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EX-32 - ANDALAY SOLAR EXHIBIT 32 - Andalay Solar, Inc.exhibit_32.htm
EX-31 - ANDALAY SOLAR EXHIBIT 31 - Andalay Solar, Inc.exhibit_31.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

x
 
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2014

or

o
 
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 001-33695

Andalay Solar Logo
Andalay Solar, Inc.
(Exact name of registrant as specified in its charter)

Delaware
90-0181035
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer Identification No.)
 
2071 Ringwood Ave., Unit C, San Jose, CA
95008
(Address of principal executive offices)
(Zip Code)

(408) 402-9400
(Registrant’s telephone number, including area code)

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

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

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. (Check one):

Large accelerated filer  o
 
Accelerated filer  o
 
Non-accelerated filer  o
(Do not check if a smaller reporting company)
Smaller reporting company  x
 

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

As of November 13, 2014, 261,642,775 shares of the issuer’s common stock, par value $0.001 per share, were outstanding (including non-vested restricted shares).


 
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PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
Andalay Solar, Inc.
Condensed Consolidated Balance Sheets
(unaudited)
   
September 30, 2014
   
December 31, 2013
 
Assets
           
Current assets:
           
Cash
  $ 439,396     $ 150,081  
Accounts receivable, net
    140,298       567,523  
Other receivables
    282       21,378  
Inventory
    624,870       786,636  
Prepaid expenses and other current assets
    168,276       317,510  
Total current assets
    1,373,122       1,843,128  
Property and equipment, net
    2,563       13,854  
Patents, net
    1,159,673       1,244,712  
Other assets, net
    149,579       163,711  
Assets of discontinued operations – long-term
    200,000       200,000  
Total assets
  $ 2,884,937     $ 3,465,405  
                 
Liabilities, Redeemable Convertible Preferred Stock and Stockholders’ Deficit
               
Current liabilities:
               
Accounts payable
  $ 3,131,781     $ 4,199,511  
Accrued liabilities
    74,957       89,730  
Accrued warranty
    366,128       344,990  
Deferred revenue
    20,000        
Credit facility
    500,000       500,000  
Capital lease obligations – current portion
          299  
Derivative liability – embedded conversion feature
    165,901       177,927  
Current portion of long-term debt
          129,839  
Convertible notes – short-term
    70,000       60,000  
Liabilities of discontinued operations
    912,776       967,928  
Total current liabilities
    5,241,543       6,470,224  
                 
Convertible notes, less current portion (net of discount)
    645,198       382,084  
Total liabilities
    5,886,741       6,852,308  
                 
Commitments and contingencies (Note 17)
               
                 
Series C convertible redeemable preferred stock, $0.001 par value; 0 and 87 issued and outstanding as of September 30, 2014 and December 31, 2013, respectively
          163,998  
                 
Series D convertible redeemable preferred stock, $0.001 par value; 0 and 860 shares issued and outstanding as of September 30, 2014 and December 31, 2013, respectively
          858,565  
                 
Stockholders’ deficit:
               
Series B convertible redeemable preferred stock, $0.001 par value; 0 and 467 shares issued and outstanding as of September 30, 2014 and December 31, 2013, respectively
          146,224  
Common stock, $0.001 par value; 500,000,000 shares authorized; 249,317,132 and 116,339,293 shares issued and outstanding as of September 30, 2014 and December 31, 2013, respectively
    249,317       116,339  
Additional paid-in capital
    81,429,766       78,717,997  
Accumulated deficit
    (84,680,887 )     (83,390,026 )
Total stockholders’ deficit
    (3,001,804 )     (4,409,466 )
Total liabilities, redeemable convertible preferred stock and stockholders’ deficit
  $ 2,884,937     $ 3,465,405  

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


Andalay Solar, Inc.
Condensed Consolidated Statements of Comprehensive Loss
(Unaudited)

   
Three Months Ended 
September 30,
   
Nine Months Ended 
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
                         
Net revenue
  $ 605,943     $ 156,630     $ 1,055,344     $ 367,870  
Cost of goods sold
    550,630       167,891       982,658       407,359  
        Gross profit (loss)
    55,313       (11,261 )     72,686       (39,489 )
Operating expenses
                               
Sales and marketing
    93,861       201,590       232,577       804,048  
General and administrative
    481,398       595,241       1,622,944       1,816,338  
Total operating expenses
    575,259       796,831       1,855,521       2,620,386  
Loss from continuing operations
    (519,946 )     (808,092 )     (1,782,835 )     (2,659,875 )
Other income (expense)
                               
Interest income (expense), net
    (99,212 )     (1,367 )     (290,171 )     (6,730 )
Adjustment to the fair value of embedded derivatives
    48,607             31,924        
Adjustment to the fair value of common stock warrants
                      9  
Settlement of prior debt owed
                769,148       420,000  
Total other income (expense), net
    (50,605 )     (1,367 )     510,901       413,279  
Loss before provision for income taxes and discontinued operations
    (570,551 )     (809,459 )     (1,271,934 )     (2,246,596 )
Provision for income taxes
                       
Net loss from continuing operations
    (570,551 )     (809,459 )     (1,271,934 )     (2,246,596 )
Net income from discontinued operations, net of tax (Note 3)
          3,200             10,797  
Net loss
    (570,551 )     (806,259 )     (1,271,934 )     (2,235,799 )
Preferred stock dividend
    (83 )     (28,980 )     (18,927 )     (124,509 )
Preferred deemed dividend
          (501,304 )           (875,304 )
Net loss attributable to common stockholders
  $ (570,634 )   $ (1,336,543 )   $ (1,290,861 )   $ (3,235,612 )
                                 
Net loss attributable to common stockholders per common share (basic and diluted)
  $ (0.00 )   $ (0.02 )   $ (0.01 )   $ (0.06 )
                                 
Weighted-average shares used in computing loss per common share:
    240,341,308       81,746,372       188,131,135       56,695,767  
 
The accompanying notes are an integral part of these condensed consolidated financial statements.



 
Andalay Solar, Inc.
Condensed Consolidated Statements of Changes in Redeemable Convertible Preferred Stock and Stockholders’ Deficit
(Unaudited)

   
Series C Convertible Redeemable Preferred Stock
   
Series D Convertible Redeemable Preferred Stock
   
Series B Convertible Redeemable Preferred Stock
   
Common Stock
                   
   
Number of Shares
   
Amount
   
Number of Shares
   
Amount
   
Number of Shares
   
Amount
   
Number of Shares
   
Amount
   
Additional Paid-in Capital
   
Accumulated Deficit
   
Stockholders' Equity (Deficit)
 
Balance as of January 1, 2014
    87     $ 163,998       860     $ 858,565       467     $ 146,224       116,339,293     $ 116,339     $ 78,717,997     $ (83,390,026 )   $ (4,409,466 )
Issuance of common stock pursuant to registration statement
                                        39,864,947       39,865       835,135             875,000  
Issuance of common stock upon conversion of note payable
                                        24,496,404       24,496       470,848             495,344  
Conversion of Series B Convertible Redeemable preferred stock to common stock
                            (467 )     (146,224 )     21,020,015       21,020       125,204              
Conversion of Series C Convertible Redeemable preferred stock to common stock
    (87 )     (163,998 )                             4,333,350       4,333       159,665             163,998  
Conversion of Series D Convertible Redeemable preferred stock to common stock
                (860 )     (858,565 )                 43,000,000       43,000       815,565             858,565  
Convertible Redeemable Preferred Stock dividends paid in common stock
                                        643,520       644       18,283       (18,927 )      
Placement agent and registration fees and other direct costs
                                                    (36,618 )           (36,618 )
Convertible note embedded derivative and warrants: accretion of note to face value
                                                    170,767             170,767  
Grants of restricted stock, net of forfeitures and upon exercise or expiration of warrants
                                        (380,397 )     (380 )     (8,312 )           (8,692 )
Stock-based compensation
                                                    161,232               161,232  
Net loss
                                                          (1,271,934 )     (1,271,934 )
Balance as of September 30, 2014
        $           $           $       249,317,132     $ 249,317     $ 81,429,766     $ (84,680,887 )   $ (3,001,804 )

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

 
 Andalay Solar, Inc.
Condensed Consolidated Statements of Cash Flows
 (Unaudited)
   
 Nine Months Ended September 30,
 
   
2014
   
2013
 
Cash flows from operating activities
           
Net loss
  $ (1,271,934 )   $ (2,235,799 )
Adjustments to reconcile net loss to net cash used in operations:
               
Depreciation
    11,291       27,784  
Amortization
    85,039       83,969  
Bad debt expense
    4,492       89,325  
Unrealized (gain) loss on fair value adjustment of common stock warrants
          (9 )
Unrealized (gain) loss on fair value of embedded derivatives
    (31,924 )      
Accretion of interest on convertible note
    129,414        
Non-cash stock-based compensation expense
    161,232       30,488  
Non-cash settlement of prior debt owed
    (769,148 )      
Accrued interest payable
    66,498        
Changes in assets and liabilities:
               
Accounts receivable
    422,733       242,741  
Other receivables
    21,096       121,948  
Inventory
    161,766       (61,228 )
Prepaid expenses and other current assets
    149,234       196,756  
Assets of discontinued operations – short term
          10,895  
Other assets
    14,132       (1,546 )
Accounts payable
    111,418       1,186,329  
Accrued liabilities and accrued warranty
    10,217       (419,393 )
Deferred revenue
    20,000        
Liabilities of discontinued operations
    (55,152 )     (61,886 )
Net cash used in operating activities
    (759,596 )     (789,626 )
Cash flows from financing activities
               
Borrowing on convertible notes payable
    600,000       201,363  
Repayment of notes payable
    (130,480 )      
Proceeds from equity credit agreement
    625,000        
Borrowing on line of credit
          350,000  
Repayments on capital lease obligations
    (299 )     (3,425 )
Proceeds from convertible redeemable preferred stock offering
          550,000  
Payment of placement agent and registration fees and other direct costs
    (36,618 )     (55,919 )
Employee taxes paid for vesting of restricted stock
    (8,692 )     (302 )
Net cash provided by financing activities
    1,048,911       1,041,717  
Net increase in cash
    289,315       252,091  
Cash
               
Beginning of period
    150,081       127,385  
End of period
  $ 439,396       379,476  

Supplemental cash flows disclosures:
           
Cash paid during the period for interest
  $ 51,667     $ 6,759  
Supplemental disclosure of non-cash financing activity:
               
Conversion of preferred stock to common stock
  $ 1,168,787     $ 1,809,317  
Return of Series D Convertible Preferred Stock
          $ 80,123  
Embedded derivative on convertible note issued
  $ 122,630     $  
Embedded derivative converted to equity
  $ 102,731     $  
Grant of warrants on issue of convertible note
  $ 170,767     $  
Preferred deemed dividend
  $     $ 875,304  
Preferred stock dividends paid in common stock
  $ 18,927     $ 124,509  
Preferred stock issued for payment of financial advisor fees
  $     $ 210,000  
Conversion of convertible note to common stock
  $ 392,612     $  
Common stock issued to settle claim
  $ 250,000     $  
Convertible note issued to financial advisor in exchange for accounts payable
  $ 160,000     $  
 
The accompanying notes are an integral part of these condensed consolidated financial statements.

Andalay Solar, Inc.
Notes to Condensed Consolidated Financial Statements
September 30, 2014
(Unaudited)
 
1. Basis of Presentation and Description of Business

Basis of Presentation — Interim Financial Information

The accompanying condensed consolidated financial statements are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. They should be read in conjunction with the consolidated financial statements and related notes to the consolidated financial statements of Andalay Solar, Inc. (“we”, “us”, “our” or the “Company”), formerly Westinghouse Solar, Inc. and Akeena Solar, Inc., for the years ended December 31, 2013 and 2012 appearing in our Form 10-K. The September 30, 2014 unaudited interim condensed consolidated financial statements included in this Quarterly Report on Form 10-Q have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in annual financial statements filed with our Annual Report on Form 10-K have been condensed or omitted as permitted by those rules and regulations. In the opinion of management, all adjustments, consisting of normal recurring accruals, necessary for a fair statement of the results of operations for the interim periods presented have been reflected herein. The results of operations for interim periods are not necessarily indicative of the results to be expected for the entire year or any future interim period.

Description of Business

We are a designer of solar power systems and solar panels with integrated microinverters (which we call AC solar panels) and a solar power residential installer. We design, market and sell these solar power systems to other solar installers and do-it-yourself customers in the United States, Canada, the Caribbean and South America through distribution partnerships, our dealer network and retail outlets. Our products are designed for use in solar power systems for residential and commercial rooftop customers. We exited the solar power installation business in September 2010, but we have recently re-entered that market.

We were incorporated in February 2001 as Akeena Solar, Inc. in the State of California and elected at that time to be taxed as an S corporation. During June 2006, we reincorporated in the State of Delaware and became a C corporation. On August 11, 2006, we entered into a reverse merger transaction with Fairview Energy Corporation, Inc. (“Fairview”). Pursuant to the Merger, the stockholders of the Company received one share of Fairview common stock for each issued and outstanding share of The Company’s common stock. The Company’s common shares were also adjusted from $0.01 par value to $0.001 par value at the time of the Merger. On May 17, 2010, we entered into an exclusive worldwide license agreement with Westinghouse, Inc, which permitted us to manufacture, distribute and market solar panels under the Westinghouse name and in connection therewith, on April 6, 2011, we changed our name to Westinghouse Solar, Inc. On August 23, 2013, the license agreement with Westinghouse, Inc. was terminated and on September 19, 2013, we changed our name to our current name, Andalay Solar, Inc.

On May 7, 2012, we entered into a merger agreement with CBD Energy Limited, an Australian corporation (“CBD”). We had originally targeted completion of the merger during the third quarter of 2012, however the target date for completion had been repeatedly delayed, and the necessary registration statement had yet to be completed and filed. The uncertainty resulted in a disruption in our supply relationships, leading to a significant decline in our revenue and the implementation of significant cost reductions including the layoff of employees during the time we pursued the merger. Given the continued delays and uncertainty of whether and when the closing conditions for the merger as set for in the merger agreement would be satisfied, we terminated the merger agreement with CBD effective July 18, 2013. We are committed to focus our attention on rebuilding our core business, expanding our current product offerings and exploring strategic opportunities.

2. Significant Accounting Policies

Liquidity and Financial Position

We currently face challenges meeting the working capital needs of our business. Our primary requirements for working capital are to fund purchases for solar panels and microinverters, and to cover our payroll and lease expenses. We have incurred net losses and negative cash flows from operations for the quarter and the nine months ended September 30, 2014, and for each of the years ended December 31, 2013 and 2012. During recent years, we have undertaken several equity and debt financing transactions to provide the


capital needed to sustain our business. We have dramatically reduced our headcount and other variable expenses. As of September 30, 2014, we had approximately $439,000 in cash on hand.  We intend to address ongoing working capital needs through sales of remaining inventory, along with raising additional debt and equity financing.  In January 2013, our board of directors approved actions to dramatically reduce our variable operating costs, including a 12 person employee headcount reduction effective January 15, 2013, for the period through the anticipated merger closing with CBD, which merger was terminated in July 2013. No restructuring charges or severance payments were incurred.  Our revenue levels remain difficult to predict, and we anticipate that we will continue to sustain losses in the near term, and we cannot assure investors that we will be successful in reaching break-even.

During 2012, because of our cash position and liquidity constraints, we were late in making payments to both of our former panel suppliers, Suntech and Lightway. We currently have no unshipped orders from these suppliers. In May 2013, we entered into a new supply agreement for assembly of our proprietary modules with Environmental Engineering Group Pty Ltd (“EEG”), an assembler of polycrystalline modules located in Australia. In August 2013, we began receiving product from EEG and began shipping product to customers during the third calendar quarter of 2013. In September 2013, we entered into a second supply agreement for assembly of our proprietary modules with Tianwei New Energy Co, Ltd., a panel supplier located in China. We began receiving product from Tianwei in February 2014 and stopped as of June 2014. In July 2014, we entered into a supply agreement for assembly of our proprietary modules with Auxin Solar, Inc., a panel supplier located in the United States. We expect to begin receiving product from Auxin in the fourth quarter of 2014. Although we believe we can find alternative suppliers for solar panels manufactured to our specifications, our operations would be disrupted unless we are able to rapidly secure alternative sources of supply, our inventory and revenue could diminish significantly, causing disruption to our operations.

The accompanying consolidated financial statements have been prepared assuming we will continue as a going concern. Our significant operating losses, negative cash flow from operations, and challenges in rapidly securing alternative sources of supply for solar panels, raise substantial uncertainty about our ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty, and contemplate the realization of assets and the settlement of liabilities and commitments in the normal course of business. There can be no assurance that we will be able to raise additional funds on commercially reasonable terms, if at all. There is uncertainty to our anticipated revenue levels and to the timing of cash receipts, which are needed to support our operations. It also worsens the market conditions for seeking equity and debt financing. We currently anticipate that we will retain all of our earnings, if any, for development of our business and do not anticipate paying any cash dividends on common stock in the foreseeable future.

Securities Purchase Agreement

On February 25, 2014, we entered into a securities purchase agreement with a certain institutional accredited investor relating to the sale and issuance of a (i) convertible note in the principal amount of $200,000 that matures February 25, 2016 and (ii) five-year warrant (with a cashless exercise feature under certain circumstances) to purchase 5,000,000 shares of our common stock at an exercise price of $0.02 per share, subject to adjustment under certain circumstances.  On March 18, 2014, we issued under the Securities Purchase Agreement we entered into with the institutional investor on February 25, 2014 a (i) convertible note in the principal amount of $300,000 that matures March 18, 2016 and (ii) five–year warrant (with a cashless exercise feature under certain circumstances) to purchase 7,500,000 shares of our common stock at an exercise price of $0.02 per share, subject to adjustment under certain circumstances.  The convertible notes bears interest at the rate of 8% per annum compounded annually, are payable at maturity and the principal and interest outstanding under the convertible notes are convertible into shares of our common stock, at any time after issuance, at the option of the purchaser, at a conversion price equal to $0.02 per share, subject to adjustment upon the happening of certain events, including stock dividends, stock splits and the issuance of common stock equivalents at a price below the conversion price. Subject to us fulfilling certain conditions, including beneficial ownership limits, the convertible notes are subject to mandatory conversion if the closing price of our common stock for any 20 consecutive days commencing six months after the issue date of the convertible notes equals or exceeds $0.04 per share. Unless waived in writing by the purchaser, no conversion of the convertible notes can be effected to the extent that as a result of such conversion the purchaser would beneficially own more than 9.99% in the aggregate of our issued and outstanding common stock immediately after giving effect to the issuance of common stock upon conversion.
 
Equity Purchase Agreement

On January 23, 2014, we entered into a new Equity Purchase Agreement with Southridge Partners II, LP (“Southridge”), that superseded our prior Equity Purchase Agreement with Southridge that was entered into on November 25, 2013 (the “Prior Equity Purchase Agreement”).  The terms of the new Equity Purchase Agreement are identical to those of the Prior Equity Purchase Agreement other than that the New Equity Purchase Agreement provides that the Agreement may not be amended by either party. Pursuant to the New Equity Purchase Agreement and as provided in the Prior Equity Purchase Agreement, Southridge has committed to purchase up to $5,000,000 worth of our common stock, over a period of time terminating on the earlier of: (i) 18 months from the effective date of the registration statement to be filed by us for the New Equity Purchase Agreement; or (ii) the date on which Southridge has purchased an aggregate maximum purchase price of $5,000,000 pursuant to the New Equity Purchase Agreement;


Southridge’s commitment to purchase our common stock is subject to various conditions, including, but not limited to, limitations based on the trading volume of our common stock. On March 11, 2014, we filed a Registration Statement on Form S-1/A to register 35 million shares of common stock related to our Equity Purchase Agreement with Southridge and on March 21, 2014, the Securities and Exchange Commission declared the Registration Statement effective. On March 26, 2014, we submitted an initial take-down request of $300,000 to Southridge pursuant to the terms of the Equity Purchase Agreement of which partial proceeds of $100,000 was received on March 31, 2014 and $200,000 on April 16, 2014. On April 17, 2014, we issued 8,079,800 shares of our common stock in a Section 3(a) (10) proceeding that generated proceeds in the amount of $250,000 in full settlement of a claim (see Note 17. Commitments and Contingencies). On June 4, 2014, June 18, 2014 and July 8, 2014, we submitted additional take-down requests for $100,000, $100,000 and $125,000, respectively, pursuant to the terms of the Equity Purchase Agreement. We issued a total of 31,760,578 shares of our common stock at an average price of $0.02 per share pursuant to the terms of the Equity Purchase Agreement. We have approximately 2.2 million shares remaining under our effective Form S-1 and available pursuant to the terms of our Equity Purchase Agreement following our take-downs through November 12, 2014.

Settlement of Potential Claims Agreement

On January 22, 2014, we entered into a Settlement of Potential Claims Agreement with ASC Recap LLC (“ASCR”). Pursuant to the Agreement, ASCR has offered to purchase (and in one (1) case has already purchased) approximately $3.7 million of our prior debt owed to four creditors (“Creditors”) for past due services at a substantial discount to face value to which we have agreed to issue to ASCR certain shares of our common stock in a §3(a)(10) 1933 Act proceeding. The shares of our common stock that we have agreed to issue to ASCR in full payment for, and as a release of any debt it purchases from the Creditors, is anticipated to have, upon issuance, a market value equal to approximately 25% of the principal amount of our outstanding debt. In the case of the debt ASCR already purchased from one (1) Creditor, we entered into a Settlement Agreement and Stipulation on February 26, 2014 that was filed with the Circuit Court of the Second Judicial Circuit, Leon County, Florida pursuant to which we agreed, subject to court approval, to issue shares of our common stock that generate proceeds in the amount of $250,000 in full settlement of the claim in the amount of $1,027,705 that ASCR acquired from one Creditor (the value of the stock that we have agreed to issue was two hundred and fifty percent (250%) of the discounted purchase price ASCR paid to purchase the debt from the Creditor, and approximately 25% of the original amount we owed to the Creditor), resulting in a gain on settlement of $769,148, net of expenses. On March 24, 2014, the Circuit Court of the Second Judicial Circuit, Leon County, Florida, approved the §3(a)(10) 1933 Act proceeding and Settlement Agreement and Stipulation and in April 2014, we issued 8,079,800 shares of common stock at an average price of $0.031 for the full settlement of the agreement with ASCR. The stock to be issued by us and the purchase of the debt by ASCR of the remaining three Creditors is subject to the acceptance of offers by the Creditors.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Revenue Recognition

Revenue from sales of products is recognized when: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the sale price is fixed or determinable, and (4) collection of the related receivable is reasonably assured. We recognize revenue when the solar power systems are shipped to the customer.

Cash and Cash Equivalents

We consider all highly liquid investments with maturities of three months or less, when purchased, to be cash equivalents. We maintain cash and cash equivalents which consist principally of demand deposits with high credit quality financial institutions. At certain times, such amounts exceed FDIC insurance limits. We have not experienced any losses on these investments and, as of September 30, 2014 and December 31, 2013, we had no cash equivalents.

Accounts Receivable

Accounts receivable consist of trade receivables. We regularly evaluate the collectibility of our accounts receivable. An allowance for doubtful accounts is maintained for estimated credit losses, and such losses have historically been minimal and within our expectations. We consider a number of factors when estimating credit losses, including the aging of a customer’s account, creditworthiness of specific customers, historical trends and other information.



Discontinued Operations

Discontinued operations are presented and accounted for in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 360, “Impairment or Disposal of Long-Lived Assets,” (“ASC 360”). When a qualifying component of the Company is disposed of or has been classified as held for sale, the operating results of that component are removed from continuing operations for all periods presented and displayed as discontinued operations if: (a) elimination of the component’s operations and cash flows from the Company’s ongoing operations has occurred (or will occur) and (b) significant continuing involvement by the Company in the component’s operations does not exist after the disposal transaction.

On September 10, 2010, we announced that we were exiting the solar panel installation business. The exit from the installation business was essentially completed by the end of 2010, other than potential warranty payments related to past installations. (See “Manufacturer and Installation Warranties”). The exit from the installation business was therefore classified as discontinued operations for all periods presented under the requirements of ASC 360.

Manufacturer and Installation Warranties

The manufacturer directly warrants the solar panels and inverters for a range from 15 to 25 years. We warrant the balance of system components of our products against defects in material and workmanship for five years. We assist our customers in the event of a claim under the manufacturer warranty to replace a defective solar panel or inverter. The warranty liability for the material and the workmanship of the balance of system components of approximately $366,000 as of September 30, 2014 and $345,000 as of December 31, 2013, is included within “Accrued warranty” in the accompanying consolidated balance sheets.

The liability for our manufacturing warranty consists of the following:
   
September 30, 2014
   
December 31, 2013
 
Beginning accrued warranty balance
  $ 344,990     $ 329,680  
Reduction for labor payments and claims made under the warranty
          (4,400 )
Accruals related to warranties issued during the period
    21,138       19,710  
Ending accrued warranty balance
  $ 366,128     $ 344,990  

We previously recorded a provision for warranty liability related to our discontinued installation operations. We provided for a 5-year or a 10-year warranty on the installation of a system and all equipment and incidental supplies other than solar panels and inverters that are covered under the manufacturer warranty. The liability for the installation warranty of approximately $913,000 as of September 30, 2014 and $968,000 as of December 31, 2013 is included within “Liabilities of Discontinued Operations” in the accompanying condensed consolidated balance sheets. Defective solar panels or inverters are covered under the manufacturer warranty. In the event that a panel or inverter needs to be replaced, we will replace the defective item within the manufacturer’s warranty period (between 5 – 25 years).

Patent Costs

We capitalize external legal costs and filing fees associated with obtaining or defending our patents. Upon issuance of new patents or successful defense of existing patents, we amortize these costs using the straight line method over the shorter of the legal life of the patent or its economic life. We believe the remaining useful life we assign to these patents, approximately 10.25 years as of September 30, 2014, are reasonable. We periodically review our patents to determine whether any such cost have been impaired and are no longer being used. To the extent we are no longer using certain patents, the associated costs will be written off at that time.

Significant Accounting Policies and Estimates

There have been no material developments or changes to the significant accounting policies discussed in our 2013 Annual Report on Form 10-K or accounting pronouncements issued or adopted, except as described below.

Recent Accounting Pronouncements

In May 2014, as part of its ongoing efforts to assist in the convergence of U.S. GAAP and International Financial Reporting Standards (“IFRS”), the FASB issued Accounting Standard Update (“ASU”) 2014-09, “Revenue from Contracts with Customers.” The new guidance sets forth a new five-step revenue recognition model which replaces the prior revenue recognition guidance in its entirety and is intended to eliminate numerous industry-specific pieces of revenue recognition guidance that have historically existed in U.S. GAAP. The underlying principle of the new standard is that a business or other organization will recognize revenue to depict the


transfer of promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. The standard also requires more detailed disclosures and provides additional guidance for transactions that were not addressed completely in the prior accounting guidance. The ASU provides alternative methods of initial adoption and is effective for annual and interim periods beginning after December 15, 2016. We are currently evaluating the impact that this standard will have on our consolidated financial statements.
 
In June 2014, the FASB issued ASU No. 2014-12, "Compensation – Stock Compensation: Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could be Achieved After a Requisite Service Period" ("ASU 2014-12") Companies commonly issue share-based payment awards that require a specific performance target to be achieved in order for employees to become eligible to vest in the awards. ASU 2014-12 requires that a performance target that affects vesting and that could be achieved after the requisite service period should be treated as a performance condition. The performance target should not be reflected in estimating the grant date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved. ASU 2014-12 will be effective for the Company's fiscal years beginning fiscal 2016 and interim reporting periods within that year, using either the retrospective or prospective transition method. Early adoption is permitted. We are currently evaluating the effect of the adoption of this guidance on the condensed consolidated financial statements.

In August 2014, the FASB issued ASU No. 2014-15, "Presentation of Financial Statements – Going Concern: Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern" ("ASU 2014-15"), to provide guidance on management's responsibility in evaluating whether there is substantial doubt about a company's ability to continue as a going concern and to provide related footnote disclosures. ASU 2014-15 is effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. Since ASU 2014-15 only impacts financial statement disclosure requirements regarding whether there is substantial doubt about an entity's ability to continue as a going concern, we do not expect its adoption to have an impact on our consolidated financial statements.

3. Discontinued Operations

On September 10, 2010, we announced that we were exiting the solar panel installation business and we were expanding our distribution business to include sales of our Andalay Solar Power Systems directly to dealers in California. The exit from the installation business was essentially completed by the end of 2010. The assets and liabilities of discontinued operations are presented separately under the captions “Assets of discontinued operations,” “Liabilities of discontinued operations” and “Long-term liabilities of discontinued operations,” respectively, in the accompanying condensed consolidated balance sheets as of September 30, 2014 and December 31, 2013, and consist of the following:

Assets of discontinued operations:
 
September 30, 2014
   
December 31,
2013
 
Security deposit – escrow account for installation jobs
  $ 200,000     $ 200,000  
Total assets of discontinued operations
  $ 200,000     $ 200,000  


Liabilities of discontinued operations:
 
September 30, 2014
   
December 31, 2013
 
Accrued warranty
  $ 912,775     $ 967,928  
Total current liabilities
  $ 912,775     $ 967,928  

We entered into a Supply and Warranty Agreement and Master Assignment Agreement with Real Goods Solar, Inc. (“Real Goods”), pursuant to which Real Goods has agreed to perform certain warranty work. The terms of the agreement provide that an escrow account be established as a source of funds from which to satisfy our obligation to pay Real Goods for its fees and reimburse it for its expenses for this warranty work. In March 2011, we entered into an Escrow Agreement with Real Goods and deposited $200,000 into an escrow account. The amount is reflected in long-term assets of discontinued operations in the balance sheet. The escrow deposit will be released to us in the amount of $40,000, or one-fifth of the remaining escrow funds, per year after each of the fifth through the ninth anniversary of the escrow agreement.

4. Accounts Receivable

Accounts receivable consists of the following:
 
   
September 30, 2014
   
December 31,
 2013
 
Trade accounts
  $ 157,388     $ 575,375  
Less: Allowance for bad debts
    (7,391 )     (2,899 )
Less: Allowance for returns
    (9,699 )     (4,953 )
    $ 140,298     $ 567,523  

The following table summarizes the allowance for doubtful accounts as of September 30, 2014 and December 31, 2013:

   
Balance at Beginning of Period
   
Provisions, net
   
Write-Off/
Recovery
   
Balance at End of Period
 
Nine months ended September 30, 2014
  $ 2,899     $ 4,492     $     $ 7,391  
Year ended December 31, 2013
  $ 108,750     $ 92,224     $ (198,325 )   $ 2,899  



5. Inventory

Inventory consists of the following:

   
September 30, 2014
   
December 31,
 2013
 
Finished goods
  $ 593,255     $ 654,970  
Work in process
    31,615       131,666  
    $ 624,870     $ 786,636  

Included in inventory as of December 31, 2013, is a $5,000 credit related to a pricing adjustment from a supply agreement.

Inventory is stated at the lower of cost (on an average basis) or market value. We determine cost based on our weighted-average purchase price and include both the costs of acquisition and the shipping costs in our inventory. We regularly review the cost of inventory against its estimated market value and record a lower of cost or market write-down to cost of goods sold, if any inventory has a cost in excess of estimated market value.

6. Property and Equipment, Net

Property and equipment, net consist of the following:
   
September 30, 2014
   
December 31,
 2013
 
Office equipment
  $ 436,051     $ 436,051  
Leasehold improvements
    123,278       123,278  
Vehicles
    17,992       17,992  
      577,321       577,321  
Less: Accumulated depreciation and amortization
    (574,758 )     (563,467 )
    $ 2,563     $ 13,854  

Depreciation expense for the three months ended September 30, 2014 and 2013 was approximately $3,000 and $8,000, respectively. Depreciation expense for the nine months ended September 30, 2014 and 2013 was approximately $11,000 and $28,000, respectively.

7. Accrued Liabilities
 
Accrued liabilities consist of the following:
   
September 30, 2014
   
December 31,
 2013
 
Accrued salaries, wages, benefits and bonus
  $ 39,988     $ 45,456  
Sales tax payable
          4,409  
Accrued accounting and legal fees
    16,050        
Customer deposit payable
    8,500       580  
Accrued interest
    2,436       6,288  
Other accrued liabilities
    7,983       32,997  
    $ 74,957     $ 89,730  
 
8. Convertible Notes Payable and Credit Facility

Convertible Notes Payable

On August 30, 2013, we entered into a securities purchase agreement with certain institutional accredited investors relating to the sale and issuance of a convertible note in the principal amount of $200,000 that matures August 29, 2015 (the "Convertible Note").  Subsequently, on November 25, 2013 and December 19, 2013, we entered into additional securities purchase agreements with the same institutional accredited investors relating the sale and issuance of convertible notes in the principal amount of $200,000 and $250,000, respectively, which mature on November 25, 2015 and December 19, 2015. On January 27, 2014, we issued a convertible note in the principal amount of $100,000 that matures January 27, 2016 under the Securities Purchase Agreement we entered into with an accredited investor on December 19, 2013. In connection with the issuance of the December 19, 2013 convertible note, we also


issued 6,250,000 warrants to purchase shares of our common stock at a price of $0.02 per share. On February 25, 2014, we entered into a Securities Purchase Agreement with the same accredited investor related to the sale and issuance of a convertible note in the principal amount of $200,000 that matures February 25, 2016. In connection with the issuance of the February 25, 2014 convertible note, we issued 5,000,000 warrants to purchase shares of our common stock at a price of $0.02 per share. On March 18, 2014, we issued a convertible note in the principal amount of $300,000 that matures March 18, 2016 under the Securities Purchase Agreement we entered into with an accredited investor on February 25, 2014. In connection with the issuance of the March 18, 2013 convertible note, we also issued 7,500,000 warrants to purchase shares of our common stock at a price of $0.02 per share. Each of the Convertible Notes bear interest at the rate of 8% per annum compounded annually, are payable at maturity and the principal and interest outstanding under the convertible notes are convertible into shares of our common stock, at any time after issuance, at the option of the purchaser, at a conversion price equal to $0.02 per share, subject to adjustment upon the happening of certain events, including stock dividends, stock splits and the issuance of common stock equivalents at a price below the conversion price. Subject to our fulfilling certain conditions, including beneficial ownership limits, the convertible notes are subject to a mandatory conversion if the closing price of our common stock for any 20 consecutive days commencing six months after the issue date of the convertible notes equal or exceeds $0.04. Unless waived in writing by the purchaser, no conversion of the convertible notes can be effected to the extent that as a result of such conversion the purchaser would beneficially own more than 9.99% in the aggregate of our issued and outstanding common stock immediately after giving effect to the issuance of common stock upon conversion.
 
We have the option of repaying the outstanding principal amount of the convertible notes, in whole or in part, by paying the purchaser a sum of money equal to one hundred and twenty percent (120%) of the principal together with accrued but unpaid interest upon 30 days notice, subject to certain beneficial ownership limits. For so long as we have any obligation under the convertible notes, we have agreed to certain restrictions regarding, among other things, incurrence of additional debt, liens, amendments to charter documents, repurchase of stock, payment of cash dividends, affiliated transactions. We are also prohibited from entering into certain variable priced agreements until the convertible notes are repaid in full.

Because of certain down-round protection in the conversion rate of the convertible notes, we determined that the derivative liability related to the embedded conversion feature met the criteria for bifurcation. Accordingly, we recognized an aggregate liability of approximately $123,000 on the three issuance dates during the nine months ended September 30, 2014. This was in addition to the carrying value of the derivative liability on three previously recorded derivatives of approximately $178,000. The derivative liability is carried at fair value with changes in the fair value reflected in the “Adjustment to the fair value of embedded derivatives” line item of our condensed consolidated statements of operations. We recognized a non-cash benefit for the three months ended September 30, 2014 of approximately $49,000 and a non-cash benefit for the nine months ended September 30, 2014 of approximately $32,000 on a total of six convertible notes.

In addition, the relative fair value of the warrants issued in the December 2013 convertible note issuance of $250,000, were allocated to additional paid-in capital. Such value was determined assuming volatility of 149.1%, a risk free interest rate of 0.7% and an expected term of 4.1 years. The resulting debt discount from the derivative liability and warrant issuance of $109,000 is being accreted to interest using the effective interest method. The relative fair value of the warrants issued in the February 2014 convertible note issuance of $200,000, were allocated to additional paid-in capital. Such value was determined assuming volatility of 169.1, a risk free interest rate of 0.7% and an expected term of 4.1 years. The resulting debt discount from the derivative liability and warrant issuance of $101,000 is being accreted to interest using the effective interest method. The relative fair value of the warrants issued in the March 2014 convertible note issuance of $300,000, were allocated to additional paid-in capital. Such value was determined assuming volatility of 168.8%, a risk free interest rate of 0.8% and an expected term of 4.1 years. The resulting debt discount from the derivative liability and warrant issuance of $154,000 is being accreted to interest using the effective interest method.

On November 1 and December 1, 2013, and on January 1, February 1 and March 1, 2014, we issued convertible notes to our financial advisory firm in the principal amount of $30,000 each for a total of $150,000, which mature on October 31, November 30 and December 31, 2014, and on January 31 and February 28, 2015, respectively. On April 1, May 1 and June 1, 2014, we issued convertible notes to our financial advisory firm in the principal amount of $20,000 each, for a total of $60,000, which mature on March 31, April 30 and May 31, 2015, respectively. On July 1, 2014, we issued convertible notes to our financial advisory firm in the principal amount of $10,000, which matures on June 15, 2015. Each of the Convertible Notes bear interest at the rate of 8% per annum compounded annually, are payable at maturity and the principal and interest outstanding under the convertible notes are convertible into shares of our common stock, at any time after issuance, at the option of the purchaser, at a conversion price equal to $0.02. Unless waived in writing by the purchaser, no conversion of the convertible notes can be effected to the extent that as a result of such conversion the purchaser would beneficially own more than 9.99% in the aggregate of our issued and outstanding common stock immediately after giving effect to the issuance of common stock upon conversion. As of September 30, 2014, convertible notes in the principal amount of $460,000, along with accrued interest of $27,153, were converted into 24,496,404 shares of our common stock.
 
Below is a table showing the convertible notes payable, the embedded conversion feature and fair value of the warrants as of September 30, 2014 and December 31, 2013:

   
September 30, 2014
   
December 31, 2013
 
Convertible notes payable cash proceeds
  $ 940,000     $ 650,000  
Convertible notes payable issued for financial advisory services 
    70,000       60,000  
Less: Derivative liability
    (250,615 )     (243,889 )
Less: Relative fair value of warrants
    (200,795 )     (53,623 )
Accreted interest
    106,286       21,889  
Accrued interest
    50,322       7,707  
Convertible notes payable, net
    715,198       442,084  
Less current portion
    (70,000 )     (60,000 )
    $ 645,198     $ 382,084  
 
Line of Credit

On September 30, 2013, we entered into a loan and security agreement with Alpha Capital Anstalt and Collateral Services, LLC (“Alpha Capital” or “the lender”) to provide financing, on a discretionary basis, for one year, against our accounts receivable and inventory.  The maximum amount that can be borrowed under the Agreement is $500,000. We have the right to borrow up to 80% of our eligible accounts receivable, not in excess of $200,000, 50% of the value of our raw materials in inventory, 65% of our finished goods inventory and 95% of cash, but not in the aggregate amount in excess of $300,000.  The advances are secured by a lien on all of our assets. All advances under the agreement bear interest at a per annum rate of 12% and monthly interest shall be a minimum of $500. At the time of initial funding we paid a loan fee of 50 shares of our Series D Preferred Shares to the lender, in addition to other payments for legal fees. In addition, we paid the collateral agent an initial fee of $5,000 and have agreed to pay an administrative fee to the collateral agent of 0.5% per month of the daily balance during the preceding month or $500 whichever is less. In the event that of a prepayment, we are obligated to pay a prepayment fee in an amount equal to one-half of one percent (0.5%) of $500,000. On September 30, 2013, we requested and received an initial borrowing under the Agreement totaling $350,000. Subsequently, on October 21, 2013, we requested and received an additional $100,000 and on November 20, 2013, we requested and received an additional $50,000. As of September 30, 2014, the balance outstanding under our line of credit was $500,000. The Loan and Security Agreement was amended to provide for an extension of the expiration date from September 30, 2014 to December 31, 2014.

9. Stockholders’ Deficit
 
We have 501,000,000 shares of capital stock authorized under our certificate of incorporation, consisting of 500,000,000 shares of common stock and 1,000,000 shares of preferred stock. As of September 30, 2014, we have authorized (i) 2,000 shares of Series A Convertible Preferred Stock, par value $0.001, (ii) 4,000 shares of Series B 4% Convertible Preferred Stock, par value $0.001, (iii) 1,175 shares of our Series C 8% Convertible Preferred Stock, par value $0.001, and (iv) 1,180 shares of our Series D 8% Convertible Preferred Stock, par value $0.001. All preferred stock has been converted or cancelled and none remain outstanding

On March 11, 2014, we filed a Registration Statement on Form S-1/A to register 35 million shares of common stock related to our Equity Purchase Agreement with Southridge and on March 21, 2014, the Securities and Exchange Commission declared the Registration Statement effective. On March 26, 2014, we submitted an initial take-down request of $300,000 to Southridge pursuant to the terms of the Equity Purchase Agreement of which partial proceeds of $100,000 was received on March 31, 2014 and $200,000 on April 16, 2014. On April 17, 2014, we issued 8,079,800 shares of our common stock in a Section 3(a) (10) proceeding that generated proceeds in the amount of $250,000 in full settlement of a claim (see Note 17. Commitments and Contingencies). On June 4, 2014, June 18, 2014 and July 8, 2014, we submitted additional take-down requests for $100,000, $100,000 and $125,000, respectively, pursuant to the terms of the Equity Purchase Agreement. We issued a total of 31,760,578 shares of our common stock at an average price of $0.02 per share pursuant to the terms of the Equity Purchase Agreement. We have approximately 3.2 million shares remaining under our effective Form S-1 and available pursuant to the terms of our Equity Purchase Agreement following our take-downs through August 11, 2014.

Pursuant to the terms of our Equity Purchase Agreement, a placement fee of 1 million shares of unregistered common stock was due to Southridge pursuant to the terms of the Equity Purchase Agreement. As of March 31, 2014, we issued 500,000 shares of unregistered common stock due upon the declaration of effectiveness of our Form S-1/A by the Securities and Exchange Commission of our Form S-1/A. In April 2014, we issued the remaining 500,000 shares of unregistered common stock to Southridge upon the completion of our initial take-down request under the Equity Purchase Agreement. The sales of the above securities were deemed to be exempt from registration under the Securities Act in reliance upon Section 4(a) (2) of the Securities Act as transactions by an issuer not involving any public offering. The recipients of the securities in each of these transactions represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were placed upon the stock certificates issued in these transactions.


10. Convertible Redeemable Preferred Stock and Preferred Deemed Dividend

On October 18, 2012, we entered into a securities purchase agreement with certain institutional accredited investors relating to the sale and issuance of up to 1,245 shares of our newly created Series C Preferred Stock, for aggregate proceeds of up to $1,245,000.  At the initial closing, we sold and issued 750 shares of Series C Preferred, for initial aggregate proceeds of $750,000. On November 2, 2012, we provided to the purchasers of our Series C Preferred Stock a draw down notice under the Purchase Agreement. As a result of the draw down, we sold an aggregate of 350 additional shares of our Series C Preferred to the purchasers for aggregate proceeds of $350,000.  Based on the closing price of our common stock as reported on the OTCQB Marketplace (OTCQB) on November 2, 2012 (which was $0.08 per share), the 350 shares of Series C Preferred issued pursuant to the draw down was convertible into 4,375,000 shares of our common stock. As a result of the contingent conversion feature on the Series C Preferred, which reduced the conversion price from $0.155 to $0.08 per share on the total 750 shares of Series C Preferred Stock issued and outstanding at November 2, 2012, and which resulted in an increase in the number of common shares issuable, we recognized a preferred deemed dividend of $363,000.

On January 24, 2013, we provided to the purchasers of our Series C Preferred Stock a draw down notice under the purchase agreement. The purchasers agreed to accept the new draw down notice and thereby extend our right to exercise a “put” to sell additional Series C Preferred beyond the securities purchase agreement’s prior expiration date of December 31, 2012. As a result of the draw down, we sold an aggregate of 75 additional shares of Series C Preferred to the purchasers for aggregate proceeds of $75,000. Based on the closing price of our common stock as reported on the OTCQB Marketplace on January 24, 2013 (which was $0.05 per share), the 75 shares of Series C Preferred to be issued pursuant to the draw down would be convertible into 1,500,000 shares of our common stock. As a result of the contingent conversion feature on the Series C Preferred, which reduced the conversion price from $0.08 to $0.05 per share on the total 720 shares of Series C Preferred Stock issued and outstanding at January 24, 2013, and which resulted in an increase in the number of common shares issuable, we recognized additional preferred deemed dividends of $270,000.

As a result of the January 24, 2013 draw down notice, the conversion price of the Series C Preferred issued under the initial closing was reduced from $0.08 per share of common stock to become equal to $0.05. As a result of the May 13, 2013 draw down notice, the conversion price of the Series C Preferred was further reduced from $0.05 per share of common stock to $0.03 per share. As a result of our August 30, 2013 financing, the conversion price of the Series C Preferred was further reduced from $0.03 per share of common stock to $0.02 per share.

On February 15, 2013, we entered into a securities purchase agreement with an institutional accredited investor relating to the sale and issuance of up to 1,180 shares of our newly created Series D Preferred Stock at a price per share equal to the stated value, which is $1,000 per share, for aggregate proceeds of up to $1,000,000. At the initial closing, concurrent with entering the agreement, we issued 150 shares of Series D Preferred, for initial aggregate proceeds of $150,000. After the initial closing, the securities purchase agreement permits the purchaser to exercise a “call” right to purchase additional Series D Preferred in multiple draw downs from time to time until December 31, 2013, subject to certain limits, terms and conditions. In March 2013, the Company and investors entered into a letter agreement to the securities purchase agreement dated as of February 15, 2013, modifying the number of shares of Series D Preferred Stock to be issued upon settlement of any purchaser draw downs made on or after March 18, 2013, equal to the purchaser investment amount divided by the stated value multiplied by a number agreed upon by the Company and the purchaser, which shall not be higher than $1.67.  Subsequently, on March 21, 2013, we issued 167 shares of Series D Preferred for aggregate proceeds of $100,000. On May 13, 2013, the Company and investors entered into a letter agreement amendment to the securities purchase agreement dated as of February 15, 2013, modifying the number of shares of Series D Preferred Stock that may be issued upon draw downs made on or after May 13, 2013, equal to the purchaser investment amount divided by the stated value multiplied by a number agreed upon by the Company and the purchaser, which shall not be higher than $3.34. The corresponding conversion price into underlying shares of our common stock was $0.03 per share. On May 13, 2013, we issued 583 shares of Series D Preferred to an investor for aggregate proceeds of $175,000. As a result of the contingent conversion feature on the Series C Preferred, which reduced the conversion price from $0.05 to $0.03 per share on the total 260 shares of Series C Preferred Stock issued and outstanding as of May 13, 2013, and which resulted in an increase in the number of common shares issuable, we recognized additional preferred deemed dividends of $104,000. On August 30, 2013, we entered into an agreement to sell $200,000 in convertible notes. As a result of the sale of these convertible notes and as a result of the contingent conversion feature on the Series C Preferred and Series D Preferred, which reduced the conversion price from $0.03 to $0.02 per share on the Series C and from $0.10 to $0.02 per share on the Series D on the total 147 shares and 930 shares, respectively, of Series C Preferred Stock and Series D Preferred Stock issued and outstanding as of August 30, 2013, and which resulted in an increase in the number of common shares issuable, we recognized additional preferred deemed dividends of $36,000 on the Series C Preferred Stock and $465,000 on the Series D Preferred Stock. The net loss attributable to common shareholders reflects both the net loss and the deemed dividend. As a result of the $500,000 loan and security agreement entered into on September 30, 2013, we issued to the lender 50 shares of our Series D Preferred stock for the $50,000 loan origination fee.


During the nine months ended September 30, 2014, the remaining 467 shares of Series B Preferred Stock were converted into 21,020,015 shares of common stock, the remaining 87 shares of Series C Preferred Stock were converted into 4,333,350 shares of common stock and the remaining 860 shares of Series D Preferred Stock were converted into 43,000,000 shares of common stock.

See Note 12 for a discussion of the accounting treatment of the stock warrant transactions described above.

11. Stock Option Plan and Stock Incentive Plan
 
On August 8, 2006, we adopted the Akeena Solar, Inc. 2006 Stock Incentive Plan (the “Stock Plan”) pursuant to which shares of common stock are available for issuance to employees, directors and consultants under the Stock Plan as restricted stock and/or options to purchase common stock. The Stock Plan allows for issuance of up to 50,000,000 shares and there were 45,593,221 shares available for issuance under the Stock Plan as of September 30, 2014.

Restricted stock and options to purchase common stock may be issued under the Stock Plan. The restriction period on restricted stock grants generally expires at a rate of 25% per year over four years, unless decided otherwise by our Compensation Committee. Options to purchase common stock generally vest and become exercisable as to one-third of the total amount of shares subject to the option on each of the first, second and third anniversaries from the date of grant. Options to purchase common stock generally have a 5-year term.

We use the Black-Scholes-Merton Options Pricing Model (“Black-Scholes”) to estimate fair value of our employee and our non-employee director stock-based awards. Black-Scholes requires various judgmental assumptions, including estimating stock price volatility, expected option life and forfeiture rates. If we had made different assumptions, the amount of our deferred stock-based compensation, stock-based compensation expense, gross margin, net loss and net loss per share amounts could have been significantly different. We believe that we have used reasonable methodologies, approaches and assumptions to determine the fair value of our common stock, and that our deferred stock-based compensation and related amortization were recorded properly for accounting purposes. If any of the assumptions we used change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

We measure compensation expense for non-employee stock-based compensation under ASC 505-50, “Equity-Based Payments to Non-Employees.” The fair value of the option issued is used to measure the transaction, as this is more reliable than the fair value of the services received. The estimated fair value is measured utilizing Black-Scholes using the value of our common stock on the date that the commitment for performance by the counterparty has been reached or the counterparty’s performance is complete (generally the vesting date). The fair value of the equity instrument is charged directly to expense and additional paid-in capital.

We recognized stock-based compensation expense of approximately $50,000 and $107,000 during the three months ended September 30, 2014 and 2013, respectively, and we recognized stock-based compensation expense of approximately $321,000 and $240,000 during the nine months ended September 30, 2014 and 2013, respectively, relating to compensation expense calculated based on the fair value at the time of grant for restricted stock and based on Black-Scholes for stock options granted under the Stock Plan. Stock-based compensation expense for the three and nine months ended September 30, 2014, included $10,000 and $160,000, respectively, related to the issuance of convertible notes for our financial advisor.

The following table sets forth a summary of restricted stock activity for the nine months ended September 30, 2014:

   
Number of Restricted Shares
   
Weighted-Average Grant Date
Fair Value
 
Outstanding and not vested beginning balance as of January 1, 2014
    1,890,952     $ 0.05  
Granted
        $  
Forfeited/cancelled
        $  
Released/vested
    (1,883,766 )   $ 0.04  
Outstanding and not vested as of September 30, 2014
    7,186     $ 2.16  

Restricted stock is valued at the grant date fair value of the common stock and expensed over the requisite service period or vesting period. We estimate forfeitures when recognizing stock-based compensation expense for restricted stock, and the estimate of forfeitures is adjusted over the requisite service period should actual forfeitures differ from such estimates. As of September 30, 2014, there was approximately $10,000 of unrecognized stock-based compensation expense associated with the grants of unvested restricted stock. Stock-based compensation expense relating to these restricted shares is being recognized over a weighted-average period of 0.4 years. The total fair value of shares vested during the nine months ended


September 30, 2014 and 2013, was approximately $43,000 and $700, respectively. Tax benefits resulting from tax deductions in excess of the compensation cost recognized (excess tax benefits) are classified as financing cash flows on our condensed consolidated statements of cash flows. During the three and nine months ended September 30, 2014 and 2013, there were no excess tax benefits relating to restricted stock and therefore there is no impact on the accompanying condensed consolidated statements of cash flows.

The following table sets forth a summary of stock option activity for the nine months ended September 30, 2014:

   
Number of Shares Subject to Option
   
Weighted-Average Exercise Price
 
Outstanding as of January 1, 2014
    6,618,233     $ 0.11  
Granted
    15,450,000     $ 0.02  
Forfeited/cancelled/expired
    (17,500 )   $ (6.62 )
Exercised
        $  
Outstanding as of September 30, 2014
    22,050,733     $ 0.04  
Exercisable as of September 30, 2014
    2,333,983     $ 0.21  

Stock options are valued at the estimated fair value grant date or the measurement date and expensed over the requisite service period or vesting period. The weighted-average volatility was based upon the historical volatility of our common stock price. There were no stock options issued during the three and nine month period ended September 30, 2013. The fair value of stock option grants during the three and nine months ended September 30, 2014 was estimated using the Black-Scholes option-pricing model with the following assumptions:

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Weighted-average volatility
    212.8 %           197.6 %      
Expected dividends
    0.0 %           0.0 %      
Expected life
    4.5             4.2        
Weighted-average risk-free interest rate
    1.5 %           1.3 %      

The weighted-average remaining contractual term for the stock options outstanding (vested and expected to vest) and exercisable as of September 30, 2014 and December 31, 2013, was 4.5 years and 4.7 years, respectively. The total estimated fair value of stock options vested during the nine months ended September 30, 2014 and 2013 was approximately $29,000 and $45,000, respectively. The aggregate intrinsic value of stock options outstanding as of September 30 2014 was zero.

We estimate forfeitures when recognizing stock-based compensation expense for stock options and the estimate of forfeitures is adjusted over the requisite service period should actual forfeitures differ from such estimates. As of September 30, 2014 and December 31, 2013, there was approximately $341,000 and $81,000, respectively, of unrecognized stock-based compensation expense associated with stock options granted. Stock-based compensation expense relating to these stock options is being recognized over a weighted-average period of 3.2 years. Tax benefits resulting from tax deductions in excess of the compensation cost recognized (excess tax benefits) is classified as financing cash flows on our consolidated statements of cash flows. During the three and nine months ended September 30, 2014, there were no excess tax benefits relating to stock options and therefore there is no impact on the accompanying consolidated statements of cash flows.

12. Stock Warrants and Warrant Liability

During March 2009, in connection with an equity financing, we issued Series E Warrants to purchase 334,822 shares of common stock at an exercise price of $5.36 per share. The fair value of the warrants was estimated using Black-Scholes with the following weighted average assumptions: risk-free interest rate of 2.69%, an expected life of five years; an expected volatility factor of 112% and a dividend yield of 0.0%. The value assigned to these warrants was approximately $1.0 million, of which $1.0 million was reflected as common stock warrant liability with an offset to additional paid-in capital as of the offering close date. The fair value of the warrants decreased to zero as of December 31, 2013.

On December 19, 2013 and February 25, 2014, we entered into securities purchase agreements with certain institutional accredited investors relating to the sale and issuance of a (i) convertible notes in the principal amount of $250,000, $200,000 and $300,000 that mature on December 19, 2015, February 25, 2016 and March 19, 2016, respectively and (ii) five- year warrants (with a cashless exercise feature under certain circumstances) to purchase 6,250,000, 5,000,000 and 7,500,000 shares, respectively, of our common


stock at an exercise price of $0.02 per share, subject to adjustment under certain circumstances. See Note 8 for further discussion of the issuance of the convertible note.

The following table summarizes the warrant activity for the nine months ended September 30, 2014:

   
Warrants for Number of Shares
   
Weighted-Average Exercise Price
 
Outstanding as of December 31, 2013
    9,648,045     $ 0.49  
Issued
    12,500,000       0.02  
Exercised
           
Cancelled/expired
           
Outstanding as of September 30, 2014
    22,148,045     $ 0.23  

The majority of our warrants outstanding are not exercisable for nine months from the date of issuance and are exercisable for either 4.5 years or 5 years thereafter. Our outstanding warrants expire on various dates between December 2014 and March 2019.

13. Earnings Per Share

On January 1, 2009, we adopted ASC 260 (formerly Financial Accounting Standards Board Staff Position (“FSP”) Emerging Issues Task Force (“EITF 03-6-1”) (“ASC 260”), Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (the “Staff Position”), which states that unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents are considered participating securities and shall be included in the computation of net income (loss) per share pursuant to the two-class method described in ASC 260 (formerly Statement of  Financial Accounting Standards (“SFAS”) No. 128), Earnings Per Share.
 
 
In accordance with the ASC 260, basic net income (loss) per share is computed by dividing net income (loss), excluding net income (loss) attributable to participating securities, by the weighted average number of shares outstanding less the weighted average unvested restricted shares outstanding. Diluted net income (loss) per share is computed by dividing net income (loss), excluding net income (loss) attributable to participating securities, by the denominator for basic net income (loss) per share and any dilutive effects of stock options, restricted stock, convertible notes and warrants.

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Basic:
                       
Numerator:
                       
Net loss
  $ (570,551 )   $ (806,259 )   $ (1,271,934 )   $ (2,235,799 )
Preferred deemed dividend and preferred stock dividend
    (83 )     (530,284 )     (18,927 )     (999,813 )
Less: Net loss allocated to participating securities
    598       169       5,975       801  
    $ (570,036 )   $ (1,336,374 )   $ (1,284,886 )   $ (3,234,811 )
Denominator:
                               
Weighted-average shares outstanding
    240,593,277       81,763,478       189,005,946       56,716,084  
Weighted-average unvested restricted shares outstanding
    (251,969 )     (17,106 )     (874,811 )     (20,317 )
Denominator for basic net loss per share
    240,341,308       81,746,372       188,131,135       56,695,767  
                                 
Basic net loss per share attributable to common stockholders
  $ (0.00 )   $ (0.02 )   $ (0.01 )   $ (0.06 )



The following table sets forth potential shares of common stock at the end of each period presented that are not included in the calculation of diluted net loss per share because to do so would be anti-dilutive:

   
September 30, 2014
   
September 30, 2013
 
Stock options outstanding
    22,050,733       268,704  
Unvested restricted stock
    7,186       16,889  
Warrants to purchase common stock
    22,148,045       3,398,045  
Preferred stock convertible into common stock
          89,353,584  
 
14. Concentration of Risk

Financial instruments that potentially subject us to credit risk are comprised of cash and cash equivalents, which are maintained at high quality financial institutions. As of September 30, 2014 and December 31, 2013, we had no deposits in excess of the Federal Deposit Insurance Corporation limit of $250,000.

Supplier Relationships

Historically, we obtained virtually all of our solar panels from Suntech and Lightway. During 2012, because of our cash position and liquidity constraints, we were late in making payments to both of these suppliers. On March 30, 2012, pursuant to our Supply Agreement with Lightway, we issued 1,900,000 shares of our common stock to Lightway in partial payment of our past due account payable to them. At the time of issuance, the shares were valued at $1,045,000. On May 1, 2012, Suntech filed a complaint for breach of contract, goods sold and delivered, account stated and open account against us in the Superior Court of the State of California, County of San Francisco. Suntech alleged that it delivered products and did not receive full payment from us. On July 31, 2012, we and Suntech entered into a settlement of this dispute. Because of our inability to make scheduled settlement payments, on March 15, 2013, Suntech entered a judgment against us in the amount of $946,438. As of September 30, 2014, Suntech has not sought to enforce its judgment. As of September 30, 2014, we have included in accounts payable in our Condensed Consolidated Balance Sheets a balance due to Suntech America of $946,438. We currently have no unshipped orders from Suntech or Lightway.

In May 2013, we entered into a new supply agreement for assembly of our proprietary modules with Environmental Engineering Group Pty Ltd (“EEG”), an assembler of polycrystalline modules located in Australia. In August 2013, we began receiving product from EEG and began shipping product to customers during the third calendar quarter of 2013. In September 2013, we entered into a second supply agreement for assembly of our proprietary modules with Tianwei New Energy Co, Ltd. (“Tianwei”), a panel supplier located in China. We began receiving product from Tianwei in February 2014 and stopped as of June 2014. In July 2014, we entered into a supply agreement for assembly of our proprietary modules with Auxin Solar, Inc., a panel supplier located in the United States. We expect to begin receiving product from Auxin in the fourth quarter of 2014. Although we believe we can find alternative suppliers for solar panels manufactured to our specifications, our operations would be disrupted unless we are able to rapidly secure alternative sources of supply, our inventory and revenue could diminish significantly, causing disruption to our operations.

Customer Relationships

The relative magnitude and the mix of revenue from our largest customers have varied significantly quarter to quarter. During the nine months ended September 30, 2014, six customers have accounted for significant revenues, varying by period, to our company: Smart Energy Today (“Smart Energy”), which specializes in helping home owners and business owners become more energy efficient, WDC Solar, Inc. (“WDC”), a leading construction, integration and installation of commercial, residential and utility scale solar installations in the Washington D.C. area, JCF Wholesale (“JCF”) a provider of residential and commercial electrical services in Southern California, Sustainable Environmental Enterprises (“SEE”), a leading provider of renewable energy and development projects located in New Orleans, Louisiana, PROSOL, S.A. Total (“PROSOL”) an international solar installation company and Starwood Vacation Ownership, Inc. (“Starwood”), a leading international vacation ownership/timeshare company. For the nine months ended September 30, 2014, the percentages of sales of our top six customers are as follows:
 
   
Nine Months Ended September 30,
 
   
2014
   
2013
 
Smart Energy Today
    13.5 %      
WDC Solar, Inc.
    14.7 %      
JCF Wholesale
    10.6 %      
Sustainable Environmental Enterprises
    1.6 %     28.3 %
PROSOL S.A. Total
          19.1 %
Starwood Vacation Ownership, Inc.,
          12.4 %



The percentage of our gross accounts receivable for our top six customers as of September 30, 2014 and December 31, 2013, are as follows:

   
September 30, 2014
   
December 31, 2013
 
Smart Energy Today
           
WDC Solar, Inc.
    60.7 %      
JCF Wholesale
          2.4 %
Sustainable Environmental Enterprises
          86.7 %
PROSOL S.A. Total
           
Starwood Vacation Ownership, Inc.,
          0.2 %

We maintain reserves for potential credit losses and such losses, in the aggregate, have generally not exceeded management’s estimates. Our top three vendors accounted for approximately 31% and 41% of purchases as of September 30, 2014 and December 31, 2013, respectively. As of September 30, 2014 and December 31, 2013, accounts payable included amounts owed to our top three suppliers of approximately $959,000 and $1.1 million, respectively.

15. Fair Value Measurement

We use a fair-value approach to value certain assets and liabilities. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. We use a fair value hierarchy, which distinguishes between assumptions based on market data (observable inputs) and an entity’s own assumptions (unobservable inputs). The hierarchy consists of three levels:

Level one — Quoted market prices in active markets for identical assets or liabilities;
   
Level two — Inputs other than level one inputs that are either directly or indirectly observable; and
   
Level three — Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a market participant would use.

Determining which category an asset or liability falls within the hierarchy requires significant judgment. We evaluate our hierarchy disclosures each quarter. Assets and liabilities measured at fair value on a recurring basis are summarized as follows:

Liabilities
 
Level 1
   
Level 2
   
Level 3
   
September 30, 2014
 
Fair value of derivative liability – embedded conversion feature
  $     $     $ 165,901     $ 165,901  
Total
  $     $     $ 165,901     $ 165,901  
                                 
                                 
Liabilities
 
Level 1
   
Level 2
   
Level 3
   
December 31, 2013
 
Fair value of derivative liability – embedded conversion feature
  $     $     $ 177,927     $ 177,927  
Total
  $     $     $ 177,927     $ 177,927  

On August 30, 2013, November 25, 2013, December 19, 2013, January 27, 2014, February 25, 2014, and March 18, 2014 we entered into securities purchase agreements relating to the sale and issuance of convertible notes in the principal amounts of $200,000, $200,000, $250,000, $100,000, $200,000 and $300,000. Each of the Convertible Notes are convertible into shares of our common stock, at any time after issuance, at the option of the purchaser, at a conversion price equal to $0.02 per share, subject to adjustment upon the happening of certain events, including stock dividends, stock splits and the issuance of common stock equivalents at a price below the conversion price. Subject to our fulfilling certain conditions, including beneficial ownership limits, the convertible notes are subject to a mandatory conversion if the closing price of our common stock for any 20 consecutive days commencing six months after the issue date of the convertible notes equal or exceeds $0.04 per share. The terms of the convertible notes meet the criteria for the bifurcation of an embedded derivative. Therefore, we recorded the fair value of the embedded derivative liability as of the issuance date for each of the convertible notes for an aggregate fair value of $366,519.

We use a model based on Monte Carlo simulation to value the embedded conversion feature of our notes payable that are subject to


fair value liability accounting. The determination of the fair value as of the reporting date is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, expected stock price volatility over the term of the security and risk-free interest rate. In addition, the model uses multiple Monte Carlo simulations requiring the input of an expected life for the securities for which we have estimated and expectations of the timing and amount of future financing we may require. The fair value of the embedded conversion feature liability is revalued each balance sheet date utilizing our Monte Carlo simulation-based model computations with the decrease or increase in fair value being reported in the statement of comprehensive loss as other income or expense, respectively. The primary factors affecting the fair value of the embedded conversion feature liability are our stock price and volatility. In addition, the use of a Monte Carlo simulation-based model requires the input of highly subjective assumptions, and other reasonable assumptions could provide differing results.

Our reported net loss was $1.3 million for the nine months ended September 30, 2014. If the closing stock price of our common stock had been 10% lower, our net loss would have been approximately $17,000 lower. If the closing stock price of our common stock had been 10% higher, our net loss would have been approximately $22,000 higher. If our volatility assumption on September 30, 2014 had been 10% lower, our net loss would have been approximately $22,000 lower and if our volatility assumption had been 10% higher, our net loss would have been approximately $19,000 higher.

The following table shows the changes in Level 3 liabilities measured at fair value on a recurring basis for the nine months ended September 30, 2014:
 
   
Derivative Liability – Embedded Conversion Feature
   
Total Level 3
 
Beginning balance – January 1, 2014
  $ 177,927     $ 177,927  
Issuances
    122,630       122,630  
Conversions     (102,731 )      
Total realized and unrealized gains or losses
    (31,925 )     (134,656 )
Ending balance – September 30, 2014
  $ 165,901     $ 165,901  

16. Income Taxes
 
Deferred income taxes arise from timing differences resulting from income and expense items reported for financial account and tax purposes in different periods. A deferred tax asset valuation allowance is recorded when it is more likely than not that deferred tax assets will not be realized. During the three and nine months ended September 30, 2014, there was no income tax expense or benefit for federal and state income taxes in the accompanying condensed consolidated statements of operations due to our net loss and a valuation allowance on the resulting deferred tax asset. Our deferred tax asset has a 100% valuation allowance.

17. Commitments and Contingencies

Litigation

On February 21, 2014, ASCR filed with the Circuit Court of the Second Judicial Circuit, Leon County, Florida (the “Court”) an amended complaint and demand for payment of the debt it acquired from one of our creditors.  On February 26, 2014, we entered  into a Settlement Agreement and Stipulation with ASCR that was filed with the Court pursuant to which we agreed, subject to court approval,  to issue shares of our common stock in a Section 3(a) (10) proceeding that generate proceeds in the amount of $250,000 in full settlement of a claim in the amount of $1,027,705 that ASCR acquired form one Creditor (the value of the stock that we  agreed to issue was two hundred and fifty percent (250%) of the discounted purchase price ASCR paid to purchase the debt from the Creditor, and approximately 25% of the original amount we owed to the Creditor), resulting in settlement of prior debt owed of $769,148.  On March 24, 2014, the Circuit Court of the Second Judicial Circuit, Leon County, Florida, approved the §3(a)(10) 1933 Act proceeding and Settlement Agreement and Stipulation and in April 2014, we issued 8,079,800 shares of common stock at an average price of $0.031 for the full settlement of the agreement with ASCR.

On May 1, 2012, Suntech America, Inc., a Delaware corporation (“Suntech America”), filed a complaint for breach of contract, goods sold and delivered, account stated and open account against us in the Superior Court of the State of California, County of San Francisco. Suntech America alleged that it delivered products and did not receive full payment from us. On July 31, 2012, we and Suntech entered into a settlement of this dispute. Because of our inability to make scheduled settlement payments, on March 15, 2013, Suntech entered a judgment against us in the amount of $946,438. As of September 30, 2014, Suntech has not sought to enforce its judgment. As of September 30, 2014, we have included in our condensed consolidated balance sheets a balance due to Suntech America of $946,438.
 


We are also involved in other litigation from time to time in the ordinary course of business. In the opinion of management, the outcome of such proceedings will not materially affect our financial position, results of operations or cash flows.

18. Subsequent Events

On October 23, 2014, we submitted a take-down request for approximately $51,000 pursuant to the terms of the Equity Purchase Agreement. We issued a total 4,214,853 shares of our common at an average price of $0.012 per share pursuant to the terms of the Equity Purchase Agreement. As of November 12, 2014, 2,528,912 of those shares have been sold at an average price of $0.012 per share, resulting in total proceeds of approximately $30,000.
 
Subsequent to September 30, 2014, $150,000 in notes payable and $9,626 in accrued interest was converted into 8,110,790 shares of common stock.


Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

All references to the “Company,” “we,” “our,” and “us” refer to Andalay Solar, Inc. and its subsidiaries (“Andalay Solar”).
 
The following discussion highlights what we believe are the principal factors that have affected our financial condition and results of operations as well as our liquidity and capital resources for the periods described. This discussion should be read in conjunction with our financial statements and related notes appearing elsewhere in this Quarterly Report and in our Annual Report on Form 10-K. This discussion contains “forward-looking statements,” including but not limited to expectations regarding revenue growth, net sales, gross profit, operating expenses and performance objectives, and statements using the terms “believes,” “expects,” “will,” “could,” “plans,” “anticipates,” “estimates,” “predicts,” “intends,” “potential,” “continue,” “should,” “may,” or the negative of these terms or similar expressions. These forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from those expressed or implied by these forward-looking statements. Such risks and uncertainties include, without limitation, the risks described below in Item 1A. of Part II of this Quarterly Report. Further information on potential risk factors that could affect our future business and financial results and financial condition can be found in our periodic filings with the Securities and Exchange Commission (the “SEC”). We undertake no obligation to update any of these forward-looking statements.

Company Overview

We are a designer of solar power systems and solar panels with integrated microinverters (which we call AC solar panels) and a solar power residential installer. We design, market and sell these solar power systems to other solar installers and do-it-yourself customers in the United States, Canada, the Caribbean and South America through distribution partnerships, our dealer network and retail outlets. Our products are designed for use in solar power systems for residential and commercial rooftop customers. We exited the solar power installation business in September 2010, but we have recently re-entered that market.

In September 2007, we introduced our “plug and play” solar panel technology (under the brand name “Andalay”), which we believe significantly reduces the installation time and costs, and provides superior reliability and aesthetics, when compared to other solar panel mounting products and technology. Our panel technology offers the following features: (i) mounts closer to the roof with less space in between panels; (ii) no unsightly racks underneath or beside panels; (iii) built-in wiring connections; (iv) approximately 70% fewer roof-assembled parts and approximately 50% less roof-top labor required; (v) approximately 25% fewer roof attachment points; (vi) complete compliance with the National Electric Code and UL wiring and grounding requirements. We have five U.S. patents (Patent No. 7,406,800, Patent No. 7,832,157, Patent No. 7,866,098, Patent No. 7,987,614 and Patent No. 8,505,248) that cover key aspects of our Andalay solar panel technology, as well as U.S. Trademark No. 3481373 for registration of the mark “Andalay.” In addition to these U.S. patents, we have 7 foreign patents. Currently, we have 12 issued patents and 15 other pending U.S. and foreign patent applications that cover the Andalay technology working their way through the USPTO and foreign patent offices.

In February 2009, we announced a strategic relationship with Enphase, a leading manufacturer of microinverters, to develop and market solar panel systems with ordinary AC house current output instead of high voltage DC output. We introduced Andalay AC panel products and began offering them to our customers in the second quarter of 2009. Andalay AC panels cost less to install, are safer, and generally provide higher energy output than ordinary DC panels. Andalay AC panels deliver 5-25% more energy compared to ordinary panels, produce safe household AC power, and have built-in panel level monitoring, racking, wiring, grounding and microinverters. With 80% fewer parts and 5 – 25% better performance than ordinary DC panels, we believe Andalay AC panels are an ideal solution for solar installers and do-it-yourself customers.

As a result of our announced exit from the solar panel installation business, our installation business has been reclassified in our financial statements as discontinued operations. The exit from the installation business was essentially completed by the end of the fourth quarter of 2010.

Concentration of Risk

Financial instruments that potentially subject us to credit risk are comprised of cash and cash equivalents, which are maintained at high quality financial institutions. As of September 30, 2014 and December 31, 2013, we had no deposits in excess of the Federal Deposit Insurance Corporation limit of $250,000.

Supplier Relationships

In May 2013, we entered into a new supply agreement for assembly of our proprietary modules with Environmental Engineering Group Pty Ltd (“EEG”), an assembler of polycrystalline modules located in Australia. In August 2013, we began receiving product from EEG and began shipping product to customers during the third calendar quarter of 2013. In September 2013, we entered into a


second supply agreement for assembly of our proprietary modules with Tianwei New Energy Co, Ltd. (“Tianwei”), a panel supplier located in China. We began receiving product from Tianwei in February 2014 and stopped as of June 2014. In July 2014, we entered into a supply agreement for assembly of our proprietary modules with Auxin Solar, Inc., a panel supplier located in the United States. We expect to begin receiving product from Auxin in November 2014. Although we believe we can find alternative suppliers for solar panels manufactured to our specifications, our operations would be disrupted unless we are able to rapidly secure alternative sources of supply, our inventory and revenue could diminish significantly, causing disruption to our operations.

Historically, we obtained virtually all of our solar panels from Suntech and Lightway. During 2012, because of our cash position and liquidity constraints, we were late in making payments to both of these suppliers. On March 30, 2012, pursuant to our Supply Agreement with Lightway, we issued 1,900,000 shares of our common stock to Lightway in partial payment of our past due account payable to them. At the time of issuance, the shares were valued at $1,045,000. On May 1, 2012, Suntech filed a complaint for breach of contract, goods sold and delivered, account stated and open account against us in the Superior Court of the State of California, County of San Francisco. Suntech alleged that it delivered products and did not receive full payment from us. On July 31, 2012, we and Suntech entered into a settlement of this dispute. Because of our inability to make scheduled settlement payments, on March 15, 2013, Suntech entered a judgment against us in the amount of $946,438. As of September 30, 2014, Suntech has not sought to enforce its judgment. As of September 30, 2014, we have included in accounts payable in our Condensed Consolidated Balance Sheets a balance due to Suntech America of $946,438. We currently have no unshipped orders from Suntech or Lightway.

Customer Relationships

The relative magnitude and the mix of revenue from our largest customers have varied significantly quarter to quarter. During the nine months ended September 30, 2014, six customers have accounted for significant revenues, varying by period, to our company: Smart Energy Today (“Smart Energy”), which specializes in helping home owners and business owners become more energy efficient, WDC Solar, Inc. (“WDC”), a leading construction, integration and installation of commercial, residential and utility scale solar installations in the Washington D.C. area, JCF Wholesale (“JCF”) a provider of residential and commercial electrical services in Southern California, Sustainable Environmental Enterprises (“SEE”), a leading provider of renewable energy and development projects located in New Orleans, Louisiana, PROSOL, S.A. Total (“PROSOL”) an international solar installation company and Starwood Vacation Ownership, Inc. (“Starwood”), a leading international vacation ownership/timeshare company. For the nine months ended September 30, 2014, the percentages of sales of our top six customers are as follows:
 
   
Nine Months Ended September 30,
 
   
2014
   
2013
 
Smart Energy Today
    13.5 %      
WDC Solar, Inc.
    14.7 %      
JCF Wholesale
    10.6 %      
Sustainable Environmental Enterprises
    1.6 %     28.3 %
PROSOL S.A. Total
          19.1 %
Starwood Vacation Ownership, Inc.,
          12.4 %

The percentage of our gross accounts receivable for our top six customers as of September 30, 2014 and December 31, 2013, are as follows:

   
September 30, 2014
   
December 31, 2013
 
Smart Energy Today
           
WDC Solar, Inc.
    60.7 %      
JCF Wholesale
          2.4 %
Sustainable Environmental Enterprises
          86.7 %
PROSOL S.A. Total
           
Starwood Vacation Ownership, Inc.,
          0.2 %

We maintain reserves for potential credit losses and such losses, in the aggregate, have generally not exceeded management’s estimates. Our top three vendors accounted for approximately 31% and 41% of purchases as of September 30, 2014 and December 31, 2013, respectively. As of September 30, 2014 and December 31, 2013, accounts payable included amounts owed to our top three suppliers of approximately $959,000 and $1.1 million, respectively.



Three Months Ended September 30, 2014 as Compared to Three Months Ended September 30, 2013

Results of Operations

The following table sets forth, for the periods indicated, certain information related to our operations, expressed in dollars and as a percentage of net revenue:

   
Three Months Ended September 30,
 
   
2014
   
2013
 
Net revenue
  $ 605,943       100.0 %   $ 156,630       100.0 %
Cost of goods sold
    550,630       90.9 %     167,891       107.2 %
        Gross profit (loss)
    55,313       9.1 %     (11,261 )     (7.2 )%
Operating expenses
                               
Sales and marketing
    93,861       15.5 %     201,590       128.7 %
General and administrative
    481,398       79.4 %     595,241       380.0 %
Total operating expenses
    575,259       94.9 %     796,831       508.7 %
Loss from continuing operations
    (519,946 )     (85.8 )%     (808,092 )     (515.9 )%
Other income (expense)
                               
Interest (expense), net
    (99,212 )     (16.4 )%     (1,367 )     (0.9 )%
Adjustment to the fair value of embedded derivatives
    48,607       8.0 %           0.0 %
Adjustment to the fair value of common stock warrants
          0.0 %           0.0 %
Settlement of prior debt owed
          0.0 %           0.0 %
Total other expense, net
    (50,605 )     (8.4 )%     (1,367 )     (0.9 )%
Loss before provision for income taxes and discontinued operations
    (570,551 )     (94.2 )%     (809,459 )     (516.8 )%
Provision for income taxes
          0.0 %           0.0 %
Net loss from continuing operations (Note 3)
    (570,551 )     (94.2 )%     (809,459 )     (516.8 )%
Net income (loss) from discontinued operations, net of tax
          0.0 %     3,200       2.0 %
Net loss
    (570,551 )     (94.2 )%     (806,259 )     (514.8 )%
Preferred stock dividend
    (83 )     (0.0 )%     (28,980 )     (18.5 )%
Preferred deemed dividend
          0.0 %     (501,304 )     (506.2 )%
Net loss attributable to common stockholders
  $ (570,634 )     (94.2 )%   $ (1,336,543 )     (1,309.5 )%
                                 
Net loss attributable to common stockholders per common share (basic and diluted)
  $ (0.00 )           $ (0.02 )        
                                 
Weighted-average shares used in computing loss per common share (basic and diluted)
    240,341,308               81,746,372          
 
Net Revenue

We generate revenue from the sale of solar power systems. For the three months ended September 30, 2014, we generated $606,000 of revenue, an increase of $449,000, or 286.9%, compared to $157,000 of revenue for the three months ended September 30, 2013. The increase in revenue was due to an increase in watts sold, partially offset by a decrease in our average selling price per watt.

Cost of Goods Sold

Cost of goods sold as a percent of revenue for the three months ended September 30, 2014, was 90.9% of net revenue, compared to 107.2% for the three months ended September 30, 2013. Gross profit for the three months ended September 30, 2014 was $55,000, or 9.1% of revenue, compared to gross loss of $11,000 or 7.2% of revenue for the same period in 2013. The increase in gross margin in the three months ended September 30, 2014 compared to the three months ended September 30, 2013, was due to lower solar module costs and lower inventory overhead allocations due to increase in revenue.


Sales and Marketing Expenses

Sales and marketing expenses for the three months ended September 30, 2014 were $94,000, or 15.5% of net revenue as compared to $202,000, or 128.7% of net revenue during the same period of the prior year. The $108,000 decrease in sales and marketing expenses for the three months ended September 30, 2014 compared to the same period in 2013 was primarily due to decreases in licensing fees owed to Westinghouse Electric Corporation of $138,000, partially offset by an increase in $27,000 in payroll and commission expense. The decrease in licensing fees was due to the termination of the licensing agreement with Westinghouse Electric and the decrease in stock compensation expense was due expense recognized in the prior year for convertible notes issued to our financial advisory firm. The increase in payroll costs was due to higher headcount.

General and Administrative Expenses

General and administrative expenses for the three months ended September 30, 2014 were $481,000, or 79.4% of net revenue as compared to $595,000, or 380.0% of net revenue during the same period of the prior year. The decrease in general and administrative expense for the three months ended September 30, 2014 compared to the same period in 2013, was due primarily to decreases in stock compensation expense of $59,000, rent expense of $29,000, patent filing fees of $20,000, bad debt expense of $17,000, and insurance of $13,000, partially offset by an increase in payroll and benefits of $48,000. The decrease in stock compensation expense was due to the timing of restricted stock and stock option grants. The decrease in rent and insurance was due to the consolidation of our administrative offices with our warehouse. The decrease in professional fees was primarily due to the timing of our annual meeting. The decrease in patent filing fees was due to the filing of patents in the prior year. The increase in payroll and benefits expense was due to higher headcount.

Interest Expense, Net

During the three months ended September 30, 2014, net interest expense was approximately $99,000 compared with net interest expense of $1,000 for the same period in 2013. The increase in interest expense was associated with the increase in notes payable and convertible debt.

Adjustment to the Fair Value of Embedded Derivatives

During the three months ended September 30, 2014, we recorded mark-to-market adjustments to reflect the fair value of embedded derivatives, resulting in an unrealized gain of approximately $49,000.
 
Income Taxes

During the three months ended September 30, 2014 and 2013, there was no income tax expense or benefit for federal and state income taxes reflected in our condensed consolidated statements of operations due to our net loss and a valuation allowance on the resulting deferred tax asset.

Net Loss from Continuing Operations

Net loss from continuing operations for the three months ended September 30, 2014 was $571,000, compared to a net loss from continuing operations of $809,000 for the three months ended September 30, 2013.

Net Income (Loss) from Discontinued Operations

As a result of the exit from the installation business on September 7, 2010, we recorded net income of $3,000 from the discontinuance of our installation business segment for the three months ended September 30, 2013.



Nine Months Ended September 30, 2014 as Compared to Nine Months Ended September 30, 2013

Results of Operations

The following table sets forth, for the periods indicated, certain information related to our operations, expressed in dollars and as a percentage of net revenue:
 
   
Nine Months Ended September 30,
 
   
2014
   
2013
 
Net revenue
  $ 1,055,344       100.0 %   $ 367,870       100.0 %
Cost of goods sold
    982,658       93.1 %     407,359       110.7 %
        Gross profit (loss)
    72,686       6.9 %     (39,489 )     (10.7 )%
Operating expenses
                               
Sales and marketing
    232,577       22.0 %     804,048       218.6 %
General and administrative
    1,622,944       153.8 %     1,816,338       493.7 %
Total operating expenses
    1,855,521       175.8 %     2,620,386       712.3 %
Loss from continuing operations
    (1,782,835 )     (168.9 )%     (2,659,875 )     (723.0 )%
Other income (expense)
                               
Interest (expense), net
    (290,171 )     (27.5 )%     (6,730 )     (1.8 )%
Adjustment to the fair value of embedded derivatives
    31,924       3.0 %           0.0 %
Adjustment to the fair value of common stock warrants
          0.0 %     9       0.0 %
Settlement of prior debt owed
    769,148       72.9 %     420,000       114.2 %
Total other expense, net
    510,901       48.4 %     413,279       112.3 %
Loss before provision for income taxes and discontinued operations
    (1,271,934 )     (120.5 )%     (2,246,596 )     (610.7 )%
Provision for income taxes
          0.0 %           0.0 %
Net loss from continuing operations (Note 3)
    (1,271,934 )     (120.5 )%     (2,246,596 )     (610.7 )%
Net income (loss) from discontinued operations, net of tax
          0.0 %     10,797       2.9 %
Net loss
    (1,271,934 )     (120.5 )%     (2,235,799 )     (607.8 )%
Preferred stock dividend
    (18,927 )     (1.8 )%     (124,509 )     (33.8 )%
Preferred deemed dividend
          0.0 %     (875,304 )     (237.9 )%
Net loss attributable to common stockholders
  $ (1,290,861 )     (122.3 )%   $ (3,235,612 )     (879.6 )%
                                 
Net loss attributable to common stockholders per common share (basic and diluted)
  $ (0.01 )           $ (0.06 )        
                                 
Weighted-average shares used in computing loss per common share (basic and diluted)
    188,131,135               56,695,767          
 
Net Revenue

We generate revenue from the sale of solar power systems. For the nine months ended September 30, 2014, we generated $1,055,000 of revenue, an increase of $687,000, or 186.9%, compared to $368,000 of revenue for the nine months ended September 30, 2013. The increase in revenue was due to an increase in watts sold, partially offset by a decrease in our average selling price per watt.

Cost of Goods Sold

Cost of goods sold as a percent of revenue for the nine months ended September 30, 2014, was 93.1% of net revenue, compared to 110.7% for the nine months ended September 30, 2013. Gross profit for the nine months ended September 30, 2014 was $73,000, or 6.9% of revenue, compared to gross loss of $39,000 or 10.7% of revenue for the same period in 2013. The increase in gross margin in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, was due to lower solar module costs and lower inventory overhead allocations due to increase in revenue.


Sales and Marketing Expenses

Sales and marketing expenses for the nine months ended September 30, 2014 were $233,000, or 22.0% of net revenue as compared to $804,000, or 218.6% of net revenue during the same period of the prior year. The $571,000 decrease in sales and marketing expenses for the nine months ended September 30, 2014 compared to the same period in 2013 was primarily due to decreases in licensing fees owed to Westinghouse Electric Corporation of $638,000, partially offset by an increase in $30,000 in stock compensation expense. The decrease in licensing fees was due to the termination of the licensing agreement with Westinghouse Electric. The increase in stock compensation expense was due to grants of restricted stock to certain sales and marketing employees.

General and Administrative Expenses

General and administrative expenses for the nine months ended September 30, 2014 were $1.6 million, or 153.8% of net revenue as compared to $1.8 million, or 493.7% of net revenue during the same period of the prior year. The decrease in general and administrative expense for the nine months ended September 30, 2014 compared to the same period in 2013, was due primarily to a decrease in rent expense of $85,000, a decrease in bad debt expense of $85,000 and a decrease in insurance expense of $72,000, partially offset by increases in payroll and benefits of $108,000, stock compensation expense of $51,000, professional fees of $35,000 and recruitment fees of $33,000. The decrease in bad debt was primarily due to an increase in bad debt in the prior year and the decrease in insurance and rent expense was due to the consolidation of our administrative offices with our warehouse. The increase in stock compensation, payroll and benefits and recruitment fees was primarily due to expenses incurred in the replacement of our CEO. The increase in professional fees was primarily due to an increase in accounting fees.

Interest Expense, Net

During the nine months ended September 30, 2014, net interest expense was approximately $290,000 compared with net interest expense of $7,000 for the same period in 2013. The increase in interest expense was associated with the increase in notes payable and convertible debt.

Adjustment to the Fair Value of Embedded Derivatives

During the nine months ended September 30, 2014, we recorded mark-to-market adjustments to reflect the fair value of embedded derivatives, resulting in an unrealized gain of approximately $32,000.
 
Adjustment to the Fair Value of Common Stock Warrants

During the nine months ended September 30, 2013, we recorded mark-to-market adjustments to reflect the fair value of outstanding common stock warrants accounted for as a liability, resulting in an unrealized gain of $9.

Settlement of Prior Debt Owed

During the nine months ended September 30, 2014, we recorded a gain in other income of $769,000 as a result of a favorable settlement on a prior debt owed to a creditor.

Income Taxes

During the nine months ended September 30, 2014 and 2013, there was no income tax expense or benefit for federal and state income taxes reflected in our condensed consolidated statements of operations due to our net loss and a valuation allowance on the resulting deferred tax asset.

Net Loss from Continuing Operations

Net loss from continuing operations for the nine months ended September 30, 2014 was $1.3 million, compared to a net loss from continuing operations of $2.2 million for the nine months ended September 30, 2013.

Net Income (Loss) from Discontinued Operations

As a result of the exit from the installation business on September 7, 2010, we recorded net income of $11,000 from the discontinuance of our installation business segment for the nine months ended September 30, 2013.



Liquidity and Capital Resources

We currently face challenges meeting the working capital needs of our business. Our primary requirements for working capital are to fund purchases for solar panels and microinverters, and to cover our payroll and lease expenses. For the nine months ended September 30, 2014 and for each of the two years in the period ended December 31, 2013, we have incurred net losses and negative cash flows from operations. During the recent years, we have undertaken several equity and debt financing transactions to provide the capital needed to sustain our business. We have dramatically reduced our headcount and other variable expenses. As of September 30, 2014, we had approximately $439,000 in cash on hand.  We intend to address ongoing working capital needs through sales of products, along with raising additional debt and equity financing.  In January 2013, our board of directors approved actions to dramatically reduce our variable operating costs, including a 12 person employee headcount reduction effective January 15, 2013, for the period through the anticipated merger closing with CBD, which merger was terminated in July 2013. No restructuring charges or severance payments were incurred.  Our revenue levels remain difficult to predict, and we anticipate that we will continue to sustain losses in the near term, and we cannot assure investors that we will be successful in reaching break-even.

During 2012, because of our cash position and liquidity constraints, we were late in making payments to both of our former panel suppliers, Suntech and Lightway. We currently have no unshipped orders from these suppliers. In May 2013, we entered into a new supply agreement for assembly of our proprietary modules with Environmental Engineering Group Pty Ltd (“EEG”), an assembler of polycrystalline modules located in Australia. In August 2013, we began receiving product from EEG and began shipping product to customers during the third calendar quarter of 2013. In September 2013, we entered into a second supply agreement for assembly of our proprietary modules with Tianwei New Energy Co, Ltd. (“Tianwei”), a panel supplier located in China. We began receiving product from Tianwei in February 2014 and stopped as of June 2014. In July 2014, we entered into a supply agreement for assembly of our proprietary modules with Auxin Solar, Inc., a panel supplier located in the United States. We expect to begin receiving product from Auxin in the fourth quarter of 2014. Although we believe we can find alternative suppliers for solar panels manufactured to our specifications, our operations would be disrupted unless we are able to rapidly secure alternative sources of supply, our inventory and revenue could diminish significantly, causing disruption to our operations.

The accompanying condensed consolidated financial statements have been prepared assuming we will continue as a going concern. Our significant operating losses, negative cash flow from operations, and challenges in rapidly securing alternative sources of supply for solar panels, raise substantial uncertainty about our ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty, and contemplate the realization of assets and the settlement of liabilities and commitments in the normal course of business. There can be no assurance that we will be able to raise additional funds on commercially reasonable terms, if at all. The current economic downturn adds uncertainty to our anticipated revenue levels and to the timing of cash receipts, which are needed to support our operations. It also worsens the market conditions for seeking equity and debt financing. As a result of our delisting from the Nasdaq Capital Market in September 2012, we are no longer eligible to file new registration statements on Form S-3, which may make it more costly and more difficult for us to obtain additional equity financing.  We currently anticipate that we will retain all of our earnings, if any, for development of our business and do not anticipate paying any cash dividends on common stock in the foreseeable future.

Despite our recent financings, we have insufficient cash to operate our business at the current level for the next twelve months and insufficient cash to achieve our business goals. The success of our business plan is contingent upon us increasing sales and obtaining additional financing. We intend to fund operations through debt and/or equity financing arrangements such as the Equity Purchase Agreement with Southridge and the loan and security agreement discussed below; however there can be no assurance that we will continue to meet the conditions necessary to be able to use the Equity Line under the Equity Purchase Agreement (described below) or the loan and security agreement (described below). Other than the Equity Line and the loan and security agreement described below, we do not have any formal commitments or arrangements for the sales of stock or the advancement or loan of funds at this time. There can be no assurance that any additional financing will be available to us on acceptable terms, or at all.

On January 22, 2014, we entered into a Settlement of Potential Claims Agreement (the “ASCR Agreement”) with ASC Recap LLC (“ASCR”), an entity affiliated with Southridge. Pursuant to the ASCR Agreement, ASCR has offered to purchase (and in one (1) case has already purchased) approximately $3.7 million of our prior debt owed to four creditors (“Creditors”) for past due services at a substantial discount to face value to which we have agreed to issue to ASCR certain shares of its common stock in a §3(a)(10) 1933 Act proceeding. The shares of common stock that we have agreed to issue to ASCR in full payment for, and as a release of any debt it purchases from the Creditors, is anticipated to have, upon issuance, a market value equal to approximately 25% of the principal amount of our outstanding debt. In the case of the debt ASCR already purchased from one (1) Creditor, we entered into a Settlement Agreement and Stipulation on February 26, 2014 that was filed with the Circuit Court of the Second Judicial Circuit, Leon County, Florida pursuant to which we agreed, subject to court approval,  to issue shares of our common stock that generate proceeds in the amount of $250,000 in full settlement of a claim in the amount of $1,027,705 that ASCR acquired form one Creditor (the value of the stock that we agreed to issue was two hundred and fifty percent (250%) of the discounted purchase price ASCR paid to purchase the debt from the Creditor, and approximately 25% of the original amount we owed to the Creditor). On March 24, 2014, the Circuit Court of the Second Judicial Circuit, Leon County, Florida, approved the §3(a)(10) 1933 Act proceeding and Settlement Agreement


and Stipulation and in April 2014, we issued 8,079,800 shares of common stock at an average price of $0.031 for the full settlement of the agreement with ASCR. The stock to be issued by us and the purchase of the debt by ASCR of the remaining three Creditors is subject to the acceptance of offers by the Creditors and court approval of the terms of the settlement.

Registration Statement

On March 11, 2014, we filed a Registration Statement on Form S-1/A to register 35 million shares of common stock related to our Equity Purchase Agreement with Southridge and on March 21, 2014, the Securities and Exchange Commission declared the Registration Statement effective. On March 26, 2014, we submitted an initial take-down request of $300,000 to Southridge pursuant to the terms of the Equity Purchase Agreement of which partial proceeds of $100,000 was received on March 31, 2014 and $200,000 on April 16, 2014. On June 4, 2014, June 18, 2014 and July 8, 2014, we submitted additional take-down requests for $100,000, $100,000 and $125,000, respectively, pursuant to the terms of the Equity Purchase Agreement. We issued a total of 31,760,578 shares of our common stock at an average price of $0.02 per share pursuant to the terms of the Equity Purchase Agreement. On October 23, 2014, we submitted a take-down request for approximately $51,000 pursuant to the terms of the Equity Purchase Agreement. We issued a total 4,214,853 shares of our common at an average price of $0.012 per share pursuant to the terms of the Equity Purchase Agreement. As of November 12, 2014, 2,528,912 shares have been sold at an average price of $0.012 per share, resulting in total proceeds of approximately $30,000.

Convertible Notes Payable

On August 30, 2013, we entered into a securities purchase agreement with certain institutional accredited investors relating to the sale and issuance of a convertible note in the principal amount of $200,000 that matures August 29, 2015 (the "Convertible Note").  Subsequently, on November 25, 2013 and December 19, 2013, we entered into additional securities purchase agreements with the same institutional accredited investors relating to the sale and issuance of convertible notes in the principal amount of $200,000 and $250,000, respectively, which mature on November 25, 2015 and December 19, 2015. On January 27, 2014, we issued a convertible note in the principal amount of $100,000 that matures January 27, 2016 under the Securities Purchase Agreement we entered into with an accredited investor on December 19, 2013. In connection with the issuance of the December 19, 2013 convertible note, we also issued 6,250,000 warrants to purchase shares of our common stock at a price of $0.02 per share. On February 25, 2014, we entered into a Securities Purchase Agreement with the same accredited investor related to the sale and issuance of a convertible note in the principal amount of $200,000 that matures February 25, 2016. In connection with the issuance of the February 25, 2014 convertible note, we issued 5,000,000 warrants to purchase shares of our common stock at a price of $0.02 per share. On March 18, 2014, we entered into a Securities Purchase Agreement we entered into with the same accredited investor related to the sale and issuance of a convertible note in the principal amount of $300,000 that matures March 18, 2016.  In connection with the March 18, 2014 convertible note, we issued a five–year warrant to purchase 7,500,000 shares of our common stock at an exercise price of $.02. Each of the Convertible Notes bear interest at the rate of 8% per annum compounded annually, are payable at maturity and the principal and interest outstanding under the convertible notes are convertible into shares of our common stock, at any time after issuance, at the option of the purchaser, at a conversion price equal to $0.02 per share, subject to adjustment upon the happening of certain events, including stock dividends, stock splits and the issuance of common stock equivalents at a price below the conversion price. Subject to our fulfilling certain conditions, including beneficial ownership limits, the convertible notes are subject to a mandatory conversion if the closing price of our common stock for any 20 consecutive days commencing six months after the issue date of the convertible notes equal or exceeds $0.04. Unless waived in writing by the purchaser, no conversion of the convertible notes can be effected to the extent that as a result of such conversion the purchaser would beneficially own more than 9.99% in the aggregate of our issued and outstanding common stock immediately after giving effect to the issuance of common stock upon conversion.
 
We have the option of repaying the outstanding principal amount of the convertible notes, in whole or in part, by paying the purchaser a sum of money equal to one hundred and twenty percent (120%) of the principal together with accrued but unpaid interest upon 30 days notice, subject to certain beneficial ownership limits. For so long as we have any obligation under the convertible notes, we have agreed to certain restrictions regarding, among other things, incurrence of additional debt, liens, amendments to charter documents, repurchase of stock, payment of cash dividends, affiliated transactions. We are also prohibited from entering into certain variable priced agreements until the convertible notes are repaid in full.

Because of certain down-round protection in the conversion rate of the convertible notes, we determined that the derivative liability related to the embedded conversion feature met the criteria for bifurcation. Accordingly, we recognized an aggregate liability of $123,000 on the three issuance dates during the nine months ended September 30, 2014. This was in addition to the carrying value of the derivative liability on three previously recorded derivatives of $178,000. The derivative liability is carried at fair value with changes in the fair value reflected in the “Adjustment to the fair value of embedded derivatives” line item of our condensed consolidated statements of operations. We recognized a non-cash benefit for the three months ended June 30, 2014 of $49,000 and a non-cash benefit for the nine months ended September 30, 2014 of $32,000 on a total of six convertible notes.


In addition, the relative fair value of the warrants issued in the December 2013 convertible note issuance of $250,000, were allocated to additional paid-in capital. Such value was determined assuming volatility of 149.1%, a risk free interest rate of 0.7% and an expected term of 4.1 years. The resulting debt discount from the derivative liability and warrant issuance of $109,000 is being accreted to interest using the effective interest method. The relative fair value of the warrants issued in the February 2014 convertible note issuance of $200,000, were allocated to additional paid-in capital. Such value was determined assuming volatility of 169.1, a risk free interest rate of 0.7% and an expected term of 4.1 years. The resulting debt discount from the derivative liability and warrant issuance of $101,000 is being accreted to interest using the effective interest method. The relative fair value of the warrants issued in the March 2014 convertible note issuance of $300,000, were allocated to additional paid-in capital. Such value was determined assuming volatility of 168.8%, a risk free interest rate of 0.8% and an expected term of 4.1 years. The resulting debt discount from the derivative liability and warrant issuance of $154,000 is being accreted to interest using the effective interest method.

On November 1 and December 1, 2013, and on January 1, February 1 and March 1, 2014, we issued convertible notes to our financial advisory firm in the principal amount of $30,000 each for a total of $150,000, which mature on October 31, November 30 and December 31, 2014, and on January 31 and February 28, 2015, respectively. On April 1, May 1 and June 1, 2014, we issued convertible notes to our financial advisory firm in the principal amount of $20,000 each, for a total of $60,000, which mature on March 31, April 30 and May 31, 2015, respectively. On July 1, 2014, we issued convertible notes to our financial advisory firm in the principal amount of $10,000, which matures on June 30, 2015. Each of the Convertible Notes bear interest at the rate of 8% per annum compounded annually, are payable at maturity and the principal and interest outstanding under the convertible notes are convertible into shares of our common stock, at any time after issuance, at the option of the purchaser, at a conversion price equal to $0.02. Unless waived in writing by the purchaser, no conversion of the convertible notes can be effected to the extent that as a result of such conversion the purchaser would beneficially own more than 9.99% in the aggregate of our issued and outstanding common stock immediately after giving effect to the issuance of common stock upon conversion. As of September 30, 2014, convertible notes in the principal amount of $460,000, along with accrued interest of $27,153, were converted into 24,496,564 shares of our common stock.

Line of Credit

On September 30, 2013, we entered into a loan and security agreement with Alpha Capital Anstalt and Collateral Services, LLC to provide financing, on a discretionary basis, for one year, against our accounts receivable and inventory.  The maximum amount that can be borrowed under the Agreement is $500,000. We have the right to borrow up to 80% of our eligible accounts receivable, not in excess of $200,000, 50% of the value of our raw materials in inventory, 65% of our finished goods inventory and 95% of cash, but not in the aggregate amount in excess of $300,000. The advances are secured by a lien on all of our assets. All advances under the agreement bear interest at a per annum rate of 12% and monthly interest shall be a minimum of $500. At the time of initial funding we paid a loan fee of 50 shares of our Series D Preferred Shares to the lender, in addition to other payments for legal fees. In addition, we paid the collateral agent an initial fee of $5,000 and have agreed to pay an administrative fee to the collateral agent of 0.5% per month of the daily balance during the preceding month or $500 whichever is less. In the event that of a prepayment, we are obligated to pay a prepayment fee in an amount equal to one-half of one percent (0.5%) of $500,000. On September 30, 2013, we requested and received an initial borrowing under the Agreement totaling $350,000. Subsequently, on October 21, 2013, we requested and received an additional $100,000 and on November 20, 2013, we requested and received an additional $50,000. As of September 30, 2014, the balance outstanding under our line of credit was $500,000.

Cash Flow Analysis

Our primary capital requirement is to fund purchases of solar panels and inverters. Significant sources of liquidity are cash on hand, cash flows from operating activities, working capital and proceeds from equity financings. As of September 30, 2014, we had approximately $439,000 in cash on hand.

Cash used in operating activities was approximately $760,000 for the nine months ended September 30, 2014. Cash provided by operating activities was primarily due our net loss adjusted for non-cash items of $1.6 million, partially offset by a $423,000 decrease in accounts receivable, a $162,000 decrease in inventory, a $149,000 decrease in prepaid expenses and other current assets, and a $111,000 decrease in accounts payable. The increases and decreases in assets and liabilities were primarily due to the timing of payments and receipts.

Cash provided by financing activities was approximately $1.0 million for the nine months ended September 30, 2014. During the nine months ended September 30, 2014, we received $600,000 in proceeds from borrowings on long-term debt and $625,000 in proceeds from an equity offering, less $37,000 in payment of placement agent fees, and repayment of $130,000 in notes payable.

Application of Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires estimates and assumptions that affect the reporting of assets, liabilities, sales and expenses, and the disclosure of contingent assets and liabilities. Note 2 to our consolidated financial statements for the years ended December 31, 2013 and 2012 as filed in our Annual


Report on Form 10-K provides a summary of our significant accounting policies, which are all in accordance with generally accepted accounting policies in the United States. Certain of our accounting policies are critical to understanding our consolidated financial statements, because their application requires management to make assumptions about future results and depends to a large extent on management’s judgment, because past results have fluctuated and are expected to continue to do so in the future.

The application of the accounting policies described in the following paragraphs is highly dependent on critical estimates and assumptions that are inherently uncertain and highly susceptible to change. For all these policies, we caution that future events rarely develop exactly as estimated, and the best estimates routinely require adjustment. On an ongoing basis, we evaluate our estimates and assumptions, including those discussed below.

Revenue recognition. Revenue from sales of products is recognized when: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the sale price is fixed or determinable, and (4) collection of the related receivable is reasonably assured. We recognize revenue when the solar power systems are shipped to the customer.

Inventory. Inventory is stated at the lower of cost (on an average basis) or market value. We determine cost based on our weighted-average purchase price and include both the costs of acquisition and the shipping costs in our inventory. We regularly review the cost of inventory against its estimated market value and record a lower of cost or market write-down to cost of goods sold, if any inventory has a cost in excess of estimated market value. Our inventory generally has a long life cycle and obsolescence has not historically been a significant factor in its valuation.

Long-lived assets. We periodically review our property and equipment and identifiable intangible assets for possible impairment whenever facts and circumstances indicate that the carrying amount may not be fully recoverable. Assumptions and estimates used in the evaluation of impairment may affect the carrying value of long-lived assets, which could result in impairment charges in future periods. Significant assumptions and estimates include the projected cash flows based upon estimated revenue and expense growth rates and the discount rate applied to expected cash flows. In addition, our depreciation and amortization policies reflect judgments on the estimated useful lives of assets.

Patent costs.  We capitalize external legal costs and filing fees associated with obtaining or defending our patents. Upon issuance of new patents or successful defense of existing patents, we amortize these costs using the straight line method over the shorter of the legal life of the patent or its economic life. We believe the remaining useful life we assign to these patents, approximately 10.25 years as of September 30, 2014, are reasonable. We periodically review our patents to determine whether any such cost have been impaired and are no longer being used. To the extent we are no longer using certain patents, the associated costs will be written off at that time.

Stock-based compensation. We use the Black-Scholes-Merton Options Pricing Model (“Black-Scholes”) to estimate fair value of our employee and our non-employee director stock-based awards. Black-Scholes requires various judgmental assumptions, including estimating stock price volatility, expected option life and forfeiture rates. We measure compensation expense for non-employee stock-based compensation under Accounting Standards Codification (“ASC”) ASC 505-50, “Equity-Based Payments to Non-Employees.” The fair value of the option issued is used to measure the transaction, as this is more reliable than the fair value of the services received. The estimated fair value is measured utilizing Black-Scholes using the value of our common stock on the date that the commitment for performance by the counterparty has been reached or the counterparty’s performance is complete.

Warranty provision. The manufacturer directly warrants the solar panels and inverters for a range from 15 to 25 years. We warrant the balance of system components of our products against defects in material and workmanship for five years. We assist our customers in the event of a claim under the manufacturer warranty to replace a defective solar panel or inverter.

Common stock warrant liabilities.  In March 2009 and February 2011, we issued warrants to purchase shares of our common stock in connection with certain capital financing transactions. The terms of the warrant agreements related to these two offerings contained a cash-out provision which may be triggered at the option of the warrant holders if we “go private,” if we are acquired for all cash or upon the occurrence of certain other fundamental transactions involving us. In addition, the terms of the warrant agreement related to the February 2011 offering contain a provision that may require us to reduce the exercise price of the warrants to purchase shares of our common stock upon the occurrence of certain lower-priced future offerings of our equity securities. Under ASC 480, Distinguishing Liabilities from Equity (“ASC 480”), financial instruments that may require the issuer to settle the obligation by transferring assets or to reduce the exercise price of its warrants to purchase shares of its common stock are classified as a liability. Therefore, we have classified the warrants as liabilities and will record mark-to-market adjustments to reflect the fair value at each period end.

Significant Accounting Policies and Estimates

There have been no material changes or developments to the significant accounting policies discussed in our 2013 Annual Report on Form 10-K or accounting pronouncements issued or adopted, except as described below.



Recent Accounting Pronouncements

In May 2014, as part of its ongoing efforts to assist in the convergence of U.S. GAAP and International Financial Reporting Standards (“IFRS”), the Financial Accounting Standards Board (“FASB”) issued ASU 2014-09, “Revenue from Contracts with Customers.” The new guidance sets forth a new five-step revenue recognition model which replaces the prior revenue recognition guidance in its entirety and is intended to eliminate numerous industry-specific pieces of revenue recognition guidan