Turtle Beach Corp - FORM 10-Q - November 10, 2014

Attached files

Weighted Average Grant Date Fair Value Per Share

Nonvested restricted stock at December 31, 2013

Nonvested restricted stock at September 30, 2014

file	filename
EXCEL - IDEA: XBRL DOCUMENT - Turtle Beach Corp	Financial_Report.xls
EX-31.1 - CERTIFICATION OF CEO PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 - Turtle Beach Corp	ex-31111.htm
EX-32.1 - CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 - Turtle Beach Corp	ex-32111.htm
EX-31.2 - CERTIFICATION OF CFO PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 - Turtle Beach Corp	ex-31211.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

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

For the quarterly period ended September 30, 2014

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

For the transition period from to

Commission File Number: 001-35465

TURTLE BEACH CORPORATION

(Exact name of registrant as specified in its charter)



Nevada	27-2767540
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

100 Summit Lake Drive, Suite 100 Valhalla, New York	10595
(Address of principal executive offices)	(Zip Code)

(914) 345-2255

(Registrant’s telephone number, including area code)

Parametric Sound Corporation

13771 Danielson Street, Suite L, Poway, CA 92064

September 30, 2013

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ý Yes ¨ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ý Yes ¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨ Accelerated filer ý Non-accelerated filer ¨ Smaller reporting company ¨

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes ý No

The number of shares of Common Stock, $0.001 par value, outstanding on October 31, 2014 was 42,027,991.

INDEX



		Page
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)

	Condensed Consolidated Balance Sheets as of September 30, 2014 and December 31, 2013	2

	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2014 and 2013	3

	Condensed Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months Ended September 30, 2014 and 2013	4

	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2014 and 2013	5

	Condensed Consolidated Statement of Convertible Preferred Stock and Stockholders' Equity (Deficit)	6

	Notes to Condensed Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	37

Item 4.	Controls and Procedures	37

PART II. OTHER INFORMATION		37

Item 1.	Legal Proceedings	37

Item 1A.	Risk Factors	37

Item 6.	Exhibits	48

SIGNATURES		49

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

Turtle Beach Corporation

Condensed Consolidated Balance Sheets

(unaudited)



	September 30, 2014		December 31, 2013
ASSETS	(in thousands, except par value and share amounts)
Current Assets:
Cash and cash equivalents	$	4,416	$	6,509
Accounts receivable, net	26,712		48,542
Inventories, net	46,557		49,643
Deferred income taxes	13,918		2,214
Prepaid income taxes	1,329		2,925
Prepaid expenses and other current assets	5,866		3,561
Total Current Assets	98,798		113,394
Property and equipment, net	5,174		7,369
Goodwill	80,974		—
Intangible assets, net	40,025		3,972
Deferred income taxes	6,101		827
Other assets	650		1,745
Total Assets	$	231,722	$	127,307
LIABILITIES, CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (DEFICIT)
Current Liabilities:
Revolving credit facilities	$	28,663	$	39,736
Term loan	—		14,500
Subordinated notes - related parties	7,506		—
Accounts payable	28,650		44,136
Due to shareholders	—		3,125
Other current liabilities	8,039		9,712
Total Current Liabilities	72,858		111,209
Series B redeemable preferred stock	14,621		13,713
Deferred income taxes	14,325		850
Subordinated notes	—		10,342
Other liabilities	2,041		1,986
Total Liabilities	103,845		138,100
Commitments and Contingencies
Series A convertible preferred stock, $0.01 par value - 50,000,000 shares authorized; 48,689,555 shares issued and outstanding as of December 31, 2013	—		24,345
Stockholders' Equity (Deficit)
Common stock, $0.001 par value - 50,000,000 shares authorized; 42,011,463 and 12,700,460 shares issued and outstanding as of September 30, 2014 and December 31, 2013, respectively	42		13
Additional paid-in capital	126,739		(54,031		)
Retained earnings	929		18,775
Accumulated other comprehensive income	167		105
Total Stockholders' Equity (Deficit)	127,877		(35,138		)
Total Liabilities, Convertible Preferred Stock and Stockholders' Equity (Deficit)	$	231,722	$	127,307

See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

Turtle Beach Corporation

Condensed Consolidated Statements of Operations

(unaudited)



	Three Months Ended						Nine Months Ended
	September 30, 2014			September 30, 2013			September 30, 2014			September 30, 2013
	(in thousands, except per-share data)
Net Revenue	$	33,325		$	38,299		$	93,909		$	92,352
Cost of Revenue	25,576			29,653			69,053			68,759
Gross Profit	7,749			8,646			24,856			23,593
Operating expenses:
Selling and marketing	7,962			7,665			22,660			21,783
Research and development	2,797			1,027			6,866			3,239
General and administrative	4,311			1,648			12,582			5,678
Business transaction costs	—			1,607			3,744			2,287
Total operating expenses	15,070			11,947			45,852			32,987
Operating loss	(7,321		)	(3,301		)	(20,996		)	(9,394		)
Interest expense	866			2,017			6,161			4,580
Other non-operating expense (income), net	334			(217		)	239			256
Loss before income tax benefit	(8,521		)	(5,101		)	(27,396		)	(14,230		)
Income tax benefit	(2,883		)	(3,699		)	(9,550		)	(7,186		)
Net loss	$	(5,638	)	$	(1,402	)	$	(17,846	)	$	(7,044	)

Net loss per share:
Basic	$	(0.13	)	$	(0.11	)	$	(0.46	)	$	(0.55	)
Diluted	$	(0.13	)	$	(0.11	)	$	(0.46	)	$	(0.55	)
Weighted average number of shares:
Basic	41,962			12,700			38,869			12,700
Diluted	41,962			12,700			38,869			12,700

See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

Turtle Beach Corporation

Condensed Consolidated Statements of Comprehensive Income (Loss)

(unaudited)



	Three Months Ended						Nine Months Ended
	September 30, 2014			September 30, 2013			September 30, 2014			September 30, 2013
	(in thousands)
Net loss	$	(5,638	)	$	(1,402	)	$	(17,846	)	$	(7,044	)

Other comprehensive income (loss):
Foreign currency translation adjustment	(574		)	138			62			29
Other comprehensive income (loss)	(574		)	138			62			29
Comprehensive loss	$	(6,212	)	$	(1,264	)	$	(17,784	)	$	(7,015	)

See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

Turtle Beach Corporation

Condensed Consolidated Statements of Cash Flows

(unaudited)



	Nine Months Ended
	September 30, 2014			September 30, 2013
	(in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss	$	(17,846	)	$	(7,044	)
Adjustments to reconcile net loss to net cash provided by (used for) operating activities:
Depreciation and amortization	4,339			3,051
Amortization of intangible assets	808			712
Amortization of debt financing costs	2,587			1,209
Stock-based compensation	3,916			1,919
Accrued interest on Series B redeemable preferred stock	908			745
Paid in kind interest	953			—
Deferred income taxes	(10,282		)	(5,224		)
Reversal of sales returns reserve	(3,534		)	(5,756		)
Reversal of doubtful accounts	(8		)	(350		)
Provision for obsolete inventory	179			(347		)
Loss (Gain) on disposal of property and equipment	9			(9		)
Changes in operating assets and liabilities:
Accounts receivable	25,419			38,882
Inventories	3,559			(21,217		)
Accounts payable	(16,027		)	26,290
Due to shareholders	(3,125		)	(3,125		)
Prepaid expenses and other assets	(2,418		)	(3,832		)
Income taxes payable	1,784			(8,105		)
Other liabilities	(3,318		)	(2,540		)
Net cash provided by (used for) operating activities	(12,097		)	15,259
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment	(1,947		)	(4,109		)
Cash acquired in business combination	4,093			—
Net cash provided by (used for) investing activities	2,146			(4,109		)
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowings on revolving credit facilities	93,057			30,250
Repayment of revolving credit facilities	(104,130		)	(33,064		)
Repayment of capital leases	(25		)	—
Repayment of term loan	(14,500		)	(17,500		)
Repayment of subordinated notes	(10,789		)	—
Proceeds from sale of common stock, net of issuance costs	37,230			—
Proceeds from exercise of stock options	1,552			—
Debt financing costs	(1,509		)	(1,021		)
Proceeds from issuance of subordinated notes	7,000			10,000
Net cash provided by (used for) financing activities	7,886			(11,335		)
Effect of exchange rate changes on cash and cash equivalents	(28		)	28
Net decrease in cash and cash equivalents	(2,093		)	(157		)
Cash and cash equivalents - beginning of period	6,509			5,219
Cash and cash equivalents - end of period	$	4,416		$	5,062

SUPPLEMENTAL DISCLOSURE OF INFORMATION
Cash paid for interest	$	1,782		$	2,349
Cash paid for income taxes	$	190		$	8,224
Value of shares issued to acquire HyperSound business	$	113,782		$	—

See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

Turtle Beach Corporation

Condensed Consolidated Statement of Convertible Preferred Stock and Stockholders' Equity (Deficit)

(unaudited)



	Series A Convertible Preferred Stock					Common Stock			Additional Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive Income		Total
	Shares		Amount			Shares	Amount		Additional Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive Income		Total
	(in thousands)
Balance at December 31, 2013	48,690		$	24,345		12,700	$	13	$	(54,031	)	$	18,775		$	105	$	(35,138	)
Net loss	—		—			—	—		—			(17,846		)	—		(17,846		)
Other comprehensive income	—		—			—	—		—			—			62		62
Adjustment for reverse merger						7,275	7		113,775						—		113,782
Conversion of Series A Preferred	(48,690	)	(24,345		)	17,527	18		24,327						—		24,345
Cashless exercise of warrants	—		—			24	—		—			—			—		—
Sale of common stock, net of issuance costs	—		—			4,000	4		37,226			—			—		37,230
Stock options exercised and related tax activity	—		—			486	—		1,526			—			—		1,526
Stock-based compensation	—		—			—	—		3,916						—		3,916
Balance at September 30, 2014	—		$	—		42,012	$	42	$	126,739		$	929		$	167	$	127,877

See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 1. Background and Basis of Presentation

Organization

Turtle Beach Corporation (“Turtle Beach” or the “Company”) is a premier audio innovation company with deep expertise and relevant experience in developing, commercializing and marketing audio technologies across a range of large addressable markets under the Turtle Beach and HyperSound brands. Turtle Beach is a worldwide leading provider of feature-rich headset solutions for use across multiple platforms, including video game and entertainment consoles, handheld consoles, personal computers, Macintosh computers, tablets and mobile devices. HyperSound is a novel patent-protected sound delivery technology that delivers immersive, directional audio offering unique benefits in a variety of commercial and consumer audio devices, including improved clarity and comprehension for hard of hearing listeners.

Turtle Beach (f/k/a Parametric Sound Corporation “Parametric”) was incorporated in the state of Nevada in 2010 as a new wholly-owned subsidiary of LRAD Corporation and, after a spin off, became a stand-alone independent public company later that year with an administrative office and a manufacturing facility located in Poway, California.

VTB Holdings, Inc. (“VTBH”), the parent holding company of the historical business of Voyetra Turtle Beach, Inc. (“VTB”), was incorporated in the state of Delaware in 2010 and is headquartered in Valhalla, New York, with additional administrative and research and development offices in San Diego and San Jose, California.

Voyetra Turtle Beach, Inc. was incorporated in the state of Delaware in 1975 and is headquartered in Valhalla, New York, with warehouse distribution centers in New York, New Jersey, Texas and California. In October 2012, VTB acquired Lygo International Limited (“Lygo”), a private limited company organized under the laws of England and Wales, which was subsequently renamed Turtle Beach Europe Limited (“TB Europe”).

Merger with Parametric Sound

On January 15, 2014 (the “Closing Date”), VTB Holdings, Inc., which operated the Turtle Beach business, and Parametric, which operated the HyperSound® business, completed the merger (the “Merger”) of Paris Acquisition Corporation (“Merger Sub”) with and into VTBH in accordance with the terms and conditions of the Agreement and Plan of Merger dated August 5, 2013, by and among Parametric, Merger Sub and VTBH (the “Merger Agreement”). As a result of the Merger, VTBH, the accounting acquirer and surviving entity, became a wholly-owned subsidiary of Parametric, a publicly-traded company.

In connection with the Merger, Parametric issued to the former holders of VTBH common stock and Series A Preferred Stock an aggregate of 30,227,100 shares of Parametric Common Stock, par value $0.001 per share (“Parametric Common Stock”). The number of shares of Parametric Common Stock issued was computed in accordance with a formula specified in the Merger Agreement using an exchange ratio of 0.35997 shares of Parametric Common Stock for every one share of VTBH common stock or Series A Preferred Stock. Accordingly, all historical equity is presented as if subsequent to this conversion. In addition, in accordance with the terms of the Merger Agreement, all outstanding options to purchase shares of VTBH common stock were converted into options to purchase shares of Parametric Common Stock and were assumed by Parametric. These newly issued shares of Parametric Common Stock, together with the converted options, represented approximately 80% of the total issued and outstanding shares of Parametric Common Stock, on a fully-diluted basis, as of the closing date of the Merger.

As a result of the 0.35997 exchange ratio pursuant to the Merger, the 35,282,286 shares of VTBH Common Stock presented on its previously filed balance sheet as of December 31, 2013, are presented herein as 12,700,460 shares. On January 15, 2014, upon the close of the Merger, VTBH's Series A Preferred Stock was converted into 17,526,640 shares of Parametric Common Stock, which when added to the outstanding 12,700,460 shares of VTBH common stock then outstanding, comprised the 30,227,100 shares of Parametric Common Stock issued to the former holders discussed above. These shares were combined with 7,274,622 shares of outstanding Parametric Common Stock, to arrive at a total of 37,501,722 shares issued and outstanding as of the closing date of the Merger.

For accounting purposes, the Merger was treated as a “reverse acquisition” and VTBH was considered the accounting acquirer. Accordingly, VTBH’s historical results of operations replace Parametric’s historical results of operations for all periods prior to the Merger, and for all periods following the Merger, the results of operations of both companies will be included.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

On May 20, 2014, Parametric filed a Certificate of Amendment to its Articles of Incorporation to change the company's name from “Parametric Sound Corporation” to “Turtle Beach Corporation” effective May 28, 2014.

Basis of Presentation

The accompanying interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and, in the opinion of management, reflect all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation of the financial position, results of operations, and cash flows for the periods presented. All intercompany accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures, normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”), have been condensed or omitted pursuant to those rules and regulations. We believe that the disclosures made are adequate to make the information presented not misleading.

The December 31, 2013 Condensed Consolidated Balance Sheet has been derived from the Company's most recent audited financial statements in our Prospectus Supplement filed with the SEC on April 24, 2014.

Since VTBH is considered the accounting acquirer, the December 31, 2013 balance sheet and the comparative information for the three and nine months ended September 30, 2013 contain the results of VTBH only. The results of operations as of, and for the three and nine months ended September 30, 2014 contain the results of the Turtle Beach business and HyperSound business from the January 15, 2014 acquisition date forward. The results of operations for the interim periods are not necessarily indicative of the results of operations for the entire fiscal year.

During 2013, VTBH recorded its results on a four-four-five week basis such that its quarterly financial periods ended on the Saturday closest to the last day of the calendar quarter, except for the fourth quarter which ended on December 31. For 2014, Turtle Beach has changed to recording results on a calendar month and quarterly basis. This change is not expected to have a material impact on the Company's 2014 financial results or their comparability with prior year periods.

These financial statements should be read in conjunction with the annual financial statements (“Annual Report”) and the notes thereto included in our Prospectus Supplement filed with the SEC on April 24, 2014 that contains information useful to understanding the Company's businesses and financial statement presentations.

Reclassification

Certain prior period amounts in the accompanying consolidated financial statements and related notes have been reclassified to conform to the 2014 presentation.

Note 2. Summary of Significant Accounting Policies

The preparation of consolidated annual and quarterly financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. The Company can give no assurance that actual results will not differ from those estimates.

There have been no material changes to the critical accounting policies and estimates from the information provided in Note 2 of the notes to our consolidated financial statements in our Annual Report.

Recent Accounting Pronouncements

In August 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, which defines management's responsibility to assess an entity's ability to continue as a going concern, and to provide related footnote disclosures if there is substantial doubt about its ability to continue as a going concern. The pronouncement is effective for annual reporting periods ending after December 15, 2016 with early adoption permitted. The adoption of this guidance is not expected to have a significant impact on the Company's consolidated financial statements.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements - (Continued)

(unaudited)

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires entities to recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. The new guidance also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The amendment is effective for annual reporting periods beginning after December 15, 2016 and interim periods within those annual periods. The Company is currently evaluating the impact, if any, this new standard will have on our consolidated financial statements and have not yet determined the method of adoption.

In April 2014, the FASB issued ASU No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, which changes the criteria for determining which disposals can be presented as discontinued operations and modifies related disclosure requirements. Under the new guidance, a discontinued operation is defined as a disposal of a component or group of components that is disposed of or is classified as held for sale and “represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results.” The new standard applies prospectively to new disposals and new classifications of disposal groups as held for sale after the effective date. The amendment is effective for annual reporting periods beginning after December 15, 2014 and interim periods within those annual periods. The adoption of this guidance is not expected to have a significant impact on the Company's consolidated financial statements.

Note 3. Business Combination

On January 15, 2014, VTBH completed the Merger with and into a wholly-owned subsidiary of Turtle Beach (f/k/a Parametric), a publicly-traded audio technology company focused on developing new directed audio products for commercial, consumer and health care markets, in an all-stock, tax-free reorganization pursuant to the Merger Agreement. VTBH entered into the Merger to acquire and commercialize Parametric’s technology and gain access to capital market opportunities as a public company.

Subsequent to the Merger, Turtle Beach is under the leadership of the former VTBH management team and the Company's board of directors is currently comprised of one former director from Parametric and five directors selected by the former stockholders of VTBH.

Business Transaction Costs

Business transaction costs as a result of the merger of $3.7 million and $2.3 million were recognized for the nine months ended September 30, 2014 and September 30, 2013, respectively. The components of business transaction costs are presented below.



	Nine Months Ended
	September 30,
	2014		2013
	(in thousands)
Legal fees	$	786	$	1,179
Accounting fees	84		968
Advisory fees	2,219		—
Termination and severance	450		—
Other	205		140
Total Transaction Costs	$	3,744	$	2,287

Advisory fees include success based fees payable to investment bankers for both merger parties.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements - (Continued)

(unaudited)

Purchase Consideration and Net Assets Acquired

The fair value of Parametric Common Stock used in determining the purchase price was $14.30 per share, the closing price on January 15, 2014. The fair value of outstanding stock options included in the purchase consideration was determined by calculating the cumulative vesting attributable to Parametric employees for periods prior to the Merger, using the Black-Scholes option pricing model. Assumptions used in Black-Scholes calculations during such periods included: volatility ranging from 87% to 90%; risk-free interest rates ranging between 0.47% and 0.92%; forfeiture rates ranging from 1.1% to 4.1%; and expected lives ranging from 3.28 to 4.61 years.

The purchase price is as follows:



	(in thousands)
Fair Value of Parametric shares outstanding	$	104,027
Fair Value of Parametric stock options	9,755
Purchase Price	$	113,782

The following presents the allocation of the purchase consideration to the assets acquired and liabilities assumed:



	(in thousands)
Cash and cash equivalents	$	4,093
Accounts receivable	47
Deferred tax asset	6,696
Other current assets	710
Property and equipment	206
Intangible assets:
In-process research and development (IPR&D)	27,100
Developed technology	8,880
Customer relationships	270
Trade name	170
Goodwill	80,974
Accounts payable and accrued liabilities	(1,769		)
Capital lease obligation	(120		)
Deferred tax liabilities	(13,475		)
Total Net Assets Acquired	$	113,782

Any changes in the estimated fair values of the net assets recorded for this business combination upon the finalization of more detailed analyses of the facts and circumstances that existed at the date of the transaction will change the allocation of the purchase price. Any subsequent changes to the purchase price allocation during the measurement period that are material will be adjusted retrospectively.

The amount allocated to in-process research and development represents an estimate of the fair value of purchased in-process technology for research projects (“IPR&D”), primarily related to directed audio solutions that beam sound to a specific listening area without the ambient noise of traditional speakers. IPR&D is considered an indefinite-lived intangible asset until the completion or abandonment of the associated research and development efforts. Accordingly, during the development period, the IPR&D is not amortized but rather subject to impairment review. No amortization of the IPR&D has been reflected in the combined consolidated financial statements as the assets are considered indefinite-lived.

The acquired intangible assets relating to developed technology, customer relationships and trade name are subject to amortization. Developed technology is being amortized over an estimated useful life of approximately seven years with the amortization being included within cost of revenue. Customer relationships and trade name are being amortized over an estimated useful life of two years and five years with the amortization being included within sales and marketing expense.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements - (Continued)

(unaudited)

The excess purchase consideration over the fair values of assets acquired and liabilities assumed is recorded as goodwill. Goodwill is not amortized but tested for impairment on an annual basis or when the indicator for impairment exists.

The goodwill recorded is not tax deductible since the transaction was structured as a tax-free exchange.

Amounts allocated to deferred tax assets of $6.7 million and deferred tax liabilities of $13.5 million relate to acquired net operating loss carryforwards and indefinite lived intangible assets, respectively.

Pro Forma Financial Information (Unaudited)

The following table summarizes certain supplemental pro forma financial information which was prepared as if the Merger had occurred as of January 1, 2013. The unaudited pro forma financial information was prepared for comparative purposes only and is not necessarily indicative of what would have occurred had the acquisition been made at that time or of results which may occur in the future.



	Three Months Ended
	September 30, 2013
	Reported			Proforma
	(in thousands)
Net Revenue	$	38,299		$	38,386
Net Loss	$	(1,402	)	$	(4,023	)



	Nine Months Ended						Nine Months Ended
	September 30, 2014						September 30, 2013
	Reported			Proforma			Reported			Proforma
	(in thousands)
Net Revenue	$	93,909		$	93,909		$	92,352		$	92,806
Net Loss	$	(17,846	)	$	(19,936	)	$	(7,044	)	$	(13,612	)

Pro forma results for the nine months ended September 30, 2014 include $1.2 million in pre-merger business transaction costs in addition to the $3.7 million in merger-related business transaction costs recorded in the Condensed Consolidated Financial Statements.

Pro forma results for the three and nine months ended September 30, 2013 include $1.3 million in pre-merger business transaction costs in addition to the $1.6 million and $2.3 million, respectively, in merger-related business transaction costs recorded in the Condensed Consolidated Financial Statements.

Note 4. Equity Offering

On April 24, 2014, the Company entered into an Underwriting Agreement (the “Underwriting Agreement”) with Needham & Company, LLC, as representative for the several other underwriters named therein, relating to an underwritten public offering (the “Offering”) of 4,000,000 shares of our common stock, at a price to the public of $10.00 per share (the “Offering Price”). Under the terms of the Underwriting Agreement, the Company also granted the underwriters a 30-day option to purchase up to an additional 600,000 shares of common stock at the Offering Price less the underwriting discount and estimated offering expenses payable by Turtle Beach. Total net proceeds received from the Offering totaled approximately $37.2 million after deducting the underwriting discount and estimated offering expenses. The net proceeds from the Offering were used to repay certain indebtedness, including $10 million then outstanding under the revolving credit agreement as contemplated upon the occurrence of a public offering, and for working capital and other general corporate purposes. See Note 9, “Credit Facilities and Long-Term Debt” for further information.

Note 5. Fair Value Measurement

The Company follows a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)


•	Level 1 — Quoted prices in active markets for identical assets or liabilities.


•	Level 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for markets that are not active, or other inputs that are observable or can be corroborated by observable market data.


•	Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.

Cash equivalents are stated at amortized cost, which approximated fair value as of the consolidated balance sheet dates, due to the short period of time to maturity. Cash, accounts receivable and accounts payable are stated at their carrying value, which approximates fair value due to the short time to the expected receipt or payment. The revolving credit facilities and long-term debt and subordinated notes are stated at the carrying value as the stated interest rate approximates market rates currently available to the Company. As of September 30, 2014 and December 31, 2013, the Company has not elected the fair value option for any financial assets and liabilities for which such an election would have been permitted.

The following table sets forth the fair value of financial assets and liabilities by level within the fair value hierarchy:



	December 31, 2013
	Level I		Level II			Level III		Total
	(in thousands)
Financial Assets and Liabilities:
Cash and cash equivalents - money market funds	$	19	$	—		$	—	$	19
Total financial assets	$	19	$	—		$	—	$	19

Other current liabilities - derivative liabilities	$	—	$	(392	)	$	—	$	(392	)
Total financial liabilities	$	—	$	(392	)	$	—	$	(392	)

At September 30, 2014, there were no outstanding financial assets and liabilities recorded at fair value on a recurring basis.

Note 6. Allowance for Sales Returns

The following tables provide the changes in our sales return reserve, which is classified as a reduction of accounts receivable:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2014			2013			2014			2013
	(in thousands)
Balance, beginning of period	$	2,429		$	1,636		$	6,266		$	7,748
Reserve accrual	2,686			3,599			7,526			9,554
Recoveries and deductions, net	(2,383		)	(3,243		)	(11,060		)	(15,310		)
Balance, end of period	$	2,732		$	1,992		$	2,732		$	1,992

Note 7. Composition of Certain Financial Statement Items

Concentration of Revenue and Accounts Receivable

Our three largest individual customers accounted for approximately 44% of our gross sales in the aggregate for the nine months ended September 30, 2014, or individually 16%, 15% and 13%. In addition, two customers accounted for 15% and 16%, respectively, of accounts receivable as of September 30, 2014 and 24% and 20%, respectively, for December 31, 2013.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements - (Continued)

(unaudited)

Inventories, net

Inventories, net consist of the following:



	September 30, 2014		December 31, 2013
	(in thousands)
Raw materials	$	3,129	$	5,499
Finished goods	43,428		44,144
Total inventories, net	$	46,557	$	49,643

Property and Equipment, net

Property and equipment, net consists of the following:



	September 30, 2014			December 31, 2013
	(in thousands)
Machinery and equipment	$	510		$	249
Software and software development	748			581
Furniture and fixtures	222			144
Tooling	2,047			1,756
Leasehold improvements	103			59
Demonstration units and convention booths	11,256			10,014
Total property and equipment, gross	14,886			12,803
Less: accumulated depreciation and amortization	(9,712		)	(5,434		)
Total property and equipment, net	$	5,174		$	7,369

Note 8. Goodwill and Other Intangible Assets

At acquisition, we estimate and record the fair value of purchased intangible assets. The fair values of these intangible assets are estimated based on our assessment. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill and certain other intangible assets having indefinite lives are not amortized to earnings, but instead are subject to periodic testing for impairment. Intangible assets determined to have definite lives are amortized over their remaining useful lives.

We assess the impairment of long‑lived assets, identifiable intangibles assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. With respect to goodwill and identifiable intangible assets having indefinite lives, we test for impairment on an annual basis or in interim periods if an event occurs or circumstances change that may indicate the fair value is below its carrying amount. Factors we consider important, which could trigger an impairment review, include the following: (a) significant underperformance relative to expected historical or projected future operating results; (b) significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and (c) significant negative industry or economic trends. No impairment indicators were noted in the third quarter of 2014 which would trigger the need for testing.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

Goodwill

Changes in the carrying values of goodwill for the nine months ended September 30, 2014 are as follows:



	(in thousands)
Balance as of January 1, 2014	$	—
Activity in 2014
Acquisition of HyperSound business	$	80,974
Balance as of September 30, 2014	$	80,974

Acquired Intangible Assets

Acquired identifiable intangible assets, and related accumulated amortization, as of September 30, 2014 and December 31, 2013 consist of:



	September 30, 2014
	Gross Carrying Value		Accumulated Amortization		Net Book Value
	(in thousands)
Customer relationships	$	5,840	$	2,211	$	3,629
Non-compete agreements	179		134		45
In-process Research and Development	27,100		—		27,100
Developed technology	8,880		80		8,800
Trade names	170		25		145
Patent and trademarks	306		—		306
Total Intangible Assets	$	42,475	$	2,450	$	40,025


	December 31, 2013
	Gross Carrying Value		Accumulated Amortization		Net Book Value
	(in thousands)
Customer relationships	$	5,526	$	1,623	$	3,903
Non-compete agreements	177		108		69
Total	$	5,703	$	1,731	$	3,972

In October 2012, VTB acquired Lygo International Limited, subsequently renamed TB Europe. The acquired intangible assets relating to customer relationships and non-compete agreements are being amortized over an estimated useful life of thirteen years and two years, respectively, with the amortization being included within sales and marketing expense.

In January 2014, the merger between VTBH and Parametric was completed. The acquired intangible assets relating to developed technology, customer relationships and trade name are subject to amortization. Developed technology is being amortized over an estimated useful life of approximately seven years with the amortization being included within cost of revenue. Customer relationships and trade name are being amortized over an estimated useful life of two years and five years, respectively, with the amortization being included within sales and marketing expense. IPR&D is considered an indefinite-lived intangible asset until the completion or abandonment of the associated research and development efforts. Accordingly, during the development period, the IPR&D is not amortized but rather subject to impairment review. No amortization of the IPR&D has been reflected in the combined consolidated financial statements as the assets are considered indefinite-lived.

Amortization expense related to definite lived intangible assets of $0.2 million and $0.8 million was recognized in the three and nine months ended September 30, 2014, respectively, and $0.2 million and $0.7 million for the three and nine months ended September 30, 2013, respectively.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

As of September 30, 2014, estimated annual amortization expense related to definite lived intangible assets in future periods is as follows:



	(in thousands)
2014	$	572
2015	2,348
2016	2,053
2017	1,885
2018	1,805
Thereafter	3,956
Total	$	12,619

Note 9. Credit Facilities and Long-Term Debt



	September 30, 2014			December 31, 2013
	(in thousands)
Revolving credit facility, maturing March 2019	$	28,663		$	—
Revolving line of credit, repaid in March 2014	—			39,736
Term loans	—			14,500
Subordinated notes	7,506			10,342
Total outstanding debt	36,169			64,578
Less: current portion of revolving line of credit	(28,663		)	(39,736		)
Less: current portion of term loan	—			(14,500		)
Less: current portion of subordinated notes	(7,506		)	—
Total noncurrent portion of long-term debt	$	—		$	10,342

Total interest expense, inclusive of amortization of deferred financing costs, on long-term debt obligations was $0.9 million and $6.2 million for the three and nine months ended September 30, 2014, respectively, and $2.0 million and $4.6 million for the three and nine months ended September 30, 2013, respectively.

Amortization of deferred financing costs was $20,000 and $2.6 million for the three and nine months ended September 30, 2014, respectively, and $0.8 million and $1.2 million for the three and nine months ended September 30, 2013, respectively. The amount for the nine months ended September 30, 2014 includes the write-off of $2.2 million in deferred financing costs associated with the repayment of the Company's former loan and security agreement (see below).

Revolving Credit Facility

On March 31, 2014, Turtle Beach and certain of its subsidiaries entered into a new asset-based revolving credit agreement (“Credit Facility”) with Bank of America, N.A., as Agent, Sole Lead Arranger and Sole Bookrunner, which replaced the then existing loan and security agreement (“the Credit Agreement” as described below). The Credit Facility, which expires on March 31, 2019, provides for a line of credit of up to $60 million inclusive of a sub-facility limit of $10 million for TB Europe, a wholly owned subsidiary of Turtle Beach. The Credit Facility may be used for working capital, the issuance of bank guarantees, letters of credit and other corporate purposes.

The maximum credit availability for loans and letters of credit under Credit Facility is governed by a borrowing base determined by the application of specified percentages to certain eligible assets, primarily eligible trade accounts receivable and inventories, and is subject to discretionary reserves and revaluation adjustments.

Amounts outstanding under the Credit Facility bear interest at a rate equal to either a rate published by Bank of America or the LIBOR rate, plus in each case, an applicable margin, which is between 1.00% to 1.50% for U.S. base rate loans and between 2.00% to 2.50% for U.S. LIBOR loans and U.K. loans. As of September 30, 2014, interest rates for outstanding borrowings were 4.75% for base rate loans and 2.75% for LIBOR rate loans, which is referred to as the Base Rate. In addition,

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

Turtle Beach is required to pay a commitment fee on the unused revolving loan commitment at a rate ranging from 0.25% to 0.50%, and letter of credit fees and agent fees.

If certain availability thresholds are not met, meaning that the Company does not have receivables and inventory which are eligible to borrow on under the Credit Facility in excess of amounts borrowed, the Credit Facility requires the Company and its restricted subsidiaries to maintain a fixed charge coverage ratio. The fixed charge ratio is defined as the ratio, determined on a consolidated basis for the most recent four fiscal quarters, of (a) EBITDA minus capital expenditures, excluding those financed through other instruments, and cash taxes paid, and (b) Fixed Charges defined as the sum of cash interest expense plus scheduled principal payments.

The Credit Facility also contains affirmative and negative covenants that, subject to certain exceptions, limit our ability to take certain actions, including our ability to incur debt, pay dividends and repurchase stock, make certain investments and other payments, enter into certain mergers and consolidations, engage in sale leaseback transactions and transactions with affiliates and encumber and dispose of assets. Obligations under the Credit Facility are secured by a security interest and lien upon substantially all of the Company's assets.

As of September 30, 2014, the Company was in compliance with all financial covenants, and excess borrowing availability was approximately $13.7 million.

Credit Agreement

In August 2012, VTBH entered into a loan and security agreement (“the Credit Agreement”) with various financial institutions, which amended and restated the then existing $28 million term loan and $15 million credit facility. The Credit Agreement, which was to expire on August 22, 2015, provided for a $45 million term loan that bore interest at VTBH’s option at (i) the Adjusted Base Rate plus the applicable margin ranging from 2.50% to 3.25% as determined by VTBH’s total leverage ratio, or (ii) LIBOR, plus the applicable margin ranging from 3.50% to 4.25%. The Applicable Base Rate is equal to the highest of (a) the Prime Rate as determined by the syndication agent, (b) the federal funds rate plus 0.5% and (c) the LIBOR rate plus 1.0%. VTBH’s obligations under the Credit Agreement were secured by a first priority lien against substantially all of VTBH’s assets.

Further, the Credit Agreement was amended to increase the borrowing capacity on the revolving line of credit from $15 million to $55 million. The revolving line of credit was subject to limitations based on specific percentages of eligible accounts receivables and inventory.

2013 Amendments

VTBH entered into amendments to the Credit Agreement in July 2013 and August 2013 (the “2013 Amendments”). The 2013 Amendments waived certain defaults of the fixed charge coverage ratio and also provided for a new minimum EBITDA financial covenant, modifications of the fixed charge coverage ratio and maximum total leverage ratio for periods ending on or after September 28, 2013, and a modification of annual clean-down requirements with which VTBH would need to comply in order to provide for an increase in the eligible amount outstanding under the facility. In addition, the 2013 Amendments amended the interest rate on the outstanding term loans and required the issuance of $10 million of subordinated notes to reduce the outstanding borrowings on the term loan.

2014 Amendments

On January 15, 2014, in connection with the consummation of the Merger, the Company entered into a Third Amendment to the Credit Agreement in which Parametric became an obligor and guarantor under the loan and security agreement, and to (i) allow the Company to incur an additional $7 million of subordinated indebtedness, (ii) provide for the repayment of the term loan portion of the facility by February 28, 2014, (iii) change the maturity of the revolving line of credit portion of the facility to September 27, 2014, (iv) reduce the commitments under the revolving line of credit to $35 million after March 1, 2014, (v) increase the margin pursuant to which interest on outstanding amounts under the Credit Agreement was calculated by 0.75%, and (vi) modify the financial covenants contained in the Credit Agreement.

On March 13, 2014, the Company entered into a Fourth Amendment to the Credit Agreement to (i) increase the maximum principal amount of the lenders’ revolving loan commitment between February 28, 2014 and April 15, 2014 from $35 million to approximately $39 million, (ii) provide that the borrowers, on or prior to April 15, 2014, would reduce the aggregate dollar amount of revolving loans outstanding under the Credit Agreement to the lesser of $35 million or the Company’s borrowing base as of such date, (iii) waive the Company’s obligation to deliver certain certificates regarding its liquidity and borrowing

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

base for the fiscal month ended February 28, 2014, and to specify the delivery date of such certificates during March 2014 and April 2014, (iv) eliminate a requirement that the borrowers reduce the aggregate dollar amount of revolving loans and swing loans outstanding to an amount no greater than $25 million for a thirty consecutive day period during the first fiscal quarter of each fiscal year, and (v) eliminate the lenders’ obligation to make additional revolving loan commitments after February 28, 2014.

In connection with the above, on January 15, 2014, we repaid $7.0 million of the term loan with proceeds from the issuance of a subordinated note, and on February 28, 2014 repaid the remaining $7.5 million principal balance with funds from operations, as required by the “2014 Amendments.”

Invoice Factoring

TB Europe utilized accounts receivable factoring arrangements with a third-party financial institution in order to accelerate its cash collections from product sales. These arrangements provided for the transfer of ownership of eligible trade accounts receivable up to a maximum of £5.0 million at any time, without recourse, to the third-party financial institution in exchange for cash. This invoice factoring arrangement was terminated on March 31, 2014, and related borrowings were fully paid with proceeds from the Credit Facility described above.

As of December 31, 2013, TB Europe had sold $5.7 million of trade accounts receivable to the third-party financial institution, which were netted against accounts receivable on the accompanying Condensed Consolidated Balance Sheet.

Subordinated Notes - Related Party

On August 30, 2013, VTBH issued $10 million of subordinated notes (the “August Notes”) to SG VTB Holdings, LLC (“SG VTB”), VTBH’s largest shareholder, Ronald Doornink, a director of VTBH, and Juergen Stark, VTBH’s chief executive officer, that bear interest at a rate of (i) 10% per annum for the first year and (ii) 20% per annum for all periods thereafter, with interest accruing and being added to the principal amount of the August Notes quarterly. Principal and interest on the August Notes are due upon maturity, which shall occur on the one year anniversary of the later of (i) the term loan maturity date under the Credit Agreement or (ii) the revolving line of credit termination date thereunder. The proceeds from the August Notes were used to repay an equivalent portion of the then outstanding term loans. In June 2014, we repaid the $10 million outstanding principal amount plus related accrued interest of the August Notes with proceeds from an equity offering.

In connection with the Third Amendment to the Credit Agreement, on January 15, 2014, the Company issued an additional $7 million subordinated note (the “January Note”) to SG VTB, the proceeds of which were applied against the outstanding balance of the term loan under the Credit Agreement. The January Note bears interest at a rate of (i) 10% per annum until December 31, 2014 (which is the maturity date of the January Note) and (ii) 20% per annum for all periods thereafter, with interest accruing and being added to the principal amount of the January Note quarterly. The other terms of the January Note are substantially similar to the terms of the August Notes.

Note 10. Income Taxes

In order to determine the quarterly provision for income taxes, we use an estimated annual effective tax rate, which is based on expected annual income and statutory tax rates in the various jurisdictions. However, to the extent that application of the estimated annual effective tax rate is not representative of the quarterly portion of actual tax expense expected to be recorded for the year, we determine the quarterly provision for income taxes based on actual year-to-date income (loss). Certain significant or unusual items are separately recognized in the quarter during which they occur and can be a source of variability in the effective tax rates from quarter to quarter.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

The following table presents our income tax benefit and effective income tax rate:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2014			2013			2014			2013
	(in thousands)
Income tax benefit	$	(2,883	)	$	(3,699	)	$	(9,550	)	$	(7,186	)
Effective income tax rate	33.8		%	72.5		%	34.9		%	50.5		%

Income tax benefit for the three and nine months ended September 30, 2014 was $2.9 million at an effective tax rate of 33.8% and $9.6 million at an effective tax rate of 34.9%, respectively. The effective tax rate for the three and nine months ended September 30, 2014 was impacted by differences in book and tax treatment of transaction costs, interest on the Series B Redeemable Preferred Stock and other non-deductible expenses as well as foreign earnings.

Income tax benefit for the three and nine months ended September 30, 2013 was $3.7 million at an effective tax rate of 72.5% and $7.2 million at an effective tax rate of 50.5%, respectively, which were higher than the federal statutory rate primarily due to the projected tax benefit relating to the loss incurred to date.

As a result of the Merger and legacy net operating loss of the HyperSound business, the Company has a net operating loss of approximately $13 million which is available to offset future taxable income, subject to IRS code Section 382 limitations on actual usage. The Company has not recorded a valuation allowance against the related deferred tax asset because it is considered more-likely-than-not that the Company will have future taxable income sufficient to utilize its deferred tax assets.

The Company is subject to income taxes domestically and in various foreign jurisdictions. Significant judgment is required in evaluating uncertain tax positions and determining its provision for income taxes.

The Company recognizes only those tax positions that meet the more-likely-than-not recognition threshold, and establish tax reserves for uncertain tax positions that do not meet this threshold. Interest and penalties associated with income tax matters are included in the provision for income taxes in the condensed consolidated statement of operations. As of September 30, 2014 and December 31, 2013, the Company had uncertain tax positions of $1.5 million, inclusive of $0.5 million of interest and penalties, and does not anticipate any significant events or circumstances that would cause a material change to these uncertainties during the ensuing year.

The Company files U.S., state and foreign income tax returns in jurisdictions with various statutes of limitations, and its consolidated federal tax return for 2012 is currently under examination. The federal tax years open under the statute of limitations are 2010 through 2012, and the state tax years open under the statute of limitations are 2009 through 2012.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 11. Stock-Based Compensation

Total estimated stock-based compensation expense for employees and non-employees, related to all of the the Company's stock-based awards, was comprised as follows:



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2014		2013		2014		2013
	(in thousands)
Cost of revenue	$	151	$	15	$	219	$	56
Selling and marketing	279		93		607		251
Product development	241		93		656		249
General and administrative	848		455		2,434		1,363
Total stock-based compensation	$	1,519	$	656	$	3,916	$	1,919
Related income tax benefit	$	608	$	262	$	1,567	$	767
	$	911	$	394	$	2,349	$	1,152

On October 30, 2013 the Board of Directors adopted, and on December 27, 2013 the stockholders approved, the 2013 Stock-Based Incentive Compensation Plan (the “2013 Plan”), that became effective upon consummation of the Merger on January 15, 2014. The 2013 Plan succeeds the VTBH 2011 Equity Incentive Plan (the “2011 Plan”) and the Parametric 2012 Stock Option Plan (the “2012 Plan”). The total number of shares of common stock authorized for grant under the 2013 Plan is 2,250,000 shares plus 122,000 shares authorized to be granted but not issued under the 2012 Plan, plus any shares that may become available through forfeitures or otherwise terminate under the 2012 Plan.

The 2011 Plan and 2012 Plan were terminated as to new grants at the Merger but vested and unvested stock options previously granted of 3,960,783 and 1,392,854, respectively, as of the Merger continued.

The following table presents the stock activity and the total number of shares available for grant as of September 30, 2014:



	(in thousands)
Balance at December 31, 2013	1,439
VTBH 2011 Plan terminated at Merger	(1,439	)
2013 Plan adopted at Merger	2,372
Options granted	(1,777	)
Restricted Stock granted	(6	)
Forfeited/Expired shares added back	50
Balance at September 30, 2014	639

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

Stock Option Activity



	Options Outstanding
	Number of Shares Underlying Outstanding Options		Weighted-Average Exercise Price	Weighted-Average Remaining Contractual Term	Aggregate Intrinsic Value
				(In years)
Outstanding at December 31, 2013	3,960,793		4.71	8.45	3,031,094
Granted	1,777,327		11.92
Assumed in acquisition	1,392,854		6.02
Exercised	(485,559	)	3.19
Forfeited	(218,749	)	5.52
Outstanding at September 30, 2014	6,426,666		7.08	7.04	13,476,250
Vested and expected to vest at September 30, 2014	6,426,666		7.08	7.04	13,476,250
Exercisable at September 30, 2014	3,041,492		4.83	5.31	9,655,119

As described in Note 1, “Background and Basis of Presentation” option share and exercise prices reflect the application of the 0.35997 conversion ratio to historical VTBH share and weighted-average share amounts.

Stock options are time-based and exercisable within 10 years of the date of grant, but only to the extent they have vested. The options generally vest as specified in the option agreements subject, in some instances, to acceleration in certain circumstances. In the event participants in the 2011 Plan cease to be employed or engaged by the Company, then all of the options would be forfeited if they are not exercised within 90 days. The Company has a limited history of forfeiture of unvested options or grants. Accordingly, at this time the Company believes that an estimated forfeiture rate of 0% is reasonable. The Company reviews this assumption periodically and will adjust it if it is not representative of future forfeiture data and trends within employee types (executive vs. non-executive).

Aggregate intrinsic value represents the difference between the estimated fair value of the underlying common stock and the exercise price of outstanding, in-the-money options. The aggregate intrinsic value of options exercised was $4.0 million for the nine months ended September 30, 2014.

The Company uses the Black-Scholes option-pricing model to estimate the fair value of options granted as of the grant date. The following are assumptions for the nine months ended September 30, 2014.



Expected term (in years)	6.0 - 6.3
Risk-free interest rate	1.8% - 2.0%
Expected volatility	47.5% - 49.8%
Dividend rate	0%

Each of these inputs is subjective and generally requires significant judgment to determine.

The weighted average grant date fair value of options granted during the nine months ended September 30, 2014 was $7.30. The total estimated fair value of employee options vested during the nine months ended September 30, 2014 was $4.7 million. As of September 30, 2014, total unrecognized compensation cost related to non-vested stock options granted to employees was $13.3 million, which is expected to be recognized over a remaining weighted average vesting period of 2.9 years.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

Restricted Stock Activity

As of September 30, 2014 total unrecognized compensation cost related to the nonvested restricted stock awards granted was $0.1 million, which is expected to be recognized over a remaining weighted average vesting period of 3.3 years.

Series B Redeemable Preferred Stock

In September 2010, VTBH issued 1,000,000 shares of its Series B Redeemable Preferred Stock with a fair value of $12.4 million. The Series B Redeemable Preferred Stock is required to be redeemed on the earlier of September 28, 2030, or the occurrence of a liquidation event at its original issue price of $12.425371 per share plus any accrued but unpaid dividends. The redemption value was $14.6 million and $13.7 million as of September 30, 2014 and December 31, 2013, respectively.

Phantom Equity Activity

In November 2011, VTBH adopted a 2011 Phantom Equity Appreciation Plan ("the Appreciation Plan") that covers certain employees, consultants, and directors of VTBH (“Participants”) who are entitled to phantom units, as applicable, pursuant to the provisions of their respective award agreements. The Appreciation Plan is shareholder-approved, which permits the granting of phantom units to VTBH’s Participants of up to 1,500,000 units. These units are not exercisable or convertible into shares of common stock but give the holder a right to receive a cash bonus equal to the appreciation in value between the exercise price and value of common stock at the time of a change in control event as defined in the plan.

As September 30, 2014 and 2013, 1,135,048, and 1,255,280 phantom units at a weighted-average exercise price of $0.77 and $0.89 have been granted and are outstanding. Because these phantom units are not exercisable or convertible into common shares, said amounts and exercise prices were not subject to the exchange ratio provided by the Merger agreement. As of September 30, 2014, compensation expense related to the Appreciation Plan units remained unrecognized because as of those dates a change in control, as defined in the plan, had not occurred.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 12. Net Loss Per Share

The following table sets forth the computation of basic and diluted net loss per share of common stock attributable to common stockholders:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2014			2013			2014			2013
	(in thousands, except per-share data)
Net Loss	$	(5,638	)	$	(1,402	)	$	(17,846	)	$	(7,044	)

Weighted average common shares outstanding — Basic	41,962			12,700			38,869			12,700
Plus incremental shares from assumed conversions:
Dilutive effect of stock options	—			—			—			—
Weighted average common shares outstanding — Diluted	41,962			12,700			38,869			12,700
Net loss per share:
Basic	$	(0.13	)	$	(0.11	)	$	(0.46	)	$	(0.55	)
Diluted	$	(0.13	)	$	(0.11	)	$	(0.46	)	$	(0.55	)

As described in Note 1, “Background and Basis of Presentation” current period and historical weighted-average shares amounts reflect the application of a 0.35997 conversion ratio to historical VTBH share and weighted-average share amounts. For the three and nine months ended September 30, 2013, weighted-average shares used in computing net loss per share are for VTBH common shares only in conformity with U.S. GAAP reporting standards.

Incremental shares from stock options and restricted stock awards are computed by the treasury stock method. The weighted average shares listed below were not included in the computation of diluted earnings per share because to do so would have been anti-dilutive for the periods presented or were otherwise excluded under the treasury stock method. The treasury stock method calculates dilution assuming the exercise of all in-the-money options and vesting of restricted stock, reduced by the repurchase of shares with the proceeds from the assumed exercises, unrecognized compensation expense for outstanding awards and the estimated tax benefit of the assumed exercises.



	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2014	2013	2014	2013
	(in thousands)
Stock options	6,118	3,658	6,066	3,658
Warrants	31	—	38	—
Unvested restricted stock awards	6	—	6	—
Total	6,155	3,658	6,110	3,658

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 13. Geographic Information

The following table represents total net revenues based on where customers are physically located:



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2014		2013		2014		2013
	(in thousands)
United States	$	18,689	$	17,810	$	56,668	$	51,093
International	14,636		20,489		37,241		41,259
Total revenues	$	33,325	$	38,299	$	93,909	$	92,352

The United Kingdom comprised $5.8 million and $18.6 million, respectively, for the three and nine months ended September 30, 2014 and $6.3 million and $16.1 million for the three and nine months ended September 30, 2013. No other country outside of the United States comprised 10% or greater of total revenues.

Note 14. Commitments and Contingencies

Litigation

The Company is subject to various legal proceedings and claims that arise in the ordinary course of its business. Although the amount of any liability that could arise with respect to these actions cannot be determined with certainty, in the Company’s opinion, any such liability will not have a material adverse effect on its consolidated financial position, consolidated results of operations or liquidity.

On August 5, 2013, VTBH and the Company (f/k/a Parametric) announced that they had entered into the Merger Agreement pursuant to which VTBH would acquire an approximately 80% ownership interest and existing shareholders would maintain an approximately 20% ownership interest in the combined company. Following the announcement, several shareholders filed class action lawsuits in California and Nevada seeking to enjoin the Merger. The plaintiffs in each case alleged that members of the Company’s Board of Directors breached their fiduciary duties to the shareholders by agreeing to a Merger that allegedly undervalued the Company. VTBH and the Company were named as a defendant in these lawsuits under the theory that they had aided and abetted Company's Board of Directors in allegedly violating their fiduciary duties. The plaintiffs in both cases sought a preliminary injunction seeking to enjoin closing of the Merger, which by agreement was heard by the Nevada court with the California plaintiffs invited to participate. On December 26, 2013, the court in the Nevada cases denied the plaintiffs’ motion for a preliminary injunction. Following the closing of the Merger, the Nevada plaintiffs filed a second amended complaint, which made essentially the same allegations and seeks monetary damages as well as an order rescinding the Merger. The California plaintiffs dismissed their action without prejudice, and sought to intervene in the Nevada action, which was granted. Subsequent to the intervention, the plaintiffs filed a third amended complaint, which made essentially the same allegations as prior complaints and seeks monetary damages. On June 20, 2014, VTBH and the Company moved to dismiss the action, but that motion was denied on August 28, 2014. VTBH and the Company are currently seeking review of that decision from the Nevada Supreme Court. The Company believes that the plaintiffs’ claims against it are without merit and intends to vigorously defend itself in the litigation. As of September 30, 2014, the Company is unable to estimate a possible loss or range of possible loss in regards to this matter; therefore, no litigation reserve has been recorded in the consolidated financial statements.

On November 20, 2013, Shana Vasek, a purported shareholder of the Company, filed a class action lawsuit in the United States District Court for the District of Nevada, under the caption Vasek v. Parametric Sound Corp., Case No.2:13-cv-02148-JAD-GWF, naming the same defendants, asserting substantially the same allegations and seeking substantially the same relief as named, asserted and sought in the above-referenced consolidated action pending in Nevada state court. In addition to asserting substantially the same claims for breach of fiduciary duty and aiding and abetting as asserted in the above-referenced consolidated action pending in Nevada state court, the plaintiff in the federal court action asserted a claim for violations of Sections 14(a) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 14a-9. The federal court action was dismissed without prejudice on April 29, 2014 due to failure of service by the plaintiff.

Turtle Beach Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

Warranties

We warrant our products against certain manufacturing and other defects. These product warranties are provided for specific periods of time depending on the nature of the product. Warranties are generally fulfilled by replacing defective products with new products. The following table provides the changes in our product warranties, which are included in accrued liabilities:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2014			2013			2014			2013
	(in thousands)
Warranty, beginning of period	$	260		$	32		$	139		$	165
Warranty costs accrued	—			136			354			320
Settlements of warranty claims	(192		)	(151		)	(425		)	(468		)
Warranty, end of period	$	68		$	17		$	68		$	17

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our operations should be read together with our unaudited condensed consolidated financial statements and the related notes included in Part I of this Quarterly Report on Form 10-Q and with our audited consolidated financial statements and the related notes included in our Prospectus Supplement filed with the Securities Exchange Commission on April 24, 2014. This discussion and analysis contains forward-looking statements that are based on the beliefs, as well as assumptions made by, and information currently available to, its management. Actual results could differ materially from those discussed in or implied by forward-looking statements for various reasons.

This Quarterly Report on Form 10-Q contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements in this Report are indicated by words such as “anticipates,” “expects,” “believes,” “intends,” “plans,” “estimates,” “projects,” “strategies” and similar expressions. These statements represent our expectations based on current information and assumptions and are inherently subject to risks and uncertainties. Our actual results could differ materially from those which are anticipated or projected as a result of certain risks and uncertainties, including, but not limited to, changes in business relationships with our major customers and in the timing, size and continuation of our customers’ programs; the ability of our customers to achieve their projected sales; competitive product and pricing pressures; increases in production or material costs that cannot be recouped in product pricing; the performance of the aftermarket and original equipment service markets; changes in the product mix and distribution channel mix; economic and market conditions (including access to credit and financial markets); our significant indebtedness; successful integration of acquired businesses; our ability to achieve cost savings from our restructuring initiatives; litigation, product liability and environmental matters; as well as other risks and uncertainties, such as those described under Risk Factors, Quantitative and Qualitative Disclosures About Market Risk and those detailed herein and from time to time in the filings of the Company with the SEC. Forward-looking statements are made only as of the date hereof, and the Company undertakes no obligation to update or revise the forward-looking statements, whether as a result of new information, future events or otherwise. In addition, historical information should not be considered as an indicator of future performance. The following discussion should be read in conjunction with the unaudited consolidated financial statements, including the notes thereto, included elsewhere in this Report.

Merger with Parametric Sound

On January 15, 2014, VTB Holdings, Inc. (“VTBH”) and Parametric Sound Corporation (“Parametric”) completed a merger (the “Merger”) that resulted in a company with a new investment profile and unaudited pro forma combined net revenue of $179 million for the year ended December 31, 2013.

As a result, VTBH became a wholly-owned subsidiary of Parametric. For accounting purposes, the merger was treated as a “reverse acquisition” and VTBH was considered the accounting acquirer. Accordingly, VTBH's historical results of operations replace Parametric’s historical results of operations for all periods prior to the merger, and for all periods following the merger, the results of operations of both companies will be included.

As such, the historical revenues are primarily derived from the sale of gaming headsets and accessories, including replacement parts for gaming headsets and audio cables. During 2014, revenues will also include the sale of HyperSound® products for commercial applications.

Business Overview

Turtle Beach Corporation (herein referred to as the “Company,” “we,” “us,” or “our”) is a premier audio innovation company with deep expertise and relevant experience in developing, commercializing and marketing audio technologies across a range of large addressable markets under the Turtle Beach and HyperSound brands. Turtle Beach (TurtleBeach.com) is the worldwide leading provider of feature-rich headset solutions for use across multiple platforms, including video game and entertainment consoles, handheld consoles, PC and Macintosh computers, tablets and mobile devices. HyperSound (HyperSound.com) is a novel patent-protected sound delivery technology that delivers immersive, directional audio offering unique benefits in a variety of commercial settings and consumer devices, including improved clarity and comprehension for listeners with hearing loss. Our mission is to utilize innovative technology to create exceptional audio experiences across a wide range of consumer and commercial applications.

Audio technology and digital signal processing are core competencies of the combined companies, and we intend to leverage these competencies to continue to expand both our headset and HyperSound product portfolios. We consider continued innovation and state-of-the-art product development key factors to our future success. The merger combined the unique intellectual property and HyperSound product platform with the commercialization skills and resources of Turtle Beach, including proven product design, product development, supply chain management, sales and marketing. We believe that the strength of the Turtle Beach headset business provides a strong foundation that will enable us to invest in the advancement and commercialization of HyperSound.

The Company's stock is traded on NASDAQ under the symbol HEAR.

Headset Business Overview

Turtle Beach launched its first gaming headset in 2005 and played a significant role in developing the market for advanced gaming headsets. Today’s consumers know Turtle Beach for advanced gaming headsets, which allow video game players to experience high-quality, immersive surround sound and to communicate with others while playing video games. Turtle Beach has licensing agreements with major software and entertainment brands, including Activision, Blizzard, Disney and Marvel to create co-branded headsets with popular franchises, such as Call of Duty® and Star Wars. Turtle Beach branded headsets are distributed internationally across North America, South America, Europe, the Middle East, Africa, Australia, and Asia, and sold at thousands of storefronts, including major retailers such as Amazon, Apple, Best Buy, GameStop, HMV, Target and Walmart.

We offer a variety of headsets at retail price points ranging from $30 to $300 and have offerings across all major gaming platforms. As gaming consoles have evolved from dedicated video game platforms to home entertainment hubs, and mobile devices have become platforms for entertainment, we have continued to evolve our headsets to reflect how content is consumed.

We believe that the primary growth drivers for our console gaming headset business are:

• Cumulative sales of 163 million consoles, in the aggregate, of Xbox 360, Xbox One, PlayStation®3, and PlayStation®4 consoles as of year-end 2013, as estimated in the June 2014 DFC Intelligence: Worldwide Console Forecast;

• Projected sales of next-generation Xbox One and PlayStation®4 consoles, which are forecasted to reach 178 million cumulative units by the end of 2018, as estimated in the June 2014 DFC Intelligence: Worldwide Console Forecast;

• The increase in multiplayer online gaming, whether console-, mobile-, or PC-based, in which a gaming headset provides the additional benefit of being a communication device;

• The launch of new console video game titles, which we believe increases foot traffic into retail stores and lifts console gaming headset sales; and

• The estimated installed base of more than 7 million Turtle Beach headsets, which we expect to drive upgrades and replacements.

In addition, industry analysts expect Microsoft and Sony to continue to support their current generation consoles over the next few years and, as a result, we anticipate that there will continue to be a significant market through 2014 for our headsets that are compatible with Xbox 360 and PlayStation®3.

Business Trends

The gaming industry experienced a cyclical event in 2013 as Microsoft and Sony each introduced new consoles for the first time in eight years. Turtle Beach’s gaming headset business was materially impacted in 2013 by the beginning of this multi-year transition from sixth generation consoles to seventh generation consoles. After Sony announced the PlayStation®4 in February 2013 and Microsoft announced the Xbox One in May 2013, consumers began delaying gaming purchases in advance of the introduction of the new consoles, negatively impacting global sales of console hardware and software.

Therefore, we focused on investment in personnel and infrastructure with the goal of positioning for renewed growth in 2014 and to enter or strengthen our position in new geographic regions and expand the product line into areas outside of console gaming headsets.

In 2014, new product highlights include:


•	The first gaming headsets for the PlayStation®4 and Xbox One with DTS Headphone:X 7.1 surround sound technology, an innovative new sound experience designed to make movies, music and games sound better over headphones.


•	The first gaming headset to provide fully wireless game and chat audio for the Xbox One.


•	The first headset for the PlayStation®4 with noise cancellation and invisible microphones.

PlayStation®4

In preparation for the launch of the PlayStation®4 in November 2013, we introduced two headsets designed for the new console, the P4C and PX4, and aggressively marketed many current generation headsets in our portfolio that are also compatible with the new console. As a result, sales of PlayStation®4 compatible headsets played a large role in the improved performance at the end of 2013, which carried over to the first half of 2014.

In January 2014, we announced an agreement with Sony Computer Entertainment Inc. to make officially licensed headsets for the PlayStation®4. During 2014, we added three wireless headsets -- the ELITE 800, Stealth 500P and Stealth 400 -- and the P12, a new entry-level headset for the PlayStation®4 which expanded our core portfolio of headsets for the PlayStation®4 from two to six models.

Xbox One

In order for headsets to receive integrated voice and chat audio from the Xbox One, a Microsoft proprietary hardware adapter is currently required, and in the future a Microsoft proprietary computer chip will be required, to receive the integrated voice and chat audio. Due to the inclusion of this proprietary adapter, older headsets lacking a license from Microsoft, including older Turtle Beach headsets, are not compatible with the Xbox One without the separately purchased adapter.

In October 2013, Microsoft informed us that the adapter and software created by Microsoft required to enable full headset functionality on the Xbox One would not be implemented until the first quarter of 2014. As a result, we deferred the launch of the first-ever Xbox One compatible headsets -- the XO FOUR, XO SEVEN and Titanfall Atlas -- until March 6, 2014. In addition, we unveiled the XO ONE and Stealth 500X to expand our portfolio of Xbox One compatible headsets.

Seasonality

Our gaming headset business is seasonal with a significant portion of sales and profits typically occurring around the holiday period. Historically, more than 50% of headset business revenues are generated during the period from September through December as new headsets are introduced and consumers engage in holiday shopping.

Geographic Expansion

We have a strong market position in North America, United Kingdom, and Australia, and believe there is further opportunity for growth in the rest of Europe. Asia, in particular China, and Latin America are viewed as additional long-term growth opportunities. The Company intends to continue investing in a stronger presence and growth in these regions.

In September 2014, sales of our XO Four and XO Seven officially-licensed Xbox One gaming headsets began in China. The launch of the gaming headsets coincided with the launch of the Xbox One console, which debuted in China on September 29. In concert with the introduction of our officially-licensed Xbox One headsets, we have created a Chinese language version of the Turtle Beach brand and logo. Phonetically pronounced “Huan Jing,” the Chinese language version of the brand name translates as “Fantasy Space.”

HyperSound Business Overview

Technology Target Markets

Several innovations have made HyperSound a distinctly different technology from previous utltrasonic audio solutions. These patent-protected innovations provide a competitive advantage over other solutions in the marketplace. Digital signal processing has significantly improved audio quality and frequency response, electronics advancements have enabled the use of low voltage cables and lowered overall power consumption, and innovations in emitter panel design have improved the ratio of audio volume to panel size, allowing for the production of much smaller panels. Combined, these improvements open the door to the use of HyperSound in a host of commercial and consumer applications that was closed to past ultrasonic sound technologies.

We are currently focusing our product development efforts for HyperSound-based products in the following three areas: commercial, health care and consumer applications. We are also pursuing licensing opportunities in addition to the products we are commercializing.

Commercial Applications

Among potential commercial applications, we are currently marketing our HyperSound technology to retailers and audio-visual integrators for use in settings where directed audio and sound zones are beneficial, such as digital signage and interactive retail displays. Digital signage is a growing form of direct advertising, capturing an increasing share of advertising spending. Restaurants, banking, retail outlets, museums and other outlets and organizations employ commercial displays to communicate with patrons, many of which currently have no audio. Interactive retail displays and related computer terminals such as ATMs, power applications for communication, commerce, entertainment and education. Electronic gaming and casino slot machines are also becoming increasingly sophisticated computerized entertainment devices. We believe the ability to focus sound on the user in front of such displays or devices, while limiting or removing sound disruption outside the listening area, offers utility unavailable with traditional speakers. HyperSound creates discrete in-store promotional audio zones that offer a personal experience to an individual while preventing noise pollution that could be heard by surrounding customers.

Health Care

Our research indicates that HyperSound technology delivers improved clarity and comprehension for hard of hearing listeners. Individuals with normal and impaired hearing reported improved comprehension and clarity of sounds generated by HyperSound Audio Systems compared to standard speakers in our consumer preference research involving more than 90 subjects. Data from a clinical study we sponsored involving ten adults demonstrated improvement in sound clarity over conventional speakers in those with mild to severe hearing loss. In February 2014 we received clearance from the U.S. Food and Drug Administration, or FDA, to market the HyperSound Audio System to improve the clarity and comprehension of sounds from various sources for listeners with or without hearing loss and with or without the use of hearing aids. There are over 48 million people with hearing loss in the United States. We believe that a large percentage of that market can use HyperSound Audio Systems to improve their listening experiences from sources such as TV, CD/DVD players and stereo systems.

Consumer Applications

Our HyperSound technology has the potential to be developed into consumer products for various applications, including computers, video game consoles, televisions, home theater and home audio. With the advent of flat panel displays for use in televisions and mobile devices, manufacturers have been focused on creating thinner products often at the expense of sound quality. We believe this has created an opportunity to develop integrated and companion HyperSound products that improve the audio experience by providing immersive 3D sound. We believe that our ability to create a 3D sound image from two thin emitters, compared to a five- or seven-speaker surround sound set-up using conventional speakers can deliver a compelling and enhanced audio experience for certain consumers.

Key Performance Indicators and Non-GAAP Measures

Management routinely reviews key performance indicators including revenue, operating income and margins, earnings per share, among others. In addition, we consider other certain measures to be useful to management and investors evaluating our operating performance for the periods presented, and believe these additional measures provide a tool for evaluating our ongoing operations, liquidity and management of assets. These metrics, however, are not measures of financial performance

under accounting principles generally accepted in the United States of America (“GAAP”) and should not be considered a substitute for net income (loss) or other consolidated income statement data as determined in accordance with GAAP. These other measures may not be comparable to similarly titled measures employed by other companies. We consider the following non-GAAP measure, which may not be comparable to similarly titled measures reported by other companies, to be key performance indicators:

Adjusted EBITDA

“Adjusted EBITDA” is defined as net income (loss) before interest, taxes, depreciation and amortization, stock-based compensation (non-cash), non-cash amortization of payments to founders and certain business transaction expenses. Management adjusts net income (loss) for business transaction costs because it believes that such items are not representative of core operations. For the nine months ended September 30, 2014, business transaction costs consisted of acquisition-related costs in the amount of $3.7 million related to the Merger. The three and nine months ended September 30, 2013 included $1.6 million and $2.3 million, respectively, in merger-related business transaction costs.

We believe Adjusted EBITDA provides useful information to investors about us and our financial condition and results of operations for the following reasons: (i) it is one of the measures used by our board of directors and management team to evaluate our operating performance; (ii) it is one of the measures used by our management team to make day-to-day operating decisions; (iii) the adjustments made in our calculation of Adjusted EBITDA (business transaction costs, payments to our founders, and stock-based compensation) are often viewed as either non-recurring or not reflective of ongoing financial performance or have no cash impact on operations; and (iv) it is used by securities analysts, investors and other interested parties as a common operating performance measure to compare results across companies in our industry by backing out potential differences caused by variations in capital structures (affecting relative interest expense), and the age and book value of facilities and equipment (affecting relative depreciation and amortization expense).

Adjusted EBITDA has limitations as an analytical tool, and when assessing our operating performance, it should not consider Adjusted EBITDA in isolation or as a substitute for net income (loss) or other consolidated income statement data. Some of these limitations include, but are not limited to:

• Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;

• Adjusted EBITDA does not reflect interest expense, or the cash requirements necessary to service interest or principal payments, on our debt;

• Adjusted EBITDA does not reflect income taxes or the cash requirements for any tax payments; and

• Other companies may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.

Adjusted EBITDA (and a reconciliation to Net loss, the nearest GAAP financial measure) for the three and nine months ended September 30, 2014 and 2013 are as follows:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2014			2013			2014			2013
	(in thousands)
Net loss	$	(5,638	)	$	(1,402	)	$	(17,846	)	$	(7,044	)
Interest expense	866			2,017			6,161			4,580
Depreciation and amortization	1,602			1,412			5,147			3,763
Stock-based compensation	1,519			656			3,916			1,919
Income tax benefit	(2,883		)	(3,699		)	(9,550		)	(7,186		)
Business transaction costs	—			1,607			3,744			2,287
Payments to founders	—			—			—			527
Adjusted EBITDA	$	(4,534	)	$	591		$	(8,428	)	$	(1,154	)

Adjusted EBITDA decreased for the three months ended September 30, 2014 as compared to the prior year period driven largely by lower sales volumes, incremental costs related to the HyperSound business, certain customer credits and the write-off of scrap material primarily in connection with our refurbished product vendor transition.

Adjusted EBITDA decreased for the nine months ended September 30, 2014 as compared to the prior year periods driven largely by costs to package the Microsoft Xbox One Headset Chat Adapter with our headsets and ship them to retailers, an increase to inventory reserves, and incremental costs related to the HyperSound business.

Results of Operations

The following table sets forth the Company’s statement of operations for the periods presented:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2014			2013			2014			2013
	(in thousands)
Net Revenue	$	33,325		$	38,299		$	93,909		$	92,352
Cost of Revenue	25,576			29,653			69,053			68,759
Gross Profit	7,749			8,646			24,856			23,593
Operating expenses	15,070			11,947			45,852			32,987
Operating loss	(7,321		)	(3,301		)	(20,996		)	(9,394		)
Interest expense	866			2,017			6,161			4,580
Other non-operating expense (income), net	334			(217		)	239			256
Loss before income tax benefit	(8,521		)	(5,101		)	(27,396		)	(14,230		)
Income tax benefit	(2,883		)	(3,699		)	(9,550		)	(7,186		)
Net loss	$	(5,638	)	$	(1,402	)	$	(17,846	)	$	(7,044	)

Net Revenue

Net revenues for the three months ended September 30, 2014 totaled $33.3 million which was a decrease of 13.0% over the comparable 2013 period. Net revenues for the quarter were negatively impacted by the timing of releases of certain new products, specifically the Elite 800 and Stealth 500X, and international shipments, including a decline in sales to our Canadian distributor as the comparable prior quarter included incremental initial stock orders. However, September provided solid momentum heading into the holiday season bolstered by recent AAA multi-player game launches and our release of the Xbox One compatible XO ONE and PlayStation® compatible headsets, the Ear Force Stealth 400 and Stealth 500P.

For the nine months ended September 30, 2014, net revenues increased $1.6 million, or 1.7%, compared to the nine months ended September 30, 2013 on the strength of our headset portfolio, reflected by continued positive consumer reaction to the XO FOUR, XO SEVEN and the Ear Force X12 and PX22 headsets as well as encouraging initial response to our recently released PlayStation® compatible headsets. In addition, Microsoft delayed gaming headset audio when the Xbox One console was launched in November 2013 until March 2014 which resulted in a deferral of headset sales from the 2013 holiday season into the first half of 2014.

Cost of Revenue and Gross Profit

Gross profit as a percentage of net revenues for the three months ended September 30, 2014 was 23.3% versus 22.6% in the comparable 2013 period. We experienced a year-over-year increase in gross margin rate performance driven largely by sales of higher margin headsets and customer mix as North American sales increased as a percentage of revenue, offset, in part, by increased royalties, certain customer credits and a write-off of scrap material.

For the nine months ended September 30, 2014, gross profit as a percentage of net sales increased to 26.5% from 25.5% in the comparable 2013 period driven by an increased penetration of higher margin headsets compared to the shift towards lower-priced models ahead of the new console introductions in the comparable prior period. Excluding the negative impact of

shipping and handling costs entirely related to the Microsoft Xbox One Headset Chat Adapter in connection with the new console release, gross profit as a percentage of net sales would have been 29.4%.

Operating Expenses



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2014		2013		2014		2013
	(in thousands)
Selling and marketing	$	7,962	$	7,665	$	22,660	$	21,783
Research and development	2,797		1,027		6,866		3,239
General and administrative	4,311		1,648		12,582		5,678
Business transaction costs	—		1,607		3,744		2,287
Total operating expenses	$	15,070	$	11,947	$	45,852	$	32,987

Selling and Marketing

Selling and marketing expense for the three months ended September 30, 2014 totaled $8.0 million, or 23.9% as a percentage of net revenues, compared to $7.7 million, or 20.0% as a percentage of net revenues, for the three months ended September 30, 2013. The 3.9% increase was primarily due to incremental costs related to the HyperSound business offset, in part, by lower direct media promotional activity as the comparable quarter included our iSeries media headset marketing campaign.

For the nine months ended September 30, 2014, selling and marketing expense totaled $22.7 million, or 24.1% as a percentage of net revenues, compared to $21.8 million, or 23.6% as a percentage of net revenues, for the prior year period. The increase in expense was primarily due to $1.1 million of incremental costs related to the HyperSound business and additional depreciation costs related to the expansion of interactive retail display kiosks into two large retailers in the fourth quarter of 2013, offset, in part, by lower direct media promotional activity and reduced trade show related costs.

Research and Development

The increase in research and development expenses for the three and nine months ended September 30, 2014 versus the comparable prior-year periods was primarily due to higher costs associated with additional headcount and incremental costs related to our product development efforts for HyperSound-based products.

General and Administrative

The increase in general and administrative expenses for the three and nine months ended September 30, 2014 versus the comparable prior-year periods was primarily due to incremental costs to support being a public company, including additional headcount to build our internal capabilities and higher stock compensation costs, as well as consultant and legal fees in connection with our bank refinancing and merger-related public filings.

Business Transaction

Business transaction expenses for the nine months ended September 30, 2014 related to investment banker success fees of $2.2 million payable upon the close of the merger as well as associated legal and accounting fees. Business transaction expenses of $2.3 million from the nine months ended September 30, 2013 related to due diligence and legal costs incurred in connection with the Merger.

Interest Expense

Interest expense decreased by $1.2 million for the three months ended September 30, 2014, as compared to September 30, 2013, primarily due to lower average borrowings outstanding on our credit facility which was paid down with funds from our equity offering.

Interest expense increased $1.6 million for the nine months ended September 30, 2014 primarily due to the write-off of $2.2 million of unamortized debt issuance costs related to the refinancing of our credit facility on March 31, 2014, additional interest

related to the issuance of the subordinated notes and higher interest rates on the revolver and term loan balance outstanding under our previous credit facility.

Income Taxes

Liquidity and Capital Resources

Our primary source of working capital is cash flow from operations. We have funded operations and acquisitions in recent periods with operating cash flows, proceeds from debt financings and invoice factoring.

The following table summarizes our sources and uses of cash:



	Nine Months Ended
	September 30,
	2014			2013
	(in thousands)
Cash and cash equivalents at beginning of period	$	6,509		$	5,219
Net cash provided by (used for) operating activities	(12,097		)	15,259
Net cash provided by (used for) investing activities	2,146			(4,109		)
Net cash provided by (used for) financing activities	7,886			(11,335		)
Effect of foreign exchange on cash	(28		)	28
Cash and cash equivalents at end of period	$	4,416		$	5,062

Operating activities

Cash used for operating activities for the nine months ended September 30, 2014 was $12.1 million, a decline of $27.4 million as compared to cash provided by operating activities of $15.3 million for the nine months ended September 30, 2013. The year-over-year decrease is primarily the result of lower net income adjusted for non-cash expenses and a reduction in net working capital items, primarily accounts payable payments and accounts receivables, and an increase in deferred taxes related to acquired net operating loss credits.

Investing activities

Cash provided by investing activities was $2.1 million during the nine months ended September 30, 2014 compared to cash used for investing activities of $4.1 million during the nine months ended September 30, 2013, as a result of $4.1 million of cash acquired in the merger. Capital expenditures decreased $2.2 million compared to the prior year period to $1.9 million for the nine months ended September 30, 2014.

Financing activities

Net cash provided by financing activities was $7.9 million during the nine months ended September 30, 2014 compared to net cash used of $11.3 million during the nine months ended September 30, 2013. Financing activities during the nine months ended included $37.2 million of proceeds from the sale of common stock and the issuance of $7.0 million principal amount of subordinated notes partially offset by (i) net payments on our revolving credit facilities of $11.1 million with cash from

operations and funds from our equity offering, (ii) repayment of our $14.5 million legacy term loan and (iii) repayment of $10.8 million of outstanding subordinated notes. The net cash used in the nine months ended September 30, 2013 was primarily due to net repayments of the revolving line of credit and term loan, partially offset by the issuance of $10 million principal amount of subordinated notes.

Management assessment of liquidity

Management believes that its current cash and cash equivalents, proceeds received from the equity offering (see below), and the amounts available under its asset-based credit facility and its cash flows derived from operations will be sufficient to meet anticipated cash needs for working capital and capital expenditures for at least the next 12 months. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity or capital requirements.

On April 24, 2014, we entered into an Underwriting Agreement (the “Underwriting Agreement”) with Needham & Company, LLC, as representative for the several other underwriters named therein, relating to an underwritten public offering (the “Offering”) of 4,000,000 shares of our common stock, at a price to the public of $10.00 per share (the “Offering Price”). Under the terms of the Underwriting Agreement, we also granted the underwriters a 30-day option to purchase up to an additional 600,000 shares of common stock at the Offering Price less the underwriting discount and estimated offering expenses payable by us. We received net proceeds from the Offering of approximately $37.2 million after deducting the underwriting discount and estimated offering expenses. The net proceeds from the Offering were used to repay certain indebtedness, including $10 million then outstanding under the Credit Facility as contemplated upon the occurrence of a public offering, and for working capital and other general corporate purposes.

We may explore additional financing sources to fund expansion, to respond to competitive pressures, to acquire or to invest in complementary products, businesses or technologies, or to lower our cost of capital, which could include equity and debt financings. There can be no guarantee that any additional financing will be available on acceptable terms, if at all. If additional funds are raised through the issuance of equity or convertible debt, existing stockholders could suffer significant dilution, and if we raise additional funds through the issuance of debt securities or other borrowings, these securities or borrowings could have rights senior to common stock and could contain covenants that could restrict operations.

Foreign cash balances at September 30, 2014 and December 31, 2013 were $1.2 million and $1.4 million, respectively.

As of September 30, 2014, we have begun to transition our refurbishing activities from a revenue sharing arrangement in which an authorized third-party refurbished and resold product in exchange for a share of the revenues to a "Fee For Service" arrangement. Under such an arrangement, Turtle Beach, for an agreed upon per unit cost, would designate certain returned product to be refurbished into a saleable condition and resell the product through our own network of dealers and distributors. As a result, the timing of cash flows and write-offs related to our refurbishing activities will differ from the former arrangement, since those items will be recorded upon management's determination of which product to refurbish or to scrap.

Revolving Credit Facility

Turtle Beach is required to pay a commitment fee on the unused revolving loan commitment at a rate ranging from 0.25% to 0.50%, and letter of credit fees and agent fees.

As of September 30, 2014, the Company was in compliance with all financial covenants, and excess borrowing availability was approximately $13.7 million.

Credit Agreement

2013 Amendments

2014 Amendments

Invoice Factoring

Subordinated Notes - Related Party

Series A convertible stock

In conjunction with the Merger, $24.4 million principal amount of the Series A convertible stock was converted into shares of common stock pursuant to an exchange ratio specified in the Merger agreement.

Series B redeemable preferred stock

In September 2010, VTBH issued 1,000,000 shares of its Series B Redeemable Preferred Stock with a fair value of $12.4 million. We are required to redeem the Series B Redeemable Preferred Stock on the earlier to occur of September 28, 2030 or the occurrence of a liquidation event at its original issue price of $12.425371 per share plus any accrued but unpaid dividends. The redemption value was $14.6 million and $13.7 million as of September 30, 2014 and December 31, 2013, respectively.

Critical Accounting Estimates

Our discussion and analysis of our results of operations and capital resources are based on our condensed consolidated financial statements, which have been prepared in conformity with GAAP. The preparation of these condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities,

revenue and expenses and the disclosure of contingent assets and liabilities. Management bases its estimates, assumptions and judgments on historical experience and on various other factors that it believes to be reasonable under the circumstances.

Different assumptions and judgments would change the estimates used in the preparation of the condensed consolidated financial statements, which, in turn, could change the results from those reported. Management evaluates its estimates, assumptions and judgments on an ongoing basis.

There have been no significant changes in the information concerning our critical accounting estimates as stated in Note 2 - Summary of Significant Accounting Policies in our Prospectus Supplement filed with the SEC on April 24, 2014.

See Note 2, “Recently Issued Accounting Pronouncements,” in the Notes to the condensed consolidated financial statements for a complete discussion of recent accounting pronouncements. We are currently evaluating the impact of certain recently issued guidance on our financial condition and results of operations in future periods.

Off-Balance Sheet Arrangements

Off balance sheet arrangements are transactions, agreements, or other contractual arrangements with an unconsolidated entity for which we have an obligation to the entity that is not recorded in the consolidated financial statements. As of September 30, 2014, there are no significant off-balance sheet arrangements.

Contractual Obligations

Our principal commitments primarily consist of obligations for minimum payment commitments to leases for office space, redeemable preferred stock and the revolving credit facility. As of September 30, 2014, the future non-cancelable minimum payments under these commitments were as follows:



	Payments Due by Period
	(in thousands)
	Total		Less Than One Year		1 - 3 Years		3 - 5 Years		More Than Five Years
Contractual Obligations: (1)
Operating lease obligations (2)	$	3,124	$	812	$	1,161	$	1,105	46
Series B redeemable preferred stock (3)	51,928		—		—		—		51,928
Principal payments on long term debt (4)	28,663		28,663		—		—		—
Subordinated notes (5)	7,506		7,506		—		—		—
Total	$	91,221	$	36,981	$	1,161	$	1,105	$	51,974

(1) Contractual obligations exclude tax liabilities of $1.5 million related to uncertain tax positions because we are unable to make a reasonably reliable estimate of the timing of settlement, if any, of these future payments.

(2) Operating lease agreements represent obligations to make payments under non-cancelable lease agreements for its facilities.