NOTES
TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Unaudited)
Note 1 – Description of Business and Summary of
Significant Accounting Policies
Description of Business
Item 9 Labs Corp. (“Item 9 Labs”
or the “Company”), formerly Airware Labs Corp., is a Delaware corporation. The Company was incorporated under the laws
of the state of Delaware on June 15, 2010 as Crown Dynamics Corp. On October 26, 2012, the Articles of Incorporation were amended
to reflect a name change to Airware Labs Corp, and on April 2, 2018, they were amended again to reflect the name change to Item
9 Labs Corp.
On October
18, 2018 the Company effected a 1 for 20 reverse stock split of the Company’s common stock. The par value and number of authorized
shares were not adjusted as a result of the reverse stock split. The total number of shares outstanding at the time of the split
was adjusted from 1,095,332,835 to 54,766,642. All share information in these consolidated condensed financial statements has been
retroactively adjusted to reflect the effect of the reverse split.
On March 20, 2018, the Company closed on an
Agreement and Plan of Exchange (the “Agreement”) to acquire all of the membership interests of BSSD Group, LLC (“BSSD”),
an Arizona limited liability company formed on May 2, 2017, in exchange for newly issued restricted shares of the Company’s
common stock (the “Shares”), which represented approximately 75% of the issued and outstanding shares of the Company’s
common stock on a fully-diluted basis. The 40,355,771 Shares were distributed pro-rata to the BSSD members. As part of the Agreement,
the Company agreed to increase its authorized shares of common stock to two billion.
For accounting purposes the transaction was
recorded as a reverse recapitalization, with BSSD as the accounting acquirer. Consequently, the historical pre-merger financial
statements of BSSD are now those of the Company. In its determination that BSSD was the accounting acquirer, the Company considered
pertinent facts and circumstances, including the following: (i) the BSSD owners received the largest portion of the voting rights
of the combined entity; (ii) the management team of the combined entity is primarily comprised of owners or management of BSSD;
(iii) the continuing business of the combined entity will be the business of BSSD.
Through a licensing agreement, the Company
grows medical marijuana and produces cannabis related products at their facility in Pinal County, Arizona on behalf of licensed
medical marijuana dispensaries in the state of Arizona. The major assets of the Company, consisting of five acres of land and a
cultivation facility, were contributed by the members of BSSD in May 2017 and were recorded at the historical carrying value (original
cost less any related accumulated depreciation) of the members as of the contribution date.
On September 12, 2018, the Company executed
a $1,500,000 promissory note (see Note 8) which was used to make a capital contribution into Strive Management, LLC, a Nevada
limited liability company (“Strive Management”). In exchange for the contribution, the Company received a 20% membership
interest in Strive Management. The remaining interests are held by three individuals one of which is the Company’s former
Chief Executive Officer. Through a management agreement with Strive Wellness of Nevada, LLC, a related party (the Company’s
former CEO is a member of this LLC), Strive Management will facilitate the cultivation, processing and distribution of marijuana
in Nevada. Strive Wellness of Nevada, LLC has been allocated cultivation, processing and distribution licenses from the state
of Nevada. Additionally, the Company will acquire an additional 31% ownership of Strive Management upon the approval from the
state of Nevada to operate the cultivation and processing facility. See Note 15.
Principles of Consolidation
Item
9 Labs consolidates all variable interest entities (“VIEs”) in which the Company is deemed to be the primary beneficiary
and all other entities in which it has a controlling voting interest. An entity is generally a VIE if it meets any of the
following criteria: (i) the entity has insufficient equity to finance its activities without additional subordinated financial
support from other parties, (ii) the equity investors cannot make significant decisions about the entity’s operations
or (iii) the voting rights of some investors are not proportional to their obligations to absorb the expected losses of the
entity or receive the expected returns of the entity and substantially all of the entity’s activities involve or are conducted
on behalf of the investor with disproportionately few voting rights. The Company periodically makes judgments in determining whether
its investees are VIEs and, at each reporting period, the Company assesses whether it is the primary beneficiary of any of its
VIEs. As of December 31, 2019 and September 30, 2019, the Company is deemed the primary beneficiary of Strive Management because
the entity has insufficient equity to finance its activities without additional subordinated support. The interests in Strive Management
held by non-controlling members have been presented on the statement of operations and statement of stockholders’ equity
as non-controlling interest. See Note 15.
The consolidated condensed financial statements
include the accounts of the Company, its wholly-owned subsidiaries and variable interest entities in which the Company is the primary
beneficiary. Intercompany balances and transactions have been eliminated.
The accompanying unaudited consolidated
condensed financial statements of the Company as of December 31, 2019 have been prepared by us without audit pursuant to the rules
and regulations of the Securities and Exchange Commission (“SEC”) and do not
include all the information and notes necessary for a presentation of financial position and results of operations in accordance
with GAAP and should be read in conjunction with our September 30, 2019 audited financial statements filed with the SEC on our
Form 10-K filed January 14, 2020. It is management’s opinion that all material adjustments (consisting of normal recurring
adjustments) have been made, which are necessary for a fair financial statement presentation. We derived the September 30, 2019
consolidated condensed balance sheet data from audited consolidated financial statements, however, we did not include all disclosures
required by GAAP. The results for the interim period are not necessarily indicative of the results to be expected for the year
ending September 30, 2020.
Accounting Estimates
The preparation of financial statements in
conformity with Accounting Principles Generally Accepted in the United States of America (“GAAP”) requires management
to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.
Actual results could materially differ from those estimates. Significant estimates of the Company include but are not limited to
accounting for depreciation and amortization, current and deferred income taxes, deferred costs, accruals and contingencies, carrying
value of goodwill and intangible assets, collectability of notes receivable, the fair value of common stock and the estimated fair
value of stock options and warrants. Due to the uncertainties in the formation of accounting estimates, and the significance of
these items, it is reasonably possible that these estimates could be materially changed in the near term.
Cash and Cash Equivalents and Restricted
Cash
Cash represents cash on hand, demand deposits
placed with banks and other financial institutions and all highly liquid instruments purchased with a remaining maturity of three
months or less as of the purchase date of such investments. The Company maintains cash on deposit, which, can exceed federally
insured limits. The Company has not experienced any losses on such accounts nor believes it is exposed to any significant credit
risk on cash. Restricted cash represents funds held by a bank pending resolution of a dispute with a former officer of the Company.
Accounts Receivable
Accounts receivable are reported at the amount
management expects to collect from outstanding balances. Differences between the amount due and the amount management expects
to collect are reported in the results of operations of the period in which those differences are determined, with an offsetting
entry to a valuation allowance for accounts receivable.
Deferred Costs
Deferred costs consist of the costs directly
related to the production and cultivation of marijuana crops and cannabis derived concentrates. Deferred costs are relieved to
cost of services as products are delivered to dispensaries.
Property and Equipment
Property and equipment are recorded at cost.
Depreciation is provided for on the straight-line method, over the estimated useful lives of the assets. Maintenance and repairs
that neither materially add to the value of the property nor appreciably prolong its life are charged to expense as incurred. Betterments
or renewals are capitalized when incurred. Gains and losses on the disposition of property and equipment are recorded in the period
incurred.
The estimated useful lives of property and
equipment are:
|
·
|
Cultivation and manufacturing equipment 2-7 years
|
Notes and Other Receivables, net
Notes and other receivables are reported at
the amount management expects to collect from outstanding balances. Differences between the amount due and the amount management
expects to collect are reported in the results of operations of the period in which those differences are determined, with an offsetting
entry to a valuation allowance for receivables. Management assesses all receivables individually and in total, considering historical
credit losses as well as existing economic conditions to determine the likelihood of future credit losses. The Company stops accruing
interest on interest bearing receivables when the receivable is in default. There was a total valuation allowance as of December
31, 2019 and September 30, 2019 of $376,430.
Impairment of Long-Lived Assets
We analyze long-lived assets, including property
and equipment and definite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the
carrying amounts may not be recoverable. We review the amortization method and estimated period of useful life at least at each
balance sheet date. We record the effects of any revision to operations when the change arises. We recognize impairment when the
estimated undiscounted cash flow generated by those assets are less than the carrying amount of such assets. The amount of impairment
is the excess of the carrying amount over the fair value of such assets, which is generally calculated using discounted cash flows.
Intangible Assets Subject to Amortization
Intangible assets include trade name, customer
relationships, website, a noncompete agreement and intellectual property obtained through a business acquisition (see Note 2).
Intangible assets acquired in a business combination are recognized at fair value using generally accepted valuation methods deemed
appropriate for the type of intangible asset acquired. Intangible assets with finite lives are amortized over their estimated
useful life and reported net of accumulated amortization, separately from goodwill. Amortization is calculated on the straight-line
basis using the following estimated useful lives:
|
•
|
Customer
relationships
|
2 years
|
|
•
|
Noncompete
agreement
|
4 months (settlement agreement, see Note 2)
|
|
•
|
Websites
and other intellectual property
|
5
years
|
Generally, the Company utilizes the relief
from royalty method to value trade name, the with or without method for valuing the customer relationships, and the discounted
cash flow method for valuing website and intellectual property.
Goodwill
Goodwill represents the excess of the purchase
price paid for the acquisition of a business over the fair value of the net tangible and intangible assets acquired. Goodwill is
not subject to amortization and is tested annually for impairment, or more frequently if events or changes in circumstances indicate
that the carrying value of goodwill may not be recoverable. The goodwill included in these consolidated condensed financial statements
represents the amount of consideration paid above the amount of the individually identifiable assets acquired. In assessing potential
impairment, management first considers qualitative factors to determine if an impairment of goodwill exists. Upon the determination
of a likely impairment, management assesses the recorded goodwill balance with the fair value of the business acquired.
Income Taxes
The Company accounts for income taxes under
FASB ASC 740, Income Taxes. Deferred income tax assets and liabilities are determined based upon differences between
financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be
in effect when the differences are expected to reverse. Valuation allowances are established to reduce deferred tax assets to the
amount expected to be realized.
The Company files income tax returns in the
U.S. federal jurisdiction, and the State of Arizona. The Company is subject to U.S. federal, and state income tax examinations
by tax authorities. Generally all periods beginning on or after January 1, 2015 are open to examination by taxing authorities.
The Company believes it has no tax positions for which the ultimate deductibility is highly uncertain.
Revenue Recognition
On October 1, 2017,
the Company adopted ASC Topic 606, “Revenue from Contracts with Customers” (“ASC 606”) and all the related
amendments.
The core principle
of ASC 606 requires that an entity recognize revenue to depict the transfer of promised goods or services to customers in an amount
that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. ASC 606 defines
a five-step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required
within the revenue recognition process than previously required under GAAP, including identifying performance obligations in the
contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price
to each separate performance obligation.
All of the Company’s
revenue is associated with a customer contract that represents an obligation to perform services that are delivered at a single
point in time. Any costs incurred prior to the period in which the services are performed to completion are deferred and
recognized as cost of revenues in the period in which the performance obligations are completed. For the three months ended December
31, 2019, approximately 92% of the Company’s revenue was generated from performance obligations completed in the state of
Arizona and for the three months ended December 31, 2018, all revenues were generated for performance obligations completed in
the state of Arizona.
The Company recognizes
revenue as services are rendered. Services are considered complete upon successful delivery of the product to the dispensary as
the Company has no further performance obligations at this point in time and collection is assured. Under the performance contract,
the Company acts as an agent for the dispensary, does not own the marijuana, cannot exchange the marijuana, prepares invoices for
the dispensary and all employees that are in contact with marijuana are dispensary agents of the dispensary with which we have
our contract. Given these facts and circumstances, it is the Company’s policy to record the revenue related to the contract
net of the amount retained by the dispensary. Per the dispensary contract, the Company is paid 85% of the wholesale market price
of the marijuana for the services rendered.
The Company’s
revenues accounted for under ASC 606, do not require significant estimates or judgments based on the nature of the Company’s
revenue stream. The sales price is generally fixed at the point of sale and all consideration from the contract is included in
the transaction price. The Company’s contracts do not include multiple performance obligations or variable consideration.
Fair Value of Financial Instruments
The carrying value of the Company’s financial
instruments, consisting of cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses approximate fair
value due to their short term to maturity. The Company’s receivable resulting from the sale of Airware, notes receivable
and notes payable were discounted to its estimated fair value.
ASC Topic 820, Fair Value Measurements, defines
fair value as the price that would be received in the sale of an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date. Topic 820 also specifies a fair value hierarchy that requires an entity to
maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes
three levels of inputs that may be used to measure fair value as follows:
Level 1: Quoted prices in active markets for
identical assets or liabilities;
Level 2: Observable inputs other than Level
1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs
that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities;
and
Level 3: Valuation is generated from model-based
techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect our own estimate
of assumptions that market participants would use in pricing the asset or liability.
Net Loss Per Share
Basic earnings per share does not include dilution
and is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding
for the period. Diluted earnings per share reflects the potential dilution of securities that could share in the earnings of an
entity. Dilutive securities are not included in the weighted average number of shares when inclusion would be anti-dilutive. At
December 31, 2019 and September 30, 2019, there were 632,701, and 656,112 shares underlying convertible notes payable, warrants
and options, that were anti-dilutive, respectively.
Stock-Based Compensation
The Company accounts for its stock-based awards
in accordance with ASC Subtopic 718-10, “Compensation – Stock Compensation”, which requires fair value
measurement on the grant date and recognition of compensation expense for all stock-based payment awards made to employees and
directors. For stock options, the Company estimates the fair value using a closed option valuation (Black-Scholes) model. The estimated
fair value is then expensed over the requisite service period of the award which is generally the vesting period and the related
amount is recognized in the consolidated condensed statements of operations. The Company recognizes forfeitures at the time they
occur.
The Black-Scholes option-pricing model requires
the input of certain assumptions that require the Company’s judgment, including the expected term and the expected stock
price volatility of the underlying stock. The assumptions used in calculating the fair value of stock-based compensation represent
management’s best estimates, but these estimates involve inherent uncertainties and the application of judgment. As a result,
if factors change resulting in the use of different assumptions, stock-based compensation expense could be materially different
in the future.
Recently Issued Accounting
Pronouncements
Adopted
In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill
and Other (Topic 350). The update simplifies the process for assessing goodwill for impairment. The amended guidance removes the
second step that was previously required. ASU 2017-04 is effective for us on October 1, 2023, with early adoption permitted for
periods beginning after January 1, 2017. The Company adopted ASU 2017-04 on October 1, 2018.
In February 2016, the FASB issued ASU 2016-02,
Leases (Topic 842). The update improves financial reporting about leasing transactions by requiring a lessee to record on the balance
sheet the assets and liabilities for the rights and obligations created by lease terms of more than 12 months. The Company adopted
ASU 2016-02 effective October 1, 2019.The most significant change was related to the recognition of a right-of-use asset and lease
liability on our consolidated condensed balance sheet for our real estate operating lease. The impact on our results of operations
and cash flows is not material. See Note 10.
Pending Adoption
In June 2016, the FASB issued ASU 2016-13,
Financial Instruments – Credit Losses (Topic 326), which provides guidance on measuring credit losses on financial instruments.
The amended guidance replaces current incurred loss impairment methodology of recognizing credit losses when a loss is probable
with a methodology that reflects expected credit losses and requires a broader range of reasonable and supportable information
to assess credit loss estimates. ASU 2016-13 is effective for the Company on October 1, 2023, with early adoption permitted on
October 1, 2019. The Company is assessing the provisions of this amended guidance; however, the adoption of the standard is not
expected to have a material effect on our consolidated condensed financial statements.
There have been no other recent accounting pronouncements or changes
in accounting pronouncements that have been issued but not yet adopted that are of significance, or potential significance, to
the Company.
Note
2 –Business Combination
On
November 26, 2018, the Company’s wholly owned subsidiary AZ DP Holdings, LLC (“AZDP”) performed an acquisition
of the majority of the assets of Arizona DP Consulting, LLC (“AZDPC”), a consulting firm specializing in obtaining
marijuana dispensary permits and developing cannabis related business plans. The purchase price was $9,270,000, $1,500,000 in
cash and 3,000,000 shares of restricted common stock having an aggregate value of $7,770,000 or $2.59 per share based on the market
price of the Company’s shares at the time the asset purchase agreement was executed. There were no significant costs relating
to the acquisition. Pursuant to the agreement, Sara Gullickson transitioned from President to CEO under a 3 year employment agreement
and became a member of the board of directors of the Company. Additionally, AZDP agreed to hire the employees of AZDPC and lease
its existing office space which required $3,200 of monthly rent through May 2019, which was subsequently extended through August
2019. The primary reason for the acquisition was to utilize the assets held by AZDPC to assist in the expansion of the Company.
Assets and liabilities of AZDPC were negligible so presentation was not deemed necessary.
In
accordance with ASC 805, Business Combinations, the Company accounted for the acquisition of AZDPC using the acquisition
method of accounting. The purchase price was allocated to specific identifiable intangible assets at their respective fair values
at the date of acquisition. There were no tangible assets or liabilities acquired.
Identifiable
intangible assets consist of the following as of December 31, 2019:
|
|
Balance at
|
|
|
|
|
|
Balance at
|
|
|
October 1, 2019
|
|
Other Additions
|
|
Amortization
|
|
December 31, 2019
|
Trade names
|
|
$
|
161,848
|
|
|
$
|
144,120
|
|
|
$
|
(3,000
|
)
|
|
$
|
302,968
|
|
Customer relationships
|
|
|
181,250
|
|
|
|
—
|
|
|
|
(36,250
|
)
|
|
|
145,000
|
|
Websites and other intellectual property
|
|
|
1,144,277
|
|
|
|
—
|
|
|
|
(67,310
|
)
|
|
|
1,076,967
|
|
Non-compete agreement
|
|
|
352,500
|
|
|
|
—
|
|
|
|
(139,167
|
)
|
|
|
213,333
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total other intangible assets
|
|
|
1,839,875
|
|
|
|
144,120
|
|
|
|
(245,727
|
)
|
|
|
1,738,268
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Goodwill
|
|
|
1,116,396
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1,116,396
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
2,956,271
|
|
|
$
|
144,120
|
|
|
$
|
(245,727
|
)
|
|
$
|
2,854,664
|
|
On November 15, 2019, Ms. Sara Gullickson
voluntarily resigned as Chief Executive Officer and member of the Board of Directors of Item 9 Labs Corp. The resignation was
not the result of any disagreement with the Company on any matter relating to the Company’s operations, policies, or practices.
Ms. Gullickson and the Company have mutually agreed to amend the terms of the employment agreement and non-competition agreement
between Ms. Gullickson and the Company dated November 26, 2018 pursuant to which (i) the non-competition period shall be reduced
from three (3) years to four (4) months; (ii) Ms. Gullickson shall receive her full salary and health benefits for four (4) months
from the resignation date (a significantly reduced period of time); and (iii) Ms. Gullickson shall cancel and return to treasury
an aggregate amount 2,300,000 restricted shares of Company Common Stock which were acquired by Gullickson pursuant to that certain
Asset Purchase Agreement dated November 26, 2018 by and between Arizona DP Consulting LLC, an Arizona limited liability company,
as seller, and Gullickson as the sole member of the seller on the one hand, and the Company and AZ DP Holdings, LLC, a Nevada
limited liability company as buyer, on the other hand. The returning of the stock was accounted for as a capital contribution
and treasury stock transaction. As such, there was no impact on total equity.
In
exchange for the aforementioned terms, the Company and Gullickson agreed to a release of claims against each other, among other
things. The agreement contains representations and warranties customary for agreements of this type.
Note
3 - Property and Equipment, Net
The
following represents a summary of our property and equipment as of December 31, 2019 and September 30, 2019:
|
|
December 31,
|
|
September 30,
|
|
|
2019
|
|
2019
|
Cultivation and manufacturing equipment
|
|
$
|
171,271
|
|
|
$
|
154,059
|
|
Construction in progress
|
|
|
4,085,435
|
|
|
|
4,060,297
|
|
Land and building
|
|
|
3,093,549
|
|
|
|
3,093,549
|
|
|
|
|
7,350,255
|
|
|
|
7,307,905
|
|
Accumulated Depreciation
|
|
|
(169,593
|
)
|
|
|
(137,483
|
)
|
|
|
$
|
7,180,662
|
|
|
$
|
7,170,422
|
|
Depreciation
expense for the three months ended December 31, 2019 and 2018 was $32,110 and $12,961, respectively.
Note
4 – Sale of Airware Assets and Investment in Health Defense LLC
On
May 3, 2018, the Company entered into an intellectual property sales agreement with Health Defense LLC. Pursuant to the terms
of the agreement, the Company sold all of the assets related to the former business of the Company, nasal dilator sales.
In
consideration for entering into the agreement, the Company is to receive: (i) $300,000 in cash at execution, (ii) $700,000 in
cash within one year of execution and (iii) an additional $300,000 by December 31, 2019.
As
additional consideration, the Company was given a 10% ownership interest in Health Defense LLC. This ownership is valued at $100,000
and is reflected on the consolidated condensed balance sheets as Investment in Health Defense at December 31, 2019 and September
30, 2019.
As
of December 31, 2019 and September 30, 2019, management determined that the receivable described above should be classified as
long-term on the consolidated condensed balance sheets as the payments have not been made as scheduled. Additionally,
management has recorded an allowance on the receivable of $307,430 at December 31, 2019 and September 30, 2019.
Note
5 – Notes Receivable
On
May 11, 2018, the Company entered into a Promissory Note Agreement with a borrower in the principal amount of $150,000. This is
a one year note with 20% non-compounded annual interest payable at maturity. It is convertible at the discretion of the Company
into a unit offering of the borrower at a 15% discount. The note is personally guaranteed by the borrower. This note is in default
and is on non-accrual status. The Company is currently negotiating an amendment to the note.
On
May 15, 2018, the Company entered into a Promissory Note Agreement with a borrower in the principal amount of $60,000. This is
a one year note with 15% non-compounded annual interest payable at maturity. It is convertible at the discretion of the Company
into an interest in a strategic partnership of ownership and operations of a certain dispensary license. The note is personally
guaranteed by the borrower. This note is in default and is on non-accrual status. At December 31, 2019, the principal and interest
has been fully reserved in the amount of $69,000.
At
December 31, 2019 and September 30, 2019, the Company has accrued $39,000 of interest receivable related to these
notes which is included in notes and interest receivables on the accompanying consolidated condensed balance
sheets.
Note
6 – Short Term Note Payable
On
August 28, 2019, Item 9 Properties, LLC, a Nevada limited liability company, and BSSD Group, LLC, an Arizona limited liability
company, each wholly owned subsidiaries of Item 9 Labs Corp. collectively, entered into a Loan Agreement up to $2.5 million (the
“Loan Agreement”) with Aeneas Venture Partners 3, LLC, an Arizona limited liability company (the “Lender”).
Pursuant
to the Loan Agreement, the Company may make multiple borrowings under the Loan Agreement in the total aggregate principal amount
of up to $2.5 million (the “Loan”) for the purpose of completing development and construction on certain real property
located in Pahrump, Nevada owned by the Company. The Loan is a multiple advance credit facility. The Company drew $2,000,000 on
August 28, 2019 and an additional $200,000 on November 26, 2019. Interest in the amount of 15% of the total amount borrowed (based
on total draws) under the Loan will be paid in addition to principal at the maturity date. The Loan has a term of sixty days from
funding of the Loan and may be extended for additional sixty days subject to the satisfaction of certain conditions including
ten days’ notice and an extension loan fee of 15% of the aggregate total of advances under the Loan. The Loan is secured
by a first priority interest in the Company’s real property located in Coolidge, Arizona, including improvements and personal
property thereon (the “Property”) and includes an unconditional guarantee by Item 9 Labs Corp. The 5-acre property
has 20,000 square feet of buildings, housing the cultivation and processing operations. The total balance of the loan, including
accrued interest as of December 31, 2019 was $3,050,000, after the Company executed extensions in October and December 2019.
Note
7 – Unsecured Convertible Note Payable
In
the reverse recapitalization disclosed in Note 1, the Company assumed one unsecured convertible note payable with principal balance
totaling $20,000 which was due in August 2012, carries an interest rate of 8% and is convertible including accrued interest to
common stock at $.50 per share, which would be 62,710 shares as of December 31, 2019 and September 30, 2019. As of December 31,
2019 and September 30, 2019, this unsecured convertible note payable is considered in default and has been presented as a current
liability on the consolidated condensed balance sheets.
Note
8 – Long Term Debt in Default
On
September 13, 2018, the Company entered into a Loan and Revenue Participation Agreement with Viridis Group I9 Capital LLC (“Viridis”)
in which Viridis has agreed to loan the Company up to $2.7 million for the expansion of the Company’s Arizona and Nevada
properties (see Note 12). As of September 30, 2018, the Company received $1,500,000 of proceeds from Viridis in the form of a
promissory note. The $1,500,000 proceeds were utilized to acquire a 20% ownership in Strive Management, LLC as described in Notes
1 and 9, and is collateralized with a Deed of Trust on the Company’s approximately 5 acre property and construction in progress.
In exchange for the loan, Viridis will be repaid in the form of waterfall revenue participation schedules. Viridis shall receive
5% of the Company’s gross revenues from the Nevada operations until the loan is repaid, 2% until repaid 200% of the amount
loaned, and 1% of gross revenues in perpetuity or until a change in control. Payments on the loan will commence 90 days after
the Nevada operation begins earning revenue. Parties acknowledge that the Company was expected to own only 51% of the Nevada operations
and therefore Viridis’ revenue participation is limited to the Company’s interest. On February 14, 2020, the Company
acquired the remaining 80% membership interest in Strive Management, LLC. Therefore, the revenue participation payments will be
based on 100% of the revenues of the Company’s Nevada operations. The operations in Nevada have not yet begun as of the
date of this filing. On August 26, 2019, the loan was amended to include 6% annualized interest in exchange for Viridis subordinating
its debt to another lender. Interest of $294,084 has been accrued as of December 31, 2019.
The
additional $1,200,000 of proceeds drawn during the year ended September 30, 2019 were utilized to construct an additional 10,000
square foot cultivation and processing facility in Arizona that became operational in June 2019. The loan was originally collateralized
with a Deed of Trust on the Company’s 5 acre parcel in Coolidge, AZ and its two 10,000 square foot buildings. In August
2019, Viridis agreed to subordinate its first priority Deed of Trust and move into a 2nd position. The proceeds were
received as construction draws between November 2018 and January 2019. In exchange for the loan, Viridis will be repaid in the
form of waterfall revenue participation schedules. Viridis shall receive 5% of the Company’s gross revenues from the Arizona
operations until the loan is repaid, 2% until repaid 200% of the amount loaned, and 1% of gross revenues in perpetuity or until
a change in control. Payments on the loan will commence 90 days after the Arizona operation begins earning revenue. Interest on
the notes accrue monthly at a 2.9% annual rate. On August 26, 2019, the loan was amended to include 6% annualized interest in
exchange for Viridis subordinating its debt to another lender. Interest of $249,245 has been accrued as of December 31, 2019.
Both
notes are in default as of December 31, 2019. As such, the notes are presented as current liabilities on the consolidated condensed
balance sheets. The notes are with a related party, Viridis. The former CEO of Viridis is the CEO and a board member of Item 9
Labs Corp.
The Company’s subsidiary, BSSD Group, LLC borrowed $269,000
from Viridis Group during the three months ended December 31, 2019. This note bears annualized interest at 15%. The remaining
terms of the note are still being negotiated.
Note
9 – Variable Interest Entity
As of December 31, 2019 and September 30, 2019,
the Company has determined that it holds a variable interest in Strive Management due to the Company being its sole source of capital.
Further, the Company has agreed to raise $4,000,000 on Strive Management’s behalf through promissory note agreements that
the Company will guarantee. No funds have been raised as of the date of these consolidated condensed financial statements. If the
funds are not raised, the additional 31% interest due to the Company upon operational approval from the State of Nevada as discussed
in Note 1 would be subject to reclamation by the other members of Strive Management. The Company has been determined to be the
primary beneficiary of Strive Management as the Company has the power to direct the activities that significantly impact Strive
Management’s economic performance and the obligation to absorb losses. Strive Management’s financial statements as
of December 31, 2019 and September 30, 2019 and for the quarters ending December 31, 2019 and 2018 have been consolidated with
the Company. Upon consolidation, the assets of Strive Management were recorded at its carrying amounts. The effects of consolidating
Strive Management resulted in an increase in assets of $517,664 and $553,851 as of December 31, 2019 and September 30, 2019, respectively,
and an increase in expenses of $31,423 and $60,598 for the three months ended December 31, 2019 and 2018, respectively. Though
consolidated, all assets and liabilities of Strive Management LLC are non-recourse in that they can only be used to settle obligations
of Strive Management and creditors can only seek recourse against Strive Management, not the Company, even though it has been deemed
the primary beneficiary.
As
discussed in Note 15, the Company completed the purchase of the remaining ownership interests of Strive Management LLC in February
2020.
Note
10 – Leases
The
Company leases its corporate office from an entity controlled by the CEO of the Company, under an operating lease. The lease is
for a term of 5 years beginning September 1, 2019. The following is a schedule by years of future minimum payments required under
the lease together with their present value as of December 31, 2019:
|
|
Future Minimum
|
|
|
Payments
|
|
2020
|
|
|
$
|
58,478
|
|
|
2021
|
|
|
|
80,013
|
|
|
2022
|
|
|
|
82,114
|
|
|
2023
|
|
|
|
84,215
|
|
|
2024
|
|
|
|
78,963
|
|
|
|
|
|
|
|
|
|
|
|
|
|
383,783
|
|
|
|
|
|
|
|
|
|
less
imputed interest
|
|
|
|
(140,756
|
)
|
|
|
|
|
|
|
|
|
|
|
|
$
|
243,027
|
|
As
of the inception of the lease, the lease liability and right of use asset was recorded at $268,359, the amount of the present
value of all lease payments. To calculate the lease liability and right of use asset, the Company used a 20% discount rate, the
approximate interest rate the Company would borrow at.
Amortization
in the amount of $25,332 has been recorded against the right of use asset and lease liability, leaving a balance in each of $243,027
as of December 31, 2019.
Note
11 - Concentrations
For
the three months ended December 31, 2019 and 2018, respectively, 92% and 100% of the Company’s revenue were generated from
a single customer.
Note 12 - Commitments and Contingencies
The production and possession of marijuana
is prohibited by the United States of America, though the state of Arizona allows these activities to be performed at licensed
facilities such as BSSD. If the federal government decides to enforce the Controlled Substances Act, it could have a material adverse
effect on our business. However, the Company does not currently believe the federal prohibition of these activities will negatively
impact the business. As such, the Company has not elected to record a related accrual contingency.
The Company is in default on convertible notes
payable totaling $20,000 (see Note 7). The Company has attempted to communicate with the note holder to request extension or conversion,
but has been unsuccessful in doing so. The full balance on this note is included in current liabilities.
On April 20, 2018, the Company entered into
an agreement for the purchase of approximately 44 acres of land from an affiliate of a founding member of BSSD. The purchase price
of the property is $3,000,000, payable as follows; (i) $200,000 deposited with escrow agent as an initial earnest money deposit,
(ii) on or before February 1, 2019, the Company will deposit an additional $800,000 into escrow as additional earnest money deposit
and (iii) the balance of the purchase price shall be paid via a promissory note. The earnest money amounts are non-refundable.
The Company has negotiated an amendment to this agreement that will spread the $800,000 payment over the course of 4 months. As
of the date of these consolidated condensed financial statements, $600,000 has been deposited in escrow which has been classified
as a long-term asset on the consolidated condensed balance sheet as of December 31, 2019 and September 30, 2019.
On June 26, 2018, the Company entered into
a contractor agreement with Chase Herschman pursuant to which he will provide services in exchange for $120,000 annually, payable
each month; up to $420,000 in common stock options which shall vest upon the occurrence of certain benchmarks as described in the
contractor agreement and a commission of 1% of the gross profits of the Nevada Operations of the Company. The term of the agreement
is a period of three years.
On September 13, 2018, the Company entered
into a Loan and Revenue Participation Agreement with Viridis Group I9 Capital LLC (“Viridis”). Viridis agreed to make
secured loans of up to $2.7 million to the Company which is represented by two separate notes, one for the construction and enhancement
of the Company’s Arizona property and one for the Company’s proposed ventures in Nevada. In exchange for the loans,
Viridis will be repaid in the form of waterfall revenue participation schedules. Viridis shall receive 5% of the Company’s
gross revenues from each of the Company’s Arizona and Nevada operations, respectively, until the loan is repaid, 2% until
repaid 200% of the amount loaned, and 1% of gross revenues in perpetuity or until a change in control.
Under the terms of the Loan and Revenue Participation
Agreement, upon a change in control of the Company, Viridis will be entitled to receive 200% of the principal amount of the loans
to the Company computed after considering previous revenue participation payments through the date of change of control and 1%
of the aggregate sales price or consideration received in the change in control transaction.
As of December 31, 2019, the Company has received
the $1,500,000 and invested the funds in Strive Management (see Notes 8 and 9). The remaining $1,200,000 has been provided by Viridis
directly to contractors of the Arizona property from an account owned and controlled by Viridis. The Company recorded the $2,700,000
as debt at December 31, 2019 and September 30, 2019.
As part of the agreement to invest in Strive
Management, the Company has committed to raise funding of approximately $4,000,000 through promissory notes that the Company will
guarantee so that Strive Management can develop the property in Nevada through promissory notes that the Company will guarantee.
On July
1, 2019, the Company entered into a 3 year agreement with a concert venue to be the name sponsor for the venue. In exchange, the
Company issued 45,457 shares of restricted common stock valued at $200,000 ($4.40/share) and is to pay $5,000 monthly for the first
12 months and $60,000 in July 2020 and 2021.
The
Company entered into a 60 month lease with VGI Citadel LLC to rent office space for its corporate headquarters which began on
September 1, 2019. The lease payments total $6,478 monthly for the first twelve months, include all utilities and an estimated
amount for common area maintenance and real estate taxes. The monthly lease rate increases to $6,653, $6,828, $7,003, and $7,178
for years two through five, respectively.
Note 13– Related Party Transactions
As discussed
in Note 1, on March 20, 2018, the Company issued 40,355,771 shares of common stock to the members of BSSD for their membership
interests.
As discussed
in Note 12, the Company has entered into an agreement as of April 20, 2018 for the purchase of land. The land owner is one of the
original members of BSSD and a current employee of the Company.
As discussed
in Note 14, on May 8, 2018, the Company issued 22,500 options for the purchase of common stock to three board members.
As discussed
in Notes 8 and 12, the Company has entered into a Loan and Revenue Participation Agreement and Promissory Note with Viridis. The
member of Viridis was elected to the Company’s board of directors on December 21, 2018 and is currently the Company’s
CEO.
As discussed
in Note 8, BSSD Group, LLC, a wholly owned subsidiary of the Company entered into a loan agreement with Viridis.
As discussed
in Note 2, the Company issued 3,000,000 shares of restricted common stock as part of the asset purchase agreement dated November
26, 2018. As part of November 15, 2019 settlement agreement, Gullickson returned 2,300,000 shares of stock to the Company.
During
the three months ended December 31, 2018, the Company issued 3,000,000 shares of restricted common stock to Viridis I9 Capital
LLC, an LLC in which, Andrew Bowden, director and CEO of the Company is a member. The sales price was $1.00 per share with net
proceeds of $3,000,000.
The Company
has a construction management agreement with the Viridis Group to oversee the Nevada construction project totaling $20,000 monthly.
The Company owes Viridis $60,000 for these services as of December 31, 2019 and September 30, 2019.
As discussed
in Note 12, the Company has a lease agreement with VGI Capital LLC. A member of VGI Capital was elected to the Company’s
board of directors on December 21, 2018 and is currently the Company’s CEO.
Included
in our accounts payable at December 31, 2019 and September 30, 2019 is approximately $160,000 in amounts due to related parties.
Note
14 - Stockholders’ Equity
Common
Stock
During
the three months ended December 31, 2018, the Company raised approximately $3,150,000 via private placement. 3,000,000 shares
were issued for $1 per share and 100,000 shares were issued for $1.50 per share.
As
discussed in Note 2, the Company issued 3,000,000 shares of restricted common stock, valued at $7,770,000 as consideration for
the acquisition of the majority of the assets in AZ DP Consulting, LLC.
In
the three months ended December 31, 2018, in the normal course of business, the Company issued 30,000 shares of restricted common
stock, valued at $123,500 as consideration for various consulting contracts.
In
the three months ended December 31, 2019, in the normal course of business, the Company issued 55,618 shares of restricted common
stock, valued at $132,106 as consideration for various contracts, including venue sponsorships, marketing, and investor relations.
In
the three months ended December 31, 2019, the Company issued 26,282 shares of restricted common stock to employees, valued at
$75,000.
Warrants
As of December 31, 2019, there are 275,000
warrants for purchase of the Company’s common stock outstanding. 23,411 warrants expired during the three months ended December
31, 2019. Warrants outstanding as of December 31, 2019 are as follows:
|
|
Common Shares
|
|
|
|
|
|
|
|
|
Issuable Upon
|
|
Exercise Price of
|
|
Date
|
|
Expiration
|
|
|
Exercise of Warrants
|
|
Warrants
|
|
Issued
|
|
Date
|
Warrants issued by predecessor
|
|
|
175,000
|
|
|
$
|
2.00
|
|
|
3/31/2015
|
|
|
8/31/2020
|
|
Warrants issued by predecessor
|
|
|
100,000
|
|
|
$
|
1.00
|
|
|
7/28/2016
|
|
|
7/28/2021
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance of Warrants at December 31, 2019
|
|
|
275,000
|
|
|
|
|
|
|
|
|
|
|
|
As
discussed in Note 1, on March 20, 2018 the Company executed an agreement to acquire all the voting interest in BSSD Group, LLC.
As BSSD Group, LLC is the accounting acquirer, all previously outstanding warrants were re-issued under the new company.
Stock
Options
On
May 8, 2018, the Company granted 22,500 stock options to board members. The options are exercisable at $2.40 per share with a
ten year term. The options will vest equally over three years unless there is a change of control of the Company at which time
any unvested options vest immediately. As of December 31, 2019 and September 30, 2019, there are 294,991 stock options outstanding.
The
Company determines the fair value of stock options issued on the date of grant using the Black-Scholes option-pricing model.
There
was no option activity during the three months ended December 31, 2019 and 2018.
Note
15 - Subsequent Events
In
December 2019, BSSD Group LLC, a wholly owned subsidiary of the Company terminated its personal services agreement with Buds &
Roses. This agreement allowed the Company to cultivate, process and distribute cannabis in the state of Arizona. The agreement
has a run-out period through March 31, 2020, during which time, BSSD Group LLC was negotiating with other Arizona dispensaries
to perform under a similar contract. BSSD had to make a payment of approximately $400,000 in December 2019 to settle the outstanding
balance on the current contract, and is required to pay $80,000 monthly on the first of January, February and March 2020. In February
2020, the Company entered into a similar agreement with another company with a flat monthly rate of $40,000.
In February 2020, the Company executed an
agreement with the other members of Strive Management, LLC to purchase the remaining 80% of Strive Management, LLC, as well as
the Nevada licenses its members held in another entity. The Company agreed to pay $500,000 in cash, $1,000,000 in an unsecured
note payable and issue 3,250,000 membership units of Strive Management and Strive Wellness which are exchangeable for shares of
the Company’s restricted common stock. Additionally, the Company issued a cashless warrant for 2,000,000 membership units
of Strive Management and Strive Wellness which are exchangeable for shares of the Company’s restricted common stock. In
order to close the transaction, the Company borrowed $500,000 from Stockbridge Enterprises, a related party. The note bears interest
at 6% per annum and entitles Stockbridge Enterprises to a cashless warrant for 500,000 shares of common stock of the Company with
an exercise price of $1.00. The Company is to repay the loan by April 11, 2020. Upon default, the interest rate increases to 11%
per annum and the exercise price of the warrants decreases to $.75 for the next thirty days, $.50 for the following thirty days
and finally $.05 thereafter.
In
February 2020, the Company appointed Doug Bowden to its Board of Directors.
Note
16 – Going Concern
The
accompanying consolidated condensed financial statements have been prepared in conformity with GAAP, which contemplate continuation
of the Company as a going concern. The Company has not yet established an ongoing source of revenue sufficient to cover its operating
costs and has incurred net losses since its inception. These losses, with the associated substantial accumulated deficit, are
a direct result of the Company’s planned ramp up period as it is pursuing market acceptance and geographic expansion. In
view of these matters, realization of a major portion of the assets in the accompanying consolidated condensed balance sheets
is dependent upon continued operations of the Company which in turn is dependent upon the Company’s ability to meet its
financing requirements, and the success of its future operations. The Company operates in a new, developing industry with a variety
of competitors. These factors raise substantial doubt about the Company’s ability to continue as a going concern. As a result,
the Company’s independent registered public accounting firm included an emphasis-of-matter paragraph with respect to the
consolidated financial statements for the year ended September 30, 2019, expressing uncertainty regarding the Company’s
assumption that it will continue as a going concern.
In
order to continue as a going concern, the Company will need to generate additional revenue and obtain additional capital to fund
its operating losses and service its debt. Management’s plans in regard to these matters are described as follows:
Sales
and Marketing. Historically, the Company has generated the majority of its revenues by providing its products to dispensaries
throughout the state of Arizona. The Company’s revenues have increased significantly since its inception in May 2017.
Management will continue its plans to increase revenues in the Arizona market by providing superior products. Additionally,
as capital resources become available, the Company plans to expand into additional markets outside of Arizona, with
construction of a cultivation and processing facility underway in Nevada.
Financing.
To date, the Company has financed its operations primarily with loans from shareholders, private placement financings and sales
revenue. Management believes that with continued production efficiencies, production growth, and continued marketing efforts,
sales revenue will grow significantly, thus enabling the Company to reverse its negative cash flow from operations and raise additional
capital as needed. However, there is no assurance that the Company’s overall efforts will be successful.
If
the Company is unable to generate significant sales growth in the near term and raise additional capital, there is a risk that
the Company could default on additional obligations, and could be required to discontinue or significantly reduce the scope of
its operations if no other means of financing operations are available. The consolidated condensed financial statements do not
include any adjustments relating to the recoverability and classification of recorded asset amounts or the amount and classification
of liabilities or any other adjustment that might be necessary should the Company be unable to continue as a going concern.
END
NOTES TO FINANCIALS