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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2011
 
Commission File Number 000-32501

REED’S, INC.

(Exact name of registrant as specified in its charter)
 
Delaware
 
35-2177773
State or other jurisdiction of incorporation or organization
 
I.R.S. Employer Identification Number
     
13000 South Spring Street
   
Los Angeles, California
 
90061
Address of principal executive offices
 
Zip Code
 
(310) 217-9400
Registrant’s telephone number, including area code
 
Securities registered pursuant to Section 12(b) of the Act:
     
Title of Class
 
 
Name of each exchange where registered
 
Common Stock, $.0001 par value per share
 
The NASDAQ Stock Market LLC
 
Securities registered pursuant to Section 12(g) of the Act: None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.     Yes  o No  x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.     Yes  o No  x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  No  o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  No  o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act.
 
Large Accelerated filer o        Accelerated filer o        Non-accelerated filer  o       Smaller reporting company x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes o    No x
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates (excluding voting shares held by officers and directors) as of June 30, 2011 was $15,665,000
 
10,941,397 common shares, $.001 par value, were outstanding on March 13, 2012.
 


 
 

 

 
 

TABLE OF CONTENTS
 
     
   
Page
PART I
 
1
Item 1.
Business
1
Item 2.
Properties
9
Item 3.
Legal Proceedings
9
Item 4.
Mine Safety Disclosures.
9
     
PART II
 
10
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
10
Item 6.
Selected Financial Data
12
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
12
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
19
Item 8.
Financial Statements
20
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
21
Item 9A.
Controls and Procedures
21
Item 9B.
Other Information
22
     
PART III
 
23
Item 10.
Directors, Executive Officers and Corporate Governance
23
Item 11.
Executive Compensation
27
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
29
Item 13.
Certain Relationships and Related Transactions, and Director Independence
30
Item 14.
Principal Accountant Fees and Services
30
     
PART IV
 
32
Item 15.
Exhibits, Financial Statement Schedules
32



 

 
i

 

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS AND INFORMATION
 
This Annual Report on Form 10-K (“Annual Report”), the other reports, statements, and information that we have previously filed or that we may subsequently file with the Securities and Exchange Commission (“SEC”) and public announcements that we have previously made or may subsequently make include, may include, incorporate by reference or may incorporate by reference certain statements that may be deemed to be forward-looking statements. The forward-looking statements included or incorporated by reference in this Annual Report and those reports, statements, information and announcements address activities, events or developments that Reed’s, Inc. (together with its subsidiaries hereinafter referred to as “we,” “us,” “our” or “Reed’s”) expects or anticipates will or may occur in the future. Any statements in this document about expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “will continue,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,” “would” and “outlook,” and similar expressions. Accordingly, these statements involve estimates, assumptions and uncertainties, which could cause actual results to differ materially from those expressed in them. Any forward-looking statements are qualified in their entirety by reference to the factors discussed throughout this document. All forward-looking statements concerning economic conditions, rates of growth, rates of income or values as may be included in this document are based on information available to us on the dates noted, and we assume no obligation to update any such forward-looking statements.
 
The risk factors referred to in this Annual Report could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us, and you should not place undue reliance on any such forward-looking statements. Any forward-looking statement speaks only as of the date on which it is made and we do not undertake any obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict which will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
 
Management cautions that these statements are qualified by their terms and/or important factors, many of which are outside of our control, involve a number of risks, uncertainties and other factors that could cause actual results and events to differ materially from the statements made, including, but not limited to, the following risk factors.
 
·
Our ability to generate sufficient cash flow to support capital expansion plans and general operating activities,
   
·
Decreased demand for our products resulting from changes in consumer preferences,
   
·
Competitive products and pricing pressures and our ability to gain or maintain its share of sales in the marketplace,
   
·
The introduction of new products,
   
·
Our being subject to a broad range of evolving federal, state and local laws and regulations including those regarding the labeling and safety of food products, establishing ingredient designations and standards of identity for certain foods, environmental protections, as well as worker health and safety. Changes in these laws and regulations could have a material effect on the way in which we produce and market our products and could result in increased costs,
   
·
Changes in the cost and availability of raw materials and the ability to maintain our supply arrangements and relationships and procure timely and/or adequate production of all or any of our products,
   
·
Our ability to penetrate new markets and maintain or expand existing markets,
   
·
Maintaining existing relationships and expanding the distributor network of our products,
   
·
The marketing efforts of distributors of our products, most of whom also distribute products that are competitive with our products,
   
·
Decisions by distributors, grocery chains, specialty chain stores, club stores and other customers to discontinue carrying all or any of our products that they are carrying at any time,
   
·
The availability and cost of capital to finance our working capital needs and growth plans,
   
·
The effectiveness of our advertising, marketing and promotional programs,
   
·
Changes in product category consumption,
   
·
Economic and political changes,
   
·
Consumer acceptance of new products, including taste test comparisons,
   
·
Possible recalls of our products, and
   
·
Our ability to make suitable arrangements for the co-packing of any of our products.
 
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. 

 
ii

 

PART I
 
Item 1.    Business
 
Background

We develop, manufacture, market and sell natural non-alcoholic carbonated soft drinks and “New Age” beverages, candies and ice creams. “New Age Beverages” is a category that includes natural soda, fruit juices and fruit drinks, ready-to-drink teas, sports drinks and water. We currently manufacture, market and sell six unique product lines:

 
·
Reed’s Ginger Brews,
 
·
Virgil’s Root Beer, Cream Sodas, Dr. Better and Real Cola, including ZERO diet sodas,
 
·
China Colas,
 
·
Reed’s Ginger Chews,
 
·
Reed’s Ginger Ice Creams,
 
·
Sonoma Sparkler Sparkling Juices,

In addition, we have a growing private label business.

We sell most of our products in specialty gourmet and natural food stores (estimated at approximately 4,000 smaller or specialty stores and approximately 3,000 supermarket format stores), supermarket chains (estimated at approximately 7,000 stores), retail stores and restaurants in the United States and, to a lesser degree, in Canada, Europe and other international territories.  We primarily sell our products through a network of natural, gourmet and independent distributors.  We also maintain an organization of in-house sales managers who work mainly in the stores serviced by our natural, gourmet and mainstream distributors and with our distributors.  

We produce and co-pack our products in part at our facility in Los Angeles, California, known as the Brewery, and primarily at a contracted co-packing facility in Pennsylvania. The co-pack facility in Pennsylvania supplies us with soda products for the eastern half of the United States and nationally for soda products that we do not produce at The Brewery.
 
Key elements of our business strategy include:
 
·
increase our relationship with and sales to the approximately 10,500 supermarkets that carry our products in natural and mainstream,
 
·
stimulate consumer demand and awareness for our existing brands and products,
 
·
develop additional alternative and natural beverage brands and other products, including specialty packaging and alternative uses for our products, such as our new nausea relief product,
 
·
develop and produce private-label products for select customers,
 
·
lower our cost of sales for our products, and
 
·
optimize the size and focus of our sales force to manage our relationships with distributors and retail outlets.

Our current sales effort is focused on building our business in our approximately 10,500 natural and mainstream supermarket accounts in the U.S. and Canada.

We create consumer demand for our products by:
 
·
supporting in-store sampling programs of our products,
 
·
generating free press through public relations,
 
·
advertising in store publications,
 
·
maintaining a company website (www.reedsgingerbrew.com),
 
·
participating in large public events as sponsors; and
 
·
partnering with alcohol brands such as Dewar’s and Bacardi to create co-branded cocktail recipes such as “Dewar’s and Reeds” and a “Reed’s Dark and Stormy.”


 
1

 

Our principal executive offices are located at 13000 South Spring Street, Los Angeles, California 90061.  Our telephone number is (310) 217-9400. Our Internet address is (www.reedsgingerbrew.com). Information contained on our website or that is accessible through our website should not be considered to be part of this Annual Report.
 
Historical Development
 
Reed’s Original Ginger Brew was created in 1987 by Christopher J. Reed, our founder and Chief Executive Officer, and was introduced to the market in Southern California stores in 1989.  By 1990, we began marketing our products through United Natural Foods (UNFI), and other natural food distributors and moved our production to a larger facility in Boulder, Colorado.

In 1991, we incorporated our business operations in the state of Florida under the name of Original Beverage Corporation and moved all of our production to a co-pack facility in Pennsylvania.  Throughout the 1990’s, we continued to develop and launch new Ginger Brew varieties.  Reed’s Ginger Brews reached broad placement in natural and gourmet foods stores nationwide through UNFI and other major specialty, natural/gourmet and mainstream food and beverage distributors.

In 1997, we began licensing the products of China Cola and eventually acquired the rights to that product in 2000.  In 1999, we purchased the Virgil’s Root Beer brand from the Crowley Beverage Company.  In 2000, we moved into an 18,000 square foot warehouse property, the Brewery, in Los Angeles, California, to house our west coast production and warehouse facility.  The Brewery now also serves as our principal executive offices.  In 2001, pursuant to a reincorporation merger, we changed our state of incorporation to Delaware and also changed our name to Reed’s, Inc.  

On December 12, 2006, we completed the sale of 2,000,000 shares of our common stock at an offering price of $4.00 per share in our initial public offering. The public offering resulted in gross proceeds of $8,000,000.  Following the public offering, we expanded sales and operations dramatically, initially using a direct store delivery strategy in Southern California, along with other regional independent direct store distributors (DSD).  The relationships with DSD’s were supported by our sales staff.  In 2007, we raised a net of $7,600,000 in a private placement.  We re-focused our sales strategy to eliminate company direct store delivery sales and to expand sales to DSD’s and natural food distributors on a national level. We also started selling directly to supermarket grocery stores, which has become a significant portion of our business today.

We continually introduce new products and line extensions, such as our Virgil’s diet line of ZERO beverages introduced in 2010 and Dr. Better and Extra Light 55 Calories in 2011.  We commenced offering private label products in 2010, and increased that business significantly in 2011.

Industry Overview

We offer natural premium carbonated soft drinks (CSD), which are a growing segment of the $10 billion CSD market nationwide.  Within natural food store markets, we are among the top-selling natural soft drinks.  This market is steady and growing.  We also sell in major grocery chains nationally.  The trend in grocery stores is to expand offerings of natural products and we have the scale and capability to develop these direct customer relationships.
 
Our Products

We currently manufacture and sell 20 beverages, three candies and three ice creams. We make all of our products using premium all-natural ingredients. Our primary brands are our Reed’s ginger brew line and our Virgil’s line of root beer and other products.  Our candy products, include Reed’s Crystallized Ginger Candy and Reed’s Chews, represent a lesser portion of revenues, however, the products are popular and sales are expanding.  We also sell ginger ice cream.


 
2

 

Reed’s Ginger Brews

Ginger ale is the oldest known soft drink.  Before modern soft drink technology existed, non-alcoholic beverages were brewed at home directly from herbs, roots, spices, and fruits.  These handcrafted brews were then aged like wine and highly prized for their taste and their tonic, health-giving properties.  Reed’s Ginger Brews are a revival of this home brewing art and we make them with care and attention to wholesomeness and quality, using the finest fresh herbs, roots, spices, and fruits.  Our expert brew masters brew each batch and age it with great pride.

We believe that Reed’s Ginger Brews are unique in their kettle brewed origin among all mass-marketed soft drinks. Reed’s Ginger Brews contain between 8 and 26 grams of fresh ginger in every 12-ounce bottle. We use no refined sugars as sweeteners. Our products differ from commercial soft drinks in three particular characteristics: sweetening, carbonation and coloring for greater adult appeal. Instead of using injected-based carbonation, we produce our carbonation naturally, through slower, beer-oriented techniques.  This process produces smaller, longer lasting bubbles that do not dissipate rapidly when the bottle is opened.  We do not add coloring.  The color of our products comes naturally from herbs, fruits, spices, roots and juices.

In addition, since Reed’s Ginger Brews are pasteurized, they do not require or contain any preservatives.  In contrast, modern commercial soft drinks generally are produced using natural and artificial flavor concentrates prepared by flavor laboratories, tap water, and highly refined sweeteners. Typically, manufacturers make a centrally processed concentrate that will lend itself to a wide variety of situations, waters and filling systems.  The final product is generally cold-filled and requires preservatives for stability.  Colors are added that are either natural, although highly processed, or artificial.

Our Reed’s line contains the following products:

 
·
Reed’s Original Ginger Brew was our first creation, and is a Jamaican recipe for homemade ginger ale using 17 grams of fresh ginger root, lemon, lime, honey, fructose, pineapple, herbs and spices. Reed’s Original Ginger Brew is 20% fruit juice.
 
·
Reed’s Extra Ginger Brew is the same approximate recipe, with 25 grams of fresh ginger root for a stronger bite. Reed’s Extra Ginger Brew is 20% fruit juice.
 
·
Reed’s Premium Ginger Brew is sweetened only with honey and pineapple juice. Reed’s Premium Ginger Brew is 20% fruit juice.
 
·
Reed’s Raspberry Ginger Brew is brewed from 17 grams of fresh ginger root, raspberry juice and lime. Reed’s Raspberry Ginger Brew is 20% raspberry juice.
 
·
Reed’s Spiced Apple Brew uses 8 grams of fresh ginger root, the finest tart German apple juice and such apple pie spices as cinnamon, cloves and allspice. Reed’s Spiced Apple Brew is 50% apple juice.
 
·
Reed’s Cherry Ginger Brew is naturally brewed from 22 grams of fresh ginger root, cherry juice from concentrate and spices.
 
·
Reed’s Natural Energy Elixir, an energy drink infused with all natural ingredients designed to provide consumers with a healthy and natural boost to energy levels
 
·
Reed’s Nausea Relief, based on our Ginger Brews with added B vitamins. Both ginger and B vitamins have been studied for their effectiveness in combating nausea.


 
3

 

Virgil’s Root Beer

Virgil’s is a premium root beer. We use all-natural ingredients, including filtered water, unbleached cane sugar, anise from Spain, licorice from France, bourbon vanilla from Madagascar, cinnamon from Sri Lanka, clove from Indonesia, wintergreen from China, sweet birch and molasses from the southern United States, nutmeg from Indonesia, pimento berry oil from Jamaica, balsam oil from Peru and cassia oil from China. We collect these ingredients worldwide and gather them together at the brewing and bottling facilities we use in the United States and Germany. We combine and brew these ingredients under strict specifications and finally heat-pasteurize Virgil’s Root Beer, to ensure quality.  We sell Virgil’s Root Beer in three packaging styles: 12-ounce bottles in a four-pack, a special swing-lid style pint bottle and a 5-liter self-tapping party keg.
 
In addition to our Virgil’s Root Beer, we also offer the following products under our Virgil’s brand:

 
·
Virgil’s Cream Soda
 
·
Virgil’s Orange Cream Soda.
 
·
Virgil’s Black Cherry Cream Soda
 
·
Virgil’s Real Cola
 
·
Virgil’s Dr. Better
 
·
Virgil’s ZERO line, including Root Beer, Cream Soda, Real Cola, Dr. Better and Black Cherry Cream Soda.  Our ZERO line is naturally sweetened with Stevia.
 
·
Virgil’s juice beverages, including Clementine, Peach Lemonade and Pomegranate

We have other popular brands that currently have limited distribution, including China Cola, Sonoma Sparkler and Flying Cauldron Butterscotch Beer.  We are continually developing new brands and products.

Private Label Products

We design and manufacture drinks for private label customers in our Los Angeles Brewery.  We are experts in flavor development and in matching existing products in the market.  We develop the recipe and may design the label and/or the bottle style.  We do not private label any of our own branded product recipes.  Private label manufacturing is different than copacking, as we build the products and purchase the ingredients.  The customer is purchasing a finished product, not a copacking service.

Our private label products have been primarily sparkling juices, waters and teas.  We develop the sources for glass and ingredients.  We have a variety of packaging options, including swing-lid bottles, foil capsules and various label types.

New Product Development
 
We are always working on ideas and products to continue expanding our Reed’s Ginger Brews, Virgil’s product line, Reed’s Ginger Ice Cream, and Reed’s Ginger Candy product lines and packaging styles.  Among the advantages of our self-operated Brewery are the flexibility to try innovative packaging and the capability to experiment with new product flavors at less cost to our operations or capital.
 
Our private label products require continual product development.  We are able to be nimble and innovative, producing new products in a short amount of time.


 
4

 

Manufacture of Our Products
 
We produce our carbonated beverages at two facilities:

 
·
a facility in Los Angeles, California, known as The Brewery, at which we produce certain soda products and our private label products, and
 
·
a packing, or co-pack, facility in Pennsylvania which supplies us with product we do not produce at The Brewery.  The co-packer assembles our products and charges us a fee, generally by the case, for the products they produce.

We follow a “fill as needed” manufacturing model to the best of our ability and we have no significant backlog of orders.  Substantially all of the raw materials used in the preparation, bottling and packaging of our products are purchased by us or by our contract packers in accordance with our specifications. Reed’s Crystallized Ginger is made to our specifications in Fiji. Reed’s Ginger Candy Chews are made and packed to our specifications in Indonesia.

Generally, we obtain the ingredients used in our products from domestic suppliers and each ingredient has several reliable suppliers. We have no major supply contracts with any of our suppliers. As a general policy, we pick ingredients in the development of our products that have multiple suppliers and are common ingredients. This provides a level of protection against a major supply constriction or calamity.

We believe that as we continue to grow, we will be able to keep up with increased production demands. We believe that the Brewery has ample capacity to handle increased West Coast business. To the extent that any significant increase in business requires us to supplement or substitute our current co-packers, we believe that there are readily available alternatives, so that there would not be a significant delay or interruption in fulfilling orders and delivery of our products. In addition, we do not believe that growth will result in any significant difficulty or delay in obtaining raw materials, ingredients or finished product that is repackaged at the Brewery.
 
Our Primary Markets

We target a niche in the estimated $60 billion carbonated and non-carbonated soft drink markets in the US, Canada and International.  Our brands are generally regarded as premium and natural, with upscale packaging and are loosely defined as the artisanal, premium bottled carbonated soft drink category.

The soft drink industry is highly fragmented and the artisanal soft drink category consists of such competitors as, Henry Weinhards, Thomas Kemper, Hansen's, Izze, Boylans and Jones Soda, to name a few.  These brands have the advantage of being seen widely in the national market and being commonly known for years through well-funded ad campaigns.  Despite our products having a relatively high price for an artisanal premium beverage product, no mass media advertising and a relatively small but growing presence in the mainstream market compared to many of our competitors, we believe that results to date demonstrate that Reed's Ginger Brews and Virgil's sodas are making strong inroads and market share gains against some of the larger brands in the market.

We sell the majority of our products in the natural food store, mainstream supermarket chains and foodservice locations, primarily in the United States and, to a lesser degree, in Canada and Europe.


 
5

 

Natural Food Stores

Our primary and historical marketing and distribution source of our products has been natural food and gourmet stores throughout the US.  These stores include Whole Foods Market, Trader Joe's, Sprouts, Sunflowers, Earth Fare, New Seasons, just to name a few.  Our brands are also sold in gourmet restaurants and delis nationwide.  With the advent of large natural food store chains and specialty merchants, the natural foods segment continues to grow each year, helping fuel the continued growth of our brands.

Mainstream Supermarkets and Retailers

We also sell our products to direct store delivery distributors (DSD) who specialize in distributing and selling our products directly to mainstream retail channels, natural foods, and specialty retail stores.  Our brands are further sold directly to some retailers who require that we sell directly to their distribution centers since they have developed their own logistics capabilities.  Examples of chains that fall into the "direct" category are retailers such as, Costco, Trader Joe's, some Whole Foods Market Regions, and Kroger.

Supermarkets, particularly supermarket chains and prominent local/regional chains, often impose slotting fees in order to gain shelf presence within their stores.  These fees can be structured to be paid one-time only or in installments.  We pursue broad based slotting in supermarket chains throughout the US and to a lesser degree, in Canada.  However, our local and national sales team has been able to place our products without having to pay significant slotting from time to time.  Slotting fees for new item placements on average have cost anywhere between $10 to $150 per store, per new item.

Food Service Placement

We also market our beverages to industrial cafeterias (corporate feeders), and to on premise bars and restaurants.  As our business continues to mature, we intend to place our beverages in stadiums, sport arenas, concert halls, theatres, and other cultural centers as long-term marketing and pouring relationships are developed within this business segment.

International Sales

We have developed a limited market for our products in Canada, Europe and Asia. Sales outside of North America currently represent less than 1% of our total sales. Sales in Canada represent about 1.3% of our total sales. We are currently analyzing our international sales and marketing plan. Our analysis will explore options that may include outsourcing the international sales effort to third or related parties.  We have an export company that orders our products on a regular basis for distribution in Japan. We are holding preliminary discussions with other trading companies and import/export companies for the distribution of our products throughout Asia, Europe and South America. We believe that these areas are a natural fit for Reed’s ginger products, because of the importance of ginger in International, but especially the Asian diet and nutrition. Recently, we launched into the South African marketplace and Israel. Both of these markets are showing early signs of success.

Distribution, Sales and Marketing

We currently have a national network of mainstream, natural and specialty food distributors in the United States and Canada. We sell directly to our distributors, who in turn sell to retail stores. We also use our own internal sales force and independent sales representatives to promote our products for our distributors and direct sales to our retail customers. One of the main goals of our sales and marketing efforts is to increase sales and grow our brands. Our sales force consists of eight field sales representatives and four internal telemarketing sales representatives. Generally, our sales managers are responsible for all activities related to the sales, distribution and marketing of our brands to our entire distributor and retail partner network in North America.  We distribute our products primarily through several national natural foods distributors and an increasing number of regional mainstream DSD distributors.  We have entered into agreements with some of our distributors that commit us to "termination fees" if we terminate our agreements early or without cause. These agreements call for our customer to have the right to distribute our products to a defined type of retailer within a defined geographic region. As is customary in the beverage industry, if we should terminate the agreement or not automatically renew the agreement, we would be obligated to make certain payments to our customers. We have no plans to terminate or not renew any agreement with any of our customers.  We also offer our products and promotional merchandise directly to consumers via the Internet through our website, www.reedsgingerbrew.com.


 
6

 

Marketing to Distributors

We market to distributors using a number of marketing strategies, including direct solicitation, telemarketing, trade advertising and trade show exhibition. These distributors include natural food, gourmet food, and mainstream distributors. Our distributors sell our products directly to natural food, gourmet food and mainstream supermarkets for sale to the public. We maintain direct contact with our distributor partners through our in-house sales managers.  From time to time and in very limited markets, when use of our own sales force is not cost effective, we will utilize independent sales brokers and outside representatives.

Marketing to Retail Stores

The primary focus of our sales efforts is supermarket sales. We have a small highly trained sales force that is directly contacting supermarket chains and setting up promotional calendars. In addition, we market to retail stores by utilizing trade shows, trade advertising, telemarketing, direct mail pieces and direct contact with the store. Our sales managers and representatives visit these retail stores to sell directly in many regions. Sales to retail stores are coordinated through our distribution network and our regional warehouses.

Competition

The beverage industry is highly competitive. The principal areas of competition are pricing, packaging, development of new products and flavors and marketing campaigns. Our products compete with a wide range of drinks produced by a relatively large number of manufacturers. Most of these brands have enjoyed broad, well-established national recognition for years, through well-funded ad and other branding campaigns. In addition, the companies manufacturing these products generally have greater financial, marketing and distribution resources than we do.  Important factors affecting our ability to compete successfully include taste and flavor of products, trade and consumer promotions, rapid and effective development of new, unique cutting edge products, attractive and different packaging, branded product advertising and pricing. We also compete for distributors who will concentrate on marketing our products over those of our competitors, provide stable and reliable distribution and secure adequate shelf space in retail outlets. Competitive pressures in the soft drink category could cause our products to be unable to gain or to lose market share or we could experience price erosion.  We believe that our innovative beverage recipes and packaging and use of premium ingredients and a trade secret brewing process provide us with a competitive advantage and that our commitments to the highest quality standards and brand innovation are keys to our success.

Proprietary Rights
 
We own trademarks that we consider material to our business. Three of our material trademarks are registered trademarks in the U.S. Patent and Trademark Office: Virgil’s ®, Reed’s Original Ginger Brew All-Natural Jamaican Style Ginger Ale ® and Tianfu China Natural Soda ®. Registrations for trademarks in the United States will last indefinitely as long as we continue to use and police the trademarks and renew filings with the applicable governmental offices. We have not been challenged in our right to use any of our material trademarks in the United States. We intend to obtain international registration of certain trademarks in foreign jurisdictions.

In addition, we consider our finished product and concentrate formulae, which are not the subject of any patents, to be trade secrets.  Our brewing process is a trade secret.  This process can be used to brew flavors of beverages other than ginger ale and ginger beer, such as root beer, cream soda, cola, and other spice and fruit beverages.  We have not sought any patents on our brewing processes because we would be required to disclose our brewing process in patent applications.

We generally use non-disclosure agreements with employees and distributors to protect our proprietary rights.

 
7

 

Government Regulation
 
The production, distribution and sale in the United States of many of our Company’s products are subject to the Federal Food, Drug, and Cosmetic Act, the Federal Trade Commission Act, the Lanham Act, state consumer protection laws, federal, state and local workplace health and safety laws, various federal, state and local environmental protection laws and various other federal, state and local statutes and regulations applicable to the production, transportation, sale, safety, advertising, labeling and ingredients of such products. Outside the United States, the distribution and sale of our many products and related operations are also subject to numerous similar and other statutes and regulations.
 
A California law requires that a specific warning appear on any product that contains a component listed by the State as having been found to cause cancer or birth defects. The law exposes all food and beverage producers to the possibility of having to provide warnings on their products. This is because the law recognizes no generally applicable quantitative thresholds below which a warning is not required. Consequently, even trace amounts of listed components can expose affected products to the prospect of warning labels.  Products containing listed substances that occur naturally or that are contributed to such products solely by a municipal water supply are generally exempt from the warning requirement. No Company beverages produced for sale in California are currently required to display warnings under this law. We are unable to predict whether a component found in a Company product might be added to the California list in the future, although the state has initiated a regulatory process in which caffeine will be evaluated for listing. Furthermore, we are also unable to predict when or whether the increasing sensitivity of detection methodology that may become applicable under this law and related regulations as they currently exist, or as they may be amended, might result in the detection of an infinitesimal quantity of a listed substance in a beverage of ours produced for sale in California.
 
Bottlers of our beverage products presently offer and use nonrefillable, recyclable containers in the United States and various other markets around the world. Some of these bottlers also offer and use refillable containers, which are also recyclable. Legal requirements apply in various jurisdictions in the United States and overseas requiring that deposits or certain ecotaxes or fees be charged for the sale, marketing and use of certain nonrefillable beverage containers. The precise requirements imposed by these measures vary. Other types of beverage container-related deposit, recycling, ecotax and/or product stewardship statutes and regulations also apply in various jurisdictions in the United States and overseas. We anticipate that additional, similar legal requirements may be proposed or enacted in the future at local, state and federal levels, both in the United States and elsewhere.
 
All of our facilities and other operations in the United States are subject to various environmental protection statutes and regulations, including those relating to the use of water resources and the discharge of wastewater. Our policy is to comply with all such legal requirements. Compliance with these provisions has not had, and we do not expect such compliance to have, any material adverse effect on our capital expenditures, net income or competitive position.

Environmental Matters
 
Our primary cost environmental compliance activity is in recycling fees and redemption values.  We are required to collect redemption values from our customers and remit those redemption values to the state, based upon the number of bottles of certain products sold in that state.

Employees
 
We have 22 full-time employees on our corporate staff, as follows: 3 in general management, 14 in sales and marketing support, and 5 in administration and operations.  We also have 33 production employees that work both full and part time. We employ additional people on a part-time basis as needed.  We have never participated in a collective bargaining agreement. We believe that the relationship with our employees is good.


 
8

 

Item 2.    Property
 
We lease a facility of approximately 43,000 square feet, which serves as our principal executive offices, our West Coast Brewery and bottling plant and our Southern California warehouse facility.  Approximately 30,000 of the total space is leased under a long-term lease expiring in 2024.  We also lease a warehouse of approximately 13,000 square feet under a two-year lease expiring in 2012 and a warehouse of 10,000 square feet on a month to month basis.

Item 3.    Legal Proceedings
 
From time to time, we are a party to claims and legal proceedings arising in the ordinary course of business. Our management evaluates our exposure to these claims and proceedings individually and in the aggregate and provides for potential losses on such litigation if the amount of the loss is estimable and the loss is probable.

From August 3, 2005 through April 7, 2006, we issued 333,156 shares of our common stock in connection with our initial public offering. These securities represented all of the shares issued in connection with the initial public offering prior to October 11, 2006. These shares issued in connection with the initial public offering may have been issued in violation of either Federal or State securities laws, or both, and may be subject to rescission.

On August 12, 2006, we made a rescission offer to all holders of the outstanding shares that we believe are subject to rescission, pursuant to which we offered to repurchase these shares then outstanding from the holders. At the expiration of the rescission offer on September 18, 2006, the rescission offer was accepted by 32 of the offerees to the extent of 28,420 shares for an aggregate of $119,000, including statutory interest. The shares that were tendered for rescission were agreed to be purchased by others and not from our funds.

Federal securities laws do not provide that a rescission offer will terminate a purchaser’s right to rescind a sale of stock that was not registered as required or was not otherwise exempt from such registration requirements. With respect to the offerees who rejected the rescission offer, we may continue to be liable under federal and state securities laws for up to an amount equal to the value of all shares of common stock issued in connection with the initial public offering plus any statutory interest we may be required to pay. If it is determined that we offered securities without properly registering them under federal or state law, or securing an exemption from registration, regulators could impose monetary fines or other sanctions as provided under these laws. However, we believe the rescission offer provides us with additional meritorious defenses against any future claims relating to these shares.

Except as set forth above, we believe that there are no material litigation matters at the current time. Although the results of such litigation matters and claims cannot be predicted with certainty, we believe that the final outcome of such claims and proceedings will not have a material adverse impact on our financial position, liquidity or results of operations.

Item 4.    Mine Safety Disclosures

Not applicable.

 
9

 

PART II
 
Item 5.    Market for Common Equity and Related Stockholder Matters

Our common stock is listed for trading on the NASDAQ Capital Market trading under the symbol “REED”.  The following is a summary of the high and low bid prices of our common stock on the NASDAQ Capital Market for the periods presented:  
 
   
Sales Price
 
   
High
   
Low
 
Year Ending December 31, 2010
           
First Quarter
  $
2.44
    $
1.27
 
Second Quarter
   
3.08
     
1.62
 
Third Quarter
   
2.25
     
1.65
 
Fourth Quarter
   
2.46
     
1.88
 

   
Sales Price
 
   
High
   
Low
 
Year Ending December 31, 2011
           
First Quarter
  $
3.00
    $
1.95
 
Second Quarter
   
2.29
     
1.74
 
Third Quarter
   
2.10
     
1.61
 
Fourth Quarter
   
1.76
     
1.11
 

As of December 31, 2011, there were approximately 226 stockholders of record of the common stock (not including the number of persons or entities holding stock in nominee or street name through various brokerage firms) and approximately 10,885,833 outstanding shares of common stock.

Unregistered Sales of Equity Securities

During the fiscal year ended December 31, 2011, we issued the following equity securities that were unregistered under the Securities Act:

 
·
We issued 72,873 shares of common stock in exchange for consulting and legal services.  The value of the stock was based on the closing price of the stock on the issuance or agreed upon date.  The total value of shares issued for services was $146,000.  The shares were issued pursuant to exemption from registration under Section 4(2) of the Securities Act.

Dividend Policy

We have never declared or paid dividends on our common stock. We currently intend to retain future earnings, if any, for use in our business, and, therefore, we do not anticipate declaring or paying any dividends in the foreseeable future. Payments of future dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including the terms of our credit facility and our financial condition, operating results, current and anticipated cash needs and plans for expansion.
 
We are obligated to pay a non-cumulative 5% dividend from lawfully available assets to the holders of our Series A preferred stock and $0.13 per share per quarter on our Series B preferred stock in either cash or additional shares of common stock at our discretion. In 2011 and 2010, we paid dividends on our Series A preferred stock in an aggregate of 11,455 and 11,211 shares of common stock in each such year, respectively, and anticipate that we will be obligated to issue at least this many shares annually to the holders of the Series A preferred stock so long as such shares are issued and outstanding. In 2010, we accrued $50,000 of dividends on our outstanding Series B shares and paid $6,000 of dividends by issuing 3,394 shares of our common stock.   In 2011, we accrued $42,000 of dividends on our outstanding Series B shares and paid $3,000 of dividends by issuing 2,708 shares of our common stock.

 
10

 

Securities Authorized for Issuance Under Equity Compensation Plans

2001 Stock Option Plan and 2007 Stock Option Plan

We are authorized to issue options to purchase up to 500,000 shares of common stock under our 2001 Stock Option Plan, and we are authorized to issue options to purchase up to 1,500,000 shares of common stock under our 2007 Stock Option Plan.  On August 28, 2001, our board of directors adopted the 2001 Stock Option Plan and the plan was approved by our stockholders.  On October 8, 2007, our board of directors adopted the 2007 Stock Option Plan and the plan was approved by our stockholders on November 19, 2007.

The plans permit the grant of options to our employees, directors and consultants.  The options may constitute either “incentive stock options” within the meaning of Section 422 of the Internal Revenue Code or “non-qualified stock options.”  The primary difference between “incentive stock options” and “non-qualified stock options” is that once an option is exercised, the stock received under an “incentive stock option” has the potential of being taxed at the more favorable long-term capital gains rate, while stock received by exercising a “non-qualified stock option” is taxed according to the ordinary income tax rate schedule.

The plans are currently administered by the board of directors.  The plan administrator has full and final authority to select the individuals to receive options and to grant such options as well as a wide degree of flexibility in determining the terms and conditions of options, including vesting provisions.
 
The exercise price of an option granted under the plan cannot be less than 100% of the fair market value per share of common stock on the date of the grant of the option.  The exercise price of an incentive stock option granted to a person owning more than 10% of the total combined voting power of the common stock must be at least 110% of the fair market value per share of common stock on the date of the grant.  Options may not be granted under the plan on or after the tenth anniversary of the adoption of the plan.  Incentive stock options granted to a person owning more than 10% of the combined voting power of the common stock cannot be exercisable for more than five years.
 
When an option is exercised, the purchase price of the underlying stock will be paid in cash, except that the plan administrator may permit the exercise price to be paid in any combination of cash, shares of stock having a fair market value equal to the exercise price, or as otherwise determined by the plan administrator.
 
If an optionee ceases to be an employee, director, or consultant with us, other than by reason of death, disability, or retirement, all vested options must be exercised within three months following such event.  However, if an optionee’s employment or consulting relationship with us terminates for cause, or if a director of ours is removed for cause, all unexercised options will terminate immediately.  If an optionee ceases to be an employee or director of, or a consultant to us, by reason of death, disability, or retirement, all vested options may be exercised within one year following such event or such shorter period as is otherwise provided in the related agreement.
 
When a stock award expires or is terminated before it is exercised, the shares set aside for that award are returned to the pool of shares available for future awards.
 
No option can be granted under the plan after ten years following the earlier of the date the plan was adopted by the board of directors or the date the plan was approved by our stockholders.

2010 Incentive Stock Plan and 2010-2 Incentive Stock Plan

We are authorized to issue up to an aggregate of 75,000 shares of common stock to employees, officers, directors, consultants, independent contractors, advisors, or other service providers to Reed’s under our 2010 Incentive Stock Plan and 2010-2 Incentive Stock Plan (collectively, the “2010 Plans”).  The 2010 Incentive Stock Plan was adopted by our board of directors on March 31, 2010; the 2010-2 Incentive Stock Option Plan was adopted on May 5, 2010.  The 2010 Plans are administered by a committee of the board of directors.  The plan committee may from time to time, and subject to the provisions of the plan and such other terms and conditions as the plan committee may prescribe, grant to any eligible person one or more shares of common stock of  Reed’s ("Award Shares"). The grant of Award Shares or grant of the right to receive Award Shares shall be evidenced by either a written consulting agreement or a separate written agreement confirming such grant, executed by Reed’s and the recipient, stating the number of Award Shares granted and stating all terms and conditions of such grant.  During 2010, 72,025 shares of common stock were issued under the 2010 Plans, and in 2011 there were no additional shares issued under the 2010 Plans.


 
11

 

Equity Compensation Plan Information
 
The following table provides information, as of December 31, 2011, with respect to equity securities authorized for issuance under compensation plans:
 
Plan Category
 
  Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights
 (a)
    Weighted-Average Exercise Price of Outstanding Options,Warrants and Rights (b)    
Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (excluding securities reflected in Column(a))
(c)
 
                       
Equity compensation plans approved by security holders
   
1,172,000
    $
1.55
   
828,000
 
Equity compensation plans not approved by security holders
   
2,006,870
    $
 4.32
   
-
 
                       
TOTAL
   
3,178,870
    $
 3.30
   
828,000
 
 
Item 6.  Selected Financial Data
 
As a smaller reporting company, Reed’s is not required to provide the information required by this Item 6.

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes appearing elsewhere in this Annual Report. This discussion and analysis may contain forward-looking statements based on assumptions about our future business. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to those set forth under “Risk Factors” and elsewhere in this Annual Report.

Overview

We continued to experience significant increases in sales of our branded products in 2011, and we anticipate that those increases will continue into 2012.  Our gross margin on sales of branded products and private label products improved in 2011, and we feel that the gross margin percentage will remain constant in 2012, with increasing sales.  Our branded sales increases are driven by new distributor relationships in key regions, as well as expanded sales to our direct customers.  Private label opportunities are numerous and our capabilities are increasing, so that we can accommodate growth in this segment of our business.  We have adequate capital for our existing business and we are increasing margin contribution without significant increases in operating and sales costs.
 
 
 
12

 
 
Results of Operations
 
Year ended December 31, 2011 Compared to Year ended December 31, 2010

Sales

Sales of $25,013,000 for the year ended December 31, 2011 represented an increase of $4,637,000, or 23%, as compared to the prior year same period.  Sales from branded products increased over 19% during 2011, over 2010, with an overall volume increase of 23% in our core 12-ounce branded beverages. Sales of private label products increased to approximately $4.2 million in 2011, an increase of approximately 46% over 2010.  Sales increases are due to higher volumes with key customers as well as the addition of several regional direct store delivery (DSD) distributors selling our products.  Both branded and private label sales are anticipated to increase further in 2012.

Cost of Tangible Goods Sold

Cost of tangible goods sold consists of the costs of raw materials and packaging utilized in the manufacture of products, co-packing fees, repacking fees, in-bound freight charges, as well as certain internal transfer costs.  The total cost of $15,847,000 for the year December 31, 2011 decreased, as a percentage of sales, to 63% as compared to 64% of sales in the prior year.  Despite price increases in certain key raw ingredients, we were able to lower our average costs on our 12 ounce branded sodas overall by approximately 2% in the year ended  December 31, 2011, as compared to the prior year same period, due primarily to lower costs of certain packaging materials.

Cost of Goods Sold – Idle Capacity
 
Cost of goods sold – idle capacity consists of direct production costs in excess of charges allocated to our finished goods in production. Plant costs include labor costs, production supplies, repairs and maintenance, and inventory write-off.  Our charges for labor and overhead allocated to our finished goods are determined on a market cost basis, which is lower than our actual costs incurred.  Plant costs in excess of production allocations are expensed in the period incurred rather than added to the cost of finished goods produced.  Idle capacity expenses increased to $1,761,000 in the year ended December 31, 2011, from $1,195,000 in the prior year.  The increase is due to higher unabsorbed costs of production, primarily in payroll, workers compensation insurance and depreciation expense.  During 2011, we performed a number of plant upgrades and maintenance which required labor costs which could not be capitalized and which required periods of down time from production.  Despite the down periods, our copack volume in the Los Angeles brewery increased by over 20% in 2011, as compared to 2010.  We also reduced our internal absorption rates on certain products, to reflect market costs, which resulted in higher unabsorbed period costs.

Gross Profit

Our gross profit of $7,405,000 in the year ended December 31, 2011 represents 30% of sales, as compared to the same percentage in 2010. The improvement in tangible costs of goods sold, as a percentage in sales, is offset by increased cost of goods sold – idle capacity as described above.

Delivery and Handling Expenses

Delivery and handling expenses consist of delivery costs to certain customers and warehouse costs incurred for handling our finished goods after production.  Delivery and handling costs increased to $2,307,000 in the year ended December 31, 2011 from $1,728,000 in 2010.  The 34% increase is due to higher sales volume, increased freight costs on certain customers and increased inventory handling costs.  As a percentage of sales, delivery and handling expenses increased to 9% in the year ended December 31, 2011, as compared to 2010.
 
 
 
13

 

 
Selling and marketing expenses

Selling and marketing expenses consist primarily of direct charges for staff compensation costs, advertising, sales promotion, marketing and trade shows. Selling and marketing costs increased overall to $2,470,000 in the year ended December 31, 2011 from $2,319,000 in 2010.  The $151,000 increase is primarily due to increased compensation and travel costs of approximately $197,000, offset partially by decreases in facilities and trade show related costs.

As a percentage of sales, selling and marketing costs decreased to 10% in the year ended December 31, 2011, as compared to 11% in 2010.

General and Administrative Expenses
 
General and administrative expenses consist primarily of the cost of executive, administrative, and finance personnel, as well as professional fees. General and administrative expenses during the year ended December 31, 2011 increased to $2,878,000 from $2,740,000 in 2010.  A legal matter asserted by a former industrial employee resulted in legal costs of $327,000 during 2011.  Also, we adjusted an over-accrual of recycling fees payable in the amount of $82,000, resulting in a one-time reduction in costs during the year. Aside from these two one-time events, general and administrative expenses decreased by $107,000 in 2011, as compared to the prior year. The decrease is primarily due to decreased professional and consulting costs.
 
We believe that our existing executive and administrative staffing levels are sufficient to allow for moderate growth without the need to add personnel and related costs for the foreseeable future.
 
Loss from Operations
 
Loss from operations was $250,000 in the year ended December 31, 2011, as compared to a loss of $724,000 in the same period of 2010.  The improvement of $474,000 is primarily due to increased sales and margin contribution.

Interest Expense

Interest expense increased to $691,000 in the year ended December 31, 2011, compared to interest expense of $586,000 in the same period of 2010.  The increase is due to increased borrowing under a loan and security agreement with PMC Financial, LLC, secured primarily by our inventory and accounts receivable.  The agreement includes both a revolving line of credit and a term loan, allowing increased borrowing as compared to our former line of credit.
 
Modified EBITDA

The Company defines modified EBITDA (a non-GAAP measurement) as net loss before interest, taxes, depreciation and amortization, and non-cash expense for securities.  Other companies may calculate modified EBITDA differently.  Management believes that the presentation of modified EBITDA provides a measure of performance that approximates cash flow before interest expense, and is meaningful to investors.

 
14

 

MODIFIED EBITDA SCHEDULE
 
   
Year ended December 31,
 
   
2011
   
2010
 
   
(unaudited)
   
(unaudited)
 
                 
Net loss
  $ (941,000 )   $ (1,310,000 )
                 
Modified EBITDA adjustments:
               
Depreciation and amortization
    653,000       616,000  
Interest expense
    691,000       586,000  
Stock option and warrant compensation
    300,000       198,000  
Other stock compensation for services and finance fees
    131,000       366,000  
Total EBITDA adjustments
    1,775,000       1,766,000  
                 
Modified EBITDA income from operations
  $ 834,000     $ 456,000  

Liquidity and Capital Resources

As of December 31, 2011, we had stockholders equity of $4,305,000 and we had working capital of $2,655,000, compared to stockholders equity of $4,142,000 and working capital of $1,830,000 at December 31, 2010. The cash balance was $713,000 as of December 31, 2011, as compared to $1,084,000 at December 31, 2010. The increase in our working capital of $825,000 was primarily a result of our sale of our equity securities and proceeds from a long term loan; offset by losses from operations, before depreciation and other non-cash expenses.

Our decrease in cash and cash equivalents to $713,000 at December 31, 2011 compared to $1,084,000 at December 31, 2010 was primarily a result of cash used in operating activities, primarily for increases in accounts receivable and inventory prepayments that are related to our overall increases in ongoing revenues.  Such cash used in operations was offset primarily by sales of equity securities. In addition to our cash position on December 31, 2011, we had availability under our line of credit of $307,000.

On February 4, 2011, we sold 304,880 shares of our common stock and 121,952 warrants for $750,000.  We paid $78,000 in expenses in connection with the transaction.  The net proceeds are being used for working capital.  We also gained $25,000 through the exercise of warrants.

During the year ended December 31, 2011, we invested $356,000 in plant improvements.  We are upgrading the facilities as well as adding new equipment to our production line that will increase our flexibility in product offerings and increase our plant performance.

Our Loan and Security Agreement with PMC Financial Services Group, LLC provides a $3 million revolving line of credit and a $750,000 term loan.  The revolving line of credit is based on 85% of eligible accounts receivable and 50% of eligible inventory. The interest rate on the revolving line of credit is at the prime rate plus 3.75% (7% at December 31, 2011).  The term loan is for $750,000 and bears interest at the prime rate plus 11.6%, which shall not be below 14.85%, is secured by all of the unencumbered assets of the Company, and is to be repaid in 48 equal installments of principal and interest of $21,000.


 
15

 

We believe that the Company currently has the necessary working capital to support existing operations for at least the next 12 months. Our primary capital source will be cash flow from operations as we gain profitability.  If our sales goals do not materialize as planned, we believe that the Company can become leaner and our costs can be managed to produce profitable operations.  Historically, we have financed our operations primarily through private sales of common stock, preferred stock, convertible debt, a line of credit from a financial institution and cash generated from operations.

We may not generate sufficient revenues from product sales in the future to achieve profitable operations. If we are not able to achieve profitable operations at some point in the future, we eventually may have insufficient working capital to maintain our operations as we presently intend to conduct them or to fund our expansion and marketing and product development plans. In addition, our losses may increase in the future as we expand our manufacturing capabilities and fund our marketing plans and product development. These losses, among other things, have had and may continue to have an adverse effect on our working capital, total assets and stockholders’ equity. If we are unable to achieve profitability, the market value of our common stock would decline and there would be a material adverse effect on our financial condition.

If we continue to suffer losses from operations, our working capital may be insufficient to support our ability to expand our business operations as rapidly as we would deem necessary at any time, unless we are able to obtain additional financing. There can be no assurance that we will be able to obtain such financing on acceptable terms, or at all. If adequate funds are not available or are not available on acceptable terms, we may not be able to pursue our business objectives and would be required to reduce our level of operations, including reducing infrastructure, promotions, personnel and other operating expenses. These events could adversely affect our business, results of operations and financial condition.  If adequate funds are not available or if they are not available on acceptable terms, our ability to fund the growth of our operations, take advantage of opportunities, develop products or services or otherwise respond to competitive pressures, could be significantly limited.

Critical Accounting Policies and Estimates
 
Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. GAAP requires us to make estimates and assumptions that affect the reported amounts in our financial statements including various allowances and reserves for accounts receivable and inventories, the estimated lives of long-lived assets and trademarks and trademark licenses, as well as claims and contingencies arising out of litigation or other transactions that occur in the normal course of business. The following summarize our most significant accounting and reporting policies and practices:
 
Revenue Recognition.  Revenue is recognized on the sale of a product when the product is shipped, which is when the risk of loss transfers to our customers, and collection of the receivable is reasonably assured.  A product is not shipped without an order from the customer and credit acceptance procedures performed.  The allowance for returns is regularly reviewed and adjusted by management based on historical trends of returned items. Amounts paid by customers for shipping and handling costs are included in sales. The Company reimburses its wholesalers and retailers for promotional discounts, samples and certain advertising and promotional activities used in the promotion of the Company’s products. The accounting treatment for the reimbursements for samples and discounts to wholesalers results in a reduction in the net revenue line item. Reimbursements to wholesalers and retailers for certain advertising activities are included in selling and marketing expenses.


 
16

 

Trademark License and Trademarks.  We own trademarks that we consider material to our business. Three of our material trademarks are registered trademarks in the U.S. Patent and Trademark Office: Virgil’s ®, Reed’s Original Ginger Brew All-Natural Jamaican Style Ginger Ale ® and Tianfu China Natural Soda ®. Registrations for trademarks in the United States will last indefinitely as long as we continue to use and police the trademarks and renew filings with the applicable governmental offices. We have not been challenged in our right to use any of our material trademarks in the United States. We intend to obtain international registration of certain trademarks in foreign jurisdictions.
  
We account for these items in accordance with FASB guidance; we do not amortize indefinite-lived trademark licenses and trademarks.

In accordance with FASB guidance, we evaluate our non-amortizing trademark license and trademarks quarterly for impairment. We measure impairment by the amount that the carrying value exceeds the estimated fair value of the trademark license and trademarks. The fair value is calculated by reviewing net sales of the various beverages and applying industry multiples. Based on our quarterly impairment analysis the estimated fair values of trademark license and trademarks exceeded the carrying value and no impairments were identified during the year ended December 31, 2011.
 
Long-Lived Assets. Our management regularly reviews property, equipment and other long-lived assets, including identifiable amortizing intangibles, for possible impairment. This review occurs quarterly or more frequently if events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. If there is indication of impairment of property and equipment or amortizable intangible assets, then management prepares an estimate of future cash flows (undiscounted and without interest charges) 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 fair value is estimated at the present value of the future cash flows discounted at a rate commensurate with management’s estimates of the business risks. Quarterly, or earlier, if there is indication of impairment of identified intangible assets not subject to amortization, management compares the estimated fair value with the carrying amount of the asset. An impairment loss is recognized to write down the intangible asset to its fair value if it is less than the carrying amount. Preparation of estimated expected future cash flows is inherently subjective and is based on management’s best estimate of assumptions concerning expected future conditions. No impairments were identified during the year ended December 31, 2011. 

Management believes that the accounting estimate related to impairment of our long lived assets, including our trademark license and trademarks, is a “critical accounting estimate” because: (1) it is highly susceptible to change from period to period because it requires management to estimate fair value, which is based on assumptions about cash flows and discount rates; and (2) the impact that recognizing an impairment would have on the assets reported on our balance sheet, as well as net income, could be material. Management’s assumptions about cash flows and discount rates require significant judgment because actual revenues and expenses have fluctuated in the past and we expect they will continue to do so.
 
In estimating future revenues, we use internal budgets. Internal budgets are developed based on recent revenue data for existing product lines and planned timing of future introductions of new products and their impact on our future cash flows.
 
Accounts Receivable. We evaluate the collectability of our trade accounts receivable based on a number of factors. In circumstances where we become aware of a specific customer’s inability to meet its financial obligations to us, a specific reserve for bad debts is estimated and recorded which reduces the recognized receivable to the estimated amount our management believes will ultimately be collected. In addition to specific customer identification of potential bad debts, bad debt charges are recorded based on our historical losses and an overall assessment of past due trade accounts receivable outstanding. 


 
17

 

Inventories.  Inventories are stated at the lower of cost to purchase and/or manufacture the inventory or the current estimated market value of the inventory. We regularly review our inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on our estimated forecast of product demand and/or our ability to sell the product(s) concerned and production requirements. Demand for our products can fluctuate significantly. Factors that could affect demand for our products include unanticipated changes in consumer preferences, general market conditions or other factors, which may result in cancellations of advance orders or a reduction in the rate of reorders placed by customers. Additionally, our management’s estimates of future product demand may be inaccurate, which could result in an understated or overstated provision required for excess and obsolete inventory.
 
Stock-Based Compensation. We periodically issue 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 FASB ASC Topic 718, “Compensation – Stock Compensation”, whereas the award is measured at its fair value at the date of grant and is amortized ratably over the vesting period.  We account for stock option and warrant grants issued and vesting to non-employees in accordance with ASC Topic 718 whereby the fair value of the stock compensation is based on 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 instrument is complete.
 
We estimate the fair value of stock options using the Black-Scholes option-pricing model, which was developed for use in estimating the fair value of options that have no vesting restrictions and are fully transferable. This model requires the input of subjective assumptions, including the expected price volatility of the underlying stock and the expected life of stock options. Projected data related to the expected volatility of stock options is based on the historical volatility of the trading prices of the Company’s common stock and the expected life of stock options is based upon the average term and vesting schedules of the options. Changes in these subjective assumptions can materially affect the fair value of the estimate, and therefore the existing valuation models do not provide a precise measure of the fair value of our employee stock options.

We believe there have been no significant changes, during the year ended December 31, 2011, to the items disclosed as critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

Recent Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”.  ASU No. 2011-4 does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting.  The ASU is effective for interim and annual periods beginning after December 15, 2011. The Company will adopt the ASU as required.  The ASU will affect the Company’s fair value disclosures, but will not affect the Company’s results of operations, financial condition or liquidity.

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income”.  The ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity, and instead requires consecutive presentation of the statement of net income and other comprehensive income either in a continuous statement of comprehensive income or in two separate but consecutive statements.  ASU No. 2011-5 is effective for interim and annual periods beginning after December 15, 2011.  The Company will adopt the ASU as required.  It will have no affect on the Company’s results of operations, financial condition or liquidity.


 
18

 
 
 
In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment”, an update to existing guidance on the assessment of goodwill impairment.  This update simplifies the assessment of goodwill for impairment by allowing companies to consider qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount before performing the two step impairment review process.  It also amends the examples of events or circumstances that would be considered in a goodwill impairment evaluation.  The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted.  The Company is currently evaluating the affects adoption of ASU 2011-08 may have on its goodwill impairment testing.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission (the "SEC") did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.

Inflation
 
Although management expects that our operations will be influenced by general economic conditions, we do not believe that inflation has a material effect on our results of operations.
 
Item 7A.    Quantitative and Qualitative Disclosures About Market Risk
 
As a smaller reporting company, Reed’s is not required to provide the information required by this Item 7A.
 
 
 
 
 

 
19

 


Item 8.  Financial Statements
 
 
Report of Independent Registered Public Accounting Firm
F-1
   
Financial Statements:
 
   
Balance Sheets as of December 31, 2011 and December 31, 2010
F-2
   
Statements of Operations for the years ended December 31, 2011 and 2010
F-3
   
Statements of Changes in Stockholders’ Equity for the years ended December 31, 2011         and 2010
F-4
   
Statements of Cash Flows for the years ended December 31, 2011 and 2010
F-5
   
Notes to Financial Statements
F-6
 


 
20

 
 
 
Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of:
Reed’s, Inc.


We have audited the accompanying balance sheets of Reed’s, Inc. as of December 31, 2011 and 2010 and the related statements of operations, changes in stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly in all material respects, the financial position of Reed’s, Inc. as of December 31, 2011 and 2010 and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.


/s/ Weinberg & Company, P.A.

Weinberg & Company, P.A.
Los Angeles, California
March 26, 2012

 
F-1

 
 
REED’S, INC.
BALANCE SHEETS
   
December 31,
2011
   
December 31,
2010
 
ASSETS
           
Current assets:
           
Cash
  $ 713,000     $ 1,084,000  
Inventory
    6,099,000       4,555,000  
Trade accounts receivable, net of allowance for doubtful accounts and returns and discounts of $135,000 and $105,000, respectively
    1,626,000       1,295,000  
Prepaid inventory
    168,000       138,000  
Prepaid and other current assets
    123,000       78,000  
Total Current Assets
    8,729,000       7,150,000  
                 
Property and equipment, net of accumulated depreciation of $1,739,000 and $1,178,000, respectively
    3,512,000       3,650,000  
Brand names
    1,029,000       1,029,000  
Deferred financing fees, net of amortization of $50,000 and $8,000, respectively
    85,000       47,000  
Total assets
  $ 13,355,000     $ 11,876,000  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current Liabilities:
               
Accounts payable
  $ 2,310,000     $ 2,586,000  
Accrued expenses
    196,000       162,000  
Dividends payable
    83,000       44,000  
Recycling fees payable
    111,000       325,000  
Line of credit
    3,095,000       2,038,000  
Current portion of long term financing obligation
    71,000       55,000  
Current portion of capital leases payable
    56,000       39,000  
Current portion of note payable
    -       71,000  
Current portion of term loan
    152,000       -  
Total current liabilities
    6,074,000       5,320,000  
                 
Long term financing obligation, less current portion, net of discount of $626,000 and $677,000, respectively
    2,247,000       2,268,000  
Capital leases payable, less current portion
    153,000       146,000  
Term loan, less current portion
    576,000       -  
       Total Liabilities
    9,050,000       7,734,000  
                 
Commitments and contingencies
               
Stockholders’ equity:
               
Series A Convertible Preferred stock, $10 par value, 500,000 shares authorized, 46,621 shares issued and outstanding
    466,000       466,000  
Series B Convertible Preferred stock, $10 par value, 500,000 shares authorized, 80,415 and 85,766 shares issued and outstanding, respectively
    804,000       858,000  
Common stock, $.0001 par value, 19,500,000 shares authorized, 10,885,833  and 10,446,090  shares issued and outstanding, respectively
    1,000       1,000  
Additional paid in capital
    22,924,000       21,701,000  
Accumulated deficit
    (19,890,000 )     (18,884,000 )
Total stockholders’ equity
    4,305,000       4,142,000  
Total liabilities and stockholders’ equity
  $ 13,355,000     $ 11,876,000  

The accompanying notes are an integral part of these financial statements

 
F-2

 

REED’S, INC.
STATEMENTS OF OPERATIONS
For the Years Ended December 31, 2011 and 2010
 
   
2011
   
2010
 
                 
Sales
  $ 25,013,000     $ 20,376,000  
Cost of tangible goods sold
    15,847,000       13,118,000  
Cost of goods sold – idle capacity
    1,761,000       1,195,000  
Gross profit
    7,405,000       6,063,000  
                 
Operating expenses:
               
Delivery and handling expenses
    2,307,000       1,728,000  
Selling and marketing expense
    2,470,000       2,319,000  
General and administrative expense
    2,878,000       2,740,000  
Total operating expenses
    7,655,000       6,787,000  
                 
Loss from operations
    (250,000 )     (724,000 )
                 
Interest expense
    (691,000 )     (586,000 )
                 
Net loss
    (941,000 )     (1,310,000 )
                 
Preferred stock dividend
    (65,000 )     (73,000 )
                 
Net loss attributable to common stockholders
  $ (1,006,000 )   $ (1,383,000 )
                 
Loss per share available to common stockholders - basic and diluted
  $ (0.09 )   $ (0.14 )
Weighted average number of shares outstanding - basic and diluted
    10,785,719       10,186,600  

 

The accompanying notes are an integral part of these financial statements
 
 




 
F-3

 

REED’S, INC.
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY 
For the Years Ended December 31, 2011 and 2010

    Common Stock     Series A Preferred Stock     Series B Preferred Stock    
 Additional Paid-in
     Accumulated      Total Stockholders'  
   
Shares
   
Amount
   
Shares
   
Amount
   
Shares
   
Amount
   
Capital
   
Deficit
   
Equity
 
Balance, December 31, 2009
    9,606,127     $ 1,000       46,621     $ 466,000       120,820     $ 1,208,000     $ 20,203,000     $ (17,501,000 )   $ 4,377,000  
                                                                         
Fair Value of Common Stock issued for bonuses and services
    204,828       -       -       -       -       -       366,000       -       366,000  
Common stock issued upon conversion of Series B preferred stock
    334,838       -       -       -       (47,834 )     (478,000 )     478,000       -       -  
Sale of common stock in shelf offering
    277,359       -       -       -       -       -       432,000       -       432,000  
Sale of Series B preferred stock, net of offering costs
    -       -       -       -       12,780       128,000       (11,000 )     -       117,000  
Exercise of stock options
    8,333       -       -       -       -       -       6,000       -       6,000  
Fair value vesting of options issued to employees
    -       -       -       -       -       -       198,000       -       198,000  
Series A and Series B preferred stock dividend
    -       -       -       -       -       -       -       (73,000 )     (73,000 )
Common stock paid for Series A and Series B dividend
    14,605       -       -       -       -       -       29,000       -       29,000  
Net Loss
    -       -       -       -       -       -       -       (1,310,000 )     (1,310,000 )
Balance, December 31, 2010
    10,446,090       1,000       46,621       466,000       85,766       858,000       21,701,000       (18,884,000 )     4,142,000  
                                                                         
Fair value of common  stock issued for services and finance fees
    72,873       -       -       -       -       -       146,000       -       146,000  
Common stock issued upon conversion of Series B preferred stock
    37,457       -       -       -       (5,351 )     (54,000 )     54,000       -       -  
Sale of common stock in private offering
    304,880       -       -       -       -       -       672,000       -       672,000  
Exercise of warrants
    11,000       -       -       -       -       -       25,000       -       25,000  
Fair value vesting of options issued to employees
    -       -       -       -       -       -       258,000       -       258,000  
Fair value of warrants issued for services
    -       -       -       -       -       -       42,000       -       42,000  
Series A and Series B preferred stock dividend
    -       -       -       -       -       -       -       (65,000 )     (65,000 )
Common stock paid for Series A and Series B preferred stock dividend
    13,533       -       -       -       -       -       26,000       -       26,000  
Net loss
    -       -       -       -       -       -       -       (941,000 )     (941,000 )
Balance, December 31, 2011
    10,885,833     $ 1,000       46,621     $ 466,000       80,415     $ 804,000     $ 22,924,000     $ (19,890,000 )   $ 4,305,000  
 
 
The accompanying notes are an integral part of these financial statements

 
F-4

 

REED’S, INC.
STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2011 and 2010

   
2011
   
2010
 
Cash flows from operating activities:
           
Net loss
  $ (941,000 )   $ (1,310,000 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    653,000       616,000  
Fair value of stock options issued to employees
    258,000       198,000  
Fair value of warrants issued for services
    42,000       -  
Fair value of common stock issued for services
    131,000       366,000  
Increase in allowance for doubtful accounts
    30,000       15,000  
Changes in assets and liabilities:
               
Accounts receivable
    (361,000 )     (444,000 )
Inventory
    (1,544,000 )     (1,671,000 )
Prepaid expenses and inventory and other current assets
    (75,000 )     (117,000 )
Accounts payable
    (276,000 )     1,632,000  
Accrued expenses
    34,000       35,000  
Recycling fees payable
    (215,000 )     (131,000 )
Net cash used in operating activities
    (2,264,000 )     (811,000 )
Cash flows from investing activities:
               
Purchase of property and equipment
    (356,000 )     (383,000 )
Net cash used in investing activities
    (356,000 )     (383,000 )
Cash flows from financing activities:
               
Proceeds from issuance of common stock in shelf offering, net of offering costs
    -       432,000  
Proceeds from issuance of common stock in private placement, net of offering costs
    672,000       -  
Proceeds from stock option and warrant exercises
    25,000       6,000  
Proceeds from the issuance of Series B preferred stock, net of offering costs
    -       117,000  
Payments for deferred financing fees
    (65,000 )     (30,000 )
Proceeds received from term loan
    750,000       -  
Principal repayments on term loan
    (22,000 )     -  
Principal repayments on long term financing obligation
    (54,000 )     (42,000 )
Principal repayments on capital lease obligation
    (43,000 )     (32,000 )
Net borrowings on existing line of credit
    3,404,000       -  
Net (payoff) borrowings on former line of credit
    (2,347,000 )     623,000  
Principal repayments on note payable
    (71,000 )     (102,000 )
Net cash provided by financing activities
    2,249,000       972,000  
Net decrease in cash
    (371,000 )     (222,000 )
Cash at beginning of year
    1,084,000       1,306,000  
Cash at end of year
  $ 713,000     $ 1,084,000  
Supplemental Disclosures of Cash Flow Information:
               
Cash paid during the year for:
               
Interest
  $ 671,000     $ 561,000  
Taxes
  $ -     $ -  
Non Cash Investing and Financing Activities
               
Series B preferred stock converted to common stock
  $ 54,000     $ 478,000  
Common Stock issued in settlement of Series A and Series B preferred stock  dividend
  $ 26,000     $ 29,000  
Series B preferred stock dividend payable in common stock
  $ 42,000     $ 50,000  
Property and equipment acquired through capital lease obligation
  $ 67,000     $ 64,000  
Common stock issued for deferred financing fees
  $ 15,000       -  

The accompanying notes are an integral part of these financial statements

 
F-5

 
 
 
REED’S, INC.
NOTES TO FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2011 AND 2010
 
(1)
Operations and Summary of Significant Accounting Policies
 
 
A)
Nature of Operations
 
Reed’s, Inc. (the “Company”) was organized under the laws of the state of Florida in January 1991. In 2001, the Company changed its name from Original Beverage Corporation to Reed’s, Inc. and changed its state of incorporation from Florida to Delaware. The Company is engaged primarily in the business of developing, manufacturing and marketing natural non-alcoholic beverages, as well as candies and ice creams. The Company currently offers seven Reed’s Ginger Brew flavors (Extra, Original, Premium, Light 55 Calorie Extra, Cherry Ginger, Raspberry Ginger and Spiced Apple Ginger); Reed’s Energy Elixir; five Virgil’s beverages (Root Beer, Cream Soda, Orange Cream Soda, Black Cherry Cream Soda, and Real Cola); four zero calorie Virgil’s versions; two China Cola beverages (regular and cherry); two Sonoma Sparkler sparkling juices; three kinds of  ginger candies (crystallized ginger, ginger chews and peanut butter ginger chews); and three flavors of ginger ice cream (Original, Green Tea, and Chocolate).  In 2010 the Company introduced its nausea relief product and reformulated its Virgil’s diet products into its new ZERO line with stevia natural sweetener.
 
The Company sells its products primarily in upscale gourmet and natural food stores and supermarket chains in the United States and Canada.
 
 
B)
Cash
 
Cash includes unrestricted deposits.
 
 
C)
Use of 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 disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.  Those estimates and assumptions include estimates for reserves of uncollectible accounts, inventory obsolescence, analysis of impairments of recorded intangibles, accruals for potential liabilities and assumptions made in valuing stock instruments issued for services.
 
 
D)
Accounts Receivable
 
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 and discounts is established through a provision for returns and discounts charged against sales. Receivables are charged off against the allowance when payments are received or products returned. The allowance for doubtful accounts and returns and discounts as of December 31, 2011 was approximately $135,000 and December 31, 2010 was approximately $105,000.
 

 
F-6

 


 
E)
Property and Equipment and Related Depreciation
 
Property and equipment is stated at cost. Depreciation is calculated using accelerated and straight-line methods over the estimated useful lives of the assets as follows:
  
Property and Equipment Type
 
Years of Depreciation
 
Building
   
39 years
 
Machinery and equipment
   
5-12 years
 
Vehicles
   
5 years
 
Office equipment
   
5-7 years
 
 
Management regularly reviews property, equipment and other long-lived assets for possible impairment. This review occurs quarterly, or more frequently if events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. If there is indication of impairment, management prepares an estimate of future cash flows (undiscounted and without interest charges) 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 recognize impairment for the years ended December 31, 2011 and 2010.
 
 
F)
Intangible Assets and Impairment Policy
 
The Company records intangible assets in accordance with FASB ASU Topic 350 “Intangibles – Goodwill and Other”.  Intangible assets consist mostly of brand names and are deemed to have indefinite lives not subject to annual amortization. Intangible assets which have finite lives are amortized on a straight line basis over their remaining useful life; they are also subject to annual impairment reviews.
 
Management regularly reviews intangible assets for possible impairment. This review occurs quarterly, or more frequently if events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. If there is indication of impairment, management prepares an estimate of future cash flows (undiscounted and without interest charges) 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. No impairments were identified for the years ended December 31, 2011 and 2010.
  
 
G)
Concentrations
 
The Company’s cash balances on deposit with banks are guaranteed by the Federal Deposit Insurance Corporation up to $250,000 at December 31, 2011. The Company may be exposed to risk for the amounts of funds held in bank accounts in excess of the insurance limit. In assessing the risk, the Company’s policy is to maintain cash balances with high quality financial institutions. The Company had cash balances in excess of the guarantee during the years ended December 31, 2011 and 2010.
 
During the year ended December 31, 2011, the Company had two customers who accounted for approximately 28% and 11% of its sales, respectively; and during the year ended December 31, 2010 the Company had three customers who accounted for approximately 29% and 11% and 10% of its sales, respectively. No other customer accounted for more than 10% of sales in either year. As of December 31, 2011 the Company had accounts receivable due from two customers who comprised $475,000 (27%), and $264,000 (15%), respectively, of its total accounts receivable; and as of December 31, 2010 the Company had accounts receivable due from three customers who comprised $199,000 (14%), $197,000 (14%), and $159,000 (11%), respectively, of its total accounts receivable.
 

 
F-7

 

The Company currently relies on a single contract packer for a majority of its production and bottling of beverage products. The Company has different packers available for their production of products. Although there are other packers and the Company has outfitted their own brewery and bottling plant, a change in packers may cause a delay in the production process, which could ultimately affect operating results.
 
 
H)
Fair Value of Financial Instruments
 
The Company uses various inputs in determining the fair value of its investments and measures these assets on a recurring basis. Financial assets recorded at fair value in the balance sheets are categorized by the level of objectivity associated with the inputs used to measure their fair value. Authoritative guidance provided by the FASB defines the following levels directly related to the amount of subjectivity associated with the inputs to fair valuation of these financial assets:

Level 1—Quoted prices in active markets for identical assets or liabilities.
Level 2—Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly.
Level 3—Unobservable inputs based on the Company's assumptions.

The Company has no such assets or liabilities recorded to be valued on the basis above at December 31, 2011 and 2010.

 
I)
Cost of sales
 
The Company classifies cost of sales in two categories. Cost of tangible goods sold is comprised of the costs of raw materials and packaging utilized in the manufacture of products, co-packing fees, repacking fees, in-bound freight charges, as well as certain internal transfer costs.  Cost of goods sold – idle capacity consists of direct production costs in excess of charges allocated to finished goods in production. Plant costs include labor costs, production supplies, repairs and maintenance, and inventory write-off.  Charges for labor and overhead allocated to finished goods are determined on a market cost basis, which is lower than the actual costs incurred.  Plant costs in excess of production allocations are expensed in the period incurred rather than added to the cost of finished goods produced.  Expenses not related to the production of our products are classified as operating expenses.

 
J)
Delivery and Handling Expenses
 
Shipping and handling costs are comprised of purchasing and receiving costs, inspection costs, warehousing costs, transfer freight costs, and other costs associated with product distribution after manufacture and are included as part of operating expenses.

 
K)
Income Taxes
 
Current income tax expense is the amount of income taxes expected to be payable for the current year. A deferred income tax asset or liability is established for the expected future consequences of temporary differences in the financial reporting and tax bases of assets and liabilities. The Company considers future taxable income and ongoing, prudent and feasible tax planning strategies, in assessing the value of its deferred tax assets. If the Company determines that it is more likely than not that these assets will not be realized, the Company will reduce the value of these assets to their expected realizable value, thereby decreasing net income. Evaluating the value of these assets is necessarily based on the Company’s judgment. If the Company subsequently determined that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made.


 
F-8

 


 
L)
Revenue Recognition
 
Revenue is recognized on the sale of a product when the product is shipped, which is when the risk of loss transfers to our customers, and collection of the receivable is reasonably assured. A product is not shipped without an order from the customer and credit acceptance procedures performed. The allowance for returns is regularly reviewed and adjusted by management based on historical trends of returned items. Amounts paid by customers for shipping and handling costs are included in sales.

The Company accounts for certain sales incentives, including slotting fees, as a reduction of gross sales. These sales incentives for the years ended December 31, 2011 and 2010 approximated $1,463,000 and $933,000, respectively.

 
M)
Net Loss Per Share
 
Basic earnings (loss) per share is computed by dividing the net income (loss) applicable to Common Stockholders by the weighted average number of shares of Common Stock outstanding during the year. Diluted earnings (loss) per share is computed by dividing the net income (loss) applicable to Common Stockholders 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 as their effect is antidilutive.
 
For the years ended December 31, 2011 and 2010 the calculations of basic and diluted loss per share are the same because potential dilutive securities would have an anti-dilutive effect. The potentially dilutive securities consisted of the following as of:
 
   
December 31,
 
   
2011
   
2010
 
Warrants
    2,006,870       2,009,028  
Series A Preferred Stock
    186,484       186,484  
Series B Preferred Stock
    562,905       600,362  
Options
    1,172,000       840,000  
Total
    3,928,259       3,635,874  

 
N)
Advertising Costs
 
Advertising costs are expensed as incurred and are included in selling expense in the amount of $25,000 and $171,000, for the years ended December 31, 2011 and 2010, respectively.

 
O)
Stock Compensation Expense
 
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 Financial Accounting Standards Board (FASB) ASC Topic 718, “Compensation – Stock Compensation”, whereas the award is measured at its fair value at the date of grant and is amortized ratably over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with ASC Topic 718 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.

 
F-9

 


 
P)
Recent Accounting Pronouncements
 
In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”.  ASU No. 2011-4 does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting.  The ASU is effective for interim and annual periods beginning after December 15, 2011. The Company will adopt the ASU as required.  The ASU will affect the Company’s fair value disclosures, but will not affect the Company’s results of operations, financial condition or liquidity.

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income”.  The ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity, and instead requires consecutive presentation of the statement of net income and other comprehensive income either in a continuous statement of comprehensive income or in two separate but consecutive statements.  ASU No. 2011-5 is effective for interim and annual periods beginning after December 15, 2011.  The Company will adopt the ASU as required.  It will have no affect on the Company’s results of operations, financial condition or liquidity.

In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment”, an update to existing guidance on the assessment of goodwill impairment.  This update simplifies the assessment of goodwill for impairment by allowing companies to consider qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount before performing the two step impairment review process.  It also amends the examples of events or circumstances that would be considered in a goodwill impairment evaluation.  The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted.  The Company is currently evaluating the affects adoption of ASU 2011-08 may have on its goodwill impairment testing.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission (the "SEC") did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.

 
Q)
Reclassification
 
In presenting the Company’s statement of operations for the year ended December 31, 2010, the Company previously presented $1,728,000 of delivery and handling expenses as part of cost of goods sold. In presenting the Company’s statement of operations for the year ended December 31, 2011, the Company has reclassified the delivery and handling expenses to operating expenses.
 
(2)
Inventory
 
Inventory is valued at the lower of cost (first-in, first-out) or market, and is comprised of the following as of:

   
December 31,
2011
   
December 31,
2010
 
Raw Materials and Packaging
  $ 3,538,000     $ 2,328,000  
Finished Goods
    2,561,000       2,227,000  
    $ 6,099,000     $ 4,555,000  
 

 
F-10

 


(3)
Property and Equipment
 
Fixed assets are comprised of the following as of:

   
December 31,
2011
   
December 31,
2010
 
Land
  $ 1,108,000     $ 1,108,000  
Building
    1,708,000       1,551,000  
Vehicles
    320,000       320,000  
Machinery and equipment
    1,702,000       1,454,000  
Office equipment
    413,000       392,000  
      5,251,000       4,828,000  
Accumulated depreciation
    (1,739,000 )     (1,178,000 )
    $ 3,512,000     $ 3,650,000  
 
Depreciation expense for the years ended December 31, 2011 and 2010 was $561,000 and $452,000, respectively.

Machinery and equipment at December 31, 2011 and 2010 includes equipment held under capital leases of $294,000 and $227,000, respectively. Accumulated depreciation on equipment held under leases was $104,000 and $53,000 as of December 31, 2011 and 2010, respectively.

(4)
Intangible Assets
 
Brand Names
 
Brand names consist of three trademarks for natural beverages,. As long as the Company continues to renew its trademarks, these intangible assets will have an indefinite life. Accordingly, they are not subject to amortization. The Company determines fair value for brand names by reviewing the net sales of the associated beverage and applying industry multiples for which similar beverages are sold. The carrying amounts for brand names were $1,029,000 as of December 31, 2011 and 2010.

Deferred Financing Fees

Deferred financing are comprised of the following as of:
 
   
December 31,
2011
   
December 31,
2010
 
Loan fees relating to financing
  $ 135,000     $ 55,000  
Accumulated amortization
    (50,000 )     (8,000 )
    $ 85,000     $ 47,000  

 
Amortization expense for the years ended December 31, 2011 and 2010 was approximately $42,000 and $115,000 respectively.
 
Amortization of deferred financing fees is as follows for the years ending December 31:
 
Year
 
Amount
 
2012
  $ 64,000  
2013
    8,000  
2014
    8,000  
2015
    3,000  
2016
    2,000  
Total
  $ 85,000  


 
F-11

 


(5)
Line of Credit
 
On November 18, 2009, the Company executed a revolving line of credit (RLOC) commitment with GemCap Lending I, LLC to replace its existing line of credit.  The senior RLOC was for $3 million, based on 80% of eligible accounts receivable and 50% of eligible inventory, with a maximum inventory advance of $1.5 million.  Interest was accrued and paid monthly on outstanding loans under the credit facility at a rate of 18% per annum.  At December 31, 2010, the aggregate amount outstanding under the line of credit was $2,038,000 and the Company had approximately $52,000 of availability on the line of credit.  The loan was secured by all of the business assets of the Company and was personally guaranteed by the principal shareholder and chief executive officer.

On November 9, 2011, the Company entered into a Loan and Security Agreement with PMC Financial Services Group, LLC.  The Loan and Security Agreement replaced the Company’s existing RLOC and added a $750,000 term loan to the credit (see Note 7).  The RLOC is for $3 million, based on 85% of eligible accounts receivable and 50% of eligible inventory. The interest rate on the revolving line of credit is at the prime rate plus 3.75% (7% at December 31, 2011).  The three-year Agreement is secured by all of the unencumbered assets of the Corporation. There is an early termination fee of 2% of the maximum revolver amount during the first two years and 1% of the maximum revolver during the third year. The Agreement includes a financial covenant debt service coverage ratio that is effective if the credit availability under the RLOC falls below $100,000.  On November 30, 2011, the maximum RLOC amount was temporarily raised to $3.5 million, and on February 16, 2012 the temporary maximum of $3.5 million was extended until March 30, 2012.  At December 31, 2011, the amount outstanding under the RLOC was $3,095,000 and the Company had $307,000 of availability.

(6)
Long Term Financing Obligation

Long term financing obligation is comprised of the following as of:
 
   
December 31,
 
   
2011
   
2010
 
Financing obligation
  $ 2,944,000     $ 3,000,000  
Valuation discount
    (626,000 )     (677,000 )
      2,318,000       2,323,000  
Less current portion
    (71,000 )     (55,000 )
Long term financing obligation
  $ 2,247,000     $ 2,268,000  

On June 15, 2009, the Company closed escrow on the sale of its two buildings and its brewery equipment and concurrently entered into a long-term lease agreement for the same property and equipment. In connection with the lease the Company has the option to repurchase the buildings and brewery equipment from 12 months after the commencement date to the end of the lease term at the greater of the fair market value or an agreed upon amount. Since the lease contains a buyback provision and other related terms, the Company determined it had continuing involvement that did not warrant the recognition of a sale; therefore, the transaction has been accounted for as a long-term financing.  The proceeds from the sale, net of transaction costs, have been recorded as a financing obligation in the amount of $3,056,000. Monthly payments under the financing agreement are recorded as interest expense and a reduction in the financing obligation at an implicit rate of 9.9%. The financing obligation is personally guaranteed up to a limit of $150,000 by the principal shareholder and Chief Executive Officer, Christopher J. Reed.


 
F-12

 

In connection with the financing obligation, the Company issued an aggregate of 400,000 warrants to purchase its common stock at $1.20 per share for five years. The 400,000 warrants were valued at $752,000 and reflected as a debt discount, using the Black Scholes option pricing model. The following assumptions were utilized in valuing the 400,000 warrants: strike price of $2.10 to $2.25; term of 5 years; volatility of 91.36% to 110.9%; expected dividends 0%; and discount rate of 2.15% to 2.20%. The 400,000 warrants were recorded as valuation discount and are being amortized over 15 years, the term of the purchase option.  Amortization of valuation discount was $50,000 and $51,000, respectively, during the years ended December 31, 2011 and 2010.

The aggregate amount due under the financing obligation at December 31, 2011 and 2010 was $2,944,000 and $3,000,000, respectively.  Aggregate future obligations under the financing obligation are as follows:

Year
       
2012
    $ 71,000  
2013
      90,000  
2014
      111,000  
2015
      134,000  
2016
      160,000  
Thereafter
      2,378,000  
Total         
    $ 2,944,000  

(7)
Term Loan

   
December 31,
 
   
2011
   
2010
 
Term loan
  $ 728,000     $ -  
Less current portion
    (152,000 )     -  
 Long term debt
  $ 576,000     $ -  

In connection with the Loan and Security Agreement with PMC Financial Services Group, LLC (see Note 5), the Company entered into a Term Loan. The loan is for $750,000, bears interest at the prime rate plus 11.6%, which shall not be below 14.85%, is secured by all of the unencumbered assets of the Company, and is to be  repaid in 48 equal installments of principal and interest of $21,000.

Aggregate future obligations under the term loan are as follows:

Year
       
2011
    $ 152,000  
2012
      176,000  
2013
      204,000  
2014
      196,000  
Total
    $ 728,000  


 
F-13

 


(8)
Obligations Under Capital Leases
 
The Company leases equipment for its brewery operations with an aggregate value of $294,000 under seven non-cancelable capital leases.  Most of the leases are personally guaranteed by the Company’s chief executive officer.  Monthly payments range from $341 to $1,680 per month, including interest, at interest rates ranging from 6.51% to 17.32% per annum. At December 31, 2011, monthly payments under these leases aggregated $7,250. The leases expire at various dates through 2016.
 
Future minimum lease payments under capital leases are as follows:

Years Ending December 31,
       
2012
    $ 87,000  
2013
      87,000  
2014
      66,000  
2015
      24,000  
2016
      10,000  
Total payments
      274,000  
Less: Amount representing interest
      65,000  
Present value of net minimum lease  payments
      209,000  
Less: Current portion
      56,000  
Non-current portion
    $ 153,000  

 (9)
Stockholders’ Equity

Preferred Stock
 
Series A

Series A Preferred stock consists of 500,000 shares authorized to Series A, $10.00 par value, 5% non-cumulative, participating, preferred stock. As of December 31, 2011 and 2010 there were 46,621shares outstanding, with a liquidation preference of $10.00 per share.
 
These preferred shares have a 5% pro-rata annual non-cumulative dividend. The dividend can be paid in cash or, in the sole and absolute discretion of our board of directors, in shares of common stock based on its then fair market value. We cannot declare or pay any dividend on shares of our securities ranking junior to the preferred stock until the holders of our preferred stock have received the full non-cumulative dividend to which they are entitled. In addition, the holders of our preferred stock are entitled to receive pro rata distributions of dividends on an “as converted” basis with the holders of our common stock. During the year ended December 31, 2011 the Company accrued and paid a $23,000 dividend payable to the preferred shareholders, which the board of directors elected to pay through the issuance of 11,455 shares of its common stock; and during the year ended December 31, 2010 the Company accrued and paid a $23,000 dividend payable to the preferred shareholders, which the board of directors elected to pay through the issuance of 11,211 shares of its common stock.
 
In the event of any liquidation, dissolution or winding up of the Company, or if there is a change of control event, then, subject to the rights of the holders of our more senior securities, if any, the holders of our Series A preferred stock are entitled to receive, prior to the holders of any of our junior securities, $10.00 per share plus all accrued and unpaid dividends. Thereafter, all remaining assets shall be distributed pro rata among all of our security holders.  Since June 30, 2008, we have the right, but not the obligation, to redeem all or any portion of the Series A preferred stock by paying the holders thereof the sum of the original purchase price per share, which was $10.00, plus all accrued and unpaid dividends.
 

 
F-14

 

The Series A preferred stock may be converted, at the option of the holder, at any time after issuance and prior to the date such stock is redeemed, into four shares of common stock, subject to adjustment in the event of stock splits, reverse stock splits, stock dividends, recapitalization, reclassification and similar transactions. We are obligated to reserve out of our authorized but unissued shares of common stock a sufficient number of such shares to effect the conversion of all outstanding shares of Series A preferred stock. During the years ended December 31, 2011 and 2010, no shares of Series A preferred stock were converted into shares of common stock.

Except as provided by law, the holders of our Series A preferred stock do not have the right to vote on any matters, including, without limitation, the election of directors. However, so long as any shares of Series A preferred stock are outstanding, we shall not, without first obtaining the approval of at least a majority of the holders of the Series A preferred stock, authorize or issue any equity security having a preference over the Series A preferred stock with respect to dividends, liquidation, redemption or voting, including any other security convertible into or exercisable for any equity security other than any senior preferred stock.

Series B

Series B Preferred stock consists of 500,000 shares authorized to Series B, $10.00 par value, 5% non-cumulative, participating, preferred stock.  As of December 31, 2011 and 2010 there were 80,415 and 85,766 shares outstanding, respectively.

On February 5, 2010, the Company completed a standby offering of 12,780 shares of its Series B Convertible Preferred Stock at $10.00 per share, for gross proceeds of $127,800. In connection with the offering, the Company also issued warrants to purchase 3,575 shares of common stock at $1.79 per share for five years. The Company paid legal and broker fees of approximately $11,000 in connection with the offering, resulting in net proceeds to the Company of $117,000.

These preferred shares have a 5% pro-rata annual non-cumulative dividend payable quarterly for a period of three years. The dividend can be paid in cash or, in the sole and absolute discretion of our board of directors, in shares of common stock based on its then fair market value. We cannot declare or pay any dividend on shares of our securities ranking junior to the preferred stock until the holders of our preferred stock have received the full non-cumulative dividend to which they are entitled. During the year ended December 31, 2011, $42,000 in dividends were accrued and $3,000 of dividends were paid by the issuance of 2,078 shares of common stock, as shares of Series B Preferred were converted into shares of common stock. During the year ended December 31, 2010, $50,000 in dividends were accrued and $6,000 of dividends were paid by the issuance of 3,394 shares of common stock.
 
In the event of any liquidation, dissolution or winding up of the Company, or if there is a change of control event, then, subject to the rights of the holders of our more senior securities, if any, the holders of our Series B preferred stock are entitled to receive, prior to the holders of any of our junior securities, $10.00 per share plus all accrued and unpaid dividends. Thereafter, all remaining assets shall be distributed pro rata among all of our security holders.
 
The Series B preferred stock may be converted, at the option of the holder, at any time after issuance and prior to the date such stock is redeemed, into seven shares of common stock, subject to adjustment in the event of stock splits, reverse stock splits, stock dividends, recapitalization, reclassification and similar transactions. We are obligated to reserve out of our authorized but unissued shares of common stock a sufficient number of such shares to effect the conversion of all outstanding shares of Series B preferred stock. During the year ended December 31, 2011, 5,351 shares of preferred stock were converted into 37,457 shares of common stock.  During the year ended December 31, 2010, 47,834 shares of Series B preferred stock were converted into 334,838 shares of common stock.
 

 
F-15

 

Except as provided by law, the holders of our Series B preferred stock do not have the right to vote on any matters, including, without limitation, the election of directors. However, so long as any shares of Series B preferred stock are outstanding, we shall not, without first obtaining the approval of at least a majority of the holders of the Series B preferred stock, authorize or issue any equity security having a preference over the Series B preferred stock with respect to dividends, liquidation, redemption or voting, including any other security convertible into or exercisable for any equity security other than any senior preferred stock.

Common Stock
 
Common stock consists of $.0001 par value, 19,500,000 shares authorized, 10,885,833 shares issued and outstanding as of December 31, 2011 and 10,446,090 shares issued and outstanding as of December 31, 2010.

On February 18, 2010, the Company sold an aggregate of 277,359 shares of common stock at a price of $1.70 per share for gross proceeds of $472,000.  Investors were also issued warrants to purchase 83,208 shares of common stock, in connection with the transaction.  The warrants are exercisable at a price of $2.10 per share for a period of five years commencing nine months from the closing date of the offering.  In connection with the sale, the Company paid direct costs of approximately $40,000.  The Company received proceeds, after deducting offering expenses, of approximately $432,000.

During the year ended December 31, 2010, the Company issued 86,824 shares of common stock for services rendered at prices ranging from $1.35 to $2.30 per share with a value of $163,000 and 118,004 shares of common stock to employees as a bonus at stock prices ranging from $1.32 to $2.12 per share with a value of $203,000, including $51,000 accrued as of December 31, 2009.

 On February 3, 2011 the Company sold 304,880 shares of common stock at $2.46 per share for $750,000.  In connection with the sale, the Company granted to the investors warrants to purchase 121,952 shares of common stock for $2.77 for five years.  The Company paid an 8% placement agent fee of $60,000.  The Company received proceeds from the private placement, after deducting placement agent fees and offering expenses, of $672,000.  On March 25, 2011, the Registration Statement of the common stock to be sold and the common stock underlying the warrants with the Securities and Exchange Commission was declared effective, in accordance with the Registration Rights Agreement.

During the year ended December 31, 2011, the Company issued 63,873 shares of common stock for services rendered at prices ranging from $1.32 to $2.69 per share with a value of $131,000.  During the year ended December 31, 2011, the Company issued 9,000 shares of common stock at a price of $1.75 with a value of $15,000 for financing fees related to the capital leases.  The value of the shares has been recorded as deferred financing fees and are being amortized over the term of the capital leases.

(10)
Stock Options and Warrants
 
 
A)
Stock Options
 
In 2001, the Company adopted the Original Beverage Corporation 2001 Stock Option Plan and in 2007 the Company adopted the Reed’s Inc 2007 Stock Option Plan (the “Plans”). The options under both plans shall be granted from time to time by the Compensation Committee. Individuals eligible to receive options include employees of the Company, consultants to the Company and directors of the Company. The options shall have a fixed price, which will not be less than 100% of the fair market value per share on the grant date. The total number of options authorized is 500,000 and 1,500,000, respectively for the Original Beverage Corporation 2001 Stock Option Plan and the Reed’s Inc 2007 Stock Option Plan.
 

 
F-16

 

During the years ended December 31, 2011 and 2010, the Company granted 437,000 and 245,000 options, respectively, to purchase the Company's common stock at a weighted average price of $1.48 and $2.03, respectively, to employees under the Plans.  The aggregate value of the options vesting, net of forfeitures, during the years ended December 31, 2011 and 2010 was $210,000 and $198,000, respectively, and has been reflected as compensation cost. As of December 31, 2011, the aggregate value of unvested options was $299,000, which will be amortized as compensation cost as the options vest, over 2 - 3 years. On December 23, 2011, the Company repriced 20,000 employee options to an exercise price of $1.14, which were previously $2.06 per share; and extended the termination date of 420,000 employee options until December 22, 2016.  Such options previously were to expire on dates that were between 8 months and 48 months from the extension date.  The total increase in stock compensation expense, as a result of the repricing and extensions, was $53,000; of which $48,000 was recognized in the year ended December 31, 2011 and $5,000 will be expensed in 2012.  During the year ended December 31, 2010 there were 8,333 stock options exercised at a price of $0.75 per share resulting in proceeds to the Company of $6,000.  No options were exercised in 2011.

The weighted-average grant date fair value of options granted during 2011 and 2010 was $0.66 and $0.86, respectively.  The fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table.  For purposes of determining the expected life of the option, an average of the estimated holding period is used. The risk-free rate for periods within the contractual life of the options is based on the U. S. Treasury yield in effect at the time of the grant.

   
Year ended December 31,
 
   
 
2011
   
2010
 
Expected volatility
  48%- 92%     44%- 78%  
Weighted average volatility
  61%     63%  
Expected dividends
       
Expected average term (in years)
  3.0     3.0  
Risk free rate - average
  1.30%     1.74%  
Forfeiture rate
  0%     0%  
 
A summary of option activity as of December 31, 2011 and changes during the two years then ended is presented below:

   
 
Shares
 
Weighted-Average
Exercise Price
 
Weighted-Average
Remaining
Contractual
Terms (Years)
 
Aggregate
Intrinsic
Value
Outstanding at December 31, 2009
 
690,000
   
$1.74
       
Granted
 
245,000
   
$2.03
       
Exercised
 
(8,333
)  
$0.75
       
Forfeited or expired
  (86,667
)
 
$2.62
       
Outstanding at December 31, 2010
 
840,000
   
$1.74
       
Granted
 
437,000
   
$1.48
       
Exercised
  -
 
 
-
       
Forfeited or expired
   (105,000
)
 
$2.59
       
Outstanding at December 31, 2011
   1,172,000
 
 
$1.55
 
  4.4
 
$133,000
Exercisable at December 31, 2011
   667,000 
 
 
$1.50
 
  4.2
 
$133,000
 

 
F-17

 

The aggregate intrinsic value was calculated as the difference between the market price and the exercise price of the Company’s stock, which was $1.11 as of December 31, 2011.

A summary of the status of the Company’s nonvested shares granted under the Company’s stock option plan as of December 31, 2011 and changes during the year then ended is presented below:

   
Shares
   
Weighted-
Average
Grant Date
Fair Value
 
Nonvested at December 31, 2010
    385,000     0.77  
Granted
    437,000     0.66  
Vested
    (242,000 )   0.56  
Forfeited
    (75,000 )   0.99  
Nonvested at December 31, 2011
    505,000     0.74  

Additional information regarding options outstanding as of December 31, 2011 is as follows:

     
Options Outstanding at December 31, 2011
   
Options Exercisable at December 31, 2011
 
Range of Exercise Price
   
Number of Shares Outstanding
 
Weighted Average Remaining Contractual Life (years)
   
Weighted Average Exercise Price
   
Number of Shares Exercisable
   
Weighted Average Exercise Price
 
                                 
$ 0.01 - $1.99       852,000       4.69     1.00       570,333     0.92  
$ 2.00 - $4.99       270,000       4.08     2.16       46,667     2.05  
$ 5.00 - $6.99       -       -       -       -       -  
$ 7.00 - $8.50       50,000       0.42     7.55       50,000     7.55  
          1,172,000                       667,000          

 
B)
Warrants
 
During the year ended December 31, 2008, 200,000 warrants were granted in connection with a distribution agreement between the Company and a company which is owned by two brothers of Christopher Reed, President of the Company.  The warrants are issuable only upon the attainment of certain international product sales goals.  The warrants will be valued and a corresponding expense will be recorded upon the attainment of the sales goals identified when the warrants were granted.  In April 2009, the 200,000 warrants were re-priced to $1.35 from a weighted average price of $2.77.  Since these are performance-based warrants and no performance criteria have been met as of December 31, 2011, no expense was recognized in the re-pricing of these warrants.

On February 9, 2010, the Company granted warrants to purchase 3,575 shares of common stock to a dealer-manager in connection with the placement of its Series B Convertible Preferred Stock.  The warrants are exercisable for five years at an exercise price of $1.79.  On February 22, 2010, the Company granted warrants to purchase 83,208 shares of common stock to investors who purchased 277,359 shares of its common stock.  The warrants are exercisable for five years at an exercise price of $2.10.
 
 
 
F-18

 
 
On February 3, 2011, the Company granted warrants in connection with a placement of 304,880 shares of its common stock to purchase 121,952 shares of common stock for $2.77 for a term of five years.  In connection with the same placement, the Company also granted warrants to purchase 24,390 shares of common stock to a dealer-manager at a price of $3.075 for five years.  In February 2011, 11,000 warrants were exercised at a price of $2.25 per share resulting in proceeds to the Company of $25,000.

On April 8, 2011, the Company granted to a consultant 250,000 warrants to purchase common stock at a price of $3.00 for five years.  The warrants vest monthly over 24 months.  In October 2011, the consultant agreement was terminated, so no further vesting shall occur on these warrants.  During the year ended December 31, 2011, 62,500 of such warrants vested, resulting in expense of $42,000, and 187,500 of such warrants were forfeited.
The following table summarizes warrant activity for the two years ended December 31, 2011:

   
 
Shares
 
Weighted-Average
Exercise Price
 
Weighted-Average
Remaining
Contractual
Terms (Years)
 
Aggregate
Intrinsic
Value
 
Outstanding at December 31, 2009
    1,991,690     4.70            
Granted
    86,783     2.09            
Exercised
    -       -            
Forfeited or expired
    (69,445 )   1.80            
Outstanding at December 31, 2010
    2,009,028     4.68            
Granted
    396,342     2.93            
Exercised
    (11,000 )   2.25            
Forfeited or expired
    (387,500 )   4.86            
Outstanding at December 31, 2011
    2,006,870     4.32  
1.7
    -  
Exercisable at December 31, 2011
    1,806,870     4.55  
1.7
    -  

The aggregate intrinsic value was calculated, as of December 31, 2011, as the difference between the market price and the exercise price of the Company’s stock, which was $1.11 as of December 31, 2011.

The fair value of each warrant is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table. Expected volatility is based on the historical volatility of the Company. For purposes of determining the expected life of the warrant, the full contract life of the warrant is used. The risk-free rate for periods within the contractual life of the warrants is based on the U. S. Treasury yield in effect at the time of the grant. 

   
Year ended December 31,
 
   
2011
   
2010
 
Expected volatility
    48% - 76%       61% - 70%  
Weighted average volatility
    54%       70%  
Expected dividends
    -       -  
Expected term (in years)
    5       5  
Risk free rate
    1.6%       2.4%  
 
The weighted-average grant date fair value of warrants granted during 2011 and 2010 was $0.70 and $0.98 respectively.
 
 
F-19

 
 
The following table summarizes the outstanding warrants to purchase Common Stock at December 31, 2011:

Number
Exercise
Price
Expiration Dates
400,000
 
$1.20
May 2014
200,000
 
$1.35
May 2013
33,796
 
$1.79
December 2014
3,575
 
$1.79
February 2015
83,208
 
$2.10
August 2015
162,454
 
$2.25
April 2015
121,952
 
$2.77
February 2016
62,500
 
$3.00
April 2016
24,390
 
$3.08
August 2016
165,000
 
$6.60
June 2012
749,995
 
$7.50
June 2012
2,006,870
     
 
(11)
Income Taxes
 
At December 31, 2011 and 2010, the Company had available Federal and state net operating loss carryforwards to reduce future taxable income. The amounts available were approximately $17.0 million and $16.3 million for Federal purposes, respectively, and $12.9 million and $12.5 million for state purposes respectively. The Federal carryforward expires in 2032 and the state carryforward expires in 2017. Given the Company’s history of net operating losses, management has determined that it is more likely than not that the Company will not be able to realize the tax benefit of the carryforwards. Accordingly, the Company has not recognized a deferred tax asset for this benefit.

Accounting guidance requires that a valuation allowance be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. Due to restrictions imposed by Internal Revenue Code Section 382 regarding substantial changes in ownership of companies with loss carry-forwards, the utilization of the Company’s net operating loss carry-forwards will likely be limited as a result of cumulative changes in stock ownership.  The company has not recognized a deferred tax asset and, as a result, the change in stock ownership has not resulted in any changes to valuation allowances.

Upon the attainment of taxable income by the Company, management will assess the likelihood of realizing the tax benefit associated with the use of the carryforwards and will recognize a deferred tax asset at that time.
 
Significant components of the Company’s deferred income tax assets are as follows as of:
  
   
December 31,
2011
   
December 31,
2010
 
Deferred income tax asset:
       
 
 
Net operating loss carry forward
  $ 6,150,000     $ 5,900,000  
Valuation allowance
    (6,150,000 )     (5,900,000 )
Net deferred income tax asset
  $     $  
 
 
F-20

 
 
Reconciliation of the effective income tax rate to the U.S. statutory rate is as follows:
  
   
Year Ended
   
December 31,
   
2011
 
2010
Federal Statutory tax rate
    (34 ) %     (34 ) %
State tax, net of federal benefit
    (5 ) %     (5 ) %
Change in valuation
    (39 ) %     (39 ) %
Allowance
    39   %     39   %
Effective tax rate
    -   %     -   %
 
(12)
Commitments and Contingencies
 
Lease Commitments
 
The Company leases machinery and warehouse space under non-cancelable operating leases. Rental expense for the years ended December 31, 2011 and 2010 was $129,000 and $108,000, respectively.
 
Future payments under these leases as of December 31, 2011 are as follows:
 
Year ending December 31,
 
Amount
 
   2012
  $ 33,000  
   2013
    -  
   2014
    -  
      Total
  $ 33,000  
 
Other Commitments

The Company has entered into contracts with customers with clauses that commit the Company to fees if the Company terminates the agreement early or without cause.  The contracts call for the customer to have the right to distribute the Company’s products to a defined type of retailer within a defined geographic region.  If the Company should terminate the contract or not automatically renew the agreements, amounts would be due to the customer.  As of December 31, 2011 and 2010, the Company has no plans to terminate or not renew any agreement with any of their customers; therefore no fees have been accrued in the accompanying financial statements.