UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 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, 2016

or

¨

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

 

For the transition period from ______to______.

 

		XG SCIENCES, INC.
		(Exact name of registrant as specified in its charter)

 

Michigan		333-209131		20-4998896
(State or other jurisdiction of incorporation or organization)		(Commission File No.)		(I.R.S. Employer Identification No.)

 

3101 Grand Oak Drive

Lansing, MI 48911

 

(Address of principal executive offices) (zip code)

 

(517) 703-1110

(Issuer Telephone number)

 

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

 

Indicate by check mark whether the registrant 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 ¨ No x

 

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

 

Large Accelerated Filer ¨

Accelerated Filer ¨

Non-Accelerated Filer ¨

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 ¨ No x

 

As of November 3, 2016, there were 1,236,673 shares outstanding of the registrant’s common stock.

 

 

XG SCIENCES, INC.

FORM 10-Q

SEPTEMBER 30, 2016

INDEX

 

PART I
ITEM 1.	FINANCIAL STATEMENTS	4
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	14
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	24
ITEM 4.	CONTROLS AND PROCEDURES	24
PART II
ITEM 1.	LEGAL PROCEEDINGS	24
ITEM 1A.	RISK FACTORS	24
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	25
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	25
ITEM 4.	MINE SAFETY DISCLOSURES	25
ITEM 5.	OTHER INFORMATION	25
ITEM 6.	EXHIBITS	26
SIGNATURES		27

 

  

FORWARD-LOOKING STATEMENTS

The information in this Quarterly Report on Form 10-Q contains “forward-looking statements” and information within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) relating to XG Sciences, Inc., a Michigan corporation and its subsidiary, XG Sciences IP, LLC, a Michigan corporation (collectively referred to as “we”, “us”, “our”, “XG Sciences”, “XGS”, or the “Company”), which are subject to the “safe harbor” created by those sections. These forward-looking statements include, but are not limited to, statements concerning our strategy, future operations, future financial position, future revenues, projected costs, prospects and plans and objectives of management. The words “anticipates,” “believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. These forward-looking statements involve known and unknown risks and uncertainties that could cause our actual results, performance or achievements to differ materially from those expressed or implied by the forward-looking statements, including, without limitation, the risks set forth on beginning on page 18 under the section entitled “Risk Factors” in our Post-Effective Amendment No. 2 (declared effective August 31, 2016) to the Existing Registration Statement No. 4 to our Registration Statement on Form S-1 (File No. 333-209131) as filed with the Securities and Exchange Commission (the “SEC”) on April 12, 2016, and declared effective on April 13, 2016.

 

 

XG SCIENCES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

 

		September 30, 2016				December 31,  2015
		(unaudited)
ASSETS
CURRENT ASSETS
Cash		$	637,504			$	1,060,224
Accounts receivable, less allowance for doubtful accounts of $10,000 at September 30, 2016 and December 31, 2015			58,458				54,413
Inventories			226,599				229,034
Other current assets			295,093				194,096
			1,217,654				1,537,767
Total current assets
PROPERTY, PLANT AND EQUIPMENT, NET			3,153,234				3,753,248
RESTRICTED CASH FOR LETTER OF CREDIT			195,425				195,206
INTANGIBLE ASSETS, NET			455,587				411,789
TOTAL ASSETS		$	5,021,900			$	5,898,010
LIABILITIES AND STOCKHOLDERS’ DEFICIT
CURRENT LIABILITIES
Accounts payable and other liabilities		$	1,184,343			$	704,177
Short-term promissory notes			379,600				497,324
Current portion of capital lease obligations			247,229				178,487
Total current liabilities			1,811,172				1,379,988
LONG TERM LIABILITIES
Long term portion of capital lease obligations			190,938				354,483
Derivative liability - warrants			7,843,076				8,235,163
Total long term liabilities			8,034,014				8,589,646
TOTAL LIABILITIES			9,845,186				9,969,634
STOCKHOLDERS’ DEFICIT
Series A convertible preferred stock, 3,000,000 shares authorized, 1,822,116 and 1,800,696 shares issued and outstanding, liquidation value of $21,865,392 and $21,608,376 at September 30, 2016 and December 31, 2015, respectively			21,548,926				21,291,912
Series B Preferred Stock, 1,500,000 shares authorized, 269,987 shares issued and outstanding, liquidation value of $4,319,792 at September 30, 2016 and December 31, 2015			3,651,533				3,651,533
Common stock, no par value, 25,000,000 shares authorized, 1,224,298 and 836,544 shares issued and outstanding at September 30, 2016 and December 31, 2015, respectively			11,128,617				8,565,225
Additional paid in capital			6,208,741				5,791,074
Accumulated deficit			(47,361,103	)			(43,371,368	)
Total stockholders’ deficit			(4,823,286	)			(4,071,624	)
TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT		$	5,021,900			$	5,898,010

 

See notes to unaudited condensed consolidated financial statements.

 

 

XG SCIENCES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015 (unaudited)

 

		For the Three Months Ended September 30,								For the Nine Months Ended  September 30,
		2016				2015				2016				2015
REVENUES
Product sales		$	88,856			$	38,295			$	230,635			$	156,608
Grants			50,111				80,967				208,475				299,879
Licensing revenue			25,000				25,000				75,000				75,000
Total revenue			163,967				144,262				514,110				531,487
COST OF GOODS SOLD
Direct costs			44,344				24,848				101,397				77,516
Unallocated manufacturing expenses			323,051				447,872				1,071,000				1,264,432
Total cost of goods sold			367,395				472,720				1,172,397				1,341,948
GROSS LOSS			(203,428	)			(328,458	)			(658,287	)			(810,461	)
OPERATING EXPENSES
Research and development			231,312				359,340				866,668				1,135,326
Sales, general and administrative			896,650				997,404				2,618,252				3,133,375
Total operating expenses			1,127,962				1,356,744				3,484,920				4,268,701
OPERATING LOSS			(1,331,390	)			(1,685,202	)			(4,143,207	)			(5,079,162	)
OTHER INCOME (EXPENSE)
Incentive refund and interest income			24,197				28,996				72,423				80,624
Interest expense			(56,013	)			(583,980	)			(241,011	)			(1,640,668	)
Gain (loss) from change in fair value of derivative liability – warrants			108,056				(414,858	)			340,669				(143,845	)
Loss on disposal of equipment			(18,609	)			-				(18,609	)			-
Total other income (expense)			57,631				(969,842	)			153,472				(1,703,889	)
NET LOSS		$	(1,273,759	)		$	(2,655,044	)		$	(3,989,735	)		$	(6,783,051	)
WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING –
Basic and diluted			914,648				835,544				959,904				836,544
NET LOSS PER SHARE – Basic and diluted		$	(1.39	)		$	(3.18	)		$	(4.16	)		$	(8.11	)

 

See notes to unaudited condensed consolidated financial statements.

 

 

XG SCIENCES, INC.

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ (DEFICIT) FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016

(unaudited)

 

		Preferred stock (A)								Preferred stock (B)								Common stock								Additional paid-in				Accumulated
		Shares				Amount				Shares				Amount				Shares				Amount				capital				deficit				Total
Balances, December 31, 2015			1,800,696			$	21,291,912				269,987			$	3,651,533				836,544			$	8,565,225			$	5,791,074			$	(43,371,368	)		$	(4,071,624	)
Stock issued for cash			-				-				-				-				387,754				3,102,032				-				-				3,102,032
Stock issuance fees and expenses			-				-				-				-				-				(538,640	)			-				-				(538,640	)
Reclassification of Derivative Liability Warrants to Equity			-				-				-				-				-				-				51,418				-				51,418
Warrants issued with Bridge Financings			-				-				-				-				-				-				24,060				-				24,060
Preferred stock issued to pay capital lease obligations			21,420				257,014				-				-				-				-				-				-				257,014
Stock based compensation expense			-				-				-				-				-				-				342,189				-				342,189
Net loss			-				-				-				-				-				-				-				(3,989,735	)			(3,989,735	)
Balances, September 30, 2016			1,822,116			$	21,548,926				269,987			$	3,651,533				1,224,298			$	11,128,617			$	6,208,741			$	(47,361,103	)		$	(4,823,286	)

 

See notes to unaudited condensed consolidated financial statements.

 

 

XG SCIENCES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015 (unaudited)

 

		2016				2015
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss		$	(3,989,735	)		$	(6,783,051	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization			684,199				641,304
Amortization of intangible assets			26,856				21,105
Loss on disposal of intangible assets			18,609				-
Stock based compensation expense			342,189				420,048
Non-cash interest expense			213,906				1,550,616
Gain from change in fair value of derivative liability - warrants			(340,669	)			143,845
(Increase) Decrease in:
Accounts receivable			(4,044	)			(42,275	)
Inventory			2,434				(78,593	)
Other current and non-current assets			(101,216	)			27,700
Increase (Decrease) in:
Accounts payable and other liabilities			480,164				(491,842	)
NET CASH USED IN OPERATING ACTIVITIES			(2,667,307	)			(4,591,143	)
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property and equipment			(84,187	)			(157,983	)
Purchases of intangible assets			(89,264	)			(59,663	)
NET CASH USED IN INVESTING ACTIVITIES			(173,451	)			(217,646	)
CASH FLOWS FROM FINANCING ACTIVITIES
Advances (repayments) of capital lease obligations			29,896				(28,764	)
Repayments of short-term notes			(750,000	)			-
Advances on short-term notes			574,750				-
Proceeds from issuance of preferred stock and warrants			-				4,319,792
Proceeds from issuance of common stock			3,102,032				14,000
Common stock issuance fees and expenses			(538,640	)			-
NET CASH PROVIDED BY FINANCING ACTIVITIES			2,418,038				4,305,028
NET (DECREASE) IN CASH			(422,720	)			(503,761	)
CASH AT BEGINNING OF PERIOD			1,060,224				2,088,866
CASH AT END OF PERIOD		$	637,504			$	1,585,105
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest		$	27,107			$	90,052
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING:
Value of preferred stock issued for AAOF capital lease obligations		$	257,014			$	257,015
Property and equipment under capital leases		$	38,998
Reclassification of derivative liability warrants to equity		$	51,418
Warrants issued with bridge financings		$	24,060

 

See notes to unaudited condensed consolidated financial statements.

 

 

XG SCIENCES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2016

 

NOTE 1 - NATURE OF BUSINESS AND BASIS OF PRESENTATION

 

XG Sciences, Inc., a Michigan company located in Lansing, Michigan and its subsidiary, XGS IP, LLC (collectively referred to as “we”, “us”, “our”, or the “Company”) manufactures graphene nanoplatelets made from graphite, using a proprietary manufacturing process to split natural flakes of crystalline graphite into very small and thin particles, which we sell as xGnP® graphene nanoplatelets. These particles are then used in products like battery electrodes, thin sheets, films, inks and coatings that we sell to other companies. We also sell our nanoparticles in the form of bulk powders or dispersions to other companies for use as additives to make composite and other materials with specially engineered characteristics. Additionally, we license our technology to other companies in exchange for royalties and other fees.

 

Basis of Presentation

 

The accompanying interim condensed consolidated financial statements are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and the instructions to Form 10-Q and do not include all of the information and footnotes required by GAAP for complete financial statements. All intercompany transactions have been eliminated in consolidation.

 

Certain information and footnote disclosures normally included in the Company’s annual audited consolidated financial statements and accompanying notes have been condensed or omitted in these interim condensed consolidated financial statements. Accordingly, the unaudited condensed consolidated financial statements included herein should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2015, as filed with the Securities and Exchange Commission (“SEC”) on Form S-1 (Registration No. 333-209131), as amended and having an effective date of August 31, 2016.

 

The results of operations presented in this quarterly report are not necessarily indicative of the results of operations that may be expected for any future periods. In the opinion of management, these unaudited condensed consolidated financial statements include all adjustments and accruals, consisting only of normal recurring adjustments that are necessary for a fair statement of the results of all interim periods reported herein.

 

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Going Concern

 

We have historically incurred recurring losses from operations and we may continue to generate negative cash flows as we implement our business plan. Our unaudited condensed consolidated financial statements are prepared using GAAP as applicable to a going concern, which contemplates the realization of assets and liquidation of liabilities in the normal course of business.

 

We currently do not have sufficient cash or commitments for financing to sustain our operations for the next twelve months. Our plan is to develop customer relationships and increase our revenues derived from our products and IP licensing. Although we have historically incurred operating losses, we have been able to fund such losses primarily by selling common and preferred stock and convertible notes. We expect that our cash on hand at September 30, 2016 of $637,504 and proceeds from our initial public offering of common stock (“IPO”) $3,102,032 at September 30, 2016 will sustain our operations for the next twelve months. However, we cannot make any assurances that additional financing will be available to us and, if available, completed on a timely basis, on acceptable terms, or at all.

 

There has been no public market for our securities and a public market may never develop, or, if any market does develop, it may not be sustained. Our common stock is not currently quoted on or traded on any exchange or to our knowledge, on any over-the-counter market. In the event we are unable to fund our operations from existing cash on hand, operating cash flows, additional borrowings or raising equity capital, we may be forced to reduce our expenses, slow down our growth rate, or discontinue operations.  Our condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.

 

 

XG SCIENCES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2016

 

Use of Estimates

 

The preparation of our condensed consolidated financial statements in conformity with GAAP requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, together with amounts disclosed in the related notes to the financial statements. Actual results and outcomes may differ from our estimates, judgments and assumptions. Significant estimates, judgments and assumptions used in these condensed consolidated financial statements include, but are not limited to, those related to revenues, accounts receivable and related allowances, contingencies, useful lives and recovery of long-term assets, income taxes, the fair value of stock-based compensation and derivative financial instrument liabilities. These estimates, judgments, and assumptions are reviewed periodically and the effects of material revisions in estimates are reflected in the financial statements prospectively from the date of the change in estimate.

 

Inventory

 

Inventory consists of raw materials, work-in-process and finished goods, all of which are valued at standard cost, which approximates average cost.

 

Derivative Financial Instruments

 

We do not use derivative instruments to hedge exposures to cash flow, market or foreign currency risk. The terms of convertible preferred stock and convertible notes that we issue are reviewed to determine whether or not they contain embedded derivative instruments that are required by ASC 815: “Derivatives and Hedging” to be accounted for separately from the host contract, and recorded at fair value. In addition, freestanding warrants are also reviewed to determine if they achieve equity classification. Certain warrants that we have issued did not meet the conditions for equity classification and are classified as derivative instrument liabilities measured at fair value. The fair values of these derivative liabilities are revalued at each reporting date, with the change in fair value recognized in earnings.

 

Fair Value Measurements

 

The following is a reconciliation of the beginning and ending balances for liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the nine months ended September 30, 2016 and 2015:

 

		2016				2015
Balance at January 1		$	8,235,163			$	5,000,752
Warrants issued with private placement of Series B Preferred Stock			—				660,378
Warrants issued with preferred stock sold under preemptive rights			—				7,881
Warrants reclassified to equity			(51,418	)			—
Gain recognized in earnings			(340,669	)			143,845
Balance at September 30		$	7,843,076			$	5,812,856

 

NOTE 3 – PRIVATE PLACEMENT AND PREEMPTIVE RIGHTS

 

Private Placement

 

In April 2015, we commenced a private placement offering of up to $18,000,000 in Series B Units consisting of up to 1,125,000 shares of Series B convertible preferred stock (“Series B Preferred Stock”) and warrants to purchase common stock (the “Warrants”) at an offering price of $16.00 per Unit. The offering terminated on August 31, 2015 and as of such date, we had sold 266,987 shares of Series B Preferred Stock and Warrants to purchase 222,262 shares of common stock, for aggregate gross proceeds of $4,270,192.

 

Each share of Series B Preferred Stock has a stated value of $16.00 per share and is convertible, at the option of the holder into common shares, at a conversion price of $16.00 per share, subject to adjustments for stock dividends, splits, combinations and similar events. The Warrants have an exercise price of $16.00 per share and expire 7 years from issuance. During the period from closing of the offering and ending on the earlier of i) December 31, 2017 and ii) the date the Company consummates the sale of new securities resulting in gross proceeds of at least $18,000,000, the holder has the right to exchange their Series B Units (Series B Preferred Stock and Warrants) into any new security sold to third parties at the same relative price per share and other terms at which such new security is sold to such third parties.

 

 

XG SCIENCES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2016

 

The cash proceeds from the private placement were allocated first to the derivative liabilities resulting from warrants, at their fair values, with the residual being allocated to the Series B Preferred Stock.

 

Preemptive Rights

 

On January 15, 2014, as part of our financing agreements with Samsung Ventures (“Samsung”), Aspen Advanced Opportunity Fund LP (“AAOF”) and XGS II, LLC (“XGS II”), we agreed to allow all shareholders to purchase one share of Series A convertible preferred stock (“Series A Preferred Stock”) at a price of $12.00 per share for every two (2) shares of Series A Preferred Stock or common stock owned by the shareholder. In addition, for every two preemptive shares purchased, the Company issued the shareholder a warrant to purchase one additional share of Series A Preferred Stock with the same terms as the warrants issued to AAOF and XGS II. The Company also agreed to issue warrants with the same terms to those shareholders who exercised preemptive rights in October 2013.

 

Under the January 15, 2014 preemptive rights offering, 101,000 shares of Series A Preferred Stock were sold to existing stockholders at a price of $12.00 per share. In addition, warrants indexed to 56,054 shares of Series A Preferred Stock were issued in conjunction with these stock purchases, including 5,554 warrants related to the preemptive rights exercised in October 2013.

 

As part of our Series B Unit private placement in April 2015, shareholders and holders of our convertible notes were provided the right to purchase their pro rata share of any class of stock that the Company sells or issues. The sale of Series B Preferred Stock in the April 2015 offering triggered the preemptive rights. As of September 30, 2016, 3,100 shares of Series B Convertible Stock have been sold to existing shareholders at a price of $16.00 per share. In addition, the Warrants indexed to 2,635 shares of common stock were issued as part of the Series B Units.

 

As of September 30, 2016, the total number of warrants issued due to the preemptive rights offerings was 58,689.

 

NOTE 4 – BRIDGE FINANCINGS

 

From December 31, 2015 through April 7, 2016, the Company entered into private placement bridge financings with 14 investors, seven of whom are board members or affiliates of board members, totaling $1,124,750 (the “Bridge Financings”). The investors in the Bridge Financings received common stock warrant coverage of 30% for investments made prior to December 31, 2015 and 20% coverage thereafter.

 

During June 2016 the Company repaid i) outstanding principal of $550,000 plus accrued interest of $22,000 to the December 2015 Bridge Financing investors and ii) outstanding principal of $200,000 plus accrued interest of $5,032 to two of the March 2016 Bridge Financing investors. These investors, who are also members of the board of directors of the Company, used the proceeds from repayment of their notes, plus additional funds, to purchase 199,879 additional shares of the Company’s common stock for approximately $1.6 million.

  

 

XG SCIENCES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2016

 

The Bridge Financing Warrants issued in December 2015 inadvertently provided the holder with the right to exchange their warrants on a price per share basis into a new security on the same relative price per share terms as any new securities sold to third parties resulting in gross proceeds of at least $18,000,000. As a result of these exchange rights, the December 2015 Bridge Financing warrants did not achieve equity classification at inception and were recorded as derivative liabilities, at fair value. During the second quarter of 2016, the warrant holders from the December 2015 Bridge Financing agreed to waive their exchange rights at which time the warrants were reclassified to equity. This resulted in the current fair value of the Bridge Financing Warrants of $51,418, being reclassified from derivative liabilities to equity.

 

The following table reconciles the Bridge Financings balance recorded on the balance sheet at September 30, 2016:

 

		2016
Balance at January 1		$	550,000
Proceeds from Bridge Financings received January through April 7			574,750
Subtotal			1,124,750
Proceeds allocated to warrants – liability at inception			(52,676	)
Proceeds allocated to warrants – equity at inception			(24,060	)
Accrued interest January through September 30			108,617
Payoff of principal ($750,000) and accrued interest			(777,031	)
Balance at September 30, 2016		$	379,600

 

Number of Common Stock Warrants issued with Bridge Financings        32,120.

 

NOTE 5 – DERIVATIVE LIABILITY WARRANTS

 

As of September 30, 2016, all 1,197,617 derivative liability classified warrants issued to AAOF, XGS II, and holders of Series A and Series B Preferred Stock have vested.

 

Shares indexed to derivative liabilities as of September 30, 2016 and December 31, 2015 were as follows:

 

		Type of shares indexed		Exercise Price				September  30, 2016				December 31, 2015
Warrants issued with Secured Convertible Notes		Series A PS		$	6.40				833,333				833,333
Warrants issued with equipment financing leases		Series A PS		$	6.40				83,333				83,333
Warrants issued with Series A preemptive rights		Series A PS		$	6.40				56,054				56,054
Warrants issued with Series B preemptive rights		Common		$	16.00				2,635				2,635
Warrants issued with Series B Units		Common		$	16.00				222,262				222,262
Warrants issued with Bridge Financings		Common		$	8.00				—				20,625
Total shares indexed to derivative liabilities									1,197,617				1,218,242

 

The following table summarizes the fair value of the derivative liabilities as of September 30, 2016 and December 31, 2015:

 

		September 30, 2016				December 31,2015
Warrants issued with Secured Convertible Notes		$	6,495,660			$	6,743,997
Warrants issued with equipment financing leases			649,568				674,397
Warrants issued with preemptive rights			439,984				457,265
Warrants issued with 2015 Series B Unit private placement			257,864				306,828
Warrants issued with Bridge Financings			—				52,676
Total derivative liabilities		$	7,843,076			$	8,235,163

 

 

XG SCIENCES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2016

 

The Company estimated the fair value of their warrant derivative liabilities as of September 30, 2016 and December 31, 2015, using a lattice model and the following assumptions:

 

		September 30, 2016				December 31, 2015
Fair value of underlying stock			$7.63 - $12.64				$7.63 - $12.64
Equivalent risk free interest rate			0.81%- 0.92%				1.06%- 1.39%
Expected term (in years)			5.58- 7.30				5.01- 8.05
Equivalent stock price volatility			38.10%- 38.17%				38.00%- 38.61%
Expected dividend yield			—				—

 

The fair value of the warrants is estimated using a binomial lattice model. Equivalent amounts reflect the net results of multiple modeling simulations that the lattice model applies to underlying assumptions. Because the Company’s common stock is not publicly traded on a national exchange or to our knowledge, an over-the-counter market, the expected volatility of the Company’s stock was developed using historical volatility for a peer group for a period equal to the expected term of the warrants. The fair value of the warrants will be significantly influenced by the fair value of our common stock, stock price volatility and the risk free interest components of the lattice technique. Changes in the fair value of Derivative Liabilities, carried at fair value, are reported as “Change in fair value of derivative liability - warrants” in the Statement of Operations, and were as follows:

 

		Three months ended September 30,
		2016				2015
Warrants issued with Secured Convertible Notes		$	69,666			$	(583,332	)
Warrants issued with equipment financing leases			6,967				(58,334	)
Warrants issued with preemptive rights			5,000				(36,122	)
Warrants issued with 2015 private placement			26,423				262,930
Total Derivative Gain (Loss)		$	108,056			$	(414,858	)

 

		Nine months ended September 30,
		2016				2015
Warrants issued with Secured Convertible Notes		$	248,337			$	(379,999	)
Warrants issued with equipment financing leases			24,829				(38,001	)
Warrants issued with preemptive rights			17,281				(21,993	)
Warrants issued with 2015 private placement			48,963				296,148
Warrants issued with Bridge Financings			1,259				—
Total Derivative Gain (Loss)		$	340,669			$	(143,845	)

 

NOTE 6 – OTHER COMMON STOCK WARRANTS

 

In addition to the warrants described in Note 5, we had 42,694 warrants to purchase common stock that were issued in 2012 and prior years which are accounted for as equity instruments. As of September 30, 2016, the remaining warrants, all of which are exercisable, have exercise prices ranging from $8.00 to $12.00 and expire at various dates through 2027, as follows:

 

Date Issued		Expiration Date		Exercise Price				Number of  Warrants
7/1/2009		7/1/2019		$	8.00				6,000
10/8/2012		10/8/2027		$	12.00				5,000
									11,000

 

NOTE 7 - INCENTIVE STOCK OPTION PLAN

 

We have established an incentive stock option plan (the “Plan”) under which the Company may grant key employees and directors options to purchase common stock of the Company at not less than fair market value as of the grant date. Options for up to 600,000 shares may be awarded under the Plan. Each option is exercisable into one share of common stock of the Company. The Plan expires in December 2017. The fair value of the options granted was estimated on the dates of grant using the Black Scholes option-pricing model. As of September 30, 2016, 419,750 option shares have been granted and are outstanding, of which 253,819 are exercisable at an exercise price of $12.00. Vesting of the options ranges from immediately to 20% per year, with most options vesting on a straight-line basis over a three or four year period from the date issued. Rights to exercise the options vest immediately upon a change in control of the Company or termination of the employee’s continuous service due to death or disability. The options expire at various dates through October 2023.

 

 

XG SCIENCES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2016

 

NOTE 8 – CAPITAL LEASES

 

As of September 30, 2016 and December 31, 2015, we have capital lease obligations as follows:

 

		September 30, 2016				December 31, 2015
Capital lease obligations		$	522,448			$	682,564
Unamortized warrant discount			(84,281	)			(149,594	)
Net obligations			438,167				532,970
Short-term portion of obligations			(247,229	)			(178,487	)
Long-term portion of obligations		$	190,938			$	354,483

 

The 83,333 common stock warrants issued as consideration for the equipment financing leases are recorded as derivative liabilities at fair value. The initial value of these warrants was recorded as a reduction of the capital lease obligation and is being amortized as part of the effective interest cost on the capital lease obligations.

 

NOTE 9 - RELATED PARTY TRANSACTIONS

 

We have a licensing agreement for exclusive use of patents and pending patents with Michigan State University (“MSU”), a shareholder of the Company via the MSU Foundation. During the three and nine months ended September 30, 2016 and 2015 we incurred expenses of $12,500 and $25,000, respectively. We have also entered into product licensing agreements with certain other shareholders. No royalty revenue or expenses have been recognized related to these agreements during the nine months ended September 30, 2016 and 2015.

 

Beginning in 2014, POSCO Corporation (“POSCO”), one of our shareholders, has a contractual obligation to pay us a minimum of $100,000 per year to license certain technologies we license from MSU. This obligation is due annually on February 28 of the following year. We record this license revenue at a rate of $25,000 per quarter. POSCO is disputing that they are obligated to pay the royalties. A petition for arbitration has been filed for this matter by the Company on March 9, 2016. On July 7 we received a letter from the International Court of Arbitration and they have assigned an arbitrator to the case. No assessment or decision has made by the arbitrator as of the filing date of these financial statements. An allowance in the amount of $137,500 and $100,000 has been recorded at September 30, 2016 and December 31, 2015, respectively, to reflect an estimate of the portion of the 2016, 2015 and 2014 royalties that we believe may not be collectible. The accrued royalty and allowance are netted together and reflected in other current assets on the condensed consolidated balance sheet.

 

The financing arrangements as previously disclosed were provided by AAOF and XGS II, two private funds that were formed for the sole purpose of investing in the Company by two investors affiliated with ASC-XGS, LLC, a shareholder of the Company. Pursuant to the Company’s Shareholders’ Agreement dated March 18, 2013 (as amended on February 26, 2016), a principal of each private fund serves as a director of the Company.

 

The Bridge Financings discussed in Note 4 above include loans from entities controlled by existing shareholders. Three of these shareholders are also directors of the Company. In conjunction with these short-term borrowings, the Company issued Warrants (see also discussed in Note 5).

 

NOTE 10 – SUBSEQUENT EVENTS

 

During the period from October 1 through November 3, 2016, we received common stock proceeds of $99,000 for the sale of 12,375 shares.

 

 

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

 

Forward-Looking Statements

 

In this Quarterly Report on Form 10-Q, unless otherwise indicated, the words “we”, “us”, “our”, “XG”, “XGS”, “XG Sciences” or the “Company” refer to XG Sciences, Inc. and its wholly owned subsidiary, XG Sciences IP, LLC, a Michigan limited liability company.

 

Introduction

 

The following discussion and analysis should be read in conjunction with the unaudited condensed consolidated financial statements, and the notes thereto included herein. The information contained below includes statements of the Company’s or management’s beliefs, expectations, hopes, goals and plans that, if not historical, are forward-looking statements subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. For a discussion on forward-looking statements, see the information set forth in the introductory note to this quarterly report on Form 10-Q under the caption “Forward-Looking Statements”, which information is incorporated herein by reference.

 

Overview of our Business

 

XG Sciences was formed in May 2006 for the purpose of commercializing certain technology to produce graphene nanoplatelets. First isolated and characterized in 2004, graphene is a single layer of carbon atoms configured in an atomic-scale honeycomb lattice. Among many noted properties, monolayer graphene is harder than diamonds, lighter than steel but significantly stronger, and conducts electricity better than copper. Graphene nanoplatelets are particles consisting of multiple layers of graphene. Graphene nanoplatelets have unique capabilities for energy storage, thermal conductivity, electrical conductivity, barrier properties, lubricity and the ability to impart strength when incorporated into plastics or other matrices.

 

We believe the unique properties of graphene and graphene nanoplatelets will enable numerous new product applications and the market for such products will quickly grow to be a significant market opportunity. Our business model is to design, manufacture and sell advanced materials we call xGnP^® graphene nanoplatelets and value-added products based on these nanoplatelets. We believe our proprietary processes have enabled us to be a low-cost producer of high quality, graphene nanoplatelets and that we are well positioned to address a wide range of end-use applications.

 

Our Customers

 

We sell products to customers around the world and have sold materials to over 1,000 customers in 47 countries since 2008. Some of these customers are research organizations and some are commercial organizations. Our customers have included well-known automotive and OEM suppliers around the world; world-scale lithium ion battery manufacturers in the US, South Korea and China; and diverse specialty material companies as well as leading research centers such as Lawrence Livermore National Laboratory and Oakridge National Laboratory. We have also licensed some of our base manufacturing technology to POSCO, the fourth largest steel manufacturer in the world by volume of output, and Cabot Corporation (“Cabot”), a leading global specialty chemicals and performance materials company. These licensees further extend our technology through their customer networks.

 

Our Focus Areas

 

We target our xGnP^® nanoplatelets for use in a wide range of large and growing end-use markets. We believe we are a “platform play” in advanced materials, because our proprietary manufacturing processes allow us to produce varying grades of graphene nanoplatelets that can be mapped to a variety of applications in many market segments.  However, we are prioritizing our efforts in specific areas that we believe represent opportunities for either relatively near-term revenue or especially large and attractive markets. At this time, we are focused on three high priority areas:

 

 

·

Energy Storage: Within energy storage we focus on lead acid batteries and lithium ion batteries. Within lithium ion batteries, we develop silicone-graphene composite materials for lithium-ion battery anodes. This is a material that has shown superior early results in laboratory and early prototype battery testing. Although there is still scientific development, testing and prototyping that remains to be done, we perceive a significant market opportunity for this new anode material. We also develop a cathode conductive additive to improve rate capability, especially for higher power applications. XG Sciences’ graphene nanoplatelets demonstrate higher discharge capacity at high rates, which translates into more battery power needed during heavy power requirements: start-up, acceleration, and/or elevation ascent. In lead acid batteries we develop anode conductive additives demonstrating improved performance for lifetime and charge acceptance.

 

·

Thermal Management. Thermal management products may take on many forms. Their underlying intent is to improve the movement of heat where excessive heat may cause a reduction in product lifetime and/or performance. XG Leaf® materials for thermal applications in electronics is one such product. XG Leaf® is a paper-like product comprised of xGnP® graphene nanoplatelets. Early testing with customers has produced promising results in applications requiring high thermal conductivity in thin (20–50 microns) and thick (50–120 microns) sheets, depending upon the end-use application. Typical applications include the use of these materials in smart phones, tablets, and portable computers. While there are many other applications for XG Leaf®, including electrostatic dissipation (“ESD”), electromagnetic interference (“EMI”) shielding and resistive heating, our initial focus is on thermal management. TIM, or thermal interface materials, in the form of greases or pastes is another product in this category. XG Sciences’ TIM’s have been shown to improve the thermal dissipation of heat generated by light emitting diodes when incorporated in various lighting devices. Other products may include inks or coating formulations specifically designed for use in such applications as portable electronics, heaters and other industrial equipment benefiting from the use of coatings to improvement heat dissipation.

 

·

Composites. Incorporation of our xGnP® graphene nanoplatelets into various polymers have been shown to impart improvements in strength, electrical conductivity, thermal conductivity and/or barrier performance. The company pursues several end-use applications that may benefit from one or more properties and believes that composites represent a potentially large opportunity for commercial sales.

 

XGS Market/Application Focus Areas & 2018 Market Size

 

 

 

¹ Avicenne Energy, "The Worldwide Rechargeable Battery Market 2014 - 2025", 24th Edition - V3, July 2015.

² Avicenne Energy, "The Worldwide Rechargeable Battery Market 2014 - 2025", 24th Edition - V3, July 2015 & Internal Estimates.

³ ArcActive via Nanalyze, April 3, 2015.

⁴ ArcActive via Nanalyze, April 3, 2015 & Internal Estimates.

⁵ Future Markets Insights, "Consumer Electronics Market: Global Industry Analysis and opportunity Assessment 2015 - 2020", May 8, 2015.

⁶ Prismark, "Market Assessment: Thin Carbon-Based Heat Spreaders", August 2014.

⁷ Reporterlink.com, "Semiconductor & IC Packaging Materials Market…", May 2014.

⁸ Prismark, 2015.

⁹ Grand View Research, "Global Plastics Market Analysis…", August 2014.

¹⁰ From (9) and internal estimates: 2018 = 305 million tons of plastic, if 10% of the market adopted xGnP to enhance their properties, and at only 1% by weight as an additive, then in 2018 305,000 tons or 305,000,000 kilos of xGnP would be required. At $30 a Kg - the value is $9.1 Bn per year.

 

Our Products

 

Our proprietary manufacturing processes allow us to produce nanoplatelets with varying performance characteristics that can be tuned to specific end-use applications based on customer requirements. We currently offer four commercial “grades” of bulk materials, each of which is available in various particle sizes, which allows for surface areas ranging from 50 to 800 square meters per gram of material depending on the product. Other grades may be made available, depending on the needs for specific applications. In addition, we sell our material in the form of pre-dispersed mixtures with water, alcohol, or other organic solvents and resins. In addition to selling bulk graphene nanoplatelets, we also offer the following value added products that contain our graphene nanoplatelets in various forms:

 

Energy Storage Materials. These consist of specialty advanced materials that have been formulated for specific applications in the energy storage segment. Chief among these is our proprietary, specially formulated silicon-graphene composite material (also referred to as “SiG” or “XG SiG^®”) for use in lithium-ion battery anodes. XG SiG^® targets the never-ending need for higher battery capacity and longer life. In several customer trials, our SiG material has demonstrated the potential to increase battery energy storage capacity by 3-5x what is currently available with conventional lithium ion batteries today. Additionally, we offer various bulk materials for use as conductive additives for cathodes and anodes in li-ion batteries, as an additive to anode slurries for lead-carbon batteries, and we are investigating the use of our materials as part of other battery components.

 

Thermal Management Materials. These consist mainly of two types of products, our XG Leaf^® sheet products and various thermal interface materials (“TIM”) in the form of custom greases or pastes. XG Leaf^® is a family of sheet products ideally suited for use in thermal management in portable electronics, which may include cell phones, tablets and notebook PC’s. As these devices continue to adopt faster electronics, higher data management capabilities, brighter displays with ever increasing definition, they generate more and more heat. Managing that heat is a key requirement for the portable electronics market and our XG Leaf^® product line is well suited to address the need. These sheets are made using special formulations of xGnP^® graphene nanoplatelets as precursors, along with other materials for specific applications. There are several different types of XG Leaf^® available in various thicknesses, depending on the end-use requirements for thermal conductivity, electrical conductivity, or resistive heating. Our custom TIM greases and pastes are also designed to be used in various high temperature environments. Additionally, we offer various bulk materials for use as active components in liquids, coatings and plastic composites to impart improved thermal management performance to such matrices.

 

Inks and Coatings. These consist of specially-formulated dispersions of xGnP^® together with solvents, binders, and other additives to make electrically or thermally conductive products designed for printing or coating and which are showing promise in diverse customer applications such as advanced packaging, electrostatic dissipation and thermal management. We also offer a set of standardized ink formulations suitable for printing. These inks offer the capability to print electrical circuits or antennas, or might be suitable for other electrical or thermal applications. All of these formulations can be customized for specific customer requirements.

 

 

Commercialization Process

 

Because graphene is a new material, most of our customers are still developing applications that use our products, and thus historically most customers have purchased products in quantities consistent with development purposes. The process of “designing-in” new materials is relatively complex and involves the use of relatively small amounts of the new material in laboratory and engineering development for an extended period of time. Following successful development, we expect customers that incorporate our materials into their products will then order much larger quantities of material to support commercial production. Thus, while many of our customers are currently purchasing our materials in kilogram (one or two pound) quantities, we expect many will require tons or even hundreds of tons of material when they commercialize products that incorporate our materials. Although, our customers are under no obligation to report to us on the usage of our materials, some have indicated that they have introduced or will soon introduce commercial products that use our materials.

 

Commercialization is a process, the exact timing of which is often difficult to predict. It starts with our own internal R&D to validate performance for an identified market or customer-specific need. Our customers then validate the performance of our materials and determine that our products can be incorporated into their manufacturing processes. This is initially done at the pilot scale. Our customers then have to introduce products that incorporate our materials to their own customers to validate performance. After their customers have validated performance, our customers will then move to commercial scale production. Every customer goes through the same process, but will do so at varying speeds, depending on the customer, the product and the end-use market. Thus, we are not always able to predict when our customers will begin ordering commercial volumes of our materials or their expected volumes over time. However, as customers move through the process, we generally receive a lot of feedback and gain greater insights regarding their commercialization plans. The following are recent examples of where our products are providing value to our customers at levels that we believe will warrant their use on a commercial basis:

 

·

Lead acid battery manufacturer demonstrating approximately 90% improvement in measured cycle life, appreciable improvement in capacity and charge acceptance and without any loss in water retention performance, and

 

·

Light emitting diode module and product company demonstrated approximately 50% improvement in thermal management capability when compared to existing commercial thermal management products, translating into a 15% improvement in thermal management at the device level, and

 

·

Automotive parts supplier demonstrating improvements in thermal stability for polymer composites incorporating our materials, allowing for approximately 20% higher operating temperatures and a 50% improvement in strength at the elevated temperature, and

 

·

Industrial refrigeration equipment supplier demonstrating improved heat transfer efficiency and energy savings when our xGnP® graphene nanoplatelets are incorporated as a component in the thermal-transfer fluids, and

 

·

Construction company demonstrating less than one weight percent of our product in construction material composites improves flexural strength by more than 30%, and

 

·

Large oil and lubricant supplier showing gear and friction improvements when incorporated into industrial and automotive greases, and

 

·

Engineering design firm for automotive manufacturers found approximately 20% reduction in operating temperature and in thermal uniformity when XG Leaf® replaces standard cooling fins in lithium ion battery packs, and

 

·

Auto manufacturer showing increased tensile and flexural strength and reduced weight in automotive composites.

 

 

The below graphs show total orders and customers based on actual purchases of our materials and do not include free samples or materials used in joint development programs. Since the majority of our customers are still in the development stage, our product sales to date have consisted mainly of orders for relatively small quantities of materials being used in a variety of research or development activities and in early phase limited commercial applications. The average order size for the first nine months of 2016 was $1,032, as compared to $600 for the full year 2015, which indicates these orders were for materials that were not yet incorporated into large-volume commercial products.

 

 

Expected 2016 and 2017 Revenue

 

We are tracking the commercial and development status of more than 100 customer/product engagements. We currently have seven customers who are using our materials in their products and actively selling them to their customers or actively promoting them for future sales, up from the five reported last quarter. In addition, we have another five customers who have indicated that they expect to begin shipping product incorporating our materials in the next 3-6 months, and have another eight customers who have indicated an intent to commercialize in the next 6-9 months. We also have tens of customers with whom we are working that have not yet indicated an exact date for commercialization, but for whom we believe have the potential to contribute to revenue in 2017. As a result, we expect to begin shipping significantly greater quantities of our products as 2016 progresses and into 2017. For example, the average order size for the product revenue reflected in our statement of operations increased 225% for the three months ended September 30, 2016 as compared to the same period in 2015. For the nine months ended September 30, 2016, the increase was 172% as compared to the same period in 2015. These increases are resulting from larger orders primarily from customers entering into initial commercial production with our materials. Based on the status of current discussions with such customers, we believe that we will continue to ramp up revenue through the rest of 2016 and that we believe we will be able to recognize approximately $1 million of revenue in 2016 and approximately $10-15 million of revenue in 2017. 

 

 

Addressable Markets

 

The markets that we serve are large and rapidly growing. For example, as shown in the figure below (Avicenne Energy, “The Rechargeable Battery Market, 2014–2025”, July 2015), the market for materials used in lithium ion battery anodes is currently approximately $1 billion, but is expected to approximately double over the next ten years. We believe our ability to address next generation anode materials represents a significant opportunity for us.

 

 

According to Prismark Partners, LLC, a leading electronics industry consulting firm specializing in advanced materials, the 2014 market for finished graphitic heat spreaders as sold to the OEM and EMS companies with adhesive, PET, and/or copper backing for selected portable applications was $600 million, and is expected to reach $900 million in 2018. The market is currently in a significant expansion period driven by the demand for portable devices. In a press release dated March 3, 2015, Gartner, Inc., a leading research organization, estimated the 2014 global cell phone market at 1.88 billion units. Every cell phone has some form of thermal management system, and we believe many of the new smart phones being developed can benefit from the thermal management properties of our XG Leaf^® product line. In August 2015, International Data Corporation (IDC) in their Worldwide Quarterly Tablet Tracker, estimated the global shipment of tablets in 2015 at 212 million units. Thus, we believe our XG Leaf^® product line is well positioned to address a very large and rapidly growing market.

 

Intellectual Property

 

We believe that our intellectual property (“IP”) is an important asset. Our strategy is to keep our production processes as legally defined and protected trade secrets rather than to patent them. Some of our proprietary manufacturing processes were developed at Michigan State University (MSU) and licensed to us in 2006. We licensed three U.S. patents and patent applications from MSU. However, over time, our scientists and engineers have made many further discoveries and inventions that are embodied in the form of five additional U.S. patents, two China patents, two patent application that are allowed but not yet granted (one in each China and Taiwan) and 17 additional U.S. patent applications, and numerous trade secrets. For each patent application filed in the U.S., we make a determination on the nature and value of the patent. For many of the applications filed in the U.S., additional filings are made in other countries such as the European Union, Japan, South Korea, China, Taiwan or other applicable countries. These filings and analyses are made on a case-by-case basis. Typically, patents that are defensive in nature are not filed abroad, while those that are protective of active XGS products or applications are filed in relevant countries abroad. Our general IP strategy is to keep as trade secrets those manufacturing processes that are difficult to enforce should they be disclosed and to seek patent coverage for other manufacturing processes, materials derived from those processes, unique combinations of materials and end uses of materials containing graphene nanoplatelets. We believe that the combination of our rights under the MSU license, our patents and patent applications, and our trade secrets create a strong intellectual property position.

 

 

Operating Segment

 

We have one reportable operating segment that manufactures xGnP^® graphene nanoplatelets and value-added products produced therefrom, conducts research on graphene nanoplatelets and related products, and licenses our technology as appropriate. As of September 30, 2016 we shipped products on a worldwide basis, but all of our assets were located within the United States.

 

Results of Operations for the Three and Nine Months Ended September 30, 2016 Compared with the Three and Nine Months Ended September 30, 2015

 

The following table summarizes the results of our operations for the three and nine months ended September 30, 2016 and 2015.

 

Summary Income Statement		For the Three Months Ended September 30,												For the Nine Months Ended September 30,
		2016				2015				Change				2016				2015				Change
Revenues
Product Sales		$	88,856			$	38,295			$	50,561			$	230,635			$	156,608				74,027
Grants			50,111				80,967				(30,856	)			208,475				299,879				(91,404	)
Licensing Revenue			25,000				25,000				-				75,000				75,000				-
Total Revenues			163,967				144,262				19,705				514,110				531,487				(17,377	)
Cost of Goods Sold			367,395				472,720				(105,325	)			1,172,397				1,341,948				(169,551	)
Gross Loss			(203,428	)			(328,458	)			125,030				(658,287	)			(810,461	)			152,174
Research & Development Expense			231,312				359,340				(128,028	)			866,668				1,135,326				(268,658	)
Sales, General & Administrative Expense			896,650				997,404				(100,754	)			2,618,252				3,133,375				(515,123	)
Total Operating Expense			1,127,962				1,356,744				(228,782	)			3,484,920				4,268,701				(783,781	)
Operating Loss			(1,331,390	)			(1,685,202	)			353,812				(4,143,207	)			(5,079,162	)			935,955
Other Income (Expense)			57,631				(969,842	)			1,027,473				153,472				(1,703,889	)			1,857,361
Net Loss		$	(1,273,759	)		$	(2,655,044	)		$	1,381,285			$	(3,989,735	)		$	(6,783,051	)		$	2,793,316

 

Product sales consist of two broad categories: (1) material sold to customers for research or development purposes and (2) production orders for customers. Typically, the order sizes for the first category are relatively small, however we expect orders in the second category to be much larger in the future. In the nine months ended September 30, 2016, product sales increased by $74,027, or 32%. The main reason for the increase was customers moving through development programs towards commercialization, requiring larger quantities of our materials for advanced testing and pilot production activities.

 

We ship our products from our Lansing manufacturing facilities to customers around the world. During the nine months ended September 30, 2016, we shipped materials to customers in 24 different countries, as compared to 26 countries during the same period in 2015. Shipments to South Korea accounted for approximately 19.9% and 11.5% and shipments to the United Kingdom accounted for approximately 10.3% and 4.2% of total product revenues during the nine months ended September 30, 2016 and 2015, respectively. No other countries accounted for more than 10% of product revenue in each of these respective periods.

 

The table below shows a comparison of orders received, both domestic and international. The table also includes the average order size for product sales reflected in our Statement of Operations. These numbers indicate that our customer base remains active with development or research projects that use our materials and indicate the breadth of our geographic coverage. The average order size for the product revenue reflected in our statement of operations increased 225% for the three months ended September 30, 2016 as compared to the same period in 2015. For the nine months ended September 30, 2016, the increase was 172% as compared to the same period in 2015. These increases are resulting from larger orders primarily from customers entering into initial commercial production with our materials. Although the average size of these orders is still relatively small, we are encouraged that the trend is increasing. The current average order size indicates that most of our orders are for R&D and development activity. We expect that our average order size will continue to increase as more customers begin to commercialize products that incorporate our materials within them and existing customers ramp up production volume.

 

Order Summary		For the Three Months Ended September 30,												For the Nine Months Ended September 30,
		2016				2015				Change				2016				2015				Change
Number of orders - domestic			69				72				-3				195				212				-17
Number of orders - international			55				43				12				193				152				41
Number of orders - total			124				115				9				388				364				24
Average order size for product sales recorded in our Statement of Operations		$	1,307			$	580			$	727			$	1,032			$	601			$	431
											225	%											172	%

 

Grant revenues for the nine months ended September 30, 2016 and 2015 were $208,475 and $299,879, respectively. The current year consists of: $158,365 of revenue from the Phase II SBIR grant from the US Department of Energy, $25,110 for a new $150,000 nine month DOE Phase I SBIR grant to develop and demonstrate a composite anode material that delivers improved capacity retention during full Lithium-ion battery charge to further the nation’s energy strategy to reduce reliance on fossil fuels and improve the environment, and $25,000 from the Michigan Emerging Technologies Fund to assist with commercialization of the technology investigated under the DOE Phase I SBIR grant. Grant revenues for the nine months ended September 30, 2015 consisted of the II SBIR grant from the DOE. This program, entitled “Low-cost, High-Energy Si/Graphene Anodes for Li-Ion Batteries” was an award for a total of $1M to fund the research project over a planned two-year period commencing in January 2014 and originally expiring December 2015; a no cost contract extension had been approved with a new expiration date of June 22, 2016. The grant has been billed in full and is now considered completed. DOE grant revenues are recorded as time and expenses are incurred for allowable charges specified in the grant contracts. Time and charges for the DOE activity was higher in 2015 than 2016 and thus the grant revenues from this source is lower in the current year by $116,404.

 

 

Cost of Goods Sold

 

We use a standard cost system to estimate the direct costs of products sold. Direct costs include estimates of raw material costs, packaging, freight charges net of those billed to customers, and an allocation for direct labor and manufacturing overhead. Because of the nature of our production processes, there is a substantial fixed manufacturing expense requirement that represents the ongoing cost of maintaining production facilities that are not directly related to products sold, so we use a “full capacity” allocation of overhead based on an estimate of what product costs would be if the manufacturing facilities were operating on a full-time basis and producing products at the designed capacity. This estimate involves estimating both the level of expenses as well as production amounts as if the manufacturing facility were operating on a continuous, three-shift, production basis.

 

The following table shows the relationship of direct costs to product sales for the three and nine months ended September 30, 2016 and 2015:

 

Gross Profit Summary		For the Three Months Ended September 30,												For the Nine Months Ended September 30,
		2016				2015				Change				2016				2015				Change
Product Sales		$	88,856			$	38,295			$	50,561			$	230,635			$	156,608			$	74,027
Direct Costs			44,344				24,848				19,496				101,397				77,516				23,881
Direct Cost Margin		$	44,512			$	13,447			$	31,065			$	129,238			$	79,092			$	50,146
% of Sales			50.1	%			35.1	%							56	%			50.5	%
Unallocated Manufacturing Expense			323,051				447,872				(124,821	)			1,071,000				1,264,432				(193,432	)
Gross Loss on Product Sales		$	(278,539	)		$	(434,425	)		$	155,886			$	(941,762	)		$	(1,185,340	)		$	243,578

 

We believe that the fluctuations in direct cost from period to period are not indicative of overall performance or of future margins because of the relatively small size of our sales in comparison to our future expectations. Direct costs vary depending on the size of an order, the specific products being ordered and other factors like shipping destination.

 

Costs associated with grant revenues tend to be a mixture of facilities use, management time, labor from scientists, technicians and manufacturing personnel, and some supplies. Because of the difficulty of developing and maintaining an administrative system to gather direct costs for grants, together with the relatively small size of grant revenues, we do not track direct costs for grant revenues as a separate cost category. Therefore, we do not calculate direct cost margins associated with grant revenues but, rather, we view these revenues as being supported by indirect corporate expenses.

 

 

Costs associated with licensing revenue tend to be a mixture of IP costs as well as management and administrative expenses that are indirect in nature. As such, we do not assign direct costs to licensing revenues. Where revenues from a license agreement can be assigned to specific product revenues, we classify these revenues as product sales and, using our standard cost system, assign direct costs to those sales.

 

The remaining “non-direct” costs of operating our manufacturing facilities are recorded as unallocated manufacturing expenses. These expenses include personnel costs, rent, utilities, indirect supplies, depreciation, and related indirect expenses. Unallocated manufacturing expenses are expensed as incurred. We allocate these costs as direct product costs on the basis of the proportion of these expenses that would be representative product costs if we were operating our factory at full capacity.

 

For the nine months ended September 30, 2016, unallocated manufacturing expenses decreased by $193,432 or 18% from the same period in 2015. The largest part of this decrease was due to decreased payroll, tax and benefit costs as compared with the prior year.

 

Research and Development Expenses

 

Research and development expenses totaled $866,668 for the nine months ended September 30, 2016. This is a decrease of $268,658 or 31% from the previous year. The largest part of this decrease was due to reduced payroll, tax and benefit costs as compared with the prior year.

 

Selling, General and Administrative Expenses

 

During the first nine months of 2016 we incurred selling, general and administrative expenses (SGA) of $2.6 million. This is a decrease of $515,123 or 19.7% from the same period in the prior year. This decrease was driven by a reduction in payroll and related expenses as well as a reduction in professional fees. Common stock issuance costs incurred in 2016 for legal, accounting, and other fees were $538,640 and these expenses are recorded as an offset to common stock on the balance sheet. As we continue to grow and gain traction in the marketplace our SGA expenses will fluctuate but should stabilize and become more fixed in nature as we achieve economies of scale.

 

Other Income (Expense)

 

The following table shows a comparison of other income and expense by major component for the three and nine months ended September 30, 2016 and 2015:

 

Other Income (Expense)		For the Three Months Ended September 30,												For the Nine Months Ended September 30,
		2016				2015				Change				2016				2015				Change
Incentive Refund & Interest Income		$	24,197			$	28,996			$	(4,799	)		$	72,423			$	80,624			$	(8,201	)
Interest Expense			(56,013	)			(583,980	)			527,967				(241,011	)			(1,640,668	)			1,399,657
Gain from change in fair value of derivative liability - warrants			108,056				(414,858	)			522,914				340,669				(143,845	)			484,514
Loss on disposal of equipment			(18,609	)			-				(18,609	)			(18,609	)			-				(18,609	)
Total		$	57,631			$	(969,842	)		$	1,027,473			$	153,472			$	(1,703,889	)		$	1,857,361

 

Interest expense for the three and nine months ended September 30, 2016 was substantially lower than the same periods in 2015 because the convertible notes outstanding in 2015 were converted to equity on December 31, 2015.

 

 

Cash Flow Summary

 

The following condensed cash flow statement compares cash flow from operating, investing and financing activities for the nine months ended September 30, 2016 and 2015. Net cash used by operating activities decreased by 49% during the nine months ended September 30, 2016 as compared to the same period in 2015, because of reduced operating expenses, as discussed above.

 

		Nine Months Ended September 30								Change 2015 – 2016
		2016				2015				$				%
Cash, beginning of period		$	1,060,224			$	2,088,866			$	(1,028,642	)			(49.2	)
Net Cash provided (used) by:
Operating activities			(2,667,307	)			(4,591,143	)			(1,923,836	)			(41.9	)
Investing Activities			(173,451	)			(217,646	)			(44,195	)			(20.3	)
Financing Activities			2,418,038				4,305,028				(1,886,990	)			(43.8	)
Net increase (decrease) in cash			(422,720	)			(503,761	)			(81,041	)			(16.1	)
Cash, end of period		$	637,504			$	1,585,105			$	(947,601	)			(59.8	)

 

Investment activities for the nine months ended September 30, 2016 included net capital expenditures for the purchase of property and equipment of $84,187 and $89,264 for IP as compared with $157,983 for property and equipment and $59,663 for IP during the corresponding period in 2015. These levels of capital expenditures are significantly lower than expected in the future as we begin to ramp up our production capacity to meet customer orders. Therefore, these expenditures should not be interpreted as indicative of future expenditures in this area.

 

Financing activity for the nine months ended September 30, 2016 included: $3,102,032 of proceeds from the issuance of common stock, $574,750 of proceeds from short-term notes, net advances from capital leases of $29,896, repayment of short-term notes of $750,000, and expenses of $538,640 for IPO related costs. Financing activity for the nine months ended September 30, 2015 included $4,319,792 of proceeds from the issuance of Series B preferred stock, $14,000 from the issuance of common stock, and repayments of capital leases of $28,764.

 

Liquidity and Capital Expenditures

 

Ongoing cash flow from operations has been negative throughout our history. In addition, we have invested significant amounts in research and manufacturing capabilities. We anticipate that we will need to invest further to support ongoing operations for a minimum of another one to two years. We are currently are in the process of conducting sales of common stock through our IPO in accordance with our registration statement on Form S-1 declared effective on April 13, 2016, and as amended on August 31, 2016. We expect that our cash on hand at September 30, 2016 of $637,504 and proceeds from our IPO will sustain our operations for the next twelve months. Our plan is also to further develop customer relationships and increase our revenues derived from our products and IP licensing.

 

The Company’s financial projections show that the Company may need to raise an additional $15,000,000 or more before it is capable of achieving sustainable cash flow from operations. We intend that the primary means for raising such funds will be through our currently ongoing IPO. However, we cannot make any assurance that we will be able to raise these funds or that the terms and conditions of future financing will be workable or acceptable for the Company and its shareholders.

 

We also currently forecast a need for additional capital expenditures to execute on our business plan. The amount and timing of such expenditures will be dependent on the timing and magnitude of sales orders received from customers, but we currently anticipate a need to invest approximately $1,000,000 to $6,000,000 during the next twelve months. We plan to fund these investments through a mixture of capital lease financing, debt financing, and from the proceeds of our IPO. If we are unable to obtain such financing, we may be forced to curtail our investment activities and this may limit our ability to grow our revenues as fast as we would like.

 

Additionally, we anticipate that as our sales increase we will need to invest funds in working capital to support additional inventory and accounts receivable. Taken together, these multiple cash requirements will likely exceed our cash flow from operations for at least one to two more years.

 

Although there can be no guarantee of successful funding in the future, we intend to pursue the sale of additional equity securities, as well as additional debt or lease financing in the future, until such time as ongoing revenues allow us to generate a positive monthly cash flow from the business sufficient to cover our cash requirements.

 

 

In the event we are unable to fund our operations from existing cash on hand, operating cash flows, or additional debt or equity capital, we may be forced to reduce our expenses by curtailing operations, slow down our growth rate, or discontinue operations. Our condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.

 

Critical Accounting Estimates

 

In preparing the consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”), we have adopted various accounting policies. Our most significant accounting policies are disclosed in Note 2 to the consolidated financial statements included in our registration statement on Form S-1 for the year ended December 31 2015, which became effective April 13, 2016.

 

The preparation of the consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Our estimates and assumptions, including those related to inventories, intangible assets, property, plant and equipment, legal proceedings, research and development, warranty obligations, product liability, fair valued liabilities, sales returns and discounts, and income taxes are updated as appropriate, which in most cases is at least quarterly. We base our estimates on historical experience, or various judgements about the reported values of assets, liabilities, revenues and expenses. Actual results may materially differ from these estimates.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Smaller reporting companies are not required to provide this information.

 

Item 4. Controls and Procedures

 

(a) Evaluation of disclosure controls and procedures. At the conclusion of the period ended September 30, 2016, we carried out an evaluation, under the supervision and with the participation of our management, including our Principal Executive Officer/Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based upon that evaluation, our Principal Executive Officer/Principal Financial Officer concluded that as of September 30, 2016, our disclosure controls and procedures were effective and adequately designed to ensure that the information required to be disclosed by us in the reports we submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the applicable rules and forms and that such information was accumulated and communicated to our Principal Executive Officer/Principal Financial Officer, in a manner that allowed for timely decisions regarding required disclosure.

 

We do not expect that our disclosure controls and procedures will prevent all errors and all instances of fraud. Disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Further, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and the benefits must be considered relative to their costs. Because of the inherent limitations in all disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that we have detected all our control deficiencies and instances of fraud, if any. The design of disclosure controls and procedures also is based partly on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

 

(b) Changes in internal controls. There were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings.

 

Beginning in 2014, POSCO, one of our licensees and a shareholder, has had a contractual obligation to pay us a minimum fee of $100,000 per year to license certain technologies. This obligation is due annually on February 28 of the following year. We record this license revenue at a rate of $25,000 per quarter. POSCO is disputing that they are obligated to pay the royalties. A petition for arbitration has been filed for this matter by the Company on March 9, 2016. On July 7 we received a letter from the International Court of Arbitration and they have assigned an arbitrator to the case. No assessment or decision has made by the arbitrator as of the issuance date of this report.

 

Item 1A. Risk Factors.

 

Smaller reporting companies are not required to provide this information.

 

However, the Company is supplementing its risk factors contained in the Company's registration statement on Form S-1 (File No. 333-209131) initially declared effective on April 13, 2016, as amended on August 31, 2016 with the following:

 

Newly purchased shares in the Company will experience immediate dilution

 

Newly purchased shares of common stock purchased will experience immediate dilution of $4.04 per share or 50.5% as a result of the public offering pursuant to the Company's registration statement initially declared effective on April 13, 2016, as amended on August 31, 2016.

 

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

 

None.

 

Item 3. Defaults Upon Senior Securities.

 

None.

 

Item 4. Mine Safety Disclosures.

 

None.

 

Item 5. Other Information.

 

The Company is filing its updated Form of Subscription Agreement effective as of November 3, 2016 as Exhibit 10.1. This agreement updates the "Form of Subscription Agreement for Primary Offering" originally filed as Exhibit 10.37 to the Company's registration statement on Form S-1 on January 27, 2016.

 

The Company is also filing its Form of Indemnification Agreement, as approved at the meeting of the Board of Directors on October 28, 2016, as Exhibit 10.2. This agreement sets forth the indemnification obligations of the Company to its directors for their services to the Company.

 

 

Item 6. Exhibits.

 

EXHIBIT NUMBER		DESCRIPTION		LOCATION
10.1		Form of Subscription Agreement for Primary Offering (updated as of November 3, 2016)		Filed herewith
10.2		Form of Indemnification Agreement		Filed herewith
31.1		Certifications of the Chief Executive Officer and Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		Filed herewith
32.1		Certification Pursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 of the Sarbanes-Oxley Act Of 2002*		Furnished herewith
101. INS		XBRL Instance Document		Filed herewith
101. CAL		XBRL Taxonomy Extension Calculation Link base Document		Filed herewith
101. DEF		XBRL Taxonomy Extension Definition Link base Document		Filed herewith
101. LAB		XBRL Taxonomy Label Link base Document		Filed herewith
101. PRE		XBRL Extension Presentation Link base Document		Filed herewith
101. SCH		XBRL Taxonomy Extension Scheme Document		Filed herewith

 

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized.

 

XG SCIENCES, INC.

 

Dated: November 3, 2016	By:		/s/ Philip L. Rose
	Name:		Philip L. Rose
	Title:		Chief Executive Officer, President, Treasurer, Principal Executive Officer and Principal Financial Officer
Dated: November 3, 2016	By:		/s/ Corinne Lyon
	Name:		Corinne Lyon
	Title:		Controller and Principal Accounting Officer