ITEM 1.
BUSINESS.
Creative Learning Corporation, operating under the trade names of Bricks 4 Kidz® and Sew Fun Studios®, offers educational and enrichment programs to children ages 3 to 13+ through its franchisees. The Companys business model is to sell franchise territories and collect a one-time franchise fee and subsequent monthly royalty fees from each territory. Through the Companys franchise business model, which includes a proprietary curriculum and marketing strategy plus a proprietary franchise management tool, the Company provides a wide variety of programs designed to enhance students problem solving and critical thinking skills. At September 30, 2015, the Company had 696 Bricks 4 Kidz®, Challenge Island® (which was sold during 2015) and Sew Fun Studios® franchises, 23 Bricks 4 Kidz® master franchises, and 20 Bricks 4 Kidz® sub-franchises operating in 38 countries.
Company Background
The Company was formed in March 2006 under the name B2 Health, Inc. to design, manufacture and sell chiropractic tables and beds. The Company generated only limited revenue and essentially abandoned its business plan in March 2008. In July 2010, the Companys name was changed to Creative Learning Corporation (CLC).
On July 2, 2010 the Company acquired BFK Franchise Company, LLC (BFK), a Nevada limited liability company formed in May 2009, under a Stock Exchange Agreement with the members of BFK for 9,000,000 shares of the Companys common stock. BFK offers a franchise concept known as Bricks 4 Kidz®, a mobile business operated by franchisees within a specific geographic territory offering project-based programs designed to teach principles and methods of engineering to children ages 3-13+. BFK began selling franchises in July 2009.
On September 14, 2012, the Company formed CI Franchise Company LLC (CI) as a wholly owned subsidiary for the purpose of offering a second franchise concept known as Challenge Island®, a service business within a defined exclusive territory, pursuant to which franchisees provide unique challenge-based programs designed to foster critical and creative thinking skills, problem solving methodology, and core STEM (Science, Technology, Engineering, Mathematics) principles in children between the ages of 6 and 12. CI began selling franchises during the 2013 fiscal year. On December 9, 2015, the Company sold the assets and liabilities of the CI business to a third party. See Recent Developments and Note 14 to the Consolidated Financial Statements.
On January 26, 2015 the Company formed SF Franchise Company, LLC (SF) as a wholly owned subsidiary for the purpose of offering a third franchise concept known as Sew Fun Studios®. Sew Fun Studios® is a mobile business operated by franchisees within a specific geographic territory offering creative project-based activities, classes and programs in fashion and interior design and sewing to children and adults.
On July 22, 2015 and with immediate effect, the Companys Board of Directors removed Brian Pappas as Chief Executive Officer of the Company. Also on July 22, 2015, the Board took a series of actions to reconstruct the management of the Company. On that day, the Board with immediate effect: (i) elected Charles (Chuck) Grant as Chairman of the Board, (ii) elected two additional new independent directors, JoyAnn Kenny-Charlton, Esq. and Michael Gorin, (iii) named Rod Whiton interim Chief Executive Officer, (iv) named Michelle Cote President, and (v) placed Brian Pappas on paid administrative leave. Mr. Pappas employment at the Company was subsequently terminated on October 2, 2015. On April 6, 2016, Dan ODonnell resigned as the Companys Chief Operating Officer and from the Companys Board of Directors.
The Companys new management at the board and executive levels has implemented numerous changes and reforms since late July 2015 as discussed herein: including under Item 9A. Controls and Procedures.
Recent Developments
On December 9, 2015, CI completed the sale of the Challenge Island business to an unaffiliated third party, pursuant to an asset purchase agreement entered into on that date. See Note 14 to the Consolidated Financial Statements. From the commencement of operations, starting in fiscal year 2013, CI had a net operating loss of approximately $315,000 through September 30, 2015. The total revenues for the three year period ($820,000) represented less than 4.5% of total revenues for the Company during that period. The Company considered, among other factors, the strategic fit of the concept, historical information and operating projections in the near term in reaching its decision to sell. In connection with the sale, in December 2015, the Company repurchased two Challenge Island franchise territories from the applicable franchisees, for an aggregate purchase price of approximately $39,500.
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As of January 29, 2016, the Company has temporarily suspended domestic franchise offer and sales of Bricks 4 Kidz® and Sew Fun Studios® franchises in compliance with FTC Franchise Rule, Section 436.7(a) due to delay in completion of the Companys FY2015 consolidated audited financial statements.. In turn, this has delayed completion of the Companys 2016 FDDs for the Bricks 4 Kidz® and Sew Fun Studios® franchise offerings. The Company expects that offer and sales efforts will resume in approximately 70% of the states in which Bricks 4 Kidz® and Sew Fun Studios® currently sell franchises immediately upon completion of the FDD, and in the rest of the states upon either filing or approval of the renewal applications, based upon the applicable rules of each such state. In a number of these states, the Company did not have active franchise offer and sales efforts even before the temporary suspension. This temporary suspension of domestic franchise offer and sales does not affect the Companys international franchise offer and sales activity or its royalty fee collections from existing franchisees.
BFK
BFK franchises, which conduct business under the trade name BRICKS 4 KIDZ®, offers programs designed to teach principles and methods of engineering to children between the ages of 3 and 13 using LEGO® plastic bricks and other LEGO® products through classes, field trips, and other organized activities that are designed to enhance and enrich the traditional school curriculum, trigger young childrens lively imaginations and build self-confidence. BFKs programs foster creativity and provide a unique atmosphere for students to develop problem solving and critical thinking skills by designing and building machines, catapults, pyramids, race cars, buildings and numerous other systems and devices using LEGO® bricks and other LEGO® products. The Company may provide training and corporate franchisee support to all franchisees and recognizes revenue from the sale of its franchises when all initial training, pursuant to the terms of the franchise agreements, is completed.
BFK franchises are mobile models, with activities scheduled in locations such as preschools, elementary and middle schools, camps, birthday parties, community centers and churches.
At September 30, 2015, BFK had 636 operating franchise territories, 23 master franchises, and 20 sub-franchises operating in 43 states, the District of Columbia and 36 foreign countries including Puerto Rico. For the Year ended September 30, 2015, 28 franchises were terminated and 27 franchises were transferred to new owners.
BFK
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Operating
Franchise
Territories
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September 30, 2013
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380
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Additions
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210
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Deletions
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(6
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September 30, 2014
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584
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Additions
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123
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Deletions
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(28
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September 30, 2015
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679
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Current BFK Programs
In-school workshops
. One-hour classes during school hours. Classes are correlated to the typical science curriculum for a particular grade level. Teacher guides, student worksheets, and step-by-step instruction are provided.
After-school classes
. One hour, one day a week class held after school.
Pre-school classes
. Classes can be held in pre-schools for children of pre-school ages.
Classes for home-schooled children
. Classes can be held in the home of one of the parents of a home-schooled child.
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Camps
. Normally three hours per day for five days. Camps can take place at schools or at other child-related venues. Children use LEGO® bricks to explore various science and math concepts while working in an open, friendly environment. The material covered each session varies depending on students ages, experience, and skill level. A new project is built each week. Architectural concepts are taught while assembling buildings, castles and other structures. Instructional content includes concepts of friction, gravity and torque, scale, gears, axles and beams. The children work and play with programmable LEGO® bricks along with electric motors, sensors, system bricks, and LEGO® Technic pieces (i.e. gears, axles, and beams).
Birthday parties
. In the home of the birthday child.
Special events
. Activities with LEGO® bricks can be held in various locations including church centers, lodges, child-related venues, private schools, pre-schools, etc. Program can include parents, grandparents and all children in the family.
BFK Franchise Program
BKF sells franchises both domestically and internationally. International sales can be a single franchise or a master franchise, where the master franchisee operates a franchise in the territory, and is also able to develop, sell and manage sub-franchises in the territory under the master franchise agreement. BFK does not offer master franchises in the United States.
Under a franchise agreement, a franchisee pays a one-time, non-refundable franchise fee upon the execution of the franchise agreement. Domestically, there can be variations on the franchise fees depending on the size or territories being purchased, and other factors of the territory. The typical sized, domestic, single territory franchise fee is $25,900. If the franchisee is granted an additional geographic area to increase the size of their territory, then the franchisee must pay an additional fee in the amount of $10,000. If the franchisee is in good standing and is granted a second or additional franchise, then the franchisee must pay a franchise fee in the amount of $18,000 for each additional franchise.
International franchise fees vary and are set relative to the potential of the franchised territories. During the fiscal year ended September 30, 2015, BFK sold four master franchises at an average price of approximately $90,000. In the case of a master franchise, BFK receives a percentage of the franchise fee paid to the master franchisee by any sub-franchisee operating in the master franchisees territory. During the 2015 fiscal year, the average international franchise fees were as follows: First Territories: $29,687; Second Territories: $19,400; and Master Agreements: $89,375.
The Company uses a network of franchise advertising and promotion media to contact prospective franchisees. When a potential contact is received, the initial information relating to a buyer is passed to a franchise sales broker to initiate contact with the potential new franchisees. The responsibility of the sales broker is to thoroughly vet the potential franchisee for compatibility with the franchise concept, among other things. As part of the process of vetting potential franchisees, the Company requires all prospective franchisees to complete a Request for Consideration form. Upon completion of the process the sales broker is paid a commission typically ranging from 20% to 30% of the franchise fee. Prior to the change in Company management in July 2015, sales brokers included brokers that were related-parties (friends and relatives of former CEO Brian Pappas) as well as independent brokers. Beginning in or about late July 2015, the Company terminated all related-party brokers and now any brokers that are used must be independent.
The franchisee is granted an exclusive territory and a license to use the Bricks 4 Kidz® name, trademarks and course materials in the franchised territory. The franchisee is required to conform to certain standards of business practices and comply with all applicable laws. Each franchise is run as an independent business and, as such, is responsible for its operation, including employment of adequate staff.
In October 2015, the Company revised its form of franchise agreement to address common franchise issues consistent with best practices.
The term of the franchise is for ten years. BFK has the right to terminate any franchisee in the event of the franchisees bankruptcy, a default under the franchise agreement, or other events. The franchisee has the right to renew the franchise for an additional ten years if, at the time of renewal, the franchisee is in good standing and pays a renewal fee in the amount of $5,000. The Company is suspended from selling franchises in the United States for a portion of the 2016 fiscal year.
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Franchise Disclosure Document
Under federal law, the Company is required to (a) prepare a franchise disclosure document (FDD) including federally mandated information, (b) provide each prospective franchisee with a copy of the FDD, and (c) wait 14 calendar days before entering into a binding agreement with the prospective franchisee or collecting any payment from any prospective franchisee. Federal law does not regulate the franchise relationship or require any filing or registration on the part of a franchisor. The Company is also required to comply with certain state regulations in connection with the offer and sale of franchises, including the requirement of the Company to submit the FDD for registration with a number of states before offering or selling franchises within those states. The list of states requiring registration of the FDD are: California, Florida, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. In these states, state regulatory agencies review the FDD to confirm compliance with state statutory requirements. These state agencies can deny registration if they determine that the FDD fails to meet state statutory requirements. If a state denies the issuance of an effective registration, a franchisor is prohibited from offering or selling franchises in that state. See "--Government Regulation" below for more information.
Royalty and Marketing Fees
The Company invoices all applicable franchisees a royalty fee on a monthly basis. Every U.S. franchisee, upon signing a franchise agreement, has authorized and provided the required banking information to allow the electronic collection of all fees. Approximately three days after the invoice has been issued to the franchisee, an ACH draft (automatic deduction from the franchisee bank account) for the royalty fee withdrawal is processed through the Companys banking system.
Based upon the number of franchise territories owned and the length of time the franchisee has been in operations, historically, domestic and international franchisees were required to pay BFK a royalty fee amounting to 7% of gross receipts reported in the Franchise Management Tool (FMT). BFK also received a percentage of royalty payments received by master franchisees from their sub-franchisees. Franchisees were billed monthly for their 7% royalty payments, based upon gross receipts, due to the Company. The franchisees were required to pay the Company a minimum royalty fee per each franchise territory they own. Billing of the minimum royalty fee amount to each franchisee took place every 12 weeks and the minimum amount was calculated by comparing the amounts between the regular royalties billed for the prior 12 weeks to the 12 week minimum royalty payment due to the Company, per the franchise agreement. The 12-week minimum royalty payment due to the Company was $1,500 for the first franchise territory owned (equating to a minimum average fee of $500 per month) and $750 for the second franchise territory owned (equating to a minimum average fee of $250 per month). The minimum amount due for the third franchise territory was $1,500 and the fourth franchise territory was $750. After the end of each 12-week period, franchisees are required to pay to the Company the amount, if any, by which the minimum royalty exceeds the sum of the royalties paid over the 12-week period.
Beginning October 1, 2015, the Company adopted a flat-fee approach, eliminating the previous approach based upon revenue collections by the franchisee. The Company made the change to a flat-fee approach for a variety of reasons, including without limitation: to better enable franchisees to manage their cash flow; to enrich relations with our franchisees by being responsive to their needs; to facilitate the Companys ability to collect minimum fees across the board; and to make the companys fee structure more attractive to new potential franchisees.
On October 1, 2015, the Company commenced implementation of a new royalty fee structure, which is disclosed in the table below:
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Time Period During the Initial Term of Franchise Agreement
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Royalty Fees Amount (U.S. Dollars)
(per month)
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October 1, 2015 through September 30, 2016
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$400 USD
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October 1, 2016 through September 30, 2017
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$425 USD
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October 1, 2017 through September 30, 2018
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$450 USD
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October 1, 2018 through September 30, 2019
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$475 USD
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October 1, 2019 and for the remainder of the initial term of the Franchise Agreement
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$500 USD
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If any franchisee owns and operates more than one territory, the royalty fees payable to the Company for the second territory and each additional territory shall be as follows:
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Time Period During the Initial Term of Franchise Agreement
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Royalty Fees Amount (U.S. Dollars)
(per month)
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October 1, 2015 through September 30, 2016
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$200 USD
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October 1, 2016 through September 30, 2017
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$225 USD
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October 1, 2017 and for the remainder of the initial term of the Franchise Agreement
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$250 USD
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Each franchisee has been given the option to amend their franchise agreement contract and elect this new royalty fee structure. At August 12, 2016, less than 2% of franchisees have formally rejected the new royalty fee program and 7% of franchisees have not yet communicated their decision regarding the new program. Any franchisees which do not elect the new royalty fee structure will remain subject to the historic royalty structure described above.
BFK administers a marketing fund for domestic and Canadian franchisees for the purpose of building national brand awareness. The marketing fund expenditures are funded with BFK collecting a 2% marketing fee, based upon gross receipts reported in the FMT, from domestic and Canadian franchisees. The respective franchisees are typically invoiced the middle of each month for the prior months receipts. These marketing fee and expenses are accounted for separately and are not reported as revenue or expenses for BFK. The collections of these funds are done using the Companys ACH program, as agreed to by each franchisee in their Franchise Agreement. The Marketing Fund is segregated into a separate bank account.
BFK Competition
Although BFK pioneered the LEGO® modeling-based curriculum for after school programs, we believe there are at least two other companies franchising a model similar to that of Bricks 4 Kidz®, Engineering 4 Kids and Snapology. In addition, Play-Well Teknologies offers after-school classes, camps and birthday parties using LEGO® bricks. Vision Education and Media offers after school classes using LEGO® bricks in the New York metropolitan area. In addition, several other small businesses around the country offer after-school classes and vacation camps using LEGO® bricks. These classes and camps are typically held in elementary schools, middle schools and community colleges.
Sew Fun Studios
The Company is in the process of revising SFs form of franchise agreement to address common franchise issues consistent with best practices. SF expects to file state-required registrations or amended or renewed registrations during the 1st quarter of fiscal year 2017. Franchises sold under this franchise concept operate businesses offering creative project-based activities, classes and programs in fashion and interior design and sewing to children and adults at locations such as elementary and middle schools, camps, social events, community centers and churches. At September 30, 2015, SF has granted 12 developmental franchises in locations and states that do not require registration and is operating in five states, with one franchisee in Canada, and one in Puerto Rico. When the Company finalizes the disclosure document and it is accepted by the regulatory states, we expect that general sales of franchises will begin in those regulatory states.
Franchising Process
Initial contact between a potential franchisee and the Company may result from a potential franchisee contacting the Company, either by phone or electronically. Potential franchisees may also be introduced to the Company by brokers and/or other parties, and the Company may pay commissions and consulting fees to the brokers. The Company has discontinued its previous practice of introducing franchisee candidates to third party financing sources to cover franchising expenses, as well as, paying commissions and consulting fees to the Companys directors, officers and employees and their family members. See Item 11, Executive Compensation Summary Compensation Table and Item 13, Certain Relationships and Related Transactions.
After initial contact, one of the Companys franchise consultants interviews each prospective franchisee (the candidate) to determine whether the candidate may make a successful franchisee. If the franchise consultant determines that the candidate may make a successful franchisee, the candidate submits a request for consideration (RFC). The Company reviews the RFC and if the RFC is approved, the franchise consultant continues the vetting process, which focuses on financial and other factors.
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Upon receipt of the RFC, the candidate is emailed a copy of the Companys franchise disclosure document. The franchise consultant reviews the franchise disclosure document with the candidate and answers any questions concerning the franchise and the franchise agreement. The Company does not provide projections of a franchises financial model or performance to prospective franchisees.
Assuming the candidate has cleared the initial vetting process and remains interested in operating one of the Companys franchises, the candidate is invited to attend a discovery day held at the Companys headquarters, or in some instances at another location, during which representatives of the Company and the candidate meet face to face. If the Company decides that the candidate meets its objectives for the franchise, the required disclosure waiting period has expired and the candidate wants to move forward and become a franchisee, the parties execute a franchise agreement.
The Company will sell a franchise for a particular territory only when the Company believes that there is a reasonable chance for a franchise to succeed in that territory. If a franchisee is not successful, the Company may terminate the franchise agreement by providing notice to the franchisee or repurchasing the franchise from the franchisee. Until the Company provides a notice of termination or repurchases the franchise, the Company considers the franchise to be active. During fiscal years 2015 and 2014, the termination rate for active franchises was approximately three percent and two percent, respectively.
CI
CI Operations
CI, which conducts business under the trade name, Challenge Island®, provides unique challenge-based programs designed to foster critical and creative thinking skills, problem solving methodology, and core STEM (Science, Technology, Engineering, Mathematics) principles in children ages 3-13+.
Current Programs Offered by CI
CI has the same event types, possible venues and programs as BFK above.
CI Operating Units
CI franchises are mobile models, with activities which can be offered in a variety of venues and event types, including after-school programs. However, and in contrast to BFK, the CI franchise program does not have a store-front Center model available.
CI sold the first franchise in May 2013 and as of September 30, 2015, CI had 49 franchises operating in 19 states, the District of Columbia, Puerto Rico and two foreign countries.
CI Franchise Program
CI sells franchises both domestically and internationally. International sales can be individual international franchises, or where warranted, they could be sold as Master License agreements where the Master Licensee can operate a franchise, but also develop, sell and manage sub-franchisees. There are no Master licenses issued in the United States.
A franchisee pays a one-time, non-refundable franchise fee upon the execution of the franchise agreement. Domestically, there can be variations on the franchise fees depending on the size and other factors of the territory, or territories being purchased. The typical size, domestic, single territory franchise fee is $17,500. Internationally, franchise fees are set relative to the potential of the proposed territories, and can vary. In the case of a Master Franchise, CI could receive a percentage of the price the Master Franchisee receives from the sub-franchisees.
Domestic and international franchisees are required to pay CI a royalty fee of 7%. CI also could receive a percentage of royalty payments received by Master licensees from their sub-franchisees.
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Franchisees are required to pay the Company a minimum royalty amount per each franchise territory they own beginning six months after acquisition of the franchise. Billing of the minimum royalty amount to each franchisee takes place every 12 weeks and the minimum amount is calculated by comparing the amounts between the regular monthly royalties billed for the prior 12 weeks to the 12 week minimum royalty payment due to the Company, per the franchise agreement. The 12 week minimum royalty payment due to the Company is $900 for each franchise territory owned. After the end of each 12 week period, franchisees are required to pay to the Company the amount, if any, by which the minimum royalty exceeds the sum of the royalties, paid over the 12 week period.
CI administers a Marketing Fund for domestic and Canadian franchisees with the purpose of building national brand awareness. The Marketing Fund expenditures are funded with CI collecting a 2% marketing fee from domestic and Canadian franchisees. These marketing fee and expenses are accounted for separately and are not reported as revenue or expense for CI.
The franchisee is granted an exclusive territory and a license to use the Challenge Island® name and trademarks in the franchised territory. The franchisee is required to conform to certain standards of business practices. Each franchise is run as an independent business and, as such, is responsible for its operation, including employment of adequate staff. A franchisee can also purchase additional territories.
Franchisees are permitted to assign their franchise provided that CI receives advance notice of the proposed assignment, the transferee assumes the obligations under the franchise agreement, the transferee meets certain conditions and qualifications, and CI receives a transfer fee based on a percentage of the current Franchise Fee rate for a single territory.
The term of the franchise is for ten years. CI has the right to terminate any franchisee in the event of the franchisees bankruptcy, a default under the franchise agreement, or other events. The franchisee has the right to renew the franchise for an additional ten years if, at the time of renewal, the franchisee is in good standing and pays a renewal fee in the amount of $5,000.
In addition to the franchise fee, a franchisee is advised that an additional investment of between $8,000 and $23,000 will be required for such things as equipment and supplies, insurance, marketing and working capital during the start-up phase of the business.
CI Competition
We know of no companies franchising a model similar to that of Challenge Island®. However, in the after-school program market, there are many different concepts that vie for this time slot. Addressed in Note 12, CI was sold on December 9, 2015
Government Regulation
The offer and sale of franchises is regulated by the Federal Trade Commission (the FTC) and some state governments.
In 1979, the Federal Trade Commission promulgated what became known as the FTC Franchise Rule. The FTC Franchise Rule requires that the franchisor provide a franchise disclosure document (FDD) to each prospective franchisee prior to execution of a binding franchise agreement or payment of money by the prospective franchisee. The FTC Franchise Rule does not regulate the franchise relationship or require any filing or registration on the part of a franchisor.
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However, the FTC Franchise Rule does not preempt state law and, as a result, states are not prohibited from imposing additional requirements on franchisors. For example, the following states require franchisors to register with the state prior to the offer and sale of franchises in the state, and to provide all prospective franchisees with a registered FDD prior to the offer and sale of a franchise in the state: California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin (the Franchise Registration States). The registration process is not uniform in each Franchise Registration State. Most Franchise Registration States require the franchisor to submit an application, which includes a FDD, in order to register to sell franchises within that state. Many, but not all, of the state regulatory agencies in the Franchise Registration States review the franchisors registration application, the FDD, the proposed franchise agreement and any other agreements franchisees must sign, the financial condition of the franchisor, and other material information provided by the franchisor in its application. These state agencies have the authority to deny a franchisors application for registration and prohibit the franchisor from offering or selling franchises in the state.
In addition, there are numerous states that have laws that regulate the relationship between a franchisor and a franchisee after the sale of the franchise.
Under the FTC Franchise Rule, the FTC has the authority to seek civil penalties against a franchisor for violations of the FTC Franchise Rule. Each of the Franchise Registration States has similar authority to seek penalties for violations of their state franchise registration and disclosure laws. Violations may include offering or selling an unregistered franchise, failing to timely provide the disclosure document to a prospective franchisee or making misrepresentations in the FDDs. Additionally, officers of the franchisor may have personal liability if they had knowledge of or participated in the violations.
There is no direct, private right of action for a violation of the FTC Franchise Rule. However, most of the Franchise Registration States provide for a private right of action for a violation of the states franchise registration and disclosure law. Remedies available under these laws typically include damages, rescission of the franchise agreement and attorneys fees.
General
The Companys offices, consisting of approximately 4,500 square feet, are located in an office/condo complex at 701 Market, Suite 113, St. Augustine, FL 32095. The Company owns three of the office condominiums and rents two additional units.
At August 12, 2016 the Company had 9 employees on a full time basis.
Available Information
We make available free of charge on or through our Internet website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission, or SEC. Our corporate website is www.creativelearningcorp.com. The information in this website is not a part of this report.
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ITEM 1A.
RISK FACTORS.
Ownership of our securities involves a high degree of risk. Holders of our securities should carefully consider the following risk factors and the other information contained in this Form 10-K, including our historical financial statements and related notes included herein. The following discussion highlights some of the risks that may affect future operating results. Additional risks and uncertainties not presently known to us, which we currently deem immaterial or which are similar to those faced by other companies in our industry or businesses in general, may also impair our businesses operations. If any of the following risks or uncertainties actually occur, our business, financial condition and operating results could be adversely affected in a material way. This could cause the trading prices of our common stock to decline, perhaps significantly, and you may lose part or all of your investment. Please see Cautionary Notes Regarding Forward-Looking Statements.
Risks Related to Our Business
We currently are not able to sell franchises in the United States.
As of January 29, 2016, Creative Learning Corporation (the Company) has temporarily suspended domestic franchise offer and sales of Bricks 4 Kidz® and Sew Fun Studios® franchises in compliance with FTC Franchise Rule, Section 436.7(a) due to delay in completion of the Companys 2015 10-K. In turn, this has delayed completion of the Companys 2016 Franchise Disclosure Documents (FDDs) for the Bricks 4 Kidz® and Sew Fun Studios® franchise offerings. The Company expects that offer and sales efforts will resume in approximately 70% of the states in which Bricks 4 Kidz® and Sew Fun Studios® currently sell franchises immediately upon filing of the 2015 10-K, and completion of the FDD, and in the rest of the states upon either filing or approval of the renewal applications, depending upon the applicable rules of each such state. The Company expects to file the renewal applications and the associated FDDs as soon as they are completed. In a number of these states, the Company did not have active franchise offer and sales efforts even before the temporary suspension. This temporary suspension of domestic franchise offer and sales does not affect the Companys international franchise offer and sales activity or its royalty fee collections from existing franchisees. In addition, it does not affect US transfers.
Our financial results are affected by the operating and financial results of and our relationships with our franchisees.
A substantial portion of our revenues come from royalties, which have been generally based on a percentage of our franchisees revenues. As a result, our financial results have been largely dependent upon the operational and financial results of our franchisees. Negative economic conditions, including inflation, increased unemployment levels and the effect of decreased consumer confidence or changes in consumer behavior, could materially harm our franchisees financial condition, which would cause our royalty and other revenues to decline and materially and adversely affect our results of operations and financial condition as a result. In addition, if our franchisees fail to renew their franchise agreements, these revenues may decrease, which in turn could materially and adversely affect our results of operations and financial condition. In part to support franchisee growth and financial planning and to enrich relations with our franchisees, the Company altered its royalty fee structure beginning and effective October 1, 2015, changing it to a fixed monthly charge on an escalating scale over five years. Comparing first quarter fiscal 2015 results under the prior royalty system with fiscal 2016 results under the new flat-rate system, there has been a revenue reduction of approximately $7,000 for that quarter. The Company makes no projection as to whether revenue reduction will continue at this rate for the rest of the year, decrease or increase.
Our franchisees could take actions that harm our business.
Our franchisees are independent third party business owners who are contractually obligated to operate in accordance with the operational and other standards set forth in the franchise agreement. We cannot be certain that our franchisees will have the business acumen or financial resources necessary to operate successful franchises in their approved territories. In addition, certain state franchise laws may limit our ability to terminate, not renew or modify these franchise agreements. As independent business owners, the franchisees oversee their own daily operations. As a result, the ultimate success and quality of any franchise rests with the franchisee. If franchisees do not successfully operate in a manner consistent with required standards and comply with local laws and regulations, franchise fees and royalties paid to us may be adversely affected and our brand image and reputation could be harmed, which in turn could adversely affect our results of operations and financial condition.
Moreover, although we believe we generally maintain positive working relationships with our franchisees, disputes with franchisees could damage our brand image and reputation and our relationships with our franchisees, generally.
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Our success depends substantially on the value of our brand.
Our success is substantially dependent upon our ability to maintain and enhance the value of our brand, the customers of our franchisees connection to our brand and a positive relationship with our franchisees. Brand value can be severely damaged even by isolated incidents, particularly if the incidents receive considerable negative publicity or result in litigation. Some of these incidents may relate to the way we manage our relationships with our franchisees, our growth strategies, our development efforts or the ordinary course of our, or our franchisees, businesses. Other incidents that could be damaging to our brand may arise from events that are or may be beyond our ability to control, such as:
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actions taken (or not taken) by one or more franchisees or their employees relating to health, safety, welfare or otherwise;
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data security breaches or fraudulent activities associated with our and our franchisees
’
electronic payment systems;
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litigation and legal claims;
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third-party misappropriation, dilution or infringement of our intellectual property; and
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illegal activity targeted at us or others.
Consumer demand for our products and services and our brand
’
s value could diminish significantly if any such incidents or other matters erode consumer confidence in us or our products or services, which would likely result in fewer sales of our products and services and, ultimately, lower royalty revenue, which in turn could materially and adversely affect our results of operations and financial condition.
If we fail to successfully implement our growth strategy, our ability to increase our revenues and net income could be adversely affected.
Our growth strategy relies in large part upon new business development by existing and new franchisees. Our franchisees face many challenges in growing their businesses, including:
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availability and cost of financing;
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securing required domestic or foreign governmental permits and approvals;
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trends in new geographic regions and acceptance of our products and services;
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competition with competing franchise systems;
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employment, training and retention of qualified personnel; and
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general economic and business conditions.
In particular, because the majority of our business development is funded by franchisee investment, our growth strategy is dependent on our franchisees (or prospective franchisees) ability to access funds to finance such development. If our franchisees (or prospective franchisees) are not able to obtain financing at commercially reasonable rates, or at all, they may be unwilling or unable to invest in business development, and our future growth could be adversely affected.
Our growth strategy also relies on our ability to identify, recruit and enter into franchise agreements with a sufficient number of qualified franchisees. In addition, our ability and the ability of our franchisees to successfully expand into new markets may be adversely affected by a lack of awareness or acceptance of our brand as well as a lack of existing marketing efforts and operational execution in these new markets. To the extent that we are unable to implement effective marketing and promotional programs and foster recognition and affinity for our brand in new markets, our franchisees may not perform as expected and our growth may be significantly delayed or impaired. In addition, franchisees may have difficulty securing adequate financing, particularly in new markets, where there may be a lack of adequate history and brand familiarity. Our franchisees business development efforts may not be successful, which could materially and adversely affect our business, results of operations and financial condition.
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Our planned growth could place strains on our management, employees, information systems and internal controls, which may adversely impact our business.
Our planned future growth may place significant demands on our administrative, operational, financial and other resources. Any failure to manage growth effectively could seriously harm our business. To be successful, we will need to continue to implement management information systems and improve our operating, administrative, financial and accounting systems and controls. We will also need to train new employees and maintain close coordination among our executive, accounting, finance, legal, human resources, risk management, marketing, technology, sales and operations functions. These processes are time-consuming and expensive, increase management responsibilities and divert management attention, and we may not realize a return on our investment in these processes. Our failure to successfully execute on our planned expansion could materially and adversely affect our results of operations and financial condition.
Changing economic conditions, including unemployment rates, may reduce demand for our products and services.
Our revenues and other financial results are subject to general economic conditions. Our revenues depend, in part, on the number of dual-income families and working single parents who require child development or educational services. A deterioration of general economic conditions, including a soft housing market and/or rising unemployment, may adversely impact us because of the tendency of out-of-work parents to diminish or discontinue utilization of these services. Finally, there can be no assurance that demographic trends, including the number of dual-income families in the work force, will continue to lead to increased demand for our products and services.
We may require additional financing to execute our business plan and fund our other liquidity needs.
We currently have no revolving credit facility or other committed source of recurring capital. Unless we are able to increase our revenues or decrease our operating expenses from recent historical run-rate levels, we expect that we may need to obtain additional capital during fiscal year 2016 to fund our planned operations. If our cash flows from operations do not meet or exceed our projections, we may need to pursue one or more alternatives, such as to:
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reduce or delay planned capital expenditures or investments in our business;
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seek additional financing or restructure or refinance all or a portion of our indebtedness at or before maturity;
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sell assets or businesses;
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sell additional equity; or
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curtail our operations.
Any such actions may materially and adversely affect our future prospects. In addition, we cannot ensure that we will be able to raise additional equity capital, restructure or refinance any of our indebtedness or obtain additional financing on commercially reasonable terms or at all.
We are subject to a variety of additional risks associated with our franchisees.
Our franchise business model subjects us to a number of risks, any one of which may impact our royalty revenues collected from our franchisees, may harm the goodwill associated with our brand, and may materially and adversely impact our business and results of operations.
Bankruptcy of franchisees.
A franchisee bankruptcy could have a substantial negative impact on our ability to collect payments due under such franchisees franchise agreement(s). In a franchisee bankruptcy, the bankruptcy trustee may reject its franchise agreement(s) pursuant to Section 365 under the U.S. bankruptcy code, in which case there would be no further royalty payments from such franchisee, and we may not ultimately recover those payments in a bankruptcy proceeding of such franchisee in connection with a damage claim resulting from such rejection.
Franchisee changes in control.
Our franchises are operated by independent business owners. Although we have the right to approve franchise owners, and any transferee owners, it can be difficult to predict in advance whether a particular franchise owner will be successful. If an individual franchise owner is unable to successfully establish, manage and operate its business, the performance and quality of its service could be adversely affected, which could reduce its sales and negatively affect our royalty revenues and brand image. Although our franchise agreements prohibit changes in control of a franchisee without our prior consent as the franchisor, a franchise owner may desire to transfer a franchise. In addition, in any transfer situation, the transferee may not be able to successfully operate the business. In such a case the performance and quality of service could be adversely affected, which could also reduce its sales and negatively affect our royalty revenues and brand image.
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Franchisee insurance.
Our franchise agreements require each franchisee to maintain certain insurance types and levels. Losses arising from certain extraordinary hazards, however, may not be covered, and insurance may not be available (or may be available only at prohibitively expensive rates) with respect to many other risks. Moreover, any loss incurred could exceed policy limits and policy payments made to franchisees may not be made on a timely basis. Any such loss or delay in payment could have a material adverse effect on a franchisees ability to satisfy its obligations under its franchise agreement or other contractual obligations, which could cause a franchisee to terminate its franchise agreement and, in turn, negatively affect our operating and financial results.
Some of our franchisees are operating entities.
Franchisees may be natural persons or legal entities. Our franchisees that are operating companies (as opposed to limited purpose entities) are subject to business, credit, financial and other risks, which may be unrelated to the operation of their franchise businesses. These unrelated risks could materially and adversely affect a franchisee that is an operating company and its ability to service its customers and maintain its operations while making royalty payments, which in turn may materially and adversely affect our business and operating results.
Franchise agreement termination; nonrenewal.
Each franchise agreement is subject to termination by us as the franchisor in the event of a default, generally after expiration of applicable cure periods, although under certain circumstances a franchise agreement may be terminated by us upon notice without an opportunity to cure. Our right to terminate franchise agreements may be subject to certain limitations under any applicable state relationship laws that may require specific notice or cure periods despite the provisions in the franchise agreement. The default provisions under the franchise agreements are drafted broadly and include, among other things, any failure to meet operating standards and actions that may threaten the licensed intellectual property. Moreover, a franchisee may have a right to terminate its franchise agreement in certain circumstances.
In addition, each franchise agreement has an expiration date. Upon the expiration of a franchise agreement, we or the franchisee may, or may not, elect to renew the franchise agreement. If the franchise agreement is renewed, the franchisee will receive a successor franchise agreement for an additional term. Such option, however, is contingent on the franchisees execution of our then-current form of franchise agreement (which may include increased royalty revenues, advertising fees and other fees and costs), the satisfaction of certain conditions and the payment of a renewal fee. If a franchisee is unable or unwilling to satisfy any of the foregoing conditions, the expiring franchise agreement will terminate upon expiration of its term. Our right to elect to not renew a franchise agreement may be subject to certain limitations under any applicable state relationship laws that may require specific notice periods or good cause for non-renewal despite the provisions in the franchise agreement.
Franchisee litigation; effects of regulatory efforts.
We and our franchisees are subject to a variety of litigation risks, including, but not limited to, customer claims, personal injury claims, litigation with or involving our relationship with franchisees, litigation alleging that the franchisees are our employees or that we are the co-employer of our franchisees employees, employee allegations against the franchisee or us of improper termination and discrimination, landlord/tenant disputes and intellectual property claims, among others. Each of these claims may increase costs, reduce the execution of new franchise agreements and affect the scope and terms of insurance or indemnifications we and our franchisees may have. In addition, we and our franchisees are subject to various regulatory enforcement actions regarding among other things franchise and employment laws, such as: failure to comply with franchise registration and disclosure requirements; the provision to prospective franchisees of business projections; efforts to categorize franchisors as the co-employers of their franchisees employees; legislation to categorize individual franchised businesses at large employers for the purposes of various employment benefits; and other legislation or regulations that may have a disproportionate impact on franchisors and/or franchised businesses. These changes may impose greater costs and regulatory burdens on franchising, and negatively affect our ability to sell new franchises.
Franchise agreements and franchisee relationships.
Our franchisees develop and operate their business under terms set forth in our franchise agreements. These agreements give rise to long-term relationships that involve a complex set of mutual obligations and mutual cooperation. We have a standard set of franchise agreements that we typically use with our franchisees, but various franchisees have negotiated specific terms in these agreements. Furthermore, we may from time to time negotiate terms of our franchise agreements with individual franchisees or groups of franchisees (e.g., a franchisee association). We seek to have positive relationships with our franchisees, based in part on our common understanding of our mutual rights and obligations under our agreements, to enable both the franchisees business and our business to be successful. However, we and our franchisees may not always maintain a positive relationship or always interpret our agreements in the same way. Our failure to have positive relationships with our franchisees could individually or in the aggregate cause us to change or limit our business practices, which may make our business model less attractive to our franchisees or our members.
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While our franchisee revenues are not concentrated among one or a small number of parties, the success of our business is significantly affected by our ability to maintain contractual relationships with franchisees in profitable stores. A typical franchise agreement has a ten-year term. If we fail to maintain or renew our contractual relationships on acceptable terms, or if one or more significant franchisees were to become insolvent or otherwise were unwilling to pay amounts due to us, our business, reputation, financial condition and results of operations could be materially adversely affected.
Our business is subject to various laws and regulations and changes in such laws and regulations, or failure to comply with existing or future laws and regulations, could adversely affect our business.
We are subject to the FTC Franchise Rule promulgated by the FTC that regulates the offer and sale of franchises in the United States and that requires us to provide to all prospective franchisees certain mandatory disclosure in a FDD. In addition, we are subject to state franchise sales laws in 14 states that regulate the offer and sale of franchises by requiring us to make a franchise filing or obtain franchise registration prior to our making any offer or sale of a franchise in those states and to provide a FDD to prospective franchisees in accordance with such laws. We are also subject to franchise laws in certain provinces in Canada, which, like the FTC Franchise Rule, require presale disclosure to prospective franchisees prior to the sale of a franchise. We must also comply with international laws, including franchise laws, in the countries where we have franchise operations or conduct franchise offer and sales activities. Failure to comply with such laws may result in a franchisees right to rescind its franchise agreement and damages, and may result in investigations or actions from federal or state franchise authorities, civil fines or penalties, and stop orders, among other remedies. We are also subject to franchise relationship laws in approximately 24 states that regulate many aspects of the franchisor-franchisee relationship, including renewals and terminations of franchise agreements, franchise transfers, the applicable law and venue in which franchise disputes must be resolved, discrimination and franchisees right to associate, among others. Our failure to comply with such franchise relationship laws could result in fines, damages, restitution and our inability to enforce franchise agreements where we have violated such laws. Our non-compliance with federal and state franchise laws could result in liability to franchisees and regulatory authorities (as described above), inability to enforce our franchise agreements, required rescission of franchise agreements and a reduction in our anticipated royalty revenue, which in turn may materially and adversely affect our business and results of operating.
We and our franchisees are also subject to the Fair Labor Standards Act of 1938, as amended, and various other laws in the United States and foreign countries governing such matters as minimum-wage requirements, overtime and other working conditions. A significant number of our and our franchisees employees are paid at rates related to the U.S. federal minimum wage, and past increases in the U.S. federal minimum wage have increased labor costs, as would future increases. Any increases in labor costs might result in our and our franchisees inadequately staffing stores. Such increases in labor costs and other changes in labor laws could affect franchisee performance and quality of service, decrease royalty revenues and adversely affect our brand.
We have identified material weaknesses in our internal controls over financial reporting.
Maintaining effective internal controls over financial reporting is necessary for us to produce accurate financial statements on a timely basis. In connection with the preparation of our financial statements for the year ended September 30, 2014, we identified material weaknesses in our internal control over financial reporting specifically related to identifying and accounting for related party arrangements, which led to the restatement of our historical financial results to disclose these related party transactions. In an effort to remediate the identified material weakness and other deficiencies and enhance our internal control over financial reporting, beginning in January 2015, we engaged an outside accounting firm with public company reporting experience to assist with our technical accounting issues. Further, in April 2015, two new independent directors were added to the Board of Directors, and the Board of Directors formed an audit committee which consists of three directors, as of the date of this report each of whom qualify as independent as defined in Section 803(A)(1) of the NYSE MKT Company Guide and two of whom meet the qualifications of being financial experts. The Companys efforts here are further addressed in Part II, Item 9A, Controls and Procedures -- Managements Remediation Initiative
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We are in the process with a new board and management of reviewing the Companys accounting controls and, where necessary to remediate any identified material weaknesses or other deficiencies as well as to address any other Sarbanes-Oxley compliance. For example, the Company has implemented new policies barring the payment of commissions or consulting fees to employees, a delegation of authority policy, and other enhancements. The Company has also retained outside operational and financial consultants with meaningful Sarbanes-Oxley experience. We expect to continue to incur costs associated with implementing other appropriate processes and internal controls, which could include costs and fees for additional audit and consulting services, which could negatively affect our financial condition and operating results.
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During each of the quarters ended December 31, 2014 and March 31, 2015, we identified material weaknesses in our internal control over financial reporting and our principal executive officer and principal financial officer determined that our disclosure controls and procedures were not effective as of such dates. Furthermore, during the quarter ended June 30, 2015, we identified material weaknesses in our internal control over financial reporting, including insufficient segregation of duties over authorization, review and recording of transactions, internal review and approval of financial reporting responsibilities and processes, insufficient technical accounting expertise, lack of central information technology system and controls, and lack of institutional controls and competency. Consequently, as of August 15, 2016, our principal executive officer and principal financial officer evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) and concluded that, because of the material weakness in our internal control over financial reporting and disclosure lapse described above and in Item 9A of our Form 10-K, our disclosure controls and procedures were not effective.
If our remedial measures are insufficient to address the material weakness or if additional material weaknesses or significant deficiencies in our internal control are discovered or occur in the future, we may be unable to accurately report our financial results, or report them within the required timeframes, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results in the future, which could cause investors and others to lose confidence in our financial statements, limit our ability to raise capital and could adversely affect our reputation, results of operations and consolidated financial condition.
We have engaged in a number of related party transactions which may have violated provisions of the Exchange Act and the Sarbanes-Oxley Act of 2002.
Section 13(k) of the Exchange Act (implementing Section 402 of the Sarbanes-Oxley Act of 2002) prohibits a company such as ours, which has a class of securities registered under Section 12(g) of the Exchange Act, from directly or indirectly extending or maintaining credit or arranging for the extension of credit in the form of a personal loan to or for any of our directors or executive officers.
As described elsewhere in this report, we entered into a number of related party transactions with entities affiliated with or controlled by certain of our executive officers. For example, on October 23, 2013, we made a non-interest bearing loan in the amount of $125,000 to MC Logic, LLC, which is wholly-owned by Michelle Cote, our President and Secretary and a director and founder of the Company. MC Logic repaid the loan on December 30, 2013. Shortly prior to the replacement of Brian Pappas as Chief Operating Officer of the Company, Pappas caused the Company to issue a Sew Fun Studios local territory to MC Logic (owned by Michelle Cote) to assist in the development and possible improvement of that franchise concept. MC Logic was granted the territory with no franchise fee, royalty fee obligation, or marketing fee obligation. After completing all of the training, development, and signatory requirements necessary to become operational, the franchise became active on July 10, 2015. The Company entered into an arrangement with MC Logic under which it will begin paying the standard Sew Fun Studios royalty fee for this territory beginning on June 1, 2016. In addition, in July 2013, we made a loan of $70,000 to AudioFlix, Inc., a company owned by Brian Pappas, our director and then-chief executive officer. In late July 2015, the Board of Directors resolved that all outstanding funds due on the loan had to fully paid by July 31, 2015. AudioFlix did repay the note including all interest due in August 2015. Although we have sought and received full repayment of both of these loans, they could still be deemed to be in violation of Section 13(k) of the Exchange Act. Such violations, including violations of other laws under former management of which we are not aware, could subject us to civil sanctions, including injunctive remedies and monetary penalties, as well as criminal sanctions. The imposition of any of such sanctions on us may have a material adverse effect on our business, financial position, results of operations or cash flows.
The markets for our services are competitive and we may be unable to compete successfully.
The markets for our services are competitive, and we may be subject to increased competition in our markets in the future. We expect existing competitors and new entrants into the markets where we do business to constantly revise and improve their business models in light of challenges from us or other companies in the industry. If we cannot respond effectively to advances by our competitors, our business and financial performance may be adversely affected. Increased competition may result in new products and services that fundamentally change our markets, reduce prices, reduce margins or decrease our market share. We may be unable to compete successfully against current or future competitors, some of whom may have significantly greater financial, technical, manufacturing, marketing, sales and other resources than we do.
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Our quarterly revenues and operating results are difficult to predict and may fluctuate significantly in the future.
Our quarterly revenues and operating results are difficult to predict and may fluctuate significantly from quarter to quarter, although we expect that our new royalty fee structure, which was effective October 1, 2015, may reduce these fluctuations. These fluctuations may cause the market price of our common stock to decline. We base our planned operating expenses in part on expectations of future revenues, and our expenses are relatively fixed in the short term. If revenues for a particular quarter are lower than we expect, we may be unable to proportionately reduce our operating expenses for that quarter, which would harm our operating results for that quarter. In future periods, our revenue and operating results may be below the expectation of analysts and investors, which may cause the market price of our common stock to decline. Factors that are likely to cause our revenues and operating results to fluctuate include those discussed elsewhere in this section.
We have a limited operating history, which may make it difficult to evaluate its business and prospects.
We commenced our current business operations in July 2010, upon our acquisition of BFK. Accordingly, we have a limited operating history for operations upon which you can evaluate the viability and sustainability of our business and its acceptance by consumers. These circumstances may make it difficult to evaluate our business and prospects.
We rely upon trademark, copyright and trade secret laws and contractual restrictions to protect our proprietary rights, and if these rights are not sufficiently protected, our ability to compete and generate revenues could be harmed.
We rely on a combination of trademark, copyright and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. The steps taken by us to protect our proprietary information may not be adequate to prevent misappropriation of our technology. Our proprietary rights may not be adequately protected because:
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laws and contractual restrictions may not prevent misappropriation of our technologies or deter others from developing similar technologies; and
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policing unauthorized use of our products and trademarks is difficult, expensive and time-consuming, and we may be unable to determine the extent of any unauthorized use.
The laws of certain foreign countries may not protect the use of unregistered trademarks or other proprietary rights to the same extent as do the laws of the United States. As a result, international protection of our image may be limited and our right to use our trademarks and other proprietary rights outside the United States could be impaired. Other persons or entities may have rights to trademarks that contain portions of our marks or may have registered similar or competing marks for digital signage in foreign countries. There may also be other prior registrations of trademarks identical or similar to our trademarks in other foreign countries. Our inability to register our trademarks or other proprietary rights or purchase or license the right to use the relevant trademarks or other proprietary rights in these jurisdictions could limit our ability to penetrate new markets in jurisdictions outside the United States.
Litigation may be necessary to protect our trademarks and other intellectual property rights, to enforce these rights or to defend against claims by third parties alleging that we infringe, dilute or otherwise violate third-party trademark or other intellectual property rights. Any litigation or claims brought by or against us, whether with or without merit, or whether successful or not, could result in substantial costs and diversion of our resources, which could have a material adverse effect on our business, financial condition, results of operations or cash flows. Any intellectual property litigation or claims against us could result in the loss or compromise of our intellectual property rights, could subject us to significant liabilities, require us to seek licenses on unfavorable terms, if available at all or prevent us from manufacturing or selling certain products, any of which could have a material adverse effect on our business, financial condition, results of operations or cash flows.
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We may face intellectual property infringement claims that could be time-consuming, costly to defend and result in its loss of significant rights.
Other parties may assert intellectual property infringement claims against us, and our products and services may infringe the intellectual property rights of third parties. We may also initiate claims against third parties to defend our intellectual property. Intellectual property litigation is expensive and time-consuming and could divert managements attention from our core business. If there is a successful claim of infringement against us, we may be required to pay substantial damages to the party claiming infringement, develop non-infringing technology or enter into royalty or license agreements that may not be available on acceptable terms, if at all. Our failure to develop non-infringing technologies or license the proprietary rights on a timely basis could harm our business. Also, we may be unaware of filed patent applications that relate to our products. Parties making infringement claims may be able to obtain an injunction, which could prevent us from operating portions of our business or using technology that contains the allegedly infringing intellectual property. Any intellectual property litigation could adversely affect our business, financial condition or results of operations.
We depend on key executive management and other key personal, and may not be able to retain or replace these individuals or recruit additional personnel, which could harm our business.
The Company is actively recruiting additional experienced senior management. Because of the intense competition for these employees and because of other risk factors identified in this report, we may be unable to retain our management team and other key personnel and may be unable to find qualified replacements. All of our key employees are employed on an at will basis and we do not have key-man life insurance covering any of our employees. The loss of the services of any of our executive management members or other key personnel could have a material adverse effect on our business and prospects, as we may not be able to find suitable individuals to replace such personnel on a timely basis or without incurring increased costs, or at all.
Any long-term indebtedness we may incur could adversely affect our business and limit our ability to expand our business or respond to changes, and we may be unable to generate sufficient cash flow to satisfy our debt service obligations.
We currently have no outstanding debt, other than the current liabilities reflected in the accompanying consolidated financial statements.
We may incur indebtedness in the future. Any long-term indebtedness we may incur and the fact that a substantial portion of our cash flow from operating activities could be needed to make payments on this indebtedness could have adverse consequences, including the following:
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reducing the availability of our cash flow for our operations, capital expenditures, future business opportunities, and other purposes;
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limiting our flexibility in planning for, or reacting to, changes in our business and the industries in which we operate, which would place us at a competitive disadvantage compared to our competitors that may have less debt;
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limiting our ability to borrow additional funds;
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increasing our vulnerability to general adverse economic and industry conditions; and
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failing to comply with the covenants in our debt agreements could result in all of our indebtedness becoming immediately due and payable.
Our ability to borrow any funds needed to operate and expand our business will depend in part on our ability to generate cash. Our ability to generate cash is subject to the performance of our business as well as general economic, financial, competitive, legislative, regulatory, and other factors that are beyond our control. If our business does not generate sufficient cash flow from operating activities or if future borrowings are not available to us in amounts sufficient to enable us to fund our liquidity needs, our operating results, financial condition, and ability to expand our business may be adversely affected. Moreover, our inability to make scheduled payments on our debt obligations in the future would require us to refinance all or a portion of our indebtedness on or before maturity, sell assets, delay capital expenditures or seek additional equity.
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We could be subject to changes in tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities.
We are subject to income taxes in the U.S. and other foreign jurisdictions. Significant judgment is required in determining our tax provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are subject to the examination of our income tax returns, payroll taxes and other tax matters by the Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for income taxes and payroll tax accruals. There can be no assurances as to the outcome of these examinations. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical tax provisions and payroll accruals. The results of an audit or litigation could have a material effect on our consolidated financial statements in the period or periods for which that determination is made. Our effective income tax rate in the future could be adversely affected by a number of factors, including changes in the mix of earnings in countries with different statutory tax rates, changes in tax laws, the outcome of income tax audits, and any repatriation of non-U.S. earnings for which we have not previously provided for U.S. taxes.
Risks Related to Our Common Stock
The concentration of our capital stock ownership with insiders will likely limit your ability to influence corporate matters.
As of December 31, 2015, our executive officers and directors
and affiliated persons and entities collectively beneficially owned approximately 34% of our outstanding common stock. As a result, these persons and entities have the ability to exercise control over most matters that require approval by our stockholders, including the election of directors and approval of significant corporate transactions. Corporate action might be taken even if other stockholders oppose them. This concentration of ownership might also have the effect of delaying or preventing a change in control of our company that other stockholders may view as beneficial.
Compliance with the Sarbanes-Oxley Act of 2002 will require substantial financial and management resources.
Section 404 of the Sarbanes-Oxley Act of 2002 requires that we evaluate and report on our system of internal controls and, if and when we are no longer a smaller reporting company, will require that we have such system of internal controls audited. If we fail to maintain the adequacy of our internal controls, we could be subject to regulatory scrutiny, civil or criminal penalties and/or Stockholder litigation. Any inability to provide reliable financial reports could harm our business. Furthermore, any failure to implement required new or improved controls, or difficulties encountered in the implementation of adequate controls over our financial processes and reporting in the future, could harm our operating results or cause us to fail to meet our reporting obligations. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our securities.
Provisions in our charter documents and Delaware law may discourage or delay an acquisition that stockholders may consider favorable, which could decrease the value of our common stock.
Our certificate of incorporation, our bylaws, and Delaware corporate law contain provisions that could make it harder for a third party to acquire us without the consent of our board of directors. These provisions include those that: authorize the issuance of up to 10,000,000 shares of preferred stock in one or more series without a stockholder vote. In addition, in certain circumstances, Delaware law also imposes restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock.
We have not paid cash dividends to our shareholders and currently have no plans to pay future cash dividends.
We plan to retain earnings to finance future growth and have no current plans to pay cash dividends to shareholders. Any indebtedness that we incur in the future may also limit our ability to pay dividends. Because we have not paid cash dividends, holders of our securities will experience a gain on their investment in our securities only in the case of an appreciation of value of our securities. You should neither expect to receive dividend income from investing in our securities nor an appreciation in value.
ITEM 1B.