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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2004
|_| TRANSITION REPORT PURSUANT SECTION 13 OR 15 (d)
OF SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From ______TO_________
Commission File Number 333-13287
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EARTHSHELL CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 77-0322379
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3916 STATE ST. SUITE 110, SANTA BARBARA, CA 93105
(Address of principal executive office) (Zip Code)
(805) 563-7590
(Registrant's telephone number, including area code)
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 is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes |X| No |_|
The number of shares outstanding of the Registrant's Common Stock as of November
9, 2004 is 18,234,615.
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EARTHSHELL CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2004
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements Page
----
a) Consolidated Balance Sheets as of September 30, 2004 (unaudited) and
December 31, 2003...............................................................
b) Consolidated Statements of Operations for the three months and nine months
ended September 30, 2004 and September 30, 2003 (unaudited).....................
c) Consolidated Statements of Cash Flows for the nine months ended
September 30, 2004 and September 30, 2003 (unaudited)...........................
d) Notes to Consolidated Financial Statements (unaudited)..........................
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations...........................................................................
Item 3. Quantitative and Qualitative Disclosures About Market Risk...........................
Item 4. Controls and Procedures .............................................................
PART II. OTHER INFORMATION
Item 1. Legal Proceedings....................................................................
Item 2. Changes in Securities and Use of Proceeds and Issuer Repurchases of Equity
Securities...........................................................................
Item 3. Defaults Upon Senior Securities......................................................
Item 4. Submission of Matters to a Vote of Security Holders..................................
Item 5. Other Information....................................................................
Item 6 Exhibits and Reports on Form 8-K.....................................................
SIGNATURE...............................................................................................
EARTHSHELL CORPORATION
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------- -------------
(UNAUDITED)
ASSETS
CURRENT ASSETS
Cash and cash equivalents ................................................ $ 178,938 $ 1,901,639
Prepaid expenses and other current assets ................................ 249,749 323,680
------------- -------------
Total current assets ................................................ 428,687 2,225,319
PROPERTY AND EQUIPMENT, NET .................................................... 9,537 61,794
EQUIPMENT HELD FOR SALE ........................................................ 1 1
------------- -------------
TOTALS ......................................................................... $ 438,225 $ 2,287,114
============= =============
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Accounts payable and accrued expenses .................................... $ 4,561,831 $ 4,853,413
Short-term notes payable to related party ................................ 136,000 --
Current portion of deferred revenues ..................................... 200,000 --
Convertible debentures, net of discount of $943,842 and $1,505,755
as of September 30, 2004 and December 31, 2003, respectively ......... 7,243,658 5,294,245
------------- -------------
Total current liabilities ........................................... 12,141,489 10,147,658
PAYABLES TO RELATED PARTY ...................................................... 2,970,122 1,839,108
SUBORDINATED NOTES PAYABLE TO RELATED PARTY, NET OF DISCOUNT OF
$143,330 AND $219,210 AS OF SEPTEMBER 30, 2004 AND
DECEMBER 31, 2003, RESPECTIVELY ................. 2,611,670 2,535,790
DEFERRED REVENUES, LESS CURRENT PORTION ........................................ 225,000 --
OTHER LONG-TERM LIABILITIES .................................................... 179,126 33,333
------------- -------------
Total liabilities ................................................... 18,127,407 14,555,889
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' DEFICIT
Preferred stock, $.01 par value, 10,000,000 shares authorized; 9,170,000 Series
A shares designated; no shares issued and outstanding as of
September 30, 2004 and December 31, 2003 .................................. -- --
Common stock, $.01 par value, 40,000,000 shares
authorized; 14,353,843 and 14,128,966 shares issued and outstanding as
of September 30, 2004 and December 31, 2003, respectively ................. 143,538 141,290
Additional paid-in common capital .............................................. 302,047,408 302,033,746
Common stock to be issued, 166,666 shares ...................................... 500,000 --
Accumulated deficit ............................................................ (320,327,852) (314,350,681)
Accumulated other comprehensive loss ........................................... (52,276) (93,130)
------------- -------------
Total stockholders' deficit .............................................. (17,689,182) (12,268,775)
------------- -------------
TOTALS ......................................................................... $ 438,225 $ 2,287,114
============= =============
See Notes to Consolidated Financial Statements.
F-2
EARTHSHELL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
FOR THE FOR THE
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
------------------------------ ------------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Revenues ..................................... $ 50,000 $ -- $ 75,000 $ --
Operating Expenses
Related party license fee and research and
development expenses ................ 200,000 353,907 800,000 1,012,374
Other research and development expenses .. 64,121 1,287,516 329,572 4,892,009
Related party general and administrative
reimbursements ...................... -- -- -- (4,074)
Other general and administrative expenses 99,162 1,361,900 2,344,133 4,408,944
Depreciation and amortization ............ 3,164 95,207 41,735 311,483
------------ ------------ ------------ ------------
Total operating expenses ............. 366,447 3,098,530 3,515,440 10,620,736
Operating Loss ............................... 316,447 3,098,530 3,440,440 10,620,736
Other (Income) Expenses
Interest income .......................... (705) (16,705) (3,476) (80,956)
Related party interest expense ........... 131,030 95,697 406,895 265,931
Other interest expense ................... 205,121 292,251 628,406 1,214,988
Gain on sales of property and equipment .. (14,785) (122,964) (168,320) (185,964)
Premium due to debenture default ......... 1,008,823 -- 1,672,426 --
Other income ............................. -- (486,659) -- (399,701)
Loss on extinguishment of debentures ..... -- -- -- 1,697,380
Debenture conversion costs ............... -- 60,647 -- 166,494
------------ ------------ ------------ ------------
Loss Before Income Taxes ..................... 1,645,931 2,920,797 5,976,371 13,298,908
Income taxes ................................. -- -- 800 800
------------ ------------ ------------ ------------
Net Loss ..................................... $ 1,645,931 $ 2,920,797 $ 5,977,171 $ 13,299,708
============ ============ ============ ============
Basic and Diluted Loss Per Common Share ...... $ 0.12 $ 0.21 $ 0.42 $ 1.02
Weighted Average Number of Common Shares
Outstanding ............................. 14,223,402 13,595,973 14,160,674 12,993,999
See Notes to Consolidated Financial Statements.
F-3
EARTHSHELL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
------------------------------
2004 2003
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss ................................................................... $ (5,977,171) $(13,299,708)
Adjustments to reconcile net loss to net cash used in operating activities
Depreciation and amortization ............................................ 41,736 311,483
Amortization and accretion of debenture issue costs ...................... 592,316 753,428
Premium due to debenture default ......................................... 1,672,426 --
Debenture issuance and conversion costs .................................. -- 166,494
Gain on change in fair value of warrant obligation ....................... -- (399,701)
Loss on extinguishment of debentures ..................................... -- 1,697,380
Beneficial conversion value due to change in debentures conversion price . -- 360,000
Gain on sales of property and equipment .................................. (168,320) (185,964)
Equity in the losses of joint venture .................................... -- 280,018
Other non-cash expense items ............................................. 19,865 590
Changes in operating assets and liabilities
Prepaid expenses and other current assets ................................ 70,157 157,916
Accounts payable and accrued expenses .................................... (266,883) (2,955,813)
Payables to related party ................................................ 1,131,014 768,877
Deferred revenues ........................................................ 425,000 --
Other long-term liabilities .............................................. 145,793 50,000
------------ ------------
Net cash used in operating activities ................................. (2,314,067) (12,295,000)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of property and equipment .............................. 187,570 214,949
Investment in joint venture ................................................ -- (26,104)
Purchases of property and equipment ........................................ (8,729) (1,320)
------------ ------------
Net cash provided by investing activities ............................. 178,841 187,525
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of common stock ..................................... 504,097 --
Common stock issuance costs ................................................ (117,342) --
Proceeds from issuance of common stock and convertible debentures, net of
issuance costs and discounts amounting to approximately $3.4 million ..... -- 8,659,079
Proceeds from release of restricted time deposit upon conversion
of convertible debentures into common stock .............................. -- 1,800,000
Proceeds from release of restricted cash upon exchange of
convertible debentures ................................................... -- 2,000,000
Proceeds from release of restricted cash for repayment of
convertible debentures ................................................... -- 5,200,000
Repayment of convertible debentures ........................................ (110,294) (5,200,000)
Proceeds from issuance of notes payable to related party ................... 136,000 1,010,000
------------ ------------
Net cash provided by financing activities ............................. 412,461 13,469,079
------------ ------------
Effect of exchange rate changes on cash and cash equivalents ............... 64 (3,449)
------------ ------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ........................... (1,722,701) 1,358,155
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ............................. 1,901,639 111,015
------------ ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD ................................... $ 178,938 $ 1,469,170
============ ============
NINE MONTHS ENDED
SEPTEMBER 30,
------------ ------------
2004 2003
------------ ------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for
Income taxes .......................................................... $ 800 $ --
Interest .............................................................. 9,220 77,579
Transfer of property to EKI ,a related party ............................. 78,409 --
Common stock warrants issued in connection with convertible debentures -- 745,562
Conversion of convertible debentures into common stock ................... 174,632 6,975,000
Interest paid in common stock ............................................ 4,097 92,234
Commission paid in common stock .......................................... -- 29,500
Common stock issued to service providers in connection with the March 2003
financing ........................................................... -- 484,500
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
In March 2003, warrants for the purchase of $1.055 million in aggregate
principal amount of convertible debentures and 70,477 shares of common stock
were issued in connection with the issuance of convertible debentures. The
estimated fair value of the warrants of $442,040, based upon the Black-Scholes
method of valuation, was recorded as an original issue discount, thereby
reducing the carrying value of the convertible debentures, and as an increase in
additional paid-in common capital.
In March 2003, warrants for the purchase of 83,333 shares of common stock were
issued to EKI, in connection with the issuance of convertible debentures, in
consideration for its willingness to subordinate amounts owed to it. The
estimated fair value of the warrants of $303,522, based upon the Black-Scholes
method of valuation, was recorded as an original issue discount, thereby
reducing the carrying value of the notes payable to EKI, and as an increase in
additional paid-in common capital.
See Notes to Consolidated Financial Statements.
F-4
EARTHSHELL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
SEPTEMBER 30, 2004
- --------------------------------------------------------------------------------
OVERVIEW OF OPERATIONS
Organized in November 1992 as a Delaware corporation, EarthShell Corporation is
engaged in the commercialization of composite material technology for the
manufacture of foodservice disposable packaging designed with the environment in
mind. EarthShell Packaging(R) is based on patented composite material technology
(collectively, the "EarthShell Technology"), licensed on an exclusive, worldwide
basis from E. Khashoggi Industries LLC and its wholly owned subsidiaries.
The EarthShell Technology has been developed over many years in consultation
with leading material scientists and environmental experts to reduce the
environmental burdens of foodservice disposable packaging through the careful
selection of raw materials, processes, and suppliers. EarthShell Packaging(R),
including hinged-lid sandwich containers, plates, bowls, foodservice wraps, and
cups, is primarily made from commonly available natural raw materials such as
natural ground limestone and potato starch. EarthShell believes that EarthShell
Packaging(R) has comparable or superior performance characteristics and can be
commercially produced and sold at prices that are competitive with comparable
paper and plastic foodservice disposables.
EarthShell was a development stage enterprise through the first quarter of 2004.
With the recognition of the Company's first revenues in the second quarter of
2004, the Company was no longer a development stage enterprise.
PRESENTATION OF FINANCIAL INFORMATION
The foregoing interim financial information is unaudited and has been prepared
from the books and records of EarthShell Corporation. EarthShell Corporation's
consolidated financial statements include the accounts of its wholly-owned
subsidiary, EarthShell GmbH. All significant intercompany balances and
transactions have been eliminated in consolidation. In the opinion of
management, the financial information reflects all adjustments necessary for a
fair presentation of the financial condition, results of operations and cash
flows of the Company in conformity with generally accepted accounting
principles. All such adjustments were of a normal recurring nature for interim
financial reporting.
The accompanying unaudited consolidated financial statements and these notes do
not include certain information and footnote disclosures required by accounting
principles generally accepted in the United States, which were included in the
Company's consolidated financial statements for the year ended December 31,
2003. The information included in this Form 10-Q should be read in conjunction
with Management's Discussion and Analysis of Financial Condition and Results of
Operations and the Company's consolidated financial statements and notes thereto
for the year ended December 31, 2003 included in the Company's Annual Report on
Form 10-K, including Form-10K/A - Amendment No. 1.
The accompanying consolidated financial statements have been prepared on a going
concern basis, which contemplates the realization of assets and the satisfaction
of liabilities in the normal course of business. During the period from November
1, 1992 (inception) to September 30, 2004, the Company has incurred a cumulative
net loss of $320.3 million and has a stockholders' deficit of $17.7 million at
September 30, 2004. These factors among others may indicate that the Company
will be unable to continue as a going concern for a reasonable period of time
(see "Critical Accounting Policies - Going Concern Basis").
The consolidated financial statements do not include any adjustments relating to
the recoverability and classification of recorded asset amounts or the amounts
and classification of liabilities that might be necessary should the Company be
unable to continue as a going concern. The Company's continuation as a going
concern is dependent upon its ability to generate sufficient cash flow to meet
its obligations on a timely basis, to obtain additional financing or refinancing
as may be required, and ultimately to attain successful operations.
F-5
Basic loss per common share is computed by dividing net loss available to common
stockholders by the weighted-average number of common shares outstanding during
the period, including Common stock to be issued. Diluted loss per common share
is computed by dividing net loss available to common stockholders by the
weighted-average number of common shares outstanding (including Common stock to
be issued) plus an assumed increase in common shares outstanding for potentially
dilutive securities, which consist of options and warrants to acquire common
stock and convertible debentures. Potentially dilutive shares are excluded from
the computation in loss periods, as their effect would be anti-dilutive. The
dilutive effect of options and warrants to acquire common stock is measured
using the treasury stock method. The dilutive effect of convertible debentures
is measured using the if-converted method. Basic and diluted loss per common
share is the same for all periods presented because the impact of potentially
dilutive securities is anti-dilutive.
Since June 21, 2004, the Company's common stock has been listed through the OTC
Bulletin Board. The Company's common stock trades under the symbol "ERTH.OB."
RELATED PARTY TRANSACTIONS
E. Khashoggi Industries LLC and its wholly owned subsidiaries ("EKI") own
approximately 35% of the Company's outstanding shares, and may be deemed to be a
controlling stockholder. In connection with the formation of the Company, the
Company entered into a Master License Agreement with EKI (the "EKI License
Agreement"), pursuant to which the Company has an exclusive, worldwide,
royalty-free license to use and license the EKI technology to manufacture and
sell disposable, single-use containers for packaging or serving food or
beverages intended for consumption within a short period of time (less than 24
hours). Effective January 1, 2001, EKI granted to the Company priority rights to
license certain product applications on an exclusive basis from Biotec, a wholly
owned subsidiary of EKI, in consideration for payment by the Company of a $0.1
million minimum monthly licensing fee to Biotec. In addition, Biotec agreed to
render technical services to the Company, as required, at Biotec's cost plus 5%.
Effective July 29, 2002, the Company restated its agreements with Biotec in a
definitive License & Information Transfer Agreement with Biotec to utilize the
Biotec technology for foodservice applications, including food wraps used in
foodservice applications (the "Biotec License Agreement"). Under the terms of
the Biotec License Agreement, the Company paid or accrued $0.2 million and $0.4
million during the three months ended September 30, 2004 and 2003 and $0.8
million and $1.0 million during the nine months ended September 30, 2004 and
2003, respectively. As part of the new convertible debenture financing ("2006
Debentures") completed in March 2003 (see "Convertible Debentures"), payment of
this licensing fee was subordinated to the new debentures with strict covenants
governing payment. No cash payments have been made to Biotec from May 2003
through September 2004, and the total amount of accrued and unpaid licensing
fees payable to Biotec as of September 30, 2004 is approximately $2.5 million,
including accrued interest payable on the unpaid licensing fees. In September
2004, as part of an overall restructuring of the 2006 Debentures and other
long-term liabilities of the Company, agreement was reached with Biotec to
restructure the unpaid licensing fees and accrued interest payable, which will
result in a cash payment and the issuance of shares of the Company's common
stock to Biotec upon closing (see "Subsequent Events").
In September 2002, the Company entered into a Loan Agreement with EKI whereby
EKI agreed to extend certain loans to the Company at EKI's sole discretion, at
interest rates of 7% to 10%. As of December 31, 2003 and September 30, 2004 the
outstanding principal amount of outstanding loans was $2.755 million. As part of
the 2006 Debentures financing (see "Convertible Debentures"), repayment of these
loans and related interest was subordinated to the new debentures with strict
covenants governing their repayment. Therefore, at September 30, 2004, the loans
totaling $2.755 million and related interest of approximately $0.5 million are
classified as noncurrent liabilities. During the third quarter of 2004, as part
of an overall restructuring of the 2006 Debentures and other long-term
liabilities of the Company, agreement was reached with EKI to convert the entire
outstanding loan balance and all accrued but unpaid interest into unregistered
shares of the Company's common stock (see "Subsequent Events").
F-6
In September 2004 the Company hired an executive assistant to support its CEO,
who serves as an officer of both EKI and EarthShell. The Company pays the salary
and benefits of the executive assistant and charges EKI for the portion of her
time that was spent supporting EKI activities. In October 2004, the Company
invoiced EKI $1,392 for support provided in September.
In May 2004, the Company sold non-essential machine shop equipment and excess
office furniture and equipment with a net book value of approximately $19,122 to
EKI for $78,409. The transaction was reviewed and approved by the Conflicts
Committee of the Board of Directors.
On September 22, 2004, Simon K. Hodson, Chief Executive Officer of the Company,
loaned $50,000 to the Company on a short-term basis at an annual interest rate
of 7%, and on September 29, 2004 Mr. Hodson loaned the Company an additional
$86,000. On October 1, 2004, the Company repaid the $86,000 short-term loan. On
October 22, 2004, the Company repaid the $50,000 loan with interest.
CONVERTIBLE DEBENTURES
On March 5, 2003, the Company issued secured convertible debentures due in 2006
(the "2006 Debentures"). The 2006 Debentures bear interest at a rate of 2.0% per
annum, payable quarterly in arrears on each January 31, April 30, July 31 and
October 31. At September 30, 2004, the outstanding principal balance of the 2006
Debentures was $6.5 million, which is reflected on the accompanying balance
sheet net of an unamortized discount of approximately $0.9 million.
The Company did not make required interest payments related to the 2006
Debentures on January 31, 2004, April 30, 2004 and July 31, 2004. In addition,
on March 8, 2004, the Company's common stock was delisted from the Nasdaq
Smallcap Market. These actions put the Company in non-compliance with its
covenants under the 2006 Debentures. Two of the debenture holders, including the
debenture holder with the largest ownership position, notified the Company in
writing that the Company was in default and requested that the Company
repurchase the entire principal amount of the 2006 Debentures held at the price
specified in the debenture, along with any accrued and unpaid interest.
Therefore, the entire outstanding principal amount of the 2006 Debentures was
classified as a current liability as of September 30, 2004 and December 31,
2003. In addition, the Company accrued in the second quarter of 2004
approximately $0.7 million of the repurchase premium specified in the debenture.
With the execution of the amended and restated debenture purchase agreements at
the end of September, an additional $1.0 million of repurchase premium was
recognized in the third quarter of 2004.
During the third quarter of 2004, with the assistance of its largest
shareholder, the Company signed agreements with the holders of all $6.5 million
outstanding principal amount of its 2006 Debentures to convert, retire or
restructure the debentures and all accrued but unpaid interest. This transaction
closed subsequent to September 30, 2004 (see "Subsequent Events").
COMMITMENTS
During 1998, EKI entered into certain agreements with an equipment manufacturer
providing for the purchase by EKI of certain technology applicable to
starch-based disposable packaging. EKI licenses such technology to the Company
on a royalty-free basis pursuant to the EKI License Agreement. In connection
with the purchase, the Company would be required to pay the seller $3.0 million
over the five-year period commencing January 1, 2004 if EKI, the Company or
their respective licensees make active use of the technology. As of September
30, 2004, the Company and its respective licensees have not actively used the
technology. The Company does not plan to make active use of the technology
during the year ending December 31, 2004. EKI has agreed to indemnify the
Company to the extent the Company is required to pay any portion of this $3.0
million obligation solely as a result of EKI's or its licensees' active use of
such patents and related technology (other than use by the Company or its
sublicenses). The $3.0 million obligation to the seller of the technology is
subject to reduction in an amount equal to 5% of the purchase price of any
equipment purchased from the seller by EKI, the Company or their sublicenses
during the five-year period commencing January 1, 2004.
F-7
PROPERTY AND EQUIPMENT AND EQUIPMENT HELD FOR SALE
The cost and accumulated depreciation of property and equipment and equipment
held for sale at September 30, 2004 and December 31, 2003 were as follows:
SEPTEMBER 30, DECEMBER 31,
2004 2003
----------- -----------
Property and Equipment
Product development center .............................. $ 893,657 $ 1,175,394
Office furniture and equipment .......................... 245,274 356,339
----------- -----------
Total cost ................................................... 1,138,931 1,531,733
Less: Accumulated depreciation .............................. (1,129,394) (1,469,939)
----------- -----------
Property and equipment - net ................................. $ 9,537 $ 61,794
=========== ===========
Equipment held for sale ...................................... $ 1 $ 1
=========== ===========
A commercial production line in Goettingen, Germany was financed and constructed
by the Company. Because the Company is unable to determine with certainty the
proceeds that will be realized upon sale of the equipment, the Company wrote the
line down to $1 as of December 31, 2003 and reclassified it to the long-term
asset account "Equipment held for sale." If the equipment is sold, the Company
will recognize a gain equal to the proceeds received for the equipment.
STOCK OPTIONS
The Company accounts for stock options in accordance with the provisions of
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued
to Employees," and complies with the disclosure provisions of Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation." Under APB Opinion No. 25, compensation expense is based on the
difference, if any, on the date of grant, between the fair value of the
Company's common stock and the exercise price of the option. For disclosure
purposes, to measure stock-based compensation in accordance with SFAS No. 123,
the fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model. The fair value of each option grant is then
amortized as pro forma compensation expense over the vesting period of the
options. The following table sets forth the pro forma net loss and loss per
share resulting from applying SFAS No. 123.
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
--------------------------------- ---------------------------------
2004 2003 2004 2003
-------------- -------------- -------------- --------------
Net Loss as reported ........................ $ 1,645,931 $ 2,920,797 $ 5,977,171 $ 13,299,708
Deduct: Stock-based employee compensation
expense included in reported net loss, net
of tax ................................... -- -- -- --
Add: Total stock-based employee compensation
determined under fair value based method
for all awards, net of tax 381,462 498,509 488,899 695,320
-------------- -------------- -------------- --------------
Pro forma net loss .......................... $ 2,027,393 $ 3,419,306 $ 6,466,070 $ 13,995,028
Net loss per common share
As reported .............................. $ 0.12 $ 0.21 $ 0.42 $ 1.02
Pro forma ................................ 0.14 0.25 0.46 1.08
SUBSEQUENT EVENTS
Debenture Purchase Agreements. On September 30, 2004, the Company entered into
agreements with each of the holders (collectively, the "Holders") of its Secured
Convertible Debentures due March 5, 2006 (the "Debentures") to amend and restate
the Debenture Purchase Agreements entered into in July 2004 by EarthShell and
the Holders (as amended and restated, the "Debenture Purchase Agreements" and
the transactions contemplated therein, collectively, the "Debenture
Transactions"). The Debentures were in default and their outstanding principal
balance totaled $6.5 million prior to their repurchase.
Collectively, the Debenture Purchase Agreements required (i) E. Khashoggi
Industries, LLC ("EKI") to pay $1 million cash ( EarthShell was obligated to
reimburse EKI for this cash payment as discussed below), (ii) the Holders to
convert the Debentures in accordance with their terms, resulting in the issuance
by EarthShell of 1,091,666 shares of its common stock, which shares were
previously registered for resale by the Company in connection with the issuance
of the Debentures, (iii) EarthShell to issue to the Holders an aggregate of
512,500 additional shares EarthShell common stock and (iv) EarthShell to pay
$2.3 million to one of the Debenture holders from 33% of any equity funding
received by the Company (excluding the first $2.7 million funded by MBS) or 50%
of the royalties received by EarthShell in excess of $250,000 per month
(determined on a cumulative basis commencing July 1, 2004). EarthShell has the
right to convert the unpaid portion of the $2.3 million into shares of the
Company's common stock at a price equal to the lesser of $3.00 per share or the
price per share price that EarthShell subsequently receives upon the issuance of
its common stock (or other convertible security) during the three year period
commencing September 30, 2004. The 512,500 shares of common stock issued to the
Holders on October 6, 2004 are not registered for resale under the Securities
Act, and EarthShell has agreed to file a registration statement to register the
shares no later than 60 days after the closing. The consideration for the
repurchase of the Debentures has been paid or issued, but the actual closure of
the transactions will occur upon the Company's receipt of the cancelled
Debentures (all of the Debentures have either been received or they are in the
process of being submitted by the holders). Upon receipt of the Debentures, they
will be retired by EarthShell and the Company shall also cancel all of the
related agreements, including the security agreement pursuant to which the
Company pledged its rights under the license agreement with EKI.
Receipt of Proceeds from Sale of Common Stock to MBS. On August 5, 2004,
EarthShell and Meridian Business Solutions, LLC ("MBS") entered into a Stock
Purchase Agreement (the "Stock Purchase Agreement") pursuant to which MBS agreed
to fund $5 million to EarthShell in exchange for EarthShell's issuance of a
total of 1,666,666 shares of common stock at a price of $3.00 per share. On
August 20, 2004, EarthShell received $500,000 from MBS, for which the Company
issued 166,666 shares of its common stock to MBS. On October 1, 2004, EarthShell
received an additional $1.2 million of the $5 million committed by MBS, and the
Company issued 400,000 shares of its common stock to MBS. On October 11, 2004,
EarthShell was informed that MBS had funded an additional $0.5 million and,
pending completion of certain documentation, another $.5 million will be
remitted to EarthShell in exchange for the issuance of an additional 333,333
shares of its common stock. The Company has been informed by MBS that the
remaining $2.3 million of the $5 million commitment under the Stock Purchase
Agreement will be funded in November, 2004. The shares of common stock issued to
MBS are not registered for resale under the Securities Act of 1933, as amended
(the "Securities Act"), and the Company has agreed to file a registration
statement to register the shares no later than 60 days after the closing. The
cash received from MBS was used, in part, to fund the repurchase of the
Debentures(as defined below) and to restructure the Company's long-term debt.
EKI Agreements. In connection with its purchase of the Debentures from Holders,
on September 30, 2004, EKI entered into an agreement with EarthShell to sell the
Debentures it purchased back to the Company for $1 million cash, the cash price
paid by EKI for the purchased Debentures (the "EKI Debenture Purchase
Agreement"). In connection therewith, immediately after its acquisition, EKI
sold the purchased Debentures to the Company and, as discussed above, the
Company expects to retire the Debentures shortly.
In addition, on September 30, 2004, the Company and EKI agreed to convert
certain existing loans from EKI to the Company into shares of EarthShell's
common stock (the "EKI Conversion Agreement"). This transaction closed after the
closing of the Debenture Transactions and, pursuant to the EKI Conversion
Agreement, EKI converted the $2,755,000 principal amount of such debt into
shares of EarthShell's common stock at a conversion price of $3 per share. In
addition, under the terms of the EKI Conversion Agreement, EKI converted the
accrued and unpaid interest on such loans into shares of EarthShell's common
stock at a conversion price equal to the greater of (i) $3 per share, and (ii)
the maximum per share price (not to exceed $4 per share) obtained by the Company
upon the sale of its common stock to any investor during the three month period
following the closing. The 1,051,494 shares of common stock issued to EKI will
not be registered for resale under the Securities Act, and EarthShell has agreed
to file a registration statement to register the shares no later than 60 days
after the closing.
Biotec Agreement. EarthShell also reached agreement on October 11, 2004 to amend
its existing agreements with its affiliates, bio-tec Biologische
Naturverpackungen GmbH & Co. and bio-tec Biologische Naturverpackungen
Forschungs und Entwicklungs GmbH (collectively, "Biotec"; and such agreement,
the "Biotec Amendment"). Under the terms of the Biotec Amendment, EarthShell has
agreed to satisfy the approximate $2.5 million in indebtedness owed to Biotec by
(i) paying $750,000 to Biotec ($250,000 currently and $500,000 upon any
subsequent equity funding by MBS or other investor) (ii) converting
approximately $1.25 million principal amount of the Biotec debt into shares of
EarthShell's common stock at a conversion price of $3 per share and (iii) at
EarthShell's option, on the first anniversary of the closing, pay $250,000 to
Biotec or convert the remaining $250,000 Biotec debt into 133,333 shares of
EarthShell's common stock at a conversion price of $3 per share. In
consideration for the above, Biotec also agreed to suspend the monthly license
fees payable by EarthShell for two years after the date of the closing. The
common stock to be issued pursuant to the Biotec Amendment will not initially be
registered for resale under the Securities Act, and EarthShell has agreed to
file a registration statement to register the shares no later than 60 days after
the closing. The Biotec transaction is expected to close by November 15, 2004.
The Company has agreed to prepare and file, no later than 60 days after the
closing date, a registration statement with the Securities and Exchange
Commission covering the resale of all of the unregistered shares issued or to be
issued in conjunction with the above agreements.
F-8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD LOOKING STATEMENTS
Information contained in this Quarterly Report on Form 10-Q, including but not
limited to "Management's Discussion and Analysis of Financial Condition and
Results of Operations," contains forward-looking statements within the meaning
of the Private Securities Litigation Reform Act of 1995, as amended. These
statements may be identified by the use of forward-looking terminology such as
"may," "will," "expect," "anticipate," "estimate," or "continue," or the
negative thereof or other comparable terminology. Any one factor or combination
of factors could cause the Company's actual operating performance or financial
results to differ substantially from those anticipated by management that are
described herein. Investors should carefully review the risk factors set forth
in other Company reports or documents filed with the Securities and Exchange
Commission, including Forms 10-Q, 10-K, 10-K/A and 8-K. Factors influencing the
Company's operating performance and financial results include, but are not
limited to, the performance of licensees, changes in the general economy, the
availability of financing, governmental regulations concerning, but not limited
to, environmental issues, and other risks and unforeseen circumstances affecting
the Company's business. This Quarterly Report on Form 10-Q should be read in
conjunction with the Company's Annual Report on Form 10-K, including Form 10-K/A
- - Amendment No. 1, for the fiscal year ended December 31, 2003.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements and related disclosures in conformity
with generally accepted accounting principles requires management to make
judgments, assumptions and estimates that affect the amounts reported in the
Company's financial statements and the accompanying notes. The amounts of assets
and liabilities reported in the Company's balance sheet and the amounts of
expenses reported for each fiscal period are affected by estimates and
assumptions which are used for, but not limited to, the accounting for asset
impairments. Actual results could differ from these estimates. The following
critical accounting policies are significantly affected by judgments,
assumptions and estimates used in the preparation of the consolidated financial
statements.
Going Concern Basis. The consolidated financial statements have been prepared on
a going concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. During the period
from November 1, 1992 (inception) to September 30, 2004, the Company has
incurred a cumulative net loss of $320.3 million and has a working capital
deficit of $11.7 million at September 30, 2004. These factors, along with
others, may indicate that the Company will be unable to continue as a going
concern for a reasonable period of time. Even after the restructuring of the
2006 Debentures and other long-term liabilities of the Company and the sale of
common stock subsequent to September 30, 2004 (see "Subsequent Events"), the
Company will have to raise additional funds to meet its current obligations and
to cover operating expenses through the year ending December 31, 2004. If the
Company is not successful in raising additional capital it may not be able to
continue as a going concern for a reasonable period of time. Management plans to
address this need by raising cash through either the issuance of debt or equity
securities. In addition, the Company expects to receive additional technology
fee payments towards the end of 2004 in connection with a sublicense agreement
(the "Sublicense Agreement") entered into between the Company and Meridian
Business Systems in the second quarter of 2004. Upon execution of the Sublicense
Agreement, the Company received a payment of $500,000 towards the $2.0 million
technology fee provided for in the agreement. Pursuant to the terms of the
Sublicense Agreement, the balance of the technology fee is to be paid over the
next twelve months as certain milestones are achieved. Another possible source
of funds is the sale or transfer of the commercial production line in
Goettingen, Germany to an operating partner. The Company can not assure that
additional financing will be available to it, or, if available, that the terms
will be satisfactory, that it will receive any further technology fee payments
in 2004 pursuant to the Sublicense Agreement, or that it will be able to
negotiate mutually agreeable terms for the transfer of its commercial production
line in Germany to an operating partner. Management also plans to continue in
its efforts to reduce expenses, but can not assure that it will be able to
reduce expenses below current levels. The consolidated financial statements do
not include any adjustments relating to the recoverability and classification of
recorded asset amounts or the amounts and classification of liabilities that
might be necessary should the Company be unable to continue as a going concern.
2
Estimated Net Realizable Value of Property and Equipment. The Company has been
engaged in the development of manufacturing equipment to validate acceptance of
EarthShell products and their pricing. To this end the Company financed and
constructed a commercial production line in Goettingen, Germany for the
Company's joint venture with Huhtamaki. During 2001, $1.2 million of the
Goettingen line was written off to reflect equipment that had no further
application in the product development cycle. During the third quarter of 2002
the Company concluded, after obtaining quotations from various machinery
suppliers for an identical line, that $1.7 million of the cost of the line would
not be recoverable and therefore the carrying value of the line was written down
by this amount in the second half of 2002. With the conclusion of the joint
venture with Huhtamaki in 2003, the Company is seeking other operating partners
to purchase the production line. However, because the Company is unable to
determine with certainty the proceeds that will be realized upon sale of the
equipment, the Company wrote the line down to $1 as of December 31, 2003 and
reclassified it to the long-term asset account "Equipment held for sale."
The key accounting estimates and policies are reviewed with the Audit Committee
of the Board of Directors.
THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED WITH THE THREE MONTHS ENDED
SEPTEMBER 30, 2003.
The Company's net loss decreased $1.3 million to $1.6 million from $2.9 million
for the three months ended September 30, 2004 compared to the three months ended
September 30, 2003, respectively.
REVENUES. The Company recorded revenues of $0.05 million for the three months
ended September 30, 2004. These revenues reflect amortization of the $2.0
million technology fee payable under the Sublicense Agreement that was entered
into in the second quarter of 2004 over the ten years of the agreement. The
amortization of the technology fee will result in the recognition of $0.2
million in revenues per year during the life of the agreement.
RESEARCH AND DEVELOPMENT EXPENSES. Total research and development expenses are
comprised of Related party license fee and research and development expenses and
Other research and development expenses. Total research and development expenses
for the development of EarthShell Packaging(R) decreased $1.3 million to $0.3
million from $1.6 million for the three months ended September 30, 2004 compared
to the three months ended September 30, 2003, respectively.
o Related party license fees and research and development expenses are
comprised of the $100,000 monthly licensing fee for the use of the
EarthShell Technology and technical services, both of which are
payable to EKI, a stockholder of the Company, or Biotec, a wholly
owned subsidiary of EKI. It should be noted that payment of these
related party expenses has been deferred pursuant to subordination
agreements entered into by the EKI entities in connection with the
convertible debenture financing concluded in March 2003. In
addition, in September 2004, the Company entered into an agreement
with Biotec to eliminate the $0.1 million per month minimum
licensing fee from September 2004 through August 2006 (see
"Subsequent Events"). Related party license fees and research and
development expenses decreased $0.2 million to $0.2 million from
$0.4 million for the three months ended September 30, 2004 compared
to the three months ended September 30, 2003, respectively. The
decrease was due to the elimination of the monthly licensing fee in
September 2004, as noted above, combined with a decrease in
technical services provided to the Company by Biotec.
o Other research and development expenses are comprised of personnel
costs, travel and direct overhead for development and demonstration
production. Other research and development expenses decreased $1.2
million to $0.01 million from $1.3 million for the three months
ended September 30, 2004 compared to the three months ended
September 30, 2003, respectively. The reduction was due to the
non-recurrence of the following 2003 activities: support of
day-to-day manufacturing activities of a new manufacturing line for
plates and bowls built and financed by Detroit Tool and Engineering
Company (DTE) at their Lebanon, Missouri facility, costs incurred in
connection with testing of the Goettingen, Germany manufacturing
equipment during the third quarter, losses of the Company's joint
venture and various non-recurring expenses. In addition, the
Company's expense reduction efforts resulted in reduced personnel
and other costs in 2004.
3
OTHER GENERAL AND ADMINISTRATIVE EXPENSES. Other general and administrative
expenses are comprised of personnel costs, travel and direct overhead for
marketing, finance and administration. Total general and administrative expenses
decreased $1.3 million to $0.1 million from $1.4 million for the three months
ended September 30, 2004 compared to the three months ended September 30, 2003,
respectively. As a result of the Company's efforts to reduce general and
administrative expenses, actual expenses incurred in the third quarter of 2004
were approximately $0.9 million lower than the third quarter of 2003 expenses.
The largest reductions were in personnel costs (approximately $0.4 million, due
to a reduction in headcount from 29 employees at September 30, 2003 to 9
employees at September 30, 2004) and professional fees and services
(approximately $0.4 million), with additional reductions in business insurance
and facility and support costs. In addition, the Company was able to reduce
previously provided expense accruals by approximately $0.6 million due to their
favorable resolution in the third quarter of 2004. Most of the credit to general
and administrative expenses related to the favorable resolution of property tax
disputes within the states of California and Maryland. Additional reductions
resulted from approximately $0.2 million of accounts payable settlement gains
that further reduced the third quarter 2003 expenses. The settlement gains were
the result of a program began by the Company in the second quarter of 2003 to
satisfy vendors for outstanding aged invoices.
INTEREST EXPENSE. Interest expense is comprised of Related party interest
expense and Other interest expense.
o Related party interest expense was $0.1 million in both the three
months ended September 30, 2004 and the three months ended September
30, 2003. Related party interest expense includes interest accrued
on outstanding loans made to the Company by EKI under the Loan
Agreement (see "Related Party Transactions"), accretion of the
discount related to the warrants issued to EKI in conjunction with
the March 2003 financing transactions, plus accrued interest payable
on amounts owed to EKI for monthly licensing fees that were accrued
rather than being paid in accordance with the terms of the
subordination agreements entered into in connection with the 2006
Debentures ("see Related Party Transactions").
During the third quarter of 2004, agreements were negotiated with
EKI to convert all outstanding loans and accrued but unpaid interest
into common stock of the Company and to restructure the unpaid
licensing fees under the Biotec License Agreement (see "Subsequent
Events"). The final agreements were signed subsequent to September
30, 2004, and therefore there will be no Related party interest
expense for these items subsequent to the third quarter.
o Other interest expense decreased $0.1 million to $0.2 million from
$0.3 million for the three months ended September 30, 2004 compared
to the three months ended September 30, 2003, respectively. Other
interest expense in both years is primarily composed of accretion of
the discount and interest accrued on the 2006 Debentures. However,
the 2004 accretion of the discount is lower than the 2003 accretion
of the discount because of the conversion of almost $5.0 million
principal amount of the 2006 Debentures into common stock of the
Company in the second half of 2003, which resulted in a
corresponding portion of the un-accreted discount being charged
against additional paid-in common capital.
During the third quarter of 2004, the Company signed agreements with
the holders of all $6.5 million outstanding principal amount of its
2006 Debentures to convert, retire or restructure the debentures and
all accrued but unpaid interest. This transaction closed subsequent
to September 30, 2004 (see "Subsequent Events"). Therefore, there
will be no Other interest expense for the 2006 Debentures subsequent
to September 30, 2004.
4
PREMIUM DUE TO DEBENTURE DEFAULT. At September 30, 2004, the Company was in
non-compliance with certain covenants of the 2006 Debentures. Two of the
debenture holders, including the debenture holder with the largest ownership
position, notified the Company in writing that the Company was in default and
requested that the Company repurchase the entire principal amount of the 2006
Debentures held at the price specified in the debenture, along with any accrued
and unpaid interest. The debenture contains a provision for repurchase of the
debenture at a premium if the repurchase is due to an event of default, and in
the second quarter of 2004 the Company accrued the amount of the premium that
the Company anticipated they would have to pay out based upon negotiated
settlement and conversion agreements with the debenture holders. However,
because the Company was unable to close the agreements within the prescribed
time period, they had to renegotiate settlement and conversion agreements with
the majority of the debenture holders. The renegotiated settlement and
conversion agreements resulted in the inclusion of additional premium amounts of
approximately $1.0 million which the Company accrued in the third quarter of
2004. The accrued premium amounts are included in the current liabilities
account "Convertible debentures" of the September 30, 2004 balance sheet (See
"Subsequent Events").
OTHER INCOME. Other income of $0.5 million was recorded for the three months
ended September 30, 2003. This represents the net gain realized from reducing
the balance of the warrant obligation that was initially recorded in connection
with the March 2003 financing transactions to its estimated fair value of zero.
NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED WITH THE NINE MONTHS ENDED
SEPTEMBER 30, 2003.
The Company's net loss decreased $7.3 million to $6.0 million from $13.3 million
for the nine months ended September 30, 2004 compared to the nine months ended
September 30, 2003, respectively.
REVENUES. The Company recorded revenues of $0.08 million for the nine months
ended September 30, 2004. These revenues reflect amortization of the $2.0
million technology fee payable under the Sublicense Agreement that was entered
into in the second quarter of 2004 over the ten years of the agreement. The
amortization of the technology fee will result in the recognition of $0.2
million in revenues per year during the life of the agreement.
RESEARCH AND DEVELOPMENT EXPENSES. Total research and development expenses are
comprised of Related party license fee and research and development expenses and
Other research and development expenses. Total research and development expenses
for the development of EarthShell Packaging(R) decreased $4.8 million to $1.1
million from $5.9 million for the nine months ended September 30, 2004 compared
to the nine months ended September 30, 2003, respectively.
o Related party license fee and research and development expenses are
comprised of the $100,000 monthly licensing fee for the use of the
EarthShell Technology and technical services, both of which are
payable to EKI, a stockholder of the Company, or Biotec, a wholly
owned subsidiary of EKI. It should be noted that payment of these
related party expenses has been deferred pursuant to subordination
agreements entered into by the EKI entities in connection with the
convertible debenture financing concluded in March 2003. In
addition, in September 2004 the Company entered into an agreement
with Biotec that eliminates the $0.1 million per month licensing fee
from September 2004 through August 2006 (see "Subsequent Events").
Related party license fee and research and development expenses
decreased $0.2 million to $0.8 million from $1.0 million for the
nine months ended September 30, 2004 compared to the nine months
ended September 30, 2003, respectively. The decrease was due to the
elimination of the monthly licensing fee in September 2004, as noted
above, combined with a decrease in technical services provided to
the Company by Biotec.
o Other research and development expenses are comprised of personnel
costs, travel and direct overhead for development and demonstration
production. Other research and development expenses decreased $4.6
million to $0.3 million from $4.9 million for the nine months ended
September 30, 2004 compared to the nine months ended September 30,
2003, respectively. The reduction was due to the non-recurrence of
the following 2003 activities: the winding down of on-going
demonstration manufacturing in Goleta, California in the first
quarter of 2003 and the start-up in mid-May 2003 of a new
manufacturing line for plates and bowls built and financed by
Detroit Tool and Engineering Company (DTE) at their Lebanon,
Missouri facility, as well as expenses incurred to vacate the
Company's demonstration manufacturing facility in Goleta at the
expiration of the lease on May 31, 2003. In early August 2003, the
Company discontinued its day-to-day support of manufacturing
activities at DTE. In addition, as previously noted, the Company's
expense reduction efforts resulted in significantly reduced
personnel and other costs in 2004.
5
OTHER GENERAL AND ADMINISTRATIVE EXPENSES. Other general and administrative
expenses are comprised of personnel costs, travel and direct overhead for
marketing, finance and administration. Total general and administrative expenses
decreased $2.1 million to $2.3 million from $4.4 million for the nine months
ended September 30, 2004 compared to the nine months ended September 30, 2003,
respectively. This was primarily the result of efforts to significantly reduce
general and administrative expenses throughout 2003 and 2004, which resulted in
reductions in the following expenses: personnel costs by $0.9 million (due to a
reduction in headcount from 40 employees at December 31, 2002 to 14 employees at
December 31, 2003), professional fees and services by $0.6 million, facility and
support costs by $0.2 million, travel and entertainment expenses by $0.1
million, business insurance costs by $0.1 million and franchise taxes by $0.1
million. In addition, the Company was able to reduce previously provided expense
accruals by approximately $0.6 million due to their favorable resolution in the
third quarter of 2004. Most of the credit to general and administrative expenses
related to the favorable resolution of property tax disputes within the states
of California and Maryland. Additional reductions of approximately $0.5 million
resulted from accounts payable settlement gains in 2003. The settlement gains
were the result of a program began by the Company in the second quarter of 2003
to satisfy vendors for outstanding aged invoices.
INTEREST EXPENSE. Interest expense is comprised of Related party interest
expense and Other interest expense.
o Related party interest expense increased $0.1 million to $0.4
million from $0.3 million for the nine months ended September 30,
2004 compared to the nine months ended September 30, 2003,
respectively. Related party interest expense includes interest
accrued on outstanding loans made to the Company by EKI under the
Loan Agreement (see "Related Party Transactions"), accretion of the
discount related to the warrants issued to EKI in conjunction with
the March 2003 financing transactions, plus accrued interest payable
on amounts owed to EKI for monthly licensing fees that were not paid
in accordance with the terms of the subordination agreements entered
into in connection with the 2006 Debentures (see "Related Party
Transactions"). The increase is primarily due to accrued interest
payable on amounts owed for the monthly licensing fees. As the
amount of unpaid licensing fees increases each month due to the
subordination agreements, the monthly charge for interest expense
also increases.
During the third quarter of 2004, agreement was reached with EKI to
convert all outstanding loans and accrued but unpaid interest into
common stock of the Company and to restructure the unpaid licensing
fees under the Biotec License Agreement (see "Subsequent Events").
The final agreements signed subsequent to September 30, 2004, so the
transaction will be booked in the fourth quarter. There will be no
Related party interest expense for these items subsequent to the
third quarter.
o Other interest expense decreased $0.6 million to $0.6 million from
$1.2 million for the nine months ended September 30, 2004 compared
to the nine months ended September 30, 2003, respectively. Other
interest expense for the nine months ended September 30, 2004 is
primarily composed of accretion of the discount and interest accrued
on the 2006 Debentures. Other interest expense for the nine months
ended September 30, 2003 was primarily composed of accretion of the
discount on the 2006 Debentures and a beneficial conversion charge
in the amount of $.04 million due to a change in the conversion
price of the convertible debentures due in August 2007 (the "2007
Debentures"). In addition, Other interest expense for 2003 also
included accretion of the discount on the 2007 debentures and
accrued interest payable on the 2006 and 2007 Debentures.
During the third quarter of 2004, the Company negotiated and signed
agreements with the holders of all $6.5 million outstanding
principal amount of its 2006 Debentures to convert, retire or
restructure the debentures and all accrued but unpaid interest (see
"Subsequent Events"). Therefore, there will be no Other interest
expense for the 2006 Debentures subsequent to September 30, 2004.
6
GAIN ON SALES OF PROPERTY AND EQUIPMENT. The Company realized a gain of
approximately $0.2 million in both the nine months ended September 30, 2004 and
the nine months ended September 30, 2003. The gains were realized due to the
sale of non-essential machine shop equipment and excess office furniture and
equipment over their net book value, most of which was fully depreciated.
PREMIUM DUE TO DEBENTURE DEFAULT. At September 30, 2004, the Company was in
non-compliance with certain covenants of the 2006 Debentures. Two of the
debenture holders, including the debenture holder with the largest ownership
position, notified the Company in writing that the Company was in default and
requested that the Company repurchase the entire principal amount of the 2006
Debentures held at the price specified in the debenture, along with any accrued
and unpaid interest. The debenture contains a provision for repurchase of the
debenture at a premium if the repurchase is due to an event of default, and the
Company accrued the amount of the premium that the Company anticipated they
would have to pay out based upon negotiated settlement and conversion agreements
with the debenture holders. However, because the Company was unable to close the
agreements within the prescribed time period, they had to renegotiate settlement
and conversion agreements with the majority of the debenture holders. The
renegotiated settlement and conversion agreements resulted in the payment of
inclusion of additional premium amounts of approximately $1.0 million which the
Company accrued in the third quarter of 2004. The accrued premium amounts are
included in the current liabilities account "Convertible debentures" of the
September 30, 2004 balance sheet (See "Subsequent Events").
LOSS ON EXTINGUISHMENT OF DEBENTURES. In connection with the March 2003
financing transactions, the Company prepaid $5.2 million aggregate principal
amount of the 2007 Debentures, resulting in a prepayment penalty of
approximately $0.2 million. The Company also issued to the holders of the
prepaid 2007 Debentures 52,083 shares of common stock, valued at approximately
$0.2 million based upon the closing price of the Company's common stock of $4.56
per share on March 5, 2003. In addition, one of the holders of the 2007
Debentures exchanged $2.0 million aggregate principal amount of 2007 Debentures
for $2.0 million aggregate principal amount of 2006 Debentures. In connection
with the prepayment and exchange transactions, the Company incurred cash
transaction costs of approximately $0.3 million, excluding the prepayment
penalty. In addition, the Company incurred a charge of approximately $0.9
million for the prorated portion of the original discount attributed to the $7.2
million of the 2007 Debentures repaid and exchanged. Therefore, the Company
recognized a $1.7 million loss upon extinguishment of the 2007 debentures
through the prepayment and exchange in 2003.
DEBENTURE CONVERSION COSTS. Debenture conversion costs of $0.2 million for the
nine months ended September 30, 2003 represent the prorated portion of the
original discount attributed to the 2007 Debentures whose conversion was forced
by Company in the first six months of 2003.
LIQUIDITY AND CAPITAL RESOURCES AT SEPTEMBER 30, 2004
Cash Flow. The Company's principal use of cash for the nine months ended
September 30, 2004 was to fund operations. Net cash used in operations was $2.3
million for the nine months ended September 30, 2004, compared to $12.3 million
for the nine months ended September 30, 2003. As of September 30, 2004 the
Company had cash and cash equivalents totaling $0.2 million and a working
capital deficit of $11.7 million. These factors, along with others, may indicate
that the Company will be unable to continue as a going concern for a reasonable
period of time.
Capital Requirements. The Company made less than $10,000 of capital expenditures
during the nine months ended September 30, 2004, and the Company does not expect
to make significant capital expenditures in the year 2004.
7
Sources of Capital. The Company did not make required interest payments related
to the 2006 Debentures on January 31, 2004, April 30, 2004 and July 31, 2004. In
addition, on March 8, 2004, the Company's common stock was delisted from the
Nasdaq Smallcap Market. These actions put the Company in non-compliance with its
covenants under the 2006 Debentures. Two of the debenture holders, including the
debenture holder with the largest ownership position, notified the Company in
writing that the Company was in default and requested that the Company
repurchase the entire principal amount of the 2006 Debentures held at the price
specified in the debenture, along with any accrued and unpaid interest.
Therefore, the entire outstanding principal amount of the 2006 Debentures
totaling $6.55 million was classified as a current liability as of September 30,
2004 and December 31, 2003. During the third quarter of 2004, the Company
negotiated agreements with the holders of all $6.5 million outstanding principal
amount of its 2006 Debentures to convert, retire or restructure the debentures
and all accrued but unpaid interest. The transaction was closed just after
September 30 and will be booked in the fourth quarter of 2004 (see "Subsequent
Events").
Even after the restructuring of the 2006 Debentures and other long-term
liabilities of the Company and the sale of common stock subsequent to September
30, 2004, the Company will have to raise additional funds to meet its current
obligations and to cover operating expenses through the year ending December 31,
2004. If the Company is not successful in raising additional capital it may not
be able to continue as a going concern for a reasonable period of time.
Management plans to address this need by raising cash through either the
issuance of debt or equity securities. In addition, the Company expects to
receive additional technology fee payments towards the end of 2004 in connection
with the Sublicense Agreement that was entered into in the second quarter of
2004. Upon execution of the Sublicense Agreement, the Company received a payment
of $500,000 towards the $2.0 million technology fee provided for in the
agreement. Pursuant to the terms of the Sublicense Agreement, the balance of the
technology fee is to be paid over the next twelve months as certain milestones
are achieved. Another possible source of funds is the sale or transfer of the
commercial production line in Goettingen, Germany to an operating partner.
However, the Company can not assure that additional financing will be available
to it, or, if available, that the terms will be satisfactory, that it will
receive any further technology fee payments in 2004 pursuant to the Sublicense
Agreement, or that it will be able to negotiate mutually agreeable terms for the
transfer of its commercial production line to an operating partner. Management
also plans to continue in its efforts to reduce expenses, but can not assure
that it will be able to reduce expenses below current levels.
Off-Balance Sheet Arrangements. The Company does not have any off-balance sheet
arrangements as of September 30, 2004 and has not entered into any transactions
involving unconsolidated, limited purpose entities.
SUBSEQUENT EVENTS
Debenture Purchase Agreements. On September 30, 2004, the Company entered into
agreements with each of the holders (collectively, the "Holders") of its Secured
Convertible Debentures due March 5, 2006 (the "Debentures") to amend and restate
the Debenture Purchase Agreements entered into in July 2004 by EarthShell and
the Holders (as amended and restated, the "Debenture Purchase Agreements" and
the transactions contemplated therein, collectively, the "Debenture
Transactions"). The Debentures were in default and their outstanding principal
balance totaled $6.5 million prior to their repurchase.
Collectively, the Debenture Purchase Agreements required (i) E. Khashoggi
Industries, LLC ("EKI") to pay $1 million cash (EarthShell was obligated to
reimburse EKI for this cash payment as discussed below), (ii) the Holders to
convert the Debentures in accordance with their terms, resulting in the issuance
by EarthShell of 1,091,666 shares of its common stock, which shares were
previously registered for resale by the Company in connection with the issuance
of the Debentures, (iii) EarthShell to issue to the Holders an aggregate of
512,500 additional shares EarthShell common stock and (iv) EarthShell to pay
$2.3 million to one of the Debenture holders from 33% of any equity funding
received by the Company (excluding the first $2.7 million funded by MBS) or 50%
of the royalties received by EarthShell in excess of $250,000 per month
(determined on a cumulative basis commencing July 1, 2004). EarthShell has the
right to convert the unpaid portion of the $2.3 million into shares of the
Company's common stock at a price equal to the lesser of $3.00 per share or the
price per share price that EarthShell subsequently receives upon the issuance of
its common stock (or other convertible security) during the three year period
commencing September 30, 2004. The 512,500 shares of common stock issued to the
Holders on October 6, 2004 are not registered for resale under the Securities
Act, and EarthShell has agreed to file a registration statement to register the
shares no later than 60 days after the closing. The consideration for the
repurchase of the Debentures has been paid or issued, but the actual closure of
the transactions will occur upon the Company's receipt of the cancelled
Debentures (all of the Debentures have either been received or they are in the
process of being submitted by the holders). Upon receipt of the Debentures, they
will be retired by EarthShell and the Company shall also cancel all of the
related agreements, including the security agreement pursuant to which the
Company pledged its rights under the license agreement with EKI.
8
Receipt of Proceeds from Sale of Common Stock to MBS. On August 5, 2004,
EarthShell and Meridian Business Solutions, LLC ("MBS") entered into a Stock
Purchase Agreement (the "Stock Purchase Agreement") pursuant to which MBS agreed
to fund $5 million to EarthShell in exchange for EarthShell's issuance of a
total of 1,666,666 shares of common stock at a price of $3.00 per share. On
August 20, 2004, EarthShell received $500,000 from MBS, for which the Company
issued 166,666 shares of its common stock to MBS. On October 1, 2004, EarthShell
received an additional $1.2 million of the $5 million committed by MBS, and the
Company issued 400,000 shares of its common stock to MBS. On October 11, 2004,
EarthShell was informed that MBS had funded an additional $0.5 million and,
pending completion of certain documentation, another $.5 million will be
remitted to EarthShell in exchange for the issuance of an additional 333,333
shares of its common stock. The Company has been informed by MBS that the
remaining $2.3 million of the $5 million commitment under the Stock Purchase
Agreement will be funded in November, 2004. The shares of common stock issued to
MBS are not registered for resale under the Securities Act of 1933, as amended
(the "Securities Act"), and the Company has agreed to file a registration
statement to register the shares no later than 60 days after the closing. The
cash received from MBS was used, in part, to fund the repurchase of the
Debentures(as defined below) and to restructure the Company's long-term debt.
EKI Agreements. In connection with its purchase of the Debentures from Holders,
on September 30, 2004, EKI entered into an agreement with EarthShell to sell the
Debentures it purchased back to the Company for $1 million cash, the cash price
paid by EKI for the purchased Debentures (the "EKI Debenture Purchase
Agreement"). In connection therewith, immediately after its acquisition, EKI
sold the purchased Debentures to the Company and, as discussed above, the
Company expects to retire the Debentures shortly.
In addition, on September 30, 2004, the Company and EKI agreed to convert
certain existing loans from EKI to the Company into shares of EarthShell's
common stock (the "EKI Conversion Agreement"). This transaction closed after the
closing of the Debenture Transactions and, pursuant to the EKI Conversion
Agreement, EKI converted the $2,755,000 principal amount of such debt into
shares of EarthShell's common stock at a conversion price of $3 per share. In
addition, under the terms of the EKI Conversion Agreement, EKI converted the
accrued and unpaid interest on such loans into shares of EarthShell's common
stock at a conversion price equal to the greater of (i) $3 per share, and (ii)
the maximum per share price (not to exceed $4 per share) obtained by the Company
upon the sale of its common stock to any investor during the three month period
following the closing. The 1,051,494 shares of common stock issued to EKI will
not be registered for resale under the Securities Act, and EarthShell has agreed
to file a registration statement to register the shares no later than 60 days
after the closing.
Biotec Agreement. EarthShell also reached agreement on October 11, 2004 to amend
its existing agreements with its affiliates, bio-tec Biologische
Naturverpackungen GmbH & Co. and bio-tec Biologische Naturverpackungen
Forschungs und Entwicklungs GmbH (collectively, "Biotec"; and such agreement,
the "Biotec Amendment"). Under the terms of the Biotec Amendment, EarthShell has
agreed to satisfy the approximate $2.5 million in indebtedness owed to Biotec by
(i) paying $750,000 to Biotec ($250,000 currently and $500,000 upon any
subsequent equity funding by MBS or other investor) (ii) converting
approximately $1.25 million principal amount of the Biotec debt into shares of
EarthShell's common stock at a conversion price of $3 per share and (iii) at
EarthShell's option, on the first anniversary of the closing, pay $250,000 to
Biotec or convert the remaining $250,000 Biotec debt into 133,333 shares of
EarthShell's common stock at a conversion price of $3 per share. In
consideration for the above, Biotec also agreed to suspend the monthly license
fees payable by EarthShell for two years after the date of the closing. The
common stock to be issued pursuant to the Biotec Amendment will not initially be
registered for resale under the Securities Act, and EarthShell has agreed to
file a registration statement to register the shares no later than 60 days after
the closing. The Biotec transaction is expected to close by November 15, 2004.
9
The Company has agreed to prepare and file, no later than 60 days after the
closing date, a registration statement with the Securities and Exchange
Commission covering the resale of all of the unregistered shares issued or to be
issued in conjunction with the above agreements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's treasury function controls all decisions and commitments regarding
cash management and financing arrangements. Treasury operations are conducted
within a framework that has been authorized by the board of directors.
The Company is exposed to interest rate risk on its fixed rate long-term working
capital loans to EKI and its fixed rate long-term convertible debentures. As of
September 30, 2004, the principal amount of these long-term fixed rate debt
obligations totaled approximately $9.3 million. The working capital loans bear
interest at a fixed rate of 10% per annum. The convertible debentures bear
interest at a fixed rate of 2% per annum. While generally an increase in market
interest rates will decrease the value of this debt, and decreases in rates will
have the opposite effect, we are unable to estimate the impact that interest
rate changes will have on the value of the substantial majority of this debt as
there is no active public market for this debt.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. The Company's Chief Executive
Officer and Chief Financial Officer have evaluated the effectiveness of the
Company's disclosure controls and procedures (as such term is defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended
(the "Exchange Act")) as of the end of the period covered by this quarterly
report on Form 10-Q (the "Evaluation Date"). Based on such evaluation, such
officers have concluded that, as of the Evaluation Date, the Company's
disclosure controls and procedures are effective in alerting them on a timely
basis to material information relating to the Company required to be included in
the Company's periodic filings under the Exchange Act.
Changes in internal control over financial reporting. No changes in the
Company's internal control over financial reporting have come to management's
attention during the Company's last fiscal quarter that have materially
affected, or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Not applicable
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS AND ISSUER REPURCHASES OF
EQUITY SECURITIES
Not applicable
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
The Company did not make required interest payments related to the 2006
Debentures on January 31, 2004, April 30, 2004 and July 31, 2004. In addition,
on March 8, 2004, the Company's common stock was delisted from the Nasdaq
Smallcap Market. These actions put the Company in non-compliance with its
covenants under the 2006 Debentures. Two of the debenture holders, including the
debenture holder with the largest ownership position, notified the Company in
writing that the Company was in default and requested that the Company
repurchase the entire principal amount of the 2006 Debentures held at the price
specified in the debenture, along with any accrued and unpaid interest. During
the third quarter, 2004, with the assistance of its largest shareholder, the
Company negotiated agreements with the holders of all $6.5 million outstanding
principal amount of its 2006 Debentures to convert, retire or restructure the
debentures and all accrued but unpaid interest (see "Subsequent Events").
10
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Stockholders of the Company was held on July 26, 2004. The
meeting, originally convened on June 28, 2004, was adjourned to July 26, 2004
because a quorum was not present at that time. At the reconvened meeting the
following actions were taken:
1) Re-elected the entire membership of the Board of Directors, as
listed in the Company's Proxy Statement dated June 8, 2004, until
the next Annual Meeting of Stockholders. Voting for the individual
nominees was as follows:
VOTES WITHHELD
NOMINEE VOTES FOR OR AGAINST
------------------------------ ------------- ---------------------
Mr. Essam Khashoggi 7,529,763 540,894
Mr. Simon K. Hodson 7,529,908 540,749
Mr. John Daoud 7,529,846 540,811
Dr. Hamlin M. Jennings 7,529,906 540,751
Ms. Layla Khashoggi 7,529,672 540,985
Mr. Walker Rast 7,529,823 540,834
Dr. George W. Roland 7,529,906 540,751
2) Approved an amendment to the Company's Certificate of Incorporation
to increase, upon filing, the number of Common Stock the Company is
authorized to issue from 25,000,000 to 40,000,000 shares and in
connection therewith to increase the total number of shares of all
classes of stock the Company is authorized to issue from 35,000,000
to 50,000,000. The votes were cast as follows:
Votes for 7,249,071
Votes withheld or against 757,924
Abstentions 63,662
Broker non-votes 0
ITEM 5. OTHER INFORMATION
Not applicable
11
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following documents are filed as a part of this report:
Exhibit Number Description
10.1 Meridian Business Solutions Sublicense Agreement dated May
13, 2004.
10.2 Amended and Restated Debenture Purchase Agreement by and
among the Company, EKI and SF Capital Partners, Ltd. dated
September 30, 2004
10.3 Amended and Restated Debenture Purchase Agreement by and
among the Company, EKI and Omicron Master Trust dated
September 29, 2004
10.4 Amended and Restated Debenture Purchase Agreement by and
among the Company, EKI and Islandia, Ltd. dated September
29, 2004
10.5 Amended and Restated Debenture Purchase Agreement by and
among the Company, EKI and Midsummer Investment, Ltd. dated
September 29, 2004
10.6 Conversion Agreement by and among the Company, EKI and RHP
Master Fund, Ltd. dated July 20, 2004
10.7 Amended and Restated Debenture Purchase Agreement by and
among the Company, EKI and Straus-GEPT L.P. dated September
29, 2004
10.8 Amended and Restated Debenture Purchase Agreement by and
among the Company, EKI and Straus Partners L.P. dated
September 29, 2004
10.9 Amended and Restated Debenture Purchase Agreement by and
among the Company and EKI dated September 30, 2004
10.10 Agreement with EKI dated July 16, 2004 to convert debt to
equity
10.11 Agreement dated September 1, 2004 for conversion of Biotec
indebtedness
10.12 Meridian Business Solutions, LLC Stock Purchase Agreement
dated August 5, 2004
31.1 Certification of the CEO pursuant to Rules 13a-14 and 15d-14
under the Exchange Act, as Adopted Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.
31.2 Certification of the CFO pursuant to Rules 13a-14 and 15d-14
under the Exchange Act, as Adopted Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
12
(b) Reports on Form 8-K
The Company filed one report on Form 8-K during the quarter ended September 30,
2004. Information regarding the item reported on is as follows:
DATE ITEM REPORTED ON
- ----------------------------------- -----------------------------------------
July 27, 2004 Press releases of the Company
SIGNATURE
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.
EarthShell Corporation
Date: November 9, 2004 By: /S/ D. SCOTT HOUSTON
--------------------
D. Scott Houston
Chief Financial Officer
(PRINCIPAL FINANCIAL OFFICER AND
DULY AUTHORIZED OFFICER)