Generation Alpha, Inc. - Quarter Report: 2020 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, 2020

For the transition period from __________ to __________

Commission File Number: 000-53635

GENERATION ALPHA, INC.

(Exact name of registrant as specified in its charter)

1689-A Arrow Route

Upland, California 91786

(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, 2020 was 52,738,920.

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)

Three months ended June 30, 2020

Six months ended June 30, 2020

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 an integral part of these condensed consolidated financial statements.

GENERATION ALPHA INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2020 AND 2019

(UNAUDITED)

NOTE 1 – BASIS OF PRESENTATION

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, Solis Tek changed its corporate name to Generation Alpha, Inc. Effective September 25, 2018, Generation Alpha, Inc. (f/k/a Solis Tek Inc.) (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. 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 focused on the research, design, development and manufacturing of advanced, energy efficient indoor horticulture lighting, plant nutrient products, and ancillary equipment.

COVID-19 Considerations

In the quarter ended June 30, 2020, the COVID-19 pandemic did not have a material net impact on our operating results. In the future, the pandemic may cause reduced demand for our products if, for example, the pandemic results in a recessionary economic environment which negatively effects the consumers who purchase our products.

Our ability to operate without significant negative operational impact from the COVID-19 pandemic will in part depend on our ability to protect our employees and our supply chain. The Company has endeavored to follow the recommended actions of government and health authorities to protect our employees. For the three months ended June 30, 2020, we maintained the consistency of our operations during the onset of the COVID-19 pandemic. However, the uncertainty resulting from the pandemic could result in an unforeseen disruption to our workforce and supply chain (for example an inability of a key supplier or transportation supplier to source and transport materials) that could negatively impact our operations.

Through June 30, 2020, the COVID-19 pandemic has not negatively impacted the Company’s liquidity position as of such date. Through June 30, 2020, the Company continues to generate cash flows to meet its short-term liquidity needs, and it expects to maintain access to the capital markets. The Company has not observed any material impairments of its assets or a significant change in the fair value of its assets due to the COVID-19 pandemic.

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, 2020, the Company incurred a net loss of $3,058,000 and used cash in operations of $111,000, and had a shareholders’ deficit of $11,555,000 at June 30, 2020. 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, 2019 financial statements, has raised substantial doubt about the Company’s ability to continue as a going concern.

At June 30, 2020, the Company had cash on hand in the amount of $447,000. Management estimates that the current funds on hand will be sufficient to continue operations through March 2021. 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 shareholders, in case of 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.

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, 2020, options to acquire 5,995,800 shares of common stock, warrants to acquire 21,283,140 shares of common stock, and 187,773,607 shares to be issued upon conversion of our convertible notes 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, 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.

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, 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.

Segment Reporting

The Company operates in one segment for the manufacture and distribution of its products. In accordance with the “Segment Reporting” Topic of the ASC, the Company’s chief operating decision maker has been identified as the Chief Executive Officer and President, who reviews operating results to make decisions about allocating resources and assessing performance for the entire Company. Existing guidance, which is based on a management approach to segment reporting, establishes requirements to report selected segment information quarterly and to report annually entity-wide disclosures about products and services, major customers, and the countries in which the entity holds material assets and reports revenue. All material operating units qualify for aggregation under “Segment Reporting” due to their similar customer base and similarities in: economic characteristics; nature of products and services; and procurement, manufacturing and distribution processes. Since the Company operates in one segment, all financial information required by “Segment Reporting” can be found in the accompanying consolidated financial statements.

Revenue Recognition

The Company recognizes revenue in accordance with Accounting Standard Update (“ASU”) No. 2014-09. This 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 cost 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, 2020 and December 31, 2019, the Company recorded reserves for returned product in the amounts of less than $1,000 and $60,000, respectively, which reduced the accounts receivable balances as of those periods.

In the following table, revenue is disaggregated by major product line for three months ended June 30, 2020:

In the following table, revenue is disaggregated by major product line for the three months ended June 30, 2019:

In the following table, revenue is disaggregated by major product line for six months ended June 30, 2020:

In the following table, revenue is disaggregated by major product line for the six months ended June 30, 2019:

Concentration Risks

The Company maintains the majority of its cash balances with one financial institution, in the form of demand deposits. Periodically, 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’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, 2020 and 2019, its ballasts, lamps and reflectors, which comprised the clear majority of the Company’s purchases during those periods, were each only purchased from one and three separate vendors, respectively.

The Company performs a regular review of customer activity and associated credit risks and does not require collateral or other arrangements. One customer accounted for 16% of the Company’s revenue for the three months ended June 30, 2020, and no customer accounted for more than 10% of the Company’s revenue for the three months ended June 30, 2019. Five customers accounted for 24%, 15%, 11%, 11%, and 11% of the Company’s revenue for the six months ended June 30, 2020, and no customer accounted for more than 10% of the Company’s revenue for the six months ended June 30, 2019. There were no other customers that accounted for more than 10% of the Company’s revenue. Shipments to customers outside the United States comprised less than 5% of our sales for the three and six months ended June 30, 2020 and 2019.

As of June 30, 2020, four customers accounted for 29%, 21%, 20% and 13% of the Company’s trade accounts receivable balance, and as of December 31, 2019, two customers accounted for 24% and 10% of the Company’s trade accounts receivable balance.

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, accounts payable and accrued liabilities, and legal settlements payable, approximate the related fair values due to the short-term maturities of these instruments. The carrying values of notes payable approximate their fair values due to the fact that the interest rates on these obligations are based on prevailing market interest rates.

The fair value of the derivative liabilities of $2,997,000 and $1,332,000 at June 30, 2020 and December 31, 2019, respectively, was valued using Level 2 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.

Recently Issued Accounting Pronouncements

In June 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments. ASU 2016-13 requires entities to use a forward-looking approach based on current expected credit losses (“CECL”) to estimate credit losses on certain types of financial instruments, including trade receivables. This may result in the earlier recognition of allowances for losses. ASU 2016-13 is effective for the Company beginning January 1, 2023, and early adoption is permitted. The Company does not believe the potential impact of the new guidance and related codification improvements will be material to its financial position, results of operations and cash flows.

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

NOTE 3 – CONTRACT OBLIGATION ACQUIRED FROM RELATED PARTIES

In May 2018, the Company entered into an acquisition agreement with the members, which in the aggregate, owned 100% of the membership interests in YLK, a related party. The major asset of YLK is a Cultivation Management Services Agreement (the “Management Agreement”) with an Arizona licensee that was entered into on January 5, 2018. During the year ended December 31, 2019, the Company determined the acquired assets were fully impaired, and recorded an impairment charge accordingly. The Company has a continuing obligation under the Management Agreement of $799,000 (net of discount of $51,000) as of December 31, 2019. As of June 30, 2020, the remaining Management Agreement obligation was $807,000 (net of discount of $43,000) and is reflected as a current liability in the accompanying condensed consolidated balance sheet. As of June 30, 2020, the Company is past due on its installment payments obligations under the Management Agreement.

NOTE 4 – NOTES PAYABLE TO RELATED PARTIES – PAST DUE

Notes payable to related parties consists of the following at June 30, 2020 and December 31, 2019:

At December 31, 2019, accrued interest on the notes payable to related parties balance was $149,000 and included in accrued interest to related parties on the condensed consolidated balance sheet. During the six months ended June 30, 2020, the Company added $35,000 of additional accrued interest, and made interest payments of $20,000, leaving an accrued interest on the notes payable to related parties balance of $164,000 at June 30, 2020.

NOTE 5 – LEASE PAYABLE

The Company leases its executive offices and warehouse space. The Company analyzes all leases at inception to determine if a right of use (“ROU”) asset and lease liability should be recognized. Leases with an initial term of 12 months or less are not included on the condensed consolidated balance sheets. The lease liability is measured at the present value of future lease payments as of the lease commencement date.

On March 6, 2018, the Company entered into a lease for its principal executive offices and warehouse located in Carson, California. The Company occupies a 17,640 square foot facility pursuant to a five-year lease ending on September 30, 2023, with an unaffiliated party, pursuant to which it pays $15,000 per month in rental charges. As required by ASC 842, the Company recorded an ROU asset and lease liability of $659,000 at January 1, 2019 for the net present value of future lease obligations related to the Carson property. As of December 31, 2019, balance of ROU asset amounted to $527,000 and lease liability amounted to $556,000.

In January 2020, the Company vacated its office and warehouse in Carson and is currently trying to sublease the said property. The Company remains obligated under its Carson, California lease, until such time the landlord releases the Company from the lease agreement. As of December 31, 2019, the Company recorded an impairment charge related to the ROU asset amounting to $100,000, which reflected management’s best estimate of the cost to sublease the premises. As of the date of this report, the Company has not been released from the lease agreement, and no lease payments were made during the six months ended June 30, 2020. During the six months ended June 30, 2020, management revised its estimate and recorded an additional impairment charge to the ROU asset amounting to $82,000, which was charged to operating expenses in the consolidated statements of operations for the six months ended June 30, 2020.

On January 1, 2020, the Company relocated its principal executive offices and warehouse to 1689-A Arrow Rt., Upland, California, 91786. The Upland, California lease is for a 2,974 square foot facility pursuant to a four-year lease with an independent party ending on January 31, 2023, pursuant to which it pays $2,800 per month in rental charges. On January 1, 2020, the Company recognized an operating lease ROU asset and lease liability of $89,000, related to the Upland, California operating lease. During the six months ended June 30, 2020, the Company reflected amortization of the ROU assets of $12,000 related to its Upland, California operating lease, and recorded an impairment charge of $82,000 related to the abandoned Carson, California lease, resulting in an ROU asset balance of $422,000 as of June 30, 2020.

As of December 31, 2019, liabilities recorded under operating leases were $556,000. During the six months ended June 30, 2020, the Company added $89,000 in lease liabilities related to its Upland, California operating lease, and made lease payments of $10,000 towards its operating lease liability. As of June 30, 2020, liabilities under operating leases amounted to $635,000, of which $225,000 were reflected as current due.

As of June 30, 2020, the weighted average remaining lease terms for operating lease are 2.96 years, and the weighted average discount rate for operating leases is 10%. Rent expense during the three and six months ended June 30, 2020 and 2019 was $6,000 and $18,000, and $63,000 and $279,000, respectively.

NOTE 6 – LEGAL OBLIGATIONS PAYABLE – PAST DUE

As of December 31, 2019, the Company was obligated to pay $2,550,000, including accrued interest, related to legal settlements. The legal settlements obligation carries interest at rates ranging from 12% to 18%.

On September 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. The Plaintiff claimed damages for breach of an employment contract when the Company terminated the Plaintiff’s employment agreement on February 22, 2018. On June 26, 2020, the Plaintiff was awarded a default judgment against the Company in the amount of $448,000. In addition, during the six months ended June 30, 2020, $7,000 of additional settlement related expenses, and $224,000 of accrued interest were added, leaving a settlements payable balance of $3,229,000 at June 30, 2020, which was past due (see Note 12).

NOTE 7 – LOANS PAYABLE

Notes payable consists of the following at June 30, 2020 and December 31, 2019:

NOTE 8 – CONVERTIBLE SECURED NOTES PAYABLE TO RELATED PARTY

Secured notes payable to related party consists of the following as of June 30, 2020 and December 31, 2019:

On May 10, 2018 and October 29, 2019, the Company issued convertible secured debentures (“Notes”) to YA II PN Ltd. (“YA II PN”) in the principal amounts of $1,500,000 and $275,000, respectively, with interest rates of 8% and 10%, respectively, that matured in June 2020 and April 2020, respectively. The notes are currently past due. The Company is in discussion with YA II PN to extend the maturity date of the Notes. The Notes provides 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 at 75% of the lowest volume weighted average price (VWAP) of the Company’s Common Stock during the 10 trading days immediately preceding the conversion date. As part of the issuance, the Company also granted YA II PN 5-year warrants, which were modified, to purchase a total of 13,000,000 shares of the Company at an exercise price of $0.05 per share, with expiration dates ranging from May 2024 to December 2024.

On February 13, 2020, the Company issued a Note to YAII PN in the amount of $150,000. The Note bears interest at a rate of 10% per annum (15% on default) and has a maturity date of August 10, 2021. The Company received net proceeds of $125,000, net of closing costs of $25,000. The Note is secured by all the assets of the Company and its subsidiaries. The 2020 Note provides a conversion right, in which any portion of the principal amount of the 2020 Note, together with any accrued but unpaid interest, may be converted into the Company’s common stock at a conversion price equal to 75% of the lowest VWAP of the Company’s common stock during the ten (10) trading days immediately preceding the date of conversion, subject to adjustment. As such, the Company determined that the conversion feature created a derivative with a fair value of $140,000 at the date of issuance. The Company also granted YA II PN 5-year warrants to purchase a total of 3,000,000 shares of the Company at an exercise price of $0.05 per common share. The aggregate amount of the closing costs, and the fair value of the derivative liability, was $165,000, of which $150,000 was recorded as a valuation discount on the Note to be amortized over the life of the Note, and $15,000 was recorded as a financing cost during the six months ended June 30, 2020.

The unamortized balance of the valuation discounts was $178,000 at December 31, 2019. During the six months ended June 30, 2020, valuation discounts of $150,000 were added as discussed above, and amortization of valuation discount of $216,000 was recorded as an interest cost, leaving a $112,000 remaining unamortized balance of the valuation discount at June 30, 2020.

At December 31, 2019, accrued interest on the convertible secured notes payable to related parties of $202,000 was included in accrued interest to related parties on the condensed consolidated balance sheet. During the six months ended June 30, 2020, interest of $29,000 was converted into common stock (see Note 10), and the Company added $79,000 of additional accrued interest, leaving an accrued interest to related parties balance of $252,000 at June 30, 2020.

NOTE 9 – 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 8 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, 2020 and December 31, 2019, 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, 2019 was $1,332,000. During the six months ended June 30, 2020, the Company recognized derivative liabilities of $140,000 upon issuance of a secured convertible note (see Note 8), and recognized $1,525,000 as other expense, which represented the change in the fair value of the derivative from the respective prior period.

NOTE 10 – SHAREHOLDERS’ EQUITY

Common Shares Issued on Conversion of Convertible Note Payable

During the six months ended June 30, 2020, the Company was notified by YA II PN (see Note 8) in writing of their election to convert $29,000 of interest accrued into 2,287,066 shares of the Company’s common at $0.0127 per share.

Common Shares Issued to Directors

The Company appointed certain directors and issued shares as part of their director compensation agreements. During the six months ended June 30, 2020, the Company issued an aggregate of 2,631,290 shares of common stock, with a fair value of $52,000 at date of grant, which was recognized as compensation cost.

Summary of Stock Options

A summary of stock options for the six months ended June 30, 2020, is as follows:

On October 31, 2019, the Board of Directors of the Company reappointed Ms. Tiffany Davis as Chief Executive Officer, Chief Financial Officer and as a director, effective immediately. In connection with the appointment of Ms. Davis, Ms. Davis is entitled to receive stock options of $25,000 of shares per quarter at the then closing market price on the last trading day at the end of each calendar quarter. Accordingly, Ms. Davis was granted 2,500,000 stock options at the closing market price of $0.01 on March 31, 2020, and 1,562,500 stock options at the closing market price of $0.016 on June 30, 2020. The fair value of the 4,062,500 stock options granted was determined to be $46,000, of which $25,000 and $46,000 was recorded to stock-based compensation expense during the three and six months ended June 30, 2020, respectively.

Information relating to outstanding options at June 30, 2020, summarized by exercise price, is as follows:

As of June 30, 2020, the Company has no outstanding unvested options with future compensation costs. In addition, there will be future compensation related to the options to be awarded to Ms. Davis under her employment agreement discussed above. The weighted-average remaining contractual life of options outstanding and exercisable at June 30, 2020 was 2.54 years. Both the outstanding and exercisable stock options had an intrinsic value of $15,000 at June 30, 2020.

Summary of Warrants

A summary of warrants for the six months ended June 30, 2020, is as follows:

Information relating to outstanding warrants at June 30, 2020, summarized by exercise price, is as follows:

During the six months ended June 30, 2020, the Company issued five-year warrants to purchase 3,000,000 shares of common stock at an exercise price of $0.05 as part of a secured convertible promissory note (see Note 8).

The weighted-average remaining contractual life of warrants outstanding and exercisable at June 30, 2020 was 3.83 years. Both the outstanding and exercisable warrants had an intrinsic value of $30,000 at June 30, 2020.

NOTE 11 – COMMITMENTS AND CONTINGENCIES

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 $1,429,000 per calendar year. For the three and six months ended June 30, 2020 $25,000 and $50,000, respectively, and for each of the three and six months ended June 30, 2019, $50,000 was recorded as research and development expense under the agreement on the condensed consolidated statements of operations related to the minimum annual fee. For each of six months ended June 30, 2020 and 2019, no royalty was recorded as cost of goods sold on the Condensed Consolidated Statements of Operations. A total of $289,000 and $239,000 was owed under the amended agreement at June 30, 2020 and December 31, 2019, respectively, and is included in accounts payable and accrued liabilities on the accompanying condensed consolidated balance sheets.

Litigation

On September 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. The Plaintiff claimed damages of $335,000 for breach of an employment contract when the Company terminated the Plaintiff’s employment agreement on February 22, 2018. On June 26, 2020, the Plaintiff was awarded a default judgment against the Company in the amount of $448,000 (see Note 6).

NOTE 12 – SUBSEQUENT EVENTS

In July 2020, the Company entered into two settlement agreements related to legal judgements discussed in Note 6. The aggregate of $463,000 of legal settlement were settled for $36,000 in cash, and one million shares of common stock valued at $17,000. In July 2020, the Company recorded a gain on settlement of $410,000 related to these settlements.

In July 2020, the Company entered into a settlement agreement with a vendor for an outstanding accounts payable account. The vendor agreed to settle their accounts payable balance of $61,000 for $9,000. In July 2020, the Company recorded a gain on settlement of $52,000 related to the settlement.

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 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.

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.

Previously, we attempted to expand our operations in cannabis cultivation and processing management services. In 2018, we acquired YLK Partners AZ, LLC, or YLK Partners, an Arizona-based company to provide turn-key services for the management, administration, and operation of a medical marijuana cultivation and processing facility. YLK had a cultivation management services agreement with an Arizona licensee. In 2019, we purchased real property in Phoenix, Arizona for $3,500,000, which property held 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. Later in 2019, we conveyed the property to our lender in full settlement of the outstanding amounts we borrowed to acquire the property. For various reasons, we decided to abandon the expanded business lines and to re-focus on our core business of lights and nutrients.

Known Trends and Uncertainties

In March 2020, the World Health Organization declared the outbreak of COVID-19 a global pandemic. The responses by federal, state and local governments to restrict public gatherings and travel rapidly grew to include stay-at-home orders, school closures and mandatory restrictions on non-essential businesses and services that has adversely affected workforces, economies, and financial markets resulting in a significant economic downturn. In particular, on March 19, 2020, California Governor Gavin Newsom issued an executive order requiring all California residents to stay home, making it the first state to impose that strict mandate on all residents to counteract a looming surge of new infections. The Company’s executive offices are located in Upland, California. While we currently believe we are an “essential” business, we have been following the recommendations of local health authorities to minimize exposure risk for our employees, including temporary closures of our offices and having employees work remotely to the extent possible. The order, which has subsequently been modified to provide for a gradual re-opening of businesses and travel, is to remain in place until further notice. While California is currently in early stage 2 (out of 4 stages) of re-opening, there is no known timeframe as to when California may move to stage 3, and there remains a risk that California may regress.

While this disruption is currently expected to be temporary, there is considerable uncertainty around the duration. We are actively monitoring the COVID-19 situation and its impact in the markets we serve. We are taking all precautionary measures as directed by health authorities and local and national governments. Due to continuing uncertainties regarding the ultimate scope and trajectory of COVID-19’s spread and evolution, it is impossible to predict the total impact that the pandemic will have on our business. If public and private entities continue to implement restrictive measures, the material adverse effect on our business, results of operations, financial condition and cash flows could persist.

On May 7, 2020, we were granted a loan (the “PPP loan”) from Wells Fargo Bank in the aggregate amount of $205,000, pursuant to the Paycheck Protection Program (the “PPP”) under the CARES Act. The PPP loan agreement is dated May 8, 2020, matures on May 7, 2022, bears interest at a rate of 1% per annum, with the first six months of interest deferred, and is unsecured and guaranteed by the U.S. Small Business Administration. The loan term may be extended to May 7, 2025, if mutually agreed to by us and lender. We applied ASC 470, Debt, to account for the PPP loan. The PPP loan may be prepaid at any time prior to maturity with no prepayment penalties. Funds from the PPP loan may only be used for qualifying expenses as described in the CARES Act, including qualifying payroll costs, qualifying group health care benefits, qualifying rent and debt obligations, and qualifying utilities. We intend to use the entire loan amount for qualifying expenses. Under the terms of the PPP, certain amounts of the loan may be forgiven if they are used for qualifying expenses. We intend to apply for forgiveness of the PPP loan with respect to these qualifying expenses, however, we cannot assure that such forgiveness of any portion of the PPP loan will occur. As for the potential loan forgiveness, once the PPP loan is, in part or wholly, forgiven and a legal release is received, the liability would be reduced by the amount forgiven and a gain on extinguishment would be recorded. The terms of the PPP loan provide for customary events of default including, among other things, payment defaults, breach of representations and warranties, and insolvency events. We were in compliance with the terms of the PPP loan as of June 30, 2020.

On June 7, 2020, we obtained an Economic Injury Disaster Loan from the United States Small Business Administration in the amount of $150,000. Interest on the loan is at the rate of 3.75% per year, and all loan payments are deferred for twelve months, at which time the balance is payable in monthly installments of $731 over a 30-year term. The loan is secured by all of our assets.

We continue to review and consider any available potential benefit under the CARES Act for which we qualify. We cannot predict the manner in which such benefits or any of the other benefits described herein will be allocated or administered and we cannot assure you that we will be able to access such benefits in a timely manner or at all. If the U.S. government or any other governmental authority agrees to provide such aid under the CARES Act or any other crisis relief assistance it may impose certain requirements on the recipients of the aid, including restrictions on executive officer compensation, dividends, prepayment of debt, limitations on debt and other similar restrictions that will apply for a period of time after the aid is repaid or redeemed in full.

Results of Operations

Results of operations for the three months ended June 30, 2020 compared to the three months ended June 30, 2019.

Revenue and Cost of Goods Sold

Revenue for the three months ended June 30, 2020 and 2019 was $276,000 and $683,000, respectively, a decrease of $407,000, or 60%. The decrease was due to two significant factors during three months ended June 30, 2020, as compared to the prior year period. Those factors were: 1) a failed expansion of operations into cannabis cultivation and processing management services, which diverted resources and management attention; and 2) stagnation of the cannabis industry in terms of new markets and granting of new cultivation licenses, which resulted in few new companies obtaining licenses to legally grow cannabis, which ultimately resulted in a lack of orders for our lights.

Cost of sales for the three months ended June 30, 2020 and 2019 was $134,000 and $190,000, respectively. Gross profit for the three months ended June 30, 2020 and 2019, was $142,000 and $493,000, respectively. As a percentage of revenue, gross profit for the three months ended June 30, 2020 was 51%, compared to 72% for the three months ended June 30, 2019. The decrease 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, 2020 and 2019 were $260,000 and $873,000, respectively, a decrease of $613,000, or 70%. Our SG&A expenses decreased primarily due to reductions in the number of employees, benefits, and professional fees.

Research and Development Expenses

Research and development (“R&D”) expenses for the three months ended June 30, 2020 and 2019 was $25,000 and $145,000, respectively, a decrease of $120,000, or 83%. The decrease in R&D expenses was primarily due to decreased royalty expense.

Legal Judgment

On September 25, 2018, Matthew Geschke (the “Plaintiff”) filed a breach of contract case against us in the San Diego Superior Court of San Diego, California. The Plaintiff claimed damages for breach of an employment contract when we terminated the Plaintiff’s employment agreement on February 22, 2018. On June 26, 2020, the Plaintiff was awarded a default judgment against us in the amount of $448,000.

Loss on Abandonment of Leasehold Improvements

Loss on abandonment of leasehold improvement for the three months ended June 30, 2019 was $41,000. In February 2019, we terminated our Arizona facility lease, thereby abandoning $41,000 of leasehold improvements during the three months ended June 30, 2019. No similar activity occurred during the current year period.

Impairment of Intangible Assets

Impairment of intangible assets for the three months ended June 30, 2019 was $1,139,000. In June 2019, we determined that our intangible assets were impaired and recorded an impairment charge accordingly. No similar activity occurred during the current year period.

Other Income and Expenses

Other expense for the three months ended June 30, 2020 was $829,000, as compared to other income of 1,572,000 for the three months ended June 30, 2019. The decrease was due to the difference in the change in fair value of derivative liability of $2,210,000 and increased interest expense of $191,000 due to our increased debt levels.

Net Loss

Our net loss for the three months ended June 30, 2020 and 2019 was $1,420,000 and $214,000, respectively. The increase in net loss was due primarily to the change in other income and expenses, offset by the decrease in loss from operations.

Results of operations for the six months ended June 30, 2020 compared to the six months ended June 30, 2019.

Revenue and Cost of Goods Sold

Revenue for the six months ended June 30, 2020 and 2019 was $583,000 and $1,420,000, respectively, a decrease of $837,000, or 59%. The decrease was due to two significant factors during the six months ended June 30, 2020, as compared to the prior year period. Those factors were: 1) a failed expansion of operations into cannabis cultivation and processing management services, which diverted resources and management attention; and 2) stagnation of the cannabis industry in terms of new markets and granting of new cultivation licenses, which resulted in few new companies obtaining licenses to legally grow cannabis, which ultimately resulted in a lack of orders for our lights.

Cost of sales for the six months ended June 30, 2020 and 2019, was $329,000 and $765,000, respectively. Gross profit for the six months ended June 30, 2020 and 2019, was $254,000 and $655,000, respectively. As a percentage of revenue, gross profit for the six months ended June 30, 2020 was 44%, compared to 46% for the six months ended June 30, 2019. The decrease 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 3, 2020 and 2019 were $621,000 and $2,268,000, respectively, a decrease of $1,647,000, or 73%. Our SG&A expenses decreased primarily due to reductions in the number of employees, benefits, and professional fees.

Research and Development Expenses

R&D expenses for the six months ended June 30, 2020 and 2019 were $50,000 and $154,000, respectively, a decrease of $104,000, or 68%. The decrease in R&D expenses was primarily due to decreased royalty expense.

Legal Judgment

On September 25, 2018, the Plaintiff filed a breach of contract case against us in the San Diego Superior Court of San Diego, California. The Plaintiff claimed damages for breach of an employment contract when we terminated the Plaintiff’s employment agreement on February 22, 2018. On June 26, 2020, the Plaintiff was awarded a default judgment against us in the amount of $448,000.

Impairment of Right of Use (ROU”) Asset

Impairment of ROU asset for the six months ended June 30, 2020 was $82,000. In March 2020, we determined that our ROU asset was impaired and recorded an impairment charge accordingly. (See Note 5 to the accompanying condensed consolidated financial statements). No similar activity occurred during the prior year period.

Loss on Abandonment of Leasehold Improvements

Loss on abandonment of leasehold improvement for the six months ended June 30, 2019 was $218,000. In February 2019, we terminated our Arizona facility lease, thereby abandoning $218,000 of leasehold improvements during the six months ended June 30, 2019. No similar activity occurred during the current year period.

Impairment of Intangible Assets

Impairment of intangible assets for the six months ended June 30, 2019 was $1,139,000. In June 2019, we determined that our intangible assets were impaired and recorded an impairment charge accordingly. No similar activity occurred during the current year period.

Other Income and Expenses

Other expense for the six months ended June 30, 2020 was $2,111,000, as compared to other income of 1,051,000 for the six months ended June 30, 2019. The decrease was due to the difference in the change in fair value of derivative liability of $3,054,000, increased interest expense of $222,000 due to our increased debt levels and the decrease in financing costs of $114,000.

Net Loss

Our net loss for the six months ended June 30, 2020 and 2019 was $3,058,000 and $2,236,000, respectively. The increase in net loss was due primarily to the change in other income and expenses, offset by the decrease in loss from operations.

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, 2020 and 2019, we used cash in operating activities of $111,000 and $717,000, respectively. During the six months ended June 30, 2020, cash was primarily used to fund our operating loss of $3,058,000, partially offset by non-cash related items such as the impairment of ROU asset, financing costs, and the change in the fair value of derivative liabilities. Non-cash items during the six months ended June 30, 2020 in aggregate were $1,859,000. The remaining changes were due to a $679,000 increase in legal settlements payable, a $104,000 increase in accounts payable and accrued expenses, and a $305,000 change in our remaining working capital accounts.

Cash Flows Used in Investing Activities

During the six months ended June 30, 2020 and 2019, we used $0 and $218,000, respectively, in cash from investing activities to purchase property and equipment.

Cash Flows Provided by Financing Activities

During the six months ended June 30, 2020 and 2019, we generated cash from financing activities of $454,000 and $288,000, respectively. During the six months ended June 30, 2020, we received proceeds of $125,000, net of fees of $25,000, from a secured convertible note payable, $355,000 from loans payable, offset by $26,000 of payments on our notes payable to related parties. 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 $12,000.

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, 2020, we incurred a net loss of $3,058,000 and used cash in operations of $111,000 and had a shareholders’ deficit of $11,555,000 at June 30, 2020. 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. In addition, our independent registered public accounting firm, in its report on our December 31, 2019 financial statements, has raised substantial doubt about our ability to continue as a going concern.

At June 30, 2020, we had cash on hand in the amount of $447,000. Management estimates that the current funds on hand will be sufficient to continue operations through March 2021. 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 shareholders, in case of equity financing.

Historically, we have financed our operations primarily through private sales of common stock, a line of credit, loans from a third party financial institutions, related parties, and operations. We anticipate that our primary capital source will be from the issuance of notes payable or the proceeds from the sale of our common stock. However, we may not generate sufficient revenues from product sales in the future to achieve profitable operations. If we are not able to achieve profitable operations at some point in the future, we may have insufficient working capital to maintain our operations as we presently intend to conduct them or to fund our expansion, marketing, and product development plans. There can be no assurance that we will be able to obtain such financing on acceptable terms, or at all.

Notes Payable to Related Parties

On May 9, 2016, we entered into note payable agreements with Alan Lien and Alvin Hao, former officers and directors, 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 notes are currently past due. A total of $600,000 was due on the combined notes at June 30, 2020 and December 31, 2019.

On May 8, 2019, we entered into a note agreement with the sister of Alvin Hao, a former officer and director, to borrow $150,000. The loan accrues interest at 8% per annum, are unsecured and due on November 8, 2019. The note is currently past due. A total of $150,000 was due on the note at June 30, 2020 and December 31, 2019.

We entered into note agreements with the parents of Alan Lien, a former officer and director. The loans accrue interest at 10% per annum, are unsecured and were due on or before December 31, 2016. The loans are currently past due. A total of $40,000 was due on the loans at each of June 30, 2020 and December 31, 2019.

Secured Convertible Notes 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 June 30, 2020, and provide a conversion right, in which the principal amount of the 2018 Note, together with any accrued but unpaid interest, could be converted into our common stock at a conversion price at 75% of the lowest volume weighted average price (VWAP) of our common stock during the 10 trading days immediately preceding the conversion date. A total of $1,728,000, including accrued interest, was due on the 2018 Note as of June 30, 2020. The 2018 Note is past due.

On October 29, 2019, we issued a convertible secured debenture (the “2019 Note”) to YA II PN in the principal amount of $275,000 with interest at 10% per annum (15% on default) and due on April 29, 2020. The 2019 Note provides a conversion right, in which the principal amount of the Note, together with any accrued but unpaid interest, could be converted into our common stock at a conversion price at 75% of the lowest volume weighted average price (VWAP) of our common stock during the 10 trading days immediately preceding the conversion date. A total of $293,000, including accrued interest, was due on the 2019 Note as of June 30, 2020. The 2019 Note is past due.

On February 13, 2020, we issued a secured convertible debenture (the “2020 Note”) in the principal amount of $150,000 with interest at 10% per annum (15% on default) and due on August 10, 2021. The 2020 Note provides a conversion right, in which any portion of the principal amount of the 2020 Note, together with any accrued but unpaid interest, may be converted into our common stock at a conversion price equal to 75% of the lowest VWAP of our common stock during the ten (10) trading days immediately preceding the date of conversion, subject to adjustment. A total of $156,000, including accrued interest, was due on the 2020 Note as of June 30, 2020.

Term Loans

On May 21, 2019, we entered into a loan agreement with Celtic Bank in the principal amount of $150,000 (the “Celtic Loan”) with interest at 40.44% per annum and due on May 21, 2020. The loan was guaranteed by Alvin Hao, one of our former officers. We have made principal payment of $112,000, leaving a total of $38,000 due on the term loan as of June 30, 2020. The Celtic Loan is past due.

On May 8, 2020, we obtained a Paycheck Protection Program loan in the amount of $205,000 pursuant to the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). Interest on the loan is at the rate of 1% per year, and all loan payments are deferred for six months, at which time the balance is payable in 18 monthly installments if not forgiven in accordance with the CARES Act and the terms of the promissory note we executed in connection with the loan.

On June 7, 2020, we obtained an Economic Injury Disaster Loan from the United States Small Business Administration in the amount of $150,000. Interest on the loan is at the rate of 3.75% per year, and all loan payments are deferred for twelve months, at which time the balance is payable in monthly installments of $731 over a 30 year term. The loan is secured by all of our assets.

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, we concluded that, as of the date of this report, our remediation efforts continue related to each of the material weaknesses that we have identified in our internal control over financial reporting, and additional time and resources will be required in order to fully address these material weaknesses. We have not been able to complete all actions necessary and test the remediated controls in a manner that would enable us to conclude that such controls are effective. We are committed to implementing the necessary controls to remediate the material weaknesses described below as our resources permit. These material weaknesses will not be considered remediated until (1) the new processes are designed, appropriately controlled and implemented for a sufficient period of time and (2) we have sufficient evidence that the new processes and related controls are operating effectively. The following material weaknesses in our internal control over financial reporting were identified by management as of June 30, 2020:

Ineffective Control Environment. The Company did not maintain an effective control environment, which is the foundation necessary for effective internal control over financial reporting. Specifically, the Company (i) did not maintain a functioning independent audit committee; (ii) did not have its Board of Directors review and approve significant transactions; (iii) had an insufficient number of personnel appropriately qualified to perform control design, execution and monitoring activities; (iv) had an insufficient number of personnel with an appropriate level of U.S. GAAP knowledge and experience and ongoing training in the application of U.S. GAAP and SEC disclosure requirements commensurate with the Company’s financial reporting requirements; (v) had inadequate segregation of duties consistent with control objectives; and (vi) lack of written documentation of the Company’s key internal control policies and procedures over financial reporting. The Company is required under Section 404 of the Sarbanes-Oxley Act to have written documentation of key internal controls over financial reporting. The Company did not formally document policies and controls to enable management and other personnel to understand and carry out their internal control responsibilities including the lack of closing checklists, budget-to-actual analyses, balance sheet variation analysis, and pro-forma financial statements. Additionally, the Company did not have an adequate process in place to complete its testing and assessment of the design and operating effectiveness of internal control over financial reporting in a timely manner;

Ineffective controls over financial statement close and reporting process. The Company did not maintain effective controls over its financial statement close and reporting process. Specifically, the Company: (i) had insufficient preparation and review procedures for disclosures accompanying the Company’s financial statements; and (ii) did not provide reasonable assurance that accounts were complete and accurate and agreed to detailed support and that reconciliations of accounts were properly performed, reviewed and approved; and

Insufficient segregation of duties in our finance and accounting functions due to limited personnel. We do not have sufficient segregation of duties within accounting functions. During the quarter ended June 30, 2020, we had limited personnel that performed nearly all aspects of our financial reporting process, including, but not limited to, access to the underlying accounting records and systems, the ability to post and record journal entries and responsibility for the preparation of the financial statements. Due to the fact that these duties were often performed by the same person, this creates a lack of review over the financial reporting process that would likely result in a failure to detect errors in spreadsheets, calculations, or assumptions used to compile the financial statements and related disclosures as filed with the SEC. These control deficiencies could result in a material misstatement to our interim or annual financial statements that would not be prevented or detected.

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, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II

Item 1. Legal Proceedings.

For information that updates the disclosures set forth under Part I, Item 3, “Legal Proceedings” in our 2019 Annual Report, refer to Note 6, Legal Settlements Payable – Past Due, and Note 12, Subsequent Events, to the Condensed Consolidated Financial Statements contained in Part I, Item 1 of this report, which are incorporated herein by reference.

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.

For information regarding senior securities that are currently in default, please refer to Note 8, Convertible Secured Note Payable to Related Party, to the Condensed Consolidated Financial Statements contained in Part I, Item 1 of this report, which is incorporated herein by reference.

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.