Eastside Distilling, Inc. - Quarter Report: 2018 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the transition period from ______________ to _________________

Commission File No.: 001-38182

EASTSIDE DISTILLING, INC.

(Exact name of registrant as specified in its charter)

1001 SE Water Avenue, Suite 390

Portland, Oregon 97214

(Address of principal executive offices)

Issuer’s telephone number: (971) 888-4264

Indicate by check mark whether the registrant (1) 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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting 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 14, 2018, 7,313,130 shares of our common stock, $0.0001 par value, were outstanding.

EASTSIDE DISTILLING, INC.

FORM 10-Q

September 30, 2018

TABLE OF CONTENTS

PART I: FINANCIAL INFORMATION

ITEM 1 –FINANCIAL STATEMENTS (unaudited)

Eastside Distilling, Inc. and Subsidiaries

Consolidated Balance Sheets

September 30, 2018 and December 31, 2017 

(unaudited)

Eastside Distilling, Inc. and Subsidiaries

Consolidated Statements of Operations

For the three and nine months ended September 30, 2018 and 2017

(unaudited)

Eastside Distilling, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

For the nine months ended September 30, 2018 and 2017

(unaudited)

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Eastside Distilling, Inc. (referred to herein as “Eastside,” “EAST,” “the Company,” “us,” or “we”) is an Oregon-based producer and marketer of craft spirits, founded in 2008. Our products span several alcoholic beverage categories, including bourbon, American whiskey, vodka, gin and rum. Unlike other distillers, we operate several retail tasting rooms in Oregon to market our brands directly to consumers. Our strategy for growth is to build on our local base in the Pacific Northwest and expand selectively to other markets, using major spirits distributors. In December 2016, we retained Sandstrom Partners, an internationally-known spirit branding firm that branded St-Germain and Bulleit Bourbon, to guide our marketing strategy and branding. Sandstrom Partners subsequently became an investor in our company. During 2017, with the assistance of Sandstrom Partners and using our in-house spirits expertise, we created Redneck Riviera Whiskey (“RRW”) in collaboration with country music superstar John Rich, of the duo “Big & Rich.” Supported by John Rich’s marketing efforts, we launched RRW in the Southeastern and Gulf States in early 2018 primarily through Republic National Distributing Company (“RNDC”). We believe that RRW will achieve commercial success on a broad scale, and we have therefore focused our sales efforts on RRW outside Oregon. RRW has been a key growth engine in 2018 to date and we believe it will continue to be a growth area into 2019. We further believe that the success of RRW will also provide a “coattail” effect for our other brands, helping them to achieve improved national recognition and success.

Operating as a small business in a large, international spirits marketplace occupied by massive conglomerates, we seek to turn our small size from a disadvantage into an advantage. As the success of our RRW launch and Sandstrom Partners collaboration demonstrate, our team can leverage its smaller size to launch new brands more quickly than larger conglomerates because we are able to dedicate more of our attention and resources to developing innovative products. We believe that the dominance of Canadian whiskeys in the light-whiskey segment is vulnerable to a light whiskey that is 100% American, and we are exploiting that vulnerability with RRW, a product that went from idea, to celebrity collaboration, to design and formulation, to market roll-out in less than nine months. We are innovative in targeting emerging trends with our products; for example, we developed our Hue-Hue Coffee Rum with cold brew coffee and low sugar, as well as our gluten-free potato vodka. We seek to be both a leader in creating spirits that offer better value than comparable spirits (for example, our value-priced Portland Potato Vodka), and an innovator in creating imaginative spirits that offer a unique taste experience, like our Hue-Hue Coffee Rum, Oregon oak-aged whiskeys and Marionberry Whiskey.

As a Nasdaq-traded company, we have access to public capital markets to support our growth initiatives, including strategic acquisitions. In May 2017, we used our shares to acquire 90% of Big Bottom Distillery (“BBD”), known for its award-winning, super-premium gins and whiskeys, including The Ninety One Gin, Navy Strength Gin, Oregon Gin, Delta Rye and American Single Malt Whiskey. BBD’s super-premium spirits give us a presence at the “high end” of the market. In addition, through MotherLode Craft Distillery (“MotherLode”), our wholly-owned subsidiary acquired in March 2017, we also provide contract bottling and packaging services for existing and emerging spirits producers, some of whom contract with us to blend or distill spirits. During 2018, we have begun to use our “slim line” canning equipment, newly installed at MotherLode, to profit from an emerging consumer interest in canned wine. We believe our location close to vineyards in Oregon and Washington is a competitive advantage.

We currently sell our products in 41 states (Oregon, Washington, California, Alabama, Alaska, Arizona, Arkansas, Colorado, Connecticut, Florida, Georgia, Idaho, Indiana, Illinois, Iowa, Kansas, Kentucky, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Nebraska, Nevada, New Jersey, New Mexico, New York, North Carolina, North Dakota, Oklahoma, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Virginia, West Virginia, Wisconsin and Wyoming) as well as the District of Columbia and Ontario, Canada. The Company also generates revenue from tastings, tasting room tours, private parties, and merchandise sales from its retail tasting rooms in Oregon. The Company is subject to the Oregon Liquor Control Commission (OLCC) and the Alcohol and Tobacco Tax and Trade Bureau (TTB).

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Historically, the Company has funded its cash and liquidity needs through the issuance of notes, convertible notes, extended credit terms and the sale of equity. The Company has incurred a net loss of $5,851,503 and has an accumulated deficit of $23,942,464 for the nine months ended September 30, 2018. The Company has been dependent on raising capital from debt and equity financings to fund its operating activities. For the nine months ended September 30, 2018, the Company raised $13,569,457 in proceeds from financing activities.

At September 30, 2018, the Company had $4,856,389 of cash on hand with a positive working capital of $14,570,070. The Company’s ability to meet its ongoing operating cash needs is dependent on generating positive operating cash flow, primarily through increased sales, improved profit growth and controlling expenses. Management has taken actions to improve profitability, by managing expenses while increasing sales. In addition, through November 14, 2018, the Company raised an additional $482,004 in cash through the exercise of previously issued warrants (see Note 15, Subsequent Events). Management believes that cash on hand and proceeds generated from the most recent financings, along with revenue that the Company expects to generate from operations, will be sufficient to meet the Company’s cash needs over the next twelve months.

Basis of Presentation and Consolidation

The accompanying unaudited condensed consolidated financial statements for Eastside Distilling, Inc. and Subsidiaries were prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with instructions for Form 10-Q and, therefore, do not include all disclosures necessary for a complete presentation of financial condition, results of operations, and cash flows in conformity with GAAP. In our opinion, the unaudited condensed consolidated financial statements include all material adjustments, all of which are of a normal and recurring nature, necessary to present fairly our financial position as of September 30, 2018, our operating results for the three and nine months ended September 30, 2018 and 2017 and our cash flows for the nine months ended September 30, 2018 and 2017. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year ending December 31, 2018. The condensed consolidated financial statements include the accounts of Eastside Distilling, Inc.’s wholly-owned subsidiary, MotherLode (beginning as of March 8, 2017), and majority-owned subsidiary, BBD (beginning as of May 1, 2017). All intercompany balances and transactions have been eliminated in consolidation.

Segment Reporting

The Company determined its operating segment on the same basis that it uses to evaluate its performance internally. The Company has one business activity, producing, marketing and distributing hand-crafted spirits, and operates as one segment. The Company’s chief operating decision makers, its chief executive officer and chief financial officer, review the Company’s operating results on an aggregate basis for purposes of allocating resources and evaluating financial performance.

Use of Estimates

The preparation of financial statements in accordance with GAAP 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 revenues and expenses during the reporting period. Actual results could differ from those estimates.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Revenue Recognition

Net revenue includes product sales, less excise taxes and customer programs and incentives. The Company recognizes revenue by applying the following steps in accordance with Accounting Standards Codification (“ASC”) Topic 606 – Revenue from Contracts with Customers: (i) identify the contract with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to each performance obligation in the contract; and (5) recognize revenue when each performance obligation is satisfied.

The Company recognizes sales when merchandise is shipped from a warehouse directly to wholesale customers (except in the case of a consignment sale). For consignment sales, which include sales to the OLCC, the Company recognizes sales upon the consignee’s shipment to the customer. Postage and handling charges billed to customers are also recognized as sales upon shipment of the related merchandise. Shipping terms are generally FOB shipping point, and title passes to the customer at the time and place of shipment or purchase by customers at a retail location. For consignment sales, title passes to the consignee concurrent with the consignee’s shipment to the customer. The customer has no cancellation privileges after shipment or upon purchase at retail locations, other than customary rights of return. The Company excludes sales tax collected and remitted to various states from sales and cost of sales. Sales from items sold through the Company’s retail locations are recognized at the time of sale.

Revenue received from online merchants who sell discounted gift certificates for the Company’s merchandise and tastings is deferred until the customer has redeemed the discounted gift certificate or the gift certificate has expired, whichever occurs earlier.

Customer Programs and Incentives

Customer programs and incentives, which include customer promotional discount programs, customer incentives and other payments, are a common practice in the alcohol beverage industry. The Company makes these payments to customers and incurs these costs to promote sales of products and to maintain competitive pricing. Amounts paid in connection with customer programs and incentives are recorded as reductions to net sales or as advertising, promotional and selling expenses based on the nature of the expenditure. Amounts paid to customers totaled $192,801 and $118,389 for the nine months ended September 30, 2018 and 2017, respectively.

Advertising, Promotional and Selling Expenses

The following expenses are included in advertising, promotions and selling expenses in the accompanying consolidated statements of operations: media advertising costs, special event costs, tasting room costs, sales and marketing expenses, salary and benefit expenses, travel and entertainment expenses for the sales, brand and sales support workforce and promotional activity expenses. Advertising, promotional and selling costs are expensed as incurred. Advertising, promotional and selling expense was $2,838,417 and $1,499,751 for the nine months ended September 30, 2018 and 2017, respectively.

Cost of Sales

Cost of sales consists of the costs of ingredients utilized in the production of spirits, manufacturing labor and overhead, warehousing rent, packaging, and in-bound freight charges. Ingredients account for the largest portion of the cost of sales, followed by packaging and production costs.

Shipping and Fulfillment Costs

Freight costs incurred related to shipment of merchandise from the Company’s distribution facilities to customers are recorded in cost of sales.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Cash and Cash Equivalents

Cash equivalents are considered to be highly liquid investments with maturities of three months or less at the time of the purchase. The Company had no cash equivalents at September 30, 2018 and December 31, 2017.

Concentrations

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of trade receivables. At September 30, 2018, five customers represented 72% of trade receivables, and at December 31, 2017, two customers represented 79% of trade receivables. Sales to two customers accounted for approximately 44% of net sales for the nine months ended September 30, 2018 and 2017.

Fair Value Measurements

GAAP defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements. GAAP permits an entity to choose to measure many financial instruments and certain other items at fair value and contains financial statement presentation and disclosure requirements for assets and liabilities for which the fair value option is elected. At September 30, 2018 and December 31, 2017, management has not elected to report any of the Company’s assets or liabilities at fair value under the “fair value option” provided by GAAP.

The hierarchy of fair value valuation techniques under GAAP provides for three levels: Level 1 provides the most reliable measure of fair value, whereas Level 3, if applicable, generally would require significant management judgment. The three levels for categorizing assets and liabilities under GAAP’s fair value measurement requirements are as follows:

None of the Company’s assets or liabilities were measured at fair value at September 30, 2018 and December 31, 2017. However, GAAP requires the disclosure of fair value information about financial instruments that are not measured at fair value. Financial instruments consist principally of trade receivables, accounts payable, accrued liabilities, notes payable, and convertible notes payable. The estimated fair value of trade receivables, accounts payable, and accrued liabilities approximates their carrying value due to the short period of time to their maturities. At September 30, 2018 and December 31, 2017, the Company’s notes payable, convertible notes payable and secured credit facility balances outstanding are at fixed rates and their carrying value approximates fair value.

Items Measured at Fair Value on a Nonrecurring Basis

Certain assets and liabilities acquired in a business acquisition are valued at fair value at the date of acquisition.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Inventories

Inventories primarily consist of bulk and bottled liquor and merchandise and are stated at the lower of cost or market. Cost is determined using an average costing methodology, which approximates cost under the first-in, first-out (FIFO) method. A portion of inventory is held by certain independent distributors on consignment until it is sold to a third party. The Company regularly monitors inventory quantities on hand and records write-downs for excess and obsolete inventories based primarily on the Company’s estimated forecast of product demand and production requirements. Such write-downs establish a new cost basis of accounting for the related inventory. The Company has recorded no write-downs of inventory for the nine months ended September 30, 2018 and 2017.

Property and Equipment

Property and equipment is stated at cost, less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, ranging from three to seven years. Amortization of leasehold improvements is computed using the straight-line method over the life of the lease or the useful lives of the assets, whichever is shorter. The cost and related accumulated depreciation and amortization of property and equipment sold or otherwise disposed of are removed from the accounts and any gain or loss is reported as current period income or expense. The costs of repairs and maintenance are expensed as incurred.

Intangible Assets / Goodwill

The Company accounts for long-lived assets, including property and equipment, at amortized cost. Management reviews long-lived assets for probable impairment whenever events or circumstances indicate that the carrying amount of such assets may not be recoverable. If there is an indication of impairment, management would prepare an estimate of future cash flows (undiscounted and without interest charges) expected to result from the use of the asset and its eventual disposition. If these estimated cash flows were less than the carrying amount of the asset, an impairment loss would be recognized to write down the asset to its estimated fair value. At December 31, 2017, an impairment loss of $218,374 was recognized related to its acquisition of Big Bottom Distillery, LLC. At September 30, 2018, no additional impairment loss was recognized.

Long-lived Assets

The Company accounts for long-lived assets, including property and equipment, at amortized cost. Management reviews long-lived assets for probable impairment whenever events or circumstances indicate that the carrying amount of such assets may not be recoverable. If there is an indication of impairment, management would prepare an estimate of future cash flows (undiscounted and without interest charges) expected to result from the use of the asset and its eventual disposition. If these estimated cash flows were less than the carrying amount of the asset, an impairment loss would be recognized to write down the asset to its estimated fair value.

Income Taxes

The provision for income taxes is based on income and expenses as reported for financial statement purposes using the “asset and liability method” for accounting for deferred taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. At September 30, 2018 and December 31, 2017, the Company established valuation allowances against its net deferred tax assets.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Income tax positions that meet the “more-likely-than-not” recognition threshold are measured at the largest amount of income tax benefit that is more than 50 percent likely to be realized upon settlement with the applicable taxing authority. The portion of the benefits associated with income tax positions taken that exceeds the amount measured as described above would be reflected as a liability for unrecognized income tax benefits in the accompanying consolidated balance sheets along with any associated interest and penalties that would be payable to the taxing authorities upon examination. Interest and penalties associated with unrecognized income tax benefits would be classified as additional income taxes in the accompanying condensed consolidated statements of operations. There were no unrecognized income tax benefits, nor any interest and penalties associated with unrecognized income tax benefits, accrued or expensed at and for the nine months ended September 30, 2018 and 2017.

The Company files federal income tax returns in the U.S. and various state income tax returns. The Company is no longer subject to examinations by the related tax authorities for the Company’s U.S. federal and state income tax returns for years prior to 2012.

Comprehensive Income

The Company does not have any reconciling other comprehensive income items for the nine months ended September 30, 2018 and 2017.

Excise Taxes

The Company is responsible for compliance with the TTB regulations, which includes making timely and accurate excise tax payments. The Company is subject to periodic compliance audits by the TTB. Individual states also impose excise taxes on alcohol beverages in varying amounts. The Company calculates its excise tax expense based upon units produced and on its understanding of the applicable excise tax laws. Excise taxes totaled $360,229 and $654,136 for the nine months ended September 30, 2018 and 2017, respectively.

Stock-Based Compensation

The Company recognizes as compensation expense all stock-based awards issued to employees. The compensation cost is measured based on the grant-date fair value of the related stock-based awards and is recognized over the service period of stock-based awards, which is generally the same as the vesting period. The fair value of stock options is determined using the Black-Scholes valuation model, which estimates the fair value of each award on the date of grant based on a variety of assumptions including expected stock price volatility, expected terms of the awards, risk-free interest rate, and dividend rates, if applicable. Stock-based awards issued to nonemployees are recorded at fair value on the measurement date and are subject to periodic market adjustments at the end of each reporting period and as the underlying stock-based awards vest. Stock-based compensation was $986,193 and $486,194 for the nine months ended September 30, 2018 and 2017, respectively.

Accounts Receivable Factoring Program

During the three months ended June 30, 2017, we terminated our previous receivable factoring program. Under the prior program, we had the option to sell certain customer account receivables in advance of payment for 75% of the amount due. When the customer remitted payment, we would receive the remaining 25%. We were charged interest on the advanced 75% payment at a rate of 1.5% per month. Under the terms of the agreement with the factoring provider, any factored invoices had recourse should the customer fail to pay the invoice. Thus, we recorded factored amounts as a liability until the customer remitted payment and we received the remaining 25% of the non-factored amount. We did not factor any invoices and did not incur any fees associated with the factoring program during the nine months ended September 30, 2018. At September 30, 2018 and 2017, we had no factored invoices outstanding. We incurred fees associated with the factoring program of $63,238 during the nine months ended September 30, 2017.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Recent Accounting Pronouncements

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date:

Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). The new lease guidance simplified the accounting for sale and leaseback transactions primarily because lessees must recognize lease assets and lease liabilities. Lessees will no longer be provided with a source of off-balance sheet financing. Public business entities should apply the amendments in ASU 2016-02 for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019, for a calendar year entity). Early application is permitted for all public business entities upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. We are currently evaluating the impact ASU 2016-02 will have on the Company’s condensed consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09 which will supersede virtually all existing revenue guidance. Under this update, an entity is required to recognize revenue upon transfer of promised goods or services to customers, in an amount that reflects the expected consideration received in exchange for those goods or services. As such, an entity will need to use more judgment and make more estimates than under the current guidance. ASU 2014-09 is to be applied retrospectively either to each prior reporting period presented in the financial statements, or only to the most current reporting period presented in the financial statements with a cumulative effect adjustment to retained earnings. The Company will elect to apply the impact (if any) of applying ASU 2014-09 to the most current reporting period presented in the financial statements with a cumulative effect adjustment to retained earnings. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date (“ASU 2015-14”). ASU 2015-14 deferred the effective date of ASU 2014-09 for one year, making it effective for the year beginning December 31, 2017, with early adoption permitted as of January 1, 2017. We adopted ASU 2014-09 as of January 1, 2018. The Company does not believe the adoption of ASU 2014-09 had any material impact on its condensed consolidated financial statements.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

During the fiscal year 2017, the Company completed the following acquisitions:

MotherLode Craft Distillery, LLC

On March 8, 2017, the Company completed the acquisition of MotherLode Craft Distillery, LLC (“MotherLode”), a small Portland, Oregon-based provider of bottling services and production support to craft distilleries. The Company’s condensed consolidated financial statements for the three and nine months ended September 30, 2018 include MotherLode’s results of operations. For the three and nine months ended September 30, 2017, MotherLode’s results of operations are included from the acquisition date of March 8, 2017 through September 30, 2017. The Company’s condensed consolidated financial statements reflect the final purchase accounting adjustments in accordance with ASC 805 “Business Combinations,” whereby the purchase price was allocated to the assets acquired and liabilities assumed based upon their estimated fair values on the acquisition date. MotherLode had approximately $375,000 in revenues (unaudited) in 2016.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

The allocation of the purchase price is as follows:

Intangible assets are recorded at estimated fair value, as determined by management based on available information. The fair value assigned to the customer list intangible asset was determined through the use of the income approach, specifically the relief from royalty and the multi-period excess earning methods. The major assumptions used in arriving at the estimated identifiable intangible asset value included management’s estimates of future cash flows, discounted at an appropriate rate of return which is based on the weighted average cost of capital for both the Company and other market participants, projected customer attrition rates, as well as applicable royalty rates for comparable assets. The useful lives for intangible assets were determined based upon the remaining useful economic lives of the tangible assets that are expected to contribute directly or indirectly to future cash flows. The customer relationships estimated useful life is seven years. The fair values assigned to the license intangible asset were determined through the use of the cost approach. The license has an indefinite life and will not be amortized.

Big Bottom Distillery, LLC

On May 1, 2017, the Company acquired 90% of the ownership of Big Bottom Distillery, LLC (“BBD”), a Hillsboro, Oregon-based distiller of super premium spirits. The Company’s condensed consolidated financial statements for the three and nine months ended September 30, 2018 include BBD’s results of operations. The Company’s condensed consolidated financial statements reflect the final purchase accounting adjustments in accordance with ASC 805 “Business Combinations,” whereby the purchase price was allocated to the assets acquired and liabilities assumed based upon their estimated fair values on the acquisition date. BBD had approximately $201,000 in revenues (unaudited) in 2016.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

The allocation of the purchase price is as follows:

Intangible assets are recorded at estimated fair value, as determined by management based on available information. The fair value assigned to the license intangible asset was determined through the use of the cost approach. The license has an indefinite life and will not be amortized. For the year ended December 31, 2017, the Company recognized an impairment of $218,374 for the intangible asset – license and the goodwill originally recorded as part of the purchase price allocation for BBD.

Inventories consist of the following:

Property and equipment consists of the following:

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Purchases of property and equipment totaled $944,248 and $381,837 for the nine months ended September 30, 2018 and 2017, respectively. Depreciation and amortization expense totaled $190,441 and $25,736 for the nine months ended September 30, 2018 and 2017, respectively.

Intangible assets and goodwill at September 30, 2018 and December 31, 2017 consists of the following:

Amortization expense totaled $37,655 and $28,033 for the nine months ended September 30, 2018 and 2017, respectively.

Other assets consist of the following:

As of September 30, 2018, the Company had $285,000 of capitalized costs related to services provided for the rebranding of its Burnside product line. This amount is being amortized over a seven-year life. Additionally, there was $190,000 in deposits for the branding services related to the future release of other product lines. The remaining deposits of $23,109 represent office and retail space lease deposits.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Notes payable consists of the following:

Maturities on notes payable as of September 30, 2018, are as follows:

Year ending December 31:

On May 10, 2018, Eastside Distilling, Inc. (the “Company”) entered into a credit and security agreement (the “Credit and Security Agreement”), by and between the Company and The KFK Children’s Trust, Jeffrey Anderson – Trustee (the “Lender”). Pursuant to the Credit and Security Agreement, the Lender will make loans to the Company in an aggregate principal amount not to exceed $3,000,000 (the “Loans”). The proceeds of the Loans are to be used by the Company to purchase bulk whiskey, bourbon and rye inventory for use in distilling and producing its spirits products, and for no other purpose.

The Loans have an annual interest rate of 7.00%. The Company will pay accrued and unpaid interest on the Loans, for the period commencing on the date each such Loan is made and continuing until each such Loan is paid in full. The Company will pay the outstanding principal amount of the Loans: (i) in a one-time payment on the termination date of the Credit and Security Agreement, which shall take place 37 months from the effective date thereof, or earlier pursuant to other provisions thereof; and (ii) the Company may prepay the Loans or any portion thereof at any time, and from time to time, without premium or penalty.

The current market value of the Company’s bulk whiskey, bourbon and rye inventories must be at least 120% of the outstanding Loan balance.

Operating Leases

The Company leases its corporate office, warehouse, kiosks, and tasting room space under operating lease agreements which expire at various dates through March 2021. Monthly lease payments range from $1,913 to $21,635 over the terms of the leases. For operating leases which contain fixed escalations in rental payments, the Company records the total rent expense on a straight-line basis over the lease term. The difference between the expense computed on a straight-line basis and actual payments for rent represents deferred rent, which is included within accrued liabilities on the accompanying consolidated balance sheets. Retail spaces under lease are subject to monthly percentage rent adjustments when gross sales exceed certain minimums.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

At September 30, 2018, future minimum lease payments required under the operating leases are approximately as follows:

Total rent expense was $295,319 and $248,535 for the nine months ended September 30, 2018 and 2017, respectively.

Legal Matters

We are not currently subject to any material legal proceedings; however, we could be subject to legal proceedings and claims from time to time in the ordinary course of our business. Regardless of the outcome, litigation can, among other things, be time consuming and expensive to resolve, and divert management resources.

Basic loss per common share is computed by dividing net loss by the weighted average number of common shares outstanding during the period, without considering any dilutive items. Diluted net loss per common share is computed by dividing net loss by the sum of the weighted average number of common shares outstanding and the potential number of any dilutive common shares outstanding during the period. Potentially dilutive securities consist of the incremental common stock issuable upon exercise of stock options and convertible notes. Potentially dilutive securities are excluded from the computation if their effect is anti-dilutive. There were no dilutive common shares at September 30, 2018 and 2017. The numerators and denominators used in computing basic and diluted net loss per common share in 2018 and 2017 are as follows:

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Reverse Stock Splits

All shares related and per share information in these financial statements has been adjusted to give effect to the 20-for-1 reverse stock split of the Company’s common stock, effected on October 18, 2016, and the 3-for-1 reverse stock split of the Company’s common stock, effected on June 15, 2017.

Issuance of Common Stock

During the nine months ended September 30, 2018, the Company issued 1,345,978 shares of common stock at $5.40 per share in connection with the exercise of warrants for cash proceeds of $7,268,281, and 500,000 shares of common stock at $5.40 per share in connection with the exercise of warrants in exchange for a reduction in outstanding note principal of $2,700,000. In addition, the Company issued 167,273 shares of common stock at $6.00 per share in exchange for outstanding note principal and interest.

During the nine months ended September 30, 2018, the Company issued 120,000 shares of common stock at $5.40 per share in connection with the exercise of underwriter units. Each unit consisted of one share of common stock and one common stock warrant exercisable at $5.40 per share.

During the nine months ended September 30, 2018, the Company issued 25,000 shares of common stock at an average of $4.00 per share in connection with the exercise of warrants for proceeds of $100,000. In addition, the Company issued 54,308 shares of common stock at an average of approximately $4.07 per share in exchange for services rendered.

During the nine months ended September 30, 2018, the Company issued 53,608 shares of common stock to directors and employees for stock-based compensation of $489,029. The shares were valued using the closing share price of our common stock on the date of grant, with the range of $3.99 - $8.50 per share.

During the nine months ended September 30, 2018, the Company issued 29,211 shares of common stock in connection with existing option exercises, at an average exercise price of $4.62.

During the nine months ended September 30, 2018, the Company issued 17,525 shares of common stock to consultants in exchange for services. The shares were valued using the closing share price of our common stock on the date of grant, with a range of $3.99 - $7.40 per share, for a total value of $87,118.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

In December 2017, the Company issued 18,371 shares of common stock to directors and employees for stock-based compensation of $79,351. The shares were valued using the closing share price of our common stock on the date of grant, with the range of $3.78 - $4.33 per share.

In December 2017, the Company issued 32,000 shares of common stock to a consultant in exchange for services, which were subject to a claw-back provision tied to specific performance. The shares were valued using the closing share price of our common stock on the date of grant, $4.54 per share.

In December 2017, the Company issued 14,384 shares of its common stock upon conversion of 8% convertible promissory notes with an aggregate principal amount converted of $52,500. No gain or loss recorded on the transactions.

In September 2017, the Company issued 14,760 shares of common stock to directors and employees for stock-based compensation of $56,221. The shares were valued using the closing share price of our common stock on the date of grant, with the range of $3.78 - $4.38 per share.

In August 2017, the Company issued 83,334 shares of its common stock upon conversion of a 6% convertible promissory note with an aggregate principal amount converted of $500,000. No gain or loss recorded on the transactions.

In August 2017, the Company issued 5,209 shares of common stock to a third-party consultant in exchange for services rendered. The shares were valued using the closing share price of our common stock on the date of grant, with the range of $3.40 - $3.50 per share.

In August 2017, the Company completed an underwritten public offering of 1,200,000 units consisting of 1,200,000 shares of its common stock and warrants to purchase up to an aggregate of 1,200,000 shares of its common stock (each, a “Unit”) at a public offering price of $4.50 per Unit. The warrants have a per share exercise price of $5.40, are exercisable immediately, and will expire five years from the date of issuance. The gross proceeds to the Company from this offering were $5.4 million, before deducting underwriting discounts and commissions and other estimated offering expenses. On August 24, 2017, the underwriters exercised their option to purchase an additional 180,000 Units to cover over-allotments, that resulted in additional gross proceeds to the Company of $810,000, before deducting offering expenses.

In June 2017, the Company issued 2,716 shares of common stock to employees for stock-based compensation of $15,943, all of which were fully vested upon issuance. The shares were valued using the closing share price of our common stock on the date of grant, with the range of $4.38 - $6.00 per share.

In May 2017, the Company completed the acquisition of a majority stake in BBD. We issued 28,096 shares of common stock to the owners of BBD as consideration for 90% of the BBD LLC units. Based on the closing share price of our common stock of $4.80 on May 1, 2017, the value of the transaction was $134,858. Issuance costs incurred were $14,400.

In April 2017, the independent directors, Messrs. Trent Davis and Michael Fleming, respectively, each exercised 4,630 stock options to purchase common stock at $5.40 per share.

In April 2017, the Company issued 50,335 shares of common stock to three third-party consultants in exchange for services rendered. The shares were valued using the closing share price of our common stock on the date of grant, with the range of $4.35 - $4.50 per share.

In April 2017, the Company approved a restricted stock unit grant of 33,334 shares of common stock to the Company’s Chief Executive Officer, Grover Wickersham. The grant vested on April 5, 2017, of which 10,218 shares were withheld in order to satisfy Mr. Wickersham’s personal tax withholding responsibility. The shares were valued using the $4.80 closing share price of our common stock on the date of grant.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

In April 2017, the Company issued 16,667 shares of its common stock upon conversion of 50 shares of preferred stock.

In March 2017, the Company issued 83,334 shares of its common stock upon conversion of 250 shares of preferred stock.

In March 2017, the Company issued 22,436 shares of its common stock upon conversion of 8% convertible promissory notes with an aggregate principal amount converted of $87,500. No gain or loss recorded on the transactions.

On March 8, 2017, the Company completed the acquisition of MotherLode. We issued 86,667 shares of common stock to the owners of MotherLode as consideration for the acquisition. Based on the closing share price of our common stock of $4.35 on March 8, 2017, the value of the transaction was $377,000. Issuance costs incurred were $5,580.

In March 2017, the Company issued 575 shares of common stock to employees for stock-based compensation of $2,517. The shares were valued using the $4.38 closing share price of our common stock on the date of grant.

In March 2017, the Company issued 19,796 shares of common stock to four third-party consultants in exchange for services rendered. The shares were valued using the closing share price of our common stock on the date of grant, with the range of $3.90 - $4.35 per share.

From March 31, 2017 to June 2, 2017, the Company issued 400,019 shares of its common stock for aggregate cash proceeds of $1,560,000, including 400,019 warrants for common stock.

From January 15, 2017 through February 16, 2017, the Company received warrant exercises and common stock subscriptions for 40,834 shares for aggregate cash proceeds of $159,250.

From January 4, 2017 to January 22, 2017, the Company sold 15,001 shares of common stock to accredited investors at a price of $3.90 per share for aggregate cash proceeds of $58,500.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Issuance of Convertible Preferred Stock

Each share of Series A Preferred has a stated value of $1,000, which is convertible into shares of the Company’s common stock at a fixed conversion price equal to $4.50 per share. The Series A Preferred accrue dividends at a rate of 8% per annum, cumulative. Dividends are payable quarterly in arrears at the Company’s option either in cash or “in kind” in shares of common stock; provided, however that dividends may only be paid in cash following the fiscal year in which the Company has net income (as shown in its audited financial statements contained in its Annual Report on Form 10-K for such year) of at least $500,000, to the extent permitted under applicable law out of funds legally available therefore. For “in-kind” dividends, holders will receive that number of shares of common stock equal to (i) the amount of the dividend payment due such stockholder divided by (ii) 90% of the average of the per share market values during the twenty (20) trading days immediately preceding a dividend date.

In the event of any voluntary or involuntary liquidation, dissolution or winding up, or sale of the Company, each holder of Series A Preferred is entitled to receive its pro rata portion of an aggregate payment equal to: (i) $1,000 multiplied by (ii) the total number of shares of Series A Preferred issued under the Series A Certificate of Designation multiplied by (iii) 2.5.

For all matters submitted to a vote of the Company’s stockholders, the holders of the Series A Preferred as a class have an aggregate number of votes equal to the product of (x) the number of shares of Common Stock (rounded to the nearest whole number) into which the total shares of Series A Preferred Stock issued under the Series A Certificate of Designation on such date of determination are convertible multiplied by (y) 2.5 (the “Total Series A Votes”), with each holder of Series A Preferred entitled to vote its pro rata portion of the Total Series A Votes. Holders of Common Stock do not have cumulative voting rights. In addition, the holders of Series A Preferred vote separately a class to change any of the rights, preferences and privileges of the Series A Preferred.

As of September 30, 2018, the Company has zero shares of preferred stock outstanding.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

Stock-Based Compensation

On September 8, 2016, the Company adopted the 2016 Equity Incentive Plan (the “2016 Plan”). The total number of shares available for the grant of either stock options or compensation stock under the 2016 Plan is 166,667 shares, subject to adjustment. On January 1, 2017, the number of shares available for grant under the 2016 Plan reset to 307,139 shares, equal to 8% of the number of outstanding shares of the Company’s capital stock, calculated on an as-converted basis, on December 31 of the preceding calendar year. On October 18, 2017, the Board of Directors (the “Board”) approved amendments to the 2016 Plan to (i) increase the number of shares of the common stock that may be issued under the 2016 Plan (the “Aggregate Limit”) by an additional 192,861 shares of common stock, for a total of 500,000 shares of common stock, (ii) increase the number of shares of common stock that may be granted to any participant pursuant to options to purchase common stock and stock appreciation rights under the 2016 Plan in any one-year period (the “Individual Option Limit”) from 8,333 shares to 200,000 shares, (iii) increase the number of shares of common stock that may be granted to any participant pursuant to other awards (the “Individual Award Limit”) under the 2016 Plan in any one-year period from 8,333 shares to 200,000 shares and (iv) increase the number of shares of common stock that may be paid to any one participant under the 2016 Plan for a performance period pursuant to performance compensation awards under the 2016 Plan (the “Individual Performance Award Limit”) from 8,333 shares to 200,000 shares, which amendments were adopted and approved at the December 2017 meeting of stockholders. The exercise price per share of each stock option will not be less than 100 percent of the fair market value of the Company’s common stock on the date of grant. On January 1, 2018, the number of shares available for grant under the 2016 Plan reset to 1,131,880 shares, equal to 8% of the number of outstanding shares of the Company’s capital stock, calculated on an as-converted basis, on December 31 of the preceding calendar year, added to the prior year plan amount. At September 30, 2018, there were 778,237 options and 186,317 restricted stock units (“RSUs”) issued under the 2016 Plan, with vesting schedules varying between immediate and five (5) years from the grant date.

On January 29, 2015, the Company adopted the 2015 Stock Incentive Plan (the 2015 Plan). The total number of shares available for the grant of either stock options or compensation stock under the 2015 Plan is 50,000 shares, subject to adjustment. The exercise price per share of each stock option will not be less than 20 percent of the fair market value of the Company’s common stock on the date of grant. At September 30, 2018, there were 14,584 options issued under the Plan outstanding, which options vest at the rate of at least 25 percent in the first year, starting 6-months after the grant date, and 75% in year two.

The Company also issues, from time to time, options which are not registered under a formal option plan. At September 30, 2018, there were no options outstanding that were not issued under the Plans.

A summary of all stock option activity at and for the nine months ended September 30, 2018 is presented below:

The aggregate intrinsic value of options outstanding at September 30, 2018 was $2,445,582.

At September 30, 2018, there were 441,125 unvested options with an aggregate grant date fair value of $1,153,548. The unvested options will vest in accordance with the vesting schedule in each respective option agreement, which varies between immediate and five (5) years from the grant date. The aggregate intrinsic value of unvested options at September 30, 2018 was $1,597,548. During the nine months ended September 30, 2018, 153,509 options became vested.

The Company uses the Black-Scholes valuation model to measure the grant-date fair value of stock options. The grant-date fair value of stock options issued to employees is recognized on a straight-line basis over the requisite service period. Stock-based awards issued to nonemployees are recorded at fair value on the measurement date and are subject to periodic market adjustments as the underlying stock-based awards vest. To determine the fair value of stock options using the Black-Scholes valuation model, the calculation takes into consideration the effect of the following:

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

The calculation includes several assumptions that require management’s judgment. The expected term of the options is calculated using the simplified method described in GAAP. The simplified method defines the expected term as the average of the contractual term and the vesting period. Estimated volatility is derived from volatility calculated using historical closing prices of common shares of similar entities whose share prices are publicly available for the expected term of the options. The risk-free interest rate is based on the U.S. Treasury constant maturities in effect at the time of grant for the expected term of the options.

The following weighted-average assumptions were used in the Black-Scholes valuation model for options granted during the nine months ended September 30, 2018:

The weighted-average grant-date fair value per share of stock options granted during the nine months ended September 30, 2018 was $2.59. The aggregate grant date fair value of the 486,500 options granted during the nine months ended September 30, 2018 was $1,250,405.

For the nine months ended September 30, 2018 and 2017, total stock option expense related to stock options was $586,016 and $373,278, respectively. At September 30, 2018, the total compensation cost related to stock options not yet recognized is approximately $1,271,455, which is expected to be recognized over a weighted-average period of approximately 2.57 years.

Warrants

During the nine months ended September 30, 2018, the Company issued an aggregate of 500,000 common stock warrants in connection with the purchase of $5.0 million in promissory notes. $4.08 million was purchased with new cash proceeds and $922,980 was purchased from the conversion of prior existing notes. The Company has determined the warrants should be classified as equity on the condensed consolidated balance sheet as of September 30, 2018. The estimated fair value of the warrants at issuance was $1,951,080, based on a combination of closing market trading price on the date of issuance for the public offering warrants, and the Black-Scholes option-pricing model using the weighted-average assumptions below:

A total of 1,870,978 warrants were exercised during the nine months ended September 30, 2018 for cash proceeds of $7,368,281 and a $2,700,000 reduction of outstanding note principal. In addition, 54,308 warrants were exercised during the nine month period at an average of approximately $4.07 per share in exchange for services rendered.

Eastside Distilling, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2018

(unaudited)

A summary of activity in warrants is as follows:

The following is a description of transactions since January 1, 2016 as to which the amount involved exceeds the lesser of $120,000 or one percent (1%) of the average of our total assets at year-end for the last two completed fiscal years and in which any related person has or will have a direct or indirect material interest, other than equity, compensation, termination and other arrangements.

On June 2, 2017, Mr. Wickersham purchased 15,189 units at $3.90 per unit, with each unit consisting of one share of common stock and one three-year common stock purchase warrant exercisable at $7.50 per share (subject to adjustment), for total proceeds of $59,237 in cash.

On August 10, 2017, Mr. Wickersham and his affiliates purchased 55,555 units at $4.50 per unit, with each unit consisting of one share of common stock and one Public Warrant, for total proceeds of approximately $250,000 in cash. On August 9, 2018, Mr. Wickersham and his affiliates exercised the 55,555 warrants associated with the 2017 unit offering at an exercise price of $5.40 per share, for total proceeds of approximately $300,000.

On August 23, 2017, our Board appointed Jack Peterson to the Board to fill an existing vacancy on the Board effective immediately. Mr. Peterson is also the President of Sandstrom Partners. In late 2016, with the goal of increasing its brand value and accelerating sales, the Company retained Sandstrom and tasked them with reviewing the Company’s current product portfolio, as well as its new ideas, and advising it with respect to marketing, creation of brand awareness and product positioning, locally and nationally. The Company is using Sandstrom’s full range of brand development services, including research, strategy, brand identity, package design, environments, advertising as well as digital design and development. The Company paid $140,000 in cash, issued 33,334 shares of stock valued at $145,000 (at the time of issuance), and issued 42,000 warrants with an exercise price of $3.50 valued at $43,596 (using a Black-Scholes value at the time of issuance) to Sandstrom Partners in 2017 for services rendered by Sandstrom under its agreement with the Company. We have also issued an additional 10,025 shares valued at $40,000 (at the time of issuance) to Sandstrom in 2018. On August 11, 2018, we issued 42,000 shares of common stock to Sandstrom in connection with the exercise of their 42,000 warrants in exchange for services rendered.

On December 29, 2017, the Grover T. Wickersham Employees’ Profit Sharing Plan (“PSP”) purchased from us a promissory note bearing interest at the rate of 8% per annum (a “Promissory Note”) for aggregate consideration of $464,750. Interest is paid monthly. The note is due on June 30, 2019 or in the event the Company completes a private or public offering of its equity or debt securities in which the gross amount raised in such financing is at least $2.0 million (a “Future Financing”), all amounts due under this Note will become due and payable within five (5) business days of the final closing of such Future Financing. In lieu of receiving the cash repayment of amounts due under this Note in connection with a Future Financing, at the option of Payee, the principal amount due and payable may be used to purchase the securities offered in the Future Financing. The payee used a balance of $379,750 to purchase the Company’s new private offering of notes with warrants. The remaining principal balance of $85,000 was paid in April 2018. The new promissory notes bear interest at 8% per annum, payable monthly on the last day of the month. The entire amount of principal and any accrued and unpaid interest is due and payable on May 1, 2021. In conjunction with this new offering, the Payee was issued 37,975 warrants, exercisable at $5.40 per share. On August 9, 2018, the PSP exercised the 37,975 warrants at $5.40 per share in exchange for a reduction in outstanding note principal due.

On December 29, 2017, the Grover T. and Jill Z. Wickersham 2000 Charitable Remainder Trust (the “Wickersham Trust”) purchased from us a promissory note bearing interest at the rate of 8% per annum (a “Promissory Note”) for aggregate consideration of $179,300. Interest is paid monthly. The note is due on June 30, 2019 or in the event the Company completes a private or public offering of its equity or debt securities in which the gross amount raised in such financing is at least $2.0 million (a “Future Financing”), all amounts due under this Note will become due and payable within five (5) business days of the final closing of such Future Financing. In lieu of receiving the cash repayment of amounts due under this Note in connection with a Future Financing, at the option of Payee, the principal amount due and payable may be used to purchase the securities offered in the Future Financing. During the first quarter of 2018, the payee used the balance to purchase the Company’s new private offering of notes with warrants. The new promissory notes bear interest at 8% per annum, payable monthly on the last day of the month. The entire amount of principal and any accrued and unpaid interest is due and payable on May 1, 2021. In conjunction with this new offering, the Payee was issued 17,930 warrants, exercisable at $5.40 per share. On August 9, 2018, the Trust exercised the 17,930 warrants at $5.40 per share in exchange for a reduction in outstanding note principal due.

We believe that the foregoing transactions were in our best interests. Consistent with Section 78.140 of the Nevada Revised Statutes, it is our current policy that all transactions between us and our officers, directors and their affiliates will be entered into only if such transactions are approved by a majority of the disinterested directors, are approved by vote of the stockholders, or are fair to us as a corporation as of the time it is authorized, approved or ratified by the board. We will continue to conduct an appropriate review of all related party transactions and potential conflicts of interest on an ongoing basis. Our audit committee has the authority and responsibility to review, approve and oversee any transaction between the Company and any related person and any other potential conflict of interest situation on an ongoing basis, in accordance with Company policies and procedures in effect from time to time.

In October, the Company issued 12,595 and 6,125 shares of common stock to employees for stock-based compensation of $100,004 and $48,204, respectively. The shares were valued using the closing share price of our common stock on the date of the grants, or $7.94 and $7.57 per share, respectively. In addition, during October, the Company issued 9,875 shares of common stock to consultants in exchange for services.

During October 2018, the Company issued 1,553 shares of common stock in connection with employee option exercises.

Between October 12, 2018 and November 14, 2018, the Company received an aggregate of $482,004 upon exercise of a total of 80,334 common stock purchase warrants.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the condensed consolidated financial statements and notes. This section of the Quarterly Report includes a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, that reflect our current views with respect to future events and financial performance. Forward-looking statements are often identified by words like: believe, expect, estimate, anticipate, intend, project, and similar expressions, or words which, by their nature, refer to future events. You should not place undue certainty on these forward-looking statements, which speak only as of the date made, and except as required by law, we undertake no obligation to update any forward-looking statements, whether as a result of new information, future events, or otherwise. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from these forward-looking statements. Factors that could cause differences include, but are not limited to: customer acceptance risks for current and new brands; reliance on external sources on financing; development risks for new products and brands; dependence on wholesale distributors; inventory carrying issue; fluctuations in market demand and customer preferences, as well as general conditions of the alcohol and beverage industry; and other factors discussed in Item 1A of Part I of our annual report on Form 10-K for the year ended December 31, 2017 entitled “Risk Factors,” similar discussions in subsequently filed Quarterly Reports on Form 10-Q, including this Form 10-Q, as applicable, and those contained from time to time in our other filings with the Securities and Exchange Commission.

Business Overview

We are an Oregon-based producer and marketer of craft spirits, founded in 2008. Our products span several alcoholic beverage categories, including bourbon, American whiskey, vodka, gin and rum. Unlike other distillers, we operate several retail tasting rooms in Oregon to market our brands directly to consumers. Our strategy for growth is to build on our local base in the Pacific Northwest and expand selectively to other markets, using major spirits distributors. In December 2016, we retained Sandstrom Partners, an internationally-known spirit branding firm that branded St-Germain and Bulleit Bourbon, to guide our marketing strategy and branding. Sandstrom Partners subsequently became an investor in our company. During 2017, with the assistance of Sandstrom Partners and using our in-house spirits expertise, we created Redneck Riviera Whiskey (“RRW”) in collaboration with country music superstar John Rich, of the duo “Big & Rich.” Supported by John Rich’s marketing efforts, we launched RRW in the Southeastern and Gulf States in early 2018 primarily through Republic National Distributing Company (“RNDC”). We believe that RRW will achieve commercial success on a broad scale, and we have therefore focused our sales efforts on RRW outside Oregon. RRW has been a key growth engine in 2018 to date and we believe it will continue to be a growth area into 2019. We further believe that the success of RRW will also provide a “coattail” effect for our other brands, helping them to achieve improved national recognition and success.

Operating as a small business in a large, international spirits marketplace occupied by massive conglomerates, we seek to turn our small size from a disadvantage into an advantage. As the success of our RRW launch and Sandstrom Partners collaboration demonstrate, our team can leverage its smaller size to launch new brands more quickly than larger conglomerates because we are able to dedicate more of our attention and resources to developing innovative products. We believe that the dominance of Canadian whiskeys in the light-whiskey segment is vulnerable to a light whiskey that is 100% American, and we are exploiting that vulnerability with RRW, a product that went from idea, to celebrity collaboration, to design and formulation, to market roll-out in less than nine months. We are innovative in targeting emerging trends with our products; for example, we developed our Hue-Hue Coffee Rum with cold brew coffee and low sugar, as well as our gluten-free potato vodka. We seek to be both a leader in creating spirits that offer better value than comparable spirits (for example, our value-priced Portland Potato Vodka), and an innovator in creating imaginative spirits that offer a unique taste experience, like our Hue-Hue Coffee Rum, Oregon oak-aged whiskeys and Marionberry Whiskey.

As a Nasdaq-traded company, we have access to public capital markets to support our growth initiatives, including strategic acquisitions. In May 2017, we used our shares to acquire 90% of Big Bottom Distillery (“BBD”), known for its award-winning, super-premium gins and whiskeys, including The Ninety One Gin, Navy Strength Gin, Oregon Gin, Delta Rye and American Single Malt Whiskey. BBD’s super-premium spirits give us a presence at the “high end” of the market. In addition, through MotherLode Craft Distillery (“MotherLode”), our wholly-owned subsidiary acquired in March 2017, we also provide contract bottling and packaging services for existing and emerging spirits producers, some of whom contract with us to blend or distill spirits. During 2018, we have begun to use our “slim line” canning equipment, newly installed at MotherLode, to profit from an emerging consumer interest in canned wine. We believe our location close to vineyards in Oregon and Washington is a competitive advantage.

RESULTS OF OPERATIONS

Overview

Results for the first nine months of 2018 benefitted from the impact of several key initiatives the Company started in 2017. Third quarter gross sales increased 93% over the prior year, and gross sales for the nine months ended September 30, 2018 increased 85% over the prior year primarily due to several key factors: 1) the newly launched RRW product, which experienced very strong sales with its initial market launch, 2) increased wholesale sales traction within the Pacific Northwest, especially with our vodka product as we strategically invested in programs to promote the vodka product, 3) the re-launch of our new Burnside Bourbon packaging, which began in late 2017, and its corresponding growth, and 4) the acquisitions of MotherLode and BBD, and the expansion of our private label business with our new canning abilities.

In order to support our planned growth, we invested heavily in our infrastructure (facilities, people, and marketing programs) during 2017 and 2018. We believe we are now well positioned from a capacity and infrastructure standpoint to leverage those investments made and thus experience improved performance throughout the remainder of 2018 and into 2019.

Three Months Ended September 30, 2018 Compared to the Three Months Ended September 30, 2017

Our sales for the three months ended September 30, 2018 increased to $1,698,848, or approximately 90%, from $895,182 for the three months ended September 30, 2017. The following table compares our sales in the three months ended September 30, 2018 and 2017:

The increase in sales in the three months ended September 30, 2018 is primarily attributable to: the newly launched RRW product, increased wholesale sales traction within the Pacific Northwest, our acquisitions of MotherLode and BBD and related expansion of our private label business and canning abilities, offset by a reduction in retail due to store relocations.

Excise taxes, customer programs and incentives for the three months ended September 30, 2018 decreased to $209,801, or approximately 24%, from $276,845 for the comparable 2017 period. The decrease is primarily attributable to the lower federal excise tax rates that went into effect this year and decreased sales from our retail operations, partially offset by the increase in wholesale sales volume.

During the three months ended September 30, 2018, cost of sales increased to $886,828, or approximately 131%, from $384,265 for the three months ended September 30, 2017. The increase is attributable to the costs associated with our increased liquor sales in the period as well as higher fixed facilities costs.

Gross profit is calculated by subtracting the cost of products sold from net sales. Cost of sales consists of the costs of ingredients utilized in the production of spirits, manufacturing labor and overhead, warehousing rent, packaging, and in-bound freight charges. Ingredients account for the largest portion of the cost of sales, followed by packaging and production costs. Gross margin is gross profits stated as a percentage of net sales.

The following table compares our gross profit and gross margin in the three months ended September 30, 2018 and 2017:

Our gross margin of 40% of net sales in the three months ended September 30, 2018 increased from our gross margin of 38% for the three months ended September 30, 2017 primarily due to the lower federal excise tax in 2018, partially offset by the change in revenue mix which included a higher percentage of lower margin private label sales. While our goal is to ultimately improve our overall gross margin, it may fluctuate due to the impact of two key factors: product sales mix and the related customer programs and incentives, both of which are subject to seasonal fluctuations, specific promotional activities occurring in any given period and the overall competitive environment.

Advertising, promotional and selling expenses for the three months ended September 30, 2018 increased to $1,128,593, or approximately 100%, from $563,754 for the three months ended September 30, 2017. This increase is primarily due to our efforts to expand product sales both regionally in the Pacific Northwest as well as target national markets, particularly with the new RRW product launch. For the three months ended September 30, 2018, $465,778 in advertising, promotional and selling expenses is attributable to the RRW marketing and expansion efforts.

General and administrative expenses for the three months ended September 30, 2018 increased to $1,559,833, or approximately 50%, from $1,040,942 for the three months ended September 30, 2017. This increase is primarily due to increased headcount and the associated compensation and benefits in addition to $128,041 higher stock-based compensation expense in 2018.

Total other expense, net was $540,250 for the three months ended September 30, 2018, compared to $40,536 for the three months ended September 30, 2017, an increase of $499,714. This increase was primarily due to the recognition of $332,483 of debt discount related to the principal paydown of outstanding notes as a result of the exercise of the warrants attached to those notes in addition to higher interest expense on notes payable in 2018.

Net loss attributable to common shareholders during the three months ended September 30, 2018 was $2,626,991 as compared to a loss of $1,411,461 for the three months ended September 30, 2017. The increase in our net loss was primarily attributable to our higher general and administrative expenses, advertising, promotional and selling expenses, and interest expense during 2018, partially offset by an increase in gross profit.

Nine Months Ended September 30, 2018 Compared to the Nine Months Ended September 30, 2017

Our sales for the nine months ended September 30, 2018 increased to $4,787,097, or approximately 84%, from $2,608,373 for the nine months ended September 30, 2017. The following table compares our sales in the nine months ended September 30, 2018 and 2017:

The increase in sales for the nine months ended September 30, 2018 is primarily attributable to: the newly launched RRW product, increased wholesale sales traction within the Pacific Northwest, our acquisitions of MotherLode and BBD and related expansion of our private label business and canning abilities, and the addition of new and relocation of existing retail locations.

Excise taxes, customer programs and incentives for the nine months ended September 30, 2018 decreased to $553,030, or approximately 28%, from $772,525 for the comparable 2017 period. The decrease is primarily attributable to the lower federal excise tax rates that went into effect this year, in addition to decreased Oregon excise taxes (from our retail operations), partially offset by higher customer programs during the period.

During the nine months ended September 30, 2018, cost of sales increased to $2,278,119, or approximately 105%, from $1,101,803 for the nine months ended September 30, 2017. The increase is attributable to the costs associated with our increased liquor sales in the period as well as higher fixed facilities costs.

Gross profit is calculated by subtracting the cost of products sold from net sales. Cost of sales consists of the costs of ingredients utilized in the production of spirits, manufacturing labor and overhead, warehousing rent, packaging, and in-bound freight charges. Ingredients account for the largest portion of the cost of sales, followed by packaging and production costs. Gross margin is gross profits stated as a percentage of net sales.

The following table compares our gross profit and gross margin in the nine months ended September 30, 2018 and 2017:

Our gross margin of 46% of net sales in the nine months ended September 30, 2018 increased from our gross margin of 40% for the nine months ended September 30, 2017, primarily due to the change in revenue mix and lower federal excise taxes in 2018, which was partially offset by a higher percentage of lower margin private label sales. While our goal is to ultimately improve our overall gross margin, it may fluctuate due to the impact of product sales mix and the related customer programs and incentives, both of which are subject to seasonal fluctuations, specific promotional activities occurring in any given period, and the overall competitive environment.

Advertising, promotional and selling expenses for the nine months ended September 30, 2018 increased to $2,838,417, or approximately 89%, from $1,499,751 for the nine months ended September 30, 2017. This increase is primarily due to our efforts to expand our product sales both regionally in the Pacific Northwest as well as target national markets, particularly with the new RRW product launch. For the nine months ended September 30, 2018, $882,261 in advertising, promotional and selling expenses is attributable to the RRW marketing and expansion efforts.

General and administrative expenses for the nine months ended September 30, 2018 increased to $4,267,831, or approximately 63%, from $2,615,810 for the nine months ended September 30, 2017. This increase is primarily due to increased headcount and the associated compensation and benefits in addition to $499,999 higher stock-based compensation expense in 2018.

Total other expense, net was $701,203 for the nine months ended September 30, 2018, compared to $179,613 for the nine months ended September 30, 2017, an increase of $521,590. This increase was primarily due to the recognition of $332,483 of debt discount related to the principal paydown of outstanding notes as a result of the exercise of the warrants attached to those notes in addition to higher interest expense on notes payable in 2018.

Net loss attributable to common shareholders during the nine months ended September 30, 2018 was $5,852,140 as compared to a loss of $3,605,967 for the nine months ended September 30, 2017. The increase in our net loss was primarily attributable to our higher general and administrative expenses, advertising, promotional and selling expenses, and interest expense during 2018, partially offset by an increase in gross profit.

Liquidity and Capital Resources

Nine Months Ended September 30, 2018

The Company’s primary capital requirements are for the financing of inventories, and cash used in operating activities. Funds for the Company’s cash and liquidity needs have historically been generated from short-term credit in the form of extended payment terms from suppliers as well as from convertible debt and equity financings rather than from operations.

For the nine months ended September 30, 2018 and 2017, the Company incurred a net loss of approximately $5.9 million and $3.6 million, respectively, and has an accumulated deficit of approximately $24.0 million as of September 30, 2018. The Company has been dependent on raising capital from debt and equity financings to meet its needs for cash flow used in operating activities. For the nine months ended September 30, 2018, the Company raised approximately $13.6 million from financing activities to meet cash flows used in operating activities.

At September 30, 2018, the Company had approximately $4.9 million of cash on hand with a positive working capital of $14.6 million. The Company’s ability to meet its ongoing operating cash needs is dependent on generating positive operating cash flow, primarily through increased sales, improved profit growth and controlling expenses. Management has taken actions to improve profitability and increase sales. Management believes that cash on hand and proceeds generated from the most recent financings, along with revenue that the Company expects to generate from operations, will be sufficient to meet the Company’s cash needs over the next twelve months.

The Company’s cash flows for the nine months ended September 30, 2018 and 2017 are as follows:

Operating Activities

During the nine months ended September 30, 2018, our net loss plus non-cash adjustments used was approximately $3.8 million compared to using $2.5 million in 2017. The increase in cash usage can be primarily attributed to the larger net loss incurred in 2018 as compared to 2017. In addition, there was an increase of $6.1 million in inventory, a $0.4 million increase in trade receivables and a $0.1 increase in prepaid expenses and other assets. In 2017, there was a $1.4 million increase in inventory, a $0.2 million increase in prepaid expenses and other assets, and $0.5 million net reduction accounts payable and accrued liabilities.

Investing Activities

Cash used in investing activities consists primarily of purchases of property and equipment. Capital expenditures of $0.9 million and $0.4 million were incurred in the nine months ended September 30, 2018 and 2017, respectively.

Financing Activities

During the nine months ended September 30, 2018, the Company’s operating losses and working capital needs were primarily funded by $10.3 million in proceeds from warrant exercises, $4.1 million in proceeds from the issuance of promissory notes, $2.0 million in proceeds from a secured credit facility, and $0.3 million in proceeds from the sale of common stock. Net cash flows provided by financing activities during the nine months ended September 30, 2017 primarily consisted of $6.7 million in proceeds from the sale of common stock, warrant exercises of $0.2 million and $1.4 million in proceeds from the issuance of promissory notes.

Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations is based upon its condensed consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make significant estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. These items are monitored and analyzed by management for changes in facts and circumstances, and material changes in these estimates could occur in the future. Our critical accounting policies, summarized below, are highly dependent upon subjective or complex judgements, assumptions and estimates. Changes in estimates are recorded in the period in which they become known. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from the Company’s estimates if past experience or other assumptions do not turn out to be substantially accurate.

Revenue Recognition

Net sales includes product sales, less excise taxes, customer programs and incentives. we recognize revenue by applying the following steps in accordance with ASC 606 – Revenue from Contracts with Customers: (i) identify the contract with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to each performance obligation in the contract; and (5) recognize revenue when each performance obligation is satisfied. For the comparative periods, revenue has not been adjusted and continues to be reported under ASC 605 – Revenue Recognition, record revenue when all four of the following criteria are met: (i) there is persuasive evidence that an arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is fixed or determinable; and (iv) collectability is reasonably assured.

We recognize sales when merchandise is shipped from a warehouse directly to wholesale customers (except in the case of a consignment sale). For consignment sales, which include sales to the OLCC, the Company recognizes sales upon the consignee’s shipment to the customer. Postage and handling charges billed to customers are also recognized as sales upon shipment of the related merchandise. Shipping terms are generally FOB shipping point, and title passes to the customer at the time and place of shipment or purchase by customers at a retail location. For consignment sales, title passes to the consignee concurrent with the consignee’s shipment to the customer. The customer has no cancellation privileges after shipment or upon purchase at retail locations, other than customary rights of return. We exclude sales tax collected and remitted to various states from sales and cost of sales. Sales from items sold through the Company’s retail location are recognized at the time of sale.

Sales received from online merchants who sell discounted gift certificates for our merchandise and tastings is deferred until the customer has redeemed the discounted gift certificate or the gift certificate has expired, whichever occurs earlier.

Customer Programs and Incentives

Customer programs and incentives, which include customer promotional discount programs, customer incentives and other payments, are a common practice in the alcohol beverage industry. The Company makes these payments to customers and incurs these costs to promote sales of products and to maintain competitive pricing. Amounts paid in connection with customer programs and incentives are recorded as reductions to net revenue or as advertising, promotional and selling expenses based on the nature of the expenditure. Amounts paid to customers totaled $192,801 and $118,389 for the nine months ended September 30, 2018 and 2017, respectively.

Inventories

Inventories primarily consist of bulk and bottled liquor and merchandise and are stated at the lower of cost or market. Cost is determined using an average costing methodology, which approximates cost under the first-in, first-out (FIFO) method. A portion of inventory is held by the OLCC on consignment until it is sold to a third party. The Company regularly monitors inventory quantities on hand and records write-downs for excess and obsolete inventories based primarily on the Company’s estimated forecast of product demand and production requirements. Such write-downs establish a new cost basis of accounting for the related inventory. We have recorded no write-downs of inventory for the nine months ended September 30, 2018 and 2017.

Excise Taxes

The Company is responsible for compliance with Alcohol and Tobacco Tax and Trade Bureau (TTB) regulations, which includes making timely and accurate excise tax payments. The Company is subject to periodic compliance audits by the TTB. Individual states also impose excise taxes on alcohol beverages in varying amounts. The Company calculates its excise tax expense based upon units produced and on its understanding of the applicable excise tax laws. Excise taxes totaled $360,229 and $654,136 for the nine months ended September 30, 2018 and 2017, respectively.

Stock-Based Compensation

The Company recognizes as compensation expense all stock-based awards issued to employees in accordance with the fair value recognition provisions of Accounting Standards Codification Topic 718, Compensation - Stock Compensation. The compensation cost is measured based on the grant-date fair value of the related stock-based awards and is recognized over the service period of stock-based awards, which is generally the same as the vesting period. The fair value of stock options is determined using the Black-Scholes valuation model, which estimates the fair value of each award on the date of grant based on a variety of assumptions including expected stock price volatility, expected terms of the awards, risk-free interest rate, and dividend rates, if applicable. Stock-based awards issued to nonemployees are recorded at fair value on the measurement date and are subject to periodic market adjustments as the underlying stock-based awards vest. Stock-based compensation was $986,193 and $900,130 for the nine months ended September 30, 2018 and 2017, respectively.

Off-Balance Sheet Arrangements

We have no significant off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material.

Recent Accounting Pronouncements

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date:

Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The new lease guidance simplified the accounting for sale and leaseback transactions primarily because lessees must recognize lease assets and lease liabilities. Lessees will no longer be provided with a source of off-balance sheet financing. Public business entities should apply the amendments in ASU 2016-02 for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019, for a calendar year entity). Early application is permitted for all public business entities upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. We are currently evaluating the impact ASU 2016-02 will have on the Company’s condensed consolidated financial statements.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). ASU 2014-09 will supersede virtually all existing revenue guidance. Under this update, an entity is required to recognize revenue upon transfer of promised goods or services to customers, in an amount that reflects the expected consideration received in exchange for those goods or services. As such, an entity will need to use more judgment and make more estimates than under the current guidance. ASU 2014-09 is to be applied retrospectively either to each prior reporting period presented in the financial statements, or only to the most current reporting period presented in the financial statements with a cumulative effect adjustment to retained earnings. The Company will elect to apply the impact (if any) of applying ASU 2014-09 to the most current reporting period presented in the financial statements with a cumulative effect adjustment to retained earnings. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. ASU 2015-14 deferred the effective date of ASU 2014-09 for one year, making it effective for the year beginning December 31, 2017, with early adoption permitted as of January 1, 2017. We adopted ASU 2014-09 as of January 1, 2018. The Company does not believe the adoption of ASU 2014-09 had any material impact on its condensed consolidated financial statements.

ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this item.

ITEM 4 – CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”) that are designed to provide reasonable assurances that the information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.

In connection with the preparation of this quarterly report on Form 10-Q, an evaluation was carried out by our management, with the participation of the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

As of the end of the period covered by this report, there have been no changes in internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) during the quarter ended September 30, 2018, that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

ITEM 1 – LEGAL PROCEEDINGS

We are not currently subject to any material legal proceedings; however, we could be subject to legal proceedings and claims from time to time in the ordinary course of our business. Regardless of the outcome, litigation is time consuming and expensive to resolve, and it diverts management resources.

ITEM 1A – RISK FACTORS

An investment in our common stock involves risks. You should carefully consider the risk factors listed below together with those discussed under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2017. The risks and uncertainties we have described are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our operations. If any of these risks actually occurs, our business, results of operations, and financial condition could suffer, and you could lose your investment in us.

The Company’s organizational structure remains under development and the Company’s rapid growth continually stretches our personnel in terms of time and expertise.

Our growth over the past several years has benefited from an expanding product line (e.g., our Redneck Riviera Whiskey), key consultations with industry experts (e.g., our collaboration with Sandstrom Partners), celebrity sponsorships (e.g., John Rich), and strategic acquisitions (e.g., MotherLode and Big Bottom Distillery). While we believe our diversified approach to growth has been relatively successful, such growth has put extra demands on our management, as has the need for greater resources to maintain our expanded product line and key relationships. With so many new products and initiatives (e.g., canning wine), many of which remain unproven in the market, the Company’s ability to manage and evolve continues to require that it constantly assess and optimize the skillsets of its members of management, and there are no guarantees that the Company will succeed in organizing itself as efficiently or effectively as will prove to be necessary to succeed, or that the Company will be able to attract and retain members of management who are adequately able to handle the Company’s ever-evolving needs.

Worldwide and domestic economic trends and financial market conditions could adversely impact our financial performance.

We are subject to risks associated with worldwide and domestic economic conditions, including economic slowdowns and the disruption, volatility and tightening of credit and capital markets. Although economic conditions in the United States have improved since the economic downturn several years ago, future economic deterioration in the United States or worldwide could adversely impact our major suppliers, distributors and retailers. The inability of suppliers, distributors or retailers to conduct business or to access liquidity could impact our ability to distribute our products. There can be no assurance that market conditions will not deteriorate in the near future. A prolonged downturn, worsening or broadening of the adverse conditions in the worldwide and domestic economies could affect consumer spending patterns and purchases of our products, and create or exacerbate credit issues, cash flow issues and other financial hardships for us and for our suppliers, distributors, retailers and consumers. Depending upon their severity and duration, these conditions could have a material adverse impact on our business, liquidity, financial condition and results of operations.

We depend on our independent wholesale distributors to distribute our products. The failure or inability of even a few of our distributors to distribute our products adequately within their territories could harm our sales and result in a decline in our results of operations.

We are required by law to use state-licensed distributors or, in 18 states known as “control states,” state-owned agencies performing this function, to sell our products to retail outlets, including liquor stores, bars, restaurants and national chains in the U.S. We have established relationships for our brands with a limited number of wholesale distributors; however, failure to maintain those relationships could significantly and adversely affect our business, sales and growth.

On an ongoing basis, the Company evaluates its distribution agreements and may modify or terminate such agreements, or enter into new distribution agreements based upon sales and marketing objectives of the Company and other economic considerations. Over the past decade there has been increasing consolidation, both intrastate and interstate, among distributors. As a result, many states now have only two or three significant distributors. Also, there are several distributors that now control distribution for several states. If we fail to maintain good relations with a distributor, our products could in some instances be frozen out of one or more markets entirely. The ultimate success of our products also depends in large part on our distributors’ ability and desire to distribute our products to our desired U.S. target markets, as we rely significantly on them for product placement and retail store penetration. In addition, all of our distributors also distribute competitive brands and product lines. We cannot assure you that our U.S. alcohol distributors will continue to purchase our products, commit sufficient time and resources to promote and market our brands and product lines or that they can or will sell them to our desired or targeted markets. If they do not, our sales will be harmed, resulting in a decline in our results of operations.

ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

The following list sets forth information regarding all securities sold or granted by us during the period covered by this report that were not registered under the Securities Act, and the consideration, if any, received by us for such securities, which proceeds has been or will be used by us for general working capital purposes. The securities were offered and sold in reliance on the exemption from registration afforded by Section 4(a)(2) or Rule 506(b) of Regulation D promulgated under the Securities Act, which exempt transactions by an issuer not involving any public offering. The purchasers were “accredited investors,” as such term is defined in Regulation D. The securities are non-transferable in the absence of an effective registration statement under the Act or an available exemption therefrom, and all certificates are imprinted with a restrictive legend to that effect.

During the first nine months of 2018, the Company completed a private offering of promissory notes and accompanying warrants in which it raised $4,552,980 in gross proceeds. The promissory notes bear interest at 8% per annum, payable monthly on the last day of the month. The entire amount of principal and any accrued and unpaid interest is due and payable on May 1, 2021. For every $100,000 in principal, the Company issued to the investor 10,000 common stock purchase warrants, for a total of 125,000 warrants. The warrants, which are identical to the warrants that were issued in the Company’s public offering that was consummated in August 2017, are exercisable through August 10, 2022, unless earlier redeemed, at an exercise price of $5.40, subject to adjustment for stock splits, reverse splits and other similar recapitalization events. The Company has the option to redeem all or a part of the outstanding warrants at any time after the closing price of the Company’s common stock exceeds $7.65 for five consecutive trading days. In electing to redeem the warrants, the Company will provide 30 days’ notice of the redemption date, during which time the holders of outstanding warrants will have the opportunity to exercise their warrants at the exercise price then in effect. Any warrants remaining outstanding at the close of business on the 30th day of the notice period will be redeemed at a price of $0.15 per warrant, after which, the warrants will be cancelled.

During the first nine months of 2018, we issued 10,025 shares to our partner, Sandstrom Partners, as part of their branding work on our products, and 7,500 shares to two different service providers for services rendered.

ITEM 3 – DEFAULT UPON SENIOR SECURITIES

None

ITEM 4 – MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5 – OTHER INFORMATION

Not applicable.

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.