GNAL Generation Alpha Inc (CE)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

History and Organization

Generation Alpha, Inc. (the “Company”) was originally incorporated under the laws of the State of Nevada on March 2, 2007 as Cinjet, Inc. (“Cinjet”). Effective September 1, 2015, Cinjet changed its corporate name to Solis Tek Inc. (“Solis Tek”). Effective September 25, 2018, Solis Tek changed its corporate name to Generation Alpha, Inc. Effective September 25, 2018, Generation Alpha, Inc. (f/k/a Solis Tek Inc.) (the “Company”) entered into an agreement and plan of merger (the “Merger Agreement”), whereby a wholly-owned subsidiary of the Company (the “Merger Sub”) was merged into the Company (the “Merger”). Upon consummation of the Merger, the separate existence of Merger Sub ceased. On June 23, 2015, the Company entered into an Agreement of Merger and Plan of Reorganization (the “Agreement”) with Solis Tek Inc., a California corporation (“STI”), and CJA Acquisition Corp., a California corporation and a wholly owned subsidiary of the Company (“Merger Sub”), providing for the merger of Merger Sub with and into STI (the “Merger”), with STI surviving the Merger as a wholly-owned subsidiary of the Company. The Merger was accounted for as a recapitalization of the Company with STI being deemed the accounting acquirer.

Overview of Business

The Company is a vertically integrated technology innovator, developer, manufacturer and distributor focused on bringing products and solutions to commercial and retail cannabis growers in both the medical and adult use recreational space in legal markets across the U.S. The Company’s lighting and nutrient customers include retail stores, distributors and commercial growers in the United States and abroad.

COVID-19 Considerations

During the year ended December 31, 2020, the COVID-19 pandemic did not have a material net impact on our operating results. Although there were delays in product manufacturing and delivery from China during parts of 2020 as a result of COVID-19, manufacturing and shipping did resume later in 2020, resulting in little overall impact on operating results. We do continue to see longer lead times from product ordering to delivery. In the future, the pandemic may cause reduced demand for our products if, for example, the pandemic results in a recessionary economic environment which negatively effects the consumers who purchase our products. The Company has not observed any material impairments of its assets or a significant change in the fair value of its assets due to the COVID-19 pandemic.

Our ability to operate without significant negative operational impact from the COVID-19 pandemic will in part depend on our ability to protect our employees and our supply chain. The Company has endeavored to follow the recommended actions of government and health authorities to protect our employees. Since the onset of the COVID-19 pandemic, we maintained the consistency of our operations. However, the uncertainty resulting from the pandemic could result in an unforeseen disruption to our workforce and supply chain (for example an inability of a key supplier or transportation supplier to source and transport materials) that could negatively impact our operations.

Going Concern

The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities and commitments in the normal course of business. As reflected in the accompanying consolidated financial statements, during the year ended December 31, 2020, the Company incurred a net loss of $571,000 and used cash in operations of $499,000 and had a shareholders’ deficit of $8,736,000 as of December 31, 2020. In addition, $2,565,000 of notes payable to related parties, $531,000 of accrued interest to related parties, and $816,000 of contract obligations are past due. These factors raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date of the financial statements being issued. The ability of the Company to continue as a going concern is dependent upon the Company’s ability to raise additional funds and implement its business plan. The financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.

At December 31, 2020, the Company had cash on hand in the amount of $372,000. Management estimates that the current funds on hand will be sufficient to continue operations through September 30, 2021. The continuation of the Company as a going concern is dependent upon its ability to obtain necessary debt or equity financing to continue operations until it begins generating positive cash flow. No assurance can be given that any future financing will be available or, if available, that it will be on terms that are satisfactory to the Company. Even if the Company is able to obtain additional financing, it may contain undue restrictions on our operations, in the case of debt financing or cause substantial dilution for our stockholders, in case or equity financing.

Basis of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries: STI; Solis Tek East, Corporation (“STE”), an entity incorporated under the laws of the State of New Jersey, Zelda Horticulture, Inc. (“Zelda”), an entity incorporated under the laws of the State of California, and YLK Partners NV, LLC (“YLK”), Generation Alpha Brands, Inc., Trilogy Dispensaries, Inc., Extracting Point, LLC (“Extracting Point”), and GrowPro Solutions, Inc., all entities formed under the laws of Nevada. Intercompany transactions and balances have been eliminated in consolidation.

Use of Estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the U.S requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the financial statement date, and reported amounts of revenue and expenses during the reporting period. Significant estimates are used in valuing our allowances for doubtful accounts, reserves for inventory obsolescence, valuing derivative liabilities, valuing equity instruments issued for services, and valuation allowance for deferred tax assets, among others. Actual results could differ from these estimates.

Revenue Recognition

The Company recognizes revenue in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) 606, Revenue from Contracts with Customers (“ASC 606”). This standard provides authoritative guidance clarifying the principles for recognizing revenue and developing a common revenue standard for U.S. generally accepted accounting principles. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in the exchange for those goods or services.

Revenue is recognized when control of promised goods or services is transferred to the Company’s customers, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. The Company reviews its sales transactions to identify contractual rights, performance obligations, and transaction prices, including the allocation of prices to separate performance obligations, if applicable. Revenue and cost of sales are recognized once products are delivered to the customer’s control and performance obligations are satisfied.

All products sold by the Company are distinct individual products and consist of advanced energy efficient indoor horticulture lighting, plant nutrient products, and ancillary equipment. The products are offered for sale as finished goods only, and there are no performance obligations required post-shipment for customers to derive the expected value from them. Contracts with customers contain no incentives or discounts that could cause revenue to be allocated or adjusted over time.

The Company does not offer a general right of return on any of its sales and considers all sales as final. The Company generally provides a three-year warranty on its ballasts. However, the Company does not maintain a warranty reserve as the Company is able to chargeback its vendors for all warranty claims. As of December 31, 2020, and 2019, the Company recorded reserves for returned product in the amounts of $0 and $60,000, respectively, which reduced the accounts receivable balances as of those periods.

In the following table, revenue is disaggregated by major product line for the year ended 2020:

In the following table, revenue is disaggregated by major product line for the year ended 2019:

Accounts Receivable

Accounts receivable are recorded net of an allowance for expected losses. The Company evaluates the collectability of its trade accounts receivable based on a number of factors. In circumstances where the Company becomes aware of a specific customer’s inability to meet its financial obligations to the Company, a specific reserve for bad debts is estimated and recorded, which reduces the recognized receivable to the estimated amount the Company believes will ultimately be collected. In addition to specific customer identification of potential bad debts, bad debt charges are recorded based on the Company’s historical losses and an overall assessment of past due trade accounts receivable outstanding.

The allowance for doubtful accounts and returns is established through a provision reducing the carrying value of receivables. At December 31, 2020 and 2019, the allowance for doubtful accounts was $12,000 and $52,000, respectively.

Inventories

Inventories are stated at the lower of cost or net realizable value. Cost is computed on a first-in, first-out basis. The Company’s inventories consist almost entirely of finished goods as of December 31, 2020 and 2019.

The Company provides inventory reserves based on excess and obsolete inventories determined primarily by future demand forecasts. The write down amount is measured as the difference between the cost of the inventory and net realizable value based on upon assumptions about future demand and charged to the provision for inventory write down, which is a component of cost of sales. At the point of the loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. At December 31, 2020 and 2019, the reserve for excess and obsolete inventory was $30,000 and $125,000, respectively.

Property and Equipment

Property and equipment are carried at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets. The Company has determined the estimated useful lives of its property and equipment, as follows:

Maintenance and repairs are charged to expense as incurred. The cost and accumulated depreciation of assets sold or otherwise disposed of are removed from the related accounts and the resulting gain or loss is reflected in the statements of operations.

Management assesses the carrying value of property and equipment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If there is an indication of impairment, management prepares an estimate of future cash flows expected to result from the use of the asset and its eventual disposition. If these cash flows are less than the carrying amount of the asset, an impairment loss is recognized to write down the asset to its estimated fair value. The Company did not record an impairment loss for the years ended December 31, 2020 and 2019.

Intangible Assets

The Company accounts for intangible assets in accordance with the authoritative guidance issued by the FASB. Intangibles are valued at their fair market value and are amortized taking into account the character of the acquired intangible asset and the expected period of benefit. The Company evaluates intangible assets for impairment, at a minimum, on an annual basis and whenever events or changes in circumstances indicate that the carrying value may not be recoverable from its estimated undiscounted future cash flows. Recoverability of intangible assets is measured by comparing their net book value to the related projected undiscounted cash flows from these assets, considering a number of factors, including past operating results, budgets, economic projections, market trends and product development cycles. If the net book value of the asset exceeds the related undiscounted cash flows, the asset is considered impaired, and a second test is performed to measure the amount of impairment loss.

At December 31, 2018, the Company had intangible assets of $1,302,000 that consisted of a license right. In June 2019, and based on management’s assessment, it was determined that the intangible asset was impaired, and an impairment charge was recorded for $1,139,000 during the year ended December 31, 2019.

Leases

Prior to January 1, 2019, the Company accounted for leases under ASC 840, Accounting for Leases. Effective January 1, 2019, the Company adopted the guidance of ASC 842, Leases (“ASC 842”), which requires an entity to recognize a right of use (“ROU”) asset and a lease liability for virtually all leases. The Company adopted ASC 842 using a modified retrospective approach. The adoption of ASC 842 on January 1, 2019 resulted in the recognition of operating lease ROU assets and lease liabilities for operating leases of $645,000. There was no cumulative-effect adjustment to accumulated deficit.

Income Taxes

Income tax expense is based on pretax financial accounting income. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts. Valuation allowances are recorded to reduce deferred tax assets to the amount that will more likely than not be realized. The Company has recorded a valuation allowance against its deferred tax assets as of December 31, 2020 and 2019.

The Company accounts for uncertainty in income taxes using 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 than 50 percent likely of being realized upon settlement. The Company classifies the liability for unrecognized tax benefits as current to the extent that the Company anticipates payment (or receipt) of cash within one year. Interest and penalties related to uncertain tax positions are recognized in the provision for income taxes.

Derivative Financial Instruments

The Company evaluates its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the consolidated statements of operations. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the end of each reporting period. Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date.

Research and Development

Research and development costs are expensed in the period incurred. The costs primarily consist of personnel and supplies.

Shipping and Handling Costs

The Company’s shipping and handling costs relating to inbound freight are reported as cost of goods sold in the consolidated Statements of Operations, while shipping and handling costs relating to outbound freight are reported as selling, general and administrative expenses in the consolidated Statements of Operations. The Company classifies amounts billed to customers for shipping fees as revenues.

Fair Value Measurements

The Company determines the fair value of its assets and liabilities based on the exchange price in U.S. dollars that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs. The Company uses a fair value hierarchy with three levels of inputs, of which the first two are considered observable and the last unobservable, to measure fair value:

The carrying amounts of financial instruments such as cash, accounts receivable, inventories, and accounts payable and accrued liabilities, approximate the related fair values due to the short-term maturities of these instruments. The carrying values of notes payable approximate their fair values due to the fact that the interest rates on these obligations are based on prevailing market interest rates.

The fair value of the derivative liabilities of $2,161,000 and $1,332,000 at December 31, 2020 and 2019, respectively, was valued using Level 2 inputs.

Loss per Share Calculations

Basic earnings per share are computed by dividing net income (loss) available to common shareholders by the weighted-average number of common shares available. Diluted earnings per share is computed by dividing the net income applicable to common shareholders by the weighted average number of common shares outstanding plus the number of additional common shares that would have been outstanding if all dilutive potential common shares had been issued using the treasury stock method. Potential common shares are excluded from the computation when their effect is antidilutive. The dilutive effect of potentially dilutive securities is reflected in diluted net income per share if the exercise prices were lower than the average fair market value of common shares during the reporting period.

Options to acquire 10,002,210 shares of common stock, warrants to acquire 28,283,140 shares of common stock, and 173,780,295 shares of common stock issuable under convertible note agreements, have been excluded from the calculation of weighted average common shares outstanding at December 31, 2020, as their effect would have been anti-dilutive. Options to acquire 1,948,300 shares of common stock, warrants to acquire 18,283,140 shares of common stock, and 37,994,931 shares of common stock issuable under convertible note agreements, have been excluded from the calculation of weighted average common shares outstanding at December 31, 2019, as their effect would have been anti-dilutive.

Concentration Risks

Cash includes cash on hand and cash in banks and are reported as “Cash” in the consolidated balance sheets. At December 31, 2020 and December 31, 2019, cash includes cash on hand of $289,000 and $12,000, respectively, and cash in banks of $83,000 and $92,000, respectively. The balance of cash on hand is not insured by the Federal Deposit Insurance Corporation. The balance of cash in banks is insured by the Federal Deposit Insurance Corporation for up to $250,000.

The Company operates in markets that are highly competitive and rapidly changing. Significant technological changes, shifting customer needs, the emergence of competitive products or services with new capabilities, and other factors could negatively impact the Company’s operating results. State and federal government laws could have a material adverse impact on the Company’s future revenues and results of operations.

The Company’s products require specific components that currently are available from a limited number of sources. The Company purchases some of its key products and components from single vendors. During the years ended December 31, 2020 and 2019, its ballasts, lamps, and reflectors, which comprised the clear majority of the Company’s purchases during those periods, were each only purchased from one separate vendor.

The Company performs a regular review of customer activity and associated credit risks and does not require collateral or other arrangements. There were no customers that accounted for more than 10% of the Company’s revenue for the years ended December 31, 2020 and 2019. Shipments to customers outside the United States comprised less than 5% of our sales for the years ended December 31, 2020 and 2019, respectively.

As of December 31, 2020, three customers accounted for 37%, 23%, and 15% of the Company’s trade accounts receivable balance, and as of December 31, 2019, two customers accounted for 24% and 10% of the Company’s trade accounts receivable balance.

Segment Reporting

The Company operates in one segment for the manufacture and distribution of our products. In accordance with the “Segment Reporting” Topic of the ASC, the Company’s chief operating decision maker has been identified as the Chief Executive Officer and President, who reviews operating results to make decisions about allocating resources and assessing performance for the entire Company. Existing guidance, which is based on a management approach to segment reporting, establishes requirements to report selected segment information quarterly and to report annually entity-wide disclosures about products and services, major customers, and the countries in which the entity holds material assets and reports revenue. All material operating units qualify for aggregation under “Segment Reporting” due to their similar customer base and similarities in: economic characteristics; nature of products and services; and procurement, manufacturing and distribution processes. Since the Company operates in one segment, all financial information required by “Segment Reporting” can be found in the accompanying consolidated financial statements.

Recently Issued Accounting Pronouncements

In June 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments. ASU 2016-13 requires entities to use a forward-looking approach based on current expected credit losses (“CECL”) to estimate credit losses on certain types of financial instruments, including trade receivables. This may result in the earlier recognition of allowances for losses. ASU 2016-13 is effective for the Company beginning January 1, 2023, and early adoption is permitted. The Company does not believe the potential impact of the new guidance and related codification improvements will be material to its financial position, results of operations and cash flows.

In August 2020, the FASB issued ASU No. 2020-06 (“ASU 2020-06”) “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity.” ASU 2020-06 will simplify the accounting for convertible instruments by reducing the number of accounting models for convertible debt instruments and convertible preferred stock. Limiting the accounting models will result in fewer embedded conversion features being separately recognized from the host contract as compared with current GAAP. Convertible instruments that continue to be subject to separation models are (1) those with embedded conversion features that are not clearly and closely related to the host contract, that meet the definition of a derivative, and that do not qualify for a scope exception from derivative accounting and (2) convertible debt instruments issued with substantial premiums for which the premiums are recorded as paid-in capital. ASU 2020-06 also amends the guidance for the derivatives scope exception for contracts in an entity’s own equity to reduce form-over-substance-based accounting conclusions. ASU 2020-06 will be effective for the Company beginning January 1, 2024. Early adoption is permitted, but no earlier than January 1, 2021, including interim periods within that year. Management is currently evaluating the effect of the adoption of ASU 2020-06 on the consolidated financial statements, but currently does not believe ASU 2020-06 will have a significant impact on the Company’s accounting for its convertible debt instruments. The effect will largely depend on the composition and terms of the financial instruments at the time of adoption.

Other recent accounting pronouncements issued by the FASB, its Emerging Issues Task Force, the American Institute of Certified Public Accountants, and the Securities and Exchange Commission did not or are not believed by management to have a material impact on the Company’s present or future financial statements.

Depreciation expense for the years ended December 31, 2020 and 2019 was $7,000 and $33,000, respectively.

During the year ended December 31, 2020, the Company disposed of fully depreciated property and equipment of $14,000. During the year ended December 31, 2019, the Company disposed of property and equipment with a book value of $7,000, resulting in a loss on the disposal of property and equipment of $7,000.

In February 2019, the Company terminated its Arizona facility lease thereby abandoning of leasehold improvements with a remaining unamortized balance of $217,000. The Company recorded the abandonment of leasehold improvements of $217,000 during the year ended December 31, 2019 as a component of operating expense in the consolidated statement of operations (see Note 5).

NOTE 3 – CONTRACT OBLIGATION ACQUIRED FROM RELATED PARTIES

In May 2018, the Company entered into an acquisition agreement with the members, which in the aggregate, owned 100% of the membership interests in YLK, a related party. The major asset of YLK is a Cultivation Management Services Agreement (the “Management Agreement”) with an Arizona licensee that was entered into on January 5, 2018. During the year ended December 31, 2019, the Company determined the acquired assets were fully impaired, and recorded an impairment charge of $1,139,000 accordingly. The Company has a continuing obligation under the Management Agreement of $799,000 (net of discount of $51,000) as of December 31, 2019. As of December 31, 2020, the remaining Management Agreement obligation was $816,000 (net of discount of $34,000) and is reflected as a current liability in the accompanying consolidated balance sheet. As of December 31, 2020, the Company is past due on its installment payments obligations under the Management Agreement.

At December 31, 2019, accrued interest on the notes payable to related parties was $149,000. During the year ended December 31, 2020, the Company added $70,000 of additional accrued interest, and made interest payments of $32,000, leaving an accrued interest on the notes payable to related parties balance of $187,000 at December 31, 2020.

NOTE 5 – LEASE PAYABLE

In 2019, our principal executive offices and warehouse were located at 853 Sandhill Avenue, Carson, California, 90746. We occupied a 17,640 square foot facility pursuant to a five-year lease with an independent party ending on June 30, 2023, pursuant to which we paid $15,000 per month in rental charges. On December 31, 2019, we abandoned our Carson, California lease. The Company remains obligated under its Carson, California lease, until such time the landlord releases us from our lease agreement. Based on the abandonment, the Company determined its ROU asset was impaired and recorded an impairment charge of $100,000 during the year ended December 31, 2019. During the year ended December 31, 2020, management determined it no longer had access to the Carson, California facility, and recorded an impairment charge for the remaining ROU asset balance of $427,000, which was charged to operating expenses in the consolidated statements of operations for the year ended December 31, 2020. As of the date of this report, the Company has not been released from the lease agreement, and no lease payments were made during the year ended December 31, 2020. The remaining balance of the lease obligation was $556,000 at both December 31, 2020 and 2019.

On January 1, 2020, the Company relocated its principal executive offices and warehouse to 1689-A Arrow Rt., Upland, California, 91786. The Upland, California lease is for a 2,974 square foot facility pursuant to a three-year lease with an independent party ending on January 31, 2023, pursuant to which it pays $2,800 per month in rental charges. On January 1, 2020, the Company recognized an operating lease ROU asset and lease liability of $89,000, related to the Upland, California operating lease. During the year ended December 31, 2020, the Company reflected amortization of the ROU assets of $26,000 related to its Upland, California operating lease, resulting in an ROU asset balance of $63,000 as of December 31, 2020.

As of December 31, 2019, liabilities recorded under operating leases were $556,000. During the year ended December 31, 2020, the Company added $89,000 in lease liabilities related to its Upland, California operating lease, and made lease payments of $23,000 towards its operating lease liability. As of December 31, 2020, liabilities under operating leases amounted to $622,000, of which $440,000 were reflected as current due.

The lease agreements above have a weighted average remaining lease term of 3.50 years as of December 31, 2020. Leases with an initial term of 12 months or less are not recorded on the balance sheet. The Company accounts for the lease and non-lease components of its leases as a single lease component. Rent expense is recognized on a straight-line basis over the lease term.

Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Generally, the implicit rate of interest in arrangements is not readily determinable and the Company utilizes its incremental borrowing rate in determining the present value of lease payments. The Company’s incremental borrowing rate is a hypothetical rate based on its understanding of what its credit rating would be. The operating lease ROU asset includes any lease payments made and excludes lease incentives.

The components of rent expense and supplemental cash flow information related to leases for the period are as follows:

The supplemental balance sheet information related to leases for the period is as follows:

Maturities of the Company’s lease liabilities are as follows:

Rent expense for the twelve months ended December 31, 2020 and 2019 was $36,000 and $316,000, respectively.

NOTE 6 – LEGAL OBLIGATIONS PAYABLE

Lease Abandonment Settlement

On February 15, 2019, MSCP, L.L.C (“MSCP”), filed suit in the Superior Court of Arizona, County of Maricopa, Case No. CV2019-001613 against the Company and YLK. The case arises from YLK’s alleged breach of a certain lease agreement dated May 19, 2018 (the “Lease”), for the lease of certain real property located at 4301 W. Buckeye Road, Phoenix, Arizona 85043 (the “Premises”), between MSCP and YLK, which the Company guaranteed. MSCP filed the lawsuit after YLK provided a notice of termination for, amongst other reasons, MSCP’s failure to disclose various material information regarding code, safety, structural and other issues in the Premises that rendered the Premises unsuitable for use, unless the Company undertook significant and extraneous costs that were not contemplated under the Lease to remedy said issues in and outside of the Premises. MSCP’s complaint alleged counts for breach of lease and waste and breach of guaranty. MSCP is seeking compensatory damages, rents and other charges due under the lease, and attorney’s fees and costs. The Company just recently filed its answer denying the allegations as well as having filed counterclaims for fraud in the inducement, negligent misrepresentation, breach of the implied covenant of good faith and fair dealing, rescission of contract, unjust enrichment and punitive damages. On December 12, 2019, MSCP was awarded a default judgment against the Company in the amount of $1,487,000, which is recorded as a charge to operating expenses in the consolidated statements of operations for the year ended December 31, 2019. During the year ended December 31, 2020, interest of $147,000 was added, leaving a balance owed of $1,634,000, for which the Company negotiated a settlement for a total consideration of $193,000 and recorded a gain on the settlement of legal obligations of $1,441,000. The $193,000 settlement payments were comprised of $150,000 in cash, and the issuance of 3,333,333 shares of the Company’s common stock valued at $43,000.

Employment Matter Judgment

On or about June 25, 2018, Matthew Geschke (the “Plaintiff”) filed a breach of contract case against the Company in the San Diego Superior Court of San Diego, California. The Plaintiff claimed damages for breach of an employment contract when the Company terminated the Plaintiff’s employment agreement on February 22, 2018. On June 26, 2020, the Plaintiff was awarded a default judgment against the Company in the amount of $448,000. No payments were made during the year ended December 31, 2020.

On September 27, 2019, Dennis Forchic (the “Plaintiff”) filed a breach of contract case against the Company in the Los Angeles Superior Court of Los Angeles, California, under case number 19STCV34592, alleging that the Company wrongfully terminated the Plaintiff’s employment agreement on February 5, 2018. The Plaintiff claims damages of $646,000 for unpaid severance, unpaid reimbursed expenses, and unpaid health benefits. In addition, the Plaintiff claims damages for failing to compensate Plaintiff for 3,000,000 stock options which vested on termination. As of December 31, 2018, the Company had recorded $588,000 related to this matter. On March 3, 2020, the Plaintiff was awarded a judgment against the Company in the amount of $646,000, plus post judgment interest, as well as the vesting of options to purchase 1,000,000 shares of the Company’s common stock. During the year ended December 31, 2019, the Company recorded an additional $58,000 of legal expenses, leaving a total balance due to Plaintiff of $646,000 at December 31, 2019. During the year ended December 31, 2020, interest of $38,000 was added, leaving a balance owed of $684,000, for which the Company negotiated a settlement for a total cash consideration of $165,000 and recorded a gain on the settlement of legal obligations of $519,000.

Breach of Contract

On September 12, 2019, DPA, Inc., or DPA, filed suit in the Superior Court of Arizona, County of Maricopa, Case No. CV2019-008265 against us. The plaintiff alleges the Company breached an agreement to pay DPA for architectural design services related to a facility in Arizona and has requested a judgment for $252,000 plus interest. On September 18, 2019, the DPA was awarded a judgment against the Company for $252,000 plus interest at 18% per annum from June 6, 2019 until paid. During the year ended December 31, 2019, interest of $22,000 was added, leaving a balance owed of $274,000 at December 31, 2019. During the year ended December 31, 2020, interest of $26,000 was added, leaving a balance owed of $300,000, for which the Company negotiated a settlement for a total consideration of $37,000 and recorded a gain on the settlement of legal obligations of $263,000. The $37,000 settlement payments were comprised of $20,000 in cash, and the issuance of 1,000,000 shares of the Company’s common stock valued at $17,000.

On August 7, 2019, Rose Law Group PC (“RLG”) filed a breach of contract case against the Company in the Superior Court of the State of Arizona, County of Maricopa, Case No. CV2019-008484 against the Company. RLG alleges breach of a contract to pay RLG for legal representation, and requested a judgment for $144,000. On October 17, 2019, RLG was awarded judgment against the Company for $150,000 plus interest at 12% per annum until paid. During the year ended December 31, 2020, additional settlement-related expenses of $7,000, and interest of $12,000 was added, leaving a balance owed of $162,000, for which the Company negotiated a settlement for a total cash consideration of $15,000 and recorded a gain on the settlement of legal obligations of $147,000.

On May 10, 2018 and October 29, 2019, the Company issued convertible secured debentures (“Notes”) to YA II PN Ltd. (“YA II PN”) in the principal amounts of $1,500,000 and $275,000, respectively, with interest rates of 8% and 10%, respectively, which matured in June 2020 and April 2020, respectively. The notes are currently past due. The Company is in discussion with YA II PN to extend the maturity date of the Notes. The Notes provide a conversion right, in which the principal amount of the Note, together with any accrued but unpaid interest, could be converted into the Company’s common stock at a conversion price at 75% of the lowest volume weighted average price (VWAP) of the Company’s Common Stock during the 10 trading days immediately preceding the conversion date. As part of the issuance, the Company also granted YA II PN 5-year warrants, which were modified, to purchase a total of 13,000,000 shares of the Company at an exercise price of $0.05 per share, with expiration dates ranging from May 2024 to December 2024.

During the year ended December 31, 2019, the Company twice entered into an amendment agreement with YA II, PN, which amended the secured promissory note in the principal face amount of $1.5 million issued on May 10, 2018 (the “Note”). The maturity date of the Note was first extended to August 9, 2019 and then to June 30, 2020. Furthermore, the Note was first amended to be converted into the Company’s common stock at a conversion price of $0.50 a share, as the Note was not convertible previously, and the Note was further amended to provide a conversion right, in which the principal amount of the Note, together with any accrued but unpaid interest, could be converted into the Company’s common stock at a conversion price at 75% of the lowest volume weighted average price (VWAP) of the Company Common Stock during the 10 trading days immediately preceding the conversion date. The Company calculated the fair market value of the Secured Note Payable before and after the modifications above and recorded the difference of $962,000 as a debt extinguishment cost and included in other expenses during the twelve months ended December 31, 2019.

The 7,500,000 warrants granted as part of the Note issuances were also twice modified to ultimately change the exercise price from $0.50 per share (1,000,000 warrants), $0.75 per share (2,250,000 warrants), $1.00 per share (2,250,000 warrants) and $1.25 per share (2,000,000 warrants) to $0.05 per share for all four warrants. Furthermore, the amendments removed the Company’s right of redemption and right to compel exercise on certain Warrants. The Company calculated the fair market value of the Warrants before and after the modifications above and recorded the difference of $194,000 as a financing cost included in other expenses during the twelve months ended December 31, 2019.

On February 13, 2020, the Company issued a note (the “2020 Note”) to YAII PN in the amount of $150,000. The 2020 Note bears interest at a rate of 10% per annum (15% on default) and has a maturity date of August 10, 2021. The Company received net proceeds of $125,000, net of closing costs of $25,000. The 2020 Note is secured by all the assets of the Company and its subsidiaries. The 2020 Note provides a conversion right, in which any portion of the principal amount of the 2020 Note, together with any accrued but unpaid interest, may be converted into the Company’s common stock at a conversion price equal to 75% of the lowest VWAP of the Company’s common stock during the ten (10) trading days immediately preceding the date of conversion, subject to adjustment. As such, the Company determined that the conversion feature created a derivative with a fair value of $109,000 at the date of issuance. The Company also granted YA II PN 5-year warrants with a fair value of $66,000, to purchase a total of 3,000,000 shares of the Company at an exercise price of $0.05 per common share. The aggregate amount of the closing costs, and the fair value of the derivative liability, was $177,000, of which $150,000 was recorded as a valuation discount on the 2020 Note to be amortized over the life of the 2020 Note, and $27,000 was recorded as a financing cost during the year ended December 31, 2020.

On September 23, 2020, the Company issued a note (the “September 2020 Note”) to YAII PN in the amount of $350,000. The September 2020 Note bears interest at a rate of 10% per annum (15% on default) and has a maturity date of March 23, 2021. The Company received net proceeds of $340,000, net of closing costs of $10,000. The September 2020 Note is secured by all the assets of the Company and its subsidiaries. The September 2020 Note provides a conversion right, in which any portion of the principal amount of the September 2020 Note, together with any accrued but unpaid interest, may be converted into the Company’s common stock at a conversion price equal to 75% of the lowest VWAP of the Company’s common stock during the ten (10) trading days immediately preceding the date of conversion, subject to adjustment. As such, the Company determined that the conversion feature created a derivative with a fair value of $322,000 at the date of issuance. The Company also granted YA II PN 5-year warrants with a fair value of $68,000, to purchase a total of 7,000,000 shares of the Company at an exercise price of $0.05 per common share. The aggregate amount of the closing costs, and the fair value of the warrants and derivative liability, was $389,000, of which $350,000 was recorded as a valuation discount on the September 2020 Note to be amortized over the life of the September 2020 Note, and $39,000 was recorded as a financing cost during the year ended December 31, 2020.

During the year ended December 31, 2019, amortization of valuation discount was $89,000 and was recorded as an interest cost, leaving a $178,000 remaining unamortized balance of the valuation discount at December 31, 2019. During the year ended December 31, 2020, valuation discounts of $500,000 were added as discussed above, and amortization of valuation discount of $458,000 was recorded as an interest cost, leaving a $220,000 remaining unamortized balance of the valuation discount at December 31, 2020.

At December 31, 2019, accrued interest on the convertible secured notes payable to related parties of $202,000 was included in accrued interest to related parties on the consolidated balance sheet. During the year ended December 31, 2020, interest of $29,000 was converted into common stock (see Note 11), and the Company added $171,000 of additional accrued interest, leaving an accrued interest to related parties balance of $344,000 at December 31, 2020.

As of December 31, 2020, 239,274,957 shares of common stock were potentially issuable under the conversion terms of the convertible secured notes.

NOTE 9 – ACQUISITION OF FACILITY, LOAN AGREEMENT, AND SUBSEQUENT SETTLEMENT

Acquisition of Facility

On April 2, 2019, the Company, through its wholly-owned subsidiary Extracting Point, entered into an agreement to purchase real property located at 2601 West Holly Street in Phoenix, Arizona (the “Property”) for $3,500,000. The Property held the approval and authorization for a Conditional Use Permit, which allowed the Property to be used for the operation of a cultivation and infusion facility, allowing for the cultivation, harvesting, preparation, packaging and storing of medical cannabis, as well as extraction, refinement, infusion, production, preparation, packaging, and storage of manufactured and derivative oils, waxes, concentrates, edible and non-edible products that contain cannabis.

Loan Agreement

On April 2, 2019, Extracting Point entered into a loan agreement (the “Loan Agreement”) with Michael Cannon and Jennifer Cannon, Trustees of the Core 4 Trust Dated February 29, 2016 (the “Lender”), pursuant to which Extracting Point borrowed $3,500,000 from the Lender (the “Loan”). The Loan was evidenced by an installment note – interest included (the “Note”), guaranteed by the Company pursuant to a corporate guaranty (the “Guaranty”) and was secured by a first priority lien on the Property pursuant to a deed of trust and assignment of rents between Extracting Point and Thomas Title & Escrow, for the benefit of the Lender (the “Deed of Trust”). Extracting Point used the net proceeds from the Loan to acquire the Property.

The Note, together with accrued and unpaid interest, was due and payable on March 31, 2024 (the “Maturity Date”). Interest on the Note was to accrue at the rate of 10% per annum. For the first 12 months, Extracting Point was to pay the Lender interest only of $29,167 per month. After the first 12 months, Extracting Point was to pay the Lender principal and interest of $88,769 per month. Extracting Point had the right to prepay the Note at any time, however, Extracting Point agreed to pay the first 36 months of interest, even if the Note was repaid prior to that date.

As additional consideration for the issuance of the Loan, Extracting Point and the Company agreed to pay the Lender an amount equal to five percent (5%) of the management fees (the “Management Royalty”) received relating to the services rendered on the Property, for a period of three years from the date an “Approval to Operate” is granted by the Arizona Department of Health Services (such date, the “Commencement Date”). In the event that the Commencement Date has not occurred on or prior to April 2, 2021, then Extracting Point and the Company agreed to pay the Lender an amount equal to five percent (5%) of the fair market value of the rent of the Property as if the Property was fully occupied (the “Rental Royalty”), such payments to be made each month for a period of thirty-nine months, provided, that, if the Commencement Date occurs after the Rental Royalty has commenced, the Rental Royalty payments shall cease and the Management Royalty payments shall commence, and any amounts paid as a Rental Royalty shall be credited against any Management Royalty owed.

In connection with the Loan, the Company issued to the Lender a warrant (the “Warrant”) to purchase 1,000,000 shares of the Company’s common stock, exercisable for five years from issuance at an exercise price of $1.00 per share. The Warrant exercise price is subject to adjustment only in the event of a stock dividend or split.

Extracting Point was delinquent in payment under the Note, and the Lender informed Extracting Point and the Company that unless payment was made current or an agreement reached between the parties, the Lender would declare Extracting Point in default, call the entire Note due and payable, record a notice of default of the Deed of Trust, and take any other actions it deemed necessary or appropriate against the Company and Extracting Point.

Settlement Agreement

On May 24, 2019, the Company and Extracting Point entered into a Deed in Lieu of Foreclosure Release and Settlement Agreement (the “Settlement Agreement”) with the Lender. Pursuant to the Settlement Agreement, Extracting Point executed a Deed in Lieu of Foreclosure (the “Deed”), conveying the real property located at 2601 West Holly Street in Phoenix, Arizona to the Lender.

In exchange, the Lender agreed to release the Company and Extracting Point from all their obligations under the Loan Agreement, the Note, the Deed of Trust and the Guaranty. Pursuant to the Settlement Agreement, the Loan Agreement, the Note, the Deed of Trust and the Guaranty were terminated. In addition, the Warrant was returned to the Company and canceled.

NOTE 10 – DERIVATIVE LIABILITY

The FASB has issued authoritative guidance whereby instruments which do not have fixed settlement provisions are deemed to be derivative instruments. The conversion prices and the exercise prices of the notes as described in Note 8 were not a fixed amount because they were either subject to an adjustment based on the occurrence of future offerings or events or they were variable. Since the number of shares is not explicitly limited, the Company is unable to conclude that enough authorized and unissued shares are available to settle the conversion option. In accordance with the FASB authoritative guidance, the conversion features of the notes have been characterized as derivative liabilities to be re-measured at the end of every reporting period with the change in value reported in the statement of operations.

As of December 31, 2020, and 2019, the derivative liabilities were valued using either a probability weighted average Monte Carlo pricing model or the Black Scholes pricing model with the following assumptions:

The risk-free interest rate was based on rates established by the Federal Reserve Bank. The Company uses the historical volatility of its common stock to estimate the future volatility for its common stock. The expected life of the conversion feature of the notes was based on the remaining term of the notes. The expected dividend yield was based on the fact that the Company has not customarily paid dividends in the past and does not expect to pay dividends in the future.

The balance of the derivative liability at December 31, 2019 was $1,332,000. During the year ended December 31, 2020, the Company recognized derivative liabilities of $431,000 upon issuance of a secured convertible notes (see Note 8), and recognized $398,000 as other expense, which represented the change in the fair value of the derivative from the respective prior period, leaving a $2,161,000 balance of the derivative liability at December 31, 2020.

During the prior years, the Company issued 7,950,000 warrants as part of its Convertible Notes and Series A preferred stock financings. The Company determined that the exercises prices of the warrants were not a fixed amount because they were subject to an adjustment based on the occurrence of future offerings or events. As a result, the Company had determined at issuance that the warrants should be classified as liabilities due to variability in shares to be issued and changes in exercise price due to down round protection. The fair value of these liabilities at December 31, 2018 was $2,161,000. During the year ended December 31, 2019, the Company adopted ASU 2017-11, which simplified the accounting for financial instruments with down round features. The adoption resulted in the reclassification of the Company’s derivative liability to equity of $2,161,000 as of January 1, 2019.

During the year ended December 31, 2019, the Company recognized derivative liabilities of $167,000 upon issuance of a secured convertible note (see Note 8), and recognized $203,000 as other expense, which represented the change in the fair value of the derivative from the respective prior period. In addition, the Company recognized a derivative liability of $962,000 that resulted from a change in the terms of two convertible notes that was recorded as a financing cost and included in other expense. The balance of the derivative liability at December 31, 2019 was $1,332,000.

NOTE 11 – SHAREHOLDERS’ EQUITY

Common Shares Issued on Conversion of Convertible Note Payable

During the year ended December 31, 2020, the Company was notified by YA II PN (see Note 8) in writing of their election to convert $29,000 of interest accrued on convertible notes payable into 2,287,066 shares of the Company’s common at a conversion price of $0.0127 per share. As the closing trading price on date of conversion was $0.05 per share, the fair market value of the shares issued on conversion of interest was $114,000. The Company recorded a loss on extinguishment of accrued interest of $85,000, which represents the difference between the fair market value of the shares issued of $114,000, and the carrying value of the accrued interest of $29,000, which is included as a component of other expense on the consolidated statements of operations for the year ended December 31, 2020.

Common Shares Issued to Directors

The Company appointed certain directors and issued shares as part of their director compensation agreements. During the years ended December 31, 2020 and 2019, the Company issued an aggregate of 6,116,867 and 600,000 shares of common stock, with a fair value of $92,000 and $78,000 at date of grant, respectively, which was recognized as compensation cost.

Common Shares Issued for Services

The Company entered into various consulting agreements with third parties (“Consultants”) pursuant to which these Consultants provided business development, sales promotion, introduction to new business opportunities, strategic analysis and sales and marketing activities. No shares for services were issued for the year ended December 31, 2020. During the year ended December 31, 2019, the Company issued an aggregate of 426,000 shares of common stock to these consultants, with a fair value of $178,000 at date of grant.

Common Shares Issued for Legal Judgments

During the year ended December 31, 2020, the Company issued an aggregate of 4,333,333 shares of common stock, with a fair value of $60,000 at the date of grant, as settlement of certain legal judgments (see Note 6).

2018 Stock Incentive Plan

On November 30, 2018, the 2018 Stock Incentive Plan (the “Plan”) for officers, employees, non-employee members of the Board of Directors, and consultants of the Company was approved pursuant to a Joint Written Consent of the Board of Directors and Majority Stockholders of the Company. The Plan authorized the granting of not more than 10,000,000 restricted shares, stock appreciation rights (“SAR’s”), and incentive and non-qualified stock options to purchase shares of the Company’s common stock. The Plan provided that stock options or SAR’s granted can be exercisable immediately as of the effective date of the applicable agreement, or in accordance with a schedule or performance criteria as may be set in the applicable agreement. The exercise price for non-qualified stock options or SAR’s would be the amount specified in the agreement, but shall not be less than the fair value of the Company’s common stock at the date of the grant. The maximum term of options and SARs granted under the plan is ten years. During the years ended December 31, 2020 and 2019, the Company issued 8,068,910 and 833,300 options to purchase shares of its common stock under the Plan, and 15,000 and 7,279,391 were forfeited, respectively. As of December 31, 2020, options to purchase 2,920,867 shares of common stock remain reserved for issuance under the Plan.