HDII Hypertension Diagnositc Inc (CE)

Notes to the Consolidated Financial Statements

December 31, 2012

Note 1.   Basis of Presentation

The accompanying unaudited consolidated financial statements of Hypertension Diagnostics, Inc. (the “Company” or “HDI”) have been prepared in accordance with the instructions to Form 10-Q and do not include all the information and notes required by generally accepted accounting principles for complete financial statements.  In the opinion of management, these unaudited financial statements reflect all adjustments, consisting only of normal and recurring adjustments necessary for a fair presentation of the financial statements.  The results of operations for the three and six months ended December 31, 2012 are not necessarily indicative of the results that may be expected for the full year ending June 30, 2013.  For further information, refer to the financial statements and notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2012, as amended.  The policies described in that report are used for preparing quarterly reports.

On July 14, 2011, the Company formed HDI Plastics, Inc. (“HDIP” or “Plastics”), as a wholly-owned subsidiary of the Company. HDIP commenced operations in October 2011.  HDIP is the principal operating business of the Company.  HDIP is engaged in the processing of recycled plastic material including re-processing into pellet-form for sale to manufacturing customers.

Note 2. Going Concern

The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, assuming the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. For the six months ended December 31, 2012, we incurred losses from continuing operations of $890,194. At December 31, 2012, we had an accumulated deficit of $ 30,053,638 and negative working capital of $446,126. Our ability to continue as a going concern is dependent on our ability to raise the required additional capital or debt financing to meet short-term needs to repay certain liabilities to restart HDIP’s facility, hire production workers, and ramp up to full operating capacity and earn revenue. On February 4, 2013, HDIP borrowed $200,000 pursuant to a Secured Promissory Note (the “Note”) in a principal amount of $200,000 in favor of Mark Schwartz and Alan Stern, directors of the Company. (See Note 16 to the financial statements).  Under the terms of the Note, HDIP may borrow an additional $300,000 on the same terms and conditions as those set forth in the Note. See Note 16 to these financial statements for more information.

If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our current shareholders could be reduced, and such securities might have rights, preferences or privileges senior to our common stock. Additional financing may not be available upon acceptable terms, or at all. If adequate funds are not available or are not available on acceptable terms, we may not be able to adequately restart our plastics business, which could significantly and materially restrict our operations.

Note 3.   Summary of Significant Accounting Policies

Discontinued Operations- On August 26, 2011 (the “Effective Date”), the Company entered into and closed a definitive Asset Purchase Agreement (the “Agreement”) providing for the sale of selected assets from our Hypertension Diagnostics Business to Cohn Prevention Center, LLC (“CPC”), a Minnesota company, controlled by a Jay Cohn, a director and stockholder of HDI as of the Effective Date. See additional terms of this agreement in Note 4. As a result of the sale of selected assets of our medical device business, we have reclassified our previously reported financial results to exclude those operations affected by the sale. These results are presented on an historical basis as a separate line in our statements of operations and balance sheets entitled “Discontinued Operations.”  HDI had previously retained rights to its intellectual property including the rights to royalty payments from CPC.  Ongoing income derived from the Company’s intellectual property is reflected as continuing operations.  All of the information in the financial statements and notes to the financial statements has been revised to reflect only the results of our continuing operations from our new recycled plastics process business. On January 25, 2013, (the “Effective Date”), the Company entered into and closed a second definitive Asset Purchase Agreement (the “Agreement”) with CVC-HD, LLC, a Minnesota limited liability company (“CVC”), controlled by Jay Cohn, effectively amending the August 26, 2011 Agreement and assigning the remaining assets related to the medical device business including intellectual property assets for an additional purchase price of $75,000. A payment of $37,500 was received at closing and the remaining $37,500  plus $200,000 still due on the original sale is due over the next five months. The royalty provisions of the August 26, 2011 Agreement were eliminated in this agreement.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary (HDI Plastics, Inc.), after elimination of all intercompany accounts, transactions, and profits.

Recent Accounting Pronouncements

There were no new accounting standards issued or effective during the quarter ended December 31, 2012 that had, or are expected to have a material impact on the Company’s results of operations, financial condition or cash flows.

Note 4.   Discontinued Operations

On August 26, 2011, (the “Effective Date”), the Company entered into and closed a definitive Asset Purchase Agreement (the “Agreement”) providing for the sale of selected assets of  our medical device business to Cohn Prevention Center, LLC, a Minnesota limited liability company (“CPC”), controlled by Jay Cohn, a director and stockholder of HDI as of the Effective Date. The terms of the Agreement provided for the sale of selected operating assets of the Company’s medical device business (including inventory but excluding cash, accounts receivable, and intellectual property).  The Agreement does not limit the ability of CPC to sell the purchased inventory to any customer or in any market where they can be legally sold.  Additionally, CPC assumed all warranty and on-going product support required by regulatory agencies related to such inventory.

In connection with the Agreement, CPC paid the Company on the Effective Date a cash payment of $125,000 and issued a secured promissory note (non-interest bearing) to the Company in the amount of either $150,000 due in 12 months or $200,000 due in 18 months at the discretion of CPC (See Note 5). We received a letter on July 27, 2012 from CPC indicating the intent to pay $200,000 on February 26, 2013. Nearly all of the proceeds received on the Effective Date were allocated to cover severance and other costs related to the transactions contemplated by the Agreement. Severance costs included an agreement by the Company to pay to Greg Guettler, its former Chief Operating Officer, nine months’ salary and health benefits. The Company paid Mr. Guettler $119,463 to fulfill the agreement on March 1, 2012. Pursuant to the Agreement, CPC agreed to pay to the Company a cash payment of $1,200 upon the sale of each of the first 50 units of inventory sold by CPC within 30 days of receipt of cash from such sale. The Company has agreed to pay Mr. Guettler 10% of the royalty proceeds received by the Company less applicable transaction expenses related to such sales.  The Company has earned royalty income of $3,600 and $6,000 less 10% due to Greg Guettler for the three and six months ended December 31, 2012, respectively.

The Company and CPC also entered into a Sublicense Agreement on the Effective Date (the “Sublicense Agreement”), pursuant to which the Company granted to CPC a limited license to use the Company’s intellectual property, technology, and technical know-how related to the Company’s arterial elasticity measurement technology exclusively in CPC clinics and research related exclusively to CPC clinics.  All other applications of the Company’s intellectual property, technology and technical know-how will be retained by the Company for the benefit of the Company.  The Sublicense Agreement also provides that any development of a next generation arterial measurement device, however, would be limited exclusively to use and sale within the CPC network of clinics and to research exclusively related to CPC clinics.

CPC and the Company also entered into a Sublease Agreement as of the Effective Date, which permits CPC to lease the Waters II Suite 108, Eagan, Minnesota facility of the Company during the remaining term of the Company’s lease, which expires October 31, 2014, on the same pass-through economic terms as the underlying lease with HDI which remains as an obligation of the Company.

Upon the closing of this transaction, the Company had limited remaining operations related to its medical device business and intends to potentially seek additional opportunities to license its proprietary technology, intellectual property, technical know-how and other core assets, although there is no assurance these efforts will be successful.

The Company recorded a loss on the sale transaction in the amount of $123,702 in the quarter ended September 30, 2011.

Subsequent to December 31, 2012, on January 25, 2013, (the “Effective Date”), the Company entered into and closed a second definitive Asset Purchase Agreement (the “Agreement”) modifying the August 26, 2011 Agreement, by selling the remaining medical device business assets to CVC-HD, LLC, a Minnesota limited liability company (“CVC”), controlled by Jay Cohn, for $275,000, encompassing the original $200,000 still owed the Company and an additional purchase price of $75,000. The $275,000 consists of a cash payment in the amount of $37,500 due on the Effective Date which was received, and a promissory note in the amount of $237,500 payable in installments with the first payment of $37,500 due February 2013 and $50,000 due each subsequent month with the final payment due in June 2013. In addition, CVC paid the Company royalties due from CPC for the period of October 2012 through November 2012 in the amount of $3,600 less $2,560 for maintenance fees on the intellectual property paid by CPC.

The Company has not included the results of operations of our former medical device business in the results from continuing operations.  The income (loss) from discontinued operations for the three and six months ended December 31, 2012, and 2011 consists of the following:

The Company does not have any existing assets of discontinued operations at December 31, 2012. The only remaining liabilities of discontinued operations as of December 31, 2012 pertain to the deferred compensation of the former CEO. (See Note 9)

Note 5.   Notes Receivable – Related Parties

In connection with the Asset Purchase Agreement between HDI and CPC, CPC paid HDI on the Effective Date a cash payment of $125,000 and issued a non-interest bearing secured promissory note due to HDI in the amount of either $150,000 due in 12 months or $200,000 due in 18 months, at the discretion of CPC. The promissory note was reflected at an imputed discount rate of 15%  based upon the amount due 12 months following the Effective Date, and was originally recorded as a net note receivable of $127,500.  The balance of the Note at December 31, 2012 is $150,000. The Company received a letter from CPC on July 27, 2012 indicating CPC’s intent to pay the $200,000 due February 26, 2013. The Company has elected to not recognize the additional income forthcoming on this Note until the cash is collected in the future.

Subsequent to December 31, 2012, the Company sold the remaining intellectual property for an additional $75,000 (See Note 4). The Company received $37,500 in cash on January 25, 2013 and a promissory note in the amount of $237,500 that replaces the existing note issued by CPC listed above. The new note is payable in installments with the first payment due February 2013 for $37,500, and $50,000 due per month beginning in March 2013 with the final payment due June 2013.

Depreciation expense was $36,813 and $29,957 for the three months ended December 31, 2012 and 2011, respectively. For the six months ended December 31, 2012 and 2011, depreciation expense was $71,989 and $29,957, respectively.

The Company recognized a gain of $625 from the sale of equipment in the three month period ended December 31, 2012, and a net loss of $79,973 in the six months ended December 31, 2012 related to the abandonment of leasehold improvements associated with the property at 5330 Fleming Court, Austin, TX due to the termination of lease and the surrender of the property.

Note 7.   Litigation

The Company is involved in various legal actions in the ordinary course of its business.  

On March 28, 2012, HDIP received a Notice of Violation related to its sole processing facility located at 5330 Fleming Court, Austin, Texas, from the City of Austin Code Compliance Department.  The Notice of Violation alleges violations of Austin’s City Code and failures to obtain required permits and a Certificate of Occupancy based upon the current use of the processing facility. The violation primarily relates to the electrical design and capacity of the building. The Notice of Violation required HDIP to vacate the processing facility until such alleged violations are cured.  HDIP unsuccessfully attempted to negotiate temporary permits allowing it to continue operations while it addresses the alleged violations identified in the Notice of Violation.  On March 29, 2012, HDIP ceased processing operations at the processing facility.  On April 2, 2012, HDIP notified approximately 70 of its employees working at the facility of their termination and they were paid their outstanding vacation pay, however, no severance was paid. The Company is in the final stages of relocating its operations to a new location in Taylor, TX. At this time, the Company has not been assessed any fines or penalties by the City of Austin, but no assurances can be made that they will not do so in the future. At the time of this filing, the Company is engaged in limited production activities at its Taylor facility and expects to initiate full production during its third quarter.

Because the City of Austin required HDIP to vacate the property at 5330 Fleming Court, the landlord, Flemtex Properties (“Flemtex”) denied access to the premises; therefore, the Company did not pay rent and utilities for April and May 2012. On May 30, 2012, the Company received a Notice of Termination of Lease from Flemtex, for failure to pay rent and reimbursable costs. The letter stated that the Lease was terminated effective May 31, 2012, and that HDI was to quit and surrender the Leased Premises to the landlord in accordance with the requirements of the Lease on May 31, 2012, and to remove all of the Tenant’s personal property from the Leased Premises. The Company is in the process of negotiating a final Termination Agreement related to its Austin lease. The Company has been informed that the landlord is withholding a final release of all obligations of the Company related to the lease until all of the discharge water is removed from the property, which was completed as of October 31, 2012. The Company has accrued as of December 31, 2012, the utility and rent payments due for April and May 2012 totaling $139,493.

On July 12, 2012, a representative of the Travis County, (Texas) Attorney Office, Texas Parks and Wildlife, and the Texas Commission on Environmental Quality (TEEQ) searched the Company’s Austin offices pursuant to an affidavit signed by a representative of Texas Parks and Wildlife seeking evidence that the Company committed the offense of intentional or knowing unauthorized discharge of a pollutant under Section 7.145 of the Texas Water Code. No charge of illegal discharge has been made against the Company. The Company has not been contacted further relative to alleged discharge and strongly denies any such discharge occurred. As of October 31, 2012 the removal and disposal of the waste water at the Company’s former facility was completed.

On December 14, 2012, Flemtex Properties filed a lawsuit alleging breach of the commercial lease at the Fleming Court location. The lawsuit seeks damages totaling $412,711 as of November 16, 2012 and future obligations due under the lease which extends to December 2017. The Company intends to vigorously defend itself and may seek compensation for losses resulting from the willful and malicious interference into its Fleming Court operations by the landlord and its agent. Due to the uncertainty regarding the outcome of this matter, the Company does not believe that it is probable that they will owe all of the damages claimed by Flemtex and have only accrued for the costs of the lease up until Flemtex terminated the lease on May 31, 2012, as noted above. The Company does not believe they are liable for any additional lease costs beyond May 31, 2012.

Note 8.  Stock Options

The Company regularly grants stock options to individuals under various plans as described in Note 13 to the Consolidated Financial Statements set forth in the Company’s Annual Report on Form 10-K for the year ended June 30, 2012, as amended.  The Company recognizes share-based payments, as compensation costs for transactions, including grants of employee stock options, to be recognized in the financial statements.  Stock-based compensation expense is measured based on the fair value of the equity or liability instrument issued.  Share-based compensation arrangements may include: stock options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans.  The Company measures the cost of employee services received in exchange for stock options based on the grant-date fair value of the award, and expenses the cost over the period in which the employee is required to provide services for the award.  The Company uses the Black-Scholes option-pricing model that meets the fair value objective.

During the three and six months ended December 31, 2012 and 2011, there were no stock options granted. The Company recognized compensation expense of $0 for the three and six months ended December 31, 2012, and $22,500 and $87,125 for the three and six months ended December 31, 2011, which were related to options previously granted.

Note 9.

Deferred Compensation Liability

The Company is a party to a Deferred Equity Compensation Agreement with its former CEO, Mark N. Schwartz (the “Agreement”), whereby the Company granted phantom shares of its common stock to Mr. Schwartz for every month of employment over the years of his employment. Mr. Schwartz resigned as the Company’s CEO effective September 22, 2011 and as a result, agreed as of October 1, 2011 that no additional phantom shares will be granted him under the Agreement. Under the Agreement, a cash payment will be made equal to the price per share of the Company’s common stock times the number of phantom shares accrued at the earliest of certain events to occur.

The Company has accrued a total deferred compensation liability of $144,649 at December 31, 2012, which is the fair market value of 13,125,000 phantom shares outstanding as of December 31, 2012 ($131,250) plus $13,399 of accrued payroll taxes and vacation pay related to the agreement.  Due to the fluctuations in the price of the Company’s common stock during the six months ended December 31, 2012, the Company recorded a net compensation expense (benefit) of ($407,982) and ($135,994) for the three and six months ended December 31, 2012, respectively. For the three and six months ended December 31, 2011, the Company recorded a net compensation expense (benefit) of ($131,250) and $558,750, respectively. An increase in the Company’s common stock price would cause an increase in the deferred compensation, while a decrease in the Company’s stock price would cause a decrease in the deferred compensation liability. Expenses related to the Deferred Compensation arrangement with its former CEO are accounted for as part of Discontinued Operations.

Under the original terms of Mr. Schwartz’s deferred equity compensation agreement, payment of the deferred compensation benefit would occur upon one of the following events: i) execution of a definitive agreement resulting in a change of control of the Company’s common stock; ii) termination of employment; iii) death of the CEO; or iv) no later than January 1, 2012. Upon one of these events, a cash payment over 24 months was to be made to the CEO equal to the trading price per share of the Company’s common stock times the number of phantom stock shares accrued to date.  Mr. Schwartz and the Company modified the original Agreement on December 31, 2011, whereby Mr. Schwartz agreed to eliminate the requirement for a cash payment as of a date certain pursuant to the Agreement. This deferred compensation is classified as a long-term liability with no definitive payout date specified. The Company and Mr. Schwartz are negotiating a permanent settlement to satisfy both parties.

Note 10.  Factoring Line of Credit

On October 10, 2011, HDI Plastics, Inc. entered into an Accounts Receivable Discount line facility with Charter Capital Holdings, L.P.  (“Charter”). Under the terms of the full-recourse financing agreement, which is guaranteed by HDI, Charter advances to HDIP and amount equal to 80% of eligible pledged receivables up to a total advance of $1 million. Charter retains a priority and perfected security interest in all accounts receivable and inventory of HDI Plastics, Inc.  The financing cost under the agreement is 0.59% for each 10-day period or an approximate annualized interest cost of approximately 21.25%. HDIP began borrowing under this facility in November 2011.  The outstanding balance as of December 31, 2012 is $9,629 and $0 as of June 30, 2012.

Note 11. Note Payable-Taylor Economic Development

On December 24, 2012, HDIP entered into a Letter of Agreement with the Taylor Economic Development Corporation (“TEDCO”).  Under the terms of the TEDCO Agreement, TEDCO agreed to advance up to $140,000 for improvements and upgrades to the Company’s new facility located in Taylor, Texas. The advances are in the form of a forgivable loan which will convert to a grant in 10 years provided among other conditions, HDIP continues to operate in Taylor and maintain at least 50 full-time jobs at the Taylor facility.  Should HDIP default under its agreement with TEDCO, the Company may be required to repay the advances with interest at the prime rate plus 3%.  As of December 31, 2012, $49,556 had been advanced under the TEDCO Agreement. As of February 11, 2013, the advanced amount was $103,232.

Note 12.   Note Payable - Subordinated Debt

In December 2011, the Company commenced a private placement offering of 14.5% Five Year Subordinated Notes (the “Notes”) with Warrants to its existing preferred shareholders, directors of the Company and certain other accredited investors. The notes are issued by HDIP and are guaranteed by the Company.  Interest is payable monthly in cash. The offering was completed February 10, 2012 and resulted in the issuance of $833,600 in notes and five-year warrants to purchase an aggregate of 11,908,572 shares of the Company’s common stock with an exercise price of $.07 per share. The notes are due five years from the closing date at 105% of face value. The total estimated value of the warrants using the Black-Scholes Option Pricing Model, with a volatility rate of 153%, had an estimated fair value of $0.03 per warrant. After calculating the relative fair value of the debt and warrants, $252,393 was recorded as a debt discount to the notes for the warrants. The discount is being amortized over the term of the debt using the effective interest method.