The accompanying Notes to Consolidated Financial
Statements are an integral part of these statements.
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
NOTE 1 — BUSINESS
ACTIVITY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
: Monster Digital, Inc. (“MDI”),
a Delaware corporation (formed in November 2010), and its subsidiary, SDJ Technologies, Inc. (“SDJ”) (collectively
referred to as the “Company”), is an importer of high-end memory storage products, flash memory and action sports cameras
marketed and sold under the Monster Digital brand name acquired under a long-term licensing agreement with Monster, Inc. The Company
sources its products from China, Taiwan and Hong Kong.
Public Offering
: The Company closed its initial
public offering (the “Offering”) on July 13, 2016 and its common stock and warrants are listed on the Nasdaq
Capital Market under the symbols “MSDI” and “MSDIW”, respectively. The Offering generated gross
proceeds of $9,132,750 on the sale of 2,025,000 common shares at $4.50 per share and 2,025,000 warrants at $0.01 per
warrant.
Basis of Presentation
: The accompanying unaudited
consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United
States (“U.S. GAAP”) for interim financial information and with the SEC’s instructions for interim financial
information. They do not include all information and footnotes necessary for a fair presentation of financial position, operating
results and cash flows in conformity with U.S. GAAP for complete financial statements. These consolidated financial statements
should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2015
which are included in Form S-1 filed by the Company that was declared effective on July 7, 2016. In the opinion of management,
all adjustments (consisting of normal recurring adjustments and accruals) considered necessary for a fair presentation of the operating
results for the periods presented have been included in the interim periods. Operating results for the three and nine months ended
September 30, 2016 are not necessarily indicative of the results that may be expected for other interim periods or the year ending
December 31, 2016. For interim financial reporting purposes, income taxes are recorded based upon estimated annual effective income
tax rates taking into consideration discrete items occurring in a quarter. The consolidated balance sheet as of December 31, 2015
is derived from the 2015 audited financial statements.
Principles of Consolidation
: The consolidated
financial statements include the accounts of MDI and SDJ. All significant intercompany transactions have been eliminated in consolidation.
Use of Estimates
: The preparation of financial
statements in conformity with accounting principles generally accepted in the United States of America requires management to make
certain estimates and assumptions that affect the reported amounts of assets and liabilities (including sales returns, price protection
allowances, bad debts, inventory reserves, warranty reserves, and asset impairments), disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results
could differ significantly from those estimates
Concentration of Cash
: The Company maintains
its cash in bank accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such
accounts. Management believes the Company is not exposed to any significant credit risk on its cash balances.
Accounts Receivable
: Accounts receivable are
carried at original invoice amount less allowance for doubtful accounts. Management determines the allowance for doubtful accounts
by identifying troubled accounts and by using historical experience applied to an aging of accounts. Accounts receivable are written
off when deemed uncollectible. Recoveries of receivables previously written off are recorded when received. Accounts receivable
are considered to be past due if any portion of the receivable balance is outstanding for more than 90 days past the customer’s
granted terms. The Company does not charge interest on past due balances or require collateral on its accounts receivable. As of
December 31, 2015 and September 30, 2016, the allowance for doubtful accounts was approximately $99,000 and $252,000, respectively.
Inventories
: Inventories are stated at the
lower of cost or market, with cost being determined on the weighted average cost method of accounting. The Company purchases finished
goods and materials to assemble kits in quantities that it anticipates will be fully used in the near term. Changes in operating
strategy, customer demand, and fluctuations in market values can limit the Company’s ability to effectively utilize all products
purchased and can result in finished goods with above-market carrying costs which may cause losses on sales to customers. The Company’s
policy is to closely monitor inventory levels, obsolescence and lower market values compared to costs and, when necessary, reduce
the carrying amount of its inventory to its market value. As of December 31, 2015 and September 30, 2016, inventory on hand was
comprised primarily of finished goods ready for sale and packaging and supplies.
Fair Value of Financial Instruments
: Fair
value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date. As such, fair value is a market-based measurement that should
be determined based on the assumptions that market participants would use in pricing an asset or liability. Fair value is based
on a hierarchy of valuation techniques, which is determined on whether the inputs to those valuation techniques are observable
or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the
Company’s own market assumptions. These two types of inputs create a three-tier fair value hierarchy, which prioritizes the
inputs used in measuring fair value as follows:
|
Level 1:
|
Quoted prices for identical instruments in active markets.
|
|
Level 2:
|
Quoted prices for similar instruments in active markets;
quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant
inputs and significant value drivers are observable in active markets.
|
|
Level 3:
|
Valuations derived from valuation techniques in which one
or more significant inputs or significant value drivers are unobservable.
|
The carrying amount for other financial instruments, which include
cash, accounts receivable, accounts payable, and line of credit, approximate fair value based upon their short term nature and
maturity.
Revenue Recognition
: Revenue is realized or
realizable and earned when all of the following criteria are met: (1) persuasive evidence of an arrangement exists, (2) the sales
price is fixed or determinable, (3) collectability is reasonably assured, and (4) products have been shipped and the customer has
taken ownership and assumed the risk of loss. Distributors and retailers take full ownership of their product upon delivery and
sales are fully recognized at that time.
Revenue is reduced by reserves for price protection, sales returns,
allowances and rebates. Our reserve estimates are based upon historical data as well as projections of sales, customer inventories,
market conditions and current contractual sales terms. If the Company reduces the list price of its products, certain customers
may receive a credit from the Company (i.e. price protection). The Company estimates the impact of such pricing changes on a regular
basis and adjusts its allowances accordingly. Amounts charged to operations for price protection are calculated based on actual
price changes on individual products and customer inventory levels. The reserve is then reduced by actual credits given to these
customers at the time the credits are issued. We calculate the allowance for doubtful accounts and provision for sales returns
and rebates based on management’s estimate of the amount expected to be uncollectible or returned on specific accounts. We
provide for future returns, price protection and rebates at the time the products are sold. We calculate an estimate of future
returns of product by analyzing units shipped, units returned and point of sale data to ascertain consumer purchases and inventory
remaining with retail to establish anticipated returns. Price protection is calculated on a product by product basis. The objective
of price protection is to mitigate returns by providing retailers with credits to ensure maximum consumer sales. Price protection
is granted to retailers after they have presented the Company an affidavit of existing inventory.
The Company also offers market development credits (“MDF
credits”) to certain of its customers. These credits are also charged against revenue.
Shipping and Handling Costs
: Historically,
the Company has not charged its customers for shipping and handling costs, which is a component of marketing and selling expenses.
These costs totaled approximately $175,000 and $24,000 in the three months ended September 30, 2015 and 2016, respectively, and
approximately $269,000 and $118,000 in the nine months ended September 30, 2015 and 2016. respectively.
Income Taxes
: Deferred tax assets and liabilities
are determined based on the temporary differences between the financial reporting and tax basis of assets and liabilities and net
operating loss carryforwards, applying enacted statutory tax rates in effect for the year in which the differences are expected
to reverse. A valuation allowance is recorded when it is more likely than not that some or all of the deferred tax assets will
not be realized.
The Company uses a two-step approach to recognizing and measuring
uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available
evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related
appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more likely
than not to be realized upon settlement. As of December 31, 2015 and September 30, 2016, there are no known uncertain tax positions.
The Company’s policy is to classify the liability for
unrecognized tax benefits as current to the extent that it is more likely than not to be realized upon settlement and to the extent
that the Company anticipates payment (or receipt) of cash within one year. The Company recognizes interest and penalties, if any,
related to unrecognized tax benefits in the tax provision.
Product Warranty
: The Company’s memory
products are sold under various limited warranty arrangements ranging from three years to five years on solid state drives and
a limited lifetime warranty on all other products. Company policy is to establish reserves for estimated product warranty costs
in the period when the related revenue is recognized. The Company has the right to return defective products to the manufacturer.
As of December 31, 2015 and September 30, 2016, the Company has established a warranty reserve of $234,000 and $217,000, respectively.
The warranty reserve is included in accrued expenses in the accompanying consolidated balance sheets.
Research and Development
: The Company incurs
costs to improve the appeal and functionality of its products. Research and development costs are charged to expense when incurred.
Earnings (Loss) per
Share
: Basic earnings (loss) per share is calculated by dividing net earnings (loss) attributable to common
stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings (loss)
per share is calculated similarly but includes potential dilution from the exercise of common stock warrants and options and
conversion of debt to equity, except when the effect would be anti-dilutive. Earnings (loss) per share are computed using
the “treasury stock method.” At September 30, 2016, outstanding warrants to acquire 3,755,100 shares of common
stock (2,025,000 issued further to the Offering, 1,405,007 issued in connection with the conversion of preferred stock and
bridge loans upon closing of the Offering and 325,093 other warrants), 96,602 stock options, and
$38,000 in convertible notes payable have been excluded from the computation of diluted loss per share because their effect
was anti-dilutive.
Recently Issued Accounting Pronouncements
— In
April 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”)
No. 2014-08,
Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued
Operations and Disclosures of Disposals of Components of an Entity
. Under ASU 2014-08, only disposals that represent a strategic
shift that has (or will have) a major effect on the entity’s results and operations would qualify as discontinued operations,
which could include a disposal of a major geographical area, a major line of business, a major equity method investment, or other
major parts of an entity. ASU 2014-08 also expands the disclosure requirements for disposals of operations to include more information
about assets, liabilities, income and expenses and requires entities to disclose information about disposals of individually significant
components. ASU 2014-08 is effective in the first quarter of 2015, with early adoption permitted. ASU 2014-08 could impact our
consolidated financial results in the event of a transaction as described above.
In May 2014, the FASB issued ASU No. 2014-09,
Revenue from
Contracts with Customers (Topic 606).
ASU 2014-09 is based on the principle that revenue is recognized to depict the transfer
of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange
for those goods or services. ASU 2014-09 also requires additional disclosure about the nature, amount, timing and uncertainty of
revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized
from costs incurred to obtain or fulfill a contract. ASU 2014-09 is effective in the first quarter of 2018 and requires either
a retrospective or a modified retrospective approach to adoption. We have not yet selected a transition method and are currently
evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.
In August 2014, the FASB issued ASU No. 2014-15,
Presentation
of Financial Statements — Going Concern
, which requires that management of an entity evaluate whether there
are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue
as a going concern within one year after the date that the financial statements are issued or available to be issued. This update
will become effective beginning December 31, 2016, with early adoption permitted. The provisions of this standard are not expected
to significantly impact the Company.
In April 2015, the FASB issued ASU 2015-03,
Interest — Imputation
of Interest
, which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet
as a direct deduction from the carrying amount of the related debt liability instead of being presented as an asset. Debt disclosures
will include the face amount of the debt liability and the effective interest rate. The update requires retrospective application
and represents a change in accounting principle. The update is effective for fiscal years beginning after December 15, 2015 and
was adopted as of January 1, 2016. The adoption of ASU 2015-03 did not have a material impact on the Company’s consolidated
financial statements.
In July 2015, the FASB issued ASU 2015-11,
Inventory (Topic
330): Simplifying the Measurement of Inventory
. The standard requires entities to measure most inventory “at the lower
of cost and net realizable value,” thereby simplifying the current guidance under which an entity must measure inventory
at the lower of cost or market (market in this context is defined as one of three different measures, one of which is net realizable
value). The standard is effective for the Company prospectively beginning January 1, 2017. The Company is currently evaluating
the impact of the adoption of this guidance on its financial statements.
In February 2016, the FASB issued ASU No. 2016-02,
Leases
(Topic 842)
, which requires lessees to recognize assets and liabilities for the rights and obligations created by most leases
on their balance sheet. The guidance is effective for fiscal years beginning after December 15, 2018, including interim periods
within those fiscal years. Early application is permitted. ASU 2016-02 requires modified retrospective adoption for all leases
existing at, or entered into after, the date of initial application, with an option to use certain transition relief. The Company
is currently evaluating the impact the standard may have on its consolidated financial statements and related disclosures.
Other pronouncements issued by the FASB or other authoritative
accounting standards groups with future effective dates are either not applicable or not significant to the consolidated financial
statements of the Company.
NOTE 2 — GOING
CONCERN
As of September 30, 2016, the Company has incurred cumulative
net losses from its inception of approximately $31 million and has incurred a year to date loss of approximately $5 million. These
circumstances raise substantial doubt as to the Company’s ability to continue as a going concern. In response to this uncertainty,
Management has taken certain measures in 2015 and to date in 2016 and has plans for the remainder of 2016 and beyond, with the
objective of alleviating this concern. They include the following:
|
•
|
On July 13, 2016, the Company received gross proceeds of
approximately $9.1 million upon closing the Offering.
|
|
•
|
In order to meet customers’ needs for consumer products,
the Company is continuing to develop new products to complement existing products and expand overall product offerings, with the
objective of increasing revenue and gross profit percentages. The Company introduced two new action sports camera in the third
quarter of 2016 and will be introducing additional new action sports cameras in 2017.
|
While the Company believes it will be successful in obtaining
the necessary financing to fund its operations, there are no assurances that such additional funding will be achieved and that
it will succeed in its future operations. The financial statements do not include any adjustments relating to the recoverability
and classification of recorded asset amounts or amounts of liabilities that might be necessary should the Company be unable to
continue in existence.
NOTE 3 — DEBT
AND EQUITY FINANCING
Credit Facility
In June 2015, the Company secured an accounts receivable financing
facility with Bay View Funding. The contract provides for maximum funding of $4 million and a factoring fee of 1.35% for the first
30 days and .45% for each 10-day period thereafter that the financed receivable remains outstanding. Upon the execution of this
contract, the balance owed under a prior credit facility was repaid and that contract was terminated. The total amount outstanding
under this facility as of December 31, 2015 and September 30, 2016 was $215,000 and $0, respectively. There are no financial or
similar covenants associated with this facility.
Debt to Equity Exchange Offer
In December 2014, the Company extended an offer to its convertible
Note holders for the exchange of convertible Notes, accrued interest and common stock purchase warrants into common stock. In the
offer, the conversion rate on the principal amount of the Notes was reduced from $22.27 per share to $14.85 per share, with accrued
interest being cancelled. Furthermore, in exchange for the cancellation of all warrants, the Note holders received .07 shares of
common stock for every .13 shares that would have been issued upon exercise of the warrants.
As further inducement to the offer for the new shares issued
in connection with the exchange offer, the Company’s principal shareholder agreed to put back to the Company an equal number
of shares owned by him (to a maximum of 336,682 shares) and have such shares cancelled.
Through December 31, 2014, a total of $3,428,000 in convertible
Notes had been converted to equity pursuant to the exchange offer. As a result of the foregoing exchange, $5,870,000 was credited
to additional paid-in capital, which is the net amount of the principal of the Notes, unpaid accrued interest, unamortized debt
discount, and the debt conversion expense.
For the year ended December
31, 2015, the Company continued its private offering of convertible Notes concurrent with a related offer to exchange the notes
for shares of common stock on the terms indicated above. During the nine-month period ended September 30, 2015, gross proceeds
of $1,645,000 were raised in the offering from the issuance of convertible Notes payable. In March 2015, these Notes were converted
to common stock pursuant to the exchange offer, resulting in an inducement charge of $898,000. As a result of these transactions,
an additional 158,265 common shares were issued during the period. As of December 31, 2015 and September 30, 2016, a total of $38,000
in principal of convertible Notes payable remain outstanding. These Notes matured in the second quarter of 2015 and remain outstanding
as of September 30, 2016.
Promissory notes
From October 2015 through March 7, 2016, the Company issued
promissory notes; the notes are due and payable at the earlier of one year from the date of issuance or the closing date of the
Company’s initial public offering, bear an interest rate of 15% that is accrued upon issuance, irrespective of whether the
promissory note is outstanding for part or full term until maturity, and have a loan origination fee of $.225 for each dollar loaned.
The loan origination fee associated with the notes as of September 30, 2016 was $756,000 and was recorded as accrued interest and
debt discount to the notes payable and is being amortized over the life of the notes. Debt discount amortized as interest expense
in the three and nine months ended September 30, 2016 was approximately $25,000 and $389,000, respectively. All principal, fees
and interest were payable on the due date. In July 2016, the Company completed the Offering whereby 90% of the outstanding promissory
notes totaling $3,024,000 were converted to 672,000 shares of common stock and 672,000 warrants at the offering price of $4.50
per share. The 15% accrued interest and the 22.5% origination fee were waived as part of the conversion. The remaining, unconverted
$336,000 of promissory notes were paid out of the proceeds of the Offering along with the accrued interest and origination fee
attributable to those notes. As of December 31, 2015, a total of $3.0 million in principal of these notes payable was outstanding
and no balance is due as of September 30, 2016.
Due to Monster, Inc
.
In addition to the issuance of shares of common stock and common
stock purchase warrants (see Note 5), the Company has agreed to pay Monster, Inc. $500,000 as consideration for use of the name
Monster Digital, Inc. pursuant to Amendment No. 3 to the Trademark License Agreement between the Company and Monster, Inc. Of this
total balance, the Company agreed to pay $125,000 in December 2015 and the balance from the proceeds of the planned Offering. The Company
paid $50,000 of the $125,000 in December 2015, $75,000 in January 2016 and the full remaining balance due in September 2016.
Notes payable consists of the following (in thousands):
|
|
December 31,
2015
|
|
|
September 30,
2016
|
|
Note payable, convertible debt
|
|
$
|
38
|
|
|
$
|
38
|
|
Due to Monster, Inc.
|
|
|
450
|
|
|
|
—
|
|
Interest and loan origination fee accrued related to promissory notes payable and accrued at issuance
|
|
|
1,108
|
|
|
|
—
|
|
Promissory notes payable, 2015 bridge loans, net of debt discount of $563 and $0, respectively, and net of debt issuance cost of $483 and $0, respectively
|
|
|
1,909
|
|
|
|
—
|
|
Total
|
|
$
|
3,505
|
|
|
$
|
38
|
|
NOTE 4 — ACCRUED EXPENSES
Accrued expenses consist of the following (in thousands):
|
|
December 31,
2015
|
|
|
September 30,
2016
|
|
Royalties
|
|
$
|
103
|
|
|
$
|
125
|
|
Market development credits
|
|
|
336
|
|
|
|
112
|
|
Price protection
|
|
|
563
|
|
|
|
139
|
|
Return reserves
|
|
|
891
|
|
|
|
218
|
|
Reserve for legal contingencies
|
|
|
300
|
|
|
|
468
|
|
Accrued purchase orders
|
|
|
123
|
|
|
|
982
|
|
Others
|
|
|
995
|
|
|
|
1,231
|
|
Total
|
|
$
|
3,311
|
|
|
$
|
3,275
|
|
NOTE 5 — STOCKHOLDERS’
EQUITY
Common Stock Purchase Warrants
: From 2011
through June 30, 2015, the Company issued common stock purchase warrants in connection with the initial formation of the Company,
the execution of a license agreement, and the issuance of convertible notes payable. All warrants have been valued on the date
of their issuance using the Black-Scholes option pricing model using various assumptions regarding stock price volatility, risk-free
interest rates, expected dividend rates, and expected term of the contract. Through September 30, 2016, none of the warrants have
been exercised, and for the year ended December 31, 2015 and nine months ended September 30, 2016, 99,681 warrants have been canceled
in connection with the exchange offer described above (see Note 3).
In August 2015, the Company issued 191,289 common stock purchase
warrants in connection with an Advisory Board Agreement with Noel Lee, the Chief Executive Officer of Monster, Inc., and recognized
a $156,000 charge related to the issuance. As of December 31, 2015 and September 30, 2016, warrants to purchase 325,093 shares
of common stock are outstanding. Unexercised warrants will expire from 2016 to 2019.
The Company utilizes the Black-Scholes valuation method to value
warrants. The expected life represents the period that these warrants are expected to be outstanding. The expected volatility was
estimated by analyzing the historic volatility of similar public companies. No dividend payouts were assumed as the Company has
not historically paid, and is not anticipating to pay, dividends in the foreseeable future. The risk-free rate of return reflects
the interest rate offered for US treasury rates over the expected life of the warrants.
A summary of significant assumptions used to estimate the fair
value of the warrants issued in August 2015 are as follows:
Fair value of warrants issued
|
|
$
|
.89
|
|
Expected term (years)
|
|
|
5.0
|
|
Risk-free interest rate
|
|
|
1.60
|
%
|
Volatility
|
|
|
45.4
|
%
|
Dividend yield
|
|
|
None
|
|
Common Stock Purchase Rights Offering
: In
April 2015, the Company initiated a common stock purchase rights offering to its existing shareholders. The offering consists of
108,138 Units, with each Unit consisting of 2 newly issued shares of common stock and 3 shares of common stock owned by the Company’s
principal shareholder and chairman. Each Unit is offered for $44.55, with all proceeds going to the Company. In April 2015 through
September 2015, the Company closed on the sale of approximately 78,800 Units (representing 236,403 newly issued common shares)
and has received net proceeds of approximately $2,969,000.
Reverse Stock Splits
: By action by written consent of
the Company’s stockholders effective as of November 6, 2015, the Company’s stockholders approved a reverse stock split
in a range of between one-for-five and one-for-twelve, such exact amount to be determined by the Company’s Board of Directors
prior to the effective date of a planned equity offering. On January 7, 2016, the Board of Directors of the Company approved a
one-for-11.138103 reverse
stock split. On June 6, 2016, the Board of Directors of the
Company approved an additional one-for-1.2578616 reverse stock split. On June 23, 2016, the Board of Directors of the Company approved
an additional one-for-1.06 reverse stock split. All share and per share information in these consolidated financial statements,
except for par value and authorized shares, have been amended to reflect the reverse stock splits.
Restricted Shares
: In August 2015, the Company
issued 84,170 shares of restricted common stock to the Company’s Chairman of the Board pursuant to a consulting agreement.
The consulting agreement was effective in May 2015 and $69,000 and $110,000 of compensation expense was recognized in the three
and nine months ended September 30, 2015, respectively. Also related to the stock issuance, $68,000 and $205,000 of compensation
expense was recognized in the three and nine months ended September 30, 2016, respectively.
In August 2015, the Company issued 382,575 shares of restricted
common stock in connection to the Trademark License Agreement with Monster, Inc. The fair value of the 382,575 shares approximating
$2,103,000 were recorded as part of the Trademark in August 2015. In regards to the valuation of the Company’s common stock,
the Board of Directors engaged an independent third party valuation of the Company. Factors included in the valuation included
the Company’s present value of future cash flows, its capital structure, valuation of comparable companies, its existing
licensing agreements and the growth prospects for its product line. These factors were incorporated into an income approach and
a market approach in order to derive an overall valuation of the Company’s common stock of $5.49 per share at August 2015.
In August 2016, the Company authorized the issuance of 545,000
shares of restricted common stock pursuant to employment agreements and recognized $66,000 of compensation expense during the three
months ended September 30, 2016 related to the restricted shares. Also in August 2016, the Company authorized the issuance of 40,000
shares of restricted common stock pursuant to a services agreement with an investment relations firm and recognized $16,000 of
compensation expense related to restricted shares during the three months ended September 30, 2016. In addition, the Company authorized
the issuance of 125,000 shares of restricted common stock to Jawahar Tandon pursuant to a consulting agreement and recognized $563,000
of compensation expense related to the restricted shares during the three months ended September 30, 2016.
Preferred Stock
: In March 2016, the Company issued a
confidential Private Placement Memorandum (“PPM”) for a maximum of 3,000,000 shares of Series A Convertible Preferred
Stock, with a purchase price of $1.00 per share and convertible into one share of the Company’s common stock and having an
8%, noncumulative dividend. Pursuant to the PPM, as of June 30, 2016, 2,802,430 shares of Series A Preferred Stock were subscribed
for net proceeds of approximately $2.4 million. In July 2016, the Company completed the Offering in which all shares of Series
A Preferred Stock was converted into 622,762 shares of common stock and 622,762 warrants at the public offering price of $4.50
per share and the issuance of 134,044 shares of common stock further to the conversion.
NOTE 6 — STOCK
OPTIONS
In 2012, the Company’s Board of Directors approved the
2012 Omnibus Incentive Plan (the “Plan”) which allows for the granting of stock options, stock appreciation rights,
awards of restricted stock and restricted stock Units, stock bonuses and other cash and stock-based performance awards. A total
of 101,005 shares of common stock have been approved and reserved for issuance under the Plan. In November 2015, the Company’s
stockholders approved a 269,345 share increase in that number of shares reserved for issuance under the Plan such that a total
of 370,350 shares of common stock have been approved and reserved for issuance under the Plan. As of December 31, 2015 and September
30, 2016, 71,040 options had been granted under the Plan. During the nine months ended September 30, 2016, 60,940 options were
forfeited for employees who were no longer with the Company and were returned to the pool of available options.
On December
23, 2015, the Company authorized restricted stock grants under its 2012 Omnibus Incentive Plan of 13,467 shares to David Clarke
in connection with his appointment as the Company’s President and Chief Executive Officer and 33,668 shares to Neal Bobrick
in connection with his appointment as the Company’s Executive Vice President, Sales and Marketing, grants accepted and effective
January 4, 2016. The Company recorded non-cash stock-based compensation of $21,000 and $65,000 during the three and nine months
ended September 30, 2016, respectively, related to the issuance of restricted stock. An additional $194,000 of stock-based compensation
remains to be recognized over 27 months.
On the effective date of the Offering, 25,000 shares of restricted
stock were granted to each of David Olert, the Company’s Chief Financial Officer, Vivek Tandon, the Company’s Executive
Vice President - Operations and Marc Matejka, the Company’s Vice President of Operations as well as 36,332 restricted shares
to Neal Bobrick, its Executive Vice President – Sales and Marketing.
Concurrently, 10,000 shares of restricted stock
were granted to each of the Company’s four outside directors.
The Company recorded non-cash stock-based compensation
of $80,000 during the three months ended September 30, 2016 related to these issuances of restricted stock. An additional $601,000
of stock-based compensation remains to be recognized over 45 months.
Also granted on the effective date of the Offering were previously
approved options to acquire 16,834 and 33,668 common shares at an exercise price per share of $4.50 to David Olert and Neal Bobrick,
respectively. Options to purchase 18,000 common shares at an exercise price per share of $4.50 were granted each to Vivek Tandon
and Marc Matejka. The Company recorded non-cash stock-based compensation of $12,000 during the three months ended September 30,
2016 related to these issuances of common stock options. An additional $164,000 of stock-based compensation remains to be recognized
over 45 months.
In August 2016, pursuant to a services agreement, the Company
granted options to acquire 38,143 shares of common stock to an investor relations firm and recognized $2,000 of non-cash stock-based
compensation related to the issuance during the three months ended September 30, 2016. An additional $32,000 of stock-based compensation
remains to be recognized over 9 months.
The Company follows the provision of ASC Topic 718,
Compensations
– Stock Compensation
which requires the measurement and recognition of compensation expense for all stock-based payment
awards made to employees and non-employee directors, including employee stock options. Stock compensation expense based on the
grant date fair value estimated in accordance with the provisions of ASC 718 is generally recognized as an expense over the requisite
service period.
In 2015 and 2016, the following stock option grants were made:
Option Date
|
|
Options
Granted
|
|
|
Exercise
Price
|
|
|
Estimated
Fair
Value of
Underlying
Stock
|
|
|
Intrinsic
Value
|
May 2015
|
|
|
71,040
|
|
|
$
|
29.71
|
|
|
$
|
5.79
|
|
|
None
|
July 2016
|
|
|
86,502
|
|
|
$
|
4.50
|
|
|
$
|
4.50
|
|
|
None
|
August 2016
|
|
|
6,004
|
|
|
$
|
5.00
|
|
|
$
|
3.00
|
|
|
None
|
August 2016
|
|
|
7,230
|
|
|
$
|
7.00
|
|
|
$
|
3.00
|
|
|
None
|
August 2016
|
|
|
9,986
|
|
|
$
|
9.00
|
|
|
$
|
3.00
|
|
|
None
|
August 2016
|
|
|
14,923
|
|
|
$
|
11.00
|
|
|
$
|
3.00
|
|
|
None
|
The Company’s Board of Directors granted options for 71,040
shares of common stock to certain employees on May 8, 2015. The option prices were determined based on such factors as recent equity
transactions and other factors as deemed necessary and relevant in the circumstances. The exercise prices for options granted were
set by the Company’s Board of Directors at a premium over fair market value of its common stock at the time the grants were
authorized.
In regards to the valuation of the Company’s common stock
prior to the Offering, the Board of Directors engaged an independent third party valuation of the Company. Factors included in
the valuation included the Company’s present value of future cash flows, its capital structure, valuation of comparable companies,
its existing licensing agreements and the growth prospects for its product line. These factors were incorporated into an income
approach and a market approach in order to derive an overall valuation of the Company’s common stock of $5.79 per share at
May 8, 2015.
The Company utilizes the Black-Scholes valuation method to
value stock options and recognizes compensation expense over the vesting period. The expected life represents the period that
the Company’s stock-based compensation awards are expected to be outstanding. The Company uses a simplified method provided
in Securities and Exchange Commission release Staff Accounting Bulletin No. 110 which averages an awards weighted average vesting
period and contractual term for “plain vanilla” share options. The expected volatility was estimated by analyzing
the historic volatility of similar public companies. No dividend payouts were assumed as the Company has not historically paid,
and is not anticipating to pay, dividends in the foreseeable future. The risk-free rate of return reflects the weighted average
interest rate offered for U.S. treasury rates over the expected life of the options.
A summary of significant assumptions used to estimate the fair
value of the stock options granted in 2015 are as follows:
Weighted average fair value of options granted
|
|
$
|
0.45
|
|
Expected term (years)
|
|
|
6.0 to 6.25
|
|
Risk-free interest rate
|
|
|
1.89
|
%
|
Volatility
|
|
|
45.4
|
%
|
Dividend yield
|
|
|
None
|
|
A summary of significant assumptions used to estimate the fair
value of the stock options granted in 2016 are as follows:
Weighted average fair value of options granted
|
|
$
|
1.70
|
|
Expected term (years)
|
|
|
6.0 to 10.0
|
|
Risk-free interest rate
|
|
|
1.21% to 1.51
|
%
|
Volatility
|
|
|
45.4
|
%
|
Dividend yield
|
|
|
None
|
|
The Company recorded non-cash stock-based compensation related
to stock options of $28,000 during the nine months ended September 30, 2016. An additional $197,000 of stock-based compensation
related to stock options remains to be amortized over 45 months.
A summary of option activity for the Plan as of September 30,
2016 and changes for the nine months then ended are represented as follows:
|
|
Number of
Options
|
|
|
Weighted
Average
Exercise
Price
|
|
|
Weighted
Average
Remaining
Contract
Term (Years)
|
|
|
Aggregate
Intrinsic
Value
|
|
Options outstanding January 1, 2016
|
|
|
71,040
|
|
|
$
|
29.71
|
|
|
|
9.50
|
|
|
$
|
—
|
|
Granted
|
|
|
124,645
|
|
|
|
5.81
|
|
|
|
9.83
|
|
|
|
—
|
|
Forfeited
|
|
|
(60,940
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Outstanding at September 30, 2016
|
|
|
134,745
|
|
|
$
|
7.60
|
|
|
|
9.75
|
|
|
$
|
—
|
|
NOTE 7 — RELATED
PARTY TRANSACTIONS
Borrowings
: From time to time, the Company
receives short-term, non-interest bearing loans from Tandon Enterprises, Inc. for the purpose of funding temporary working capital
needs. For the nine months ended September 30, 2016, the Company borrowed $24,000, net of repayments. The $346,100 owed to Tandon
Enterprises at June 30, 2016 was converted into 76,911 shares of common stock and warrants at the effective date of the Offering.
In September 2015 David Clarke, the Company’s Chairman
of the Board and a significant stockholder of the Company, loaned the Company $100,000 further to a promissory note bearing interest
at 5% per annum, principal and unpaid interest payable on demand. In addition, Mr. Clarke incurred expenses on behalf of the Company
totaling approximately $50,000. Concurrent with the closing of the Offering, the loan and liability related to the expenses were
converted into 33,333 shares of common stock and 33,333 warrants at the public offering price of $4.50.
NOTE 8 — INCOME
TAXES
For the nine months ended September 30, 2015 and 2016, respectively,
there was a $1,000 and $2,000 income tax provision recorded related to state minimum taxes due. The Company’s income tax
provision generally consists of state income taxes currently paid or payable.
The ultimate realization of the deferred tax asset is dependent
upon the generation of future taxable income during the periods in which temporary differences become deductible. Due to the uncertainty
surrounding the realization of these deferred tax assets, the Company has recorded a 100% valuation allowance. Net operating loss
carryforwards expire between the years 2029 and 2035. Tax years ended December 31, 2014, 2013 and 2012 are open and subject to
audit.
The effective income tax provision as a percentage of pre-tax
loss differs from expected combined federal and state income tax of 40% as a result of the full valuation allowance.
Management is not aware of any uncertain tax positions and does
not expect the total amount of recognized tax benefits to change significantly in the next twelve months.
NOTE 9 — CUSTOMER
AND VENDOR CONCENTRATIONS
Customers
:
Approximately 69% of the Company’s gross sales were made
to three customers with each exceeding 10% of total gross sales for the nine months ended September 30, 2015. Approximately 42%
of the Company’s gross sales were made to one customer for the nine months ended September 30, 2016. At September 30, 2016,
the amount included in outstanding accounts receivable related to this customer was approximately $684,000.
Vendors
:
Approximately 69% of the
Company’s purchases were provided by four vendors for the nine months ended September 30, 2015. Approximately 95% of the
Company’s purchases were provided by three vendors for the nine months ended September 30, 2016. At September 30, 2016, the
amount in accounts payable related to these vendors was approximately $21,000.
NOTE 10 — COMMITMENTS
AND CONTINGENCIES
Royalty
The Company entered into the initial trademark license agreement
with Monster, Inc. (formerly Monster Cable Products, Inc.) effective July 7, 2010. In 2012, the agreement was amended giving the
Company exclusive rights to utilize the name “Monster Digital” on memory products for a period of 25 years (expires
July 7, 2035) under the following payment schedule of royalties to Monster, Inc. This license agreement contains various termination
clauses that include (i) change in control, (ii) breach of contract and (iii) insolvency, among others. The Company is required
to remit royalty payments to Monster, Inc. on or before the 30
th
day following the end of each calendar quarter. At
any time during the term of the agreement, a permanent license may be negotiated.
The royalty schedule became effective in August 2011 and was
further amended in April 2012. As amended, royalties under this contract are as follows:
|
•
|
Years 1 (2012) and 2: Royalties on all sales
excluding sales to Monster, Inc. at a rate of four (4) percent, with no minimum.
|
|
•
|
Years 3 through 6: Minimum royalty payments
of $50,000 per quarter up to a maximum of four (4) percent of all sales excluding sales to Monster, Inc.
|
|
•
|
Years 7 through 10: Minimum royalty payments
of $125,000 per quarter up to a maximum of four (4) percent of all sales excluding sales to Monster, Inc.
|
|
•
|
Years 11 through 15: Minimum royalty payments
of $187,500 per quarter up to a maximum of four (4) percent of all sales excluding sales to Monster, Inc.
|
|
•
|
Years 16 through 25: Minimum royalty payments
of $250,000 per quarter up to a maximum of four (4) percent of all sales excluding sales to Monster, Inc.
|
Effective July 1, 2014, the royalty rate on certain products
was reduced from 4% to 2% for a period of 12 months, based on a mutual understanding between the Company and the licensor.
For the three months ended September 30, 2015 and 2016, royalty
expense amounted to approximately $44,000 and $125,000, respectively. For the nine months ended September 30, 2015 and 2016, royalty
expense amounted to approximately $112,000 and $246,000, respectively, and is included as a component of selling and marketing
expenses in the accompanying consolidated statements of operations (see Note 4).
Operating Lease
The Company occupies executive offices in Simi Valley, CA pursuant
to a lease through January 31, 2018 at a monthly rental rate of $13,850.
Customer Payment Agreement
In July 2015, the Company entered into an agreement with a customer
under which the Company will pay the customer a total of $835,000 owed to the customer for promotional and other credits related
to sales that occurred in 2014. The credits were accrued as contra-sales in 2014. Under the terms of the agreement, there is no
interest and the Company will make 12 monthly payments of $65,000 beginning in August 2015, and one final payment of $65,000 in
August 2016. The Company is not in compliance with the payment agreement and the balance owed is $445,000 at September 30, 2016.
Legal Matters
The Company is subject to certain legal proceedings and claims
arising in connection with the normal course of its business. In the opinion of management, the reserve established for the three
cases noted below is adequate so that the claims will have no material adverse effect on its consolidated financial position, results
of operations or cash flows.
On March 9, 2015, Memphis Electronics, Inc. (“MEI”)
filed a complaint against SDJ and the Company, case no. 4:15-cv-1104; in U.S. District Court for the Southern District of
Texas. The complaint alleged breach of contract and tort for an alleged order or orders for computer components. Plaintiff’s
claims are based in contract and tort (negligent and intentional misrepresentations) relating to nonpayment of approximately $275,000
for goods ordered. In August 2016, the Company settled the complaint for (i) a payment of $170,000 to MEI, (ii) the return from
MEI of the components that were in dispute, and (iii) the parties mutually releasing each other from all claims that were filed
or that could have been filed in this litigation.
On August 18, 2015, Phison Electronics Corp. (“Phison”)
filed a complaint against SDJ, case no. 115 CV284516, in California Superior Court in Santa Clara County. The complaint alleged
breach of contract and breach of implied covenant of good faith and fair dealing resulting in claimed damages of approximately
$585,000 in connection with SDJ’s alleged failure to purchase products manufactured on its account by Phison. While the complaint
has been filed, Phison has not yet served it. For this reason, the Court dismissed the case, without prejudice, for failure of
Phison to file a return of service and no case is currently pending. SDJ believes the claims are without merit.
On August 28, 2015, Unigen Corporation (“Unigen”)
filed a complaint against SDJ, case no. HG15-78385, in California Superior Court in Alameda County. The complaint alleged
breach of contract for an alleged order or orders for 219,200 specially constructed computer components. The complaint seeks $180,000
in lost profit; $678,669 for the cost of parts ordered; and $35,000 in incidental expenses. In February 2016, the Company
met with Unigen in an attempt to mediate the matter. However, the mediation was not successful. The parties were required to engage
in a second mediation before December 31, 2016 to be followed by a January 6, 2017 settlement conference. On October 26, 2016,
the parties met again to mediate the matter and entered into a stipulated settlement whereby SDJ is to pay Unigen $225,000 within
thirty days at which time the case will be dismissed with prejudice. This settlement amount has been fully accrued in a legal reserve.
On February 16, 2016, we received a letter from GoPro, Inc.,
or GoPro, alleging that we infringe on at least five U.S. patents held by GoPro, and requesting that we confirm in
writing that we will permanently cease the sale and distribution of our Villain camera, along with any camera accessories, including
the waterproof camera case and standard housing. The five patents specifically identified by GoPro in the letter
were U.S. Patent No. D710,921: camera housing design, U.S. Patent No. D702,747: camera housing design, U.S. Patent No. D740,875:
camera housing design, U.S. Patent No. D737,879: camera design and U.S. Patent No. 721,935: camera design. Based upon our preliminary
review of these patents, we believe we have some defenses to GoPro’s allegations. Our outside counsel has been in discussion
with GoPro’s outside counsel and has forwarded them material which we believe supports defense to these allegations, all
in an effort to move the matter to resolution. As of yet, there is no final resolution to this matter and there can be no assurance
that we will be successful in defending against these allegations or reaching a business resolution that is satisfactory to us.
The supplier of our Villain camera has contractually represented
and warranted that it owns or has paid royalties to any and all intellectual property, designs, software, hardware, packaging,
components, manuals and any other portion, part or element that is or may be subject to the Villain and the parts and accessories
thereof sourced by the supplier. This supplier has contractually agreed to pay any claims, damages, or costs that we suffer as
a result of the patent infringement or a violation of international, U.S. or state laws or regulations as detailed in the prior
sentence.