2017 Annual Report CONTENTS Letter to Shareholders Management’s Discussion and Analysis Management’s Responsibility for Financial Reporting Auditors’ Report Consolidated Financial Statements Notes to the Consolidated Financial Statements Corporate Information 3 5 34 35 37 41 64 2 April 9, 2018 Dear Shareholders, At the beginning of 2017, we set on a clear path to reposition TeraGo with a sharpened focus on providing managed cloud and connectivity solutions tailored for mid-sized business. Over the past year, our organization has been dedicated to executing our strategic plan and we have made great strides to simplify our products and services, improve our go-to-market effectiveness, and enhance the customer experience. PRODUCTS AND SERVICES: In 2017, we streamlined and re-launched our portfolio of services reducing our number of SKU’s by 60% to better align to customer needs and improve sales efficiency. We also enhanced our offers to feature in-demand services and improve the customer experience as we: • • • Launched new packages for popular Cloud and Colocation configurations; Introduced Cloud Ready Internet Bundles (20/50/100), doubling the multi-product penetration in the customer base; and Established our AWS Practice and achieved the Standard Partner tier. GO TO MARKET EFFECTIVENESS: To reinvigorate growth around Cloud and Colocation we have built a practice around the Hybrid IT Framework and made investments in sales and marketing to target the right customers: • Increased our sales headcount by 25% and restructured teams into vertically-focused accounts to foster strong client relationships; Restructured marketing campaign spending; and • • Developed and launched new branding which was accompanied by a new and improved website. CUSTOMER EXPERIENCE: We implemented systems and processes to strengthen our relationships and transform customers into ambassadors, including cross-selling new offers to reduce overall customer churn as we target and acquire new customers: • Designed and launched a new Customer Lifecycle Management Framework • Developed and implemented a new support model for high value customers. The improvements we have made to our operation were critical to building the capabilities needed to deepen relationships with existing customers, capture new customers and new market share, and put TeraGo in a much stronger competitive position going forward. ADDING KEY OPERATING PERFORMANCE INDICATORS However, 2017 was not without its challenges as total revenue decreased 6.3% to $55.4 million, driven by a 10.7% decline in Connectivity revenue partially offset by a 3.6% increase in Cloud and Colocation revenue. The decline in our Connectivity business was expected and consistent throughout the year, but Cloud and Colocation growth slowed as we restructured our sales organization and rebuilt our sales funnel. To that end, I’m very encouraged about some of the trends we have seen in our key performance indicators as we enter 2018. 3 To provide investors and analysts with greater transparency in tracking the operating trends in our business, we also introduced several new metrics with our 2017 year-end results – monthly recurring revenue backlog (MRR), average revenue per user (ARPU), and customer churn. Notably, in the third quarter of 2017 we signed the largest colocation agreement in TeraGo’s history, ending the year with significant improvement in our Cloud and Colocation MRR backlog. Meanwhile ARPU for both our Connectivity and Cloud & Colocation businesses has been stable and customer churn in the Connectivity business improved modestly from 1.7% in the first half of 2017 to 1.5% - 1.6% in the second half of 2017. As we manage churn in our Connectivity business and continue to implement and add to our MRR backlog by penetrating the mid-sized business market, we expect to see the returns of our efforts from executing our strategic plan. UNLOCKING HIDDEN VALUE A strong operational foundation has taken shape in 2017 and we remain focussed on execution and delivering results. Concurrently, and building upon this foundation, the Executive management team is engaged in initiatives to unlock the hidden value of our assets. One of these assets is our licensed millimetre wave spectrum. TeraGo has spectrum licences in the 24 and 38 GHz bands covering approximately 8.5 billion MHz/Pops across Canada. Innovation, Science and Economic Development Canada (“ISED”) has identified 38 GHz as a band for next-generation 5G wireless deployments, and we believe inclusion of the 24 GHz band will eventually follow. As ISED’s decisions around the use of 5G spectrum are finalized, TeraGo is exploring options for broader use application of its spectrum assets including enhancing its current product offering or expanding to target new products and services. Lastly, TeraGo is free cash flow positive and has sufficient balance sheet flexibility to address its strategic growth needs, ending 2017 with $7.0 million in cash and cash equivalents, $36.2 million in long-term debt, and access to an additional $35.0 million in unused credit facilities. In summary, I believe we have the right team, offering, and strategy in place to return TeraGo to growth and create long-term value for our shareholders. I would like to thank the employees of TeraGo for their dedication and efforts, our customers, and you – the shareholders, for your ongoing commitment. Thank you. (signed) “Antonio Ciciretto” Antonio (Tony) Ciciretto President & Chief Executive Officer 4 TERAGO INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL RESULTS FOR THE THREE MONTHS AND FISCAL YEAR ENDED DECEMBER 31, 2017 AND 2016 The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and financial condition of TeraGo Inc. All references in this MD&A to “TeraGo”, the “Company”, “we”, “us”, “our” and “our company” refer to TeraGo Inc. and its subsidiaries, unless the context requires otherwise. This MD&A is dated February 21, 2018 and should be read in conjunction with our audited consolidated financial statements for the year ended December 31, 2017 and the notes thereto. Additional information relating to TeraGo, including our most recently filed Annual Information Form (“AIF”), can be found on SEDAR at www.sedar.com and our website at www.terago.ca. For greater certainty, the information contained on our website is not incorporated by reference or otherwise into this MD&A. All dollar amounts included in this MD&A are in Canadian dollars unless otherwise indicated. Certain information included herein is forward-looking and based upon assumptions and anticipated results that are subject to uncertainties. Should one or more of these uncertainties materialize or should the underlying assumptions prove incorrect, actual results may vary significantly from those expected. For a description of material factors that could cause our actual results to differ materially, see the “Forward-Looking Statements” section and the “Risk Factors” section in this MD&A. This MD&A also contains certain industry-related non-GAAP and additional GAAP measures that management uses to evaluate performance of the Company. These non-GAAP and additional GAAP measures are not standardized and the Company’s calculation may differ from other issuers. See “Definitions – IFRS, Additional GAAP and Non-GAAP Measures”. FORWARD-LOOKING STATEMENTS This MD&A includes certain forward-looking statements that are made as of the date hereof only and based upon current expectations, which involve risks and uncertainties associated with our business and the economic environment in which the business operates. All such statements are made pursuant to the ‘safe harbour’ provisions of, and are intended to be forward-looking statements under, applicable Canadian securities laws. Any statements contained herein that are not statements of historical facts may be deemed to be forward-looking statements. For example, the words anticipate, believe, plan, estimate, expect, intend, should, may, could, objective and similar expressions are intended to identify forward-looking statements. This MD&A includes, but is not limited to, forward looking statements regarding TeraGo’s growth strategy, strategic plan, the growth in TeraGo’s cloud and data centre businesses, retention campaign and initiatives to improve customer service, additional capital expenditures, investments in data centres, products and other IT services. By their nature, forward-looking statements require us to make assumptions and are subject to inherent risks and uncertainties. We caution readers of this document not to place undue reliance on our forward-looking statements as a number of factors could cause actual future results, conditions, actions or events to differ materially from the targets, expectations, estimates or intentions expressed with the forward-looking statements. When relying on forward-looking statements to make decisions with respect to the Company, you should carefully consider the risks, uncertainties and assumptions, including the risk that TeraGo’s growth strategy and strategic plan will not generate the result intended by management, cross-selling of TeraGo’s cloud services may not succeed, retention efforts decreasing profit margins, opportunities for expansion and acquisition not being available or at unfavourable terms, TeraGo’s “go-to-market” strategy may not materialize, trends in the global cloud and data centre sectors may not be accurately projected, the outcome of the ISED 5G Consultation may not be favourable to the Company, the partnership with AWS not resulting in a favourable outcome, and those risks set forth in the “Risk Factors” In particular, if any of the risks materialize, the section of this MD&A and other uncertainties and potential events. expectations, and the predictions based on them, of the Company may need to be re-evaluated. Consequently, all of the forward-looking statements in this MD&A are expressly qualified by these cautionary statements and other cautionary statements or factors contained herein, and there can be no assurance that the actual results or developments anticipated by the Company will be realized or, even if substantially realized, that they will have the expected consequences for the Company. Except as may be required by applicable Canadian securities laws, we do not intend, and disclaim any obligation, to update or revise any forward-looking statements whether in words, oral or written as a result of new information, future events or otherwise. 5 OVERVIEW Financial Highlights • • • Total revenue decreased 7.2% to $13.5 million for the three months ended December 31, 2017 compared to $14.6 million for the same period in 2016. The decrease in revenue is primarily driven by lower connectivity revenue which decreased 10.0% to $8.8 million compared to $9.8 million for the same period in 2016. In addition, cloud and colocation revenue decreased 1.5% to $4.7 million compared to $4.8 million for the same period in 2016. However, the percentage of revenues from cloud and colocation of our total revenue have increased steadily quarter over quarter during 2017 (Q1 = 33.7%, Q2 = 34.0%, Q3 = 34.0%, Q4 = 35.0%) as the Company makes a shift towards these higher growth service offerings. Total revenue decreased 6.3% to $55.4 million for the year ended December 31, 2017, compared to $59.1 million for the same period in 2016. The decrease was driven by the factors described above. Net loss was $4.1 million for the three months ended December 31, 2017 compared to a net income of $0.4 million for the same period in 2016. The increase in net loss was primarily driven by the impairment charge on certain network assets, property and equipment and intangible assets to adjust the carrying amount to their recoverable amount. In addition, the Company saw a decrease in revenue, increase in cost of services, increase in other operating costs, increase in finance costs, and an increase in stock based compensation, partially offset by lower restructuring and related costs, as well as lower depreciation and amortization. For the year ended December 31, 2017, net loss was $7.3 million compared to a net loss of $4.3 million for the same period in 2016. The increase in net loss was driven by the factors described above. Adjusted EBITDA(1)(2) decreased to $2.9 million for the three months ended December 31, 2017 compared to $4.9 million for the same period in 2016. The decrease was primarily driven by the reduction of connectivity revenue, higher third party costs, higher real estate fees, higher software license costs, higher salary and related costs to support strategic initiatives, and increases in other operating expenses. For the year ended December 31, 2017, Adjusted EBITDA(1) decreased to $12.9 million compared to $18.9 million for the same period in 2016. The decrease in Adjusted EBITDA was driven by the factors above, partially offset by higher cloud & colocation revenue. Key Developments • • the Company’s wholly-owned subsidiaries, TeraGo Networks Inc. (“TeraGo Effective January 1, 2017, Networks”), RackForce Networks Inc. (“RackForce”), RackForce Cloud Video Inc. and Codeninja Ltd. (“BoxFabric”) completed a vertical short-form amalgamation (the “Amalgamation”). The amalgamated corporation continues to carry on business as “TeraGo Networks Inc.” and remains a wholly-owned subsidiary of TeraGo Inc. The Amalgamation was undertaken to simplify the Company's corporate structure and to obtain certain administrative and financial reporting efficiencies. In April 2017, TeraGo was selected as one of Canada’s Top Small and Medium Employers for 2017 which recognizes small and medium enterprises in Canada that lead in creating exceptional workplaces. TeraGo was selected as a Top Employer based on a list of eight criteria consisting of the physical workplace environment, atmosphere, benefits, vacation, employee communications, performance management, community involvement and training and skills development. • On June 14, 2017, TeraGo entered into an amending agreement to its credit facilities whereby, TeraGo and its Lenders (defined below) agreed, among other things, to extend the maturity date from June 30, 2018 to June 14, 2021. The total credit facilities will decrease from an aggregate amount of $85.0 million to $75.0 million, to reflect principal repayments previously made which have reduced the non-revolving term facility from $50.0 million to $40.0 million. The other facilities consist of a $10.0 million revolving operating credit facility and a $25.0 million non-revolving acquisitions facility, the latter of which remains undrawn and available. National Bank of Canada, Royal Bank of Canada and The Toronto-Dominion Bank (collectively, the “Lenders”) remain as syndicate lenders under the Credit Agreement. The covenants and other terms and conditions under the Credit Agreement remain substantially unchanged. (1) Adjusted EBITDA is a Non-GAAP measure. See "Definitions - IFRS, Additional GAAP and Non-GAAP Measures. (2) See “Adjusted EBITDA” for a reconciliation of net loss to Adjusted EBITDA 6 • On June 15, 2017, the Company announced Mr. Matthew Gerber as the new Chair of the Board, who replaced Mr. Jim Nikopoulos who did not stand for re-election. Mr. Gerber joined TeraGo’s Board in June 2016 and currently serves as the Chief Executive Officer and a board member at Rohinni LLC. In addition, at TeraGo’s shareholders’ meeting, a resolution was approved to reserve an additional 300,000 common shares issuable pursuant to the Directors’ Share Compensation Program. • In June 2017, Innovation, Science and Economic Development Canada (ISED) issued the Consultation on Releasing Millimetre Wave Spectrum to Support 5G. This Consultation contemplates the future use of certain millimetre wave spectrum to support the deployment of 5th generation (5G) wireless networks and systems. The spectrum bands identified by ISED includes (amongst others) the 38 GHz band which TeraGo currently holds licences in. TeraGo has participated in this Consultation by submitting its comment letter to ISED on September 14, 2017. In addition, the Company has also since submitted a comment letter to another Consultation released from ISED in October 2017 titled Consultation on the Spectrum Outlook 2018 to 2022. This Consultation seeks comments from stakeholders on ISED’s overall approach and planned activities for spectrum over the next five years. • On July 10, 2017, the Company announced Mr. David Charron has been appointed as Chief Financial Officer, which took effect on September 5, 2017. • On August 15, 2017, the Company announced that it had signed the largest data centre services agreement in Company history. The colocation agreement with a Canadian IT services provider is in respect to the Company’s Vancouver Vault data centre facility. TERAGO OVERVIEW TeraGo provides businesses across Canada with cloud, colocation and connectivity services. The Company provides cloud Infrastructure as a Service (“IaaS”) computing and storage solutions, data centre colocation solutions, and operates five (5) data centres across Canada. With respect to the Company’s connectivity services, it owns and operates a carrier-grade, Multi-Protocol Label Switching (“MPLS”) enabled fixed wireless, IP communications network in Canada targeting businesses that require Internet access, private interconnection, and data connectivity services. The Company provides enterprise-class cloud services to multiple high value, mid-market and enterprise customers across a variety of industry verticals, federal, provincial and municipal governments and agencies, as well as non-profit organizations. The Company is focussed on providing customers with tailored hybrid IT solutions, running their IT workloads with the appropriate mix of on-premise, data centre colocation, private and public cloud environments. It currently has strategic relationships with several technology partners that give it access to certain products and solutions to provide enterprise cloud services. The Company has aligned with Amazon Web Services (“AWS”) in preparation to provide managed public cloud services and is an AWS Consulting Partner, part of the AWS APN partner network. During the year, TeraGo attained the Standard Partner tier in the AWS Partner Program. The Company’s subscription-based business model generally generates stable and predictable recurring revenue from cloud, colocation and connectivity services. Once a customer is obtained, TeraGo’s strategy is to generate incremental recurring revenue from that customer by cross-selling to bundle customers with multiple services and up-selling within services provided. 7 Cloud Services Colocation Services Connectivity Services • • • • Private and hybrid cloud IaaS utility computing on virtual and dedicated compute platforms High performance and secure data storage and archiving Business Continuity services for critical situations • Managed Services for public and hybrid cloud offerings • Colocation services in partial, full, or customized cabinets • Managed, Private Dedicated, and Co-location hosting services • Private Vaults protected with biometrics for maximum security • Other value added services such as hybrid cloud • • National high performance, scalable Internet access principally via wireless and fibre optics Active redundancy capability with bundled connectivity solution • Managed network service TERAGO’S BUSINESS MODEL TeraGo’s business strategy is to provide enterprise-class hybrid IT solutions tailored to the mid-market. The Company leverages its existing nationwide data centre footprint, VMware private/multi-tenant cloud and AWS, all underpinned by a resilient national carrier grade network infrastructure, to align with customers’ current IT landscape. This allows customers to operate on platforms best suited for their workloads – on-premise, data centre colocation, TeraGo private and multi-tenant cloud, and AWS public cloud – all securely interconnected. TeraGo’s customers typically sign one, two or three-year contracts. The majority of new customers sign contracts for three years or more. Services are billed monthly over the term of the contract. CLOUD SERVICES TeraGo provides cloud services that seek to meet the complex and evolving IT needs of our customers. TeraGo provides IaaS for compute, storage, disaster recovery cloud solutions and other offerings. These solutions allow the Company to compete in the cloud services market. TeraGo offers customized cloud storage and compute offerings to customers across Canada. TeraGo cloud can offer a virtualized computing environment whereby customers can access on-demand computing without the need to acquire and maintain expensive server equipment. TeraGo can also provide offsite cloud storage for key backup and disaster recovery situations, including utilizing partnerships with software and hardware vendors such as Veeam and Solidfire. The Company has strategic relationships and partnerships with technology leaders such as Amazon Web Services, IBM, Cisco, VMware, Microsoft, Mitel and others that gives it early access to intelligence, products and solutions to provide enterprise cloud services. COLOCATION SERVICES TeraGo provides data centre colocation services valuable information assets. Customers can provision their computing equipment within shared partial cabinets or full, private cabinets, as well as customized caged space designed for their specific needs. TeraGo provides connectivity on redundant routes in and out of the facilities. that protect and connect our customers’ Hosting and colocation revenue is derived from set-up fees for new installations and monthly recurring charges based on the number of cabinets and/or the quantity of cage space, power requirements, managed services provided and Internet/data bandwidth requirements. Other services, such as disaster recovery services, are provided under custom contractual arrangements. TeraGo also offers a variety of managed hosting solutions, which may require us to manage various aspects of a customer’s hardware, software or operating systems in public or privately accessible environment. TeraGo offers disaster recovery services on a custom basis. These facilities can be provisioned at the data centre location and provide customers with the capability to restore office functionality with direct access to their information located in the data centre. 8 Our network can provide these customers Internet and/or secure private interconnections between the data centre facility and the customer’s office location(s). Data centre services customers typically include national government agencies, financial services companies, IT service providers, content and network service providers, and small and medium businesses which rely on TeraGo to store and manage their critical IT equipment and provide the ability to directly connect to the networks that enable our information-driven economy. Data Centre Facilities TeraGo’s data centres provide IT solutions, including colocation and disaster recovery, to a roster of small and medium- sized businesses, enterprises, public sector and technology service providers. TeraGo has approximately 60,000 square feet of data centre capacity in the five (5) facilities it operates across Canada: Mississauga, Ontario TeraGo operates a 10,000 square foot AT 101 SOC2 Type 2 certified data centre facility in Mississauga, Ontario that was previously managed by BlackBerry Limited and built to a tier 3 standard. This facility predominantly serves the Greater Toronto Area. Vaughan, Ontario TeraGo operates a 16,000 square foot AT 101 SOC2 Type 2 certified data centre facility in Vaughan, Ontario, serving the Greater Toronto Area. Kelowna, British Columbia TeraGo operates its 18,000 square feet AT 101 SOC2 Type 2 certified data centre in Kelowna named the GigaCenter. The GigaCenter is built to a tier 3 standard and the location in Kelowna is considered ideal for a data centre as the region is considered a seismically stable geographic location, has a temperate climate and has a lower probability of both natural and man-made events that may be a risk. Vancouver, British Columbia TeraGo operates two AT 101 SOC2 Type 2 certified data centre facilities in downtown Vancouver. Its first facility, is 5,000 square feet and is expandable to 7,000 square feet. The facility has redundant fibre facilities between the data centre and the ‘telco hotel’, 555 West Hastings, in downtown Vancouver. The second facility is 7,000 square feet and is served by TeraGo’s fiber optic lines. Both facilities are used to service the Greater Vancouver Area. CONNECTIVITY SERVICES TeraGo owns and operates a carrier-grade Multi-Protocol Label Switching (“MPLS”) enabled wireline and fixed wireless, Internet Protocol (“IP”) communications network in Canada, providing businesses with high performance, scalable, and secure access and data connectivity services. TeraGo’s carrier grade IP communication network serves an important and growing demand among Canadian businesses for network access diversity by offering wireless services that are redundant to their existing wireline broadband connections. TeraGo’s IP network has been designed to eliminate single points of failure and the Company backs its services with customer service level commitments, including 99.9% service availability, industry leading mean time to repair, 24 x 7 telephone and e-mail access to technical support specialists. TeraGo offers Canadian businesses high performance unlimited and usage-based dedicated Internet access with upload and download speeds from 5 megabits per second (“Mbps”) up to 1 gigabit per second (“Gbps”). Unlike asymmetrical DSL services offered by many of our competitors, TeraGo provides services that are symmetrical, hence customers can have the same high speed broadband performance whether uploading or downloading. TeraGo enhances service performance by minimizing the number of networks between our customers and their audiences, using peering arrangements with multiple tier-one carriers to connect to the Internet. To deliver its services, the Company has built and operates a carrier-grade, IP network, using licensed and license- exempt spectrum and fibre-optic wireline infrastructure that supports commercially available equipment. The Company owns and controls a national MPLS distribution network from Vancouver that aggregates customer voice and data traffic and interconnects where necessary with carrier diverse leased fiber optic facilities. Major Internet peering and core locations are centralized in Vancouver, Toronto and Seattle, although Internet access is also available in all regional markets for further redundancy. to Montreal 9 TeraGo offers a range of diverse Ethernet-based services over a secured wireless connection to customer locations up to 20 kilometres from a hub (provided line of sight or wireline networks exist) or through a fibre optic connection. Quality of Service Capabilities TeraGo’s MPLS network, including key high traffic hub sites, is equipped with Quality of Service (“QoS”) capabilities to improve performance and traffic management. All of TeraGo’s major national markets are end-to-end QoS enabled providing the foundation to support voice traffic and other potential future applications. Radio Spectrum 24-GHz and 38-GHz Wide-area Licences The Company owns and leases a national spectrum portfolio of exclusive 24GHz and 38GHz wide-area spectrum licences which covers major regions throughout Canada including 2,120 MHz of spectrum across Canada’s 6 largest cities. This spectrum is used to deploy point-to-point and point-to-multipoint microwave radio systems, interconnecting core hubs in ring architectures (where possible) to backhaul metro area network traffic and in the access network or “last mile” to deliver high capacity (speeds of 20Mbps to 1Gbps) IP-based services for business, government and mobile backhaul. In June 2017, Innovation, Science and Economic Development Canada (ISED) issued the Consultation on Releasing Millimetre Wave Spectrum to Support 5G. This Consultation contemplates the future use of certain millimetre wave spectrum to support the deployment of 5th generation (5G) wireless networks and systems. The spectrum bands identified by ISED includes (amongst others) the 38 GHz band which TeraGo currently holds licences in. As of the date, hereof, the Company has submitted a comment letter in response to the Consultation and final decisions from ISED on this Consultation are yet to be released. In October 2017, ISED issued the Consultation on the Spectrum Outlook 2018 to 2022. This Consultation seeks comments from stakeholders on ISED’s overall approach and planned activities for spectrum over the next five years. This Consultation references the 24 GHz band, among several other bands, being considered for release in the future for mobile use. As of the date, hereof, the Company has submitted a comment letter in response to the Consultation and final decisions from ISED on this Consultation are yet to be released. For additional stakeholders, gst.nsf/eng/h_sf11245.html. please information on these Consultations and to review the response letter of refer to ISED’s Consultation webpage: the Company or other https://www.ic.gc.ca/eic/site/smt- For further details on our licensed spectrums, please refer to the Company’s 2017 AIF. 10 SELECTED ANNUAL INFORMATION The following table displays a summary of our Consolidated Statements of Comprehensive Earnings (Loss) for the three months ended December 31, 2017 and 2016 and the years ended December 31, 2017, 2016 and 2015 and a summary of select Balance Sheet data as at December 31, 2017, 2016 and 2015. (in thousands of dollars, except with respect to earnings (loss) per share) Three months ended December 31 2016 2017 Years ended December 31 2017 2016 2015 $ 4,798 9,795 14,593 3,322 4,660 2,239 792 2,859 13,872 721 (2) (379) - 340 15 355 (63,498) (63,143) 0.02 0.02 14,223 14,223 18,961 36,431 55,392 14,103 19,088 13,574 3,052 11,272 61,088 (5,696) 50 (1,698) 50 (7,294) 18,296 40,790 59,086 13,477 21,195 10,845 3,529 11,796 60,842 (1,756) 16 (1,882) 8 (3,614) 13,166 44,554 57,720 13,159 20,587 10,062 3,697 11,400 58,905 (1,185) (171) (2,624) 37 (3,943) - (700) 1,133 $ $ $ $ (7,294) (63,143) (70,437) (0.51) (0.51) (4,314) (58,829) (63,143) (0.23) (0.23) (2,810) (56,019) (58,829) (0.34) (0.34) 14,307 12,252 11,588 14,307 12,252 11,588 As at December 31 2016 13,034 3,673 3,150 44,161 102,837 11,027 40,778 1,567 48,648 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 2015 13,066 3,306 3,351 48,520 110,002 9,128 45,781 2,163 52,215 Revenue Cloud and colocation revenue Connectivity revenue Total Revenue Expenses Cost of services Salaries and related costs Other operating expenses Amortization of intangible assets Depreciation of network assets, property and equipment Earnings (loss) from operations Foreign exchange loss Finance costs Finance income Earnings (loss) before income taxes Income taxes Income tax recovery (expense) Net earnings (loss) and comprehensive earnings (loss) Deficit, beginning of year Deficit, end of year Basic earnings (loss) per share Diluted earnings (loss) per share Basic weighted average number of shares outstanding Diluted weighted average number of shares outstanding Selected Balance Sheet Data Cash and cash equivalents Accounts receivable Prepaid expenses and other assets Network assets, property and equipment Total Assets Accounts payable and accrued liabilities Long-term debt Other long-term liabilities Shareholders' equity $ $ $ $ $ $ $ $ $ $ $ $ $ $ 4,727 8,816 13,543 3,544 4,495 5,583 745 2,746 17,113 (3,570) 15 (523) 17 (4,062) - (4,061) (66,376) (70,437) (0.28) (0.28) 14,335 14,335 2017 6,986 3,389 2,516 38,822 87,858 8,519 36,183 475 41,917 11 RESULTS OF OPERATIONS Comparison of the three months and year ended December 31, 2017 and 2016 (in thousands of dollars, except with respect to gross profit margin, earnings per share, Backlog MRR, and ARPU) Financial Cloud and Colocation Revenue Connectivity Revenue Total Revenue Cost of Services(1) Gross profit margin (1) Adjusted EBITDA(1) (2) Income tax recovery (expense) Net Income (Loss) Basic loss per share Diluted loss per share Operating Backlog MRR(1) Connectivity Cloud & Colocation Churn Rate(1) Connectivity Cloud & Colocation ARPU(1) Connectivity Cloud & Colocation $ $ $ $ $ $ $ $ $ $ $ $ $ Three months ended December 31 2016 Years ended December 31 2016 2017 $ $ $ $ $ $ $ $ $ $ $ 4,798 9,795 14,593 3,322 77.2% 4,889 15 355 0.02 0.02 73,923 20,223 1.7% 1.7% $ $ $ $ $ $ $ $ $ $ $ 18,961 36,432 55,392 14,103 74.5% 12,864 - (7,294) (0.51) (0.51) 84,191 291,698 1.6% 1.6% 18,296 40,790 59,086 13,477 77.2% 18,941 (700) (4,314) (0.30) (0.30) 73,923 20,223 1.4% 1.5% 2017 4,727 8,816 13,543 3,544 73.8% 2,937 - (4,061) (0.28) (0.28) 84,191 291,698 1.6% 1.4% $ $ $ $ $ $ $ $ $ $ $ 996 3,027 $ $ 963 3,113 $ $ 980 3,106 $ $ 961 3,039 (1) See "Definitions – Key Performance Indicators, IFRS, Additional GAAP and Non-GAAP Measures” (2) See “Adjusted EBITDA” for a reconciliation of net loss to Adjusted EBITDA Refer to “Definitions – Key Performance Indicators, IFRS, Additional GAAP and Non-GAAP Measures” for a description of the components of relevant line items below. Revenue Total revenue decreased 7.2% to $13.5 million for the three months ended December 31, 2017 compared to $14.6 million for the same period in 2016. Total revenue decreased 6.3% to $55.4 million for the year ended December 31, 2017, compared to $59.1 million for the same period in 2016. Cloud and Colocation Revenue For the three months ended December 31, 2017, cloud and colocation revenue decreased 1.5% to $4.7 million compared to $4.8 million for the same period in 2016. The decrease was driven by churn impacts throughout the year. For the year ended December 31, 2017, cloud and colocation revenue increased 3.6% to $19.0 million compared to $18.3 million for the same period in 2016. The increase was driven by greater provisioning of cloud and colocation services to new and existing customers. Connectivity Revenue For the three months ended December 31, 2017, connectivity revenue decreased 10.0% to $8.8 million compared to $9.8 million for the same period in 2016. Connectivity revenues were impacted by a variety of factors, including churn, certain customers renewing long term contracts at lower current market rates, and lower usage revenues as certain customers have shifted to unlimited usage plans. For the year ended December 31, 2017, connectivity revenue decreased 10.7% to $36.4 million compared to $40.1 million for the same period in 2016. The decrease was driven by the factors described above. 12 Cost of services For the three months ended December 31, 2017, cost of services increased 6.7% to $3.5 million compared to $3.3 million for the same period in 2016. The increase was primarily driven by higher third party network costs, higher software costs related to the growth in cloud revenue, and higher data centre costs, partially offset with savings from fewer property access leases. For the year ended December 31, 2017, cost of services increased 4.6% to $14.1 million compared to $13.5 million for the same period in 2016. The increase was driven by the factors described above. Salaries and related costs and other operating expenses (“SG&A”) For the three months ended December 31, 2017, SG&A increased 46.1% to $10.1 million compared to $6.9 million for the same period in 2016. The increase was primarily driven by an impairment charge recognized to adjust the carrying value of assets to their recoverable amount. In addition, the Company incurred higher personnel costs, higher data centre rent, higher marketing costs, increased stock based compensation, and higher software license costs, partially offset by lower restructuring, acquisition-related and integration costs, an increase in proportion of capital labour activities, and lower billing related charges. For the year ended December 31, 2017, SG&A increased 1.9% to $32.7 million compared to $32.0 million for the same period in 2016. The increase was driven primarily by the impairment charge discussed above. In addition, the Company had higher data centre rent, salary and consultancy fees to support strategic initiatives, marketing costs, and recruiting fees for key management personnel, partially offset by decreased restructuring, acquisition-related and integration costs, an increase in proportion of capital labour, lower stock-based compensation related to executive-level headcount departures, and stronger network inventory management. Net loss For the three months ended December 31, 2017, net loss was $4.1 million compared to a net income of $0.4 million for the same period in 2016. The increase in net loss was primarily driven by the impairment charge on certain network assets, property and equipment and intangible assets to adjust the carrying amount to their recoverable amount. In addition, the Company saw a decrease in revenue, increase in cost of services, increase in other operating costs, increase in finance costs, and an increase in stock based compensation, partially offset by lower restructuring and related costs, as well as lower depreciation and amortization. For the year ended December 31, 2017, net loss was $7.3 million compared to a net loss of $4.3 million for the same period in 2016. The increase in net loss was driven by the factors described above. Adjusted EBITDA(1) For the three months ended December 31, 2017, Adjusted EBITDA(1) decreased 39.9% to $2.9 million for the three months ended December 31, 2017 compared to $4.9 million for the same period in 2016. The decrease was primarily driven by the reduction of connectivity revenue, higher third party costs, higher real estate fees, higher software license costs, higher salary and related costs to support strategic initiatives, and increases in other operating expenses. The increase in costs is primarily a result of the Company benefiting from several non-recurring recoveries in 2016 for which it did not see a similar benefit in 2017. For the year ended December 31, 2017, Adjusted EBITDA(1) decreased 32.1% to $12.9 million compared to $18.9 million for the same period in 2016. The decrease in Adjusted was driven by the factors above, partially offset by higher cloud & colocation revenue. 13 The table below reconciles net loss to Adjusted EBITDA(1) for the three months and year ended December 31, 2017 and 2016. (in thousands of dollars) Three months ended December 31 Year ended December 31 Net earnings (loss) for the period $ (4,061) $ 355 $ (7,294) $ 2017 2016 2017 Foreign exchange loss (gain) Finance costs Finance income Income tax (recovery) expense Earnings (loss) from operations Add: Depreciation of network assets, property and equipment and amortization of intangible assets Loss on disposal of network assets Impairment of Assets and Related Charges Stock-based Compensation Expense Restructuring, acquisition-related, integration costs and other Adjusted EBITDA(1) $ (15) 523 (17) - (3,570) 3,492 15 2,851 156 (7) 2,937 2 379 - (15) 721 3,651 85 - 16 (50) 1,698 (50) - 14,324 109 2,851 201 (5,696) (1,756) 2016 (4,314) (16) 1,882 (8) 700 15,325 397 - 866 4,109 18,941 $ $ 416 4,889 $ $ 1,075 12,864 $ $ (1) See "Definitions – Key Performance Indicators, IFRS, Additional GAAP and Non-GAAP Measures” Backlog MRR Cloud and colocation backlog MRR was $291,698 as at December 31, 2017 compared to $20,223 as at December 31, 2016. The increase is driven by growth in Cloud and Colocation sales bookings in the second half of 2017 with provisioning scheduled into 2018. Connectivity backlog MRR was $84,191 as at December 31, 2017, compared to $73,923 as at December 31, 2016. The change in backlog MRR is driven primarily by the timing of customer provisioning. ARPU Cloud and colocation ARPU was $3,027 and $3,106, respectively, for the three and twelve months ended December 31, 2017 compared to $3,113 and $3,039 for the same periods in 2016. ARPU remained relatively flat in the period, with recent large new customer colocation contracts scheduled to be provisioned in the first half of 2018. Connectivity ARPU was $996 and $980, respectively, for the three and twelve months ended December 31, 2017 compared to $963 and $961 for the same periods in 2016. The increase is driven by the churn of low ARPU customers, and the Company's focus on acquiring mid-market customers. Churn Cloud and colocation churn was 1.4% and 1.6%, respectively, for the three and twelve months ended December 31, 2017 compared to 1.7% and 1.5% for the same period in 2016. While the rate of churn will fluctuate based on the timing of contract renewals and product lifecycles, the Company's investments in developing a robust customer experience framework are expected to positively impact churn rates moving forward. Connectivity churn was 1.6% and 1.6%, respectively, for the three and twelve months ended December 31, 2017 compared to 1.7% and 1.4% for the same period in 2016. The Company continues to focus on servicing and retaining mid-market customers with churn expected to continue from lower ARPU customers due to competition at the low end of the market. Finance costs For the three months ended December 31, 2017, finance costs increased 38.0% to $0.52 million compared to $0.38 million for the same period in 2016. The increase was a result of a favourable revaluation of the Company’s interest rate swap contract in the prior year in addition to unfavourable valuation impacts of the Company’s asset retirement obligation in the current year. For the year ended December 31, 2017, finance costs decreased 9.8% to $1.7 million compared to $1.9 million for the same period in 2016. The decrease in both periods was primarily driven by lower interest expense on the Company’s term facility. 14 Income tax expense The income tax expense in the 2016 periods was from a reduction in the carrying value of the deferred income tax asset. No such charge or recovery was recorded in 2017. Depreciation and amortization For the three months ended December 31, 2017, depreciation of network assets, property and equipment and amortization of intangibles decreased 4.4% to $3.5 million compared to $3.7 million for the same period in 2016. The decrease is mainly attributed to certain intangible assets reaching zero net book value after the three months ended December 31, 2016. For the year ended December 31, 2017, depreciation of network assets, property and equipment and amortization of intangibles decreased 6.5% to $14.3 million compared to $15.3 million for the same period in 2016. The decrease was driven by the factors described above. Summary of Quarterly Results All financial results are in thousands, with the exception of earnings per share, Backlog MRR, and ARPU Revenue Gross Profit Margin % (1) Adjusted EBITDA (1) Net income/(loss) Basic income/(loss) per share Diluted income/(loss) per share Basic weighted average number of shares outstanding Diluted weighted average number of shares outstanding Operating Backlog MRR(1) Connectivity Cloud & Colocation Churn Rate(1) Connectivity Cloud & Colocation ARPU(1) Connectivity Cloud & Colocation $ $ $ $ $ $ $ $ $ Q4-17 Q3-17 Q2-17 Q1-17 Q4-16 Q3-16 Q2-16 Q1-16 13,543 73.8% 2,937 (4,061) (0.28) 13,680 74.3% 3,213 (1,047) (0.07) 13,892 74.3% 3,003 (1,131) (0.08) 14,277 75.6% 3,711 (1,055) (0.07) 14,593 77.2% 4,889 355 0.02 14,780 77.5% 4,481 (3,454) (0.24) 14,784 77.3% 4,895 (395) (0.03) 14,929 76.8% 4,676 (820) (0.06) (0.28) (0.07) (0.08) (0.07) 0.02 (0.24) (0.03) (0.06) 14,335 14.334 14,283 14,258 14,223 14,190 14,159 14,135 14,335 14.334 14,283 14,258 14,230 14,190 14,159 14,135 84,191 291,698 98,345 134,283 76,254 39,977 69,518 33,962 73,923 20,223 1.6% 1.4% 996 3,027 1.5% 1.5% 984 3,112 1.7% 2.2% 972 3,124 1.7% 1.2% 968 3,160 1.7% 1.7% 963 3,113 69,455 46,612 1.3% 0.8% 962 2,995 n/a(2) n/a(2) 1.1% 1.3% 960 2,998 n/a(2) n/a(2) 1.3% 2.1% 959 3,050 (1) See "Definitions – Key Performance Indicators, IFRS, Additional GAAP and Non-GAAP Measures" (2) Information was tracked Q3 2016 and onwards Seasonality The Company’s net customer growth, with respect to its connectivity business, is typically impacted adversely by weather conditions as the majority of new customer locations require the installation of rooftop equipment. Typically, harsher weather in the first quarter of the year results in a reduction of productive installation days. In addition, certain customers using our cloud services may have higher usage during certain times of the year based on the seasonality of their respective businesses. The Company’s cash flow and earnings are typically impacted in the first quarter of the year due to several annual agreements requiring payments in the first quarter including annual rate increases in long-term contracts and the restart on January 1st of payroll taxes and other levies related to employee compensation. LIQUIDITY AND CAPITAL RESOURCES TeraGo has historically financed its growth and operations through cash generated by operations, the issuance of equity securities and long-term debt. 15 The table below is a summary of cash inflows and outflows by activity. (in thousands of dollars) Statement of Cash Flows Summary Cash inflows and (outflows) by activity: Operating activities Investing activities Financing activities Net cash inflows (outflows) $ Cash and cash equivalents, beginning of period Cash and cash equivalents, end of period $ Three months ended December 31 Year ended December 31 2017 2016 2017 2016 4,459 (3,201) (1,398) (140) 7,126 6,986 5,067 $ (2,312) (1,614) 1,141 11,893 13,034 $ 10,362 (10,294) (6,116) (6,048) 13,034 6,986 16,358 (9,565) (6,825) (32) 13,066 13,034 Operating Activities For the three months ended December 31, 2017, cash generated from operating activities was $4.5 million compared to cash generated of $5.1 million for the same period in 2016. The decrease in cash from operating activities is mainly due to the decrease in revenues partially offset by favourable changes in working capital. For the year ended December 31, 2017, cash generated from operating activities was $10.4 million compared to cash generated of $16.4 million for the same period in 2016. The decrease was driven by the factors described above in addition to higher severances and stock based compensation costs paid in 2017. Investing Activities For the three months ended December 31, 2017, cash used in investing activities was $3.2 million compared to cash used of $2.3 million for the same period in 2016. The increase in cash used in investing activities was due to increased capital expenditures partially offset by favourable timing of payments for network assets, property and equipment and intangible assets. For the year ended December 31, 2017, cash used in investing activities was $10.3 million compared to cash used of $9.6 million for the same period in 2016. The increase in cash used in investing activities was mainly due to increased capital expenditures and unfavourable timing of payments for network assets, property and equipment and intangible asset. Financing Activities For the three months ended December 31, 2017, cash used in financing activities was $1.4 million compared to cash used of $1.6 million for the same period in 2016. For the year ended December 31, 2017, cash used in financing activities was $6.1 million compared to $6.8 million for the same period in 2016. The decrease in cash used in financing activities is mainly due to a reduction of the Company’s interest expense and a reduction of principal repayments required under the amended credit facilities, partially offset by financing fees related to the amended credit facilities. Capital Resources As at December 31, 2017, the Company had cash and cash equivalents of $7.0 million and access to approximately $35.0 million undrawn portion of its $75 million credit facilities, subject to the terms and conditions of the credit facilities. The Company anticipates incurring additional capital expenditures for the purchase and installation of network, colocation and cloud assets and customer premise equipment. As economic conditions warrant, the Company may expand its network coverage into new Canadian markets and making additional investments in colocation, cloud and other IT services through acquisitions or expansion. Management believes the Company’s current cash, anticipated cash from operations, access to the undrawn portion of debt facilities and its access to additional financing in the form of debt or equity will be sufficient to meet its working capital and capital expenditure requirements for the foreseeable future. Term Debt Facility In June 2014, the Company entered into an agreement with a syndicate led by the National Bank of Canada (“NBC”) to provide a $50.0 million credit facility that is principally secured by a general security agreement over the Company’s assets. 16 In March 2015, the Company entered into an amended agreement with the Lenders that increases the credit facility by $35.0 million ($30.0 million increase to the term debt facility and $5.0 million increase to the revolving facility) and extended the term from June 6, 2017 to June 30, 2018. Other terms are substantially consistent with the existing credit facilities. In June 2017, the Company entered into a second amended agreement with the Lenders that reduced the term debt facility from $50.0 million to $40.0 million (as a result of principal previously repaid), reduced the quarterly principal installment from $1.25 million to $1.0 million and extended the term from June 30, 2018 to June 14, 2021. Other terms were substantially consistent with the existing credit facilities. The total $75.0 million facility that matures June 14, 2021 is made up of the following: • • $10.0 million revolving facility which bears interest at prime plus a margin percent. As of December 31, 2017, $nil amount is outstanding. Letters of credit issued under the facility totaled $0.7 million as of December 31, 2017. $40.0 million term facility which bears interest at prime or Banker’s Acceptance (at the Company’s option) plus a margin percent and is repayable in quarterly principal installments of $1.0 million. This facility was fully drawn upon signing the second amended agreement. On December 31, 2017, $36.8 million of the term facility principal was in a Banker’s Acceptance and the remaining $0.2 million was at a floating rate. In 2015, the Company entered into amended interest rate swap contracts that matures June 29, 2018. The interest rate on the Banker’s Acceptance at December 31, 2017 was 3.99%. The interest rate swap contract has not been designated as a hedge and will be marked-to-market each quarter. The fair value of the interest rate swap contract at December 31, 2017 was an asset of $0.03 million (December 31, 2016 liability of $0.3 million) and is recorded in other long-term assets/liabilities, with a corresponding charge (recovery) for the change in fair value recorded in finance costs. As at December 31, 2017, the Company prepaid interest in the amount of $0.4 million which represents the net settlement of the Banker’s Acceptance and is recorded as a reduction in the carrying value of the debt. • $25.0 million available for funding acquisitions and will bear interest at prime or Banker’s Acceptance (at the Company’s option) plus a margin percent and is repayable in quarterly principal installments of 2.5% of the aggregate amount outstanding. As of December 31, 2017, this facility remains undrawn. In connection with the second amended agreement, the Company incurred financing fees of $0.29 million, which have been deferred and will be amortized using the effective interest method over the amended term of the facility. The balance of previously incurred financing fee is also amortized over the same amended term. The NBC facility is subject to certain financial and non-financial covenants which the Company is in compliance with at December 31, 2017. Under this facility, the Company is subject to a cash flow sweep that could accelerate a certain amount of principal repayment based on a calculation outlined by the credit agreement not later than 120 days after the end of each fiscal year. Equity Offering On June 11, 2015, the Company completed an equity offering to issue and sell 1,755 common shares for gross proceeds of $10,004 (the “Offering”). Proceeds net of commissions, legal, accounting and listing fees were $9,210. The Offering was carried out pursuant to an underwriting agreement with a syndicate of underwriters led by National Bank Financial Inc. and TD Securities Inc. and included Cormark Securities Inc., PI Financial Corp. and RBC Capital Markets. The Company allocated $9,210 of the intended use of net proceeds from the equity offering as follows: Intended Use of Net Proceeds a) Fund its continued growth strategy, which is expected Allocation $4.0 million Use of Net Proceeds as at December 31, 2017 $3.6 million to include potential strategic acquisitions b) Fund operational efficiency initiatives c) Invest in new product development activities, specifically in the cloud and data centre segments $3.2 million $2.0 million $1.7 million $1.1 million As of December 31, 2017, $6.4 million of the net proceeds from the equity offering were used. The Company’s intended use of these proceeds has not changed. 17 Contractual Obligations The Company is committed to leases for premises, office equipment, network real estate access, automobiles, telecommunication facilities and radio spectrum licenses. Annual minimum payments over the next five years and thereafter are as follows: 2018 2019 2020 2021 2022 Thereafter Amount 9,932 8,010 6,175 5,035 3,664 15,316 48,132 $ $ Off-balance Sheet Arrangements As of December 31, 2017, the Company had no off-balance sheet arrangements apart from operating leases noted above. Transactions with Related Parties Two former Directors of the Company, who retired effective June 23, 2016, also served as Chairman of the Board and a Director of a customer of the Company. Revenue from this customer for the year ended December 31, 2017 was $nil and $40 thousand. Accounts receivable from this customer as at December 31, 2017 was $nil (2016 - $nil). The terms governing these related party transactions are consistent with those negotiated on an arm’s length basis with non-related parties. Share Capital TeraGo’s authorized share capital consists of an unlimited number of Common Shares, an unlimited number of Class A Non-Voting Shares and two Class B Shares. A detailed description of the rights, privileges, restrictions and conditions attached to the authorized shares is included in the Company’s 2016 Annual Information Form, a copy of which can be found on SEDAR at www.sedar.com. As of February 21, 2018, there were 14,399 Common Shares issued and outstanding and two Class B Shares issued and outstanding. In addition, as of February 21, 2018, there were 97 Common Shares issuable upon exercise of TeraGo stock options. Financial Instruments The Company initially measures financial instruments at fair value. Transaction costs that are directly attributable to the issuance of financial assets or liabilities are accounted for as part of the carrying value at inception (except for transaction costs related to financial instruments recorded as FVTPL financial assets which are expensed as incurred), and are recognized over the term of the assets or liabilities using the effective interest method. Subsequent measurement and treatment of any gain or loss is recorded as follows: (i) (ii) (iii) Financial assets and financial liabilities at FVTPL are measured at fair value at the balance sheet date with any gain or loss recognized immediately in net loss. Interest and dividends earned from financial assets are also included in net loss for the period. Loans and receivables are measured at amortized cost using the effective interest method. Any gains or losses are recognized in net loss for the period. Other financial liabilities are measured at amortized cost using the effective interest method. Any gains or losses are recognized in net loss for the period. The following is a summary of the Company’s significant categories of financial instruments as at December 31, 2017: Impairment of Financial Assets A financial asset carried at amortized cost is considered impaired if objective evidence indicates that one or more events have had a negative effect on the estimated future cash flow of that asset that can be estimated reliably. An 18 impairment loss is calculated as the difference between its carrying amount and the present value of the estimated future cash flows discounted at the asset's original effective interest rate. In assessing impairment, the Company uses historical trends of the probability of default, timing of recoveries and the amount of loss incurred, adjusted for management's judgment as to whether current economic and credit conditions are such that the actual losses are likely to be greater or less than suggested by historical trends. Losses are recognized in the consolidated statements of loss and reflected in an allowance account against the financial asset. Loans and receivables Loans and receivables are financial assets with fixed or determinable payments that are not quoted in an active market. Such assets currently are comprised of cash and cash equivalents, accounts receivable and restricted cash. (i) (ii) Cash and Cash Equivalents and restricted cash Cash and cash equivalents consists of bank balances, cash on hand, demand deposits that can be withdrawn without penalty and short-term, highly liquid securities such as debt securities with an initial maturity date of not more than three months from the date of acquisition, that can readily be converted into known amounts of cash and are subject to an insignificant risk of change in value. Bank overdrafts that are repayable upon demand and form an integral part of the Company’s cash management are included as a component of cash and cash equivalents. Cash and cash equivalents and restricted cash are carried at amortized cost. Accounts Receivable Accounts receivable are measured at the amount the item is initially recognized. The allowance for doubtful accounts is based on the Company’s assessment of the collectability of outstanding trade receivables. The evaluation of collectability of customer accounts is done on an individual account If, based on an evaluation of accounts, it is concluded that it is probable that a customer will basis. not be able to pay all amounts due, an expected impairment loss is recognized. Recoveries are only recorded when objective verifiable evidence supports the change in the original allowance. Changes in the carrying amount of the allowance account are recognized in the statement of comprehensive loss for the period. Other financial liabilities The Company recognizes debt securities issues and subordinated liabilities on the date that they originated. All other financial liabilities are recognized initially on the date that the Company becomes a party to the contractual provisions. The Company has the following non-derivative financial liabilities: current and long-term debt, accounts payable and accrued liabilities, and current portion and long-term portion of other long term liabilities. Such liabilities are recognized initially at fair value less any directly attributable transaction costs. Subsequent to initial recognition these financial liabilities are measured at amortized cost using the effective interest method. Interest on loans and borrowings is expensed as incurred unless capitalized for qualifying assets in accordance with IAS 23, Borrowing Costs. Loans and borrowings are classified as a current liability unless the Company has an unconditional right to defer settlement for at least 12 months after the end of the year. Derivative instruments The Company uses an interest rate swap contract to manage the risk associated with the fluctuations of interest rates on its long-term debt. Management does not apply hedge accounting on the interest rate swap contract. As a result, the interest rate swap contract is marked to market each period, resulting in a gain or loss in net loss for the year. Financial Instrument Risks Fair value of financial instruments The Company has determined the estimated fair values of its financial instruments based on appropriate valuation methodologies. Where quoted market values are not readily available, the Company may use considerable judgment to develop estimates of fair value. Accordingly, any estimated values are not necessarily indicative of the amounts the Company could realize in a current market exchange and could be materially affected by the use of different assumptions or methodologies. The Company classifies its fair value measurements within a fair value hierarchy, 19 which reflects the significance of the inputs used in making the measurements as defined in IFRS 7 – Financial Instruments – Disclosures. Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities; Level 2 - Inputs other than quoted prices included in Level 1, that are observable for the asset or liability, either directly or indirectly; and Level 3 - Unobservable inputs for the asset or liability which are supported by little or no market activity The fair values of cash and cash equivalents, short-term investments and restricted cash, which are primarily money market and fixed income securities, are based on quoted market values. The fair values of short-term financial assets and liabilities, including accounts receivable, accounts payable and accrued liabilities, as presented in the consolidated statements of financial position, approximate their carrying amounts due to their short-term maturities. The fair value of long-term debt approximates its carrying value because management believes the interest rates approximate the market interest rate for similar debt with similar security. The fair value of our interest rate swap contract is based on broker quotes and therefore, these contracts are measured using Level 2 inputs. Similar contracts are traded in an active market and the quotes reflect the actual transactions in similar instruments. Credit risk The Company’s cash and cash equivalents and restricted cash subject the Company to credit risk. The Company maintains cash and investment balances at Tier 1 Canadian financial institutions. The Company’s maximum exposure to credit risk is limited to the amount of cash and cash equivalents. Credit risk related to our interest rate swap contract arises from the possibility that the counter party to the agreement may default on their obligation. The Company assesses the creditworthiness of the counterparty to minimize the risk of counterparty default. The interest rate swap is held by National Bank Financial. The Company, in the normal course of business, is exposed to credit risk from its customers and the accounts receivable are subject to normal industry risks. The Company attempts to manage these risks by dealing with credit worthy customers. If available, the Company reviews credit bureau ratings, bank accounts and industry references for all new customers. Customers that do not have this information available are typically placed on a pre-authorized payment plan for service or provide deposits to the Company. This risk is minimized as the Company has a diverse customer base located across various provinces in Canada. As at December 31, 2017 and 2016, the Company had no material past due trade accounts receivable. Interest rate risk The Company is subject to interest rate risk on its cash and cash equivalents and long-term debt. The Company is exposed to interest rate risk on its operating line of credit since the interest rates applicable are variable and is, therefore, exposed to cash flow risks resulting from interest rate fluctuations. As at December 31, 2017, the operating line of credit balance was $nil. The drawn term facility as at December 31, 2017 was $37.0 million, $36.8 million of which was held in a Bankers Acceptance. In 2015, the Company entered into amended interest rate swap contracts that matures June 29, 2018. The interest rate on the Banker’s Acceptance at December 31, 2017 was 3.99%. The remaining $200 thousand drawn under this facility bears interest for the period at prime rate plus a margin. Liquidity risk The Company believes that its current cash and cash equivalents and anticipated cash from operations will be sufficient to meet its working capital and capital expenditure requirements for the foreseeable future. As at December 31, 2017, the Company had cash and cash equivalents of $7.0 million. The Company has access to the $34.3 million undrawn portion of its $75 million credit facilities after consideration of outstanding letters of credit, subject to certain financial and non-financial covenants. SIGNIFICANT ACCOUNTING ESTIMATES The preparation of financial statements in conformity with IFRS requires management to make judgments, estimates and assumptions that affect the application of accounting policies and the reported amounts of assets, liabilities, income and expenses. Actual results may differ from these estimates. Estimates and assumptions are reviewed on an ongoing 20 basis. Revisions to accounting estimates are recognized in the period in which the estimates are revised and in any future periods affected. Key areas of estimation and information about critical judgments in applying accounting policies that have the most significant effect on amounts recognized in the consolidated financial statements are: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) Estimates of useful lives of network assets, property and equipment and intangible assets: Management's judgment involves consideration of intended use, industry trends and other factors in determining the expected useful lives of depreciable assets, to determine depreciation methods, the asset's residual value and whether an asset is a qualifying asset for the purposes of capitalizing borrowing costs. Capitalization of costs: Judgments and estimates are used in assessing the direct labour and other costs capitalized to network assets, property and equipment. Cash generating units: Judgment is required to assess the Company’s determination of cash generating units for the purpose of impairment testing. Impairment of non-financial assets: The process to calculate the recoverable amount of our cash generating unit requires use of valuation methods such as the discounted cash flow method which uses assumptions of key variables including future cash flows, discount rate and terminal growth rates. Allowance for doubtful accounts: In developing the estimates for an allowance against existing receivables, the Company considers general and industry economic and market conditions as well as credit information available for the customer and the aging of the account. Changes in the carrying amount due to changes in economic and market conditions could significantly affect the loss for the period. Stock-based compensation: Estimating fair value for stock-based payments requires determining the most appropriate valuation model for a grant, which is dependent on the terms and conditions of the grant. In valuing stock options, the Company uses the Black-Scholes option pricing model. Several assumptions are used in the underlying calculation of fair values of the Company's stock options using the Black-Scholes option pricing model including the expected life of the option, risk-free interest rate and volatility of the underlying stock. Business combination: The amount of goodwill initially recognized as a result of a business combination, the fair value estimate of any contingent consideration and the determination of the fair value of the identifiable assets acquired and the liabilities assumed is based, to a considerable extent, on management's estimate of future cash flows expected to be derived from the assets acquired. Income taxes: A deferred tax asset tax credits and deductible temporary differences to the extent that it is probable that future taxable income will be available against which they can be utilized. Significant estimates are required in evaluating the recoverability of deferred tax assets. The Company’s assessment is based on existing tax laws, estimates of future profitability and tax planning strategies. is recognized for unused losses, Provisions: Judgment is required to assess the likelihood of an outflow of the economic benefits to settle contingencies, such as litigations or decommissioning and restoration obligations, which may require a liability to be recognized. Significant judgments include assessing estimates of future cash flows, selection of discount rates and the probability of the occurrence of future events. 21 RISK FACTORS TeraGo is exposed to a number of risks and uncertainties that are common to other companies engaged in the same or similar businesses. The following is a summary of the material risks that could significantly affect the financial condition, operating results or business of TeraGo. Revenues and Operating Results Can Fluctuate Our revenue in past periods may not be indicative of future performance from quarter to quarter or year to year. In addition, our operating results may not follow any past trends. The factors affecting our revenue and results, many of which are outside of our control, include: • competitive conditions in the industry, including strategic initiatives by us or our competitors, new services, service announcements and changes in pricing policy by us or our competitors; • market acceptance of our services; • • timing and contractual terms of orders for our services, which may delay the recognition of revenue; the discretionary nature of purchase and budget cycles of our customers and changes in their budgets for, and timing of, services orders; strategic decisions by us or our competitors, such as acquisitions, divestitures, spin-offs, joint ventures, strategic investments or changes in business strategy; general weakening of the economy resulting in a decrease in the overall demand for telecommunications, data centre, cloud or IT services or otherwise affecting the capital investment levels of medium-sized and enterprise businesses; timing of the development of new service offerings; no assurance that the Company’s current and future competitors will not be able to develop data centre or cloud services or other infrastructure expertise comparable or superior to those developed by the Company or to adapt more quickly than the Company to new technologies, evolving industry standards or customer requirements; seasonal factors which may cause certain cloud service customers to increase or decrease their usage based services • • • • • Transition of the Company to a Multi-Product IT Services Company In the past, the core business of the Company was to provide internet access services. The Company has recently transitioned to a multi-product IT services company focused on the management of its customer’s data flow. In doing so, TeraGo is offering colocation services through its data centres and is offering cloud storage and cloud services. If TeraGo is unable to execute on its new business strategy and to grow the business, either as a result of the risks identified in this section or for any other reason, the business, prospects, financial condition and results of operations will be materially and adversely affected. Reliance on Certain Third Parties We rely on third-party suppliers, in some cases sole suppliers or limited groups of suppliers, to provide us with components necessary for the operation and upgrading of our network and infrastructure. If we are unable to obtain sufficient allocations of components, our network expansion will be delayed, we may lose customers and our profitability will be affected. Reliance on suppliers also reduces our control over costs, delivery schedules, reliability and quality of components. Any inability to obtain timely deliveries of quality components, or any other circumstances that would require us to seek alternative suppliers, could adversely affect our ability to expand and maintain our network or infrastructure. In addition, the Company relies on third party partners, agents and resellers to carry out its business. If these third parties do not honour their contractual commitments or cease to do business, it may have a significant impact on our business. Replacements for such third parties may require a lengthy period of time in order to establish a commercially comparable relationship. The Company has recently aligned with AWS in preparation to provide managed public cloud services. During the most recent year, TeraGo attained the Standard Partner tier in the AWS Partner Program. The benefits of such partnership has not yet been proven and an early termination of the partnership or any unanticipated setbacks may have a material impact on the Company’s business and strategic plan. Regulatory Environment We are subject to the laws of Canada and to regulations set by regulatory authorities of the Canadian government, primarily the CRTC and Innovation, Science, Economic Development Canada (“ISED”, formerly Industry Canada). Regulatory authorities may adopt new laws, policies or regulations, or change their interpretation of existing laws, 22 policies or regulations, that could cause our existing authorizations to be changed or cancelled, require us to incur additional costs, or otherwise adversely affect our operations, revenue or cost of capital. Any currently held regulatory approvals or licences may be subject to rescission and non-renewal. Additional approvals or licences may be necessary that we may not be able to obtain on a timely basis or on terms that are not unduly burdensome. Further, if we fail to obtain or maintain particular approvals on acceptable terms, such failure could delay or prevent us from continuing to offer some or all of our current or new services, or offer new services, and adversely affect our results of operations, business prospects and financial condition. Even if we were able to obtain the necessary approvals, the licences or other approvals we obtain may impose significant operational restrictions. The acquisition, lease, maintenance and use of spectrum are extensively regulated in Canada. These regulations and their application are subject to continual change as new legislation, regulations or amendments to existing regulations are adopted from time to time by governmental or regulatory authorities, including as a result of judicial interpretations of such laws and regulations. Current regulations directly affect the breadth of services we are able to offer and may impact the rates, terms and conditions of our services. The breach of the conditions of a licence or applicable law, even if inadvertent, can result in the revocation, suspension, cancellation or reduction in the term of a licence or the imposition of fines. In addition, regulatory authorities may grant new licences to third parties, resulting in greater competition in markets where we already have rights to licenced spectrum. In order to promote competition, licences may also require that third parties be granted access to our bandwidth, frequency capacity, facilities or services. We may not be able to obtain or retain any required licence, and we may not be able to renew our licences on favourable terms, or at all. Our internet access services may become subject to greater regulation in the future. If we become subject to proceedings before the CRTC or ISED with respect to our compliance with the relevant legislation and regulations relating to restrictions on foreign ownership and control, we could be materially adversely affected, even if it were ultimately successful in such a proceeding. There can be no assurance that a future CRTC or ISED determination or events beyond our control will not result in our ceasing to comply with the relevant legislation or regulations. If this occurs, our ability to operate as a Canadian carrier under the Telecommunications Act or to hold, renew or secure licences under the Radio Communication Act could be jeopardized and our business, operating results and financial condition could be materially adversely affected. Obtaining and Maintaining Licenced Spectrum in Certain Markets To offer our internet services using licenced spectrum in Canada, we depend on our ability to acquire and maintain sufficient rights to use spectrum through ownership or long-term leases in each of the markets in which we operate or intend to operate. Obtaining the necessary amount of licenced spectrum can be a long and difficult process that can be costly and require a disproportionate amount of our resources. We may not be able to acquire, lease or maintain the spectrum necessary to execute our business strategy. In addition, we may spend significant resources to acquire spectrum licences, even if the amount of spectrum actually acquired in certain markets is not adequate to deploy our network on a commercial basis in all such markets. Using licenced spectrum, whether owned or leased, poses additional risks to us, including: • • • • • • • • • • inability to satisfy build-out or service deployment or research and development requirements upon which our spectrum licences or leases are, or may be, conditioned; adverse changes to regulations or licence conditions governing our spectrum rights; inability to use the spectrum we have acquired or leased due to interference from licenced or licence-exempt operators in our band or in adjacent bands; refusal by ISED to recognize our acquisition or lease of spectrum licences from others or our investments in other licence holders; inability to offer new services or to expand existing services to take advantage of new capabilities of our network resulting from advancements in technology due to regulations governing our spectrum rights; inability to control leased spectrum due to contractual disputes with, or the bankruptcy or other reorganization of, the licence holders; failure of ISED to renew our spectrum licences as they expire and our failure to obtain extensions or renewals of spectrum leases before they expire; imposition by ISED of new or amended conditions of licence, or licence fees, upon the renewal of our spectrum licences or in other circumstances; potentially significant increases in spectrum prices, because of increased competition for the limited supply of licenced spectrum in Canada; and invalidation of our authorization to use all or a significant portion of our spectrum, resulting in, among other things, impairment charges related to assets recorded for such spectrum. 23 In particular, in June 2017, ISED issued the Consultation on Releasing Millimetre Wave Spectrum to Support 5G. This Consultation contemplates the future use of certain millimetre wave spectrum to support the deployment of 5th generation (5G) wireless networks and systems. The spectrum bands identified by ISED includes (amongst others) the 38 GHz band which the Company currently holds licences in. As of the date, hereof, the Company has submitted a comment letter in response to the Consultation and final decisions from ISED on this Consultation are yet to be released. For additional information on the Consultation and to review the response letter of the Company or other https://www.ic.gc.ca/eic/site/smt- stakeholders, gst.nsf/eng/h_sf11245.html. The final decisions made by ISED may have a negative and material impact on the Company, if there is a decision to not renew the Company’s spectrum licences in the 38 GHz band, or a renewal is only permitted for a portion of such licences, all such outcomes currently contemplated via the abovementioned Consultation. If the 38 GHz licences are not permitted to renew beyond their current licencing terms, the value of such licences will decrease and the Company will be forced to seek alternative spectrum and bands, and may incur significant costs to continue to provide certain of its connectivity services. Consultation webpage: ISED’s please refer to We expect ISED to make additional spectrum available from time to time. Additionally, other companies hold spectrum rights that could be made available for lease or sale. The availability of additional spectrum in the marketplace could change the market value of spectrum rights generally and, as a result, may adversely affect the value of our spectrum assets. We also use radio equipment under individual radio licences issued by ISED, and subject to annual renewal. We may not be able to obtain the licences we require thereby jeopardizing our ability to reliably deliver our internet services. ISED may decline to renew our licences, or may impose higher fees upon renewal, or impose other conditions that adversely affect us. ISED may decide to reassign the spectrum in the bands we use to other purposes, and may require that we discontinue our use of radio equipment in such bands. Licence-exempt Spectrum We presently utilize licence-exempt spectrum in connection with a majority of our internet customers. Licence-exempt or “free” spectrum is available to multiple simultaneous users and may suffer bandwidth limitations, interference and slowdowns if the number of users exceeds traffic capacity. The availability of licence-exempt spectrum is not unlimited and others do not need to obtain permits or licences to utilize the same licence-exempt spectrum that we currently or may in the future utilize, threatening our ability to reliably deliver or expand our services. Moreover, the prevalence of licence-exempt spectrum creates low barriers to entry in our business, creating the potential for heightened competition. Integration and Anticipated Benefits Pursuant to Past Acquisitions On March 27, 2015, the Company completed the acquisition of RackForce, on September 18, 2015, the Company completed the acquisition of BoxFabric and on May 26, 2016 the Company completed the acquisition of certain assets from AirVM Inc (the “Hosting Business”) (collectively the “Acquisitions”). The Company may not be able to fully realize the anticipated future benefits and synergies of the Acquisitions on a timely basis or at all. The Acquisitions involve challenges and risks, including risks that the transactions do not advance TeraGo’s business strategy or that the Company will not realize a satisfactory return. The potential failure of the due diligence processes to identify significant problems, liabilities or other shortcomings or challenges with respect to assets of RackForce, BoxFabric and the Hosting Business including customer contracts, condition of the equipment acquired, intellectual property, revenue recognition or other accounting practices, taxes, corporate governance and internal controls, regulatory compliance, employee, supplier or partner disputes or issues and other legal and financial contingencies could decrease or eliminate the anticipated benefits and synergies of the Acquisitions and could negatively affect the Company’s future business and financial results. The overall success of the Acquisitions will depend, in part, on the Company’s ability to realize the anticipated benefits and synergies from combining and integrating the acquired businesses into TeraGo’s existing business. In particular, the Company’s offering of cloud services is relatively new and the limited experience of management in providing cloud services prior to the Acquisitions may limit the full benefits or continued growth of such business. Integration of acquisitions require significant management attention and expansion of TeraGo’s staff in operations, marketing, sales and general and administrative functions. The Company may have difficulties in the integration of the acquired company’s departments, systems, including accounting, human resource and other administrative systems, technologies, books and records, and procedures, as well as in maintaining uniform standards, controls, including internal control over financial reporting required by Canadian securities laws and related procedures and policies. If we cannot integrate the acquisitions successfully, it could have a material adverse impact on our business, financial condition and results of operations. As part of the Company’s business strategy, TeraGo may also continue to acquire additional companies, assets or technologies principally related to, or complementary to, our current operations. Any such acquisitions will be accompanied by certain risks including but not limited to exposure to unknown liabilities of acquired companies, higher than anticipated acquisition costs and expenses, the difficulty and expense of integrating operations, systems, and 24 personnel of acquired companies, disruption of the Company’s ongoing business, inability to retain key customers, distributors, vendors and other business partners of the acquired company, diversion of management’s time and attention; and possible dilution to shareholders. Price Sensitive Market The competitive market in which the Company conducts its business could require the Company to reduce its prices. If competitors offer discounts on certain products or services in an effort to recapture or gain market share or to sell other products, the Company may be required to lower prices or offer other favourable terms to compete successfully. Any such changes would likely reduce the Company’s margins and could adversely affect operating results. Some of the Company’s competitors may bundle services that compete with the Company for promotional purposes or as a long-term pricing strategy or provide guarantees of prices and product implementations. These practices could, over time, limit the prices that the Company can charge for its products. If the Company cannot offset price reductions with a corresponding increase in volume, bundling of services or with lower spending, then the reduced revenues resulting from lower prices would adversely affect the Company’s margins and operating results. Market Demand for Available Capacity The Company currently has available capacity in its data centres and intends to expand its footprint in the cloud and data centre market. There can be no assurance that the existing or future market demand will be sufficient to fill this capacity. Should the demand for the Company’s cloud and data centre services decline or fail to increase, this may negatively affect the Company’s ability to capitalize on its high operating leverage and may adversely affect the Company’s future financial performance. Reductions in the amount or cancellations of customers’ orders would adversely affect our business, results of operations and financial condition. Cyber Security Risk Our network security, data centre security and the authentication of our customer credentials are designed to protect unauthorized access to data on our network and to our data centre premises. Because techniques used to obtain unauthorized access to or to sabotage networks (including DDoS attacks) change frequently and may not be recognized until launched against a target, we may be unable to anticipate or implement adequate preventive measures against unauthorized access or sabotage. Consequently, unauthorized parties may overcome our network security and obtain access to confidential, customer or employee data on our network, including on a device connected to our network. In addition, because we own and operate our network, unauthorized access or sabotage of our network could result in damage to our network and to the computers or other devices used by our customer. An actual or perceived breach of network security or data centre security could harm public perception of the effectiveness of our security measures, adversely affect our ability to attract and retain customers, expose us to significant liability and adversely affect our business and revenue prospects. The Company aims to mitigate and manage certain cyber security risks by employing specific policies and procedures, carrying out IT security-related audits, establishing internal controls relevant to mitigating security risks, performing certain “penetration” tests either internally or with help of third party consultants, obtaining IT security-related compliance certificates, designating a security officer that oversees the IT security of the Company, designating a privacy officer that is accountable for the Company’s compliance with applicable privacy laws, using DDoS mitigation, tools and services, utilizing back-up and disaster recovery services and maintaining specific cyber liability insurance coverage to insure against cyber security incidents. The Audit Committee of Company has been tasked to periodically review the various measures management and the Company has undertaken to manage its cyber security risks. Excessive Customer Churn The successful implementation of our business strategy depends upon controlling customer churn. Customer churn is a measure of customers who stop using our services. Customer churn could increase as a result of: • • • • billing errors and/or reduction in the quality of our customer service; interruptions to the delivery of services to customers; the availability of competing technology and other emerging technologies, some of which may, from time to time, be less expensive or technologically superior to those offered by us; and competitive conditions in the industry, including strategic initiatives by us or our competitors, new services, service announcements and changes in pricing policy by us or our competitors. An increase in customer churn can lead to slower customer growth, increased costs and a reduction in revenue. Given the current economic environment, there is risk that churn levels could increase in the future. 25 Insufficient Capital The continued growth and operation of our business may require additional funding for working capital, debt service, the enhancement and upgrade of our network, the build-out of infrastructure to expand the coverage area of our services, possible acquisitions and possible bids to acquire spectrum licences. We may be unable to secure such funding when needed in adequate amounts or on acceptable terms, if at all. To execute our business strategy, we may issue additional equity securities in public or private offerings, potentially at a price lower than the market price at the time of such issuance. Similarly, we may seek debt financing and we may be forced to incur significant interest expense. If we cannot secure sufficient funding, we may be forced to forego strategic opportunities or delay, scale back or eliminate network deployments, operations, acquisitions, spectrum acquisitions and other investments. Reliance on Credit Facilities and Restrictive Debt Covenants The Company relies on its Credit Facilities to operate its business, including for the maintenance of a certain level of liquidity and to carry out its strategy. There can be no assurance that the Company will continue to have access to appropriate Credit Facilities on reasonable terms and conditions, if at all beyond the maturity date of June 14, 2021 for the existing Credit Facilities. An inability to draw down upon the Credit Facilities could have a material adverse effect on the Company’s business, liquidity, financial condition and results of operations. Covenants in our Credit Facilities with our lenders impose operating and financial restrictions on us. A breach of any of these covenants could result in a default under our Credit Facilities. These restrictions may limit our ability to obtain additional financing, withstand downturns in our business and take advantage of business opportunities. Moreover, we may be required to seek additional debt financing on terms that include more restrictive covenants, may require repayment on an accelerated schedule or may impose other obligations that limit our ability to grow our business, acquire needed assets, or take other actions we might otherwise consider appropriate or desirable. Key Competitors are More Established and Have More Resources The market for internet access, data connectivity, cloud and data centre services is highly competitive and we compete with several other companies within each of our markets. Many of our competitors are better established or have greater financial resources than we have. Our competitors include: • • • • • • • • ILECs and CLECs providing DSL and fibre-optic enabled services over their existing wide, metropolitan and local area networks and who have started to provide cloud and colocation services; Utelcos offering or planning to offer internet and data connectivity over fibre optic networks; Large cloud service providers and IT companies; Colocation and disaster recovery service providers; cable operators offering high-speed Internet connectivity services and voice communications; wireless Internet service providers using licenced or licence-exempt spectrum; satellite and fixed wireless service providers offering or developing broadband Internet connectivity and VoIP; and resellers providing wireless Internet or other wireless services using infrastructure developed and operated by others. Many of our competitors are well established with larger and better developed networks and support systems, longer standing relationships with customers and suppliers, greater name recognition and greater financial, technical and marketing resources than we have. Our competitors may subsidize competing services with revenue from other sources and, thus, may offer their products and services at prices lower than ours. We may not be able to reduce our prices which may make it more difficult to attract and retain customers. We expect other existing and prospective competitors to adopt technologies and/or business plans similar to ours, or seek other means to develop services competitive with ours, particularly if our services prove to be attractive in our target markets. Acquisitions and Other Strategic Transactions We may from time to time make strategic acquisitions of other assets and businesses. Any such transactions can be risky, may require a disproportionate amount of our management and financial resources and may create unforeseen operating difficulties or expenditures, including: • difficulties in integrating acquired businesses and assets into our business while maintaining uniform standards, controls, policies and procedures; 26 • • • • obligations imposed on us by counterparties in such transactions that limit our ability to obtain additional financing, our ability to compete in geographic areas or specific lines of business or other aspects of our operational flexibility; increasing cost and complexity of assuring the implementation and maintenance of adequate internal control and disclosure controls and procedures; difficulties in consolidating and preparing our financial statements due to poor accounting records, weak financial controls and, in some cases, procedures at acquired entities not based on IFRS, particularly those entities in which we lack control; and inability to predict or anticipate market developments and capital commitments relating to the acquired company, business or assets. If we do not successfully address these risks or any other problems encountered in connection with an acquisition, the acquisition could have a material adverse effect on our business, results of operations and financial condition. In addition, if we proceed with an acquisition, our available cash may be used to complete the transaction, diminishing our liquidity and capital resources, or additional equity may be issued which could cause significant dilution to existing shareholders. Changes to Technologies and Standards The industries TeraGo operates is characterized by rapidly changing technology, evolving industry standards and increasingly sophisticated customer requirements. The introduction of new or alternative technology and the emergence of new industry standards may render our existing network, equipment and/or infrastructure obsolete and our services unmarketable and may exert price pressures on existing services. It is critical to our success that we be able to anticipate changes in technology or in industry standards and ensure that we can leverage such new technologies and standards in a timely and cost-effective manner to remain competitive from a service and cost perspective. Investments in Development of New Technologies, Products and Services The Company has and will continue to make significant investments in the development and introduction of new products and services that make use of the Company’s network, infrastructure and equipment. There is no assurance that the Company will be successful in implementing and marketing these new products and services in a reasonable time, or that they will gain market acceptance. Development could be delayed for reasons beyond our control. Alternatively, we may fail to anticipate or satisfy the demand for certain products or services, or may not be able to offer or market these new products or services successfully to customers. The failure to attract customers to new products or services, cross-sell service to our existing customer base or failure to keep pace with changing consumer preferences for products or services would slow revenue growth and could have a materially adverse effect on our business, results of operations and financial condition. Expanding, Upgrading and Maintaining Network and Infrastructure We expect to allocate significant resources in expanding, maintaining and improving our network. Additionally, as the number of our customer locations increases, as the usage habits of our customers change and as we increase our service offerings, we may need to upgrade our network to maintain or improve the quality of our services. If we do not successfully implement upgrades to our network, the quality of our services may decline and our churn rate may increase. We may experience quality deficiencies, cost overruns and delays with the expansion, maintenance and upgrade of our network and existing infrastructure including the portions of those projects not within our control. Expansion of our network or infrastructure may require permits and approvals from governmental bodies and third parties. Failure to receive approvals in a timely fashion can delay expansion of our network. In addition, we are typically required to obtain rights from land, building and tower owners to install the antennas and other equipment that provide our internet access service to our customers. We may not be able to obtain, on terms acceptable to us or at all, the rights necessary to expand our network or existing infrastructure. We also may face challenges in managing and operating our network and existing infrastructure. These challenges include ensuring the availability of customer equipment that is compatible with our network and managing sales, advertising, customer support, and billing and collection functions of our business while providing reliable network service that meets our customers’ expectations. Our failure in any of these areas could adversely affect customer satisfaction, increase churn, increase our costs, decrease our revenue and otherwise have a material adverse effect on our business, prospects, financial condition and results of operations. Foreign Exchange While the majority of the Company’s revenues are earned in Canadian dollars, a portion of its costs, including for certain capital expenditures are paid in U.S. dollars. As a result, the Company is exposed to currency exchange rate risks. A 27 change in the currency exchange rate may increase or decrease the amount of Canadian dollars required to be paid by the Company for its U.S. expenditures. The Company does not currently have any foreign exchange contracts to manage the foreign exchange risk. As a result, there can be no assurance that currency fluctuations will not have a material adverse effect on the Company. Interest Rates As the Company currently borrows funds through its credit facility, certain portions of the facility are based on a variable interest rate. A significant rise in interest rates may materially increase the cost of either its revolving or non-revolving credit facilities. The Company mitigates a portion of the underlying interest rate risk with respect to the non-revolving term credit facility by entering into an interest rate swap contract to effectively fix the underlying interest rate on a variable rate debt. Similar interest rate swap contracts have not been entered into for the other portions of the credit facility. To the extent funds have been drawn down from such facilities, the Company will be exposed to interest rate fluctuations. Interruption or Failure of Information Technology and Communications Systems We have experienced service interruptions in some markets in the past and may experience service interruptions or system failures in the future. Our services depend on the continuing operation of our cloud and data centre, information technology and communications systems. Any service interruption adversely affects our ability to operate our business and could result in an immediate loss of revenue. If we experience frequent or persistent system, power or network failures, our reputation and brand could be permanently harmed. We may make significant capital expenditures to increase the reliability and security of our systems, but these capital expenditures may not achieve the results we expect. Our systems and data centres are vulnerable to damage or interruption from earthquakes, terrorist attacks, floods, fires, power loss, telecommunications failures, computer viruses, computer denial of service attacks or other attempts to harm our systems, and similar events. Some of our systems are not fully redundant and our disaster recovery planning may not be adequate. The occurrence of a natural disaster or unanticipated problems at our network centres or data centres could result in lengthy interruptions in our service and adversely affect our operating results. The Company could also be required to make significant expenditures if the Company’s systems were damaged or destroyed, or pay damages if the delivery of the Company’s services to its customers were delayed or stopped by any of these occurrences. Retention and Motivation of Personnel We depend on the services of key technical, sales, marketing and management personnel. The loss of any of these key persons could have a material adverse effect on our business, results of operations and financial condition. Our success is also highly dependent on our continuing ability to identify, hire, train, motivate and retain highly qualified technical, sales, marketing and management personnel. Competition for such personnel can be intense and we cannot provide assurance that we will be able to attract or retain highly qualified technical, sales, marketing and management personnel in the future. Our inability to attract and retain the necessary technical, sales, marketing and management personnel may adversely affect our future growth and profitability. It may be necessary for us to increase the level of compensation paid to existing or new employees to a degree that our operating expenses could be materially increased. If we cannot hire, train and retain motivated and well-qualified individuals, we may face difficulties in attracting, recruiting and retaining various sales and support personnel in the markets we serve, which may lead to difficulties in growing our subscriber base. Leased Data Centre Facilities The Company’s data centres are located in leased premises and there can be no assurance that the Company will remain in compliance with the Company’s leases, that the landlord will continue to support the operation of the Company’s data centre and that the leases will not be terminated despite negotiation for long term lease periods and renewal provisions. Termination of a lease could have a material adverse effect on the Company’s business, results of operations and financial condition. Electrical Power and Outages The Company’s data centres are susceptible to regional variations in the cost of power, electrical power outages, planned or unplanned power outages and limitations on availability of adequate power resources. Power outages can harm, and in the past, have harmed the Company’s customers and its business, including the loss of customers' data and extended service interruptions. While the Company attempts to limit exposure to system downtime by using backup generators and power supplies, the Company cannot limit the Company’s exposure entirely even with these protections in place. With respect to any increase in energy costs, the Company may not always be able to pass these increased 28 costs on to the Company’s customers which could have a material adverse effect on the Company’s business, results of operations and financial condition. Litigation Risk and Intellectual Property Claims Competitors or other persons may independently develop, patent technologies or copyright software that are substantially equivalent or superior to those we currently use or plan to use or that are necessary to permit us to deploy and operate our network, data centres or provide cloud services. Some of these patents, copyrights or rights may grant very broad protection to the owners. We cannot determine with certainty whether any existing third party intellectual property or the issuance of any third party intellectual property would require us to alter technology or software we use, obtain licences or cease certain activities. Defending against infringement claims, even meritless ones, would be time consuming, distracting and costly. If we are found to be infringing the proprietary rights of a third party, we could be enjoined from using such third party’s rights, may be required to pay substantial royalties and damages, and may no longer be able to use the intellectual property subject to such rights on acceptable terms or at all. Failure to obtain licences to intellectual property held by third parties on reasonable terms, or at all, could delay or prevent us from providing services to customers and could cause us to expend significant resources to acquire technology which includes non-infringing intellectual property. If we have to negotiate with third parties to establish licence arrangements, or to renew existing licences, it may not be successful and we may not be able to obtain or renew a licence on satisfactory terms or at all. If required licences cannot be obtained, or if existing licences are not renewed, litigation could result. Operating Losses Our accumulated deficit at December 31, 2017 was $70.4 million and have incurred a net loss in the last three fiscal years. We cannot anticipate with certainty what our earnings, if any, will be in any future period. However, we could incur further net losses as we continue to expand our network into new and existing markets and pursue our business strategy in providing cloud and data centre services. Accordingly, our results of operations may fluctuate significantly, which may adversely affect the value of an investment in our Common Shares. We may also invest significantly in our business before we expect cash flow from operations to be adequate to cover our anticipated expenses. Economic and Geopolitical Risk The market for our services depends on economic and geopolitical conditions affecting the broader market. Economic conditions globally are beyond our control. In addition, acts of terrorism and the outbreak of hostilities and armed conflicts between countries can create geopolitical uncertainties that may affect the global economy. Downturns in the economy or geopolitical uncertainties may cause customers to delay or cancel projects, reduce their overall capital or operating budgets or reduce or cancel orders for our services, which could have a material adverse effect on our business, results of operations and financial condition. Regulation of Internet Regulation of the Internet and the content transmitted through that medium is a topic that receives considerable political discussion from time to time, from both a “pro-regulation” and an “anti-regulation” perspective, including discussions on whether all internet traffic should be delivered equally. It is unclear as to what impact decisions made on either side of this issue by various political and governing bodies could have on us and our business or on the ability of our customers to utilize our internet services. UPCOMING ACCOUNTING PRONOUNCEMENTS NOT YET ADOPTED Certain new standards, interpretations, amendments and improvements to existing standards have been issued by the IASB. The standards impacted that may be applicable to the Company are as follows: (a) IFRS 15 Revenue from Contracts with Customers On May 28 2014, the IASB issued IFRS 15 which supersedes existing standards and interpretations including IAS 18, Revenue and IFRIC 13, Customer Loyalty Programmes. IFRS 15 introduces a single model for recognizing revenue from contracts with customers with the exception of certain contracts under other IFRSs. The standard requires revenue to be recognized in a manner that depicts the transfer of promised goods or services to a customer and at an amount that reflects the expected consideration receivable in exchange for transferring those goods or services. This is achieved by applying the following five steps: 29 1. 2. 3. 4. 5. Identify the contract with a customer; Identify the performance obligations in the contract; Determine the transaction price; Allocate the transaction price to the performance obligations in the contract; and Recognize revenue when (or as) the entity satisfies a performance obligation. IFRS 15 also provides guidance relating to the treatment of contract acquisition and contract fulfillment costs. The standard is effective for annual periods beginning on or after January 1, 2018 with early adoption permitted. The Company will adopt IFRS 15 and the clarifications in its financial statements for annual period beginning on January 1, 2018. The Company has a team focused on the adoption and compliance with IFRS 15. This team is responsible for determining existing policies, differences between existing policies and IFRS 15, ensuring the Company’s data collection is appropriate, and communicating the upcoming changes with various stakeholders. In addition, this team is assisting with the development, implementation, and monitoring of processes and policies that are involved with the transition. The Company continues to assess all potential impacts of the new revenue recognition standard. The Company currently believes the most significant impacts will relate to expanded disclosure on revenue, performance obligations, and contract balances. The Company expects revenue from certain revenue streams to have a significant presentation reclassification impact. Furthermore, the Company anticipates the development of new internal controls to ensure timely and accurate revenue reporting in accordance with the new standard. (b) IFRS 9 Financial Instruments On July 24, 2014, the IASB issued the final publication of the IFRS 9 standard, superseding the current IAS 39, Financial Instruments: recognition and measurement (“IAS 39”) standard. IFRS 9 includes revised guidance on the classification and measurement of financial instruments, including a new expected credit loss model for calculating impairment on financial assets, and the new general hedge accounting requirements. It also carries forward the guidance on recognition and derecognition of financial instruments from IAS 39. The standard is effective for annual periods beginning on or after January 1, 2018 with early adoption permitted. The Company is assessing the impact of this standard on the consolidated financial statements. The extent of the impact has not yet been determined. The adoption of IFRS 9 is not expected to have a material impact on the Company’s consolidated financial statements. (c) IFRS 16 Leases On January 13, 2016, the IASB issued the final publication of the IFRS 16 standard, which will supersede the current IAS 17, Leases standard. Under IFRS 16, a lease will exist when a customer controls the right to use an identified asset as demonstrated by the customer having exclusive use of the asset for a period of time. IFRS 16 introduces a single accounting model for lessees and all leases will require an asset and liability to be recognized on the statement of financial position at inception. The accounting treatment for lessors will remain largely the same as under IAS 17. The standard is effective for annual periods beginning on or after January 1, 2019 with early adoption permitted, but only if the entity is also applying IFRS 15. The extent of the impact of the adoption of this standard has not yet been determined. INTERNAL CONTROL OVER FINANCIAL REPORTING AND DISCLOSURE CONTROLS AND PROCEDURES Our President and Chief Executive Officer and Chief Financial Officer, designed or caused to be designed under their supervision, TeraGo’s disclosure controls and procedures and internal control over financial reporting. TeraGo’s disclosure controls and procedures are designed to provide reasonable assurance that material information relating to TeraGo is made known to management by others, particularly during the period in which the interim filings are being prepared and that information required to be disclosed by TeraGo in its annual filings, interim filings or other 30 reports filed or submitted by it under securities legislation is recorded, processed, summarized and reported within the time periods specified in securities legislation. TeraGo’s disclosure controls and procedures includes controls and procedures designed to ensure that information required to be disclosed by TeraGo in its annual filings, interim filings or other reports filed or submitted under securities legislation is accumulated and communicated to management, as appropriate to allow timely decisions regarding required disclosure. TeraGo’s internal control over financial reporting are designed to provide reasonable assurance regarding reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. TeraGo’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of TeraGo; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of TeraGo are being made only in accordance with authorizations of management and directors of TeraGo; and (iii) are designed to provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of TeraGo’s assets that could have a material effect on TeraGo’s financial statements. The control framework used to design TeraGo’s internal control over financial reporting is based on the Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO 2013). Due to its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may change. There were no changes in the Company’s internal controls over financial reporting for the year ended December 31, 2017 that have materially affected or are reasonably likely to materially affect internal controls over financial reporting. Management has concluded that there are no material weaknesses relating to the design of TeraGo’s internal controls over financial reporting as of December 31, 2017. EXECUTIVE MANAGEMENT CHANGES Effective March 16, 2017, Joe Prodan (Chief Financial Officer) was no longer with the Company. Effective February 1, 2017, Ron Perrotta joined the Company as Vice President, Marketing & Strategy. Mr. Perrotta previously provided consulting services to the Company on an interim basis. Effective August 31, 2017 Daren Hanson (Vice President, Sales) was no longer with the Company. Effective September 5, 2017, David Charron joined the Company as Chief Financial Officer. Effective September 18, 2017, Christine Gauthier joined the Company as Vice President, Sales. Effective October 10, 2017, Jeffrey Yim (Vice President, Finance and Corporate Development) was no longer with the Company. 31 DEFINITIONS – KEY PERFORMANCE INDICATORS, IFRS, ADDITIONAL GAAP AND NON-GAAP MEASURES IFRS Measures Cost of services Cost of services consists of expenses related to delivering service to customers and servicing the operations of our networks. These expenses include costs for the lease of intercity facilities to connect our cities, internet transit and peering costs paid to other carriers, network real estate lease expense, spectrum lease expenses and lease and utility expenses for the data centres and salaries and related costs of staff directly associated with the cost of services. Gross profit margin % Gross profit margin % consists of gross profit margin divided by revenue where gross profit margin is revenue less cost of services. Other operating expenses Other operating expenses includes sales commission expense, advertising and marketing expenses, travel expenses, administrative expenses including insurance and professional fees, communication expenses, maintenance expenses and rent expenses for office facilities. Foreign exchange gain (loss) Foreign exchange gain (loss) relates to the translation of monetary assets and liabilities into Canadian dollars using the exchange rate in effect at that date. The resulting foreign exchange gains and losses are included in net income in the period. Finance costs Finance costs consist of interest charged on our short- and long-term debt, amortization of deferred financing costs including expenses associated with closing our long-term debt facility and accretion expense on the Company’s decommissioning and restoration obligations. The deferred financing costs are amortized using the effective interest method over the term of the loan. Finance income Finance income consists of interest earned on our cash and cash equivalent and short-term investment balances. Additional GAAP Measures Earnings (loss) from operations Earnings (loss) from operations exclude foreign exchange gain (loss), income taxes, finance costs and finance income. We include earnings (loss) from operations as an additional GAAP measure in our consolidated statement of earnings. We consider earnings (loss) from operations to be representative of the activities that would normally be regarded as operating for the Company. We believe this measure provides relevant information that can be used to assess the consolidated performance of the Company and therefore, provides meaningful information to investors. Non-GAAP Measures Adjusted EBITDA The term “EBITDA” refers to earnings before deducting interest, taxes, depreciation and amortization. The Company believes that Adjusted EBITDA is useful additional information to management, the Board and investors as it provides an indication of the operational results generated by its business activities prior to taking into consideration how those activities are financed and taxed and also prior to taking into consideration asset depreciation and amortization and it excludes items that could affect the comparability of our operational results and could potentially alter the trends analysis in business performance. Excluding these items does not necessarily imply they are non-recurring, infrequent or unusual. Adjusted EBITDA is also used by some investors and analysts for the purpose of valuing a company. The Company calculates Adjusted EBITDA as earnings before deducting interest, taxes, depreciation and amortization, foreign exchange gain or loss, finance costs, finance income, gain or loss on disposal of network assets, property and equipment, impairment of property, plant, & equipment and intangible assets, stock-based compensation and restructuring, acquisition-related and integration costs. Investors are cautioned that Adjusted EBITDA should not be construed as an alternative to operating earnings or net earnings determined in accordance with IFRS as an indicator of our financial performance or as a measure of our liquidity and cash flows. Adjusted EBITDA does not take into account the impact of working capital changes, capital expenditures, debt principal reductions and other sources and uses of cash, which are disclosed in the consolidated statements of cash flows. 32 Adjusted EBITDA does not have any standardized meaning under GAAP. TeraGo’s method of calculating Adjusted EBITDA may differ from other issuers and, accordingly, Adjusted EBITDA may not be comparable to similar measures presented by other issuers. See “Results of Operations – Adjusted EBITDA” for reconciliation of net loss to Adjusted EBITDA. Key Performance Indicators Backlog MRR The term “Backlog MRR” is a measure of contracted monthly recurring revenue (MRR) from customers that have not yet been provisioned. The Company believes backlog MRR is useful additional information as it provides an indication of future revenue. Backlog MRR is not a recognized measure under IFRS and may not translate into future revenue, and accordingly, investors are cautioned in using it. The Company calculates backlog MRR by summing the MRR of new customer contracts and upgrades that are signed but not yet provisioned, as at the end of the period. TeraGo’s method of calculating backlog MRR may differ from other issuers and, accordingly, backlog MRR may not be comparable to similar measures presented by other issuers. ARPU The term “ARPU” refers to the Company’s average revenue per customer per month in the period. The Company believes that ARPU is useful supplemental information as it provides an indication of our revenue from an individual customer on a per month basis. ARPU is not a recognized measure under IFRS and, accordingly, investors are cautioned that ARPU should not be construed as an alternative to revenue determined in accordance with IFRS as an indicator of our financial performance. The Company calculates ARPU by dividing our total revenue before revenue from early terminations by the number of customers in service during the period and we express ARPU as a rate per month. TeraGo’s method of calculating ARPU has changed from the Company’s past disclosures to exclude revenue from early termination fees, where ARPU was previously calculated as revenue divided by the number of customers in service during the period. TeraGo’s method may differ from other issuers, and accordingly, ARPU may not be comparable to similar measures presented by other issuers. Churn The term “churn” or “churn rate” is a measure, expressed as a percentage, of customer cancellations in a particular month. The Company calculates churn by dividing the number of customer cancellations during a month by the total number of customers at the end of the month before cancellations. The information is presented as the average monthly churn rate during the period. The Company believes that the churn rate is useful supplemental information as it provides an indication of future revenue decline and is a measure of how well the business is able to renew and keep existing customers on their existing service offerings. Churn and churn rate are not recognized measures under IFRS and, accordingly, investors are cautioned in using it. TeraGo’s method of calculating churn and churn rate may differ from other issuers and, accordingly, churn may not be comparable to similar measures presented by other issuers. 33 MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL REPORTING The accompanying consolidated financial statements of TeraGo Inc. and its subsidiaries and all the information in Management’s Discussion and Analysis are the responsibility of management and have been approved by the Board of Directors. The consolidated financial statements have been prepared by management in accordance with International Financial Reporting Standards. The consolidated financial statements include certain amounts that are based on the best estimates and judgments of management and in their opinion present fairly, in all material respects, TeraGo lnc.’s financial position, results of operations and cash flows. Management has prepared the financial information presented elsewhere in the Management’s Discussion and Analysis and has ensured that it is consistent with the consolidated financial statements, or has provided reconciliations where inconsistencies exist. Management of TeraGo Inc., in furtherance of the integrity of the consolidated financial statements, has developed and maintains a system of internal controls. Management believes the internal controls provide reasonable assurance that transactions are properly authorized and recorded, financial records are reliable and form a proper basis for the preparation of consolidated financial statements and that TeraGo lnc.’s material assets are properly accounted for and safeguarded. The internal control processes include management’s communication to employees of policies that govern ethical business conduct. The Board of Directors is responsible for overseeing management’s responsibility for financial reporting and is ultimately responsible for reviewing and approving the consolidated financial statements. The Board carries out this responsibility through its Audit Committee. The Audit Committee meets periodically with management and the Company’s independent auditors to review the Company’s reported financial performance and to discuss audit, internal controls, accounting policies, and financial reporting matters; and to review Management’s Discussion and Analysis, the consolidated financial statements and the external auditors’ report. The Audit Committee reports its findings to the Board of Directors for consideration when approving the consolidated financial statements for issuance to the shareholders. The Audit Committee also considers, for review by the Board of Directors and approval by the shareholders, the engagement or re-appointment of the external auditors. The consolidated financial statements have been audited by KPMG LLP, the external auditors, in accordance with Canadian generally accepted auditing standards on behalf of the shareholders. KPMG LLP has full and free access to the Audit Committee. February 21, 2018 “Antonio Ciciretto” “David Charron” President and Chief Executive Officer Chief Financial Officer 34 KPMG LLP Vaughan Metropolitan Centre 100 New Park Place, Suite 1400 Vaughan ON L4K 0J3 Canada Tel 905-265-5900 Fax 905-265-6390 INDEPENDENT AUDITORS' REPORT To the Shareholders of TeraGo Inc. We have audited the accompanying consolidated financial statements of TeraGo Inc., which comprise the consolidated statements of financial position as at December 31, 2017 and 2016, the consolidated statements of comprehensive loss, changes in equity and cash flows for the years then ended, and notes, comprising a summary of significant accounting policies and other explanatory information. Management's Responsibility for the Consolidated Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors' Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on our judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, we consider internal control relevant to the entity's preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion. 35 Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the consolidated financial position of TeraGo Inc. as at December 31, 2017 and 2016, and its consolidated financial performance and its consolidated cash flows for the years then ended in accordance with International Financial Reporting Standards. Chartered Professional Accountants, Licensed Public Accountants February 21, 2018 Vaughan, Canada 36 TERAGO INC. Consolidated Statements of Financial Position (In thousands) Assets Cash and cash equivalents Accounts receivable Prepaid expenses and other assets Current portion of other long-term assets Total current assets Network assets, property and equipment Intangible assets Goodwill Total non-current assets Total Assets Liabilities Accounts payable and accrued liabilities Current portion of deferred revenue Current portion of long-term debt Current portion of other long-term liabilities Total current liabilities Decommissioning and restoration obligations Deferred revenue Long-term debt Other long-term liabilities Total non-current liabilities Total Liabilities Shareholders' Equity Share capital Contributed surplus Deficit Total Shareholders' Equity Total Liabilities and Shareholders' Equity Note 6(a) 6(b) 10(a) 7 8 8 9 10(b) 11 9 10(b) 13 $ $ $ $ $ December 31 2017 December 31 2016 $ 6,986 3,389 2,516 27 12,918 38,822 16,699 19,419 74,940 13,034 3,673 3,150 - 19,857 44,161 19,400 19,419 82,980 87,858 $ 102,837 $ 8,519 282 4,000 56 12,857 277 205 32,183 419 33,084 45,941 86,653 25,701 (70,437) 41,917 87,858 $ $ 11,027 287 5,170 774 17,258 207 323 35,608 793 36,931 54,189 86,171 25,620 (63,143) 48,648 102,837 On behalf of the Board: (signed) “Matthew Gerber” (signed) “Gary Sherlock” Director Director The accompanying notes are an integral part of these financial statements. 37 TERAGO INC. Consolidated Statements of Comprehensive Loss (In thousands, except per share amounts) Revenue Expenses Cost of services Salaries and related costs Other operating expenses Depreciation of network assets, property and equipment Amortization of intangible assets Loss from operations Foreign exchange gain Finance costs Finance income Loss before income taxes Income taxes Income tax expense Net loss and comprehensive loss Deficit, beginning of year Deficit, end of year Basic loss per share Diluted loss per share Basic weighted average number of shares outstanding Diluted weighted average number of shares outstanding Year ended December 31 2017 55,392 Year ended December 31 2016 59,086 Note 16 $ 7 8 12 15 15 $ $ $ $ $ $ 14,103 19,088 13,573 11,272 3,052 61,088 (5,696) 50 (1,698) 50 (7,294) - (7,294) (63,143) (70,437) (0.51) (0.51) 14,307 14,307 13,477 21,195 10,845 11,796 3,529 60,842 (1,756) 16 (1,882) 8 (3,614) (700) (4,314) (58,829) (63,143) (0.30) (0.30) 14,177 14,177 The accompanying notes are an integral part of these financial statements. 38 TERAGO INC. Consolidated Statements of Cash Flows (In thousands) Operating Activities Net loss for the year Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Severance, acquisition, and other costs Depreciation of network assets, property and equipment Amortization of intangible assets Stock-based compensation expense Finance costs Finance income Income tax expense Loss on adjustments and disposal of network assets and intangible assets Impairment of assets and related charges Severance, acquisition, and other costs paid Stock-based compensation paid Changes in non-cash working capital items: Accounts receivable Prepaid expenses Accounts payable and accrued liabilities Deferred revenue Cash from Operating Activities Investing Activities Acquisitions, net of cash acquired Change in restricted cash Purchase of network assets, property and equipment Purchase of intangible assets Change in non-cash working capital related to network assets, property and equipment and intangible assets Cash used in Investing Activities Financing Activities Proceeds from exercise of stock options Interest paid, net of received Repayment of long-term debt Financing costs incurred Note 7 8 14 7 7,8 5 7 8 9 9 Cash used in Financing Activities Net change in cash and cash equivalents, during the year Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year $ The accompanying notes are an integral part of these financial statements. 39 Year ended December 31 2017 Year ended December 31 2016 $ (7,294) $ (4,314) 1,076 11,272 3,052 201 1,698 (50) - 109 2,851 (3,233) (644) 284 634 529 (123) 10,362 - - (8,490) (754) (1,050) (10,294) 196 (1,604) (4,420) (288) (6,116) (6,048) 13,034 6,986 $ 3,650 11,796 3,529 866 1,882 (8) 700 397 - (1,943) (26) (367) 201 (134) 129 16,358 (1,102) 172 (7,697) (496) (442) (9,565) 182 (1,746) (5,261) - (6,825) (32) 13,066 13,034 TERAGO INC. Consolidated Statements of Changes in Equity (In thousands) Balance, January 1, 2017 Issuance of shares upon exercise of options Stock-based compensation Issuance of shares for directors' fees Net loss and comprehensive loss Share Capital Number 14,250 $ Amount 86,171 Contributed Surplus $ 25,620 $ Deficit (63,143) $ Total 48,648 49 - 66 - 196 - 286 - - 81 - - - - - 196 81 286 (7,294) (7,294) Balance, December 31, 2017 14,365 $ 86,653 $ 25,701 $ (70,437) $ 41,917 Balance, January 1, 2016 Issuance of shares upon exercise of options Stock-based compensation Issuance of shares for directors' fees Net loss and comprehensive loss Share Capital Number 14,133 $ Amount 85,636 Contributed Surplus $ 25,408 $ Deficit (58,829) $ Total 52,215 46 - 71 - 182 - 353 - - 212 - - - - - (4,314) (63,143) 182 212 353 (4,314) 48,648 Balance, December 31, 2016 14,250 86,171 25,620 See Note 13 – Share capital for classes of shares. The accompanying notes are an integral part of these financial statements. 40 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) 1. Reporting Entity TeraGo Inc. (the “Company”) provides businesses across Canada with connectivity services, colocation services and enterprise infrastructure cloud services. The Company’s head office is located in Canada at Suite 800 – 55 Commerce Valley Drive West, Thornhill, Ontario. The Company was incorporated under the Canada Business Corporations Act on December 21, 2000 and owns and operates a carrier-grade, fixed wireless, fibre-based, IP communications network, as well as cloud and colocation facilities in Canada targeting enterprise customers that require cloud, colocation, and connectivity services. The Company’s common shares are listed on the Toronto Stock Exchange (TSX) under the symbol TGO. 2. Basis of Preparation and Presentation (a) Basis of preparation The consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board ("IASB"). The Board of Directors authorized the consolidated financial statements for issue on February 21, 2018. (b) Basis of Measurement The consolidated financial statements have been prepared on a historical cost basis except for the following material items in the statement of financial position: • • financial instruments at fair value through profit (loss) (“FVTPL”) are measured at fair value through net income or loss liabilities for cash-settled stock-based payment arrangements are measured at fair value Functional and Presentation Currency (c) These consolidated financial statements are presented in Canadian dollars, which is the Company’s functional currency. (d) Use of Estimates and Judgments The preparation of financial statements in conformity with IFRS requires management to make judgments, estimates and assumptions that affect the application of accounting policies and the reported amounts of assets, liabilities, income and expenses. Actual results may differ from these estimates. Estimates and assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognized in the period in which the estimates are revised and in any future periods affected. Key areas of estimation and information about critical judgments in applying accounting policies that have the most significant effect on amounts recognized in the consolidated financial statements are: (i) Estimates of useful lives of network assets, property and equipment and intangible assets: Management's judgment intended use, industry trends and other factors in determining the expected useful lives of depreciable assets, to determine depreciation methods, the asset's residual value and whether an asset is a qualifying asset for the purposes of capitalizing borrowing costs. involves consideration of (ii) Capitalization of costs: Judgments and estimates are used in assessing the direct labour and other costs capitalized to network assets, property and equipment. (iii) Cash generating units: Judgment is required to assess the Company’s determination of cash generating units for the purpose of impairment testing. (iv) Impairment of non-financial assets: The process to calculate the recoverable amount of our cash generating unit requires use of valuation methods such as the discounted cash flow method which uses assumptions of key variables including future cash flows, discount rate and terminal growth rates. 41 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) (v) Allowance for doubtful accounts: In developing the estimates for an allowance against existing receivables, the Company considers general and industry economic and market conditions as well as credit information available for the customer and the aging of the account. Changes in the carrying amount due to changes in economic and market conditions could significantly affect the loss for the period. When the Company determines amounts previously recognized through an allowance are not probable to be collected, the allowance is written off through revenue. (vi) Stock-based compensation: Estimating fair value for stock-based payments requires determining the most appropriate valuation model for a grant, which is dependent on the terms and conditions of the grant. In valuing stock options, the Company uses the Black-Scholes option pricing model. Several assumptions are used in the underlying calculation of fair values of the Company's stock options using the Black-Scholes option pricing model including the expected life of the option, risk-free interest rate and volatility of the underlying stock. (vii) Business combination: The amount of goodwill initially recognized as a result of a business combination, the fair value estimate of any contingent consideration and the determination of the fair value of the identifiable assets acquired and the liabilities assumed is based, to a considerable extent, on management's estimate of future cash flows expected to be derived from the assets acquired. (viii) Income taxes: it that is probable that A deferred tax asset is recognized for unused losses, tax credits and deductible temporary differences to the extent future taxable income will be available against which they can be utilized. Significant estimates are required in evaluating the recoverability of deferred tax assets. The Company’s assessment is based on existing tax laws, estimates of future profitability and tax planning strategies. (ix) Provisions: Judgment is required to assess the likelihood of an outflow of the economic benefits to settle contingencies, such as litigations or decommissioning and restoration obligations, which may require a liability to be recognized. Significant judgments include assessing estimates of future cash flows, selection of discount rates and the probability of the occurrence of future events. 3. Significant Accounting Policies (a) Revenue Recognition The Company earns revenue by providing cloud, colocation, and connectivity services. Revenue is measured at the fair value of the consideration received or receivable for services, net of discounts and sales taxes. Revenue is recognized as the related services are provided to customers, if evidence of an arrangement exists, collection is deemed probable by management and revenue and costs are reliably measurable. The principal sources of revenue to the Company and recognition of these revenues are as follows: (i) Monthly recurring revenue from cloud, colocation, and connectivity are recognized as service revenue ratably over the number of months in the contract term as related services are provided to the customer. (ii) Revenue from installation services that do not have standalone value from the ongoing service are deferred and recognized over the term of the contract. (iii) Usage revenue is recorded as service revenue in the month the usage occurs. Billings or payments received from customers in advance of revenue recognition are recorded in deferred revenue on the consolidated statement of financial position. (b) Basis of Consolidation The consolidated financial statements include the accounts of TeraGo Inc., TeraGo Networks Inc. and its wholly owned subsidiaries RackForce Networks Inc., RackForce Cloud Video Inc., and Codeninja Ltd. (collectively, the Company). A subsidiary is an entity that is controlled by another entity, known as the parent. Control is the power to govern the The accompanying notes are an integral part of these financial statements. 42 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) financial and operating policies of an entity so as to obtain benefits from its activities. All intercompany transactions between subsidiaries are eliminated on consolidation. On January 1, 2017, TeraGo Networks Inc., RackForce Networks Inc., RackForce Cloud Video Inc., and Codeninja Ltd were amalgamated. Financial Instruments (c) The Company initially measures financial instruments at fair value. Transaction costs that are directly attributable to the issuance of financial assets or liabilities are accounted for as part of the carrying value at inception (except for transaction costs related to financial instruments recorded as FVTPL financial assets which are expensed as incurred), and are recognized over the term of the assets or liabilities using the effective interest method. Subsequent measurement and treatment of any gain or loss is recorded as follows: (i) (ii) (iii) Financial assets and financial liabilities at FVTPL are measured at fair value at the balance sheet date with any gain or loss recognized immediately in net loss. Interest and dividends earned from financial assets are also included in net loss for the period. Loans and receivables are measured at amortized cost using the effective interest method. Any gains or losses are recognized in net loss for the period. Other financial liabilities are measured at amortized cost using the effective interest method. Any gains or losses are recognized in net loss for the period. Impairment of Financial Assets A financial asset carried at amortized cost is considered impaired if objective evidence indicates that one or more events have had a negative effect on the estimated future cash flow of that asset that can be estimated reliably. An impairment loss is calculated as the difference between its carrying amount and the present value of the estimated future cash flows discounted at the asset's original effective interest rate. In assessing impairment, the Company uses historical trends of the probability of default, timing of recoveries and the amount of loss incurred, adjusted for management's judgment as to whether current economic and credit conditions are such that the actual losses are likely to be greater or less than suggested by historical trends. Losses are recognized in the consolidated statements of loss and reflected in an allowance account against the financial asset. The following is a summary of the Company’s significant categories of financial instruments as at December 31, 2017: Loans and receivables Loans and receivables are financial assets with fixed or determinable payments that are not quoted in an active market. Such assets currently are comprised of cash and cash equivalents, accounts receivable and restricted cash. (i) (ii) Cash and Cash Equivalents and restricted cash Cash and cash equivalents consists of bank balances, cash on hand, demand deposits that can be withdrawn without penalty and short-term, highly liquid securities such as debt securities with an initial maturity date of not more than three months from the date of acquisition, that can readily be converted into known amounts of cash and are subject to an insignificant risk of change in value. Bank overdrafts that are repayable upon demand and form an integral part of the Company’s cash management are included as a component of cash and cash equivalents. Cash and cash equivalents and restricted cash are carried at amortized cost. Accounts Receivable Accounts receivable are measured at the amount the item is initially recognized. The allowance for doubtful accounts is based on the Company’s assessment of the collectability of outstanding trade receivables. The evaluation of collectability of customer accounts is done on an individual account basis. If, based on an evaluation of accounts, it is concluded that it is probable that a customer will not be able to pay all amounts due, an expected impairment loss is recognized. Recoveries are only recorded when objective verifiable evidence supports the change in the original allowance. Changes in the carrying amount of the allowance account are recognized in the statement of comprehensive loss for the period. Other financial liabilities The Company recognizes debt securities issues and subordinated liabilities on the date that they originated. All other financial liabilities are recognized initially on the date that the Company becomes a party to the contractual provisions. The accompanying notes are an integral part of these financial statements. 43 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) The Company has the following non-derivative financial liabilities: current and long-term debt, accounts payable and accrued liabilities, and current portion and long-term portion of other long term liabilities. Such liabilities are recognized initially at fair value less any directly attributable transaction costs. Subsequent to initial recognition these financial liabilities are measured at amortized cost using the effective interest method. Interest on loans and borrowings is expensed as incurred unless capitalized for qualifying assets in accordance with IAS 23, Borrowing Costs. Loans and borrowings are classified as a current liability unless the Company has an unconditional right to defer settlement for at least 12 months after the end of the year. Derivative instruments The Company uses an interest rate swap contract to manage the risk associated with the fluctuations of interest rates on its long-term debt. Management does not apply hedge accounting on the interest rate swap contract. As a result, the interest rate swap contract is marked to market each period, resulting in a gain or loss in net loss for the year. The gain (loss) on revaluation is recognized in finance income (costs) on the statement of comprehensive loss. (d) Network Assets, Property and Equipment Network assets, property and equipment are recorded at cost less accumulated depreciation and impairment charges, if any. These costs include expenditures directly attributable to the acquisition of the asset. The cost of self-constructed network assets includes the cost of materials and direct labour and any other costs directly attributable to bringing the assets to a working condition for their intended purpose. This includes direct costs to design, acquire and build the asset and include directly attributable internally and externally generated engineering and construction costs and equipment on-hand. They also include the cost of dismantling and removing items and restoring the site on which they are located and specifically attributable borrowing costs on qualifying assets. Subsequent costs are included in the asset’s carrying amount or recognized as a separate asset only when it is probable that future economic benefits associated with the item will flow to the Company and the costs of the item can be reliably measured. All other expenditures are charged to operating expenses as incurred. When major components of an item of network assets and property and equipment have different useful lives, they are accounted for as separate items. Depreciation of network assets and property and equipment is based on the estimated useful life of the assets as follows: Estimated useful life/ Asset depreciation method Network assets Cloud and Data centre infrastructure Computer equipment Office furniture and equipment Leasehold improvements Vehicles 6 to 25 years straight line 10 to 15 years straight line 3 years straight line 5 years straight line over the term of lease 30% declining balance Depreciation methods, useful lives and residual values are reviewed at least annually. Adjustments, if necessary, are recognized prospectively. (e) Goodwill and Intangible Assets Intangible assets include the following: Radio Spectrum Licenses Radio spectrum licenses are classified as indefinite life intangible assets and are not amortized but are tested for impairment on an annual basis. The licenses are granted with an auto-renewal policy and non-renewal of licenses by the regulatory body is considered remote unless license conditions are breached. As such, it is difficult to determine the period over which these assets are expected to generate future net cash inflows to the Company and it is common industry practice for established telecommunications companies to treat these licenses as indefinite life. The accompanying notes are an integral part of these financial statements. 44 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) Computer Software Computer software is recorded at cost less accumulated amortization and amortized on a straight-line basis over 3 years or where there is a term license for the software, over the shorter of the term of the license or the useful life of the software. Customer Relationships, Brand, Non-compete agreements, and Acquired Real Estate Leases Customer relationships, brand, non-compete agreements and vendor’s real estate leases are recorded at cost less accumulated amortization, initially measured at fair value on the acquisition date if acquired in a business combination. Customer relationships are amortized on a straight-line basis over a range of 5 to 10 years, brands are amortized over a period of 5 to 20 years, non-compete agreements are amortized on a straight-line basis in accordance with the term of the contracts and acquired real estate leases are amortized over the term of the lease. Amortization methods, useful lives and residual values are reviewed at least annually. Adjustments, if necessary, are recognized prospectively. Goodwill Goodwill is the amount that results when the fair value of consideration transferred for an acquired business exceeds the net fair value of the identifiable assets and liabilities acquired. When the Company enters into a business combination, the acquisition method of accounting is used. Goodwill is assigned, as of the date of the business combination, to cash generating units that are expected to benefit from the business combination. Impairment of non-financial assets (f) The Company monitors events and changes in circumstances that may require an assessment of the recoverability of its non-financial long-lived assets. When an impairment test is performed, the recoverable amount is assessed by reference to the higher of i) the net present value of the expected future cash flows (value-in-use) and ii) the fair value less cost to sell. If the recoverable amount is estimated to be less than the carrying amount, the carrying amount of the asset is reduced to its recoverable amount and an impairment loss is charged to operations in the period in which the impairment is identified. For the purposes of assessing impairment, assets are grouped at the lowest levels for which there are separately identifiable cash flows (“cash generating units” or “CGUs”). The carrying values of identifiable intangible assets with indefinite lives and goodwill are tested at minimum annually for impairment. Goodwill and indefinite life intangible assets are allocated to CGUs for the purpose of impairment testing based on the level at which management monitors it, which is not higher than an operating segment. The allocation is made to those CGUs that are expected to benefit from the business combination in which the goodwill arose. The Company currently has assessed that it has a single CGU. The carrying values of non-financial assets with finite useful lives, such as network assets, property and equipment and intangible and other assets subject to amortization, are assessed for impairment whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. If any such indication exists, the recoverable amount of the asset must be determined. Such assets are impaired if their recoverable amount is lower than their carrying amount. If it is not possible to estimate the recoverable amount of an individual asset, the recoverable amount of the CGU to which the asset belongs is tested for impairment. (g) Subscriber acquisition costs Subscriber acquisition costs are expensed as incurred. (h) Business Combinations Acquisitions of businesses are accounted for using the acquisition method. The consideration for each acquisition is measured at the aggregate of the fair values (at the date of exchange) of assets given, liabilities incurred or assumed, and equity instruments issued by the Company in exchange for control of the acquiree. Acquisition-related costs are recognized in loss in the period incurred. Where applicable, the consideration for the acquisition includes any asset or liability resulting from a contingent consideration arrangement, measured at its acquisition-date fair value. Subsequent changes in such fair values are adjusted against the cost of acquisition where they qualify as measurement period adjustments. All other subsequent changes in the fair value of contingent consideration classified as an asset or liability are accounted for in accordance The accompanying notes are an integral part of these financial statements. 45 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) with relevant IFRS sections. Changes in the fair value of contingent consideration initially classified as equity are not recognized. Where a business combination is achieved in stages, the Company’s previously held interests in the acquired entity are remeasured to fair value at the acquisition date (i.e. the date the Company attains control) and the resulting gain or loss, if any, is recognized in profit or loss. Amounts arising from interests in the acquiree prior to the acquisition date that have previously been recognized in other comprehensive income are reclassified to profit or loss, where such treatment would be appropriate if that interest were disposed. The acquiree’s identifiable assets, liabilities and contingent liabilities that meet the conditions for recognition under IFRS 3 are recognized at their fair value at the acquisition date. If the initial accounting for a business combination is incomplete by the end of the reporting period in which the combination occurs, the Company reports provisional amounts for the items for which the accounting is incomplete. Those provisional amounts are adjusted during the measurement period or additional assets or liabilities are recognized, to reflect new information obtained about facts and circumstances that existed as of the acquisition date that, if known, would have affected the amounts recognized as of that date. The measurement period is the period from the date of acquisition to the date the Company obtains complete information about facts and circumstances that existed as of the acquisition date and is subject to a maximum period of one year. Leases (i) Leases entered into by the Company as lessee that transfer substantially all the benefits and risks of ownership to the Company are recorded as finance leases and are included in property and equipment and obligations under finance leases. Obligations under finance leases are reduced by lease payments net of imputed interest. All other leases are classified as operating leases under which lease payments are expensed on a straight-line basis over the term of the lease. Lease incentives received are recognized as an integral part of the total lease cost, over the term of the lease. Contingent lease payments are accounted for in the period incurred. Provisions (j) A provision is recognized if, as a result of a past event, the Company has a present legal or constructive obligation that can be estimated reliably, and it is probable that an outflow of economic benefits will be required to settle the obligation. Where the impact is significant, provisions are determined by discounting the expected future cash flows at a pre-tax rate that reflects the current market assessments of the time value of money and the risk specific to the liability. The unwinding of the discount is recognized as a finance cost. Decommissioning and Restoration Obligations: In the course of the Company's operations, network and other assets are utilized on leased premises. Often costs are expected to be incurred associated with decommissioning these assets and restoring the location where these assets are situated upon ceasing their use on those premises. These decommissioning and restoration provisions are calculated on the basis of the identified costs for the current financial year, extrapolated into the future based on management's best estimates of future trends in prices, inflation, and other factors, and are discounted to present value at a risk-adjusted rate specifically applicable to the liability. Assumptions related to the amount and timing of cash flows required to satisfy the Company's future legal obligations include labour costs based on current marketplace wages and the rate of inflation over expected years to settlement; the length of facility lease renewal periods and probability of such renewals; and the appropriate discount rate to present value the future cash flows. Forecasts of estimated future provisions are reviewed periodically in light of future changes in business conditions or technological requirements. The Company records these decommissioning and restoration costs as Network Assets, Property and Equipment, and life. The subsequently allocates them to expense using a systematic and rational method over the asset's useful Company records the accretion of the liability (unwinding of the discount) as a charge to finance costs. Foreign Currency Translation (k) Foreign currency accounts are translated into Canadian dollars as follows: At the transaction date, each asset, liability, revenue, and expense is translated into Canadian dollars using the exchange rate in effect at that date. At the year-end The accompanying notes are an integral part of these financial statements. 46 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) date, monetary assets and liabilities are translated into Canadian dollars by using the exchange rate in effect at that date. The resulting foreign exchange gains and losses are included in net loss in the current year. Finance income and finance costs (l) Finance income comprises interest income on funds invested, dividend income, gains on sale of available-for-sale financial assets, and changes in fair value of financial assets at FVTPL. Finance costs comprise interest expense on borrowings, accretion of discounts on provisions, and changes in fair value of financial assets at FVTPL. Borrowing costs that are not directly attributable are recognized in loss for the year. Income Taxes (m) Income taxes on losses include current and deferred taxes. Income taxes are recognized in loss except to the extent that it relates to business combinations, or items recognized directly in equity or in other comprehensive income. Current tax is the expected tax payable or receivable on the taxable income or loss for the year, using tax rates enacted or substantively enacted at the reporting date, and any adjustment to tax payable in respect of previous years. Deferred tax is generally recognized in respect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for taxation purposes. Deferred tax assets and liabilities are measured, on an undiscounted basis, at the tax rates that are expected to be applied to temporary differences when they reverse, based on the laws that have been enacted or substantively enacted by the reporting date. Deferred tax assets and liabilities are recognized where the carrying amount of an asset or liability in the consolidated statement of financial position differs from its tax base, except for differences arising on: • • • the initial recognition of goodwill; the initial recognition of an asset or liability in a transaction which is not a business combination and at the time of the transaction affects neither accounting or taxable profit; and investments in subsidiaries, branches and associates, and interests in joint ventures where the Company is able to control the timing of the reversal of the difference and it is probable that the difference will not reverse in the foreseeable future. A deferred tax asset is recognized to the extent it is probable that it will be realized. Deferred tax assets are reviewed at each reporting date and are reduced to the extent it is no longer probable the related tax benefit will be realized. (n) Government incentives From time to time, the Company applies for government incentive programs such as investment tax credits. Government incentives are recognized when there is reasonable assurance of realization and reflected as a reduction of the expenditure to which the incentive relates. In the event the investment tax credits received differs from the amount claimed, the difference will be reflected in operations in the year in which it is determined. (o) Stock-based Compensation Plans The Company has equity-settled and cash-settled stock-based compensation plans. The grant date fair values of equity settled stock-based payment awards to employees and directors are recognized as compensation cost, with a corresponding increase to equity, over the vesting period of the award. For cash-settled awards, the awards are classified as a liability and are re-measured to fair value at each reporting date. The Company accounts for the effects of service and non-market performance conditions in measuring the fair value of the liability in cash-settled awards by adjusting the number of rights to receive cash that are expected to satisfy any service and non- market performance conditions on a best estimate basis. Awards with graded vesting are valued and recognized as compensation cost based on the respective vesting tranche. The amount of compensation cost recognized is adjusted to reflect the number of awards expected to vest based on continued employment vesting conditions, such that the amount ultimately recognized as compensation cost is based on the number of awards that vest. The Employee share purchase plan allows employees to voluntarily participate in a share purchase plan. Under the terms of the plan, employees can contribute a specified percentage of their regular earnings through payroll deductions and the Company makes a contribution match which is recorded as compensation expense. The accompanying notes are an integral part of these financial statements. 47 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) Operating Segments (p) Management has determined that the Company operates in a single reportable operating segment. The Company provides cloud, colocation, and connectivity services and earns revenues primarily in Canada. As at December 31, 2017 substantially all of the Company’s identifiable assets are located in Canada, with an immaterial amount of assets located in the United States and the United Kingdom. Loss Per Share (q) The basic loss per share has been computed by dividing the net loss for the year by the weighted average number of common shares outstanding during the year. Diluted loss per share is computed by adjusting the net loss attributable to common shareholders for the year and the weighted average number of common shares outstanding for the period for the effects of all potentially dilutive common shares including shares subject to the exercise of stock options, where dilutive. The Company uses the treasury stock method for calculating diluted loss per share. 4. Upcoming accounting pronouncements not yet adopted The IASB has issued new standards and amendments to existing standards. These changes are not yet adopted as at December 31, 2017 and could have an impact on future periods. IFRS 15 Revenue from Contracts with Customers On May 28 2014, the IASB issued IFRS 15 which supersedes existing standards and interpretations including IAS 18, IFRS 15 introduces a single model for recognizing revenue Revenue and IFRIC 13, Customer Loyalty Programmes. from contracts with customers with the exception of certain contracts under other IFRSs. The standard requires revenue to be recognized in a manner that depicts the transfer of promised goods or services to a customer and at an amount that reflects the expected consideration receivable in exchange for transferring those goods or services. This is achieved by applying the following five steps: 1. 2. Identify the contract with a customer; Identify the performance obligations in the contract; 3. Determine the transaction price; 4. Allocate the transaction price to the performance obligations in the contract; and 5. Recognize revenue when (or as) the entity satisfies a performance obligation. IFRS 15 also provides guidance relating to the treatment of contract acquisition and contract fulfillment costs. The standard is effective for annual periods beginning on or after January 1, 2018 with early adoption permitted. The Company will adopt IFRS 15 and the clarifications in its financial statements for annual period beginning on January 1, 2018. The Company has a team focused on the adoption and compliance with IFRS 15. This team is responsible for determining existing policies, differences between existing policies and IFRS 15, ensuring the Company’s data collection is appropriate, and communicating the upcoming changes with various stakeholders. In addition, this team is assisting with the development, implementation, and monitoring of processes and policies that are involved with the transition. The Company continues to assess all potential impacts of the new revenue recognition standard. The Company currently believes the most significant impacts will relate to expanded disclosure on revenue, performance obligations, and contract balances. The Company expects revenue from certain revenue streams to have a presentation reclassification impact. Furthermore, the Company anticipates the development of new internal controls to ensure timely and accurate revenue reporting in accordance with the new standard. IFRS 9 Financial Instruments On July 24, 2014, the IASB issued the final publication of the IFRS 9 standard, superseding the current IAS 39, Financial Instruments: recognition and measurement (“IAS 39”) standard. IFRS 9 includes revised guidance on the classification and measurement of financial instruments, including a new expected credit loss model for calculating impairment on financial assets, and the new general hedge accounting requirements. It also carries forward the guidance on recognition and derecognition of financial instruments from IAS 39. The accompanying notes are an integral part of these financial statements. 48 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) The standard is effective for annual periods beginning on or after January 1, 2018 with early adoption permitted. The Company will adopt IFRS 9 and the classifications in its financial statements for annual period beginning on January 1, 2018. The Company is assessing the impact of this standard on the consolidated financial statements. The extent of the impact has not yet been determined. The adoption of IFRS 9 is not expected to have a material impact on the Company’s consolidated financial statements. IFRS 16 Leases On January 13, 2016, the IASB issued the final publication of the IFRS 16 standard, which will supersede the current IAS 17, Leases standard. Under IFRS 16, a lease will exist when a customer controls the right to use an identified asset as demonstrated by the customer having exclusive use of the asset for a period of time. IFRS 16 introduces a single accounting model for lessees and all leases will require an asset and liability to be recognized on the statement of financial position at inception. The accounting treatment for lessors will remain largely the same as under IAS 17. The standard is effective for annual periods beginning on or after January 1, 2019 with early adoption permitted, but only if the entity is also applying IFRS 15. The extent of the impact of the adoption of this standard has not yet been determined. 5. Business Combinations AirVM Hosting Business On May 26, 2016, the Company closed an asset purchase agreement to acquire the Hosting Business of Ottawa-based AirVM Inc. for consideration of $1,102. The acquisition brought expanded Infrastructure as a Service (Iaas) offerings to the Company from locations in the United States and the United Kingdom. The acquisition was accounted for using the acquisition method in accordance with IFRS 3, Business Combinations, with the results of operations consolidated with those of the Company effective from the acquisition date. In connection with the acquisition, the Company recorded network assets, property and equipment of $137, customer relationships and other intangible assets of $609, and goodwill of $356. Goodwill recognized in the transaction represents the expected operational synergies with the acquiree including intangible assets that do not qualify for separate recognition. The goodwill and intangibles assets are tax deductible. The identifiable intangible assets are being amortized over periods of 2 to 5 years. 6. Current Assets Details of selected current asset balances are as follows: (a) Cash and cash equivalents The Company’s cash and cash equivalents are comprised of bank balances at major Canadian financial institutions. (b) Accounts receivable The Company’s accounts receivable is comprised of the following: The accompanying notes are an integral part of these financial statements. 49 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) Trade receivables Allowance for doubtful accounts Other December 31 2017 December 31 2016 $ 3,137 (21) 273 3,389 $ 3,531 (124) 266 3,673 $ $ 7. Network Assets, Property and Equipment Cost Balance, January 1, 2017 Additions / reclassifications Disposals / Adjustments Impairment Balance, December 31, 2017 Accumulated Depreciation Balance, January 1, 2017 Depreciation for the period Disposals / Adjustments Impairment Balance, December 31, 2017 Net Book Value, December 31, 2017 Cost Balance, January 1, 2016 Additions / reclassifications Acquisitions Disposals / Adjustments Balance, December 31, 2016 Accumulated Depreciation Balance, January 1, 2016 Depreciation for the period Disposals / Adjustments Balance, December 31, 2016 Net Book Value, December 31, 2016 Network Assets Cloud & Datacentre Infrastructure Computer Equipment Office Furniture and Equipment Leasehold Improvements Vehicles $ 118,609 $ 14,386 $ 2,660 $ 2,332 $ 1,648 $ 49 $ 7,007 (1,121) (7,325) 620 (7) (421) 156 - (46) 25 - - 682 - - - - - Total 139,684 8,490 (1,128) (7,792) $ $ $ $ 117,170 $ 14,578 $ 2,770 $ 2,357 $ 2,330 $ 49 $ 139,254 87,527 $ 2,479 $ 2,245 $ 2,172 $ 1,051 $ 49 $ 95,523 9,158 (1,024) (5,207) 1,531 (3) (105) 321 - (24) 50 - - 212 - - - - - 11,272 (1,027) (5,336) 90,454 $ 3,902 $ 2,542 $ 2,222 $ 1,263 $ 49 $ 100,432 26,716 $ 10,676 $ 228 $ 135 $ 1,067 $ - $ 38,822 Network Assets Cloud & Datacentre Infrastructure Computer Equipment Office Furniture and Equipment $ 114,869 $ 13,752 $ 2,173 $ 6,530 5 (2,795) 645 - (11) 355 132 - 2,211 $ 121 - - Leasehold Improvements Vehicles 1,602 $ 49 $ 46 - - - - - Total 134,656 7,697 137 (2,806) $ $ $ $ 118,609 $ 14,386 $ 2,660 $ 2,332 $ 1,648 $ 49 $ 139,684 80,080 $ 888 $ 2,133 $ 2,132 $ 854 $ 49 $ 86,136 9,857 (2,410) 1,590 1 112 - 40 - 197 - - - 11,796 (2,409) 87,527 $ 2,479 $ 2,245 $ 2,172 $ 1,051 $ 49 $ 95,523 31,082 $ 11,907 $ 415 $ 160 $ 597 $ - $ 44,161 For the years ended December 31, 2017 and 2016, the Company had additions of capitalized wages and other directly attributable costs of $2,157 and $2,097, respectively, in network assets. During 2017, the Company wrote off assets with a net book value of $101 (Cost of $1,128 less accumulated depreciation of $1,027). During 2016, the Company wrote off assets with a net book value of $397 (Cost of $2,806 less accumulated depreciation of $2,409). The corresponding loss on disposal of assets was included in other operating expenses. The accompanying notes are an integral part of these financial statements. 50 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) Impairment of Property, Plant, and Equipment The annual impairment test of Property, Plant, and Equipment was performed on December 31, 2017 and a charge of $2,456 was recorded in other operating expenses on the statement of comprehensive loss (December 31, 2016 – $nil). The Company tests assets for impairment when events or circumstances may indicate the carrying value is no longer recoverable. The asset is impaired when the recoverable amount is less than the net book value. The recoverable amount is the higher of (i) an asset‘s fair value less costs to sell and (ii) its value-in-use. In performing the annual impairment test the Company identified evidence of impairment in certain assets and an analysis was done on the recoverable amount. During the annual review, the Company determined that the recoverable amount of certain network assets, cloud and data centre infrastructure, and computer equipment was less than their carrying values. This was the result of the loss of certain connectivity customers, changes in services demanded and provided to certain customers in primarily connectivity offerings, and assets not expected to be deployed. The fair value less costs to sell (or salvage value) for the impaired assets was insignificant. 8. Intangible Assets and Goodwill Cost Balance, January 1, 2017 Additions Disposals / Adjustments Impairment Balance, December 31, 2017 Accumulated Depreciation Balance, January 1, 2017 Amortization for the period Impairment Balance December 31, 2017 $ $ $ $ Radio spectrum licenses Computer Software Customer relationships Other Total Intangibles Goodwill Total Intangibles and Goodwill 7,041 $ 9,056 $ 18,241 $ 4,880 $ 39,218 $ 19,419 $ 58,637 - - - 754 (7) - - 4 (555) - (5) (44) 754 (8) (599) - - - 7,041 $ 9,803 $ 17,690 $ 4,831 $ 39,365 $ 19,419 $ 2,371 $ 7,999 $ 7,481 $ 1,967 $ - - $ 585 - $ 1,866 601 (170) $ (34) $ 2,371 $ 8,584 $ 9,177 $ 2,534 $ 19,818 $ 3,052 (204) $ 22,666 $ - $ - - $ - $ 754 (8) (599) 58,784 19,818 3,052 (204) 22,666 Net Book Value, December 31, 2017 $ 4,670 $ 1,219 $ 8,513 $ 2,297 $ 16,699 $ 19,419 $ 36,118 Cost Balance, January 1, 2016 Additions Acquisitions Disposals / Adjustments Balance, December 31, 2016 Accumulated Depreciation Balance, January 1, 2016 Amortization for the period Balance December 31, 2016 $ $ $ $ Radio spectrum licenses Computer Software Customer relationships Other Total Intangibles Goodwill Total Intangibles and Goodwill 7,041 $ 8,560 $ 17,677 $ 4,835 $ 38,113 $ 19,063 $ 57,176 - - - 496 - - - 564 - - 45 - 496 609 - - 356 - 496 965 - 7,041 $ 9,056 $ 18,241 $ 4,880 $ 39,218 $ 19,419 $ 58,637 2,371 $ 7,178 $ 5,385 $ 1,355 $ 16,289 $ - 821 2,096 612 3,529 2,371 $ 7,999 $ 7,481 $ 1,967 $ 19,818 $ - $ - - $ 16,289 3,529 19,818 Net Book Value, December 31, 2016 $ 4,670 $ 1,057 $ 10,760 $ 2,913 $ 19,400 $ 19,419 $ 38,819 The accompanying notes are an integral part of these financial statements. 51 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) Impairment of Intangible Assets The annual impairment test of intangible assets was performed on December 31, 2017 and a charge of $395 was recorded in other operating expenses on the statement of comprehensive loss (December 31, 2016 – $nil). The Company tests assets for impairment when events or circumstances may indicate the carrying value is no longer recoverable. The asset is impaired when the recoverable amount is less than the net book value. The recoverable amount is the higher of (i) an asset‘s fair value less costs to sell and (ii) its value-in-use. In performing the annual impairment test the Company identified evidence of impairment in certain assets and an analysis was done on the recoverable amount. During the annual review, the Company determined that the recoverable amount of certain customer relationships and brand assets was less than their carrying value. This was the result of a strategic shift in cloud product offerings and the strategic focus made on the Company’s customer base. Impairment of Goodwill The annual impairment test of goodwill and indefinite life intangible assets was performed on December 31, 2017 and December 31, 2016 and did not result in any goodwill impairment loss. In The recoverable amount is the higher of (i) an asset‘s or CGU’s fair value less costs to sell and (ii) its value-in-use. performing the annual impairment test for the Company’s single CGU, the Company measured the value-in-use of the CGU using certain key management assumptions. Cash flow projections, which were made over a five-year period, were based primarily on the financial budget reviewed by the Board of Directors plus a terminal value using a 3% terminal growth rate. The Company discounted these estimates of future cash flows to their present value using an after-tax discount rate of 9.9% which reflects the entity’s weighted average cost of capital. The fair value less costs to sell, primarily based on the Company’s market capitalization as at December 31, 2017, also significantly exceeded the net carrying amount of the CGU. 9. Long-term Debt Term debt facility Equipment loans less: financing fees less: current portion Term Debt Facility December 31 2017 36,611 - (428) 36,183 (4,000) 32,183 $ $ December 31 2016 40,897 170 (289) 40,778 (5,170) 35,608 $ $ In June 2014, the Company entered into an agreement with a syndicate led by the National Bank of Canada (“NBC”) to provide a $50,000 credit facility that is principally secured by a general security agreement over the Company’s assets. In March 2015, the Company entered into an amended agreement with the syndicate led by NBC that increased the credit facility by $35,000 ($30,000 increase to the term debt facility and $5,000 increase to the revolving facility) and extended the term from June 6, 2017 to June 30, 2018. Other terms were substantially consistent with the existing credit facilities. In June 2017, the Company entered into a second amended agreement with the syndicate led by NBC that reduced the term debt facility from $50,000 to $40,000 (as a result of principal previously repaid), reduced the quarterly principal installment from $1,250 to $1,000 and extended the term from June 30, 2018 to June 14, 2021. Other terms were substantially consistent with the existing credit facilities. The total $75,000 facility that matures June 14, 2021 is made up of the following: The accompanying notes are an integral part of these financial statements. 52 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) • • $10,000 revolving facility which bears interest at prime plus a margin percent. As of December 31, 2017, $nil amount is outstanding (2016 - $nil). Letters of credit issued under the facility totaled $655 as of December 31, 2017 (2016 - $655). $40,000 term facility which bears interest at prime or Banker’s Acceptance (at the Company’s option) plus a margin percent and is repayable in quarterly principal installments of $1,000. This facility was fully drawn upon signing the second amended agreement. On December 31, 2017, $36,800 of the term facility principal balance outstanding was in a Banker’s Acceptance and the remaining $200 was at a floating rate. In 2015, the Company entered into amended interest rate swap contracts that mature June 29, 2018. The interest rate on the Banker’s Acceptance at December 31, 2017 was 3.99%. The interest rate swap contract has not been designated as a hedge and will be marked-to-market each quarter. The fair value of the interest rate swap contract at December 31, 2017 was an asset of $27 (December 31, 2016 – liability of $261) and is recorded in other long-term assets/liabilities (Note 10(a)), with a corresponding charge (recovery) for the change in fair value recorded in finance costs. As at December 31, 2017, the Company prepaid interest in the amount of $389 which represents the net settlement of the Banker’s Acceptance and is recorded as a reduction in the carrying value of the debt. • $25,000 available for funding acquisitions and will bear interest at prime plus a margin percent and is repayable in quarterly principal installments of 2.5% of the aggregate amount outstanding. As of December 31, 2017, this facility remains undrawn. In connection with the second amended agreement, the Company incurred financing fees of $288 which have been deferred and will be amortized using the effective interest method over the amended term of the facility. The balance of previously incurred financing fee is also amortized over the same amended term. The NBC facility is subject to certain financial and non-financial covenants which the Company is in compliance with at December 31, 2017. Under this facility, the Company is subject to a cash flow sweep that could accelerate a certain amount of principal repayment based on a calculation outlined by the credit agreement not later than 120 days after the end of each fiscal year. 10. Other Long-Term Assets/Liabilities (a) Other long-term assets Fair value of interest rate swap contract (Note 9)$ less: current portion $ December 31 2017 27 27 (27) - $ $ December 31 2016 - - - - The accompanying notes are an integral part of these financial statements. 53 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) (b) Other long-term liabilities Performance based share units (Note 14(c)) Restricted share units (Note 14 (b)) Fair value of interest rate swap contract (Note 9) Lease inducement liability less: current portion 11. Decommissioning and Restoration Obligations December 31 2017 43 171 - 261 475 (56) 419 $ $ December 31 2016 318 707 261 281 1,567 (774) 793 $ $ The Company’s hub sites are established in leased or licensed premises. As part of these arrangements, the Company is liable for all restoration costs to ensure that the space is returned to its original state upon termination of the leases. The decommissioning and restoration obligations related to future site restoration costs related to these arrangements or licenses. The decommissioning and restoration obligations were determined using a discount rate of 9.9% over a range of periods from 2025 to 2045. As at December 31, 2017, the estimated amount of undiscounted cash flows required to settle this liability was $1,345. The following table presents the reconciliation of decommissioning and restoration obligations associated with the retirement of network assets: the beginning and ending aggregate carrying amount of the Obligation, beginning of year Accretion expense included in finance costs Changes in assumptions Obligation, end of year 12. Income Taxes (a) Income tax expense (recovery) Profit (Loss) before income taxes (recovery) Income taxes at enacted rate of 26.5% Non-deductible expenses and permanent differences Change in unrecognized deductible temporary differences True-up adjustment Other December 31 2017 207 19 51 277 $ $ December 31 2016 234 17 (44) 207 December 31 2017 (7,294) (1,933) 109 1,672 152 - - $ $ December 31 2016 (3,614) (958) 150 2,048 (428) (112) 700 $ $ $ $ (b) Recognized deferred tax assets and liabilities The Company has a history of tax losses, including a taxable loss during the fiscal year-ended December 31, 2017. As such, deferred tax assets are only recognized to the extent of deferred tax liabilities recorded. The Company had no deferred tax liabilities as at December 31, 2017 and as a result no deferred tax asset was recognized. The accompanying notes are an integral part of these financial statements. 54 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) (c) Unrecognized deferred tax assets Deferred tax assets have not been recognized in respect of the following items because they do not meet the criteria for recognition. Excess of tax value of network assets, property and equipment, and intangible assets over net book value Non-capital tax loss carryforwards Other deductible temporary differences (d) Reconciliation of effective tax rate Loss before Income taxes Income tax recovery at statutory rates Permanent differences Unrecognized deferred tax assets Provision to return adjustment for prior year Other Income tax expense (recovery) (e) Tax loss expiry schedule December 31 2017 December 31 2016 5,351 7,354 1,436 14,141 $ $ 9,027 1,964 1,478 12,469 December 31 2017 % December 31 2016 % (7,294) (1,933) 109 1,672 152 - - $ $ (26.5) 1.5 22.9 2.1 - - (3,614) (958) 150 2,048 (428) (112) 700 (26.5) 4.2 56.7 (11.8) (3.1) 19.4 $ $ $ $ The non-capital tax losses carried forward are available to reduce future taxable income in Canada and expire as follows: 2030 2031 2032 2033 2034 2035 2036 2037 and later $ $ 1,386 1,356 - 647 674 1,651 2,640 19,440 27,794 The accompanying notes are an integral part of these financial statements. 55 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) 13. Share Capital Authorized Unlimited Common Shares Two Class B Shares, non-transferable unless approved by the Board, non-participating and redeemable. Holder of Class B shares are entitled to nominate and elect one director for each Class B Share held. Issued Balance, January 1, 2016 Issuance of common shares on exercise of stock options Issuance of common shares for directors' fees Balance, December 31, 2016 Issuance of common shares on exercise of stock options Issuance of common shares for directors' fees Balance, December 31, 2017 Dividends Number of Common Shares 14,133 46 71 14,250 49 66 14,365 Common Shares 92,086 182 353 92,621 196 286 93,103 In $ Share Issue Costs (6,450) - - (6,450) - - (6,450) Total 85,636 182 353 86,171 196 286 86,653 Dividends are payable in an equal amount on each common share if declared by the Board of Directors of the Company. No dividends were declared for the years ended December 31, 2017 and 2016. 14. Stock-Based Compensation (a) Stock Options There are 986 common shares reserved for issuance under the Company’s previous stock option plan. Upon closing of the Company’s initial public offering on June 26, 2007, 799 options granted under the Company’s original option plan (the “Old Plan”) fully vested. Options granted under the Old Plan expire 10 years from date of vesting and as at December 31, 2017, there are nil (2016 – 63) options outstanding under the Old Plan with a weighted average exercise price of $4.00. On June 18, 2007, the Company adopted a new option plan (the “2007 Option Plan”) which is available to directors, officers, employees and other persons approved by the Board from time to time. On closing of the Company’s initial public offering, 833 common shares were reserved for issuance under the 2007 Option Plan. The options granted under the 2007 Option Plan expire 10 years from the date of grant and vest over three years. All options under the 2007 Option Plan will vest immediately on a change of control of the Company. As of December 31, 2017, there are 588 (2016 – 609) options outstanding under the 2007 option plan. The accompanying notes are an integral part of these financial statements. 56 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) For the years ended December 31, 2017 and 2016, the Company recorded stock-based compensation related to stock options of $81 and $212, respectively. A summary of the status of the Company’s stock option plan as at December 31, 2017 and 2016 is presented below. Outstanding - January 1 Granted Exercised Forfeited / Expired Outstanding - December 31 Exercisable 2017 Weighted Average Exercise Price $5.99 $4.40 $4.00 $7.26 $5.58 $5.78 Number of Options 672 101 (49) (136) 588 501 2016 Weighted Average Exercise Price $5.89 $5.12 $4.00 $5.00 $5.99 $6.05 Number of Options 684 40 (46) (6) 672 592 As at December 31, 2017, the range of exercise prices, the weighted average exercise price and the weighted average remaining contractual life are as follows: Range of exercise prices $4.01 - $5.50 $4.01 - $5.50 $5.51 - $11.50 Number outstanding 85 503 588 Options Outstanding Options Exercisable Weighted average remaining contractual life (years) 9.64 6.21 6.60 Weighted average exercise price $4.40 $5.78 $5.58 Number exercisable - 501 501 Weighted average exercise price - $5.78 $6.05 The fair value of stock option grants made to directors during the year is estimated using the Black-Scholes option pricing model, with the following weighted average assumptions: risk-free rate of 1.23% (2016 – 1.08%); dividend yield of nil (2016 – nil); volatility of 39.55% (2016 – 46.60%); and expected lives of stock options of 10 years (2016 – 7.9). Expected volatility has been based on an evaluation of the historical period commensurate with the expected term. The expected term of the stock options has been based on historical experience and general option holder behavior. The fair value of the stock options is expensed over the vesting period of the options using the graded method. (b) Restricted Share Units (RSUs) On March 12, 2009, the Company established a RSU Plan which is available to the directors, officers, and full-time employees approved by the Board. The value of one RSU is equal to the value of one Common Share. Plan participants are granted a specific number of RSUs for a given period based on their position and level of contribution. At the end of the three-year vesting period, the RSUs vest if the plan participant is employed by the Company. Vested RSUs are expected to be paid in cash or Common Shares purchased on the open market, or a combination of both, as the Company chooses. In 2017, the Company granted 180 RSUs to certain executives (2016 – 12). In 2017, 150 RSUs vested and the Company paid cash of $587 (2016 – nil). For the year ended December 31, 2017 and December 31, 2016, the Company recorded compensation expense of $51 and $266, respectively, related to the RSUs granted. As of December 31, 2017, a liability of $171 (2016 - $707) related to the RSUs granted is included in other long-term liabilities (Note 10(b)). The accompanying notes are an integral part of these financial statements. 57 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) The following table is a summary of the number of outstanding RSU as at: Opening Balance, January 1, 2017 Granted Forfeited Vested and paid Ending Balance, December 31, 2017 (c) Performance Based Share Units (PSUs) December 31 2017 162 180 (43) (150) 149 December 31 2016 150 12 - - 162 Plan participants are granted a specific number of PSUs for a given period based on their role within the Company and level of performance. PSUs are also issued pursuant to the RSU Plan. At the end of the three-year vesting period, the PSUs vest if the plan participant is employed by the Company and certain non-market performance criteria are met. Vested PSUs are expected to be paid in cash or Common Shares purchased on the open market, or a combination of both, as the Company chooses. The PSUs are re-measured to fair value each reporting period. The value of one PSU is equal to the value of one Common Share. In 2017, the Company granted nil PSUs to certain executives (2016 – 256). In 2017, 12 PSUs vested and the Company paid cash of $58 (2016 – $25). For the year ended December 31, 2017 and December 31, 2016, the Company recorded stock-based compensation expense (recovery) of ($217) and $35, respectively, related to the PSUs outstanding. As at December 31, 2017, a liability of $43 (2016 - $318) related to the PSUs granted is included in the other long-term liabilities (Note 10(b)). The following table is a summary of the number of outstanding PSUs as at: Opening Balance, January 1, 2017 Granted Vested and paid Forfeited / Expired Ending Balance, December 31, 2017 December 31 2017 195 - (12) (164) 19 December 31 2016 252 256 (5) (308) 195 (d) Stock-Based Compensation Summary The following table is a summary of the stock-based compensation expense (recovery): Restricted share units Performance-based share units Stock options Directors' fees paid in shares Year ended December 31 2017 51 (217) 81 286 201 $ $ Year ended December 31 2016 266 35 212 353 866 $ $ The accompanying notes are an integral part of these financial statements. 58 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) 15. Loss Per Share The following table sets forth the calculation of basic and diluted loss per share. Numerator for basic and diluted loss per share: Net loss for the period Denominator for basic and diluted loss per share: Basic weighted average number of shares outstanding Effect of stock options, RSUs and PSUs Diluted weighted average number of shares outstanding Loss per share: Basic Diluted $ $ $ Year ended December 31 2017 Year ended December 31 2016 (7,294) $ (4,314) 14,307 14,177 - - 14,307 14,177 (0.51) (0.51) $ $ (0.30) (0.30) For the year ended December 31, 2017, the impact of all options, RSUs and PSUs totaling 859 (2016 – 1,223) were excluded in the calculation of diluted loss per share because they were antidilutive. 16. Revenue The Company’s revenue is comprised of the following: Cloud and Colocation Revenue Connectivity Revenue 17. Key Management Personnel Compensation Year ended December 31 2017 18,961 36,431 55,392 $ $ Year ended December 31 2016 18,296 40,790 59,086 $ $ Key management personnel are those persons having authority and responsibility for planning, directing and controlling the activities of the Company, including the directors of the Company. Key management personnel compensation, including directors, is as follows: Salaries, fees and benefits Termination expense Share-based compensation expense Year ended December 31 2017 Year ended December 31 2016 $ 1,787 1,126 201 3,114 $ 1,759 2,860 866 5,485 $ $ The accompanying notes are an integral part of these financial statements. 59 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) 18. Commitments The Company is committed to leases for premises, office equipment, network real estate access, telecommunication facilities and radio spectrum licenses. Annual minimum payments over the next five years and thereafter are as follows: 2018 2019 2020 2021 2022 Thereafter Amount 9,932 8,010 6,175 5,035 3,664 15,316 48,132 $ $ For the year ended December 31, 2017, the Company recorded rent expense of $7,777 (2016 - $7,494) relating to premises and network real estate access leases. It is common practice for the Company to re-negotiate network real estate access lease or license arrangements as they become due for renewal. Included in the amounts above are estimates for the renewal of leases or licenses that are currently due for renewal or are due for renewal in 2017. The Company is required to pay, under a CRTC-administered regime, a percentage (2017 - 0.60%, 2016 – 0.53%) of its adjusted Canadian telecommunications service revenue (as defined by CRTC and excluding retail Internet revenue) into a fund administered by CRTC. 19. Fair value of financial instruments The Company has determined the estimated fair values of its financial instruments based on appropriate valuation methodologies. Where quoted market values are not readily available, the Company may use considerable judgment to develop estimates of fair value. Accordingly, any estimated values are not necessarily indicative of the amounts the Company could realize in a current market exchange and could be materially affected by the use of different assumptions or methodologies. The Company classifies its fair value measurements within a fair value hierarchy, which reflects the significance of the inputs used in making the measurements as defined in IFRS 7 – Financial Instruments – Disclosures. Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities; Level 2 - or indirectly; and Level 3 - Unobservable inputs for the asset or liability which are supported by little or no market activity Inputs other than quoted prices included in Level 1, that are observable for the asset or liability, either directly The fair values of cash and cash equivalents is based on quoted market values. The fair values of short-term financial assets and liabilities, including accounts receivable, accounts payable and accrued liabilities, as presented in the consolidated statements of financial position, approximate their carrying amounts due to their short-term maturities. The fair value of long-term debt approximates its carrying value because management believes the interest rates approximate the market interest rate for similar debt with similar security. The fair value of our interest rate swap contract is based on broker quotes and therefore, these contracts are measured using Level 2 inputs. Similar contracts are traded in an active market and the quotes reflect the actual transactions in similar instruments. The accompanying notes are an integral part of these financial statements. 60 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) The Company has classified its financial instruments as follows: Financial assets: Loans and receivables, measured at amortized cost Cash and cash equivalents Accounts receivable Fair value of interest rate swap contract Financial liabilities: Accounts payable and accrued liabilities, measured at amortized cost Fair value of interest rate swap contract Long-term debt, measured at amortized cost December 31 2017 December 31 2016 Carrying amount Fair Value Carrying amount Fair Value $ $ 6,986 3,389 27 $ 6,986 3,389 27 $ 13,034 3,673 - 13,034 3,673 - $ 8,519 $ 8,519 $ 11,027 $ 11,027 - - 261 261 36,183 36,183 40,778 40,778 Credit risk The Company’s cash and cash equivalents and restricted cash subject the Company to credit risk. The Company maintains cash and investment balances at Tier 1 Canadian financial institutions. The Company’s maximum exposure to credit risk is limited to the amount of cash and cash equivalents. Credit risk related to our interest rate swap contract arises from the possibility that the counter party to the agreement may default on their obligation. The Company assesses the creditworthiness of the counterparty to minimize the risk of counterparty default. The interest rate swap is held by National Bank Financial. The Company, in the normal course of business, is exposed to credit risk from its customers and the accounts receivable are subject to normal industry risks. The Company attempts to manage these risks by dealing with credit worthy customers. If available, the Company reviews credit bureau ratings, bank accounts and industry references for all new customers. Customers that do not have this information available are typically placed on a pre-authorized payment plan for service or provide deposits to the Company. This risk is minimized as the Company has a diverse customer base located across various provinces in Canada. As at December 31, 2017 and 2016, the Company had no material trade receivable accounts that were not expected to be collected. The following table provides the aging of the trade accounts receivable: Current 31 to 60 days 61 to 90 days over 90 days December 31 2017 2,311 608 103 115 3,137 $ $ December 31 2016 2,597 650 116 168 3,531 $ $ Interest rate risk The Company is subject to interest rate risk on its cash and cash equivalents and long-term debt. The Company is exposed to interest rate risk on its operating line of credit since the interest rates applicable are variable and is, therefore, exposed to cash flow risks resulting from interest rate fluctuations. As at December 31, 2017, the operating line of credit balance was $nil. The drawn term facility as at December 31, 2017 was $37,000, $36,800 of which was held in a Bankers The accompanying notes are an integral part of these financial statements. 61 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) Acceptance. In 2015, the Company entered into amended interest rate swap contracts that matures June 29, 2018. The interest rate on the Banker’s Acceptance at December 31, 2017 was 3.99%. The remaining $200 drawn under this facility bears interest for the period at prime rate plus a margin. Liquidity risk The Company believes that its current cash and cash equivalents and anticipated cash from operations will be sufficient to meet its working capital and capital expenditure requirements for the foreseeable future. As at December 31, 2017, the Company had cash and cash equivalents of $6,986. The Company has access to the $34,300 undrawn portion of its $75,000 credit facilities after consideration of outstanding letters of credit. The Company’s financial liabilities that have contractual maturities are summarized below: Long-term debt Accounts payable Stock-based compensation(1) Total Less than 1 year $ 4,000 2,950 - 2 - 3 years $ 32,183 - 215 6,950 $ 32,398 $ $ $ Total 36,183 2,950 215 39,348 (1) Represents recognized amounts for cash-settled stock-based compensation arrangements (See Note 14). Settlement is subject to achievement of vesting criteria. Currency risk The Company has suppliers that are not based in Canada which gives rise to a risk that earnings and cash flows may be adversely affected by fluctuations in foreign currency exchange rates. The Company is primarily exposed to the fluctuations in the dollar. The Company believes this risk is minimal and does not use financial instruments to hedge these risks. A one cent appreciation in the U.S. dollar to Canadian dollar foreign exchange rate would have resulted in a decrease (increase) in income of $6. Balances denominated in foreign currencies that are considered financial instruments are as follows: Cash and cash equivalents Accounts payable and accrued liabilities Currency USD $ USD December 31 2017 336 $ December 31 2016 275 915 744 20. Capital Risk Management The Company’s objectives when managing capital are: (a) (b) (c) to ensure that the Company will continue as a going concern so that it can continue to provide services to its customers and offer a return on investment to its shareholders; to maintain a capital structure which optimizes the cost of capital while providing flexibility and diversity of funding sources and timing of debt maturities along with adequate anticipated liquidity for future growth; and to comply with debt covenants The accompanying notes are an integral part of these financial statements. 62 TERAGO INC. Notes to the Consolidated Financial Statements (In thousands, except for per share amounts) The Company defines capital that it manages as the aggregate of its cash and cash equivalents, short-term investments, debt facilities including finance leases and equity comprising of share capital, contributed surplus and deficit. Cash and cash equivalents Long term debt Share capital Contributed surplus Deficit December 31 2017 December 31 2016 $ $ $ (6,986) 36,183 86,653 25,701 (70,437) 71,114 $ (13,034) 40,778 86,171 25,620 (63,143) 76,392 The Company manages its capital structure and makes adjustments to it in light of economic conditions. The Company, upon approval from its Board of Directors, will make changes to its capital structure as deemed appropriate under the specific circumstances. The Company’s overall strategy with respect to management of capital remains unchanged from the year ended December 31, 2017. 21. Related Party Transactions Two former Directors of the Company, who retired effective June 23, 2016, also served as Chairman of the Board and a Director of a customer of the Company. Revenue from this customer for the year ended December 31, 2017 and 2016 was nil and $40, respectively. Accounts receivable from this customer as at December 31, 2017 and 2016 was nil and nil, respectively. The terms governing these related party transactions are consistent with those negotiated on an arm’s length basis with non-related parties. The accompanying notes are an integral part of these financial statements. 63 CORPORATE INFORMATION DIRECTORS Matthew Gerber Chairman, TeraGo Inc. Chief Executive Officer, Rohinni LLC Antonio Ciciretto President & Chief Executive Officer, TeraGo Inc. Richard Brekka Managing Partner, Second Alpha Partners Jerry S. Grafstein, Q.C. Corporate Director Michael Martin Senior Executive, IBM Canada CORPORATE HEAD OFFICE 55 Commerce Valley Drive West Suite 800 Thornhill, Ontario L3T 7V9 1.866.TeraGo.1 (837-2461) EXCHANGE LISTING Toronto Stock Exchange STOCK SYMBOL TGO INVESTOR RELATIONS CONTACT Dennis Fong, LodeRock Advisors Inc. Telephone: 1-416-282-9930 IR@terago.ca Jim Sanger Managing Partner, Second Alpha Partners Gary Sherlock Corporate Director WEBSITE www.terago.ca YEAR END December 31 AUDITORS KPMG LLP Vaughan, Ontario, Canada TRANSFER AGENT Computershare Investor Services Inc. Toronto, Ontario, Canada EXECUTIVE MANAGEMENT Antonio Ciciretto President & Chief Executive Officer David Charron Chief Financial Officer Ron Perrotta Vice President, Marketing & Strategy Duncan McGregor Vice President, Operations & Engineering Christine Gauthier Vice President, Sales Mark Lau Vice President, Legal, General Counsel & Corporate Secretary Certain trademarks used in this annual report, such as “TeraGo”, “TeraGo Networks” and www.terago.ca, are trademarks owned by TeraGo or its subsidiaries. Other trademarks or service marks appearing in this annual report are trademarks or service marks of the person who owns them. 64
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