UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 1-K
ANNUAL REPORT
ANNUAL REPORT PURSUANT TO REGULATION A OF THE SECURITIES ACT OF 1933
For the fiscal year ended December 31, 2018
CNote Group, Inc.
(Exact name of issuer as specified in its charter)
| Delaware | 81-2784287 |
|
State of other jurisdiction of incorporation or organization |
(I.R.S. Employer Identification No.) |
CNote Notes
(Title of each class of securities issues pursuant to Regulation A)
2323 Broadway, Oakland, California 94612
(Full mailing address of principal executive offices)
800-449-6275
(Issuer’s telephone number, including area code)
PART II
| Item 1. | BUSINESS |
Overview
CNote Group, Inc. (hereafter also referred to as “Us”, “We”, “the Company”, “CNote”) is an early stage financial technology company operating an online impact investment platform www.mycnote.com. We use all the investors’ capital to provide loans to Community Development Financial Institutions (CDFIs), the organizations certified by the CDFI Fund, and which, in turn, directly provide loans to population segments underserved by traditional banks and lenders, such as women- and minority-owned businesses.
As of December 31, 2018, we had 4 full-time employees and also rely on outside consultants for various technical and business functions. We are located in Oakland, California. Since inception through December 31, 2018, we have lent about $13 million to CDFIs.
CDFIs have been in existence for over 20 years
and originated from the Riegle Community Development and Regulatory Improvement Act of 1994. Over the last two decades, CDFIs have
grown to become an approximately $110 billion industry with participation from nearly every major bank in the United States. Despite
these traditional sources of funding, the demand for loans made by CDFIs continues to grow faster than available traditional sources
of funding, leading many CDFIs to seek new sources of diversified capital.
CNote is a technology-driven platform that allows the Company to aggregate investor capital to make loans to CDFIs. The platform is open to institutional, accredited, and non-accredited investors. Our accredited investors (“Reg. D”) invest via Regulation D of the Securities Act of 1933 (the “Securities Act”), and our non-accredited investors (“Reg. A+”) invest via Regulation A of the Securities Act by purchasing CNote Notes.
Proceeds from CNote Notes may be aggregated with funds from institutional and accredited investors to collectively fund the loans to CDFI partners. Final decisions on use of proceeds allocations will be made by management on a loan-by-loan basis.
Under our business model, we generate revenue
by keeping the difference between the interest rate we charge our CDFI partners and the interest distributed to CNote Note investors.
The interest rates we charge our CDFI partners and the interest rates of CNote Notes are reviewed by management on a quarterly
or semi-annual basis, in view of a variety of competitive conditions including the federal rate environment, fluctuations in the
cost of capital averages for CDFIs, and the economics facing the Company. We also consider the competitiveness of CNote Notes as
compared to rates offered by other investment products.
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CNote Notes
CNote Notes are available to non-accredited investors via our online platform. CNote Notes are general obligations of the Company, regardless of payments received from any specific CDFI partner. CNote might provide investors information on CDFI partners we have partnered with in the past and details on the types of projects they fund and their social impact, which may include stories from prior specific borrowers. However, we will not be directly connecting investors to CDFI partners or to their borrowers.
Our CNote Notes pay interest at a current rate of 2.75% per annum, compounded monthly, fixed for the duration of the notes. Management may change the interest rate of CNote Notes offered from time-to-time, in a range from 2.5% to 3.5% per annum. The rate was increased to 2.75% from 2.5% effective January 1, 2019. The change in the rate was applied to new CNote Notes and CNote Notes issued prior to such change. Interest rate changes are at the sole discretion of CNote. CNote Note investors may choose whether to receive interest on their investments each month, or to have this interest compounded on a monthly basis. An investor who refers at least three new investors who each purchase at least $1,000 in principal of CNote Notes will also receive an additional, one-time, 0.25% per annum increase in interest on his or her then outstanding principal amount of CNote Notes, applied on a prospective basis.
The term for CNote Notes currently offered is 30 months. CNote Notes may be repurchased from investors at any time at the par value of outstanding principal plus the interest accrued through the repurchase date. CNote Notes are held on our platform in electronic form and are not listed on any securities exchange. The transfer of CNote Notes to third parties is prohibited unless expressly permitted in writing.
An investor may withdraw up to 10% of the investor’s
principal and accrued, but unpaid, interest each quarter, generally upon 30 days’ notice and subject to available funds from
loans to our CDFI partners and other cash available to the Company. Management retains discretion to allow investors to withdraw
additional amounts, subject to the availability of additional funds.
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Our website allows investors to commit to purchase CNote Notes upon completion of the registration process. We issue CNote Notes in a series of Closings, which occur within 24 hours or as soon as reasonably practicable after the Company has obtained commitments from investors to purchase an aggregate of at least $100,000 in principal of CNote Notes. On the Closing Date, funds will be drawn from the investor’s bank account into the investor’s CNote account. Interest begins accruing from six business days following the investor’s Closing Date (”Accrual Date”). CNote Notes are issued to the investor on the Accrual Date and held on our platform in electronic form. CNote Notes can be viewed under “Documents” tab in the investor’s account dashboard accessed by entering login-credentials.
Proceeds from the sales of CNote Notes are used
to make loans to CDFI partners.
CNote Borrowers
Leveraging technology, we aggregate investor capital and make loans to CDFIs. As of December 31, 2018, we have partnered with seven
CDFI partners, one of which is itself lending to a portfolio of CDFIs thereby diversifying our investors’ funds even further.
In addition, we are in the process of partnering with four additional CDFIs. As we expand our footprint, this diversification will
help ensure that we have sufficient funds to repay our investors, as repayment of CNote Notes to our investors is not tied to any
particular loan being repaid but rather comes from our aggregated pool.
We are currently legally authorized to lend in 45 states plus the District of Columbia as a non-bank commercial lender.
Underwriting Process
We use technology, data analytics, and a proprietary liquidity algorithm to match investors’ funds with the funding needs of CDFI partners. CNote conducts three stages of due diligence on prospective CDFI partners, which include internal due diligence following industry best practices, reviewing opinions from AERIS, the rating agency that specializes in CDFIs and/or the opinion of OFN, the national membership association of CDFIs, and a third-party review conducted by an independent social finance committee, with expertise in the CDFI industry, and with no ties, financial or otherwise, either to us or to the potential CDFI partner, to provide tertiary, third-party assessments of potential CDFI partners, including geo-specific and product-specific risks to be identified.
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Our credit policy targets potential CDFI partners with higher creditworthiness, stable financial situation and proven impact. In
order to borrow from CNote, potential CDFI partners must display characteristics indicative of a healthy loan portfolio and a durable
financial situation. The factors we consider include repayment rates, loan delinquencies, loan loss reserves, availability of credit
enhancements and guarantees, length of time in business, and other financial and credit variables. Additionally, our CDFI partners
are required to provide us with audited relevant financial and impact data about their operational and lending activities.
The overall due diligence process typically takes at least four to six weeks to complete.
Our determination of what loan amount to approve, how the loan will be priced, and the length of such loan is primarily based on the due diligence analysis. We also may consider additional factors such as the products line-up of potential CDFI partners or the general economic environment. Our loans are typically issued to CDFI partners in the form of a master promissory note, which allows them to make multiple requests for capital. If a CDFI partner makes an additional request for a loan, we will re-evaluate the CDFI partner in accordance with our underwriting process, and we conduct these reviews on at least a quarterly basis. If the results of our analyses differ, a CDFI partner may receive different financial terms on subsequent draw downs. Our loans to CDFI partners are full recourse to the CDFI, and are not reliant on proceeds from the loans each CDFI makes. The loans to CDFI partners are not amortizing and CDFI partners repay the loans monthly through electronic bank payments.
Loan Servicing
CNote has built a platform to manage investor servicing and loan servicing in-house. Investors can
access and manage their account online at www.mycnote.com by
entering their login credentials.
Distinctive Characteristics and Risks
The Company is subject to a number of regulatory
requirements. Both the lending and investing industries are regulated by state and federal regulators, and as such, create an environment
where CNote operations can be directly influenced by various regulatory bodies. Changes in regulations, or in the way current or
newly enacted state or federal regulations are applied to our business, or the increased cost due to compliance with these regulations,
or inadvertent regulatory miscues, could all adversely affect our business. Ongoing compliance with Regulation A+, which is a relatively
new regulatory scheme subject to the potential for more, and more frequent, amendments and differing interpretations, and the reporting
thereof to the SEC could be more costly than anticipated.
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As part of its operations, the Company lends to CDFIs and has yet to endure a major adverse phase in the credit cycle. Worsening
economic conditions or a changing political climate may result in decreased demand for our loans, cause our CDFI borrowers’
default rates to increase, and harm our operating results.
CDFIs may be negatively impacted by political
or administrative actions, which could include decreased federal or state support for CDFIs or rollback of supportive policies.
Losing access to state or federal funding could make it more likely that CDFI partners would default on their obligations to us
in the event they are unable to collect on the loans they make to borrowers, who, as small businesses, may be more sensitive to
macroeconomic factors.
Finally, the Company is an early-stage company with a history of net operating losses, and we may not become profitable. We rely
on outside capital to fund our operations. If we are unable to obtain or maintain profitability, we will not be able to attract
investment, compete, or maintain operations. Holders of CNote Notes are exposed to the credit risk of the Company.
Investors should read this report, our other filings with the SEC, and the Offering Statement filed with the SEC with respect to
CNote Notes for a full list of potential risks related to the industry, the Company, and CNote Notes.
Tax and Legal Treatment
CNote Notes investors will receive interest income. At the end of the calendar year, investors with over $10 of realized interest
will receive a form 1099-INT. The interest earned on CNote Notes investment will need to be declared in accordance with the United
States Tax Code. An investor’s tax situation will likely vary greatly, and all tax and accounting questions should be directed
towards a Certified Public Accountant. CNote does not provide investment, accounting, tax or legal advice to CNote Notes investors
and encourages investors to seek out advice from their professional advisers to fully understand their particular tax situations.
We are not subject to any bankruptcy, receivership, or similar and other legal proceedings.
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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of the Company’s financial condition and results of its operations should be read together with the consolidated financial statements and the related notes and other financial information included elsewhere in this filing.
Overview
The Company is an online investment platform that makes loans to Community Development Financial Institutions (“CDFIs”) dispersed across the United States who in turn make loans to underserved communities. As of December 31, 2018, the Company has $11,807,319 of outstanding principal amount of loans made to CDFIs. The Company generates revenue by retaining the difference between the interest earned on the CDFI loans versus the interest paid to its investors/note holders.
Operating Results
Revenues represent interest earned from loans to CDFIs.
Cost of revenues consists of (A) interest paid (and payable) to note holders, (B) direct costs to support the Company’s online platform, and (C) estimated loan loss reserves.
Operating expenses represent the cost for platform development, sales and marketing (travel, advertising and collateral) and general and administrative expenses (office, professional fees and insurance). Since inception, the Company has focused on developing the online platform, setting up the legal framework for the product and establishing industry partnerships.
Revenues
During the fiscal year ended December 31, 2018, the Company generated $275,139 in revenue compared to $55,122 reported in the fiscal year ended December 31, 2017. The increase is a result of the higher loan origination.
In the fiscal year ended December 31, 2018, the cost associated with revenues increased to $646,162 from $231,276 in the fiscal year ended December 31, 2017 as our lending operations scale. The increase is primarily explained by a larger loan loan reserve due to higher volumes of loan origination.
Operating Expenses
For the fiscal year ended December 31, 2018, we had operating expenses of $476,339 compared to $304,004 in the fiscal year ended December 31, 2017. The largest line items of operating expenses were payroll and payroll taxes, marketing expenses, and legal and other professional services
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Liquidity and Capital Resources
Sources of Liquidity
To date, the Company has funded operations primarily through Simple Agreements for Future Equity (“SAFEs”) agreements, convertible promissory notes (“convertible notes”) and has funded its lending activities through investments in notes payable by accredited and non-accredited investors.
Equity and Convertible Debt Financing
As of December 31, 2018, the Company has raised $1,619,500 by selling SAFEs, which will convert to preferred stock as part of a qualified equity financing, if and when such an event occurs. SAFEs do not have maturity dates, nor do they accrue interest.
It’s expected that the SAFEs will convert into preferred stock in the future at a price to be determined relative to the valuation caps set by the Company on the SAFEs, or, in the event the Company were to undergo a change of control or initial public offering prior to a qualified equity financing, the SAFEs may convert into either Common Stock or a right to receive payment, at the election of the holders.
As of December 31, 2018, the Company has raised $100,000 by selling a convertible note. Subsequent to December 31, 2018, the Company has raised an additional $637,000 in convertible notes. The convertible notes have a maturity date of two (2) years and an interest of four (4) percent per annum.
In the event of a qualified equity financing, the convertible notes will convert into equity securities issued sold in the Qualified Financing at a conversion price as set in the convertible note agreement. In the event the Company were to undergo a change of control prior to a qualified financing, the holders of the convertible notes will receive cash payments in the amount set in the convertible note agreement.
The capital raised has been used to develop and maintain the Company’s platform, to fund legal expenses, for marketing and advertising, for expanding operations, and for other general corporate purposes.
Operating and Capital Expenditure Requirements
The Company expects these existing funds, together with the proceeds of a planned capital raise in 2019, to be sufficient to meet anticipated near-term cash operating expenses and capital expenditure requirements. If those funds are insufficient to satisfy liquidity requirements, the Company intends to seek additional equity or debt financing. The sale of equity may result in dilution to our stockholders and those securities may have rights senior to those of our common shares. If the Company raises additional funds through the issuance of debt, the agreements governing such debt could contain covenants that would restrict our operations and such debt would rank senior to shares of our Common Stock. The Company may require additional capital beyond currently anticipated amounts and additional capital may not be available on reasonable terms, or at all.
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Trends and Key Factors Affecting Our Performance
Investment in Long-Term Growth.
The core elements of the Company’s growth strategy include acquiring new customers, broadening distribution capabilities through strategic partnerships, extending customer lifetime value, enhancing data and analytical capabilities, and expanding product offerings. The Company plans to continue to invest significant resources to accomplish these goals, and the Company anticipates that its operating expenses will continue to increase for the foreseeable future, particularly sales and marketing and technology expenses. These investments are intended to contribute to long-term growth, but they may affect near-term profitability.
Originations.
The Company’s future growth will continue to depend, in part, on attracting new customers (i.e. investors) while engaging more CDFI partners (as Borrowers). The Company plans to increase its sales and marketing spending and seek to attract these investors. We expect to rely on strategic distribution partners, affinity networks and conference and speaking events for investor growth.
The Company expects CDFI partners’ need for capital to increase in the future. The extent to which the Company can satisfy that increased demand for capital will be an important factor in its continued revenue growth. Building the relationships with the membership industry network and CDFI coalitions proved to be a stable source of referrals to CDFI borrowers, and we expect this trend to continue.
Summary of Critical Accounting Policies
This management’s discussion and analysis of the Company’s financial condition and results of operations is based on its consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reported period. In accordance with GAAP, the Company bases estimates on historical experience and on various other assumptions that the Company believes are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
The Company’s significant accounting policies are fully described in Note 2 to the consolidated financial statements appearing elsewhere in this filing. The Company believes those accounting policies are critical to the process of making significant judgments and estimates in the preparation of our consolidated financial statements.
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Forward-Looking Statements
The following information contains certain forward-looking statements. Forward-looking statements are statements that estimate the happening of future events and are not based on historical fact. Forward-looking statements may be identified by the use of forward-looking terminology, such as “may,” “could,” “expect,” “estimate,” “anticipate,” “plan,” “predict,” “probable,” “possible,” “should,” “continue,” or similar terms, variations of those terms or the negative of those terms. The forward-looking statements specified in the following information have been compiled by our management on the basis of assumptions made by management and considered by management to be reasonable. Our future operating results, however, are impossible to predict and no representation, guaranty, or warranty is to be inferred from those forward-looking statements.
| Item 3. | DIRECTORS AND OFFICERS |
Our executive officers and directors, and ages are as follows:
| Name | Age | Position | Term of Office | |||
| Executive officers: | ||||||
| Catherine Berman | 43 | President, Chief Executive Officer, Co-founder, Director | Since June 17, 2016 | |||
| Yuliya Tarasava | 35 | Chief Operating Officer, Co-Founder, Treasurer, Secretary, Director | Since April 22, 2016 | |||
| Significant Employees: |
||||||
| Jared Casner | 37 | VP of Engineering | Since September 25, 2017 | |||
| John "Michael" Ivancie, Jr. |
36 | Director of Growth and Partnerships | Since October 2, 2017 |
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Catherine Berman
Ms. Berman co-founded CNote and has served as our President and Chief Executive Officer and a member of our Board of Directors since June 2016. Before launching CNote, Ms. Berman served as Managing Director of Charles Schwab, one of America’s leading financial services businesses. At Schwab, Ms. Berman led a strategy division focusing on the future of financial services. Prior to Schwab, Ms. Berman maintained a host of management positions including Senior Vice President of Astia (venture capital), Strategy & Operations Manager at Deloitte Consulting, LLP (management consulting) and Vice President of Evins Communications, LLC. Her international work experience spans from India to Israel with extensive work in Central and South America. Her last startup, Global Brigades, grew into a multi-million dollar firm in less than four years and is now the world’s largest student development firm. Ms. Berman graduated magna cum laude from Boston University and received her MBA from the University of Oxford where she founded the Oxford Women in Business Network.
Yuliya Tarasava
Ms. Tarasava co-founded CNote and has served as our Chief Operating Officer, Treasurer, Secretary and a member of our Board of Directors since the Company’s inception. Ms. Tarasava began her career conducting intensive quantitative research on new market opportunities and designing investment solutions across asset classes for AMG Funds—a $75 billion asset firm providing access to boutique investment strategies. Ms. Tarasava then went on to Summit Rock Advisors, a $10 billion OCIO firm, where she developed and implemented the firm’s proprietary analytics and risk management framework. Most recently, she worked with a high-growth financial services company in Kenya where she led both product development and scale strategy efforts working directly with the company’s chief executive officer. Her prior experience also includes creating an investment education portal in Russia and providing pro-bono consulting for non-profits and startups around the world. Ms. Tarasava graduated magna cum laude from Belarusian State University and received her MS in Finance from Fairfield University.
Jared Casner
Mr. Casner is CNote’s VP of Engineering. Prior to joining CNote, Jared ran engineering at Sindeo, a digital mortgage brokerage. Before that, he led the application engineering teams at OpenGov, developing new financial reporting and budgeting tools for city, county, and state level governments. He has served at Numenta, a machine learning research company, participated in an exit at Aprimo, worked in 30 countries in Europe, the Middle East, and Africa, and once held a top-secret security clearance with the US government. Mr. Casner holds a BS in Computer Science from the University of Denver and an MBA from the University of Colorado.
John "Michael" Ivancie, Jr.
Mr. Ivancie is CNote’s Director of Growth and Partnerships. Prior to CNote, Mike worked as a Staff Attorney at the Department of Homeland Security, which he left to start a niche law practice. After spending three years growing and marketing his practice, he transitioned to a full-time career in marketing. Mike holds a BA in Criminology with a minor in Management from UC Irvine. He received his JD from the University of Arizona in 2009, and he is a licensed California attorney. He is currently an MBA candidate at UC Berkeley's Haas School of Business.
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Advisory Board
Suparna Bhasin
Ms. Bhasin is CEO of She Creates Change and a thought leader in change management and executive coaching. She currently runs an international impact investment fund.
Alex Dang
Mr. Dang is Director of Lending for Opportunity Fund, one of the largest micro lending organizations in California. He maintains extensive experience in product development and partnerships.
Anna Fabian
Ms. Fabian is Senior Director of Product at SoFi, a leading financial technology company. Prior to SoFi, Anna had leadership positions at Wells Fargo and Chase Securities. She has deep experience developing and managing products in both large financial institutions and startups.
Mark Keheler
Mr. Keheler is an Investment Executive and Financial Strategist who successfully started a global investment management and investment services business line within Mellon Bank N.A. that became an award-winning global provider.
Francis Lutz
Mr. Lutz has over 25 years of international, corporate, for-profit and nonprofit executive management experience. He served as a CFO at OFN, the national leadership network of community development financial institutions (CDFIs).
Emily Jennings
Ms. Jennings is a seasoned finance professional and served previously as Director of Institutional Capital at SoFi and Vice President of Barclays. She is currently Head of Finance at Branch.
Cheryl Traverse
Ms. Traverse is a serial entrepreneur and has been CEO of five successful technology companies. She secured funding, set the strategic direction, delivered market-leading products, built revenue traction and created successful exits for all five companies.
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Family Relationships
None.
Conflicts of Interest
We do not believe that we are a party to any transactions that contain or give rise to a conflict of interest between any of our directors, officers and major stockholders on the one hand, and CNote on the other hand. Two co-founders have invested $5,000 each through our platform, but we do not believe these small investments present a conflict of interest.
Involvement in Certain Legal Proceedings
None.
| Item 4. | COMPENSATION OF DIRECTORS AND EXECUTIVE OFFICERS |
The Company has two directors who also serve as executive officers. Their compensation for the 2018 fiscal year was as follows:
| Executive Officers |
Position | Cash Compensation |
Other Compensation |
Total Compensation | ||||
| Catherine Berman |
President, Chief Executive Officer, Co-Founder, Director | $71,500 | $0 | $71,500 | ||||
| Yuliya Tarasava |
Chief Operating Officer, Co-Founder, Treasurer, Secretary, Director | $71,500 | $0 | $71,500 |
Executive compensation is set annually, based on several factors including company and individual leadership, performance compensation of competitor peer group, and other factors.
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Item 5.
SECURITY OWNERSHIP OF MANAGEMENT AND CERTAIN SECURITYHOLDERS
| Name and Address of Beneficial Owner(1) |
Amount and nature of beneficial ownership as of December 31, 2018 |
Amount and nature of beneficial ownership acquirable as of December 31, 2018 |
Percent of class(6) | |||
| Catherine Berman |
2,062,500 shares of common stock (2) | 2,200,000 shares of common stock (4) | 36.7% | |||
| Yuliya Tarasava | 1,800,000 shares of common stock (3) | 1,912,500 shares of common stock(5) | 31.9% | |||
| All executive officers and directors as a group (2 persons) |
3,862,500 shares of common stock | 4,112,500 shares of common stock |
________________________
| (1) | Unless otherwise noted, the address of each executive officer and director is CNote Group, Inc., 2323 Broadway, Oakland, CA 94612. |
| (2) | Does not reflect the unvested balance of a grant of an aggregate 3,300,000 shares of common stock, of which 62.5% (or 2,062,500 shares) vested on December 17, 2018 and which will continue to vest in equal monthly installments of 1/48th of such grant thereafter. |
| (3) | Does not reflect the unvested balance of a grant of an aggregate 2,700,000 shares of common stock, of which 66.67% (or 1,800,000 shares) vested on December 22, 2018 and which will continue to vest in equal monthly installments of 1/48th of such grant thereafter. |
| (4) | Reflects vesting of two monthly installments of 68,750 shares of common stock (or 137,500 shares total) through on February 28, 2019. |
| (5) | Reflects vesting of two monthly installments of 56,250 shares of common stock (or 112,250 shares total) through February 28, 2019. |
| (6) | Calculated on basis of beneficial ownership acquirable as of December 31, 2018. |
Item 5.
INTEREST OF MANAGEMENT AND OTHERS IN CERTAIN TRANSACTIONS
We do not believe that we are a party to any transactions that contain or give rise to a conflict of interest between any of our directors, officers and major stockholders on the one hand, and CNote on the other hand. Two co-founders Ms. Berman and Ms. Tarasava have invested $5,000 each through our platform, but we do not believe these small investments present a conflict of interest.
| Item 6. | OTHER INFORMATION |
None.
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Item 7.
CNOTE GROUP, INC.
CONSOLIDATED FINANCIAL STATEMENTS
For the years ended December 31, 2018 and 2017
Table of Contents
| Pages | |
| Independent Auditors’ Report | F-2 |
| Consolidated Balance Sheets | F-3 |
| Consolidated Statements of Operations | F-4 |
| Consolidated Statements of Stockholders’ Deficit | F-5 |
| Consolidated Statements of Cash Flows | F-6 |
| Notes to the Consolidated Financial Statements | F-7 |
| F-1 |
INDEPENDENT AUDITORS’ REPORT
To the Board of Directors and Stockholders
CNote Group, Inc.
Report on the Consolidated Financial Statements
We have audited the accompanying consolidated financial statements of CNote Group, Inc. and subsidiary (collectively, the “Company”) which comprise the consolidated balance sheets as of December 31, 2018 and 2017, the related consolidated statements of operations, stockholders' deficit, and cash flows for the years then ended, and the related notes to the consolidated financial statements.
Management’s Responsibility for the Consolidated Financial Statements
Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.
Auditors’ Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor's judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity's preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.
Opinion
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CNote Group, Inc. as of December 31, 2018 and 2017, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
Emphasis of Matter Regarding Going Concern
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, certain conditions including the Company not generating significant revenue from principal operations, viability of the Company’s business model, and projected continued losses raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter.
/s/ dbbmckennon
Newport Beach, CA
April 30, 2019
| F-2 |
CNOTE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2018 AND 2017
| 2018 | 2017 | |||||||
| Assets | ||||||||
| Current assets: | ||||||||
| Cash | $ | 435,209 | $ | 410,276 | ||||
| Accrued interest receivable | 230,412 | 42,647 | ||||||
| Current portion of loans receivable | 5,577,242 | 1,816,194 | ||||||
| Total current assets | 6,242,863 | 2,269,117 | ||||||
| Software, net | 178,571 | 162,952 | ||||||
| Loans receivable, net of loan loss reserve | 5,875,857 | 2,588,077 | ||||||
| Total assets | $ | 12,297,291 | $ | 5,020,146 | ||||
| Liabilities and Stockholders' Deficit | ||||||||
| Current liabilities: | ||||||||
| Accounts payable | $ | - | $ | 1,681 | ||||
| Accrued liabilities | 26,070 | 15,322 | ||||||
| Interest payable | 227,687 | 42,021 | ||||||
| Current portion of notes payable, net | 5,679,630 | 1,780,585 | ||||||
| Current portion of notes payable - related parties | 25,000 | 10,000 | ||||||
| Total current liabilities | 5,958,387 | 1,849,609 | ||||||
| Notes payable, net | 6,046,427 | 2,681,382 | ||||||
| Notes payable - related parties | - | 15,000 | ||||||
| Convertible note - related party | 100,000 | - | ||||||
| Contingent obligations to issue future equity - SAFE | 1,619,500 | 1,015,000 | ||||||
| Total liabilities | 13,724,314 | 5,560,991 | ||||||
| Commitments and contingencies (Note 5) | - | - | ||||||
| Stockholders' Deficit: | ||||||||
| Common stock; par value of $0.00001 per share; 10,000,000 shares authorized; 6,000,000 shares issued and outstanding as of December 31, 2018 and 2017 | 60 | 60 | ||||||
| Additional paid in capital | 3,984 | - | ||||||
| Accumulated deficit | (1,431,067 | ) | (540,905 | ) | ||||
| Total stockholders' deficit | (1,427,023 | ) | (540,845 | ) | ||||
| Total liabilities and stockholders' deficit | $ | 12,297,291 | $ | 5,020,146 | ||||
See accompanying notes to the consolidated financial statements.
| F-3 |
CNOTE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017
| 2018 | 2017 | |||||||
| Revenues | $ | 275,139 | $ | 55,122 | ||||
| Cost of revenues | 646,162 | 231,276 | ||||||
| Gross loss | (371,023 | ) | (176,154 | ) | ||||
| Operating Expenses: | ||||||||
| General and administrative | 179,157 | 173,042 | ||||||
| Sales and marketing | 170,390 | 61,606 | ||||||
| Research and development | 126,792 | 69,356 | ||||||
| Total operating expenses | 476,339 | 304,004 | ||||||
| Operating loss | (847,362 | ) | (480,158 | ) | ||||
| Other (income) expense: | ||||||||
| Interest expense | 42,000 | 10,500 | ||||||
| Other expense | - | 891 | ||||||
| Other income | - | (8,000 | ) | |||||
| Total other (income) expense | 42,000 | 3,391 | ||||||
| Loss before provision for income taxes | (889,362 | ) | (483,549 | ) | ||||
| Provision for income taxes | 800 | 800 | ||||||
| Net loss | $ | (890,162 | ) | $ | (484,349 | ) | ||
| Weighted average common shares outstanding - basic and diluted | 6,000,000 | 6,000,000 | ||||||
| Basic and diluted net loss per share | $ | (0.15 | ) | $ | (0.08 | ) | ||
See accompanying notes to the consolidated financial statements.
| F-4 |
CNOTE GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT
FOR THE YEARS ENDED DECEMBER 31, 2018
AND 2017
| Common Stock | Additional | Total | ||||||||||||||||||
| Shares | Amount | Paid in Capital | Accumulated Deficit | Stockholders' Deficit | ||||||||||||||||
| January 1, 2017 | 6,000,000 | $ | 60 | $ | - | $ | (56,556 | ) | $ | (56,496 | ) | |||||||||
| Net Loss | - | - | - | (484,349 | ) | (484,349 | ) | |||||||||||||
| December 31, 2017 | 6,000,000 | 60 | - | (540,905 | ) | (540,845 | ) | |||||||||||||
| Stock-based Compensation | - | - | 3,984 | - | 3,984 | |||||||||||||||
| Net Loss | - | - | - | (890,162 | ) | (890,162 | ) | |||||||||||||
| December 31, 2018 | 6,000,000 | $ | 60 | $ | 3,984 | $ | (1,431,067 | ) | $ | (1,427,023 | ) | |||||||||
See accompanying notes to the consolidated financial statements.
| F-5 |
CNOTE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017
| 2018 | 2017 | |||||||
| CASH FLOWS FROM OPERATING ACTIVITIES: | ||||||||
| Net loss | $ | (890,162 | ) | $ | (484,349 | ) | ||
| Adjustments to reconcile loss to net cash used in operating activities: | ||||||||
| Depreciation and amortization | 42,236 | 10,559 | ||||||
| Amortization of offering costs | 42,000 | 10,500 | ||||||
| Stock-based compensation | 3,984 | - | ||||||
| Provision for loan losses | 218,006 | 136,215 | ||||||
| Changes in operating assets and liabilities: | ||||||||
| Accrued interest receivable | (187,765 | ) | (42,647 | ) | ||||
| Accounts payable | (1,681 | ) | (819 | ) | ||||
| Accrued liabilities | 10,748 | (30,701 | ) | |||||
| Interest payable | 185,666 | 41,846 | ||||||
| Net cash used in operating activities | (576,968 | ) | (359,396 | ) | ||||
| CASH FLOWS FROM INVESTING ACTIVITIES: | ||||||||
| Net lendings under loans receivable | (7,266,834 | ) | (4,540,486 | ) | ||||
| Software development costs | (57,855 | ) | (173,511 | ) | ||||
| Net cash used in investing activities | (7,324,689 | ) | (4,713,997 | ) | ||||
| CASH FLOWS FROM FINANCING ACTIVITIES: | ||||||||
| Net borrowings on notes payable | 7,222,090 | 4,396,467 | ||||||
| Payment of notes payable to related parties | - | (15,000 | ) | |||||
| Issuance of convertible note - related party | 100,000 | - | ||||||
| Issuance of Simple Agreements for Future Equity ("SAFEs") | 604,500 | 825,000 | ||||||
| Net cash provided by financing activities | 7,926,590 | 5,206,467 | ||||||
| Increase in cash and cash equivalents | 24,933 | 133,074 | ||||||
| Cash and cash equivalents, beginning of year | 410,276 | 277,202 | ||||||
| Cash and cash equivalents, end of year | $ | 435,209 | $ | 410,276 | ||||
| Supplemental disclosures of cash flow information: | ||||||||
| Cash paid for interest | $ | 15,197 | $ | 1,326 | ||||
| Cash paid for income taxes | $ | 800 | $ | 800 |
See accompanying notes to the consolidated financial statements.
| F-6 |
CNOTE GROUP, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 – NATURE OF OPERATIONS
CNote Group, Inc. was incorporated on April 22, 2016 (“Inception”) in the State of Delaware. The Company’s headquarters are located in Oakland, California. The consolidated financial statements of CNote Group, Inc. (which may be referred to as "CNote", the "Company," "we," "us," or "our") are prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”).
Through its online platform, CNote provides an opportunity for individuals to invest their money by lending it to CNote, which in turn, lends funds to Community Development Financial Institutions (“CDFIs”) dispersed across the United States. CDFIs are banks, credit unions, loan funds, microloan funds or venture capital providers that focus on providing loans to businesses in economically underdeveloped cities and neighborhoods in the United States and, as such, become qualified as a CDFI by the United States Treasury. Once qualified, CDFIs are eligible to be partially funded by the United States Treasury through the CDFI Fund established in 1994.
The Company intends to offer individuals higher rates of return on their investments than is available to them through more traditional low-risk investment vehicles such cash alternatives and fixed income. The Company also intends to earn revenues by earning higher rates of return on its loans to CDFIs than the rates it must pay its individual lenders. The difference, or spread, between the rates CNote earns from its borrowers and the rates it pays to its lenders will constitute the primary component of the Company’s gross profits, before other direct costs of revenues such as web site costs and customer support costs, and operating expenses.
In December 2018, the Company formed a wholly owned subsidiary CNote Lending, LLC, for the purpose of holding a California Finance Lenders license pursuant to the California Financing Law and to make loans to CDFIs. CNote Lending, LLC is in the process of filing for a California Finance Lenders license. To date, the subsidiary has no operations.
The Company is still in the very early stages of developing its business. Accordingly, risks associated with startup, early stage companies apply to the Company. Such risks include, but are not limited to, the need to raise additional funding, the need to generate additional revenues, the need to develop ongoing relationships with additional lenders and borrowers, the need to hire skilled employees, the need to comply with regulatory requirements, and the need to achieve profitability and sustainability.
Management Plans and Going Concern
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.
To date, the Company has not generated significant revenues from principal operations and has not yet proved the viability of its business model. Because losses will continue until such time that profitable operations can be achieved, the Company is reliant on financing to support operations. These factors, among others, raise substantial doubt about the ability of the Company to continue as a going concern within one year after the date that the consolidated financial statements are issued.
During the next 12 months, the Company intends to fund its operations through the sale of equity and/or debt securities to third parties and related parties, as well as through increased operating revenues. If the Company cannot raise additional short-term capital, it may consume all of its cash reserved for operations. There are no assurances that management will be able to raise capital on terms acceptable to the Company or increase revenues and margins sufficiently to sustain operations. If the Company is unable to obtain sufficient amounts of additional capital, it may be required to reduce the scope of planned operations, which could harm the business, financial condition and operating results. The consolidated financial statements do not include any adjustments that might result from these uncertainties.
| F-7 |
NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, and the reported amount of revenues and expenses during the reporting period. Actual results could materially differ from these estimates.
Significant estimates include but are not limited to the valuation of SAFEs and convertible promissory notes, loan loss reserves, and the valuation allowance related to deferred tax assets. It is reasonably possible that changes in estimates will occur in the near term.
Cash and Cash Equivalents
The Company maintains its cash with a major financial institution located in the United States of America which it believes to be creditworthy. Balances are insured by the Federal Deposit Insurance Corporation up to $250,000. At times, the Company may maintain balances in excess of the federally insured limits.
Cash equivalents include all highly liquid debt instruments purchased with an original maturity of three months or less.
Fair Value of Financial Instruments
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants as of the measurement date. Applicable accounting guidance provides an established hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in valuing the asset or liability and are developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the factors that market participants would use in valuing the asset or liability. There are three levels of inputs that may be used to measure fair value:
Level 1 – Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2 – Include other inputs that are directly or indirectly observable in the marketplace.
Level 3 – Unobservable inputs which are supported by little or no market activity.
The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.
Fair-value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of December 31, 2018 and 2017. The respective carrying value of all financial instruments approximated their fair values. These financial instruments include SAFEs, convertible promissory notes (“convertible notes”), loans receivable and notes payable and interest receivable and payable.
The SAFEs are considered a level 3 liability as there are no observable direct or indirect inputs. Based on management’s estimates as of December 31, 2018 and 2017, the fair value of these instruments is considered to be the carrying value. Management’s estimates are based on the short duration of the outstanding SAFEs, the fact that market circumstances have not changed materially since the instruments were originated, and that the Company has continuously issued additional SAFEs to third parties with materially the same terms and features. Accordingly, there has been no change in valuation during the periods presented.
| F-8 |
Loans Receivable and Notes Payable
Management expects that the terms of the Company’s loans receivable and notes payable used to fund the loans receivable typically will be 30 months based on the current operating structure. In the normal course of business, the Company expects to hold such instruments to maturity. However, provisions within the terms of these instruments allow for liquidity on demand of 10% per quarter. Accordingly, should the need arise, 40% of loans receivable and notes payable can be due on demand within one year, and therefore the Company has classified its loans receivable and notes payable as available for sale with the due on demand portion considered short-term.
Deferred Offering Costs
The Company accounts for offering costs in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 340, Other Assets and Deferred Costs. Prior to the completion of an offering, offering costs will be capitalized as deferred offering costs on the consolidated balance sheet. The deferred offering costs will be netted against the debt offering proceeds upon the completion of an offering or to expense if the offering is not completed. As of December 31, 2017, $104,995 offering costs were incurred related to the Company’s Regulation A offering. As of December 31, 2017, all deferred offering costs were recorded as a discount to notes payable from the Regulation A offering and are being amortized over 30 months, which is the life of the initial notes payable under the offering. As of December 31, 2018, $52,500 of the debt discount has been amortized and recorded as interest expense in the accompanying consolidated statements of operations and $52,495 remains to be amortized over the next 15 months on a straight-line basis.
Internal Use Software
The Company has incurred software development costs to develop software programs to be used solely to meet its internal needs and cloud-based applications used to deliver services. In accordance with ASC 350-40, Internal-Use Software, the Company has capitalized development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed, the software will be used to perform the function intended, and the value will be recoverable. Reengineering costs, minor modifications and enhancements that do not significantly improve the overall functionality of the software are expensed as incurred. During 2017, the Company commenced capitalization of internal software. Software development capitalized during 2017 totaled $173,511 of which $126,709 was for an initial release of software. The Company is amortizing the initial release of the software based on the in-service date over 36 months on a straight-line basis. Software development costs totaling $57,855 for not yet released programs and applications were capitalized in 2018. Amortization of capitalized software development costs recorded to expense was $42,236 and $10,559 for the years ended December 31, 2018 and 2017, respectively. Accumulated amortization as of December 31, 2018 and 2017 was $52,795 and 10,559, respectively.
Simple Agreements for Future Equity (“SAFEs”)
The Company has issued several Simple Agreements for Future Equity “SAFEs” in exchange for cash financing. These funds have been classified as long-term liabilities. (See Note 4.)
The Company has accounted for its SAFE investments as liability derivatives under the FASB’s ASC section 815-40 and ASC section 815-10. If any changes in the fair value of the SAFEs occur, the Company will record such changes through earnings, under the guidance prescribed by ASC 825-10. As of December 31, 2018 and 2017, the fair values of the SAFEs are equal to their face amounts that are the amounts of initial investment, as evidenced by the SAFE amounts being transacted in arm’s length transactions with unrelated parties.
Convertible Promissory Notes (“convertible notes”)
The Company reviews the terms of convertible debt and equity instruments it issues to determine whether there are derivative financial instruments, including an embedded conversion option that is required to be bifurcated and accounted for separately as a derivative financial instrument. In circumstances where a host instrument contains more than one embedded derivative instrument, including a conversion option, that is required to be bifurcated, the bifurcated derivative instruments are accounted for as a single, compound derivative instrument.
| F-9 |
When the Company has determined that the embedded conversion options should not be bifurcated from their host instruments, the Company records, when necessary, discounts to the convertible notes for the intrinsic value of conversion options embedded in debt instruments based upon the differences between the fair value of the underlying common stock at the commitment date of the note transaction and the effective conversion price embedded in the note. Debt discounts under these arrangements are amortized over the term of the related debt to their stated date of redemption.
The Company has determined that the terms of the convertible notes do not require bifurcation as discussed above. The Company determined that these notes may contain a beneficial conversion feature contingent upon a future event due to the discounted conversion provisions. Following FASB ASC 470-20, the Company determined the intrinsic value of the conversion features on these convertible notes based on the issuance date fair value of the Company’s stock and the discounted conversion features. In accordance with FASB ASC 470-20, a contingent beneficial conversion feature in an instrument that becomes convertible only upon the occurrence of a future event outside the control of the holder is not recognized in earnings until the contingency is resolved. Therefore, these beneficial conversion features were not recorded as note discounts at the issuance dates of the notes, but rather will be recognized upon the occurrence of the contingent event. (See Note 4.) The convertible notes are recorded as long-term liabilities at their face value, which is equivalent to the proceeds received for issuance.
Stock Options and Warrants
The Company has issued stock options and warrants to employees and to key advisors as compensation for services performed. The Company has accounted for these awards under ASC section 718 and Accounting Standards Update (“ASU”) 2018-07. The options and warrants and the services received were recorded at the fair value of the options and warrants at their grant dates, using an established options pricing model. (See Note 8.)
Revenue Recognition and Cost of Revenues
CNote uses the money it borrows from individuals to loan money to CDFIs. The Company earns interest on its loans to CDFIs, which are currently the primary source of its revenues. All such loans to CDFIs are governed by signed contracts between the Company and the CDFI borrowers. Interest income is recorded based on the terms of the master promissory agreement with each CDFI. The interest is accrued monthly. If ninety (90) days pass without the interest being paid in accordance with normal disbursement practices per the agreement, then the Company will cease recording revenue until such time that the interest is collected.
CNote borrows money from individuals through the Company’s online platform. The Company must pay interest on the borrowings to its lenders. All such loans are governed by signed contracts between the Company and individual lenders. The interest, which accrues according to the agreements governing terms of the loans from individual lenders, constitutes the major portion of the Company’s direct cost of revenues. Other direct costs of revenues include costs of operating the online platform, provision for loan loss reserves and amortization of development costs of internal use software.
Loan Loss Reserve
The Company establishes a reserve of three (3) percent for potential losses to all new loans extended to CDFIs. The amount of the loan loss reserve was determined based on industry norms and trends and will be updated periodically once a history of loan losses sufficient to reasonably modify the estimate of future loan losses has been established.
Reversals to the loan loss reserve will happen only when the loans mature. If no loss has occurred on a particular loan, the loss reserve will be reversed and recognized as other income at maturity of the loan. On the other hand, if any loan becomes completely unrecoverable, the entire amount of the loan will be written off, with a charge to bad debt expense, when and if facts and circumstances indicate that such a write off is necessary.
| F-10 |
Research and Development
The Company incurs research and development costs during the process of researching and developing new technologies and future online offerings. Such costs are expensed as incurred.
Advertising
The Company expenses the cost of advertising and promotions as incurred. Advertising costs expensed were $23,897 and $1,041 for the years ended December 31, 2018 and 2017, respectively.
Income Taxes
The Company applies ASC section 740. Deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial statement reported amounts at each period end, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. The provision for income taxes represents the tax expense for the period, if any, and the change during the period in deferred tax assets and liabilities. At December 31, 2018 and 2017, the Company has established a full reserve against all deferred tax assets.
ASC 740 also provides criteria for the recognition, measurement, presentation and disclosure of uncertain tax positions. A tax benefit from an uncertain position is recognized only if it is “more likely than not” that the position is sustainable upon examination by the relevant taxing authority based on its technical merit.
Loss per Common and Common Equivalent Share
The computation of basic earnings per common share is computed using the weighted average number of common shares outstanding during the year. The computation of diluted earnings per common share is based on the weighted average number of shares outstanding during the year plus Common Stock equivalents which would arise from the exercise of securities outstanding using the treasury stock method and the average market price per share during the year. There are no Common Stock equivalents included in the diluted earnings per share calculation for the periods ended December 31, 2018 and 2017. In addition, any such Common Stock equivalents in periods where losses are incurred would be excluded as they are anti-dilutive. The Common Stock equivalents excluded from diluted earnings per share total 431,250 and 0 share equivalents as of December 31, 2018 and 2017, respectively.
Concentration of Credit Risk
During the early stages of the Company’s development, it is to be expected that the Company will extend loans to a relatively low number of CDFIs. For example, as of December 31, 2018, CNote has extended loans to seven CDFIs. When the Company extends loans to a low number of borrowers, this results in a concentration of credit risk, wherein each CDFI borrower represents a relatively high risk, as compared with the relatively low risk that each individual borrower would constitute if the Company had loans outstanding with many CDFI borrowers.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of CNote Group, Inc., and its wholly owned subsidiary, CNote Lending, LLC. All intercompany accounts and transactions have been eliminated in consolidation.
Reclassifications
Certain amounts in the Statement of Consolidated Cash Flows have been reclassified for the year ended December 31, 2017 to conform with the presentation for the year ended December 31, 2018.
Recent Accounting Pronouncements
In August 2018, the FASB issued ASU No. 2018-13, “Fair Value Measurement (Topic 820) Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement”, which modifies the disclosure requirements on fair value measurement. The amendments are effective for all entities for fiscal years beginning after December 31, 2019. Early adoption is permitted. The Company does not expect the adoption of this standard to materially affect the Company’s consolidated financial statements.
| F-11 |
In July 2017, the FASB issued ASU No. 2017-11, I “Accounting for Certain Financial Instruments with Down Round Features” and II “Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception”. The amendments in Part I of this Update change the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features. As a result, a freestanding equity-linked financial instrument (or embedded conversion option) no longer would be accounted for as a derivative liability at fair value as a result of the existence of a down round feature. The amendments in Part II of this Update recharacterize the indefinite deferral of certain provisions of Topic 480 that now are presented as pending content in the Codification, to a scope exception. Those amendments do not have an accounting effect. The ASU is effective for private business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted. The Company does not expect this update to materially affect the Company’s consolidated financial statements.
In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)”, which significantly changes the accounting for operating leases by lessees. The accounting applied by lessors is largely unchanged from that applied under previous guidance. The new guidance requires lessees to recognize lease assets and lease liabilities in the balance sheet, initially measured at the present value of the lease payments, for leases which were classified as operating leases under previous guidance. Lease cost included in the statement of income will be calculated so that the cost of the lease is allocated over the lease term, generally on a straight-line basis. Lessees may make an accounting policy election to exclude leases with a term of 12 months or less from the requirement to record related assets and liabilities. The new standard is effective for public companies for fiscal years beginning after December 15, 2018 and for non-public entities after December 15, 2019. The Company plans to adopt the new standard effective for periods after December 31, 2018. The Company does not expect the adoption of this standard to have a material impact on its results of operations or cash flows.
The Financial Accounting Standards Board issues Accounting Standard Updates to amend the authoritative literature in ASC. There have been a number of ASUs to date that amend the original text of ASC. The Company believes those issued to date either (i) provide supplemental guidance, (ii) are technical corrections, (iii) are not applicable to the Company or (iv) are not expected to have a significant impact on the Company.
NOTE 3 – LOANS RECEIVABLE AND INTEREST RECEIVABLE
Loans receivable represent the principal amounts of outstanding loans the Company has made to CDFIs, less loan loss reserves as described below. Interest receivable represents the outstanding interest due from CDFI borrowers.
As of December 31, 2018, the Company has outstanding loans to seven CDFI borrowers totaling $11,807,320. Under terms of the respective master promissory notes, the loans earn interest at rates ranging from 3.0% to 3.7% per annum. The loans mature in 30 months and may be prepaid by the borrower at any time without penalty. The Company has the option to request repayment of 10% of the original loan amount on a quarterly basis. These requests are based on the requests of note payable holders disclosed in Note 4. As a result, the Company has classified 40% of the loan balance with 13 to 30 months remaining term as a current asset on its consolidated balance sheet.
During the year ended December 31, 2018, the Company was repaid approximately $1,091,000 on the principal of loans receivables which were used to repay notes payable.
As of December 31, 2017, the Company had outstanding Loans to two CDFI borrowers totaling $4,540,487. During the year ended December 31, 2017, the Company was repaid approximately $181,000 on the principal of loans receivables which were used to repay notes payable.
| F-12 |
As described in Note 2, the Company has recorded a provision for loan losses equal to 3% of the gross loans outstanding. The loan loss reserve, which has been netted against the long-term portion of loans receivable, totaled $354,221 and $136,215 as of December 31, 2018 and 2017, respectively.
NOTE 4 – NOTES PAYABLE, INTEREST PAYABLE AND LONG-TERM LIABILITIES
Notes Payable
Notes payable represent the principal amounts of outstanding borrowings from individuals. Interest payable represents the outstanding interest the Company owes to the individual note holders. Notes payable from individuals are not a source of financing the Company’s operations; rather, they are used to fund CDFI loans receivable (Note 3).
As of December 31, 2018, notes payable totaled $11,803,552. Notes mature in 30 months and earn interest at the rate of 2.5-2.75% per annum although the interest rate may be higher in the event a note holder provides stipulated new referral business to the Company. Additionally, the interest rate may be adjusted to the extent rates earned from loans to CDFIs vary in the future. Notes issued under Regulation D ($7,915,190 at December 31, 2018) may be rolled over for additional 30-month terms at the option of the holder. Notes provide the holder an option to call 10% of the original note balance each quarter. As a result, the Company has classified 40% of notes payable with contractual maturities of 13-30 months as a current liability on its accompanying consolidated balance sheets. As of December 31, 2018, a total of $25,000 of notes are due from related parties subject to the same terms.
As of December 31, 2017, notes payable totaled $4,581,463, of which $25,000 was due to related parties. Of the total due to related parties, $10,000 was shown as current due to the provisions described above.
As of December 31, 2018, notes payable mature as follows:
| Year Ending December 31, | ||||
| 2019 | $ | 1,636,780 | ||
| 2020 | 5,629,107 | |||
| 2021 | 4,537,665 | |||
| Total | $ | 11,803,552 | ||
SAFEs
As of December 31, 2018, the Company has raised $1,619,500 via the issuance of SAFEs.
Under the SAFEs, the funds contributed by the investors will convert to shares of preferred stock in a priced preferred stock financing round, at a conversion price per share equal to the lesser of:
| a. | the price per share of the newly issued preferred stock multiplied by the Discount Rate; or |
| b. | the Valuation Cap, as defined by the various agreements and described below, divided by the number of shares and potential shares of Common Stock, on a fully diluted basis, outstanding immediately prior to the preferred stock financing. |
The SAFE terms vary (discount rate varies from 0% to 20%, and the Valuation Cap varies from $4,000,000 to $8,000,000). While the SAFEs remain outstanding, each SAFE holder will have the option of receiving his or her cash investment amount returned or receiving the number of shares of Common Stock purchased with his or her SAFE investment amount at the same price at which other shares of Common Stock are sold in a change of control.
If the Company dissolves or ceases operations, the SAFE holders, as a class, will have a preferential right to receive cash, up to the amount of their original investments, to the extent such funds are available to be paid, unless a SAFE holder notifies that the Company that he or she elects to receive shares of Common Stock purchased with his or her SAFE investment amount. Cash payments to SAFE investors in this situation would hold a preferential position to payments to the holders of Common Stock.
| F-13 |
For one particular SAFE, if the SAFE has not been converted to shares of Preferred Stock after four years, that SAFE holder shall have the option of converting his SAFE investment to shares of Common Stock by purchasing the number of shares of Common Stock with his SAFE investment amount at a price equal to the Valuation Cap divided by the number of shares of stock and potential shares of stock, on a fully diluted basis, outstanding immediately prior to the conversion.
As of December 31, 2018, there has not been any priced round of preferred stock financing that would trigger a conversion of the SAFE funds to preferred stock. The SAFEs are marked-to-market each reporting period as described in Note 2. As of December 31, 2018 and 2017, management has determined that the carrying value is considered the fair value as the Company has continued to sell the SAFEs with consistent terms during 2018.
Convertible Notes
As of December 31, 2018, the Company has issued one convertible note to a related party in exchange for cash financing in the amount of $100,000. The note bears interest at a rate of four percent per annum, and matures December 18, 2020.
This note contains both optional and automatic conversion features. Automatic conversion can be triggered upon a Qualified Financing, defined as a transaction or series of transactions in which the Company sells shares of equity securities to investors resulting in not less than $1,000,000 in proceeds to the Company, excluding the effects of conversion of Convertible Instruments as defined in the convertible notes. Upon such event, the then outstanding principal amount and interest amount of the convertible note and shall convert into Equity Securities sold in the Qualified Financing at a conversion price equal to the lesser of (i) the cash price paid per share for Equity Securities by the Investors in the Qualified Financing (excluding any discount in connection with the conversion of any Convertible Instruments) multiplied by the Conversion Rate as defined in the convertible note, and (ii) the per share price equal to the quotient resulting from dividing the Valuation Cap as defined in the convertible note by the number of Fully Diluted Shares as defined in the convertible note.
If the Company issues and sells Equity Securities in an event that does not qualify as a Qualified Financing, then upon the election of the Majority Holders of the convertible notes, the outstanding principal and interest of the convertible notes shall convert under the terms described above.
If a Change of Control as defined by the terms of the convertible notes occurs while the convertible notes are outstanding, the Company shall repay the Holder from the proceeds of the Change of Control according to the terms of the convertible notes.
No convertible notes were issued in 2017.
NOTE 5 – COMMITMENTS AND CONTINGENCIES
Litigation
The Company is not currently involved with, and does not know of any pending or threatening litigation against the Company or any of its officers.
NOTE 6 – INCOME TAXES
The Tax Cuts and Jobs Act, or TCJA, reduced the U.S. maximum federal corporate income tax rate from 35% to 21%. As a result, carryforwards have been recalculated to recognize the effect of future rates on deferred tax assets and liabilities recorded in 2016 and prior years. This resulted in a reduction in the deferred tax asset of approximately $16,000 in 2017, with a corresponding decrease in the valuation allowance in the same amount, for zero net impact on the consolidated financial statements.
| F-14 |
The following table presents the current and deferred tax provision for federal and state income taxes for the years ended December 31, 2018, and 2017:
| 2018 | 2017 | |||||||
| Current tax provision | ||||||||
| Federal | $ | - | $ | - | ||||
| State | 800 | 800 | ||||||
| Total | $ | 800 | $ | 800 | ||||
| Deferred tax provision (benefit) | ||||||||
| Federal | $ | (196,000 | ) | $ | (85,000 | ) | ||
| State | (82,000 | ) | (41,000 | ) | ||||
| Valuation allowance | 278,000 | 126,000 | ||||||
| Total | - | - | ||||||
| Total provision for income taxes | $ | 800 | $ | 800 | ||||
In assessing the potential realization of these deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the Company attaining future taxable income during the periods in which those temporary differences become deductible. As of December 31, 2018 and 2017, management was unable to determine if it is more likely than not that the Company’s deferred tax assets will be realized, and has therefore recorded an appropriate valuation allowance against deferred tax assets at such dates.
The components of our deferred tax assets (liabilities) for federal and state income taxes consisted of the following as of December 31, 2018 and 2017:
| 2018 | 2017 | |||||||
| Deferred tax asset attributable to: | ||||||||
| Net operating loss carryover | $ | 329,000 | $ | 145,000 | ||||
| Temporary differences | 97,000 | 3,000 | ||||||
| Valuation allowance | (426,000 | ) | (148,000 | ) | ||||
| Net deferred tax asset | $ | - | $ | - | ||||
The valuation allowance for deferred tax assets increased to $426,000 and $148,000 during the years ended December 31, 2018 and 2017, respectively.
Based on federal tax returns filed, or to be filed, through December 31, 2018, the Company has available approximately $1,103,000 in U.S. tax net operating loss carryforwards, pursuant to the Tax Reform Act of 1986, which assesses the utilization of a Company’s net operating loss carryforwards resulting from retaining continuity of its business operations and changes within its ownership structure. Net operating loss carryforwards start to expire in 2036 or 20 years for federal income and state tax reporting purposes.
The Company is subject to tax in the United States (“U.S.”) and files tax returns in the U.S. Federal jurisdiction and California state jurisdiction. The Company is subject to U.S. Federal, state and local income tax examinations by tax authorities starting in 2016. The Company currently is not under examination by any tax authority.
| F-15 |
NOTE 7 – RELATED PARTY TRANSACTIONS
As of December 31, 2018, $25,000 of the individual notes payable are due to Company’s two co-founders and two close relatives of one of the co-founders, and $100,000 of convertible notes payable are due to a close relative of a key member of management. See Note 4 for terms.
NOTE 8 – STOCKHOLDERS’ DEFICIT
Common Stock
The Company is authorized to issue 10,000,000 shares of Common Stock, each having a par value of $0.00001. Upon Inception, and shortly after Inception, 6,000,000 shares of Common Stock were issued to the Company’s two co-founders. As of December 31, 2018 and 2017, 6,000,000 shares of Common Stock are issued and outstanding, all of which are held by the Company two co-founders who remain active in the daily operations of the Company.
Stock Options
In 2018, the Company’s Board of Directors adopted the CNote Group, Inc. 2018 Equity Incentive Plan (the “2018 Equity Incentive Plan”). The 2018 Equity Incentive Plan provides for the grant of equity awards to employees, and consultants, including stock options, stock appreciation rights and other stock or cash-based awards. Up to 1,500,000 shares of our Common Stock may be issued pursuant to awards granted under the 2018 Equity Incentive Plan. The 2018 Equity Incentive Plan is administered by our Board of Directors, has no fixed expiration date, and may be amended, suspended, or terminated by the Board at any time.
In 2018, the Company granted 412,500 stock options under the 2018 Equity Incentive Plan to various advisors and employees. The granted options had an exercise price of $0.04, expire in ten years from the date of the grant, and ranged from 100% immediate vesting to vesting over a four-year period. The stock options were valued at a total grant date fair value of $8,250 using the Black-Scholes pricing model as indicated below:
| December 31, 2018 | ||
| Expected life (range) | 5.0-5.8 years | |
| Risk-free interest rate (range) | 2.8-2.9% | |
| Expected volatility | 56.8% | |
| Annual dividend yield | 0% |
The expected term of employee stock options is calculated using the simplified method which takes into consideration the contractual life and vesting terms of the options.
The risk-free interest rate assumption for options granted is based upon observed interest rates on the United States government securities appropriate for the expected term of the Company's employee stock options.
The Company determined the expected volatility assumption for options granted using the historical volatility of comparable public companies’ common stock. The Company will continue to monitor peer companies and other relevant factors used to measure expected volatility for future stock option grants, until such time that the Company’s Common Stock has enough market history to use historical volatility.
The dividend yield assumption for options granted is based on the Company's history and expectation of dividend payouts. The Company has never declared or paid any cash dividends on its Common Stock, and the Company does not anticipate paying any cash dividends in the foreseeable future.
Management estimated the fair value of Common Stock by looking at a market approach which takes into consideration the value of development to date and subscriber base.
| F-16 |
Stock Purchase Warrants
In 2018, the Company granted to an advisor a Common Stock Purchase Warrant for the purchase of 18,750 shares at a purchase price of $0.04 per share. The term of the warrant was ten years. The warrant was valued at a total grant date fair value of $375 using the Black-Scholes pricing model as indicated below.
| December 31, 2018 | ||
| Expected life (years) | 5.0 | |
| Risk-free interest rate | 2.9% | |
| Expected volatility | 56.8% | |
| Annual dividend yield | 0% |
The expected term, risk-free interest rate, expected volatility, and dividend yield assumptions used in pricing the warrants granted were derived as described above for options granted.
No stock-based awards were issued in the year ended December 31, 2017.
Share-Based Awards Available for Grant
A summary of share-based awards available for grant under our 2018 Equity Incentive Plan for the year ended December 31, 2018 was as follows:
| Shares Available for Grant | ||||
| Authorized at inception of plan | 1,500,000 | |||
| Options granted | (412,500 | ) | ||
| Balance at December 31, 2018 | 1,087,500 | |||
Stock Option Activity and Related Share-Based Compensation Expense
A summary of stock option activity for the year ended December 31, 2018 was as follows:
| Options Outstanding | ||||||||||||
Number of Shares | Weighted Average Exercise Price Per Share | Weighted Average Remaining Contractual Life (in Years) | ||||||||||
| Balance at December 31, 2017 | - | $ | - | - | ||||||||
| Granted | 412,500 | 0.04 | 10.0 | |||||||||
| Exercised | - | - | - | |||||||||
| Canceled or expired | - | - | - | |||||||||
| Balance at December 31, 2018 | 412,500 | $ | 0.04 | 9.5 | ||||||||
At December 31, 2018, options for the purchase of 180,473 shares at a weighted average price of $0.04 per share were vested and exercisable.
Expense for the issuance of stock options and warrants for the years ended December 31, 2018 and 2017 was $3,984 and $0, respectively.
| F-17 |
The Company will recognize the remaining value of the options and warrants through 2021 as follows:
| 2019 | $ | 1,875 | ||
| 2020 | 1,672 | |||
| 2021 | 1,093 | |||
| $ | 4,640 |
The Company recognizes stock option forfeitures as the occur, as there is insufficient historical data to accurately determine future forfeiture rates.
NOTE 9 – SUBSEQUENT EVENTS
Subsequent to December 31, 2018, the Company issued several additional convertible notes in exchange for $637,000 of cash financing. Thus, the total amount of cash financing from convertible note investors totals $737,000 through the date of these consolidated financial statements. The new convertible notes have terms similar to the convertible note issued prior to December 31, 2018 as disclosed in Note 4.
Subsequent to December 31, 2018, Common Stock purchase warrants for the purchase of 18,750 common shares at a purchase price of $0.04 per share were exercised by the warrant holder.
Effective April 15, 2019, the Company has granted incentive stock options for the purchase of 11,250 shares of Common Stock at a purchase price of $0.04 per share. These options will vest over a four-year period and will expire in ten years.
The Company has evaluated subsequent events that occurred after December 31, 2018 through April 30, 2019, the issuance date of these consolidated financial statements. There have been no other events or transactions during this time which would have a material effect on these consolidated financial statements, other than those disclosed.
| F-18 |
| Item 8. | EXHIBITS |
| Exhibit Number | Description | Incorporated by Reference | |
| 2.1 | Certificate of Incorporation. | Exhibit 2.1 to Offering Statement filed March 22, 2017 (File no. 024-10686) | |
| 2.2 | Bylaws. | Exhibit 2.2 to Offering Statement filed March 22, 2017 (File no. 024-10686) | |
| 3.1 | Form of CNote Note. | Exhibit 3.1 to Offering Statement filed March 22, 2017 (File no. 024-10686) | |
| 3.2 | Form of SAFE. | Exhibit 3.2 to Offering Statement filed May 31, 2017 (File no. 024-10686) | |
| 3.3 | Form of Convertible Note | ||
| 4.1 | Form of Subscription Agreement. | Exhibit 4.1 to Offering Statement filed March 22, 2017 (File no. 024-10686) | |
| 6.1 | Form of Master Promissory Note. | Exhibit 15.1 to Offering Statement filed March 22, 2017 (File no. 024-10686) |
| 14 |
Pursuant to the requirements of Regulation A, the issuer has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized authorized in the City of Oakland, State of California, on the 30th day of April, 2019.
| CNOTE GROUP, INC. By: /s/ Catherine Berman Name: Catherine Berman Title: President and Chief Executive Officer |
Pursuant to the requirements of Regulation A, this report has been signed below by the following persons on behalf of the issuer and in the capacities and on the dates indicated.
| Name and Signature | Title | Date | ||
| /s/ Catherine Berman | President, Chief Executive Officer, | April 30, 2019 | ||
| Catherine Berman | Co-Founder, Director, Principal Executive Officer | |||
| /s/ Yuliya Tarasava |
Chief Operating Officer, Co-Founder, Treasurer, Secretary, Director, Principal Financial and |
April 30, 2019 | ||
| Yuliya Tarasava |
Accounting Officer |
15
Exhibit 3.3
THIS NOTE AND THE SECURITIES ISSUABLE UPON THE CONVERSION HEREOF HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE “ACT”), OR UNDER THE SECURITIES LAWS OF ANY STATES IN THE UNITED STATES. THESE SECURITIES ARE SUBJECT TO RESTRICTIONS ON TRANSFERABILITY AND RESALE AND MAY NOT BE TRANSFERRED OR RESOLD EXCEPT AS PERMITTED UNDER THE ACT AND THE APPLICABLE STATE SECURITIES LAWS, PURSUANT TO REGISTRATION OR EXEMPTION THEREFROM. THE ISSUER OF THESE SECURITIES MAY REQUIRE AN OPINION OF COUNSEL IN FORM AND SUBSTANCE SATISFACTORY TO THE ISSUER TO THE EFFECT THAT ANY PROPOSED TRANSFER OR RESALE IS IN COMPLIANCE WITH THE ACT AND ANY APPLICABLE STATE SECURITIES LAWS.
CNOTE GROUP, INC.
CONVERTIBLE PROMISSORY NOTE
| Note Series: | |
| Date of Note: | |
| Principal Amount of Note: | $ |
For value received, CNote Group, Inc., a Delaware corporation (the “Company”), promises to pay to the undersigned holder or such party’s assigns (the “Holder”) the principal amount set forth above with interest on the outstanding principal amount at the rate of four percent (4%) per annum. Interest shall commence with the date hereof and shall continue on the outstanding principal amount until paid in full or converted. Interest shall be computed on the basis of a year of 365 days for the actual number of days elapsed. All unpaid interest and principal shall be due and payable upon request of the Majority Holders (as defined below) on or after the two (2) year anniversary of the date hereof (the “Maturity Date”). If any interest payment due hereunder is determined to be in excess of the legal maximum rate, then that portion of each interest payment representing an amount in excess of the then legal maximum rate shall instead be deemed a payment of principal and shall be applied against the principal of this Convertible Promissory Note (this “Note”).
| 1. | Basic Terms. |
(a) Series of Notes. This Note is issued as part of a series of notes designated by the Note Series above (collectively, the “Notes”) and issued in a series of multiple closings in an aggregate principal amount of two million dollars ($2,000,000) (the “Offering Amount”) to certain persons and entities (collectively, the “Holders”); provided that, in the event that investor interest in the Notes exceeds the Offering Amount, the Company may increase the Offering Amount up to an aggregate principal amount not to exceed three million dollars ($3,000,000) without the need to notify or obtain the consent of the Holder or the Majority Holders (as defined below). The Company shall maintain a ledger of all Holders in the form attached as Exhibit A which shall be amended to reflect each Note issued and the Company shall deliver to each existing Holder on the date any new Note is issued an amended Exhibit A reflecting each such additional Note and such amended Exhibit A shall become a part of this Note replacing the prior Exhibit A.
(b) Payments. All payments of interest and principal shall be in lawful money of the United States of America and shall be made pro-rata among all Holders. All payments shall be applied first to accrued interest, and thereafter to principal.
(c) Prepayment. The Company may not prepay this Note prior to the Maturity Date without the consent of the Holders of Notes representing a majority of the outstanding unpaid principal amount of the Notes (the “Majority Holders”).
| 2. | Conversion and Repayment. |
(a) Conversion upon a Qualified Financing. In the event that, on or prior to the Maturity Date, the Company issues and sells shares of its equity securities (“Equity Securities”) to investors (the “Investors”) for capital raising purposes in a transaction or series of related transactions resulting in total gross proceeds to the Company of not less than $1,000,000 (excluding the conversion of the Notes, other indebtedness and/or other convertible securities (e.g., Simple Agreements for Future Equity) (collectively, “Convertible Instruments”)) (such transaction, a “Qualified Financing”), then the outstanding principal amount of this Note and any unpaid accrued interest thereon shall automatically convert in whole without any further action by the Holder into Equity Securities sold in the Qualified Financing at a conversion price equal to the lesser of (i) the cash price paid per share for Equity Securities by the Investors in the Qualified Financing (excluding any discount in connection with the conversion of any Convertible Instruments) multiplied by the Conversion Rate (as defined below), and (ii) the per share price equal to the quotient resulting from dividing the Valuation Cap (as defined below) by the number of Fully Diluted Shares (as defined below) calculated in good faith by the Company’s Board of Directors (the “Board”) as of immediately prior to the conversion of the Note and subject to the approval of the Majority Holders. The issuance of Equity Securities pursuant to the conversion of this Note shall be upon and subject to the same terms and conditions applicable to Equity Securities sold in the Qualified Financing. In the event of a Qualified Financing after the Maturity Date, upon the election of the Majority Holders the outstanding principal amount of this Note and any unpaid accrued interest thereon shall convert upon the same terms set forth in this Section 2(a) as would apply on or prior to the Maturity Date.
For purposes of this Note, “Conversion Rate” shall mean eighty percent (80%), and “Valuation Cap” shall mean ten million dollars ($10,000,000).
(b) Optional Conversion upon a non-Qualified Financing. In the event the Company issues and sells Equity Securities to Investors in a bona fide third party financing that does not qualify as a Qualified Financing (a “Non-Qualified Financing”), then upon the election of the Majority Holders the outstanding principal amount of this Note and any unpaid accrued interest thereon shall convert in whole without any further action by the Holder into such Equity Securities sold in the Non-Qualified Financing using the same methodology set forth in Section 2(a) above.
(c) Treatment upon Maturity Date. In the event that this Note remains outstanding on the Maturity Date, then upon the election of the Majority Holders:
(i) the outstanding principal amount of this Note any unpaid accrued interest thereon shall be repaid by the Company in full;
(ii) the Maturity Date shall be extended; or
(iii) the Holder shall continue to hold the Note without extending the Maturity Date (in which case interest shall continue to accrue thereon).
(d) Change of Control. If a Change of Control occurs (as defined below) while this Note remains outstanding, then upon the election of the Majority Holders the Company shall repay the Holder from the proceeds of the Change of Control an amount in cash equal to the greater of (i) the outstanding principal amount of this Note plus any unpaid accrued interest on the original principal, and (ii) the amount the Holder would receive upon the conversion of the outstanding principal balance of this Note and any unpaid accrued interest into shares of the Company’s common stock (“Common Stock”) at a conversion price equal to the quotient resulting from dividing the Valuation Cap by the number of Fully Diluted Shares.
| 2 |
For purposes of this Note, a “Change of Control” means (i) a consolidation or merger of the Company with or into any other corporation or other entity or person, or any other corporate reorganization, other than any such consolidation, merger or reorganization in which the shares of capital stock of the Company immediately prior to such consolidation, merger or reorganization continue to represent a majority of the voting power of the surviving entity immediately after such consolidation, merger or reorganization; (ii) any transaction or series of related transactions in which in excess of 50% of the Company’s voting power is transferred; or (iii) the sale or transfer of all or substantially all of the Company’s assets, or the exclusive license of all or substantially all of the Company’s material intellectual property. The Company shall give the Holder notice of a Change of Control not less than 10 days prior to the anticipated date of consummation of the Change of Control. Any repayment pursuant to this paragraph in connection with a Change of Control shall be subject to any required tax withholdings.
(e) Procedure for Conversion. In connection with any conversion of this Note into capital stock, the Holder shall surrender this Note to the Company and deliver to the Company any documentation reasonably required by the Company (including, in the case of a Qualified Financing, all financing documents executed by the Investors in connection with such Qualified Financing). The Company shall not be required to issue or deliver the capital stock into which this Note may convert until the Holder has surrendered this Note to the Company and delivered to the Company any such documentation. Upon the conversion of this Note into capital stock pursuant to the terms hereof, in lieu of any fractional shares to which the Holder would otherwise be entitled, the Company shall pay the Holder cash equal to such fraction multiplied by the price at which this Note converts. The Company shall take whatever actions may be required to create the securities into which this Note is convertible at the time of any conversion pursuant hereto, and to cause the stockholders of the Company to take any such actions that may be required, including the amendment of the Company’s Certificate of Incorporation as necessary to create sufficient authorized shares of capital stock into which this Note converts. If the Company has failed such that the Note may not be converted when a conversion right occurs, the holder of this Note shall nonetheless be treated for all purposes as the holder of the securities into which this Note would have converted.
(f) Interest Accrual. If a Change of Control or Qualified Financing is consummated, all interest on this Note shall be deemed to have stopped accruing as of the business day prior to the signing of the definitive agreement for the Change of Control or Qualified Financing, or Non-Qualified Financing if applicable.
(g) Calculation of Fully Diluted Shares. As used herein, “Fully Diluted Shares” means the number of shares of capital stock of the Company equal to the sum of (a) all shares of Common Stock issued and outstanding, (b) other than the Notes, all shares of Common Stock issuable upon exercise or conversion, as applicable, of all outstanding shares of preferred stock, options, stock grants, warrants and other convertible securities for capital stock of the Company, assuming full vesting and conversion of all such outstanding preferred stock, options, stock grants, warrants and other convertible securities, and (c) all unallocated shares of Common Stock reserved for issuance pursuant to any equity incentive plan, stock plan or similar plan or arrangement (including any increase in shares of Common Stock reserved for issuance pursuant to any equity incentive plan, stock plan or similar plan or arrangement that is contemplated in connection with the Qualified Financing or Non-Qualified Financing, as the case may be); provided that no share of capital stock of the Company shall be counted more than once in connection with such calculation; and provided, further, that, for purposes of Section 2(d) of this Note, Fully Diluted Shares shall not include any unallocated shares of Common Stock reserved for issuance pursuant to any equity incentive plan, stock plan or similar plan or arrangement.
| 3 |
| 3. | Representations and Warranties. |
(a) Representations and Warranties of the Company. The Company hereby represents and warrants to the Holder as of the date of this Note as follows:
(i) Organization, Good Standing and Qualification. The Company is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware. The Company has the requisite corporate power to own and operate its properties and assets and to carry on its business as now conducted and as proposed to be conducted. The Company is duly qualified and is authorized to do business and is in good standing as a foreign corporation in all jurisdictions in which the nature of its activities and of its properties (both owned and leased) makes such qualification necessary, except for those jurisdictions in which failure to do so would materially and adversely affect the business, assets, liabilities, financial condition, operations or prospects of the Company (a “Material Adverse Effect”).
(ii) Corporate Power. The Company has all requisite corporate power to issue this Note and to carry out and perform its obligations under this Note. The Board has approved the issuance of this Note based upon a reasonable belief that the issuance of this Note is appropriate for the Company after reasonable inquiry concerning the Company’s financing objectives and financial situation.
(iii) Authorization. All corporate action on the part of the Company, the Board and the Company’s stockholders necessary for the issuance and delivery of this Note has been taken. This Note constitutes a valid and binding obligation of the Company enforceable in accordance with its terms, subject to laws of general application relating to bankruptcy, insolvency, the relief of debtors and, with respect to rights to indemnity, subject to federal and state securities laws. Any securities issued upon conversion of this Note (the “Conversion Securities”), when issued in compliance with the provisions of this Note, will be validly issued, fully paid, nonassessable, free of any liens or encumbrances and issued in compliance with all applicable federal and securities laws.
(iv) Governmental Consents. All consents, approvals, orders or authorizations of, or registrations, qualifications, designations, declarations or filings with, any governmental authority required on the part of the Company in connection with issuance of this Note has been obtained.
(v) Compliance with Laws. To its knowledge, the Company is not in violation of any applicable statute, rule, regulation, order or restriction of any domestic or foreign government or any instrumentality or agency thereof in respect of the conduct of its business or the ownership of its properties, which violation of which would have a Material Adverse Effect.
(vi) Compliance with Other Instruments. The Company is not in violation or default of any term of its certificate of incorporation or bylaws, or of any provision of any mortgage, indenture or contract to which it is a party and by which it is bound or of any judgment, decree, order or writ, other than such violation(s) that would not have a Material Adverse Effect. The execution, delivery and performance of this Note will not result in any such violation or be in conflict with, or constitute, with or without the passage of time and giving of notice, either a default under any such provision, instrument, judgment, decree, order or writ or an event that results in the creation of any lien, charge or encumbrance upon any assets of the Company or the suspension, revocation, impairment, forfeiture, or nonrenewal of any material permit, license, authorization or approval applicable to the Company, its business or operations or any of its assets or properties. Without limiting the foregoing, the Company has obtained all waivers reasonably necessary with respect to any preemptive rights, rights of first refusal or similar rights, including any notice or offering periods provided for as part of any such rights, in order for the Company to consummate the transactions contemplated hereunder without any third party obtaining any rights to cause the Company to offer or issue any securities of the Company as a result of the consummation of the transactions contemplated hereunder.
| 4 |
(vii) No “Bad Actor” Disqualification. The Company has exercised reasonable care to determine whether any Company Covered Person (as defined below) is subject to any of the “bad actor” disqualifications described in Rule 506(d)(1)(i) through (viii), as modified by Rules 506(d)(2) and (d)(3), under the Act (“Disqualification Events”). To the Company’s knowledge, no Company Covered Person is subject to a Disqualification Event. The Company has complied, to the extent required, with any disclosure obligations under Rule 506(e) under the Act. For purposes of this Note, “Company Covered Persons” are those persons specified in Rule 506(d)(1) under the Act; provided, however, that Company Covered Persons do not include (a) any Holder, or (b) any person or entity that is deemed to be an affiliated issuer of the Company solely as a result of the relationship between the Company and any Holder.
(viii) Offering. Assuming the accuracy of the representations and warranties of the Holder contained in subsection (b) below, the offer, issue, and sale of this Note and the Conversion Securities (collectively, the “Securities”) are and will be exempt from the registration and prospectus delivery requirements of the Act, and have been registered or qualified (or are exempt from registration and qualification) under the registration, permit or qualification requirements of all applicable state securities laws.
(ix) Use of Proceeds. The Company shall use the proceeds of this Note solely for working capital and other general corporate purposes related to the operations of its business, and not for any personal, family or household purpose.
(b) Representations and Warranties of the Holder. The Holder hereby represents and warrants to the Company as of the date of this Note as follows:
(i) Purchase for Own Account. The Holder is acquiring the Securities solely for the Holder’s own account and beneficial interest for investment and not for sale or with a view to distribution of the Securities or any part thereof, has no present intention of selling (in connection with a distribution or otherwise), granting any participation in, or otherwise distributing the same, and does not presently have reason to anticipate a change in such intention.
(ii) Information and Sophistication. Without lessening or obviating the representations and warranties of the Company set forth in subsection (a) above, the Holder hereby: (A) acknowledges that the Holder has received all the information the Holder has requested from the Company and the Holder considers necessary or appropriate for deciding whether to acquire the Securities, (B) represents that the Holder has had an opportunity to ask questions and receive answers from the Company regarding the terms and conditions of the offering of the Securities and to obtain any additional information necessary to verify the accuracy of the information given the Holder and (C) further represents that the Holder has such knowledge and experience in financial and business matters that the Holder is capable of evaluating the merits and risk of this investment.
(iii) Ability to Bear Economic Risk. The Holder acknowledges that investment in the Securities involves a high degree of risk, and represents that the Holder is able, without materially impairing the Holder’s financial condition, to hold the Securities for an indefinite period of time and to suffer a complete loss of the Holder’s investment.
| 5 |
(iv) Further Limitations on Disposition. Without in any way limiting the representations set forth above, the Holder further agrees not to make any disposition of all or any portion of the Securities unless and until:
(1) There is then in effect a registration statement under the Act covering such proposed disposition and such disposition is made in accordance with such registration statement; or
(2) The Holder shall have notified the Company of the proposed disposition and furnished the Company with a detailed statement of the circumstances surrounding the proposed disposition, and if reasonably requested by the Company, the Holder shall have furnished the Company with an opinion of counsel, reasonably satisfactory to the Company, that such disposition will not require registration under the Act or any applicable state securities laws; provided that no such opinion shall be required for dispositions in compliance with Rule 144 under the Act, except in unusual circumstances.
(3) Notwithstanding the provisions of paragraphs (1) and (2) above, no such registration statement or opinion of counsel shall be necessary for a transfer by the Holder to a partner (or retired partner) or member (or retired member) of the Holder in accordance with partnership or limited liability company interests, or transfers by gift, will or intestate succession to any spouse or lineal descendants or ancestors, if all transferees agree in writing to be subject to the terms hereof to the same extent as if they were the Holders hereunder.
(v) Accredited Investor Status. The Holder is an “accredited investor” as such term is defined in Rule 501 under the Act.
(vi) No “Bad Actor” Disqualification. The Holder represents and warrants that neither (A) the Holder nor (B) any entity that controls the Holder or is under the control of, or under common control with, the Holder, is subject to any Disqualification Event, except for Disqualification Events covered by Rule 506(d)(2)(ii) or (iii) or (d)(3) under the Act and disclosed in writing in reasonable detail to the Company. The Holder represents that the Holder has exercised reasonable care to determine the accuracy of the representation made by the Holder in this paragraph, and agrees to notify the Company if the Holder becomes aware of any fact that makes the representation given by the Holder hereunder inaccurate.
(vii) Foreign Investors. If the Holder is not a United States person (as defined by Section 7701(a)(30) of the Internal Revenue Code of 1986, as amended (the “Code”)), the Holder hereby represents that he, she or it has satisfied itself as to the full observance of the laws of the Holder’s jurisdiction in connection with any invitation to subscribe for the Securities or any use of this Note, including (A) the legal requirements within the Holder’s jurisdiction for the purchase of the Securities, (B) any foreign exchange restrictions applicable to such purchase, (C) any governmental or other consents that may need to be obtained, and (D) the income tax and other tax consequences, if any, that may be relevant to the purchase, holding, redemption, sale or transfer of the Securities. The Holder’s subscription, payment for and continued beneficial ownership of the Securities will not violate any applicable securities or other laws of the Holder’s jurisdiction.
| 6 |
(viii) Forward-Looking Statements. With respect to any forecasts, projections of results and other forward-looking statements and information provided to the Holder, the Holder acknowledges that such statements were prepared based upon assumptions deemed reasonable by the Company at the time of preparation. There is no assurance that such statements will prove accurate, and the Company has no obligation to update such statements.
| 4. | Events of Default. |
(a) If there shall be any Event of Default (as defined below) hereunder, at the option and upon the declaration of the Majority Holders and upon written notice to the Company (which election and notice shall not be required in the case of an Event of Default under subsection (ii) or (iii) below), this Note shall accelerate and all principal and unpaid accrued interest shall become due and payable. The occurrence of any one or more of the following shall constitute an “Event of Default”:
(i) The Company fails to pay timely any of the principal amount due under this Note on the date the same becomes due and payable or any unpaid accrued interest or other amounts due under this Note on the date the same becomes due and payable;
(ii) The Company files any petition or action for relief under any bankruptcy, reorganization, insolvency or moratorium law or any other law for the relief of, or relating to, debtors, now or hereafter in effect, or makes any assignment for the benefit of creditors or takes any corporate action in furtherance of any of the foregoing; or
(iii) An involuntary petition is filed against the Company (unless such petition is dismissed or discharged within 60 days under any bankruptcy statute now or hereafter in effect, or a custodian, receiver, trustee or assignee for the benefit of creditors (or other similar official) is appointed to take possession, custody or control of any property of the Company).
(b) In the event of any Event of Default hereunder, the Company shall pay all reasonable attorneys’ fees and court costs incurred by the Holder in enforcing and collecting this Note.
| 5. | Miscellaneous Provisions. |
(a) Senior Debt. The Company shall not incur any debt that is senior to the Notes without the written consent of the Majority Holders.
(b) Waivers. The Company hereby waives demand, notice, presentment, protest and notice of dishonor.
(c) Further Assurances. The Holder agrees and covenants that at any time and from time to time the Holder will promptly execute and deliver to the Company such further instruments and documents and take such further action as the Company may reasonably require in order to carry out the full intent and purpose of this Note and to comply with state or federal securities laws or other regulatory approvals.
(d) Transfers of Notes. This Note may be transferred only upon its surrender to the Company for registration of transfer, duly endorsed, or accompanied by a duly executed written instrument of transfer in form satisfactory to the Company. Thereupon, this Note shall be reissued to, and registered in the name of, the transferee, or a new Note for like principal amount and interest shall be issued to, and registered in the name of, the transferee. Interest and principal shall be paid solely to the registered holder of this Note. Such payment shall constitute full discharge of the Company’s obligation to pay such interest and principal. Notwithstanding the foregoing, the Holder and the Company agree and acknowledge that this Note shall not be transferable to a competitor of the Company (as determined in good faith by the Board).
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(e) Amendment and Waiver. Except as expressly provided herein, any term of this Note may be amended or waived with the written consent of the Company and the Majority Holders.
(f) Governing Law. This Note shall be governed by and construed under the laws of the State of Delaware, as applied to agreements among Delaware residents, made and to be performed entirely within the State of Delaware, without giving effect to conflicts of laws principles.
(g) Binding Agreement. The terms and conditions of this Note shall inure to the benefit of and be binding upon the respective successors and assigns of the parties. Nothing in this Note, expressed or implied, is intended to confer upon any third party any rights, remedies, obligations or liabilities under or by reason of this Note, except as expressly provided in this Note.
(h) Counterparts; Manner of Delivery. This Note may be executed in two or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. Counterparts may be delivered via facsimile, electronic mail (including pdf or any electronic signature complying with the U.S. federal ESIGN Act of 2000, Uniform Electronic Transactions Act or other applicable law) or other transmission method and any counterpart so delivered shall be deemed to have been duly and validly delivered and be valid and effective for all purposes.
(i) Titles and Subtitles. The titles and subtitles used in this Note are used for convenience only and are not to be considered in construing or interpreting this Note.
(j) Notices. All notices required or permitted hereunder shall be in writing and shall be deemed effectively given: (i) upon personal delivery to the party to be notified, (ii) when sent by confirmed electronic mail or facsimile if sent during normal business hours of the recipient, if not, then on the next business day, (iii) five days after having been sent by registered or certified mail, return receipt requested, postage prepaid, or (iv) one day after deposit with a nationally recognized overnight courier, specifying next day delivery, with written verification of receipt. All communications to a party shall be sent to the party’s address set forth on the signature page hereto or at such other address(es) as such party may designate by 10 days’ advance written notice to the other party hereto. A copy of any notice to the Company shall be sent to SPZ Legal, P.C., 344 Thomas L. Berkley Way, Oakland, CA 94612, attention: Hash Zahed, with an electronic copy via email to hash@spzlegal.com.
(k) Expenses. The Company and the Holder shall each bear its respective expenses and legal fees incurred with respect to the negotiation, execution and delivery of this Note and the transactions contemplated herein.
(l) Delays or Omissions. It is agreed that no delay or omission to exercise any right, power or remedy accruing to the Holder, upon any breach or default of the Company under this Note shall impair any such right, power or remedy, nor shall it be construed to be a waiver of any such breach or default, or any acquiescence therein, or of or in any similar breach or default thereafter occurring; nor shall any waiver of any single breach or default be deemed a waiver of any other breach or default theretofore or thereafter occurring. It is further agreed that any waiver, permit, consent or approval of any kind or character by the Holder of any breach or default under this Note, or any waiver by the Holder of any provisions or conditions of this Note, must be in writing and shall be effective only to the extent specifically set forth in writing and that all remedies, either under this Note, or by law or otherwise afforded to the Holder, shall be cumulative and not alternative. This Note shall be void and of no force or effect in the event that the Holder fails to remit the full principal amount to the Company within five calendar days of the date of this Note.
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(m) Entire Agreement. This Note constitutes the full and entire understanding and agreement between the parties with regard to the subjects hereof, and no party shall be liable or bound to any other party in any manner by any representations, warranties, covenants and agreements except as specifically set forth herein.
(n) Exculpation among Holders. The Holder acknowledges that the Holder is not relying on any person, firm or corporation, other than the Company and its officers and Board members, in making its investment or decision to invest in the Company.
(o) Broker’s Fees. Each party hereto represents and warrants that no agent, broker, investment banker, person or firm acting on behalf of or under the authority of such party hereto is or will be entitled to any broker’s or finder’s fee or any other commission directly or indirectly in connection with the transactions contemplated herein. Each party hereto further agrees to indemnify each other party for any claims, losses or expenses incurred by such other party as a result of the representation in this subsection being untrue.
[Signature pages follow]
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The parties have executed this Convertible Promissory Note as of the date first noted above.
| COMPANY: | ||||
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CNOTE GROUP, INC. | |||
| By: | ||||
| Name: | ||||
| Title: | ||||
| E-mail: | ||||
| Address: | ||||
The parties have executed this Convertible Promissory Note as of the date first noted above.
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HOLDER:
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| By: | |||
| Name: | |||
| Title: | |||
| E-mail: | |||
| Address: | |||
EXHIBIT A
Schedule of Holders
| Holder | Principal Amount | Date of Note | Address |
| $ |