Notes to Condensed Consolidated Financial
Statements
(Unaudited)
Note 1. Description of Business
Description of Business
MusclePharm Corporation,
or the Company, was incorporated in Nevada in 2006.
Except
as otherwise indicated herein, the terms “Company,” “we,” “our” and “us” refer
to MusclePharm Corporation and its subsidiaries. The Company is a scientifically driven, performance lifestyle company that develops,
manufactures, markets and distributes branded nutritional supplements. The Company is headquartered in Denver, Colorado and,
as of September 30, 2016, had the following wholly-owned operating subsidiaries: MusclePharm Canada Enterprises Corp (“MusclePharm
Canada”), MusclePharm Ireland Limited (“MusclePharm Ireland”) and MusclePharm Australia Pty Limited (“MusclePharm
Australia”). A former subsidiary of the Company, BioZone Laboratories, Inc. (“BioZone”), was sold on May 9, 2016.
On August 24, 2015, the Company’s Board of Directors
(the “Board”) approved a restructuring plan for the Company. The approved restructuring plan was designed to reduce
costs and to better align the Company’s resources for profitable growth. Specifically, through September 30, 2016, the
restructuring plan resulted in: 1) reducing the Company’s workforce; 2) abandoning certain leased facilities; 3) renegotiating
or terminating a number of contracts with endorsers in a strategic shift away from such arrangements and toward more cost effective
marketing and advertising efforts; 4) discontinuing a number of stock keeping units (“SKUs”) and writing down inventory
to net realizable value, or to zero in cases where the product was discontinued; and 5) writing off certain assets. Management
has substantially completed the approved restructuring plan, and as such, we do not anticipate any additional restructuring charges. See
Note 4 for further detail.
Management’s Plans with Respect to Liquidity
and Capital Resources
The Company’s management believes the restructuring
plan implemented during August 2015, the reduction in ongoing operating costs and expense controls and the sale of BioZone, as
further described in Note 6, may enable the Company ultimately to be profitable. However, the Company may need to continue to raise
capital. There can be no assurance that such capital will be available on acceptable terms or at all.
As of September 30, 2016, the Company had an accumulated
deficit of $159.8 million and recurring losses from operations. The Company may incur additional losses until such time it can
generate significant revenues and/or reduce operating costs. In September 2014, the Company borrowed $8.0 million under a
line of credit with a bank. In February 2015, the Company entered into a term loan agreement with the same bank and borrowed
$4.0 million. In December 2015, the Company received $6.0 million upon the issuance of a convertible note with a related party
and subsequently repaid all borrowings. In January 2016, the Company entered into a secured borrowing arrangement, pursuant to
which the Company has the ability to borrow up to $10.0 million subject to sufficient amounts of accounts receivable to secure
the loan. Under this arrangement, during the nine months ended September 30, 2016, the Company received $39.5 million in cash and
subsequently repaid $40.0 million, including fees and interest, on or prior to September 30, 2016.
As of September 30, 2016, the Company had approximately
$5.9 million in cash and $21.0 million in working capital deficit.
The accompanying Condensed Consolidated Financial Statements
as of, and for, the three and nine months ended September 30, 2016 were prepared on the basis of a going concern, which contemplates,
among other things, the realization of assets and satisfaction of liabilities in the ordinary course of business. Accordingly,
they do not give effect to adjustments that would be necessary should the Company be required to liquidate its assets. The
Company has not established an ongoing source of revenue sufficient to cover its operating costs for at least the next 12 months
in order to continue as a going concern. The ability of the Company to meet its total liabilities of $54.8 million as of September
30, 2016, and to continue as a going concern is dependent on the Company obtaining adequate capital to fund operating losses until
it becomes profitable. The Company can give no assurances that any additional capital that it is able to obtain, if any, will be
sufficient to meet its needs, or that any such financing will be obtainable on acceptable terms. If the Company is unable to obtain
adequate capital, it could be forced to cease operations or substantially curtail its commercial activities. These conditions raise
substantial doubt as to the Company’s ability to continue as a going concern. The accompanying Condensed Consolidated Financial
Statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts
and classification of liabilities that might result from the outcome of these uncertainties.
Note 2. Summary of Significant Accounting Policies
Basis of Presentation and Principles of Consolidation
The accompanying Condensed Consolidated Financial Statements
have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”). The Condensed
Consolidated Financial Statements include the accounts of MusclePharm Corporation and its wholly-owned subsidiaries. All significant
intercompany balances and transactions have been eliminated in consolidation.
Unaudited Interim Financial Information
The accompanying unaudited interim Condensed Consolidated
Financial Statements have been prepared in accordance with GAAP and with the instructions to Form 10-Q and Article 10 of Regulation
S-X for interim financial information. Accordingly, these statements do not include all of the information and notes required by
GAAP for complete financial statements. The Company’s management believes the unaudited interim Condensed Consolidated Financial
Statements include all adjustments of a normal recurring nature necessary for the fair presentation of the Company’s financial
position as of September 30, 2016, results of operations for the three and nine months ended September 30, 2016 and 2015,
and cash flows for the nine months ended September 30, 2016 and 2015. The results of operations for the three and
nine months ended September 30, 2016 are not necessarily indicative of the results to be expected for the year ending December
31, 2016.
These unaudited interim Condensed Consolidated Financial
Statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s
Annual Report on Form 10-K for the year ended December 31, 2015, filed with the SEC on March 17, 2016.
Use of Estimates
The preparation of consolidated financial statements
in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported and disclosed in
the consolidated financial statements and accompanying notes. Such estimates include, but are not limited to, allowance for doubtful
accounts, revenue discounts and allowances, the valuation of inventory and tax assets, the assessment of useful lives, recoverability
and valuation of long-lived assets, likelihood and range of possible losses on contingencies, restructuring liabilities, valuations
of equity securities and intangible assets, fair value of derivatives, warrants and options, among others. Actual results could
differ from those estimates.
Revenue Recognition
Revenue is recognized when
all of the following criteria are met:
|
·
|
Persuasive evidence of an arrangement exists.
Evidence of an arrangement consists of an order from the Company’s
distributors, resellers or customers.
|
|
·
|
Delivery has occurred.
Delivery is deemed to have occurred when title and risk of loss has transferred, either
upon shipment of products to customers or upon delivery.
|
|
·
|
The fee is fixed or determinable.
The Company assesses whether the fee is fixed or determinable based on the terms
associated with the transaction.
|
|
·
|
Collection is reasonably assured.
The Company assesses collectability based on credit analysis and payment history.
|
The Company’s standard
terms and conditions of sale allow for product returns or replacements in certain cases. Estimates of expected future product returns
are recognized at the time of sale based on analyses of historical return trends by customer type. Upon recognition, the Company
reduces revenue and cost of revenue for the estimated return. Return rates can fluctuate over time, but are sufficiently predictable
with established customers to allow the Company to estimate expected future product returns, and an accrual is recorded for future
expected returns when the related revenue is recognized. Product returns incurred from established customers were insignificant
for the three and nine months ended September 30, 2016 and 2015, respectively.
The Company offers sales incentives
through various programs, consisting primarily of advertising related credits, volume incentive rebates and sales incentive reserves.
The Company records advertising related credits with customers as a reduction to revenue as no identifiable benefit is received
in exchange for credits claimed by the customer. Volume incentive rebates are provided to certain customers based on contractually
agreed upon percentages once certain thresholds have been met. Sales incentive reserves are computed based on historical trending
and budgeted discount percentages, which are typically based on historical discount rates with adjustments for any known changes,
such as future promotions or one-time historical promotions that will not repeat for each customer. The Company records sales incentive
reserves and volume rebate reserves as a reduction to revenue.
During the three and nine months ended September 30,
2016, the Company recorded discounts, and to a lesser degree, sales returns, totaling $10.8 million and $27.9 million, respectively,
which accounted for 26% and 21% of gross revenue in each period, respectively. During the three and nine months ended September
30, 2015, the Company recorded discounts, and to a lesser degree, sales returns, totaling $5.9 million and $19.9 million, respectively,
which accounted for 15% and 14% of gross revenue in each period, respectively.
Stock-Based Compensation
The Company estimates the fair value of employee stock
options on the date of grant using the Black-Scholes option-pricing model. The determination of the fair value of each stock award
using this option-pricing model is affected by the Company’s assumptions regarding a number of complex and subjective variables.
These variables include, but are not limited to, the expected stock price volatility over the term of the awards and the expected
term of the awards based on an analysis of the actual and projected employee stock option exercise behaviors and the contractual
term of the awards. The Company recognizes stock-based compensation expense over the requisite service period, which is generally
consistent with the vesting of the awards, based on the estimated fair value of all stock-based payments issued to employees and
directors that are expected to vest.
Recent Accounting Pronouncements
During August 2016, the Financial
Accounting Standards Board (“FASB”) issued ASU 2016-15,
Statement of Cash Flows - Classification of Certain Cash
Receipts and Cash Payments
, which addresses eight specific cash flow issues with the objective of reducing the existing diversity
in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The standard
is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption
is permitted, including adoption in an interim period. The Company is currently in the process of evaluating the impact of this
new pronouncement on the Company’s Condensed Consolidated Statements of Cash Flows.
In March 2016, the FASB issued Accounting Standards Update
(“ASU”) No. 2016-08,
Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting
Revenue Gross versus Net)
(“ASU 2016-08”) which clarified the revenue recognition implementation guidance on principal
versus agent considerations and is effective during the same period as ASU 2014-09. In April 2016, the FASB issued ASU No. 2016-10,
Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing
(“ASU 2016-10”)
which clarified the revenue recognition guidance regarding the identification of performance obligations and the licensing implementation
and is effective during the same period as ASU 2014-09. In May 2016, the FASB issued ASU No. 2016-12,
Revenue from Contracts
with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients
(“ASU 2016-12”) which narrowly amended
the revenue recognition guidance regarding collectability, noncash consideration, presentation of sales tax and transition. ASU
2016-12 is effective during the same period as ASU 2014-09. The Company is still evaluating the impact of the adoption of ASU 2016-08,
ASU 2016-10 and ASU 2016-12.
In March 2016, the FASB issued ASU No. 2016-09,
Compensation
– Stock Compensation (Topic 718)
(“ASU 2016-09”). The standard identifies areas for simplification involving
several aspects of accounting for share-based payment transactions, including the income tax consequences, classification of awards
as either equity or liabilities, an option to recognize gross stock compensation expense with actual forfeitures recognized as
they occur, as well as certain classifications on the statement of cash flows. ASU 2016-09 is effective for fiscal years beginning
after December 15, 2016, and interim periods within those fiscal years, with early adoption permitted. The Company is currently
evaluating the impact of the adoption of ASU 2016-09.
In February 2016, the FASB issued ASU No. 2016-02,
Leases
(Topic 842)
, which supersedes Topic 840,
Leases
(“ASU 2016-02”). The guidance in this new standard requires
lessees to put most leases on their balance sheets but recognize expenses on their income statements in a manner similar to the
current accounting and eliminates the current real estate-specific provisions for all entities. The guidance also modifies the
classification criteria and the accounting for sales-type and direct financing leases for lessors. ASU 2016-02 is effective for
fiscal years beginning after December 15, 2018, and interim periods within those fiscal years, with early adoption permitted. The
Company is currently evaluating the impact of the adoption of ASU 2016-02.
In July 2015, the FASB issued ASU No. 2015-11,
Inventory
(Topic 330): Simplifying the Measurement of Inventory
(“ASU 2015-11”), which simplifies the subsequent measurement
of inventory by requiring inventory to be measured at the lower of cost and net realizable value. Net realizable value is the estimated
selling price of inventory in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation.
ASU 2015-11 is effective for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. The
Company is currently evaluating the impact of the adoption of ASU 2015-11.
In August 2014, the FASB issued ASU No. 2014-15,
Presentation
of Financial Statements— Going Concern (Subtopic 205-40)
(“ASU 2014-15”). The standard provides guidance
about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue
as a going concern and to provide related footnote disclosures and was issued to reduce diversity in the timing and content of
disclosures. ASU 2014-15 is effective for the annual period ending after December 15, 2016, with early adoption permitted. The
Company adopted ASU 2014-15 as of December 31, 2015.
In May 2014, the FASB issued ASU No. 2014-09,
Revenue
from Contracts with Customers
(“ASU 2014-09”), which provides guidance for revenue recognition. ASU 2014-09 affects
any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer
of nonfinancial assets and supersedes the revenue recognition requirements in Topic 605,
Revenue Recognition
, and most industry-specific
guidance. This ASU also supersedes some cost guidance included in Subtopic 605-35,
Revenue Recognition- Construction-Type and
Production-Type Contracts
. ASU 2014-09’s core principle is that a company will recognize revenue when it transfers promised
goods or services to customers in an amount that reflects the consideration to which a company expects to be entitled in exchange
for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under today’s
guidance, including identifying performance obligations in the contract, estimating the amount of variable consideration to include
in the transaction price and allocating the transaction price to each separate performance obligation. In August 2015, the FASB
issued ASU No. 2015-14,
Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date
(“ASU
2015-14”), which delays the effective date of ASU 2014-09 by one year. The FASB also agreed to allow entities to choose to
adopt the standard as of the original effective date. As such, the updated standard will be effective for the Company in the first
quarter of 2018, with the option to adopt it in the first quarter of 2017. The Company may adopt the new standard under the full
retrospective approach or the modified retrospective approach. The Company has not yet selected a transition method nor has determined
the effect of ASU 2014-09 on its ongoing financial reporting.
Note 3. Fair Value of Financial Instruments
Management believes the fair value of the obligation
under secured borrowing arrangement and convertible note with a related party approximates carrying value because the debt carries
market rates of interest, and are both short-term in nature. The Company’s remaining financial instruments consisted primarily
of accounts receivable, accounts payable, accrued liabilities, and accrued restructuring charges, all of which are short-term in
nature with fair values approximating carrying value.
Note 4. Restructuring
As part of an effort to better focus and align the Company’s
resources toward profitable growth, on August 24, 2015, the Board authorized the Company to undertake steps to commence a
restructuring of the business and operations, which concluded during the current quarter. The Company closed certain facilities,
reduced headcount, discontinued products, and renegotiated certain contracts resulting in restructuring and other charges of $21.2 million
in 2015, of which $2.9 million was included in “Cost of revenue” and $18.3 million was included in operating
expenses in the Consolidated Statements of Operations for the year ended December 31, 2015.
For the three and nine months ended September 30, 2016,
the Company recorded restructuring charges in “Cost of revenue” of $0.1 million and $2.3 million, respectively, related
to the write-down of inventory identified to be discontinued in the restructuring plan. For the three and nine months ended September
30, 2015, such write-down for discontinued inventory recorded in “Cost of revenue” was $1.3 million, respectively.
For the three months ended September 30, 2016, the Company
recorded restructuring charges of $1.7 million. During the period, the Company closed its accounting and administration office
in Denver, Colorado and its distribution center in Pittsburg, California.
For the nine months ended September 30, 2016, the Company
recorded a credit in “Restructuring and other charges” of $2.6 million comprised of: (i) an expense credit of
$4.8 million related to the release of a restructuring accrual of $7.0 million, offset by the cash payment of $2.2 million related
to the settlement agreement which terminated all future commitments between ETW Corporation (“ETW”) and the Company
(see Note 14); (ii) $1.3 million related to write-off of long-lived assets related to the abandonment of certain lease facilities;
and (iii) $0.9 million related to severance and other employee compensation costs. With the restructuring plan substantially complete,
the Company does not anticipate incurring any additional restructuring charges for the remainder of 2016.
For the nine months ended September 30, 2015, the Company
recorded expense of $16.7 million in “Restructuring and other charges” comprised of: (i) $9.3 million related to severance
and other employee compensation costs; (ii) $6.6 million related to cancellation of certain contracts and sponsorship agreements;
and (iii) $0.8 million for costs associated with permanently vacating certain leased facilities.
As of September 30, 2016, the restructuring charges to
be paid in cash totaled $2.5 million.
The following table illustrates the provision of the
restructuring charges and the accrued restructuring charges balance as of September 30, 2016 and December 31, 2015 (in thousands):
|
|
Employee Severance Costs
|
|
Contract Termination Costs
|
|
Purchase Commitment of Discontinued Inventories Not Yet Received
|
|
Abandoned Lease Facilities
|
|
Total
|
Balance as of December 31, 2014
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
Expensed
|
|
|
1,353
|
|
|
|
6,979
|
|
|
|
350
|
|
|
|
467
|
|
|
|
9,149
|
|
Cash payments
|
|
|
(845
|
)
|
|
|
(949
|
)
|
|
|
—
|
|
|
|
(56
|
)
|
|
|
(1,850
|
)
|
Reclassification from accounts payable to restructuring charges
|
|
|
—
|
|
|
|
2,120
|
|
|
|
—
|
|
|
|
—
|
|
|
|
2,120
|
|
Balance as of December 31, 2015
|
|
|
508
|
|
|
|
8,150
|
|
|
|
350
|
|
|
|
411
|
|
|
|
9,419
|
|
Expensed
|
|
|
636
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1,338
|
|
|
|
1,974
|
|
Benefit from settlement of Endorsement Agreement with ETW
|
|
|
—
|
|
|
|
(4,750
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
(4,750
|
)
|
Cash payments
|
|
|
(1,109
|
)
|
|
|
(2,366
|
)
|
|
|
(175
|
)
|
|
|
(513
|
)
|
|
|
(4,163
|
)
|
Reclassification from capital lease liabilities to restructuring charges
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
35
|
|
|
|
35
|
|
Balance as of September 30, 2016
|
|
$
|
35
|
|
|
$
|
1,034
|
|
|
$
|
175
|
|
|
$
|
1,271
|
|
|
$
|
2,515
|
|
The total future payments under the restructuring
plan as of September 30, 2016 are as follows (in thousands):
|
|
|
|
Year Ending December 31,
|
|
|
Outstanding Payments
|
|
Remainder of 2016
|
|
2017
|
|
2018
|
|
2019
|
|
2020
|
|
2021
|
|
Total
|
Contract termination costs
|
|
$
|
1,034
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
1,034
|
|
Purchase commitment of discontinued inventories not yet received
|
|
|
175
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
175
|
|
Employee severance costs
|
|
|
35
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
35
|
|
Abandoned leased facilities
|
|
|
206
|
|
|
|
370
|
|
|
|
378
|
|
|
|
296
|
|
|
|
21
|
|
|
|
—
|
|
|
|
1,271
|
|
Total future payments
|
|
$
|
1,450
|
|
|
$
|
370
|
|
|
$
|
378
|
|
|
$
|
296
|
|
|
$
|
21
|
|
|
$
|
—
|
|
|
$
|
2,515
|
|
Note 5. Capstone Nutrition Agreements
The Company entered into a series of agreements with
Capstone Nutrition (“Capstone”) effective March 2, 2015, including an amendment (the “Amendment”)
to a Manufacturing Agreement dated November 27, 2013 (as amended, the “Manufacturing Agreement”). Pursuant to
the Amendment, Capstone shall be the Company’s nonexclusive manufacturer of dietary supplements and food products sold or
intended to be sold by the Company. The Amendment includes various agreements including amended pricing terms. The initial term
per this Amendment was to end on January 1, 2022, and could have been extended for three successive 24-month terms, and includes
renewal options.
The Company agreed to pay to Capstone a non-refundable
sum of $2.5 million to be used by Capstone solely in connection with the expansion of its facility necessary to fulfill anticipated
Company requirements under the Manufacturing Agreement and Amendment. The Company paid Capstone this $2.5 million during 2015.
The Company and Capstone entered into a Class B Common
Stock Warrant Purchase Agreement (“Warrant Agreement”) whereby the Company could purchase approximately 19.9% of Capstone’s
parent company, INI Parent, Inc. (“INI”), on a fully-diluted basis as of March 2, 2015. Pursuant to the Warrant
Agreement, INI issued to the Company a warrant (the “Warrant”) to purchase shares of INI’s Class B common stock,
par value $0.001 per share, at an exercise price of $0.01 per share (the “Warrant Shares”). The Warrant could have
been exercised if the Company was in compliance with the terms and conditions of the Amendment.
The Company utilized the Black-Scholes valuation model
to determine the value of the Warrant and recorded an asset of $977,000, which was accounted for under the cost method and assessed
for impairment. The Warrant was included in long-term investments on the Condensed Consolidated Balance Sheet as of December 31,
2015. However, during the three months ended June 30, 2016, the Company reassessed the value of the Warrant and considered it to
be fully impaired as the Company no longer believes there is any remaining value to the Warrant. The Company also had recorded
$1.5 million of prepaid expenses and other assets on the Condensed Consolidated Balance Sheet as of December 31, 2015, which
were being amortized over the remaining life of the Manufacturing Agreement of 6.5 years. However, during the three months
ended June 30, 2016, the Company reassessed the Manufacturing Agreement, which was the basis of the prepaid asset, and considered
the entire remaining balance of $1.4 million impaired as the Company no longer believes there is any remaining value to the Manufacturing
Agreement. These conclusions were based in large part on the fact that Capstone sold its primary powder manufacturing facility
during the quarter ended June 30, 2016, which significantly reduced its manufacturing capacity, and the ongoing dispute which is
discussed below.
In total, the Company recognized $2.4 million of impairment
expense during the nine months ended September 30, 2016 related to previously recorded Capstone-related assets.
The Company and INI also entered into an option agreement
(the “Option Agreement”). Subject to additional provisions and conditions set forth in the Option Agreement, at any
time on or prior to June 30, 2016, the Company had the right to purchase for cash all of the remaining outstanding shares
of INI’s common stock not already owned by the Company after giving effect to the exercise of the Warrant, based on an aggregate
enterprise value, equal to $200.0 million. The fair value of the option was deemed de minimis as of the transaction date.
The Company did not exercise the option to purchase the remaining outstanding shares of INI’s common stock and such option
expired on June 30, 2016.
The Company is engaged in a dispute with Capstone arising
out of a Manufacturing Agreement between the parties. Capstone claims $65.0 million in damages, including approximately $22.0 million
it claims the Company owes pursuant to the Manufacturing Agreement, of which $21.9 million was included in the Company’s
accounts payable and accrued liabilities balances as of September 30, 2016. The Company claims that Capstone owes the Company at
least $13.5 million for losses caused by, among other things, Capstone’s failure to timely manufacture and supply the Company’s
products. On February 12, 2016, Capstone commenced a mediation with the American Arbitration Association. Subsequent to September 30, 2016, the parties entered into a settlement agreement. See Note 18.
Note 6. Sale of BioZone
In May 2016, the Company completed the sale of its wholly-owned
subsidiary, BioZone, for gross proceeds of $9.8 million, including cash of $5.9 million, a $2.0 million credit for future inventory
deliveries reflected as a prepaid asset in the Condensed Consolidated Balance Sheets and $1.5 million which is subject to an earn-out
based on the financial performance of BioZone for the twelve months following the closing of the transaction. In addition, the
Company agreed to pay down $350,000 of BioZone’s accounts payables, which was deducted from the purchase price. As part of
the transaction, the Company also agreed to transfer to the buyer 200,000 shares of its common stock with a market value on the
date of issuance of $640,000, for consideration of $50,000. The Company recorded a loss of $2.1 million related to the sale of
BioZone. The loss on the sale of BioZone primarily related to the subsidiary’s pre-tax losses for 2016. Pre-tax loss for
BioZone for the nine months ended September 30, 2016 was $1.5 million.
Upon closing of the sale of BioZone, the Company entered
into a manufacturing and supply agreement whereby the Company is required to purchase a minimum of $3.0 million of products from
BioZone annually for an initial term of three years. The sale of BioZone did not qualify as discontinued operations as the disposal
of BioZone did not represent a strategic shift that had (or will have) a major effect on the Company’s operations and financial
results.
The following table summarizes the components of the
loss from the sale of BioZone (in thousands):
Cash proceeds from sale
|
|
$
|
5,942
|
|
Consideration for common stock transferred
|
|
|
50
|
|
Prepaid inventory
|
|
|
2,000
|
|
Fair market value of the common stock transferred
|
|
|
(640
|
)
|
Assets sold:
|
|
|
|
|
Accounts receivable, net
|
|
|
(923
|
)
|
Inventory, net
|
|
|
(1,761
|
)
|
Fixed assets, net
|
|
|
(2,003
|
)
|
Intangible assets, net
|
|
|
(5,657
|
)
|
All other assets
|
|
|
(41
|
)
|
Liabilities transferred
|
|
|
1,197
|
|
Transaction and other costs
|
|
|
(279
|
)
|
Loss on sale of subsidiary
|
|
$
|
(2,115
|
)
|
In connection with the sale of BioZone, the Company and
BioZone entered into a transition services agreement to provide administrative support which concluded in August 2016, and a sub-lease
to the buyer for certain premises. The Company also entered into a product development and supply agreement with Flavor Producers,
Inc. (“FPI”), the parent company of the buyer, to develop certain products to be sold by the Company. If the product
development effort is successful, the minimum purchase commitment under the product development and supply agreement with FPI is
$3.0 million over the term of 12 months. Pursuant to the agreement, product pricing is fixed for one year, and was negotiated as
an arms-length transaction. As of September 30, 2016, the product development effort had not yet commenced.
Note 7. Balance Sheet Components
Inventory
Inventory consisted of the following as of September
30, 2016 and December 31, 2015 (in thousands):
|
|
September 30,
2016
|
|
December 31,
2015
|
Raw materials
|
|
$
|
—
|
|
|
$
|
1,385
|
|
Work-in-process
|
|
|
—
|
|
|
|
22
|
|
Finished goods
|
|
|
8,047
|
|
|
|
11,142
|
|
Inventory
|
|
$
|
8,047
|
|
|
$
|
12,549
|
|
The Company records charges for obsolete and slow moving
inventory based on the age of the product as determined by the expiration date. Products within one year of their expiration dates
are considered for write-off purposes. Historically, the Company has had minimal returns with established customers. Other than
write-off of inventory during restructuring activities, the Company incurred insignificant inventory write-offs during the three
and nine months ended September 30, 2016 and 2015. Inventory write-downs, once established, are not reversed as they establish
a new cost basis for the inventory.
As disclosed further in Note 4, the Company executed
a restructuring plan in August 2015 and wrote off inventory related to discontinued products. For the three and nine months
ended September 30, 2016, discontinued inventory of $0.1 million and $2.3 million, respectively, was written off and included as
a component of “Cost of revenue” in the accompanying Condensed Consolidated Statements of Operations. For the three
and nine months ended September 30, 2015, discontinued inventory of $1.3 million, respectively, was written off and included as
a component of “Cost of revenue” in the accompanying Condensed Consolidated Statements of Operations.
In May 2016, the Company completed the sale of BioZone,
which resulted in a reduction of inventory of $1.8 million. See additional information in Note 6. Additionally, $0.4 million of
inventory related to the Arnold Schwarzenegger product line was considered impaired, and included as a component of the “Impairment
of assets” in the accompanying Condensed Consolidated Statements of Operations for the nine months ended September 30, 2016.
See additional information in Note 14.
Property and Equipment
Property and equipment consisted of the following as
of September 30, 2016 and December 31, 2015 (in thousands):
|
|
September 30,
2016
|
|
December 31,
2015
|
Furniture, fixtures and equipment
|
|
$
|
3,333
|
|
|
$
|
3,621
|
|
Leasehold improvements
|
|
|
2,498
|
|
|
|
3,227
|
|
Manufacturing and lab equipment
|
|
|
3
|
|
|
|
1,659
|
|
Vehicles
|
|
|
625
|
|
|
|
1,146
|
|
Displays
|
|
|
486
|
|
|
|
483
|
|
Website
|
|
|
478
|
|
|
|
463
|
|
Construction in process
|
|
|
70
|
|
|
|
54
|
|
Property and equipment, gross
|
|
|
7,493
|
|
|
|
10,653
|
|
Less: accumulated depreciation and amortization
|
|
|
(4,195
|
)
|
|
|
(3,960
|
)
|
Property and equipment, net
|
|
$
|
3,298
|
|
|
$
|
6,693
|
|
Depreciation and amortization expense related to property
and equipment was $0.3 million and $0.5 million for the three months ended September 30, 2016 and 2015, respectively, and $1.2
million and $1.3 million for the nine months ended September 30, 2016 and 2015, respectively, which is included in “Selling,
general, and administrative” expense in the accompanying Condensed Consolidated Statements of Operations.
In May 2016, the Company completed the sale of BioZone,
which resulted in a reduction of various components of property and equipment of $2.0 million. See additional information in Note
6. As disclosed further in Note 4, the Company executed a restructuring plan in August 2015 and wrote off certain long-lived
assets, primarily leasehold improvements, related to the abandonment of certain leased facilities. The write-off of long-lived
assets was $0.3 million for the nine months ended September 30, 2016 and $0.4 million for the three and nine months ended September
30, 2015, respectively, and was included as a component of “Restructuring and other charges” in the accompanying Condensed
Consolidated Statements of Operations.
Intangible Assets
Intangible assets included the assets acquired pursuant
to the BioZone asset acquisition and MusclePharm’s apparel rights reacquired from Worldwide Apparel as of December 31, 2015.
BioZone was sold during the nine months ended September 30, 2016. Intangible assets consisted of the following (in thousands):
|
|
As of September 30, 2016
|
|
|
Gross Value
|
|
Accumulated
Amortization
|
|
Net
Carrying
Value
|
|
Remaining Weighted-
Average
Useful Lives
(years)
|
Amortized Intangible Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Brand
|
|
$
|
2,244
|
|
|
$
|
(526
|
)
|
|
$
|
1,718
|
|
|
|
5.4
|
|
Total intangible assets
|
|
$
|
2,244
|
|
|
$
|
(526
|
)
|
|
$
|
1,718
|
|
|
|
|
|
|
|
As of December 31, 2015
|
|
|
Gross Value
|
|
Accumulated
Amortization
|
|
Net
Carrying
Value
|
|
Weighted-
Average
Useful Lives
(years)
|
Amortized Intangible Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Customer relationships
|
|
$
|
3,130
|
|
|
$
|
(417
|
)
|
|
$
|
2,713
|
|
|
|
15.0
|
|
Non-compete agreements
|
|
|
69
|
|
|
|
(69
|
)
|
|
|
—
|
|
|
|
—
|
|
Patents
|
|
|
2,158
|
|
|
|
(540
|
)
|
|
|
1,618
|
|
|
|
8.0
|
|
Trademarks
|
|
|
933
|
|
|
|
(133
|
)
|
|
|
800
|
|
|
|
6.7
|
|
Brand
|
|
|
4,020
|
|
|
|
(522
|
)
|
|
|
3,498
|
|
|
|
10.5
|
|
Domain name
|
|
|
54
|
|
|
|
(31
|
)
|
|
|
23
|
|
|
|
5.0
|
|
Total intangible assets
|
|
$
|
10,364
|
|
|
$
|
(1,712
|
)
|
|
$
|
8,652
|
|
|
|
|
|
Intangible assets amortization expense was $80,000 and
$278,000 for the three months ended September 30, 2016 and 2015, respectively, and $496,000 and $776,000 for the nine months ended
September 30, 2016 and 2015, respectively, which is included in the “Selling, general, and administrative” expense
in the accompanying Condensed Consolidated Statements of Operations. Additionally, $1.2 million of trademarks with a net carrying
value of $0.8 million related to the Arnold Schwarzenegger product line were considered impaired, and included as a component of
the “Impairment of assets” in the accompanying Condensed Consolidated Statements of Operations for the nine months
ended September 30, 2016. See additional information in Note 14.
As of September 30, 2016, the estimated future amortization
expense of intangible assets is as follows (in thousands):
Year Ending December 31,
|
|
|
|
The remainder of 2016
|
|
|
$
|
80
|
|
|
2017
|
|
|
|
321
|
|
|
2018
|
|
|
|
321
|
|
|
2019
|
|
|
|
321
|
|
|
2020
|
|
|
|
321
|
|
|
2021
|
|
|
|
321
|
|
|
Thereafter
|
|
|
|
33
|
|
|
Total amortization expense
|
|
|
$
|
1,718
|
|
Note 8. Other Expense, net
During the three and nine months ended September 30,
2016 and 2015, “Other expense, net” consisted of the following (in thousands):
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Other expense, net:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest expense
|
|
$
|
(166
|
)
|
|
$
|
(99
|
)
|
|
$
|
(536
|
)
|
|
$
|
(357
|
)
|
Interest expense, factored accounts receivable
|
|
|
(9
|
)
|
|
|
—
|
|
|
|
(636
|
)
|
|
|
—
|
|
Foreign currency transaction gain (loss)
|
|
|
19
|
|
|
|
(456
|
)
|
|
|
213
|
|
|
|
(717
|
)
|
Other
|
|
|
34
|
|
|
|
(4
|
)
|
|
|
(467
|
)
|
|
|
(16
|
)
|
Total other expense, net
|
|
$
|
(122
|
)
|
|
$
|
(559
|
)
|
|
$
|
(1,426
|
)
|
|
$
|
(1,090
|
)
|
Note 9. Debt
As of September 30, 2016 and December 31, 2015,
the Company’s debt consisted of the following (in thousands):
|
|
September 30,
2016
|
|
December 31,
2015
|
Revolving line of credit
|
|
$
|
—
|
|
|
$
|
3,000
|
|
Term loan
|
|
|
—
|
|
|
|
2,949
|
|
Convertible note – with a related party, net of discount
|
|
|
5,988
|
|
|
|
5,952
|
|
Obligations under secured borrowing arrangement
|
|
|
—
|
|
|
|
—
|
|
Other
|
|
|
11
|
|
|
|
21
|
|
Total debt
|
|
|
5,999
|
|
|
|
11,922
|
|
Less: current portion
|
|
|
(5,999
|
)
|
|
|
(5,970
|
)
|
Long term debt
|
|
$
|
—
|
|
|
$
|
5,952
|
|
In September 2014, the Company entered into a line
of credit facility with ANB Bank for up to $8.0 million of borrowings. The line of credit originally matured in September 2017,
and accrued interest at the prime rate plus 2%. The line of credit was secured by inventory, accounts receivable, intangible assets
and equipment. As of December 31, 2015, the outstanding borrowings under the line of credit were $3.0 million. The Company
was not in compliance with certain financial covenants under the line of credit as of December 31, 2015, which limited further
borrowings. The Company repaid its outstanding principal and accrued interest under the line of credit in full in January 2016
in conjunction with the Company’s secured borrowing arrangement as described below. This line is no longer available to the
Company.
In February 2015, the Company entered into a $4.0
million term loan agreement with ANB Bank. The term loan carried a fixed interest rate of 5.25% per annum, was repayable in
36 equal monthly installments of principal and interest, and originally matured in February 2018. The term loan contained
various events of default, including cross default provisions related to the line of credit, which could have required repayments
of the term loan. The Company was not in compliance with certain financial covenants under the term loan as of December 31,
2015, and received various waivers from the lender during the year ended December 31, 2015. As of December 31, 2015,
the outstanding borrowings under the term loan were $2.9 million. The Company repaid its outstanding principal and accrued interest
under the term loan in full in January 2016 to retire the term loan in conjunction with the Company’s secured borrowing arrangement
as described below.
In October 2015, the Company entered into loan modification
agreements with ANB Bank under the line of credit and term loan to: (i) change the maturity date of the loans to January 15,
2016, (ii) prohibit the loans to be declared in default prior to December 10, 2015, except for defaults resulting from failure
to make timely payments, and (iii) delete certain financial covenants from the line of credit. In consideration for these modifications,
Ryan Drexler, Interim Chief Executive Officer, Interim President and Chairman of the Board, and a family member provided their
individual guaranty for the remaining balance of the term loan and line of credit of $6.2 million. In consideration for executing
his guaranty, the Company issued to Mr. Drexler 28,571 shares of the Company’s common stock with a grant date fair value
of $80,000 (based upon the closing price of the Company’s common stock on the date of issuance).
In December 2015, the Company entered into a convertible
secured promissory note agreement with Mr. Drexler, pursuant to which he loaned the Company $6.0 million. Proceeds from
the note were used to fund working capital requirements. The convertible note is secured by all assets and properties of the Company
and its subsidiaries whether tangible or intangible. The convertible note carries an interest at a rate of 8% per annum, or 10%
in the event of default. Both the principal and the interest under the convertible note are due in January 2017, unless converted
earlier. The holder can convert the outstanding principal and accrued interest into shares of common stock (2,608,695 shares) for
$2.30 per share at any time. The Company may prepay the convertible note at the aggregate principal amount therein plus accrued
interest by giving the holder between 15 and 60 day-notice, depending upon the specific circumstances, provided that the holder
may convert the note during the notice period. The Company recorded the convertible note of $6.0 million as a liability in the
balance sheet and also recorded a beneficial conversion feature of $52,000 as a debt discount upon issuance of the convertible
note, which is being amortized over the term of the convertible debt using the effective interest method. The beneficial conversion
feature was calculated based on the difference between the fair value of common stock and the effective conversion price of the
convertible note. As of September 30, 2016 and December 31, 2015, the convertible note had an outstanding principal balance
of $6.0 million.
In January 2016, the Company entered into a Purchase
and Sale Agreement (the “Agreement”) with Prestige Capital Corporation (“Prestige”) pursuant to which the
Company agreed to sell and assign and Prestige agreed to buy and accept, certain accounts receivable owed to the Company (“Accounts”).
Under the terms of the Agreement, upon the receipt and acceptance of each assignment of Accounts, Prestige will pay the Company
80% of the net face amount of the assigned Accounts, up to a maximum total borrowings of $10.0 million subject to sufficient
amounts of accounts receivable to secure the loan. The remaining 20% will be paid to the Company upon collection of the assigned
Accounts, less any chargeback, disputes, or other amounts due to Prestige. Prestige’s purchase of the assigned Accounts from
the Company will be at a discount fee which varies based on the number of days outstanding from the assignment of Accounts to collection
of the assigned Accounts. In addition, the Company granted Prestige a continuing security interest in and lien upon all accounts
receivable, inventory, fixed assets, general intangibles and other assets. The Agreement’s initial term of six months has
been extended by the Company to March 31, 2017. Prestige may cancel the Agreement with 30-day notice.
During the three months ended September 30, 2016, the
Company had no new transactions with Prestige. During the nine months ended September 30, 2016, the Company sold to Prestige accounts
with an aggregate face amount of approximately $49.3 million, for which Prestige paid to the Company approximately $39.5 million
in cash. During the three and nine months ended September 30, 2016, $8.7 million and $40.0 million was subsequently repaid
to Prestige, including fees and interest. The proceeds from the initial assignment to Prestige under this secured borrowing arrangement
were primarily utilized to pay off the balance of the existing line of credit and term loan with ANB Bank.
Other
Other debt primarily consists of debt in default, which
was immaterial, as of September 30, 2016 and December 31, 2015 and is included as a component of short-term debt. Debt in
default is related to convertible debt issued during the year ended December 31, 2012 and prior where the convertible debt
was never converted to common stock, nor was the principal repaid. The Company is in the process of contacting the remaining debt
holder and negotiating settlement of the debt.
Note 10. Commitments and Contingencies
Operating Leases
The Company leases office and warehouse facilities under
operating leases, which expire at various dates through 2020. The amounts reflected in the table below are for the aggregate future
minimum lease payments under non-cancelable facility operating leases for properties that have not been abandoned as part of the
restructuring plan. See Note 4 for additional details regarding the restructured leases. Under lease agreements that contain escalating
rent provisions, lease expense is recorded on a straight-line basis over the lease term. Rent expense was $0.2 million and $0.4
million for the three months ended September 30, 2016 and 2015, respectively, and $0.8 million and $1.2 million for the nine months
ended September 30, 2016 and 2015, respectively.
As of September 30, 2016, future minimum lease payments
are as follows (in thousands):
Year Ending December 31,
|
|
|
|
The remainder of 2016
|
|
|
$
|
100
|
|
|
2017
|
|
|
|
156
|
|
|
2018
|
|
|
|
161
|
|
|
2019
|
|
|
|
135
|
|
|
2020
|
|
|
|
139
|
|
|
2021
|
|
|
|
—
|
|
|
Thereafter
|
|
|
|
—
|
|
|
Total minimum lease payments
|
|
|
$
|
691
|
|
Capital Leases
In December 2014, the Company entered into a capital
lease agreement providing for approximately $1.8 million in credit to lease up to 50 vehicles as part of a fleet lease program.
As of September 30, 2016, the Company was leasing 10 vehicles under the capital lease which were included in Property and equipment,
net in the Condensed Consolidated Balance Sheets. The original cost of leased assets was $330,000 and the associated accumulated
depreciation was $104,000. As of December 31, 2015, the Company was leasing 21 vehicles under the capital lease which were included
in Property and equipment, net in the Condensed Consolidated Balance Sheets. The original cost of leased assets was $670,000 and
the associated accumulated depreciation was $90,000. The Company also leases manufacturing and warehouse equipment under capital
leases, which expire at various dates through February 2020. All but one of such leases were reclassified to the restructuring
liability as of September 30, 2016, and related assets were written off to restructuring expense.
As of September 30, 2016 and December 31, 2015,
short-term capital lease liabilities of $100,000 and $186,000, respectively, were included as a component of current liabilities,
and the long-term capital lease liabilities of $103,000 and $330,000, respectively, were included as a component of long-term liabilities
in the Condensed Consolidated Balance Sheets.
As of September 30, 2016, the Company’s future
minimum lease payments under capital lease agreements are as follows (in thousands):
Year Ending December 31,
|
|
|
|
The remainder of 2016
|
|
|
$
|
31
|
|
|
2017
|
|
|
|
94
|
|
|
2018
|
|
|
|
62
|
|
|
2019
|
|
|
|
28
|
|
|
2020
|
|
|
|
1
|
|
|
Total minimum lease payments
|
|
|
|
216
|
|
|
Less amounts representing interest
|
|
|
|
(13
|
)
|
|
Present value of minimum lease payments
|
|
|
$
|
203
|
|
As described in Note 6, the Company entered into a product
development and supply agreement with FPI, the parent company of the buyer of BioZone, to develop certain products to be sold by
the Company. If the product development effort is successful, the minimum purchase commitment under the product development and
supply agreement with FPI is $3.0 million over the term of 12 months. As of September 30, 2016, the product development effort
had not yet commenced.
Contingencies
In the normal course of business or otherwise, the Company
may become involved in legal proceedings. The Company will accrue a liability for such matters when it is probable that a liability
has been incurred and the amount can be reasonably estimated. When only a range of possible loss can be established, the most probable
amount in the range is accrued. If no amount within this range is a better estimate than any other amount within the range, the
minimum amount in the range is accrued. The accrual for a litigation loss contingency might include, for example, estimates of
potential damages, outside legal fees and other directly related costs expected to be incurred. As of September 30, 2016 and December 31,
2015, the Company was involved in the following material legal proceedings described below.
Third-Party Manufacturer Dispute
As of September 30, 2016, the Company was engaged
in a dispute with Capstone concerning amounts allegedly owed under the Manufacturing Agreement. See Note 5 and Note 18 for
further details.
Supplier Complaint
In January 2016, ThermoLife International LLC (“ThermoLife”),
a supplier of nitrates to MusclePharm, filed a complaint against the Company in Arizona state court. In its complaint, ThermoLife
alleges that the Company failed to meet minimum purchase requirements contained in the parties’ supply agreement. In March
2016, the Company filed an answer to ThermoLife’s complaint, denying the allegations contained in the complaint, and filed
a counterclaim alleging that ThermoLife breached its express warranty to MusclePharm because ThermoLife’s products were defective
and could not be incorporated into the Company’s products. Therefore, the Company believes that ThermoLife’s complaint
is without merit.
Former Executive Lawsuit
In December 2015, the Company accepted notice by Mr. Richard
Estalella (“Estalella”) to terminate his employment as the Company’s President. Although Estalella sought
to terminate his employment with the Company for “Good Reason,” as defined in Estalella’s employment agreement
with the Company (the “Employment Agreement”), the Company advised Estalella that it deemed his resignation to be without
Good Reason.
In February 2016, Estalella filed a complaint in
Colorado state court against the Company and Ryan Drexler, Interim Chief Executive Officer, Interim President and Chairman of
the Board, alleging, among other things, that the Company breached the Employment Agreement, and seeking certain equitable
relief and unspecified damages. The Company believes Estalella’s claims are without merit. At the Company’s 2016
Annual Meeting of Stockholders in June 2016, Estalella was not reelected to the Board and is no longer a member of the Board.
As of the date of this report, the Company has evaluated the potential outcome of this lawsuit and recorded the liability
consistent with its policy.
Shareholder Derivative Complaint
In October 2015, Brian D. Gartner, derivatively and on
behalf of MusclePharm Corporation, filed a verified shareholder derivative complaint in the 8th District Court, State of Nevada,
Clark County (No. A-15-726810-B) alleging, among other things, breaches of fiduciary duty as members of the Board and/or executive
officers of the Company against Brad Pyatt, Lawrence S. Meer, Donald W. Prosser, Richard Estalella, Jeremy R. Deluca, Michael
J. Doron, Cory Gregory, L. Gary Davis, James J. Greenwell, John H. Bluher and Daniel J. McClory. Mr. Gartner alleges a series
of accounting and disclosure failures resulted in the filing of materially false and misleading filings with the SEC from 2010
through July 2014, resulting in settlement with the SEC requiring payment of $700,000 of civil penalties. Mr. Gartner seeks various
remedies, including interpretation of bylaws provisions, permanent injunctive relief, damages against the defendants for breaches
of their fiduciary duty, corporate governance changes to ensure the Company maintains proper internal controls and SEC reporting
procedures, as well as costs and reasonable attorneys’ fees, accountants’ and experts’ fees, costs and expenses.
The individual defendants sought removal of the action to federal court, which was granted. The plaintiff moved to remand the case
back to state court, and the parties await decision on that motion.
Insurance Carrier Lawsuit
The Company is engaged in litigation with insurance carrier
Liberty Insurance Underwriters, Inc. arising out of Liberty’s denial of coverage. In 2014, the Company sought coverage under
an insurance policy with Liberty for claims against directors and officers of the Company arising out of an investigation
by the Securities and Exchange Commission. Liberty denied coverage, and, on February 12, 2015, the Company filed a complaint in
the District Court, City and County of Denver, Colorado against Liberty claiming wrongful and unreasonable denial of coverage for
the cost and expenses incurred in connection with the SEC investigation and related matters. Liberty removed the complaint to the
United States District Court for the District of Colorado, which in August 2016 granted Liberty’s motion for summary judgment,
denying coverage and dismissing the Company’s claims with prejudice, and denied the Company’s motion for summary judgment.
The Company has filed a motion for reconsideration that has not yet been decided.
Arnold Schwarzenegger
The Company is engaged in a dispute with Arnold
Schwarzenegger, Marine MP, LLC, & Fitness Publications, Inc. (“AS Parties”) concerning amounts allegedly owed
under the parties’ Endorsement Licensing and Co-Branding Agreement. In May 2016, the contract was terminated, and the
AS Parties commenced arbitration, alleging that the Company breached the parties’ agreement and misappropriated
Schwarzenegger’s likeness. They seek more than $13.0 million for royalties, purported misuse of Schwarzenegger’s
likeness, and attorney fees. The Company filed its response and counterclaimed for breach of contract and breach of the
implied covenant of good faith and fair dealing. The parties are engaged in discovery.
Manchester City Football Group
The Company is engaged in a dispute with City Football
Group Limited (“CFG”), the owner of Manchester City Football Group, concerning amounts allegedly owed by the Company
under a Sponsorship Agreement with CFG. In August 2016, CFG commenced arbitration in the United Kingdom against the Company, seeking
approximately $8.3 million for the Company’s purported breach of the Agreement. The Company answered on October 7, 2016.
An arbitrator has not yet been appointed and discovery has not yet begun.
Sponsorship and Endorsement Contract Liabilities
The Company has various non-cancelable endorsement and
sponsorship agreements with terms expiring through 2019. The total value of future contractual payments as of September 30, 2016
are as follows (in thousands):
|
|
|
|
Year Ending December 31,
|
|
|
|
|
Remainder
of 2016
|
|
2017
|
|
2018
|
|
2019
|
|
2020
|
|
Thereafter
|
|
Total
|
Outstanding Payments
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Endorsement
|
|
$
|
44
|
|
|
$
|
80
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
124
|
|
Sponsorship
|
|
|
1,151
|
|
|
|
2,294
|
|
|
|
2,404
|
|
|
|
985
|
|
|
|
—
|
|
|
|
—
|
|
|
|
6,834
|
|
Total future payments
|
|
$
|
1,195
|
|
|
$
|
2,374
|
|
|
$
|
2,404
|
|
|
$
|
985
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
6,958
|
|
Note 11. Stockholders’ Equity
Common Stock
For the nine months ended September 30, 2016, the Company
had the following transactions related to its common stock including restricted stock awards (in thousands, except share and per
share data):
Transaction Type
|
|
Quantity (Shares)
|
|
Valuation ($)
|
|
Range of
Value per Share
|
Shares issued to employees, executives and directors
|
|
|
372,154
|
|
|
$
|
914
|
|
|
$
|
1.89-2.95
|
|
Shares issued related to sale of subsidiary
|
|
|
200,000
|
|
|
|
640
|
|
|
$
|
3.20
|
|
Cancellation and forfeiture of executive restricted stock
|
|
|
(433,000
|
)
|
|
|
(456
|
)
|
|
$
|
4.29-13.00
|
|
Total
|
|
|
139,154
|
|
|
$
|
1,098
|
|
|
$
|
1.89-13.00
|
|
For the nine months ended September 30, 2015, the Company
issued common stock including restricted stock awards, as follows (in thousands, except share and per share data):
Transaction Type
|
|
Quantity
(Shares)
|
|
Valuation
($)
|
|
Range of Value per Share
|
Stock issued to employees, executives and directors, net of cancellations
|
|
|
186,354
|
|
|
$
|
10,029
|
|
|
$
|
3.48-8.60
|
|
Stock issued in conjunction with product line expansion
|
|
|
150,000
|
|
|
|
1,198
|
|
|
$
|
7.99
|
|
Stock issued in conjunction with MusclePharm apparel rights acquisition
|
|
|
170,000
|
|
|
|
1,394
|
|
|
$
|
8.20
|
|
Stock issued in conjunction with financing agreement
|
|
|
50,000
|
|
|
|
325
|
|
|
$
|
6.49
|
|
Stock issued in conjunction with consulting/endorsement agreement
|
|
|
55,189
|
|
|
|
320
|
|
|
$
|
5.30-5.85
|
|
Total
|
|
|
611,543
|
|
|
$
|
13,266
|
|
|
$
|
3.48-8.60
|
|
The fair value of all stock issuances above is based
upon the quoted closing trading price on the date of issuance.
Common stock outstanding as of September 30, 2016 and
December 31, 2015 includes shares legally outstanding even if subject to future vesting.
Treasury Stock
For the three and nine months ended September 30, 2016
and 2015, the Company did not repurchase any shares of its common stock and held 875,621 shares in treasury as of September 30,
2016 and December 31, 2015. As of December 31, 2015, 860,900 of the Company’s shares held in treasury were subject to a pledge
with a lender in connection with a term loan which was cancelled when the term loan was paid off in January 2016.
Note 12. Stock-Based Compensation
Restricted Stock
The Company’s stock-based compensation for the
three and nine months ended September 30, 2016 consist primarily of restricted stock awards. The activity of restricted stock awards
granted to employees, executives and Board members was as follows:
|
|
|
|
|
Unvested Restricted Stock Awards
|
|
|
|
|
|
|
Number of
Shares
|
|
|
|
Weighted-Average
Grant Date Fair
Value
|
|
|
Unvested balance – December 31, 2015
|
|
|
|
1,025,999
|
|
|
$
|
12.34
|
|
|
Granted
|
|
|
|
372,154
|
|
|
|
2.46
|
|
|
Vested
|
|
|
|
(675,140
|
)
|
|
|
10.84
|
|
|
Cancelled
|
|
|
|
(260,000
|
)
|
|
|
13.00
|
|
|
Forfeited
|
|
|
|
(100,000
|
)
|
|
|
8.65
|
|
|
Unvested balance – September 30, 2016
|
|
|
|
363,013
|
|
|
|
5.40
|
|
The total fair value of restricted stock awards granted
to employees and Board members was $0.5 million and $0.2 million for the three months ended September 30, 2016 and 2015, respectively,
and $0.9 million and $1.1 million for the nine months ended September 30, 2016 and 2015, respectively. As of September 30, 2016,
the total unrecognized expense for unvested restricted stock awards, net of expected forfeitures, was $1.0 million, which is expected
to be amortized over a weighted-average period of 0.9 years.
Accelerated Vesting of Restricted Stock Awards Related
to Termination of Employment Agreement with Brad Pyatt, Former Chief Executive Officer
In March 2016, Brad Pyatt, the Company’s former
Chief Executive Officer, terminated his employment with the Company. Pursuant to the terms of the separation agreement with the
Company, in exchange for a release of claims, the Company agreed to pay severance in the amount of $1.1 million, payable over a
12-month period, a lump sum of $250,000 payable in March 2017 and reimbursement of COBRA premiums. In addition, the remaining unvested
restricted stock awards held by Brad Pyatt of 500,000 shares vested in full upon his termination in accordance with the original
grant terms. In connection with the accelerated vesting of these restricted stock awards, the Company recognized stock compensation
expense of $3.9 million, which is included in “Salaries and benefits” in the accompanying Condensed Consolidated Statements
of Operations for the nine months ended September 30, 2016.
Restricted Stock Awards Issued to Ryan Drexler, Interim
Chief Executive Officer, Interim President and Chairman of the Board, Related to Loan Modification
In October 2015, the Company entered into loan modification
agreements with the banking institution under its line of credit and term loan to: (i) change the maturity date of the loans to
January 15, 2016, (ii) prohibit the loans to be declared in default prior to December 10, 2015, except for defaults resulting
from failure to make timely payments, and (iii) delete certain financial covenants from the line of credit. In consideration for
these modifications, Ryan Drexler, Interim Chief Executive Officer, Interim President and Chairman of the Board, and a family member,
provided their individual guaranty for the remaining balance of the loans ($6.2 million). In consideration for executing his guaranty,
the Company issued to Mr. Drexler 28,571 shares of common stock with a grant date fair value of $80,000 (based upon the closing
price of the Company’s common stock on the date of issuance).
Restricted Stock Awards Issued Related to Attempted
Financing Agreement
In May 2015, the Company negotiated the termination
of an attempted financing agreement with a lending institution and issued 50,000 shares of its common stock. The fair value of
the common stock was $325,000 based upon the closing price of the Company’s common stock on the date of issuance, and was
recorded as “Selling, general and administrative” expense.
Restricted Stock Awards Issued Related to Consulting/Endorsement
Agreement
In May 2015, the Company entered into consulting
and endorsement agreements with William Phillips. In connection with the endorsement agreements, the Company agreed to issue a
total of 50,000 shares of its restricted common stock. The restricted common stock issued had a grant date fair value of $292,000,
which was included as a component of prepaid stock compensation and “Additional paid-in capital” in the Consolidated
Balance Sheet upon issuance. The prepaid stock compensation was originally amortized over the performance period of three years.
In connection with the restructuring disclosed in Note 4, the Company terminated the consulting and endorsement agreements with
William Phillips and wrote off the unamortized prepaid stock compensation balance of $268,000 in August 2015.
In connection with the consulting agreement, the Company
also agreed to issue restricted shares worth $25,000 (based upon the weighted average stock price during the 15-day-period prior
to issuance) within 10 days after each subsequent three-month period term. In July 2015, the Company issued 5,189 shares of
its common stock to William Phillips. The fair value of the common stock was $28,000 based upon the closing price of the Company’s
common stock on the date of issuance, and was recorded as “Advertising and promotion” expense. No additional common
stock will be issued to William Phillips under this agreement.
Restricted Stock Awards Related to Energy Drink Agreement
In January 2015, the Company entered into an energy
drink agreement with Langer Juice and Creative Flavor Concepts to expand into a new product line. In connection with the agreement,
the Company issued a total of 150,000 shares of its restricted common stock with trade restrictions for a period of three years.
The restricted stock awards issued had a grant date fair value of approximately $1.2 million, which was initially included as a
component of “Prepaid stock compensation” and “Additional paid-in capital” in the Consolidated Balance
Sheet upon issuance. The prepaid stock compensation was originally amortized over the performance period of ten years. In connection
with the restructuring plan disclosed further in Note 4, the Company discontinued this product and wrote off the unamortized prepaid
stock compensation balance of $1.1 million in August 2015.
Restricted Stock Awards to Non-Employees
In July 2014, in connection with an endorsement
agreement, the Company issued 446,853 shares of its restricted common stock to ETW with an aggregate market value of $5.0 million,
as further described in Note 14. In September 2014, the Company entered into a consulting agreement with a third-party
service provider and issued 30,000 shares of its restricted common stock with an aggregate market value of $402,000. These restricted
stock awards granted to non-employees were initially included as a component of “Prepaid stock compensation” and “Additional
paid-in capital” in the Consolidated Balance Sheet upon issuance. The prepaid stock compensation was originally amortized
over the performance period. In connection with the restructuring plan disclosed further in Note 4, the Company wrote off the unamortized
prepaid stock compensation balance related to these restricted stock awards to non-employees of $3.8 million in August 2015.
Stock Options
In February 2016, the Company issued options under the
2015 Equity Incentive Plan to purchase 137,362 shares of its common stock to Mr. Drexler, the Company’s Interim Chief
Executive Officer, Interim President and Chairman of the Board, and 54,945 to Michael Doron, the Lead Director of the Board. These
stock options have an exercise price of $1.89 per share, a contractual term of 10 years and a grant date fair value of $331,000,
which is amortized on a straight-line basis over the vesting period of two years. The Company determined the fair value of
the stock options using the Black-Scholes model. For the three and nine months ended September 30, 2016, the Company recorded stock
compensation expense of $42,000 and $97,000, respectively. There were no options granted nor outstanding during the nine
months ended September 30, 2015.
Other Stock-Based Compensation- Agreements with
Worldwide Apparel, LLC – MusclePharm Apparel Rights
In February 2015, the Company entered into an agreement
with Worldwide Apparel, LLC (“Worldwide”) to terminate Worldwide’s right to use MusclePharm’s brand images
in apparel effective March 28, 2015. The brand rights were originally licensed in May 2011, and amended in March 2014 prior to
the termination. The consideration related to the acquisition of the MusclePharm apparel from Worldwide consisted of a cash consideration
of $850,000 and 170,000 shares of MusclePharm common stock with an aggregate fair value of $1.4 million. The total cost of the
MusclePharm apparel acquisition of $2.2 million was included in the caption brand within “Intangible assets, net” in
the Condensed Consolidated Balance Sheets, and was subject to amortization over a period of seven years.
Note 13. Net Loss per Share
Basic net loss per share is computed by dividing net
loss for the period by the weighted-average number of shares of common stock outstanding during each period. There was no dilutive
effect for the outstanding potentially dilutive securities for the three and nine months ended September 30, 2016 and 2015, respectively,
as the Company reported a net loss for all periods.
The following table sets forth the computation of the
Company’s basic and diluted net loss per share for the periods presented (in thousands, except share and per share data):
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Net loss
|
|
$
|
(1,447
|
)
|
|
$
|
(27,648
|
)
|
|
$
|
(12,248
|
)
|
|
$
|
(42,152
|
)
|
Weighted-average common shares used in computing net loss per share, basic and diluted
|
|
|
13,978,833
|
|
|
|
13,723,213
|
|
|
|
13,886,496
|
|
|
|
13,504,455
|
|
Net loss per share, basic and diluted
|
|
$
|
(0.10
|
)
|
|
$
|
(2.01
|
)
|
|
$
|
(0.88
|
)
|
|
$
|
(3.12
|
)
|
Diluted net income per share is computed by dividing
net income for the period by the weighted-average number of shares of common stock, common stock equivalents and potentially dilutive
securities outstanding during each period. The Company uses the treasury stock method to determine whether there is a dilutive
effect of outstanding potentially dilutive securities, and the if-converted method to assess the dilutive effect of the convertible
note.
There was no dilutive effect for the outstanding awards
for the three and nine months ended September 30, 2016 and 2015, respectively, as the Company reported a net loss for all periods.
However, if the Company had net income for the three and nine months ended September 30, 2016, the potentially dilutive securities
included in the earnings per share computation would have been 2,608,695 for both periods. If the Company had net income for the
three and nine months ended September 30, 2015, the no dilutive securities would have been included in the diluted earnings per
share computation for either period.
Total outstanding potentially dilutive securities were
comprised of the following:
|
|
As of September 30,
|
|
|
2016
|
|
2015
|
Stock options
|
|
|
192,307
|
|
|
|
—
|
|
Warrants
|
|
|
100,000
|
|
|
|
100,000
|
|
Unvested restricted stock
|
|
|
363,014
|
|
|
|
1,880,374
|
|
Convertible note
|
|
|
2,608,695
|
|
|
|
—
|
|
Total common stock equivalents
|
|
|
3,264,016
|
|
|
|
1,980,374
|
|
Note 14. Endorsement Agreements
Arnold Schwarzenegger
In July 2013, the Company entered into an Endorsement
Licensing and Co-Branding Agreement by and among the Company, Arnold Schwarzenegger, Marine MP, LLC, and Fitness Publications,
Inc. Under the terms of the agreement, Mr. Schwarzenegger was co-developing a special Arnold Schwarzenegger product line being
co-marketed under Mr. Schwarzenegger’s name and likeness. In connection with this agreement, the Company also issued to Marine
MP, LLC fully vested restricted shares of common stock with an aggregate market value of $8.5 million. The issuance was being amortized
over the original three-year term of the agreement to “Advertising and promotion” expense.
In May 2016, the Company received written notice to
terminate the Endorsement Licensing and Co-Branding Agreement effective immediately. As a result, $2.1 million of intangible assets,
prepaid assets and inventory related to the Arnold Schwarzenegger product line was written off as an impairment expense. The agreement
to terminate the product line stipulates that no further use of his likeness or sales of the inventory were allowed and therefore,
the Company disposed all the remaining product in inventory and other related assets. The Company is engaged in a dispute with
Mr. Schwarzenegger concerning the termination of the Endorsement Licensing and Co-Branding Agreement. See Note 10 for further details.
ETW
In July 2014, the Company entered into an Endorsement
Agreement with ETW. Under the terms of the agreement, Tiger Woods agreed to endorse certain of the Company’s products and
use a golf bag during all professional golf play that prominently displayed the MusclePharm name and logo.
In conjunction with this agreement, the Company issued
446,853 shares of the Company’s restricted common stock to ETW, with an aggregate market value of $5.0 million. The shares
were amortized over the original four-year term of the agreement. The current and non-current portions of the unamortized stock
compensation were initially included as a component of “Prepaid stock compensation” in the Condensed Consolidated Balance
Sheets. The amount of unamortized stock compensation expense of $3.5 million related to this agreement was written off in connection
with the restructuring plan disclosed further in Note 4.
In May 2016, the Company entered into a settlement
agreement with ETW, which eliminates all costs and terminates all future commitments under the Endorsement Agreement. Pursuant
to the settlement agreement, the Company paid ETW $2.2 million to terminate the parties’ obligations under Endorsement Agreement
and to resolve all disputes between the parties. As a result, the Company adjusted its restructuring accrual balance from $7.0
million to $2.2 million according to the settlement agreement and recorded an expense credit of $4.8 million during the nine months
ended September 30, 2016.
Johnny Manziel
In July 2014, the Company entered into an Endorsement
Agreement for the services of Johnny Manziel. As part of this agreement, the Company issued a warrant to purchase 100,000 shares
of its common stock at an exercise price of $11.90 per share. The warrants vest monthly over a period of 24 months beginning August 15,
2014, and have a five-year contractual term. The Company recognized stock-based compensation expense of $0 and $17,000 for
the three months ended September 30, 2016 and 2015, respectively, and $6,000 and $50,000 for the nine months ended September 30,
2016 and 2015, respectively, related to these warrants, which is included as a component of “Advertising and promotion”
expense in the accompanying Condensed Consolidated Statements of Operations. The Company used the Black-Scholes model to determine
the estimated fair value of the warrants, with the following assumptions: contractual life of five years, risk free interest
rate of 1.7%, dividend yield of 0%, and expected volatility of 55%. In connection with the restructuring disclosed in Note 4, the
Company notified Johnny Manziel of its intention to terminate the endorsement agreement; however, Johnny Manziel has disputed the
termination notice. As of September 30, 2016, all shares were vested under the warrant.
Note 15. Income Taxes
The Company did not record an additional tax provision
for the three months ended September 30, 2016. The Company recorded an income tax provision $71,000 for the three months ended
September 30, 2015, and $138,000 and $104,000 for the nine months ended September 30, 2016 and 2015, related to foreign income
taxes and federal and state minimum taxes.
Income taxes are provided for the tax effects of transactions
reported in the Condensed Consolidated Financial Statements and consist of taxes currently due. Deferred taxes relate to differences
between the basis of assets and liabilities for financial and income tax reporting which will be either taxable or deductible when
the assets or liabilities are recovered or settled. In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The ultimate
realization of deferred income tax assets is dependent upon the generation of future taxable income during the periods in which
those temporary differences become deductible. Management considers the scheduled reversal of deferred income tax liabilities,
projected future taxable income, and tax planning strategies in making this assessment. Based on consideration of these items,
management has established a full valuation allowance as it is more likely than not that the tax benefits will not be realized
as of September 30, 2016.
Note 16. Segments, Geographical Information
The Company’s chief operating decision maker
reviews financial information presented on a consolidated basis for purposes of allocating resources and evaluating financial performance.
As such, the Company currently has a single reporting segment and operating unit structure. In addition, most of the Company’s
revenue and substantially all long-lived assets are attributable to operations in the U.S. for all the periods presented.
Revenue, net by geography is based on the company addresses
of the customers. The following table sets forth revenue, net by geographic area (in thousands):
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Revenue, net:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
United States
|
|
$
|
18,744
|
|
|
$
|
23,676
|
|
|
$
|
71,955
|
|
|
$
|
91,534
|
|
International
|
|
|
11,950
|
|
|
|
10,306
|
|
|
|
34,518
|
|
|
|
34,246
|
|
Total revenue, net
|
|
$
|
30,694
|
|
|
$
|
33,982
|
|
|
$
|
106,473
|
|
|
$
|
125,780
|
|
Note 17. Related Party Transactions
Interim Chief Executive Officer,
President and Chairman Convertible Secured Promissory Note Agreement
In December 2015, the Company
entered into a convertible secured promissory note agreement with Mr. Drexler, pursuant to which he loaned the Company $6.0 million.
Proceeds from the note were used to fund working capital requirements. The convertible note is secured by all assets and properties
of the Company and its subsidiaries whether tangible or intangible. In connection with the Company entering into the convertible
promissory note with Mr. Drexler, the Company granted Mr. Drexler the right to designate two directors to the Board.
The Company agreed to take all actions necessary to permit such designation. See additional information in Note 9.
Sports Tickets
The Company maintains a luxury
box at the Sports Authority Field in Denver, Colorado. Employees are able to attend Denver Bronco football games and utilize
the luxury box. During 2015, the Company’s former CEO donated tickets to a game to a youth football team in which his
family member is a participant. Additionally, other family members also attended the game. The total cost for the event
was approximately $15,000.
Key Executive Life Insurance
During the year ended December 31,
2015, the Company purchased split dollar life insurance policies on certain key executives. In September 2015, the Company
increased the coverage on one of the key executives. These policies provide a split of 50% of the death benefit proceeds to the
Company and 50% to the officer’s designated beneficiaries.
Lease Agreement with Significant
Shareholder
In October 2013, the Company
entered into an Office Lease Agreement with Frost Real Estate Holdings, LLC, a Florida limited liability company owned by Dr. Phillip
Frost, a significant shareholder. Pursuant to the lease, the Company rented 1,437 square feet of office space for an initial term
of three years, with an option to renew the lease for an additional three-year term. This facility was closed in September 2015
and included in the Company’s restructuring plan. The remaining lease obligation through April 2017 for $77,000 was
included in the restructuring expense for the year ended December 31, 2015.
Lease Agreement with Former
Employee
The Company leased office and
warehouse facility in Hamilton, Ontario, Canada from 2017275 Ontario Inc., which is a company owned by Renzo Passaretti, former
VP and General Manager of MusclePharm Canada Enterprises Corp, the Company’s wholly-owned Canadian subsidiary. Mr. Passaretti
separated from the Company on September 2, 2015. For the three and nine months ended September 30, 2015, the Company paid
rent of $25,000 and $75,000, respectively. The lease was terminated in November 2015.
Business Relationship with Former Employee
Ryan DeLuca, the former Chief
Executive Officer of Bodybuilding.com, is the brother of Jeremy DeLuca, the Company’s former EVP, MusclePharm Brand and Global
Business Development. The Company maintained a business relationship with Bodybuilding.com prior to hiring Mr. DeLuca. The Company
does not offer preferential pricing of our products to Bodybuilding.com based on these relationships. Mr. DeLuca separated
from the Company on September 15, 2015. Net revenue from products sales to Bodybuilding.com were $2.8 million and $13.7
million for the three and nine months ended September 30, 2015, respectively. The Company had $1.5 million in trade receivables
with Bodybuilding.com as of December 31, 2015. The Company purchased marketing services from Bodybuilding.com of $0.1 million
and $0.3 million for the three and nine months ended September 30, 2015, respectively.
Note 18. Subsequent Events
GAAP requires an entity to disclose events that occur
after the balance sheet date but before financial statements are issued or are available to be issued (“subsequent events”)
as well as the date through which an entity has evaluated subsequent events. There are two types of subsequent events. The first
type consists of events or transactions that provide additional evidence about conditions that existed at the date of the balance
sheet, including the estimates inherent in the process of preparing financial statements, (“recognized subsequent events”).
The second type consists of events that provide evidence about conditions that did not exist at the date of the balance sheet
but arose subsequent to that date (“non-recognized subsequent events”). The following significant non-recognized subsequent
events occurred as of the date of this filing.
As previously disclosed, the Company has been
engaged in a dispute with F.H.G. Corporation (d/b/a Capstone Nutrition), INI Parent, Inc., INI Buyer, Inc. and Medley Capital
Corporation (together, “Capstone”) arising out of a Manufacturing Agreement between the parties. On November 7,
2016, the parties executed a settlement agreement (the “Settlement Agreement”). Under the Settlement Agreement,
the Company has agreed to pay to Capstone cash in the amount of $11.0 million within five business days following the
execution of the Settlement Agreement. All pending litigation will be dismissed with prejudice. The Settlement Agreement
releases all parties from any and all claims, actions, causes of action, suits, controversies or counterclaims that the
parties have had, now have or thereafter can, shall or may have. The Company will also issue to INI Buyer, Inc. a warrant to
purchase an amount of the Company’s common stock equal to 7.5% of the issued and outstanding capital stock of the
Company on a fully diluted basis as of the date of execution of the warrant agreement, estimated to be approximately
1,289,378 shares of Company common stock (the “Warrant”). The exercise price of the Warrant will be $1.83 per share, subject to adjustment under certain circumstances provided for therein, with a term of four years. The Company has valued
these warrants by utilizing the Black Scholes model at approximately $1.9 million based upon the best available information
as of the date of this Quarterly Report on Form 10-Q. The Warrant will be subject to adjustment upon certain events provided
for therein.
The Company has approximately $21.9 million
in accounts payable and accrued liabilities associated with the Capstone liability. Based upon the amounts included herein,
the Company anticipates recording a gain of approximately $8.9 million based on the Capstone settlement. Due to the
nature of this gain contingency, the Company has not reflected these amounts in its third quarter Condensed Consolidated
Balance Sheet and Statement of Operations. The Company intends to record this transaction in the fourth quarter of 2016.
In conjunction with the above transaction, on November 8, 2016, the Company entered into
a convertible secured promissory note agreement (the “2016 Convertible Note”) with Mr. Ryan Drexler, the Company’s
Chairman of the Board, Interim Chief Executive Officer and Interim President, pursuant to which Mr. Drexler loaned the Company
$11.0 million. Proceeds from the note were used to fund the Settlement Agreement. The 2016 Convertible Note is secured by
all assets and properties of the Company and its subsidiaries, whether tangible or intangible. The 2016 Convertible Note carries
interest at a rate of 10% per annum, or 12% if there is an event of default. Both the principal and the interest under the 2016
Convertible Note are due in November 2017, unless converted earlier. Mr. Drexler may convert the outstanding principal and accrued
interest into shares of the Company’s common stock for $1.83 per share at any time (estimated to be approximately 6,010,929
shares as of the date of this Quarterly Report on Form 10-Q). The Company may prepay the 2016 Convertible Note at the aggregate
principal amount therein, plus accrued interest, by giving Mr. Drexler between 15 and 60 days’ notice depending upon the
specific circumstances, provided that Mr. Drexler may convert the 2016 Convertible Note during the applicable notice period. The
Company intends to record this liability as a convertible note with a related party in the fourth quarter of 2016.