UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

[X]   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2016

 

or

 

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from _______________________ to ___________________________

 

Commission File Number: 000-53913

 

QUANTUMSPHERE, INC.

(Exact name of registrant as specified in its charter)

 

Nevada		20-3925307
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
2905 Tech Center Drive, Santa Ana, CA		92705
(Address of principal executive offices)		(Zip Code)

 

714-545-6266

(Registrant’s telephone number, including area code)

 

(Former name, former address and former fiscal year, if changed since last report)

 

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 [X] No [  ]

 

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 [X] No [  ]

 

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer	[  ]	Accelerated filer	[  ]
Non-accelerated filer	[  ]  (Do not check if a smaller reporting company)	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 [  ] No [X]

 

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY

PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

 

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes [  ] No [  ]

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of November 21, 2016: 22,965,544

 

 

 

CAUTIONARY STATEMENT

 

All statements included or incorporated by reference in this Quarterly Report on Form 10-Q (this “Form 10-Q”), other than statements or characterizations of historical fact, are “forward-looking statements.” Examples of forward-looking statements include, but are not limited to, statements concerning projected sales, costs, expenses and gross margins; our accounting estimates, assumptions and judgments; the prospective demand for our products; the projected growth in our industry; the competitive nature of and anticipated growth in our industry; and our prospective needs for, and the availability of, additional capital. These forward-looking statements are based on our current expectations, estimates, approximations and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. Forward-looking statements can often be identified by such words as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” similar expressions and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, some of which are set forth in the “Risk Factors” section of this Report, which could cause our financial results, including our net income or loss or growth in net income or loss to differ materially from prior results, which in turn could, among other things, cause the price of our common stock to fluctuate substantially. These forward-looking statements speak only as of the date of this report. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, except as otherwise required by law.

 

 

TABLE OF CONTENTS

 

PART I

FINANCIAL INFORMATION

 

		Page
Item 1	Financial Statements	4
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3	Quantitative and Qualitative Disclosures About Market Risk	25
Item 4	Controls and Procedures	25

 

PART II

OTHER INFORMATION

 

Item 1	Legal Proceedings	26
Item 1A	Risk Factors	26
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	26
Item 3	Default upon Senior Securities	26
Item 4	Mine Safety Disclosures	26
Item 5	Other Information	26
Item 6	Exhibits	26
Signatures		27

 

 

PART I – FINANCIAL INFORMATION

 

ITEM 1 - FINANCIAL STATEMENTS

 

QUANTUMSPHERE, INC.

CONDENSED BALANCE SHEETS

 

		September 30, 2016				June 30, 2016
		(unaudited)
ASSETS
Current Assets
Cash		$	706			$	180,805
Prepaid expenses and other current assets			93,674				43,114
Total current assets			94,380				223,919
Property and equipment, net			896,663				985,231
Patents, net			93,515				95,451
Other assets			24,578				24,578
Total assets		$	1,109,136			$	1,329,179
LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current Liabilities
Accounts payable and accrued expenses		$	2,143,021			$	1,758,158
Notes payable, net of discount			1,068,192				795,287
Convertible notes payable, net of discount			1,260,661				1,014,952
Derivative liabilities			54,164				7,387
Total current liabilities			4,526,038				3,575,784
Total Liabilities			4,526,038				3,575,784
Stockholders’ Deficit
Convertible preferred stock, $0.001 par value, 10,000,000 shares authorized, no shares issued or outstanding			–				–
Common stock, $0.001 par value, 500,000,000 shares authorized, 22,857,082 and 22,728,437 shares issued and outstanding as of September 30, 2016 and June 30, 2016, respectively			22,857				22,728
Additional paid-in capital			44,309,930				44,209,388
Accumulated deficit			(47,749,689	)			(46,478,721	)
Total stockholders’ deficit			(3,416,902	)			(2,246,605	)
Total liabilities and stockholders’ deficit		$	1,109,136			$	1,329,179

 

The accompanying notes are an integral part of these financial statements.

 

 

QUANTUMSPHERE, INC.

CONDENSED STATEMENTS OF OPERATIONS (Unaudited)

 

		Three Months Ended September 30,
		2016				2015
Net Sales		$	27,299			$	9,057
Cost of Sales			2,508				1,076
Gross Profit			24,791				7,981
Operating Expenses
Research and development			199,199				308,078
Selling, marketing and advertising			1,466				5,394
General and administrative			451,909				1,046,465
Total operating expenses			652,574				1,359,937
Loss from Operations			(627,783	)			(1,351,956	)
Other Expense
Interest expense, net			(94,058	)			(65,253	)
Interest expense – amortization of debt discounts			(529,935	)			(146,766	)
Gain on disposal of assets			28,385				-
Gain (loss) from change in fair value of derivative liabilities			(46,777	)			609,400
Total other income (expense), net			(642,385	)			397,381
Loss Before Provision for Income Taxes			(1,270,168	)			(954,575	)
Provision for Income Taxes			800				800
Net Loss		$	(1,270,968	)		$	(955,375	)
Basic and Diluted Loss Per Common Share		$	(0.06	)		$	(0.04	)
Basic and Diluted Weighted-Average Common Shares Outstanding			22,789,373				22,391,232

 

The accompanying notes are an integral part of these financial statements.

 

 

QUANTUMSPHERE, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(unaudited)

 

		Three Months Ended September 30,
		2016				2015
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss		$	(1,270,968	)		$	(955,375	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization			90,635				97,201
Stock based compensation			17,420				40,552
(Gain) loss from change in fair value of derivative liabilities			46,777				(609,400	)
Stock issued for services			83,250				402,128
Debt discount amortization			529,935				146,766
Changes in operating assets and liabilities:
Accounts receivable			1,445				225
Prepaid expenses and other current assets			(52,006	)			(45,641	)
Accounts payable and accrued expenses			384,864				287,040
Net cash used in operating activities			(168,648	)			(636,504	)
CASH FLOWS FROM INVESTING ACTIVITIES
Payments for development of patents			(130	)			(1,545	)
Purchase of property and equipment			-				(14,126	)
Net cash used in investing activities			(130	)			(15,671	)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuances of notes payable			25,000				410,000
Payments of notes payable			(36,321	)			(47,615	)
Net cash provided by (used in) financing activities			(11,321	)			362,385
NET DECREASE IN CASH			(180,099	)			(289,790	)
CASH – beginning of period			180,805				398,570
CASH – end of period		$	706			$	108,780
ADDITIONAL CASH FLOW INFORMATION
Interest paid		$	11,910			$	23,618
Taxes paid		$	800			$	800

 

The accompanying notes are an integral part of these financial statements.

 

 

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES

 

During the three months ended September 30, 2016, the Company entered into the following noncash transactions:

 

●	Issued 129,000 shares of common stock valued at $83,000 in connection with services rendered.

 

During the three months ended September 30, 2015, the Company entered into the following noncash transactions:

 

●	Issued 250,000 shares of common stock valued at $875,000 in connection with services rendered.
●	Issued 140,000 warrants to purchase common stock with a relative fair value of approximately $87,000 in connection with the issuance of notes payable.
●	Issued 30,000 warrants to purchase common stock with a relative fair value of approximately $13,000 in connection with services rendered.

 

The accompanying notes are an integral part of these financial statements.

 

 

QUANTUMSPHERE, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS

September 30, 2016

 

1. ORGANIZATION AND BUSINESS

 

QuantumSphere, Inc. (the “Company” or “QuantumSphere”) was organized under the laws of the State of Nevada on December 1, 2005. The Company has developed a process to manufacture metallic nanopowders with end-use applications focused on the chemical sector. The Company’s products are used on a stand-alone basis, in the validation of the Company’s nano-iron catalysts coated onto commercial iron catalysts used in the production of ammonia on a prospective basis. The Company’s major activities to date have included capital formation, research and development, and marketing of its metallic nanopowder products.

 

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Use of Estimates

 

The accompanying financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. The use of estimates may also affect the reported amounts of revenues and expenses during the reporting periods. Significant estimates made by management include among others, fair value of derivative liabilities, realization of capitalized assets, valuation of equity instruments, and deferred income tax asset valuation allowances. Actual results could differ from those estimates.

 

Revenue Recognition

 

The Company recognizes revenue when all four of the following criteria are met: (i) persuasive evidence that an arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is fixed or determinable; and (iv) collectability is reasonably assured. The Company does not grant customers the right to return the products after such products have been accepted. Amounts billed for shipping and handling are recorded as a component of net sales and the cost incurred for freight is included as a component of operating expenses in the statements of operations.

 

Cash and Cash Equivalents

 

The Company considers demand deposits, U.S. treasury securities and highly-liquid debt investments purchased with original maturities of three months or less to be cash equivalents. The Company did not have any cash equivalents as of September 30, 2016 and June 30, 2016.

 

The Company maintains its cash in major banks. From time to time, the Company’s cash balances exceed the Federal Deposit Insurance Corporation limit. The Company has not experienced and does not anticipate any losses relating to these amounts.

 

Inventory

 

Inventory consists primarily of manufactured nano materials and is comprised of raw materials, labor and manufacturing overhead. Inventory is stated at the lower of cost, determined on a first-in, first-out basis, or market. An inventory reserve is created when potentially slow-moving or obsolete inventories are identified in order to reflect the appropriate inventory value. While the Company’s inventory is not perishable and does not degrade with time, the Company recorded a reserve as its inventory was over one year old and there is no certainty that the inventory will be sold. At September 30, 2016 and June 30, 2016, all inventory was reserved.

 

 

Property and Equipment

 

Property and equipment is stated at cost, less accumulated depreciation. Repairs and maintenance of equipment are charged to expense as incurred. Expenditures for major renewals and betterments that extend the useful lives of property and equipment are capitalized. Gains or losses on dispositions of property and equipment are included in the results of operations when realized. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, ranging from three to seven years. Leasehold improvements are amortized over the shorter of terms of the leases or their estimated useful lives. Depreciation expense on assets acquired under capital leases is included in depreciation expense.

 

Patents

 

Costs incurred in applying for patents relating to the Company’s process for production of nanopowders have been capitalized. Patents are amortized to reflect the pattern of economic benefits consumed, on a straight-line basis, over the estimated periods benefited. As of September 30, 2016, ten patents have been issued and two patent applications are pending approval. Amortization relating to issued patents was not significant during the periods presented. Additional significant costs may be required for the continued development of end-use applications for the Company’s technology. Patents costs are reviewed periodically as to if any patents are no longer being pursued and associated costs should be written off.

 

Impairment of Long-Lived Assets

 

Long-lived assets and intangible assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company evaluates potential impairment by comparing the carrying amount of the assets with the estimated undiscounted future cash flows associated with them. Should the review indicate that an asset is not recoverable, the Company’s carrying value of the asset would be reduced by the estimated shortfall to fair value.

 

Fair Value of Financial Instruments and Certain Other Assets and Liabilities

 

GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

 

●	Level 1: Observable inputs such as quoted prices in active markets;
●	Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
●	Level 3: Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions

 

The Company’s financial instruments consist of cash, accounts receivable, accounts payable, and accrued expenses. The carrying amounts of such assets and liabilities approximate their respective fair values because of the short-term nature of these items. The carrying amounts of the Company’s debt agreements approximate their fair values as interest approximates current market rates for similar instruments. Derivative liabilities recorded in connection with convertible debt agreements are reported at estimated fair value with changes in fair value reported in results of operations.

 

Other than derivative liabilities referenced above, the Company did not have any assets or liabilities that are measured at fair value on a recurring or nonrecurring basis during the three months ended September 30, 2016 and the year ended June 30, 2016.

 

 

The following details the fair value measurement within the fair value hierarchy of the Company’s financial assets and liabilities at September 30, 2016.

 

		Fair Value Measurement
		Total Fair Value				Level 1				Level 2				Level 3
Derivative liabilities		$	54,164			$	-			$	-			$	54,164

 

The following details the fair value measurement within the fair value hierarchy of the Company’s financial assets and liabilities at June 30, 2016.

 

		Fair Value Measurement
		Total Fair Value				Level 1				Level 2				Level 3
Derivative liabilities		$	7,387			$	-			$	-			$	7,387

 

There were no transfers among Level 1, Level 2 and Level 3 during the three months ended September 30, 2016 and the year ended June 30, 2016.

 

The fair values of derivative liabilities were estimated using the Black-Scholes-Merton pricing model and the following assumptions for the three months ended September 30, 2016 and the year ended June 30, 2016:

 

			September 30, 2016				June 30, 2016
Risk free interest rate			0.4% - 1.1	%			0.5% - 1.0	%
Expected term			1 - 5 years				1 - 5 years
Expected volatility			87.0% - 136.1	%			86.8% - 131.7	%
Dividend yield			-				-

 

The change in fair value of the derivative liabilities during the three months ended September 30, 2016 and the year ended June 30, 2016 are summarized as follows:

 

Fair value at June 30, 2015		$	1,141,700
Issuance of derivative liabilities			871,611
Change in fair value			(2,020,698	)
Fair value at June 30, 2016			7,387
Change in fair value			46,777
Fair value at September 30, 2016		$	54,164

 

Derivative Liabilities

 

A derivative is an instrument whose value is “derived” from an underlying instrument or index such as a future, forward, swap, option contract, or other financial instrument with similar characteristics, including certain derivative instruments embedded in other contracts and for hedging activities. As a matter of policy, we do not invest in separable financial derivatives or engage in hedging transactions. However, we have entered into certain financing transactions that involve financial equity instruments containing certain features that have resulted in the instruments being deemed derivatives. We may engage in other similar complex financing transactions in the future, but not with the intention to enter into derivative instruments. Derivatives are measured at fair value using the Black-Scholes-Merton model and marked to market through earnings. However, such new and/or complex instruments may have immature or limited markets. As a result, the pricing models used for valuation of derivatives often incorporate significant estimates and assumptions. Changes in these subjective assumptions can materially affect the estimate of the fair value of derivative liabilities and, consequently, the related amount recognized as loss due to change in fair value of derivative liabilities on the consolidated statement of operations. Furthermore, depending on the terms of a derivative, the valuation of derivatives may be removed from the financial statements upon exercise or conversion of the underlying instrument into some other security. The classification of a derivative instrument is reassessed at each balance sheet date. If the classification changes as a result of events during a reporting period, the instrument is reclassified as of the date of the event that caused the reclassification. There is no limit on the number of times a contract may be reclassified.

 

 

Research and Development Costs

 

Research and development costs are expensed as incurred. Costs incurred for research and development for new or improved processes to produce nanocatalysts as well as end use applications for the nanocatalysts are expensed until the production process or applications have been determined to be commercially viable. Costs incurred after the production process is viable and a working model of the equipment has been completed will be capitalized as long-lived assets.

 

Income Taxes

 

Deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. The provision for income taxes represents the tax payable for the period, if any, and the change during the period in deferred tax assets and liabilities.

 

The Company provides for tax contingencies, if any, for federal, state and local exposures relating to audit results, tax planning initiatives and compliance responsibilities. The development of these reserves requires judgments about tax issues, potential outcomes and timing. Although the outcome of such matters is uncertain, in management’s opinion adequate provisions for income taxes have been made for potential liabilities emanating from these reviews. If actual outcomes differ materially from these estimates, they could have a material impact on the Company’s results.

 

Loss Per Share

 

The Company calculates basic loss per share by dividing the net loss attributable to common stockholders by the weighted-average number of common shares outstanding. Diluted loss per share is computed similar to basic loss per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if such additional common shares had been issued and were dilutive.

 

Potential common shares, consisting of options and warrants, totaling 15,193,141 and 12,923,761, have been excluded from the computations of diluted net loss per share because the effect would have been anti-dilutive for the three months ended September 30, 2016 and 2015, respectively.

 

Stock-Based Compensation

 

The Company measures all employee stock-based compensation awards using the Black-Scholes-Merton valuation model and allocates the related expense over the requisite service period. The expected volatility is based on the historical volatility of the Company’s stock as determined by its private placement offerings and recent market activity. The expected life of the award is based on the simplified method.

 

The Company accounts for nonemployee stock-based transactions using the fair value of the consideration received (i.e. the value of the goods or services) or the fair value of the equity instruments issued, whichever is more reliably measurable.

 

Going Concern

 

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. The Company has incurred recurring losses from operations from inception and has limited working capital. As of September 30, 2016, the Company had an accumulated deficit of approximately $47.8 million. In addition, at September 30, 2016 the Company is in default on certain of its debt obligations.

 

The Company’s activities will necessitate significant uses of working capital during and beyond fiscal 2017. Additionally, the Company’s capital requirements will depend on many factors, including the success of its continued research and development efforts and the status of competitive products. The Company plans to continue financing its operations with cash received from financing activities. The Company has engaged U.S. Capital Partners and Avalon Securities for a proposed issuance of up to $5.0 million of 8% Series A convertible preferred stock. The Company has completed the due diligence phase and both firms are in the process of presenting the offering to potential accredited investors. The Company anticipates that, if the issuance is partially or completely successful, some or all of the issuance will be received by December 31, 2016. Should the issuance not be successful, then absent another form of financing or capital raise, the Company expects it will not be able to service current obligations and anticipates that it will have to liquidate assets and will no longer operate as a going concern. The financial statements do not include any adjustments that might result for the outcome of this uncertainty. The Company currently has sufficient cash for operations through November 2016.

 

 

Risks and Uncertainties

 

The Company faces risks and uncertainties relating to its ability to successfully implement and fulfill its strategy. Among other things, these risks include the ability to obtain revenues; manage operations; competition; attract, retain and motivate qualified personnel; maintain and develop new strategic relationships; and the ability to anticipate and adapt to the changing nanotechnology market and any changes in government regulations.

 

Therefore, the Company may be subject to the risks of delays in consummating contracts with customers and suppliers, raising sufficient capital to achieve its objectives and other uncertainties, including financial, operational, technological, regulatory and other risks associated with an emerging business, including the potential risks of business failure. Technology and manufacturing companies with whom the Company is expected to compete, in general, are well capitalized. The Company is competing against entities with the financial and intellectual resources and expressed intent of performing rapid technological innovation. The Company’s resources are limited and must be allocated to focused objectives in order to succeed.

 

The Company has evaluated events subsequent to September 30, 2016 through the date that the accompanying condensed financial statements were filed with the Securities and Exchange Commission for transactions and other events which may require adjustment or disclosure in such financial statements. The Company did not have any material transactions or other events.

 

Recent Accounting Pronouncements

 

The FASB issued ASU 2016-2, Leases, which will require a lessee to recognize assets and liabilities for leases of more than 12 months. Both capital and operating leases will need to be recognized on the balance sheet. The guidance is effective for annual reporting periods beginning after December 15, 2018. The Company is currently evaluating the impact of this guidance on the financial statements.

 

In August 2014, the FASB issued ASU 2014-15, “Presentation of Financial Statements-Going Concern (Subtopic 205-40).” This ASU provides guidance to determine when and how to disclose going-concern uncertainties in the financial statements. The new standard requires management to assess an entity’s ability to continue as a going concern, and to provide related footnote disclosure in certain circumstances. ASU 2014-15 will be effective for all entities in the first annual period ending after December 15, 2016. Earlier adoption is permitted. ASU 2014-15 will be effective for the Company beginning June 30, 2017. The Company does not believe that this pronouncement will have a significant impact on its financial statements.

 

In May 2014, the FASB issued ASU 2014-09, as amended by ASU 2015-14, “Revenue from Contracts with Customers (Topic 606),” which is the new comprehensive revenue recognition standard that will supersede all existing revenue recognition guidance under U.S. GAAP. The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to a customer in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In July 2015, the FASB issued ASU 2015-14 to defer the effective date by one year to December 15, 2017 for interim and annual reporting periods beginning after that date and permitted early adoption of the standard, but not before the original effective date of December 15, 2016. The Company is currently evaluating the impact of adopting this guidance.

 

3. NOTES PAYABLE

 

Novus

 

On June 19, 2014, the Company signed a loan and security agreement with Novus Capital Group that provides a loan in the amount of $500,000. The loan accrues at an annual rate of 15.5%, has a term of thirty-six months, and monthly payments are $17,455. The agreement includes a warrant to purchase 20,000 shares of common stock at an exercise price of $2.00 per share. The warrants were valued at approximately $11,000, using the Black Scholes Merton option pricing model, and recorded as a discount to the note payable.

 

 

On June 5, 2015, the Company signed a loan and security agreement with Novus Capital Group that provides a loan in the amount of $127,500. The loan accrues interest at an annual rate of 15.5%, has a term of thirty-six months, and monthly payments are $4,451, beginning July 10, 2015. The agreement includes a warrant to purchase 2,555 shares of common stock at an exercise price of $2.00 per share that expires June 30, 2020. The vested warrants were valued at approximately $2,000, using the Black Scholes Merton option pricing model, and recorded as a discount to the note payable.

 

The two loans with Novus Capital Group are secured by substantially all of the Company’s assets.

 

Bridge Notes

 

On July 28, 2015, the Company issued a promissory note for $60,000. The note was due October 12, 2015 and interest was set at $20,000. On December 7, 2015, the note and interest were paid in full.

 

In September 2015, the Company issued promissory notes totaling $350,000. The promissory notes bear interest at the rate of 10% per thirty (30) day period and are due six months from the date of issuance. In connection with the promissory notes, the Company also issued warrants exercisable at $3.00 per share and for a period of five (5) years. The number of warrants to be issued ranges between 120% - 160% of the face value of the promissory note depending on repayment date. The warrants were valued at approximately $87,000 using the Black-Scholes-Merton option pricing model, and recorded as a discount to the notes payable. In December 2015, $150,000 in principal and related accrued interest were paid in cash. In December 2015, $200,000 in principal and $45,000 of related accrued interest were converted to Series O-2 convertible notes payable. The Company accounted for the conversion as a debt extinguishment and recorded a net loss of approximately $69,000 in the quarter ended December 31, 2015. In total, 140,000 warrants were issued and remain outstanding as of September 30, 2016.

 

On November 9, 2015 and February 25, 2016, the Company issued promissory notes totaling $100,000. The notes were due December 9, 2015 and March 25, 2016, respectively and bear interest at 10% per each 30 day period. The agreement include a warrant to purchase shares of common stock at 110% of the face value of the notes if the note is repaid within 30 days, and an additional 10% of the face value of the note for each month the note remains unpaid. The exercise price is $3.00 per share and the warrant expires November 9, 2020. The warrants were valued at approximately $15,000 using the Black-Scholes-Merton option pricing model, and recorded as a discount to the note payable. As of September 30, 2016, the note remains unpaid.

 

On January 15, 2016, the Company issued a promissory note for $75,000. The note was due July 15, 2016 and interest was 10% per annum. On June 8, 2016, the note was converted into a promissory note at the amount of $86,250 that bore interest at 5% per annum. The new note is due October 8, 2016. Warrant agreement and security agreement are the same as the June 8, 2016 promissory notes listed below.

 

On April 29, 2016, the Company issued a promissory note for $100,000. The note was due May 29, 2016 and interest was set at $25,000. On June 10, 2016, the principal was paid. As of September 30, 2016, the interest remains accrued.

 

On June 8, 2016, the Company issued promissory notes for cash totaling $500,000. The principal amount due on the notes was $587,500. The notes are due October 8, 2016 and bear interest at 5% per annum. The agreements include warrants to purchase shares of common stock at 150% of the face value of the notes with an exercise price equal to the price per share of the Company’s next equity round of financing. In the event of default, the note holders may convert the notes and accrued interest into shares of common stock at a price equal to 60% of the volume weighted average price of the common stock during the 30 day consecutive trading day period immediately preceding the trading day that the Company receives a notice of conversion. The warrants were valued at approximately $254,000 using the Black-Scholes-Merton option pricing model, and recorded as a discount to the note payable, along with the original issue discount. Because the number of warrants was fixed, such instruments were not considered derivative liabilities. The notes are secured by all of the stock, options, and warrants of the Company owned by Kevin Maloney and Gregory Hrncir. All such notes and accrued interest were outstanding as of September 30, 2016. The Company is currently in default on payment of the promissory notes.

 

 

On September 16, 2016, the Company issued a promissory note for $25,000. The note is due March 16, 2017 and interest is 10% per annum.

 

As of September 30, 2016, notes payable net of discount balance of $1,068,192 consisted of $1,096,844 principal and $28,652 discount. 

 

4. CONVERTIBLE NOTES PAYABLE

 

Series O-1 Notes

 

In May 2015, the Company issued convertible promissory notes (“Series O-1 Notes”) totaling $510,000. The Series O-1 Notes bear interest at the rate of 10% per annum. The Series O-1 Notes will mature upon the earlier of (i) one year from the date of the issuance of the notes, or (ii) closing of an equity financing of Four Million Dollars or more (“Qualifying Equity Offering”). The Series O-1 Notes were convertible and had certain price protection features based on the closing of a Qualifying Equity Offering in the future. Additionally, the Company issued detachable warrants equal to 50% of the face value of the Series O-1 Notes based on the closing of a Qualifying Equity Offering in the future. As a Qualifying Equity Offering has not yet occurred, the total number of warrants to be issued was not yet fixed. Due to the price protection features of the convertible notes as well as the variable number of warrants that can be issued in connection with these notes, both the embedded conversion feature and the warrants were considered to be derivative liabilities. As such, the Company allocated the entire face amount of the notes as a debt discount and amortized the discount using the effective interest method. In December 2015, all $510,000 in principal and approximately $27,000 in accrued interest of the Series O-1 Notes were converted to Series O-2 Notes. All Series O-1 Notes and the initial warrants were surrendered as part of the conversion.

 

Series O-2 Notes

 

In October and November 2015, the Company issued convertible promissory notes (“Series O-2 Notes”) totaling $625,000. In December 2015, the Company converted $245,000 principal and accrued interest of September 2015 bridge notes and $537,058 principal and accrued interest of May 2015 Series O-1 notes into Series O-2 notes. The notes bear interest at the rate of 10% per annum, with a default rate of 18% per annum. The Series O-2 Notes will mature upon the earlier of (i) one year from the date of the issuance of the notes, or (ii) closing of an equity financing of Four Million Dollars or more (Qualifying Equity Financing”). All outstanding principal and accrued interest under the Series O-2 Notes will be automatically converted into shares of common stock at the closing of a Qualifying Equity Offering based upon a conversion price equal to $1.60 per share. Alternatively, the outstanding principal and accrued interest may be voluntarily converted at the sole discretion of the Lender, at any time prior to the close of the Qualifying Equity Offering, in whole or in part, at a conversion price per share equal to $1.60 per share. In connection with the Series O-2 Notes, the Company also issued approximately 469,000 warrants exercisable at $3.00 per share, exercisable for a period of five (5) years. Both the Series O-2 Notes and warrants also had certain price protection features based on the closing of a Qualifying Equity Offering in the future. Due to the price protection features of the convertible notes as well as the variable number of warrants that can be issued in connection with these notes, both the embedded conversion feature and the warrants were considered to be derivative liabilities. As such, the Company allocated $727,841 as a debt discount and is amortizing the discount using the effective interest method over the term of the Series O-2 notes. All Series O-2 Notes were outstanding as of September 30, 2016.

 

As of September 30, 2016, convertible notes payable net of discount balance of $1,260,661 consisted of $1,407,058 principal and $146,397 discount.

 

5. STOCKHOLDERS’ EQUITY

 

Common Stock

 

In early April 2014, the Company executed a 10,000 for 1 reverse split. As a result of the reverse split, the Company cancelled and repurchased fractional shares comprising approximately 585,000 shares of common stock for $2.00 per share. Shortly after the reverse split, the Company executed a 1 for 10,000 forward split. As of September 30, 2016, the Company had approximately $205,000 of accrued liabilities associated with the share cancellation.

 

 

Convertible Preferred Stock

 

The Company has authorized the issuance of 10,000,000 shares of convertible preferred stock with a $0.001 par value. As of September 30, 2016, no convertible preferred stock was outstanding.

 

Stock Options

 

In 2004, the Company adopted the 2004 Stock Option and Incentive Plan (the “2004 Plan”) for directors, employees, consultants and other persons acting on behalf of the Company. Options granted under the 2004 Plan vest on the date of grant, over a fixed period of time, or upon the occurrence of certain events and are exercisable for up to ten years. As of September 30, 2016, the total shares authorized for issuance, were 7,500,000 shares of common stock. As of September 30, 2016, there were 1,282,133 shares of common stock available for grant under the 2004 Plan.

 

No stock options were granted for the three months ended September 30, 2016 and 2015.

 

During the three months ended September 30, 2016 and 2015, the company recognized stock based compensation expense of $17,420 and $40,552, respectively, and as of September 30, 2016 there was unrecognized stock based compensation expense totaling $135,931, that is expected to be recognized over the following fifteen months.

 

6. RELATED PARTY TRANSACTIONS

 

From July 2015 through September 2016, Kevin Maloney, CEO of the Company, has provided short-term loans or paid expenses on behalf of the Company totaling $130,497. As of September 30, 2016, $91,965 has been repaid. The loans/expense payments are similar to a revolving line of credit. Payment in full is to be made upon a financing of $1 million or more and interest is 10% per month (interest rate is the same as the September 2015 and February 2016 promissory notes with third parties). As of September 30, 2016, accrued interest was $53,908.

 

7. CONCENTRATIONS

 

For the three months ended September 30, 2016, 83% of net sales were to the United States and 17% of net sales were to South Korea. For the three months ended September 30, 2015, 48% of net sales were to the United States, 28% of net sales were to South Korea, 13% of net sales were to Japan, and 11% of net sales were to China. For the three months ended September 30, 2016, 88% of net sales were to four customers. For the three months ended September 30, 2015, 94% of net sales were to four customers.

 

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS

 

Forward Looking Statements

 

This Form 10-Q contains statements that must be deemed “forward-looking” statements under Section 27A of the Securities Act, including, among other things, discussions as to our business strategies, expectations, market position and services, anticipated revenues and performance, future operations, profitability, liquidity and capital resources. Words including, but not limited to, “may,” “will,” “likely,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential,” “continue,” “seek,” or the negative of these terms or other comparable terminology. Although we believe that the expectations reflected in such forward-looking statements are generally reasonable and reflect the current views of our management, such statements are inherently uncertain, and we can give no assurance that such statements will ultimately prove to be correct. Our operations are subject to a number of uncertainties and risks, many of which are outside our control, and any one of which, or any combination of which, could materially adversely affect our results of operations. Important factors, including, but not limited to, those discussed in the section titled “Risk Factors,” beginning on page 15 of our Form 10-K filed on October 13, 2016, could cause actual results to differ materially from such statements. Therefore, you are cautioned not to place undue reliance on these forward-looking statements.

 

These forward-looking statements may relate to the following:

 

	●	our future operating results and business prospects;
	●	our ability to develop and market products that compete effectively in our targeted market segments;
	●	market acceptance of our current and future products and the degree and nature of our competition;
	●	our ability to meet customer demand;
	●	our ability to protect and enforce our current and future intellectual property;
	●	our ability to obtain sufficient funding to continue to pursue our business plan;
	●	our ability to implement a long-term business strategy that will be profitable or generate sufficient cash flow;
	●	our ability to manage our foreign manufacturing and development operations and international business risks;
	●	the loss of any of our key members of management;
	●	changes in our industry, interest rates or the general economy; and
	●	changes in governmental regulations, tax rates and similar matters.

 

We believe that the expectations reflected in the forward-looking statements are reasonable. However, there may be events in the future that we are not able to accurately predict or control and that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. Except as required by applicable law, we do not plan to publicly update or revise any forward-looking statements, whether as a result of any new information, future events, or otherwise.

 

 

 

Overview

 

QuantumSphere, Inc. was incorporated in the State of Nevada on December 1, 2005.

 

On May 5, 2015, the Company announced that commercial validation of its nano-iron catalyst had been achieved in a production-scale ammonia plant in China.

 

On May 27, 2015, the Company entered into a multi-year Joint Development Agreement with Swiss-based Casale, S.A. (Casale), a global leader in production technologies for ammonia, urea, melamine, methanol, syngas, nitrates and phosphates. Casale’s reactor production technologies are utilized in approximately 38 percent of global ammonia production and 39 percent of global methanol production. Casale and QSI have agreed to collaborate on commercial technologies for ammonia, methanol, and other industrial chemicals, which collectively account for several hundred billion USD of production annually. Casale also agreed to utilize QSI as its exclusive provider of nanocatalysts for its chemical synthesis processes during the term of the agreement based on QSI’s demonstrated increase in catalytic activity and patented high-volume manufacturing process. The first objective of the Joint Development Agreement is to validate and optimize QSI-Nano catalysts with Casale production reactor technologies. Following a successful validation phase, the second objective is to enter into a long-term agreement with Casale for the joint global distribution and sale of QSI-Nano catalysts with Casale reactor technologies to chemical plant owners and operators.

 

On March 8, 2016, the Company entered into a multi-year Commercialisation Partnership Agreement with Swiss-based Casale S.A. (Casale), pursuant to which the parties agreed to the terms of commercialization of the Company’s QSI-Nano iron catalysts for ammonia synthesis. During the term, Casale is restricted from entering into any agreement with any third party for any purpose relating to the use of nano-sized particle based catalysts in ammonia synthesis. Further, during the term, Casale has exclusive rights to commercially market, co-brand and sell the FeNIX™ product into the ammonia market globally, with the exception of China. The Company will not license the FeNIX™ product for use outside of China to an ammonia plant owner/operator if such party does not commit to use the ammonia technology developed and owned by Casale.

 

On March 15, 2016, the Company announced that it had been issued a patent by the U.S. Patent and Trademark Office for a key patent related to its advanced FeNIX™ nanocatalyst accelerator technology. The patent covers claims around the application of iron nanocatalysts, applied as a coating onto existing commercial ammonia catalysts, for increased catalytic activity and production efficiency in ammonia synthesis.

 

On April 25, 2016, Marc Goroff, Steven Myers, Robert Venable, and Jeffery Palmer voluntarily resigned from the Board of Directors, effective immediately and from their respective roles as members of the company’s Audit, Compensation, Nominating, and Governance Committees. All have agreed to serve as non-director advisors to the Company. Kevin Maloney and Francis Poli, our lead director, continue to serve as directors of the Company. Francis Poli serves as chairman of each of the board committees.

 

Emerging Growth Company

 

We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). We will remain an emerging growth company until the earlier of the following: (1) the last day of the fiscal year following the fifth anniversary of the date of the first sale of our common stock pursuant to an effective registration statement under the Securities Act of 1933, as amended (the “Securities Act”); (2) the last day of the fiscal year where we have total annual gross revenues of at least $1.0 billion; (3) the date on which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeded $700.0 million as of the prior June 30; and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.

 

 

As an emerging growth company, we may take advantage of specified reduced disclosure and other requirements that may otherwise be applicable to public companies. These provisions include:

 

	●	Only two years of audited consolidated financial statements in addition to any required unaudited interim financial statements with correspondingly reduced “Management’s Discussion and Analysis of Financial Condition and Results of Operations” disclosure;
	●	Reduced disclosure about our executive compensation arrangements;
	●	No requirement that we hold non-binding advisory votes on executive compensation or golden parachute arrangements; and
	●	Exemption from the auditor attestation requirement in the assessment of our internal control over financial reporting.

 

We have taken advantage of some of these reduced burdens and may continue to do so for so long as we remain an emerging growth company, and thus the information we provide stockholders may be different from what you might receive from other public companies in which you hold shares.

 

To the extent that we continue to qualify as a “smaller reporting company,” as such term is defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), after we cease to qualify as an emerging growth company, certain of the exemptions available to us as an emerging growth company may continue to be available to us as a smaller reporting company, including: (1) not being required to comply with the auditor attestation requirements of our internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act of 2002; (2) scaled executive compensation disclosures; and (3) the requirement to provide only two years of audited financial statements, instead of three years.

 

Critical Accounting Policies and Estimates

 

Use of Estimates. We make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. The use of estimates may also affect the reported amounts of revenues and expenses during the reporting periods. Significant estimates made by management include, among others, realization of capitalized assets, valuation of equity instruments, and deferred income tax valuation allowances. Actual results could differ from those estimates.

 

Revenue Recognition. We recognize revenue when all four of the following criteria are met: (1) persuasive evidence that an arrangement exists; (2) delivery of the products and/or services has occurred; (3) the selling price is fixed or determinable; and (4) collectability is reasonably assured. We do not grant customers the right to return the products after such products have been accepted. Amounts billed for shipping and handling are recorded as a component of net sales and the cost incurred for freight is included as a component of operating expenses in the statements of operations.

 

Cash and Cash Equivalents. The Company considers demand deposits, U.S. treasury securities and highly-liquid debt investments purchased with original maturities of three months or less to be cash equivalents. The Company did not have any cash equivalents as of September 30, 2016 and June 30, 2016.

 

 

The Company maintains its cash in major banks. From time to time, the Company’s cash balances exceed the Federal Deposit Insurance Corporation limit. The Company has not experienced and does not anticipate any losses relating to these amounts.

 

Accounts Receivable. The Company makes periodic evaluations of the creditworthiness of its customers and manages its exposure to losses from bad debts by limiting the amount of credit extended whenever deemed necessary and generally does not require collateral. The Company maintains an allowance for estimated uncollectible accounts receivable, as appropriate, and such losses have historically been minimal and within management’s expectations. There were no allowances for estimated uncollectible accounts at June 30, 2016 and 2015.

 

Inventory. Inventory consists primarily of manufactured nano materials and is comprised of raw materials, labor and manufacturing overhead. Inventory is stated at the lower of cost, determined on a first-in, first-out basis, or market. An inventory reserve is created when potentially slow-moving or obsolete inventories are identified in order to reflect the appropriate inventory value. While the Company’s inventory is not perishable and does not degrade with time, the Company recorded a reserve as its inventory was over one year old and there is no certainty that the inventory will be sold. At September 30, 2016 and June 30, 2016, all inventory was reserved.

 

Property and Equipment. Purchased property and equipment is stated at cost, less accumulated depreciation. Repairs and maintenance of equipment are charged to expense as incurred. Expenditures for major renewals and betterments that extend the useful lives of property and equipment are capitalized. Gains or losses on dispositions of property and equipment are included in the results of operations when realized. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, ranging from three to seven years. Leasehold improvements are amortized over the shorter of terms of the leases or their estimated useful lives. Depreciation expense on assets acquired under capital leases is included in depreciation expense.

 

Patents. Costs incurred in applying for patents relating to the Company’s process for production of nanopowders have been capitalized. Patents are amortized to reflect the pattern of economic benefits consumed, on a straight-line basis, over the estimated periods benefited. As of September 30, 2016, ten patents have been issued and two patents are pending approval. Amortization relating to issued patents was not significant during the periods presented. Additional significant costs may be required for the continued development of end-use applications for the Company’s technology. Patents costs are reviewed periodically as to if any patents are no longer being pursued and associated costs should be written off.

 

Impairment of Long-Lived Assets. Long-lived assets and intangible assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We evaluate potential impairment by comparing the carrying amount of the assets with the estimated undiscounted future cash flows associated with them. Should the review indicate that an asset is not recoverable, our carrying value of the asset would be reduced by the estimated shortfall to fair value.

 

Fair Value of Financial Instruments and Certain Other Assets and Liabilities. U.S. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

 

●	Level 1: Observable inputs such as quoted prices in active markets;
●	Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
●	Level 3: Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions

 

 

The Company’s financial instruments consist of cash, accounts receivable, accounts payable, and accrued expenses. The carrying amounts of such assets and liabilities approximate their respective fair values because of the short-term nature of these items. The carrying amounts of the Company’s debt agreements approximate their fair values as interest approximates current market rates for similar instruments. Derivative liabilities recorded in connection with convertible debt agreements are reported at estimated fair value with changes in fair value reported in results of operations.

 

Other than derivative liabilities referenced above, the Company did not have any assets or liabilities that are measured at fair value on a recurring or nonrecurring basis during the three months ended September 30, 2016 and the year ended June 30, 2016.

 

Derivative Liabilities. A derivative is an instrument whose value is “derived” from an underlying instrument or index such as a future, forward, swap, option contract, or other financial instrument with similar characteristics, including certain derivative instruments embedded in other contracts and for hedging activities. As a matter of policy, we do not invest in separable financial derivatives or engage in hedging transactions. However, we have entered into certain financing transactions that involve financial equity instruments containing certain features that have resulted in the instruments being deemed derivatives. We may engage in other similar complex financing transactions in the future, but not with the intention to enter into derivative instruments. Derivatives are measured at fair value using the Black-Scholes-Merton model and marked to market through earnings. However, such new and/or complex instruments may have immature or limited markets. As a result, the pricing models used for valuation of derivatives often incorporate significant estimates and assumptions. Changes in these subjective assumptions can materially affect the estimate of the fair value of derivative liabilities and, consequently, the related amount recognized as loss due to change in fair value of derivative liabilities on the consolidated statement of operations. Furthermore, depending on the terms of a derivative, the valuation of derivatives may be removed from the financial statements upon exercise or conversion of the underlying instrument into some other security. The classification of a derivative instrument is reassessed at each balance sheet date. If the classification changes as a result of events during a reporting period, the instrument is reclassified as of the date of the event that caused the reclassification. There is no limit on the number of times a contract may be reclassified.

 

Research and Development. Research and development costs are expensed as incurred. Costs incurred for research and development for new or improved processes to produce nanopowders as well as end use applications for the nanopowders are expensed until the production process or applications have been determined to be commercially viable. Costs incurred after the production process is viable and a working model of the equipment has been completed will be capitalized as long-lived assets.

 

Income Taxes. Deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts at each period end, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. The provision for income taxes represents the tax payable for the period, if any, and the change during the period in deferred tax assets and liabilities.

 

Loss Per Share. The Company calculates basic loss per share by dividing the net loss attributable to common stockholders by the weighted-average number of common shares outstanding. Diluted loss per share is computed similar to basic loss per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if such additional common shares had been issued and were dilutive.

 

Potential common shares, consisting of options and warrants, totaling 15,193,141 and 12,923,761, have been excluded from the computations of diluted net loss per share because the effect would have been anti-dilutive for the three months ended September 30, 2016 and 2015.

 

Stock-Based Compensation. We measure all employee stock-based compensation awards using the Black-Scholes-Merton valuation model and allocate the related expense over the requisite service period. The expected volatility is based on the historical volatility of our stock as determined by its private placement offerings, the expected life of the award is based on the simplified method. We account for nonemployee stock-based transactions using the fair value of the consideration received (i.e. the value of the goods or services) or the fair value of the equity instruments issued, whichever is more reliably measurable.

 

 

Going Concern. The Company has incurred recurring losses from operations from inception and has limited working capital. As of September 30, 2016, the Company had an accumulated deficit of approximately $47.8 million. The Company’s activities will necessitate significant uses of working capital beyond fiscal 2017. Additionally, the Company’s capital requirements will depend on many factors, including the success of its continued research and development efforts and the status of competitive products. The Company plans to continue financing its operations with cash received from financing activities. Management is currently working on securing equity capital from financing activities to sustain operations until the Company is able to generate sufficient cash flows from operations. There is no assurance that the Company will be able to raise sufficient capital to continue operations and, if available, on terms satisfactory to the Company. These factors raise substantial doubt about the Company’s ability to continue as a going concern.

 

Results of Operations

 

The following sets forth a discussion and analysis of the financial condition and results of operations of QSI for the three months ended September 30, 2016 and 2015. This discussion and analysis should be read in conjunction with our financial statements appearing elsewhere in this Form 10-Q. The following discussion contains forward-looking statements. Our actual results may differ significantly from the results discussed in such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section titled “Risk Factors,” beginning on page 15 of our Form 10-K filed on October 13, 2016.

 

Three Months Ended September 30, 2016 Compared to Three Months Ended September 30, 2015

 

The following discussions are based on the balance sheets as of September 30, 2016 and June 30, 2016 and statements of operations for the three months ended September 30, 2016 and September 30, 2015 and notes thereto.

 

The tables presented below, which compare QSI’s results of operations from one period to another, present the results for each period and the change in those results from one period to another in dollars. The columns present the following:

 

	●	The first two data columns in each table show the dollar results for each period presented.
	●	The column entitled “Dollar variance” shows the change in results in dollars. This column show favorable changes as positive and unfavorable changes as negative. For example, when net sales increase from one period to the next, that change is shown as a positive number. Conversely, when expenses increase from one period to the next, that change is shown as a negative.

 

 

		2016				2015				Dollar variance favorable (unfavorable)
Net Sales		$	27,299			$	9,057			$	18,242
Cost of Sales			2,508				1,076				(1,432	)
Gross Profit			24,791				7,981				16,810
Operating Expenses
Research and development			199,199				308,078				108,879
Selling, marketing and advertising			1,466				5,394				3,928
General and administrative			451,909				1,046,465				594,556
Total operating expenses			652,574				1,359,937				707,363
Loss from Operations			(627,783	)			(1,351,956	)			724,173
Other Expense
Interest expense, net			(94,058	)			(65,253	)			(28,805	)
Interest expense – amortization of note discounts			(529,935	)			(146,766	)			(383,169	)
Gain in disposal of asset			28,385				-				28,385
Gain (loss) from change in fair value of derivative liabilities			(46,777	)			609,400				(656,177	)
Total other income (expense), net			(642,385	)			397,381				(1,039,766	)
Loss Before Provision for Income Taxes			(1,270,168	)			(954,575	)			(315,593	)
Provision for Income Taxes			800				800				-
Net Loss		$	(1,270,968	)		$	(955,375	)		$	(315,593	)

 

Net Sales. Net sales increased by $18,242 in the three months ended September 30, 2016 compared to the three months ended September 30, 2015, reflecting an increase in sales of various nanomaterials and electrodes.

 

 

For the three months ended September 30, 2016, 83% of net sales were to the United States and 17% of net sales were to South Korea. For the three months ended September 30, 2015, 48% of net sales were to the United States, 28% of net sales were to South Korea, 13% of net sales were to Japan, and 11% of net sales were to China.

 

For the three months ended September 30, 2016, 88% of net sales were to four customers. For the three months ended September 30, 2015, 94% of net sales were to four customers.

 

Gross Profit. Gross profit increased by $16,810 in the three months ended September 30, 2016 compared to the three months ended September 30, 2015. The increase resulted from an increase of $18,242 in sales and decreases in costs of sales of $52,194 in manufacturing salaries and related expenses, $10,721 in utilities, $6,964 in depreciation, $6,401 in repairs and maintenance, and $1,937 in miscellaneous expenses, offset by $79,649 less allocation of nano iron analysis costs to research and development.

 

Research and Development. Research and development expenses decreased by $108,879 in the three months ended September 30, 2016 compared to the three months ended September 30, 2015. The decrease resulted from decreases of $79,649 in nano iron analysis costs, $23,115 in salaries and related expenses due to less employees, and $7,283 in ammonia research, offset by an increase of $1,168 in miscellaneous expenses.

 

Selling, Marketing and Advertising Expenses. Selling, marketing and advertising expenses decreased by $3,928 in the three months ended September 30, 2016 compared to the three months ended September 30, 2015. The decrease resulted from decreases of $1,989 in outside consultants, $1,415 in marketing expense, and $524 in miscellaneous expenses.

 

General and Administrative Expenses. General and administrative expenses decreased by $594,556 in the three months ended September 30, 2016 compared to the three months ended September 30, 2015. The decrease resulted from decreases of $440,820 in consultants and outside services (primarily for investor relations), $63,871 in payroll and related expenses (primarily stock compensation expense in the three months ended September 30, 2015), $40,796 in board members compensation (primarily less board members in the three months ended September 30, 2016 and stock compensation expense in the three months ended September 30, 2015), $23,180 in audit expense, $8,826 in travel related expenses, $6,994 in business insurance, and $10,069 in miscellaneous expenses.

 

Interest Expense. Interest expense increased by $28,805 in the three months ended September 30, 2016 compared to the three months ended September 30, 2015. The increase resulted from the addition of notes payable in November 2015, and February, April and June 2016.

 

Interest Expense – Amortization of Note Discounts. Debt discount amortization increased by $383,169 in the three months ended September 30, 2016 compared to the three months ended September 30, 2015. The increase was due to the addition of Series O-2 Notes derivative liabilities in October through December 2015 and the addition of bridge notes derivative liabilities in June 2016.

 

Gain in Disposal of Assets. Gain from disposal of assets increased $28,385 in the three months ended September 30, 2016 compared to the three months ended September 30, 2015. Several fully depreciated assets were sold.

 

Gain (Loss) from Change in Fair Value of Derivative Liabilities. Gain from change in fair value of derivative liabilities decreased by $656,177 to a loss of $46,777 in the three months ended September 30, 2016 compared to a gain of $609,400 the three months ended September 30, 2015. The loss in the three months ended September 30, 2016 was due to the September 30, 2016 revaluation of the derivative liabilities of the 2015 Series O-2 notes. The gain in the three months ended September 30, 2015 was due to the September 30, 2015 revaluation of the derivative liabilities relate to the Series O-1 convertible notes.

 

 

Liquidity and Capital Resources

 

As of September 30, 2016, we had current assets of $94,380, including $706 in cash.

 

Cash decreased $180,099 from $180,805 at June 30, 2016 to $706 at September 30, 2016. Net cash used in operating activities of $168,648 in the three months ended September 30, 2016 included $1,270,968 operating loss and $52,006 increase in prepaid expenses, offset by $384,864 increase in accounts payable and accrued expenses, $1,445 decrease in accounts receivable, and non-cash items of $529,935 in discount amortization on notes payable, $90,635 in depreciation and amortization, $83,250 in stock issued for services, $46,777 in loss from change in fair value of derivative liabilities, and $17,420 stock based compensation. $636,504 in cash was used in operating activities for the three months ended September 30, 2015.

 

$130 of cash was used in investing activities in the three months ended September 30, 2016 for the purchase of property and equipment. $15,671 of cash was used in investing activities in the three months ended September 30, 2015.

 

$11,321 in cash was used in financing activities in the three months ended September 30, 2016. $25,000 was provided by the issuance of notes payable, offset by $36,321 principal payments on notes payable. $362,385 in cash was provided by financing activities in the three months ended September 30, 2015.

 

Immediately prior to the consummation of the Merger, the Company executed a 10,000 for 1 reverse split. As a result of the reverse split, the Company cancelled and repurchased fractional shares comprising approximately 585,000 shares of common stock for $2.00 per share. Shortly after the reverse split, the Company executed a 1 for 10,000 forward split. As of September 30, 2016, the Company had approximately $205,000 of accrued liabilities associated with the share cancellation.

 

We monitor our financial resources on an ongoing basis and may adjust planned business activities and operations as needed to ensure that we have sufficient operating capital. We evaluate our capital needs, and the availability and cost of capital on an ongoing basis and expect to seek capital when and on such terms as deemed appropriate based upon an assessment of then-current liquidity, capital needs, and theavailability and cost of capital.We expect that any capital we raise will be through the issuance of equity securities, the exercise of warrants and options, or the issuance of debt instruments, including convertible debt instruments. We believe that we will be able to obtain financing when and as needed, but the capital may be epensive.

 

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. The Company has incurred recurring losses from operations from inception and has limited working capital. As of September 30, 2016, the Company had an accumulated deficit of approximately $47.8 million. In addition, at September 30, 2016 the Company is in default on certain of its debt obligations.

 

The Company’s activities will necessitate significant uses of working capital during and beyond fiscal 2017. Additionally, the Company’s capital requirements will depend on many factors, including the success of its continued research and development efforts and the status of competitive products. The Company plans to continue financing its operations with cash received from financing activities. The Company has engaged U.S. Capital Partners and Avalon Securities for a proposed issuance of up to $5.0 million of 8% Series A convertible preferred stock. The Company has completed the due diligence phase and both firms are in the process of presenting the offering to potential accredited investors. The Company anticipates that, if the issuance is partially or completely successful, some or all of the issuance will be received by December 31, 2016. Should the issuance not be successful, then absent another form of financing or capital raise, the Company expects it will not be able to service current obligations and anticipates that it will have to liquidate assets and will no longer operate as a going concern. The financial statements do not include any adjustments that might result for the outcome of this uncertainty. The Company currently has sufficient cash for operations through November 2016.

 

 

Other Commitments and Contingencies

 

Our commitments and contingencies as of September 30, 2016 consisted of our lease agreement for our principal corporate offices located in Santa Ana, California and leased equipment. Accordingly, the following table only summarizes our minimum lease payments for the next five years and thereafter:

 

Year Ending September 30,		Amount
2017		$	44,049

 

The above minimum lease payments include a new lease for our principal corporate offices that was signed in March 2014. The lease period is from March 2014 through February 2017.

 

OFF BALANCE SHEET ARRANGEMENTS

 

We do not have any off-balance sheet arrangements.

 

Inflation

 

We do not believe that the current levels of inflation in the United States have had a significant impact on our operations. If current levels of inflation hold steady, we do not believe future operations will be negatively impacted.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

Not required by smaller reporting companies.

 

ITEM 4. CONTROLS AND PROCEDURES.

 

Evaluation of Disclosure Controls and Procedures.

 

As required by Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “Exchange Act”), we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls as of the end of the period covered by this report, September 30, 2015. This evaluation was carried out under the supervision and with the participation of our Chief Executive Officer, Mr. Kevin Maloney, and Chief Financial Officer, Mr. Stephen Gillings, (the “Certifying Officers”). Based upon that evaluation, our Certifying Officers concluded that as of the end of the period covered by this report, our disclosure controls and procedures are effective in timely alerting management to material information relating to us and required to be included in our periodic filings with the Securities and Exchange Commission (the “Commission”).

 

Our officer further concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by the issuer in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms and are also effective to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our chief executive officer and chief financial officer, to allow time for decisions regarding required disclosure.

 

Changes in Internal Control over Financial Reporting.

 

There were no changes in the Company’s internal controls over financial reporting, known to the Chief Executive Officer or the Chief Financial Officer that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

 

PART II – OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

None.

 

ITEM 1A. RISK FACTORS

 

Not Applicable.

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

 

None.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

 

None

 

ITEM 4. MINE SAFETY DISCLOSURES

 

Not Applicable.

 

ITEM 5. OTHER INFORMATION.

 

None

 

ITEM 6. EXHIBITS

 

Copies of the following documents are included as exhibits to this report pursuant to Item 601 of Regulation S-K.

 

Exhibit No.		Title of Document		Location
31		Certification of the Principal Executive Officer/ Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		Attached
32		Certification of the Principal Executive Officer/ Principal Financial Officer pursuant to U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*		Attached
101.INS		XBRL Instance Document		Attached
101.SCH		XBRL Taxonomy Extension Schema Document		Attached
101.CAL		XBRL Taxonomy Calculation Linkbase Document		Attached
101.DEF		XBRL Taxonomy Extension Definition Linkbase Document		Attached
101.LAB		XBRL Taxonomy Label Linkbase Document		Attached
101.PRE		XBRL Taxonomy Presentation Linkbase Document		Attached

 

The Exhibit attached to this Form 10-Q shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934 (the “Exchange Act”) or otherwise subject to liability under that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933, as amended, or the Exchange Act, except as expressly set forth by specific reference in such filing.

 

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

QUANTUMSPHERE, INC.

 

Date: November 21, 2016

 

By:	/s/ Kevin Maloney
	Kevin Maloney, Chief Executive Officer
By:	/s/ Stephen Gillings
	Stephen Gillings, Chief Financial Officer