The accompanying notes are an integral part
of these consolidated financial statements.
The accompanying notes are an integral part
of these consolidated financial statements.
NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2018
AND 2017
1.
|
Description of Business
|
Description of Business
QS Energy, Inc. (“QS
Energy”, “Company”) was incorporated on February 18, 1998, as a Nevada Corporation under the name Mandalay Capital
Corporation. The Company changed its name to Save the World Air, Inc. on February 11, 1999. Effective August 11, 2015, the Company
changed its name to QS Energy, Inc. The Company’s common stock is quoted under the symbol “QSEP” on the Over-the-Counter
Bulletin Board. More information including the Company’s fact sheet, logos and media articles are available at our corporate
website, www.qsenergy.com.
QS Energy develops
and commercializes energy efficiency technologies that assist in meeting increasing global energy demands, improving the economics
of oil extraction and transport, and reducing greenhouse gas emissions. The Company's intellectual properties include a portfolio
of domestic and international patents and patents pending, a substantial portion of which have been developed in conjunction with
and exclusively licensed from Temple University of Philadelphia, PA (“Temple”). QS Energy's primary technology is called
Applied Oil Technology (AOT), a commercial-grade crude oil pipeline transportation flow-assurance product. Engineered specifically
to reduce pipeline pressure loss, increase pipeline flow rate and capacity, and reduce shippers’ reliance on diluents and
drag reducing agents to meet pipeline maximum viscosity requirements, AOT is a 100% solid-state system that reduces crude oil viscosity
by applying a high intensity electrical field to crude oil feedstock while in transit. The AOT product has transitioned from the
research and development stage to initial production for continued testing in advance of our goal of seeking acceptance and adoption
by the midstream pipeline marketplace.
The Company also began
commercial development of a suite of products based around the Joule Heat technology. The Company began fabrication of prototype
equipment to be operated under a joint development agreement with a commercial entity in the fourth quarter of 2014. The Company’s
first Joule Heat prototype was installed for testing purposes at the Newfield facility in June 2015 and the system was operational;
however, changes to the prototype configuration will be required to determine commercial effectiveness of this unit. In addition,
the Company filed two additional provisional patents related to the technology’s method and apparatus. In December 2015,
we temporarily suspended Joule Heat development activities to focus Company resources on finalizing commercial development of the
AOT Midstream. We currently plan to resume Joule Heat development in in the future depending on the availability of sufficient
capital and other resources.
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 twelve-months ended December 31, 2018, the Company incurred a net loss of $3,059,000, used cash in operations of $1,476,000
and had a stockholders’ deficit of $1,482,000 as of that date. These factors raise substantial doubt about the Company’s
ability to continue as a going concern within one year after the date that the financial statements are 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, 2018,
the Company had cash on hand in the amount of $1,153,000. Management estimates that the current funds on hand will be sufficient
to continue operations through September 2019. We will need to raise additional funds in in 2019 and beyond, primarily through
the issuance of debt and equity securities for cash to operate our business, including without limitation the expenses it will
incur in connection with the license and research and development agreements with Temple University; costs associated with product
development and commercialization of the AOT technology; costs to manufacture and ship the products; costs of maintaining our status
as a public company by filing periodic reports with the SEC and costs required to protect our intellectual property. In addition,
as discussed below, the Company has substantial contractual commitments, including without limitation, payment of license and other
fees to Temple University, salaries to our executive officers pursuant to employment agreements, certain payments to a former officer
and consulting fees, during the remainder of 2019 and beyond.
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 of equity financing.
2.
|
Summary of Significant Accounting Policies
|
Consolidation Policy
The accompanying consolidated
financial statements of QS Energy Inc. include the accounts of QS Energy Inc. (the Parent) and its wholly owned subsidiaries, QS
Energy Pool, Inc. and STWA Asia Pte. Limited. Intercompany transactions and balances have been eliminated in consolidation.
Revenue Recognition Policy
Under its business
plan, the Company anticipates the leasing its primary technology. The Company will recognize lease revenue ratably over the life
of the lease upon commencement of the lease. Revenue on future product sales will be recognized in accordance with Accounting Standards
Update (ASU) No. 2014-09, Revenue from Contracts with Customers. ASU 2014-09 is a comprehensive revenue recognition standard that
supersedes nearly all existing revenue recognition guidance under current U.S. GAAP and replaces it with a principle-based approach
or determining revenue recognition. ASU 2014-09 will require that companies recognize revenue based on the value of transferred
goods or services as they occur in the contract. The ASU also will require additional disclosure about the nature, amount, timing
and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments
and assets recognized from costs incurred to obtain or fulfill a contract.
Property and Equipment and Depreciation
Property and equipment
are stated at cost. Depreciation is computed using the straight-line method based on the estimated useful lives of the assets,
generally ranging from three to ten years. Expenditures for major renewals and improvements that extend the useful lives of property
and equipment are capitalized. Expenditures for repairs and maintenance are charged to expense as incurred. Leasehold improvements
are amortized using the straight-line method over the shorter of the estimated useful life of the asset or the lease term.
Impairment of Long-lived Assets
Our long-lived assets,
such as property and equipment, are reviewed for impairment at least annually, or when events and circumstances indicate that depreciable
or amortizable long-lived assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are
less than the carrying amount of those assets. When specific assets are determined to be unrecoverable, the cost basis of the asset
is reduced to reflect the current value.
We use various assumptions
in determining the current fair value of these assets, including future expected cash flows and discount rates, as well as other
fair value measures. Our impairment loss calculations require us to apply judgment in estimating future cash flows, including forecasting
useful lives of the assets and selecting the discount rate that reflects the risk inherent in future cash flows.
If actual results are
not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be exposed
to future impairment losses that could be material to our results. Based upon management’s annual review, no impairments
were recorded for the years ended December 31, 2018, and 2017.
Loss per Share
Basic loss per share
is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during
the period. Diluted loss per share reflects the potential dilution, using the treasury stock method that could occur if securities
or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock
that then shared in the loss of the Company. In computing diluted loss per share, the treasury stock method assumes that outstanding
options and warrants are exercised, and the proceeds are used to purchase common stock at the average market price during the period.
Options and warrants may have a dilutive effect under the treasury stock method only when the average market price of the common
stock during the period exceeds the exercise price of the options and warrants.
For the years ended
December 31, 2018 and 2017, the dilutive impact of outstanding stock options of 35,301,300 shares and 35,397,675 shares; outstanding
warrants of 21,055,355 shares and 17,622,437 shares; and notes convertible into 36,477,375 and 4,847,333 shares of our common stock,
respectively, have been excluded because their impact on the loss per share is anti-dilutive.
Income Taxes
Income taxes are recognized
for the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets are recognized for the
future tax consequences of transactions that have been recognized in the Company’s consolidated financial statements or tax
returns. A valuation allowance is provided when it is more likely than not that some portion or entire deferred tax asset will
not be realized.
Stock-Based Compensation
The Company periodically
issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing
costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance
provided by the Financial Accounting Standards Board (“FASB”) whereas the value of the award is measured on the date
of grant and recognized over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to
non-employees in accordance with the authoritative guidance of the FASB whereas the value of the stock compensation is based upon
the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which
the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally are
amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance requirements
by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded in the period
of the measurement date.
The fair value of the
Company's stock options and warrants grant is estimated using the Black-Scholes Option Pricing model, which uses certain assumptions
related to risk-free interest rates, expected volatility, expected life of the stock options or warrants, and future dividends.
Compensation expense is recorded based upon the value derived from the Black-Scholes Option Pricing model, and based on actual
experience. The assumptions used in the Black-Scholes Option Pricing model could materially affect compensation expense recorded
in future periods.
Estimates
The preparation of
financial statements in conformity with generally accepted accounting principles 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 revenues and expenses during the reporting period. Significant estimates include
those related to assumptions used in impairment analysis for property and equipment, valuing accruals and equity instruments issued
for services, and realization of deferred tax assets, among others. Actual results could differ from those estimates.
Fair Value of Financial Instruments
Effective January 1,
2008, fair value measurements are determined by the Company's adoption of authoritative guidance issued by the FASB, with the exception
of the application of the statement to non-recurring, non-financial assets and liabilities as permitted. The adoption of the authoritative
guidance did not have a material impact on the Company's fair value measurements. Fair value is defined in the authoritative guidance
as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market
for the asset or liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy
was established, which prioritizes the inputs used in measuring fair value into three broad levels as follows:
Level 1—Quoted
prices in active markets for identical assets or liabilities.
Level 2—Inputs,
other than the quoted prices in active markets, are observable either directly or indirectly.
Level 3—Unobservable
inputs based on the Company's assumptions.
The Company is required
to use of observable market data if such data is available without undue cost and effort.
The carrying amounts
for cash, accounts payable, accrued expenses and convertible debentures approximate their fair value due to their short-term nature.
Patent Costs
Patent costs consist
of patent-related legal and filing fees. Due to the uncertainty associated with the successful development of our AOT product,
all patent costs are expensed as incurred. During the years ended December 31, 2018 and 2017, patent costs were $29,000 and $45,000,
respectively, and were included as part of operating expenses in the accompanying consolidated statements of operations.
Recent Accounting Pronouncements
In February 2016, the
FASB issued Accounting Standards Update (ASU) No. 2016-02,
Leases
. ASU 2016-02 requires a lessee to record a right of use
asset and a corresponding lease liability on the balance sheet for all leases with terms longer than 12 months. ASU 2016-02 is
effective for all interim and annual reporting periods beginning after December 15, 2018. Early adoption is permitted. A modified
retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after,
the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.
The Company is in the process of evaluating the impact of ASU 2016-02 on the Company’s financial statements and disclosures.
In July 2017, the FASB
issued Accounting Standards Update No. 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480);
Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features; (Part II)
Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain
Mandatorily Redeemable Noncontrolling Interests with a Scope Exception (“ASU 2017-11”). ASU 2017-11 allows companies
to exclude a down round feature when determining whether a financial instrument (or embedded conversion feature) is considered
indexed to the entity’s own stock. As a result, financial instruments (or embedded conversion features) with down round features
may no longer be required to be accounted for as derivative liabilities. A company will recognize the value of a down round feature
only when it is triggered, and the strike price has been adjusted downward. For equity-classified freestanding financial instruments,
an entity will treat the value of the effect of the down round as a dividend and a reduction of income available to common shareholders
in computing basic earnings per share. For convertible instruments with embedded conversion features containing down round provisions,
entities will recognize the value of the down round as a beneficial conversion discount to be amortized to earnings. ASU 2017-11
is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption
is permitted. The guidance in ASU 2017-11 is to be applied using a full or modified retrospective approach. The adoption of ASU
2017-11 is not currently expected to have any impact on the Company’s financial statement presentation or disclosures.
Other recent accounting
pronouncements issued by the FASB, including 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 consolidated financial statement presentation or disclosures.
3.
|
Accrued Expenses – Related Parties
|
Accrued Expenses –
Related Parties consists of unpaid salaries and corresponding payroll taxes of officer’s salaries, unused vacation of officers
and unpaid board and committee fees to members of the Company’s Board of Directors. As of December 31, 2018 and 2017, total
accrued expenses – related parties amounted to $55,000 and $31,000, respectively.
4.
|
Property and Equipment
|
At December 31,
2018 and 2017, property and equipment consists of the following:
|
|
December 31,
|
|
|
|
2018
|
|
|
2017
|
|
|
|
|
|
|
|
|
Office equipment
|
|
$
|
30,000
|
|
|
$
|
30,000
|
|
Furniture and fixtures
|
|
|
5,000
|
|
|
|
5,000
|
|
Testing equipment
|
|
|
37,000
|
|
|
|
37,000
|
|
Leasehold Improvements
|
|
|
25,000
|
|
|
|
25,000
|
|
Subtotal
|
|
|
97,000
|
|
|
|
97,000
|
|
Less accumulated depreciation
|
|
|
(73,000
|
)
|
|
|
(51,000
|
)
|
Total
|
|
$
|
24,000
|
|
|
$
|
46,000
|
|
Depreciation expense
for the years ended December 31, 2018 and 2017 was $22,000 and $19,000, respectively.
5.
|
Convertible Notes and Warrants
|
|
|
December 31,
|
|
|
|
2018
|
|
|
2017
|
|
|
|
|
|
|
|
|
Convertible note
|
|
$
|
1,886,000
|
|
|
$
|
509,000
|
|
Interest
|
|
|
123,000
|
|
|
|
71,000
|
|
Subtotal
|
|
|
2,009,000
|
|
|
|
580,000
|
|
Convertible note discount
|
|
|
(1,100,000
|
)
|
|
|
(47,000
|
)
|
Total
|
|
$
|
909,000
|
|
|
$
|
533,000
|
|
As of December 31,
2016, $417,000 of convertible notes and $23,000 if accrued interest was due to note holders. During the year ended December 31,
2017, the Company issued convertible promissory notes in the aggregate of $1,616,000 for cash proceeds of $1,469,000 and a discount
of $147,000. The notes do not bear any interest; however, the implied interest rate used was 10% since the notes were issued 10%
less than its face value, are unsecured, mature in twelve months from issuance and convertible at $0.05 per share. In addition,
the Company also granted these note holders warrants to purchase 16,160,770 shares of the Company’ common stock. The warrants
are fully vested, exercisable at $0.05 per share and expire one year from the date of issuance. As a result, the Company recorded
a note discount of $1,616,000 to account for the relative fair value of the warrants, the notes’ beneficial conversion factor
(“BCF”) and original issue discount (“OID”). The note discounts are amortized over the life of the notes
or were amortized in full upon the conversion of the corresponding notes to common stock. During 2017, a total of $1,528,000 of
notes payable were converted into 29,986,732 shares of common stock and amortized note discount of $1,661,000 was recorded as interest
expense. As of December 31, 2017, total outstanding notes payable amounted to $509,000 which are due through June 2018 and unamortized
note discount of $47,000. During the year ended December 31, 2017, the Company accrued interest of $48,000. As of December 31,
2017, total accrued interest amounted to $71,000 which was reported as part of convertible debentures in the accompanying consolidated
balance sheet. As of December 31, 2017, $381,000 of these notes were past due.
During the year ended
December 31, 2018, the Company issued convertible promissory notes in the aggregate of $1,955,000 for cash proceeds of $1,778,000
and a discount of $178,000. The notes do not bear any interest; however, the implied interest rate used was 10% since the notes
were issued 10% less than its face value, are unsecured, mature in twelve months from issuance and convertible at $0.05 to $0.08
per share. In addition, the Company also granted these note holders warrants to purchase 18,238,688 shares of the Company’
common stock. The warrants are fully vested, exercisable at $0.05 to $0.08 per share and expire one year from the date of issuance.
As a result, the Company recorded a note discount of $1,778,000 to account for the relative fair value of the warrants, the notes’
BCF and OID. The note discounts are amortized over the life of the notes or were amortized in full upon the conversion of the corresponding
notes to common stock. During 2018, a total of $579,000 of notes payable were converted into 9,299,125 shares of common stock and
amortized note discount of $902,000 was recorded as interest expense. As of December 31, 2018, total outstanding notes payable
amounted to $1,886,000 which are due through December 2019 and unamortized note discount of $1,100,000.
During the year
ended December 31, 2018, the Company accrued interest of $52,000. As of December 31, 2018, total accrued interest amounted to
$123,000 which was reported as part of convertible debentures in the accompanying consolidated balance sheet. As of December
31, 2018, $454,000 of the outstanding notes are past due and the Company is currently in negotiations with the noteholders to settle
the matured notes payable.
6.
|
Research and Development
|
The Company constructs,
develops and tests the AOT technology with internal resources and through the assistance of various third-party entities. Costs
incurred and expensed include fees such as license fees, purchase of test equipment, viscometers, SCADA systems, computer equipment,
direct costs related to AOT equipment manufacture and installation, payroll and other related equipment and various logistical
expenses for the purposes of evaluating and testing the Company’s AOT prototypes.
Costs incurred for
research and development are expensed as incurred. Purchased materials that do not have an alternative future use are also expensed.
Furthermore, costs incurred in the construction of prototypes with no certainty of any alternative future use and established commercial
uses are also expensed.
For the years ended
December 31, 2018 and 2017, our research and development expenses were $208,000 and $243,000, respectively.
AOT Prototypes
During the years ended
December 31, 2018 and 2017, the Company incurred total expenses of $20,000 and $53,000, respectively, in the manufacture and delivery
of the AOT prototype equipment under lease agreements. These expenses have been reflected as part of Research and Development expenses
on the accompanying consolidated statements of operations.
Temple University
Licensing Agreement
On August 1, 2011,
the Company and Temple University (“Temple”) entered into two (2) Exclusive License Agreements (collectively, the “License
Agreements”) relating to Temple’s patent applications, patents and technical information pertaining to technology associated
with an electric and/or magnetic field assisted fuel injector system (the “First Temple License”), and to technology
to reduce crude oil viscosity (the “Second Temple License”). The License Agreements are exclusive, and the territory
licensed to the Company is worldwide and replace previously issued License Agreements.
Pursuant to the two
licensing agreements, the Company paid Temple a non-refundable license maintenance fee of $300,000, and agreed to pay (i)
annual maintenance fees of $187,500; (ii) royalty fee ranging from 4% up to 7% from revenues generated from the licensing agreements;
and (iii) 25% of all revenues generated from sub-licensees to secure or maintain the sub-license or option thereon. The term of
the licenses commenced in August 2011 and will expire upon expiration of the patents. The agreements can also be terminated by
either party upon notification under terms of the licensing agreements or if the Company ceases the development of the patent or
fails to commercialize the patent rights.
As of December 31,
2016, the unpaid license fees to Temple were $805,000. During 2017, the Company paid Temple $130,695 and incurred an additional
$178,000 of costs (including the $187,500 annual maintenance fee). Also during 2017, the Company and Temple amended the Second
Temple License agreement. Pursuant to the amendment, the Company and Temple agreed to defer payment of $135,000 of the amount payable
until such time the Company generates revenues totaling $835,000 from the license. In addition, the parties agreed that the unpaid
balance of $135,000 will accrue interest of 9% per annum. As of December 31, 2017, the total unpaid fees due to Temple pursuant
to these agreements are $852,000, which are included as part of Accounts Payable – license agreements in the accompanying
consolidated balance sheets.
During 2018 the Company
paid Temple $10,000 and incurred an additional $230,700 of costs (including the $187,500 license fee and $43,200 of interest).
As of December 31, 2018, total unpaid fees due to Temple pursuant to these agreements are $1,073,000, which are included as part
of Accounts Payable – license agreements in the accompanying consolidated balance sheets. With regards to the unpaid fees
to Temple, a total of $135,000 are deferred until such time the Company achieves a revenue milestone of $835,000 or upon termination
of the licensing agreements and the remaining $938,000 are deemed past due. The Company is currently in negotiations with Temple
to settle or cure the past due balance.
The Company generated
$50,000 in revenue from the viscosity reduction license during the twelve-month period ended December 31, 2017. This amount is
not sufficient to be subject to additional license fees under the license agreement. The Company generated no revenue from the
viscosity reduction system during the twelve-month period ended December 31, 2018.
7.
|
Common Stock Transactions
|
Year Ending December
31, 2018
During the year ended
December 31, 2018, the Company issued an aggregate of 22,046,608 shares of its common stock as follows:
|
·
|
The Company issued 9,299,125 shares of its common stock upon the conversion of $579,000 in convertible notes pursuant to the convertible notes conversion prices of $0.05 to $0.08 per share.
|
|
·
|
The Company issued 12,517,773 shares of its common stock upon the exercise of warrants for proceeds of $634,000 at an exercise prices $0.05 per share.
|
|
·
|
The Company issued 179,710 shares of its
common stock upon the exercise of options for proceeds of $13,000 at an exercise price of $0.07 per share.
|
|
·
|
The Company issued 50,000 shares of its common stock at a value of $0.24 per share in exchange for services valued $12,000.
|
Year Ending December
31, 2017
In August 2017, shareholders
approved an increase in authorized shares of common stock from 300,000,000 to 500,000,000, approved the creation of a new class
of preferred stock, and authorize the Company to issue up to 100,000,000 shares of preferred stock. During the year ended December
31, 2017, the Company issued an aggregate of 35,031,881 shares of its common stock as follows:
|
·
|
The Company issued 181,355 shares of its common stock upon the private sale of restricted common stock for cash proceeds of $38,000 at a purchase price of $.21 per share.
|
|
·
|
The Company issued 29,986,772 shares of its common stock upon the conversion of $1,528,000 in convertible notes pursuant to the convertible notes conversion prices of $0.05 to $0.48 per share.
|
|
·
|
The Company issued 4,414,000 shares of its common stock upon the exercise of warrants for proceeds of $359,000 at exercise prices of $0.05 to $0.10 per share.
|
|
·
|
The Company issued 449,754 shares of its common stock upon the exercise of options for proceeds of $37,000 at exercise prices of $0.07 to $0.13 per share.
|
8.
|
Stock Options and Warrants
|
The Company periodically
issues stock options and warrants to employees and non-employees in capital raising transactions, for services and for financing
costs. Options and warrants vest and expire according to terms established at the grant date.
Options
Employee options vest
according to the terms of the specific grant and expire from 5 to 10 years from date of grant. The weighted-average, remaining
contractual life of employee and Non-employee options outstanding at December 31, 2018 was 5.2 years. Stock option activity for
the period January 1, 2017 to December 31, 2018, was as follows:
|
|
Options
|
|
|
Weighted Avg.
Exercise Price
|
|
Options outstanding, January 1, 2017
|
|
|
23,474,256
|
|
|
$
|
0.30
|
|
Options granted
|
|
|
12,561,852
|
|
|
|
0.12
|
|
Options exercised
|
|
|
(449,754
|
)
|
|
|
0.05
|
|
Options cancelled
|
|
|
(188,679
|
)
|
|
|
0.53
|
|
Options outstanding, December 31, 2017
|
|
|
35,397,675
|
|
|
$
|
0.23
|
|
Options granted
|
|
|
2,083,335
|
|
|
|
0.18
|
|
Options exercised
|
|
|
(179,710
|
)
|
|
|
0.07
|
|
Options cancelled
|
|
|
(2,000,000
|
)
|
|
|
0.28
|
|
Options outstanding, December 31, 2018
|
|
|
35,301,300
|
|
|
|
0.22
|
|
The weighted average
exercise prices, remaining contractual lives for options granted, exercisable, and expected to vest as of December 31, 2018
were as follows:
|
|
|
|
Outstanding Options
|
|
|
|
Exercisable Options
|
|
|
Option
Exercise Price
Per Share
|
|
|
|
Shares
|
|
|
|
Life
(Years)
|
|
|
|
Weighted
Average Exercise
Price
|
|
|
|
Shares
|
|
|
|
Weighted
Average Exercise
Price
|
|
|
$ 0.05 - $ 0.24
|
|
|
|
13,766,250
|
|
|
|
8.1
|
|
|
$
|
0.10
|
|
|
|
13,466,250
|
|
|
$
|
0.10
|
|
|
$ 0.25 - $ 0.49
|
|
|
|
20,913,552
|
|
|
|
3.3
|
|
|
|
0.27
|
|
|
|
18,913,552
|
|
|
|
0.27
|
|
|
$ 0.50 - $ 0.99
|
|
|
|
471,052
|
|
|
|
5.3
|
|
|
|
0.85
|
|
|
|
471,052
|
|
|
|
0.85
|
|
|
$ 1.00 - $ 2.00
|
|
|
|
150,446
|
|
|
|
4.6
|
|
|
|
1.18
|
|
|
|
150,446
|
|
|
|
1.18
|
|
|
|
|
|
|
35,301,300
|
|
|
|
5.2
|
|
|
$
|
0.22
|
|
|
|
33,001,300
|
|
|
$
|
0.21
|
|
As of December 31,
2018, the market price of the Company’s stock was $0.09 per share. At December 31, 2018 the aggregate intrinsic value of
the options outstanding was $286,000. Future unamortized compensation expense on the unvested outstanding options at December 31,
2018 is approximately $19,000.
Year Ending December
31, 2018
|
·
|
In January 2018, the Company issued options to purchase a total of 2,083,335 shares of common stock to employees, officers and members of the Board of Directors with a fair value of $313,000 using the Black-Scholes Option Pricing model. The options are exercisable from $0.18 per share, vesting within year and expiring in ten years from the date of grant. During the year ended December 31, 2018, the Company recognized compensation costs of $313,000 based on options that vested.
|
|
·
|
During the year ended December 31, 2018, the Company amortized $121,000 of compensation cost based on the vesting of the options granted to employees and directors in prior years.
|
Year Ending December
31, 2017
|
·
|
From January through July 2017, the Company issued options to purchase a total of 12,561,852 shares of common stock to employees, officers and members of the Board of Directors with a fair value of $647,000 using the Black-Scholes Option Pricing model. The options are exercisable from $0.07 up to $0.40 per share, vesting within one to three years and expiring in ten years from the date of grant. During the year ended December 31, 2017, the Company recognized compensation costs of $761,000 based on options that vested.
|
|
·
|
During the year ended December 31, 2017, the Company amortized $36,000 of compensation cost based on the vesting of the options granted to employees and directors in prior years.
|
Black-Scholes
Option Pricing
The Company used the
following average assumptions in its calculation using the Black-Scholes Option Pricing model:
|
|
Years Ended
|
|
|
|
2018
|
|
|
2017
|
|
Expected life (years)
|
|
|
5.5
|
|
|
|
5 – 6
|
|
Risk free interest rate
|
|
|
1.70%
|
|
|
|
1.72 – 1.94%
|
|
Volatility
|
|
|
118%
|
|
|
|
114 – 124%
|
|
Expected dividend yield
|
|
|
0%
|
|
|
|
0%
|
|
The assumptions used in the Black
Scholes models referred to above are based upon the following data: (1) the contractual life of the underlying non-employee options
is the expected life. The expected life of the employee option is estimated by considering the contractual term of the option,
the vesting period of the option, the employees’ expected exercise behavior and the post-vesting employee turnover rate.
(2) The expected stock price volatility was based upon the Company’s historical stock price over the expected term of the
option. (3) The risk-free interest rate is based on published U.S. Treasury Department interest rates for the expected terms of
the underlying options. (4) The expected dividend yield was based on the fact that the Company has not paid dividends to common
shareholders in the past and does not expect to pay dividends to common shareholders in the future.
Warrants
The following table
summarizes certain information about the Company’s stock purchase warrants.
|
|
Warrants
|
|
|
Weighted Avg.
Exercise Price
|
|
Warrants outstanding, January 1, 2017
|
|
|
11,446,892
|
|
|
|
0.15
|
|
Warrants granted
|
|
|
16,160,770
|
|
|
|
0.05
|
|
Warrants exercised
|
|
|
(4,414,000
|
)
|
|
|
0.08
|
|
Warrants cancelled
|
|
|
(5,571,225
|
)
|
|
|
0.10
|
|
Warrants outstanding, December 31, 2017
|
|
|
17,622,437
|
|
|
$
|
0.09
|
|
Warrants granted
|
|
|
18,238,688
|
|
|
|
0.05
|
|
Warrants exercised
|
|
|
(12,517,773
|
)
|
|
|
0.05
|
|
Warrants cancelled
|
|
|
(2,287,997
|
)
|
|
|
0.05
|
|
Warrants outstanding, December 31, 2018
|
|
|
21,055,355
|
|
|
|
0.09
|
|
At December 31, 2018
the price of the Company’s common stock was $0.09 per share and the aggregate intrinsic value of the warrants outstanding
was $661,000. As of December 21, 2018, all warrants were fully vested.
|
|
|
|
|
Outstanding Warrants
|
|
|
|
Exercisable Warrants
|
|
|
Warrant
Exercise Price
Per Share
|
|
|
|
Shares
|
|
|
|
Life
(Years)
|
|
|
|
Weighted
Average Exercise
Price
|
|
|
|
Shares
|
|
|
|
Weighted
Average Exercise
Price
|
|
|
$ 0.05 - $ 0.24
|
|
|
|
18,343,688
|
|
|
|
0.9
|
|
|
$
|
0.06
|
|
|
|
18,343,688
|
|
|
$
|
0.06
|
|
|
$ 0.25 - $ 0.49
|
|
|
|
2,641,667
|
|
|
|
2.2
|
|
|
|
0.30
|
|
|
|
2,641,667
|
|
|
|
0.30
|
|
|
$ 0.50 - $ 1.00
|
|
|
|
70,000
|
|
|
|
5.3
|
|
|
|
0.80
|
|
|
|
70,000
|
|
|
|
0.80
|
|
|
|
|
|
|
21,055,355
|
|
|
|
1.1
|
|
|
$
|
0.09
|
|
|
|
21,055,355
|
|
|
$
|
0.09
|
|
Year Ending December 31, 2018
|
·
|
In February through December 2018, pursuant to terms of convertible notes issued, the Company granted warrants to purchase 18,238,688 shares of common stock with an exercise price of $0.05 to $0.08 per share, vesting immediately upon grant and expiring one year from the date of grant. See Note 5 for further discussion.
|
Year Ending December 31, 2017
|
·
|
In January through May 2017, pursuant to terms of convertible notes issued, the Company granted warrants to purchase 16,160,770 shares of common stock with an exercise price of $0.05 per share, vesting immediately upon grant and expiring one year from the date of grant. See Note 5 for further discussion.
|
|
·
|
Effective May 2017, the Company amended the terms of a warrant issued in 2015, extending the expiration date of the warrant by twenty-four months with no changes to the other terms of the original grant. As a result, the Company recorded the incremental change in the fair value of this warrant before and after the date of the amendment of $90,000, computed using the Black-Scholes Option Pricing model with the following assumptions: life of 1.5 years; exercise price of $0.30 per share; stock price of $0.24 per share, average risk-free interest rate of 1.70%; average volatility of 140% and dividend yield of 0%. During the year ended December 31, 2017, the Company recognized an expense of $90,000 based on the fair value of the warrant as amended.
|
|
·
|
During the year ended December 31, 2017, the Company amortized $1,000 of compensation cost based on the vesting of the warrants granted consultants in prior years.
|
9.
|
Commitments and Contingencies
|
We are involved in
certain legal proceedings that arise from time to time in the ordinary course of our business. Except for income tax contingencies,
we record accruals for contingencies to the extent that our management concludes that the occurrence is probable and that the related
amounts of loss can be reasonably estimated. Legal expenses associated with the contingency are expensed as incurred. There is
no current or pending litigation of any significance with the exception of the matters that have arisen under, and are being handled
in, the normal course of business.
Leases
In April 2017, the
Company moved its executive offices to 23902 FM 2978, Tomball, Texas 77375. From May 2016 through May 2017, the Company’s
executive offices were located at 5266 Hollister Avenue, Suite 219, Santa Barbara, CA 93111.
Total rent expense
under these leases in effect during the years ended December 31, 2018, and 2017 was $18,000 and $20,000, respectively which are
included as part of Operating Expenses in the attached consolidated statements of operations. The Tomball Texas office is under
a month-to-month lease payable at $1,500 per month. The Tomball facility is leased from JBL Energy Partners, an entity solely owned
by Jason Lane, Company CEO.
Contractual Commitments
The Company’s
contractual commitments for future periods, including office leases, minimum guaranteed compensation payments and other agreements
as described in the following table and associated footnotes:
Year ending December 31,
|
|
License
Agreements (1)
|
|
|
Compensation
Agreements (2)
|
|
|
Total
Obligations
|
|
|
2019
|
|
|
187,500
|
|
|
|
404,100
|
|
|
|
591,600
|
|
|
2020
|
|
|
187,500
|
|
|
|
–
|
|
|
|
187,500
|
|
|
2021
|
|
|
187,500
|
|
|
|
–
|
|
|
|
187,500
|
|
|
2022
|
|
|
187,500
|
|
|
|
–
|
|
|
|
187,500
|
|
|
2023
|
|
|
187,500
|
|
|
|
–
|
|
|
|
187,500
|
|
|
Total
|
|
$
|
937,500
|
|
|
$
|
404,100
|
|
|
$
|
1,341,600
|
|
___________________
|
(1)
|
Consists of license
maintenance fees to Temple University in the amount of $187,500 paid annually through the life of the underlying patents or
until otherwise terminated by either party.
|
|
(2)
|
Consists of base
salary and certain contractually-provided benefits, to i) a former executive officer, pursuant to an severance in the amount of
$580,000 that will be paid through March 31, 2019 pursuant to a separation agreement effective April 1, 2017 as amended by letter
agreements effective August 16, 2018 and March 31, 2019, modifying the payment schedule to a payment of $10,000 per month,
continue paying his health insurance premium and extending the term on a month-to-month basis until paid in full or otherwise
terminated. As of December 31, 2018, $370,000 was payable under this agreement and was included as part of Accounts payable and
accrued expenses in the accompanying consolidated balance sheet.; ii) an executive officer, pursuant to a two-year employment
agreement effective April 1, 2017 at a base annual salary of $150,000 per year; and iii) an executive officer, pursuant to a two-year
agreement effective April 1, 2017 at a base annual salary of $158,400 per year.
|
The Company did not
provide any Federal and State income tax for the years ended December 31, 2018 and 2017 due to the Company’s net losses,
other than $1,600 for the minimum state tax provision which was reported as part of operating expense in the accompanying statements
of operations. A reconciliation of income taxes with the amounts computed at the statutory federal rate follows:
|
|
December 31,
|
|
|
|
2018
|
|
|
2017
|
|
Computed tax provision (benefit) at federal statutory rate (21% and 34%, 2018 and 2017, respectively)
|
|
$
|
(312,000
|
)
|
|
$
|
(546,000
|
)
|
State income taxes, net of federal benefit (0%
in 2018 and 8.84% in 2017, respectively)
|
|
|
–
|
|
|
|
(142,000
|
)
|
Valuation allowance
|
|
|
312,000
|
|
|
|
689,600
|
|
Income tax provision
|
|
$
|
–
|
|
|
$
|
1,600
|
|
The deferred tax assets
and deferred tax liabilities recorded on the balance sheet are as follows:
|
|
December 31,
|
|
|
|
2018
|
|
|
2017
|
|
Net operating loss carry forwards
|
|
$
|
15,226,000
|
|
|
$
|
14,746,000
|
|
Stock based compensation
|
|
|
(122,000
|
)
|
|
|
(249,000
|
)
|
Non-cash interest and financing expenses
|
|
|
(267,000
|
)
|
|
|
(480,000
|
)
|
Other temporary differences
|
|
|
(51,000
|
)
|
|
|
(176,000
|
)
|
Valuation allowance
|
|
|
(14,826,000
|
)
|
|
|
(13,841,000
|
)
|
Total deferred taxes net of valuation allowance
|
|
$
|
–
|
|
|
$
|
–
|
|
As of December 31,
2018, the Company had net operating losses available for carry forward for state and federal tax purposes of approximately $55
million expiring through 2038. These carry forward benefits will be subject to annual limitations due to the ownership change limitations
imposed by the Internal Revenue Code and similar state provisions. The annual limitation, if imposed, may result in the expiration
of net operating losses before utilization.
As of December 31,
2018, the Company recorded a valuation allowance of $14,826,000 for its deferred tax assets since the Company believes that such
assets did not meet the more likely than not criteria to be recoverable through projected future profitable operations in the foreseeable
future. This valuation is based on the new federal corporate tax rate of 21% effective 2018 resulting in an effective bended state
and federal tax rate of 28%.
Effective January 1,
2007, the Company adopted FASB guidance that addresses the determination of whether tax benefits claimed or expected to be claimed
on a tax return should be recorded in the financial statements. Under this guidance, the Company may recognize the tax benefit
from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the
taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from
such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate
settlement. The FASB also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting
in interim periods and requires increased disclosures. As of December 31, 2018 and 2017, the Company does not have a liability
for unrecognized tax benefits.
The Company files income
tax returns in the U.S. federal jurisdiction and the State of California. The Company is subject to U.S. federal or state income
tax examinations by tax authorities for years after 2002. During the periods open to examination, the Company has net operating
loss and tax credit carry forwards for U.S. federal and state tax purposes that have attributes from closed periods. Since these
net operating losses and tax credit carry forwards may be utilized in future periods, they remain subject to examination. The Company’s
policy is to record interest and penalties on uncertain tax provisions as income tax expense. As of December 31, 2018, the Company
has no accrued interest or penalties related to uncertain tax positions. The Company believes that it has not taken any uncertain
tax positions that would impact its consolidated financial statements as of December 31, 2018 and 2017.
Unregistered
Sales of Equity Securities
Subsequent to the
reporting period of this Form 10-K for the year ended December 31, 2018, the Company closed a private placement sale of
unregistered equity securities. From November 1, 2018, through March 31, 2019, the Company issued and sold to accredited US
investors and non-U.S. investors an aggregate of $2,112,000 Convertible Promissory Notes (the “Notes”) and
warrants to purchase an aggregate of 42,233,400 shares of common stock (the “Warrants”) (collectively, the
private placement sale of the Notes and Warrants shall be referred to as the “Winter 2018-2019 Offering”). The
Company received proceeds from the Winter 2018-2019 Offering of $1,920,000, which funds were used, and are being used, for
general corporate purposes and working capital.
The Notes are due twelve
(12) months from their respective issuance dates (the “Maturity Date”). The Notes do not bear interest and were issued
in the face amount equal to 110% of the purchasers’ commitments. The Notes are convertible into shares of the Company’s
common stock at a rate of $0.05 per share. If the Notes are not paid in full by the Maturity Date, the balance remaining on the
Maturity Date shall be increased by 10% and the Company shall be required to pay interest at a rate of 10% per annum thereon until
all sums thereunder are paid in full.
The Warrants are exercisable
into shares of the Company’s common stock for a term of one (1) year at an exercise price of $0.05 per share. The Warrants
also contain provisions that protect the holders against dilution by adjustment of the conversion price in certain events involving
a reduction or increase in the Company’s shares.
Due to the timing of
the Winter 2018-2019 Offering, beginning in 2018 and ending in 2019, the Notes and Warrants are and will be reported in the Company’s
Consolidated Financial Statements in two separate portions, as follows:
First,
from November 1, 2018 up to December 31, 2018, the Company issued and sold Notes in aggregate of $1,377,000 convertible to 27,533,000
shares of common stock of the Company and Warrants to purchase 13,766,500 shares of common stock of the Company, and the Company
received cash proceeds of $1,252,000. For the avoidance of doubt, this is a subset of the total Notes and Warrants sold under the
Winter 2018-2019 Offering. As a result, the Company recorded a note discount of $1,252,000 to account for the relative fair value
of the Warrants, the Notes’ beneficial conversion feature and original issue discount which is reported in these Consolidated
Financial Statements for the period end December 31, 2018 and will be amortized as interest expense over the life of the Notes.
Second,
the remainder of the Notes and Warrants in the Winter 2018-2019 Offering were issued and sold subsequent to the reporting period
of this Form 10-K. From January 1, 2019 up to March 31, 2019, the Company issued and sold Notes in aggregate of $735,000 convertible
to 14,700,400 shares of common stock of the Company and Warrants to purchase 7,350,200 shares of common stock of the Company, and
the Company received cash proceeds of $668,000. Again, for the avoidance of doubt, this is a subset of the total Notes and Warrants
sold under the Winter 2018-2019 Offering. As a result, the Company will record a note discount of $668,000 to account for the relative
fair value of the warrants, the Notes’ beneficial conversion feature and original issue discount which will be amortized
as interest expense over the life of the Notes.
The Winter 2018-2019
Offering was made to non-U.S investors and to U.S. “accredited investors,” as the term is defined in Regulation D under
the Securities Act of 1933, as amended (the “Securities Act”), and were made without general advertising or solicitation.
The securities sold in the Winter 2018-2019 Offering were not registered under the Securities Act, or the securities laws of any
state, and were offered and sold in reliance on exemptions from registration including the exemption from registration afforded
by Section 4(a)(2) of the Securities Act and Regulation S promulgated under the Securities Act, and corresponding provisions of
state securities law, which, respectively, exempt transactions by an issuer not involving any public offering or transactions with
non-U.S. Investors.
Conversion of Convertible
Notes
From January 1, 2019
up to March 31, 2019, Company issued 22,467,945 shares of common stock upon conversion of previously issued convertible notes in
aggregate value of $1,025,000.
Exercise of Warrants
In January 2, 2019
up to March 31, 2019, the Company issued 1,333,750 shares of common stock upon the exercise of previously issued warrants for aggregate
cash proceeds of $96,000.
Amendment to
Employee Agreements
Effective March 31,
2019, the Company amended employment agreements of the Company’s Chief Executive Officer (CEO) and Chief Financial Officer
(CFO). Prior these amendments, both employment agreements had been scheduled to terminate on March 31, 2019. As amended, each contract
has been extended by 90 days to give the Board sufficient time to negotiate new contracts with these Executive Officers.
Grant of Stock
Options
The Company granted
members of the Board of Directors stock options to purchase a total of 4,687,500 shares of common stock. The stock options vest
over one year, exercisable at $0.08 per share and will expire in 10 years. Total fair value of the stock options amounted to $306,000
which will be expensed over the vesting period.
Amendment to
Separation Agreement
Effective March 31,
2019, a separation agreement between the Company and a former Chief Executive Officer was amended, continuing payments of $10,000
per month, payment of health insurance premiums, and extending the term on a month-to-month basis until paid in full or otherwise
terminated.
Cash Deposit
Paid
In January 2019, the
Company paid $500,000 as a deposit under terms of a work order for work to be performed by a pipeline operator.
EXHIBITS