Generation Alpha, Inc. - Quarter Report: 2019 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 2019

For the transition period from __________ to __________

Commission File Number: 000-53635

GENERATION ALPHA, INC.

(Exact name of registrant as specified in its charter)

853 Sandhill Ave.

Carson, CA 90746

(Address of principal executive offices) (Zip code)

(888) 998-8881

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [  ]

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

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

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

Securities registered pursuant to Section 12(b) of the Act: None.

The number of shares of registrant’s common stock outstanding as of August 13, 2019 was 46,320,564.

GENERATION ALPHA, INC.

INDEX

PART I - FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements.

GENERATION ALPHA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these condensed consolidated financial statements.

GENERATION ALPHA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

GENERATION ALPHA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ DEFICIT

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

GENERATION ALPHA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ DEFICIT

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

GENERATION ALPHA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ DEFICIT

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

GENERATIONAL ALPHA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

The accompanying notes are integral part of these condensed consolidated financial statements

GENERATION ALPHA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2019 AND 2018

(UNAUDITED)

NOTE 1 – BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Generation Alpha, Inc. and its subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all normal recurring adjustments considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.

History and Organization

Generation Alpha, Inc. (the “Company”) was originally incorporated under the laws of the State of Nevada on March 2, 2007 as Cinjet, Inc. (“Cinjet”). Effective September 1, 2015, Cinjet changed its corporate name to Solis Tek Inc. (“Solis Tek”). Effective September 25, 2018, the Company entered into an agreement and plan of merger (the “Merger Agreement”), whereby a wholly-owned subsidiary of the Company (the “Merger Sub”) was merged into the Company (the “Merger”). Upon consummation of the Merger, the separate existence of Merger Sub ceased and the Company changed its name from Solis Tek to Generation Alpha, Inc. On June 23, 2015, the Company entered into an Agreement of Merger and Plan of Reorganization (the “Agreement”) with Solis Tek Inc., a California corporation (“STI”), and CJA Acquisition Corp., a California corporation and a wholly owned subsidiary of the Company (“Merger Sub”), providing for the merger of Merger Sub with and into STI (the “Merger”), with STI surviving the Merger as a wholly-owned subsidiary of the Company. The Merger was accounted for as a recapitalization of the Company with STI being deemed the accounting acquirer.

Overview of Business

The Company is a vertically integrated technology innovator, developer, manufacturer and distributor focused on bringing products and solutions to commercial and retail cannabis growers in both the medical and adult use recreational space in legal markets across the U.S. The Company’s lighting and nutrient customers include retail stores, distributors and commercial growers in the United States and abroad.

Going Concern

The accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities and commitments in the normal course of business. As reflected in the accompanying condensed consolidated financial statements, during the six months ended June 30, 2019, the Company incurred a net loss of $2,235,649 and used cash in operations of $717,355 and had a shareholders’ deficit of $5,404,912 as of June 30, 2019. These factors raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date of the financial statements being issued. The ability of the Company to continue as a going concern is dependent upon the Company’s ability to raise additional funds and implement its business plan. The financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. In addition, the Company’s independent registered public accounting firm, in its report on the Company’s December 31, 2018 financial statements, has raised substantial doubt about the Company’s ability to continue as a going concern.

At June 30, 2019, the Company had cash on hand in the amount of $240,012. Management estimates that the current funds on hand will be sufficient to continue operations through September 2019. The continuation of the Company as a going concern is dependent upon its ability to obtain necessary debt or equity financing to continue operations until it begins generating positive cash flow. No assurance can be given that any future financing will be available or, if available, that it will be on terms that are satisfactory to the Company. Even if the Company is able to obtain additional financing, it may contain undue restrictions on its operations, in the case of debt financing or cause substantial dilution for the Company’s stock holders, in case or equity financing.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries: STI; Solis Tek East, Corporation (“STE”), an entity incorporated under the laws of the State of New Jersey, Zelda Horticulture, Inc. (“Zelda”), an entity incorporated under the laws of the State of California, and YLK Partners NV, LLC (“YLK”), Generation Alpha Brands, Inc., Trilogy Dispensaries, Inc., Extracting Point, LLC (“Extracting Point”), and GrowPro Solutions, Inc., all entities formed under the laws of Nevada. Intercompany transactions and balances have been eliminated in consolidation.

Leases

Prior to January 1, 2019, the Company accounted for leases under ASC 840, Accounting for Leases. Effective January 1, 2019, the Company adopted the guidance of ASC 842, Leases (“ASC 842”), which requires an entity to recognize a ROU asset and a lease liability for virtually all leases. The Company adopted ASC 842 using a modified retrospective approach. As a result, the comparative financial information has not been updated and the required disclosures prior to the date of adoption have not been updated and continue to be reported under the accounting standards in effect for those periods. The adoption of ASC 842 on January 1, 2019 resulted in the recognition of operating lease ROU assets of and, lease liabilities for operating leases of $659,347. There was no cumulative-effect adjustment to accumulated deficit. As discussed in Note 6, the Company did not record a ROU asset and lease liability for the net present value of future lease obligations for the lease of real property in Arizona.

Loss per Share Calculations

Basic earnings per share are computed by dividing net income (loss) available to common shareholders by the weighted-average number of common shares available. Diluted earnings per share is computed by dividing the net income applicable to common stock holders by the weighted average number of common shares outstanding plus the number of additional common shares that would have been outstanding if all dilutive potential common shares had been issued using the treasury stock method. Potential common shares are excluded from the computation when their effect is antidilutive. The dilutive effect of potentially dilutive securities is reflected in diluted net income per share if the exercise prices were lower than the average fair market value of common shares during the reporting period.

For the six months ended June 30, 2019, options to acquire 8,314,391 shares of common stock, warrants to acquire 12,783,140 shares of common stock, and 3,000,000 shares to be issued upon conversion of our convertible note have been excluded from the calculation of weighted average common shares, as their effect would have been anti-dilutive. For the six months ended June 30, 2018, options to acquire 3,000,000 shares of common stock and warrants to acquire 13,783,140 shares of common stock and shares potentially issuable under our convertible note agreements have been excluded from the calculation of weighted average common shares outstanding at June 30, 2018, as their effect would have been anti-dilutive.

Use of Estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the U.S requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the financial statement date, and reported amounts of revenue and expenses during the reporting period. Significant estimates are used in valuing our allowances for doubtful accounts, reserves for inventory obsolescence, estimates for potential losses on lease abandonments, assumptions made in valuing derivative liabilities, valuing equity instruments issued for services, and valuation allowance for deferred tax assets, among others. Actual results could differ from these estimates.

Revenue Recognition

The Company recognizes revenue in accordance with Accounting Standard Update (“ASU”) No. 2014-09. This new standard provides authoritative guidance clarifying the principles for recognizing revenue and developing a common revenue standard for U.S. generally accepted accounting principles. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in the exchange for those goods or services.

Under this guidance, revenue is recognized when control of promised goods or services is transferred to the Company’s customers, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. The Company reviews its sales transactions to identify contractual rights, performance obligations, and transaction prices, including the allocation of prices to separate performance obligations, if applicable. Revenue and costs of sales are recognized once products are delivered to the customer’s control and performance obligations are satisfied.

All products sold by the Company are distinct individual products and consist of advanced energy efficient indoor horticulture lighting, plant nutrient products, and ancillary equipment. The products are offered for sale as finished goods only, and there are no performance obligations required post-shipment for customers to derive the expected value from them. Contracts with customers contain no incentives or discounts that could cause revenue to be allocated or adjusted over time.

The Company does not offer a general right of return on any of its sales and considers all sales as final. The Company generally provides a three-year warranty on its ballasts. However, the Company does not maintain a warranty reserve as the Company is able to chargeback its vendors for all warranty claims. As of June 30, 2019 and December 31, 2018, the Company recorded reserves for returned product in the amounts of $52,149 and $143,947, respectively, which reduced the accounts receivable balances as of those periods.

Inventories

Inventories are stated at the lower of cost or market. Cost is computed on a first-in, first-out basis. The Company’s inventories consist almost entirely of finished goods as of June 30, 2019 and December 31, 2018.

The Company provides inventory reserves based on excess and obsolete inventories determined primarily by future demand forecasts. The write down amount is measured as the difference between the cost of the inventory and market based upon assumptions about future demand and charged to the provision for inventory, which is a component of cost of sales. At the point of the loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. At June 30, 2019 and December 31, 2018, the reserve for excess and obsolete inventory was $420,200 and $910,778, respectively.

Concentration Risks

The Company maintains the majority of its cash balances with one financial institution, in the form of demand deposits. During the six month period ended June 30, 2019 and the year ended December 31, 2018, the Company had cash deposits that exceeded the federally insured limit of $250,000. The Company believes that no significant concentration of credit risk exists with respect to these cash balances because of its assessment of the creditworthiness and financial viability of the financial institution.

The Company operates in markets that are highly competitive and rapidly changing. Significant technological changes, shifting customer needs, the emergence of competitive products or services with new capabilities, and other factors could negatively impact the Company’s operating results. State and federal government laws could have a material adverse impact on the Company’s future revenues and results of operations.

The Company’s products require specific components that currently are available from a limited number of sources. The Company purchases some of its key products and components from single vendors. During the six months ended June 30, 2019 and 2018, its ballasts, lamps and reflectors, which comprised the majority of the Company’s purchases during those periods, were each only purchased from one separate vendor.

The Company performs a regular review of customer activity and associated credit risks and does not require collateral or other arrangements. No customer accounted for more than 10% of the Company’s revenue for the three months ended June 30, 2019, and two customers accounted for 29% and 10% of the Company’s revenue for the three months ended June 30, 2018. No customer accounted for more than 10% of the Company’s revenue for the six months ended June 30, 2019, and one customer accounted for 12% of the Company’s revenue for the six months ended June 30, 2018. Shipments to customers outside the United States were less than 5% for both the three month periods ended June 30, 2019 and 2018.

As of June 30, 2019, one customer accounted for 11% of the Company’s trade accounts receivable balance, and as of December 31, 2018, four customers accounted for 37%, 14%, 13% and 12% of the Company’s trade accounts receivable.

Fair Value Measurements

The Company determines the fair value of its assets and liabilities based on the exchange price in U.S. dollars that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs. The Company uses a fair value hierarchy with three levels of inputs, of which the first two are considered observable and the last unobservable, to measure fair value:

The carrying amounts of financial instruments such as cash, accounts receivable, inventories, and accounts payable and accrued liabilities, approximate the related fair values due to the short-term maturities of these instruments.

The fair value of the derivative liabilities of $761,478 and $2,160,806 at June 30, 2019 and December 31, 2018, respectively, was valued using Level 3 inputs.

Derivative Financial Instruments

The Company evaluates its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the consolidated statements of operations. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the end of each reporting period. Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date.

Intangible Assets

The Company accounts for intangible assets in accordance with the authoritative guidance issued by the Financial Accounting Standards Board (“FASB”). Intangibles are valued at their fair market value and are amortized taking into account the character of the acquired intangible asset and the expected period of benefit. The Company evaluates intangible assets for impairment, at a minimum, on an annual basis and whenever events or changes in circumstances indicate that the carrying value may not be recoverable from its estimated undiscounted future cash flows. Recoverability of intangible assets is measured by comparing their net book value to the related projected undiscounted cash flows from these assets, considering a number of factors, including past operating results, budgets, economic projections, market trends and product development cycles. If the net book value of the asset exceeds the related undiscounted cash flows, the asset is considered impaired, and a second test is performed to measure the amount of impairment loss.

At December 31, 2018, the Company had intangible assets of $1,301,591 that consisted of a license right. In June 2019, and based on management’s assessment, it was determined that the intangible asset was impaired, and an impairment charge was recorded for $1,138,892 during the three and six month period ended June 30, 2019 (see Note 4).

Recently Issued Accounting Pronouncements

Recent accounting pronouncements issued by the FASB, including its Emerging Issues Task Force, the American Institute of Certified Public Accountants, and the Securities and Exchange Commission are not believed by management to have a material impact on the Company’s present or future consolidated financial statements.

NOTE 3 - PROPERTY AND EQUIPMENT

Property and equipment consists of the following June 30, 2019 and December 31, 2018:

Depreciation expense for the three months ended June 30, 2019 and 2018 was $9,130 and $13,158, and $18,921 and $31,068, respectively, for the six months ended June 30, 2019 and 2018.

During the six months ended June 30, 2019, the Company incurred leasehold improvements of $217,562, and subsequently terminated its Arizona facility lease thereby abandoning $217,562 of leasehold improvements during the six months ended June 30, 2019. The Company recorded the abandonment of leasehold improvements as a component of operating expense in the condensed consolidated statement of operations (see Note 6).

NOTE 4 – LICENSE AGREEMENT ACQUIRED FROM RELATED PARTIES

License agreement acquired from related parties as of June 30, 2019 and December 31, 2018, consisted of the following:

On May 10, 2018, the Company entered into an acquisition agreement (the “Acquisition Agreement”) with the members (the “Sellers”), which in the aggregate, owned 100% of the membership interests in YLK. Pursuant to the Acquisition Agreement, in consideration of the Company acquiring all of the outstanding membership interests of YLK, the Company issued to the Sellers, a total of 5,000,000 warrants (the “Warrants”) to purchase 5,000,000 common shares, at an exercise price of $0.01 per share. The Warrants are exercisable until May 9, 2023. The aggregate fair value of the Warrants issued as consideration for the acquisition was determined to be $5,450,000.

The Sellers were the following, who were determined to be related parties:

The major asset of YLK is a Cultivation Management Services Agreement (the “Management Agreement”) with an Arizona licensee (the “Arizona Licensee”) that was entered into on January 5, 2018. No operating activity existed prior to the acquisition. The Arizona Licensee is authorized to operate a medical marijuana dispensary, one (1) onsite facility and one (1) offsite facility, to produce, sell and dispense medical marijuana and manufactured and derivative products that contain marijuana pursuant to Title 9; Chapter 17 of the Arizona Department of Health Services (“AZDHS”) Medical Marijuana Program and Arizona Revised Statute § 36-2801 et seq., as amended from time to time. Pursuant to the Management Agreement, YLK will provide the management services for the offsite facility, on behalf of the Arizona Licensee. The assets acquired also included a $250,000 receivable from Future Farm Technologies.

As consideration for the exclusive right of YLK to manage the Arizona Licensee’s facility pursuant to the Management Agreement; (i) YLK paid $750,000 to the Arizona Licensee; (ii) YLK agreed to pay an additional $250,000 within 10 days after receipt of the AZDHS approval to operate the facility; and (iii) YLK agreed to pay a total of $600,000, payable in 44 equal monthly installments commencing on April 1, 2019 (the “Installment Payments”). The term of the Management Agreement is five years. YLK has the option to extend the term for an additional five years with the payment of $1,000,000 at the commencement of the additional term and a total of $1,000,000 payable in equal monthly installments over the extended term of the Management Agreement. Before the acquisition, the Sellers paid $750,000 per the terms of the Management Agreement.

Through the acquisition, the Sellers’ rights and obligations under the CMSA transferred to the Company, including the payment of an additional $250,000 within 10 days after receipt of the AZDHS approval to operate the facility; and the Installment Payments. As the Installment Payments totaling $600,000 are noninterest bearing, the Company calculated the net present value of the Installment Payments to be $518,523 (or a discount of $81,477) based on an 8% cost of capital (which is consistent with borrowing rate of the Company’s other notes). The Company recorded the aggregate present value of these payments of $518,523 as part of the acquisition cost of the Management Agreement, which will be amortized over five years, the length of the Management Agreement. Amortization expense for three months ended June 30, 2019 and 2018, was $81,349 and $162,699, and for the six months ended June 30, 2019 and 2018, $81,349 and $81,349, respectively.

Since the assets, including a $250,000 balance due from Future Farm Technologies, was acquired from related parties, the assets were recorded at their historical acquisition cost of $1,000,000. The Company issued 5,000,000 Warrants to the Sellers with an exercise price of $0.01 and an expiration date of May 9, 2023. Based on a Black-Sholes Merton model, the Warrants were valued at $5,450,000. Since the assets acquired were acquired from related parties, the difference of $4,450,000 between the fair value of the Warrants granted of $5,450,000 and the historical acquisition cost of $1,000,000 was recorded as related party compensation cost in the accompanying condensed consolidated statements of operations. The $250,000 receivable was received by the Company during the year ended December 31, 2018.

In June 2019, the Company determined that its intangible assets were impaired after assessing the impact of the Company’s current lack of liquidity, the recent lease abandonment of its planned Arizona cultivation facility (Note 6), and the recent Deed in Lieu of Foreclosure Release and Settlement Agreement with its Lender of a facility in Arizona (Note 9). The Company based on its assessment, recorded an impairment charge of $1,138,892 during the three and six month periods ended June 30, 2019.

As of December 31, 2018, the remaining Management Agreement obligation was $781,408 (net of discount of $68,592) for which $372,727 is reflected as current and $408,681 was reflected as long term in the accompanying condensed consolidated balance sheet. As of June 30, 2018, the remaining Management Agreement obligation was $789,998 (net of discount of $60,002) for which $454,545 is reflected as current and $335,453 was reflected as long term in the accompanying condensed consolidated balance sheet. As of June 30, 2019, the Company is past due on its Installment Payments obligations under the Management Agreement.

NOTE 5 – NOTES PAYABLE TO RELATED PARTIES

Notes payable to related parties consists of the following at June 30, 2019 and December 31, 2018:

As of June 30, 2019 and December 31, 2018, accrued interest on the notes payables to related parties was $133,804 and $125,039, respectively. During the six months ended June 30, 2019, the Company added $27,964 of additional accrued interest and made interest payments of $19,200.

NOTE 6 – LEASE PAYABLE

The Company has one lease agreement for office spaces with a remaining lease terms of 4 years as of June 30, 2019. Leases with an initial term of 12 months or less are not recorded on the balance sheet. The Company accounts for the lease and non-lease components of its leases as a single lease component. Rent expense is recognized on a straight-line basis over the lease term.

Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Generally, the implicit rate of interest in arrangements is not readily determinable and the Company utilizes its incremental borrowing rate in determining the present value of lease payments. The Company’s incremental borrowing rate is a hypothetical rate based on its understanding of what its credit rating would be. The operating lease ROU asset includes any lease payments made and excludes lease incentives.

The components of rent expense and supplemental cash flow information related to leases for the period are as follows:

The supplemental balance sheet information related to leases for the period is as follows:

Maturities of the Company’s lease liabilities are as follows:

Rent expense for the three months ended June 30, 2019 and 2018 was $63,413 and $91,172, respectively, and $278,623 and $162,908, respectively, for the six months ended June 30, 2019 and 2018.

Lease Abandonment

On April 19, 2018, the Company entered into an Option Agreement, or the Option, with MSCP, LLC, a non-affiliated Arizona limited liability company, or the Lessor, pursuant to which, the Company’s subsidiary was granted an option to enter into a certain Lease Agreement, or the Lease, for the real property, including the structure and all improvements, identified in the Option, or the Premises. The Premises consists of 70,000 square feet of space and is to be used for the sole purpose of providing services related to the management, administration and operation of a cultivation and processing facility, or the Facility, on behalf of an Arizona limited liability company operating as a nonprofit organization, or the Arizona Licensee, which has been allocated a Medical Marijuana Dispensary Registration Certificate by the Arizona Department of Health Services. The activities within the Facility shall be limited to the cultivation, processing, production and packaging of medical marijuana and manufactured and derivative products which contain medical marijuana, with no right to sell or dispense any such plants or products. The Lease is for a 5-year initial term, or the Term, with an option to renew for an additional 5 year term. The base rent for the initial year of the Term is $101,500 per month with additional pro-rata net-lease charges. As consideration for the Option, the Company paid to Lessor, $160,000, or the Deposit.

On May 19, 2018, the Company exercised the Option and YLK executed the Lease, and the Deposit was treated a security deposit and rent advance, in accordance with the terms and conditions of the Lease. The Company is a guarantor of YLK’s obligations under the Lease, on behalf of Arizona Licensee.

As discussed in Note 10, the Company provided MSCP a notice of termination, and on February 15, 2019, MSCP, L.L.C (“MSCP”), filed suit in the Superior Court of Arizona, County of Maricopa, Case No. CV2019-001613 against the Company and YLK. The Company recently filed counterclaims against MSCP for fraud in the inducement, negligent misrepresentation, breach of the implied covenant of good faith and fair dealing, rescission of contract, unjust enrichment and punitive damages. The Company intends to vigorously defend this action. At the date of notice of termination, the Company had a remaining lease obligation of approximately $6,000,000. Due to the lease termination, the Company excluded the lease as a ROU asset and lease liabilities, and due to its counterclaims, is unable to determine and did not record, any estimate of liability at June 30, 2019.

As required by ASC 842, the Company must record a ROU asset and lease liability of $4,839,000 at January 1, 2019 for the net present value of future lease obligations related to the Arizona property. However, due to actions of the lessor and upon advice of counsel, management believes that it is no longer obligated under the terms of the lease and accordingly has not recorded the asset and related liability. If the Company were obligated to the lessor, the assets and liabilities of the accompanying balance sheet would increase by $4,839,000, and such assets could be subject to an impairment change of the same amount.

No liabilities have been provided for losses incurred on the Company’s early termination of the lease, as such amounts are not practicably determinable.

NOTE 7 – LOAN PAYABLE

Loan payable consisted of the following as of June 30, 2019 and December 31, 2018:

NOTE 8 – CONVERTIBLE SECURED NOTE PAYABLE TO RELATED PARTY

Secured note payable to related party consists of the following as of June 30, 2019 and December 31, 2018:

On May 10, 2018, the Company issued a secured debenture (the “2018 Note”) to YA II PN Ltd. (“YA II PN”) in the principal amount of $1,500,000 with interest at 8% per annum (18% on default) and due on February 9, 2019. The 2018 Note was amended effective February 9, 2019 (see below). The 2018 Note is secured by all the assets of the Company and its subsidiaries. As part of the issuance, the Company also granted YA II PN 5-year warrants to purchase a total of 7,500,000 shares of the Company per the following terms.

The Company determined that the exercises prices of the warrants were not a fixed amount because they were subject to an adjustment based on the occurrence of future events. As such, the Company determined that the conversion feature and the warrants created a derivative with a fair value of $7,677,406 at the date of issuance. The Company accounted for the fair value of the derivative up to the face amount of the 2018 Note of $1,500,000 as a valuation discount to be amortized over the life of the 2018 Note, and the excess of $6,177,406 was recorded as a finance cost for the twelve months ended December 31, 2018. During the six months ended June 30, 2019, amortization of valuation discount was $247,032 was recorded as an interest cost, leaving no remaining unamortized balance of the valuation discount at June 30, 2019.

Amendment to Secured Note Payable to Related Party

On February 25, 2019, the Company entered into an amendment agreement (the “Amendment”) with YA II PN, which amended (i) the secured promissory note in the principal face amount of $1.5 million issued on May 10, 2018 (the “Note”), (ii) a warrant, dated May 10, 2018 for 1,000,000 shares of the Company’s common stock at an exercise price of $1.50 (“Warrant #1”), (iii) a warrant, dated May 10, 2018 for 2,250,000 shares of the Company’s common stock at an exercise price of $1.50 (“Warrant #2”), (iv) a warrant, dated May 10, 2018 for 2,250,000 shares of the Company’s common stock at an exercise price of $1.50 (“Warrant #3”), and (v) a warrant, dated May 10, 2018 for 2,000,000 shares of the Company’s common stock at an exercise price of $1.50 (“Warrant #4”, and together with Warrant #1, Warrant #2 and Warrant #3, the “Warrants”).

Pursuant to the Amendment, the Note was amended to (i) extend the maturity date of the Note from February 9, 2019 to August 9, 2019 and (ii) provide a conversion right, in which the principal amount of the Note, together with any accrued but unpaid interest, could be converted into the Company’s common stock at a conversion price of $0.50 a share. The Note was not convertible previously.

In addition, pursuant to the Amendment, the Warrants were amended to (i) reduce the exercise price from $1.50 per share to $0.50, $0.75, $1.00 and $1.25 per share for Warrant #1, Warrant #2, Warrant #3 and Warrant #4, respectively, and (ii) remove in Warrant #2, Warrant #3 and Warrant #4, the Company’s right of redemption and right to compel exercise of such Warrants. The Company calculated the fair market value of the Warrants before and after the modifications above, and recorded the difference of $129,384 as a financing cost included in other expenses during the six months ended June 30, 2019.

The Note was not repaid as of August 9, 2019, and has subsequently become past due.

NOTE 9 – ACQUISITION OF FACILITY, LOAN AGREEMENT, AND SUBSEQUENT SETTLEMENT

Acquisition of Facility

On April 2, 2019, the Company, through its newly-formed wholly-owned subsidiary Extracting Point, entered into an agreement to purchase real property located at 2601 West Holly Street in Phoenix, Arizona (the “Property”) for $3,500,000. The Property holds the approval and authorization for a Conditional Use Permit, which allows the Property to be used for the operation of a cultivation and infusion facility, allowing for the cultivation, harvesting, preparation, packaging and storing of medical cannabis, as well as extraction, refinement, infusion, production, preparation, packaging, and storage of manufactured and derivative oils, waxes, concentrates, edible and non-edible products that contain cannabis.

Loan Agreement

On April 2, 2019, Extracting Point entered into a loan agreement (the “Loan Agreement”) with Michael Cannon and Jennifer Cannon, Trustees of the Core 4 Trust Dated February 29, 2016 (the “Lender”), pursuant to which Extracting Point borrowed $3,500,000 from the Lender (the “Loan”). The Loan is evidenced by an installment note – interest included (the “Note”), guaranteed by the Company pursuant to a corporate guaranty (the “Guaranty”) and is secured by a first priority lien on the Property pursuant to a deed of trust and assignment of rents between Extracting Point and Thomas Title & Escrow, for the benefit of the Lender (the “Deed of Trust”). Extracting Point used the net proceeds from the Loan to acquire the Property.

The Note, together with accrued and unpaid interest, was due and payable on March 31, 2024 (the “Maturity Date”). Interest on the Note was to accrue at the rate of 10% per annum. For the first 12 months, Extracting Point was to pay the Lender interest only of $29,167 per month. After the first 12 months, Extracting Point was to pay the Lender principal and interest of $88,769 per month. Extracting Point had the right to prepay the Note at any time, however, Extracting Point agreed to pay the first 36 months of interest, even if the Note was repaid prior to that date.

As additional consideration for the issuance of the Loan, Extracting Point and the Company agreed to pay the Lender an amount equal to five percent (5%) of the management fees (the “Management Royalty”) received relating to the services rendered on the Property, for a period of three years from the date an “Approval to Operate” is granted by the Arizona Department of Health Services (such date, the “Commencement Date”). In the event that the Commencement Date has not occurred on or prior to April 2, 2021, then Extracting Point and the Company agreed to pay the Lender an amount equal to five percent (5%) of the fair market value of the rent of the Property as if the Property was fully occupied (the “Rental Royalty”), such payments to be made each month for a period of thirty-six months, provided, that, if the Commencement Date occurs after the Rental Royalty has commenced, the Rental Royalty payments shall cease and the Management Royalty payments shall commence, and any amounts paid as a Rental Royalty shall be credited against any Management Royalty owed.

In connection with the Loan, the Company issued to the Lender a warrant (the “Warrant”) to purchase 1,000,000 shares of the Company’s common stock, exercisable for five years from issuance at an exercise price of $1.00 per share. The Warrant exercise price is subject to adjustment only in the event of a stock dividend or split.

Settlement Agreement

On May 24, 2019, the Company and Extracting Point entered into a Deed in Lieu of Foreclosure Release and Settlement Agreement (the “Settlement Agreement”) with the Lender. Pursuant to the Settlement Agreement, Extracting Point executed a Deed in Lieu of Foreclosure (the “Deed”), conveying the real property located at 2601 West Holly Street in Phoenix, Arizona to the Lender.

In exchange, the Lender agreed to release the Company and Extracting Point from all their obligations under the Loan Agreement, the Note, the Deed of Trust and the Guaranty. Pursuant to the Settlement Agreement, the Loan Agreement, the Note, the Deed of Trust and the Guaranty were terminated. In addition, the Warrant was returned to the Company and canceled.

Extracting Point was delinquent in payment under the Note, and the Lender informed Extracting Point and the Company that unless payment was made current or an agreement reached between the parties, the Lender would declare Extracting Point in default, call the entire Note due and payable, record a notice of default of the Deed of Trust, and take any other actions it deemed necessary or appropriate against the Company and Extracting Point.

NOTE 10 – DERIVATIVE LIABILITY

The FASB has issued authoritative guidance whereby instruments which do not have fixed settlement provisions are deemed to be derivative instruments. The conversion prices and the exercise prices of the warrants described in Note 7 were not a fixed amount because they were either subject to an adjustment based on the occurrence of future offerings or events or they were variable. Since the number of shares is not explicitly limited, the Company is unable to conclude that enough authorized and unissued shares are available to settle the conversion option. In accordance with the FASB authoritative guidance, the conversion features have been characterized as derivative liabilities to be re-measured at the end of every reporting period with the change in value reported in the statement of operations.

As of June 30, 2019, and December 31, 2018, the derivative liabilities were valued using a Black Scholes Merton pricing model with the following assumptions:

The risk-free interest rate was based on rates established by the Federal Reserve Bank. The Company uses the historical volatility of its common stock to estimate the future volatility for its common stock. The expected life of the conversion feature of the notes was based on the remaining term of the notes. The expected dividend yield was based on the fact that the Company has not customarily paid dividends in the past and does not expect to pay dividends in the future.

The balance of the derivative liability at December 31, 2018 was $2,160,806. During the three and six months ended June 30, 2019, the Company recognized $1,627,056 and $1,528,712, respectively, as other income, which represented the change in the fair value of the derivative from the respective prior period. In addition, during the three and six months ended June 30, 2019, the Company recognized $0 and $129,384, respectively, which represented a change in the terms of warrants, and was recorded as a financing cost and included in other expense.

The balance of the derivative liability at December 31, 2017 was $4,869,082. During the three and six months ended June 30, 2018, the Company recognized $4,181,874 and $6,811,926, respectively, as other income, which represented the change in the fair value of the derivative from the respective prior period. In addition, during the three and six months ended June 30, 2018, the Company recognized $2,211,533 and 4,188,430, respectively, which represented the extinguishment of derivative liabilities, of which $1,715,173 and $2,389,437, respectively, was included in other income, and the remaining $496,350 and $1,799,003, respectively, was recorded to additional paid-in-capital. In addition, during the six months ended June 30, 2018, the Company recognized derivative liabilities of $7,677,406 upon issuance of warrants.

NOTE 11 – SHAREHOLDERS’ EQUITY

Common Shares Issued for Services

The Company entered into various consulting agreements with third parties (“Consultants”) pursuant to which these Consultants provided business development, sales promotion, introduction to new business opportunities, strategic analysis and, sales and marketing activities. During the six months ended June 30, 2019 and 2018, the Company issued an aggregate of 426,000 and 1,270,000 shares of common stock, respectively, to these consultants with a fair value of $177,850 and $1,636,800 at the date of grant, respectively, which was recognized as compensation cost.

Director Appointment and Consulting Agreement

On February 5, 2019, the Board of Directors of the Company increased the number of directors and appointed Mr. David Lenigas as a director of the Company, effective immediately. In connection with the appointment of Mr. Lenigas, the Company granted him 100,000 shares of common stock with a fair value of $63,000, or $0.63 per share, which vested immediately.

Effective February 5, 2019, the Company and Mr. Lenigas entered into a consulting agreement (the “Consulting Agreement”), pursuant to which the Company shall pay Mr. Lenigas a monthly consulting fee of $13,000 per calendar month for his marketing, branding, investor and public relations services. The Company also agreed, during the term of the Consulting Agreement, to issue Mr. Lenigas such number of shares of common stock equal to two percent of the total shares then issued and outstanding upon the Company’s common stock reaching a market capitalization (as defined in the Consulting Agreement) of $76 million for ten consecutive trading days, and an additional two percent for each additional $76 million market capitalization achieved for ten consecutive trading days, up to a market capitalization of $380 million. In addition, should the Company, during the consulting term or for a period of six months thereafter, enter into a transaction that constitutes a change of control in which the enterprise value (as defined in the Consulting Agreement) of the Company equals or exceeds, $500 million, then the Company agreed to pay Mr. Lenigas a bonus equal to 5% of such enterprise value. The Consulting Agreement has a term of two years, and may be terminated by either party after one year upon 30 days’ prior written notice. As of June 30, 2019, none of the milestones have been met and therefore, no compensation expense has been recorded during the period ended June 30, 2019.

Common Shares Issued for Cash

During the six months ended June 30, 2018, the Company received proceeds of $1,068,000 from the issuance of 821,538 shares of common stock, at $1.30 per share, as part of a Regulation D offering, and the Company received proceeds of $500,000 from YA II PN from the sale of 500,000 shares of common stock at $1.00 per share.

Common Shares Issued to Employees for Services

During the six months ended June 30, 2018, the Company issued 250,000 shares of common stock to its executives valued at $335,000 and recorded an additional $356,042 of stock-based compensation expense related to the vesting of common shares previously issued to its executive and an employee.

Common Shares Issued on Conversion of Series A Convertible Preferred Stock

During the six months ended June 30, 2018, the Company received notices of conversion to convert all of the outstanding Series A into common shares of the Company. Upon the conversion of the balance of the Series A, the Company issued 368,550 shares of common stock and no Series A were outstanding as of June 30, 2018. Upon conversion, the unamortized discount of $351,000 was reflected as an interest cost.

Common Shares Issued on Conversion of Convertible Note Payable

During the six months ended June 30, 2018, the Company was notified in writing that the Note holder elected to convert all remaining outstanding principal and interest accrued, which included the conversion of $1,750,000 of principal and $38,082 of interest. Upon the conversion of the Note, the Company issued an aggregate of 1,788,082 shares of its common stock. The balance of the debt discount of $1,555,556 was recorded as an interest cost during the six months ended June 30, 2018.

Summary of Stock Options

A summary of stock options for the six months ended June 30, 2019, is as follows:

The Company recorded compensation expense pursuant to authoritative guidance provided by the ASC Topic 718 – Stock Compensation for the three and six months ended June 30, 2019 and 2018 of $7,371 and $18,426, and $0 and $561,671, respectively.

On February 5, 2018, the Company terminated its employment agreement with Mr. Forchic, and per the terms of the employment agreement, 2,000,000 unvested option immediately vested, resulting in a stock-based compensation charge of $534,310 during the six months ended June 30, 2018.

Information relating to outstanding options at June 30, 2019, summarized by exercise price, is as follows:

As of June 30, 2019, the Company has outstanding unvested options with future compensation costs of $80,577, which will be recorded as compensation cost as the options vest over their remaining average vesting period of 2.40 years. The weighted-average remaining contractual life of options outstanding and exercisable at June 30, 2019 was 4.12 years. Both the outstanding and exercisable stock options had no intrinsic value at June 30, 2019.

Summary of Warrants

A summary of warrants for the six months ended June 30, 2019, is as follows:

Information relating to outstanding warrants at June 30, 2019 summarized by exercise price, is as follows:

As of June 30, 2019, the outstanding and exercisable warrants had an intrinsic value of $544,000.

During the six months ended June 30, 2018, the Company issued five-year warrants to purchase 5,000,000 shares of common stock at an exercise price of $0.01 as consideration for an acquisition. The Company also issued five-year warrants to purchase 7,500,000 shares of common stock at an exercise price of $1.50 as part of a secured promissory note. Lastly, in connection with the SEDA discussed below, the Company issued five-year warrants to YA II PN to purchase 1,000,000 shares of common stock at an exercise price of $0.01 per share as a commitment fee.

During the six months ended June 30, 2018, the Company issued 1,306,360 shares of its common stock on the conversion of warrants, at $1.10 per share, resulting in proceeds of $1,436,996.

Standby Equity Distribution Agreement

On April 16, 2018, the Company entered into a SEDA with YA II PN. The SEDA establishes what is sometimes termed an equity line of credit or an equity draw-down facility. The $25,000,000 facility may be drawn-down upon by the Company in installments, the maximum amount of each of which is limited to $1,000,000. For each share of common stock purchased under the SEDA, YA II PN will pay 90% of the lowest VWAP of the Company’s shares during the five trading days following the Company’s draw-down notice to YA II PN. The VWAP that will be used in the calculation will be that reported by Bloomberg, LLC, a third-party reporting service. In general, the VWAP represents the sum of the value of all the sales of the Company’s common stock for a given day (the total shares sold in each trade times the sales price per share of the common stock for that trade), divided by the total number of shares sold on that day.

In connection with the SEDA, the Company issued to YA II PN, a five-year Commitment Fee Warrant (the “Fee Warrant”) to purchase 1,000,000 shares of the Company’s common stock at $0.01 per share. The aggregate fair value of the Fee Warrant granted was determined to be $1,140,000 and recorded as a financing costs in the Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2018.

NOTE 12 – COMMITMENTS

Technology License Agreement

The Company entered into a technology license agreement with a third-party vendor for consulting services. Under the agreement, the Company will pay the vendor a minimum consulting amount of $100,000 per year, plus a royalty of 7% of all net sales of the vendor’s products above $1,428,571 per calendar year. For each of the three and six months ended June 30, 2019 and 2018, $41,667 and $50,000, respectively, was recorded as research and development expense under the agreement on the Condensed Consolidated Statements of Operations related to the minimum annual fee. A total of $108,333 and $58,333 was owed under the amended agreement at each of June 30, 2019 and December 31, 2018, respectively.

Litigation

On June 25, 2018, Matthew Geschke (the “Plaintiff”) filed a breach of contract case against the Company in the San Diego Superior Court of San Diego, California, under case number 37-2018-00031350-CU-OE-NC. The Plaintiff claims damages of $335,000 for breach of an employment contract when the Company terminating the Plaintiff’s employment agreement on February 22, 2018. The case is in the early discovery phase of litigation and no trial date has been set yet. The Company believes the case is without merit, and intends to vigorously define this case.

On February 15, 2019, MSCP, L.L.C (“MSCP”), filed suit in the Superior Court of Arizona, County of Maricopa, Case No. CV2019-001613 against the Company and YLK. The case arises from YLK’s alleged breach of a certain lease agreement dated May 19, 2018 (the “Lease”), for the lease of certain real property located at 4301 W. Buckeye Road, Phoenix, Arizona 85043 (the “Premises”), between MSCP and YLK, which the Company guaranteed. MSCP filed the lawsuit after YLK provided a notice of termination for, amongst other reasons, MSCP’s failure to disclose various material information regarding code, safety, structural and other issues in the Premises that rendered the Premises unsuitable for use, unless the Company undertook significant and extraneous costs that were not contemplated under the Lease to remedy said issues in and outside of the Premises. MSCP’s complaint alleged counts for breach of lease and waste and breach of guaranty. MSCP is seeking compensatory damages, rents and other charges due under the lease, and attorney’s fees and costs. The Company just recently filed its answer denying the allegations as well as having filed counterclaims for fraud in the inducement, negligent misrepresentation, breach of the implied covenant of good faith and fair dealing, rescission of contract, unjust enrichment and punitive damages; and the Company intends to vigorously defend this action.

No amounts have been provided for damages, if any, resulting from early termination of the Arizona lease as such amounts are not practicably determinable.

On June 12, 2019, DPA, Inc., or DPA, filed suit in the Superior Court of Arizona, County of Maricopa, Case No. CV2019-008265 against us. The plaintiff alleges the Company breached an agreement to pay DPA for architectural design services related to a facility in Arizona and has requested a judgment for $251,923.45 plus interest. The Company has not filed a response yet, as the time to respond to the complaint has not passed, but the Company denies the material allegations of this complaint and intend to vigorously defend this action.

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements that reflect Management’s current views with respect to future events and financial performance. You can identify these statements by forward-looking words such as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate” and “continue,” or similar words. Those statements include statements regarding the intent, belief or current expectations of us and members of our management team as well as the assumptions on which such statements are based. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risk and uncertainties, and that actual results may differ materially from those contemplated by such forward-looking statements.

Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the Securities and Exchange Commission. Important factors currently known to Management could cause actual results to differ materially from those in forward-looking statements. We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in the future operating results over time. We believe that our assumptions are based upon reasonable data derived from and known about our business and operations. No assurances are made that actual results of operations or the results of our future activities will not differ materially from our assumptions. Factors that could cause differences include, but are not limited to, expected market demand for our products, fluctuations in pricing for materials, and competition.

Business Overview

We are focused on (i) acquiring facilities and licenses in states that permit medical cannabis, in order to operate cannabis cultivation and processing facilities, and (ii) the research, design, development and manufacturing of advanced, energy efficient indoor horticulture lighting, plant nutrient products, and ancillary equipment. Our vision is to apply the latest advances in high efficiency lighting and controls technology as well as effective manufacturing techniques to deliver highly differentiated lighting and nutrient products with clear benefits at competitive prices to the greenhouse and indoor horticulture markets.

In 2018, we acquired YLK Partners to provide turn-key services to other companies in the cannabis industry, whereby we handle the management, administration, and operation of a medical marijuana cultivation and processing facility. The Arizona Licensee is authorized to operate a medical marijuana dispensary, one (1) onsite facility and one (1) offsite facility, to produce, sell and dispense medical marijuana and manufactured and derivative products that contain marijuana pursuant to Title 9; Chapter 17 of the AZDHS, Medical Marijuana Program and Arizona Revised Statute § 36-2801 et seq., as amended from time to time. Pursuant to the Management Agreement, YLK will provide the management services for the offsite facility, on behalf of the Arizona Licensee.

Our subsidiary, Solis Tek, Inc., a California corporation, was formed in June of 2010. Its operations consist of designing, developing and sourcing of a line of Solis Tek Digital Ballasts intended for use in high intensity lighting systems used for horticulture. An electrical ballast is a device intended to limit the amount of current in an electric circuit. A familiar and widely used example is the inductive ballast used in fluorescent lamps, which limits the current through the tube, which would otherwise rise to destructive levels due to the tube’s negative resistance characteristic. Since the commencement of operations, our product line has evolved from digital ballasts to a line of lighting products including a line of specialty ballasts ranging from 400 watts to 1,000 watts with various features, our Lamp Products, a line of reflectors, high intensity lighting accessories and a new line of LED lighting technologies.

Results of Operations

Results of Operations for the Three Months Ended June 30, 2019 Compared to the Three Months Ended June 30, 2018.

Revenue and Cost of Goods Sold

Revenue for the three months ended June 30, 2019 and 2018 was $682,855 and $701,626, respectively, a decrease of $18,771, or 3%. The decrease was due to several negative factors during the second quarter of 2019, as compared to the second quarter of 2018.

Such factors included market instability and uncertainty, reports of over-capacity and price declines at the wholesale level. This state of ambiguity as to the number of licenses, announced cultivations in the building-out process, demand on a state-by-state level, and lead time to production and profitability has put a general pall on the marketplace as exhibited in our sales, and is also reflected in the sales of competitive U.S. based companies. Additionally, as the new legal adult use recreational States come on stream - the requirements for testing, oversight, and tightening of the regulatory environment caused a pause in the expansion timetable of many new licensees.

Specific reasons to beset our revenue included a change of message and direction. We had previously been a retail driven company servicing our 500+ hydro-stores targeting the home and hobbyist growers. While we continue to service those valued retail customers, we have repositioned a segment of our sales force to nationwide commercial cultivation account managers and have re-programed the sales team, changed pricing and changed marketing strategies. Our recent shift to convert to a commercial mindset, also altered our inventory strategy to longer fulfillment and lead times. For the first time, our product engineers and sales team are also offering specific consulting services into every aspect of a new cultivation, including environmental requirements as well as full build-out and growing ancillary services, up to and including production requirements and specifications.

Cost of sales for the three months ended June 30, 2019 and 2018 was $189,368 and $584,916, respectively. Gross profit for the three months ended June 30, 2019 and 2018, was $493,487 and $116,710, respectively. As a percentage of revenue, gross profit for the three months ended June 30, 2019 was 72%, compared to 17% for the three months ended June 30, 2018. The increase in gross profit and our gross margin percentage was primarily due to our decrease in reserves for inventory obsolescence and change in product mix sold.

Selling, General and Administrative Expenses

Selling, general and administrative (“SG&A”) expenses for the three months ended June 30, 2019 and 2018 was $872,729 and $2,650,018, respectively, a decrease of $1,777,289, or 67%. For the three months ended June 30, 2019, stock-based compensation expense decrease $1,101,854 to $7,371, compared to $1,109,225 for the prior year period. Excluding stock-based compensation expense, our SG&A decreased $675,435 due to a decrease in salaries and benefits, professional fees, and decreased operating expenses to support our current level of business.

Research and Development Expenses

Research and development (“R&D”) expenses for the three months ended June 30, 2019 and 2018 was $145,392 and $62,706, respectively, an increase of $82,686, or 132%. The increase in R&D expenses was primarily due to increased royalty expense.

Excess Cost of Acquisition to Related Party over Historical Basis

Excess cost of acquisition to related party over historical basis for the three months ended June 30, 2018 was $4,450,000, representing a non-cash charge related to our acquisition of YLK Partners NV from related parties on May 10, 2018 (See Note 4 to the accompanying condensed consolidated financial statements).

Impairment of Intangible Assets

Impairment of intangible assets for the three months ended June 30, 2019 was $1,138,892. In June 2019, we determined that our intangible assets were impaired and recorded an impairment charge accordingly. No similar activity occurred during the three months ended June 30, 2018.

Loss on Abandonment of Leasehold Improvements

Loss on abandonment of leasehold improvement for the three months ended June 30, 2019 was $40,905. In February 2019, we terminated our Arizona facility lease, thereby abandoning $40,905 of leasehold improvements during the three months ended June 30, 2019. No similar activity occurred during the prior year period.

Other Income and Expenses

Other income for the three months ended June 30, 2019 was $1,571,835, compared to other expense of $3,032,054 for the three months ended June 30, 2018. The change in balance was due to the difference in the change in fair value of derivative liability of $2,554, 818 offset by a decrease in financing costs of $1,556,474. During the three months ended June 30, 2018, we recorded a gain on the extinguishment of derivatives of $1,715,173, offset by financing costs of $7,317,406, and the amortization of discounts to interest expense of $1,569,357, all of which did not exist during the current year period.

Net Loss

Net loss for the three months ended June 30, 2019 was $213,946, compared to a net loss of $10,081,068 for the three months ended June 30, 2018. The decrease in net loss was primarily due to financing costs and excess cost of acquisition to related party incurred during the three months ended June 30, 2018 that were not present during the three months ended June 30, 2019, along with decreased operating expenses, as discussed above.

Results of Operations for the Six Months Ended June 30, 2019 Compared to the Six Months Ended June 30, 2018.

Revenue and Cost of Goods Sold

Revenue for the six months ended June 30, 2019 and 2018 was $1,419,737 and $1,713,375, respectively, a decrease of $293,638, or 17%. The decrease was due to several negative factors during the first six months of 2019, as compared to the first six months of 2018.

Such factors included market instability and uncertainty, reports of over-capacity and price declines at the wholesale level. This state of ambiguity as to the number of licenses, announced cultivations in the building-out process, demand on a state-by-state level, and lead time to production and profitability has put a general pall on the marketplace as exhibited in our sales, and is also reflected in the sales of competitive U.S. based companies. Additionally, as the new legal adult use recreational States come on stream - the requirements for testing, oversight, and tightening of the regulatory environment caused a pause in the expansion timetable of many new licensees.

Specific reasons to beset our revenue included a change of message and direction. We had previously been a retail driven company servicing our 500+ hydro-stores targeting the home and hobbyist growers. While we continue to service those valued retail customers, we have repositioned a segment of our sales force to nationwide commercial cultivation account managers and have re-programed the sales team, changed pricing and changed marketing strategies. Our recent shift to convert to a commercial mindset, also altered our inventory strategy to longer fulfillment and lead times. For the first time, our product engineers and sales team are also offering specific consulting services into every aspect of a new cultivation, including environmental requirements as well as full build-out and growing ancillary services, up to and including production requirements and specifications.

Cost of sales for the six months ended June 30, 2019 and 2018 was $764,706 and $1,118,841, respectively. Gross profit for the six months ended June 30, 2019 and 2018, was $655,031 and $594,534, respectively. As a percentage of revenue, gross profit for the six months ended June 30, 2019 was 46%, compared to 35% for the six months ended June 30, 2018. The increase in gross profit and our gross margin percentage was primarily due to our decrease in reserves for inventory obsolescence and change in product mix sold.

Selling, General and Administrative Expenses

SG&A expenses for the six months ended June 30, 2019 and 2018 was $2,267,601 and $6,016,940, respectively, a decrease of $3,749,339, or 62%. For the six months ended June 30, 2019, stock-based compensation expense decreased $2,630,237 to $259,276, compared to $2,889,513 for the prior year period. Excluding stock-based compensation expense, our SG&A decreased $1,119,103 due to the recording of a $449,000 severance obligation to our former Chief Executive Officer during the prior year period. The remaining difference of $670,013 is from a decrease in salaries and benefits, professional fees, and decreased operating expenses to support our current level of business.

Research and Development Expenses

R&D expenses for the six months ended June 30, 2019 and 2018 was $154,269 and $114,584, respectively, an increase of $39,685, or 35%. The increase in R&D expenses was primarily due to increased royalty expense.

Excess Cost of Acquisition to Related Party over Historical Basis

Excess cost of acquisition to related party over historical basis for the six months ended June 30, 2018 was $4,450,000, representing a non-cash charge related to our acquisition of YLK Partners NV from related parties on May 10, 2018 (See Note 4 to the accompanying condensed consolidated financial statements).

Impairment of Intangible Assets

Impairment of intangible assets for the six months ended June 30, 2019 was $1,138,892. In June 2019, we determined that our intangible assets were impaired and recorded an impairment charge accordingly. No similar activity occurred during the six months ended June 30, 2018.

Loss on Abandonment of Leasehold Improvements

Loss on abandonment of leasehold improvement for the six months ended June 30, 2019 was $217,562. In February 2019, we terminated our Arizona facility lease, thereby abandoning $217,562 of leasehold improvements during the six months ended June 30, 2019. No similar activity occurred during the prior year period.

Other Income and Expenses

Other income for the six months ended June 30, 2019 was $1,050,342, compared to other expense of $380,434 for the six months ended June 30, 2018. The change in balance was due to the difference in the change in fair value of derivative liability of $5,283,214, as well as, the recording of a gain on the change in fair value of derivative liability of $6,811,926 and a gain on the extinguishment of derivatives of $2,389,427, offset by financing costs of $7,317,406, and the amortization of discounts to interest expense of $2,177,074, all of which did not exist during the current year period. The remaining increase in interest expense increased over the prior year period was due to our increase in borrowings.

Net loss

Net loss for the six months ended June 30, 2019 was $2,235,649, compared to a net loss of $10,451,973 for the six months ended June 30, 2018. The decrease in net loss was primarily due to financing costs and excess cost of acquisition to related party incurred during the six months ended June 30, 2018 that were not present during the six months ended June 30, 2019, along with decreased SG&A expenses, as discussed above.

Liquidity and Capital Resources

Cash and Liquidity

Liquidity is the ability of a company to generate funds to support its current and future operations, satisfy its obligations, and otherwise operate on an ongoing basis. Significant factors in the management of liquidity are funds generated by operations, levels of accounts receivable and accounts payable and capital expenditures.

Cash flows used in operating activities

During the six months ended June 30, 2019, we used cash in operating activities of $717,355, compared to cash used in operating activities of $2,315,672 during the six months ended June 30, 2018. During the six months ended June 30, 2019, cash was primarily used to fund our operating loss of $2,235,649, partially offset by a $1,138,892 intangible asset impairment charge, $764,631 increase in accounts payable and accrued expenses, a $532,093 decrease in inventories, a $247,032 discount on convertible note payable, $217,562 loss on abandonment of leasehold improvements, $177,850 of fair value of common stock issued for services and $129,384 of financing costs.

Cash flows used in investing activities

During the six months ended June 30, 2019 we used $217,562 in cash from investing activities to purchase property and equipment. During the six months ended June 30, 2018 investing activities provided $203,195 in cash resulting from $250,000 of accounts receivable acquired on acquisition, offset by $46,805 of cash used to purchase property and equipment.

Cash flows provided by financing activities

During the six months ended June 30, 2019, we generated cash from financing activities of $288,236 compared to cash generated by financing activities of $3,988,530 for the six months ended June 30, 2018. During the six months ended June 30, 2019, we received $150,000 from the issuance of a note payable to related party, we received $150,000 from a loan, and we made payments on our loans payable totaling $11,764. During the six months ended June 30, 2018, we raised $1,568,000 from the sale of common stock, received proceeds of $1,500,000 from a secured note payable, raised $1,436,996 from the exercise of warrants, made payments of $505,000 on our notes payable to related parties, and made payments on loans payable and capital lease obligation totaling $11,466.

The accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities and commitments in the normal course of business. As reflected in the accompanying condensed consolidated financial statements, during the six months ended June 30, 2019, we incurred an operating loss of $2,235,649, used cash in operations of $717,355 and had a stockholders’ deficit of $5,404,912 as of June 30, 2019. These factors raise substantial doubt about our ability to continue as a going concern within one year after the date of the financial statements being issued. Our ability to continue as a going concern is dependent upon our ability to raise additional funds and implement our business plan. The financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.

At June 30, 2019, we had cash on hand in the amount of $240,012. Management estimates that the current funds on hand will be sufficient to continue operations through September 30, 2019. Our continuation as a going concern is dependent upon our ability to obtain necessary debt or equity financing to continue operations until we begin generating positive cash flow. No assurance can be given that any future financing will be available or, if available, that it will be on terms that are satisfactory to us. Even if we are able to obtain additional financing, it may contain undue restrictions on our operations, in the case of debt financing or cause substantial dilution for our stock holders, in case or equity financing.

Lease Abandonment

As discussed in Notes 6 and 12 of the accompanying condensed consolidated financial statements, we provided MSCP, L.L.C (“MSCP”) a notice of termination, and on February 15, 2019, MSCP filed suit in the Superior Court of Arizona, County of Maricopa, Case No. CV2019-001613 against us and YLK. We recently filed counterclaims against MSCP for fraud in the inducement, negligent misrepresentation, breach of the implied covenant of good faith and fair dealing, rescission of contract, unjust enrichment and punitive damages. We intend to vigorously defend this action. At the date of notice of termination, we had a remaining lease obligation of approximately $6,000,000. Due to our counterclaims, we are unable to determine and did not record, an estimate of liability at June 30, 2019.

No amounts have been provided in the financial statements for the ROU asset and related lease liability. Further, no liability has been provided for any damages arising from the early termination of the lease, as such amounts, if any, are not practicably determinable.

Notes Payable – Related Parties

On May 9, 2016, we entered into note payable agreements with Alan Lien and Alvin Hao, each an officer and director, to borrow $300,000 under each individual note. Pursuant to the terms of each of these agreements, we borrowed $300,000 from each of Alan Lien and Alvin Hao. The notes accrue interest at a rate of 8% per annum, are unsecured and were due on or before May 31, 2018. The loans are currently past due. A total of $600,000 was due on the combined notes at each of June 30, 2019 and December 31, 2018.

On May 8, 2019, we entered into a note agreement with the sister of Alvin Hao, an officer and director, to borrow $150,000. The loan accrues interest at 8% per annum, are unsecured and due on November 8, 2019. A total of $150,000 was due on the note at June 30, 2019.

We entered into note agreements with the parents of Alan Lien, our Chief Executive Officer and one of our directors. The loans accrue interest at 10% per annum, are unsecured and were due on or before December 31, 2016. A total of $40,000 was due on the loans at each of June 30, 2019 and December 31, 2018. The loans are currently past due.

Convertible Note Payable

On May 10, 2018, we issued a secured debenture (the “2018 Note”) to YA II PN in the principal amount of $1,500,000 with interest at 8% per annum (18% on default) and due on February 9, 2019. The 2018 Note was amended effective February 9, 2019 for which the maturity date was extended to August 9, 2019 and could be converted into our common stock at a conversion price of $0.50 a share (see Note 8 of the accompanying condensed consolidated financial statements). The 2018 Note is secured by all our assets and our subsidiaries. The 2018 Note was not repaid as of August 9, 2019 and has subsequently become past due.

Term Loan

On May 21, 2019, we entered into a loan agreement with Celtic Bank in the principal amount of $150,000 with interest at 40.44% per annum and due on May 21, 2020. The loan was guaranteed by Alvin Hao, one of our officers. We have made a principal payment of $10,409, leaving a total of $139,591 owed on the loan as of August 12, 2019.

Standby Equity Distribution Agreement

On April 16, 2018, we entered into a Standby Equity Distribution Agreement, or SEDA, with YA II PN. The SEDA establishes what is sometimes termed an equity line of credit or an equity draw-down facility. The $25,000,000 facility may be drawn-down upon by us in installments, the maximum amount of each of which is limited to $1,000,000. For each share of common stock purchased under the SEDA, YA II PN will pay 90% of the lowest VWAP of our shares during the five trading days following our draw-down notice to YA II PN. The VWAP that will be used in the calculation will be that reported by Bloomberg, LLC, a third-party reporting service. In general, the VWAP represents the sum of the value of all the sales of our common stock for a given day (the total shares sold in each trade times the sales price per share of the common stock for that trade), divided by the total number of shares sold on that day.

Critical Accounting Policies

The Securities and Exchange Commission (“SEC”) defines “critical accounting policies” as those that require application of management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. Not all of the accounting policies require management to make difficult, subjective or complex judgments or estimates. However, the following policies could be deemed to be critical within the SEC definition.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is based on our assessment of the collectability of customer accounts. We regularly review the allowance by considering factors such as historical experience, the age of the accounts receivable balances, credit quality, economic conditions that may affect a customer’s ability to pay and expected default frequency rates. Trade receivables are written off at the point when they are considered uncollectible.

Inventories

We provide inventory reserves based on excess and obsolete inventories determined primarily by future demand forecasts. The write down amount is measured as the difference between the cost of the inventory and market based upon assumptions about future demand and charged to the provision for inventory, which is a component of cost of sales. At the point of the loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.

Recent Accounting Pronouncements

See Note 2 of the condensed consolidated financial statements for management’s discussion of recent accounting pronouncements.

Off-Balance Sheet Arrangements

We do not have any off balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, revenues, and results of operations, liquidity or capital expenditures.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Not required under Regulation S-K for “smaller reporting companies.”

Item 4. Controls and Procedures.

Evaluation of disclosure controls and procedures.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934 as of the end of the period covered by this Quarterly Report on Form 10-Q. 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.

Based on management’s evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2019, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in internal control over financial reporting.

There were no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II

Item 1. Legal Proceedings.

Information regarding reportable legal proceedings is contained in Part I, Item 3, “Legal Proceedings,” in our Annual Report on Form 10-K for the year ended December 31, 2018. Other than disclosed below, there have been no material changes to the legal proceedings previously disclosed in the Annual Report on Form 10-K, which are incorporated by reference herein.

On June 12, 2019, DPA, Inc., or DPA, filed suit in the Superior Court of Arizona, County of Maricopa, Case No. CV2019-008265 against us. The plaintiff alleges we breached an agreement to pay DPA for architectural design services related to a facility in Arizona and has requested a judgment for $251,923.45 plus interest. We have not filed a response yet, as the time to respond to the complaint has not passed, but we deny the material allegations of this complaint and intend to vigorously defend this action.

Item 1A. Risk Factors.

Not required under Regulation S-K for “smaller reporting companies.”

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

None.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information.

None.

Item 6. Exhibits.

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.