UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Commission File Number: 001-37943

PETROSHARE CORP.

(Exact name of registrant as specified in its charter)

9635 Maroon Circle, Suite 400

Englewood, Colorado 80112

(Address of principal executive offices)(Zip Code)

(303) 500-1160

(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 ☒    No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§203.405 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 ☐

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act. ☒

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 27,718,802 shares outstanding as of November 13, 2017.

PETROSHARE CORP.

FORM 10‑Q

FOR THE QUARTER ENDED

September 30, 2017

Table of Contents

References in this report to agreements to which PetroShare Corp. is a party and the definition of certain terms from those agreements are not necessarily complete and are qualified by reference to the agreements. Readers should refer to the Company’s Annual Report on Form 10‑K for the fiscal year ended December 31, 2016, and other reports filed with the SEC, and the exhibits filed with or incorporated therein by reference.

Please see Cautionary Language Regarding Forward‑Looking Statements on page 27 of this
report for important information contained herein.

PART I.  FINANCIAL INFORMATION

Item 1.  Condensed Consolidated Financial Statements.

PetroShare Corp.

Condensed Consolidated Balance Sheets

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

PetroShare Corp.

Condensed Consolidated Statements of Operations

(unaudited)

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

PetroShare Corp.

Condensed Consolidated Statements of Cash Flows

(unaudited)

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

NOTE 1—ORGANIZATION AND NATURE OF BUSINESS

PetroShare Corp. (“PetroShare” or the “Company”) is a corporation organized under the laws of the State of Colorado on September 4, 2012 to investigate, acquire and develop crude oil and natural gas properties in the Rocky Mountain or mid-continent portion of the United States. Since inception, the Company has focused on financing activities and the acquisition, exploration and development of crude oil and natural gas prospects in the Denver-Julesburg Basin, or DJ Basin, in northeast Colorado and other parts of the State. The Company’s current operating focus is within the Wattenberg Field of the DJ Basin, which is located primarily in Adams and Weld Counties, Colorado.

NOTE 2—BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The interim condensed consolidated financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures included are adequate to make the information presented not misleading.

In management’s opinion, the Condensed Consolidated Balance Sheets as of September 30, 2017 (unaudited) and December 31, 2016 (see Note 3), the unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2017 and 2016, and the unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2017 and 2016, contained herein, reflect all adjustments, consisting solely of normal recurring items, which are necessary for the fair presentation of the Company’s financial position, results of operations and cash flows on a basis consistent with that of the Company’s prior audited financial statements. However, the results of operations for the interim periods may not be indicative of results to be expected for the full fiscal year. Therefore, these condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto and summary of significant accounting policies included in the Company’s annual report on Form 10-K for the year ended December 31, 2016. Except as noted below, there have been no changes to the footnotes from those accompanying the audited financial statements contained in the Company’s Form 10‑K for the year ended December 31, 2016.

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary CFW Resources, LLC, formed on August 1, 2017.

Loss Per Share

Basic and diluted loss per share is computed by dividing net loss by the weighted average number of common shares outstanding during the period. The Company excluded potentially dilutive securities as the effect of their inclusion would be anti-dilutive.

Capitalized Interest Costs

The Company has capitalized certain interest costs related to unproved properties that are currently undergoing activities necessary to prepare them for their intended use. These costs have been capitalized to oil and gas properties.

Deferred Equity Issuance Costs

The Company defers as other current assets the direct incremental costs of raising capital through equity offerings until such time as the offering is completed. At the time of the completion of an offering, the costs are offset against the proceeds received. Should an offering be terminated, deferred equity issuance costs are charged to operations during the period in which an offering is terminated. As of September 30, 2017 and December 31, 2016, the Company’s deferred equity issuance costs totaled $186,312 and $nil, respectively (Note 9).

Debt Discount Costs

On January 30, 2017, the Company completed the third and final closing of a private placement of units consisting of common stock purchase warrants and convertible promissory notes with a total aggregate face value of $10,000,000 (Note 6). On September 25, 2017, the Company completed the first of three closings of a private placement of Series B convertible promissory notes. The notes issued in the first closing of the Series B offering had a total aggregate face value of $1,695,000 (Note 6). Both the original convertible notes and the Series B Notes contain an embedded beneficial conversion feature. The proceeds from the sale of the securities were allocated between the convertible notes and, where applicable, the warrants based on the relative fair values of the debt instrument, without the warrants, and of the warrants themselves at the time of issuance. The fair value of the beneficial conversion feature, limited to the gross proceeds, has been recorded as a reduction of the carrying value of the convertible notes and is being amortized to interest expense using the effective interest method over the term of the notes. The fair value of warrants issued has been recorded as a reduction to the carrying value of the convertible notes, limited to the gross proceeds, and is being amortized over the term of the notes using the effective interest method. Origination fees paid in cash have been recorded as a reduction in the carrying value of the convertible notes and are being amortized over the term of the notes using the effective interest method. The fair value of warrants issued to the placement agent in connection with the offering have been recorded as a charge to additional paid-in capital.

Recently Issued Accounting Pronouncements

In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update  (“ASU”) 2016-09, “Improvements to Employee Share-Based Payment Accounting” (“ASU 2016-09”), which is intended to improve the accounting for share-based payment transactions. ASU 2016-09 changes several aspects of the accounting for share-based payment award transactions, including: (1) Accounting and Cash Flow Classification for Excess Tax Benefits and Deficiencies, (2) Forfeitures, and (3) Tax Withholding Requirements and Cash Flow Classification. ASU 2016-09 is effective for public businesses for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016, with early adoption permitted. The Company adopted this pronouncement effective January 1, 2017. Upon adoption of this standard, the Company no longer estimates the total number of awards for which the requisite service period will not be rendered, and effective January 1, 2017, began accounting for forfeitures as they occur.  The adoption of these provisions did not materially impact the condensed consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2014-09”), which establishes a comprehensive new revenue recognition standard designed to depict the transfer of goods or services to a customer in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. In doing so, companies may need to use more judgment and make more estimates than under current revenue recognition guidance. In March 2016, the FASB released certain implementation guidance through ASU 2016‑08 (collectively with ASU 2014-09, the "Revenue ASUs") to clarify principal versus agent considerations. The Revenue ASUs allow for the use of either the full or modified retrospective transition method, and the standard will be effective for annual reporting periods beginning after December 15, 2017 including interim periods within that period, with early adoption permitted for annual reporting periods beginning after December 15, 2016. Currently, the

Company has not identified any contracts that would require a change from the entitlements method, historically used for certain domestic crude oil and natural gas sales, to the sales method of accounting. The Company plans to adopt the guidance using the modified retrospective method on the effective date of January 1, 2018.

In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)" ("ASU 2016-02"), which establishes a comprehensive new lease standard designed to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply. An entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date of ASU 2016-02 in accordance with previous standards. ASU 2016-02 is effective for public businesses for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted. The Company is currently evaluating the impact of the adoption of this standard on its condensed consolidated financial statements.

There were various updates recently issued by the FASB, most of which represented technical corrections to the accounting literature or application to specific industries and are not expected to a have a material impact on the Company’s reported financial position, results of operations, or cash flows.

NOTE 3—REVISION OF PRIOR PERIOD FINANCIAL STATEMENTS

In connection with the preparation of its condensed financial statements for the quarter ended March 31, 2017, the Company identified an error related to the manner in which it accounted for the fair value of convertible notes and warrants issued in the Company’s private placement during December 2016 (Note 6). Specifically, the Company was required to apply the guidance of Accounting Standards Codification (“ASC”) 470, and more specifically, ASC 470-20-25-2 and ASC 470-20-25-3. On the balance sheet at December 31, 2016, the Company recorded the face value of convertible notes payable under liabilities, discounted by (i) the value of the original issue discount and (ii) the value of the warrants issued to the placement agent. The Company did not, however, discount the value of the convertible notes payable by the fair value of the warrants issued to individual investors.

In accordance with Staff Accounting Bulletin (“SAB”) No. 99, Materiality, and SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, the Company evaluated the error and determined that the related impact was not material to the Company’s results of operations or financial position for any prior annual or interim period. Accordingly, the Company has corrected these errors as of and for the year ended December 31, 2016 by revising the condensed financial statements. Periods not presented herein will be revised, as applicable, in future filings.

The following tables present the revisions to the balance sheet as of, and the statement of operations for the year ended, December 31, 2016:

Balance Sheet

Statement of Operations

NOTE 4—GOING CONCERN

Pursuant to ASU 2014-15, the Company has assessed its ability to continue as a going concern for a period of one year from the date of the issuance of these condensed consolidated financial statements. Substantial doubt about an entity’s ability to continue as a going concern exists when relevant conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year from the financial statement issuance date. As shown in the accompanying condensed consolidated financial statements, the Company incurred a net loss of $4.9 million during the nine months ended September 30, 2017, and as of that date, the Company’s current liabilities exceeded its current assets by $18.1 million.

At September 30, 2017, the Company had a cash balance of $0.7 million and other current assets of $3.2 million.

As of September 30, 2017, the Company has insufficient working capital and revenues from operations to meet its maturing debt obligations and other liabilities incurred in connection with the Company’s development activities. The Company will also need to generate sufficient cash flow from operations and sell equity or debt to fund further drilling and acquisition activity. If sufficient cash flow and additional financing is not available, the Company may be compelled to reduce the scope of its business activities and/or sell a portion of the Company’s interests in its oil and gas properties. This, in turn, may have an adverse effect on the Company’s ability to realize the value of its assets. These factors raise substantial doubt about the Company’s ability to continue as a going concern.

The Company’s condensed consolidated financial statements do not include any adjustments related to the realization of the carrying value of assets or the amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence. However, management believes that it can be successful in obtaining equity and/or debt financing which will enable the Company to continue as a going concern.

NOTE 5—CRUDE OIL AND NATURAL GAS PROPERTIES

The Company’s oil and gas properties are located entirely within the United States. The net capitalized costs related to the Company’s oil and gas producing activities were as follows:

Costs Incurred in Crude Oil and Natural Gas Activities.  Costs incurred in connection with the Company's crude oil and natural gas acquisition, exploration and development activities for each of the nine-month periods are shown below:

During the three months ended September 30, 2017 and 2016, depletion expense, which is included as part of the depletion, depreciation and amortization in the condensed consolidated statement of operations, was $1,153,273 and $23,525, respectively, and $3,135,614 and $23,525 for the nine months ended September 30, 2017 and 2016, respectively.

NOTE 6—DEBT

Line of credit

On May 13, 2015, the Company entered into a Revolving Line of Credit Facility Agreement (“initial line of credit”) with Providence Energy Operators, LLC (“PEO”), which provides to the Company a revolving line of credit of up to $5.0 million, maturing June 30, 2018. Effective September 1, 2017, interest on the initial line of credit was increased from 8% to 10% per annum.

As of September 30, 2017 and December 31, 2016, the outstanding balance on the initial line of credit was $5,000,000 plus accrued interest of $609,875 and $302,477, respectively. During the three and nine months ended September 30, 2017, the Company recorded interest expense of $117,375 and $305,290, respectively, which excluded $10,441 of interest that was capitalized to wells in progress during the year.  During the three and nine months ended September 30, 2016, the Company recorded interest expense of $96,157 and $153,053, respectively, related to the initial line of credit.

On September 23, 2017, the Company entered into a letter agreement with PEO and PEP III in connection with the issuance of the Series B Notes discussed below pursuant to which the Company agreed to (i) issue 250,000 shares of its common stock to PEO (Note 9), (ii)  increase the interest rate on the initial line of credit from 8% per year to 10% per year effective September 1, 2017, (iii) begin making interest payments on the initial line of credit beginning in the fourth quarter of 2017; and (iv) meet with representatives of PEO not less frequently than semi-monthly beginning November 1, 2017 to discuss and review the Company's working capital.

The Company issued 250,000 shares to PEO valued at $1.55 per share. The value of the shares has been recorded as a deferred financing fee and is being amortized over the remaining life of the initial line of credit which matures on June 30, 2018. As of September 30, 2017, the balance of the unamortized portion of the deferred financing fee amounted to $379,167.

Supplemental line of credit

On October 13, 2016, the Company entered into a revolving line of credit facility agreement (the “supplemental line of credit”) with Providence Energy Partners III, LP (“PEP III”). PEP III is an affiliate of PEO by virtue of having some common management personnel. The supplemental line of credit permitted the Company to borrow up to $10.0 million to pay costs associated with its acquisition and development of oil and gas properties in the Wattenberg Field. Interest on the supplemental line initially accrued at the rate of 8% per year.

The supplemental line of credit was amended on March 30, 2017, pursuant to which the Company agreed not to borrow additional amounts against the supplemental line of credit and to repay $3,552,500 in outstanding principal not later than April 13, 2017, in exchange for PEP III extending the maturity date of the supplemental line of credit until June 13, 2017. On April 12, 2017, the Company paid $3,552,500 in accordance with the amendment.

On June 8, 2017, the Company entered into a letter agreement (“PEP III Agreement”) with PEP III and PEO, pursuant to which PEP III agreed to modify the Company’s supplemental line of credit. The PEP III Agreement extended the maturity date of the supplemental line of credit, including approximately $3.8 million in outstanding principal and accrued interest, from June 13, 2017 until December 27, 2017, and increased the interest rate on the supplemental line from 8% to 10%, effective June 8, 2017. The Company and PEO also agreed to amend the participation agreement between the Company and PEO, dated May 13, 2015 (“Participation Agreement”), in order to expand the area of mutual interest (“AMI”) established, and to grant PEP III an option to participate under the Participation Agreement. As amended, the Participation Agreement grants PEO the option to acquire up to a 45%

interest and, so long as the supplemental line of credit remains outstanding, PEP III the option to acquire up to a 10% interest in and participate in any oil and gas development on acreage acquired by the Company within the expanded AMI. The expanded AMI covers a total of four and one-half townships in Adams and Weld Counties, Colorado.

As of September 30, 2017 and December 31, 2016, the outstanding balance on the supplemental line of credit was $3,552,500 and $7,088,698, plus accrued interest of $364,599 and $50,422, respectively. During the three and nine months ended September 30, 2017, the Company recorded interest expense of $89,542 and $314,177, respectively, related to the supplemental line of credit. No interest expense was recorded in the prior nine-month period.

Convertible Notes

On December 30, 2016, January 20, 2017 and January 30, 2017, the Company completed the private placement of units consisting of convertible promissory notes (“Convertible Notes’) with an aggregate face value of $10.0 million and common stock purchase warrants. The Company received net proceeds of approximately $9.0 million from the private placement, after placement agent fees and other associated expenses.

Debt issuance costs related to origination fees paid in cash have been recorded as a discount to the Convertible Notes and are being amortized to interest expense utilizing the effective interest method over the term of the Convertible Notes. As of September 30, 2017 and December 31, 2016, the unamortized portion of debt issuance costs amounted to $745,046 and $204,703, respectively. The Company recorded interest expense of $102,949 and $336,050 related to the accretion of the discount for the three and nine months ended September 30, 2017, respectively. No interest expense was recorded in the prior nine-month period.

In accordance with ASC 470, the proceeds from the sale of the Convertible Notes was allocated between the conversion feature and the warrants based on the fair values of the debt instrument without the warrants and of the warrants themselves at the time of issuance. The fair value of the beneficial conversion feature of $5,306,199 has been recorded as a reduction of the carrying value of the Convertible Notes and is being amortized to interest expense using the effective interest method over the term of the Convertible Notes. The fair value of the warrants of $3,682,801 has been recorded as a reduction to the carrying value of the Convertible Notes and is being amortized to interest expense using the effective interest method over the term of the Convertible Notes. The fair value of the warrants issued to the placement agent in connection with the offering of $1,001,471 has been recorded as a charge to additional paid-in capital.

As of September 30, 2017, the Company recorded accrued interest of $252,055 and recognized interest expense of $256,234 and $447,903 for the three and nine months ended September 30, 2017, respectively, related to the Convertible Notes. Interest on the Convertible Notes during 2017 of $249,315 was capitalized to oil and gas properties.

Series B Convertible Notes

On September 25, 2017, the Company sold Series B Unsecured Convertible Promissory Notes (the "Series B Notes") in the principal amount of $1,695,000 to 27 accredited investors, which includes five of the Company's officers and directors who collectively purchased Series B Notes in the principal amount of $380,000. The Series B Notes are unsecured, bear interest at 15% per year and are due and payable on December 31, 2018.  At the option of the holders of the Series B Notes, the principal amount of the Series B Notes, and any accrued but unpaid interest, are convertible into shares of the Company's common stock at a conversion price of $1.50 per share.  The Company paid sales commissions of $53,950 and associated expenses of $1,000 in connection with the sale of the Series B Notes.

Debt issuance costs related to origination fees paid in cash have been recorded as a discount to the Series B Notes and are being amortized to interest expense utilizing the effective interest method over the term of the Series B

Notes. As of September 30, 2017, the unamortized portion of debt issuance costs amounted to $54,351. The Company recorded interest expense of $599 related to the accretion of the discount for the three and nine months ended September 30, 2017, respectively.

In accordance with ASC 470, the fair value of the beneficial conversion feature of $56,500, has been recorded as a reduction of the carrying value of the Series B Notes and is being amortized to interest expense using the effective interest method over the term of the Series B Notes. As of September 30, 2017, the unamortized portion of the discount related to the beneficial conversion feature amounted to $55,890. The Company recorded interest expense of $610 related to the accretion of the discount for the three and nine months ended September 30, 2017.

As of September 30, 2017, the Company recorded accrued interest of $4,179 and recognized interest expense of $4,179 for the three and nine months ended September 30, 2017, respectively, related to the Series B Notes.

On October 17, 2017, the Company sold additional Series B Notes in the principal amount of $2,624,900 to 53 accredited investors, which includes four of the Company's officers and directors who collectively purchased Series B Notes in the principal amount of $140,000. The Company paid sales commissions of $94,145 in connection with the sale of these Series B Notes.

On October 26, 2017, the Company sold additional Series B Notes in the principal amount of $405,000 to six accredited investors, which included one of the Company's directors who purchased a Series B Note in the principal amount of $50,000. The Company paid sales commissions of $8,250, in connection with the sale of these Series B Notes.

The October 26, 2017 closing was the final closing pursuant to the Series B Notes offering. The total Series B Notes sold amounted to $4,724,900 in principal. Ten of the Company's officers and directors collectively purchased Series B Notes in the principal amount of $570,000. The Company paid total commissions in the amount of $156,345 and associated expenses of $1,000 in connection with the sale of the Series B Notes.

For every Series B Note purchased, the holders of an original Convertible Note was given the right, but not the obligation, on or prior to October 16, 2017, to convert twice the corresponding amount of their original Convertible Note into shares of the Company's common stock at a conversion price of $1.10 per share. On October 16, 2017, investors converted $5,166,800 in principal and $128,892 of accrued interest of Convertible Notes into shares of the Company’s common stock. The market value of the Company’s common stock was $1.38 at the date of the conversion. The Company is obligated to issue 4,697,090 shares and 117,175 shares, respectively, in connection with the conversion of the Convertible Notes payable and accrued interest. The Company paid $47,858 to the placement agent in connection with these conversions.

The following table reflects the net amounts recorded as debt at September 30, 2017 and December 31, 2016:

NOTE 7—ASSET RETIREMENT OBLIGATION

For the purpose of determining the fair value of the asset retirement obligation incurred during the nine months ended September 30, 2017, the Company assumed an inflation rate of 2.0%, an estimated average asset life of between 27.0 and 40.0 years, and a credit-adjusted risk-free interest rate between 11.26% and 11.86%.

The following reconciles the activity of the asset retirement obligation for the periods presented:

Accretion expense recorded for the three months ended September 30, 2017 and 2016 was $25,860 and $13,931, respectively, and for the nine months ended September 30, 2017 and 2016 was $72,772 and $15,738, respectively.

NOTE 8—ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

Accounts payable and accrued liability balances were comprised of the following:

NOTE 9—SHAREHOLDERS’ EQUITY

Public Offering

On May 19, 2017, the Company filed a registration statement on Form S-1 (File No. 333-218096), pursuant to which the Company seeks to raise up to $50.0 million in a public offering of its common stock. Closing of the offering is subject to a number of conditions, including an effective date for its registration statement from the SEC and execution of a definitive underwriting agreement with the underwriters.

Activity for the nine months ended September 30, 2017 included the following:

On September 23, 2017, the Company entered into a letter agreement with PEO pursuant to which PEO consented to the Company issuing the Series B Notes as described more fully in (Note 6).  In connection with the execution of the letter agreement, the Company issued 250,000 shares to PEO valued at $1.55 per share.

On September 25, 2017, the Company sold Series B Notes in the principal amount of $1,695,000. The Series B Notes are convertible into shares of common stock at $1.50 per share. Immediately following the closing, the Convertible Notes were convertible into 1,130,000 shares of common stock.

In connection with the completion of a private placement, the Company received $7,251,662 in net proceeds from the sale of 161.15 units consisting of Convertible Notes and warrants during the first quarter of 2017. The Convertible Notes were convertible into shares of common stock at $1.50 per share. Immediately following the closing, and including units sold during 2016, the Convertible Notes were convertible into 6,666,666 shares of common stock.

Subsequent to September 30, 2017, in connection with the conversion of Convertible Notes, the Company is obligated to issue 4,814,265,shares of common stock valued at $1.10 per share in connection with the conversion of $5,166,800 in principal and $128,892 of accrued interest of these Convertible Notes (Note 6).

On various dates, in connection with the execution of four employment agreements (Note 12) and the employment of additional employees, the Company issued 219,700 shares of restricted stock. The shares are subject to certain vesting restrictions, but all 219,700 shares have full voting rights and are eligible to receive dividends during the vesting period.

For the three and nine months ended September 30, 2017, the Company recorded stock-based compensation of $51,370 and $103,769, respectively, related to the grant and vesting of the restricted shares. As of September 30, 2017, unvested stock-based compensation amounted to $304,977 related to the restricted shares.

On April 3, 2017, the Company issued 470,555 shares valued at $1.80 per share in connection with the acquisitions of oil and gas assets.

Activity for the nine months ended September 30, 2016 included the following:

In January 2016, the Company sold 95,000 shares of common stock at $1.00 per share to one accredited investor pursuant to a private placement. 

On April 8, 2016, the Company issued 50,000 shares of common stock valued at $0.73 per share to an investor relations company in connection with the certain services to be provided pursuant to an investor relations agreement.

On May 4, 2016, the Company issued an aggregate 50,000 shares of common stock valued at $1.01 per share to two of the Company's Directors in connection with their appointment to the Board.

Warrants

The table below summarizes warrants outstanding as of September 30, 2017:

Activity for the nine months ended September 30, 2017 included the following:

On January 20, 2017 and January 30, 2017, in connection with the same private placement, the Company issued 2,216,978 and 3,154,601 warrants, respectively, to the purchasers of Convertible Notes. The warrants are exercisable at $3.00 per share and expire on December 31, 2019 (Note 6).

On January 20, 2017 and January 30, 2017, in connection with the closings of a private placement, the Company issued 221,744 and 315,526 warrants, respectively, to the placement agent. The warrants are exercisable at $1.50 per share and expire on December 31, 2021 (Note 6).

NOTE 10—STOCK-BASED COMPENSATION

On August 18, 2016, the Company’s Board of Directors adopted the Amended and Restated PetroShare Corp. Equity Incentive Plan (the “Plan”), which replaced and restated the Company’s original equity incentive plan. The Plan terminates by its terms on August 17, 2026. Among other things, the Plan increased the number of shares of common stock reserved for issuance thereunder from 5,000,000 to 10,000,000. The Company’s shareholders approved the Plan at the Company’s annual meeting of shareholders on September 8, 2016.

Activity for the nine months ended September 30, 2017 included the following:

On April 1, 2017, the Company accelerated and changed the vesting terms related to an option to purchase 700,000 shares of the Company’s stock that was initially issued on August 19, 2016. As amended, the option as to 100,000 shares was immediately exercisable and the vesting terms of the option as to the remaining 600,000 shares were accelerated. As amended, the entire option is exercisable at $1.83 per share.

On April 3, 2017, the Company issued an option to purchase 200,000 shares of the Company’s common stock, which option is exercisable at $1.83 per share. The option was issued in connection with the execution of an employment agreement (Note 12).

On May 22, 2017, the Company issued an option to purchase 22,000 shares of the Company’s common stock, which option is exercisable at $1.92 per share. The option was issued in connection with the hiring of a new employee.

On June 1, 2017 the Company issued an option to purchase 200,000 shares of the Company's common stock, which option is exercisable at $1.89 per share. The option was issued in connection with the execution of an employment agreement (Note 12). All of the options are subject to the terms and conditions of the Plan and a stock option agreement.

Activity for the nine months ended September 30, 2016 included the following:

On January 1, 2016, the Company issued an option to purchase 250,000 shares of its common stock in connection with the appointment of its Chief Financial Officer. The option is exercisable at a price of $1.00 per share and expires on November 23, 2018. The option vested one-half on January 1, 2016 and the remainder on January 1, 2017.

On January 28, 2016, the Company issued an option to purchase 875,000 shares of its common stock in connection with the appointment of its Chief Operating Officer. The option is exercisable at a price of $1.00 per share and expires on December 31, 2022. The option vested as follows: (i) 125,000 on January 28, 2016, the date of grant, and (ii) 750,000 on January 1, 2017.

On April 12, 2016, the Company issued an option to purchase 250,000 shares of its common stock in connection with the hiring of the Company's Vice President of Land. The option vests as follows: (i) 50,000 on the date of grant; (ii) 100,000 on April 15, 2017; and (iii) 100,000 on April 15, 2018, provided that the optionee has been continuously employed by the Company up to each vesting date. The option is exercisable at a price of $0.80 per share and expires on April 15, 2021.

On May 4, 2016, the Company issued an option to purchase 50,000 shares of its common stock in connection with the addition and appointment of two members of the Company's Board of Directors. The options vested on the date of grant. The options are exercisable at a price of $1.10 per share and expire on December 31, 2022. All of the options are subject to the terms and conditions of the Plan and a stock option agreement.

A summary of activity under the Plan for the nine months ended September 30, 2017 is as follows:

The fair value of each stock-based award was estimated on the date of the grant using the Black-Scholes pricing model that incorporates key assumptions including volatility of the Company’s stock, dividend yield and risk-free interest rates. As the Company’s common stock has limited historical trading data, the expected stock price volatility is based primarily on the historical volatility of a group of publicly-traded companies that share similar operating metrics and histories.  The expected term of the awards represents the period of time that management anticipates awards will be outstanding. As there was insufficient historical data available to ascertain a forfeiture rate, the plain vanilla method was applied in calculating the expected term of the options. The risk-free rates for the periods within the contractual life of the options are based on the US Treasury bond rate in effect at the time of the grant for bonds with maturity dates at the expected term of the options. The Company has never paid dividends on its common stock and currently does not intend to do so, and as such, the expected dividend yield is zero. Compensation expense related to stock options was recorded net of estimated forfeitures, which for options remaining at September 30, 2017, was $nil.

The table below summarizes assumptions utilized in the Black-Scholes pricing model for the nine months ended September 30, 2017:

During the three and nine months ended September 30, 2017, the Company recorded stock-based compensation of $345,835 and $1,024,182, respectively, related to options issued through the Plan. During the three and nine months ended September 30, 2016, the Company recorded stock-based compensation of $378,870 and $1,093,854 respectively, related to options issued through the Plan. Unvested stock-based compensation related to the options at September 30, 2017 and December 31, 2016 amounted to $856,778 and $1,025,391, respectively. 

NOTE 11—RELATED PARTY TRANSACTIONS

At September 30, 2017, the Company had drawn $5,000,000 on the initial line of credit with PEO and recorded related accrued interest of $609,875. PEO currently beneficially owns 13.2% of the Company’s common stock. Interest expense related to the initial line of credit for the three and nine months ended September 30, 2017 amounted to $117,375 and $305,290, respectively, and for the three and nine months ended September 30, 2016 was $96,157 and $153,053, respectively.

At September 30, 2017, the Company has recorded $389,885 in Accounts receivable – joint interest billing – related party. This amount relates to amounts billed to PEO related to its participation in the Company’s operated Shook drilling program and PEO’s ownership interest in the vertical wells that the Company operates.

At September 30, 2017, the Company has recorded $1,141,539 in Drilling advances – related party. This amount relates to unapplied cash advances received from PEO in connection with the Company’s operated Shook drilling program, and has recorded $11,672 in Accounts payable – related party, payable to PEO.

During the three months ended September 30, 2017 the Company issued 250,000 common shares to PEO in connection with the execution of a letter agreement (Notes 6 and 9).

On September 25, 2017 the Company sold Series B Notes to five of the Company’s officers and directors who collectively purchased Series B Notes in the principal amount of $380,000 (Note 6). Subsequent to the end of the period, five of the Company’s officers and directors purchased Series B Notes in the aggregate principal amount of $190,000 on the same terms and conditions as the other purchasers, with the exception that the Company did not pay commissions on these sales.

NOTE 12—COMMITMENTS AND CONTINGENCIES

Operating leases and agreements

The Company leases its office facility under a four-year non-cancelable operating lease expiring in March 2021. The following is a schedule by year of future minimum rental payments required under the lease agreement:

Lease expense totaled $42,245 and $92,354 for the three and nine months ended September 30, 2017, respectively, and $55 and $22,089 for the three and nine months ended September 30, 2016, respectively.

Employment agreements

On April 1, 2017, the Company entered an employment agreement with its Manager of Production and Completion Operations. The agreement provides for a base salary of $130,000 per year, an initial term expiring on March 31, 2018 with an automatic renewal for successive one-year periods unless terminated in accordance with its terms, and provisions for termination and payment of severance under various circumstances. In connection with the execution of the agreement, the employee was granted 50,000 shares of restricted stock and an option to purchase up to 200,000 shares of common stock at an exercise price of $1.83 per share.

On April 1, 2017, the Company entered into an employment agreement with its Executive Vice President for Capital Markets and Investor Relations. The agreement provides for a base salary of $156,000 per year, an initial term expiring on December 31, 2018 with an automatic renewal for successive one-year periods unless terminated in accordance with its terms, and provisions for termination and payment of severance under various circumstances. In

connection with the execution of the agreement, the employee was granted 66,700 shares of restricted stock and the vesting of 200,000 previously issued stock options were accelerated.

On June 1, 2017, the Company entered into an employment agreement with its Senior Landman. The agreement provides for a base salary of $130,000 per year, an initial term expiring on May 31, 2018 with an automatic renewal for successive one-month periods unless terminated in accordance with its terms, and provisions for termination. In connection with the execution of the agreement, the employee was granted 50,000 shares of restricted stock and an option to purchase 200,000 shares of common stock at $1.89 per share.

On June 1, 2017, the Company entered into an employment agreement with its Chief Financial Officer. The agreement provides for a base salary of $150,000 per year, an initial term expiring on December 31, 2018 with an automatic renewal for successive one-year periods unless terminated in accordance with its terms, and provisions for termination and payment of severance under various circumstances. In connection with the execution of the agreement, the employee was granted 50,000 shares of restricted stock.

NOTE 13—SUBSEQUENT EVENTS

On October 16, 2017, the Company converted $5,166,800 in Convertible Notes and $128,892 in corresponding accrued interest into 4,697,090 and 117,175 shares of common stock respectively (Note 6).

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

In the following discussion, “PetroShare Corp.,” the “Company,” “we,” “our,” and “us” refer to PetroShare Corp.

The following discussion analyzes (i) our financial condition at September 30, 2017 and compares it to December 31, 2016, and (ii) our results of operations for the three and nine months ended September 30, 2017 and 2016. The following discussion and analysis should be read in conjunction with the financial statements and related notes included in this report and our audited financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Form 10‑K for the year ended December 31, 2016. Further, we encourage you to review the Cautionary Language Regarding Forward-Looking Statements.

Overview

We are an independent oil and natural gas company focused on the acquisition and development of crude oil and natural gas properties and have assembled approximately 10,000 net acres, including mineral rights only acreage, most of which is located in the Denver-Julesburg Basin, or the DJ Basin, in northeast Colorado. Our current operating focus is within the Wattenberg Field of the DJ Basin, which is located primarily in Adams and Weld Counties, Colorado. We have concentrated our efforts in areas where we believe the geo-mechanical characteristics of the underlying formations offer the potential for greater returns on capital. Our evaluation metrics include reservoir thickness, reservoir quality and resistivity of each formation, each of which affect the number of wells we plan to drill per drilling spacing unit. We realized our first meaningful revenue in 2017 with the commencement of production from horizontal wells in which we participated. Also, during 2017, we drilled our first horizontal wells in the Wattenberg Field as an operator.

As an oil and natural gas exploration and production company, our revenue, results of operation, cash flow from operations, reserve values, access to capital and future rate of growth are influenced by the prevailing prices of oil and natural gas. Changes in prices can affect, both positively and negatively, our financial condition, liquidity, ability to obtain financing, operating results, and the amount of oil and natural gas that we choose to produce. Prevailing prices for such commodities fluctuate in response to changes in supply and demand and a variety of additional factors beyond our control, such as global, political and economic conditions. Inherently, the price received for oil and natural gas production is unpredictable, and such volatility is expected. All of our production is sold at market prices and, therefore, the amount of revenue that we realize, as well as our estimates of future revenues, is to a large extent determined by factors beyond our control. To date we have not entered into hedging arrangements with respect to any of our future production, but we may choose to do so in the future.

Recent Developments

Following are what we believe to be significant developments for our company during the third quarter of 2017:

We do not believe that we will be in a position to fracture stimulate any of our operated Shook pad wells unless and until we receive sufficient additional capital, and accordingly, we do not expect a significant change in our production profile until that time.

Going Concern

As described in the notes to our condensed consolidated financial statements, there is substantial doubt about our ability to continue as a going concern. This qualification is based on, among other things, our substantial near‑term liabilities, some of which are past-due, accumulated losses and negative working capital. We are dependent on obtaining additional cash flow from operations and funding from the sale of debt or equity to continue as a going concern.

At September 30, 2017, we had a cash balance of approximately $0.7 million and other current assets of approximately $3.2 million compared to approximately $22.0 million of current liabilities. In December 2017, we are obligated to repay approximately $3.6 million in principal and approximately $0.4 million in accrued interest to satisfy the terms of our supplemental line of credit. Also in December 2017, we are obligated to make an approximate $0.6 million accrued interest payment on our initial line of credit and cash payments for interest accrued on our convertible promissory notes. We had net losses of approximately $4.9 million during the nine months ended September 30, 2017 and $4.5 million during the year ended December 31, 2016. All of these factors raise substantial doubt about our ability to continue as a going concern.

Our ability to continue as a going concern depends on the success of our fundraising, future drilling, exploration and development efforts, and our ability to generate revenue sufficient to cover our costs and expenses. In the event we are unable to obtain adequate funding from the sale of debt or equity securities and our ongoing drilling efforts, both operated and non‑operated, we may have to delay, reduce or eliminate certain of our planned operations, reduce overall overhead expense, or divest assets. This, in turn, may have an adverse effect on our ability to realize the value of our assets.

Results of Operations for the three months ended September 30, 2017 compared to September 30, 2016

The following table summarizes our operating results and averages for the three months ended September 30, 2017 and 2016: