10-K 1 form10-k.htm

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2016

 

OR

 

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

 

For the transition period from to

 

Commission file number 000-54286

 

SURNA INC.

(Exact name of registrant as specified in its charter)

 

Nevada   27-3911608
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)

 

1780 55th Street, Suite C, Boulder, Colorado   80301
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number (303) 993-5271

 

Securities registered pursuant to Section 12(b) of the Act: None

 

Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $0.00001 per share.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. [  ] Yes [X] No

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. [  ] Yes [X] No

 

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 a 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. [X] Yes [  ] No

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [  ]

 

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

 

Large accelerated filer [  ] Accelerated filer [  ]
       
Non-accelerated filer [  ] (Do not check if a smaller reporting company) Smaller reporting company [X]

 

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

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter $9,674,453 on June 30, 2016.

 

The number of shares outstanding of the registrant’s common stock as of March 20, 2017 is 184,031,578

 

DOCUMENTS INCORPORATED BY REFERENCE – None.

 

 

 

   
 

 

TABLE OF CONTENTS

 

    PAGE NO.
PART I    
     
Item 1. Business 4
Item 1A. Risk Factors 7
Item 1B. Unresolved Staff Comments 14
Item 2. Properties 14
Item 3. Legal Proceedings 15
Item 4. Mine Safety Disclosures 15
     
PART II    
     
Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters, and Issuer Purchases of Equity Securities 15
Item 6. Selected Financial Data 16
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 16
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 23
Item 8. Financial Statements and Supplementary Data 24
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 25
Item 9A. Controls and Procedures 25
Item 9B. Other Information 26
     
PART III    
     
Item 10. Directors, Executive Officers, and Corporate Governance 27
Item 11. Executive Compensation 29
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters 30
Item 13. Certain Relationships and Related Transactions, and Director Independence 32
Item 14. Principal Accounting Fees and Services 32
     
PART IV    
     
Item 15. Exhibits, Financial Statement Schedules 33
  Signatures 35

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements contained in this Annual Report on Form 10-K other than statements of historical fact, including statements regarding our future results of operations and financial position, our business strategy and plans, and our objectives for future operations, are forward-looking statements. The words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect,” and similar expressions are intended to identify forward-looking statements. We have based these forward-looking statements largely on our current expectations and projections about future events and trends that we believe may affect our financial condition, results of operations, business strategy, short-term and long-term business operations and objectives, and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in Part I, Item 1A, “Risk Factors” in this Annual Report on Form 10-K. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the future events and trends discussed in this Annual Report on Form 10-K may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements.

 

We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

 

Unless expressly indicated or the context requires otherwise, the terms “Surna,” the “Company,” “we,” “us,” and “our” in this document refer to Surna Inc., a Nevada corporation, and, where appropriate, its wholly owned subsidiaries.

 

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PART I

 

ITEM 1. BUSINESS

 

Overview

 

Surna develops, designs, and distributes cultivation technologies for controlled environment agriculture (“CEA”). The Company’s customers include state-regulated cannabis cultivation facilities as well as traditional indoor agricultural facilities, including organic herb and vegetable producers.

 

Surna’s technologies include a comprehensive line of optimized lighting, environmental control, air sanitation and cultivation facilities. These technologies are designed to meet the specific environmental conditions required for indoor cultivation and to dramatically reduce energy and water consumption.

 

In addition, Surna offers mechanical design services specific to hydronic cooling including mechanical equipment and piping design.

 

Products and Services

 

Surna Chillers

 

Surna’s liquid-based process cooling system provides a more reliable and efficient thermal cooling solution compared to typical air conditioning products:

 

  ● Liquid-based cooling systems are more efficient. Surna’s hydronic cooling systems and proprietary technologies rely on liquid, instead of air, as a medium for heat exchange. Surna’s systems can dramatically reduce the costs associated with cooling indoor cultivation facilities compared to traditional air conditioning products, depending on the specific environment and system design.
     
  ● Redundancy is essential. Due to the high value of indoor crops like cannabis, Surna’s systems are designed to mitigate crop loss due to equipment failure. Surna’s chillers are easily scalable and allow for redundant system design for a nominal increase in cost relative to ducted systems.
     
  ● Closed-loop cooling systems reduce opportunities for contamination. Surna’s system provides for room isolation during the heat exchange process, thereby reducing the risk of cross-contamination between rooms. Surna’s system uses chilled water delivered through a closed loop and does not require ducting. Traditional air conditioning systems use ducted air for heat removal, which disseminate contaminants between rooms. This greatly increases the risk of spreading the contamination throughout the entire grow space.

 

Surna Reflectors

 

Surna’s reflector optimizes light delivery to the plant canopy. Thanks to the reflector’s internal technology, the bulb is able to produce up to 9.1% more usable light without any increase in energy consumption. Light-on-target reflectivity is also increased due to the unique design and shape of the reflector, eliminating light wasted illuminating walls and aisles. The water-cooled version uses a unique automation protocol to employ “point-source” heat removal drastically reducing the energy required to capture and remove the heat generated by the bulb.

 

Bio-Security

 

Surna offers a full-service air sanitation technology program for mold and mildew risk mitigation to cultivators. This program uses a combination of site monitoring and photocatalytic oxidation equipment to maintain facility standards while destroying harmful airborne microbes without the production of byproducts.

 

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Services

 

Surna provides a full-service engineering package for designing and engineering commercial scale thermodynamic systems specific to indoor grow facility conditions. Once the design is complete, Surna’s project management team oversees its customers’ installation through system commissioning. Surna’s on-site commissioning program is designed to ensure that the target environment is achieved. Surna then offers an ongoing maintenance plan to maintain the integrity of the system through regularly scheduled visits with a goal of keeping its customers’ system operating at peak performance.

 

Automation

 

Surna understands the importance of maintaining a consistent grow environment and as such seeks to provide “smart” equipment with onboard intelligence allowing the cultivator the ability to automate its system. Employing a number of technologies, Surna’s building automation controls can be scaled to address a variety of customer needs and expectations. From simple environment measuring devices to full scale system automation, Surna believes it understands the needs of the cultivator.

 

Hybrid Building

 

Surna’s comprehensive cultivation facility (“Hybrid Building”) combines the advantages of a greenhouse with those of an indoor grow operation for indoor cultivators seeking efficiency and accelerated time to market. The Hybrid Building uses the sun as its primary light source and high power LED lights for supplemental lighting while maintaining the environmental and security controls of an indoor facility. Surna’s technology is employed into this one fully operational building seeking to give the grower the best technology available on the market today.

 

Product Development

 

Surna places a priority on new product development and improvement both through its internal product development staff and in partnerships with other commercial entities. In the fiscal year ended December 31, 2016, the Company spent $349,000 towards the development of new products in the areas of lighting, climate control, bio-security, water purification, system automation and the hybrid building.

 

Intellectual Property

 

Surna relies on a combination of patent and trademark rights, trade secrets, laws that protect intellectual property, confidentiality procedures, and contractual restrictions with its employees and others to establish and protect its intellectual property rights. As of March 31, 2017, the Company has eight pending patent applications and four issued patents. The pending patent applications are a combination of PCT, utility and design patent applications that are directed to certain core Company technology. The Company’s four issued patents are U.S. design patents related to the Company’s reflector. The U.S. design patents provide protection for 14 years from the date of issue. Utility patents provide protection for 20 years from the earliest non-provisional application filing date. The Company has registered trademark registrations around its core brand (“Surna”) in the United States and select foreign jurisdictions, as well as the Surna logo and the combined Surna logo and name in the United States. Our wordmark is also registered in the European Union and is pending registration in Canada. These are contained in three trademarks with the United States Patent and Trademark Office (“USPTO”). Subject to ongoing use and renewal, trademark protection is potentially perpetual.

 

Operating segments

 

Surna currently operates in one primary business segment, which encompasses designing, manufacturing, and distributing indoor climate control systems, including but not limited to chillers, lights, reflectors, and irrigation systems, for use in conjunction with the state-regulated cannabis and CEA industry.

 

Competition

 

Surna’s chilled water system products and services compete with various national and local HVAC (heating, ventilation, and air conditioning) providers who traditionally resell, design, and implement climate control systems for comfort cooling of schools, offices, or other large buildings. Surna differs from these competitors by providing hydronic cooling systems tailored specifically for managing the distinct challenges in connection with the significant heat and humidity loads associated with cultivation of indoor crops.

 

Surna’s dehumidification products face competition from other dehumidification manufacturers. Surna provides its customers and clients with dehumidification options that it believes are more cost effective and more efficient at removing humidity than its competitors in the indoor cultivation space.

 

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Surna believes that few manufacturers of these products have expertise in the cannabis market and understand the needs of growers. Surna, however, is equipped to customize products for the cannabis market and advise growers on appropriate products to maximize crop yield. The Company expects increased competition in both the climate control and services divisions in the cannabis sector as an increasing number of states legalize the cultivation, distribution, and consumption of the crop.

 

Employees

 

As of March 31, 2017, Surna has 28 full-time employees. The Company may, however, utilize and has in the past utilized the services of a number of consultants, independent contractors, and professionals. Additional employees will be hired in the future depending on need and the Company’s expansion.

 

Government Regulation

 

Surna’s chillers are subject to state and municipal regulations regarding energy-efficiency standards often incorporated into building codes. Many states and municipalities have adopted some version of Standard 90.1 as published by the American Society of Heating, Refrigerating, and Air-Conditioning Engineers (“ASHRAE”); however, some states and municipalities have or may in the future adopt alternative standards that may be more or less restrictive than Standard 90.1. Similarly, Standard 90.1 is itself regularly updated—most recently in 2013. Each update of the standard generally reflects the availability of increasingly efficient technologies, resulting in stricter energy-efficiency requirements. The Company anticipates that its products will comply with these standards. With every product line, Surna offers a product that meets or exceeds the Standard 90.1.

 

Otherwise, the Company is subject substantially to the same government regulations that affect businesses generally. See, however, Item 1A - Risk Factors – “U.S. Federal and foreign regulation and enforcement may adversely affect the implementation of marijuana laws and regulations may negatively impact our revenue and profit or we could be found to be violating the Controlled Substances Act or other U.S. federal, state or foreign laws,” “Litigation by states affected by marijuana legalization,” “Variations in state and local regulation and enforcement in states that have legalized cannabis that may restrict marijuana-related activities, including activities related to cannabis, may negatively impact our revenue and profit,” and “We and our customers may have difficulty accessing the services of banks, which may make it difficult to sell our products and services.”

 

Corporate History

 

Surna incorporated in the State of Nevada on October 15, 2009.

 

Spin-off of Trebor Resource Management Group, Inc. Effective March 25, 2014, Surna completed the issuance of a dividend of all of the Company’s ownership in Trebor Resource Management Group, Inc. (“Trebor”), a wholly-owned subsidiary, to its shareholders, resulting in Trebor becoming a separate entity. Trebor was seeking to identify and develop joint opportunities with third parties in the mining business in the Philippines. See Item 1A - Risk Factors – “If it were determined that our spin-off of Trebor Resource Management Group, Inc. in March 2014 violated federal or state securities laws, we could incur monetary damages, fines or other damages that could have a material adverse effect on our financial condition and prospects.”

 

Acquisition of Safari Resource Group, Inc. On March 26, 2014, Surna exchanged 80,201,250 shares of the Company’s unregistered shares of common stock and 77,220,000 shares of the Company’s unregistered shares of preferred stock for 100% of the outstanding common stock of Safari Resource Group, Inc. (“Safari”), a Nevada corporation. Safari possessed intellectual property and strategic relationships that were integral to Surna’s entrance into the CEA and state-regulated cannabis markets.

 

Spin-off of Surna Media, Inc. On June 30, 2014, Surna entered into a separation agreement with Lead Focus Limited, a British Virgin Islands company, which is owned by a combination of prior officers, directors, and others, in which Surna sold its subsidiary, Surna Media, Inc. (“Surna Media”), including Surna Media’s subsidiaries, Surna HK and Flying Cloud, in exchange for a payment of $1 in cash and the buyer’s assumption of all of the liabilities of Surna Media and its subsidiaries. As a result of this sale, Surna eliminated from its balance sheet all assets and liabilities associated with Surna Media and recorded a credit of $2,643,881 to its additional paid in capital. As a result of this sale, Surna ceased its operations relating to the development of web and mobile games, social networks, telecommunication services, IT support services, and open-source software.

 

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Acquisition of Hydro Innovations, LLC. On July 25, 2014, Surna acquired 100% of the membership interests of Hydro Innovations, LLC, a Colorado limited liability company (“Hydro”) from its owners, Stephen Keen and Brandy Keen (the “Keens”), for a price of $500,000 payable by assumption of a $250,000 promissory note on the books and records of Hydro as well as issuance of a $250,000 promissory note to the Keens. The Keens’ promissory note bears interest at the rate of 6% per annum and is payable in monthly installments of $5,000 with a balloon payment for the balance of accrued interest and principal due on July 18, 2016, though it may be prepaid in whole or in part at any time. In addition, Surna entered into employment agreements with the Keens. Pursuant to the terms of the employment agreements, the Company agreed to employ Ms. Keen as Vice President of Sales and Mr. Keen as Vice President of Product Development, each for a period of three years beginning on July 25, 2014 and at an annual base salary of $96,000, as well as certain stock compensation, which is subject to review annually by the Board of Directors. Notwithstanding the 3-year term, both of the Keens employment agreements are at-will and may be terminated at any time, with or without cause. Mr. Keen’s position changed to President and Chief Executive Officer on August 28, 2015 and then to Director of Product Development on June 15, 2016. The terms of his employment agreement did not change with his changes in position.

 

Available Information

 

Surna’s website address is www.surna.com. The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the U.S. Securities and Exchange Commission (“SEC”). Such reports and other information filed by the Company with the SEC are available free of charge on our website at www.surna.com/investor-relations when such reports are available on the SEC’s website.

 

The public may read and copy any materials filed by Surna with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov.

 

The contents of the websites referred to above are not incorporated into this filing. Further, references to the URLs for these websites are intended to be inactive textual references only.

 

ITEM 1A. RISK FACTORS

 

Certain factors may have a material adverse effect on our business, financial condition, and results of operations. You should consider carefully the risks and uncertainties described below, in addition to other information contained in this Annual Report on Form 10-K, including our consolidated financial statements and related notes. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that adversely affect our business. If any of the following risks actually occurs, our business, financial condition, results of operations, and future prospects could be materially and adversely affected. In that event, the trading price of our common stock could decline, and you could lose part or all of your investment.

 

Risks Related to Our Business

 

We are solely dependent upon the funds we have raised so far to continue our operations, which may be insufficient to achieve significant revenue, and we may need to obtain additional financing, which may not be available to us.

 

We may require additional cash resources to finance our continued growth or other future developments, including any investments or acquisitions we may decide to pursue. We may need additional funds to complete further development of our business plan to achieve a sustainable sales level where ongoing operations can be funded out of revenue. We extinguished $3,350,523 in convertible debt owed to investors (net of an additional $500,000 in short-term borrowing), strengthening our balance sheet. In addition, in March 2017 we raised $2,685,000 in a private placement offering of common stock and warrants to accredited investors. With the addition of these funds we believe we have sufficient cash on hand to continue our operations through the year ended December 31, 2017. Before that date we will need to raise additional funds or move to profitable operations, as to which there can be no assurance.

 

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We may need additional capital in the future, which could dilute the ownership of current shareholders or we may be unable to secure additional funding in the future or to obtain such funding on favorable terms.

 

Historically, we have raised equity and debt capital to support our operations. To the extent that we raise additional equity capital, existing shareholders will experience a dilution in the voting power and ownership of their common stock, and earnings per share, if any, would be negatively impacted. Our inability to use our equity securities to finance our operations could materially limit our growth. Any borrowings made to finance operations could make us more vulnerable to a downturn in our operating results, a downturn in economic conditions, or increases in interest rates on borrowings that are subject to interest rate fluctuations. The amount and timing of such additional financing needs will vary principally depending on the timing of new product launches, investments and/or acquisitions, and the amount of cash flow from our operations. If our resources are insufficient to satisfy our cash requirements, we may seek to issue additional equity or debt securities or obtain a credit facility. If our cash flow from operations is insufficient to meet our debt service requirements, we could be required to sell additional equity securities, refinance our obligations, or dispose of assets in order to meet debt service requirements. There can be no assurance that any financing will be available to us when needed or will be available on terms acceptable to us. Our failure to obtain sufficient financing on favorable terms and conditions could have a material adverse effect on our growth prospects and our business, financial condition and results of operations.

 

Even if we obtain more customers, there is no assurance that we will make a profit.

 

Even if we obtain more customers, there is no guarantee that we will be able to generate a profit. Because we are a small company and do not have much capital, we must limit our products and services. Because we will be limiting our marketing activities, we may not be able to attract enough customers to buy our products to operate profitably. If we cannot operate profitably, we may have to suspend or cease operations.

 

If we fail to establish or maintain effective internal control over financial reporting, we may be unable to accurately report our financial results or prevent fraud, and investor confidence and the market price of our common stock may, therefore, be adversely impacted.

 

Our reporting obligations as a public company place a significant strain on our management, operational and financial resources, and systems for the foreseeable future. Annually, we are required to prepare a management report on our internal control over financial reporting containing our management’s assessment of the effectiveness of our internal control over financial reporting. Management has presently concluded that our internal control over financial reporting is not effective and shall report such in management’s report in this annual report on Form 10-K. In the event that the Company’s status with the SEC changes to that of an accelerated filer from a smaller reporting company, our independent registered public accounting firm will be required to attest to and report on our management’s assessment of the effectiveness of our internal control over financial reporting. Under such circumstances, even if our management concludes that our internal control over financial reporting are effective, our independent registered public accounting firm may still decline to attest to our management’s assessment or may issue a report that is qualified if it is not satisfied with our controls or the level at which our controls are documented, designed, operated or reviewed, or if it interprets the relevant requirements differently from us.

 

Our Directors and Officers possess the majority of our voting power, and through this ownership, control our Company and our corporate actions.

 

The officer/director group has a controlling influence in determining the outcome of any corporate transaction or other matters submitted to our shareholders for approval, including mergers, consolidations, and the sale of all or substantially all of our assets, election of directors, and other significant corporate actions. Such officers and directors may also have the power to prevent or cause a change in control. In addition, without the consent of these shareholders, we could be prevented from entering into transactions that could be beneficial to us. The interests of these shareholders may give rise to a conflict of interest with the Company and our shareholders.

 

U.S. Federal and foreign regulation and enforcement may adversely affect the implementation of marijuana laws and regulations and may negatively impact our revenue and profit or we may be found to be violating the Controlled Substances Act or other U.S. federal, state, or foreign laws.

 

Currently, twenty-eight states and the District of Columbia permit some form of whole-plant cannabis use and cultivation either for medical or recreational use. Thirty-eight states allow or are considering legislation to allow the possession and use of non-psychoactive cannabidiol (“CBD”) oil for some medical conditions only. There are efforts in many other states to begin permitting cannabis use and/or cultivation in various contexts, and it has been reported that eleven states are actively considering bills to permit recreational use or to decriminalize the use of marijuana. Nevertheless, the federal government continues to prohibit cannabis in all its forms as well as its derivatives. Under the federal Controlled Substances Act (the “CSA”), the policy and regulations of the federal government and its agencies is that cannabis has no medical benefit, and a range of activities including cultivation and use of cannabis is prohibited. Until Congress amends the CSA or the executive branch deschedules or reschedules cannabis under it, there is a risk that federal authorities may enforce current federal law. Enforcement of the CSA by federal authorities could impair the Company’s revenue and profit, and it could even force the Company to cease operating entirely in the cannabis industry. The risk of strict federal enforcement of the CSA in light of congressional activity, judicial holdings, and stated federal policy, including enforcement priorities, remains uncertain.

 

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We have recently begun selling products and services to cannabis growers in Canada, where medical marijuana currently is legal across the country both federally and provincially. Canadian Prime Minister Trudeau also is expected to introduce legislation to legalize, but strictly control, recreational use of marijuana. We believe Canada, with its federally legal regime, represents a significant business opportunity for us, but there can be no assurance that we will be able to make any additional sales of products or services in Canada.

 

In an effort to provide guidance to federal law enforcement, the US Department of Justice (the “DOJ”) has issued Guidance Regarding Marijuana Enforcement to all United States Attorneys in a memorandum from Deputy Attorney General David Ogden on October 19, 2009, in a memorandum from Deputy Attorney General James Cole on June 29, 2011 and in a memorandum from Deputy Attorney General James Cole on August 29, 2013. Each memorandum provides that the DOJ is committed to enforcement of the CSA but the DOJ is also committed to using its limited investigative and prosecutorial resources to address the most significant threats in the most effective, consistent and rational way.

 

The August 29, 2013 memorandum, known as the Cole Memo, provides updated guidance to federal prosecutors concerning marijuana enforcement in light of state laws legalizing medical and recreational marijuana possession in small amounts. The Cole Memo sets forth certain enforcement priorities that are important to the federal government:

 

  ● Distribution of marijuana to children;
     
  ● Revenue from the sale of marijuana going to criminals;
     
  ● Diversion of medical marijuana from states where is legal to states where it is not;
     
  ● Using state authorized marijuana activity as a pretext of other illegal drug activity;
     
  ● Preventing violence in the cultivation and distribution of marijuana;
     
  ● Preventing drugged driving;
     
  ● Growing marijuana on federal property; and
     
  ● Preventing possession or use of marijuana on federal property.

 

The DOJ has not historically devoted resources to prosecuting individuals whose conduct is limited to possession of small amounts of marijuana for use on private property but relied on state and local law enforcement to address marijuana activity. In the event the DOJ reverses stated policy and begins strict enforcement of the CSA in states that have laws legalizing medical marijuana and recreational marijuana in small amounts, there may be a direct and adverse impact to our revenue and profit.

 

In 2014, the US House of Representatives passed an amendment (the “Rohrabacher-Farr Amendment”) to the Commerce, Justice, Science, and Related Agencies Appropriations Bill, which funds the DOJ. The Rohrabacher-Farr Amendment prohibits the DOJ from using funds to prevent states with medical cannabis laws from implementing such laws. In August 2016, a Ninth Circuit federal appeals court ruled in United States v. McIntosh that the Rohrabacher-Farr Amendment bars the DOJ from spending funds on the prosecution of conduct that is allowed by state medical cannabis laws, provided that such conduct is in strict compliance with applicable state law. In March 2015, bipartisan legislation titled the Compassionate Access, Research Expansion, and Respect States Act (the “CARERS Act”) was introduced, proposing to allow states to regulate the medical use of cannabis by changing applicable federal law, including by reclassifying cannabis under the Controlled Substances Act to a Schedule II controlled substance and thereby changing the plant from a federally-criminalized substance to one that has recognized medical uses.

 

Although these developments have been met with a certain amount of optimism in the scientific community, the CARERS Act has not yet been adopted, and the Rohrabacher-Farr Amendment, being an amendment to an appropriations bill, must be renewed annually. The currently enacted Commerce, Justice, Science, and Related Agencies Act, which includes the Rohrabacher-Farr Amendment, is effective, by passage of a short-term continuing resolution, through April 28, 2017. The federal government could at any time change its enforcement priorities against the cannabis industry. Any change in enforcement priorities could render such operations unprofitable or even prohibit such operations.

 

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The former Obama administration effectively stated that it is not an efficient use of resources to direct law federal law enforcement agencies to prosecute those lawfully abiding by state-designated laws allowing the use and distribution of medical marijuana. However, the new Trump administration could change this policy and decide to enforce the federal laws strongly. Any such change in the federal government’s enforcement of current federal laws could cause significant financial damage to us and our shareholders.

 

Litigation by States Affected by Marijuana Legalization

 

Due to variations in state law among states sharing borders, certain states which have not approved any legal sale of marijuana may seek to overturn laws legalizing cannabis use in neighboring states. For example, in December 2014, the attorneys general of Nebraska and Oklahoma filed a complaint with the U.S. Supreme Court against the state of Colorado arguing that the Supremacy Clause (Article VI of the Constitution) prohibits Colorado from passing laws that conflict with federal anti-drug laws and that Colorado’s laws are increasing marijuana trafficking in neighboring states that maintain marijuana bans, thereby putting pressure on such neighboring states’ criminal justice systems. In March 2016 the Supreme Court, voting 6-2, declined to hear this case, but there is no assurance that it will do so in the future. Additionally, nothing prevents these or other attorneys general from using the same or similar cause of action for a lawsuit in a lower federal or other court.

 

Previously, the Supreme Court has held that drug prohibition is a valid exercise of federal authority under the commerce clause; however, it has also held that an individual state itself is not required to adopt or enforce federal laws with which it disagrees. If the Supreme Court rules that a legal cannabis state’s legislation is unconstitutional, that could result in legal action against other states with laws legalizing medical and/or recreational cannabis use. Successful prosecution of such legal actions by non-marijuana states could have significant negative effects on our business.

 

Variations in state and local regulation and enforcement in states that have legalized cannabis that may restrict marijuana-related activities, including activities related to cannabis, may negatively impact our revenue and profit.

 

Individual state laws do not always conform to the federal standard or to other states’ laws. A number of states have decriminalized marijuana to varying degrees, other states have created exemptions specifically for medical cannabis, and several have both decriminalization and medical laws. Eight states and the District of Columbia have legalized the recreational use of cannabis. Variations exist among states that have legalized, decriminalized, or created medical marijuana exemptions. For example, Alaska and Colorado have limits on the number of marijuana plants that can be grown by an individual in the home. In most states the cultivation of marijuana for personal use continues to be prohibited except by those states that allow small-scale cultivation by the individual in possession of marijuana for medicinal purposes or that person’s caregiver. Active enforcement of state laws that prohibit personal cultivation of marijuana may indirectly and adversely affect revenue and profit of the Company.

 

We and our customers may have difficulty accessing the service of banks, which may make it difficult to sell our products and services.

 

Financial transactions involving proceeds generated by cannabis-related conduct can form the basis for prosecution under the federal money laundering statutes, unlicensed money transmitter statute and the U.S. Bank Secrecy Act. Recent guidance issued by the Financial Crimes Enforcement Network, or FinCen, a division of the U.S. Department of the Treasury, clarifies how financial institutions can provide services to cannabis-related businesses consistent with their obligations under the Bank Secrecy Act. Furthermore, supplemental guidance from the DOJ directs federal prosecutors to consider the federal enforcement priorities enumerated in the Cole Memo when determining whether to charge institutions or individuals with any of the financial crimes described above based upon cannabis-related activity. Nevertheless, banks remain hesitant to offer banking services to cannabis-related businesses. Consequently, those businesses involved in the cannabis industry continue to encounter difficulty establishing banking relationships. Our inability to maintain our current bank accounts would make it difficult for us to operate our business, increase our operating costs, and pose additional operational, logistical and security challenges and could result in our inability to implement our business plan.

 

 10 
 

 

Our independent registered public accounting firm has expressed substantial doubt about our ability to continue as a going concern.

 

Our auditors have included a “going concern” provision in their opinion on our financial statements, expressing substantial doubt that we can continue as an ongoing business for the next twelve months. Our financial statements do not include any adjustments that may result from the outcome of this uncertainty. If we are unable to successfully raise the capital we need we may need to reduce the scope of our business to fully satisfy our future short-term liquidity requirements. If we cannot raise additional capital or reduce the scope of our business, we may be otherwise unable to achieve our goals or continue our operations. While we believe that we will be able to raise the capital we need to continue our operations, there can be no assurances that we will be successful in these efforts or will be able to resolve our liquidity issues or eliminate our operating losses.

 

Our inability to effectively manage our growth could harm our business and materially and adversely affect our operating results and financial condition.

 

Our strategy envisions growing our business. We plan to expand our product, sales, administrative and marketing operations. Any growth in or expansion of our business is likely to continue to place a strain on our management and administrative resources, infrastructure and systems. As with other growing businesses, we expect that we will need to further refine and expand our business development capabilities, our systems and processes and our access to financing sources. We also will need to hire, train, supervise, and manage new employees. These processes are time consuming and expensive, will increase management responsibilities and will divert management attention. We cannot assure that we will be able to:

 

  ● expand our products effectively or efficiently or in a timely manner;
     
  ● allocate our human resources optimally;
     
  ● meet our capital needs;
     
  ● identify and hire qualified employees or retain valued employees; or
     
  ● effectively incorporate the components of any business or product line that we may acquire in our effort to achieve growth.

 

Our inability or failure to manage our growth and expansion effectively could harm our business and materially and adversely affect our operating results and financial condition.

 

Our operating results may fluctuate significantly based on customer acceptance of our products. As a result, period-to-period comparisons of our results of operations are unlikely to provide a good indication of our future performance.

 

Management expects that we will experience substantial variations in our net sales and operating results from quarter to quarter due to customer acceptance of our products. If customers do not accept our products, our sales and revenue will decline, resulting in a reduction in our operating income or possible increase in losses.

 

If we do not successfully generate additional products and services, or if such products and services are developed but not successfully commercialized, we could lose revenue opportunities.

 

Our future success depends, in part, on our ability to expand our product and service offerings. To that end we have engaged in the process of identifying new product opportunities, such as our reflector and Hybrid Building to provide additional products and related services to our customers. The processes of identifying and commercializing new products is complex and uncertain, and if we fail to accurately predict customers’ changing needs and emerging technological trends our business could be harmed. We have already and may have to continue to commit significant resources to commercializing new products before knowing whether our investments will result in products the market will accept. Furthermore, we may not execute successfully on commercializing those products because of errors in product planning or timing, technical hurdles that we fail to overcome in a timely fashion, or a lack of appropriate resources. This could result in competitors providing those solutions before we do and a reduction in net sales and earnings. 

 

 11 
 

 

The success of new products depends on several factors, including proper new product definition, timely completion, and introduction of these products, differentiation of new products from those of our competitors, and market acceptance of these products. There can be no assurance that we will successfully identify additional new product opportunities, develop and bring new products to market in a timely manner, or achieve market acceptance of our products or that products and technologies developed by others will not render our products or technologies obsolete or noncompetitive.

 

Our future success depends on our ability to grow and expand our customer base. Our failure to achieve such growth or expansion could materially harm our business.

 

To date, our revenue growth has been derived from the sale of our products and services. Our success and the planned growth and expansion of our business depend on us achieving greater and broader acceptance of our products and services and expanding our commercial customer base. There can be no assurance that customers will purchase our services or products or that we will continue to expand our customer base. If we are unable to effectively market or expand our product and service offerings, we will be unable to grow and expand our business or implement our business strategy. This could materially impair our ability to increase sales and revenue and materially and adversely affect our margins, which could harm our business and cause our stock price to decline.

 

Our suppliers could fail to fulfill our orders for parts used to assemble our products, which would disrupt our business, increase our costs, harm our reputation, and potentially cause us to lose our market.

 

We depend on third party suppliers around the world, including in The People’s Republic of China, for materials used to assemble our products. These suppliers could fail to produce products to our specifications or in a workmanlike manner and may not deliver the material or products on a timely basis. Our suppliers may also have to obtain inventories of the necessary parts and tools for production. Any change in our suppliers’ approach to resolving production issues could disrupt our ability to fulfill orders and could also disrupt our business due to delays in finding new suppliers, providing specifications and testing initial production. Such disruptions in our business and/or delays in fulfilling orders could harm our reputation and could potentially cause us to lose our market.

 

Our inability to effectively protect our intellectual property would adversely affect our ability to compete effectively, our revenue, our financial condition, and our results of operations.

 

We may be unable to obtain intellectual property rights to effectively protect our branding, products, and other intangible assets. Our ability to compete effectively may be affected by the nature and breadth of our intellectual property rights. While we intend to defend against any threats to our intellectual property rights, there can be no assurance that any such actions will adequately protect our interests. If we are unable to secure intellectual property rights to effectively protect our branding, products, and other intangible assets, our revenue and earnings, financial condition, or results of operations could be adversely affected.

 

We also rely on non-disclosure and non-competition agreements to protect portions of our intellectual property portfolio. There can be no assurance that these agreements will not be breached, that we will have adequate remedies for any breach, that third parties will not otherwise gain access to our trade secrets or proprietary knowledge, or that third parties will not independently develop competitive products with similar intellectual property.

 

Our industry is highly competitive and we have less capital and resources than many of our competitors, which may give them an advantage in developing and marketing products similar to ours or make our products obsolete.

 

We are involved in a highly competitive industry where we compete with various other HVAC and dehumidification manufacturers who offer products similar to the products we sell. These competitors may have far greater resources than we do, giving our competitors an advantage in developing and marketing products similar to ours or products that make our products obsolete. While we believe we are better equipped to customize products for the cannabis market and advise growers on appropriate products to maximize crop yield as compared to traditional HVAC and dehumidification manufacturers, there can be no assurance that we will be able to successfully compete against these other manufacturers.

 

We will be required to attract and retain top quality talent to compete in the marketplace.

 

We believe our future growth and success will depend in part on our ability to attract and retain highly skilled managerial, product development, sales and marketing, and finance personnel. There can be no assurance of success in attracting and retaining such personnel. Shortages in qualified personnel could limit our ability to increase sales of existing products and services and launch new product and service offerings.

 

 12 
 

 

The market price of our common stock may be volatile and may be affected by market conditions beyond our control. The market price of our common stock is subject to significant fluctuations in response to, among other factors:

 

  ● variations in our operating results and market conditions specific to our business;
     
  ● the emergence of new competitors or new technologies;
     
  ● operating and market price performance of other companies that investors deem comparable;
     
  ● changes in our Board or management;
     
  ● sales or purchases of our common stock by insiders;
     
  ● commencement of, or involvement in, litigation;
     
  ● changes in governmental regulations, in particular with respect to the cannabis industry; and
     
  ● general economic conditions and slow or negative growth of related markets.

 

In addition, if the market for stocks in our industry, or the stock market in general, experiences a loss of investor confidence, the market price of our common stock could decline for reasons unrelated to our business, financial condition, or results of operations. If any of the foregoing occurs, it could cause the price of our common stock to fall and may expose us to lawsuits that, even if unsuccessful, could be costly to defend and a distraction to our Board of Directors and management.

 

The application of the “penny stock” rules could adversely affect the market price of our common shares and increase your transaction costs to sell those shares.

 

The SEC has adopted Rule 3a51-1, which establishes the definition of a “penny stock,” for the purposes relevant to us, as any equity security that has a market price of less than $5.00 per share or with an exercise price of less than $5.00 per share, subject to certain exceptions. For any transaction involving a penny stock, unless exempt, Rule 15g-9 requires:

 

  ● that a broker or dealer approve a person’s account for transactions in penny stocks, and
     
  ● the broker or dealer receives from the investor a written agreement to the transaction, setting forth the identity and quantity of the penny stock to be purchased.
     
  ● In order to approve a person’s account for transactions in penny stocks, the broker or dealer must:
     
  ● obtain financial information and investment experience objectives of the person, and
     
  ● make a reasonable determination that the transactions in penny stocks are suitable for that person and the person has sufficient knowledge and experience in financial matters to be capable of evaluating the risks of transactions in penny stocks.

 

The broker or dealer must also deliver, prior to any transaction in a penny stock, a disclosure schedule prescribed by the SEC relating to the penny stock market, which, in highlight form:

 

  ● sets forth the basis on which the broker or dealer made the suitability determination and
     
  ● that the broker or dealer received a signed, written agreement from the investor prior to the transaction.

 

Generally, brokers may be less willing to execute transactions in securities subject to the “penny stock” rules. This may make it more difficult for investors to dispose of our common stock and cause a decline in the market value of our stock.

 

If it were determined that our spin-off of Trebor Resource Management Group, Inc. in March 2014 violated federal or state securities laws, we could incur monetary damages, fines or other damages that could have a material adverse effect on our financial condition and prospects.

 

As we previously reported, effective March 25, 2014, we effected the issuance of a dividend/spin-off of all of our ownership our wholly owned subsidiary, Trebor Resource Management Group, Inc. (“Trebor”), to our shareholders, resulting in Trebor becoming a separate entity (the “Spin-off”). The issuance of Trebor stock was completed on a one-for-one basis to our shareholders of record on March 21, 2014.

 

 13 
 

 

Under Staff Legal Bulletin No. 4 promulgated by the Division of Corporation Finance (the “Division”) of the SEC, the Division expressed its view that the shares of a subsidiary spun off from a reporting company are not required to be registered under the Securities Act of 1933, as amended (the “Securities Act”) when certain conditions are met. Although we intended to comply with the guidance set forth in Staff Legal Bulletin No. 4, we inadvertently failed to follow all of the steps necessary to rely on this guidance.

 

If it were determined that the Spin-off did not satisfy the conditions for an exemption from registration, the SEC and relevant state regulators could impose monetary fines or other sanctions as provided under relevant federal and state securities laws. Such regulators could also require us to make a rescission offer, which is an offer to repurchase the securities, to the holders of Trebor shares. This could also give certain current and former holders of the Trebor shares a private right of action to seek a rescission remedy under Section 12(a)(2) of the Securities Act. In general, this remedy allows a successful claimant to sell its shares back to the parent company in return for their original investment.

 

We are unable to quantify the extent of any monetary damages that we might incur if monetary fines were imposed, rescission were required, or one or more other claims were successful. As of the date of this filing, we are not aware of any pending or threatened claims that the Spin-off violated any federal or state securities laws, and we do not believe that assertion of such claims by any current or former holders of the Trebor shares is probable. However, there can be no assurance that any such claim will not be asserted in the future or that the claimant in any such action will not prevail. The possibility that such claims may be asserted in the future will continue until the expiration of the applicable federal and state statutes of limitations, which generally vary from one to three years from the date of sale. Claims under the antifraud provisions of the federal securities laws, if relevant, would generally have to be brought within two years of discovery, but not more than five years after occurrence.

 

Rule 144 contains risks for certain shareholders.

 

Pursuant to SEC Rule 144 promulgated under the Securities Act, a person who has beneficially owned restricted shares of our common stock for at least six months would be entitled to sell their securities provided that: (i) such person is not deemed to have been one of our affiliates at the time of, or at any time during the three months preceding a sale, (ii) we are subject to the Exchange Act periodic reporting requirements for at least 90 days before the sale and (iii) if the sale occurs prior to satisfaction of a one-year holding period, we have provided the public with current information at the time of sale.

 

Persons who have beneficially owned restricted shares of our common stock for at least six months but who are our affiliates at the time of, or at any time during the three months preceding a sale, would be subject to additional restrictions, by which such person would be entitled to sell within any three-month period only a number of securities that does not exceed the greater of either of the following:

 

  ● 1% of the total number of securities of the same class then outstanding; or
     
  ● the average weekly trading volume of such securities during the four calendar weeks preceding the filing of a notice on Form 144 with respect to the sale;

 

Provided, in each case, we are subject to the Exchange Act periodic reporting requirements for at least three months before the sale. Such sales by affiliates must also comply with the manner of sale, current public information, and notice provisions of Rule 144.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide information under this item.

 

ITEM 2. PROPERTIES

 

We own no real property. We maintain an executive office at 1780 55th Street, Suite A, Boulder, Colorado 80301, where Surna leases approximately 18,000 square feet with the lease term through April 1, 2017. The Company is in the process of negotiating a 90-day extension for our expired lease. We are in the process of evaluating our future office and warehouse needs, so we plan to continue with 90-day extensions under our expired lease agreement until we determine our office and warehouse requirements.

 

 14 
 

 

ITEM 3. LEGAL PROCEEDINGS

 

We are not presently a party to any material litigation, nor to the knowledge of management is any litigation threatened against us that may materially affect us.

 

ITEM 4. MINE SAFETY DISCLOSURES

 

Not applicable.

 

PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Our common stock is quoted on the OTCQB under the symbol “SRNA.”

 

The following table sets forth the range of high and low bid prices for our common stock for the periods indicated. The information reflects inter-dealer prices, without retail mark-ups, markdowns, or commissions, and may not necessarily represent actual transactions.

 

Year   Quarter Ended   High     Low  
2016   December 31   $ 0.25     $ 0.12  
    September 30   $ 0.12     $ 0.08  
    June 30   $ 011.     $ 0.07  
    March 31   $ 0.08     $ 0.06  
2015   December 31   $ 0.16     $ 0.07  
    September 30   $ 0.25     $ 0.04  
    June 30   $ 0.16     $ 0.05  
    March 31   $ 0.44     $ 0.14  

Holders of Record

 

As of March 20, 2017, there were approximately 149 holders of record and the closing price of our common stock was $0.17 per share as reported by the OTCQB. Because many of our shares of common stock are held by brokers and other institutions on behalf of shareholders, we are unable to estimate the total number of shareholders represented by these record holders.

 

Dividend Policy

 

We have never declared or paid any cash dividends on our capital stock. We currently intend to retain all available funds and any future earnings for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.

 

 15 
 

 

EQUITY COMPENSATION PLAN INFORMATION

 

Outstanding options as of December 31, 2016 are summarized as follows:

 

   Number of securities to
be
issued upon exercise of
outstanding options, warrants and rights		   Weighted-average
exercise price of
outstanding options, warrants and rights		   Number of securities
remaining
available for future
issuance under
equity compensation
plans
(excluding securities
reflected in
first column)		 
Equity compensation plans approved by shareholders   6,177,600(1)  $0.00024    5,148,000(2)
Equity compensation plans not approved by shareholders   -    -    - 
Total   6,177,600(1)  $0.00024    5,148,000(2)

 

  (1) Represents shares issuable upon exercise of awards issued under the 2014 Stock Ownership Plan of Safari (the “Safari Plan”), which was assumed by the Company in connection with the acquisition of Safari on March 26, 2014.
     
  (2) The Company does not intend to issue any further awards under the Safari Plan.

 

Recent Issuances of Unregistered Securities

 

The following unregistered securities were issued by the Company during the fiscal year ended December 31, 2016:

 

   Shares 
Shares issued pursuant to conversion of debt and accrued interest   

33,365,609

 
Shares issued to employees as compensation   46,045 
Shares issued for exercise of stock options   1,493,400 
Total   

34,905,054

 

 

Subsequent to December 31, 2016, the Company issued the following unregistered securities:

 

3,416,612 shares of the Company’s common stock for the conversion of approximately $627,000 of convertible promissory notes and related accrued interest.

 

16,781,250 shares of the Company’s common stock for aggregate gross proceeds of $2,685,000.

 

3,088,800 shares of the Company’s common stock for the exercise of stock options.

 

700,000 shares issued for Board of Director agreement

 

The Company issued the shares of common stock described above in reliance upon the exemptions from registration afforded by Section 4(a)(2) and/or Rule 506 promulgated under the Securities Act of 1933, as amended.

 

ITEM 6. SELECTED FINANCIAL DATA

 

We are a smaller reporting company, as defined by Rule 12b-2 of the Exchange Act, therefore are not required to provide the information under this item.

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

 

Overview

 

Surna develops, designs, and distributes cultivation technologies for controlled environment agriculture (“CEA”). The Company’s customers include state-regulated cannabis cultivation facilities as well as traditional indoor agricultural facilities, including organic herb and vegetable producers. Surna’s technologies include a comprehensive line of optimized lighting, environmental control, air sanitation, and cultivation facilities. These technologies are designed to meet the specific environmental conditions required for CEA and to dramatically reduce energy and water consumption.

 

In addition, Surna offers mechanical design services specific to hydronic cooling, including mechanical equipment and piping design.

 

 16 
 

 

Recent Developments

 

On January 8, 2015, the Company agreed to acquire 66% of the total membership interests in Agrisoft Development Group, LLC (“Agrisoft”). In connection with the purchase agreement the Company advanced a total of $260,000 through March 31, 2015, and secured repayment against certain of Agrisoft’s assets. Prior to the closing of the transaction, however, Kind Agrisoft, LLC (“Kind Agrisoft”), with the Company’s consent, agreed to purchase 100% of Agrisoft’s assets. On June 23, 2015, in exchange for the Company’s consent to its asset purchase agreement, Kind Agrisoft guaranteed repayment of the Company’s advances to Agrisoft, the balance of which was then $272,217 plus annual interest of eight percent (8%), and it granted to the Company a secured interest in its accounts receivable and intellectual property to further guarantee such payment. Furthermore, Kind Agrisoft is obligated to make additional ongoing payments to the Company in the form of a 1% quarterly royalty on EBITDA (earnings before interest, taxes, depreciation, and amortization) until Kind Agrisoft’s total payments to the Company (including payments under the Note and royalty on EBITDA) reach $600,000. The Company abandoned this acquisition and the note was paid-off in January 2017.

 

On February 24, 2015, Tom Bollich submitted his resignation as President, Chief Executive Officer, Chairman of the Board, and a member of the Board of Directors of the Company (“Board”), effective April 15, 2015. On April 17, 2015, the Board appointed Tae Darnell as Interim Principal Executive Officer and President to replace Tom Bollich then effective immediately. On August 28, 2015, the Board appointed Stephen Keen as the Company’s President and Chief Executive Officer, replacing Tae Darnell. Mr. Keen had served as the Company’s Vice President of Product Development since July 2014. He co-founded Hydro Innovations in 2007 and served as its Chief Executive Officer until its acquisition by the Company in July 2014.

 

As further described in Note 10, on October 31, 2016, the Company began private negotiations with certain holders of certain 10% convertible promissory notes (the “Original Notes”) and warrants (the “Original Warrants” and together with the Original Notes, the “Original Securities”) with a view to amending and converting the Original Notes and amending the terms of the Original Warrants.

 

The Original Securities were issued as part of a unit (each unit consisted of 250,000 shares of Common Stock, an Original Warrant to purchase 50,000 shares of Common Stock and an Original Note in the principal amount of $50,000) to investors participating in the Company’s private placement financing that completed closings between October 31, 2014 and February 27, 2015. The Original Notes mature and become payable two years from issuance.

 

As of February 20, 2017, the Company has entered into Note Conversion and Warrant Amendment Agreements (each, an “Agreement” and together, the “Agreements”) with each of 48 holders, to: (i) amend the Original Note (each an “Amended Note”) to reduce the conversion price of such holder’s Original Note and simultaneously cause the conversion of the outstanding amount under such Original Note into shares of Common Stock of the Company (“Conversion Shares”) with the exception of agreements with three holders which provide for the payment of the principal amount in cash and the interest outstanding in stock and a further three agreements in which a cash sum was negotiated to pay the outstanding note in full; and (ii) reduce the exercise price of the Original Warrant (each, an “Amended Warrant” and together with an Amended Note, the “Amendments”) in all except three Agreements. Each Agreement has been privately negotiated so the terms vary. Pursuant to the Agreements, the Original Notes have been amended to reflect a reduced conversion price per share between $0.09 and $0.22. Additionally, pursuant to the Agreements, certain Original Warrants have been amended to reflect a reduced exercise price per share between $0.30 and $0.35, with the exception of the first Agreement signed which amended certain Original Warrants to reflect a reduced exercise price of $0.15 per share.

 

Pursuant to the Agreements, the Company has (i) converted Original Notes with an aggregate outstanding principal amount of approximately $2,536,000. under the Original Notes, (ii) issued 18,893,393 Conversion Shares in connection with the conversion of such Original Notes and (iii) amended 2,536,000 Original Warrants to reduce their exercise price. During this time the Company also obtained a short-term loan of approximately $500,000.00 for working capital.

 

In connection with the Amendments, the Company has also negotiated with some of the holders a restriction that limits the number of Conversion Shares a holder may sell, make any short sale of, loan, grant any option for the purchase of, or otherwise dispose of any of such shares issuable in connection with the Amendments without the prior written consent of the Company for a period of ninety (90) days after the date of such holder’s Agreement.

 

The Company intends to negotiate with the remaining holders of the Original Notes to convert the remaining $250,000.00 of principal; however, it cannot make any assurance that it will be successful in negotiating Agreements with any remaining holders of Original Notes.

 

On August 10, 2015, Tom Bollich transferred 21,428,023 shares of the Company’s common stock to the Company. This transfer was not the result of any direct agreements between the Company and Bollich. On August 11, 2015, the Company authorized cancelation of the shares, and the shares were canceled on August 14, 2015.

 

 17 
 

 

On August 18, 2015, the Board amended Article II § 2 of the Company’s bylaws such that the number of directorships may be set by the Board or by an action of the shareholders. Subsequent to this amendment, the Board adopted resolutions increasing the number of directorships from two (2) to five (5) and appointing Brandy Keen, Stephen Keen, and Morgan Paxhia to fill the vacant directorships until such time as their successors shall have been elected and qualified. Ms. Keen has served as the Company’s Vice President of Sales since July 2014. Mr. Keen served as the Company’s Chief Executive Officer and President from August 2015 to June 2016 and prior to that had served as the Vice President of Product Development since July 2014. Since June 2016, Mr. Keen has served as the Company’s Director of Technology. Mr. Paxhia has served as managing director of Poseidon Asset Management since January 2014.

 

On November 11, 2015, the Company appointed Trent Doucet as its Chief Operating Officer, replacing Bryon Jorgenson, who resigned his position effective October 31, 2015. On December 21, 2015, Tae Darnell submitted to the Board his resignation as a director of the Company effective immediately. Subsequent to Mr. Darnell’s resignation from the Board, the Board appointed the Company’s Chief Operating Officer, Trent Doucet, to fill the vacancy on the Board in accordance with Article II § 02 of the Company’s bylaws, as amended.

 

On January 21, 2016, the Board terminated the services of Douglas McKinnon as Chief Financial Officer, effective as of that date. Following termination of his services, on January 26, 2016, Mr. McKinnon submitted his resignation as a director on the Board, effective as of that date.

 

On January 21, 2016, the Board appointed Ellen White to serve as its Chief Financial Officer. Ms. White was serving as the Company’s Director of Finance since September 2015. Ms. White resigned on June 23, 2016. Dean Skupen currently serves as the Company’s Principal Accounting and Financial Officer.

 

On May 13, 2016, Stephen Keen notified the board of directors of his intention to no longer serve as the Company’s President and Chief Executive Officer, effective June 15, 2016. Mr. Keen became the Company’s Director of Technology. In connection with Mr. Keen’s resignation, the Board appointed Trent Doucet, as the Company’s President and Chief Executive Officer as of June 15, 2016.

 

On August 12, 2016, the Board appointed Dean S. Skupen to serve as Director of External Reporting and designated him as Principal Financial and Accounting Officer.

 

On February 21, 2017, Surna Inc. (the “Company”) entered into a Purchase Agreement (the “Purchase Agreement”) with Sante Veritas Therapeutics Inc. (“Sante Veritas”), pursuant to which the Company will design and provide equipment for the environmental control system in Sante Veritas’ first commercial cultivation facility.

 

In March 2017 (the “Investment Date”), Surna Inc. (the “Company”) entered into a Securities Purchase Agreement (the “Agreement”) with certain accredited investors (the “Investors”). The Company issued an aggregate of 16,781,250 investment units (the “Units”), for aggregate gross proceeds of $2,685,000. Each Unit consists of one share of the Company’s common stock, par value $0.00001 per share (the “Common Stock”) and one warrant for the purchase of one share of Common Stock.

 

Pursuant to each of the warrants, the holder thereof may, subject to the terms of the warrant, at any time on or after six months after the date of the warrant and on or prior to the close of business on the date that is the third anniversary of the date of the warrant, purchase up to the number of shares of Company common stock as set forth in the respective warrant. The exercise price per share of the common stock under each warrant is $0.26, subject to adjustment as set forth in the warrants. Each warrant is callable at the Company’s option commencing six months from the date of the warrant, provided the Company’s common stock trades at a VWAP of $0.42 or greater (subject to adjustment) for five consecutive trading days (the “Call Condition”). Commencing at any time after the date on which the Call Condition is satisfied, the Company has the right, upon 30 days’ notice to the holder given not later than 30 trading days after the date on which the Call Condition is satisfied, to redeem the number of warrant shares specified in the applicable Call Condition at a price of $0.01 per warrant share, subject to the terms of the warrant.

 

The Company claims an exemption from the registration requirements of the Securities Act, for the private placement of these securities pursuant to Section 4(a)(2) of the Securities Act and/or Regulation D promulgated thereunder because, among other things, the transaction did not involve a public offering, the purchasers are accredited investors, the purchasers acquired the securities for investment and not resale, and the Company took appropriate measures to restrict the transfer of the securities.

 

On March 14, 2017, the Board of Directors (the “Board”) of Surna Inc. (the “Company”) appointed Timothy J. Keating as a director to the Board. Mr. Keating will serve as the Company’s Chairman and lead independent director.

 

 18 
 

 

On March 7, 2017, Mr. Keating and the Company entered into a Board of Directors Agreement (the “Agreement”). Pursuant to the Agreement, as a non-executive director of the Company and non-employee Chairman of the Board, Mr. Keating is entitled to an annual retainer of $75,000, of which $30,000 will be in the form of restricted common stock. The Company has also issued Mr. Keating an equity retention payment of 1,400,000 shares of the Company’s restricted common stock (i) 700,000 shares of which were issued and vested immediately and (ii) 700,000 shares of which will vest on March 1, 2018.

 

Results of Operations

 

Year Ended December 31, 2016 Compared to the Year Ended December 31, 2015

 

   2016   2015 
Revenue  $7,579,000   $7,865,000 
           
Cost of revenue   5,275,000    6,924,000 
           
Gross margin   2,303,000    941,000 
Gross margin %   30%   12%
           
Operating expenses   2,836,000    4,054,000 
           
Operating loss   (533,000)   (3,114,000)
           
Other income (expense), net   (2,740,000)   (2,182,000)
           
Net loss  $(3,273,000)  $(5,296,000)

 

Revenue for the year ended December 31, 2016 decreased by 4% to $7,580,000 for the year ended December 31, 2016 as compared to $7,865,000 for 2015. A significant portion of our revenues for 2015 were derived from growers in the State of Nevada (legalized cannabis in 2014), which peaked in the third quarter of 2015. As our sales declined slightly from 2015 to 2016, our contractual sales commitments have been increasing. The sales amounts that we had under contract but which were not yet completed have increased year over year from $1,423,000 at December 31, 2015 to $2,646,000 at December 31, 2016.

 

Our contractual sales commitments increased during 2016 due to our customers having experienced increased delays in completing the construction of their facilities to accept their product. Our contractual sales cannot be canceled by our customers. Initially our sales contracts were dependent upon our customers’ ability to secure, license and build their growing facilities and thus our revenue recognition was dependent upon shipping and our customers’ ability to receive the product. We have seen an increased delay in the time frames in which our customers have been able to receive the product, most likely related to the increasing size of our projects. This factor has slowed our revenue recognition and increased our contractual sales commitments.

 

Since October 2016, all of our sales contracts have been freight-on board shipping (“FOB Shipping”). This removes any dependencies on our revenue recognition being tied to a customer’s ability to receive product. The substantial increase in revenue for fiscal year 2015 compared to the prior year resulted from Hydro contributing twelve months of revenue to our results in fiscal year 2015, while Hydro’s operations were a part of Surna for only five months in fiscal year 2014. Additional increases, and sustained, revenues from 2014 to 2016 are attributable to progress and ongoing legal and regulatory developments in an increasing number of states that permit and regulate cannabis cultivation and use for medical or recreational purposes. Our current and future revenue plan is dependent on the continued and increasing legality of the cannabis industry and our ability to effectively market our indoor agriculture products to this key segment as well as expand our reach to other markets.

 

Cost of revenue decreased by 24% to $5,276,000 for the year ended December 31, 2016 as compared to $6,924,000 for the year ended December 31, 2015. The gross margin for the year ended December 31, 2016 increased by 18% to 30% as compared to 12% for the year ended December 31, 2015 due to (i) negotiation of favorable pricing with key suppliers or sourcing new suppliers, (ii) a sales mix that consisted more of high margin products and (iii) reduced spending on installation projects, as we no longer provide installation services. These decreases are offset by a one-time charge in the year ended December 31, 2016 of approximately $530,000 for a warranty expense.

 

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Operating expenses decreased by 30% to $2,837,000 for the year ended December 31, 2016 as compared to $4,055,000 for the year ended December 31, 2015. We have decreased advertising and marketing expenses by 52% from $310,000 for 2015 to $150,000 for 2016 due to a heavier emphasis on advertising in the prior year and a focus on reigning in costs in 2016. We decreased product development costs by 51% from $708,000 in 2015 to $349,000 in 2016 due to the product life cycle of the Surna reflector product, which has moved from development stage in the first quarter of 2015 to production stage in the first quarter of 2016. Also in 2015, we had additional cost of approximately $150,000 related to the development of the Surna Hybrid Building, which we introduced at the Marijuana Daily Conference in November 2016. We decreased general and administrative expenses by 23% from $3,038,000 in 2015 to $2,338,000 in 2016 due to reductions in personnel cost of approximately $200,000 as well as a focus on cost containment related to professional fees of approximately $250,000. We also reduced selling expenses and travel by approximately $150,000.

 

Other expenses have increased by 26% to $2,740,000 for the year ended December 31, 2016 from approximately $2,182,000 for the year ended December 31, 2015. The change is attributable to (i) a decrease in amortization of debt discounts and interest expense, (ii) the conversion of certain convertible promissory notes converted in the first quarter and second quarter of 2016; (iii) the loss on the change in derivative liabilities; and (iv) the loss due to the extinguishment of debt in the fourth quarter of 2016.

 

As a result of our decrease in cost of revenue and operating expenses, we reduced our net loss to $3,273,000 for the year ended December 31, 2016 as compared to $5,296,000 for the year ended December 31, 2015.

 

Year Ended December 31, 2015 Compared to the Year Ended December 31, 2014

 

   2015   2014 
Revenue  $7,865,243   $1,838,912 
           
Cost of revenue   6,924,402    1,534,918 
           
Gross margin   940,841    303,994 
Gross margin %   12%   17%
           
Operating expenses   4,054,684    3,496,458 
           
Operating loss   (3,113,843)   (3,192,464)
           
Other income (expense), net   (2,182,179)   218,266 
           
Loss from continuing operations   (5,296,022)   (2,974,198)
           
Loss from discontinued operations   -    (17,771)
           
Net loss  $(5,296,022)  $(2,991,969)
           
Loss per common share from continuing operations - basic  $(0.04)  $(0.03)
           
Loss per common share from discontinued operations - basic  $(0.00)  $(0.00)
           
Loss per common share - basic  $(0.04)  $(0.03)

 

Revenue for the year ended December 31, 2015 was $7,865,243 as compared to $1,838,912 (328% growth) for the year ended December 31, 2014. The substantial increase in revenue for fiscal year 2015 compared to the prior year resulted from Hydro contributing twelve months of revenue to our results in fiscal year 2015, while Hydro’s operations were a part of Surna for only five months in fiscal year 2014. Additional increases in revenues are attributable to progress and ongoing legal and regulatory developments in an increasing number of states that permit and regulate cannabis cultivation and use for medical or recreational purposes. Our current and future revenue plan is dependent on the continued and increasing legality of the cannabis industry and our ability to effectively market our indoor agriculture products to this key segment as well as expand our reach to other markets.

 

Cost of revenue for the year ended December 31, 2015 was $6,924,402 as compared to $1,534,918 (351% increase) for the year ended December 31, 2014. Increases are due in large part to increases in sales as well as the fact that Hydro operated as a Surna subsidiary for twelve months during fiscal year 2015 and only five months during fiscal year 2014. Cost of revenue increased at a slightly higher rate than revenue due in part to costs related to installation contracts that Surna began in the second half of 2014. Surna has since trained several traditional HVAC installation companies on the Surna system and will cease installation and focus on core competencies in 2016. Surna saw gross margin percentages erode to 12% from 17% due primarily to the reduced margins from the installation business as well as higher manufacturing costs.

 

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Operating expenses were $4,054,684 compared to $3,496,458 for the year ended December 31, 2015 and 2014, respectively. Although operating expenses increased 16% year over year, such costs declined as percentage of revenue to 52% in 2015 from 190% in 2014. The increase is attributable to the more than doubling of product development costs to $707,517 from $319,430 as Surna makes key investments in its Hybrid building and lighting technologies. The 29% increase in advertising and marketing expenses to $309,620 from $240,784 is due in part to expenditures on potential customer tours at facilities that are now running Surna climate control systems. Additionally, now that more states have legal cannabis Surna is covering a wider geographic area with marketing events and conferences. The 3% increase in selling, general and administrative expenses to $3,037,547 from $2,936,244 for the year ended December 31, 2015 compared to the year ended December 31, 2014 represents investments in administrative staff and support to manage the more than tripling of transaction volumes. Selling, general and administrative expenses are primarily sales and marketing personnel costs as well as corporate, legal, and accounting expenses.

 

We incurred net other expenses of $2,182,179 for the year ended December 31, 2015 compared to net other income of $218,266 for the year ended December 31, 2014. This change largely resulted from $2,220,115 of amortization of debt discounts as well as greater interest expense, both in connection with convertible promissory notes issued during fiscal years 2015 and 2014.

 

Surna experienced very high growth in the second half of the year and experienced cash shortages as the Company increased inventory purchases to meet the new rates of demand. In order to meet the immediate cash requirements at that time Surna took on some debt at disadvantageous terms. Surna management is focused on improving margins by reducing costs and optimizing pricing so that reliance on outside debt is limited in the future.

 

We reported no discontinued operations for fiscal year 2015, while we incurred a loss of $17,771 from discontinued operations in connection with the sale of Surna Media, Inc. and its affiliates in fiscal year 2014.

 

Overall, we realized a net loss of $5,296,022 for the year ended December 31, 2015 as compared to $2,991,969 for the year ended December 31, 2014.

 

Liquidity and Capital Resources

 

During the year ended December 31, 2016, our primary source of liquidity was from operating activities as compared to prior years where our primary source of liquidity was from financing activities. This significant change in liquidity is due primarily to the Company’s effort in reducing the cost of goods sold and general and administrative expenses. The following summarizes our cash flows for the years ended December 31,:

 

   2016   2015 
Cash provided by (used in) operating activities  $103,496   $(1,685,358)
Cash provided by (used in) investing activities   41,619    (169,599)
Cash (used in) provided by financing activities   (156,127)   1,495,551 
Net change in cash  $(11,011)  $(359,406)

 

As a result of our decrease in cost of revenue and operating expenses, as described above, we used less cash in operating activities during the year ended December 31, 2016 as compared to December 31, 2015.

 

As of December 31, 2016 and 2015, our total assets were $2,118,000 and $3,103,000, respectively, and our total liabilities were $4,229,000 and $5,950,000, respectively. As of December 31, 2016 and 2105, we had working capital deficits of approximately of $2,860,000 and $3,020,000, respectively.

 

We reported net losses of $3,273,000 and $5,296,000 for the fiscal years ended December 31, 2016 and 2015, respectively.

 

During the years ended December 31, 2016 and 2015, we raised a total of $0 and $1,781,250 in connection with issuances of three series of convertible promissory notes.

 

In March 2017, the Company complete a private placement offering of its common stock for total proceeds of $2,685,000.

 

 21 
 

 

Cash Requirements

 

Our ability to fund our growth and meet our obligations on a timely basis is dependent on our ability to match our available financial resources to our growth strategy, which includes acquisitions for cash or a combination of cash and debt. The decisions we make with regard to acquisitions drive the level of capital required and the level of our financial obligations.

 

If we are unable to generate cash flow from operations and successfully raise sufficient additional capital through future debt and equity financings or strategic and collaborative ventures with potential partners, we would likely have to reduce the size and scope of our operations.

 

We have suffered recurring losses from operations. The continuation of our Company is dependent upon our Company attaining and maintaining profitable operations and raising additional capital as needed. In this regard, we have raised additional capital through equity offerings and loan transactions, and, in the short term, will seek to raise additional capital in such manners to fund our operations. Our officers and shareholders have not made any written or oral agreement to provide us additional financing. There can be no assurance that we will be able to continue to raise capital on terms and conditions that are acceptable to us.

 

Inflation

 

In the opinion of management, inflation has not and will not have a material effect on our operations in the immediate future. Management will continue to monitor inflation and evaluate the possible future effects of inflation on our business and operations.

 

Contractual Payment Obligations

 

We have obligations under notes payable and a non-cancelable operating lease. As of December 31, 2016, our contractual obligations are as follows:

 

Contractual Obligations  Total   Less than
1 Year		   1 - 3 Year   3 -5 Years   More than
5 Years		 
Debt obligations (including interest)  $922,000   $922,000   $-   $-   $- 
Amounts due to shareholders   69,000    57,000    12,000           
Operating lease obligations   55,000    55,000    -             -           - 
Total  $1,046,000   $1,034,000   $12,000   $-   $- 

 

As of the date of this filing, the debt obligations (including interest) were converted into the Company’s common stock or paid in in cash.

 

The Company holds a lease agreement for its manufacturing and office space consisting of approximately 18,000 square feet. The lease term extends through April 1, 2017. The Company is in the process of negotiating a 90-day extension for our expired lease. We are in the process of evaluating our future office and warehouse needs, so we plan to continue with 90-day extensions under our expired lease agreement until we determine our office and warehouse requirements.

 

Off Balance Sheet Arrangements

 

Under SEC regulations, we are required to disclose our off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, such as changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. As of December 31, 2016, we have no off-balance sheet arrangements.

 

Going Concern

 

The Company’s independent registered public auditor’s report accompanying our December 31, 2016 and 2015 audited financial statements contains an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern. The financial statements have been prepared assuming that the Company will continue as a going concern. Our ability to continue as a going concern is dependent on raising additional capital to fund our operations and ultimately on generating future profitable operations. There can be no assurance that we will be able to raise sufficient additional capital or eventually have positive cash flow from operations to address all of our cash flow needs. If we are not able to find alternative sources of cash or generate positive cash flow from operations, our business and shareholders will be materially and adversely affected.

 

 22 
 

 

Critical Accounting Policies

 

The discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. Certain accounting policies and estimates are particularly important to the understanding of our financial position and results of operations and require the application of significant judgment by our management or can be materially affected by changes from period to period in economic factors or conditions that are outside of our control. As a result, they are subject to an inherent degree of uncertainty. In applying these policies, management uses their judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical operations, our future business plans and projected financial results, the terms of existing contracts, observance of trends in the industry, information provided by our customers and information available from other outside sources, as appropriate. For information regarding the Company’s critical accounting policies as well as recent accounting pronouncements, see Note 1 to the consolidated financial statements.

 

Concentration of Credit Risk

 

Financial instruments that potentially subject Surna to concentration of credit risk consist of cash and accounts receivable. Under Section 343 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, for the two-year period of January 1, 2015 through December 31, 2016, cash balances in noninterest-bearing transaction accounts at all FDIC-insured depository institutions are provided temporary unlimited deposit insurance coverage. As of December 31, 2016, cash balances in interest-bearing accounts were approximately $280,000.

 

Two customers accounted for 14% and 10%, respectively, of the Company’s revenue for the year ended December 31, 2016. One customer accounted for 10% of the Company’s revenue for the year ended December 31, 2015.

 

The Company’s accounts receivable from two customers make up 39% and 29% of the total balance as of December 31, 2016. The Company’s accounts receivable from four customers made up 89% of the total balance as of December 31, 2015.

 

Trends, Events, and Uncertainties

 

Development of new technologies or product solutions is, by its nature, unpredictable. Although we will undertake development efforts with commercially reasonable diligence, there can be no assurance that we will have adequate capital to develop our technology or products to the extent needed to create future sales to sustain our operations.

 

No assurance can be provided that our technology or products will be adopted, that we will ever earn revenue sufficient to support our operations, or that we will ever be profitable. Furthermore, since we have no committed source of financing, we can provide no assurance that we will be able to raise money as and when we need it to continue our operations. If we cannot raise funds as and when we need them, we may be required to severely curtail, or even to cease, our operations.

 

Other than as discussed above and elsewhere in this Annual Report on Form 10-K, we are not aware of any trends, events, or uncertainties that are likely to have a material effect on our financial condition.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We are a smaller reporting company, as defined by Rule 12b-2 of the Exchange Act, therefore are not required to provide the information under this item.

 

 23 
 

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

The financial statements required by this Item 8 are included at the end of this Report beginning on page F-1 as follows:

 

    PAGE NO.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS:    
     
Report of Independent Registered Public Accounting Firm   F-1
     
Consolidated Balance Sheets as of December 31, 2015 and 2014   F-2
     
Consolidated Statements of Operations and Comprehensive Loss for the years ended December 31, 2015 and 2014   F-3
     
Consolidated Statements of Changes in Shareholders Deficit for the years ended December 31, 2015 and 2014   F-4
     
Consolidated Statements of Cash Flows for the years ended December 31, 2015 and 2014   F-5
     
Notes to Consolidated Financial Statements   F-6

 

 24 
 

 

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

None.

 

ITEM 9A. CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

Our management conducted an evaluation, with the participation of our Chief Executive Officer and our Principal Financial and Accounting Officer of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this annual report on Form 10-K. Based upon that evaluation, our Chief Operating Officer and Chief Financial Officer concluded that as a result of the material weakness in our internal control over financial reporting described below, our disclosure controls and procedures were not effective as of December 31, 2016.

 

Management’s Annual Report on Internal Control over Financial Reporting

 

Management is responsible for the preparation of our financial statements and related information. Management uses its best judgment to ensure that the financial statements present fairly, in material respects, our financial position and results of operations in conformity with generally accepted accounting principles.

 

Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in the Exchange Act. These internal controls are designed to provide reasonable assurance that the reported financial information is presented fairly, that disclosures are adequate and that the judgments inherent in the preparation of financial statements are reasonable. There are inherent limitations in the effectiveness of any system of internal controls including the possibility of human error and overriding of controls. Consequently, an effective internal control system can only provide reasonable, not absolute, assurance with respect to reporting financial information.

 

Our internal control over financial reporting includes policies and procedures that: (i) pertain to maintaining records that, in reasonable detail, accurately and fairly reflect our transactions; (ii) provide reasonable assurance that transactions are recorded as necessary for preparation of our financial statements in accordance with generally accepted accounting principles and that the receipts and expenditures of company assets are made in accordance with our management and directors authorization; and (iii) provide reasonable assurance regarding the prevention of or timely detection of unauthorized acquisition, use or disposition of assets that could have a material effect on our financial statements.

 

Under the supervision of management, including our Chief Executive Officer and our Principal Financial and Accounting Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) published in 2013 and subsequent guidance prepared by COSO specifically for smaller public companies. Based on that evaluation, our management concluded that our internal control over financial reporting was not effective as of December 31, 2016 for the reasons discussed below.

 

A material weakness is a deficiency or a combination of deficiencies in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the annual or interim consolidated financial statements will not be prevented or detected on a timely basis.

 

 25 
 

 

Management identified the following material weakness in its assessment of the effectiveness of internal control over financial reporting as of December 31, 2016:

 

The Company did not maintain effective controls over certain aspects of the financial reporting process because we lacked a sufficient complement of personnel with a level of accounting expertise and an adequate supervisory review structure that is commensurate with our financial reporting requirements. In addition, there was inadequate segregation of duties due to the limitation on the number of our accounting personnel.

 

We intend to take appropriate and reasonable steps to make the necessary improvements to remediate these deficiencies. However, due to our size and nature, segregation of all conflicting duties has not always been possible and may not be economically feasible.

 

Our management, including our Chief Executive Officer and our Principal Financial and Accounting Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Due to the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected.

 

The material weaknesses in internal control over financial reporting as of December 31, 2016 remain unchanged from December 31, 2015. Management believes that the material weaknesses set forth above did not have an effect on our financial reporting for the year ended December 31, 2016. Yet, we are committed to continuing to improve our financial organization. Subject to the availability of sufficient funds during 2017 to expand our accounting staff, we also expect to create a position to segregate duties consistent with control objectives and will increase our personnel resources, if necessary, by hiring independent third parties or consultants to provide expert advice as needed.

 

We will continue to monitor and evaluate the effectiveness of our internal control over financial reporting on an ongoing basis and are committed to taking further action and implementing additional enhancements or improvements, as necessary and as funds allow. We do not, however, expect that the material weaknesses in our disclosure controls will be remediated until such time as we have improved our internal control over financial reporting.

 

This annual report on Form 10-K does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to rules of the SEC that permit us to provide only management’s report in this annual report on Form 10-K.

 

Changes in Internal Control over Financial Reporting

 

There were no changes identified in connection with our internal control over financial reporting during the quarter ended December 31, 2016, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

ITEM 9B. OTHER INFORMATION

 

None.

 

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PART III

 

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

 

Officers and Directors

 

The name, age and positions held by our executive officers and directors:

 

Name   Age   Position(s) and Office(s) Held
Stephen Keen(1)   38   Director of Technology
Trent Doucet(2)   47   President, Chief Executive Officer and Director
Brandy Keen(3)   40   Vice President of Sales, Secretary and Director
Morgan Paxhia(4)   33   Director
Timothy Keating(5)   53   Director, Chairman of Board of Directors

 

  (1) Mr. Keen served as Chief Executive Officer from August 28, 2015 to June 15, 2016 and as a director since August 18, 2015. As of June 15, 2016, Mr. Keen has served as Director of Technology.
     
  (2) Mr. Doucet has served as President and Chief Executive Officer since June 15, 2016 and served as Chief Operating Officer from November 11, 2015 to June 15, 2016. He has served as a director since December 21, 2015.
     
  (3) Ms. Keen has served as a Vice President of Sales since July 2014 and as a director since August 18, 2015.
     
  (4) Mr. Paxhia has served as a director since August 18, 2015.
     
  (5)

Mr. Keating has served as Chairman of the Board of Directors since March 14, 2017. Prior to this date, the Company did not have an appointed Chairperson.

 

Our directors are appointed for a one-year term to hold office until the next annual general meeting of our shareholders or until removed from office in accordance with our bylaws. Our officers are appointed by our Board of Directors and hold office until removed by the Board. All officers and directors listed above will remain in office until the next annual meeting of our shareholders, and until their successors have been duly elected and qualified. There are no agreements with respect to the election of directors. Our Board appoints officers annually and each executive officer serves at the discretion of our Board.

 

Except for Stephen and Brandy Keen, who are married, there are no family relationships among any of our directors or executive officers.

 

None of the directors or officers of the Company was involved in any legal proceedings described in Item 401(f) of Regulation S-K.

 

Set forth below is a brief description of the background and business experience of our current executive officers and directors.

 

Background of Officers and Directors

 

Trent Doucet

President, Chief Executive Officer and Director

 

Mr. Doucet has served as President and Chief Executive Officer since June 15, 2016 and previously served as Chief Operating Officer from November 11, 2015 to June 15, 2016. He has served as a director since December 21, 2015. In 2000, Doucet founded Primus Networks, Inc., which was acquired in 2011 by White Glove Technologies, LLC. Mr. Doucet served as Managing Director at White Glove until 2012 when it was acquired by mindSHIFT Technologies, a nationwide managed IT service provider owned by Ricoh USA. Mr. Doucet served as Vice President and Managing Director at mindSHIFT until joining Surna in 2015, where he was responsible for revenue growth for the strategic services group.

 

In its Current Report on Form 8-K, filed on June 29, 2016, the Company inadvertently incorrectly reported that Mr. Doucet began serving as the Company’s President and Chief Executive Officer, and ceased to serve as the Company’s Chief Operating Officer, on May 13, 2016. Mr. Doucet began serving as the President and Chief Executive Officer, and ceased to serve as the Company’s Chief Operating Officer, on June 15, 2016.

 

Stephen Keen

Director of Technology and Director

 

Mr. Keen has served as Director of Technology since June 15, 2016. He previously served as Chief Executive Officer and President from August 28, 2015 to June 15, 2016. He has served as a director since August 18, 2015. Previously, he served as the Company’s Vice President of Product Development since July 2014. Mr. Keen co-founded Hydro Innovations in 2007, and served as its chief executive officer until its acquisition by the Company in July 2014.

 

Brandy Keen

Vice President of Sales, Secretary and Director

 

Ms. Keen has served as a Vice President of Sales and Secretary since July 2014 and as a Director since August 18, 2015. Ms. Keen co-founded Hydro Innovations, LLC in 2007 and served as its director of operations until its acquisition by the Company in July 2014.

 

 27 
 

 

Timothy Keating

Director – Chairman of Board of Directors

 

Mr. Keating was appointed Chairman of the Board of Directors and Lead Independent Director on March 14, 2017. He brings more than 31 years of Wall Street experience, including 17 years as the principal owner of Keating Investments, LLC. Mr. Keating also served on the Equity Capital Formation Task Force and is the chairman of the Denver chapter of Harvard Alumni Entrepreneurs. He is currently the President of Keating Wealth Management, LLC, a Denver-area investment firm serving high net worth investors and their families, with a particular focus on private business ownership. Mr. Keating is a cum laude graduate of Harvard College with an A.B. in Economics.

 

Morgan Paxhia

Director

 

Mr. Paxhia has served as an Independent Director since August 18, 2015. He is the managing director of Poseidon Asset Management, which he helped found in January 2014. From October 2013 to July 2015, he was the principal and managing director of Paxhia Investment Management. From June 2009 to November 2013, Mr. Paxhia was an investment counselor with a privately owned registered investment adviser. Previously, Mr. Paxhia worked on the municipal bond desk at UBS in New York City before moving into the wealth management as a financial advisor associate with UBS.

 

Committees of our Board of Directors

 

Our securities are not quoted on an exchange that has requirements that a majority of our Board members be independent and we are not currently otherwise subject to any law, rule or regulation requiring that all or any portion of our Board of Directors include “independent” directors, nor are we required to establish or maintain an audit committee or other committee of our Board.

 

Nevertheless, we have a compensation committee, which is chaired by Mr. Paxhia and on which Ms. Keen also serves. The Board does not have standing audit or nominating committees, nor does it have an audit committee financial expert. The Board does not believe these committees are necessary based on the size of the Company, the current levels of compensation to corporate officers, and the concentration of ownership of our securities with members of our Board. The Board will consider establishing audit and nominating committees at the appropriate time.

 

The entire Board participates in the consideration of compensation issues and of director nominees, with specific input and guidance from the members of our compensation committee. Candidates for director nominees are reviewed in the context of the current composition of the Board and the Company’s operating requirements and the long-term interests of its shareholders. In conducting this assessment, the Board considers skills, diversity, age, and such other factors as it deems appropriate given the current needs of the Board and the Company, to maintain a balance of knowledge, experience, and capability.

 

The Board’s process for identifying and evaluating nominees for director, including nominees recommended by shareholders, involves compiling names of potentially eligible candidates, conducting background and reference checks, conducting interviews with the candidate and others (as schedules permit), meeting to consider and approve the final candidates and, as appropriate, preparing an analysis with regard to particular recommended candidates.

 

Code of Ethics

 

The Board of Directors has adopted a code of ethics applicable to its executive officers, which is available online at http://www.surna.com/code-ethics. We intend to satisfy the disclosure requirements under Item 5.05 of Form 8-K regarding amendment to or waiver from, a provision of our code of ethics and by posting such information on the website address and location specified above.

 

Compliance with Section 16 of the Exchange Act

 

Based solely upon a review of Forms 3 and 4 and amendments thereto furnished to us under Rule 16a-3(e) during the year ended December 31, 2016, Forms 5 and any amendments thereto furnished to us with respect to the year ended December 31, 2016, and the representations made by the reporting persons to us, who, at any time during such fiscal year was a director, officer or beneficial owner of more than 10% of the Company’s common stock, was in compliance with timely filing with all Section 16(a) filing requirements during the fiscal year.

 

 28 
 

 

ITEM 11. EXECUTIVE COMPENSATION

 

The following table sets forth certain compensation information for our principal executive officers or other individuals serving in a similar capacity during the years ended December 31, 2016 and 2015.

 

Summary Compensation Table

 

Name and
Principal
Position		   Year     Salary     Bonus     Stock
Awards		     Option
Awards		     Non-equity
Incentive Plan Compensation		     Non-qualified
Deferred
Compensation Earnings		    

All Other

Compensation

     Total  
Stephen Keen                                                                        
Director of Technology(1)     2016     $ 110,200     $ -     $ -     $ -     $        -     $       $ 7,200 (3)   $    
Stephen Keen                                                                        
CEO(1)     2015       80,000       -       -       -       -       16,000       120  (4)        
                                                                         
Trent Doucet                                                                        
CEO(2)     2016       125,800       -       -       -       -       -       34,600 (5)        
Trent Doucet                                                                        
COO(2)     2015       17,500       -       -       -       -       -       -          

 

  (1) Mr. Keen was appointed Director of Technology on June 15, 2016. He previously served as Chief Executive Officer from August 28, 2015 to June 15, 2016. Previously, he served as Vice President of Product Development following the Company’s acquisition of Hydro Innovations, LLC on July 25, 2014. All compensation amounts presented include the amount earned during 2016 and 2015 both prior to and subsequent to his transition from Chief Executive Officer to Director of Technology.
     
  (2) Mr. Doucet has served as President and Chief Executive Officer since June 15, 2016 and previously served as Chief Operating Officer from November 11, 2015 to June 15, 2016. All compensation amounts presented include the amount earned during 2016 and 2015 both prior to and subsequent to his appointment as President and Chief Executive Officer.
     
     
  (3) Amounts set forth in the All Other Compensation column consist of the Company’s contribution to Named Executive Officer’s 401(k) Plan ($3,300) and the cost of insurance benefits borne by the Company ($3,900).
     
  (4) Amounts set forth in the All Other Compensation column consist solely of the Company’s contribution to Named Executive Officer’s 401(k) Plan.
     
  (5) Amounts set forth in the All Other Compensation column consist of rent paid by the Company for Mr. Doucet’s Boulder apartment ($30,700) and of the cost of insurance benefits borne by the Company ($3,900).

 

Outstanding Equity Awards at Fiscal Year-End December 31, 2016

 

Other than as set forth below, as of December 31, 2016, there were no outstanding unexercised options, unvested stock, and/or equity incentive plan awards issued to our named executive officers.

 

    Option Awards     Stock Awards

 

Name

   Number of
Securities
Underlying
Unexercised
Options
Exercisable		     Number of
Securities
Underlying
Unexercised
Options
Unexercisable		     Equity
Incentive
Plan
Awards:
Number of
Securities
Underlying
Unexercised
Unearned
Options		    

Option

Exercise
Price

    

Option

Expiration
Date

   Number
of
Shares
or Units
of Stock
That
have Not
Vested		     Market
Value of
Shares
or Units
of Stock
That
Have
Not
Vested		   Equity
Incentive
Plan
Awards:
Number of
Unearned
Shares,
Units or
Other
Rights
That have
Not
Vested		     Equity
Incentive
Plan
Awards:
Market or
Payout
Value of
Unearned
Shares,
Units or
Other
Rights
That Have
Not
Vested		  
Stephen Keen     1,544,400       -       -     $ 0.00024     3/18/2017     -   $ -     -     $ -  

 

 29 
 

 

Employment Agreements with Named Executive Officers

 

None

 

Compensation of Directors

 

The members of our Board other than our Chairman, Timothy Keating, are not compensated for their services as directors. The Board has not implemented a plan to award options to any directors and there are no contractual arrangements with any member of the Board or any director’s service contracts other than with Mr. Keating. However, the Company will reimburse directors for expenses incurred in connection with their director services. Pursuant to the Board of Directors Agreement entered into by the Company and Mr. Keating on March 14, 2017, as a non-executive director of the Company and non-employee Chairman of the Board, Mr. Keating is entitled to an annual retainer of $75,000, of which $30,000 will be in the form of restricted common stock. The Company has also issued Mr. Keating an equity retention payment of 1,400,000 shares of the Company’s restricted common stock (i) 700,000 shares of which vested immediately and (ii) 700,000 shares of which will vest on March 1, 2018.

 

Background and Qualifications of Directors

 

When considering whether directors and nominees have the experience, qualifications, attributes and skills, taken as a whole, to enable the Board of Directors to satisfy its oversight responsibilities effectively in light of the Company’s business and structure, the Board focuses primarily on each person’s background and experience as reflected in the information discussed in each of the directors’ individual biographies set forth above. We believe that our directors provide an appropriate mix of experience and skills relevant to the size and nature of our business. As more specifically described in the biographies set forth above, our directors possess relevant knowledge and experience in the finance, accounting, and business fields generally, which we believe enhances the Board’s ability to oversee, evaluate and direct our overall corporate strategy.

 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS

 

The following table sets forth certain information, as of March 31, 2017, with respect to the beneficial ownership of our outstanding common stock and preferred stock by:

 

  ● any holder of more than 5% of our common stock,
     
  ● each of our named executive officers listed in the summary compensation table above,
     
  ● each of our directors, and
     
  ● our directors and current executive officers as a group.

 

Unless otherwise indicated, the business address of each person listed is in care of Surna Inc., 1780 55th Street, Suite C, Boulder, Colorado, 80301. The information provided herein is based upon 139,044,878 shares of common stock and 77,220,000 shares of preferred stock outstanding as of March 31, 2016. The percentages in the table have been calculated on the basis of treating as outstanding for a particular person, all shares of our common stock outstanding on that date and all shares of our common stock issuable to that holder in the event of exercise of outstanding options, warrants, rights or conversion privileges owned by that person at that date, which are exercisable within 60 days of that date. Except as otherwise indicated, the persons listed below have sole voting and investment power with respect to all shares of our common stock owned by them.

 

 30 
 

 

Shares Beneficially Owned as of March 20, 2017

 

   Common Stock   Preferred Stock   % of Total Voting 
Name of Beneficial Owner  Shares   %   Shares   %   Power(1) 
Current and Named Executive Officers and Directors:                         
Brandy Keen+   28,749,669    15.8%   35,189,669(2)   45.6%   14.5%
Stephen Keen+   28,749,669    15.8%   35,189,669(2)   45.6%   14.5%
Morgan Paxhia+   6,575,402(3)   3.6%   33,428,023    43.3%   9.1%
Trent Doucet+   3,088,800(5)   1.7%   -    -    0.7%

Timothy Keating+

   700,000(6)   0.4%   -    -    0.2%
+ Above, which are current officers and directors, as a group (5 individuals)   67,863,540    38.1%   68,617,692(4)   88.9%   23.6%
Other 5% Shareholders:                         
None   -    -    -    -    - 

 

  + Identifies Officers and Directors as of March 20, 2016.
     
  (1) Includes 178,155,530 shares of common stock and 77,220,000 shares of preferred stock outstanding as of March 20, 2016.
     
  (2) Includes 35,189,669 shares of preferred stock beneficially owned by Brandy Keen and Stephen Keen. The holders of preferred stock have one vote per share of preferred stock equivalent to one vote of common stock.
     
  (3) Securities are held of record by Demeter Capital Group LP (“Demeter”). Poseidon Asset Management, LLC is the general partner and/or investment manager of Demeter and, in such capacity, exercises voting and dispositive power over such securities. The managing members of Poseidon are Emily Paxhia and Morgan Paxhia. As managing members, they have the joint ability to vote or dispose of the securities. The business address of Demeter is 130 Frederick Street #102, San Francisco, California 94117.
  (4) Includes shares of preferred stock beneficially owned by Brandy Keen, Stephen Keen, and Morgan Paxhia
     
  (5)

3,088,800 shares of common stock issuable upon the exercise of a stock option held by Mr. Doucet. Mr. Doucet has presented the Company with his notice to exercise, but the shares were not issued as of March 30, 2017

     
  (6)

700,000 granted but not issued to Mr. Keating as part of his Board of Directors Agreement executed on March 14, 2017

 

 31 
 

 

ITEM 13. CERTAIN RELATIONSHIPS, RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE

 

As of December 31, 2016, the Company had a balance of $69,383 due to Stephen Keen, who is the Company’s Director of Technology and a Director of the Board and his spouse, Brandy Keen, who is Vice President of Sales and a Director of the Board. Of this balance, $69,383 is related to the purchase of Hydro Innovations, LLC. The balance is payable in monthly installments of $5,000. The note may be prepaid in whole or in part at any time.

 

Director Independence

 

Our determination of the independence of our directors is made using the definition of “independent” contained in the listing standards of The NASDAQ Stock Market LLC. On the basis of information solicited from each director, the Board of Directors has determined that Timothy Keating and Morgan Paxhia are the only independent directors within the meaning of such rules.

 

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

 

The following table shows RBSM, LLP billed for the audit and other services for the years ended December 31, 2016 and 2015:

 

   2016   2015 
Audit Fees  $94,816*  $161,500**
Audit-Related Fees   -    - 
Tax Fees   16,200***   - 
All Other Fees   -    - 
Total  $111,016   $161,500 

 

  * $64,816 relates to 2015.
  * * $116,500 relates to 2014.
  *** $16,200 was for prior years’ tax returns.

 

Audit Fees—This category includes the audit of our annual financial statements, review of financial statements included in our Quarterly Reports on Form 10-Q and services that are normally provided by the independent registered public accounting firm in connection with engagements for those fiscal years. This category also includes advice on audit and accounting matters that arose during, or as a result of, the audit or the review of interim financial statements.

 

Audit-Related Fees—This category consists of assurance and related services by the independent registered public accounting firm that are reasonably related to the performance of the audit or review of our financial statements and are not reported above under “Audit Fees.” The services for the fees disclosed under this category include consultation regarding our correspondence with the Commission and other accounting consulting.

 

Tax Fees—This category consists of professional services rendered by our independent registered public accounting firm for tax compliance and tax advice. The services for the fees disclosed under this category include tax return preparation and technical tax advice.

 

All Other Fees—This category consists of fees for other miscellaneous items.

 

Our Board of Directors has adopted a procedure for pre-approval of all fees charged by our independent registered public accounting firm. Under the procedure, the Board approves the engagement letter with respect to audit, tax and review services. Other fees are subject to pre-approval by the Board, or, in the period between meetings, by a designated member of Board. Any such approval by the designated member is disclosed to the entire Board at the next meeting.

 

 32 
 

 

PART IV

 

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

 

(a) Financial Statements.

 

The consolidated financial statements and Report of Independent Registered Public Accounting Firm are listed in the “Index to Consolidated Financial Statements” on page 29 and included on pages F-1 through F-26.

 

ITEM 16. FORM 10-K SUMMARY.

 

None.

 

  33 
  

 

SURNA INC.

 

    PAGE NO.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS:    
     
Report of Independent Registered Public Accounting Firm   F-1
     
Consolidated Balance Sheets as of December 31, 2016 and 2015   F-2
     
Consolidated Statements of Operations and Comprehensive Loss for the years ended December 31, 2016 and 2015   F-3
     
Consolidated Statements of Changes in Shareholders Deficit for the years ended December 31, 2016 and 2015   F-4
     
Consolidated Statements of Cash Flows for the years ended December 31, 2016 and 2015   F-5
     
Notes to Consolidated Financial Statements   F-6

 

  34 
  

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

Surna Inc.

Boulder, Colorado.

 

We have audited the consolidated balance sheets of Surna Inc. (the Company) and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of operations, stockholders’ deficit, and cash flows for each of the years in the two year period ended December 31, 2016. Surna, Inc’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of, Surna Inc. as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years in the two year period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America.

 

The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has suffered losses from operations, which raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

/s/ RBSM, LLP

 

Larkspur, CA

March 31, 2017

 

  F-1 
  

 

Surna Inc.

Consolidated Balance Sheets

 

    December 31,  
    2016     2015  
ASSETS            
Current Assets                
Cash   $ 319,546     $ 330,557  
Accounts receivable (net of allowance for doubtful accounts of $90,839 and $40,873, respectively)     47,166       299,194  
Note receivable     157,218       207,218  
Inventory     747,905       1,261,802  
Prepaid expenses     84,976       193,969  
Total Current Assets     1,356,811       2,292,740  
Noncurrent Assets                
Property and equipment, net     93,565       162,530  
Intangible assets, net     667,445       647,464  
Total Noncurrent Assets     761,010       809,994  
                 
TOTAL ASSETS   $ 2,117,821     $ 3,102,734  
                 
LIABILITIES AND SHAREHOLDERS’ DEFICIT                
                 
CURRENT LIABILITIES                
Accounts payable and accrued liabilities   $ 1,337,853     $ 2,066,803  
Deferred revenue     1,421,344       986,445  
Current portion of long term debt     -       1,551  
Amounts due to shareholders     57,398       216,995  
Convertible promissory notes, net     761,440       1,227,761  
Convertible accrued interest     161,031       201,257  
Derivative liability on conversion feature     -       472,967  
Derivative liability on warrants     477,814       139,192  
Total Current Liabilities     4,216,880       5,312,971  
                 
NONCURRENT LIABILITIES                
Convertible promissory notes, net     -       523,822  
Convertible accrued interest     -       80,674  
Other accrued interest     -       -  
Promissory note due shareholders     11,985       -  
Vehicle loan     -       32,564  
Total Noncurrent Liabilities     11,985       637,060  
                 
TOTAL LIABILITIES     4,228,865       5,950,031  
                 
SHAREHOLDERS’ DEFICIT                
Preferred stock, $0.00001 par value; 150,000,000 shares authorized; 77,220,000 shares issued and outstanding     772       772  
Common stock, $0.00001 par value; 350,000,000 shares authorized; 160,744,916 and 125,839,862 shares issued and outstanding, respectively     1,607       1,259  
Paid in capital     12,222,789       8,214,271  
Accumulated deficit     (14,336,212 )     (11,063,599 )
Total Shareholders’ Deficit     (2,111,044 )     (2,847,297 )
                 
TOTAL LIABILITIES AND SHAREHOLDERS’ DEFICIT   $ 2,117,821     $ 3,102,734  

 

The accompanying notes are integral to the consolidated financial statements

 

  F-2 
  

 

Surna Inc.

Consolidated Statements of Operations and Comprehensive Loss
For the years ended December 31,

 

    2016     2015  
Revenue   $ 7,579,863     $ 7,865,243  
                 
Cost of revenue     5,275,968       6,924,402  
                 
Gross margin     2,303,895       940,841  
                 
Operating expenses:                
Advertising and marketing expenses     149,858       309,620  
Product development costs     349,062       707,517  
Selling, general and administrative expenses     2,337,892       3,037,547  
Total operating expenses     2,836,812       4,054,684  
                 
Operating loss     (532,917 )     (3,113,843 )
                 
Other income (expense):                
Interest and other income (expense), net     40,157       24,547  
Interest expense     (373,688 )     (873,207 )
Amortization of debt discount on convertible promissory notes     (1,529,219 )     (2,220,115 )
Loss on extinguishment of debt     (338,241 )     (78,155 )
Loss (gain) on change in derivative liabilities     (538,705 )     964,751  
Total other income (expense)     (2,739,696 )     (2,182,179  
                 
Loss from continuing operations before provision for income taxes     (3,272,613 )     (5,296,022 )
                 
Provision for income taxes     -       -  
                 
Net loss     (3,272,613 )     (5,296,022 )
                 
Comprehensive loss   $ (3,272,613 )   $ (5,296,022 )
                 
Loss per common share – basic and dilutive   $ (0.02 )   $ (0.04 )
                 
Weighted average number of common shares outstanding, basic and dilutive     140,604,764       119,967,118  

 

The accompanying notes are integral to the consolidated financial statements

 

  F-3 
  

 

Surna Inc.

Consolidated Statements of Changes in Shareholders’ Deficit
For the years ended December 31, 2016 and 2015

 

  Preferred Stock     Common Stock     Additional              
    Number of Shares     Amount     Number of Shares     Amount     Paid in Capital     Accumulated Deficit     Shareholders’ Deficit  
Balance January 1, 2015     77,220,000     $ 772       113,511,250     $ 1,135     $ 4,881,918       (5,767,577 )     (883,752 )
Common shares issued for conversion of debt and interest, net of unamortized debt discount     -       -       25,169,786       252       1,668,015       -       1,668,267  
Reclassification of derivative liability to equity for debt conversion     -       -       -       -       791,409       -       791,409  
Reclassification of derivative liability to equity for change in classification     -       -       -       -       119,348       -       119,348  
Non-cash settlement of debt to related parties     -       -       -       -       194,958       -       194,958  
Imputed interest     -       -       -       -       2,924       -       2,924  
Common shares issued for compensation     -       -       539,028       5       45,035       -       45,040  
Common shares issued for services     -       -       866,571       9       82,444       -       82,453  
Common shares issued for cash, net     -       -       4,556,250       46       427,402       -       427,448  
Common shares issued for exercise of stock options     -       -       2,625,000       26       604       -       630  
Common shares cancelled with officer termination     -       -       (21,428,023 )     (214 )     214       -       -  
Net loss     -       -       -       -       -       (5,296,022 )     (5,296,022 )
                                                         
Balance December 31, 2015     77,220,000       772       125,839,862       1,259       8,214,271       (11,063,599 )     (2,847,297 )
Common shares issued for conversion of debt and interest, net of unamortized debt discount     -       -       33,365,609       334       3,234,992       -       3,235,326  
Reclassification of derivative liability to equity for debt conversion     -       -       -       -       673,050       -       673,050  
Common shares issued for compensation     -       -       46,045       -       4,028       -       4,028  
Common shares issued for exercise of stock options     -       -       1,493,400       14       342       -       356  
Value attributed to modification of warrants     -       -       -       -       96,106       -       96,106  
Net loss     -       -       -       -       -       (3,272,613 )     (3,272,613 )
                                                         
Balance December 31, 2016     77,220,000     $ 772       160,744,916     $ 1,607     $ 12,222,789     $ (14,336,212 )   $ (2,111,044 )

 

The accompanying notes are integral to the consolidated financial statements

 

  F-4 
  

 

Surna Inc.

Consolidated Statements of Cash Flows

For the years ended December 31,

 

    2016     2015  
Cash Flows From Operating Activities:                
Net loss   $ (3,272,613 )   $ (5,296,022 )
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:                
Depreciation and intangible asset amortization expense     53,084       67,766  
Amortization of debt discounts     1,529,219       2,220,115  
Amortization of original issue discount on notes payable     -       37,795  
Gain on change in derivative liability     538,705       (964,751 )
Consulting services paid in stock     -       82,453  
Employee compensation paid in stock     4,386       45,040  
Non-cash interest expense     -       750,640  
Provision for doubtful accounts     50,127       30,873  
Loss on extinguishment of debt     338,241       78,155  
Loss on sale of assets other     4,280       -  
                 
Changes in operating assets and liabilities:                
Accounts and notes receivable     179,793       64,763  
Inventory     513,897       (997,771 )
Prepaid expenses     131,099       (136,880 )
Accounts payable and accrued liabilities     (749,709 )     1,654,975  
Deferred revenue     434,899       578,246  
Accrued interest     373,688       80,760  
Deferred compensation     (25,600 )     25,600  
Other     -       (7,115 )
Cash provided by (used in) operating activities     103,496       (1,685,358 )
                 
Cash Flows From Investing Activities                
Purchases of intangible assets     (25,292 )     -  
Purchases of property and equipment     (18,189 )     (62,381 )
Proceeds from the sale of property equipment     35,100       -  
Cash disbursed for note receivable     (80,000 )     (160,000 )
Payments received on note receivable     130,000       65,000  
Other     -       (12,218 )
Cash provided by (used in) investing activities     41,619       (169,599 )
                 
Cash Flows From Financing Activities                
Proceeds from issuances of convertible notes     -       1,781,250  
Payments of financing fees     -       (27,146 )
Proceeds from exercises of stock options     -       630  
Payments on loans     (34,115 )     (145,153 )
Payments to related parties    

(122,011

 )     (114,030 )
Cash (used in) provided by financing activities    

(156,126

 )     1,495,551  
                 
Net decrease in cash     (11,011 )     (359,406 )
Cash, beginning of period     330,557       689,963  
Cash, end of period   $ 319,546     $ 330,557  
                 
Supplemental cash flow information:                
Interest paid   $ -     $ 26,126  
                 
Non-cash investing and financial activities:                
Conversions of promissory note balances to common stock   $ 3,235,326     $ 1,336,783  
Increase in paid in capital in connection with conversions of notes   $ -     $ 1,242,241  
Derivative liability on convertible notes and warrants   $ 673,050     $ (1,335,797 )
Debt retirement to former Chief Executive Officer   $ -     $ 194,858  

 

The accompanying notes are integral to the consolidated financial statements

 

  F-5 
  

 

Surna Inc.

Notes to Consolidated Financial Statements

December 31, 2016 and 2015

 

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Company:

 

Surna Inc. incorporated in Nevada on October 15, 2009. On March 26, 2014, we acquired Safari Resource Group, Inc. (“Safari”), a Nevada Corporation, whereby we became the sole surviving corporation after the acquisition of Safari. In July 2014, we acquired 100% of the membership interest in Hydro Innovations, LLC, a Colorado limited liability company, (“Hydro”), pursuant to which Hydro became a wholly-owned subsidiary of the Company. We engineer and manufacture innovative technology and products that address the energy and resource intensive nature of indoor cultivation. Our focus lies in supplying industrial solutions to commercial indoor cannabis cultivation facilities. The engineering team is tasked with creating novel energy and resource efficient solutions, including our signature liquid-cooled climate control platform. Our engineers continuously seek to create technologies that allow growers to easily meet the highly specific demands of a cannabis cultivation environment through temperature, humidity, light, and process control. Our objective is to provide intelligent solutions that improve the quality, control and overall yield and efficiency of indoor cannabis cultivation. We are headquartered in Boulder, Colorado.

 

The Company’s operations exclude the production or sale of marijuana.

 

History:

 

On September 1, 2011, Surna Inc. acquired Surna Media, Inc. (“Surna Media”) for 20,000,000 shares of its common stock. The merger with Surna Media was accounted for as among entities under common control. Surna Media’s predecessor entity, Surna Hong Kong Limited (“Surna HK”), was formed on June 14, 2010. Surna Media was formed October 29, 2010 by the same owners and Surna HK became a wholly-owned subsidiary. Flying Cloud Information Technology Co. Ltd. was incorporated in China in April 2011 as a wholly owned subsidiary of Surna HK (“Flying Cloud”). All of the Surna HK, Surna Media, and Flying Cloud transactions are consolidated with those of the Company beginning at the formation of Surna HK on June 14, 2010. Surna Networks, Inc. (“Surna Networks I”) and Surna Networks Ltd. (“Surna Networks II”) are wholly owned subsidiaries of the Company, formed on July 19, 2011 and August 2, 2011, respectively. On March 27, 2012, the Company sold Surna Networks I and Surna Networks II to Chan Kam Ming for a total sales price of US$1 and assumption of liability related to those companies. The Company assumed the liabilities of Surna Networks I and Surna Networks II, which totaled US$9,286. All significant intercompany transactions are eliminated. We sold Surna Media and its subsidiaries in 2014.

 

Financial Statement Presentation:

 

The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect reported amounts and related disclosures. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for a fair presentation have been included.

 

The accompanying consolidated financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has not generated sufficient revenue and has funded its operating losses through the sale of common stock and the issuance of debt. The Company has a limited operating history and its prospects are subject to risks, expenses and uncertainties frequently encountered by companies in the industry. (See Note 2.)

 

  F-6 
  

 

Basis of Consolidation and Reclassifications:

 

The consolidated financial statements include the accounts of the Company and its controlled and wholly-owned subsidiaries. Intercompany transactions, profit, and balances are eliminated in consolidation.

 

Certain reclassifications have been made to amounts in prior periods to conform to the current period presentation. All reclassifications have been applied consistently to the periods presented. The reclassifications had no impact on net loss or total assets and liabilities.

 

Use of Estimates:

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and that affect the reported amounts of revenue and expenses during the reporting period. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates. In addition, any change in these estimates or their related assumptions could have an adverse effect on our operating results. Key estimates include: valuation of derivative liabilities, valuation of intangible assets, and valuation of deferred tax assets and liabilities.

 

Cash and Cash Equivalents:

 

All highly liquid investments with original maturities of three months or less at the date of purchase are considered to be cash equivalents. The Company may, from time to time, have deposits in one financial institution that exceeds the federally insured amount.

 

Accounts Receivable and Allowance for Doubtful Accounts:

 

Accounts receivable are recorded at invoiced amount and generally do not bear interest. An allowance for doubtful accounts is established, as necessary, based on past experience and other factors, which, in management’s judgment, deserve current recognition in estimating bad debts. Such factors include growth and composition of accounts receivable, the relationship of the allowance for doubtful accounts to accounts receivable and current economic conditions. The determination of the collectability of amounts due from customer accounts requires the Company to make judgments regarding future events and trends. Allowances for doubtful accounts are determined based on assessing the Company’s portfolio on an individual customer and on an overall basis. This process consists of a review of historical collection experience, current aging status of the customer accounts, and the financial condition of the Company’s customers. Based on a review of these factors, the Company establishes or adjusts the allowance for specific customers and the accounts receivable portfolio as a whole. As of December 31, 2016 and 2015 the allowance for doubtful accounts was $90,839 and $40,873, respectively.

 

Inventory:

 

Inventory is stated at the lower of cost or market. The majority of inventory is valued based on a first-in, first-out (“FIFO”) basis. Lower of cost or market is evaluated by considering obsolescence, excessive levels of inventory, deterioration and other factors. Adjustments to reduce the cost of inventory to its net realizable value, if required, are made for estimated excess, obsolescence or impaired inventory. Excess and obsolete inventory is charged to cost of revenue and a new lower-cost basis for that inventory is established and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.

 

Property and Equipment:

 

Property and equipment are stated at cost. When retired or otherwise disposed, the related carrying value and accumulated depreciation are removed from the respective accounts and the net difference less any amount realized from disposition, is reflected in earnings. For financial statement purposes, property and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which is generally five years. Leasehold improvements are amortized on a straight-line basis over the lesser of their useful lives or the life of the lease. Upon sale or retirement of assets, the cost and related accumulated depreciation and amortization are removed from the balance sheet and the resulting gain or loss is reflected in operations. Maintenance and repairs are charged to operations as incurred.

 

  F-7 
  

 

Impairment of Long-Lived Assets:

 

Long-lived tangible assets are reviewed for impairment whenever events or changes in business circumstances indicate the carrying value of the assets may not be recoverable. When such an event occurs, management determines whether there has been impairment by comparing the anticipated undiscounted future net cash flows to the related asset’s carrying value. If an asset is considered impaired, the asset is written down to fair value, which is determined based either on discounted cash flows or appraised value, depending on the nature of the asset. The Company has not identified any such impairment losses to date.

 

Goodwill and Other Intangible Assets:

 

Goodwill is reviewed for impairment annually or more frequently when events or changes in circumstances indicate that fair value of the reporting unit has been reduced to less than its carrying value. The Company performs its impairment test annually during the fourth quarter. First, the Company assesses qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. If, after assessing qualitative factors, the Company determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. If deemed necessary, a two-step test is used to identify the potential impairment and to measure the amount of goodwill impairment, if any. The first step is to compare the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is considered not impaired; otherwise, there is an indication that goodwill may be impaired and the amount of the loss, if any, is measured by performing step two. Under step two, the impairment loss, if any, is measured by comparing the implied fair value of the reporting unit goodwill with the carrying amount of goodwill. We completed this assessment as of December 31, 2016, and concluded that no impairment existed.

 

Separable intangible assets that have finite useful lives continue to be amortized over their respective useful lives.

 

All of the Company’s identifiable intangible assets are subject to amortization on a straight-line basis over their estimated useful lives. Identifiable intangibles consist of intellectual property such as patents and trademarks, and capitalized software. Identifiable intangibles are also subject to evaluation for potential impairment if events or circumstances indicate the carrying value may not be recoverable.

 

Fair Value Measurement:

 

The accounting standards regarding fair value of financial instruments and related fair value measurements define fair value, establish a three-level valuation hierarchy for disclosures of fair value measurement and enhance disclosure requirements for fair value measures.

 

ASC Topic 820 establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows:

 

Level 1 - inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities.

 

Level 2 - inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument.

 

Level 3 - inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value.

 

On a Recurring Basis:

 

A financial asset or liability’s classification within the hierarchy is determined based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires management to make judgments and consider factors specific to the asset or liability. The Company has determined that the convertible debt instruments outstanding as of the date of these financial statements include an exercise price “reset” adjustment that qualifies as derivative financial instruments under the provisions of ASC 815-40, Derivatives and Hedging - Contracts in an Entity’s Own Stock (“ASC 815-40”). See Note 10 for discussion of the impact the derivative financial instruments had on the Company’s consolidated financial statements and results of operations.

 

  F-8 
  

 

Financial assets and liabilities carried at fair value, measured on a recurring basis as follows:

 

    December 31, 2016  
Description   Level 1     Level 2     Level 3     Gains (Losses)(1)  
Derivative liability on conversion feature   $ -     $ -       $      

(200,083

)

Derivative liability on warrants     -       -       477,814       (338,622 )
Total   $ -     $ -     $ 477,814     $ (538,705 )

 

(1) The loss on change in derivative liabilities of $538,705 presented in the statement of operations for the year ended December 31, 2016 also includes gains on derivatives associated with convertible promissory note balances outstanding at various dates during the year ended December 31, 2016, which were converted to common stock prior to December 31, 2016.

 

    December 31, 2015  
Description   Level 1     Level 2     Level 3     Gains (Losses)(2)  
Derivative liability on conversion feature   $ -     $ -     $ 472,967     $ 383,049  
Derivative liability on warrants     -       -       139,192       106,829  
Total   $ -     $ -     $ 612,159     $ 489,878  

 

(2) The gain on change in derivative liabilities of $964,751 presented in the statement of operations for the fiscal year ended December 31, 2015 also includes gains on derivatives associated with convertible promissory note balances outstanding at various dates during fiscal year 2015, which were converted to common stock prior to December 31, 2015.

 

Our Level 3 fair value liabilities represent contingent consideration recorded related to the embedded conversion features in the convertible notes issued in 2014 and 2015. The change in the balance of the conversion feature derivative liabilities and warrant liabilities during the fiscal years ended December 31, 2016 and 2015 was calculated using the Black-Scholes Model, which is classified as gain on change in derivative liabilities in the consolidated statement of operations. The Black-Scholes Model does take into consideration the Company’s stock price, historical volatility, and risk-free interest rate, which do have observable Level 1 or Level 2 inputs.

 

During the year ended December 31, 2016, the Company converted all of the Series 3 and 4 convertible promissory notes (see Note 9) issued in 2015 into common stock, which gave rise to the fair value liabilities for the embedded conversion features. At conversion, the balance of the derivative liability of, $673,050 has been credited to additional paid in capital in the consolidated balance sheet.

 

During the year ended December 31, 2015, the Company converted all of the Series 1 convertible promissory notes (see Note 9) issued in 2014 into common stock, which gave rise to the fair value liabilities for the embedded conversion features. At conversion, the balance of the derivative liability of, $791,409 has been credited to additional paid in capital in the consolidated balance sheet. Additionally, the Series 2 convertible promissory notes derivative liability balance of $119,348 was also credited to additional paid in capital. The Series 2 notes embedded conversion features were classified as derivative liabilities solely due to “sequencing” such that, when the Series 1 notes were converted the Series 2 notes are no longer derivatives.

 

  F-9 
  

 

On a Non-Recurring Basis:

 

In accordance with the provisions of ASC Topic 350, Intangibles – Goodwill and Other (“ASC Topic 350”), the Company estimates the fair value of reporting units, utilizing unobservable Level 3 inputs. Level 3 inputs require significant management judgment due to the absence of quoted market prices or observable inputs for assets of a similar nature. The Company utilizes a discounted cash flow analysis to estimate the fair value of reporting units utilizing unobservable inputs. The fair value measurements for goodwill under the step-one and step-two analysis of the quantitative goodwill impairment test are classified as Level 3 inputs.

 

Intangible assets that are amortized are evaluated for recoverability whenever adverse effects or changes in circumstances indicate that the carrying value may not be recoverable. The recoverability test consists of comparing the undiscounted projected cash flows with the carrying amount. Should the carrying amount exceed undiscounted projected cash flows, an impairment loss would be recognized to the extent the carrying amount exceeds fair value. For the Company’s indefinite-lived intangible asset, the impairment test consists of comparing the fair value, determined using the market value method, with its carrying amount. An impairment loss would be recognized for the carrying amount in excess of its fair value. As of December 31, 2016, the Company concluded that no indicators of impairment relating to intangible assets or goodwill existed and an interim test was not performed.

 

Due to their short-term nature, the carrying values of cash and equivalents, accounts receivable, accounts payable, and accrued expenses, approximate fair value. Based on borrowing rates currently available to the Company for loans with similar terms, the carrying value of the notes payable approximates fair value.

 

There were no changes in valuation technique from prior periods.

 

Derivative Financial Instruments:

 

We evaluate our financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the statements of operations. For stock-based derivative financial instruments, the Company uses the Black-Scholes Option Pricing Model to value the derivative instruments. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the end of each reporting period. Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date.

 

We have determined that certain convertible debt instruments outstanding as of the date of these financial statements include an exercise price “reset” adjustment that qualifies as derivative financial instruments under the provisions of ASC 815-40, Derivatives and Hedging - Contracts in an Entity’s Own Stock (“ASC 815-40”). Certain of the convertible debentures have a variable exercise price, thus are convertible into an indeterminate number of shares for which we cannot determine if we have sufficient authorized shares to settle the transaction with. Accordingly, the embedded conversion option is a derivative liability and is marked to market through earnings at the end of each reporting period.

 

We evaluate the application of ASC 815-40-25 to the warrants to purchase common stock issued with the convertible notes, and determined that the warrants were required to be accounted for as derivatives due to the provisions in certain convertible notes that result in our being unable to determine if we have sufficient authorized shares to settle the instrument. See Note 10 for discussion of the impact the derivative financial instruments had on the Company’s consolidated financial statements and results of operations.

 

Accordingly, the embedded conversion option and the warrants are derivative liabilities and are marked to market through earnings at the end of each reporting period. Any change in fair value during the period recorded in earnings as “Other income (expense) - gain (loss) on change in derivative liabilities.”

 

Revenue Recognition:

 

We recognize revenue from the sale of our products, which we primarily manufacture. Revenue is recognized when products are shipped or delivered and title passes to the customer, provided that persuasive evidence of an arrangement exists, the price is fixed or determinable, and collection of the resulting receivable is reasonably assured. Sales of our products are not subject to regulatory requirements that vary from state to state. We generally do not provide our customers with a contractual right of return. In certain limited circumstances, revenue could be recognized using the percentage-of-completion method as performance occurs. Management believes that all relevant criteria and conditions are considered when recognizing revenue.

 

  F-10 
  

 

Sales arrangements sometimes involve delivering multiple elements, including services such as installation. In these instances, the revenue assigned to each element is based on vendor-specific objective evidence, third-party evidence or a management estimate of the relative selling price. Revenue is recognized individually for delivered elements only if they have value to the customer on a stand-alone basis and the performance of the undelivered items is probable and substantially in our control, or the undelivered elements are inconsequential or perfunctory and there are no unsatisfied contingencies related to payment. We had no revenue arise from qualifying sales arrangements that include the delivery of multiple elements in fiscal year 2015 or 2014. The vast majority of these deliverables are tangible products, with a small portion attributable to installation. We do not provide any separate maintenance. Generally, contract duration is short term and cancellation, termination or refund provisions apply only in the event of contract breach, and have historically not been invoked.

 

The Company provides climate control equipment and installation services designed for the controlled environment agriculture industry through construction-type contracts with contract terms typically less than one year. Advance payments received from customers are included in deferred revenue, a component of current liabilities, until such time that all criteria are met, as noted above, and revenue is recognized.

 

Shipping and handling costs are reported within cost of sales in the consolidated statements of operations.

 

The Company accounts for sales taxes and other related taxes on a net basis, excluding such taxes from revenue.

 

Product Warranty:

 

Products are generally subject to a warranty period of the lesser of 12 months from start-up or 18 months from shipment. Warranty provides for the repair, rework, or replacement of products (at the Company’s option) that fail to perform within stated specification. We assessed the historical claims and, in 2015, claims were insignificant. In 2016, product warranty claims were approximately 1% of total annual revenue. We will continue to assess the need to record a warranty accrual at the time of sale going forward. Accordingly, a provision of $85,000 and $0 was established for 2016 and 2015 respectively.

 

Concentrations:

 

Two customers accounted for 14% and 10% of the Company’s revenue for the year ended December 31, 2016. One customer accounted for 10% of the Company’s revenue for the year ended December 31, 2015.

 

The Company’s accounts receivable from two customers make up 39% and 29% of the total balance as of December 31, 2016. The Company’s accounts receivable from four customers made up 89% of the total balance as of December 31, 2015.

 

Product Development:

 

The Company accounts for product development cost in accordance with Accounting Standards Codification subtopic 730-10, Research and Development (“ASC 730-10”). ASC 730-10 requires such costs be charged to expenses as incurred. Accordingly, internal product development costs are expensed as incurred. Third-party product developments costs are expensed when the contracted work has been performed or as milestone results have been achieved. For the years ended December 31, 2016 and 2015, we incurred $349,062 and $705,517, respectively, on product development, which is included in the consolidated statements of operations.

 

Accounting for Stock-Based Compensation:

 

Share-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as expense over the employee’s service period. The Company recognizes compensation expense on a straight-line basis over the requisite service period of the award.

 

We determined that the Black-Scholes Option Pricing Model is the most appropriate method for determining the estimated fair value for stock options or warrants. The Black-Scholes Model requires the use of highly subjective and complex assumptions that determine the fair value of share-based awards, including the equity instrument’s expected term and the price volatility of the underlying stock.

 

Equity instruments issued to nonemployees are recorded at their fair value on the measurement date and are subject to periodic adjustment as the underlying equity instruments vest.

 

  F-11 
  

 

Share-based payments to employees for compensation and nonemployees for services provided to the Company totaled $4,028 and $127,493 for the years ended December 31, 2016 and 2015, respectively.

 

Income Taxes:

 

The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax basis of the Company’s assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. A valuation allowance is recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized.

 

We must assess the likelihood that the Company’s deferred tax assets will be recovered from future taxable income, and to the extent the Company believes that recovery is not likely, we establish a valuation allowance. Management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities, and any valuation allowance recorded against the net deferred tax assets. We recorded a full valuation allowance as of December 31, 2016 and 2015. Based on the available evidence, the Company believes it is more likely than not that it will not be able to utilize its deferred tax assets in the future. We intend to maintain valuation allowances until sufficient evidence exists to support the reversal of such valuation allowances. We make estimates and judgments about its future taxable income that are based on assumptions that are consistent with our plans. Should the actual amounts differ from our estimates, the carrying value of our deferred tax assets could be materially impacted.

 

We recognize in the financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of operating expense. We do not believe there are any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within twelve months of the reporting date. There were no penalties or interest liabilities accrued as of fiscal year end December 31, 2016 or 2015, nor were any penalties or interest costs included in expense for the years ended December 31, 2016 and 2015.

 

The years under which we conducted our evaluation coincided with the tax years currently still subject to examination by major federal and state tax jurisdictions, those being 2010 through 2016 for federal purposes and 2014 through 2016 for state purposes.

 

Comprehensive Income (Loss):

 

Comprehensive income (loss) represents the change in shareholders’ equity (deficit) of an enterprise, other than those resulting from shareholder transactions. Accordingly, comprehensive income (loss) may include certain changes in shareholders’ equity (deficit) that are excluded from net income (loss). For the years ended December 31, 2016 and 2015, the Company’s comprehensive loss is the same as its net loss.

 

Basic and Diluted Net Loss per Common Share:

 

Basic net loss per common share is computed by dividing net loss by the weighted-average number of common shares outstanding during the period. Diluted net loss per common share is determined using the weighted-average number of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents. In periods when losses are reported, the weighted-average number of common shares outstanding excludes common stock equivalents, because their inclusion would be anti-dilutive. As of December 31, 2016, the Company had approximately 11,400,000 common stock equivalents.

 

Commitments and Contingencies:

 

In the normal course of business, the Company is subject to loss contingencies, such as legal proceedings and claims arising out of its business, that cover a wide range of matters, including, among others, government investigations, environment liability and tax matters. An accrual for a loss contingency is recognized when it is probable that an asset had been impaired or a liability had been incurred and the amount of loss can be reasonably estimated.

 

  F-12 
  

 

Other Risks and Uncertainties:

 

To achieve profitable operations, the Company must successfully develop, manufacture, and market its products. There can be no assurance that any such products can be developed or manufactured at an acceptable cost and with appropriate performance characteristics, or that such products will be successfully marketed. These factors could have a material adverse effect upon the Company’s financial results, financial position, and future cash flows.

 

The Company is subject to risks common to companies who supply the cannabis industry including, but not limited to, new technological innovations, dependence on key personnel, protection of proprietary technology, compliance with government regulations, uncertainty of market acceptance of products, product liability, and the need to obtain additional financing. The Company’s ultimate success is dependent upon its ability to raise additional capital and to successfully develop and market its products.

 

Segment Information:

 

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is its senior management team. The Company has one operating segment that is dedicated to the manufacture and sale of its products.

 

Recent Accounting Pronouncements:

 

In January 2017, the FASB issued Accounting Standards Update No. 2017-01, Clarifying the Definition of a Business (“ASU 2017-01”). The standard clarifies the definition of a business by adding guidance to assist entities in evaluating whether transactions should be accounted for as acquisitions of assets or businesses. ASU 2017-01 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Under ASU 2017-01, to be considered a business, the assets in the transaction need to include an input and a substantive process that together significantly contribute to the ability to create outputs. Prior to the adoption of the new guidance, an acquisition or disposition would be considered a business if there were inputs, as well as processes that when applied to those inputs had the ability to create outputs. Early adoption is permitted for certain transactions. Adoption of ASU 2017-01 may have a material impact on the Company’s consolidated financial statements if it enters into future business combinations.

 

In January 2017, the FASB issued Accounting Standards Update No. 2017-04, Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). ASU 2017-04 simplifies the accounting for goodwill impairment by removing Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation. ASU 2017-04 is effective for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019, and should be applied on a prospective basis. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated results of operations, cash flows and financial position.

 

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). This ASU requires changes in the presentation of certain items in the statement of cash flows including but not limited to debt prepayment or debt extinguishment costs; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies and distributions received from equity method investees. This guidance will be effective for annual periods and interim periods within those annual periods beginning after December 15, 2017, will require adoption on a retrospective basis and will be effective for the Company on January 1, 2018. The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated results of operations, cash flows and financial position.

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments within this ASU replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Entities may early adopt the amendments within this ASU but not prior to the fiscal years beginning after December 15, 2018, including the interim periods within those fiscal years. An entity will apply the amendments in this Update through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (that is, a modified-retrospective approach). However, a prospective transition approach is required for debt securities for which an other-than-temporary impairment had been recognized before the effective date. The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated results of operations, cash flows and financial position.

 

  F-13 
  

 

In March 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. This ASU is designed to address simplification of several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption of this ASU is permitted and would be applied on a retrospective basis back to the beginning of fiscal year that included any such interim period in which early adoption was elected. The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated results of operations, cash flows and financial position.

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) which requires companies leasing assets to recognize on their balance sheet a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term on contracts longer than one year. The lessee is permitted to make an accounting policy election to not recognize lease assets and lease liabilities for short-term leases. How leases are recorded on the balance sheet represents a significant change from previous GAAP guidance in Topic 840. ASU 2016-02 maintains a distinction between finance leases and operating leases similar to the distinction under previous lease guidance for capital leases and operating leases. The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated results of operations, cash flows and financial position. ASU 2016-02 is effective for fiscal periods beginning after December 15, 2018, and early adoption is permitted. The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated results of operations, cash flows and financial position.

 

In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The amendments in this Update address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. ASU 2016-01 is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated results of operations, cash flows and financial position.

 

In July 2015, the FASB issued ASU 2015-11, Simplifying the Measurement of Inventory. ASU 2015-11 simplifies the subsequent measurement of inventory by replacing today’s lower of cost or market test with a lower of cost and net realizable value test. The guidance applies only to inventories for which cost is determined by methods other than last-in first-out (LIFO) and the retail inventory method (RIM). Entities that use LIFO or RIM will continue to use existing impairment models (e.g., entities using LIFO would apply the lower of cost or market test). The guidance is effective for public business entities for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. Early adoption is permitted as of the beginning of an interim or annual reporting period. The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated results of operations, cash flows and financial position.

 

 

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, issued as a new Topic, ASC Topic 606. The new revenue recognition standard supersedes all existing revenue recognition guidance. Under this ASU, an entity should recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2015-14, issued in August 2015, deferred the effective date of ASU 2014-09 to the first quarter of 2018, with early adoption permitted in the first quarter of 2017. The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated results of operations, cash flows and financial position.

 

In March, April, May, and December 2016, the FASB issued the following updates, respectively, to provide supplemental adoption guidance and clarification to ASU 2014-09. These standards must be adopted concurrently upon the adoption of ASU 2014-09. We are currently evaluating the potential effects of adopting the provisions of these updates.

 

● ASU No. 2016-08, Revenue from Contracts with Customers: Principal versus Agent Considerations (Reporting Revenue Gross versus Net)
   
● ASU No. 2016-10, Revenue from Contracts with Customers: Identifying Performance Obligations and Licensing;
   
● ASU No. 2016-12, Revenue from Contracts with Customers: Narrow-Scope Improvements and Practical Expedients; and
   
●  ASU No. 2016-19, Technical Corrections and Improvements

 

  F-14 
  

 

NOTE 2 - GOING CONCERN

 

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company has experienced recurring losses since its inception. The Company incurred a net loss of approximately $3,300,000 for the year ended December 31, 2016, and had an accumulated deficit of approximately $14,340,000 as of December 31, 2016. Since inception, the Company has financed its activities principally through debt and equity financing. Management expects to incur additional losses and cash outflows in the foreseeable future in connection with development of its operating activities.

 

The Company’s consolidated financial statements have been presented on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.

 

The Company is subject to a number of risks similar to those of other similar stage companies, including dependence on key individuals, successful development, marketing and branding of products; uncertainty of product development and generation of revenues; dependence on outside sources of financing; risks associated with research, development; dependence on third-party content providers, suppliers and collaborators; protection of intellectual property; and competition with larger, better-capitalized companies. Ultimately, the attainment of profitable operations is dependent on future events, including obtaining adequate financing to fulfil its development activities and generating a level of revenues adequate to support the Company’s cost structure. To support the Company’s financial performance, management has undertaken several initiatives, including the raising of additional financing subsequent to year end:

 

In November and December 2016 and January and February 2017, the Company was successful in negotiating the extinguishing its convertible promissory notes with the issuance of shares of its common stock (See Note 16 - Subsequent Events.

 

In March 2017, the Company raised $2,685,000 through a private placement sale of 16,781,250 shares of the Company’s common stock to accredited investors (see Note 16 - Subsequent Events).

 

There can be no assurance however that such financing will be available in sufficient amounts, when and if needed, on acceptable terms or at all. If results of operations for 2017 do not meet management’s expectations, or additional capital is not available, management believes it has the ability to reduce certain expenditures. The precise amount and timing of the funding needs cannot be determined accurately at this time, and will depend on a number of factors, including the market demand for the Company’s products and services, the quality of product development efforts, management of working capital, and continuation of normal payment terms and conditions for purchase of services. The Company is uncertain whether its cash balances and cash flow from operations will be sufficient to fund its operations for the next twelve months. If the Company is unable to substantially increase revenues, reduce expenditures, or otherwise generate cash flows for operations, then the Company will need to raise additional funding to continue as a going concern through its major shareholder(s), or through other avenues.

 

NOTE 3 - INVENTORY

 

Inventory consisted of the following as of December 31,:

 

    2016     2015  
Finished goods   $ 591,564     $ 619,319  
Work in progress     16,518       43,466  
Raw materials     187,192       599,017  
Reserve for Excess & Obsolete Inventory     (47,369 )     -  
Total inventory   $ 747,905     $ 1,261,802  

 

Overhead expenses of $26,764 and $73,125 were included in the inventory balance as of December 31, 2016 and 2015, respectively. This includes depreciation expense of $417 and $5,869 as of December 31, 2016 and 2015, respectively.

 

  F-15 
  

 

NOTE 4 - PROPERTY AND EQUIPMENT

 

Property and equipment consists of the following as of December 31,:

 

    2016     2015  
Furniture and equipment   $ 171,709     $ 168,899  
Molds     31,063       31,063  
Vehicles     15,000       62,286  
Leasehold Improvements     38,101       35,804  
      255,873       298,052  
Accumulated depreciation     (162,308 )     (135,522 )
Property and equipment, net   $ 93,565     $ 162,530  

 

Depreciation expense amounted to $55,296 for the year ended December 31, 2016, of which $8,349 was allocated to cost of revenue and inventory. Depreciation expense amounted to $59,168 for the year ended December 31, 2015, of which $16,322 was allocated to cost of revenue and inventory.

 

NOTE 5 - INTANGIBLE ASSETS

 

Intangible assets consist of the following as of December 31,:

 

    2016     2015  
Intellectual property   $ 48,004     $ 22,712  
Accumulated amortization     (11,623 )     (6,312 )
      36,381       16,400  
Goodwill     631,064       631,064  
Intangible assets, net   $ 667,445     $ 647,464  

 

Goodwill of an acquired company is neither amortized nor deductible for tax purposes and is primarily related to expected improvements in sales growth from future product and service offerings, new customers and productivity.

 

Intangible assets have an estimated life of 5 years. Amortization expense for the intangible assets was $5,311 and $4,100 for the years ended December 31, 2016 and 2015, respectively.

 

Expected future amortization expense of acquired intangible assets as of December 31, 2016 is as follows:

 

Year Ended December 31,        
2017     $ 4,757  
2018       4,757  
2019       4,757  
2020       4,757  
Total     $ 19,028  

 

NOTE 6 - PATENTS AND TRADEMARKS

 

Surna relies on a combination of patent and trademark rights, trade secrets, laws that protect intellectual property, confidentiality procedures, and contractual restrictions with its employees and others to establish and protect its intellectual property rights. As of December 31, 2016, the Company has eight pending patent applications and four issued patents. The pending patent applications are a combination of PCT, utility and design patent applications that are directed to certain core Company technology. The Company’s four issued patents are U.S. design patents related to the Company’s Reflector. The U.S. design patents provide protection for 14 years from the date of issue. Utility patents provide protection for 20 years from the earliest non-provisional application filing date. The Company has registered trademarks for its core brand (“Surna”), including the wordmark alone, the associated logo, and the combined wordmark and logo in the United States. The wordmark is also registered in the European Union and is pending registration in Canada. Subject to ongoing use and renewal, trademark protection is potentially perpetual.

 

  F-16 
  

 

NOTE 7 - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

 

Accounts payable and accrued liabilities consist of the following as of December 31,:

 

    2016     2015  
Accounts payable   $ 1,020,224     $ 1,849,544  
Sales commissions payable     40,736       73,711  
Sales tax payable     23,631       65,758  
Accrued payroll liabilities     43,573       34,965  
Other accrued expenses     209,689       42,825  
Total   $ 1,337,853     $ 2,066,803  

 

NOTE 8 - RELATED PARTY TRANSACTIONS

 

In July of 2014 the Company issued a $250,000 promissory note (“Hydro2 Note”) to Stephen and Brandy Keen. Stephen Keen was the Chief Executive Officer at the time of the note, and is now Director of Technology, and his wife, Brandy, who is Vice President of Sales as part of the purchase price of Hydro Innovations. On April 15, 2016 (the “Effective Date”) the parties entered into an amendment to the original agreement (the “Amendment”). In accordance with the terms of the Amendment, the Company made a payment of $100,000 on or around the Effective Date which resulted in the reduction of the outstanding balance from $194,514 to $94,514. Additionally, pursuant to the Amendment, the Company was not obligated to make further payments until July 2016 at which time the Company resumed monthly payments equal to $5,000 per month. The interest rate remained at 6% per annum. The parties agreed that the note no longer had to be paid in full by July 18, 2016 and no default had occurred. As of December 31, 2016, the Hydro2 Note had a balance of $69,383 with $57,398 and $11,985 reflected on the balance sheet as current and long-term respectively.

 

As of December 31, 2015, there was a deferred compensation balance of $25,600 due to Stephen and Brandy Keen. This balance was paid in full during 2016.

 

During the year ended December 31, 2015, $194,958 of debt due to the Company’s former Chief Executive Officer, Tom Bollich, was retired for a one-time, immediate cash payment of $100. The related party extinguishment has been recognized as a credit to additional paid in capital.

 

NOTE 9 - CONVERTIBLE PROMISSORY NOTES

 

The following table summarizes the convertible promissory notes for the years ended December 31, 2016 and 2015:

 

    Series 1     Series 2     Series 3     Series 4     Total  
Balance January 1, 2015   $ 1,336,783     $ 1,625,000     $       $       $ 2,961,783  
Additions             911,250       711,000       103,273       1,725,523  
Conversions     (1,336,783 )                             (1,336,783 )
Balance December 31, 2015     -       2,536,250       711,000       103,273       3,350,523  
Discounts and deferred finance charges                                     (1,598,940 )
Convertible notes payable, net                                     1,751,583  
Less current portion - December 31, 2015                                     1,227,761  
Long-term portion - December 31, 2015                                   $ 523,822  
                                         
Balance January 1, 2016                                   $ 3,350,523  
Conversions                                     (2,570,523 )
Balance December 31, 2016                                     780,000  
Discounts and deferred finance charges                                     (18,560 )
Convertible notes payable, net                                     761,440  
Less current portion - December 31, 2016                                     761,440  
Long-term portion - December 31, 2016                                   $ -  

 

  F-17 
  

 

Conversions:

 

During the year ended December 31, 2015, the Company issued 25,169,786 shares of its common stock in connection with conversions of the Series 1 Notes for $1,336,783 principal amount and $216,141 accrued interest. The total of $1,668,267 was allocated to common stock and additional paid in capital because of the conversion.

 

During the year ended December 31, 2016, the Company issued 17,888,828 shares of its common stock in connection with the conversions of the Series 3 & 4 notes for $814,273 and $74,632 accrued interest. The total of $888,905 was allocated to common stock and additional paid in capital as a result of the conversion.

 

The Company entered into negotiations with certain of the Series 4 noteholders for them to convert principal and interest into shares of the Company’s common stock. As an incentive for them to convert, the Company agreed to amend the notes and the warrants

 

During the year ended December 31, 2016, the Company entered into note conversion and warrant amendment agreements (each, an “Agreement” and together, the “Agreements”) to: (i) amend the convertible promissory notes – series 2 (Original Notes”) to reduce the conversion price of such holder’s Original Note and simultaneously cause the conversion of the outstanding amount under such Original Note into shares of common stock of the Company (“Conversion Shares”); and (ii) reduce the exercise price of the original warrant (“Original Warrants” and together with an amended notes and the amended warrants, the “Amendments”). Each Agreement has been privately negotiated so the terms vary. Pursuant to the Agreements, the Original Notes have been amended to reflect a reduced conversion price per share between $0.09 and $0.22. Additionally, pursuant to the Agreements, the Original Warrants have been amended to reflect a reduced exercise price per share between $0.30 and $0.35, except for one Original Warrants to reflect a reduced exercise price of $0.15 per share.

 

Pursuant to the Agreements, the Company has (i) converted Original Notes with an aggregate outstanding principal amount of approximately $1,756,250 and accrued interest of $399,063, of the total principal amount under the Original Notes, (ii) issued 14,871,781 shares of the Company’s common stock in connection with the conversion of such Original Notes and (iii) amended Original Warrants to reduce their exercise price.

 

The Company has accounted for the Amended agreements as debt extinguishment in accordance with ASC 470 - Debt section 470-50-40-2 where by the difference between the reacquisition price of the debt and the net carrying amount of the extinguished debt was recognized as a loss during for the year ended December 31, 2016. The following details the calculation of the loss on extinguishment of the notes payable – series 2:

 

Carrying Amount of debt      
Principal converted   $ 1,756,250  
Interest converted     399,063  
Unamortized debt discount     (51,208 )
      2,104,105  
Reacquisition price of debt        
Fair value of shares issued     2,346, 240  
Warrant modification value     96,106  
      2,442,346  
Loss on Extinguishment   $ (338,241 )

 

Convertible Promissory Notes – Series 1

 

During the period ended December 31, 2014, the Company issued Series 1 convertible promissory notes (“Series 1 Notes”) in the aggregate principal amount of $1,336,783. The Series 1 Notes (i) were unsecured, (ii) bore interest at the rate of 10% per annum, and (iii) were due two years from the date of issuance. The Series 1 Notes were convertible at any time at the option of the investor into a number of shares of the Company’s common stock that is determined by dividing the amount to be converted by the lesser of (i) $1.00 per share or (ii) eighty percent (80%) of the prior thirty-day weighted average market price for the Company’s common stock. During the fiscal year ended December 31, 2015, all of the Series 1 Notes were converted into 25,169,786 shares of common stock.

 

  F-18 
  

 

Due to the variable conversion price, the number of shares issuable upon conversion was variable and the fact that there was no cap on the number of shares that could have been issued in exchange for these convertible promissory notes, the Company determined that the conversion feature was considered a derivative liability. The accounting treatment of derivative financial instruments requires that the Company record the fair value of the derivatives as of the inception date of the convertible promissory notes and to adjust the fair value as of each subsequent balance sheet date. Upon the issuance of the Series 1 Notes, the Company determined a fair value of $1,324,283 of the embedded derivative. The fair value of the embedded derivative was determined using intrinsic value up to the face amount of the Series 1 Notes.

 

The initial fair value of the embedded debt derivative of $1,324,283 was allocated as a debt discount and a conversion feature derivative liability. The debt discount was being amortized over the two-year term of the Series 1 Notes. Upon conversion of each Series 1 Note, the unamortized portion of the debt discount was recorded as amortization of debt discount on convertible notes. The Company recognized a charge of $916,094 for the year ended December 31, 2015 for amortization of this debt discount.

 

Convertible Promissory Notes – Series 2

 

In October 2014, the Company engaged a placement agent to act on a “best efforts” basis for the Company in connection with the structuring, issuance, and private placement for the sale of debt and/or equity securities. The Company offered up to 60 investment units (each, a “Unit”) with each Unit sold at a price of $50,000 and consisting of (i) two hundred fifty thousand (250,000) shares of the Company’s common stock, par value $0.00001; (ii) a $50,000 10% convertible promissory note, (“Series 2 Note”); and (iii) warrants for the purchase of 50,000 shares of the Company’s common stock. The Series 2 Notes (i) are unsecured, (ii) bear interest at the rate of 10% per annum, and (iii) are due two years from the date of issuance. The Series 2 Notes are convertible after 360 days from the issuance date at the option of the investor into a number of shares of the Company’s common stock that is determined by dividing the amount to be converted by the $0.60 conversion price. If not converted, the debt is payable in full twenty-four months from the issuance date. Additionally, the entire principal amount due on each Series 2 Note shall be automatically converted into common stock at the automatic conversion price (the greater of $0.50 per share or 75% of the public offering price per share) without any action of the purchaser on the earlier of: (x) the date on which the Company closes on a financing transaction involving the sale of the Company’s common stock at a price of no less than $2.00 per share with gross proceeds to the Company of no less than $5,000,000; or (y) the date which is three (3) days after the common stock shall have traded at a VWAP of at least $2.00 per share for a period of ten (10) consecutive trading days. The Company raised $2,536,250 from the sale of these Units.

 

The gross proceeds from the sale of the Series 2 Notes are recorded net of a discount related to the conversion feature of the embedded conversion option. When the fair value of conversion options is in excess of the debt discount the amount has been included as a component of interest expense in the statement of operations. The fair value of the embedded conversion option and the fair value of the warrants underlying the Series 2 Note issued at the time of their issuance were calculated pursuant to the Black-Scholes Model. The fair value was recorded as a reduction to the Series 2 Notes payable and was charged to operations as interest expense in accordance with the effective interest method within the period of the Series 2 Notes. Transaction costs are apportioned to Series 2 Notes payable, common stock, warrants and derivative liabilities. The portion of transaction costs attributed to the conversion feature, warrants and common stock are immediately expensed, because the derivative liabilities are accounted for at fair value through the statement of operations. Any non-cash issuance costs are accounted for separately and apart from the allocation of proceeds. However, if the non-cash issuance costs are paid in the form of convertible instruments, the convertible instruments issued are subject to the same accounting guidance as those sold to investors after first applying the guidance of ASC 505-50 (Stock-Based Compensation Issued to Nonemployees). There were no non-cash issuance costs.

 

Convertible Notes – Series 3

 

Starting in the third fiscal quarter of 2015, the Company entered into Securities Purchase Agreements (the “SPAs”) with three accredited investors (each a “Purchaser” and together the “Purchasers”), pursuant to which the Company sold and the Purchasers purchased convertible notes with a one year term in the aggregate original principal amount of $711,000, with an aggregate original issue discount of $61,000 (each a “Note” and together the “Notes”), and warrants to purchase up to an aggregate of 2,625,000 shares of the Company’s common stock, subject to adjustment, for aggregate cash proceeds of $656,250. The conversion price is equal to 80% of the lowest trading price of our common stock as reported on the OTCQB for the fifteen prior trading days. These convertible notes and the Amended 2015 Note (see Note 9) have an embedded conversion option that qualifies for derivative accounting and bifurcation under ASC 815-15 Derivatives and Hedging. Pursuant to ASC 815, “Derivatives and Hedging”, the Company recognized the fair value of the embedded conversion feature as a derivative liability upon issuance of the Notes.

 

  F-19 
  

 

The following table outlines the key terms of the Notes:

 

    Note 1     Note 2     Note 3     Note 4     Note 5     Total  
Term     1 year       1 year       1 year       1 year       1 year          
Origination Date     Jul 2015       Jul 2015       Sept 2015       Sept 2015       Sept 2015          
Cash Received   $ 150,000     $ 100,000     $ 200,000     $ 100,000     $ 100,000     $ 650,000  
Note Face Value   $ 165,000     $ 106,000     $ 220,000     $ 110,000     $ 110,000     $ 711,000  
Original Issue Discount   $ 15,000     $ 6,000     $ 20,000     $ 10,000     $ 10,000     $ 61,000  
Financing Expense   $ -     $ -     $ 6,000     $ 3,000     $ 13,000     $ 22,000  
Interest Rate     10 %     11 %     10 %     10 %     10 %        
Conversion % of Stock Value     80 %     80 %     80 %     80 %     80 %        
Share Reserve Minimum     10,000,000       10,000,000       10,000,000       10,000,000       10,000,000       50,000,000  
Warrants     500,000       375,000       750,000       500,000       500,000       2,625,000  
Warrant Exercise Price   $ 0.25     $ 0.25     $ 0.25     $ 0.25     $ 0.25          
Warrant Term     5 Years       5 Years       5 Years       5 Years       5 Years          

 

The gross proceeds from the sale of the debentures are recorded net of a discount of related to the embedded conversion feature. When the fair value of conversion options is in excess of the debt discount the amount has been included as a component of interest expense in the statement of operations. During the year ended December 31, 2015, the Company recorded $373,881 of interest expense relating to the excess fair value of the conversion option over the face value of the debentures. The fair value of the embedded conversion option and the warrants associated with the promissory notes at the time of their issuance was calculated pursuant to the Black-Scholes Model. The fair value was recorded as a reduction to the promissory notes payable and was charged to operations as interest expense in accordance with effective interest method within the period of the promissory notes. Transaction costs are apportioned to the debt liability, common stock and derivative liabilities. The portion of transaction costs attributed to the conversion feature, warrants and common stock are immediately expensed, because the derivative liabilities are accounted for at fair value through the statement of operations. Any non-cash issuance costs are accounted for separately and apart from the allocation of proceeds. However, if the non-cash issuance costs are paid in the form of convertible instruments, the convertible instruments issued are subject to the same accounting guidance as those sold to investors after first applying the guidance of ASC 505-50 (Stock-Based Compensation Issued to Nonemployees). There were no non-cash issuance costs.

 

Upon issuance of the Notes, the Company determined a fair value of $1,023,881 for the derivative liabilities. The fair value of the warrants was determined to be $246,020 and the fair value of the conversion feature was $777,861. The aggregate debt discount is being amortized over the one year term of the convertible promissory notes.

 

Convertible Note – Series 4

 

On December 18, 2015, the July 2015 Secured Note (see Note 9) balance of $103,319 ($100,273 principal and accrued interest of $3,046) was mutually extended to a new Maturity Date from December 22, 2015 to April 30, 2016 (the “Amended 2015 Note”). In consideration of the extension the Company amended the terms to include a conversion feature. The Amended 2015 Note is convertible into shares of our common stock at any time following the Extension and Amendment Agreement date. The conversion price is equal to 70% of the lowest trading price of our common stock as reported on the OTCQB for the twenty prior trading days.

 

The Amended 2015 Note has an embedded conversion option that qualifies for derivative accounting and bifurcation under ASC 815-15 Derivatives and Hedging. Pursuant to ASC 815, “Derivatives and Hedging”, the Company recognized the fair value of the embedded conversion feature as a derivative liability when the Amended 2015 Note became convertible on December 18, 2015. The increase in the fair value of the embedded note conversion liability was $78,155, calculated using the Black-Scholes Option Pricing Model. In accordance with ASC 470, since the present value of the cash flows under the new debt instrument was at least ten percent different from the present value of the remaining cash flows under the terms of the original debt instrument, the Company accounted for the amendment as a debt extinguishment. Accordingly, for the year ended December 31, 2015, the Company recorded a $78,155 loss on extinguishment of debt in the consolidated statement of operations.

 

  F-20 
  

 

For the year ended December 31, 2016 and 2015, the Company recognized amortization expense for the debt discounts on the convertible promissory notes of $1,529,219 and $2,220,115, respectively. Also, for the years ended December 31, 2016 and 2015, the Company recognized interest expense for the convertible promissory notes of approximately $500,000 and $429,561, respectively.

 

NOTE 10 - DERIVATIVE LIABILITIES

 

The Series 1 convertible promissory notes discussed in Note 10 have a variable conversion price, which results in a variable number of shares needed for settlement that gave rise to a derivative liability for the embedded conversion feature. Due to the variable conversion price in the Series 1 convertible notes, the warrants to purchase shares of common stock are also classified as a liability. The fair value of the conversion feature derivative liability is recorded and shown separately under noncurrent liabilities. Changes in the fair values of the derivative liabilities related to the embedded conversion feature and the warrants are recorded in the statement of operations under other income (expense).

 

During the year ended December 31, 2015, the Company converted all of the Series 1 convertible promissory notes issued in 2014 into common stock, which gave rise to fair value liabilities for the embedded conversion features. At conversion, the balance of the derivative liability of $791,409 was credited to additional paid in capital in the consolidated balance sheet.

 

Additionally, the Series 2 convertible promissory notes derivative liability balance of $119,348 was also credited to additional paid in capital. The Series 2 notes embedded conversion features were classified as a derivative liability solely due to “sequencing” such that, when the Series 1 notes were converted the Series 2 notes are no longer considered a derivative.

 

Additionally, the Series 3 and 4 convertible promissory notes discussed in Note 10 have a variable conversion price, which results in a variable number of shares needed for settlement that gave rise to a derivative liability for the embedded conversion feature. Both the variable conversion price in the Series 3 convertible notes as well as a “Half Ratchet” or “Down Round Protection” clause in the warrant agreements require classification of the warrants as a derivative liability. The fair value of the conversion feature derivative liability and the warrant liability are recorded and shown separately under current liabilities. Changes in the fair values of the derivative liabilities related to the embedded conversion feature and the warrants are recorded in the statement of operations under other income (expense). At conversion, the balance of the derivative liability of $673,050 was credited to additional paid in capital in the consolidated balance sheet.

 

The following table sets forth movement in the derivative liability from the initial measurement at issuance date through December 31, 2016:

 

Balance December 31, 2014   $ 1,151,870  
Initial measurement at issuance date of convertible promissory notes     1,335,797  
Change in derivative liability, net     (1,875,508 )
Balance December 31, 2015     612,159
Change in derivative liability, net     (134,345 )
Balance December 31, 2016   $ 477,814  

 

NOTE 11 - VEHICLE LOAN

 

During the year ended December 31, 2014, the Company financed a vehicle. The original balance of the loan was $47,286. The balance of the loan as of December 31, 2015 was $34,115. In January 2016, the Company paid the balance of the loan in full.

 

NOTE 12 - COMMITMENTS AND CONTINGENCIES

 

Operating Leases

 

The Company holds a lease agreement for its manufacturing and office space consisting of approximately 18,000 square feet. The lease term extends through April 1, 2017. The Company is in the process of negotiating a 90-day extension for our expired lease. We are in the process of evaluating our future office and warehouse needs, so we plan to continue with 90-day extensions under our expired lease agreement until we determine our office and warehouse requirements.

 

Rent expense for office space amounted to $237,552 and $237,617 for the years ended December 31, 2016 and 2015, respectively.

 

  F-21 
  

 

Employment agreements

 

The Company has employment agreements with Brandy Keen as its Vice President of Sales and Stephen Keen as its Director of Technology to pay each an annual base salary of $96,000. The Company agreed to employ Mr. and Ms. Keen for a period of three years beginning on July 25, 2014. Notwithstanding the 3-year term, each of the Keens’ employment agreements are at-will and may be terminated at any time, with or without cause. The committed amount payable over the remaining term of the Keens’ agreements totals $112,000.

 

Other Commitments

 

In the ordinary course of business, the Company may provide indemnifications of varying scope and terms to customers, vendors, lessors, business partners, and other parties with respect to certain matters, including, but not limited to, losses arising out of the Company’s breach of such agreements, services to be provided by the Company, or from intellectual property infringement claims made by third parties. In addition, the Company has entered into indemnification agreements with its directors and certain of its officers and employees that will require the Company to, among other things, indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers, or employees. The Company has also agreed to indemnify certain former officers, directors, and employees of acquired companies in connection with the acquisition of such companies. The Company maintains director and officer insurance, which may cover certain liabilities arising from its obligation to indemnify its directors and certain of its officers and employees, and former officers, directors, and employees of acquired companies, in certain circumstances.

 

It is not possible to determine the maximum potential amount of exposure under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Such indemnification agreements may not be subject to maximum loss clauses.

 

Litigation

 

From time to time, the Company may become subject to legal proceedings, claims, and litigation arising in the ordinary course of business. In addition, the Company may receive letters alleging infringement of patent or other intellectual property rights. The Company is not currently a party to any material legal proceedings, nor is the Company aware of any pending or threatened litigation that would have a material adverse effect on the Company’s business, operating results, cash flows, or financial condition should such litigation be resolved unfavorably.

 

NOTE 13 - PREFERRED AND COMMON STOCK

 

Preferred Stock

 

As of December 31, 2016 and 2015, there were 77,220,000 shares of Series A Preferred Stock issued and outstanding, respectively. The Series A Preferred Stock has no conversion rights, liquidation priorities, or other preferences; it only has voting rights equal to the common stock.

 

  F-22 
  

 

Common Stock

 

During the year ended December 31, 2016, the Company issued shares of its common stock as follows:

 

A total of 46,045 shares were issued to any employee for compensation

 

A total of 1,493,400 shares were issued for the exercise of stock options

 

A total of 33,365,609 shares were issued for the conversion the convertible promissory notes (See Note 9_ - Convertible Promissory notes).

 

During the year ended December 31, 2015, the Company issued shares of its common stock as follows:

 

A total of 1,000,000 shares were issued in connection with a consulting agreement. These shares, valued at $330,000, were authorized in 2014 and deemed issued as of December 31, 2014, however were not issued by the stock transfer agent until January 7, 2015. The consulting agreement called for the consultant to provide business advisory and related consulting services, including but not limited to: study and review of the business, operations, and financial performance and development initiatives, and formulating the optimal strategy to meet working capital needs.

 

A total of 4,556,250 shares were issued in connection with the issuance of convertible promissory notes. (See Note 9 – Convertible Promissory Notes.) $427,448 of the proceeds, which is net of transaction costs of $19,042, was allocated to common stock and additional paid in capital.

 

A total of 25,169,786 shares were issued as a result of conversions of Series 1 convertible promissory notes. (See Note – 9 Convertible Promissory Notes.) $1,668,267 of the proceeds was allocated to common stock and additional paid in capital.

 

A total of 21,408,023 shares were transferred to the Company. This transfer was not the result of any agreements between the Company and the individual. On August 11, 2015, the Company authorized cancellation of the shares.

 

A total of 539,028 shares were issued to employees as compensation.

 

A total of 866,571 shares were issued for nonemployee services provided to the Company.

 

A total of 2,625,000 shares were issued for the exercise of stock options. In December 2015, stock option holders gave the Company notice of their intent to exercise the options to purchase the Company’s common shares. The issuance was accounted for as though completed in 2015, however the issuance of those shares was not actually completed until subsequent to December 31, 2015.

 

NOTE 14 - WARRANTS AND OPTIONS

 

Warrants for common stock

 

Warrant activity during the years ended December 31, 2016 and 2015 is as follows:

 

    Number of
Warrants		     Weighted-Average
Exercise Price		     Aggregate Intrinsic Value  
Outstanding and exercisable December 31, 2014     1,625,000     $ 3.00     $ 515,125  
Granted (with Series 2 convertible notes)     911,250       3.00          
Granted (with Series 3 convertible notes)     2,625,000       0.25          
Exercised     -       -          
Expired     -       -          
Outstanding and exercisable December 31, 2015     5,161,250     $ 0.70     $ 350,788  
Exercised     -                  
Expired     -                  
Outstanding and exercisable December 31, 2016     5,161,250     $ 0.70     $ 1,032,250  

 

As of December 31, 2016, there were outstanding warrants to purchase an aggregate of 5,161,250 shares of common stock. The warrants expire between October 2018 and September 2020. Those issued in connection with the Series 2 convertible promissory notes expire within four years from the date of issue. Those issued in connection with the Series 3 convertible promissory notes expire five years from the issuance date.

 

  F-23 
  

 

Stock Option Plan

 

At the closing of the merger with Safari Resource Group, Safari had stock options that had previously been granted to its founders totaling 10,000 shares, and were fully vested. At the date of grant, Safari had no operations and nominal assets. As a result, the options were deemed to have no value and no charge was made to the income statement. The options were converted at the same rate as the common shares resulting in 10,296,000 options, with an exercise price of $0.00024. In the years ended 2016 and 2015, stock option holders exercised 1,493,400 and 2,625,000 stock options respectively. No new options were granted during the year ended December 31, 2016 or the year ended December 31, 2015.

 

The following table summarizes our stock option activity:

 

    Number of Options     Weighted Average Grant-Date Fair Value  
Outstanding as of December 31, 2014     10,296,000     $ -  
Options granted     -       0.00024  
Options exercised     (2,625,000 )     -  
Options forfeited     -       -  
Outstanding as of December 31, 2015     7,671,000     $ 0.00024  
Options granted     -       -  
Options exercised     (1,493,400 )     0.00024  
Options forfeited     -       -  
Outstanding as of December 31, 2016     6,177,600     $ 0.00024  

 

The Company’s stock option activity and related information for 2016 and 2015 is summarized as follows:

 

    Year Ended December 31, 2016     Year Ended December 31, 2015  
                Weighted                       Weighted        
                Average                       Average        
          Weighted     Remaining                 Weighted     Remaining        
    Number     Average     Contractual     Aggregate     Number     Average     Contractual     Aggregate  
    of
Options		     Exercise
Price		     Term
(in years)		     Intrinsic
Value		     of
Options		     Exercise
Price		     Term
(in years)		     Intrinsic
Value		  
                                                 
Options outstanding, beginning of year     7,671,000,     $ 0.00024       1.2     $ 536,970       10,296,000     $ 0.00024       2.2     $ 3,263,832  
Options granted     -       -       -       -       -       -       -       -  
Options exercised     (1,493,400 )     0.00024       -       119,966       (2,625,000 )     0.00024       -       183,750  
Options canceled     -       -       -       -       -       -       -       -  
Options outstanding, end of year     6,177,600     $ 0.00024       .2     $ 1,155,211       7,671,000     $ 0.00024       1.2     $ 536,970  
                                                                 
Vested and exercisable and expected to vest, end of year     6,177,600     $ 0.00024       .2     $ 1,155,211       7,671,000     $ 0.00024       1.2     $ 536,970  

 

  (1) The stock options outstanding were issued under the 2014 Stock Ownership Plan of Safari. Upon the acquisition of Safari on March 26, 2014, the existing stock options in Safari were converted into stock options in Surna. All options were fully vested at the date of the acquisition. Accordingly, there was no unrecognized compensation. The options expire in March 2017.

 

  F-24 
  

 

Stock options outstanding and exercisable as of December 31, 2016 are as follows:

 

          Options Outstanding       Options Exercisable  
                          Weighted                  
                          Average               Weighted  
                  Weighted       Remaining               Average  
                  Average       Contractual               Weighted  
Exercise       Number       Exercise       Term       Number       Exercise  
Price       Outstanding       Price       (in years)       Exercisable       Price  
                                             
$ 0.00024       6,177,600     $ 0.00024       .2       6,177,600     $ 0.00024  

 

NOTE 15 - INCOME TAXES

 

In 2016 and 2015, we recorded net tax provisions of nil.

 

The components of the provision for income taxes, net for the fiscal years ended December 31, 2016 and 2015 are:

 

      2016       2015  
Current taxes:                
U.S. Federal   $ -     $ -  
U.S. State     -       -  
International     -       -  
Current taxes     -       -  
Deferred taxes:                
U.S. Federal     -       -  
U.S. State     -       -  
International     -       -  
Deferred taxes     -       -  
Provision for income taxes, net   $ -     $ -  

 

Differences between income taxes computed at the federal statutory rate and the provision recorded for income taxes are comprised of the follow items:

 

    2016     2015  
Income taxes computed at the federal statutory rate   $ (1,021,000 )   $ (1,801,000 )
Effect of:                
State taxes, net of federal benefits     (92,000 )     (162,000 )
Loss of net operating losses from discontinued operations             -  
Loss of net operating losses due to 382 limitations             596,000  
Nondeductible expenses     717,000       501,000  
Other, net     122,000       114,000  
Change in valuation allowance     274,000       752,000  
Total   $ -     $ -  

 

As of December 31, 2016, the Company has approximately $ in net operating losses carried forward for federal and state income tax purposes, which will expire, if not utilized, in 2035.

 

As a result of the Safari acquisition (see Note 1), there was a change of control (greater than 50% ownership change) and a change in lines of business, thus utilization of prior year net operations losses will be limited.

 

Deferred income tax assets as of December 31, 2016 and 2015 are as follows:

 

    2016     2015  
Deferred tax assets:                
Net operating losses   $ 3,762,000     $ 2,155,000  
Consultant Expenses     -       7,000  
Other items     19,000       12,000  
Total deferred tax assets     3,781,000       2,052,000  
Deferred tax liabilities                
Federal utilization of state benefits     (154,000 )     (82,000 )
Fixed asset basis difference     (14,000 )     (41,000 )
Consulting expense     (25,000 )        
Total deferred tax liabilities     (193,000 )     (115,000 )
Net deferred tax assets before valuation allowance     3,588,000          
Less valuation allowance     (3,588,000 )     (2,052,000 )
Net Deferred tax assets   $ -     $ -  

 

  F-25 
  

 

We are under examination, or may be subject to examination, by the Internal Revenue Service (“IRS”) for the calendar year 2009 and thereafter. These examinations may lead to ordinary course adjustments or proposed adjustments to our taxes or our net operating losses with respect to years under examination as well as subsequent periods. We have filed our past years’ federal corporate income tax returns from 2009 through 2015and may be subject to penalties, as described below, for non-compliance; however, we believe that we had no taxable income in US or in any foreign jurisdiction. We are in process of completing our US federal tax return for 2016 and state tax returns for years 2009 through 2016.

 

The Company also has net operating loss carryforwards of approximately $9,737,098 included in the deferred tax asset table above for 2016 and 2015, respectively, However, due to limitations of carryover attributes , it is unlikely the company will benefit from these NOL’s and thus Management has determined a 100% valuation reserved is required. .

 

For U.S. purposes, the Company has not completed its evaluation of NOL utilization limitations under Internal Revenue Code, as amended (the “Code”) Section 382, change of ownership rules. If the Company has had a change in ownership, the NOL’s would be limited as to the amount that could be utilized each year, based on the Code.

 

The Company has been penalized by the Internal Revenue Service for failure to file its Foreign Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations for the years 2009 through 2014 on a timely basis . The Penalties are approximate $120,000. The Company has requested the penalties be abated to the Internal Revenue Service and believes the Penalties will be abated for reasonable cause, but no assurance can be relied upon until the Internal Revenue Service acts upon the request.

 

NOTE 16 - SUBSEQUENT EVENTS

 

In accordance with ASC 855, “Subsequent Events”, the Company has evaluated all subsequent events through March 31, 2017, the date the financial statements were available to be issued. The following events occurred after December 31, 2016

 

As described in Note 9 – Convertible Promissory Notes, the Company entered negotiations to extinguish its Convertible Promissory notes. Subsequent to December 31, 2016, the Company extinguished $761,440 and $161,031 of convertible promissory notes, net and convertible accrued interest, respectively. The promissory notes and interest were extinguished by the issuance of approximately 3,416,612 shares of the Company’ common stock and cash payments of approximately $314,000.

 

In January, 2017, the Company received a payment to settle a note receivable plus accrued interest totaling $100,000 which was included in our Notes Receivable balance as of December 31, 2016.

 

March 2017, the Company entered into a Securities Purchase Agreement (the “Agreement”) with certain accredited investors (the “Investors”). The Company issued an aggregate of 16,781,250 investment units (the “Units”), for aggregate gross proceeds of $2,685,000. Each Unit consists of one share of the Company’s common stock and one warrant for the purchase of one share of Common Stock.

 

In March 2017, the Company issued a two promissory note, with identical terms, in the amount of $268,750, or $537,200 in total, with an interest rate of 6% per annum. The promissory note and all accrued interest are due and payable on November 9, 2017.

 

In March 2017, the Company’s CEO completed certain milestones as to restricting the Company’s convertible promissory notes and raised approximately $2,700,000 through a private placement of the Company’s common stock. Upon completion of these milestones certain shareholders, of the Company, transferred 3,088,800 options to purchase the Company’s common stock, at $0.00024 per share, to the Company’s CEO as a bonus. In the first quarter of 2017, the Company will record as compensation expense, the fair value of these options as of the date of transfer.

 

  F-26 
  

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

  SURNA INC.
  (the “Registrant”)
     
Dated: March 31, 2017 By: /s/ Trent Doucet
    Trent Doucet
    Chief Executive Officer and President

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

 

Dated: March 31, 2017 By: /s/ Brandy Keen
    Brandy Keen, Secretary and Director
     
Dated: March 31, 2017 By: /s/ Trent Doucet
    Trent Doucet, Chief Executive Officer, President, Director (Principal Executive Officer)
     
Dated: March 31, 2017 By: /s/ Stephen Keen
    Stephen Keen, Director
     
Dated: March 31, 2017 By: /s/ Dean S Skupen
    Dean S Skupen
   

Principal Financial and Accounting Officer

     
Dated: March 31, 2017

By:

 /s/ Morgan Paxhia
    Morgan Paxhia
    Director
     
Dated: March __, 2017

By:
    Timothy Keating
   

Director

 

  35 
  

 

EXHIBIT INDEX

 

Exhibit    
Number   Description of Exhibit
     
2.1   Membership Interest Purchase Agreement (incorporated herein by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on April 4, 2014).
     
2.2   Agreement and Plan of Merger (incorporated herein by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on May 12, 2014).
     
2.3   Modification and Amendment to the Membership Interest Purchase Agreement among Brandy Keen and Stephen Keen and Surna Inc. dated as of July 25, 2014 (incorporated herein by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on July 29, 2014).
     
3.1(a)   Articles of Incorporation (incorporated herein by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 as filed with the Securities and Exchange Commission on January 28, 2010).
     
3.1(b)   Amended Articles of Incorporation (incorporated herein by reference to Exhibit 3.3 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on June 16, 2011).
     
3.1(c)   Certificate of Designations of Preferences, Rights, and Limitations of Preferred Stock (incorporated herein by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on May 12, 2014).
     
3.2*   Bylaws of Surna Inc., as amended.
     
4.1   Form of Convertible Promissory Note (incorporated herein by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on October 21, 2014).
     
4.2   Specimen Stock Certificate (incorporated herein by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 as filed with the Securities and Exchange Commission on January 28, 2010).
     
4.3   Exclusive License Agreement (incorporated herein by reference to Exhibit 2.2 to the Company’s Report on Form 8-K as filed with the Securities and Exchange Commission on April 4, 2014).
     
4.4   Separation Agreement among the Company, Surna Media Inc., Lead Focus Limited and certain creditors of Surna Media Inc. dated as of June 30, 2014 (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on July 7, 2014).
     
4.5   Membership Interest Transfer and Assignment Agreement (incorporated herein by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on May 12, 2014).
     
4.6   Modification and Amendment to the Membership Interest Purchase Agreement effective as of July 1, 2014 (incorporated herein by reference to Exhibit 2.1(a) to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on July 30, 2014.
     
10.1+   Executive Employment Agreement between Surna Inc. and Brandy Keen effective as of July 25, 2014 (incorporated herein by reference to Exhibit 2.1(a) to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on July 30, 2014).
     
10.2+   Executive Employment Agreement between Surna Inc. and Stephen Keen effective as of July 25, 2014 (incorporated herein by reference to Exhibit 2.1(a) to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on July 30, 2014).
     
10.3+   Executive Employment Agreement between Surna Inc. and David W. Traylor effective as of December 8, 2014 (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on December 12, 2014).
     
10.4+   Executive Employment Agreement between Surna Inc. and Bryon Jorgenson effective as of January 5, 2015 (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on January 8, 2015).
     
10.5+   Executive Officer Confidentiality, Non-Competition, and Non-Solicitation Agreement between Surna Inc. and Bryon Jorgenson effective as of January 5, 2015 (incorporated herein by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on January 8, 2015).

 

  36 
  

 

10.6   Membership Interest Purchase Agreement between Surna Inc., Jim Willett, Forbeez Capital, LLC, and Agrisoft Development Group, LLC dated as of January 7, 2015 (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on January 9, 2015).
     
10.7   Agreement for Professional Services (estimate 1368) between Surna Inc. and CWNevada, LLC, dated as of January 12, 2015 (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on January 13, 2015).
     
10.8   Agreement for Professional Services (estimate 1369) between Surna Inc. and CWNevada, LLC, dated as of January 12, 2015 (incorporated herein by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on January 13, 2015).
     
10.9   Addendum to the Membership Interest Purchase Agreement between Surna Inc., Jim Willett, Forbeez Capital, LLC, and Agrisoft Development Group, LLC dated as of February 23, 2015 (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on February 27, 2015).
     
10.10   Memorandum of Understanding dated June 11, 2015 by and between Surna Inc., and Kind Agrisoft, LLC (incorporated herein by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on June 25, 2015).
     
10.11   Security Agreement dated June 23, 2015 by and between Surna Inc., and Kind Agrisoft, LLC (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on June 25, 2015).
     
10.12   Letter regarding Settlement and Satisfaction of Debts to Tom Bollich (incorporated herein by reference to Exhibit 1.01 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on August 12, 2015).
     
10.13   Promissory Note Amendment effective April 15, 2016 (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on April 20, 2016).
     
10.14   Consulting Agreement effective August 12, 2016 (incorporated by reference to Exhibit 10.2 attached to the Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, as filed with the SEC on August 15, 2016).
     
10.15*   Form of Note Conversion and Warrant Amendment Agreement
     
10.16*   Purchase Agreement between Surna Inc. and Sante Veritas Therapeutics Inc., dated February 21, 2017.
     
10.17*   Form of Securities Purchase Agreement
     
10.18*   Board of Directors Agreement between Surna Inc. and Timothy J. Keating, dated March 7, 2017.
     
21.1*   Subsidiaries
     
31.1*   Certification of Principal Executive Officer, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
31.2*   Certification of Principal Financial and Accounting Officer, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
32.1**   Certification of Principal Executive Officer and Principal Financial and Accounting Officer, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
     
 101.INS*   XBRL Instance Document
     
101.SCH*   XBRL Taxonomy Schema
     
101.CAL*   XBRL Taxonomy Calculation Linkbase
     
101.DEF*   XBRL Taxonomy Definition Linkbase
     
101.LAB*   XBRL Taxonomy Label Linkbase
     
101.PRE*   XBRL Taxonomy Presentation Linkbase
     
+ Indicates a management contract or compensatory plan.
* Filed herewith.
** Furnished herewith.

 

  37