Nano Magic Inc. - Annual Report: 2016 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

or

COMMISSION FILE NO. 1-11602

PEN Inc.

(Exact name of registrant as specified in its charter)

701 Brickell Ave., Suite 1550, Miami, Florida 33131

(Address of principal executive office, including Zip Code)

Registrant’s telephone number, including area code: (844) 273-6462

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

Securities registered pursuant to Section 12(g) of the Exchange Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. Yes [  ] No [X]

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [  ] No [X]

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 past 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 website, 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 if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained in this form and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.

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

The aggregate market value of the Common Stock held by non-affiliates of the Registrant, based upon the closing price of the Class A Common Stock on the OTCQB system on June 30, 2016 of $2.729, was approximately $3.6 million.

As of March 24, 2017, the registrant had 1,409,055 shares of Class A Common Stock (including 37,778 shares that are subject to forfeiture), 1,404,668 shares of Class B Common Stock, and 262,631 shares of Class Z Common Stock issued and outstanding.

Documents Incorporated by Reference

No documents are incorporated by reference into this annual report on Form 10-K.

PEN INC.

FORM 10-K

TABLE OF CONTENTS

PART I

Item 1. Business

PEN develops, commercializes and markets consumer and industrial products enabled by nanotechnology that solve everyday problems for customers in the optical, transportation, military, sports and safety industries. Our primary business is the formulation, marketing and sale of products enabled by nanotechnology including the ULTRA CLARITY brand eyeglass cleaner, CLARITY DEFOGIT brand defogging products and CLARITY ULTRASEAL nanocoating products for glass and ceramics. We also sell an environmentally friendly surface protector, fortifier, and cleaner. Our design center conducts product development services for us and for government and private customers and develops and sells printable inks and pastes, thermal management materials, and graphene foils and windows.

PEN was formed in 2014, and is the successor to Applied Nanotech Holdings Inc. that had been formed in 1989. In the combination that created PEN, Nanofilm, Ltd. acquired Applied Nanotech Holdings, Inc. Our principal operating segments coincide with our different business activities and types of products sold. This is consistent with our internal reporting structure. Our two reportable segments for the years ended December 31, 2016 and 2015 were (i) the Product segment and (ii) the Contract services segment (which we formerly called the Research and development segment).

Product Segment

Revenue is based on the retail and institutional sale of specialty products utilizing nanotechnology to deliver unique performance attributes at the surfaces of a wide variety of substrates. Our consumer products are sold as liquids, gels, foam and as wet and dry towelettes. Institutional products are sold in liquid form enabling application by a variety of common commercial techniques We rely on intellectual property including trade secret formulations to protect our proprietary technology.

We have three broad product technology platforms that offer solutions to some common problems such as ease of cleaning, preventing fogging, preventing accumulation of dirt or grime, improving resistance to scuffing and wear. All our products have some “nano” characteristic about them – whether it is being active at the molecular level, incorporation of submicron-particles, or creating very thin, self-assembling coatings that are 20 nanometers or less in thickness.

One line of consumer products center on our customized optical cleaning and de-fogging treatments. Another line of consumer products focuses on creating hygienic surfaces unfriendly to germs. In our consumer products, we strive to create segment leading brands that are sustainable, of high quality, and that are both easy and safe to apply. Institutional products include a family of coating liquids that create very thin, strongly-bound, clear coatings on surfaces used for glass and ceramic surface and a series of clear coatings for plastics incorporating submicron size particles to improve abrasion resistance and wear resistance without sacrificing transparency. We manufacture our formulations internally to protect our technology and maintain the highest quality for the products that we and our commercial partners bring to the marketplace.

Our products encompass:

We also believe that products enabled by nanotechnology can tackle and solve big, global problems in selected growing markets. We have three primary areas of new product focus:

In 2016, we introduced into the institutional market a hygienic product that creates surfaces unfriendly to germs. This is expected to be part of a family of cleaning products that protect and fortify surfaces at the nanoscale-level. The patent-pending product is a spray that cleans, penetrates and fortifies the surface. The product is safe for use on many surfaces, both natural and man-made. After application, the product continues to fortify and protect, keeping a clean and healthy surface.

Our product is made with safe ingredients and does not use harsh chemicals or disinfectants. We start with a natural mineral that is milled and engineered into a smaller shape and size. Then, the milled mineral is mixed with a proprietary cleaner solution to create our product. The mineral chosen is stable in air and water. No governmental approvals are required for sale of this product. The product:

We believe that our manufacturing capacity and contractors with whom we have established relationships will enable us to fill orders for the new product. Ingredients and packaging materials are readily available from a number of suppliers.

Marketing and Distribution

We sell our consumer products directly to retailers in the United States and work with outside agents and distributors. Our industrial products are sold directly to customers who frequently use our products in their own branded products.

Manufacturing Operations

Our manufacturing is divided between that done at our 50,000-square foot facility in Valley View, Ohio, and third-party contract bottlers and package manufacturers in the United States and India.

Intellectual Property and Proprietary Rights

Our nanotechnology expertise and related intellectual property used in our current products is specialized in the areas of surface science, molecular self-assembly, transparent composites, and surfactants. The intellectual property developed from this work is protected with a combination of selective patents and primarily by trade secrets. This intellectual property strategy is like that used by leading companies in the fragrance and flavors industry. No single patent is significant to any of our products.

Competition

Products sold into the optical segment have a small number of significant competitors. Our products are known to be the “benchmark” products in these segments and generally outperform our competitors’. Some of our products in these segments do compete for certain customers or certain applications against lower priced, traditional materials. Most of the companies selling products into these market segments are privately-held, U.S. packaging or catalog companies. Examples in the U.S. include Hilco Accessories, California Accessories, and Amcon Laboratories and, internationally, the catalog company, Prosben, Inc., from the Peoples Republic of China. In the nano-coating products area or the anti-fog product line we are not aware of any competitive products that match our product performance or processing characteristics.

Products sold into the hygienic, germ-unfriendly market have a diverse variety of potential competitors. Potential competitors fall into the general category of germ-killing cleaners, known as disinfectants. These disinfectants rely on the use of government-approved pesticides as their active ingredient. Examples include bleach, benzalkonium chloride, and alcohols. All disinfectant products require the use of protective gloves and masks for their safe use. Examples in the U.S. include the Clorox Company, GOJO Industries, Inc., and Reckitt Benckiser, Inc. Since our products do not include germ-killing pesticides and do not require protective clothing, it is unclear how customers will perceive our products as compared to these potential competitors.

Backlog

Sales are primarily pursuant to purchase orders for delivery of products. We do not believe that a backlog as of any date is indicative of future results. Some agreements give customers the right to purchase a specific quantity of products during a specified period, but these agreements do not obligate the customers to purchase any minimum quantity. The quantities purchased by the customer, as well as the shipment schedules, are frequently revised during the agreement term to reflect changes in the customer’s needs. Because of our relatively small size, a customer’s delay of a product shipment can make a difference in the results for an accounting period.

Geographical Information

All long-lived assets are in the United States.

Sources and availability of raw materials and the names of principal suppliers

We use third-party suppliers and contract manufacturers in the United States to obtain substantially all raw materials, components and packaging products. Over time, one unrelated third party has become our leading supplier in the United States. As is customary in our industry, historically we have not had long-term or exclusive agreements with third-party suppliers or contract manufacturers and have generally made purchases through purchase orders. We believe that we have good relationships with our suppliers and manufacturers and that there are alternative sources should one or more of these suppliers or manufacturers become unavailable. However, the disruption of our operations if a change becomes necessary and the likelihood of shipment delays means that the loss of, or a significant adverse change in our relationship with, any of our key suppliers or manufacturers, or any other supply change disruptions could have a material adverse effect on our business, prospects, results of operations, financial condition or cash flows.

Key Customers

A limited number of key customers account for a substantial portion of our commercial revenue. Revenues from two customers constituted approximately 30% and 14% of 2016 total revenue, and 28% and 11% of 2015 total revenue. Revenue from three customers was approximately 24%, 16% and 10% of 2014 revenue. Many of our customers are significantly larger than we are and, therefore, may be able to exert a high degree of influence over us. The loss of one of the largest customers or the failure to attract new customers could have a material adverse effect on our business, results of operations and financial condition.

Contract Services Segment

Our Contract services segment functions as the Design center for our new products as well as performing work for government agencies and private strategic partners. Formerly called the research and development segment, this segment has moved away from areas of research that do not involve product development, especially government contracts that require us to fund part of the research cost. This segment is now involved in proof of concepts and prototypes, for proposed PEN products and development work under contract for government and private entities. In our work on products for PEN we focus only on submicron size particles, not smaller nanoparticles that are subject to much greater government regulation. Our work generally falls under one of three technology platforms:

Much of our contract product development work is done under government contracts. Government contracts frequently limit profit on work done. With private development contracts, there is a relationship between revenues received under the contract and rights granted to the licensee under the contract. Our short-term goal when we work for others is to cover all out of pocket costs and contribute to our overall overhead. Our long-term goal is to become a trusted supplier of products to our development partners.

We have had small scale success with commercial sales of conductive inks and pastes and from thermal management materials. Our graphene foils are sold commercially but the size of the market is small. Product sales typically come from repeat business or from customer inquiries in our areas of expertise.

We continue to focus on stabilizing our financial situation and operating this segment at break-even or better based solely on revenues from our development activities.

Nanoelectronics Applications – Inks and Pastes

Metallic Inks & Pastes

Copper Inks - As flexible electronics grow, soldering is disappearing. New digital and additive manufacturing processes allow industries to move from the design process directly to the production line. We believe that only submicron particles are capable of producing inks that are compatible with the nozzles used in digital printing.

We sell copper inks and pastes to a variety of customers around the world. Certain of our products based on nano-copper are available only outside Asia under agreements with our former research partner Ishihara Chemical Company, Ltd., that has exclusive rights in Asia to patents developed under research contracts with them. Other copper products that we sell are available worldwide.

Other metallic inks – Our technology and development work in conductive inks also resulted in conductive inks and pastes using nickel, silver, and aluminum rather than copper. Research partners who funded some of our work using silver and aluminum have exclusive rights to certain products for solar applications. We are not restricted in using products for other applications, and we can sell into the solar field our products that do not infringe those specific patents.

There are silver inks on the market today, but because of the high cost of silver relative to copper, a successful copper or copper-alloy ink is likely to be of greater commercial interest to potential customers. Most inks and pastes sold in commercial quantities today are manufactured and sold by large multinational chemical companies. For example, the two largest suppliers of inks and pastes for solar cell production are DuPont and Ferro. We are unable to compete directly with companies of that size in established silver ink markets.

Technical Inks Printing Solution (TIPS)

Conductive inks have the potential to revolutionize many types of electronics manufacturing. Our strategy is to provide a comprehensive solution for end users not just by developing inks, but assisting in the process from start to finish. We call this our Technical Inks Printing Solution. We have also formed relationships with hardware manufacturers with the goal of providing seamless integration into high volume manufacturing for companies wishing to use conductive inks in their manufacturing processes. In addition to traditional 2D printing applications, we developed a multifunctional copper ink for 3D printing applications, the fastest growing segment of printed electronics.

Numerous other companies are working with other technologies for the commercial use of conductive inks and pastes. The commercialization of products using our technology depends on the results of our development work compared with results achieved by others, as well as other factors including raw material costs, marketing, resources, and production capabilities.

Sensors

Our approach to sensor technology offers the unique advantage of recognizing and sometimes measuring materials at the molecular level. Our competition in the sensor area will come from a variety of technologies and companies depending on the purpose and use of the sensor. The areas where we are currently active are:

Ion Mobility Sensors. We are developing sensors based on Ion Mobility Sensor (“IMS”) technology focusing on Differential Mobility Spectroscopy (“DMS”). These sensors are ideal for use when both high sensitivity and high selectivity (low false positives) are required. We have improved on existing IMS and DMS technology by developing our proprietary nonradioactive gas ionization sources to replace the radioactive isotopes that are traditionally used in these tools. Mercaptan and Methane sensors that we developed for use in the natural gas industry under funding from the Northeast Gas Association are currently being tested for UL certification. We expect that detectors based on this technology will start a field test under the auspices of the Northeast Gas Association starting in 2017.

We are also working on sensors for detection of citrus greening disease with collaboration from the California Citrus Research Board and funding from the U.S. Department of Agriculture (“USDA”).

Hydrogen Sensors. These sensors were initially targeted for use in fuel cells for automobiles and for remote monitoring of large power transformers. We developed a hydrogen sensor for use in the measurement of hydrogen in power transformer products. Currently, we are not aware of commercial interest in hydrogen sensors.

Carbon Monoxide Sensors. We have developed a low-power carbon monoxide sensor that can last for 10,000 hours on a single battery. The sensor will be specific to carbon monoxide with no cross sensitivity to other gases and elements and is also easily portable and highly sensitive.

Submicron Particle Formulations and Materials for Health and Safety Applications

Our work in the health and safety area builds on our understanding of certain compounds from our extensive work related to inks and pastes. The understanding of the chemistry of these particles and their interaction with surfactants and other solutions was combined with research and development work done for products already sold commercially resulted in new product concepts and materials with superior properties for applications in the field of health and safety.

Using our experience with metallic inks and our prior work with carbon nanotube composites we developed a new thin carbon foil made of layers of graphene for use in cyclotron accelerators that produce nuclear pharmaceuticals used by the medical field in Positron Emission Tomography (PET) imaging. We supply graphene foil to institutional customers who make nuclear pharmaceuticals, and our partners are testing our graphene windows for use in their equipment. The extent to which our partners are successful in the nuclear pharmaceutical marketplace is outside our control.

Intellectual Property Rights

An important part of our overall business and product development strategy is to protect our intellectual property and, when appropriate, we seek patent protection for our products and proprietary technology. Historically, we made filings in the United States and selected foreign jurisdictions. Beginning in 2014, as a cost saving measure, we became much more selective in filing patents and reduced the number of jurisdictions where we act to protect our rights. Still, our patent portfolio consists of approximately 50 patents, including issued patents and patent applications pending before foreign and United States Patent and Trademark Offices. Trade secret protection is also important to our products.

The patenting of technology-related products and processes involves uncertain and complex legal and factual questions. The legal standards change from time to time, and administrative and court interpretations are not always consistent in one jurisdiction, or across different jurisdictions. Therefore, there is no assurance that our pending United States and foreign applications will issue, or what scope of protection any issued patents will provide, or whether any such patents ultimately will be upheld as valid by a court of competent jurisdiction in the event of a legal challenge. Interference proceedings, to determine priority of invention, also could arise in any of our pending patent applications. The costs of such proceedings would be significant and an unfavorable outcome could result in the loss of rights to the invention at issue in the proceedings. If we fail to obtain patents, there can be no assurance that we can protect our rights in the technology, or that others will not independently develop substantially equivalent proprietary products and techniques, or otherwise gain access to our technology.

Competitors have filed applications for, or have been issued patents, and may obtain additional patents and proprietary rights relating to products or processes used in, necessary to, competitive with, or otherwise related to, our patents. The scope and validity of these patents, and the extent to which we may be required to obtain licenses under these patents or under other proprietary rights and the cost and availability of licenses is unknown. This may limit our ability to use and to license our technology. Litigation concerning these or other patents could be protracted and expensive. If suit were brought against us for patent infringement, we could potentially challenge the validity of the other patent but would need to overcome a presumption of validity. If we were found to infringe and the patent was held valid (or was unchallenged), there can be no assurance that the prevailing party would grant us a license. Even if a license were available, the payments that would be required are unknown and could materially reduce the value of our interest in the affected products.

We also rely upon unpatented trade secrets. No assurance can be given that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or disclose such technology or that we can meaningfully protect our rights to our unpatented trade secrets.

We require our employees, directors, consultants, outside scientific collaborators, sponsored researchers, and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed or made known to the individual through the relationship is to be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees and some consultants, the agreements provide that all inventions conceived by the individual while working for us will be our property. There is no assurance, however, that these agreements will provide sufficient protection for our trade secrets in the event of unauthorized use or disclosure of such information.

Government Contracts

A portion of our revenue in the Contract services segment consists of reimbursement of expenditures under U.S. government contracts. Our revenue from government contracts was $807,823 for the year ended December 31, 2016, and $1,187,994 and $504,130 for the years ended December 31, 2015 and 2014, respectively. These reimbursements represent all or a portion of the costs associated with such contracts. As of December 31, 2016, we have several government contracts in process that have approximately $648,143 of revenue yet to be recognized. Government contracts are subject to delays and risk of cancellation. Also, government contractors generally are subject to various kinds of audits and investigations by government agencies. These audits and investigations involve review of a contractor’s performance on its contracts, as well as its pricing practices, the costs incurred and compliance with all laws, regulations and standards. We have been audited by the government, with no material changes, and we do not expect the results of any government audit to have a significant effect on our operations or our financial statements.

Research and Development

Research and development activity is the driver for our new products and improvement of existing products. Research and development costs incurred in the development of the Company’s products was $290,402 for the year ended December 31, 2016, or 8.2% of our total operating costs. Research and development costs were $744,346 for 2015 and $607,049 in 2014. This represented approximately 15% and 13% of our total operating costs in each of those years (prior to an impairment loss). The ability to engineer product performance using nanotechnology is one of the ways we distinguish our products in marketing and sales of our products. Product research and development work includes development and refinement of formulas, engineering of liquid formulas that can be applied both by hand and by machine, optimization for a variety of performance characteristics, testing and characterization, and work on manufacturing processes and techniques both for producing the product, and for a customer’s use of the product.

Compliance with Environmental Laws

Our operations must satisfy governmental safety standards. Applicable safety standards are established by the U.S. Occupational Safety and Health Administration (“OSHA”), pollution control standards by the U.S. Environmental Protection Agency (“EPA”) and other state and local regulations, including foreign regulation for products manufactured or shipped outside the U.S. Some of our research work, and products developed may also be subject to regulation under the Radiation Control for Health and Safety Act administered by the Center for Devices and Radiological Health (“CDRH”) of the U.S. Food and Drug Administration. We take these requirements into account in product development. Cost of compliance with these regulations has not been significant in the past and we do not expect it to be material in the future.

OSHA, the EPA, the CDRH and other governmental agencies, both in the United States, the states where we or our customers sell products, and foreign countries, may adopt additional rules and regulations that may affect us and products using our technology. The cost of compliance with these regulations has not been significant to us in the past and is not expected to be material in the future. Changing regulations can affect our customers, and we have in the past, and may be required in the future, to reformulate or change packaging to address regulatory issues. This can affect timing of sales which may be significant in an accounting period.

Employees

As of December 31, 2016, we had 27 full-time employees. We do not anticipate the need to hire significant additional employees to support our existing business. If product sales increase, or we begin to see commercial sales of new products, we may hire additional employees. We are not subject to any collective bargaining agreements, and we consider our relations with our employees to be good.

Item 1A. Risk Factors

Not applicable.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This document contains forward-looking statements about us and our industry that involve substantial risks and uncertainties. All statements, other than statements of historical facts, included in this prospectus regarding our strategy, future operations, future financial position, future net sales, projected expenses, prospects and plans and objectives of management are forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievement to be materially different from those expressed or implied by the forward-looking statements.

In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “project,” “will,” “would,” “should,” “could,” “can,” “predict,” “potential,” “continue,” “objective,” or the negative of these terms, and similar expressions intended to identify forward-looking statements. However, not all forward-looking statements contain these identifying words. These forward-looking statements reflect our current views about future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Actual events or results could differ materially from those expressed or implied by these forward-looking statements as a result of various factors, including the risk factors described in greater detail in the section entitled “Risk Factors.”

These forward-looking statements represent our estimates and assumptions only as of the date of this report. Unless required by U.S. federal securities laws, we do not intend to update any of these forward-looking statements to reflect circumstances or events that occur after the statement is made or to conform these statements to actual results.

Item 1B. Unresolved Staff Comments

Not applicable.

Item 2. Properties.

We lease facilities in three locations. Our headquarters is in leased space in Miami, Florida. Our leased space in Austin, Texas is used primarily by our Contract services segment. Leased office, manufacturing and laboratory space in Valley View, Ohio is used by our Product segment. These facilities are adequate for our current needs.

Item 3. Legal Proceedings.

None.

Item 4. Mine Safety Disclosures.

Not Applicable

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our Class A common stock, $0.0001 par value, trades on the OTCQB system under the symbol “PENC”. The following table sets forth, on a per share basis for the periods indicated, the high and low sale prices for the common stock as reported by that system. These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions. On January 26, 2016, we effected a 1-for-180 reverse stock split of our common stock and the prices reported below have been retroactively adjusted to give effect to the reverse stock split.

As of March 24, 2017, the closing sale price for our Class A common stock as reported on the OTCQB system was $1.40. As of that date, there were approximately 344 shareholders of record for our Class A common stock, three holders of record of our Class B common stock and one holder of record of our Class Z common stock. This does not include beneficial owners holding Class A common stock in street name in brokerage accounts. As of our last record of total shareholders, including those holding stock in street name, there were approximately 5,115 shareholders.

Cash Dividends

We have never paid cash dividends on our common stock, have no plans to pay any dividends, and it is unlikely that we will pay any dividends in the foreseeable future. We currently intend to invest future earnings, if any, to finance expansion of our business. Any payment of cash dividends in the future will be dependent upon our earnings, financial condition, capital requirements, and other factors determined by our board of directors.

Recent Sales of Unregistered Securities

On November 14, 2016, the Company issued an aggregate of 3,636 shares of Class A common stock and 2,424 shares of Class B common stock to the Company’s directors as compensation to them for service on our board. These shares were valued on the date of grant of November 14, 2016 at $1.65 per share based on the quoted price of the stock for a total value of $10,000. On February 24, 2017, the Company issued an aggregate of 3,846 shares of Class A common stock and 2,564 shares of Class B common stock to the Company’s directors as payment for their service on the Company’s board. These shares were valued on the date of grant at $1.56 per share based on the quoted price of the stock for a total value of $10,000. The issuances of these shares were exempt from registration under the Securities Act of 1933, as amended, in reliance on Section 4(a)(2) and 3(a)(9).

Equity Compensation Plan Information

The table below sets out as of December 31, 2016 the number of securities to be issued upon the exercise of outstanding options, warrants and rights (column (a)), the weighted average exercise price of those options, warrants and rights (column (b)), and other than the securities to be issued upon the exercise of the outstanding options, warrants and rights, the number of securities remaining available for future issuance under the plan (column (c)).

Item 6. Selected Financial Data

Not applicable.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.

The following is management’s discussion and analysis of certain significant factors that have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements.

OVERVIEW

PEN develops, commercializes and markets consumer and industrial products enabled by nanotechnology that solve everyday problems for customers in the optical, transportation, military, sports and safety industries. Our primary business is the formulation, marketing and sale of products enabled by nanotechnology including the ULTRA CLARITY brand eyeglass cleaner, CLARITY DEFOGIT brand defogging products and CLARITY ULTRASEAL nanocoating products for glass and ceramics. We also sell an environmentally friendly surface protector, fortifier, and cleaner. Our design center conducts development services for us and for government and private customers and develops and sells printable inks and pastes, thermal management materials, and graphene foils and windows.

Our principal operating segments coincide with the types of products to be sold. The products from which revenues are derived are consistent with the reporting structure of the Company’s internal organization. The Company’s two reportable segments for the year ended December 31, 2016 and for the 2015 period were (i) the Product segment and (ii) the Contract services segment.

RESULTS OF OPERATIONS

The following comparative analysis on results of operations was based primarily on the comparative consolidated financial statements, footnotes and related information for the periods identified below and should be read in conjunction with the consolidated financial statements and the notes to those statements that are included elsewhere in this report. The results discussed below are for the years ended December 31, 2016 and 2015.

Comparison of Results of Operations for the Year Ended December 31, 2016 and 2015

Revenues

For the years ended December 31, 2016 and 2015, revenues consisted of the following:

For the year ended December 31, 2016, sales from the Product segment decreased by $808,201 or 10% as compared to the year ended December 31, 2015. This was primarily attributable to reduced sales volume of our optical cleaners and reduced volume of sales for anti-fog products to our traditional customers and delays in putting our products into other channels.

For the year ended December 31, 2016, revenues of our Contract services segment decreased by $761,214 or 43% due primarily to a reduction in government and private service contracts. Fewer government contracts results, in part, from our decision not to apply for contracts that require us to share a portion of the costs.

Cost of revenues

Cost of revenues includes inventory costs, materials and supplies costs, internal labor and related benefits, subcontractor costs, depreciation, overhead and shipping and handling costs incurred including costs related to government and private contracts in our Contract services segment.

For the year ended December 31, 2016, cost of revenues decreased by $1,034,163 or 16% reflecting the reduced revenues. These consisted of the following:

Gross profit and gross margin

For the year ended December 31, 2016, gross profit amounted to $2,805,687 as compared to $3,340,939 for the year ended December 31, 2015, a decrease of $535,252 or 16%. The decrease was due to reduced revenue at the top line. For the years ended December 31, 2016 and 2015, gross margins were 34.6% and 34.5%, respectively.

Gross profit and gross margin by segment and totals are as follows:

Operating expenses

For the year ended December 31, 2016, operating expenses amounted to $3,552,707 as compared to $5,104,862 for the year ended December 31, 2015, a decrease of $1,552,155 or 30%. For the years ended December 31, 2016 and 2015, operating expenses consisted of the following:

Loss from operations

For the year ended December 31, 2016, loss from operations amounted to $747,020 as compared to a loss from operations of $1,763,923 for the year ended December 31, 2015, a decrease of $1,016,903 or 58%.

Other income (expense)

Other income (expense) includes interest expense and other income, net. For the year ended December 31, 2016, total other income amounted to $191,019 as compared to total other expense of $105,324 for the year ended December 31, 2015, a difference of $296,343 or 281%. The increase in other income in 2016 was primarily attributable to income from subleasing excess space and sales of excess equipment at the Design center in Austin.

Net loss

For the year ended December 31, 2016, net loss amounted to $556,001 as compared to a net loss of $1,869,247 for the year ended December 31, 2015, a decrease of $ 1,313,246 or 70%.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity is the ability of an enterprise to generate adequate amounts of cash to meet its needs for cash requirements. We had a working capital deficit of $(1,072,691) and $189,128 of cash as of December 31, 2016 and working capital deficit of $(889,657) and $262,519 of cash as of December 31, 2015.

The following table sets forth a summary of changes in our working capital from December 31, 2015 to December 31, 2016:

The decrease in working capital was primarily attributable to reductions in accounts receivable, prepaid expenses and cash.

Net cash provided by operating activities was $444,453 for the year ended December 31, 2016 as compared to net cash used in operating activities of $804,208 for the year ended December 31, 2015, a positive change of $1,248,661.

Net cash provided by investing activities was $19,586 for the year ended December 31, 2016 as compared to cash used in investing activities of $248,123 for the year ended December 31, 2015. During the year ended December 31, 2016, the proceeds from sales of property and equipment exceeded the cost of equipment purchases while for the year ended December 31, 2015, we purchased property and equipment of $248,123.

Net cash used in financing activities was $537,430 for the year ended December 31, 2016 as compared to net cash provided by financing activities of $850,115 for the year ended December 31, 2015. During the year ended December 31, 2016, we paid down $504,231 more than we received under the line of credit and repaid other debt in the amount of $81,199. During the year ended December 31, 2015, we received net proceeds from the bank line of credit of $515,404 and received net proceeds from notes payable of $334,711.

Future Liquidity and Capital Needs.

Our principal future uses of cash are for working capital requirements, including sales and marketing expenses, legal and other professional fees, capital expenditures and reduction of accrued liabilities. These uses will depend on numerous factors including our sales and other revenues, and our ability to control costs. Recently, we have financed our working capital needs primarily through internally generated funds, and bank loans. We collect cash from our customers based on our sales to them and their respective payment terms. Over the past year we have reduced the scope of our operations to reduce our costs and enable us to operate without raising additional capital, although there can be no assurance that additional capital will not be needed in future periods. We will continue to look for opportunities to raise funds to permit us to increase the marketing of our products.

Revolving Credit Note

In April 2014, our subsidiary, Nanofilm entered into a $1,500,000 revolving credit line agreement (the “Revolving Note”) with Mackinac Commercial Credit, LLC (the “Lender”) with draws limited to a borrowing base as defined in the Revolving Note. The unpaid principal balance of this Revolving Note is payable on demand, is secured by all of Nanofilm’s assets, and bears interest computed at a rate of interest (the “Effective Rate”) which is equal to 7.0% above the LIBOR Rate, as defined, payable monthly. Nanofilm will pay to Lender a late charge of 5.0% of any monthly payment not received by Lender within 10 calendar days after its due date. The Company may, at any time or from time to time upon three business days’ written notice to Lender, prepay the Note in whole provided that if (i) Borrower prepays the Revolving Note in full and terminates the Revolving Note, or (ii) Lender terminates the Revolving Note after default, then Borrower will pay a termination premium equal to 2.0% of the maximum loan amount. On May 1, 2015, Nanofilm and the Lender entered into an amendment to the Loan and Security Agreement extending the outside maturity date to April 4, 2016 and permitting advances against an expanded borrowing base. The borrowing base was increased by $450,000 through October 31, 2015, with this amount reducing by $7,500 monthly thereafter. In addition, the Company guaranteed Nanofilm’s obligations to the Lender. On April 4, 2016, the maturity date under the Loan & Security Agreement between Nanofilm and the Lender was automatically extended for a one-year renewal term.

Without the Lender’s consent, so long as the obligation remains outstanding, in addition to other covenants as defined in the Revolving Note, Nanofilm shall not a) merge or consolidate with any other company, except for the Combination and shall not suffer a change of control; b) make any capital expenditures, as defined, materially affecting the business; c) declare or pay cash dividends upon any of its stock, or distribute any of its property, make any loans, make investments, redeem, retire or acquire any of its stock, d) become liable for the indebtedness of anyone else, as defined, and e) incur indebtedness, other than trade payables.

At December 31, 2016 and 2015, the Company had $979,688 and $1,288,748, respectively, in borrowings outstanding under the Revolving Note, which includes accrued interest of $17,494 and $14,340, respectively, with availability of up to $537,805 and $211,252, respectively, depending on the borrowing base at the time of the request for the advance. The weighted average interest rate during the years ended December 31, 2016 and 2015 was approximately 8.0% and 7.3%, respectively.

Equipment Financing

On February 10, 2015, Nanofilm entered into a $373,000 promissory note (the “Equipment Note”) with KeyBank, N.A. (the “Bank”). The unpaid principal balance of this Equipment Note is payable in 60 equal monthly installments payments of principal and interest through June 10, 2020. The Equipment Note is secured by certain equipment, as defined in the Equipment Note, and bears interest computed at a rate of interest of 4.35% per annum based on a year of 360 days. At December 31, 2016 and 2015, the principal amount due under the Equipment Note amounted to $260,331, and $334,711, respectively.

CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of our financial condition and results of operations are based upon our audited consolidated financial statements, that have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We continually evaluate our estimates, including those related to income taxes, and the valuation of equity transactions. We base our estimates on historical experience and on various other assumptions that we believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Any future changes to these estimates and assumptions could cause a material change to our reported amounts of revenues, expenses, assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the unaudited consolidated financial statements.

Impairment of long-lived assets

In accordance with ASC Topic 360, we review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable, or at least annually. We recognize an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value.

Revenue recognition

Pursuant to the guidance of ASC Topic 605, we recognize sales when persuasive evidence of an arrangement exists, delivery has occurred or services have been provided, the purchase price is fixed or determinable and collectability is reasonably assured.

Types of Revenue:

Revenue Recognition Criteria:

Research and development

Research and development costs incurred in the development of our products and under other Company sponsored research and development projects are expensed as incurred. Costs such as direct labor, direct costs, and other allocated costs incurred to perform contract services under government and private contracts are included in cost of sales.

Stock-based compensation

Stock-based compensation is accounted for based on the requirements of the Share-Based Payment Topic of ASC 718 which requires recognition in the financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the period the employee or director is required to perform the services in exchange for the award (presumptively, the vesting period). The ASC also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award.

Pursuant to ASC Topic 505-50, for share-based payments to consultants and other third-parties, compensation expense is determined at the “measurement date.” The expense is recognized over the service period of the award. Until the measurement date is reached, the total amount of compensation expense remains uncertain. We initially record compensation expense based on the fair value of the award at the reporting date.

Segment reporting

We use “the management approach” in determining reportable operating segments. The management approach considers the internal organization and reporting used by our chief operating decision maker for making operating decisions and assessing performance as the source for determining our reportable segments. Our chief operating decision maker is the Chairman and chief executive officer (“CEO”) of the Company, who reviews operating results to make decisions about allocating resources and assessing performance for the entire Company. We classified the reportable operating segments into (i) the development, manufacture and sale of consumer and institutional products using nanotechnology to deliver unique performance attributes at the surfaces of a wide variety of substrates (the “Product segment”) and (ii) nanotechnology design and development services for our future products and for government and private entities and sales of products developed for third parties (the “Contract services segment”).

RECENT ACCOUNTING PRONOUNCEMENTS

See Note 2 of the Notes to our consolidated financial statements for information related to recent accounting pronouncements.

OFF-BALANCE SHEET ARRANGEMENTS

We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder’s equity or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

Not Applicable.

Item 8. Financial Statements and Supplementary Data.

PEN INC. AND SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 and 2015

PEN INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2016 and 2015

CONTENTS

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of:

PEN Inc.

We have audited the accompanying consolidated balance sheets of PEN Inc. and Subsidiaries as of December 31, 2016 and 2015 and the related consolidated statements of operations, changes in stockholders’ equity (deficit), and cash flows for each of the two years in the period ended December 31, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of PEN Inc. and Subsidiaries as of December 31, 2016 and 2015 and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has a net loss in 2016 of $556,001, and has an accumulated deficit, stockholders’ deficit and working capital deficit of $5,900,167, $578,096 and $1,072,691, respectively, at December 31, 2016. These matters raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plan in regards to these matters is also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ Salberg & Company, P.A.

SALBERG& COMPANY, P.A.

Boca Raton, Florida

March 29, 2017

PEN INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

PEN INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to consolidated financial statements.

PEN INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)

FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015

(1) Includes cash issuance costs of $2,000.

See accompanying notes to consolidated financial statements.

PEN INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to consolidated financial statements.

PEN INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

NOTE 1 – ORGANIZATION AND BASIS OF PRESENTATION

Organization

PEN Inc. (“we”, “us”, “our”, “PEN” or the “Company”), a Delaware company, develops and sells a portfolio of nano-layer coatings, nano-based cleaners, and nano-composite products based on its proprietary technology, and performs nanotechnology product research and development generating revenues through performing contract services.

Through our wholly-owned subsidiary, Nanofilm, Ltd., we develop, manufacture and sell consumer and institutional products using nanotechnology to deliver unique performance attributes at the surfaces of a wide variety of substrates. These products are marketed internationally primarily to customers in the optical industry.

Through our wholly-owned subsidiary, Applied Nanotech, Inc., we primarily perform design and development services for ourselves and for governmental and private customers.

Basis of presentation and principles of consolidation

The Company’s consolidated financial statements include the financial statements of its wholly-owned subsidiaries, Applied Nanotech, Inc., PEN Technology LLC, and Nanofilm, Ltd. On December 15, 2016, our wholly-owned subsidiary, PEN Technology LLC, was merged into Nanofilm. All significant intercompany accounts and transactions have been eliminated in consolidation.

On January 26, 2016, each one hundred eighty (180) shares of our (i) Class A Common Stock, (ii) Class B Common Stock and (iii) Class Z Common Stock, then issued and outstanding were automatically combined into one (1) validly issued, fully paid and non-assessable share of Class A Common Stock, Class B Common Stock and Class Z Common Stock, respectively, without any further action by us or the holder (the “Reverse Stock Split”). Additionally, the authorized number of shares of common stock were reduced to 10,000,000 shares comprised of 7,200,000 shares of Class A Common Stock, 2,500,000 shares of Class B Common Stock, and 300,000 shares of Class Z Common Stock. The par value of each class of common stock remained the same at $0.0001 per common share. All share and per share data in the accompanying consolidated financial statements have been retroactively restated to reflect the effect of the Reverse Stock Split and authorized shares.

Going concern

These 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 consolidated financial statements, the Company had a net loss of $556,001 and $1,869,247 for the years ended December 31, 2016 and 2015, respectively. The net cash provided by (used in) operations were $444,453 and $(804,208) for the years ended December 31, 2016 and 2015, respectively. Additionally, the Company had an accumulated deficit, a stockholders’ deficit and a working capital deficit of $5,900,167, $578,096 and $1,072,691, respectively, at December 31, 2016. These factors raise substantial doubt about the Company’s ability to continue as a going concern. Management cannot provide assurance that the Company will ultimately achieve profitable operations or become cash flow positive, or raise additional debt and/or equity capital. During 2016, management has taken measures to reduce operating expenses. Although the Company has historically raised capital from sales of equity and from the issuance of promissory notes, there is no assurance that it will be able to continue to do so. These consolidated financial statements do not include any adjustments related to the recoverability and classification of assets or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

PEN INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates for the years ended December 31, 2016 and 2015 include estimates for allowance for doubtful accounts on accounts receivable, the estimates for obsolete inventory, the useful life of property and equipment, assumptions used in assessing impairment of long-term assets, estimates of current and deferred income taxes and deferred tax valuation allowances, the fair value of non-cash equity transactions, and the fair value of equity incentives.

Fair value of financial instruments and fair value measurements

The Company adopted the guidance of Accounting Standards Codification (“ASC”) 820 for fair value measurements which clarifies the definition of fair value, prescribes methods for measuring fair value, and establishes a fair value hierarchy to classify the inputs used in measuring fair value as follows:

Level 1- Inputs are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.

Level 2- Inputs are quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other than quoted prices that are observable, and inputs derived from or corroborated by observable market data.

Level 3- Inputs are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accounts receivable, loans and lines of credit, accounts payable, accrued expenses, and other payables approximate their fair market value based on the short-term maturity of these instruments.

The Company analyzes all financial and non-financial instruments with features of both liabilities and equity under the FASB’s accounting standard for such instruments. Under this standard, financial and non-financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The Company accounts for three instruments at fair value using level 3 valuation.

PEN INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

A roll forward of the level 3 valuation of these three financial instruments is as follows:

ASC 825-10 “Financial Instruments”, allows entities to voluntarily choose to measure certain financial assets and liabilities at fair value (fair value option). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, unrealized gains and losses for that instrument should be reported in earnings at each subsequent reporting date. The Company did not elect to apply the fair value option to any outstanding instruments.

Cash and cash equivalents

For purposes of the consolidated statements of cash flows, the Company considers all highly liquid instruments with a maturity of three months or less at the purchase date and money market accounts to be cash equivalents.

Accounts receivable

The Company recognizes an allowance for losses 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 experience, current receivables aging, and expected future write-offs, as well as an assessment of specific identifiable customer accounts considered at risk or uncollectible. The expense associated with the allowance for doubtful accounts is recognized as general and administrative expense.

Inventory

Inventory is stated at the lower of cost or market. Cost is determined using the first-in, first-out (FIFO) method.

Property and equipment

Property and equipment are stated at cost and are depreciated using the straight-line method over their estimated useful lives, which range from three to ten years. Leasehold improvements are depreciated over the shorter of the useful life or lease term including scheduled renewal terms. Maintenance and repairs are charged to expense as incurred. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition. The Company examines the possibility of decreases in the value of these assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable.

Impairment of long-lived assets

In accordance with ASC Topic 360, the Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable, or at least annually. The Company recognizes an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value.

PEN INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

Revenue recognition

Pursuant to the guidance of ASC Topic 605, the Company recognizes sales when persuasive evidence of an arrangement exists, delivery has occurred or services have been provided, the purchase price is fixed or determinable and collectability is reasonably assured.

Types of Revenue:

Revenue Recognition Criteria:

PEN INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

Sales incentives and consideration paid to customers

The Company accounts for certain promotional costs such as sales incentives and cooperative advertising as a reduction of sales. For the years ended December 31, 2016 and 2015, the Company recorded approximately $139,711 and $156,792, respectively, as a reduction of sales related to these costs.

Cost of sales

Cost of sales includes inventory costs, materials and supplies costs, internal labor and related benefits, subcontractor costs, depreciation, overhead and shipping and handling costs incurred.

Shipping and handling costs

Shipping and handling costs incurred relating to the purchase of inventory are included in inventory which is charged to cost of sales as product are sold. Shipping and handling costs charged to customers are included in sales. For the years ended December 31, 2016 and 2015, shipping and handling costs incurred for product shipped to customers are included in cost of sales and amounted to $184,177 and $179,584, respectively.

Research and development

Research and development costs incurred in the development of the Company’s products and under other Company sponsored research and development projects are expensed as incurred. Costs such as direct labor, direct costs, and other allocated costs incurred to perform contract services pursuant to government and private contracts are included in cost of sales. For the years ended December 31, 2016 and 2015, research and development costs incurred in the development of the Company’s products were $290,402 and $744,346, respectively, and are included in operating expenses on the accompanying consolidated statements of operations.

Advertising costs

The Company participates in various advertising programs. All costs related to advertising of the Company’s products are expensed in the period incurred. For the years ended December 31, 2016 and 2015, advertising costs charged to operations were $31,523 and $93,336, respectively and are included in sales and marketing on the accompanying consolidated statements of operations. These advertising expenses do not include cooperative advertising and sales incentives which have been deducted from sales.

Federal and state income taxes

The Company accounts for income tax using the liability method prescribed by ASC 740, “Income Taxes”. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the year in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if based on the weight of available evidence, it is more-likely-than-not that some portion, or all, of the deferred tax assets will not be realized. The effect on deferred taxes of a change in tax rates is recognized as income or loss in the period that includes the enactment date.

The Company follows the accounting guidance for uncertainty in income taxes using the provisions ASC 740. Using that guidance, tax positions initially need to be recognized in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. As of December 31, 2016 and 2015, the Company had no uncertain tax positions that qualify for either recognition or disclosure in the financial statements. The Company does not expect any significant changes in its unrecognized tax benefits within twelve months of the reporting date. The Company recognizes interest and penalties related to uncertain income tax positions in other expense. However, no such interest and penalties were recorded as of December 31, 2016 or 2015.

PEN INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

Stock-based compensation

Stock-based compensation is accounted for based on the requirements of the Share-Based Payment Topic of ASC 718 which requires recognition in the financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the period the employee or director is required to perform the services in exchange for the award (presumptively, the vesting period). The ASC also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award.

Pursuant to ASC Topic 505-50, for share-based payments to consultants and other third-parties, compensation expense is determined at the “measurement date.” The expense is recognized over the service period of the award. Until the measurement date is reached, the total amount of compensation expense remains uncertain. The Company initially records compensation expense based on the fair value of the award at the reporting date.

Loss per share of common stock

ASC 260 “Earnings Per Share”, requires dual presentation of basic and diluted earnings per share (“EPS”) with a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. Basic EPS excludes dilution. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Basic net loss per common share is computed by dividing net loss available to common shareholders by the weighted average number of shares of common shares outstanding during the period. Diluted net loss per common share is computed by dividing net loss by the weighted average number of shares of common stock, common stock equivalents and potentially dilutive securities outstanding during each period. As of December 31, 2016 and 2015, 37,778 contingently issuable common shares that are issuable based on certain market conditions (see Note 9) are not included in the potential dilutive shares in calculating the diluted EPS. Additionally, potentially dilutive common shares consist of common stock options (using the treasury stock method). These common stock equivalents may be dilutive in the future. Potentially dilutive common shares were excluded from the computation of diluted shares outstanding as they would have an anti-dilutive impact on the Company’s net losses. Those excluded were the following:

Additionally, there are an unknown quantity of common stock equivalents that result from a potential conversion of equity credits and stock appreciation rights (See Notes 13 and 14).

PEN INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

Net loss per share for each class of common stock is as follows:

Segment reporting

The Company uses “the management approach” in determining reportable operating segments. The management approach considers the internal organization and reporting used by the Company’s chief operating decision maker for making operating decisions and assessing performance as the source for determining the Company’s reportable segments. The Company’s chief operating decision maker is the Chairman and chief executive officer (“CEO”) of the Company, who reviews operating results to make decisions about allocating resources and assessing performance for the entire Company. The Company classified the reportable operating segments into (i) the development, manufacture and sale of consumer and institutional products using nanotechnology to deliver unique performance attributes at the surfaces of a wide variety of substrates (the “Product segment”) and (ii) nanotechnology design and development services for our future products and for government and private entities and sales of products developed for third parties (the “Contract services segment”).

Recent accounting pronouncements

In May 2014, the FASB issued an update (“ASU 2014-09”), Revenue from Contracts with Customers. ASU 2014-09 establishes a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most of the existing revenue recognition guidance. ASU 2014-09 requires an entity to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services and also requires certain additional disclosures. ASU 2014-09 is effective for interim and annual reporting periods in fiscal years that begin after December 15, 2016. The Company is currently evaluating the impact of the adoption of ASU 2014-09 on its consolidated financial statements.

In July 2015, the FASB issued ASU No. 2015-11, “Simplifying the Measurement of Inventory,” (“ASU 2015-11”) which requires an entity to measure most inventory at the lower of cost and net realizable value, thereby simplifying the current guidance under which an entity must measure inventory at the lower of cost or market. The accounting standard is effective prospectively for annual periods beginning after December 15, 2016, and interim periods therein. Early adoption is permitted as of the beginning of an interim or annual reporting period. The Company is currently evaluating the impact of adoption of ASU 2015-11 on its consolidated financial statements.

On January 5, 2016, the FASB issued ASU No. 2016-01 to amend the accounting guidance on the classification and measurement of financial instruments. The standard requires that all investments in equity securities, including other ownership interests, are carried at fair value through net income. This requirement does not apply to investments that qualify for equity method accounting or to those that result in consolidation of the investee or for which the entity has elected the predictability exception to fair value measurement. Additionally, the standard requires that the portion of the total fair value change caused by a change in instrument-specific credit risk for financial liabilities for which the fair value option has been elected would be recognized in other comprehensive income. Any accumulated amount remaining in other comprehensive income is reclassified to earnings when the liability is extinguished. This guidance is effective for fiscal years and interim periods beginning after December 15, 2017. The Company does not anticipate the guidance to have a material impact on its consolidated financial statements or notes to its consolidated financial statements.

PEN INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

On February 25, 2016, the FASB issued ASU No. 2016-02 (“ASU 2016-02”) to amend the accounting guidance for leases. The accounting applied by a lessor is largely unchanged under ASU 2016-02. However, the standard requires lessees to recognize lease assets and lease liabilities for leases classified as operating leases on the balance sheet. Lessees will recognize in the statement of financial position a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. If a lessee makes this election, it will recognize lease expense for such leases generally on a straight-line basis over the lease term. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018 and early adoption is permitted. The Company is currently assessing the impact of the guidance on its consolidated financial statements and notes to its consolidated financial statements.

On March 30, 2016, the FASB issued ASU No. 2016-09 (“ASU 2016-09”) to amend the accounting guidance for share-based payment accounting. The areas for simplification in ASU 2016-09 involve several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 is effective for annual periods beginning after December 15, 2016. The Company is currently assessing the impact of the guidance on its consolidated financial statements and notes to its consolidated financial statements.

In April 2016, the FASB issued ASU 2016-10, “Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing” (“ASU 2016-10”). The amendments in this update clarify the following two aspects to Topic 606: identifying performance obligations and the licensing implementation guidance, while retaining the related principles for those areas. The entity first identifies the promised goods or services in the contract and reduce the cost and complexity. An entity evaluates whether promised goods and services are distinct. Topic 606 includes implementation guidance on determining whether an entity’s promise to grant a license provides a customer with either a right to use the entity’s intellectual property (which is satisfied at a point in time) or a right to access the entity’s intellectual property (which is satisfied over time). ASU 2016-10 is effective for annual and interim reporting periods beginning after December 15, 2017 and early application is permitted. The Company is currently evaluating ASU 2016-10 and its impact on its consolidated financial statements or disclosures.

There are no other recently issued accounting standards that apply to us or that are expected to have a material impact on our results of operations, financial condition, or cash flows.

Reclassifications

Certain prior period amounts in the consolidated financial statements have been reclassified for comparative purposes to conform to the fiscal 2016 presentation. These reclassifications have no impact on the previously reported net loss.

NOTE 3 –ACCOUNTS RECEIVABLE

At December 31, 2016 and 2015, accounts receivable consisted of the following:

Bad debt expense, net of recoveries, was $12,021 and $641 for the years ended December 31, 2016 and 2015, respectively.

PEN INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

NOTE 4 – INVENTORY

At December 31, 2016 and 2015, inventory consisted of the following:

NOTE 5 - PROPERTY AND EQUIPMENT

At December 31, 2016 and 2015, property and equipment consisted of the following: