22nd Century Group, Inc. - Quarter Report: 2017 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE

COMMISSION WASHINGTON, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2017

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From ________  to ________

Commission File Number: 001-36338

22nd Century Group, Inc.

(Exact name of registrant as specified in its charter)

9530 Main Street, Clarence, New York 14031

(Address of principal executive offices)

(716) 270-1523

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

As of November 9, 2017, there were 123,564,117 shares of common stock issued and outstanding.

22nd CENTURY GROUP, INC.

INDEX

22nd CENTURY GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017

(unaudited)

NOTE 1. - NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation - The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments consisting of normal recurring accruals considered necessary for a fair and non-misleading presentation of the financial statements have been included.

Operating results for the nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. The balance sheet as of December 31, 2016 has been derived from the audited consolidated financial statements at that date, but does not include all the information and footnotes required by GAAP for complete financial statements.

These interim consolidated financial statements should be read in conjunction with the December 31, 2016 audited consolidated financial statements and the notes thereto.

Principles of Consolidation - The accompanying consolidated financial statements include the accounts of 22nd Century Group, Inc. (“22nd Century Group”), its three wholly-owned subsidiaries, 22nd Century Limited, LLC (“22nd Century Ltd”), NASCO Products, LLC (“NASCO”), and Botanical Genetics, LLC (“Botanical Genetics”), and two wholly-owned subsidiaries of 22nd Century Ltd, Goodrich Tobacco Company, LLC (“Goodrich Tobacco”) and Heracles Pharmaceuticals, LLC (“Heracles Pharma”) (collectively, “the Company”). All intercompany accounts and transactions have been eliminated.

Nature of Business - 22nd Century Ltd is a plant biotechnology company specializing in technology that allows (i) for the level of nicotine and other nicotinic alkaloids in tobacco plants to be decreased or increased through genetic engineering and plant breeding and (ii) the levels of cannabinoids in cannabis/hemp plants to be decreased or increased through genetic engineering and plant breeding. Goodrich Tobacco and Heracles Pharma are business units for the Company’s (i) potential modified risk tobacco products and premium cigarettes and (ii) smoking cessation product, respectively. The Company acquired the membership interests of NASCO on August 29, 2014. NASCO is a federally licensed tobacco products manufacturer, a subsequent participating member under the tobacco Master Settlement Agreement (“MSA”) between the tobacco industry and the settling states under the MSA, and operates the Company’s cigarette manufacturing business in North Carolina. Botanical Genetics is a wholly-owned subsidiary of 22nd Century Group, and was incorporated to facilitate an investment more fully described in Note 9.

Preferred stock authorized - The Company is authorized to issue “blank check” preferred stock, which could be issued with voting, liquidation, dividend and other rights superior to our common stock.

Accounts receivable - The Company periodically reviews aged account balances for collectability. At September 30, 2017 and December 31, 2016, the Company established an allowance for doubtful accounts in the amount of $0 and $10,000, respectively.

Inventory - Inventories are valued at the lower of cost or net realizable value. Cost is determined using an average cost method for tobacco leaf inventory and raw materials inventory and standard cost is primarily used for finished goods inventory. Inventories are evaluated to determine whether any amounts are not recoverable based on slow moving or obsolete condition and are written off or reserved as appropriate. Inventories at September 30, 2017 and December 31, 2016 consisted of the following:

Machinery and equipment - Machinery and equipment are recorded at their acquisition cost and depreciated on a straight-line basis over their estimated useful lives ranging from 3 to 10 years. Depreciation commences when the asset is placed in service.

Intangible Assets - Intangible assets are recorded at cost and consist primarily of (1) expenditures incurred with third parties related to the processing of patent claims and trademarks with government authorities, as well as costs to acquire patent rights from third parties, (2) license fees paid for third-party intellectual property, (3) costs to become a signatory under the tobacco MSA, and (4) license fees paid to acquire a predicate cigarette brand. The amounts capitalized relate to intellectual property that the Company owns or to which it has exclusive rights. The Company’s intellectual property capitalized costs are amortized using the straight-line method over the remaining statutory life of the primary patent in each of the Company’s two primary groupings of patent families, which expire in 2018 and 2028 (the assets’ estimated lives, respectively). Periodic maintenance or renewal fees are expensed as incurred. Annual minimum license fees are charged to expense. License fees paid for third-party intellectual property are amortized on a straight-line basis over the last to expire patents, which patent expiration dates range from 2028 through 2035. The Company believes costs associated with becoming a signatory to the MSA and acquiring a predicate cigarette brand have an indefinite life and as such, no amortization is taken. Total intangible assets at September 30, 2017 and December 31, 2016 consisted of the following:

Amortization expense relating to the above intangible assets for the three and nine months ended September 30, 2017 amounted to $145,934 and $429,832, respectively ($129,807 and $380,689 for the three and nine months ended September 30, 2016, respectively).

The estimated annual average amortization expense for the next five years is approximately $396,000 for patent costs and $98,000 for license fees.

Impairment of Long-Lived Assets - The Company reviews the carrying value of its amortizing long-lived assets whenever events or changes in circumstances indicate that the historical cost-carrying value of an asset may no longer be recoverable. The Company assesses recoverability of the asset by estimating the future undiscounted net cash flows expected to result from the asset, including eventual disposition. If the estimated future undiscounted net cash flows are less than the carrying value of the asset, an impairment loss is recorded equal to the difference between the asset’s carrying value and its fair value. There was no impairment loss recorded during the nine months ended September 30, 2017 or 2016, respectively.

Income Taxes - The Company recognizes deferred tax assets and liabilities for any basis differences in its assets and liabilities between tax and GAAP reporting, and for operating loss and credit carry-forwards.

Considering the Company’s history of cumulative net operating losses and the uncertainty of their future utilization, the Company has established a valuation allowance to fully offset its net deferred tax assets as of September 30, 2017 and December 31, 2016.

The Company’s federal and state tax returns for the years ended December 31, 2014 through December 31, 2016 are currently open to audit under the statutes of limitations. There were no pending audits as of September 30, 2017.

Stock Based Compensation - The Company uses a fair-value based method to determine compensation for all arrangements under which Company employees and others receive shares or options to purchase common shares of the Company. Stock based compensation expense is recorded over the requisite service period based on estimates of probability and time of achieving milestones and vesting. For accounting purposes, the shares will be considered issued and outstanding upon vesting.

Revenue Recognition - The Company recognizes revenue from product sales at the point the product is shipped to a customer and title has transferred. Revenue from the sale of the Company’s products is recognized net of cash discounts, sales returns and allowances. Cigarette and filtered cigar federal excise taxes and other regulatory fees in the approximate amount of $2,436,000 and $5,980,000 are included in net sales for the three and nine months ended September 30, 2017, respectively (approximately $1,810,000 and $5,387,000 for the three and nine months ended September 30, 2016, respectively), except on sales of SPECTRUM research cigarettes, exported cigarettes, exported filtered cigars and in-bond sales of filtered cigars to other federally licensed tobacco products manufacturers, to which such taxes do not apply.

The Company was chosen to be a subcontractor for a 5-year government contract between RTI International (“RTI”) and the National Institute on Drug Abuse (“NIDA”) to supply NIDA with research cigarettes. The contract was renewed in 2015 for an additional 5 years. These government research cigarettes are distributed under the Company’s mark SPECTRUM. There were no SPECTRUM research cigarettes delivered during the nine months ended September 30, 2017. Revenue generated from the sale of SPECTRUM research cigarettes amounted to $0 and $329,321 for the nine months ended September 30, 2017 and 2016, respectively. In May 2017, the Company received a purchase order from RTI for approximately 2.4 million SPECTRUM research cigarettes that are expected to be shipped in the fourth quarter of 2017 and generate sales revenue of approximately $325,000. The Company recorded deferred income in the approximate amount of $158,000 during the third quarter of 2017 primarily resulting from a down payment from RTI on the SPECTRUM research cigarette order.

Derivatives - The Company does not use derivative instruments to hedge exposures to cash flow, market or foreign currency risks. The Company evaluates all our financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair market value and then is revalued at each reporting date, with changes in fair value reported in the Consolidated Statements of Operations. The methodology for valuing our outstanding warrants classified as derivative instruments utilizes a lattice model, which includes probability weighted estimates of future events, including volatility of our common stock. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or equity, is evaluated at the end of each reporting period. Derivative instrument liabilities are classified on the balance sheet as current or non-current based on if the net-cash settlement of the derivative instrument could be required within twelve months of the balance sheet date.

Research and Development - Research and development costs are expensed as incurred.

Advertising - The Company expenses advertising costs as incurred. Advertising expense was approximately $6,000 and $49,000 for the three and nine months ended September 30, 2017, respectively ($24,000 and $259,000 for the three and nine months ended September 30, 2016, respectively).

Loss Per Common Share - Basic loss per common share is computed using the weighted-average number of common shares outstanding. Diluted loss per share is computed assuming conversion of all potentially dilutive securities. Potential common shares outstanding are excluded from the computation if their effect is anti-dilutive.

Commitment and Contingency Accounting - The Company evaluates each commitment and/or contingency in accordance with accounting standards, which state that if the item is more likely than not to become a direct liability, then the Company will record the liability in the financial statements. If not, the Company will disclose any material commitments or contingencies that may arise.

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

Fair Value of Financial Instruments - Financial instruments include cash, accounts receivable, accounts payable, accrued expenses, accrued severance, note payable and warrant liability. Other than warrant liability, fair value is assumed to approximate carrying values for these financial instruments, since they are short term in nature, they are receivable or payable on demand, or have stated interest rates that approximate the interest rates available to the Company as of the reporting date. The determination of the fair value of the warrant liability includes unobservable inputs and is therefore categorized as a Level 3 measurement, as further discussed in Note 12.

Equity Investments - The Company accounts for investments in equity securities of other entities under the equity method of accounting if the Company’s investment in the voting stock is greater than or equal to 20% and less than a majority, and the Company has the ability to have significant influence over the operating and financial policies of the investee. When the Company’s investment in equity securities falls below 20% and the Company does not have the ability to have significant influence over the operating and financial policies of the investee, the Company carries the equity investment at its cost basis.

Accounting Pronouncements - In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU 2014-09, “Revenue from Contracts with Customers,” which supersedes nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenue when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five-step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing GAAP. The revised effective date for the ASU is for annual periods beginning after December 15, 2017, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). In August 2015, the FASB issued ASU 2015-14, “Revenue from Contracts with Customers (Topic 606) - Deferral of the Effective Date,” which deferred the effective date of ASU 2014-09 to annual reporting periods beginning after December 15, 2017 and interim periods therein, with earlier application permitted as of annual reporting periods beginning after December 15, 2016. In March 2016, the FASB issued ASU No. 2016-08, “Revenue from Contracts with Customers (Topic 606) - Principal versus Agent Considerations,” to clarify the implementation guidance on principal versus agent. In April 2016, the FASB issued ASU No. 2016-10, “Revenue from Contracts with Customers (Topic 606) - Identifying Performance Obligations and Licensing,” which clarifies the identifying performance obligations and licensing implementation guidance. The Company is continuing to evaluate the effect this guidance will have on its consolidated financial statements, including potential impacts on the amount and timing of revenue recognition and additional information that may be necessary for the required expanded disclosures. The Company has substantially completed its review of all outstanding contracts and is in the process of applying the five-step model to those contracts to evaluate the quantitative and qualitative impacts the new standard will have on its business and reported revenues.  Within this process, the Company has begun to assess when to recognize revenues related to certain manufacturing contracts to produce customers’ products and the presentation of certain federal excise taxes and other regulatory fees. At this time, the Company is unable to quantify the impact this new guidance will have on its reported revenues.

In February 2016, the FASB issued ASU 2016-02, “Leases,” which supersedes existing lease guidance under GAAP. Under the new guidance, lessees will be required to recognize leases as right of use assets and liabilities for leases with lease terms of more than twelve months. The guidance will apply for both finance and operating leases. The effective date for the ASU is for annual periods beginning after December 15, 2018 and interim periods therein. The Company is currently evaluating the impact of the ASU on its consolidated financial statements.

NOTE 2. – JUNE 2017 WARRANT EXERCISE AGREEMENTS

On June 19, 2017, the Company entered into Warrant Exercise Agreements (the “Agreements”) with all of the holders (the “Holders”) of outstanding warrants to purchase up to 7,043,211 shares of common stock of the Company at $1.00 per share and warrants to purchase up to 4,250,000 shares of common stock of the Company at $1.45 per share (collectively, the “Warrants”). These Warrants to purchase shares of the Company’s common stock were acquired by the Holders in registered direct offerings in October of 2016 and in July of 2016, respectively, as more fully described in Notes 3 and 4 below. The Company and the Holders agreed that the Holders would, subject to beneficial ownership limitations on exercise contained in the Warrants, exercise all the Warrants for cash. In June 2017, the Holders exercised 3,229,711 Warrants at $1.00 per share and 2,354,948 Warrants at $1.45 per share, resulting in net proceeds to the Company in the amount of $6,169,212, after deducting expenses associated with the transaction. In July and August of 2017, the Holders exercised 3,813,500 Warrants at $1.00 per share and 1,895,052 Warrants at $1.45 per share, resulting in net proceeds to the Company in the amount of $6,167,646, after deducting expenses associated with the transaction.

In consideration for the Holders exercising their Warrants for cash, the Company issued to each Holder a new warrant (the “New Warrants”) to purchase shares of common stock of the Company equal to the number of shares of common stock received by each Holder upon the cash exercise of the Holder’s Warrants. The terms of the New Warrants are substantially similar to the terms of the Warrants exercised, except the New Warrants (i) have an exercise price equal to $2.15 per share and (ii) are exercisable six months from the date of issuance of the New Warrants for a period of five (5) years. Accordingly, the Company issued an aggregate of 11,293,211 New Warrants to the Holders, upon exercise of the Holder’s Warrants as described above. The New Warrants had a fair value of $16,049,031 at issuance and have been recorded as an adjustment to capital in excess of par.

NOTE 3. – OCTOBER 2016 REGISTERED DIRECT OFFERING

On October 19, 2016, the Company closed a registered direct offering with two institutional investors of units consisting of 8,500,000 shares of the Company’s common stock and warrants to purchase 4,250,000 shares of the Company’s common stock at an exercise price of $1.45 per share. The warrants were exercisable for a period of sixty-six (66) months after issuance, were not exercisable for a period of six months immediately following the issuance and had a fair value of approximately $3,380,000 at issuance. The holders of the warrants did not have the right to exercise any portion of the warrants if the holders, together with its respective affiliates, would beneficially own in excess of 4.99% of the number of shares of the Company’s common stock (including securities convertible into common stock) outstanding immediately after the exercise; provided, however, that the holder could increase or decrease this limitation at any time, although any increase shall not be effective until the 61st day following the notice of increase and the holder could not increase this limitation in excess of 9.99%. The common stock and warrants were sold for $1.3425 per unit, resulting in net proceeds to the Company in the amount of $10,707,823, after deducting expenses associated with the transaction. All of the warrants issued in the offering were exercised as described in Note 2 above.

NOTE 4. – JULY 2016 REGISTERED DIRECT OFFERING

On July 27, 2016, the Company closed a registered direct offering of common stock and warrants consisting of 6,172,840 shares of the Company’s common stock and warrants to purchase 7,043,211 shares of the Company’s common stock. The warrants provided for an exercise price of $1.00 per share and 1,543,210 of the warrants were exercisable immediately and had a fair value of approximately $858,000 at issuance and 5,500,001 of the warrants were exercisable six months from the date of issuance and had a fair value of approximately $3,058,000 at issuance. All the warrants had a term of 5.5 years. The common stock and warrants were sold for $0.81 per unit, resulting in net proceeds to the Company in the amount of $4,682,764, after deducting expenses associated with the transaction. All of the warrants issued in the offering were exercised as described in Note 2 above. In addition, on July 27, 2016, the Company terminated an aggregate of 5.5 million warrants with exercise prices of $1.21 and $1.25 per share previously issued in conjunction with registered direct offerings in February of 2016 and June of 2015.

NOTE 5. - FEBRUARY 2016 REGISTERED DIRECT OFFERING

On February 5, 2016, the Company closed a registered direct offering of common stock and warrants consisting of 5,000,000 shares of the Company’s common stock and warrants to purchase 2,500,000 shares of the Company’s common stock at an exercise price of $1.21 per share. The warrants were exercisable for a period of sixty-six (66) months after issuance, were not exercisable for a period of six months immediately following the issuance and had a fair value of approximately $1,940,000 at issuance. The common stock and warrants were sold for $1.10 per unit, resulting in net proceeds to the Company in the amount of $5,091,791, after deducting expenses associated with the transaction. The warrants associated with this transaction were terminated on July 27, 2016.

NOTE 6. - JOINT VENTURE, CONSULTING AGREEMENT AND ASSOCIATED WARRANTS

On June 22, 2015, the Company terminated its joint venture arrangement with Crede CG III, Ltd. (“Crede”) and a third-party due to non-performance and other breaches of the arrangement by Crede and its principals. The Company also notified Crede that the Company reserved and did not waive any rights that the Company may have to assert any and all claims that it may have against Crede, its employees, agents, representatives or affiliates thereof, which are allowable by law or in equity, including claims for breach of the warrant agreements entered into with Crede.

The six-month Consulting Agreement (the “Consulting Agreement”), entered into with Crede on September 29, 2014, expired on March 29, 2015. The value of the warrants issued in conjunction with the Consulting Agreement in the aggregate amount of $4,070,000 and initially recorded as prepaid consulting fees have been fully amortized. The final amortization of the prepaid consulting fees amounted to $1,978,785 for the three months ended March 31, 2015, and were included in General and administrative expenses in the Company’s Consolidated Statements of Operations.

Four tranches of warrants were issued to Crede in conjunction with the Consulting Agreement as follows: Tranche 1A warrant to purchase 1,250,000 shares of Company common stock, Tranche 1B warrant to purchase 1,000,000 shares of Company common stock, Tranche 2 warrant to purchase 1,000,000 shares of Company common stock and Tranche 3 warrant to purchase 1,000,000 shares of Company common stock. The Tranche 1A warrant contained an exchange rights clause that required derivative liability treatment under FASB ASC 480 - “Distinguishing Liabilities from Equity.” The Company valued the derivative liability associated with the Tranche 1A warrant at inception at $2,810,000 and the liability was recorded on the Company’s Consolidated Balance Sheets in Warrant liability. In March 2016, the Company provided notice to Crede that Crede repeatedly breached the activity restrictions contained in the warrant agreements and because the terms of the Tranche 1A warrant provide that the availability of the exchange feature was subject to compliance with such activity restrictions, the exchange rights clause contained in the Tranche 1A warrant was no longer available and was thereafter void (although the remaining amount of shares underlying the warrant without the exchange feature remained fully exercisable at $3.36 per share through the warrant expiration date of September 29, 2016). Accordingly, the Company reclassified the warrant liability associated with the Tranche 1A warrant to Capital in excess of par on its Consolidated Balance Sheets during March 2016. The Tranche 1A and Tranche 1B warrants all expired without exercise on September 29, 2016.

The Tranche 2 and Tranche 3 warrants were not exercisable unless and until certain revenue milestones were attained, as defined in the prior joint venture agreement between Crede and the Company. As stated above, the Company terminated the joint venture agreement on June 22, 2015. Accordingly, such revenue milestones will never be satisfied, and the Tranche 2 and Tranche 3 warrants will never be exercisable.

NOTE 7. - MANUFACTURING FACILITY

The Company’s manufacturing operations at its North Carolina factory were not at full production capacity throughout the nine months ended September 30, 2017, and the Company significantly expanded capacity during the second and third quarters of 2017 in order to fulfill anticipated new manufacturing contracts. In mid-May of 2017, the Company began the first phase of a manufacturing contract for an existing brand of filtered cigars under a new contract manufacturing agreement (the “New Agreement”) with a third-party and continued manufacturing a third-party MSA cigarette brand and other filtered cigars on a contract basis. The New Agreement has increased revenue, has resulted in an increase in the utilization of production capacity, and has required the hiring of additional personnel. Raw material component costs, direct manufacturing costs, and an overhead allocation are included in the Cost of goods sold and Finished goods inventory. General and administrative expenses of the factory amounted to $300,824 and $635,514 for the three and nine months ended September 30, 2017, respectively ($140,690 and $422,626 for the three and nine months ended September 30, 2016, respectively).

NOTE 8. - MACHINERY AND EQUIPMENT

Machinery and equipment at September 30, 2017 and December 31, 2016 consisted of the following:

Depreciation expense was $88,711 and $265,296 for the three and nine months ended September 30, 2017, respectively ($81,354 and $243,018 for the three and nine months ended September 30, 2016, respectively).

NOTE 9. - INVESTMENT IN ANANDIA

The Company (through its wholly-owned subsidiary, Botanical Genetics) used the equity method of accounting to record its 24.4% ownership interest in Anandia Laboratories, Inc., a Canadian plant biotechnology company (“Anandia”). The Company’s ownership was 25% prior to a dilutive event on September 8, 2016, that reduced the Company’s ownership in Anandia to 24.4%. On February 17, 2017, an additional dilutive event (the “Dilutive Event”) reduced the Company’s ownership in Anandia to 19.4%, an ownership percentage below the 20% threshold for use of the equity method of accounting. Accordingly, the Company discontinued applying the equity method of accounting for the investment in Anandia, effective on the date of the Dilutive Event. At September 30, 2017 and December 31, 2016, the Company’s investment balance in Anandia was $1,366,493 and $1,020,313, respectively, and is classified within Other assets on the accompanying Consolidated Balance Sheets. After the Dilutive Event, the Company accounts for its investment in Anandia under the cost method. On July 25, 2017, a third dilutive event occurred resulting in an additional reduction of the Company’s ownership in Anandia to 19.0%.

The Company recorded a gain on investment of $0 and $16,872 for the three and nine months ended September 30, 2017, respectively, and a loss of $15,585 and $128,832 for the three and nine months ended September 30, 2016, respectively (the gain for the nine months ended September 30, 2017, reflects the Company’s proportionate gain through the Dilutive Event). As of September 15, 2014, the carrying value of the Company’s investment in Anandia was approximately $1,199,000 in excess of the Company’s share of the book value of the net assets of Anandia, with such difference being attributable to intangible assets. This intangible asset was being amortized over the expected benefit period and this amortization expense amounted to $0 and $7,526 for the three and nine months ended September 30, 2017, respectively ($14,412 and $43,236 for the three and nine months ended September 30, 2016, respectively). After the Dilutive Event, the Company discontinued amortizing this intangible asset. In addition, and as a result of the Dilutive Event, the Company recorded a gain in accordance with the derecognition provisions of Accounting Standards Codification 323 (“ASC 323”). ASC 323 states that an investor (the Company) shall account for an issuance by an investee (Anandia) as if the investor had sold a proportionate share of its investment in the investee and the investor will record a gain or loss resulting from the investee share issuance. As such, the Company recorded a gain of $336,834 during the three months ended March 31, 2017, as a result of the Dilutive Event. The Company’s overall gain (loss) on the investment when aggregating the Company’s share of Anandia’s gain (loss), the intangible asset amortization and the gain recorded under ASC 323 amounted to $0 and $346,180 for the three and nine months ended September 30, 2017, respectively, and amounted to ($29,997) and ($172,068) for the three and nine months ended September 30, 2016, respectively.

NOTE 10. - NOTES PAYABLE AND PATENT ACQUISITION

On December 22, 2014, the Company entered into a Purchase Agreement (the “Purchase Agreement”) with the National Research Council of Canada (“NRC”) to acquire certain patent rights that the Company had previously licensed from NRC under a license agreement between the parties. The Purchase Agreement provided for payment by the Company to NRC for the NRC patent rights of a total amount of $1,213,000, of which $213,000 was paid in cash at the closing on December 23, 2014, and with the remaining $1,000,000 balance to be paid in three equal installments of $333,333 in December of 2015, 2016 and 2017, respectively, with no interest on the installment payments unless the Company defaults on any such installment payments. As such, the Company computed the present value of the note payable using the Company’s incremental borrowing rate. The resulting present value of the note payable amounted to $925,730 at December 31, 2014. After the scheduled installment payments of $333,333 made by the Company to NRC on each of December 22, 2016 and 2015, and the accretion of interest, the remaining present value of the note payable amounts to $326,924 and $307,938 at September 30, 2017 and December 31, 2016, respectively, and the amounts are reported as Current portion of note payable on the Company’s Consolidated Balance Sheets. The cost of the acquired patents in the amount of $1,138,730 (cash of $213,000 plus the original discounted notes payable in the amount of $925,730) are included in Intangible assets, net on the Company’s Consolidated Balance Sheets. All previous license agreements between NRC and the Company were terminated as a condition of the Purchase Agreement. NRC has a security interest in these patent rights acquired by the Company from NRC until the note payable has been satisfied.

NOTE 11. - SEVERANCE LIABILITY

The Company recorded an accrual for severance during the fourth quarter of 2014 in the initial amount of $624,320 in accordance with FASB ASC 712 - “Compensation - Nonretirement Postemployment Benefits.” The severance accrual relates to the October 25, 2014 termination of Joseph Pandolfino, the Company’s former Chairman of the Board and Chief Executive Officer. The prior Employment Agreement with Mr. Pandolfino provided that in certain circumstances Mr. Pandolfino would receive severance payments in the gross amount of $18,750 per month, subject to customary withholdings, over a term of 36 months. Amounts owed to Mr. Pandolfino have been discounted using the Company’s incremental borrowing rate. As a result of the severance benefit payments made through the third quarter of 2017, the discounted current balance of the severance liability amounted to $38,793 and $199,657, at September 30, 2017 and December 31, 2016, respectively. The severance liability will be fully satisfied during the fourth quarter of 2017.

NOTE 12. - WARRANTS FOR COMMON STOCK

At September 30, 2017, the Company had outstanding warrants to purchase 12,204,580 shares of common stock of the Company, of which warrants to purchase 94,721 shares contain an anti-dilution feature, and excluding 2,000,000 Tranche 2 and 3 warrants that will never become exercisable, as discussed in Note 6.

During the third quarter of 2017, warrants to purchase 240,667 shares of common stock were exercised on a cashless basis resulting in the issuance of 146,320 shares of the Company’s common stock and 5,708,552 warrants to purchase shares of common stock were exercised on a cash basis under the June 2017 Warrant Exercise Agreements discussed in Note 2.

During July and August of 2017, the Company issued warrants to purchase 5,708,552 shares of common stock with an exercise price of $2.15 per share. These warrants have a term of sixty-six (66) months, were not exercisable for six months immediately following the date of issuance, do not contain an anti-dilution feature and had a fair value of $9,135,223 at issuance. See Note 2 for additional details.

During the second quarter of 2017, warrants to purchase 843,110 shares of common stock were exercised on a cashless basis resulting in the issuance of 525,118 shares of the Company’s common stock and 5,657,157 warrants to purchase shares of common stock were exercised on a cash basis (including 5,584,659 warrants to purchase shares of common stock under the June 2017 Warrant Exercise Agreements discussed in Note 2). On May 15, 2017, warrants to purchase 45,834 shares of common stock expired without being exercised.

During June of 2017, the Company issued warrants to purchase 5,584,659 shares of common stock with an exercise price of $2.15 per share. These warrants had a term of sixty-six (66) months, were not exercisable for six months immediately following the date of issuance, do not contain an anti-dilution feature and had a fair value of approximately $6,913,031 at issuance. See Note 2 for additional details.

During March of 2017, warrants to purchase 202,500 shares of common stock were exercised on a cashless basis resulting in the issuance of 100,928 shares of the Company’s common stock. On February 8, 2017, warrants to purchase 172,730 shares of common stock expired without being exercised.

On January 25, 2016, warrants to purchase 67,042 shares of common stock were exercised, primarily on a cashless basis, resulting in the issuance of 2,618 shares of the Company’s common stock. On January 25, 2016, warrants to purchase 6,831,115 shares of common stock expired without being exercised.

Pursuant to the registered direct offering that closed on October 19, 2016, and discussed in Note 3, the Company issued warrants to purchase 4,250,000 shares of common stock with an exercise price of $1.45 per share. These warrants had a term of sixty-six (66) months, were not exercisable for six months immediately following the date of issuance, did not contain an anti-dilution feature, and had a fair value of approximately $3,380,000 at issuance. Pursuant to the June 2017 Warrant Exercise Agreements, as discussed in Note 2, warrants to purchase 4,250,000 shares of common stock were exercised on a cash basis at an exercise price of $1.45 per share (2,354,948 Warrants were exercised in June of 2017 and 1,895,052 Warrants were exercised in July and August of 2017).

Pursuant to the registered direct offering that closed on July 27, 2016, and discussed in Note 4, the Company issued warrants to purchase 7,043,211 shares of common stock. The warrants provide for an exercise price of $1.00 per share and 1,543,210 of the warrants were exercisable immediately and had a fair value of approximately $858,000 at issuance and 5,500,001 of the warrants were exercisable six months from the date of issuance and had a fair value of approximately $3,058,000 at issuance. All the warrants had a term of 5.5 years and do not contain an anti-dilution feature. In addition, on July 27, 2016, the Company terminated an aggregate of 5.5 million warrants with exercise prices of $1.21 and $1.25 per share previously issued in conjunction with registered direct offerings in February of 2016 and June of 2015. Pursuant to the June 2017 Warrant Exercise Agreements, as discussed in Note 2, warrants to purchase 7,043,211 shares of common stock were exercised on a cash basis at an exercise price of $1.00 per share (3,229,711 Warrants were exercised in June of 2017 and 3,813,500 Warrants were exercised in July and August of 2017).

Pursuant to the registered direct offering that closed on February 5, 2016, and discussed in Note 5, the Company issued warrants to purchase 2,500,000 shares of common stock with an exercise price of $1.21 per share. These warrants had a term of sixty-six (66) months, were not exercisable for six months immediately following the date of issuance, did not contain an anti-dilution feature, and had a fair value of approximately $1,940,000 at issuance. The warrants associated with this transaction were terminated on July 27, 2016 (see Note 4 – July 2016 Registered Direct Offering for additional information).

Pursuant to the registered direct offering that closed on June 2, 2015, the Company issued warrants to purchase 3,000,000 shares of common stock with an exercise price of $1.25 per share. These warrants had a term of sixty-six (66) months, were not exercisable for six months immediately following the date of issuance, did not contain an anti-dilution feature, and had a fair value of approximately $2,067,000 at issuance. The warrants associated with this transaction were terminated on July 27, 2016 (see Note 4 – July 2016 Registered Direct Offering for additional information).

Outstanding warrants at September 30, 2017 consisted of the following:

(1) Includes anti-dilution features.

(2) Excludes 2,000,000 Tranche 2 and Tranche 3 warrants that will never become exercisable, as discussed in Note 6.

The Company estimates the value of warrant liability upon issuance of the warrants and at each balance sheet date using the binomial lattice model to allocate total enterprise value to the warrants and other securities in the Company’s capital structure. Volatility was estimated based on historical observed equity volatilities and implied (forward) or expected volatilities for a sample group of guideline companies and consideration of recent market trends.

As a result of the previously exercisable exchange rights contained in the Tranche 1A warrants, the financial instrument was previously considered a liability in accordance with FASB Accounting Standards Codification Topic 480 - “Distinguishing Liabilities from Equity” (“ASC 480”). More specifically, ASC 480 requires a financial instrument to be classified as a liability if such financial instrument contains a conditional obligation that the issuer must or may settle by issuing a variable number of its equity securities if, at inception, the monetary value of the obligation is based on a known fixed monetary amount. As a result of the actions by Crede that caused the exchange rights feature to be voided (see Note 6 - Joint Venture, Consulting Agreement and Associated Warrants for additional information), the Company reclassified the Tranche 1A warrant liability to Capital in excess of par.

The following table is a roll-forward summary of the warrant liability:

The aggregate loss as a result of the Company’s warrant liability for the three and nine months ended September 30, 2017 amounted to $55,886 and $138,813, respectively (the aggregate net (loss) gain for the three and nine months ended September 30, 2016 amounted to ($46,995) and $14,602, respectively), which are included in Other income (expense) under Warrant liability (loss) gain - net in the accompanying Consolidated Statements of Operations.

FASB ASC 820 - “Fair Value Measurements and Disclosures” establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows:

A financial asset’s or a financial liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. The warrant liability is measured at fair value using certain estimated factors such as volatility and probability which are classified within Level 3 of the valuation hierarchy. Significant unobservable inputs that are used in the fair value measurement of the Company’s derivative warrant liabilities include volatility. Significant increases (decreases) in the volatility input would result in a significantly higher (lower) fair value measurement.

The following table summarizes the Company’s warrant activity since December 31, 2015:

(1) Tranche 2 and Tranche 3 warrants that will never become exercisable, as discussed in Note 6.

(2) Tranche 1A and Tranche 1B warrants expired unexercised on September 29, 2016.

NOTE 13. - COMMITMENTS AND CONTINGENCIES

License Agreements - Under its exclusive worldwide license agreement with North Carolina State University (“NCSU”), the Company is required to pay minimum annual royalty payments, which are credited against running royalties on sales of licensed products. The minimum annual royalty is $225,000. The license agreement continues through the life of the last-to-expire patent, which is expected to be 2022. The license agreement also requires a milestone payment of $150,000 upon FDA approval or clearance of a product that uses the NCSU licensed technology. The Company is also responsible for reimbursing NCSU for actual third-party patent costs incurred. These costs vary from year to year and the Company has certain rights to direct the activities that result in these costs. During the three and nine months ended September 30, 2017, the aggregate costs incurred related to capitalized patent costs and patent maintenance expense amounted to $11,022 and $42,730, respectively ($62,303 and $76,299 during the three and nine months ended September 30, 2016, respectively).

On December 8, 2015, the Company entered into an additional license agreement (the “License”) with NCSU. Under the terms of the License, the Company paid NCSU a non-refundable, non-creditable lump sum license fee of $150,000. Additionally, the License calls for the Company to pay NCSU a non-refundable, non-creditable minimum annual royalty beginning on December 31, 2018 in the amount of $10,000. The minimum annual royalty payment increases to $15,000 in 2019, $25,000 in 2020 and 2021, and $50,000 per year thereafter for the remaining term of the License. The Company is also responsible for reimbursing NCSU for actual third-party patent costs incurred. During the three and nine months ended September 30, 2017, the aggregate costs incurred related to capitalized patent costs and patent maintenance expense amounted to $236 and $30,102, respectively ($0 and $6,075 for the three and nine months ended September 30, 2016, respectively). This License continues through the life of the last-to-expire patent, expected to be in 2035.

On February 10, 2014, the Company entered into a sponsored research and development agreement (the “Agreement”) with NCSU. Under the terms of the Agreement, the Company paid NCSU $162,408 over the two-year term of the Agreement, which grants certain licensed rights to the Company. The Company had extended the Agreement through January 31, 2017 at an additional cost of $85,681. The Company is currently negotiating an additional extension to this Agreement.

All payments made under the above referenced license agreements and the sponsored research and development agreement are initially recorded as a Prepaid expense on the Company’s Consolidated Balance Sheets and subsequently expensed on a straight-line basis over the applicable period and included in Research and development costs on the Company’s Consolidated Statements of Operations. The amounts expensed during the three and nine months ended September 30, 2017 were $56,250 and $175,890, respectively ($115,170 and $345,137 for the three and nine months ended September 30, 2016, respectively).

On August 22, 2014, the Company entered into a Commercial License Agreement with Precision PlantSciences, Inc. (the “Precision License”). The Precision License grants the Company a non-exclusive, but fully paid up right and license to use technology and materials owned by Precision PlantSciences for a license fee of $1,250,000. The Precision License continues through the life of the last-to-expire patent, which is expected to be in 2028.

On August 27, 2014, the Company entered into an additional exclusive License Agreement (the “License Agreement”) with NCSU. Under the License Agreement, the Company paid NCSU a non-refundable, non-creditable lump sum license fee of $125,000, and the Company must pay to NCSU an additional non-refundable, non-creditable lump sum fee of $75,000 upon issuance of a U.S. utility patent included in the patent rights. A patent was issued during the first quarter of 2017 under this clause, and accordingly, the $75,000 was due and payable to NCSU. The $75,000 cost was included in Research and development costs on the Company’s Consolidated Statements of Operations for the three months ended March 31, 2017. Additionally, the License Agreement calls for the Company to pay NCSU three non-refundable, non-creditable license maintenance fees in the amount of $15,000 per annum in each of December 2015, 2016 and 2017. Beginning in calendar year 2018, the Company is obligated to pay to NCSU an annual minimum royalty fee of $20,000 in 2018, $30,000 in 2019, and $50,000 per year thereafter for the remaining term of the License Agreement. The Company is also responsible for reimbursing NCSU for actual third-party patent costs incurred. During the three and nine months ended September 30, 2017, the aggregated costs incurred related to capitalized patent costs and patent maintenance expense amounted to $12,928 and $37,170, respectively ($4,056 and $37,995 for the three and nine months September 30,2016, respectively). The License Agreement continues through the life of the last-to-expire patent, which is expected to be in 2034.

On September 15, 2014, the Company entered into a Sublicense Agreement with Anandia Laboratories, Inc. (the “Anandia Sublicense”). Under the terms of the Anandia Sublicense, the Company was granted an exclusive sublicense in the United States and a co-exclusive sublicense in the remainder of the world, excluding Canada, to the licensed intellectual property. The Anandia Sublicense required an up-front fee of $75,000, an annual license fee of $10,000, the payment of patent filing and maintenance costs, and a running royalty on future net sales. The Anandia Sublicense continues through the life of the last-to- expire patent, which is expected to be in 2035.

The Precision License, the License Agreement with NCSU and the Anandia Sublicense are included in Intangible assets, net in the Company’s Consolidated Balance Sheets and the applicable license fees will be amortized over the term of the agreements based on their last-to-expire patent date. Amortization amounted to $24,505 and $73,516 for the three months and nine months ended September 30, 2017, respectively ($24,505 and $73,516 for the three and nine months ended September 30, 2016, respectively) and was included in Amortization expense on the Company’s Consolidated Statements of Operations.

On September 28, 2015, the Company’s wholly-owned subsidiary, Botanical Genetics, entered into a Sponsored Research Agreement (the “Agreement”) with Anandia Laboratories Inc. (“Anandia”). Pursuant to the Agreement, Anandia is conducting research on behalf of the Company relating to the cannabis/hemp plant. The Agreement had an initial term of twelve (12) months from the date of the Agreement and can be extended at the sole option of the Company for two (2) additional periods of twelve (12) months each (of which the option on the first twelve (12) month period has been extended). The Company paid Anandia $379,800 over the initial term of the Agreement. On March 13, 2017, the Company entered into Amendment No. 1 to the Agreement (the “Amendment”). The Amendment has a term of twelve (12) months and calls for the Company to pay Anandia a total of $785,100 in equal monthly installments of $65,425. During the three and nine months ended September 30, 2017, expenses related to the Agreement amounted to $196,275 and $457,975, respectively ($84,200 and $263,400, for the three and nine months ended September 30, 2016, respectively) and are included in Research and development costs on the Company’s Consolidated Statements of Operations. Under the terms of the Agreement, the Company will have co-exclusive worldwide rights with Anandia to all the intellectual property resulting from the sponsored research between the Company and Anandia. The party that commercializes such intellectual property in the future will pay royalties in varying amounts to the other party, with the amount of such royalties being dependent upon the type of products that are commercialized in the future. If either party sublicenses such intellectual property to a third-party, then the Company and Anandia will share equally in such sublicensing consideration.

The Company had an R&D agreement with the University of Virginia (“UVA”) relating to nicotine biosynthesis in tobacco plants. The extended term of the R&D agreement with UVA expired on October 31, 2016. In December 2016, the Company entered into a new sponsored research agreement with UVA and an exclusive license agreement with the University of Virginia Patent Foundation d/b/a University of Virginia Licensing & Ventures Group (“UVA LVG”) pursuant to which the Company will invest approximately $1,000,000 over a three-year period with UVA to create unique industrial hemp plants with guaranteed levels of THC below the legal limits and optimize other desirable hemp plant characteristics to improve the plant’s suitability for growing in Virginia and other legacy tobacco regions of the United States. This work with UVA will also involve the development and study of medically important cannabinoids to be extracted by UVA from the Company’s hemp plants. UVA and the Company will conduct all activities in this scientific collaboration within the parameters of state and federal licenses and permits held by UVA for such work. The agreements with UVA and UVA LVG grant the Company exclusive rights to commercialize all results of the collaboration in consideration of royalty payments by the Company to UVA LVG. During the three and nine months ended September 30, 2017, expenses related to the agreements amounted to $113,942 and $225,516, respectively ($74,769 and $187,742 for the three and nine months ended September 30, 2016, respectively) and are included in Research and development costs on the Company’s Consolidated Statements of Operations.

Lease Agreements - The Company leases a manufacturing facility and warehouse located in North Carolina on a triple net lease basis. The lease commenced on January 14, 2014, and had an initial term of twelve (12) months. The lease contains four (4) additional extensions; with one lease extension for an additional one (1) year and with the other three (3) lease extensions each being for an additional two (2) years in duration, exercisable at the option of the Company. The Company is currently in the first two-year lease extension term that will expire on October 31, 2017 and intends to exercise the second two-year lease extension. The lease expense for the three and nine months ended September 30, 2017 amounted to $38,438 and $115,314, respectively, ($36,131 and $108,393, for the three and nine months ended September 30, 2016, respectively). The future minimum lease payments if the Company exercises each of the additional extensions are approximately as follows:

The Company has a lease for its office space in Clarence, New York and extended the lease for an additional one-year renewal period that expired on August 31, 2017. The Company is currently leasing the office space on a month-to-month basis at a monthly lease payment of $5,267. On October 4, 2017, the Company entered a new lease for new office space at a new location with an initial three-year term and with a monthly lease payment of $6,375 commencing thirty (30) days after the Company occupies the new office space. The Company expects to occupy the new lease space in early 2018.

On November 1, 2015, the Company entered into a one-year lease for 25,000 square feet of warehouse space in North Carolina to store the Company’s proprietary tobacco leaf. The lease calls for a monthly lease payment of $3,750 and contains a three-year renewal option after the initial one-year term. In October of 2016, the Company exercised the three-year renewal option after the one-year initial term, but intends on terminating this lease, without further obligation, when the tobacco leaf is transferred to a new leased facility in the fourth quarter of 2017.

On May 1, 2016, the Company entered into a sublease for laboratory space in Buffalo, New York. The sublease calls for a monthly payment of $1,471 through April 30, 2018. Additionally, on February 1, 2017, the Company entered into an amendment to the initial sublease calling for the sublease of additional lab space at a cost of $1,219 per month, bringing the total monthly lease obligation to $2,690. On April 26, 2017, the Company entered into an amendment to the sublease to extend the term of the sublease for an additional twelve (12) months, commencing on May 1, 2017 at a total cost of $2,770 per month for the total lease obligation. Future minimum lease payments for the years ended December 31, 2017 and 2018 will be approximately $8,000 and $11,000, respectively.

On September 1, 2016, the Company entered into a sublease for warehouse space in North Carolina to store and operate tobacco leaf processing equipment. The sublease calls for a monthly payment of $1,200 and expired on August 31, 2017. The Company has leased a new space in different facility in North Carolina, more fully described below, and moved the equipment to the new leased facility during the third quarter of 2017. There are no future minimum lease payments due under the sublease.

On April 20, 2017, the Company entered into a lease for warehouse space in North Carolina to store cigarette and filtered cigar raw materials. The lease calls for a monthly payment of $3,500 on a month-to-month basis. Future minimum lease payments remaining for the year ended December 31, 2017 are $10,500 and future minimum lease payments in subsequent years will be $42,000 as long as the Company continues to lease the warehouse space.

On August 14, 2017, the Company entered into a lease for warehouse space in North Carolina to store and operate tobacco leaf processing equipment and to eventually store the Company’s proprietary tobacco leaf. The lease calls for a monthly payment of $4,665, expires on August 14, 2018 and contains twelve-month renewal options as long as the Company continues to lease the warehouse. Future minimum lease payments for the year ended December 31, 2017 are approximately $14,000 and future minimum lease payments will be approximately $56,000 per year for each subsequent year the warehouse space is leased by the Company.

Litigation - In accordance with applicable accounting guidance, the Company establishes an accrued liability for litigation and regulatory matters when those matters present loss contingencies that are both probable and estimable. In such cases, there may be an exposure to loss in excess of any amounts accrued. When a loss contingency is not both probable and estimable, the Company does not establish an accrued liability. As a litigation or regulatory matter develops, the Company, in conjunction with any outside counsel handling the matter, evaluates on an ongoing basis whether such matter presents a loss contingency that is probable and estimable. If, at the time of evaluation, the loss contingency related to a litigation or regulatory matter is not both probable and estimable, the matter will continue to be monitored for further developments that would make such loss contingency both probable and estimable. When a loss contingency related to a litigation or regulatory matter is deemed to be both probable and estimable, the Company will establish an accrued liability with respect to such loss contingency and record a corresponding amount of litigation-related expense. The Company will then continue to monitor the matter for further developments that could affect the amount of any such accrued liability.

On April 26, 2016, Crede CG III, LTD. (“Crede”) filed a complaint against the Company in the United States District Court for the Southern District of New York (the “SDNY Court”) entitled Crede CG III, LTD. v. 22nd Century Group, Inc. On May 19, 2016, Crede filed an Amended Complaint that included seven counts, alleging among other things, that the Company allegedly breached and/or interfered with certain agreements entered into with Crede, including the joint venture agreement relating to efforts to sell the Company’s proprietary tobacco into China, the Tranche 1A warrant and the prior securities purchase agreement with Crede. The Amended Complaint seeks money damages, to rescind the securities purchase agreement, to obtain declaratory and injunctive relief to require the Company to issue to Crede 2,077,555 shares of the Company’s common stock under the exchange provision of the Tranche 1A warrant, and entry of an injunction prohibiting the Company from selling tobacco into China without the joint venture’s involvement. The Amended Complaint also seeks attorney’s fees and such other relief as the Court may deem just and proper. We believe that the claims are frivolous, meritless and that the Company has substantial legal and factual defenses to the claims.

On May 19, 2016, Crede filed a motion for preliminary injunction, asking the SDNY Court to require the Company to issue 2,077,555 shares of its common stock to Crede under the exchange provision of the Tranche 1A warrant. After conducting an evidentiary hearing on this motion on June 14, 2016, the SDNY Court denied Crede’s motion and held, among other things, that Crede did not prove the potential for irreparable harm or a likelihood of success on its claim for such 2,077,555 shares under the Tranche 1A warrant, and that there was a likelihood that Crede had violated the activity restrictions of the Tranche 1A warrant, which would bar Crede’s claim for such shares from the Company.

Following such ruling, on July 11, 2016, the Company filed a motion to sever the Crede lawsuit into two separate cases, requesting all claims relating to the Tranche 1A warrant and the securities purchase agreement to stay in the SDNY Court and all claims relating to the China joint venture agreement to be transferred to the United States District Court for the Western District of New York (the “WDNY Court”), where the Company’s headquarters are located. On January 20, 2017, the SDNY Court granted the Company’s motion.

On February 14, 2017, Crede voluntarily dismissed its lawsuit against the Company in the WDNY Court.

On February 21, 2017, the SDNY Court granted the Company’s request to file a motion for summary judgment for the claims remaining in the SDNY Court, with all discovery in the case being deferred until after the SDNY Court issues its decision on the summary judgment motion of the Company.

On March 20, 2017, the Company filed its motion for summary judgment for the claims remaining in the SDNY Court. The response by Crede to the Company’s summary judgment motion was filed by Crede on May 1, 2017. On May 15, 2017, the Company filed its response to Crede’s filing. The parties are now awaiting the SDNY Court to issue its decision on such summary judgment motion.

We believe that the claims are frivolous, meritless and that the Company has substantial legal and factual defenses to the claims. The Company has defended and intends to continue to defend against these claims vigorously.

NOTE 14. - EARNINGS PER COMMON SHARE

The following table sets forth the computation of basic and diluted earnings per common share for the three month periods ended September 30, 2017 and 2016:

The following table sets forth the computation of basic and diluted earnings per common share for the nine month periods ended September 30, 2017 and 2016:

Securities outstanding that were excluded from the computation because they would have been anti-dilutive are as follows:

NOTE 15. – EQUITY BASED COMPENSATION

On April 12, 2014, the stockholders of the Company approved the 22nd Century Group, Inc. 2014 Omnibus Incentive Plan (the “OIP”) and on April 29, 2017, the stockholders approved an amendment to the OIP to increase the number of shares available for issuance by 5,000,000 shares. The OIP allows for the granting of equity and cash incentive awards to eligible individuals over the life of the OIP, including the issuance of up to an aggregate of 10,000,000 shares of the Company’s common stock pursuant to awards under the OIP. The OIP has a term of ten years and is administered by the Compensation Committee of the Company’s Board of Directors to determine the various types of incentive awards that may be granted to recipients under this plan and the number of shares of common stock to underlie each such award under the OIP. As of September 30, 2017, we had available 3,929,765 shares remaining for future awards under the OIP.

During the three and nine months ended September 30, 2017, the Company issued stock option awards from the OIP for 20,000 and 1,392,000 shares, respectively, to eligible individuals having vesting periods ranging from one to three years from the date of the award. During the three and nine months ended September 30, 2016, the Company issued stock option awards from the OIP for 665,000 shares and 2,389,037 shares, respectively. All stock option awards were valued using the Black-Scholes option-pricing model on the date of the award.

For the three and nine months ended September 30, 2017, the Company recorded compensation expense related to restricted stock and stock option awards granted under the OIP of $259,415 and $582,398, respectively ($204,860 and $677,076 for the three and nine months ended September 30, 2016, respectively).

During the three and nine months ended September 30, 2017, there were no issuances of stock or stock options to third-party service providers. During the three and nine months ended September 30, 2016, the Company issued stock to third-party service providers in the amount of 0 and 15,811 shares, respectively, and during the three and nine months ended September 30, 2016, the Company issued stock options in the amount of 0 and 100,000 shares, respectively, to third-party service providers. The Company had no equity based compensation expense related to third-party providers for the three and nine months ended September 30, 2017. During the three and nine months ended September 30, 2016, the Company recorded equity based compensation expense related to third-party providers in the amount of $0 and $30,873, respectively.

As of September 30, 2017, unrecognized compensation expense related to non-vested restricted shares and stock options amounted to approximately $2,165,000, which is expected to be recognized approximately as follows: $262,000, $848,000, $448,000 and $140,000 during 2017, 2018, 2019 and 2020, respectively. Approximately $467,000 of the unrecognized compensation expense relates to previously issued stock options, with the vesting of such stock options being based on the achievement of a certain milestone, and the attainment of such milestone cannot be determined at this time.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The following assumptions were used for the nine months ended September 30, 2017 and 2016:

The Company estimated the expected volatility based on data used by a peer group of public companies. The expected term was estimated using the contract life of the option. The risk-free interest rate assumption was determined using yield of the equivalent U.S. Treasury bonds over the expected term. The Company has never paid any cash dividends and does not anticipate paying any cash dividends in the foreseeable future. Therefore, the Company assumed an expected dividend yield of zero.

A summary of all stock option activity since December 31, 2015 is as follows:

There were stock options granted during the nine months ended September 30, 2017 and 2016, to purchase a total of 1,392,000 shares and 2,489,037 shares, respectively. The weighted average grant date fair value of options issued during the nine months ended September 30, 2017 was $0.98 ($0.66 for the nine months ended September 30, 2016). The total fair value of options that vested during the nine months ended September 30, 2017 amounted to $750,265 ($1,242,110 for the nine months ended September 30, 2016). There were 85,988 options exercised on a cashless basis during the nine months ended September 30, 2017 resulting in the issuance of 51,927 shares of the Company’s common stock, and during the nine months ended September 30, 2016 no options were exercised.

NOTE 16. - SUBSEQUENT EVENTS

On October 10, 2017, the Company closed a registered direct offering (the “Offering”) with institutional investors purchasing an aggregate of 20,570,000 shares of the Company’s common stock at a price of $2.6250 per share generating net cash proceeds for the Company of approximately $50,700,000, after deducting expenses associated with the transaction. The securities purchase agreement entered into with the institutional investors provides that, subject to certain exceptions, for a period of one year following the closing of the Offering, the Company will be prohibited from effecting or entering into an agreement to effect any issuance by the Company or any of its subsidiaries of common stock or common stock equivalents (or a combination of units thereof) involving a variable rate transaction, which generally includes any transaction in which the Company (i) issues or sells any debt or equity securities that are convertible into, exchangeable or exercisable for, or include the right to receive additional shares of common stock either (A) at a conversion price or exchange rate that is based upon and/or varies with the trading prices of or quotations for the shares of common stock at any time after the initial issuance of such securities, or (B) with a conversion, exercise or exchange price that is subject to being reset at some future date after the initial issuance of such debt or equity security or upon the occurrence of specified or contingent events directly or indirectly related to the business of the Company or the market for the common stock or (ii) enters into any agreement, whereby the Company may issue securities at a future determined price. The securities purchase agreement also provides that, subject to certain exceptions, the Company will not enter into any agreement to sell common stock for a period of ninety (90) days.

Effective on October 31, 2017, the Company appointed James E. Swauger, Ph.D., as our Senior Vice President of Science and Regulatory Affairs. Dr. Swauger entered into an employment agreement with the Company containing customary terms and conditions with an initial three-year term. In connection with his appointment, Dr. Swauger was awarded a time vesting stock option to purchase nine hundred thousand (900,000) shares of the Company’s common stock at an exercise price of $2.12 per share. One-third of this time vesting stock option vests over each of the next three years and such stock option had a fair value upon issuance of approximately $1,400,000. In addition, Dr. Swauger was awarded a performance vesting stock option to purchase three hundred thousand (300,000) shares of the Company’s common stock at an exercise price of $2.12 per share that vests on the attainment of various performance based milestones and had a fair value upon issuance of approximately $480,000.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains “forward-looking statements” that reflect, when made, the Company’s expectations or beliefs concerning future events that involve risks and uncertainties. Forward-looking statements frequently are identified by the words “believe,” “anticipate,” “expect,” “estimate,” “intend,” “project,” “will be,” “will continue,” “will likely result,” or other similar words and phrases. Similarly, statements herein that describe the Company’s objectives, plans or goals also are forward-looking statements. Actual results could differ materially from those projected, implied or anticipated by the Company’s forward-looking statements. Some of the factors that could cause actual results to differ include: our ability to continue to monetize the licensing of our technology and products; our ability to achieve profitability; our ability to manage our growth effectively; our ability to have a Modified Risk Tobacco Product approved by the FDA; our ability to obtain FDA clearance for our Modified Risk Cigarettes; our ability to obtain FDA approval for our X-22 smoking cessation product; our ability to gain market acceptance for our products, our ability to prevail in litigation and our ability to maintain our rights to our intellectual property licenses. For a discussion of these and all other known risks and uncertainties that could cause actual results to differ from those contained in the forward-looking statements, see “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, which is available on the SEC’s website at www.sec.gov. All forward-looking statements are qualified in their entirety by this cautionary statement, and the Company undertakes no obligation to revise or update this Quarterly Report on Form 10-Q to reflect events or circumstances after the date hereof.

For purposes of this Management’s Discussion and Analysis of Financial Condition and Results of Operations, references to the “Company,” “we,” “us” or “our” refer to the operations of 22nd Century Group, Inc. and its direct and indirect subsidiaries for the periods described herein.

Overview

We are a plant biotechnology company focused on (i) potentially reduced risk tobacco cigarettes and smoking cessation products produced from modifying the nicotine content in tobacco plants through genetic engineering and plant breeding, and (ii) research and development of unique cannabis/hemp plants through genetic engineering and plant breeding to alter levels of cannabinoids for new medicines and improved agricultural uses. We have an extensive intellectual property portfolio of issued patents and patent applications relating to the tobacco and cannabis plants. Our management team is focused on monetizing our intellectual property portfolio, obtaining regulatory approval to market both our reduced exposure cigarettes and our smoking cessation product in development, establishing international strategic partnerships to sell and distribute our proprietary tobacco and products, and developing and commercializing high value products derived from our unique cannabis/hemp plants. Additional information about our business and operations is contained in our Annual Report on Form 10-K for the year ended December 31, 2016.

Strategic Objectives

Our strategic objectives include the following:

For the third quarter of 2017, our accomplishments and notable events include:

On July 28, 2017, the FDA announced it plans to mandate the lowering of nicotine levels in all combustible cigarettes sold in the United States to minimally or non-addictive levels. The FDA announcement stated that “lowering nicotine levels could decrease the likelihood that future generations become addicted to cigarettes and allow more currently addicted smokers to quit smoking.” On July 31, 2017, we announced that we are already capable of achieving the FDA’s new reduced nicotine standard. Our proprietary Very Low Nicotine tobacco, with up to 95% less nicotine than tobacco contained in conventional cigarettes, is grown on independently-owned farms in the United States – without any artificial extraction or chemical processes. 22nd Century’s proprietary Very Low Nicotine cigarettes have demonstrated that the FDA’s planned mandate for cigarettes with non-addictive levels of nicotine is both achievable and realistic. The Company believes that the implementation of an FDA mandate that lowers nicotine levels in all combustible cigarettes sold in the United States will save millions of lives and billions of dollars in healthcare costs per year. Matthew Myers, the president of anti-smoking group Campaign for Tobacco-Free Kids, asserted in an August 9, 2017 Bloomberg News article that the new FDA plan could lead to “the most fundamental change the tobacco industry has ever seen.”

On August 23, 2017, we also announced that, over the last 6 years, agencies of the U.S. federal government have invested more than $100 million in independent clinical research with our proprietary SPECTRUM cigarettes, with the results of these independent studies supporting the conclusion that lowering nicotine levels in combustible tobacco cigarettes would drastically improve public health. There are at least 17 completed independent clinical trials using our proprietary Very Low Nicotine tobacco and at least 25 on-going clinical trials using our proprietary Very Low Nicotine cigarettes. We have also previously publicly announced that we stand ready to partner with the FDA and with any companies that are committed to improving the health of American smokers.

In July and August of 2017, certain of the holders of warrants exercised warrants for cash to purchase an aggregate of 3,813,500 shares of our common stock at an exercise price of $1.00 per share and exercised for cash warrants to purchase an aggregate of 1,895,052 shares of our common stock at an exercise price of $1.45 per share, resulting in net cash proceeds to us of $6,167,646, after deducting expenses associated with the exercise. In consideration for these holders exercising their warrants for cash, we issued those holders new warrants to purchase shares of our common stock equal to the number of shares of common stock received by each such holder upon cash exercise of the holder’s warrants. The terms of the new warrants are substantially similar to the terms of the warrants exercised, except the new warrants (i) have an exercise price equal to $2.15 per share and (ii) are exercisable beginning December 20, 2017 for a period of five (5) years. Accordingly, we issued new warrants in July and August of 2017 to such exercising warrant holders to purchase an aggregate of 5,708,552 shares of our common stock upon exercise of the existing warrants of such holders.

On September 25, 2017, we announced that the 2013 Research License and Commercial Option Agreement between 22nd Century and British American Tobacco had ended. With the end of this agreement, 22nd Century is once again in sole control of our extensive intellectual property portfolio. As a result, we have since recommenced discussions with global tobacco companies and international pharmaceutical companies that have expressed interest in developing a business relationship with 22nd Century.

Subsequent to the close of the third quarter of 2017, we also announced:

On October 5, 2017, Dr. Dorothy Hatsukami publicly revealed at The Vermont Center on Behavior and Health’s Tobacco Regulatory Science Conference the findings of a highly anticipated Phase III clinical study conducted with 1,250-patients over a 20-week study period that investigated which application of Very Low Nicotine cigarettes is best: (i) an immediate reduction in nicotine to non-addictive levels or (ii) a gradual reduction in nicotine to non-addictive levels. Though the Phase III study is still under peer review prior to publication, Dr. Hatsukami indicated at the Vermont conference that an immediate reduction in nicotine poses a “greater likelihood of more rapid smoking cessation.” We provided all the research cigarettes used in such Phase III study.

On October 10, 2017, we closed a registered direct common stock offering with institutional investors to receive approximately $54 million in gross proceeds through the sale of 20.57 million shares of common stock at a price of $2.625 per share. This no-warrant financing is the largest capital raise – at the highest offering price per share – in the history of 22nd Century. The net proceeds of the financing will be used for general corporate purposes, including working capital as we enter licensing and strategic partnership discussions with major companies around the world.

On October 19, 2017, we announced that we had successfully completed our hemp field trials with the University of Virginia (“UVA”) in which we used multiple oil and fiber varieties of hemp and UVA identified proprietary varieties of our unique hemp plants that have excellent agronomic properties for growth in the Commonwealth of Virginia. 22nd Century and UVA are currently working on expanded plantings of the most promising varieties of our proprietary hemp plants to optimize plant growth in the legacy tobacco growing region of the United States. 22nd Century is also working with UVA on the development of high-value medicinal cannabinoid varieties and specialized cannabinoid extraction processes for use in human therapeutics, as well as the use of our unique hemp plants for phytoremediation to clean up and reclaim polluted soils in Virginia. We also announced at that same time that we are expanding our hemp activities in our home State of New York after the announcement by New York Governor Andrew Cuomo that New York State intends to become a leading grower and producer of hemp and hemp-derived products. To take advantage of the favorable hemp climate in New York, 22nd Century has obtained a New York hemp research and grower license and looks forward to expanding its Buffalo, NY-based laboratory to include important new hemp research.

Effective on October 31, 2017, the Company appointed James E. Swauger, Ph.D., as our Senior Vice President of Science and Regulatory Affairs. Dr. Swauger was previously the leader of the scientific and regulatory functions at Reynolds American Inc. Dr. Swauger’s primary responsibility at 22nd Century will be to lead and oversee the scientific and regulatory activities of the Company, including the re-submission to the FDA of the Company’s Modified Risk Tobacco Product (“MRTP”) application for BRAND A Very Low Nicotine Content cigarettes. Dr. Swauger will also work with the Company in support of the FDA’s plan to mandate the reduction of nicotine levels in cigarettes to minimally or non-addictive levels.

Three Months Ended September 30, 2017 Compared to Three Months Ended September 30, 2016

Revenue - Sale of products

In the three months ended September 30, 2017, we realized net sales revenue from the sale of products in the amount of $4,530,865, an increase of $1,433,217, or 46.3%, from net sales revenue of $3,097,648 for the three months ended September 30, 2016. The increase in net sales revenue for the third quarter of 2017 was primarily the result of additional net sales revenue generated from a new contract to manufacture an existing brand of filtered cigars as compared to net sales revenue for the second quarter of 2016. Production under that new contract began in mid-May of 2017.

Cost of goods sold - Products

During the three months ended September 30, 2017, cost of goods sold were $4,871,234, or 107.5%, of net sales revenue. Excise taxes and certain regulatory fees in the approximate amount of $2,436,000 are included in the cost of goods sold for the three months ended September 30, 2017. We were not yet operating our factory at full production capacity throughout the third quarter of 2017, but we began utilizing a portion of the excess capacity as a result of the new filtered cigar contract manufacturing agreement that commenced in mid-May of 2017. As a result, the cost of goods sold relating to product sales, which included the cost of raw material components, direct manufacturing costs and an overhead allocation, exceeded net sales revenue.

During the three months ended September 30, 2016, cost of goods sold were $3,282,266, or 106.0%, of net sales revenue. Excise taxes and certain regulatory fees in the approximate amount of $1,810,000 are included in the cost of goods sold for the three months ended September 30, 2016. We were not operating our factory at full production capacity during the third quarter of 2016. As a result, the cost of goods sold relating to product sales, which included the cost of raw material components, direct manufacturing costs and an overhead allocation, was in excess of net sales revenue.

Research and development expense

Research and development (“R&D”) expense was $784,587 in the three months ended September 30, 2017, an increase of $92,617, or 13.4%, from $691,970 in the three months ended September 30, 2016. This increase was primarily a result of an increase in R&D sponsored research costs in the approximate amount of $127,000, an increase patent maintenance expenses of approximately $37,000 and an increase in payroll and related benefits of approximately $14,000, partially offset by a decrease in research license fees of approximately $38,000 and a decrease in costs associated with our modified risk tobacco products of approximately $55,000.

General and administrative expense

General and administrative expense was $1,635,226 in the three months ended September 30, 2017, an increase of $404,259, or 32.8%, from $1,230,967 in the three months ended September 30, 2016. The increase was mainly due to an increase in investor relations expenses of approximately $173,000, an increase in payroll and related benefit costs of approximately $147,000, an increase in equity based compensation of approximately $36,000, an increase in industry conferences and related travel expenses of approximately $38,000 and a net increase in other general and administrative expenses of approximately $40,000, partially offset by a decrease in legal and accounting expenses of approximately $30,000.

Sales and marketing expense

During the three months ended September 30, 2017, we incurred sales and marketing expenses of $279,254 an increase of $2,158, or 0.8%, from $277,096 in the three months ended September 30, 2016. The increase in sales and marketing expenses were primarily the result of an increase in payroll and related benefit costs of approximately $23,000, increase in equity based compensation of approximately $26,000 and an increase in industry trade show costs of approximately $36,000, partially offset by a decrease in advertising and promotional costs of approximately $42,000 and a decrease in travel related expenses of approximately $41,000.

Depreciation expense

Depreciation expense for the three months ended September 30, 2017 amounted to $88,711, an increase of $7,357, or 9.0%, from $81,354 for the three months ended September 30, 2016. The increase is due to depreciable additions to machinery and equipment over the last year in the approximate amount of $210,000, primarily consisting of equipment additions in our NASCO operations in North Carolina and our laboratory in Buffalo, New York. During the third quarter of 2017, we acquired approximately $916,000 in additional packaging equipment for our NASCO operations in North Carolina. This equipment was not placed in service during the third quarter of 2017 and accordingly, no depreciation expense was recorded.

Amortization expense

Amortization expense for the three months ended September 30, 2017 amounted to $145,934, an increase of $16,127, or 12.4%, from $129,807 for the three months ended September 30, 2016. The amortization expense relates to amortization taken on capitalized patent costs and license fees. The increase is primarily due to amortization taken on additional patent costs incurred during the nine months ended September 30, 2017 and the year ended December 31, 2016 in the amounts of $457,385 and $541,882, respectively.

Warrant liability loss - net

The warrant liability loss of $55,886 for the third quarter of 2017 was due to an increase in the estimated fair value of the warrants during the period. The increase in the estimated fair value of the warrants was primarily attributable to an increase in our underlying stock price from $1.75 per share at June 30, 2017 as compared to $2.77 per share at September 30, 2017.

The warrant liability loss of $46,995 for the third quarter of 2016 was due to an increase in the estimated fair value of the warrants during the period. The increase in the estimated fair value of the warrants was primarily attributable to an increase in our underlying stock price from $0.81 per share at June 30, 2016 as compared to $1.45 per share at September 30, 2016.

Loss on investment

On February 17, 2017, a dilutive event reduced our ownership in Anandia to 19.4%, an ownership percentage below the 20% ownership threshold for the use of the equity method of accounting. Accordingly, we discontinued applying the equity method of accounting for our equity investment in Anandia, effective on the date of the dilutive event, and as a result, there is no gain or loss recorded on the investment in Anandia during the three months ended September 30, 2017. On July 25, 2017, another dilutive event occurred resulting in an additional reduction in our ownership in Anandia to 19.0%.

The loss on investment of $29,997 for the three months ended September 30, 2016 consisted of (i) our 24.4% (25.0% ownership prior to a dilutive event on September 8, 2016) share of Anandia’s net loss for the three months ending September 30, 2016 in the amount of $15,585 plus (ii) amortization of the intangible asset represented by the difference between our equity investment in Anandia and our portion of the net assets of Anandia in the amount of $14,412.

Interest income

Interest income for the three months ended September 30, 2017 was $20,317, an increase of $18,186 from interest income of $2,131 for the three months ended September 30, 2016. The interest income earned in the three months ended September 30, 2017 and 2016 was generated from excess cash invested in a money market account, with the average cash balance being greater during the third quarter of 2017 as compared to the third quarter of 2016.

Interest expense

Interest expense decreased by $2,331, or 25.0%, in the three months ended September 30, 2017 to $6,984 from $9,315 in the three months ended September 30, 2016 and is derived from the interest component of severance payments made on accrued severance that had previously been recorded on a discounted basis using our incremental borrowing rate and the accretion of interest on the NRC note payable.

Net loss

We had a net loss in the three months ended September 30, 2017 of $3,316,634 as compared to a net loss of $2,679,988 in the three months ended September 30, 2016. The increase in the net loss of $636,646, or 23.8%, was primarily the result of an increase in the gross loss of approximately $156,000, an increase in operating expenses of approximately $523,000, partially offset by a decrease in other income (expense) in the approximate amount of $42,000.

Nine Months Ended September 30, 2017 Compared to Nine Months Ended September 30, 2016

Revenue - Sale of products

In the nine months ended September 30, 2017, we realized net sales revenue from the sale of products in the amount of $10,659,588, an increase of $1,715,226, or 19.2%, over net sales revenue of $8,944,362 for the nine months ended September 30, 2016. The increase in net sales revenue for the nine months ended September 30, 2017 was primarily the result of additional net sales revenue generated from a new contract to manufacture an existing brand of filtered cigars that began in mid-May of 2017, partially offset by a decrease in net sales revenue from the sale of SPECTRUM research cigarettes in the amount of $329,321 during the first quarter of 2016, as compared to net sales revenue for the nine months ended September 30, 2016.

Cost of goods sold - Products

During the nine months ended September 30, 2017, cost of goods sold were $11,438,909, or 107.3%, of net sales revenue. Excise taxes and certain regulatory fees in the approximate amount of $5,980,000 are included in the cost of goods sold for the nine months ended September 30, 2017. We were not yet operating our factory at full production capacity throughout the nine months ended September 30, 2017, but we began utilizing a portion of the excess capacity as a result of the new filtered cigar contract manufacturing agreement that commenced in mid-May of 2017. As a result, the cost of goods sold relating to product sales, which included the cost of raw material components, direct manufacturing costs and an overhead allocation, exceeded net sales revenue. We also recorded an increase in our inventory reserve by $95,000 during the second quarter of 2017 that resulted in an increase in the cost of goods sold by the same amount.

During the nine months ended September 30, 2016, cost of goods sold were $9,146,247, or 102.3%, of net sales revenue. Cost of goods sold relating to the sales SPECTRUM research cigarettes were $55,019, or 16.7%, of related net sales revenue and the remaining cost of goods sold was $9,091,228, or 105.5%, of related net sales revenue. Excise taxes and certain regulatory fees in the approximate amount of $5,387,000 are included in the cost of goods sold for the nine months ended September 30, 2016. We were not operating the factory at full production capacity during the first three quarters of 2016. As a result, the cost of goods sold relating to product sales (exclusive of SPECTRUM research cigarettes), which included the cost of raw material components, direct manufacturing costs and an overhead allocation, was in excess of net sales revenue.

Research and development expense

R&D expense was $2,148,725 in the nine months ended September 30, 2017, an increase of $349,289, or 19.4%, from $1,799,289 in the nine months ended September 30, 2016. This increase was primarily a result of increases in sponsored research contract costs of approximately $216,000, an increase of approximately $98,000 in costs related to our modified risk tobacco product, an increase in testing fees of approximately $60,000, an increase in patent maintenance fees of approximately $37,000 and an increase in costs associated with our laboratory in the approximate amount of $91,000, partially offset by a decrease in travel related expenses of approximately $50,000, a decrease in equity based compensation expense of approximately $59,000 and a decrease in research license fees of approximately $38,000.

General and administrative expense

General and administrative expense was $5,060,823 in the nine months ended September 30, 2017, an increase of $261,474, or 5.5%, from $4,799,349 in the nine months ended September 30, 2016. The increase was mainly due to an increase of approximately $346,000 in payroll and related benefits, an increase in investor relations expenses of approximately $141,000, an increase in industry conferences and related travel expenses of approximately $75,000, an increase of approximately $46,000 for costs relating to our annual shareholders meeting, and a net increase in other general and administrative expenses of approximately $8,000, partially offset by a decrease in equity based compensation in the approximate amount of $133,000, a decrease in legal and accounting fees of approximately $142,000, and a decrease in consulting fees of approximately $80,000.

Sales and marketing expense

During the nine months ended September 30, 2017, we incurred sales and marketing expenses of $842,558, a decrease of $388,258, or 31.5%, from $1,230,816 in the nine months ended September 30, 2016. The decrease in sales and marketing expenses were mainly the result of a decrease in advertising and promotional costs, primarily relating to our proprietary cigarette brand, RED SUN, in the approximate amount of $498,000 and a decrease in travel related expenses of approximately $68,000, partially offset by an increase in payroll and related benefit costs of approximately $76,000, an increase in equity based compensation of approximately $66,000 and an increase in industry trade show costs of approximately $38,000.

Depreciation expense

Depreciation expense for the nine months ended September 30, 2017 amounted to $265,296, an increase of 22,278, or 9.2%, from $243,018 for the nine months ended September 30, 2016. The increase is due to additions to machinery and equipment over the last year in the approximate amount of $217,000, primarily consisting of equipment additions in our NASCO operations in North Carolina and our laboratory in Buffalo, New York. During the third quarter of 2017, we acquired approximately $916,000 in additional packaging equipment for our NASCO operations in North Carolina. This equipment was not placed in service during the third quarter of 2017 and accordingly, no depreciation expense was recorded.

Amortization expense.

Amortization expense for the nine months ended September 30, 2017 amounted to $429,832, an increase of $49,143, or 12.9%, from $380,689 for the nine months ended September 30, 2016. The amortization expense relates to amortization taken on capitalized patent costs and license fees. The increase was primarily due to amortization taken on additional patent costs incurred during the nine months ended September 30, 2017 and the year ended December 31, 2016 in the amounts of $457,385 and $541,882, respectively.

Warrant liability (loss) gain - net

The warrant liability loss of $138,813 for the nine months ended September 30, 2017 was due to an increase in the estimated fair value of the warrants during the period. The increase in the estimated fair value of the warrants was primarily attributable to an increase in our underlying stock price from $1.09 per share at December 31, 2016 as compared to $2.77 per share at September 30, 2017.

The warrant liability gain of $14,602 for the nine months ended September 30, 2016 was due to the decrease in the estimated fair value of the warrants during the period. The decrease in the estimated fair value of the warrants was primarily attributable to the expiration of certain warrants and the remaining outstanding warrants aging closer to their expiration date with the passage of time, partially offset by an increase in our underlying stock price from $1.40 per share at December 31, 2015 as compared to $1.45 per share at September 30, 2016.

Gain (loss) on investment

On February 17, 2017, a dilutive event reduced our ownership in Anandia to 19.4%, an ownership percentage below the 20% ownership threshold for the use of the equity method of accounting. Accordingly, we discontinued applying the equity method of accounting for our equity investment in Anandia, effective on the date of the dilutive event, and as a result, there is no gain or loss recorded on the investment in Anandia during the three months ended June 30, 2017. We recorded a gain on investment of $16,872 for three months ended March 31, 2017 (the equity gain for the three months ended March 31, 2017, reflects our proportionate gain through February 16, 2017). In addition, and as a result of the February 17, 2017 dilutive event, we recorded a gain in accordance with the derecognition provisions of Accounting Standards Codification 323 (“ASC 323”) in the amount of $336,834. We recorded a total gain on the equity investment in the amount of $346,180 for the nine months ended September 30, 2017 (pertaining to the period up to February 17, 2017) by aggregating the Company’s share of Anandia’s gain (loss), the gain recorded under ASC 323 and the amortization of the intangible asset represented by the difference between our equity investment in Anandia and our portion of the net assets of Anandia in the amount of $7,526. On July 25, 2017, another dilutive event occurred resulting in an additional reduction in our ownership in Anandia to 19.0%.

The loss on investment of $172,068 for the nine months ended September 30, 2016 consisted of (i) our 24.4% (25.0% ownership prior to a dilutive event on September 8, 2016) share of Anandia’s net loss for the nine months ending September 30, 2016 in the amount of $128,832, plus (ii) amortization of the intangible asset represented by the difference between our equity investment in Anandia and our portion of the net assets of Anandia in the amount of $43,236.

Interest income

Interest income for the nine months ended September 30, 2017 was $48,197, an increase of $41,468 from interest income of $6,729 for the nine months ended September 30, 2016. The interest income earned in the nine months ended September 30, 2017 and 2016 was generated from excess cash invested in a money market account, with the average cash balance being greater during the nine months ending September 30, 2017 as compared to the nine months ended September 30, 2016.

Interest expense

Interest expense decreased by $6,467, or 22.3%, in the nine months ended September 30, 2017 to $22,544 from $29,011 in the nine months ended September 30, 2016 and is derived from the interest component of severance payments made on accrued severance that had previously been recorded on a discounted basis using our incremental borrowing rate and the accretion of interest on the NRC note payable.

Net loss

We had a net loss in the nine months ended September 30, 2017 of $9,293,535 as compared to a net loss of $8,834,794 in the nine months ended September 30, 2016. The increase in the net loss of $458,741, or 5.2%, was primarily the result of an increase in the gross loss of approximately $577,000, an increase in operating expenses of approximately $294,000, partially offset by a decrease in other income (expense) in the approximate amount of $412,000.

Liquidity and Capital Resources

Working Capital

As of September 30, 2017, we had positive working capital of approximately $16.3 million compared to positive working capital of approximately $13.5 million at December 31, 2016, an increase of approximately $2.7 million. The increase in our working capital for the nine months ended September 30, 2017 was primarily due to a net increase in non-cash working capital in the approximate amount of $1.2 million plus cash raised through warrant exercises in the approximate amount of $12.4 million, partially offset by cash used in operating activities of approximately $9.6 million and cash used to acquire machinery and equipment and intangible assets of approximately $1.2 million.

We must successfully execute our business plan to increase revenue in order to achieve positive cash flows from operations to sustain adequate liquidity without requiring additional funds from capital raises and other external sources to meet minimum operating requirements. On December 30, 2016, we filed a Form S-3, universal shelf registration statement, with the U.S. Securities and Exchange Commission (“SEC”) that was declared effective by the SEC on January 17, 2017. The universal shelf registration statement will allow, but not compel, the Company to raise up to $100 million of capital over a three-year period ending on January 17, 2020 through a wide array of securities at times and in amounts to be determined by the Company. On October 10, 2017, we closed a registered direct common stock offering with institutional investors to receive approximately $54 million in gross proceeds through the sale of 20.57 million shares of common stock at a price of $2.625 per share (net proceeds of approximately $50.7 million). The net proceeds of the financing will be used for general corporate purposes, including working capital as we enter licensing and strategic partnership discussions with major companies around the world. Following the offering, the universal shelf statement has approximately $46 million of remaining capacity. If required, there can be no assurance that additional capital will be available on acceptable terms or at all.

Cash demands on operations

With the net cash proceeds from our October 2017 offering plus cash on hand at September 30, 2017 of $15,022,570, we believe resulting cash balances will be adequate to sustain normal operating expenses and meet all current obligations as they come due for a period of at least five years. During the nine months ended September 30, 2017, we experienced an operating loss of approximately $9,527,000 and used cash in operations of approximately $9,621,000. Excluding discretionary expenses related to R&D, patent and trademark costs, contract growing of our proprietary tobacco, and certain nonrecurring expenses relating to factory capital expenses, investor relations, and marketing costs, our monthly cash expenditures are approximately $900,000.

Net Cash used in operating activities

In the nine months ended September 30, 2017, $9,620,986 of cash was used in operating activities as compared to $7,982,309 of cash used in operating activities in the nine months ended September 30, 2016, an increase of $1,638,677. The increase in use of cash in operations was primarily due to an increase in the cash portion of the net loss in the amount of $844,171 and an increase in the use of cash used for working capital components related to operations in the amount of $794,506 for the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016.

Net Cash used in investing activities

In the nine months ended September 30, 2017, net cash used in investing activities was $1,204,990, as compared to $362,234 of cash used in investing activities during the nine months ended September 30, 2016, an increase of $842,756. The increase was primarily the result of an increase in cash used for the acquisition of patents and trademarks in the amount of $76,081 and an increase in the acquisition of machinery and equipment in the amount of $766,675.

Net Cash provided by financing activities

During the nine months ended September 30, 2017, $12,380,358 of cash was provided by financing activities, as compared to $9,774,751 of cash provided by financing activities during the nine months ended September 30, 2016. The net cash provided by financing activities for the nine months ended September 30, 2017 was the result of net cash raised from the exercise of warrants, and the net cash provided by financing activities during the nine months ended September 30, 2016, was primarily generated by net proceeds received from registered direct offering in February and July of 2016.

Critical Accounting Policies and Estimates

There have been no material changes to the information set forth in our Annual Report on Form 10-K for the year ended December 31, 2016.

Inflation

Inflation did not have a material effect on our operating results for the nine months ended September 30, 2017 and 2016, respectively.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements as defined by Item 303(a)(4) of Regulation S-K.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes to the information set forth in our Annual Report on Form 10-K for the year ended December 31, 2016.

Item 4. Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its Securities Exchange Act of 1934 (“Exchange Act”) reports are recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including the Company’s chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Our chief executive officer and chief financial officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Exchange Act Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this quarterly report, have concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Form 10-Q to ensure information required to be disclosed is recorded, processed, summarized and reported within the time period specified by SEC rules, based on their evaluation of these controls and procedures as required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15.

There were no changes in the Company’s internal controls over financial reporting during the third quarter of 2017 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

Part II. OTHER INFORMATION

Item 1. Legal Proceedings

We are subject to various claims and legal proceedings arising in the ordinary course of business. As of the date hereof, we are unable to currently assess whether the final resolution of any of such claims or legal proceedings may have a material adverse effect on us.

On April 26, 2016, Crede CG III, LTD. (“Crede”) filed a complaint against the Company in the United States District Court for the Southern District of New York (the “SDNY Court”) entitled Crede CG III, LTD. v. 22nd Century Group, Inc. On May 19, 2016, Crede filed an Amended Complaint that included seven counts, alleging among other things, that the Company allegedly breached and/or interfered with certain agreements entered into with Crede, including the joint venture agreement relating to efforts to sell the Company’s proprietary tobacco into China, the Tranche 1A warrant and the prior securities purchase agreement with Crede. The Amended Complaint seeks money damages, to rescind the securities purchase agreement, to obtain declaratory and injunctive relief to require the Company to issue to Crede 2,077,555 shares of the Company’s common stock under the exchange provision of the Tranche 1A warrant, and entry of an injunction prohibiting the Company from selling tobacco into China without the joint venture’s involvement. The Amended Complaint also seeks attorney’s fees and such other relief as the Court may deem just and proper. We believe that the claims are frivolous, meritless and that the Company has substantial legal and factual defenses to the claims.

On May 19, 2016, Crede filed a motion for preliminary injunction, asking the SDNY Court to require the Company to issue 2,077,555 shares of its common stock to Crede under the exchange provision of the Tranche 1A warrant. After conducting an evidentiary hearing on this motion on June 14, 2016, the SDNY Court denied Crede’s motion and held, among other things, that Crede did not prove the potential for irreparable harm or a likelihood of success on its claim for such 2,077,555 shares under the Tranche 1A warrant, and that there was a likelihood that Crede had violated the activity restrictions of the Tranche 1A warrant, which would bar Crede’s claim for such shares from the Company.

Following such ruling, on July 11, 2016, the Company filed a motion to sever the Crede lawsuit into two separate cases, requesting all claims relating to the Tranche 1A warrant and the securities purchase agreement to stay in the SDNY Court and all claims relating to the China joint venture agreement to be transferred to the United States District Court for the Western District of New York (the “WDNY Court”), where the Company’s headquarters are located. On January 20, 2017, the SDNY Court granted the Company’s motion.

On February 14, 2017, Crede voluntarily dismissed its lawsuit against the Company in the WDNY Court.

On February 21, 2017, the SDNY Court granted the Company’s request to file a motion for summary judgment for the claims remaining in the SDNY Court, with all discovery in the case being deferred until after the SDNY Court issues its decision on the summary judgment motion of the Company.

On March 20, 2017, the Company filed its motion for summary judgment for the claims remaining in the SDNY Court. The response by Crede to the Company’s summary judgment motion was filed by Crede on May 1, 2017. On May 15, 2017, the Company filed its response to Crede’s filing. The parties are now awaiting the SDNY Court to issue its decision on such summary judgment motion.

We believe that the claims are frivolous, meritless and that the Company has substantial legal and factual defenses to the claims. The Company has defended and intends to continue to defend against these claims vigorously.

Item 1A. Risk Factors

Our risk factors have not changed materially from those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016, as filed with the SEC on March 8, 2017.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

During the third quarter of 2017, we issued 146,320 shares of common stock to various investors from the cashless exercise of 240,667 warrants to purchase shares of our common stock.

During October of 2017, we issued 103,500 shares of common stock to investors that exercised 103,500 warrants for cash to purchase shares of our common stock.

The shares were offered and sold pursuant to exemptions from the registration requirements under Section 4(2) of the Securities Act of 1933, as amended, and Rule 506 of Regulation D promulgated thereunder.

Item 3. Default Upon Senior Securities.

None

Item 4. Mine Safety Disclosures

None

Item 5. Other Information

None

Item 6. Exhibits

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized: