CONVERTIBLE PROMISSORY NOTES AND FAIR VALUE OF CONVERTIBLE PROMISSORY NOTES

9 Months Ended

Sep. 30, 2022

CONVERTIBLE PROMISSORY NOTES AND FAIR VALUE OF CONVERTIBLE PROMISSORY NOTES

CONVERTIBLE PROMISSORY NOTES AND FAIR VALUE OF CONVERTIBLE PROMISSORY NOTES

NOTE 15 – CONVERTIBLE PROMISSORY NOTES AND FAIR VALUE OF CONVERTIBLE PROMISSORY NOTES

Convertible promissory notes consist of the following at September 30, 2022 and December 31, 2021 (in thousands):

	September 30, 2022		December 31, 2021
Convertible promissory notes due January 31, 2019, interest payable at 8% per annum; unsecured; principal and accrued interest convertible into common stock at the lower of $1.32 per share (the price per share of the latest closing of a debt or equity offering by the Company greater than $3.0 million); accrued interest due January 31, 2019 and currently in default. The Company has offered to either repay the notes or convert them into shares of common stock of the Company. The beneficial owners of the notes have not yet communicated their intent to either receive payment or shares.	$	550	$	550
Current portion of convertible promissory notes	$	550	$	550

Fair value of Series A and B convertible promissory notes consists of the following at September 30, 2022 and December 31, 2021 (in thousands):

	September 30, 2022			December 31, 2021
Series A subordinated convertible note at fair value	$	3,136		$	3,074
Series B subordinated convertible note at fair value		11,848			11,858
Total convertible promissory notes		14,984			14,932
Less: Investor Note offset – Series B Note		(5,000	)		(5,000	)
Carrying value of convertible promissory notes at fair value		9,984			9,932
Less: current portion of convertible promissory notes at fair value		(9,984	)		(9,932	)
Convertible promissory notes, less current portion	$	-		$	-

In October 2020, the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) with an institutional investor (the “Investor”) for the purchase of a series of two convertible notes with an aggregate principal amount of $11.5 million. Concurrently, the Company consummated the sale to the Investor of a Series A subordinated convertible note (the “Series A Note”) with an initial principal amount of $4.6 million and a Series B senior secured convertible note (the “Series B Note,” and together with the Series A Note, the “Convertible Notes” and, each a “Convertible Note”) with an initial principal amount of $6.9 million in a private placement (the “Private Placement”).

The Series A Note was sold with an original issue discount of $0.6 million and the Series B Note was sold with an original issue discount of $0.9 million. The Investor paid for the Series A Note to be issued to the Investor by delivering $4.0 million in cash consideration and paid for the Series B Note to be issued to the Investor by delivering a secured promissory note (the “Investor Note”) with an initial principal amount of $6.0 million. The Company will receive cash in respect of a Series B Note only upon cash repayment of the corresponding Investor Note. In certain circumstances, the Investor Note may be automatically satisfied through netting against the Series B Note, as described more fully below, rather than through the payment of cash. Until an Investor Note is repaid, the original issue discount and the rest of the principal under the corresponding Series B Note is considered to be “restricted.” Upon any repayment of the Investor Note, the principal of the corresponding Series B Note becomes “unrestricted” on dollar-for-dollar basis, along with a proportional amount of the original issue discount. During the year ended December 31, 2020, the Company received $1.0 million from the Investor Note, leaving a remaining balance of $5.0 million of the Investor Note as of December 31, 2020, which is netted against the Series B Note and included in convertible promissory notes in the unaudited condensed consolidated balance sheet.

The placement agent received a placement agent fee of $306,000 at the closing of the Private Placement, representing 8% of the gross cash proceeds at the closing. After deducting the placement agent fee, the Company’s estimated expenses associated with the Private Placement and the repayment of the September Note, the Company’s net cash proceeds at the closing were approximately $2,340,000. If the Investor Note is subsequently satisfied in full by payment in cash, the additional financial advisory fee on the cash proceeds received from the Investor Note will be an additional $480,000, and the aggregate net cash proceeds from the Private Placement as a whole will be approximately $8,850,000. In addition, the placement agent received a warrant (the “Warrant”) exercisable for two years for the purchase of an aggregate of up to 242,424 shares of the Company’s common stock, at an exercise price of $1.32 per share. The Warrant may also be exercised by means of a “cashless exercise” or “net exercise.” Upon the achievement of certain milestones, the placement agent is entitled to receive an additional warrant, on the same terms as the Warrant, exercisable for an aggregate of up to 363,636 shares of the Company’s common stock (collectively with the shares underlying the Warrant, the “Warrant Shares”). The Warrant Shares, when issued, will have the same rights, preferences and privileges (including the registration rights described under “Registration Rights Agreement” below) as the shares underlying the Convertible Notes.

The Series A Note matures on October 30, 2022 and the Series B Note matured on October 30, 2021 (the “Maturity Date”), subject to extension in certain circumstances, including bankruptcy and outstanding events of default.

On January 5, 2022, the Company entered into a Forbearance Agreement (the “Forbearance Agreement”) with the Investor pursuant to which the Investor has agreed not to exercise, with certain exclusions, any of its judicial or administrative enforcement actions to obtain cash or other assets (excluding Common Stock or other assets issuable upon conversion or exchange of the Series B Note in accordance with the terms thereof) from the Company on account of any payment obligations of the Company under the Series B Note or the Event of Default Redemption Notice that exist as of the date of the Forbearance Agreement or that may arise from the date of this Agreement through February 15, 2022. As of September 30, 2022, the Series B Note is in default and as of the date of this Quarterly Report, the Series A Note is in default. No action from the lender has been pursued on either Convertible Note as of the date of this Quarterly Report. On April 12, 2022, the Company filed a civil action in the California Superior Court against the Investor, alleging that the investor entered into the Purchase Agreement as an unregistered securities dealer and unlicensed finance lender in violation of California law. The Company’s complaint seeks rescission of the Purchase Agreement, damages, attorneys’ fees and other relief. The Investor responded to the complaint by filing a demurrer/motion to dismiss and on August 31, 2022, the Company and Investor entered into a stipulation to stay the litigation for 30 days and allow the parties to engage in further settlement discussions.  The matter was unable to be resolved within the 30 days, and, pursuant to the Stipulation, the Company refiled its action in New York where a New York court will be required to apply California law to our causes of action for rescission and unfair competition. As of the filing date of this Quarterly Report, the Investor has not filed a response to the complaint.

Payment of Amounts Due under the Convertible Notes

On the Maturity Date, the Company shall pay to the Investor an amount in cash (other than restricted amounts under a Series B Note) presenting all outstanding principal, Make-Whole Amount (as defined in the Convertible Notes), if any, accrued and unpaid interest and accrued and unpaid Late Charges (as defined in the Convertible Notes) on such principal, except that any restricted amount under the Series B Note will be automatically satisfied on the Maturity Date (in lieu of a cash payment) by Maturity Netting (as defined in the Investor Note described below). The Company may not prepay any amounts due under the Convertible Notes.

Interest

The Convertible Notes shall bear no interest unless there is an occurrence, and during the continuance, of an Event of Default (as defined in the Convertible Notes). During any such Event of Default, the Convertible Notes will accrue interest at the rate of 18% per annum. See “—Events of Default” below.

Conversion; Alternate Conversion upon Event of Default

Each Convertible Note (other than restricted amounts under a Series B Note) is convertible, at the option of the Investor, into shares of Common Stock at a conversion price of $1.32 per share. The conversion price is subject to full ratchet antidilution protection upon any transaction in which the Company is deemed to have granted, issued or sold, any shares of Common Stock. If the Company enters into any agreement to issue any variable rate securities, other than a bona fide at-the-market offering or equity line of credit, the Investor has the additional right to substitute such variable price (or formula) for the conversion price.

If an Event of Default has occurred under the Convertible Notes, the Investor may elect to alternatively convert the Convertible Notes at the redemption premium described therein.

Conversion Limitation

The Investor will not have the right to convert any portion of the Convertible Notes, to the extent that, after giving effect to such conversion, the Investor (and other certain related parties) would beneficially own in excess of 4.99% of the shares of Common Stock outstanding immediately after giving effect to such conversion. This limit may, from time to time, be increased, up to 9.99%, or decreased; provided that any such increase will not be effective until the 61^st day after delivery of a notice to the Company of such increase.

Events of Default

The Convertible Notes include certain customary and other Events of Default. In connection with an Event of Default, the Investor may require the Company to redeem in cash any or all of the Convertible Notes. The redemption price will be at a premium to the amount due under the Convertible Notes as described therein.

Change of Control

In connection with a Change of Control (as defined in the Convertible Notes), the Investor may require the Company to redeem all or any portion of the Convertible Notes. The redemption price per share will be at a premium to the amount due under the Convertible Notes as described therein.

Covenants

The Company will be subject to certain customary affirmative and negative covenants including those regarding the payment of dividends, maintenance of its property, transactions with affiliates, and issue notes and certain securities.

Placement Agent Warrants

On October 2, 2020 and December 31, 2020, in connection with the Series A Note and Series B Note, respectively, a placement agent received a warrant (the “Warrant”) exercisable for 2 years for the purchase of an aggregate of up to 242,424 and 60,606 shares, respectively, of the Company’s common stock, at an exercise price of $1.32 per share. The Warrant may also be exercised by means of a “cashless exercise” or “net exercise.” Upon the achievement of certain milestones, the placement agent is entitled to receive an additional warrant, on the same terms as the Warrant, exercisable for an aggregate of up to 363,636 shares of the Company’s common stock.

Fair Value Option for the Series A and B Notes

The Company elected the fair value option under ASC 825, “Financial Instruments,” for both the Series A and B Notes and accounted for the Notes as follows (1) the portion of the change in the liability’s fair value that is attributable to a change in instrument-specific credit risk in other comprehensive income (2) the remaining change in the liability’s fair value in net income (3) the excess of the fair value over the proceeds is recognized as an expense and (4) upfront costs and fees are recognized in earnings as incurred gains and losses attributable to changes in credit risk are determined using observable credit default spreads for the issuer or comparable companies; these gains and losses were insignificant during all periods presented. The Company recognized a loss of $4.4 million and $5.1 million at the time of issuance of the Series A and B Notes, respectively, as a result of the make whole provision noted within the debt arrangements as the debt holders would be awarded a variable number of shares at the time of conversion which would always equate to an amount greater than the principal amount of the debt.

The Company recorded a loss of $0.1 million and $0.6 million relating to the Series A and B Notes, respectively, attributed to the change in fair value of the Series A and B Notes for the nine months ended September 30, 2022 and were recorded in the unaudited condensed consolidated statement of operations. The Company recorded a gain of $1.0 million and a gain of $0.1 million relating to the Series A and B Notes, respectively, attributed to the change if fair value of the Series A and B Notes for the nine months ended September 30, 2021 and were recorded in the unaudited condensed consolidated statement of operations.

As of September 30, 2022, the Company has valued the Series A and B notes without consideration of the terms under an existing default.  This was evaluated by the Company’s management and their third-party valuation firm.  In light of the forbearance agreement, litigation filed by the Company, and communications between the Company and the Investor the likelihood of settlement under the default terms was considered remote.  If the Company is required to settle the Series A and B Notes under those terms, the settlement would be either a cash payment of approximately $4.4 million or the issuance of 12,519,597 shares of the Company’s common stock at the option of the Investor.