NEPHROS INC - Quarter Report: 2020 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended: September 30, 2020

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: 001-32288

NEPHROS, INC.

(Exact name of registrant as specified in its charter)

(201) 343-5202

Registrant’s telephone number, including area code

N/A

(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. [X] 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). [X] YES [  ] NO

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

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

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

As of November 3, 2020, 9,864,673 shares of the registrant’s common stock, $0.001 par value per share, were outstanding.

NEPHROS, INC. AND SUBSIDIARIES

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

NEPHROS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

(Unaudited)

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

NEPHROS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(In thousands, except share and per share amounts)

(Unaudited)

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

NEPHROS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

(In thousands, except share amounts)

(Unaudited)

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

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

NEPHROS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

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

NEPHROS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (unaudited)

Note 1 – Organization and Nature of Operations

Nephros, Inc. (“Nephros” or the “Company”) was incorporated under the laws of the State of Delaware on April 3, 1997. The Company was founded by health professionals, scientists and engineers affiliated with Columbia University to develop advanced end stage renal disease (“ESRD”) therapy technology and products.

Beginning in 2009, Nephros introduced high performance liquid purification filters to meet the demand for water purification in certain medical markets. The Company’s filters, generally classified as ultrafilters, are primarily used in hospitals for the prevention of infection from waterborne pathogens, such as legionella and pseudomonas, and in dialysis centers for the removal of biological contaminants from water and bicarbonate concentrate. The Company also develops and sells water filtration products for commercial applications, focusing on the hospitality and food service markets. The water filtration business is a reportable segment, referred to as the Water Filtration segment.

The Company’s pathogen detection systems are portable, near real-time systems designed to provide actionable data for infection control teams and other organizations. The pathogen detection systems business is a reportable segment, referred to as the Pathogen Detection segment.

In July 2018, the Company formed a new subsidiary, Specialty Renal Products, Inc. (“SRP”), to drive the development of its second-generation hemodiafiltration system and other products focused on improving therapies for patients with renal disease. The Company transferred three patents to SRP, which were carried at zero book value. SRP is a reportable segment, referred to as the Renal Products segment.

The Company’s primary U.S. facilities are located at 380 Lackawanna Place, South Orange, New Jersey 07079, 3221 Polaris Avenue, Las Vegas, Nevada 89102 and 1015 Telegraph Street, Unit B, Reno, Nevada 89502. These locations house the Company’s corporate headquarters, research, manufacturing, and distribution facilities. In addition, the Company maintains small administrative offices in various locations in the United States and Ireland.

Note 2 – Basis of Presentation and Liquidity

Interim Financial Information

The accompanying unaudited condensed consolidated interim financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 8 and Article 10 of Regulation S-X. The condensed consolidated balance sheet as of December 31, 2019 was derived from the Company’s audited financial statements. Accordingly, these interim financial statements do not include all of the information and footnotes required by GAAP for annual financial statements. Results as of and for the three and nine months ended September 30, 2020 are not necessarily indicative of the results that may be expected for the year ending December 31, 2020.

The condensed consolidated interim financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.

Consolidation

The accompanying condensed consolidated financial statements include the accounts of Nephros, Inc. and its subsidiaries, including SRP, in which a controlling interest is maintained by the Company. Outside shareholders’ interest in SRP of 37.5% is shown on the condensed consolidated balance sheet as noncontrolling interest. All intercompany accounts and transactions were eliminated in the preparation of the accompanying condensed consolidated financial statements.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, at the date of the financial statements, and the reported amount of revenues and expenses, during the reporting period. Actual results could differ materially from those estimates. Included in these estimates are assumptions about the collection of accounts receivable, value of inventories, useful life of fixed assets and intangible assets, the assessment of expected cash flows used in evaluating goodwill and other long-lived assets, value of contingent consideration, the assessment of the ability to continue as a going concern and assumptions used in determining stock compensation such as expected volatility and risk-free interest rate.

Liquidity

The Company has sustained operating losses and expects such losses to continue over the next several quarters. In addition, net cash from operations has been negative since inception, generating an accumulated deficit of $131.1 million as of September 30, 2020.

On February 4, 2020, the Company completed a confidentially marketed underwritten public offering whereby the Company sold 937,500 shares of its common stock for aggregate net proceeds of $6.8 million. Additionally, the Company received $0.5 million from the U.S. Small Business Administration’s Paycheck Protection Program (“PPP”) on April 24, 2020. The PPP was established by the Coronavirus Aid, Relief and Economic Security Act (CARES Act), enacted on March 27, 2020, in response to the Coronavirus Disease 2019 (COVID-19) pandemic. Under the terms of the PPP, certain amounts of the loan may be forgiven if they are used for qualifying expenses during the first 24 weeks of the loan. The Company intends to use the entire loan amount for such qualifying expenses.

On May 26, 2020, the Company terminated its secured asset-based revolving credit facility, which had allowed the Company to borrow up to $2.5 million. As of September 30, 2020, there was no outstanding amount due under the secured asset-based revolving credit facility.

On September 5, 2018, SRP completed a private placement transaction whereby SRP sold preferred shares equivalent to 37.5% of its outstanding equity interests for aggregate proceeds of $3.0 million. As of approximately July 1, 2020, SRP had fully spent the proceeds from this private placement. During the three months ended September 30, 2020, SRP borrowed $0.8 million in operating funds from Nephros. On October 9, 2020, Nephros and SRP entered into a formal loan agreement, in which Nephros agreed to lend up to $1.3 million of operating funds to SRP, including the $0.8 million borrowed during the three months ended September 30, 2020. These funds are expected to be sufficient to fund SRP through the planned FDA 510(k) clearance process of SRP’s second-generation hemodiafiltration system, which is expected to be initially submitted to the FDA near the end of 2020.

On October 20, 2020, the Company completed a registered direct offering of 833,333 shares of its common stock at a price of $6.00 per share with net proceeds of $4.7 million.

Based on cash that is available for the Company’s operations and projections of future Company operations, the Company believes that its cash balances will be sufficient to fund its current operating plan – including the potential negative impact of the COVID-19 pandemic – through at least the next 12 months from the date of issuance of the accompanying condensed consolidated financial statements. Additionally, the Company’s operating plans are designed to help control operating costs and to increase revenue until such time as the Company generates sufficient cash flows from operations. However, there is uncertainty with respect to the Company’s projections regarding the availability of sufficient cash resources as a result of the COVID-19 pandemic and the economic conditions it has caused. In recent months, the Company has seen decreased demand for its products both with respect to new hospital customers and its existing hospital, restaurant and hospitality customers, which have been significantly impacted by the COVID-19 pandemic.

If this decrease in demand continues beyond the third quarter of fiscal year 2021 and the Company is unable to achieve its revenue plan, the Company may be forced to cut costs as appropriate to preserve its available capital resources. If the Company is unable to sufficiently decrease its spending to match any future decreased demands for its products, the Company may exhaust its capital resources sooner than it currently anticipates. Further, as a result of the recent volatility of the capital markets and economic conditions generally, it may be difficult for the Company to raise additional capital at times when it may need it, and even if the Company were able to raise additional capital, it may be on terms than are detrimental to the Company. Accordingly, the current economic conditions caused by the COVID-19 pandemic place uncertainty on the Company’s ability to maintain adequate levels of liquidity.

Recently Adopted Accounting Pronouncements

In January 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-04, “Simplifying the Test for Goodwill Impairment,” which simplifies the test for goodwill impairment. The guidance is effective for the Company beginning in the first quarter of fiscal year 2020. Early adoption is permitted for interim or annual goodwill impairments tests after January 1, 2017. The Company adopted this guidance as of January 1, 2020 and the guidance did not have an impact on its consolidated financial statements.

In August 2018, the FASB issued ASU 2018-13, “Disclosure Framework-Changes to the Disclosure Requirements for the Fair Value Measurement,” which modifies the disclosure requirements on fair value measurements. The guidance is effective for the Company beginning in the first quarter of fiscal year 2020. The Company adopted this guidance as of January 1, 2020 and the guidance did not have an impact on its consolidated financial statements.

In August 2018, the FASB issued ASU 2018-15, “Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That is a Service Contract,” which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. The guidance is effective for the Company beginning in the first quarter of fiscal year 2020. The Company adopted this guidance as of January 1, 2020 and the guidance did not have an impact on its consolidated financial statements.

In November 2018, the FASB issued ASU 2018-18, “Collaborative Arrangements: Clarifying the Interaction Between Topic 808 and Topic 606.” This guidance clarifies that, when the collaborative arrangement participant is a customer in the context of a unit-of-account, revenue from contracts with customers guidance should be applied, adds unit-of-account guidance to collaborative arrangements guidance, and precludes, in a transaction with a collaborative arrangement participant who is not a customer, presenting the transaction together with revenue recognized under contracts with customers. The guidance is effective for the Company beginning in the first quarter of fiscal year 2020. The Company adopted this guidance as of January 1, 2020 and the guidance did not have an impact on its consolidated financial statements.

In November 2019, the FASB issued ASU 2019-08, “Codification Improvements – Share-Based Consideration Payable to a Customer,” which requires that an entity measure and classify share-based payment awards granted to a customer by applying the guidance in Topic 718. The guidance is effective for the Company beginning in the first quarter of fiscal year 2020. The Company adopted this guidance as of January 1, 2020 and the guidance did not have an impact on its consolidated financial statements.

Recent Accounting Pronouncements, Not Yet Effective

In December 2019, the FASB issued ASU 2019-12, “Simplifying the Accounting for Income Taxes,” which removes certain exceptions to the general principles of the accounting for income taxes and also improves consistent application of and simplification of other areas when accounting for income taxes. The guidance is effective for the Company beginning in the first quarter of fiscal year 2021. Early adoption is permitted. The Company is assessing the impact of adopting this guidance on its consolidated financial statements.

Concentration of Credit Risk

The Company deposits its cash in financial institutions. At times, such deposits may be in excess of insured limits. To date, the Company has not experienced any impairment losses on its cash. The Company also limits its credit risk with respect to accounts receivable by performing credit evaluations when deemed necessary.

Major Customers

For the three months ended September 30, 2020 and 2019, the following customers, all of which are in the Water Filtration segment, accounted for the following percentages of the Company’s revenues, respectively:

For the nine months ended September 30, 2020 and 2019, the following customers, all of which are in the Water Filtration segment, accounted for the following percentages of the Company’s revenues, respectively:

As of September 30, 2020 and December 31, 2019, the following customers, all of which are in the Water Filtration segment, accounted for the following percentages of the Company’s accounts receivable, respectively:

Cash and Cash Equivalents

The Company considers all highly liquid money market instruments with an original maturity of three months or less when purchased to be cash equivalents. At September 30, 2020 and December 31, 2019, cash and cash equivalents were deposited in financial institutions and consisted entirely of immediately available fund balances. The Company maintains its cash deposits and cash equivalents with financial institutions it believes to be well-known and stable.

Accounts Receivable

The Company provides credit terms to customers in connection with purchases of the Company’s products. Management periodically reviews customer account activity in order to assess the adequacy of the allowances provided for potential collection issues and returns. Factors considered include economic conditions, each customer’s payment and return history and credit worthiness. Adjustments, if any, are made to reserve balances following the completion of these reviews to reflect management’s best estimate of potential losses. There was no allowance for doubtful accounts as of September 30, 2020. The allowance for doubtful accounts was approximately $25,000 as of December 31, 2019. For the three and nine months ended September 30, 2020, there was no provision for bad debt expense. For the three and nine months ended September 30, 2019, the provision for bad debt expense was approximately $19,000. Write-offs of accounts receivable were approximately $25,000 for the three and nine months ended September 30, 2020 which were reserved for in a prior period. Write-offs of accounts receivable were approximately $5,000 for the nine months ended September 30, 2019 which were reserved for in a prior period. There were no write-offs of accounts receivable for the three months ended September 30, 2019. There was no allowance for sales returns at September 30, 2020 or December 31, 2019.

Depreciation Expense

Depreciation related to equipment utilized in the manufacturing process is recognized in cost of goods sold on the consolidated statements of operations and comprehensive loss. For the three and nine months ended September 30, 2020, depreciation expense was approximately $8,000 and $18,000, respectively. Approximately $4,000 of the approximately $8,000 and approximately $12,000 of the approximately $18,000 of depreciation expense for the three and nine months ended September 30, 2020, respectively, has been recognized in cost of goods sold. For the three months ended September 30, 2019, depreciation expense was approximately $4,000 and was recognized in cost of goods sold. Approximately $10,000 of the approximately $20,000 of depreciation expense recognized for the nine months ended September 30, 2019 has been recognized in cost of goods sold.

Note 3 – Revenue Recognition

The Company recognizes revenue related to product sales when product is shipped via external logistics provider and the other criteria of ASC 606, “Revenue from Contracts with Customers” (“ASC 606”), are met. Product revenue is recorded net of returns and allowances. In addition to product revenue, the Company recognizes revenue related to royalty and other agreements in accordance with the five-step model in ASC 606. Royalty and other revenue recognized for the three and nine months ended September 30, 2020 and 2019 is comprised of:

Bellco License Agreement

With regard to the OLpūr MD190 and MD220, on June 27, 2011, the Company entered into a License Agreement (the “License Agreement”), effective July 1, 2011, with Bellco S.r.l. (“Bellco”), an Italy-based supplier of hemodialysis and intensive care products, for the manufacturing, marketing and sale of the Company’s patented mid-dilution dialysis filters (the “Products”). Under the License Agreement, as amended, the Company granted Bellco a license to manufacture, market and sell the Products under its own name, label, and CE mark in certain countries on an exclusive basis, and to do the same on a non-exclusive basis in certain other countries. Under the License Agreement with Bellco, the Company received upfront payments which were previously deferred and subsequently recognized as license revenue over the term of the License Agreement.

The License Agreement, as amended, also provides minimum sales targets which, if not satisfied, will, at the discretion of the Company, result in conversion of the license to non-exclusive status. Beginning on January 1, 2015 through and including December 31, 2021, Bellco will pay the Company a royalty based on the number of units of Products sold per year in the covered territory as follows: for the first 125,000 units sold in total, €1.75 (approximately $1.90) per unit; thereafter, €1.25 (approximately $1.40) per unit. The License Agreement also provides for a fixed royalty payment payable to the Company for the period beginning on January 1, 2015 through and including December 31, 2021 if the minimum sales targets are not met.

The Company recognized royalty income from Bellco pursuant to the License Agreement of approximately $20,000 and $10,000 for the three months ended September 30, 2020 and 2019, respectively. The Company recognized royalty income from Bellco pursuant to the License Agreement of approximately $49,000 and $50,000 for the nine months ended September 30, 2020 and 2019, respectively.

Note 4 – Fair Value Measurements

The Company measures certain financial instruments and other items at fair value.

To determine the fair value, the Company uses the fair value hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs market participants would use to value an asset or liability and are developed based on market data obtained from independent sources. Unobservable inputs are inputs based on assumptions about the factors market participants would use to value an asset or liability.

To measure fair value, the Company uses the following fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable:

Level 1 – Quoted prices in active markets for identical assets or liabilities.

Level 2 – Inputs other than Level 1 that are observable for the asset or liability, either directly or indirectly, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data by correlation or other means.

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. Value is determined using pricing models, discounted cash flow methodologies, or similar techniques and also includes instruments for which the determination of fair value requires significant judgment or estimation.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The Company evaluates its financial assets and liabilities subject to fair value measurements on a recurring basis to determine the appropriate level of classification for each reporting period.

The following table sets forth the Company’s financial assets and liabilities that were measured at fair value on a recurring basis as of September 30, 2020:

The following table sets forth the Company’s financial assets and liabilities that were measured at fair value on a recurring basis as of December 31, 2019:

The following table summarizes the change in fair value, as determined by Level 3 inputs, for the contingent consideration liability using unobservable Level 3 inputs for the nine months ended September 30, 2020:

During the three and nine months ended September 30, 2020, the change in fair value of contingent consideration of $0.2 million was due to the settlement of the contingent consideration liability. In October 2020, the Company entered into a Second Amendment to the Membership Interest Purchase Agreement dated December 31, 2018 (the “Amended Agreement”) related to the acquisition of the Aether business, in which the Company agreed to pay a lump sum of $0.1 million in full consideration for the Company’s obligation to make payments of contingent consideration under the Membership Interest Purchase Agreement (see Note 17 – Subsequent Events). Approximately $94,000 of the remaining obligation will be paid out of amounts remaining in escrow as of September 30, 2020.

During each of the three and nine months ended September 30, 2019, a change in fair value of contingent consideration of $0.1 million was recorded due to lower than planned performance.

Consideration paid in a business combination may include potential future payments that are contingent upon the acquired business achieving certain levels of earnings in the future (“contingent consideration”). Contingent consideration liabilities are measured at their estimated fair value as of the date of acquisition, with subsequent changes in fair value recorded in the consolidated statements of operations. Fair value as of the date of acquisition is estimated based on projections of expected future cash flows of the acquired business. The Company estimated the contingent consideration liability using the income approach (discounted cash flow method), which requires the Company to make estimates and assumptions regarding the future cash flows and profits. Changes in these estimates and assumptions could have a significant impact on the amounts recognized.

There were no transfers between levels in the fair value hierarchy during the three and nine months ended September 30, 2020.

Assets and Liabilities Not Measured at Fair Value on a Recurring Basis

The carrying amounts of cash and cash equivalents, accounts receivable, secured revolving credit facility, accounts payable and accrued expenses approximate fair value due to the short-term maturity of these instruments.

The carrying amounts of the secured long-term note payable, lease liabilities and equipment financing approximate fair value as of September 30, 2020 and December 31, 2019 because those financial instruments bear interest at rates that approximate current market rates for similar agreements with similar maturities and credit.

The carrying amount of the PPP loan does not include interest imputed at a market rate as the PPP loan is a transaction whereby the interest rate is prescribed by a government agency.

Note 5 – Inventory, net

Inventory is stated at the lower of cost or net realizable value using the first-in, first-out method and consists of raw materials and finished goods. The Company’s inventory components as of September 30, 2020 and December 31, 2019 were as follows:

Note 6 – Intangible Assets and Goodwill

Intangible Assets, net

Intangible assets as of September 30, 2020 and December 31, 2019 are set forth in the table below. Gross carrying values and accumulated amortization of the Company’s intangible assets by type are as follows:

The Company recognized amortization expense of approximately $10,000 for each of the three months ended September 30, 2020 and 2019 and such amounts are included in selling, general and administrative expenses on the accompanying condensed consolidated statement of operations and comprehensive loss. The Company recognized amortization expense of approximately $31,000 for each of the nine months ended September 30, 2020 and 2019 and such amounts are included in selling, general and administrative expenses on the accompanying condensed consolidated statement of operations and comprehensive loss.

As of September 30, 2020, future amortization expense for each of the next five years is (in thousands):

The Company did not recognize any intangible asset impairment charges during the three and nine months ended September 30, 2020 or 2019.

Goodwill

Goodwill had a carrying value on the Company’s condensed consolidated balance sheets of $0.8 million at each of September 30, 2020 and December 31, 2019. Goodwill has been allocated to the Water Filtration segment.

Note 7 – License and Supply Agreement, net

On April 23, 2012, the Company entered into a License and Supply Agreement (the “License and Supply Agreement”) with Medica S.p.A. (“Medica”), an Italy-based medical product manufacturing company, for the marketing and sale of certain filtration products based upon Medica’s proprietary Medisulfone ultrafiltration technology in conjunction with the Company’s filtration products, and for an exclusive supply arrangement for the filtration products. Under the License and Supply Agreement, as amended, Medica granted to the Company an exclusive license, with right of sublicense, to market, promote, distribute, offer for sale and sell the filtration products worldwide, with certain limitations on territory, during the term of the License and Supply Agreement. In addition, the Company granted to Medica an exclusive license under the Company’s intellectual property to make the filtration products during the term of the License and Supply Agreement. The filtration products covered under the License and Supply Agreement includes both certain products based on Medica’s proprietary Versatile microfiber technology and certain filtration products based on Medica’s proprietary Medisulfone ultrafiltration technology. The term of the License Agreement with Medica expires on December 31, 2025, unless earlier terminated by either party in accordance with the terms of the License and Supply Agreement.

In exchange for the license, the gross value of the intangible asset capitalized was $2.3 million. License and supply agreement, net on the condensed consolidated balance sheet is $0.7 million and $0.8 million as of September 30, 2020 and December 31, 2019, respectively. Accumulated amortization is $1.6 million and $1.5 million as of September 30, 2020 and December 31, 2019, respectively. The intangible asset is being amortized as an expense over the life of the License and Supply Agreement. Amortization expense of approximately $34,000 was recognized in each of the three months ended September 30, 2020 and 2019 on the condensed consolidated statement of operations and comprehensive loss. Amortization expense of $0.1 million was recognized in each of the nine months ended September 30, 2020 and 2019 on the condensed consolidated statement of operations and comprehensive loss.

As of September 2013, the Company has an understanding with Medica whereby the Company has agreed to pay interest to Medica at a 12% annual rate calculated on the principal amount of any outstanding invoices that are not paid pursuant to the original payment terms. There was no interest recognized for the three or nine months ended September 30, 2020 or 2019.

In addition, for the period beginning April 23, 2014 through December 31, 2025, the Company will pay Medica a royalty rate of 3% of net sales of the filtration products sold, subject to reduction as a result of a supply interruption pursuant to the terms of the License and Supply Agreement. Approximately $60,000 and $82,000 for the three months ended September 30, 2020 and 2019, respectively, was recognized as royalty expense and is included in cost of goods sold on the condensed consolidated statement of operations and comprehensive loss. Approximately $173,000 and $190,000 for the nine months ended September 30, 2020 and 2019, respectively, was recognized as royalty expense and is included in cost of goods sold on the condensed consolidated statement of operations and comprehensive loss. Approximately $60,000 in royalties are included in accrued expenses as of September 30, 2020. Approximately $83,000 in royalties are included in accounts payable as of December 31, 2019.

Note 8 – Secured Revolving Credit Facility

On August 17, 2017, the Company entered into the Loan Agreement and Security Agreement (the “Loan Agreement”) with Tech Capital, LLC (“Tech Capital”). The Loan Agreement initially provided for a secured asset-based revolving credit facility (the “Revolver”) of up to $1.0 million, which the Company drew upon and repaid from time to time during the term of the Loan Agreement. On December 20, 2019, the Company and Tech Capital entered into a First Modification to the Loan Agreement (“the Amendment”). The Amendment increased the Revolver from $1.0 million to $2.5 million. The outstanding principal balance of the Loan Agreement was $0.6 million as of December 31, 2019. The Company used these proceeds for working capital and general corporate purposes.

On May 26, 2020, the Company terminated the Revolver and, as a result, recognized fees of approximately $7,000, which are included in interest expense on the condensed consolidated statement of operations and comprehensive loss for the nine months ended September 30, 2020. Although the Revolver was terminated, the Loan Agreement, as amended on May 26, 2020 to reflect this termination, remains in place for purposes of specifying obligations related to the Secured Note Payable (see Note 9 – Secured Note Payable).

For the nine months ended September 30, 2020, excluding approximately $7,000 related to the termination of the Revolver, approximately $25,000 was recognized as interest expense on the condensed consolidated statement of operations and comprehensive loss. For the three and nine months ended September 30, 2019, approximately $17,000 and $40,000, respectively, was recognized as interest expense on the condensed consolidated statement of operations and comprehensive loss.

Note 9 – Secured Note Payable

On March 27, 2018, the Company entered into a Secured Promissory Note Agreement (the “Secured Note”) with Tech Capital for a principal amount of $1.2 million. The Secured Note was amended and restated on May 26, 2020 to reflect the then-current balance on the Secured Note. There were no other changes to the terms and conditions of the Secured Note. As of September 30, 2020, the principal balance of the Secured Note was $0.7 million.

The Secured Note has a maturity date of April 1, 2023. The unpaid principal balance accrues interest at a rate of 8% per annum. Principal and interest payments commenced on May 1, 2018 and are due on the first day of each month.

The Secured Note is subject to the terms and conditions of and is secured by security interests granted by the Company in favor of Tech Capital under the Loan Agreement and all of the riders and amendments thereto (see Note 8 – Secured Revolving Credit Facility). An event of default under such Loan Agreement is an event of default under the Secured Note and vice versa. In the event the principal balance under the Loan Agreement is due, all amounts due under the Secured Note also become due.

In addition, Nephros International Limited, a wholly-owned subsidiary of the Company, unconditionally guaranteed the Company’s obligations under the Loan Agreement.

During the three months ended September 30, 2020 and 2019, the Company made payments under the Secured Note of approximately $73,000. Included in the total payments made, approximately $14,000 and $18,000 was recognized as interest expense on the condensed consolidated statement of operations and comprehensive loss for the three months ended September 30, 2020 and 2019, respectively. During the nine months ended September 30, 2020 and 2019, the Company made payments under the Secured Note of approximately $217,000. Included in the total payments made, approximately $45,000 and $58,000 was recognized as interest expense on the condensed consolidated statement of operations and comprehensive loss for the nine months ended September 30, 2020 and 2019, respectively.

As of September 30, 2020, future principal maturities are as follows (in thousands):

Note 10 – Paycheck Protection Program Loan

On April 24, 2020, the Company was granted a PPP loan in the amount of $0.5 million. The PPP, established as part of the 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. In connection with the PPP loan, the Company issued a promissory note dated April 24, 2020, in the principal amount of $0.5 million. The loan matures on April 24, 2022 and bears interest at a rate of 1.0% per annum, payable monthly commencing November 24, 2020. The note may be prepaid at any time prior to maturity with no prepayment penalties. Funds from the loan may only be used for payroll costs, benefits, rent, utilities and interest on other debt obligations incurred prior to February 15, 2020. The Company intends to use the entire amount for such qualifying expenses. Under the terms of the PPP, certain amounts of the loan may be forgiven if they are used for qualifying expenses during the first 24 weeks of the loan. For the three and nine months ended September 30, 2020, approximately $1,000 and $2,000, respectively, was recognized as interest expense on the condensed consolidated statement of operations and comprehensive loss.

Note 11 – Leases

The Company has operating leases for corporate offices, an automobile and office equipment. The leases have remaining lease terms of 1 year to 4 years.

The Company entered into an operating lease in March 2020 for 1015 Telegraph Street, Unit B, Reno, Nevada 89502. The rental agreement commenced in March 2020 and expires in February 2022 with an option to extend for two additional years that the Company is reasonably certain to exercise. The monthly cost is approximately $5,000. Approximately $5,000 related to a security deposit for this office facility is classified as other assets on the condensed consolidated balance sheet as of September 30, 2020.

The Company entered into a finance lease in February 2020 for office equipment. The rental agreement commenced in February 2020 and expires in January 2023 with a monthly cost of approximately $1,000.

The Company entered into an operating lease in June 2020 for 923 Incline Way, #37, Incline Village, Nevada 89451. The rental agreement commenced in March 2020 and expires in January 2021. The monthly cost is approximately $2,000. The Company adopted the short-term lease practical expedient and, as such, will recognize the lease payments on a straight-lease basis over the lease term.

Operating lease cost, as presented below, includes costs associated with leases for which right of use (“ROU”) assets have been recognized as well as short-term leases.

The components of total lease costs were as follows:

Supplemental cash flow information related to leases was as follows:

Supplemental balance sheet information related to leases was as follows:

As of September 30, 2020, maturities of lease liabilities were as follows:

Note 12 – Stock Plans and Share-Based Payments

The fair value of stock options and restricted stock is recognized as stock-based compensation expense in the Company’s condensed consolidated statement of operations and comprehensive loss. The Company calculates stock-based compensation expense in accordance with ASC 718. The fair value of stock-based awards is amortized over the vesting period of the award.

Stock Options

During the three and nine months ended September 30, 2020, the Company granted stock options to purchase 157,064 and 170,675 shares, respectively, of common stock to employees. These stock options are being expensed over the respective vesting period, which is based on a service condition. The fair value of the stock options granted during the three and nine months ended September 30, 2020 was approximately $704,000 and $783,000, respectively.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. The below assumptions for the risk-free interest rates, expected dividend yield, expected lives and expected stock price volatility were utilized for the stock options granted during the three and nine months ended September 30, 2020.

Stock-based compensation expense related to stock options was $166,000 and $348,000 for the three months ended September 30, 2020 and 2019, respectively. For the three months ended September 30, 2020, approximately $150,000 and approximately $16,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations and comprehensive loss. For the three months ended September 30, 2019, approximately $335,000 and approximately $13,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations and comprehensive loss.

Stock-based compensation expense related to stock options was $483,000 and $623,000 for the nine months ended September 30, 2020 and 2019, respectively. For the nine months ended September 30, 2020, approximately $435,000 and approximately $48,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations and comprehensive loss. For the nine months ended September 30, 2019, approximately $577,000 and approximately $46,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations and comprehensive loss.

There were no stock options exercised during the three months ended September 30, 2020. During the nine months ended September 30, 2020, stock options to purchase 2,556 shares of the Company’s common stock were exercised in a cash exercise for proceeds of approximately $7,000, resulting in the issuance of 2,556 shares of the Company’s common stock. During the nine months ended September 30, 2020, stock options to purchase 1,112 shares of the Company’s common stock were exercised in a cashless exercise, resulting in the issuance of 755 shares of the Company’s common stock. There were no stock options exercised during the three or nine months ended September 30, 2019.

There was no tax benefit related to expense recognized in the three or nine months ended September 30, 2020 and 2019, as the Company is in a net operating loss position. As of September 30, 2020, there was $1.1 million of total unrecognized compensation expense related to unvested stock-based awards granted under the equity compensation plans, which will be amortized over the weighted average remaining requisite service period of 2.5 years. Such amount does not include the effect of future grants of equity compensation, if any.

Restricted Stock

There was no stock-based compensation expense for restricted stock recognized during the three months ended September 30, 2020 or 2019.

Total stock-based compensation expense for restricted stock was approximately $52,000 and $30,000 for the nine months ended September 30, 2020 and 2019, respectively. For the nine months ended September 30, 2020, approximately $42,000 and $10,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations and comprehensive loss. For the nine months ended September 30, 2019, approximately $28,000 and $2,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations and comprehensive loss.

There were no unvested shares of restricted stock as of September 30, 2020.

SRP Equity Incentive Plan

SRP’s 2019 Equity Incentive Plan was approved on May 7, 2019 under which 150,000 shares of SRP’s common stock are reserved for the issuance of options and other awards.

There were no SRP stock options granted during the three or nine months ended September 30, 2020. Stock-based compensation expense related to the SRP stock options was approximately $6,000 and $38,000 for the three and nine months ended September 30, 2020, respectively. For the three months ended September 30, 2020, approximately $2,000 and $4,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying consolidated statement of operations and comprehensive loss. For the nine months ended September 30, 2020, approximately $16,000 and $22,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying consolidated statement of operations and comprehensive loss.

Stock-based compensation expense related to the SRP stock options was approximately $6,000 and $9,000 for the three and nine months ended September 30, 2019. For the three months ended September 30, 2019, approximately $2,000 and $4,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations and comprehensive loss. For the nine months ended September 30, 2019, approximately $3,000 and $6,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations and comprehensive loss.

Stock-based compensation expense related to the SRP stock options is presented by the Company as noncontrolling interest on the consolidated balance sheet as of September 30, 2020.

Note 13 – Stockholders’ Equity

February 2020 Common Stock Issuance

On February 4, 2020, the Company issued 937,500 shares of common stock through a confidentially marketed underwritten public offering resulting in gross proceeds to the Company of $7.5 million. The purchase price for each share was $8.00. Proceeds, net of equity issuance costs of $0.7 million, recorded as a result of the offering were $6.8 million.

Noncontrolling Interest

On September 5, 2018, SRP entered into a Series A Preferred Stock Purchase Agreement with certain purchasers pursuant to which SRP sold 600,000 shares of its Series A Preferred Stock (“Series A Preferred”) for $5.00 per share. The aggregate purchase price was $3.0 million. SRP incurred transaction-related expenses of approximately $30,000, which were included in selling, general and administrative expenses on the accompanying consolidated statement of operations and comprehensive loss for the three and nine months ended September 30, 2018. The net proceeds from the issuance of the Series A Preferred are restricted to SRP expenses, and may not be used for the benefit of the Company or other affiliated entities, except to reimburse for expenses directly attributable to SRP. Following the Series A Preferred transaction, the Company retained a 62.5% ownership interest in SRP, holding 100% of the outstanding common shares, and holders of Series A Preferred retained a 37.5% interest in SRP on a fully diluted basis, holding 100% of the outstanding preferred shares. Of the 600,000 shares of Series A Preferred issued, the shares purchased by related parties comprised of persons controlled by members of management and by the Company’s largest shareholder amounted to 18,000 and 400,000 shares, respectively.

Each share of Series A Preferred is initially convertible into one share of SRP common stock, subject to adjustment for stock splits and recapitalization events. Subject to customary exempt issuances, in the event SRP issues additional shares of its common stock or securities convertible into common stock at a per share price that is less than the original Series A Preferred price, the conversion price of the Series A Preferred will automatically be reduced to such lower price.

In the event of any voluntary or involuntary liquidation, dissolution or winding up of SRP, the holders of the Series A Preferred are entitled to be paid out of the assets of SRP available for distribution to its stockholders or, in the case of a deemed liquidation event, out of the consideration payable to stockholders in such deemed liquidation event or the available proceeds, before any payment shall be made to the holders of SRP common stock by reason of their ownership thereof, an amount per share equal to one times (1x) the Series A Preferred original issue price, plus any accruing dividends accrued but unpaid thereon, whether or not declared, together with any other dividends declared but unpaid thereon (the “Series A Liquidation Preference”). If upon any such liquidation, dissolution or winding up of SRP or deemed liquidation event, the assets of SRP available for distribution to its stockholders shall be insufficient to pay the Series A Liquidation Preference in full, the holders of Series A Preferred shall share ratably in any distribution of the assets available for distribution in proportion to the respective amounts which would otherwise be payable in respect of the shares held by them upon such distribution if all amounts payable on or with respect to such shares were paid in full. After the full payment of the Series A Liquidation Preference, the holders of the Series A Preferred and the holders of common stock will share ratably in any remaining proceeds available for distribution on an as-converted to common stock basis.

Each share of Series A Preferred accrues dividends at the rate per annum of $0.40 per share. The accruing dividends shall accrue from day to day, whether or not declared, and shall be cumulative and shall be payable only when, as, and if declared by the Board.

Holders of Series A Preferred shall be entitled to cast the number of votes equal to the number of whole shares of common stock into which the shares of Series A Preferred held by such holder are convertible as of the record date for determining stockholders entitled to vote. Except as provided by law or by the other provisions, the holders of Series A Preferred vote together with the holders of common stock as a single class. Notwithstanding the foregoing, for as long as at least 150,000 shares of Series A Preferred are outstanding, SRP is required to obtain the affirmative vote or written consent of a majority of the Series A Preferred in order to effect certain corporate transactions, including without limitation, the issuance of any securities senior to or on parity with the Series A Preferred, a liquidation or deemed liquidation of SRP, amendments to SRP’s charter documents, the issuance of indebtedness in excess of $250,000, any annual budget for the Company’s operations, and the hiring or firing of any executive officers of SRP. In addition, the holders of the Series A Preferred are entitled to elect two members of SRP’s board of directors.

The noncontrolling interest in SRP held by holders of the Series A Preferred has been classified as equity on the accompanying consolidated interim balance sheet, as the noncontrolling interest is redeemable only upon the occurrence of events that are within the control of the Company.

Warrants

There were no warrants exercised during the three months ended September 30, 2020. During the nine months ended September 30, 2020, warrants to purchase 40,012 shares of the Company’s common stock were exercised, resulting in proceeds of $0.2 million and the issuance of 40,012 shares of the Company’s common stock.

During the three and nine months ended September 30, 2019, warrants to purchase 108,149 shares of the Company’s common stock were exercised, resulting in proceeds of $0.3 million and the issuance of 108,147 shares of the Company’s common stock. Of the warrants exercised during the three and nine months ended September 30, 2019, warrants to purchase 4,444 shares of the Company’s common stock were exercised by members of management, resulting in proceeds of approximately $12,000.

There were no warrants issued during the three or nine months ended September 30, 2020 or 2019.

Note 14 – Net Loss per Common Share

Basic loss per common share is calculated by dividing net loss available to common shareholders by the number of weighted average common shares issued and outstanding. Diluted loss per common share is calculated by dividing net loss available to common shareholders by the weighted average number of common shares issued and outstanding for the period, plus amounts representing the dilutive effect from the exercise of stock options and warrants, as applicable. The Company calculates dilutive potential common shares using the treasury stock method, which assumes the Company will use the proceeds from the exercise of stock options and warrants to repurchase shares of common stock to hold in its treasury stock reserves.

The following potentially dilutive securities have been excluded from the computations of diluted weighted average shares outstanding as they would be antidilutive:

Note 15 – Commitments and Contingencies

Purchase Commitments

In exchange for the rights granted under the License and Supply Agreement with Medica (see Note 7 – License and Supply Agreement, net), the Company agreed to make certain minimum annual aggregate purchases from Medica over the term of the License and Supply Agreement. For the year ended December 31, 2020, the Company agreed to make minimum annual aggregate purchases from Medica of €3.2 million (approximately $3.5 million). As of September 30, 2020, the Company’s aggregate purchase commitments totaled €4.5 million (approximately $5.0 million).

Contractual Obligations

See Note 11 – Leases for a discussion of the Company’s contractual obligations.

Note 16 – Segment Reporting

On January 1, 2020, the Company began reporting the results of its Pathogen Detection Systems business as a new segment, known as the Pathogen Detection segment. Prior to the additional reporting of Pathogen Detection as a reporting segment, the Company had two operating segments, Water Filtration and Renal Products. The Company reflected the new segment measures beginning in the three months ended March 31, 2020, and prior periods have been restated for comparability.

The Company has defined three reportable segments: Water Filtration, Pathogen Detection and Renal Products. The Water Filtration segment primarily develops and sells high performance water purification filters. The Pathogen Detection segment develops and sells portable, real-time water testing systems designed to provide actionable data on waterborne pathogens in approximately one hour. The Renal Products segment is focused on the development of medical device products for patients with renal disease, including a 2^nd generation hemodiafiltration system for the treatment of patients with ESRD.

The Company’s chief operating decision maker evaluates the financial performance of the Company’s segments based upon segment revenues, gross margin and operating expenses which include research and development and selling, general and administrative expenses. Items below loss from operations are not reported by segment, since they are excluded from the measure of segment profitability reviewed by the Company’s chief operating decision maker. The Company does not report balance sheet information by segment since it is not reviewed by the Company’s chief operating decision maker.

The accounting policies for the Company’s segments are the same as those described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.

The tables below present segment information reconciled to total Company loss from operations, with segment operating loss including gross profit less direct research and development expenses and direct selling, general and administrative expenses to the extent specifically identified by segment:

Note 17 – Subsequent Events

On October 9, 2020, Nephros and SRP entered into a formal loan agreement, in which Nephros agreed to lend up to $1.3 million of operating funds to SRP, including the $0.8 million borrowed during the three months ended September 30, 2020. These funds are expected to be sufficient to fund SRP through the planned FDA 510(k) clearance process of SRP’s second-generation hemodiafiltration system, which is expected to be initially submitted to the FDA near the end of 2020.

On October 20, 2020, the Company issued 833,333 shares of the Company’s common stock in a registered direct offering, resulting in net proceeds to the Company of $4.7 million. The purchase price for each share was $6.00.

On October 15, 2020, the Company entered into the Amended Agreement related to the acquisition of the Aether business in which the Company agreed to pay a lump sum of $0.1 million in full consideration for the Company’s obligation to make payments of contingent consideration under the Membership Interest Purchase Agreement.

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

The following discussion should be read in conjunction with our condensed consolidated financial statements and notes thereto included in Item 1 of Part I of this Quarterly Report on Form 10-Q. This discussion includes forward-looking statements about our business, financial condition and results of operations including discussions about management’s expectations for our business. These statements represent projections, beliefs and expectations based on current circumstances and conditions and in light of recent events and trends, and these statements should not be construed either as assurances of performances or as promises of a given course of action. Instead, various known and unknown factors are likely to cause our actual performance and management’s actions to vary, and the results of these variances may be both material and adverse.

Business Overview

We are a commercial-stage company that develops and sells high performance water solutions to the medical and commercial markets.

In medical markets, we sell water filtration products and waterborne pathogen detection products. Our medical water filters, mostly classified as ultrafilters, are used primarily by hospitals for the prevention of infection from waterborne pathogens, such as legionella and pseudomonas, and in dialysis centers for the removal of biological contaminants from water and bicarbonate concentrate. Because our ultrafilters capture contaminants as small as 0.005 microns in size, they minimize exposure to a wide variety of bacteria, viruses, fungi, parasites, and endotoxins.

In commercial markets, we manufacture and sell water filters that improve the taste and odor of water and reduce biofilm, bacteria, and scale build-up in downstream equipment. Marketed under both the Nephros and AETHER brands, our products are marketed primarily to the food service, hospitality, convenience store, and health care markets.

Our pathogen detection systems are portable, near real-time systems designed to provide actionable data for infection control teams, biomedical engineers in dialysis clinics, and water quality teams in building management organizations.

We also have a subsidiary, Specialty Renal Products, Inc. (“SRP”), a development-stage medical device company, focused primarily on developing hemodiafiltration (“HDF”) technology. SRP is developing a second-generation of the Nephros OLpūr H2H Hemodia-filtration System, the FDA 510(k)-cleared medical device that enables nephrologists to provide HDF treatment to patients with end stage renal disease (“ESRD”).

We were founded in 1997 by healthcare professionals affiliated with Columbia University Medical Center/New York-Presbyterian Hospital to develop and commercialize an alternative method to hemodialysis. We have extended our filtration technologies to meet the demand for liquid purification in other areas, in particular, water purification.

COVID-19 Pandemic

The COVID-19 pandemic has impacted nearly every business in the United States and around the world. To date, we have fully maintained operations through the crisis, supporting our customers and strategic partners. Our warehouse and laboratory teams have integrated disinfection procedures into their activities, while our office teams have worked primarily from home. Our manufacturing and sterilization facilities have been operational, our supply chain has not been materially impacted, and our warehouses are shipping product on normal schedules.

In recent months, the COVID-19 pandemic has negatively impacted our business in several ways, including:

As we are unable to determine the duration of the COVID-19 pandemic, we are not able to predict when we will see an increase in demand for our products and a corresponding increase to our revenue. Due to this uncertainty, we applied for and received $0.5 million from the U.S. Small Business Administration’s Paycheck Protection Program (“PPP”) on April 24, 2020, which we believe will help us offset the adverse effect on our results of operations and financial condition that could result from a prolonged decrease in demand for our products.

We believe that, as the COVID-19 pandemic subsides, we may experience over the medium-to-long-term a net positive impact on demand for all of our products, due especially to increased global awareness of infectious pathogens and the serious problems they cause. Specifically, we expect that:

In summary, the COVID-19 pandemic adds uncertainty to our business plans in the short term, while we believe that our medium-to-long-term prospects remain strong. At this time, we cannot predict the specific extent or duration of the impact of the COVID-19 pandemic on our condition, resources and results.

Our Products

Water Filtration Products

We develop and sell water filtration products used in both medical and commercial applications. Our water filtration products employ multiple filtration technologies, as described below.

In medical markets, our primary filtration mechanism is to pass liquids through the pores of polysulfone hollow fiber. Our filters’ pores are significantly smaller than those of competing products, resulting in highly effective elimination of waterborne pathogens, including legionella bacteria (the cause of Legionnaires disease) and viruses, which are not eliminated by most other microbiological filters on the market. Additionally, the fiber structure and pore density in our hollow fiber enables significantly higher flow rates than in other polysulfone hollow fiber.

Our primary sales strategy in medical markets is to sell through value-added resellers (“VARs”). Leveraging VARs has enabled us to expand rapidly our access to target customers without significant sales staff expansion. In addition, while we are currently focused in medical markets, the VARs that support these customers also support a wide variety of commercial and industrial customers. We believe that our VAR relationships will facilitate growth in filter sales outside of the medical industry.

In commercial markets, we develop and sell our Nephros- and AETHER-branded filters, for which carbon-based absorption is the primary filtration mechanism. Aether products allow us to improve water’s odor and taste, to reduce scale and heavy metals, and to reduce other water contaminants for customers who are primarily in the food service, convenience store, and hospitality industries.

Our Aether filter offerings have the potential to generate accretive revenue growth in at least three ways. First, we expect the business to continue its organic growth. Second, cross-selling opportunities are generated by offering taste/odor-focused products to the medical markets, as well as pathogen-focused filtration to the commercial markets. Finally, as part of the more substantial Nephros organization, Aether may be able to compete for larger filtration contracts than may have been available to it as a smaller, independent firm. Since we acquired the AETHER brand, we have seen some promising results in each of these strategies, but it is still too early to judge the likelihood or magnitude of their long-term success.

In commercial markets, our model combines both direct and indirect sales. Our sales staff have sold products directly to a number of convenience stores, hotels, casinos, and restaurants. We are also pursuing large corporate contracts through partnerships.

Target Markets

Our ultrafiltration products currently target the following markets: