GNLKQ GeneLink Inc (CE)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The accompanying condensed consolidated financial statements of GeneLink Inc., d/b/a GeneLink Biosciences, Inc. and subsidiaries (the “Company”) are unaudited, but in the opinion of management, reflect all adjustments (consisting only of normal recurring adjustments) necessary to fairly state the Company’s financial position, results of operations, and cash flows as of and for the dates and periods presented. The financial statements of the Company are prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information.

These unaudited financial statements should be read in conjunction with the Company’s audited financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission (SEC). The results of operations for the three month and nine month periods ended September 30, 2012 are not necessarily indicative of the results that may be expected for the entire year ending December 31, 2012 or for any future period.

Note 1.   Organization

The Company is a genetics-based, personal healthcare firm that has developed DNA assessments measuring personal DNA tendencies that can have a significant impact on overall wellness of an individual client or customer. These small differences in DNA, called SNPs (“snips”) can indicate genetic variants that may not be performing at optimal levels and can be linked to aging and other wellness issues. GeneLink scientists use the DNA assessments information on each client and then formulate products to optimize health and wellness within the normal ranges. As discussed further in Note 4, the Company divested its interest in GeneWize effective February 10, 2012 as part of a strategic realignment of its business to offer its products through third-party market partners, and to refocus efforts on research, development and manufacturing of custom products for those market partners.

Note 2.   Summary of Significant Accounting Policies

Principles of consolidation:

The condensed consolidated financial statements include the accounts of the GeneLink, Inc. and its wholly-owned Subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Use of estimates:

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Cash and cash equivalents:

Highly liquid instruments purchased with a maturity of three months or less are considered to be cash equivalents. At times, cash and cash equivalents may exceed federally insured limits. The Company has not experienced any losses on such accounts. All non-interest bearing cash balances were fully insured at September 30, 2012 due to a temporary federal program in effect from December 31, 2010 through December 31, 2012. Under the program, there is no limit to the amount of insurance for eligible accounts. Beginning 2013, insurance coverage will revert to $250,000 per depositor at each financial institution, and the Company's non-interest bearing cash balances may again exceed federally insured limits. The Company had no interest-bearing amounts on deposit in excess of federally insured limits at September 30, 2012.

Accounts Receivable:

Accounts receivable include amounts due from customers and credit card service partners of which the majority represent reserves for potential charge-backs. As of September 30, 2012 and December 31, 2011, the Company has not recorded an allowance for doubtful accounts as management believes all amounts are collectible.

Inventory :

Inventory consists primarily of raw materials for the custom nutritional and skincare products sold by the Company. Inventory is valued at the lower of cost (using the first-in, first-out method) or market.

Property and equipment:

Property and equipment are stated at cost. Expenditures for maintenance and repairs are charged against operations. Renewals and betterments that materially extend the life of the assets are capitalized. Depreciation is computed using the straight-line method over the estimated useful lives of 3 to 5 years of the related assets or the lesser of the expected life or term of the lease as to leasehold improvements.

Intangible Assets:

Intangible assets include costs incurred to apply and obtain patents for its products. Patents are amortized upon approval by regulatory authorities over the estimated useful life of the asset, generally fifteen years on a straight-line basis.

Deferred Loan Costs : Loan acquisition costs are amortized over the term of the debt using the effective interest method.

Long lived assets:

The Company reviews its long-lived assets and certain identifiable intangibles for impairment whenever events or changes indicate that the carrying amount of an asset may not be recoverable. An impairment loss would be recognized when estimated future cash flows expected to result from the use of an asset and its eventual disposition is less than its carrying amount. The Company had not identified an impairment of any such assets for the year ended December 31, 2011. In the nine months ended September 30, 2012, certain pending patents were abandoned and amounts capitalized for the patents were expensed.

Revenue recognition:

Revenue is recognized when there is persuasive evidence of an arrangement, delivery has occurred and title and risk of loss have transferred to the customer, the sales price is determinable and collectability is reasonably assured, generally upon shipment of product.

For retail sales to consumers prior to the sale of Genewize in February, 2012, revenue is reduced for refunds on certain products during the trial period which is the first 60 days after the initial order is shipped. The Company recorded a reserve for refunds based on historical refunds provided to customers which is recorded as a reduction of revenue and is included in accrued expenses on the accompanying balance sheet. The Company received advance payments from retail customers on products ordered which is recorded as deferred revenue until shipment occurs.

Prepaid sales incentives and deferred revenue-license fees represent prepaid fees that are deferred and recognized over the term of the underlying agreement with licensees.

The company recognizes revenue from licensing agreements as earned, which is generally when products are shipped from distributors, over the term of the agreement.

Research and Development:

Research and development costs are expensed as incurred.

Advertising

The Company expenses advertising when incurred. Advertising expense was $39,183 and $32,776 for the nine months ended September 30, 2012 and 2011, respectively.

Stock-Based Compensation:

Stock-based compensation is recorded for recognition of the cost of employee or director services received in exchange for an award of equity instruments in the financial statements and is measured based on the grant date fair value of the award. The stock-based compensation expense is recognized over the period during which an employee is required to provide service in exchange for the award (typically, the vesting period).

The Company estimates the fair value of each option award issued under its stock option plans on the date of grant using a lattice option-pricing model that uses the assumptions noted below. The Company estimates the volatility of its common stock at the date of grant based on the historical volatility of its common stock for a period commensurate with the expected life. These historical periods may exclude portions of time when unusual transactions occurred. The Company determines the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules and post-vesting forfeitures. For shares that vest contingent upon achievement of certain performance criteria, an estimate of the probability of achievement is applied in the estimate of fair value. If the goals are not met, no compensation cost is recognized and any previously recognized compensation cost is reversed. The Company has never paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future. In addition, the Company separates the grants into homogeneous groups and analyzes the assumptions for each group and computes the expense for each group utilizing these assumptions.

The Company granted 3,060,000 and 4,900,000 options during the nine months ended September 30, 2012 and September 30, 2011, respectively. The total fair value of shares vested during the nine months ended September 30, 2012 and September 30, 2011 was $248,150 and $220,660 respectively.

Earnings per share

Basic loss per share is calculated using the weighted average number of common shares outstanding for the period and diluted is computed using the weighted average number of common shares and dilutive common equivalent shares outstanding. Given that the Company is in a net loss position, there is no difference between basic and diluted weighted average shares since the common stock equivalents would be antidilutive.

The following common stock equivalents are excluded from the loss per share calculation as their effect would have been antidilutive:

Income taxes:

The Company has not recorded current income tax expense due to the generation of net operating losses. Deferred income taxes are accounted for using the balance sheet approach which requires recognition of deferred tax assets and liabilities for the expected future consequences of temporary differences between the financial reporting basis and the tax basis of assets and liabilities. A valuation allowance is provided when it is more likely than not that a deferred tax asset will not be realized.

The Company identifies and evaluates uncertain tax positions, if any, and recognizes the impact of uncertain tax positions for which there is more-likely-than-not probability of the position being upheld when reviewed by the relevant taxing authority. Such positions are deemed to be unrecognized tax benefits and a corresponding liability is established on the balance sheet. The Company has not recognized a liability for uncertain tax positions. If there were an unrecognized tax benefit, the Company would recognize interest accrued related to unrecognized tax benefits in interest expense and penalties in operating expenses. The Company’s remaining open tax years subject to examination by the Internal Revenue Service include the years ended December 31, 2009 through December 31, 2011.

Derivative Financial Instruments:

The Company does not use derivative instruments to hedge exposures to cash flow, market or foreign currency risk. Terms of convertible debt and equity instruments are reviewed to determine whether or not they contain embedded derivative instruments that are required to be accounted for separately from the host contract, and recorded on the balance sheet at fair value. The fair value of derivative liabilities, if any, is required to be revalued at each reporting date, with corresponding changes in fair value recorded in current period operating results. An evaluation of specifically identified conditions is made to determine whether the fair value of warrants issued is required to be classified as equity or as a derivative liability.

Beneficial Conversion and Warrant Valuation:

The Company records a beneficial conversion feature (“BCF”) related to the issuance of convertible debt instruments that have conversion features at fixed rates that are in-the-money when issued. The Company also records the fair value of warrants issued in connection with debt instruments. The BCF for the convertible instruments is recognized and measured by allocating a portion of the proceeds to warrants, based on their relative fair value, and as a reduction to the carrying amount of the convertible instrument equal to the intrinsic value of the conversion feature. The discounts recorded in connection with the BCF and warrant valuation are recognized for convertible debt as interest expense over the term of the debt using the effective interest method.

Fair Value of Financial Instruments:

The Company’s financial instruments are recorded at fair value. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair value:

Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of September 30, 2012.

The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values due to the short-term nature of these instruments. These financial instruments include cash, accounts receivable, and accounts payable and accrued expenses. The fair value of the Company’s convertible notes payable approximate their carrying value based upon current rates available to the Company.

During 2011, the Company issued warrants in connection with a license and distribution agreement (see Note 4) and engaged a third party to complete a valuation of those warrants which were recorded as Prepaid Sales Incentive on the accompanying balance sheet. The valuation was completed using Level 2 inputs.

Note 3:   2011 Restatement

The accompanying financial statements for the interim periods ended September 30, 2011 were restated for the following reasons:

Adjustments

Reclassifications:

The following table summarizes the impact of the adjustments and restatements for the periods ended September 30, 2011:

Note 4:  Sale of GeneWize

On October 13, 2011, the Company entered into a Stock Purchase Agreement (the “Stock Purchase Agreement”) with Capsalus Corp. (“Capsalus”), pursuant to which the Company agreed to sell 100% of the stock of its wholly-owned subsidiary, GeneWize Life Sciences, Inc. (“GeneWize”). The Stock Purchase Agreement provided for a purchase price of $500,000 payable at the closing, plus an earn-out of between $1.5 million and $4.5 million, subject to the performance of GeneWize after the closing. The earn-out amount is calculated as the greater of $25,000 per month or 10% to 15% of GeneWize monthly gross revenues, payable monthly through April, 2017. The effective date of the closing was February 10, 2012; the date final documents were completed following approval of the transaction by the shareholders of GeneLink. Due to continuing involvement with GeneWize subsequent to the sale, this transaction was not accounted for as a discontinued operation.

GeneLink recorded a gain on sale of subsidiary as of February 10, 2012. Consideration for the sale included the $500,000 cash received from Capsalus and an additional $39,272 for working capital. Additional consideration included the earn-out amount which was valued at $164,358, the Company’s estimate of net present value of probable cash collections under the agreement. The total consideration of $703,630 was offset by net liabilities and related costs of sale resulting in a gain on sale of $759,054. In the second quarter of 2012, a review of working capital calculations resulted in a correction of an error in the estimate of working capital of $90,000, decreasing the final gain on sale to $669,054.

GeneLink, GeneWize and Capsalus also entered into an Interim Management Agreement dated October 13, 2011, pursuant to which Capsalus managed the operation of GeneWize until the closing date of February 10, 2012. Pursuant to the Interim Management Agreement, Capsalus was responsible for all expenses and received all revenues of GeneWize from October 1, 2011 through the date of closing. Capsalus advanced $204,500 to GeneWize prior to December 31, 2011 to fund operations which was recorded as “Advances from Purchaser” on the accompanying balance sheet at December 31, 2011 and an additional $75,000 was advanced to Genewize by Capsalus prior to the closing of the sale of GeneWize. This amount was assumed by Genewize in February 2012 upon the closing of the sale of GeneWize.

On October 13, 2011, GeneLink entered into a License and Distribution Agreement (the “LDA”) with Gene Elite LLC (“Gene Elite”) which expires in 2017 with successive five-year renewal options provided Gene Elite meets sales and performance criteria. Pursuant to the LDA, GeneLink granted Gene Elite the exclusive right to sell certain skin care and nutrition products in the direct sales, multi- level marketing (MLM) and athletic formula channels. Pursuant to the LDA, the Company received $1,500,000 in license fees, of which $1,000,000 (the “Up-front fee”) was received during 2011 and $500,000 was received on February 10, 2012, the closing date of the sale of GeneWize. The LDA provides for $750,000 of the Up-front fee as a Nonrefundable Advance Deposit which accrues interest at 4% per year and will be paid through product credits or issuance of common stock at market price, at the discretion of Gene Elite. The remaining $750,000 of the license fees was recorded as “Deferred Revenue - License Fees” on the accompanying balance sheet, which will be recognized over the term of the LDA beginning on February 10, 2012.

In connection with the LDA, GeneLink and Gene Elite entered into a Warrant Purchase Agreement dated October 13, 2011 pursuant to which GeneLink granted Gene Elite warrants to purchase (i) 6,000,000 shares of common stock of GeneLink at an exercise price of $0.10 per share and (ii) 2,000,000 shares of common stock of GeneLink at an exercise price of $0.45 per share (collectively, the “non-performance warrants”). In addition, and, subject to certain performance requirements being satisfied, Gene Elite was granted warrants to purchase 6,000,000 shares of common stock of GeneLink at an exercise price of $0.20 per share (the “performance warrants”). The 8,000,000 shares underlying the non-performance warrants, valued at $460,000 at issue date, are accounted for as “Prepaid Sales Incentives” on the accompanying balance sheet and will be amortized over the life of the licensing agreement. The non-performance warrants were valued using a Binomial Lattice Option Valuation Technique (“Binomial”) and the following assumptions:

The issuance date of the performance warrants was the date of closing, February 10, 2012, and management currently does not expect the performance warrants to be earned.

On February 10, 2012, GeneLink, Gene Elite and GeneWize entered into a sub-licensing and distribution agreement (SLDA) which grants GeneWize the exclusive rights contained in the LDA to market and sell certain skin care and nutrition products in the direct sales, multi- level marketing (MLM) and athletic formula channels. The term of the SLDA is concurrent with the term of the LDA including the successive renewal options granted under the LDA.

Through September 30, 2012, Capsalus has paid $165,900 of the earn-out amount. Capsalus has failed to pay any earn-out due subsequent to June 30, 2012. The Company is in discussions with Capsalus regarding this receivable.

Note 5:   Shareholder’s Equity

During the three months ended September 30, 2012, the Company sold 7,833,333 shares of restricted Common Stock of the Company at an exercise price of $0.03 per share pursuant to a Confidential Private Offering Memorandum, and received an aggregate gross amount of $235,000.

In connection with the above offering, the Company incurred a total of $13,800 in placement fees and expenses and issued warrants to acquire 575,000 shares of Common Stock at an exercise price of $0.03 per share to First Equity Capital Securities, Inc., as placement agent, in connection with the sale of these units.

During the three months ended June 30, 2012, the Company sold 3,000,000 shares of restricted Common Stock of the Company at an exercise price of $0.03 per share pursuant to a Confidential Private Offering Memorandum, and received an aggregate gross amount of $90,000.

In connection with the above offering, the Company incurred a total of $7,200 in placement fees and expenses and issued warrants to acquire 300,000 shares of Common Stock at an exercise price of $0.03 per share to First Equity Capital Securities, Inc., as placement agent, in connection with the sale of these units.

Kenneth R. Levine, a holder of more than five percent of the equity securities of the Company, a member of the Company’s Scientific Advisory Board, and an advisor to the Company’s board of directors, is an officer and owner of First Equity Capital Securities, Inc. First Equity has been engaged by the Company to advise and support the Board and the Company with regard to numerous issues, including but not limited to, strategic business development, financial and operating issues, and legal relationships. First Equity is currently entitled to receive a stipend of $5,000 per month for such services. First Equity was compensated in the amount of $80,000 for services provided to the Company in relation to the Company’s transactions in relation to the sale of GeneWize and the development of various licenses and agreements related thereto.

Note 6:   Related Parties

Consulting Fees

The Company entered into a consulting agreement with a shareholder and officer of the Company for scientific advisory services. The agreement provides for annual payments of $30,000, payable $2,500 per month. As of September 30, 2012 and December 31, 2011, amounts due the officer were $5,000 and $2,500, respectively, and are included in accounts payable on the accompanying balance sheets. Since 2008, the Company has maintained a consulting agreement with First Equity Capital Securities, to provide advisory and other services. The agreement provides for annual payments of $60,000, payable in the amount of $5,000 per month. On March 2, 2012, First Equity converted all amounts then owed under this agreement to 1,487,220 shares of restricted common stock. At September 30, 2012 accounts payable included $30,000 for amounts due to First Equity under this agreement.

Due to Shareholder

A shareholder advanced the Company $10,000 which remained due as of September 30, 2012. Such advance does not bear interest and is due upon demand.

Note 7.   Contingencies

Marketing and advertising practices in the dietary supplement and skin care areas are subject to Federal Trade Commission (FTC) regulation. Enforcement actions have been undertaken by the FTC against companies alleged to have made false and misleading marketing statements. The FTC actions have resulted in consent decrees and required monetary payments by the involved parties. The Company believes that it currently is in compliance with all relevant FTC regulations. New regulations may be promulgated as a result of new legislation or by changing enforcement policy in any of the relevant regulatory agencies.

In March 2011, the Company received a Civil Investigative Demand (“CID”) consisting of interrogatories and a request to produce documents from the FTC as part of its investigation into unnamed persons engaged directly or indirectly in the advertising or marketing of dietary supplements, foods, drugs, devices, or any other product or service intended to provide a health benefit or to affect the structure or function of the body. The Company expended significant resources in 2011 and into 2012 in an attempt to comply with this request.

During 2012, the staff of the FTC (the “staff”) investigated the Company for potential violations of Sections 5 and 12 of the Federal Trade Commission Act, 15 U.S.C. Sections 45 and 52, in connection with the advertising, marketing and sale of its DNA Assessments and genetically customized nutritional supplements and skin repair serum products. The Company strongly believes its advertising and marketing are lawful and appropriate.

Following additional discussions with the staff, on October 26, 2012, in order to resolve this matter, the Company entered into a proposed consent decree with the Federal Trade Commission with regard to the FTC’s investigation. The proposed order is subject to approval by the full Commission.

The resolution of this matter may involve limitations on GeneLink’s activities, including but not limited to restrictions on the Company’s marketing claims and practices and the institution of monitoring obligations. These restrictions are also anticipated to apply to the marketing claims and practices of GeneLink’s marketing partners and distributors. The pending consent agreement does not include any fine and/or economic redress.

Note 8.   Going Concern and Management’s Plans

The Company has incurred recurring operating losses since inception including a loss of $2,042,689 in the nine months ending September 30, 2012 and had an accumulated deficit at September 30, 2012 of $26,603,004. These conditions raise substantial doubt about the Company's ability to continue as a going concern.

The Company's ability to continue as a going concern is dependent upon the achievement of its marketing plans to enhance sales and its ability to raise capital. Management continues to work with existing market partners as well as pursuing additional distribution opportunities. Management also believes it has the opportunities before it to increase sales which will provide a foundation for raising additional capital. The Company’s financial statements have been prepared on the basis that it is a going concern, which assumes continuity of operations and the realization of assets and satisfaction of liabilities in the ordinary course of business. The financial statements do not include any adjustments that might result if the Company was forced to discontinue its operations .