees related to Paysafe for the three and nine months ended September 30, 2023 of $4.2 million and $11.9 million, respectively.

Office Facilities

Protected had an agreement with JDI Property Holdings Limited, an entity controlled by one of our directors, which allowed Protected to use space at their property in exchange for GBP 0.1 million per year.

Protected Incentive Plan Installment Payments

In 2022, in connection with the acquisition of Protected, we effected an incentive plan for eligible recipients (the "Protected Incentive Plan"), providing up to $100.0 million payable in fully-vested shares of our Class A common stock contingent upon the achievement of the future performance of Protected’s business. The Protected Incentive Plan originally was to be paid out in two tranches based on performance of the business for 2023 and 2024. The first award (2023), consisting of $50.0 million of Class A common stock payable in January 2024, was modified to a cash award resulting in $20.0 million of payments in 2022 and 2023 with an additional final $10.0 million, payable upon the achievement of certain performance thresholds around marketing spend and operating contribution of Protected on or before December 31, 2024. On November 30, 2023, none of the performance thresholds were met, and therefore, none of the additional cash bonus payments have been paid.