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NAKED BRAND GROUP INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This quarterly report contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as "may", "should", "expects", "plans", "anticipates", "believes", "estimates", "predicts", "potential" or "continue" or the negative of these terms or other comparable terminology and include statements regarding: (1) our product line; (2) our business plan, including our plan to launch a complimentary line of women's innerwear, lounge and sleepwear products within the next 12 months and in the future extend the Naked brand to active wear, swim as well as bed and bath products; (3) our expectation that by the end of fiscal 2015, all of our primary production will be made outside of Canada; (4) the enforceability of our intellectual property rights; (5) projections of market prices and costs; (6) supply and demand for our products; (7) future capital expenditures; and (8) our need for, and our ability to raise, capital. The material assumptions supporting these forward-looking statements include, among other things: (1) our ability to obtain any necessary financing on acceptable terms; (2) timing and amount of capital expenditures; (3) the enforcement of our intellectual property rights; (4) our ability to launch new product lines; (5) retention of skilled personnel; (6) continuation of current tax and regulatory regimes; (7) current exchange rate and interest rates; and (8) general economic and financial market conditions. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, which may cause our or our industry's actual results, levels of activity or performance to be materially different from any future results, levels of activity or performance expressed or implied by these forward-looking statements. These risks and uncertainties include: (1) a continued downturn in international economic conditions; (2) any adverse occurrence with respect to the development or marketing of our apparel products; (3) any adverse occurrence with respect to any of our licensing agreements; (4) our ability to successfully bring apparel products to market; (5) product development or other initiatives by our competitors; (6) fluctuations in the availability and cost of materials required to produce our products; (7) any adverse occurrence with respect to distribution of our products; (8) potential negative financial impact from claims, lawsuits and other legal proceedings or challenges; (9) our ability to enforce our intellectual property rights; (10) our ability to hire and retain senior management and key employees; and (11) other factors beyond our control. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Except as required by applicable law, including the securities laws of the United States and Canada, we do not intend to update any of the forward-looking statements to conform these statements to actual results. Cautionary Note Regarding Management's Discussion and Analysis This Management's Discussion and Analysis should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and related notes. The discussion and analysis of our financial condition and results of operations are based upon the condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of any contingent liabilities at the financial statement date and reported amounts of revenue and expenses during the reporting period. On an on-going basis, we review our estimates and assumptions. The estimates were based on historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results are likely to differ from those estimates under different assumptions or conditions. The following discussion should be read in conjunction with our unaudited interim consolidated financial statements and the related notes that appear elsewhere in this quarterly report. Our unaudited condensed consolidated interim financial statements are stated in United States dollars (US$) and are prepared in accordance with accounting principles generally accepted in the United States of America. -------------------------------------------------------------------------------- 5 As used in this quarterly report on Form 10-Q, the terms "we", "us", "our" and "Company" mean our company, Naked Brand Group Inc., and our wholly-owned subsidiary Naked Inc., as applicable. In this quarterly report, unless otherwise specified, all dollar amounts are expressed in United States dollars. All references to "common shares" refer to the common shares in our capital stock. Corporate Information We were incorporated in the State of Nevada on May 17, 2005 under the name of Search By Headlines.com Corp. Effective August 29, 2012, we completed a merger with a newly-formed subsidiary, Naked Brand Group Inc., a Nevada corporation, which was incorporated solely to effect a change of our corporate name. As a result, effective August 29, 2012, we changed our name from "Search By Headlines.com Corp." to "Naked Brand Group Inc." ("Naked Brand Group"). Our wholly owned subsidiary is Naked Inc. ("Naked"). Naked was incorporated under the federal laws of Canada on May 21, 2009 as "In Search of Solutions Inc.", changed its corporate name to "Naked Boxer Brief Clothing Inc." on May 17, 2010 and to "Naked Inc." on February 20, 2013. Naked continued from the federal jurisdiction of Canada to the jurisdiction of the State of Nevada on July 27, 2012. As part of the continuation, all classes of shares of Naked, including Class C, D, E and F common shares, were converted into one class of common shares of the Nevada corporation. Our principal executive offices are located at 95 Madison Avenue, New York, New York, 10016, and our telephone number is (212) 851-8050. General Development On July 30, 2012, we closed an Acquisition Agreement with Naked whereby Naked's owners became the sole directors and management of our company and Naked stockholders exchanged their shares for a total of 13.5 million shares of our company, representing 50% of the company (the "Acquisition"). Naked is a manufacturer and seller of direct and wholesale men's undergarments and intimate apparel products in Canada and the United States to consumers and retailers. As a result of the Acquisition, Naked became a wholly-owned subsidiary of our company and our business became the manufacture and sales of direct and wholesale undergarments in Canada and the United States to consumers and retailers. We operate out of New York, New York and Abbotsford, British Columbia, Canada. Our mission is to build a global lifestyle brand business offering innovative apparel, home and personal products. We currently design, manufacture and sell men's innerwear and lounge apparel products under the "Naked" brand to consumers and retailers. We plan to launch a complimentary line of women's innerwear, lounge and sleepwear products, and in the future extend the Naked brand to active wear, swim as well as bed and bath products. Our core brand philosophy for Naked is to provide products that make people feel sexy and confident while being as comfortable as wearing nothing at all. Our goal is to create a new standard for how apparel products worn close to skin fit, feel and function. Our products are sold at a premium fashion stores in North America, primarily in Canada and on the West Coast of the United States including Holt Renfrew, Hudson's Bay Company and Nordstrom. Recent Corporate Developments Since the commencement of our second quarter ended July 31, 2014, we have experienced the following significant corporate developments: 1. We completed a private placement offering (the "Offering") resulting in total aggregate proceeds of $7,309,832 to the Company, before deducting commissions and other transaction related expenses, and including the conversion of convertible notes in the aggregate amount of $1,094,159. Each Unit consists of (i) a 6% convertible senior secured debenture in the principal amount of $25,000 and (ii) a warrant to purchase 166,667 common shares of the Company at an exercise price of $0.15 per share, subject to adjustment. The funds raised from the sale of the Units will be used for marketing and new product development and design, as well as general working capital requirements. -------------------------------------------------------------------------------- 6 2. On June 6, 2014 Ms. Carole Hochman accepted the appointment by the board of directors of the company to serve as the Company's Chief Executive Officer and Chief Creative Officer, and to serve as a director of the Company, with each appointment effective June 10, 2014 upon the initial closing of the Offering, as described above. Carole Hochman is a renowned designer and sleepwear pioneer. She is considered one of the single most influential women in the intimate apparel and sleepwear business in the United States and has been creating intimate apparel for more than 30 years. 3. On June 6, 2014 Mr. Michael Flanagan accepted the appointment by the board of directors of the company to serve as the Company's Chief Financial Officer and Chief Operating Officer effective June 9, 2014. Mr. Flanagan brings more than 30 years of very successful apparel experience in both finance and operations. 4. On June 6, 2014, we appointed Mr. Carlos Serra, age 45, as our company's VP Sales and Merchandising, effective June 23, 2014. Mr. Serra is a senior sales, merchandising and marketing executive with over 18 years of experience in the intimate apparel industry. 5. On June 6, 2014, our board of directors approved a 2014 Long-Term Incentive Plan (the "2014 Plan"), and on August 21, 2014, the 2014 Plan was approved and ratified through written consent by the majority of our stockholders. The 2014 Plan provides for the grant of stock options, restricted shares, restricted share units and performance stock and units to directors, officers, employees and consultants of our Company. The maximum number of shares of common stock reserved for issue under the plan is 110,000,000 shares. 6. On September 8, 2014, we filed a preliminary prospectus on Form S-1 with the Securities and Exchange Commission to cover the sale of up to 41,569,071 shares of our common stock that may be issued upon exercise of warrants issued in connection with the Offering. Outlook We will continue to operate in the men's undergarment market and have no current plans to significantly change operations. However, we do plan to make significant changes to our current collections of men's undergarments, launch a complimentary line of women's innerwear, loungewear and sleepwear products and in the future extend the Naked brand to other products. During the fiscal quarter ended July 31, 2014, we were able to secure financing which will enable management to actively pursue planned business objectives and growth strategies. In conjunction with this financing, we installed a new core management team led by fashion visionary and intimate apparel icon Carole Hochman as CEO and Chief Creative Officer. RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JULY 31, 2014 Revenues During the three months ended July 31, 2014, our net sales decreased by $38,799, or 19% over the comparative three month period ended July 31, 2013. Net sales decreased as a result of the sell-off of out of season products to discount retailers in the comparative period, as well as the introduction of new products, t-shirts and our NKD subline during the comparative period, which resulted in increased sales in that period from initial orders of these new styles. We sold to 64 boutique stores, 5 department stores, and two online retailers during the three months ended July 31, 2014, as compared to 72 boutique stores and 3 department stores during the comparative three month period. -------------------------------------------------------------------------------- 7 We expect our sales will increase gradually in subsequent quarters in the current fiscal year as a result of seasonal fluctuations, marketing and promotional activities and the addition of new customers, as management works to implement its more long-term business strategies. Gross Margins In the current quarter we wrote down inventory in the amount of $327,600 to reduce inventory to its estimated net realizable value. These write downs are a result of a new core management team and manufacturing partnership which has triggered a period of transition involving product design and production changes. We expect to continue to sell existing inventory over the remaining periods in the current fiscal year as we make this transformation, after which point we plan to launch new collections in the coming fiscal year. Operating Expenses Three months ended July 31, Change General and administrative 2014 2013 $ % Bad debts (recovery) $ 1,731 $ (6,687 ) 8,418 (125.9 ) Bank charges and interest 8,071 1,905 6,166 323.7 Consulting 24,506 277,474 (252,968 ) (91.2 ) Depreciation 6,855 5,482 1,373 25.0 Directors fees 9,900 100,633 (90,733 ) (90.2 ) Insurance 16,146 13,979 2,167 15.5 Investor relations 58,768 45,590 13,178 28.9 Marketing 123,557 87,403 36,154 41.4 Occupancy and rent 18,198 7,131 11,067 155.2 Office and miscellaneous 16,219 31,815 (15,596 ) (49.0 ) Product development 35,375 95,531 (60,156 ) (63.0 ) Professional fees 296,600 81,163 215,437 265.4 Salaries and benefits 315,456 176,211 139,245 79.0 Transfer agent and filing fees 17,276 10,611 6,665 62.8 Travel 52,993 35,135 17,858 50.8 Warehouse management 23,718 32,864 (9,146 ) (27.8 ) Total $ 1,025,369 $ 966,240 29,129 2.9 There was an overall increase in general and administrative expenses for the three months ended July 31, 2014, from the three months ended July 31, 2013. This increase is mostly attributable to an increase in marketing, professional fees, and salaries, as further explained below. Our marketing expenses increased in the current quarter as a result of a new contract with a marketing, sales and design consultant engaged to provide marketing, creative and strategic direction, including the design and development of new logos, packaging, marketing materials and point of purchase displays. Professional fees increased year over year, as a result of higher legal fees associated with new employment contracts, a new incentive stock option plan and the related written consent solicitation from our stockholders, and from the preparation of a registration statement in connection with the Offering. Salaries and benefits increased due to increased staffing levels related to a new core management team and related employment contracts. Our consulting fees decreased as a result of higher than normal consulting fees incurred in the comparative period, including non-cash share based compensation expense of $244,296 associated with stock options granted to a consultant during that period, and contracts with a branding company, merchandising consulting, and other consultants engaged in special projects in that period. Directors' fees in the current period are related to the issuance of stock to a board member appointed in the third quarter of the prior fiscal year. In the comparative period, directors fees were related to stock options granted in that period in connection with the appointment of a new director. -------------------------------------------------------------------------------- 8 Other income and expenses We incurred interest expenses of $76,929 for the three months ended July 31, 2014 as compared to $12,831 for the same period in 2013. This increase in interest is attributable to long term financings entered into during the current period, in connection with the Offering. Long-term debt is accruing interest at 6% per annum, payable in cash or in kind at the option of the company. Financing and accretion charges increased to $2,181,894 for the three months ended July 31, 2014 from $96,912 for the three months ended July 31, 2013. This is the result of the immediate recognition of all commissions and direct financing related expenses associated with the $7.2 Million Offering. Accounting rules required the immediate recognition of all transaction related expenses associated with the Offering as a result of the classification and treatment of the related host contract as a derivative financial instrument, as outlined below. During the three months ended July 31, 2014, in connection with the Offering, we issued convertible debentures and warrants, each of which were convertible or exercisable into shares of our common stock and we did not, at the date we issued these securities, have a sufficient number of authorized and unissued shares of common stock available to satisfy the conversion and exercise of all of these securities. As a result, we were required to account for these securities as derivative liabilities. In connection with the issuance of these securities in connection with the Offering, we recorded a derivative expense of $12,028,383 related to the fair value of these outstanding contracts at the contract inception date. Further, we recorded a mark to market derivative expense of $12,978,200 as a result of the application of related accounting rules, which require these derivative financial instruments to be carried at fair value which resulted in significant mark to market adjustments in correlation with fluctuations in the price of our common stock. These are non-cash income and expense items of our company Subsequent to July 31, 2014, we obtained the written consent of our stockholders to approve the increase in authorized shares of common stock sufficient to satisfy the securities underlying the Offering. However, the terms of an underlying registration rights agreement will continue to trigger derivative liability classification for the foreseeable future. We had debt conversion expense of $309,011 and net losses on extinguishment of debt of $128,920 during the three months ended July 31, 2014. These charges arose in connection with the settlement of various short term financing arrangements that had been entered into to bridge operations until the larger Offering was completed. Subsequent to and concurrent with the Offering we settled these short term obligations through a combination of cash and stock issuances, as described in detail in our financial statements filed herein. For the three months ended July 31, 2013 other expenses included a $485,704 loss associated with the amendment to the Kalamalka Notes that had entered into default in a previous reporting period. This loss is the result of providing concessions to the Lenders as compensation for defaulting on the covenants under these Notes. These concessions included a reduced conversion price for the Notes and modified terms associated with warrants issued in connection with the Notes. Net loss and comprehensive loss Our net loss for the three months ended July 31, 2014 was $29,033,373, or $0.81 per share, as compared to a net loss of $2,037,286, or $0.07 per share, for the three months ended July 31, 2013. The most significant factor for the increase in net loss in the current period is the non-cash loss associated with the derivative accounting in connection with the Offering, as described above. RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JULY 31, 2014 Revenues During the six months ended July 31, 2014, our net sales decreased by $12,551, or 4% over the comparative six month period ended July 31, 2013. Net sales decreased as a result of the sell-off of out of season products to discount retailers in the comparative period, as well as the introduction of new products, t-shirts and our NKD subline during the comparative period, which resulted in increased sales in that period from initial orders of these new styles. We sold to 90 boutique stores, 5 department stores, and two online retailers during the six months ended July 31, 2014, as compared to 86 boutique stores and 3 department stores during the comparative half year period. -------------------------------------------------------------------------------- 9 We expect our sales will increase gradually in the second half of the current fiscal year as a result of seasonal fluctuations, marketing and promotional activities and the addition of new customers, as management works to implement its more long-term business strategies. Gross Margins During the six months ended July 31, 2014, we recorded net write downs of inventory in the amount of $314,600 to reduce inventory to its estimated net realizable value. These write downs are a result of a new core management team and manufacturing partnership which has triggered a period of transition to product design and production changes. We expect to continue to sell existing inventory over the remaining periods in the current fiscal year as we make this transformation, after which point we plan to launch new collections in the coming fiscal year. Operating Expenses Six months ended July 31, Change General and administrative 2014 2013 $ % Bad debts $ 1,009 $ (1,764 ) 2,773 (157.2 ) Bank charges and interest 9,565 3,308 6,257 189.1 Consulting 29,538 337,756 (308,218 ) (91.3 ) Depreciation 13,152 10,723 2,429 22.7 Directors fees 24,900 100,633 (75,733 ) (75.3 ) Insurance 26,652 28,058 (1,406 ) (5.0 ) Investor relations 74,973 179,452 (104,479 ) (58.2 ) Marketing 143,563 164,141 (20,578 ) (12.5 ) Occupancy and rent 27,411 14,941 12,470 83.5 Office and miscellaneous 32,803 60,601 (27,798 ) (45.9 ) Product development 41,083 125,134 (84,051 ) (67.2 ) Professional fees 392,186 160,458 231,728 144.4 Salaries and benefits 479,149 319,265 159,884 50.1 Transfer agent and filing fees 21,231 12,779 8,452 66.1 Travel 70,969 66,036 4,933 7.5 Warehouse management 62,830 38,308 24,522 64.0 Total $ 1,451,014 $ 1,619,829 (168,815 ) (10.4 ) There was an overall decrease in general and administrative expenses to $1,451,014 for the six months ended July 31, 2014, from $1,619,829 for the six months ended July 31, 2013. This decrease is mostly attributable to the decrease in consulting and directors fees from the comparative period. Our consulting fees decreased as a result of higher than normal consulting fees incurred in the comparative period, including non-cash share based compensation expense of $251,339 mostly associated with stock options granted to a consultant during that period, and contracts with a branding company, merchandising consulting, and other consultants engaged in special projects in that period. Directors' fees in the current period are related to the issuance of stock to a board member appointed in the third quarter of the prior fiscal year. In the comparative period, directors fees were related to stock options granted in that period in connection with the appointment of a new director. Our investor relations expenses was significantly reduced in the first half of the current fiscal year as a result of the termination of contractual relationships with investor relations firms who had been assisting in capital raising efforts through introductions to the institutional and retail investment community. These capital raising efforts were continued internally within the company and, as described above, are reflected in the successful securing of a significant financing during the six months ended July 31, 2014. -------------------------------------------------------------------------------- 10 Professional fees increased year over year, as a result of higher legal fees associated with new employment contracts, a new incentive stock option plan and the related written consent solicitation from our stockholders, and from the preparation of a registration statement in connection with the Offering. Salaries and benefits increased due to increased staffing levels related to a new core management team and related employment contracts. Other income and expenses We incurred interest expenses of $101,358 for the six months ended July 31, 2014 as compared to $30,074 for the same period in 2013. This increase in interest is attributable to long term financings entered into during current period, in connection with the Offering. Long-term debt is accruing interest at 6% per annum, payable in cash or in kind at the option of the company. Financing and accretion charges increased to $2,282,985 for the six months ended July 31, 2014 from $96,912 for the six months ended July 31, 2013. This is the result of the immediate recognition of all commissions and direct financing related expenses associated with the $7.2 Million Offering. Accounting rules required the immediate recognition of all transaction related expenses associated with the Offering as a result of the classification and treatment of the related host contract as a derivative financial instrument, as outlined below. From time to time, the Company has issued short term debt, which arrangements were entered into to bridge operations until longer term financing could be arranged. These short term debt arrangements contained embedded conversion features with price-protection features that result in these instruments being treated as derivatives. In addition, during the six months ended July 31, 2014, in connection with the Offering, we issued convertible debentures and warrants, each of which were convertible or exercisable into shares of our common stock and we did not, at the date we issued these securities, have a sufficient number of authorized and unissued shares of common stock available to satisfy the conversion and exercise of all of these securities. As a result, we were required to account for these securities as derivative liabilities. In connection with the issuance of these securities in connection with the Offering, we recorded a derivative expense of $12,028,383 related to the fair value of these outstanding contracts at the contract inception date. Further, we recorded a mark to market derivative expense of $13,005,182 as a result of the application of related accounting rules, which require derivative financial instruments to be carried at fair value which resulted in significant mark to market adjustments in correlation with fluctuations in the price of our common stock. These are non-cash income and expense items of our company. Subsequent to July 31, 2014, we obtained the written consent of our stockholders to approve the increase in authorized shares of common stock sufficient to satisfy the securities underlying the Offering. However, the terms of an underlying registration rights agreement will continue to trigger derivative liability classification for the foreseeable future. We had debt conversion expense of $309,011 and net losses on extinguishment of debt of $826,320 during the six months ended July 31, 2014. These charges arose in connection with the settlement of various short term financing arrangements that had been entered into to bridge operations until the larger Offering was completed. Subsequent to and concurrent with the Offering we settled these short term obligations through a combination of cash and stock issuances, as described in detail in our financial statements filed herein. For the six months ended July 31, 2013 other expenses included a $485,704 loss associated with the amendment to the Kalamalka Notes that had entered into default in a previous reporting period. This loss is the result of providing concessions to the Lenders as compensation for defaulting on the covenants under these Notes. These concessions included a reduced conversion price for the Notes and modified terms associated with warrants issued in connection with the Notes. Net loss and comprehensive loss Our net loss for the six months ended July 31, 2014 was $30,267,233, or $0.86 per share, as compared to a net loss of $2,680,720, or $0.10 per share, for the six months ended July 31, 2013. The most significant factor for the increase in net loss in the current period is the non-cash loss associated with the derivative accounting in connection with the Offering, as described above. -------------------------------------------------------------------------------- 11 LIQUIDITY AND FINANCIAL CONDITION Private Placement Offering (the "Offering") During the six months ended July 31, 2014, we entered into Subscription Agreements (collectively, the "Subscription Agreements") with several investors (collectively, the "Purchasers") in connection with a brokered private placement offering (the "Offering") for aggregate gross proceeds of $7,309,482 through the sale of 292 units (the "Units") at a price of $25,000 per Unit. Each Unit consisted of (i) a 6% convertible senior secured debenture in the principal amount of $25,000 (each, a "Debenture") and (ii) warrants to purchase 166,667 of our common shares at an exercise price of $0.15 per share, subject to certain adjustment as set out in the warrant agreements (the "Warrants"). In connection with the close of the Offering, we issued Debentures in the aggregate principal amount of $7,309,482. As consideration, we (i) received gross cash proceeds equal to $6,094,100, before deducting agent fees and other transaction-related expenses; and (ii) exchanged our 6% senior secured convertible notes in the aggregate amount of $1,094,159, being the principal and accrued interest due under such notes, for the issuance of Debentures in the aggregate principal amount of $1,215,732, at an exchange rate equal to ninety percent (90%) of the purchase price paid in the Offering. The Debentures are secured against all the tangible and intangible assets of the Company. The funds raised from the sale of the Units will be used for marketing and new product development and design, as well as general working capital requirements. Bridge Financing On April 7, 2014, we entered into a Securities Purchase Agreement with certain purchasers pursuant to which we agreed to issue 6% Senior Secured Convertible Promissory Notes (the "SPA Notes") in the aggregate principal amount of $1,083,797. As consideration, the Company (i) received cash proceeds equal to $878,704 (the "Cash Proceeds"), of which $50,000 was received subsequent to July 31, 2014; (ii) exchanged a promissory note with an outstanding amount of $76,388, being the principal and accrued interest due under a convertible promissory note dated December 24, 2013 for the issuance of a SPA Note in the same amount; and (iii) exchanged a promissory note with an outstanding amount of $128,705, being the remaining principal amount due under a convertible promissory note dated October 2, 2013 for the issuance of a SPA Note in the same amount. The principal amount of $1,083,797 were to mature on April 7, 2015 (the "Maturity Date") and were bearing interest at the rate of 6% per annum, payable on the Maturity Date. The principal amount of the SPA Notes and all acquired and unpaid interest thereon were contractually exchanged for securities issued by the Company in connection with the Offering, as defined and described above, at an exchange rate equal to ninety percent (90%) of the aggregate purchase price paid in the Offering. Agency Agreement with Kalamalka Partners On August 10, 2012, we entered into the Agency Agreement with Kalamalka Partners and certain lenders (the "Lenders") as set out in the Agency Agreement whereby we agreed to borrow up to $800,000 from the Lenders under a revolving loan arrangement by the issuance of Notes from time to time as such funds are required by us. The Notes are secured by a general security agreement over the present and future assets of the Company and were bearing interest at 12% per annum, calculated and payable monthly. The principal amount outstanding under any Note and all accrued and unpaid interest therein, were convertible into common shares at $0.75 per share at any time at the option of the Lender. These terms were later amended, as described below. -------------------------------------------------------------------------------- 12 During the year ended January 31, 2013, we issued Notes in the aggregate principal amount of $500,000 and an aggregate of 100,000 share purchase warrants to the Lenders. Each of the Lender Warrants were exercisable into one common share as follows: 25,000 Lender Warrants are exercisable at $0.25 until August 10, 2015, 25,000 Lender Warrants are exercisable at $0.50 until August 10, 2015 and 50,000 Lender Warrants are exercisable at $0.25 until August 10, 2014. This financing allowed us to fund inventory levels beyond initial purchase orders so we could have sufficient inventory on hand. It also allowed us to finance accounts receivable in an efficient and economical way. Funds advanced under the loan were initially restricted for inventory and accounts receivable whereby we could fund up to 90% of the Company's accounts receivable and inventory (the "Borrowing Margin Requirements"). "Inventory" included raw materials in transit and in our possession, materials in the course of production, work in progress and unsold finished goods, all valued at cost. Receivables were marginable until 60 days from the invoice date, after which time such receivables had no value for margining purposes, except that up to $10,000 of receivables were marginable if such receivables were more than 60 days old but less than 90 days old. During the year ended January 31, 2013, our borrowing exceeded the required margins and these Notes entered into default. As a result, on July 22, 2013, we entered into an Amendment Agreement with Kalamalka and the Lenders. Pursuant to the Amendment Agreement, we amended the Notes to reduce the conversion price from $0.75 to $0.50 per share and amended the terms of the Lender Warrants, Bridge Loan Warrants and Agent's Warrants such that the expiry of all of the warrants was extended by three years. In addition, the Amendment Agreement reduced the total commitment of the revolving loan facility from $800,000 to the $500,000 already advanced. As a result, we were unable to obtain further advances under this loan arrangement. During the year ended January 31, 2014, we entered into another Agency and Interlender Agreement with Kalamalka, and certain lenders whereby we agreed to borrow up to an additional $300,000. On November 14, 2013, we made an initial drawdown of $100,000 under the loan and, on November 26, 2013, we drew down a second tranche of $100,000. In connection with these drawdowns, we issued an aggregate of 250,000 share purchase warrants to the lenders and an aggregate of 250,000 share purchase warrants to Kalamalka as consideration for facilitating the loans. Each warrant is exercisable into one common share of our stock at a price of $0.10 per share for a period of three years. These notes were initially bearing interest at a rate of 12% per annum, calculated and payable at maturity on January 31, 2014. The principal amount outstanding under these notes may be converted into shares of our common stock at a price of $0.25 per share at any time at the option of the lenders. Repayment of the notes is secured by general security agreements in favour of Kalamalka, as agent for the lenders. During the six months ended July 31, 2014, we entered into Amendment Agreements with Kalamalka and the Lenders. In connection with the Amendment Agreements, we amended several convertible promissory notes in the aggregate principal amount of $600,000 as follows: (i) we extended the due date of the Notes to October 1, 2016; (ii) we reduced the interest rate accruing under the Notes to 6% per annum, calculated and payable quarterly, in cash or in kind; (iii) we removed the Borrowing Margin Requirements; (iv) we reduced the conversion price on Notes in the aggregate principal amount of $400,000 from $0.50 per share to $0.25 per share. As consideration for entering into these amendments, 500,000 share purchase warrants exercisable at a price of $0.50 until August 10, 2018 held by Kalamalka were exchanged for 600,000 warrants exercisable at a price of $0.15 for a period of 5 years from the date of issuance ("New Warrants") and we issued an additional 1,800,000 New Warrants. Also during the six months ended July 31, 2014, we entered into a Conversion Agreement with an additional Lender, pursuant to which we issued an aggregate of 1,018,685 shares, at a conversion price of $0.10 per share, to settle a Note in the amount of $100,000 plus accrued and unpaid interest thereon of $1,868. Further, during the six months ended July 31, 2014, the other remaining principal balance of $75,000 plus accrued interest was converted into a SPA Note, as defined and described above. -------------------------------------------------------------------------------- 13 Future Financing At July 31, 2014, we required further financing to implement our proposed business plan. Working Capital (Consolidated) July 31, 2014 Jan 31, 2014 (unaudited) Current Assets $ 4,874,196 $ 861,049 Current Liabilities $ 589,398 $ 2,300,433 Working Capital (Deficit) $ 4,284,798 $ (1,439,384 ) During the six months ended July 31, 2014, we increased our working capital position as follows; (i) we extended the maturity date and certain other terms of other current obligations in the aggregate amount of $600,000, thus improving our working capital position; and (ii) we received cash proceeds of $6,094,100 in connection with the issuance of 6% senior secured convertible promissory notes During the three months ended July 31, 2014, in connection with a private placement offering, we raised aggregate gross proceeds, before debt settlements, of $7,309,832 through the issuance of units consisting of convertible debentures and share purchase warrants. Further, we settled short terms obligations totaling $221,554 through the issuance of 2,145,535 shares of our common stock. As a result of these significant events, management of the company believes we have sufficient working capital to implement our business plan over the next twelve months. Cash Flows Six months ended July 31, 2014 2013 Cash Flows Used In Operating Activities $ (1,251,254 ) $ (719,244 ) Cash Flows Used In Investing Activities (19,581 ) (2,635 ) Cash Flows Provided By Financing Activities 5,592,757 757,724 Net change in Cash During Period $ 4,321,922 $ 35,845 Operating Activities Cash flows used in our operating activities was $1,251,254 for the six months ended July 31, 2014. The cash used in operations during the period was largely the result of a net loss for the period, offset by non-cash charges of $28,180,533, mostly related to derivative liability accounting. Investing Activities Investing activities used cash of $19,581 during the six months ended July 31, 2014, compared to $2,635 for the comparative period. Investing activities in the current period included cash outlays for some retail display and for patent and trademark acquisitions, maintenance and protection being incurred as we develop new products. Financing Activities Financing activities provided cash of $5,592,757 for the six month period ended July 31, 2014, compared to $757,724 for the comparative period. We received cash of $6,094,100 in connection with the Offering, which were partially offset by repayments of short term promissory notes in the amount of $416,998 and convertible promissory notes in the amount of $364,640. We also incurred debt offering costs of $646,873 related to commissions and direct transaction related expenses related to the Offering. -------------------------------------------------------------------------------- 14 Proceeds from financing activities during the six months ended July 31, 2013 mostly included funds received related to private placements. Commitments and capital expenditures We do not anticipate that we will expend any significant amount on capital expenditures like equipment over the next twelve months or enter into any other material commitments. Disclosure of Outstanding Share Data As of September 15, 2014, there were 36,373,884 shares of our common stock issued and outstanding. In addition, at September 15, 2014, the total dilutive securities outstanding, including options, warrants and shares issuable upon conversion of convertible debt instruments was approximately 236,800,000 shares. Critical Accounting Policies Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ significantly from these estimates under different assumptions or conditions. We believe that of our significant accounting policies, which are described in Note 3 to our annual financial statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, the following policies are the most critical to aid in fully understanding and evaluating our financial condition and results of operations Revenue Recognition, Accounts Receivable and Allowance for Doubtful Accounts Sales are recorded when title and risk of loss has passed to the customer, when persuasive evidence of a sales arrangement exists, the selling price is fixed and determinable and collectability is reasonably assured. Significant management judgments and estimates must be made in connection with determination of revenue to be recognized in any accounting period in respect of the timing of when the applicable revenue recognition criteria have been met. If we made different judgments or utilized different estimates for any period material differences in the amount and timing of revenue recognized could result Accounts receivables consist of amounts due from customers and are recorded upon the shipment of product to customers. Credit terms are extended to customers in the normal course of business and no collateral is required. The Company estimates an allowance for doubtful accounts based on historical losses, the existing economic conditions and the financial stability of its customers. Accounts receivable are written off when deemed uncollectible. Significant management judgment is involved in making the determination with respect to uncollectible amounts. Inventory Inventory is stated at the lower of cost or market value. Cost is determined using the weighted average method, which under the circumstances, management believes will provide for the most practical basis for the measurement of periodic income. Management periodically reviews inventory for slow moving or obsolete items and consider realizability based on the Company's marketing strategies and sales forecasts to determine if an allowance is necessary. If market value is below cost then an allowance is created to adjust the inventory carrying amount to reflect this. Assumptions and estimates about the recoverability of certain inventory may be subject to significant judgment. A variety of factors must be incorporated into these estimates and assumptions such as industry and economic trends and internal factors such as changes in our business and forecasts. -------------------------------------------------------------------------------- 15 Impairment of Long-Lived Asset The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the related carry amounts may not be recoverable, or on an annual basis, where appropriate. Such a review involves assessing qualitative factors to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that a long-lived asset is impaired. If the Company assesses that there is a likelihood of impairment, then the Company will perform a quantitative analysis comparing the carrying value of the assets with the estimated future net undiscounted cash flows expected to result from the use of the assets, including cash flows from disposition. Should the sum of the expected future net cash flows be less than the carrying value, the company would recognize an impairment loss at that date for the amount by which the carrying amount of the asset exceeds its fair value. Assumptions and estimates about future values and remaining useful lives of our intangible and other long-lived assets are complex and subjective. These estimates and assumptions may include revenue growth rates and operating margins used to calculate projected future cash flows and risk adjusted discounted rates and future economic and market conditions. If applicable, our long-term financial forecast represent the best estimate that our management has at this time and we believe that its underlying assumptions are reasonable. Management has determined that no impairment indicators currently exists. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates. The most significant estimates we made are those relating to uncollectible receivables, inventory valuation and obsolescence, and stock-based compensation expense. Accounting for Stock-Based Compensation ASC Topic 718, Compensation - Stock Compensation, requires that compensation expense for employee stock-based compensation be recognized over the requisite service period based on the fair value of the award, at the date of grant. Stock-based compensation represents the cost related to stock-based awards granted to employees and non-employee consultants. We measure stock-based compensation cost at measurement date, based on the estimated fair value of the award, and generally recognize the cost as expense on a straight-line basis (net of estimated forfeitures) over the employee requisite service period or the period during which the related services are provided by the non-employee consultants and the options are earned. We estimate the fair value of stock options using a Black-Scholes option valuation model, which utilizes various assumptions and estimates that are subject to management judgment. As the Company has insufficient historical data on which to estimate expected future share price volatility, the Company has estimated expected share price volatility based on the historical share price volatility of comparable entities. The expected life of options granted has been determined utilizing the "simplified" method as prescribed by the SEC's Staff Accounting Bulletin ("SAB") No. 110 Share-Based Payment. As the Company has had limited trading history, we at certain times have estimated the fair value of our common shares with reference to the subscription price of the most recent share offerings. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected term of the stock options. We have not paid and do not anticipate paying cash dividends on our shares of common stock; therefore, the expected dividend yield is assumed to be zero. In addition, ASC 718 requires companies to utilize an estimated forfeiture rate when calculating the expense for the period. We applied an estimated forfeiture rate of 0% in determining the expense recorded in our consolidated statement of operations given our limited forfeiture experience history. -------------------------------------------------------------------------------- 16 Derivative Financial Instruments The Company evaluates its convertible debt and other contracts to determine if those contracts or embedded components of those contracts qualify as derivatives to be separately accounted for in accordance with ASC 815 Derivatives and Hedging. The result of applying ASC 815 to certain embedded components of these contracts is that the accounting treatment requires these financial instruments be carried at fair value and be marked-to-market at each balance sheet date. We estimate the fair value of these contracts and embedded components of these contracts using a binomial option valuation model, which utilizes various assumptions and estimates that are subject to management judgment. The assumptions and methods utilized in these models is similar to the assumptions and methods used in estimating stock based compensation awards as outlined above, with the exception that the expected life of these contracts is equal to their contractual life. Certain of the Company's embedded conversion features on debt and outstanding warrants are treated as derivative liabilities for accounting purposes under ASC 815 due to insufficient authorized shares to settle these outstanding contracts, or due to other rights connected with these contracts. These contracts are recognized currently in earnings until such time as the warrants are exercised, expire or the related rights have been waived or the authorized share capital has been amended to accommodate settlement of these contracts. The Company utilizes the latest inception date sequencing method to reclassify outstanding contracts where the classification is pursuant to insufficient authorized share capital. Recent Accounting Pronouncements On May 28, 2014, the FASB and the International Accounting Standards Board (IASB) issued a converged standard on revenue recognition from contracts with customers, ASU 2014-09 (Topic 606 and IFRS 15). This standard will supersede nearly all existing revenue recognition guidance. ASU 2014-09 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016. We are currently evaluating the impact this guidance will have on our financial condition, results of operations and cash flows. In June 2014, the FASB issued ASU No. 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period ("ASU 2014-12"). ASU 2014-12 requires that a performance target that affects vesting, and that could be achieved after the requisite service period, be treated as a performance condition. As such, the performance target should not be reflected in estimating the grant date fair value of the award. This update further clarifies that compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Earlier adoption is permitted. We are currently evaluating the impact of the adoption of ASU 2014-12. In August 2014, the FASB issued ASU No. 2014-15, Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern ("ASU 2014-15"). ASU 2014-15 will explicitly require management to assess an entity's ability to continue as a going concern, and to provide related footnote disclosure in certain circumstances. The new standard will be effective for all entities in the first annual period ending after December 15, 2016. Earlier adoption is permitted. We are currently evaluating the impact of the adoption of ASU 2014-15. Off Balance Sheet Arrangements We have no off balance sheet arrangements. |