NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

BUSINESS

Vape Holdings, Inc. (“VAPE,” the “Company,” “we,” “us,” “our,” “our company”) is a holding company with its primary focus in the manufacturing and distribution of healthy and sustainable vaporization products. The Company designs, markets and distributes ceramic vaporization products under a unique brand. The Company has introduced a nonporous, non-corrosive, chemically inert medical-grade ceramic vaporization element as a healthy, sustainable alternative to traditional titanium and quartz vaporization materials, as well as lower-grade ceramic found in traditional electronic cigarettes and vaporizers. This material can be used for a wide range of applications, including stand-alone vaporization products and “E-cigs.” Electronic cigarettes come in a variety of designs ranging from those that look vastly like traditional cigarettes, to larger vaporizer units which are capable of vaporizing liquid with varying viscosity. The process of vaporization is believed to eliminate the smoke, tar, ash, and other byproducts of traditional smoking by utilizing lower temperatures in a controlled electronic environment.

HIVE CERAMICS

HIVE Ceramics (“HIVE”) is the premier brand under the VAPE umbrella. HIVE outsource manufactures and distributes a proprietarily blended ceramic vaporization element for torched, electronic and portable vaporizers with countless design and product crossover capabilities in existing and emerging markets. HIVE is dedicated to bringing the healthiest and cleanest vaporization experience possible to the market.

HIVE Ceramics has seen a significant decrease in sales due to competition in the market and restricted operations. While sales channels are still open, without an infusion, the revenues are not large enough to support HIVE Ceramics outside of its existing product line.

GOING CONCERN

VAPE’s consolidated financial statements reflect a net loss of $247,284 during the three months ended December 31, 2016. As of December 31, 2016, we had cash of $12,098, a working capital deficit of $5,319,405, and an accumulated deficit of $35,271,952. In addition, the ongoing need to obtain financing to fund operations also raise substantial doubt about the ability of Vape to continue as a going concern. Management expects to obtain funding for the new operations for the foreseeable future; however, there are no assurances that the Company will obtain such funding. VAPE’s financial statements do not include any adjustments to reflect the possible effects on recoverability and classification of assets or the amounts and classification of liabilities that may result from the inability to continue as a going concern. See Note 8 for subsequent events regarding financing activities.

BASIS OF PRESENTATION

The accompanying unaudited interim consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the SEC. Certain information and disclosures normally included in the annual financial statements prepared in accordance with the accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, all adjustments and disclosures necessary for a fair presentation of these consolidated financial statements have been included. Such adjustments consist of normal recurring adjustments. The current results are not an indication of the full year.

Fair-value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of December 31, 2016 and September 30, 2016. The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values. These financial instruments include cash, prepaid expenses, accounts payable, accrued liabilities, and notes payable. Fair values for these items were assumed to approximate carrying values because of their short-term nature or they are payable on demand.

The following table presents the Company’s fair value hierarchy for assets measured at fair value on a recurring basis at December 31, 2016:

The following table presents the Company’s fair value hierarchy for assets measured at fair value on a recurring basis at September 30, 2016:

EARNINGS (LOSS) PER COMMON SHARE

The following is a summary of outstanding securities that would have been included in the calculation of diluted shares outstanding since the exercise prices did not exceed the average market value of the Company’s common stock had the Company generated net income for the three months ended December 31, 2016 and 2015:

The Company does not have sufficient shares to accommodate the convertible notes.

RECENT ACCOUNTING PRONOUNCEMENTS

In May 2014, the FASB issued Accounting Standards Update No. 2014-09, “Revenue from Contracts with Customers”, which supersedes most of the current revenue recognition requirements. The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for these goods or services. New disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers are also required. This guidance is effective for the Company in the first quarter of fiscal year 2018 and early application is not permitted. Entities must adopt the new guidance using one of two retrospective application methods. The Company is currently evaluating the standard but does not expect it to have a material impact on our financial position, results of operations or cash flows.

The Financial Accounting Standards Board issues Accounting Standard Updates (“ASUs”) to amend the authoritative literature in Accounting Standards Codification (“ASC”). There have been a number of ASUs to date that amend the original text of ASC. The Company believes those issued to date either (i) provide supplemental guidance, (ii) are technical corrections, (iii) are not applicable to the Company or (iv) are not expected to have a significant impact on the Company.

AMENDMENT  

We have amended the previous three months ended December 31, 2015 in this Form 10-Q to correctly account for the following non-cash transactions:

In August 2015 the Company entered into convertible notes without conversion floors resulting in an unlimited potential of shares to be issued. Accordingly, we adjusted the consolidated financial statements to recognize the embedded conversion feature of the instruments.

On August 13, 2015 and August 26, 2015, the convertible notes due to Redwood and Typenex, respectively, were amended which removed the fixed conversion floors per common share creating a potentially unlimited number of shares to be issued on the date of the amendment. Accordingly, we amended this Form 10-Q to account for the embedded conversion features as derivative financial instruments at fair value upon their original issuance dates. This increased the loss on debt extinguishments and interest expense previously recorded, as well as the derivative liabilities at fair value.

The following was the effect on the previously reported consolidated financial statements.

As of December 31, 2016, $25,000 for Kyle Tracey, $16,667 for Joe Andreae, $63,742 for Mike Cook, $93,881 for Allan Viernes, $95,548 for Benjamin Beaulieu, and $65,000 for Justin Braune are recorded in accrued wages.

At September 30, 2016, convertible notes payable consisted of the following:

Securities Purchase Agreement with Typenex Co-Investment, LLC

On November 1, 2016, the Company closed a Securities Purchase Agreement (the “Typenex Agreement”) with Typenex. Pursuant to the Typenex Agreement, Typenex purchased a Convertible Promissory Note from the Company in the original principal amount of up to $1,413,000 (the “Typenex Note”), at an interest rate of ten percent (10%) per annum. The Typenex Note is unsecured. The principal amount of the Typenex Note included an original issue discount of $128,000 and a transaction fee of $5,000.

The investment from Typenex is scheduled to occur in a series of sixteen (16) tranches, represented each by a separate Secured Investor Promissory Note (the “Tranche Notes”) in varying amounts. The first Tranche Note of $40,000 is memorialized in Secured Promissory Note #1, the funding of which occurred on or immediately after the execution of the Typenex Agreement.

Each Tranche Note, or any part of it, is convertible into fully paid and non-assessable $0.00001 par value common stock of the Company. The Conversion Price is as described in the Typenex Agreement and is based on at least a 45% discount to the trading price of the Company’s common stock.

As a part of the Typenex Agreement, the Company agreed to use its best efforts to cause its authorized but unissued stock to be increased in order for the Company to create a reserve sufficient to meet its conversion obligations under the Typenex Note. The Company is in the process of taking steps in order to increase its authorized but unissued stock to meet its obligations.

There is no guarantee that Typenex will fund the remainder of the Typenex Note and in fact it is within Typenex’s sole and absolute discretion whether it ultimately funds Tranche Notes #2- #12. However, in order to secure Typenex’s performance of its obligations under the Typenex Note, as well as any subsequent Tranche Notes, Typenex agreed to pledge a 40% membership interest in Typenex Medical, LLC, an Illinois limited liability company. Should Typenex decide it won’t fund the remainder of the Tranche Notes, the Company’s operating results will suffer and its ability to remain a going concern will be jeopardized.

Securities Purchase Agreement with GHS Investments, LLC

On October 28, 2016, the Company closed a Securities Purchase Agreement (the “GHS Purchase Agreement”) with GHS. Pursuant to the GHS Purchase Agreement, GHS agreed to purchase and the Company agreed to sell up to $1,105,000 of convertible securities, in the form of a Convertible Promissory Note (the “GHS Note”), at an interest rate of ten percent (10%) per annum. The GHS Note is also attached as Exhibit 10.6 to the 12/27/16 Form 8K and is incorporated herein by this reference. The GHS Note included a ten percent (10%) original issuance discount (i.e., $100,000) and a $5,000 initial transaction fee, as defined in the GHS Purchase Agreement. Upon the closing of the GHS Purchase Agreement, GHS funded $40,000 to the Company (the “Initial Tranche”). Within 15 days of certain conditions being met, an additional $40,000 shall be disbursed by GHS to the Company, in its sole discretion (“Second Tranche”). Within 30 days from the Second Tranche’s issuance, so long as there are no defaults under the GHS Note, GHS in its discretion may fund an additional $50,000 to the Company every 30 days (“Subsequent Tranches”) until $1,000,000 has been funded to the Company. During the three months ended December 31, 2016, GHS provided another tranche of $76,000.

The principal sum and corresponding interest due to GHS shall be prorated based on the consideration actually paid by GHS to the Company in accordance with the GHS Purchase Agreement. 

Each GHS Note, or any part of it, is convertible into fully paid and non-assessable $0.00001 par value common stock of the Company. The Conversion Price is as described in the GHS Purchase Agreement and is based on at least a 45% discount to the trading price of the Company’s common stock.

As a part of the GHS Purchase Agreement, the Company agreed to use its best efforts to cause its authorized but unissued stock to be increased in order for the Company to create a reserve sufficient to meet its conversion obligations.

There is no guarantee that GHS will fund the remainder of the Subsequent Tranches and in fact it is within GHS’s sole and absolute discretion whether it ultimately funds the Subsequent Tranches. Should GHS decide it won’t fund the Subsequent Tranches, the Company’s operating results will suffer and its ability to remain a going concern will be jeopardized.

Subsequent to year end, GHS elected to convert $365,266 of principal and interest into 191,162,022 shares of common stock.  Another shareholder received 220,000,000 shares of common stock pursuant to a note assignment agreement executed subsequent to year end.

The following weighted average variables were used in the Black Scholes model for the derivative liabilities as of December 31, 2016 and September 30, 2016:

Related Party Note Payable

The Company had outstanding accounts payable balance to a related party (shareholder of the Company) in the amount of $15,000 as of September 30, 2013. This payable was converted into a note payable on December 7, 2013. The note payable bears interest of 6% per annum with a maturity date of December 1, 2016. As of December 31, 2016, there is $2,790 in accrued interest expense related to this note and the Company recorded $230 and $230 in interest expense related to this note during the three months ended December 31, 2016 and 2015. 

Related Party Convertible Notes Payable

On December 10, 2015, the Company entered into two Secured Series B Preferred Stock Convertible Notes (the “Series B Notes”) for an aggregate principal of $300,000 including 1) $50,000 from Hive Ceramics, LLC in new capital to the Company and 2) an amended and restated note for Hive Ceramics LLC in the amount of $250,000 for capital previously contributed which is soon to be due and payable.

The Company failed to pay the Series B Note and the Amended Note on the Maturity Date (December 10, 2016). On December 15, 2016, the Company received a Notice of Default from counsel for Holder. Holder’s counsel demanded that all amounts owed under the Series B Note and the Amended Note be paid no later than December 20, 2016. The Company was unable to pay the demanded amounts by December 20, 2016. The Company believes that the Holder intends to execute on the security for the Series B Note and the Amended Note, namely, all of the assets of the Company. The Company is attempting to negotiate a resolution that does not include seizure of the Company’s assets however there is no guarantee that the Company will be able to work out a satisfactory resolution that does not include seizure of the Company’s assets.

The Series B Notes accrue interest at eight percent (8%) per annum, mature one (1) year from issuance and are secured by all of the assets and property of the Company. Upon the election of the noteholder, the Series B Notes are convertible into newly created Series B Preferred Stock on a one-for-one (1:1) basis into shares of common stock of the Company at a fixed price per share of $0.01.

Concurrently, the Company filed a Certificate of Designation with the Delaware Secretary of State on the Series B Preferred Stock which provides, in pertinent part, for the following rights and privileges:

Authorized Amount of Series B Preferred Stock : There are authorized 30,000,000 shares of Series B Preferred Stock, subject to the Certificate of Designation. There shall be no additional Series B Shares authorized or issued.

Voting Rights : Each share of Series B shall be entitled to five (5) votes for every one (1) vote entitled to each share of Common Stock.

Rank  : All shares of Series B shall rank (i) senior to the Company’s Common Stock, (ii)  pari passu  with all other series of preferred stock whether currently outstanding or hereafter created, including the Series A Preferred Stock, and specifically ranking, by its terms, on par with Series B, and (iii) junior to any class or series of capital stock of the Company hereafter created specifically ranking, by its terms, senior to the Series B, in each case as to the distribution of assets upon liquidation, dissolution or winding up of the Company, whether voluntary or involuntary.

During the three months ended December 31, 2016, the Company recorded $4,600 of interest expense related to the notes. As of December 31, 2016, $300,000 of the Series B Notes along with $45,202 of accrued interest are outstanding. The Board of Directors authorized the designation of the Series B Preferred Stock pursuant to the authority of the Certificate of Incorporation, which confers said authority on the Board, and the issuance of the Series B Notes pursuant to a unanimous written consent of the Board dated December 10, 2015. The value ascribed to the Series B Notes were based on the fixed conversion price of the instruments into common stock and such no beneficial conversion feature was recorded. See Note 8 for subsequent events related to this note.

Settlement LiabilitIES

On or about December 1, 2016, LG Capital Funding, LLC (“LG Capital”) obtained a judgment in the amount of $151,000. On or about December 10, 2016, the Company learned that LG Capital had placed a judgment lien on the Company’s operating account. The effect of the lien was that the Company’s operating account was frozen for an amount twice the judgment, or approximately $300,000. In or around December 2016 and continuing into early January 2017, GHS Investments, LLC (“GHS”) and LG Capital negotiated a transaction whereby GHS purchased the rights to the LG Capital Convertible Promissory Note and/or the right to collect on the LG Capital judgment for $161,000. As of September 30, 2016, the Company recorded a settlement liability of $151,000.

On February 22, 2016, a convertible promissory note holder, Union Capital, LLC (“Union”), filed suit against the Company in the United States District Court for the Southern District of New York claiming breach of contract and conversion and seeking specific performance, permanent injunction, and damages arising from the Company’s rejection of certain conversion notices submitted by Union. The Company and Union subsequently settled this matter without further court proceedings for $170,000 in 2017. As of September 30, 2016, the Company recorded a settlement liability of $170,000.

Justin Braune v. Vape Holdings, Inc. et.al.

On May 16, 2017, Justin Braune, the Company’s former Chief Executive Officer filed a civil lawsuit in Los Angeles County Superior Court against the Company, Allan Viernes and Ben Beaulieu claiming breach of Mr. Braune’s employment contract, including, but not limited to failure to pay wages including deferred salary and commissions, and wages upon separation of employment and seeking damages arising from the Company’s breach. The Company and Justin Braune subsequently settled this matter without further court proceedings. On September 25, 2017, the parties participated in a full-day mediation and agreed to settle and resolve all matters including the lawsuit. On December 6, 2017, the parties entered into a Settlement Agreement whereby, the Allan Viernes and Ben Beaulieu 1) shall pay the sum of $15,000 by December 8, 2017 and the Company shall, 2) $40,000 on or before December 31, 2018, and 3) a convertible promissory note in the amount of $100,000.00. The convertible note and/or any shares issued in connection shall have a buyout cash value of no less than 125% of the cash value. The Company recorded a provision for loss of approximately $165,000 during the year ended September 30, 2016.

COMMON STOCK

On November 27, 2013, the Board and shareholders approved an increase in the authorized number of shares of common and preferred stock which may be issued by the Company to 1,000,000,000 shares and 100,000,000 shares, respectively.  On December 3, 2013, the certificate of amendment was filed with the Secretary of State of Delaware to reflect the increase in authorized.

PREFERRED STOCK  

On April 1, 2014, the Board formally approved the filing of a Preferred Stock Designation in connection with the commitment of 500,000 Series A Shares to HIVE on March 27, 2014 pursuant to its authority to issue blank check preferred stock as provided in the Company’s Certificate of Incorporation.  Per the Certificate of Designation (the “Designation”), there are 100,000,000 shares of preferred stock authorized by the Company’s Certificate of Incorporation. The Company is authorized to issue 500,000 shares of Series A Shares pursuant to the Designation.  As provided in the Designation (and as set forth in the HIVE Asset Purchase Agreement), Series A Shares are entitled to vote at a 15-1 ratio to Common Stock.  Each share of preferred stock shall initially be convertible into one share of common stock (500,000 shares of common stock in the aggregate).  On the two-year anniversary of the transaction of HIVE, the preferred stock conversion ratio shall be adjusted as follows: a one-time pro rata adjustment of up to ten-for-one (10-1) based upon the Company generating aggregate gross revenues over the two years of at least $8,000,000 (e.g. If the Company generates only $4,000,000 in aggregate gross revenues over the two-year period then the convertible ratio will adjust to 5-1). In no event will the issuance convert into more than 5,000,000 shares of common stock of the Company.

On June 19, 2014, the Company formally issued the 500,000 Series A Shares to HIVE.

The value ascribed to the Series A Shares was based on the historical costs of the assets acquired on March 27, 2014 from HIVE since the transfer of assets was made among entities under common control.

On December 10, 2015, the Company approved the filing of a Preferred Stock Designation for up to 30,000,000 shares of Series B Preferred Stock. No Series B Preferred Stock are issued or outstanding. See discussion of designation of Series B Preferred Stock in Note 5.