Karat Packaging Inc. - Quarter Report: 2021 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2021
OR

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

For the transition period from ______________ to ______________

Commission file number 001-40336

Karat Packaging Inc.

(Exact name of registrant as specified in its charter)

(Former name, former address and former fiscal year, if changed since last report)  

Securities registered pursuant to Section 12(b) of the Act:

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

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes ☒  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 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 ☒

The number of shares of Common Stock, $0.001 par value, outstanding on May 27, 2021 was 19,709,500 shares.

TABLE OF CONTENTS

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KARAT PACKAGING INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

PART I - FINANCIAL INFORMATION

Item 1.    Financial Statements

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

KARAT PACKAGING INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

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

KARAT PACKAGING INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (UNAUDITED)

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

KARAT PACKAGING, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

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

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Lollicup USA Inc. (“Lollicup”) was incorporated on January 21, 2001 under the laws of the State of California as an S-corporation. Effective January 1, 2018, Lollicup elected to convert from S-Corporation to a C-Corporation. Karat Packaging Inc. (“Karat Packaging”) was incorporated on September 26, 2018 as a Delaware corporation and became the holding company for Lollicup (collectively, the “Company”) through a share exchange with the shareholders of Lollicup.

The Company is a manufacturer and distributor of environmentally friendly, single-use disposable products used in a variety of restaurant and foodservice settings. The Company supplies a wide range of products for the foodservice industry, including food containers, tableware, cups, lids, cutlery, and straws. The products are available in plastic, paper, biopolymer-based and other compostable forms. In 2020, the Company began to supply personal protective equipment related products to their customer such as face shields and face masks. In addition to manufacturing and distribution, the Company offers customized solutions to the customers, including new product development, design, printing, and logistics services.

The Company also supplies products to smaller chains and businesses including boutique coffeehouses, bubble tea cafes, pizza parlors and frozen yogurt shops. The Company is also beginning to supply products to national and regional supermarkets as well as convenience stores.

The Company currently operates manufacturing facilities and distribution and fulfillment center in Chino, California and Rockwall, Texas. In addition, the Company operates four other distribution centers located in Rockwall, Texas, Branchburg, New Jersey, Summer, Washington and Summerville, South Carolina. The distribution and fulfillment centers are strategically located in proximity to major population centers, including the Los Angeles, New York, and Seattle metro areas. Also, on March 1, 2021, we completed the acquisition of the assets of Pacific Cup Inc., a paper cup manufacturer based in Kapolei, Hawaii.

Basis of Presentation: The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles as promulgated in the United States of America (“US GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 8-03 of Regulation S-X. Accordingly, these condensed consolidated financial statements do not include all the information and footnotes required by US GAAP for complete financial statements. The financial information as of March 31, 2021 and for the three-months ended March 31, 2021 and 2020 is unaudited; however, in the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-months ended March 31, 2021 are not necessarily indicative of the results that may be expected for any other interim period or for the year ending December 31, 2021.

The condensed consolidated balance sheet at December 31, 2020 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by US GAAP for complete financial statements. These financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2020.

Principles of Consolidation: The condensed consolidated financial statements include the accounts of Karat Packaging and its wholly-owned operating subsidiaries, Lollicup, Lollicup Franchising, LLC (“Lollicup Franchising”) (effective September 1, 2020, refer to Note 3), Pacific Cup, Inc. (effective March 1, 2021, refer to Note 3), and Global Wells, a variable interest entity wherein the Company is the primary beneficiary. All intercompany accounts and transactions have been eliminated.

Noncontrolling Interests: The Company consolidates its variable interest entity, Global Wells, in which the Company is the primary beneficiary. The Company became the primary beneficiary of Global Wells on March 23, 2018 upon execution of an operating lease agreement allowing the Company to lease Global Wells’ facility. 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Noncontrolling interests represent third-party equity ownership interests in Global Wells. The Company recognizes noncontrolling interests as equity in the condensed consolidated financial statements separate from Company’s stockholders’ equity. The amount of net income (loss) attributable to noncontrolling interests is disclosed in the condensed consolidated statements of income.

Estimates and Assumptions: Management uses estimates and assumptions in preparing financial statements in accordance with generally accepted accounting principles in the United States of America. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Actual results could differ materially from the estimates that were assumed in preparing the condensed consolidated financial statements. Estimates that are significant to the condensed consolidated financial statements include stock-based compensation, allowance for doubtful accounts, reserve for slow-moving and obsolete inventory, deferred taxes, and estimated useful lives of property and equipment.

Reporting Segment: The Company manages and evaluates its operations in one reportable segment. This segment consists of manufacturing and supply of a broad portfolio of single-use products that are used to serve food and beverages and are available in plastic, paper, foam, post-consumer recycled content and renewable materials. It also consists of the distribution of personal protective equipment related products such as face shields and face masks.

Earnings per Share: Basic earnings per common share is calculated by dividing net income attributable to Karat Packaging by the weighted average number of common shares outstanding during the related period. Diluted earnings per common share is calculated by adjusting weighted average outstanding shares, assuming conversion of all potentially dilutive shares.

Cash and cash equivalents: The Company considers all highly liquid investments purchased with an original maturity at the date of purchase of three-months or less to be cash equivalents. At March 31, 2021 and December 31, 2020, cash and cash equivalents were comprised of cash held in money market, cash on hand and cash deposited with banks.

Accounts Receivable and Allowance for Doubtful Accounts: Accounts receivable consists primarily of amounts due from customers. Accounts receivable are carried at their estimated collectible amounts and are periodically evaluated for collectability based on past credit history. The Company recognizes an allowance for bad debt on accounts receivable in an amount equal to the estimated probable losses net of recoveries. The allowance is based on an analysis of historical bad debt write-offs, current past due customers in the aging as well as an assessment of specific identifiable customer accounts considered at risk or uncollectible.

Inventories: Inventories consist of raw materials, work-in-process, and finished goods. Inventory cost is determined using the first-in, first-out (FIFO) method and valued at lower of cost or net realizable value. The Company maintains reserves for excess and obsolete inventory considering various factors including historic usage, expected demand, anticipated sales price, and product obsolescence.

Property and Equipment: Property and equipment are carried at cost, net of accumulated depreciation and amortization, and net of impairment losses, if any. Depreciation of property and equipment are computed by straight-line method over the estimated useful lives of the related assets. Leasehold improvements are amortized using the straight-line method over the term of the lease, or the estimated life of the improvement, whichever is less.

The estimated useful life of property and equipment are as follows: 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Normal repairs and maintenance are expensed as incurred, whereas significant changes that materially increase values or extend useful lives are capitalized and depreciated over the estimated useful lives of the related assets.

Deposits: Deposits include payments made for machinery and equipment related to the new Rockwall, Texas manufacturing facility. As of March 31, 2021 and December 31, 2020, the Company had deposits of approximately $2.3 million and $1.8 million, respectively, relating to machinery and equipment for this facility. Included in deposits are also payments made to the lessors of leased properties as security for the full and faithful observance of contracts, which will be refunded to the Company upon expiration or termination of the contract.

Impairment of Long-lived Assets: The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. An impairment exists if the undiscounted cash flows generated by the Company’s long-lived assets are less than the net book value of the related assets. If the long-lived assets are impaired, an impairment loss is recognized and measured as the amount by which the carrying value exceeds the estimated fair value of those assets. For the period ended March 31, 2021 and March 31, 2020, management concluded that an impairment write-down was not required.

Business Combination and Goodwill: The Company applies the acquisition method of accounting for business combinations in accordance with U.S. GAAP, which requires the Company to make use of estimates and judgments to allocate the purchase price paid for acquisitions to the fair value of the assets, including identifiable intangible assets, and liabilities acquired. Such estimates may be based on significant unobservable inputs. The Company’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Fair values are subject to refinement for up to one year after the closing date of an acquisition as information relative to closing date fair values becomes available. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings.

Goodwill is the excess of the acquisition price over the fair value of the tangible and identifiable intangible net assets acquired. The Company does not amortize goodwill, but performs an impairment test of goodwill annually or whenever events and circumstances indicate that the carrying amount of goodwill may exceed its fair value. The Company operates as a single operating segment with one reporting unit and consequently evaluates goodwill for impairment based on an evaluation of the fair value of the Company as a whole. Goodwill is evaluated for impairment at least annually on October 1, or more frequently if events or changes in circumstances would more likely than not reduce the fair value of its single reporting unit below its carrying value. As of March 31, 2021, goodwill recorded in the accompanying condensed consolidated balance sheets is related to the Company’s acquisition of Pacific Cup, Inc. and Lollicup Franchising (see Note 3). Through March 31, 2021, the Company determined no impairments have occurred.

Government Grants: Government grants are not recognized unless there is reasonable assurance that the Company and Global Wells will comply with the grants’ conditions and that the grants will be received. As of March 31, 2021 and December 31, 2020, the Company and Global Wells received cumulative grants of $900,000 and $1,302,000, respectively. These grants are reported as deferred income within other liabilities in the accompanying condensed consolidated balance sheets as there are conditions attached to the grants that the Company and Global Wells have not met. These conditions include requiring its facility in Rockwall, Texas to maintain a certain minimum tax value for the next five calendar years (the “Required Period”), continue operations in the facility for the Required Period, have a minimum number of full time equivalent employees with a minimum average annual gross wage employed in the operation of the facility in the Required Period, and promise to not engage in a pattern or practice of unlawful employment of aliens during the Required Period. 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Derivative Instruments: Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) Topic No. 815, Derivatives and Hedging, requires companies to recognize all of its derivative instruments as either assets or liabilities in the statement of financial position at fair value. The accounting for changes in the fair value (i.e., gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, a company must designate the hedging instrument, based upon the exposure being hedged, as a fair value hedge, cash flow hedge, or a hedge of a net investment in a foreign operation. For derivative instruments not designated as hedging instruments, the gain or loss is recognized in the statement of income during the current period.

The Company and Global Wells are exposed to certain risks relating to its ongoing business operations. The primary risks managed by using derivative instruments applicable to the Company and Global Wells is interest rate risk. Interest rate swaps are entered into to manage interest rate risk associated with the Company and Global Wells’ fixed and floating-rate borrowings. As of March 31, 2021 and December 31, 2020, the Company and Global Wells had interest rate swaps that are accounted for as a derivative instrument under ASC 815. The Company and Global Wells did not designate interest rate swaps for hedge accounting and as such, the change in fair value of interest rate swaps is recognized as interest expense in the accompanying condensed consolidated statements of income.

Variable Interest Entities: The Company has a variable interest in two entities, Global Wells and Lollicup Franchising, LLC (prior to September 1, 2020, the acquisition date, see Note 3).

Global Wells

In 2017, Lollicup along with three other unrelated parties formed Global Wells. Lollicup has a 13.5% ownership interest and a 25% voting interest in Global Wells, located in Rockwall, Texas. The purpose of this entity is to own, construct, and manage a warehouse and manufacturing facility. Global Wells’ operating agreement may require its members to make additional contributions only upon the unanimous decision of the members or where the cash in Global Wells’ bank account falls below $50,000. In the event that a member is unable to make an additional capital contribution, the other members will be required to make contributions to offset the amount that member cannot contribute, up to $25,000.

Global Wells was determined to be a variable interest entity in accordance with ASC Topic 810, Consolidations, however, at the time the investment was made, it was determined that Lollicup was not the primary beneficiary. In 2018, Lollicup entered into an operating lease with Global Wells (“Texas Lease”). The lease term for the Texas Lease is for 10 years beginning October 1, 2018 and called for a monthly lease payment of $214,500. The lease agreement was subsequently amended for the lease term to begin in May 1, 2019 and calls for a monthly lease payment of $196,000. In June 2020, the Company entered into another operating lease with Global Wells (“New Jersey Lease”). The lease term for the New Jersey Lease is for 5 years beginning July 1, 2020 and calls for a monthly lease payment of $90,128.

Upon entering into the Texas Lease with Lollicup on March 23, 2018, it was determined that Lollicup holds current and potential rights that give it the power to direct activities of Global Wells that most significantly impact Global Wells’ economic performance, receive significant benefits, or the obligation to absorb potentially significant losses, resulting in Lollicup having a controlling financial interest in Global Wells. As a result, Lollicup was deemed to be the primary beneficiary of Global Wells and has consolidated Global Wells under the risk and reward model of ASC Topic 810, for the period from March 23, 2018. The monthly lease payments for the Texas Lease and New Jersey Lease are eliminated upon consolidation.

Assets recognized as a result of consolidating Global Wells do not represent additional assets that could be used to satisfy claims against the Company’s general assets. Conversely, liabilities recognized as a result of consolidating Global Wells do not represent additional claims of the Company’s general assets; they represent claims against the specific assets of Global Wells, except for the Company’s guarantee of Global Wells’ term loans. The Company was a guarantor for Global Wells’ construction loan, which provided for advances up to $21,640,000 and expired in May 2019. In May 2019, Global Wells entered into a loan agreement with a financial institution and used the proceeds from the new term loan to pay off the principal balance and accrued interest related to the construction loan. In June 2020, Global Wells entered into a loan agreement with a financial institution to purchase land and building in Branchburg, New Jersey, which was also guaranteed by the Company. The Company entered into an operating lease with Global Wells to utilize the facility in Branchburg, New Jersey. As of March 31, 2021 and December 31, 2020, total loan guaranteed by the Company related to Global Wells amounted to $37,319,000 and $37,491,000, respectively. The term loans are also guaranteed by the Company’s two significant stockholders.

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following financial information includes assets and liabilities of Global Wells and are included in the accompanying condensed consolidated balance sheets, except for those that eliminate upon consolidation:

Lollicup Franchising, LLC

Prior to the acquisition on September 1, 2020 (see Note 3), the Company’s two major shareholders share common ownership with Lollicup Franchising. Lollicup Franchising owns and operates one store and also licenses its name to third party store owners and operators. The Company sells inventory to Lollicup Franchising and to the licensed third-party stores. In connection with the sales to third-party stores, the Company has an incentive program with Lollicup Franchising where a certain percentage of the sales to the third-party stores are paid to Lollicup Franchising. The Company has determined that the Company held a variable interest in Lollicup Franchising, however, it was determined that the Company is not the primary beneficiary.

The Company has incurred incentive program expenses of $32,000 for the three-months ended March 31, 2020, which are reported as a contra to net sales in the accompanying condensed consolidated statements of income.

The Company does not have any explicit arrangements and implicit variable interest where the Company is required to provide financial support to Lollicup Franchising. The Company has determined that the maximum exposure to loss as a result of its involvement with Lollicup Franchising is zero. 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Stockholder’s Equity: The Company’s Certificate of Incorporation authorizes both common and preferred stock. The total number of shares of all classes of stock authorized for issuance is 110,000,000 shares, par value of $0.001, with 10,000,000 designed as preferred stock and 100,000,000 designated as common stock. Each holder of common stock and preferred stock shall be entitled to one vote per share held.

In June 2020, a $0.04 cents per qualifying share of dividend was declared by the Company. The Company recorded $606,000 of cash dividends as of December 31, 2020.

In March 2020, the Company re-acquired 10,000 of its own shares from an existing shareholder. The total amount paid to acquire the shares was $107,000 and has been deducted from shareholders’ equity.

In July 2020, the Company re-acquired 13,000 of its own shares from an existing shareholder. The total amount paid to acquire the shares was $141,000 and has been deducted from shareholders’ equity.

Revenue Recognition: As the Company generates revenues from customers that include national distributors, fast food restaurants with multiple locations, small businesses, and those that purchase for individual consumption, the Company considers revenue disaggregated by customer type to most accurately reflect the nature and uncertainty of its revenue and cash flows that are affected by economic factors. For the three-months ended March 31, 2021 and 2020, net sales disaggregated by customer type consists of the amounts shown below.

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The transaction price is the amount of consideration to which the Company expects to be entitled to in exchange for transferring goods to the customer. Revenue is recorded based on the total estimated transaction price, which includes fixed consideration and estimates of variable consideration. Variable consideration includes estimates of rebates and other sales incentives, cash discounts for prompt payment, consideration payable to customers for cooperative advertising and other program incentives, and sales returns. The Company estimate its variable consideration based on contract terms and historical experience of actual results using the expected value method. The performance obligations are generally satisfied shortly after manufacturing and shipment as purchases made by the Company’s customers are manufactured and shipped with minimal lead time.

The Company’s contract liabilities consist of rebates and other sales incentives, consideration payable to customers for cooperative advertising and other program incentives, and sales return. As of March 31, 2021 and December 31, 2020, the contract liabilities were not considered significant to the financial statements.

Shipping and handling fees billed to a customer are recorded within net sales, with corresponding shipping and handling costs recorded in selling expense on the accompanying condensed consolidated statements of income. Shipping and handling fees billed to a customer are not deemed to be separate performance obligations as these activities occur before the customer receives the products. Shipping and handling costs included within selling expenses in the condensed consolidated financial statements for the three-months ended March 31, 2021 and 2020 were $5,483,000 and $3,758,000, respectively.

Sales taxes collected concurrently with revenue-producing activities and remitted to governmental authorities are excluded from revenue.

Sales commissions are expensed as incurred due to the amortization period being less than one year and are recorded in selling expense on the accompanying consolidated statements of income.

Advertising Costs: The Company expenses costs of print production, trade show, online marketing, and other advertisements in the period in which the expenditure is incurred. Advertising costs included in operating expenses in the condensed consolidated financial statements were $388,000 and $303,000 for the three-months ended March 31, 2021 and 2020, respectively.

Income Taxes: The Company applies the asset and liability approach for financial accounting and reporting for income taxes. Deferred income taxes arise from temporary differences between income tax and financial reporting and principally relate to recognition of revenue and expenses in different periods for financial and tax accounting purposes and are measured using currently enacted tax rates and laws. In addition, a deferred tax asset can be generated by net operating loss carryforwards. If it is more likely than not that some portion or all of a deferred tax asset will not be realized, a valuation allowance is recognized. 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The Company applies ASC 740, Income Taxes, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.

The Company’s practice is to recognize potential interest and/or penalties related to income tax matters as income tax expense in the accompanying condensed consolidated statements of income. Accrued interest and penalties are included on the related tax liability in the condensed consolidated balance sheets. The Company had no uncertain tax positions as of March 31, 2021 and December 31, 2020.

Concentration of Credit Risk: Cash is maintained at financial institutions and, at times, balances exceed federally insured limits. Management believes that the credit risk related to such deposits is minimal.

The Company extends credit based on the valuation of the customers’ financial condition and general collateral is not required. Management believes the Company is not exposed to any material credit risk on these accounts.

For the three-months ended March 31, 2021 and 2020, purchases from the following vendor makes up greater than 10 percent of total purchases:

*purchases represented less than 10% of total purchases 

Amounts due to the following vendors at March 31, 2021 and December 31, 2020 that exceed 10 percent of total accounts payable are as follows:

No customer accounted for more than 10 percent of sales for the three-months ended March 31, 2021 and 2020. No customer accounted for more than 10 percent of accounts receivable as of March 31, 2021 and December 31, 2020.

Fair Value Measurements: The Company follows ASC 820, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. Fair value is defined under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants.

ASC 820 establishes a hierarchy of valuation inputs based on the extent to which the inputs are observable in the marketplace. Observable inputs reflect market data obtained from sources independent of the reporting entity and unobservable inputs reflect the entity’s own assumptions about how market participants would value an asset or liability based on the best information available. 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value.

The following describes the hierarchy of inputs used to measure fair value and the primary valuation methodologies used by the Center for financial instruments measured at fair value on a recurring basis. The three levels of inputs are as follows:

Level 1 — Quoted prices in active markets for identical assets or liabilities that the Center has the ability to access as of the measurement date.

Level 2 — Inputs that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the same term of the assets or liabilities.

Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Financial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.

The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.

At March 31, 2021 and December 31, 2020, the Company has financial instruments classified within the fair value hierarchy, which consist of the following:

The following table summarize the Company’s fair value measurements by level at March 31, 2021 for the assets and liabilities measured at fair value on a recurring basis:

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table summarize the Company’s fair value measurements by level at December 31, 2020 for the assets and liabilities measured at fair value on a recurring basis:

The Company has not elected the fair value option as presented by ASC 825, Fair Value Option for Financial Assets and Financial Liabilities, for the financial assets and liabilities that are not otherwise required to be carried at fair value. Under ASC 820, material financial assets and liabilities not carried at fair value, including accounts receivable, accounts payable, and borrowing under promissory notes, are reported at their carrying value.

The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, and accrued and other liabilities approximate fair value because of the short maturity of these instruments. The carrying amounts of long-term debt and line of credit at March 31, 2021 and December 31, 2020 approximates fair value because the interest rate approximates the current market interest rate. The fair value of these financial instruments was determined using level 2 inputs.

Foreign Currency: The Company includes gains or losses from foreign currency transactions, such as those resulting from the settlement of foreign receivables or payables, in the consolidated statements of operations. The Company recorded a loss on foreign currency transactions of $165,000 and $41,000 for the three-months ended March 31, 2021 and 2020, respectively.

Stock-Based Compensation: The Company recognizes stock-based compensation expense related to employee stock options in accordance with ASC 718, Compensation — Stock Compensation. This standard requires the Company to record compensation expense equal to the fair value of awards granted to employees and non-employees.

The fair value of share-based payment awards is estimated on the grant-date using the Black-Scholes option pricing model. Key input assumptions used in the Black-Scholes option pricing model to estimate the grant date fair value of stock options include the fair value of the Company’s common stock, the expected option term, the expected volatility of the Company’s stock over the option’s expected term, the risk-free interest rate, and the Company’s expected annual dividend yield.

The risk-free interest rate assumption for options granted under the 2019 Stock Incentive Plan is based upon observed interest rates on the United States government securities appropriate for the expected term of the Company’s stock options.

The expected term of employee stock options under the Plan represents the weighted-average period that the stock options are expected to remain outstanding. The expected term of options granted is calculated based on the “simplified method,” which estimates the expected term based on the average of the vesting period and contractual term of the stock option.

The Company determined the expected volatility assumption using the frequency of daily historical prices of comparable public company’s common stock for a period equal to the expected term of the options.

The dividend yield assumption for options granted under the Plan is based on the Company’s history and expectation of dividend payouts.

Stock-based compensation expense is based on awards that ultimately vest. Forfeitures are accounted for as they occur. The Company has elected to treat stock-based payment awards with graded vesting schedules and time-based service conditions as a single award and recognizes stock-based compensation expense on a straight-line basis over the requisite service period. 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The determination of stock-based compensation is inherently uncertain and subjective and involves the application of valuation models and assumptions requiring the use of judgment. If the Company had made different assumptions, its stock-based compensation expense, and its net loss could have been significantly different.

New and Recently Adopted Accounting Standards: The Company is an emerging growth company as that term is used in the Jumpstart Our Business Startups Act of 2012, and as such, the Company have elected to take advantage of certain reduced public company reporting requirements. In addition, Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended, or the Securities Act, for complying with new or revised accounting standards, as a result, the Company will adopt new or revised accounting standards on the relevant dates in which adoption of such standards is required for private companies.

In February 2016, the FASB issued ASU 2016-02 (Topic 842), “Leases”. This ASU amends a number of aspects of lease accounting, including requiring lessees to recognize operating leases with a term greater than one year on their balance sheet as a right-of-use asset and corresponding lease liability, measured at the present value of the lease payments. This ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, and early adoption is permitted. The FASB subsequently issued ASU 2018-11 (Topic 842), “Leases: Targeted Improvements” which amends ASC 842 in two important areas, including (i) allowing lessors to combine lease and associated nonlease components by class of underlying asset in contracts that meet certain criteria and, (ii) provides entities with an optional method for adopting the new leasing guidance by recognizing a cumulative-effect adjustment to the opening balance of the retained earnings, and not to restate the comparative periods presented at the adoption date. The effective date for ASC 842 for public business entities is annual reporting periods beginning after December 15, 2018. The effective date for all other entities is annual reporting periods beginning after December 15, 2021. The Company elects to adopt the new standard in annual reporting period beginning after December 15, 2021, and is currently assessing the impact of this standard on the Company’s consolidated financial statements.

In June 2016, the FASB issued ASU 2016-13 “Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” which adds to U.S. GAAP an impairment model known as the current expected credit loss (CECL) model that is based on expected losses rather than incurred losses. Under the new guidance, an entity recognizes as an allowance its estimate of expected credit losses, which the FASB believes will result in more timely recognition of such losses. The ASU is also intended to reduce the complexity of U.S. GAAP by decreasing the number of credit impairment models that entities use to account for debt instruments. The ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years for public business entities that are U.S. Securities and Exchange Commission (SEC) filers. For all other public business entities, the ASU is effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. For all other entities, the ASU is effective for fiscal years beginning after December 15, 2021, and interim periods within those fiscal years. Early adoption is permitted beginning after December 15, 2018, including interim periods within those fiscal years. The FASB subsequently issued ASU 2019-10 (Topic 326), “Financial Instruments-Credit Losses: Effective Dates” which amends the effective date for SEC filers that are eligible to be ‘smaller reporting companies’, non-SEC filers and all other companies, including not-for-profit companies and employee benefit plans. For calendar-year end companies that are eligible for the deferral, the effective date is January 1, 2023. The Company elects to adopt the new standard in annual reporting period beginning after January 1, 2023, and is currently assessing the impact of this standard on the Company’s consolidated financial statements.

In June 2018, the FASB issued ASU 2018-07 (Topic 718), “Compensation — Stock Compensation: Improvements to Non-employee Share based Payment Accounting”, which supersedes Subtopic 505-50 and expands the scope of ASC Topic 718 to include share-based payments issued to nonemployees for goods and services. The amendments also clarify that Topic 718 does not apply to share-based payments used to effectively provide financing to the issuer or awards granted in conjunction with selling goods or services to customers as part of a contract accounted for under ASC Topic 606. The FASB subsequently issued ASU 2019-08 (Topic 718), “Compensation — Stock Compensation” which clarifies guidance in Topic 718 on measurement and classification of share-based payments to customers. The amendments in this ASU are effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. For all other entities, the ASU is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted, but no earlier than a company’s adoption date of Topic 606. The Company adopted this ASU as of January 1, 2020 and adoption of this guidance did not have a material impact on the Company’s financial position, results of operations and cash flow. 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

In August 2018, the FASB issued ASU 2018-13 “Fair Value Measurement (Topic 820) Disclosure Framework — Changes to the Disclosure Requirements for Fair Value Measurement”. The guidance in this ASU eliminates certain disclosure requirements for fair value measurements for all entities, requires public entities to disclose certain new information and modifies some disclosure requirements. Entities are no longer required to disclose the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy but require public companies to disclose the range and weighted average used to develop significant unobservable inputs for Level 3 fair value measurements. Certain provisions are applied prospectively while others are applied retrospectively. This ASU is effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted. The Company adopted this ASU as of January 1, 2020 and adoption of this guidance did not have a material impact on the Company’s financial position, results of operations and cash flow.

In December 2019, the FASB issued ASU 2019-12 “Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes”. The guidance in this ASU eliminates certain exceptions for recognizing deferred taxes for investments, performing intraperiod allocation and calculating income taxes in interim periods. The ASU also adds guidance to reduce complexity in certain areas, including recognizing deferred taxes for tax goodwill and allocating taxes to members of a consolidated group. For public entities, the amendments in this Update are effective for fiscal years, beginning after December 15, 2020. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Early adoption of the amendment is permitted. As part of the IPO relief provided to EGC, an EGC may elect to adopt new standards on the timeline afforded a private company. The Company elects to adopt the new standard in annual reporting period beginning after December 15, 2021, and is currently assessing the impact of this standard on the Company’s consolidated financial statements.

In March 2020, the FASB issued ASU 2020-03 “Codification Improvements to Financial Instruments”. The guidance in this ASU clarifies the requirement for all entities to provide the fair value option disclosures in paragraphs 825-10-50-24 through 50-32 of the FASB’s ASC. The guidance also clarifies that the contractual term of a net investment in a lease determined in accordance with ASC 842, “Leases”, should be the contractual term used to measure expected credit losses under ASC 326, “Financial Instruments — Credit Losses”. This ASU is effective upon adoption of the amendments in ASU 2016-13. Early adoption is not permitted before an entity’s adoption of ASU 2016-13.

Pacific Cup, Inc.

On March 1, 2021, Lollicup entered into an asset purchase agreement (“the Pacific Cup Agreement”) with Pacific Cup, Inc. (“Pacific Cup”), a manufacturer and distributor of disposable products operating in Kapolei, Hawaii. Pursuant to the Pacific Cup Agreement, Lollicup paid cash consideration of $1,000,000 to acquire certain assets of Pacific Cup. Acquisition-related costs were immaterial.

The acquisition of Pacific Cup has been accounted for as a business combination pursuant to ASC 805, Business Combinations, using the acquisition method of accounting. The acquisition method requires, among other things, that assets acquired and liabilities assumed to be recognized at their fair values as of the acquisition date. The initial estimated fair value of assets acquired has been recognized based on management’s estimates and assumptions using information about facts and circumstances that existed at the acquisition date. The excess of the purchase price over the tangible assets is preliminarily recorded as goodwill. The Company is in the process of finalizing the allocation of its purchase price related to this acquisition and expects amounts to be allocated to other intangible assets. Accordingly, as of March 31, 2021, the acquired assets are reported at its provisional amounts. The Company will utilize the measurement period as defined under ASC 805-10-25-15 to finalize the accounting for this acquisition and recognize adjustments to the initial estimated fair values with a corresponding adjustment to goodwill in the reporting period the adjustments are identified. 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The goodwill recognized in this transaction was derived from expected opportunities to leverage Pacific Cup’s customer base, manufacturing facility, and sales force to expand the Company’s footprint. Goodwill recognized as a result of this acquisition is deductible for income tax purposes, and subject to annual impairment testing, which may give rise to deferred taxes in future periods.

The following table summarizes the preliminary assets acquired as a result of this acquisition:

Lollicup Franchising, LLC

On September 1, 2020, Lollicup entered into a membership interest purchase agreement (“the Franchising Agreement”) with Lollicup Franchising, LLC (“Lollicup Franchising”), a provider of specialty tea and coffee to consumers through operating retail stores within the United States. Pursuant to the Franchising Agreement, Lollicup paid cash consideration of $900,000 for the 100% membership interest of Lollicup Franchising. Prior to closing of the Franchising Agreement, the majority shareholders of the Company were also the majority shareholders of Lollicup Franchising. Acquisition-related costs were insignificant.

The acquisition of Lollicup Franchising has been accounted for as a business combination pursuant to ASC 805 using the acquisition method of accounting. The estimated fair value of assets acquired and liabilities assumed has been recognized based on management’s estimates and assumptions using information about facts and circumstances that existed at the acquisition date. The excess of the purchase price over the tangible assets and assumed liabilities is preliminarily recorded as goodwill.

The goodwill recognized in this transaction was derived from expected benefits from new management strategy and cost synergies. Goodwill recognized as a result of this acquisition is deductible for income tax purposes, and subject to annual impairment testing, which may give rise to deferred taxes in future periods. 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table summarizes the assets acquired and liabilities assumed as a result of this acquisition:

The results of operations of the Pacific Cup and Lollicup Franchising acquisitions have been included in the Company’s condensed consolidated financial statements beginning on their respective acquisition dates. All intercompany transactions were eliminated upon consolidation. The amounts of revenue and earnings of the acquirees since the acquisition date are included in the condensed consolidated statements of income for the reporting period, which is not significant from January 1, 2021 through March 31, 2021.

Inventories consist of the following:

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Property and equipment, net consist of the following:

Depreciation and amortization expense were $2,464,000 and $1,892,000 for the three-months ended March 31, 2021 and 2020, respectively. Depreciation and amortization expense are reported within general and administrative expense except for depreciation and amortization expense related to manufacturing facilities and equipment, which are included in cost of goods sold on the accompanying condensed consolidated statements of income.

The Company has a line of credit with a lender with an initial maturity date of February 23, 2019. The agreement was amended prior to maturity to extend the maturity date to May 2019. In May 2019, the line of credit was amended again to extend the maturity date to May 2021 and increase the maximum borrowing from $25,000,000 to $30,000,000. Interest accrues at an annual rate of prime less 0.25% with a minimum floor of 3.75% (3.75% at March 31, 2021 and December 31, 2020). In September 2019, the Company further increased the maximum borrowing from $30,000,000 to $40,000,000. In July 2020, the line of credit was amended again to extend the maturity date to May 2022. The Company has $33,239,000 and $33,169,000 of line of credit borrowings as of March 31, 2021 and December 31, 2020, respectively. The Company is not required to pay a commitment (unused) fee on the undrawn portion of the line of credit and interest is payable monthly. The amount that can be borrowed is subject to a borrowing base that is calculated as a percentage of the accounts receivable and inventory balances measured monthly. The loan is secured by the Company’s assets and guaranteed by the Company’s stockholders. In accordance with the line of credit agreement, the Company must comply with certain financial covenants, including a minimum current ratio, minimum tangible net worth, minimum debt service coverage ratio, and minimum debt to earnings before interest, taxes, depreciation and amortization (“EBITDA”) ratio. As of March 31, 2021 and December 31, 2020, the Company was in compliance with the financial covenants. The Line of Credit also includes a standby letter of credit sublimit. The amounts issued under the standby letter of credit was $900,000 as of March 31, 2021 and December 31, 2020.

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table summarizes information related to accrued expense liabilities:

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Long-term debt consists of the following:

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

At March 31, 2021, future maturities  :

The Company was in compliance with all its financial covenants as of March 31, 2021 and December 31, 2020.

On April 16, 2020, the Company received loan proceeds in the amount of $5,000,000 under the Paycheck Protection Program (“PPP”). The PPP, established as part of the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”), provides for loans to qualifying businesses for amounts up to 2.5 times of the average monthly payroll expenses of the qualifying business. The loans and accrued interest are potentially forgivable after eight weeks as long as the borrower uses the loan proceeds for eligible purposes, including payroll, benefits, rent and utilities, and maintains its payroll levels. The amount of loan forgiveness will be reduced if the borrower terminates employees or reduces salaries during the eight-week period.

The unforgiven portion of the PPP loan is payable over two years at an interest rate of 1%, with a deferral of payments for the first six months. In October 2020, the PPP loan was amended to extend the deferral of payments until September 2021. The application for these funds required the Company to, in good faith, certify that the current economic uncertainty made the loan request necessary to support ongoing operations. This certification further required the Company to take into account its current business activity and ability to access other sources of liquidity sufficient to support ongoing operations in a manner that is not significantly detrimental to the business. The receipt of these funds, and the potential forgiveness of these PPP loan, are dependent on the Company having initially qualified for the loan and qualifying for the forgiveness of such loan is based on its future adherence to the forgiveness criteria. If, despite the good faith belief that given the Company’s circumstances all eligibility requirements for the PPP loan were satisfied, it is later determined that the Company is ineligible to receive the PPP loan, it may be required to repay the PPP loan in its entirety and/or be subject to additional penalties. While the Company applied for the forgiveness of the loan, there is no assurance that the Company will obtain forgiveness of the loan in whole or in part.

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

In June 2019, Global Wells entered into a ten-year floating-to-fixed interest-rate swap, with an effective date of June 13, 2019, that is based on the prime rate versus a 5.05% fixed rate. The notional value was $21,580,000 as of June 30, 2019. The payment dates are the fifth day of the month beginning July 5, 2019 to the termination date of May 4, 2029. As of March 31, 2021 and December 31, 2020, the fair value of the interest rate swap was $1,322,000 and $2,604,000, respectively, which is reported as other liabilities in the accompanying condensed consolidated balance sheets. For the three-months ended March 31, 2021 and 2020, Global Wells recognized approximately $1,282,000 as interest income and $2,186,000 as interest expense, respectively, related to change in fair value of this interest rate swap.

In June 2019, the Company also entered into a five-year floating-to-fixed interest-rate swap, with an effective date of June 3, 2019, that is based on the prime rate versus 5.19% fixed rate. The notional was $10,000,000 as of June 30, 2019. The payment dates are the fifth day of the month beginning July 5, 2019 to the termination date of May 31, 2024. As of March 31, 2021 and December 31, 2020, the fair value of the interest rate swap was $201,000 and $243,000, respectively, which is reported as other liabilities in the accompanying condensed consolidated balance sheets. For the three-months ended March 31, 2021 and 2020, the Company recognized approximately $41,000 as interest income and $229,000 as interest expense, respectively, related to change in fair value of this interest rate swap.

The Company is the lessee of warehouse vehicles under capital leases that expire in various years through 2024. The assets and liabilities under capital leases are recorded at the lower of the present value of the minimum lease payments or fair value of the assets. The assets are depreciated over their estimated useful lives. Depreciation of property under capital leases is included in depreciation and amortization expense within the general and administrative operating expenses.

Interest rates on capitalized leases vary from 3.55% to 6.50% and are imputed based on the lower of the Company’s incremental borrowing rate at the inception of each lease or the lessor’s implicit rate of return.

The capital leases provide for bargain purchase options and are guaranteed by the stockholders of the Company.

In January 2019, the Company’s Board of Directors adopted the 2019 Stock Incentive Plan (the “Plan”). A total of 2,000,000 shares of common stock has been authorized and reserved for issuance under the Plan in the form of incentive or nonqualified stock options and stock awards. A committee appointed by the Board of Directors of the Company determines the terms and conditions of each grant under the Plan. Employees, directors, and consultants are eligible to receive stock options and stock awards under the Plan. The aggregate number of shares available under the Plan and the number of shares subject to outstanding options may be increased or decreased by the Plan administrator to reflect any changes in the outstanding common stock by reason of any recapitalization, reorganization, reclassification, stock split, reverse split, combination of shares, exchange of shares, stock dividend or other distribution payable in capital stock or similar transaction.

The exercise price of incentive stock options may not be less than the fair market value of the common stock at the date of grant. The exercise price of incentive stock options granted to individuals that own greater than 10% of the voting stock may not be less than 110% of the fair market value of the common stock at the date of grant.

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The term of each incentive and nonqualified option is based upon such conditions as determined by the option agreement; however, the term can be no more than ten years from the date of the grant. In the case of an incentive stock option granted to an optionee who, at the time the option is granted, owns stock representing more than 10% of the voting power of all classes of stock of the Company or any parent or subsidiary, the term of the option will be such shorter term as may be provided in the option agreement, but not more than five years from the date of the grant.

Stock Options

A summary of the Company’s stock option activity under the Plan for the period ended March 31, 2021 is as follows:

At March 31, 2021, total remaining stock-based compensation expense for unvested stock options is approximately $40,000.

Restricted stock

The Company issued restricted stock units to employees of the Company. The following table summarizes the unvested restricted stock units for the period ended March 31, 2021:

The restricted stock units and stock options granted are subjected to vesting conditions that is contingent upon the closing of an initial public offering of the Company. Given the restriction on vesting, no stock-based compensation expense was recognized for the periods ended March 31, 2021 and December 31, 2020. The restricted stock units and stock options granted began vesting on April 15, 2021, which is the date of closing of the Company’s initial public offering. The Company will start recognizing stock-based compensation over the vesting period, which is generally over 3 years for the restricted stock units and 1 year for the stock options. At March 31, 2021, total remaining stock-based compensation expense for unvested restricted stock units is approximately $2.2 million.

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Basic earnings per share is calculated by dividing the net income attributable to Karat Packaging for the year by the weighted average number of common shares outstanding during the related period.

For the purpose of calculating diluted earnings per share, the profit attributable to equity holders of the Company and the weighted average number of common shares outstanding during the related period have been adjusted for the dilutive effects of all potential convertible shares and shares issuable through stock options and restricted stock awards. The dilutive earnings per share is calculated by dividing the profit attributable to equity holders of the Company by the weighted average number of shares that would have been in issue, inclusive of all potentially dilutive shares including unexercised stock options and unvested restricted stock, adjusted by the number of such shares that would have been issued at fair value as follows:

For the period ended March 31, 2021, a total of 236,000 shares of potentially dilutive shares have been excluded in the diluted earnings per share calculation due to its anti-dilutive impact on earnings per share.

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Lease Commitments

The Company leases its facilities under various operating leases expiring through 2031. The Company also leases automobiles under various operating leases expiring through 2024.

In 2018, Lollicup entered the Texas Lease, which is an operating lease with Global Wells. The lease term for the Texas Lease is for 10 years beginning October 1, 2018 and called for a monthly lease payment of $214,500. The lease agreement was subsequently amended for the lease term to begin in May 1, 2019 and calls for a monthly lease payment of $196,000.

In June 2020, the Company entered into the New Jersey Lease, another operating lease with Global Wells. The lease term for the New Jersey Lease is for 5 years beginning July 1, 2020 and calls for a monthly lease payment of $90,128.

At March 31, 2021, approximate future minimum lease obligations, which includes payment to Global Wells under certain lease arrangements as described above, are as follows:

In September 2020, Global Wells entered into an operating lease with an unrelated party as the landlord. The lease term is for 38 months beginning September 9, 2020 and generates monthly rental payments from $57,602 to $61,110 over the lease term.

Contingencies

The Company is involved from time to time in certain legal actions and claims arising in the ordinary course of business. Management believes that the outcome of such litigation and claims, should they arise in the future, is not likely to have a material effect on the Company’s financial position or results of operations.

Lollicup Franchising was determined to be a related party by virtue of common ownership from January 1, 2020 to August 31, 2020. The Company acquired all of the membership interest of Lollicup Franchising from the Company’s two primary shareholders for $900,000 in September 2020. Lollicup Franchising is a wholly-owned subsidiary of the Company and this balance is eliminated upon consolidation as of September 30, 2020 (see Note 3). Sales for the period ended March 31, 2020 to this related party was $14,000. The Company has incurred incentive program expenses of $32,000 for the period ended March 31, 2020.

As a minority stockholder of the Company, Keary Global owns 250,004 shares of common stock as of March 31, 2021, which Keary Global acquired upon exercise of two convertible notes during the third quarter of 2018. Keary Global and its affiliate, Keary International, are owned by one of the Company’s stockholders’ family member, who is also an employee of the Company. In addition to being a stockholder, Keary Global and Keary International are inventory suppliers and purchasing agents for the Company overseas. The Company has entered into ongoing purchase and supply agreements with Keary Global. At March 31, 2021 and December 31, 2020, the Company has accounts payable due to Keary Global and Keary International, of $3,420,000 and $5,038,000, respectively. Purchases for the three-months ended March 31, 2021 and 2020 from this related party were $5,055,000 and $7,782,000, respectively. 

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

In determining the interim provision for income taxes, the Company uses the annual estimated effective tax rate applied to the actual year-to-date income and adds the tax effects of any discrete items in the reporting period in which they occur.

For the three months ended March 31, 2021 and 2020, the Company’s annual estimated effective tax rate differed from the U.S. federal statutory tax rate of 21% primarily due to exclusion of non-controlling interest income, state taxes, permanent book tax differences, and income tax credits. For the three months ended March 31, 2021 and 2020, the Company’s income tax expense was $1.2 million and $.2 million, with effective tax rates of 28.0% and 26.1%, respectively.

ASC 740, Income Taxes, provides for the recognition of deferred tax assets if realization of these assets is more-likely-than-not. In evaluating the Company’s ability to recover its deferred tax assets, the Company considers all available positive and negative evidence, including its operating results, ongoing tax planning and forecasts of future taxable income on a jurisdiction-by-jurisdiction basis. Based upon the level of historical taxable income, at this time, the Company determined that sufficient positive evidence existed to conclude that it is more likely than not there will be full utilization of the deferred tax assets in each jurisdiction.

The Company remains subject to IRS examination for the 2016 through 2019 tax years, and received notice in February 2019 that it is under examination for years 2016 and 2017. Additionally, the Company files multiple state and local income tax returns and remains subject to examination in various of these jurisdictions, including California for the 2016 through 2019 tax years, and South Carolina for the 2017 through 2019 tax years. In September 2020, the Company acquired 100% LLC member interest in Lollicup Franchising, LLC. Lollicup Franchising, LLC was treated as a partnership for income tax purposes prior to the acquisition. It is currently under audit for tax year 2015 and 2016. The Company does not believe the outcome of this audit will have a material impact on the Company’s financial statement.

The Company accounts for uncertainties in income tax in accordance with ASC 740-10 — Accounting for Uncertainty in Income Taxes. ASC 740-10 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This accounting standard also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. As of March 31, 2021, the Company does not have any unrecognized tax benefits.

On March 27, 2020, the CARES Act was signed into law by the president. The CARES act provides several favorable tax provisions. The Company evaluated the impacts of CARES Act and determined it currently has no material impact to the Company’s consolidated financial statements.

The Taxpayer Certainty and Disaster Relief Act of 2020, enacted on December 27, 2020, added a temporary exception to the 50% limit (TCJA) on the amount that businesses may deduct for food or beverages. Beginning January 1, 2021, through December 31, 2022, the temporary exception allows a 100% deduction for food or beverages from restaurants. The Company evaluated the impacts and does not believe the Act has material impact to the income tax provision.

On March 10, 2021, the ’American Rescue Plan Act of 2021’ was signed into law by the president. The American Rescue Plan Act of 2021 provides several tax provisions. The Company evaluated the impacts of the American Rescue Plan Act of 2021 and determined it has no material impact to the income tax provision.

KARAT PACKAGING INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

On January 30, 2020, the World Health Organization (“WHO”) announced a global health emergency because of a new strain of coronavirus originating in Wuhan, China (the “COVID-19 outbreak”) and the risks to the international community as the virus spreads globally beyond its point of origin. In March 2020, the WHO classified the COVID-19 outbreak as a pandemic, based on the rapid increase in exposure globally. The full impact of the COVID-19 outbreak continues to evolve as of the date of this report.

As the pandemic is ongoing, it is uncertain as to the full magnitude that the pandemic will have on the Company’s financial condition, liquidity, and future results of operations. Management is actively monitoring the impact of the global situation on its financial condition, liquidity, operations, suppliers, industry, and workforce. Given the daily evolution of the COVID-19 outbreak and the global responses to curb its spread, while the Company is not able to precisely estimate the effects of the COVID-19 outbreak, the Company does not believe that it will be adversely affected. Furthermore, in response to the pandemic, the Company started supplying personal protective equipment related products to their customers, which had a positive impact to the Company’s operations in 2020.

Although the Company cannot estimate the length or gravity of the impact of the COVID-19 outbreak at this time, if the pandemic continues, it may have a material adverse effect on the Company’s results of future operations, financial position, and liquidity in fiscal year 2021.

On April 15, 2021, the Company completed an initial public offering of our common stock (“IPO”). In connection with the Company’s IPO, the Company offered 3,950,000 shares of the Company’s common stock at the initial public offering price of $16.00 per share, resulting in gross proceeds of $63,200,000. On April 23, 2021, the Company’s lead underwriter exercised an overallotment of 592,500 shares at the initial public offering price of $16.00 per share, resulting in additional gross proceeds of $9,480,000, totaling $72,680,000 in gross IPO proceeds. In connection with the IPO, the Company used a portion of the proceeds to pay down an aggregate of $50.2 million principal of its loan obligations in April and early May, 2021. These repayments comprised:

On May 18, 2021, the Company granted 35,000 restricted stock units to employees under the 2019 Stock Incentive Plan, with a 3-year vesting period.

Unless the context requires otherwise, references in this report to “Karat,” the “Company,” “we,” “us,” and “our” refer to Karat Packaging and its consolidated subsidiaries.

Forward-Looking and Cautionary Statements

This Quarterly Report on Form 10-Q, as well as information included in oral statements or other written statements made or to be made by us, contain statements that constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are neither historical facts nor assurances of future performance. Instead, they are based on our current beliefs, expectations, and assumptions regarding the future of our business, future plans and strategies, and other future conditions. Forward-looking statements can be identified by words such as “anticipate,” “believe,” “envision,” “estimate,” “expect,” “intend,” “may,” “plan,” “predict,” “project,” “target,” “potential,” “will,” “would,” “could,” “should,” “continue,” “ongoing,” “contemplate,” and other similar expressions, although not all forward-looking statements contain these identifying words. Examples of forward-looking statements include, among others, statements we make regarding:

We make many of our forward-looking statements based on our operating budgets and forecasts, which are based upon detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the impact of known factors, and it is impossible for us to anticipate all factors that could affect our actual results.

See the “Risk Factors” section and elsewhere in this Form 10-Q and previously disclosed in our Registration Statement on Form S-1, (Registration No. 333-253270), as filed with the SEC on April 6, 2021, as amended on March 30, 2021 and April 7, 2021, for a more complete discussion of the risks and uncertainties mentioned above and for discussion of other risks and uncertainties we face that could cause actual results to differ materially from those expressed or implied by these forward-looking statements. All forward-looking statements attributable to us are expressly qualified in their entirety by these cautionary statements as well as others made in this prospectus and hereafter in our other SEC filings and public communications. You should evaluate all forward-looking statements made by us in the context of these risks and uncertainties.

Overview

We are a rapidly-growing specialty distributor and select manufacturer of environmentally-friendly disposable foodservice products and related items. We are a nimble supplier of a wide range of products for the foodservice industry, including food and take out containers, bags, tableware, cups, lids, cutlery, straws, specialty beverage ingredients, equipment, gloves and other products. Our products are available in plastic, paper, biopolymer-based and other compostable forms. Our Karat Earth® line provides environmentally friendly options to our customers, who are increasingly focused on sustainability. We offer customized solutions to our customers, including new product development, design, printing and logistics services. While a substantial majority of our revenue is generated from the distribution of our vendors’ products, we do manufacture product ourselves. Our goal is to be the single-source provider to our customers for all of their disposable foodservice products and related needs.

We operate an approximately 500,000 square foot distribution center located in Rockwall, Texas, and an approximately 300,000 square foot distribution center in Chino, California. We have selected manufacturing capabilities in both of these facilities as well. In addition, we operate three other distribution centers located in Sumner, Washington, Summerville, South Carolina, Branchburg, New Jersey. Our New Jersey location is an approximately 108,000 square foot facility that recently opened in July 2020 and was fully operational in March 2021. We also intend to double the capacity of our current distribution center in South Carolina to better service customers in the Southeast region. Also, on March 1, 2021, we completed the acquisition of the assets of Pacific Cup Inc., a paper cup manufacturer based in Kapolei, Hawaii. During the first half of 2021, we intend to add an additional distribution facility and manufacture certain of our Karat Earth products, including paper straws, at the Pacific Cup location in Hawaii. Our distribution centers are strategically located in proximity to major population centers, including the Los Angeles, Dallas, New York, Seattle, Atlanta and Honolulu metro areas.

We manage and evaluate our operations in one reportable segment.

Results of Operations

Three Months Ended March 31, 2021 Compared to the Three Months Ended March 31, 2020

Net Sales

Net sales were $75.7 million for the three months ended March 31, 2021 compared to $64.1 million for the three months ended March 31, 2020, an increase of $11.6 million, or 18%. The increase in net sales was primarily driven by an increase of $9.3 million in product sales to our existing customers as we continue to increase the number of products used by our customers, acquisition of more than 6,300 new customers in the first quarter of 2021, increase in direct-to-consumer sales through our online channel, and an increase of $1.6 million in logistic service and shipping revenue. Since it’s peak in April 2020, personal protective equipment related products have declined to approximately under 1% of net sales for the first quarter of 2021.

Cost of goods sold

Cost of goods sold increased by $7.8 million, or 17% to $54.0 million for the three months ended March 31, 2021 compared to $46.2 million for the for the three months ended March 31, 2020. The increase in cost of goods sold was primarily due to an increase of $4.9 million in product costs driven by the general increase in costs in line with the increase in product sales, an increase of $2.8 million in freight and duty costs to acquire inventory from overseas, and in increase of $0.3 million in depreciation expense related to depreciation of our manufacturing equipment.

Gross profit

Gross profit increased $3.7 million, or 21%, to $21.6 million for the three months ended March 31, 2021 compared to $17.9 million for the three months ended March 31, 2020. The increase in gross profit was primarily driven by the increase in product sales as well as an increase in profit margin. Gross profit margin was 29% for the three months ended March 31, 2021 compared to 28% for the three months ended March 31, 2020, an increase of 1%. The increase in gross profit margin was driven primarily by the increase in product sales, and higher profit margins driven by our direct-to-consumer sales through our online channel.

Operating expenses

Operating expenses for the three months ended March 31, 2021, were $17.9 million compared to $13.8 million for the three months ended March 31, 2020, an increase of $4.1 million, or 29%. The increase was primarily due to an increase of $1.7 million in shipping costs to deliver products to our customers, $0.7 million increase in payroll-related costs due to workforce expansion, $0.6 million increase in rent driven by our New Jersey and Hawaii facilities, and $0.3 million increase in professional services fees.

Operating income

Operating income for the three months ended March 31, 2021 was $3.8 million compared to $4.1 million the three months ended March 31, 2020, a decrease of $0.3 million, or 8%. The decrease was primarily due to an increase in gross profit of $3.7 million resulting from increase in sales and improvements in gross profit margin offset by the increase in operating expenses of $4.1 million.

Other income (expenses)

Other income for the three months ended March 31, 2021 was $0.5 million, compared to other expenses of $3.3 million for the three months ended March 31, 2020, an increase of $3.8 million, or 114%. The increase was driven by a decrease in interest expense of $3.6 million primarily due to a gain recorded in the current period of $1.3 million as opposed to a loss recorded in the prior period of $2.4 million for changes in interest swap fair value, and an increase in rental income of $0.2 million.

Net income

Net income for the three months ended March 31, 2021 was $3.1 million compared to $0.6 million for the three months ended March 31, 2020, an increase of $2.5 million, or 438%. The increase was primarily driven by an increase in other income of $3.8 million as discussed above partially offset by a decrease in operating income of $0.3 million and an increase in income tax expense of approximately $1.0 million. Provision for income taxes was $1.2 million and $0.2 million for the three months ended March 31, 2021 and 2020, respectively. The Company’s effective tax rate for the three months ended March 31, 2021 and 2020 was 28% and 26%, respectively.

Adjusted EBITDA

Adjusted EBITDA for the three months ended March 31, 2021 was $6.8 million, compared to $6.0 million for the three months ended March 31, 2020, an increase of $0.8 million, or 14%. The increase was primarily driven by an increase in net income of $2.5 million as discussed above, a decrease in interest expense add-back of $3.6 million, an increase in provision for income taxes of $1.0 million, and an increase in depreciation and amortization of $0.6 million, and an increase of IPO related expenses of $.4 million. We use Adjusted EBITDA to measure our financial performance. Adjusted EBITDA is a supplemental non-GAAP financial measure of operating performance and is not based on any standardized methodology prescribed by GAAP. Adjusted EBITDA should not be considered in isolation or as alternatives to net income, cash flows from operating activities or other measures determined in accordance with GAAP. Also, Adjusted EBITDA is not necessarily comparable to similarly titled measures presented by other companies.

Three Months Ended March 31,

Liquidity and Capital Resources

Trends in Our Business

The following trends have contributed to the results of our operations, and we anticipate that they will continue to affect our future results:

With the onset of the COVID-19 global pandemic, we began to supply personal protective equipment related products to our customers. We anticipate that this growing trend of personal protective equipment related products will continue to have a positive impact on our results of operations as more of our customers will require personal protective equipment to meet the safety requirements of their employees and consumers; however, we believe that our sale of such products will constitute a decreasing percentage of our net sales and gross profit moving forward. Since its peak in April 2020, personal protective equipment related products have declined to approximately under 1% of net sales for the first fiscal quarter of 2021.

The following table summarizes total current assets, liabilities and working capital at March 31, 2021 compared to March 31, 2020: