UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-K

 

 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2016

 

or

 

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

 

For the transition period from _______________ to _______________

 

Commission File Number: 001-37642

 

ENER-CORE, INC.
(Exact name of issuer as specified in its charter)

 

Delaware   46-0525350
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification Number)
     

8965 Research Drive

Irvine, California

 

 

92618

(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number, including area code (949) 616-3300

 

Securities registered pursuant to Section 12(b) of the Act:

 

Securities registered pursuant to Section 12(g) of the Act:

 

Common stock, $0.0001 par value
(Title of class)

 

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

 

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

 

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

 

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

 

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

 

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

 

  Large Accelerated Filer Accelerated Filer
  Non-accelerated filer Smaller reporting company

 

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

 

As of June 30, 2016, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $14.7 million, based on a closing price of $3.94 per share of common stock as reported on the OTCQB Marketplace on such date.

 

As of April 10, 2017, the registrant had 4,063,660 shares of common stock outstanding.

 

 

 

 

 

 

TABLE OF CONTENTS

TO ANNUAL REPORT ON FORM 10-K

FOR YEAR ENDED DECEMBER 31, 2016

 

    Page
PART I  
Item 1. Business 1
Item 1A. Risk Factors 21
Item 1B. Unresolved Staff Comments 38
Item 2. Properties 38
Item 3. Legal Proceedings 38
Item 4. Mine Safety Disclosures 38
     
PART II  
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 39
Item 6. Selected Financial Data 40
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation 40
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 63
Item 8. Financial Statements and Supplementary Data 63
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 63
Item 9A. Controls and Procedures 64
Item 9B. Other Information 65
     
PART III  
Item 10. Directors, Executive Officers and Corporate Governance 66
Item 11. Executive Compensation 69
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 88
Item 13. Certain Relationships and Related Transactions, and Director Independence 92
Item 14. Principal Accounting Fees and Services 94
     
PART IV  
Item 15. Exhibits, Financial Statement Schedules 96
     
Signatures 102

 

 

 

 

Forward Looking Statements

 

This report contains forward-looking statements. All forward-looking statements are inherently uncertain as they are based on current expectations and assumptions concerning future events or future performance of the registrant. Readers are cautioned not to place undue reliance on these forward-looking statements, which are only predictions and speak only as of the date hereof. Forward-looking statements usually contain the words “estimate,” “anticipate,” “believe,” “expect,” or similar expressions, and are subject to numerous known and unknown risks and uncertainties. In evaluating such statements, prospective investors should carefully review various risks and uncertainties identified in this report, including the matters set forth under the captions “Risk Factors” and in the registrant’s other SEC filings. These risks and uncertainties could cause the registrant’s actual results to differ materially from those indicated in the forward-looking statements. The registrant undertakes no obligation to update or publicly announce revisions to any forward-looking statements to reflect future events or developments.

 

Although forward-looking statements in this report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, without limitation, those specifically addressed under the heading “Risks Relating to Our Business” below, as well as those discussed elsewhere in this report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We file reports with the Securities and Exchange Commission, or the SEC. You can read and copy any materials we file with the SEC at the SEC’s Public Reference Room located at 100 F. Street, NE, Washington, D.C. 20549, on official business days during the hours of 10 a.m. to 3 p.m. You can obtain additional information about the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, including the registrant.

 

We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report. Readers are urged to carefully review and consider the various disclosures made throughout the entirety of this report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.

 

 

 

 

PART I

 

ITEM 1. BUSINESS.

 

Overview

 

We design, develop, license, manufacture and have commercially deployed products based on proprietary technologies that generate industrial levels of usable heat in a pressure vessel using a wide variety of organic gases as fuel for an oxidation reaction. Our technology allows for the use of gases that, historically, were unusable as fuels for traditional industrial gas to energy conversion systems, such as combustion chambers, and that typically required costly pollution abatement equipment in order for industries to reduce the pollutant gas emissions and therefore to comply with increasingly stringent air pollution standards. Our technology facilitates a high-temperature oxidation reaction for a variety of organic gases which in turn allows our pressure vessels to extract heat energy from organic gases, including many “waste” gases considered to be air pollution by many industries.

 

We refer to our technology as “Power Oxidation,” and refer to our products as “Power Oxidizers” or “Power Oxidation Vessels.” We develop applications for our technology by integrating our Power Oxidizers with traditional gas-fired industrial equipment (such as boilers, dryers, ovens, and chillers) that require steady and consistent heat sources. In our first deployed applications, our technology serves as a low-emissions alternative for combustion chambers used with gas-fired electric turbines. Our Power Oxidizers produce a steady heat source that can be used to (i) generate electricity by coupling our technology with a variety of modified gas turbines, (ii) produce steam by coupling our technology with a variety of modified steam boilers, or (iii) provide on-site heat at industrial facilities through heat exchanger applications.

 

Our proprietary and patented Power Oxidation technology is designed to create greater industrial efficiencies by providing the opportunity to convert low-quality organic waste gases generated from industrial processes into usable on-site energy, therefore decreasing both operating costs and significantly reducing environmentally harmful gaseous emissions. We design, develop, license, manufacture and market our Power Oxidizers, which, when bundled with an electricity generating turbine in the 250 kilowatt, or kW, and 2 megawatt, or MW, sizes, are called Powerstations. We currently partner and are pursuing partnerships with large established manufacturers to integrate our Power Oxidizer with their gas turbines, with the goal to open substantial new opportunities for our partners to market these modified gas turbines to industries for which traditional power generation technologies previously were not technically feasible. We currently manufacture our Powerstations in the 250 kW size and manufacture just the Power Oxidizer for the 2 MW size for the initial 2 units sold. Beginning in 2017, our 2 MW partner, Dresser-Rand a.s., a subsidiary of Dresser-Rand Group Inc., a Siemens company, or Dresser-Rand, will manufacture the 2 MW Power Oxidizers under a manufacturing license and will pay us a non-refundable license fee for each unit manufactured by Dresser-Rand.

 

Our Opportunity

 

Our economic opportunity is an enhancement to the beneficial combination of combined heat and power equipment, or CHP. CHP is rapidly becoming the choice of new power equipment installations since it can provide a superior economic return, typically by combining electricity production generated by a natural gas turbine with the capture of the heat generated and used in industrial processes. Our CHP solutions provide this same economic advantage with the additional benefit of lower fuel costs through use of low-quality by product gases as fuels and with superior organic gas air pollution abatement. 

 

The creation of organic gases is a by-product of many modern industries. Industrial by-product gases take many forms and are often subject to governmental or regulatory oversight via air quality or air standards boards. The rules and guidelines implemented by these boards lead to compliance costs for companies with industrial facilities that emit the waste gases. Our technology provides a cost-effective alternative to the typical economic and environmental costs of organic hydrocarbon pollution abatement by providing industrial facilities the option to generate power while simultaneously reducing the atmospheric pollution and avoid further pollution abatement costs.

 

 1 

 

 

Our Technology

 

Our technology involves the acceleration of a naturally occurring, gas oxidation process by injecting hydrocarbon gases into a pressure vessel under a controlled, high temperature, high pressure, and oxygen rich environment. Oxidation is a natural and commonly observed chemical change that occurs when a substance reacts with oxygen over a prolonged period of time. Under normal atmospheric conditions, oxidation is a slow reaction and is observed in nature as the rusting of metals or tarnishing of silver; however, oxidation also occurs during the decomposition of organic materials, including the decomposition of hydrocarbon gases into water, heat and carbon dioxide. Our research and development team has developed a process to accelerate the natural decomposition of hydrocarbon gases in a pressure vessel and, by doing so, accelerate the reduction of these waste gases to usable heat energy. The acceleration of the reaction allows our pressure vessels to provide for a low cost, low pollution, industrial heat source from waste gas streams, volatile organic compounds (such as paint thinners and solvents), or premium refined natural gas.

 

In nature, methane and other greenhouse gases react with oxygen in the air and are eventually decomposed through an oxidation reaction over a period of 10 to 20 years. The speed of the reaction is dependent on three primary variables: the temperature, the pressure of the gases, and the abundance of oxygen. The oxidation reaction is exothermic (i.e., generates heat as a natural output of the chemical reaction), but since the reaction occurs slowly in natural, ambient conditions, the heat generated by the reaction is dissipated and normally unnoticeable. Our Power Oxidizer accelerates the natural process by introducing a hydrocarbon-rich waste gas stream into a pressure vessel with a high concentration of air, under pressure, and at high temperature. The combination of these factors results in an oxidation reaction occurring in 0.5–1.25 seconds. By accelerating the reaction within the controlled, steady state environment of our Power Oxidizers, the heat generated from the reaction is compounded and provides a heat output within the heat profile ranges necessary to operate standard gas turbines and industrial equipment requiring heat, such as ovens, dryers, or chiller units. The process does not ignite the gaseous fuel, resulting in a much lower air pollution profile. The length (over 0.5 seconds) of resident time of the gases in our Power Oxidizers allows the reaction to not only extract thermal energy, but also serves as a highly efficient device to eliminate other air pollution that is increasingly regulated by air quality pollution regulations. 

 

Traditionally, industrial heat is provided by the combustion of a hydrocarbon, which generates pollution such as nitrogen oxide (NO2, or NOX) as a by-product. NOX emissions are highly regulated and are often a significant barrier to industrial expansion by air pollution regulators in many of our target markets. By comparison, our Power Oxidizers provide sufficient and steady heat at temperatures lower than the temperatures at which NOX is generated in a combustion reaction. The combination of our ability to utilize a low quality or “waste” fuel with the elimination of NOX generation (as compared to combustion heat sources) makes our Power Oxidizers a superior alternative to traditional heat generation sources and provides a competitive advantage for our technology.

 

Further, our Power Oxidizers are designed to operate on gases with extremely low energy densities as compared to alternative chemical reactions, such as combustion, which typically require refined and high BTU concentration fuels. Our Power Oxidizers, by comparison, can operate on waste gases with extremely low BTU concentration of organic gases or, if required, on commercially available natural gas or other high quality hydrocarbon gas products. Our Power Oxidation technology, however, is not useful for combustion of exhaust gases emitted as the result of combustion reactions, such as carbon dioxide or carbon monoxide. 

 

 2 

 

 

See Figure 1 below for the gas density operating range of our Power Oxidizers.

 

Figure 1

 

 

Our Products

 

Our first commercial product, or the EC Series, is the Ener-Core Powerstation EC250, or EC250, which consists of a combination of our Power Oxidizer and a 250 kW gas turbine. The gas turbine was initially developed by Ingersoll-Rand, plc, or Ingersoll-Rand, and subsequently enhanced by our predecessor, FlexEnergy, Inc., or FlexEnergy. The substitution of the Power Oxidizer for the combustor within a traditional turbine allows for the resulting, modified turbine to utilize low energy density waste gases as a fuel, in place of commercially purchased gases. The low energy density gases that the EC Series products can use as a fuel do not have an alternative commercial market as traditional combustion-based turbines require uncontaminated high energy fuels and thus cannot run on low energy density gases, and therefore such low energy density gases have no market value. In most of our targeted geographical markets, these low-quality gases would require pollution abatement equipment, often at considerable expense, to comply with air quality standards. Our products utilize the low quality gases as a fuel source and eliminate the gases to emissions level well below the current best practices pollution abatement alternatives. 

 

Our second commercial product is currently sold under a contract manufacturing and commercial licensing agreement, or CMLA, to Dresser-Rand. In November 2014, we entered into a commercial license agreement, or CLA, with Dresser-Rand, pursuant to which we agreed to jointly develop a Powerstation that consisted of our Power Oxidizer integrated with a Dresser-Rand KG2 turbine rated up to 2 MW of power output. The resulting product is currently being marketed and sold by Dresser-Rand’s international teams under the Dresser-Rand brand and is called the KG2-3GEF/PO (or KG2 with Power Oxidizer, or KG2/PO). In June 2016, we executed the CMLA, which was intended to replace the CLA upon satisfaction of certain requirements. In April 2017, we amended the terms of the CMLA to make the CMLA effective as of January 1, 2017, at which time it superseded and replaced the CLA. The CLA required us to fulfill, sell and warranty any Power Oxidizers sold to Dresser-Rand. The first two systems sold to Dresser-Rand were shipped to a Stockton, California biorefinery site owned Pacific Ethanol, Inc., or Pacific Ethanol, in the fourth quarter of 2016. Any future 2MW systems are expected to be sold under the CMLA based on a per unit royalty payment payable to us and without a product warranty requirement by Ener-Core.

 

We believe our Power Oxidizers provide a significantly lower fuel cost per kilowatt hour since they can operate using both premium and refined natural gas, a wide variety of lower quality, low hydrocarbon gases, traditionally considered to be “waste” gases, as well as certain volatile organic compounds, or VOCs, such as paint solvents. These gases and compounds are typically seen as a waste by-product of industrial processes, which often represent a source of pollution and, in turn, require expensive waste abatement equipment and significant recurring operating costs. As such, our Power Oxidizers are designed to serve as an opportunity for our industrial customers to reduce their fuel costs.

 

 3 

 

 

We also believe our Power Oxidizers provide a superior air pollution waste abatement solution for industrial customers. Typically, industrial customers require electricity and steam for their operations and generate industrial gases as a by-product of their facility operations. Prior to the introduction of our Powerstations, these customers would purchase energy or produce energy using a traditional gas turbine, which uses a combustion chamber to ignite refined natural gas and generates air pollution in the form of carbon dioxide, carbon monoxide and nitrogen oxides. The gas turbine and by-product gases generally require pollution control equipment and recurring costs in order to comply with existing pollution standards, which vary by geography. Since both the natural gas fuel and the industrial by-product gases oxidize in our Power Oxidizers over a much longer time than combustion heat sources, the Power Oxidizer reduces both the gas fuels and by-products to levels below substantially all of the existing and proposed air quality emission standards in most areas of the world. 

 

Competitive Advantages

 

As compared to alternative technologies, Power Oxidation provides certain advantages over alternative energy-generation technologies, including the following:

 

  Operates on a wider range of fuels. Our system is designed to operate on gases with energy densities as low as 50 BTU/scf (1700 kJ/m3). By comparison, most turbine, engine, and fuel cell systems require fuel quality of significantly higher energy densities.

 

  Lower air emissions. Our Power Oxidizer technology produces substantially lower emissions of NOX and Carbon Monoxide (CO) (< 1ppm) than, and destroys up to 99% of VOCs compared to, combustion-based systems like gas engines or gas turbines or other commonly deployed pollution abatement systems.

 

Figure 2

 

 

  No chemicals or catalysts for pollution abatement or control. Today, most of the low-quality waste gases produced by industries are processed through pollution abatement technologies that do not generate energy from the gases and are solely in place to reduce the volume of emissions to the atmosphere. Unlike other pollution abatement systems, such as selective catalytic reduction, our Power Oxidizer does not use chemicals or catalysts and, thus, cannot be rendered inactive from catalyst poisoning or degradation.

 

  Requires less fuel conditioning. Our system is capable of running on fuels with high levels of contaminants and is designed to require substantially less fuel pre-treatment than competing systems. In most cases, our system is able to process the waste gases from industrial processes without any of the fuel pre-treatment processes that are typically required by combustion-based methods to remove impurities and contaminants prior to generating energy from gases.

 

 4 

 

 

Our Power Oxidation technologies also have certain disadvantages over alternative energy-generation technologies, including the following:

 

  New and unproven technology. Our Power Oxidation technologies have only been demonstrated commercially in a 250 kW product and our technology has only been commercially available since 2013. Although we have received a purchase order for two of our larger 2 MW Power Oxidizers, we currently have no commercial deployments of these larger units and have not demonstrated their full commercial viability outside of our test facility.

 

  Commercial viability. Our Power Oxidation products have had limited commercial installation and to date have been produced on a limited scale.

 

Material Product Commercialization to Date

 

  Initial Commercial Unit—250 kW Unit: In June 2014, our first commercial EC250 Powerstation was installed at a landfill in the Netherlands that is owned and operated by Attero, one of the leading waste management companies in the Netherlands.
     
  First Licensing Agreement: On November 14, 2014, we entered into the CLA to develop and market Dresser-Rand’s KG2-3GEF 2 MW gas turbine coupled with our Power Oxidizer. The CLA and ongoing integration provides for a scale-up of our technology into the larger utility grade sized turbines requested by our customers. Under the CLA, Dresser-Rand agreed to pay an initial license fee of $1.6 million, which was initially placed in escrow, and to commercialize the technology through its sales and distribution channels. In July 2015, we successfully completed the first of two technical milestones, which enabled Dresser-Rand to begin commercialization of the KG2-3GEF/PO turbines.

 

  Initial Order—2 MW Unit into Distillery Market: On January 12, 2015, Pacific Ethanol publicly announced that it had placed an order with Dresser-Rand that included two KG2-3GEF/PO units. The order represents the first two commercial KG2/PO units that are designed to include our Power Oxidizer units. In August 2015, after the completion of the first technical test, we received a formal purchase order for $2.1 million for two Power Oxidizer units. We delivered the units associated with this initial order to the Stockton, California biorefinery site owned by Pacific Ethanol in October 2016 and installed the units in December 2016. Final commissioning has been delayed due to project changes outside of the scope of our deliverables under the larger project installation, although we expect final commissioning to occur in the first half of 2017.

 

 

Additional 250 kW Commercial Units: In May 2015, the Orange County Board of Supervisors approved a project to install an EC250 Powerstation at the Santiago Canyon landfill in Orange County, California, and in August 2015, we received a purchase order for $900,000 for the EC250 Powerstation unit. The order represents an entry into a closed landfill opportunity that we believe has the potential for additional sales in the future. In 2016, it was determined that the Santiago Canyon landfill site did not have sufficient power infrastructure on site. Alternative locations for the EC250 Powerstation are currently being evaluated.

     
  Completion of Full Scale Acceptance Test—2 MW Unit: Under the CLA, the second technical test is the full-scale acceptance test, or FSAT, which is required after achievement of the first technical milestone, the “Sub-Scale Acceptance Test,” which we successfully completed in August 2015. The FSAT consists of the building and installation of a full prototype of a working 2 MW KG2/PO unit at a site in Southern California, and then the testing of the prototype under different operating conditions for performance and life cycle validation. We completed construction of the 2 MW Power Oxidizer in 2016 and began the field testing of the 2 MW unit in the first half of 2016. In September 2016, after initial testing results were received, the $1.6 million license fee payment from Dresser-Rand was released from escrow, from which we received $1.1 million in cash, representing the $1.6 million license fee net of $500,000 paid to Dresser-Rand for engineering services. We substantially completed field testing in the fourth quarter of 2016. In April 2017, we amended the CMLA to acknowledge completion of a substantial portion of the field tests and identified additional field tests to be conducted on the initial units currently being commissioned. These additional field tests must be conducted at an industrial facility with industrial waste gases and we expect to complete these additional tests in the second quarter of 2017.

 

 5 

 

 

  Fulfillment and Delivery of Existing Customer Order Backlog of Approximately $4.6 Million: As of March 12, 2017, and prior to recognition of revenues associated with these orders, we had a backlog of approximately $3.0 million for our Power Oxidizers and approximately $1.6 million of Dresser-Rand license fees. During 2016, we (i) assembled, shipped and installed the first two Power Oxidizers for the two KG2/PO units sold by Dresser-Rand to Pacific Ethanol and (ii) received the $1.6 million license fee payment from Dresser-Rand that was previously paid into escrow, less $500,000 paid to Dresser-Rand for engineering services. We are currently evaluating the revenue recognition on these orders in conjunction with the FSAT testing process described above. We expect to complete the commissioning for the Pacific Ethanol units in the first half of 2017. Additionally, while we received payments on the EC250 Powerstation unit for which we received a purchase order in August 2015, delivery of this unit (originally sourced to deliver at the Santiago Canyon landfill location) has been delayed pending a change of the delivery location by the customer. We expect the unit to be installed at an alternative site in 2017.

 

Over the next year, we expect to continue our product commercialization efforts with the following deliverables and projects:

 

  Commercialization of EC250 Powerstations and Additional KG2 Power Oxidizers: We have a pipeline of additional opportunities through Dresser-Rand for KG2/PO units and directly sold units for our EC250 Powerstations. We expect to receive additional purchase orders for these products in 2017.
     
  New Partnerships for Additional Electric Turbine and Industrial Heat Application Manufacturers: We are in preliminary discussions with additional electric turbine partners, including a 5 MW Power Oxidizer partner and numerous industrial dryer, chiller, oven and boiler manufacturers that are interested in our 250 kW and 2 MW Power Oxidizers for use as heat sources for CHP applications. We anticipate signing definitive agreements with one or more of these partners in 2017 for initial deliveries beginning in 2018.
     
  New Partnerships for Additional Fuel Stock Sources: We are in preliminary discussions with providers of equipment such as anaerobic digesters and rotary concentrators of exhaust fumes. We believe this equipment, once integrated with our Power Oxidizers, will expand our potential waste fuel sources to include bio-mass disposal and VOCs, such as paint fumes and solvents. We believe that our products and technology will allow end customers to reduce or eliminate pollution abatement expenses for these additional waste fuels, while also converting those waste fuels into useful energy, which we expect will provide these customers with a superior return and drive more rapid adoption of our products and technology.

 

Commercial Sales Efforts

 

We are entering the CHP market, which is highly competitive and historically conservative in its acceptance of new technologies. To date, we have sold and delivered one 250 kW commercial Powerstation unit to the Netherlands and have sold one additional 250 kW Powerstation unit to a landfill site in Southern California, which is scheduled for delivery in 2017. We have also sold two 2 MW Power Oxidizers to Dresser-Rand, which were delivered to a Stockton, California biorefinery site owned by Pacific Ethanol in October 2016 and installed in December 2016, but which remain subject to final acceptance conditions that were not met as of December 31, 2016. These three systems, combined with the Dresser-Rand license fees of $1.6 million, represent our $4.6 million order backlog as of April 13, 2017. To date, we have billed $4.2 million and collected $4.1 million of our existing backlog.

 

In May 2016, we received a conditional purchase order for four 250 kW Powerstations expected to be installed on a landfill site in Southern California and scheduled for delivery in late 2017. This order is valued at approximately $4.0 million and is subject to additional pre-sales engineering and permitting requirements. 

 

In April 2017, we executed an amendment to the CMLA with Dresser-Rand, pursuant to which Dresser-Rand agreed to pay us $1.2 million in April 2017. This payment represents an advance payment on future license fees for KG2/PO units to be sold under the CMLA. We have not, as yet, received a purchase order for any system subject to this license fee advance. As such, we do not consider the $1.2 million advance to be backlog as of April 13, 2017.

 

 6 

 

 

Licensing Approach

 

On November 14, 2014, we entered into the CLA with Dresser-Rand through our wholly-owned subsidiary, Ener-Core Power, Inc., which granted Dresser-Rand the right to market and sell the Dresser-Rand KG2-3GEF 2 MW gas turbine coupled with our Power Oxidizer, or a Combined System. The CLA grants Dresser-Rand exclusive rights to commercialize our Power Oxidizer, within the 1–4 MW range of power capacity, bundled with the Dresser-Rand KG2 gas-turbine product line. As part of the CLA, Dresser-Rand agreed to pay us a $1.6 million initial license fee, under the condition that we were able to successfully scale up the technology to a size of 2 MW. Dresser-Rand also agreed to achieve annual sales thresholds agreed to by both companies in order to retain the exclusivity of the commercial license. Upon payment of the initial license fee in full, Dresser-Rand obtained an exclusive license to sell our Power Oxidizer within the 1–4 MW range of power capacity, bundled with a gas-turbine to generate electricity.

 

On June 29, 2016, we entered into the CMLA with Dresser-Rand through Ener-Core Power, Inc., which both companies intended would supersede and replace the CLA. In April 2017, we amended the terms of the CMLA to make the CMLA effective as of January 1, 2017, at which time it superseded and replaced the CLA.

 

Under the CMLA, as amended, Dresser-Rand has a worldwide license to manufacture, market, commercialize and sell the Power Oxidizer as part of the Combined System within the 1 MW to 4 MW range of power capacity, or the License. Initially, the License will be exclusive, even as to us, and will remain exclusive for so long as Dresser-Rand sells a minimum of number of units of the Combined System, constituting the “Sales Threshold,” over a predetermined Sales Threshold time period. The initial Sales Threshold shall begin on the earlier of the “Initial System Completion Date” or July 15, 2017 and shall be fifteen months long. The Initial System Completion Date is the date at which the final operational field test is accepted by D-R and is expected in the second quarter of 2017. Each subsequent Sales Threshold time period shall be one year in length thereafter. If Dresser-Rand does not meet the Sales Threshold in any Sales Threshold time period, and the Sales Threshold is not otherwise waived, Dresser-Rand may maintain exclusivity of the License by making a true-up payment to us for each unit that is in deficit of the Sales Threshold, or a True-Up Payment; provided, however, that Dresser-Rand may not maintain an exclusive License by making a True-Up Payment for more than two consecutive Sales Threshold time period. In the event Dresser-Rand does not meet the Sales Threshold, does not qualify for a waiver and elects not to make the True-Up Payment, the License will convert to a nonexclusive License. 

 

Upon a sale by Dresser-Rand of a Combined System unit to a customer, before any discounts, the CMLA requires Dresser-Rand to make a license fee payment to us equal to a percentage of the sales price of the Combined System purchased, in accordance with a predetermined fee schedule that is anticipated to result in a payment of between $370,000 and $650,000 per Combined System unit sold, or the License Fee. Payment terms to us from Dresser-Rand will be 50% of each License Fee within 30 days of order and 50% upon the earlier of the Combined System commissioning or twelve months after the order date.

 

In April 2017, we executed an amendment to the CMLA with Dresser-Rand, pursuant to which Dresser-Rand agreed to pay us $1.2 million in April 2017 in cash, which represents advance payments on license fees for KG2/PO units representing less than the required minimum number of licenses which would otherwise be required to maintain their exclusivity under the CMLA, as amended. In exchange for this payment, we have agreed to provide a total credit of $1,760,000 against future license payments associated for these KG2/PO units, consisting of a payment credit of $1,200,000 and an additional discount of $560,000.

 

Dresser-Rand may also request that we undertake design and development work on modifications to the Combined Systems, each referred to as a Bespoke Development. We and Dresser-Rand will negotiate any fees resulting from any such Bespoke Development on a case-by-case basis. Further, any obligation by us to undertake such Bespoke Development will be conditioned upon the execution of mutually agreed-upon documentation.

 

As long as the exclusive License remains in effect, we will provide certain ongoing sales and marketing support services, at no additional cost to Dresser-Rand, subject to certain restrictions. Any additional sales and marketing services agreed upon by us and Dresser-Rand will be compensated at an hourly rate to be upwardly adjusted annually.

 

Under the CLA, we were required to maintain our existing backstop security, or the Backstop Security, in favor of Dresser-Rand in support of all products manufactured, supplied or otherwise provided by us during the period beginning on the execution date of the CMLA, or the Execution Date, and continuing through the expiration of the warranty period for the Combined System units sold to customers as of the Execution Date. Concurrent with the execution of the amendment to the CMLA in April 2017, we and Dresser-Rand modified the Backstop Security requirement. As modified, we are required to maintain a $500,000 Backstop Security, reduced from $2.1 million, and the Backstop Security was extended from June 2017 to March 31, 2018.

 

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Dresser-Rand must also: (i) develop the controls strategy for the Dresser-Rand gas turbine control system and integrate it with the Power Oxidizer control system; (ii) with support from us, manufacture and commercialize the Combined System; (iii) with support from us, develop and prioritize sales opportunities for the Combined System; (iv) assume the sales lead role with respect to each customer; and (v) take commercial lead in developing sales to customers. In addition, Dresser-Rand will  be primarily responsible for overall warranty and other commercial conditions to Combined System customers, as well as sole project and service provider and interface with customers. Dresser-Rand will also be responsible for warranty, service and after-sales technical assistance for all portions of Combined Systems that comprise Dresser-Rand products. We, however, will be responsible for warranty and service for all products manufactured or otherwise provided by us prior to the execution of the Commercial and Manufacturing License Agreement. 

 

The CMLA prohibits us from, without the prior written consent of Dresser-Rand, permitting the creation of any encumbrance, lien or pledge of its intellectual property which would result in any modification to, revocation of, impairment of or other adverse effect on Dresser-Rand’s rights with respect to the exclusive License. In addition, all intellectual property rights that are owned by either us or Dresser-Rand as of the Execution Date will remain the sole property of such party, subject to the licenses described in the CMLA. The CMLA also contains provisions that govern the treatment of process and technology developments and any joint inventions that (i) relate to the subject matter of the CMLA and (ii) occur after the Execution Date and during the term thereof.

 

The CMLA also contains certain restrictions on publicity and obligates Dresser-Rand to use its commercially reasonable efforts to include our name and logo and otherwise promote our brand and Power Oxidizers in a mutually agreed-upon manner. We and Dresser-Rand have also mutually agreed to withhold disclosure of certain commercial and technologically sensitive terms of the CMLA including technical specifications, License Fee percentages, and the Sales Threshold minimum annual quantities to maintain exclusivity.

 

Markets

 

We see our total potential market consisting of industrial facilities with permanent waste gas emissions sufficient to operate our units on a constant basis. We evaluate our potential markets in two methods, geographically and vertically. Our most significant sales opportunities are those where a customer’s demand for power, heat energy, and pollution abatement intersect as presented in Figure 3 below (opportunities not to scale).

  

Figure 3

 

 

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We believe the total addressable U.S. market size is at least $5 billion for our Power Oxidizer technology, based on our assumption that our 250 kW Power Oxidizer is most appropriate for landfills and our 2 MW Power Oxidizer is most appropriate for our other targeted markets. We also believe the total addressable market size in Europe, Japan and China provides us with potentially meaningful opportunities.

 

Geographic Target Markets

 

We initially identified our geographic target markets to consist of North America, Europe, Japan and China, with selective evaluations of other regions on a case-by-case basis. While we intend to focus primarily on the North American and European geographic markets over the next year, we expect and intend to evaluate commercial opportunities in other geographic markets.

 

In the United States, we are focused on opportunities where our low-quality fuels configuration and our ultra-low emissions configuration provide competitive advantages. We are also focused on specific states where the wholesale electricity prices are the highest, as this typically results in the most attractive return on investment scenarios for prospective customers. These states include California, New Jersey, New York, Maine, New Hampshire, Massachusetts, Connecticut, Rhode Island and Vermont.

 

Internationally, we have identified similar opportunities in Canada and western European countries with similar environmental and regulatory laws as the United States, such as the Netherlands, Belgium, the United Kingdom, Germany, Italy, France and Spain.

 

Vertical Markets

 

We believe that our current products provide a superior value proposition for two customer types: (i) open and closed existing landfills and (ii) industrial facilities that could benefit from on-site CHP generation coupled with waste gas pollution abatement, or collectively CHP+A. We also believe that larger sized Power Oxidizer turbines of 5 MW and above, once developed, will likely be met with demand from large industrial facilities such as oil and gas refineries and petrochemical plants. We also see the integration of third party equipment utilizing heat (boilers, chillers, ovens and dryers) and equipment providing additional fuel sources (digesters and rotary concentrators) as central to our strategy to provide superior CHP+A customer solutions.

 

Landfills

 

When solid waste is deposited in landfills, the organic materials within the waste decompose slowly over time, resulting in the generation and emissions of methane-based waste gases. Historically, the quality of gases that has been emitted by landfills during their open phase (i.e., while trash is still being added) has been high enough for the generation of power through the installation and operation of reciprocating engines. However, the increasing prevalence of recycling and the diversion of organic materials are resulting in a reduction in the quality of the gas that is emitted from newer landfills. In addition, as landfills reach their maximum allowable size, they are eventually closed and deemed inactive. Once a landfill becomes inactive, and trash is no longer being added, the quality of the emitted gas typically falls to levels that are well below the quality thresholds (~30% methane) that are required as an inlet fuel for combustion-based power generating equipment such as reciprocating engines or standard gas turbines. For this reason, the viable power generation phase of a landfill’s life-cycle is typically limited to the years of operation when the landfill is active, and then for a few years after the landfill is closed. However, even after a landfill is closed, methane gas continues to be emitted for an additional 50 to 70 years, just at lower concentration levels than required to run combustion-based power generating equipment.

 

Our technology enables operators of existing landfill projects that utilize reciprocating engines and gas turbines for the collection and disposal of landfill-generated gases, or LFGs, to generate electricity beyond the normal operating range of their engines and turbines. In newer landfills that begin their life with less organic material, and therefore produce less methane, our technology also enables the generation of electricity where it might have been otherwise uneconomic to do so. Closed (inactive) landfills continue to emit waste gases for 50 to 70 years after the closure of the landfill, but the predictable reduction in gas quality makes it difficult (and in most cases, impossible) to generate energy from the waste gases, unless the waste gases are supplemented/enriched with a premium fuel such as natural gas or propane in order to raise their energy density. In either case, our low-quality fuel capability allows a greater percentage of the LFGs created from landfill-waste to be used for local electricity generation, as can be seen in Figure 4.

 

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Figure 4

 

 

Typical gas emissions profile of a landfill throughout its entire life-cycle. The entire shaded area (yellow and green) represents our Power Oxidizer’s operational range to use methane at varying percentage levels. The yellow area represents the operational range of traditional combustion based turbines relating to landfill gas.

 

Utilizing the market data that is available through the U.S. Environmental Protection Agency’s, or EPA, Landfill Methane Outreach Program, or LMOP, a voluntary assistance program that helps to reduce methane emissions from landfills by encouraging the recovery and beneficial use of landfill gas as a renewable energy source, we have been able to compile the data shown in Figure 5 regarding the age of the current closed landfills in California. 

 

Figure 5

 

 

Closed California landfills as of March 2015, based on data provided by Landfill Methane Outreach Program (LMOP) available at www.epa.gov/lmop/.

 

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Pollution abatement technologies (thermal oxidizers) appear to be one of the few alternative technologies for these older landfill sites once the hydrocarbon density in the LFG drops below the thresholds required by engines or other combustion technologies. Thermal oxidizers eliminate or treat waste gases but do not generate power. Closed landfills represent a large opportunity for us. We enable these older landfills to solve the pollution abatement problem and allows these sites to continue generating power (and hence revenue) from the LFG for several decades after traditional power generation technologies (reciprocating engines and gas turbines) are no longer able to operate due to the decrease in the quality of the gases.

 

Industrial Target Markets (excluding landfills)

 

Most industrial processes use heat energy in the form of heat, steam, or electricity for their operation. Many of these processes also generate by-product waste gases with many embedded contaminants and impurities that are then either vented directly into the atmosphere or put through a pollution abatement or treatment process prior to release into the atmosphere. For industries in which pollution abatement is mandated by applicable air pollution regulations, the facility typically purchases abatement equipment (scrubbers, thermal abatement, carbon absorber, etc.) separately from power production equipment, and such equipment destroys the waste gases, but does not utilize or monetize them. Our Power Oxidizers provide both functions in one unit and typically use waste gases as a partial or complete replacement of purchased commercial-grade gases. In applications where the waste gases have extremely low usable hydrocarbon content (or relatively low volumes of waste gases), significant values may still exist resulting from the coupling of power generation and pollution abatement that the Power Oxidizer provides (i.e., our CHP+A solution).  

 

Figure 6

 

 

We reviewed the industries in which we believe the combination of pollution abatement requirements, power consumption requirements, and the generation of waste gases provides the potential for superior economic returns with our products. Using these key attributes, we have identified twelve targeted vertical markets, aside from landfill opportunities, in California that we believe may result in sales. According to the EPA, these twelve markets represent in excess of 1,100 facilities in California and over 8,000 facilities in the United States that we believe have the combination of attributes that may indicate a superior economic return from installation of a Power Oxidizer.

 

In addition to landfill opportunities, we intend to first pursue the following five general vertical industrial markets, representing thousands of potential installation sites across the US, as we believe they are the most likely to benefit from the Power Oxidizer in its current sizes. We are marketing to these five vertical industrial markets, primarily for those facilities located in California, through direct contact from our sales department, tradeshow representation, and internet outreach and through Dresser-Rand’s sales and marketing efforts. Each is discussed in greater detail below:

 

  Fuel-grade ethanol and beverage ethanol/alcohol distilleries and related products production (>500 facilities throughout the U.S.)
     
  Rendering and animal processing by-products (>600 facilities)
     
 

Wastewater and sewage treatment (>3,500 facilities) 

     
  “High tech” aerospace and defense instruments and materials; semiconductor and electronics manufacturing (>2,200 facilities)
     
  Petroleum and petrochemical storage, distillation and petroleum production (>600 facilities)

 

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As we continue to increase our pipeline of commercial opportunities with industrial facilities spanning across these vertical industrial markets, we expect the majority of the opportunities to be in relation to the 2 MW KG2/PO systems, with the exception of rendering opportunities, where we expect demand for both EC250 units and KG2/PO units.

 

Fuel-grade and beverage ethanol/alcohol distilleries and related products production (NAICS Code 325193)

 

Ethanol or beverage alcohol production represents over 500 facilities across the United States, including Pacific Ethanol’s fuel grade ethanol plant in Stockton, California that purchased the first two KG2/PO units from Dresser-Rand. Both fuel grade and beverage alcohol distilleries use electricity and steam and produce a steady stream of waste hydrocarbons that can be used with our Power Oxidizer to reduce the amount of natural gas that is purchased as a fuel source, as well as reduce the amount of electricity purchased to run the industrial plants. Although the details of Pacific Ethanol’s breakdown of savings are confidential, we believe that Pacific Ethanol selected our Power Oxidizer solution based on an economic return that consisted of the avoidance of power purchases and improved pollution abatement. In this regard, Pacific Ethanol has publicly stated that it expects to achieve annual savings of $3–$4 million per year after the on-site combined heat and power plant becomes operational.

 

Rendering and animal processing by-products (NAICS Codes 311111 and 311613)

 

Meat rendering plants process animal by-product materials for the production of tallow, grease and high-protein meat and bone meal used primarily in pet food. Rendering operations produce VOCs as air pollutants. Although some greenhouse gases are produced, the primary issues related to the emissions of VOCs is the foul odor nuisance when these facilities are in proximity to residential areas.

 

Typically, the emissions control technologies that are used for rendering plants are waste heat boilers (incinerators) and multi-stage wet scrubbers. Boiler incinerators are a common technology because boilers can be used not only as odor control devices, but also to generate steam for cooking and drying operations. The waste heat boilers convert the waste gases to steam by combusting the waste gases, but this process often faces resistance from air quality authorities. Multi-stage wet scrubbers are equally as effective as incineration for high intensity odor control, but they only serve to destroy the waste gas and do not actually convert it into useful energy.

 

We believe our Power Oxidizers provide a superior abatement function as compared to such emission control technologies, as our products also provide power generation. We believe that the combination of the abatement function and power generation results in a superior economic alternative for many rendering plants, to which we have actively begun to market our Powerstations.

 

Wastewater and sewage treatment facilities, anaerobic digestion (NAICS Codes 221310 and 221320)

 

Wastewater and sewage treatment facilities use anaerobic digester units to treat raw sewage with both methane gas generation and water intensive bio-solids by-products. Typically, the methane gas is eliminated by a thermal oxidizer and the bio-solids are either dried on-site with an industrial dryer or, in certain cases, the water heavy bio-solids are transported to another facility, often long distances from the treatment facility, which results in significant tipping fees and transportation costs to the facility, which is often a municipality.

 

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We believe our Power Oxidizers, coupled with an anaerobic digester, a turbine, and using residual heat for an industrial dryer represents a significant positive economic solution by utilizing the waste methane to generate electricity and heat, allows for on-site drying with significantly lower emissions compared to a combustion dryer, and eliminates costly trucking and tipping fees for bio-solids that otherwise would have to transport these heavy waste products. We see significant sales opportunities for our solutions in nearly all of the larger metropolitan areas in California and other US locations.

 

Aerospace and defense instruments and materials manufacturing (NAICS Code 334511) and semiconductor and electronics manufacturing (NAICS Codes 334416, 334412 and 334417)

 

Manufacturers in the aerospace and defense instruments and materials industry and the semiconductor and electronics industry represent in excess of 2,200 facilities in the U.S., including nearly 600 in California. Many of these high tech manufacturers are well-capitalized and often represent industries with an increased focus on being “carbon neutral” or “green friendly.” The underlying economics are similar to the CHP+A economics of ethanol production, as described above, namely the extraction of heat energy from hydrocarbon by-product gases, the elimination of other waste gases and the avoidance of other abatement costs. To date, we have not had commercial success in the high-tech manufacturing market, but we have begun to market the solution to these manufacturers, with positive reception from some of the manufacturers with whom we have held discussions.

 

Petroleum gas and related petrochemical production (NAICS Code 32511)

 

There has been a strong, worldwide trend toward the reduction of venting, flaring, and waste of associated petroleum gas, also known as flared gas, due to concerns about its contribution to global warming. Associated petroleum gas is a form of natural gas that is commonly found within deposits of petroleum and is produced as an undesirable by-product during the extraction of the petroleum. Our technology not only destroys the harmful pollutants that reside within the associated petroleum gas, but it can also be installed to produce on-site electricity and/or steam, creating significant cost savings for oil and gas producers. We see multiple opportunities in the petroleum market sector, primarily in locations where low quality gas is permanently flared as unusable, such as tank farms, or in locations using industrial steam to produce and distill petroleum related products.

 

In September 2014, at the request of a major Canadian integrated oil company, in the first phase of a three phase commercial rollout, we successfully demonstrated the ability of our full-scale EC250 to operate on an ultra-low energy density fuel (~50 BTU/scf) similar in composition to the associated petroleum gases flared by many oil drilling sites around the world. The exhaust emissions and energy production were measured and independently verified by UCI’s combustion laboratory, and the oil company that retained us to perform the test deemed the demonstration to be successful enough to move to the next phase of its proposed commercial rollout. The customer has delayed the second phase due to internal budgetary requirements but remains interested in future commercial deployment. If the oil company deems the second phase of the rollout to be satisfactory, the oil company’s technology development team has indicated to us that there would be sufficient environmental and cost-savings advantages associated with our technology such that a large-scale, multi-year series of commercial installations at multiple sites in Canada would likely receive support from the oil company’s senior management.

 

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Other vertical markets

 

We are in the early stages of evaluating opportunities in the following industries. We have begun initial marketing efforts to these seven markets for selected project opportunities:

 

  Biological product (pharmaceutical) manufacturing (>400 facilities)

 

  Asphalt paving mixture and block manufacturing (>500 facilities)

 

  Nitrogenous fertilizer manufacturing (>400 facilities)

 

  Foam product manufacturing (>200 facilities)

 

  Paper mills (>400 facilities)

 

  Commercial printing (>2200 facilities)

 

  Commercial coatings and finishing (>50,000 facilities)

 

For many of these opportunities, additional evaluation is required and our value proposition needs to be tailored to the market or industry where the opportunity is classified to ensure that the specific facility could be a qualified candidate for our current product line. For example, while there are over 50,000 commercial coating and finishing facilities, these facilities range in size from small facilities like local painting shops that generate VOCs in very small volumes to large facilities like auto assembly plants with multiple coating and painting facilities, each of which generates a significant amount of VOCs and represents a greater commercial opportunity.

 

Competition

 

The target markets for the Power Oxidizer are highly developed and mature for solutions using combustion as a heat source but are new and fairly undeveloped for applications of our Power Oxidizer technologies. If a site already has a high quality waste gas with high enough energy density to generate power with this standard combustion-based equipment, and the resulting emissions levels do not exceed regulatory limits, then we deem such site to be outside of our target market. 

 

Our technology represents a value-added pre-process for power generation equipment such as gas turbines, reciprocating engines or steam generation equipment such as steam boilers. We do not consider ourselves competitors with the providers of this equipment but rather consider ourselves as complementary to such providers.

 

We compete with existing co-generation solutions and other power generation solutions for our current and future customers. Those existing solutions typically have more mature technology and a lower equipment cost than our Power Oxidizer units. Our Power Oxidizers typically are more expensive per kilowatt of power capacity when compared to the initial cost of equipment, and competing products typically have lower upfront costs than our Power Oxidizers. However, we believe that, in many situations, once the total cost of a co-generation project, including fuel costs and the value of pollution abatement, is quantified, our Power Oxidizers provide a superior rate of return for our customers. Our Power Oxidizers often cost less than purchasing separately combustion-based CHP+A equipment.

 

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We believe that there are very few, if any, companies that are actively pursuing the commercial utilization of oxidation technologies for generation of on-site energy, particularly in light of the technology patents we hold. In addition to our efforts to replace existing combustion technologies, we compete against other companies in two sectors, each with its distinct competitive landscape:

 

  Low-quality fuels—Within applications where the gas source has an energy density (BTU/ft3) below the minimum level required by reciprocating engines and standard gas turbines, we believe that our Power Oxidizer does not have a direct technological or manufacturing competitor. In these situations, the prospective customer can elect to do nothing and allow low BTU gas to simply be emitted into the atmosphere, often at considerable expense for pollution abatement equipment and ongoing operating costs. Alternatively, the customer can purchase gas such as propane or natural gas, mix it with the low BTU gas to make combustion feasible, and then flare the mixture. Because this alternative results in the destruction of the low BTU gas instead of converting the gas into a form of energy that could be sold or monetized, we do not consider it to be a direct form of competition.

 

  Ultra-low emissions—Within applications where a customer is required to meet emissions regulations and controls limits, typically by national, regional or local legislation, our systems compete with pollution control technologies, such as Selective Catalytic Reduction, Dry-Low-NOx, or Dry-Low-Emissions systems, and in some cases, with low-emission flares and thermal oxidizers. As many of our competitors are large, well-established companies, they derive advantages from production economies of scale, worldwide presence, and greater resources, which they can devote to product development or promotion.

 

Although we are occasionally compared to wind and solar power production, we do not consider existing renewable energy solutions to be direct competitors. Existing renewable sources such as wind and solar are economically feasible in particular geographic locations, whereas our solution is applicable to any area with a sufficient quantity of low quality gases. We expect our Power Oxidizers to be able to provide base-load power for more than 95% of the time, while wind and solar solutions typically provide intermittent power and can only provide power for 20–40% of the time. As a result, although the capital cost per kilowatt is similar, the availability of the Power Oxidizer provides a significantly lower overall cost of power produced.

 

Research and Development

 

Our engineering team is comprised of a group of experienced mechanical, electrical and chemical engineers who have worked together on the Power Oxidizer for the last eight years. Our engineers have worked in a number of larger firms, including Honeywell International, Inc., General Motors Company, Inc., AlliedSignal, Inc., Capstone Turbine Corporation, General Electric Company, and Underwriters Laboratories Inc. Combined, they have decades of experience developing and commercializing a number of gas turbines, reciprocating engines, and related products.

 

Since 2011, our research and development milestones include:

 

  In November 2011, SRI commissioned the first EC250 field test unit at the U.S. Army base at Fort Benning, Georgia. The project was funded by the U.S. Department of Defense, or DoD, Environmental Security Technology Certification Program, or ESTCP, which seeks innovative and cost-effective technologies to address high-priority environmental and energy requirements for the DoD. As part of the ESTCP protocol, SRI conducted independent verification tests in October 2012. Exhaust emission measurements were taken in accordance with standard EPA reference methods. The EC250 emissions were far below the allowable NOx limits of the California Air Resources Board 2013 waste gas standards, which are considered to be among the strictest standards in the world.

 

  In June 2014, our first commercial EC250 Powerstation was installed at a landfill in the Netherlands that is owned and operated by Attero, one of the leading waste management companies in the Netherlands.

 

  In July 2015, we completed the installation of our self-constructed Multi-Fuel Test Facility, or MFTF, located next to our corporate offices in Irvine, California. The MFTF will become a critical element to our ongoing development initiatives, enabling our engineering team to continue to test a wider range of low-quality gases that could be used to fuel our Power Oxidizers in the future, and also to experiment with (and prove the feasibility of) different sizes of future Power Oxidizer systems.
     
  In June 2016, we completed the integration of the Dresser-Rand KG2-GEF 2 MW gas turbine and our Power Oxidizer, which resulted in the first commercial KG2/PO unit. Between June and December 2016, we successfully conducted the FSAT protocols under the CLA.
     
 

In December 2016, the first two KG2/PO units were installed at a biorefinery site in Stockton, California owned by Pacific Ethanol. The two KG2/PO units were each energized and operated at power in late 2016 and operated as designed during commissioning work performed in the first quarter of 2017. Final commissioning, which we expect in the second quarter of 2017, has been delayed due to reasons outside of the scope of our involvement in the project.

 

We have made, and will continue to make, substantial investments in research and development. Research and development costs for the years ended December 31, 2016 and 2015 were $3.6 million and $3.4 million, respectively.

 

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Intellectual Property

 

Our success depends in part upon our ability to obtain and maintain proprietary protection for our products and technologies. Our goal is to develop a strong intellectual property portfolio that enables us to capitalize on the research and development that we have performed to date and will perform in the future, particularly for each of the products in our development pipeline and each of the products that we commercialize. We rely on a combination of patent, copyright, trademark and trade secret laws in the United States and other countries to obtain and maintain our intellectual property. We protect our intellectual property by, among other methods, filing patent applications with the U.S. Patent and Trademark Office and its foreign counterparts on inventions that are important to the development and conduct of our business. 

 

We also rely on a combination of non-disclosure, confidentiality and other contractual restrictions to protect our technologies and intellectual property. We require our employees and consultants to execute confidentiality agreements in connection with their employment or consulting relationships with us. We also require them to agree to disclose and assign to us all inventions conceived in connection with the relationship.

 

We believe that Power Oxidation technology is a patent domain largely independent from combustion. Within the patent domain, the technology has been described as “Gradual Oxidation,” as the patents were filed prior to our management’s decision in late 2014 to change the process name to “Power Oxidation.” Our current patent grants and pending applications consist of:

 

  Patents granted: 44

 

  33 U.S. patents
  11 non-U.S. patents

 

  Pending applications: 21

 

  6 U.S. applications
  15 non-U.S. applications

 

We intend to continue to protect our Power Oxidation technology in current patent application filings and expect to file additional patent applications for various implementations, markets and uses as we continue to develop our technology.

 

Global Energy Market and Government Policies

 

As most countries around the world continue to industrialize, the industrial plants/facilities representing a broad range of industries result in a rapidly growing demand for more electricity and more on-site steam. Our market research indicates that there are approximately three million industrial facilities around the world that could potentially use over 250kW of power, and collectively they consume approximately $800 billion in energy costs in order to operate their plants. These same industrial facilities, located all around the world and across a broad range of industries, also represent about 36% of the world’s greenhouse gas emissions. These emissions have led to environmental concerns, political legislation geared towards promoting renewable power and policy trends for eliminating harmful gases and waste products. 

 

The combination of these trends and challenges places us in a unique position to capitalize on a growing need for on-site power, steam and heat, while at the same time productively utilizing the low-quality industrial gases that are rapidly becoming a significant global concern.

 

Recent international agreements, policy announcements, and environmental legislation, either already enacted or proposed, support the continued commercialization and scale up of our Power Oxidizer technology. We believe that the capabilities of our technology fit well within the global focus on all of the following:

 

  Maximizing methane usage from all sources to eliminate flared gas;

 

  Industrial waste gas destruction to prevent emissions of the waste gases into the atmosphere; and

 

  Efficient on-site energy generation, while minimizing emissions.

 

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We believe that our technology provides an attractive financial return on investment for industrial facilities in many regions of the world, without any financial incentives that are typically necessary for renewable power projects. In addition, we are seeing an increasing amount of significant new regulations, policies and international agreements being enacted globally that potentially benefit our business and potentially accelerate the decision-making process made by companies that are considering the deployment of our technology. Some of these regulations, policies and international agreements that we believe are the most pertinent to our value proposition are listed below. While most of these policies are either non-binding or carry limited penalties, we believe they represent the general direction of air quality standards for many geographic locations. Although such policies are generally non-binding or carry limited penalties, we believe that some industries are moving to comply with such policies, which often takes months or years to plan and implement. Companies that voluntarily comply with such policies often do so to generate positive public relations and/or to avoid public backlash. As public pressure through news and social media streams to reduce air pollution intensifies, we believe that some companies are beginning to voluntarily comply with these policies. We believe that such public pressure may encourage potential customers to consider our product solutions, which they may not otherwise have considered. Notwithstanding the foregoing, we are unable to predict the likely future course of relevant regulations and policies in the United States due to recent efforts by the current presidential administration and others to rescind or repeal certain existing goals, policies and regulations designed to address climate change and reduce certain gas emissions and the uncertain impact of such actions on both federal and state levels. Any successful efforts to rescind or repeal such goals, policies and regulations may negatively impact our value proposition and/or reduce or eliminate existing incentives to adopt our products.

 

Flaring Reduction

 

  Zero Routine Flaring by 2030, endorsed by Russia, Norway, Angola, France, other countries and BP, Shell, Kuwait National Oil Company, ENI, and other major oil companies
     
  North Dakota limiting flaring to 23% of all gas produced in 2015 with required reductions down to 10% of all gas produced by 2020.

 

Ozone Pollution Reduction (NOx restrictions)

 

 

On November 25, 2014, the EPA proposed to strengthen the National Ambient Air Quality Standards for ground-level ozone, based on extensive scientific evidence about ozone’s effects on public health and welfare (reducing ozone required restricting NOX emissions to low levels).

 

  ●  558 counties in the U.S. would exceed the lower 65 ppb proposed standard, while 358 counties in the U.S. would exceed the 70 ppb proposed standard.

 

  “A Clean Air Programme for Europe” calls for action to control emissions of air polluting substances from combustion plants with a rated thermal input between 1 and 50 MW (i.e., medium combustion plants), thereby completing the regulatory framework for the combustion sector with a view of increasing the synergies between air pollution and climate change policies. Medium combustion plants are used for a wide variety of applications (including electricity generation, domestic/residential heating and cooling and providing heat/steam for industrial processes) and are an important source of emissions of sulfur dioxide, nitrogen oxides and particulate matter. The approximate number of medium combustion plants in the European Union, or EU, is 142,986.

 

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Carbon/Greenhouse Gas Levies

 

  Alberta’s New Democratic Party government announced on June 25, 2015 a phased increase in the province’s carbon emissions levy from C$15 ($12) per tonne this year (2015) to C$20 next year and C$30 by 2017.
     
  California and Quebec have announced the completion of their second joint carbon dioxide (CO2) allowance auction through a cap-and-trade system. Despite geographical distance and economic differences, California and Quebec have worked to align their CO2 emissions markets and policies. Previous auctions sold emissions allowances for electric generators and large industrial sources. The most recent auction, held in February 2015, also included allowances for the transportation sector, covering wholesale gasoline suppliers. The California and Quebec program is the first international carbon allowance program to be enacted at the subnational level (i.e., between parts of two different countries). Similar programs in Europe were the first to establish markets across several countries (the EU’s Emission Trading Scheme) and were also the first to cover certain transportation components.

 

  Figure 7 below displays the 40 countries and more than 20 cities, states and provinces now using or planning to use a price on carbon to bring down greenhouse gas emissions through emission trading systems or carbon credits or taxes. Altogether, the combined value of the carbon credits, taxes, and ETS initiatives in operation today are valued at almost $50 billion, according to the World Bank and Ecofys new Carbon Pricing Watch, which is an early brief previewing the annual State and Trends of Carbon Pricing report.

 

Figure 7

 

 

 

The regulations, policies and international agreements above are examples of the evolving policy landscape for global energy as well as the pressures on industries to reduce their emissions. Our Power Oxidizer can enable many of the intensive industrial facilities worldwide to comply and benefit from these changing environmental and energy policies. The Power Oxidizer utilizes polluting methane and waste gases to efficiently produce the heat needed to generate energy (electricity and/or steam) on-site. This enables industrial facilities to offset their purchases of utility power and fuels, while also destroying polluting gases and drastically reducing their NOX emissions. 

 

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Current and Future Efforts

 

Our research and development efforts are currently focused on the following activities:

 

  Commercializing and installing technology into vertical markets. We are currently working to successfully commercialize and install our technology into several of the five vertical industrial markets discussed under the subheading “Industrial Target Markets (excluding landfills).” Thus far, we have successfully commercialized our technology into old, inactive landfills and have worked with Dresser-Rand to commercialize our technology into a large fuel ethanol distillery. As we continue to evolve, we intend to demonstrate the technical feasibility and economic value of deploying our technology into a variety of additional industries that currently generate waste gases.

 

  Integration with heat applications. We are currently working to integrate our Power Oxidizer technology with a variety of industrial heat applications such as dryers, ovens, boilers, and water chillers and commercialized within industrial facilities (across the same broad base of industries we already target) in order to provide additional value propositions for our current and future gas turbine products.

 

  Scaling up to other sized gas turbines. We have already established close working relationships with several other gas turbine manufacturers and large industrial partners to facilitate the potential development of additional systems.

 

  Expanding the global reach of our technology. Further developing our technology to work with industrial heat applications will allow us to partner with global manufacturers of heat equipment and access new markets.

 

 

Integration with anaerobic digesters. We believe that the partnership with anaerobic digesters will provide for a greater variety of waste feed stocks that can be converted to unrefined organic gas fuels which could be used as a fuel source for our Power Oxidizers.  We see this integration as critical to penetrating some of our highest potential vertical markets such as wastewater treatment and animal rendering.

 

Figure 8

 

 

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Suppliers

 

For our Power Oxidizer units, our raw materials generally consist of readily available, pipes, tanks and machined metal products made of steel and other readily available commercial metals. We also purchase an integrated controls system that is configured from off-the-shelf units. For certain proprietary components, we use parts that are single-sourced from certain suppliers for machined parts designed and built to our specifications. We expect to move away from single-sourced suppliers as our production levels increase and with future modifications to our products.

 

For the EC250 units, we purchase gas turbines from a single supplier, FlexEnergy. The Power Oxidizers used in our KG2/PO units are bundled with Dresser-Rand gas turbines as a single sourced supplier. 

 

Environmental Laws

 

We have not incurred any expenses associated with compliance with environmental laws to date. Our customers, however, are subject to federal, state, local and foreign environmental laws, regulations and policies governing, among other things, air quality and emissions. As such, we may, in the future, incur material costs or liabilities in complying with such government regulations, whether applicable to our customers’ use of our products, due to additional development costs or indemnity costs, or to us directly. Further, as we expand our product line and pursue additional opportunities to deploy our Power Oxidizer in the field, we may assume greater operational responsibility for certain deployment sites. In the event we take on such an operational role, we may become subject to applicable air quality and other environmental rules and regulations, which would result in the incurrence of compliance and permitting costs, among others.

 

Employees

 

As of April 10, 2017, we have 13 full-time employees. None of our employees are covered by a collective bargaining agreement. We believe our relationship with our employees is good. We also employ consultants, including technical advisors and other advisors, on an as-needed basis to supplement existing staff.

 

Corporate Information

 

Ener-Core, Inc. was incorporated in Nevada in April 2010 under the name “Inventtech Inc.” Our operating subsidiary, Ener-Core Power, Inc., was incorporated in Delaware in July 2012 under the name “Flex Power Generation, Inc.” Ener-Core Power, Inc. became our subsidiary in July 2013 by way of a reverse merger transaction, or the Merger, as further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Reverse Merger.”

 

Effective as of September 3, 2015, we changed our state of incorporation from the State of Nevada to the State of Delaware, or the Reincorporation, pursuant to a plan of conversion dated September 2, 2015, following approval by our stockholders of the Reincorporation at our 2015 Annual Meeting of Stockholders held on August 28, 2015. In connection with the Reincorporation, we filed articles of conversion with the State of Nevada and a certificate of conversion and certificate of incorporation with the State of Delaware. Upon effectiveness of the Reincorporation, the rights of our stockholders became governed by the Delaware General Corporation Law, the certificate of incorporation filed in Delaware and newly adopted bylaws. As a Delaware corporation following the Reincorporation, which we refer to as Ener-Core Delaware, we are deemed to be the same continuing entity as the Nevada corporation prior to the Reincorporation, which we refer to as Ener-Core Nevada. As such, Ener-Core Delaware continues to possess all of the rights, privileges and powers of Ener-Core Nevada, all of the properties of Ener-Core Nevada and all of the debts, liabilities and obligations of Ener-Core Nevada, including all contractual obligations, and continues with the same name, business, assets, liabilities, headquarters, officers and directors as immediately prior to the Reincorporation. Upon effectiveness of the Reincorporation, all of the issued and outstanding shares of common stock of Ener-Core Nevada automatically converted into issued and outstanding shares of common stock of Ener-Core Delaware without any action on the part of our stockholders.

 

The address of our corporate headquarters is 8965 Research Drive, Irvine, California 92618, and our telephone number is (949) 616-3300. Our website address is www.ener-core.com. The information that is contained on, or that may be accessed through, our website is not a part of this report. We have included references to our website in this report solely as inactive textual references.

 

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ITEM 1A. RISK FACTORS 

 

You should carefully consider the risks and uncertainties described below, together with all of the other information contained in this report, including our financial statements and the related notes thereto, before making a decision to invest in our securities. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us, or that we currently believe are not material, also may become important factors that affect us and impair our business operations. The occurrence of any of the events or developments discussed in the risk factors below could have a material and adverse impact on our business, results of operations, financial condition and cash flows, and in such case, our future prospects would likely be materially and adversely affected. If any of such events or developments were to happen, the trading price of our common stock and the value of the warrants could decline, and you could lose part or all of your investment. Further, our actual results could differ materially and adversely from those anticipated in our forward-looking statements as a result of certain factors. All share and per share amounts have been adjusted to reflect the 30-for-1 forward split of our issued and outstanding shares of common stock by way of a stock dividend on May 6, 2013 and the 1-for-50 reverse split of our issued and outstanding shares of our common stock on July 8, 2015, retroactively.

 

Risks Relating to Our Financial Condition and Capital Requirements

 

We have experienced losses since inception and anticipate that we will continue to incur losses, which makes it difficult to assess our future prospects and financial results.

 

We have never been profitable and, as of December 31, 2016 we had an accumulated deficit of $41.2 million. We incurred net losses of $10.0 million in the year ended December 31, 2016 and net losses of $13.1 million and $10.5 million in the years ended December 31, 2015 and 2014, respectively. We expect to continue to incur net losses for the foreseeable future as we continue to develop our products and seek customers and distribution for our products. Because of the risks and uncertainties associated with developing and commercializing our products, we are unable to predict the extent of any future losses or when we will become profitable, if at all. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. If we are unsuccessful in addressing these risks, our business may fail and investors may lose all of their investment.

 

Our limited operating history makes evaluating our business and future prospects difficult, and may increase the risk of your investment.

 

We design, develop, license and manufacture products based on proprietary technologies that aim to expand the power-generation range of gaseous fuels. While we shipped our first commercial product, the Ener-Core Powerstation EC250, in November 2013, and installed our first two KG2/PO systems in 2016, to date, our other manufacturing efforts have been limited to our prototype units and the assembly of our Multi-Fuel Test Facility used in research and development. As such, we have a limited operating history with respect to designing and manufacturing systems for producing continuous energy from a broad range of sources, including previously unusable low quality waste gases, providing a limited basis for investors to evaluate our business, operating results, and prospects. Additionally, while the basic technology has been verified, our ability to accurately forecast the cost of producing and distributing our systems or technology or to determine a precise date on which our systems or technology will be widely released is limited.

 

Our plan to complete the initial commercialization of our gas-to-heat and electricity conversion technology is dependent upon the timely availability of funds and upon our finalizing the engineering, component procurement, build out, and testing in a timely manner. Any significant delays would materially adversely affect our business, prospects, operating results, and financial condition. Consequently, it is difficult to predict our future revenues and appropriately budget for our expenses, and we have limited insight into trends that may emerge and affect our business. In the event that actual results differ from our estimates or we adjust our estimates in future periods, our operating results and financial position could be materially and adversely affected. If the market for transforming methane gas, especially low quality waste gases from landfills, coal mines, oil fields, and other low-quality methane sources into continuous electricity does not develop as we currently expect, or develops more slowly than we currently expect, our business, prospects, operating results, and financial condition will be materially harmed.

 

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We expect to require substantial additional financing. Failure to obtain such financing may require us to cease our business activities and result in our stockholders losing some or all of their investment in us.

 

There is no assurance that we will operate profitably or generate positive cash flow in the future. As of December 31, 2016, we had $1.4 million in cash and cash equivalents (including restricted cash). We will require additional financing in order to proceed with the manufacture and distribution of our products, including our EC250, KG2/PO and other Power Oxidizer products. During the next 12 months, we currently project our cash needs to be in excess of $6.5 million, currently budgeted for employee, occupancy and related costs ($3.5 million), professional fees and business development costs ($0.5 million), research and development programs ($0.5 million), corporate filings ($0.5 million) and working capital ($1.5 million). We will require additional financing if the costs of the development and operation of our existing technologies are greater than we have currently anticipated or if we are not successful in earning revenues. Our sales and fulfillment cycle can exceed 24 months, and we do not expect to generate sufficient revenue in the next 12 months to cover our operating costs. 

 

We anticipate that we will rely on additional debt or equity capital in order to continue to fund our business operations until such time as we become profitable, which may never occur. Issuances of additional equity and/or convertible securities will result in dilution to our existing stockholders. Our ability to obtain additional financing will be subject to a number of factors, including market conditions, our operating performance and investor sentiment. We may not be able to obtain financing on commercially reasonable terms or terms that are acceptable to us when it is required. If we are unable to raise sufficient additional capital when required or on acceptable terms, we may have to significantly delay, scale back or discontinue the development or commercialization of one or more of our products, restrict our operations or obtain funds by entering into agreements on unattractive terms, which would likely have a material adverse effect on our business, stock price and our relationships with third parties with whom we have business relationships. Further, if we do not obtain sufficient funds to continue operations, our business could fail and investors could lose up to their entire investment.

 

Our independent registered public accounting firm has expressed substantial doubt about our ability to continue as a going concern, and if we are unable to continue as a going concern, our securities will have little or no value.

 

Since inception, we have experienced recurring operating losses and negative cash flows and we expect to continue to generate operating losses and consume significant cash resources for the foreseeable future. Without additional financing, these conditions raise substantial doubt about our ability to continue as a going concern, meaning that we may be unable to continue in operation for the foreseeable future or realize assets and discharge liabilities in the ordinary course of operations. As a result, the report of our independent registered public accounting firm that accompanies our audited consolidated financial statements for the years ended December 31, 2016 and 2015, respectively, contains going concern qualifications and our independent registered public accounting firm expressed substantial doubt about our ability to continue as a going concern. In addition to our history of losses, our accumulated deficits as of December 31, 2016, December 31, 2015, and December 31, 2014 were approximately $41.2 million, $31.1 million, and $18.0 million, respectively. At December 31, 2016, December 31, 2015 and 2014, we had cash and cash equivalents (including restricted cash) of $1.4 million, $2.8 million, and $2.2 million, respectively.

 

In order to continue as a going concern, we will need, among other things, additional capital resources. Our management’s plan is to obtain such resources by seeking additional equity and/or debt financing. During 2016, we raised a total of $4.6 million through debt financing, raised $3.0 million through equity financing and refinanced $5.0 million of our outstanding indebtedness. During 2015, we raised a total of $5.0 million through debt financing and $3.3 million through equity financing. We may be required to raise capital on unfavorable terms, assuming opportunities to raise capital are even available to us. Our failure to obtain additional capital would have an adverse effect on our financial position, results of operations, cash flows, and business prospects, and ultimately on our ability to continue as a going concern. If we are unable to obtain adequate capital, we could be forced to cease operations.

 

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Any incurrence of additional indebtedness could adversely affect our ability to operate our business, remain in compliance with existing or future debt or commercial covenants, make payments on our debt and limit our growth.

 

As of April 10, 2017, we had $10.4 million of indebtedness outstanding, consisting of the principal balance and accrued interest on our outstanding convertible senior secured notes, originally issued in April and May 2015 and December 2016, or the Senior Notes, and convertible unsecured notes, originally issued in September 2016, or the Convertible Unsecured Notes, and balances due on capital lease financings.

 

Outstanding indebtedness could have important consequences for investors, including the following:

 

  if we are unable to comply with the obligations of any agreements governing our indebtedness, including financial and other restrictive covenants, such failure could result in an event of default under such agreements;
     
  the covenants contained in our debt and commercial agreements may limit our ability to borrow additional funds, including restrictions on use of certain of our intellectual property as collateral for future borrowings;
     
  we may need to use a portion of our cash flows to pay principal and interest on our debt, which will reduce the amount of money that we have for operations, working capital, capital expenditures, expansion, acquisitions or general corporate or other business activities;
     
  we may have a higher level of debt than some of our competitors, which could put us at a competitive disadvantage;
     
  we may be more vulnerable to economic downturns and adverse developments in our industry or the economy in general; and
     
  our debt level could limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate.

 

Our ability to meet our expenses and debt obligations will depend on our future performance, which will be affected by financial, business, economic, regulatory and other factors. We will not be able to control many of these factors. We cannot be certain that our cash flows will be sufficient to allow us to pay the principal and interest on our existing or future debt and meet our other obligations. If we do not have enough money to service our existing or future debt, we may be required to refinance all or part of our existing or future debt, sell assets, borrow more money or raise equity, which we may not be able to timely consummate on terms acceptable to us, if at all.

 

Risks Relating to Our Business and Industry

 

A sustainable market for our technology and products may never develop or may take longer to develop than we currently anticipate, which would materially adversely affect our results of operations and/or cause our business to fail.

 

Our products are being sold into mature markets and represent an emerging and unproven technology. We cannot be certain as to whether our targeted customers will accept our technology or will purchase our products in sufficient quantities to allow our business to grow. To succeed, demand for our current products must increase significantly in existing markets and there must be strong demand for products that we introduce in the future. If a sustainable market fails to develop or develops more slowly than we currently anticipate, we may be unable to recover the losses we have incurred to develop our products, we may have further impairment of assets, and we may be unable to meet our operational expenses. The development of a sustainable market for our systems may be hindered by many factors, including some that are out of our control. Examples include:

 

  customer reluctance to try a new product or concept;
     
  the relaxing of regulatory requirements or policies regarding the environment;
     
  potential customers’ perception that our EC250, KG2/PO and other Power Oxidizer products that we may develop are not competitive on a cost basis;

 

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  the costs associated with the installation and commissioning of our EC250, KG2/PO and other Power Oxidizer products that we may develop;
     
  maintenance and repair costs associated with our products;
     
  economic downturns and reduction in capital spending;
     
  customer perceptions of our products’ safety, quality and effectiveness;
     
  customer and potential customer awareness of our products;
     
  the emergence of newer, more competitive technologies and products;
     
  the financial and operational stability of our turbine partners;
     
  the inability of our turbine partners to fulfill orders in a timely manner;
     
  excessive warranty-related costs associated with parts replacement for Power Oxidizer or turbine components for Powerstations operating in the field; and
     
  the inability of our commercial partners to successfully sell and market our co-branded Power Oxidizer products.

 

If we are unable to develop effectively and promote our technology timely and gain recognition in our market segment, we may not be able to achieve acceptable sales revenue and our results of operations and financial condition would then suffer. We cannot predict the rate of adoption or acceptance of our technology by potential customers or prospective channel partners. While we may be able to effectively demonstrate the feasibility of our technology, this does not guarantee the market will accept it, nor can we control the rate at which such acceptance may be achieved. Failure to achieve productive relationships with a sufficient number of prospective partners who are established resellers in the market segments of our target customers may impede adoption of our solutions. Additionally, some potential customers in our target industries are historically risk-averse and have been slow to adopt new technologies. If our technology is not accepted in the industrial combustion and power generation market, we may not earn enough by selling or licensing our technology to support our operations, recover our research and development costs or become profitable and our business could fail.

 

Our products are unproven on a large-scale commercial basis and could fail to perform as anticipated.

 

The Power Oxidizer has never been utilized on a large-scale commercial basis and we cannot predict all of the difficulties that may arise when the technology is utilized on such scale. In addition, our technology has never operated at a profitable volume level. It is possible that the technology may require further research, development, design and testing prior to implementation of a large-scale commercial application. Accordingly, we cannot assure you that our technology will perform successfully on a large-scale commercial basis, that it will be profitable to us or that our products will be cost competitive in the market.

 

We may not be able to maintain effective product distribution channels, which could limit sales of our products.

 

We may be unable to attract distributors, resellers and integrators, as planned, that can market our products effectively and provide timely and cost-effective customer support and service. There is also a risk that, after we have established such relationships, some or all of our distributors, resellers or integrators may be acquired, may change their business models or may go out of business, any of which could have an adverse effect on our business. Further, our potential distributors, integrators and resellers may carry competing products. The loss of important sales personnel, distributors, integrators or resellers could adversely affect us.

 

Our products involve a lengthy sales cycle and we may not anticipate sales levels appropriately, which could impair our results of operations. 

 

The sale of our products typically involves a significant commitment of capital by customers, and such purchase decisions often require substantial time, economic analysis, product testing and corporate approvals. Once a customer makes a formal decision to purchase our product, the fulfillment of the sales order by us and our turbine partners will require a substantial amount of additional time. For these reasons, the sales and fulfillment cycle associated with our products is typically lengthy and subject to a number of significant risks over which we have little or no control. We currently expect to plan our production and inventory levels based on internal forecasts of customer demand, which are highly unpredictable and can fluctuate substantially. If sales in any period fall significantly below anticipated levels, our financial condition, results of operations and cash flow would suffer. If demand in any period increases well above anticipated levels, we may have difficulties in responding, incur greater costs to respond, or be unable to fulfill the demand in sufficient time to retain the order, which would negatively impact our operations and our reputation. In addition, our operating expenses are based on anticipated sales levels, and a high percentage of our expenses are generally fixed in the short term. As a result of these factors, a small fluctuation in the timing of cash payments by our customers could result in additional capital being required to fund our operating and inventory needs. Further, our operating results may be subject to significant variations and, as such, our operating performance in one period may not be indicative of our future performance.

 

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We may incur significant warranty related costs, which may result in decreased gross profit per unit sold and reduce our ability to achieve our profitability targets.

 

We have sold, and our business plan anticipates that we will continue to sell, products with warranties. There can be no assurance that the provision for estimated product warranty will be sufficient to cover our warranty expenses now or in the future. We cannot ensure that our efforts to reduce our risk through warranty disclaimers will effectively limit our liability. While we expect warranty costs to decrease significantly on a per unit basis, the limited operating time for our commercial units makes our warranty and other post-sale charges difficult to estimate. Further, we may, at times, undertake programs to enhance the performance of units previously sold. Such enhancements may be provided at no cost or below our cost. If we choose to offer such programs, such actions could result in significant additional costs to our business. For example, during 2014, we provided for a warranty reserve of $242,000 for our initial EC250 commercial unit to allow for full replacement of key components primarily related to sub-components furnished by our suppliers. For the KG2/PO units delivered to Pacific Ethanol in 2016, we expect to provide a combined warranty reserve of approximately $500,000. If our commercial units have greater than expected warranty related expenses or if we experience warranty costs associated with our oxidizer units, we may experience lower gross margins on our products or we may be required to increase our expenses to re-engineer our Power Oxidizer products. Further, any significant incurrence of warranty expense in excess of estimates could have a material adverse effect on our operating results, financial condition, and cash flow.

 

We face intense competition and currently expect competition to increase in the future, which could prohibit us from developing a customer base and generating revenue.

 

The energy industry is characterized by intense competition. We compete with existing co-generation solutions and other power generation solutions for our current and future customers. Those existing solutions have typically more mature technology and have a lower equipment cost than our Power Oxidizer units. Our Power Oxidizers are typically more expensive per kilowatt of power capacity when compared to the initial cost of equipment, and competing products typically have lower upfront costs than our Power Oxidizers. Many of our existing and potential competitors have greater financial and commercial resources than us, and it may be difficult for us to compete against them. Many of our existing and potential competitors have better name recognition and substantially greater financial, technical, manufacturing, marketing, personnel, and/or research capabilities than we do. In addition, new competitors, some of whom may have extensive experience in related fields or greater financial resources, may enter the market.

 

Although at this time we do not believe that any of our potential competitors have technology similar to ours, if and when we release products based on our technology, potential competitors may respond by developing and producing similar products. Many firms in the energy industry have made and continue to make substantial investments in improving their technologies and manufacturing processes. Our competitors may achieve substantial economies of scale and scope, thereby substantially reducing their fixed production costs and their marginal production costs. In addition, they may be able to price their products below the marginal cost of production in an attempt to establish, retain, or increase market share.

 

In addition to our efforts to replace existing combustion technologies, we face competition from other companies in two sectors, each with its distinct competitive landscape:

 

  Low-quality fuels—Where the gas source has an energy density (BTU/ft3) below the minimum level required by reciprocating engines and standard gas turbines, a prospective customer can elect to do nothing and allow low BTU gas to simply be emitted into the atmosphere or can purchase gas such as propane or natural gas, mix it with the low BTU gas to make combustion feasible, and then flare the mixture. Because this alternative results in the destruction of the low BTU gas instead of converting the gas into a form of energy that could be sold or monetized, we do not consider it to be a direct form of competition, however, potential customers may utilize this approach in lieu of investing in our products.

 

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Ultra-low emissions—Within applications where a customer is required to meet emissions regulations and controls limits, typically by national, regional or local legislation, our systems compete with pollution control technologies, such as Selective Catalytic Reduction, Dry-Low-NOx, or Dry-Low-Emissions systems, and in some cases, with low-emission flares and thermal oxidizers. As many of our competitors are large, well-established companies, they derive advantages from production economies of scale, worldwide presence, and greater resources, which they can devote to product development or promotion.

 

In light of the foregoing, it may be difficult for us to compete successfully in the energy market.

 

As an alternative energy technology, our products are subject to wavering interest and levels of investment arising from the volatility of traditional energy costs and pricing.

 

In addition to environmental concerns, the market for alternative energy technologies is driven in part by customers’ desire for stable, cost-effective energy production methods, including technologies that minimize waste or allow use of waste gases to capture more value from traditional energy production methods. Although increases or volatility in the costs of traditional energy production, including the cost of additives to flare or use waste gases, may drive some interest in our technology, significant reductions in the cost of traditional energy production and resources could have the opposite effect, resulting in decreased willingness by customers to invest in comparatively unproven alternative energy technologies. If traditional energy production costs and pricing drop significantly for a sustained period of time, customers may not view our products as providing a comparative economic benefit and we may not be able to compete successfully in our target markets.

 

We anticipate the need to be able to provide a third party financing option to our current and future customers for our existing and future Power Oxidizer products in order to facilitate our planned growth. We have very limited operational history for our Power Oxidizer products, which may make financing these products very difficult. Any changes in business credit availability or cost of borrowing could adversely affect our business. 

 

We compete with products and solutions that have significantly longer operating histories than our Power Oxidizers. As such, traditional lending solutions such as capital lease providers or banks have access to a substantial amount of information regarding competing products and have established credit parameters for end user customers. Our Power Oxidizers are new to the market and lenders and potential lenders have not established credit parameters specific to our Power Oxidizer units, which puts us at a competitive disadvantage.  

 

Declines in the availability of commercially acceptable business credit and increases in corporate borrowing costs could negatively impact the number of systems we can install. Substantial declines in the business and operations of our customers could have a material adverse effect on our sales and, therefore, our business, results of operations and financial condition. If our potential customers are unable to access credit or experience increases in borrowing costs, our operating results may be materially and adversely affected and our ability to grow our business may be impaired.

 

Turbine prices, sub-component availability and reliability factors impact our price competitiveness, warranty costs and rate of market acceptance.

 

Our Power Oxidizer products are currently commercialized in a manner that is fully integrated with a gas turbine, thus providing a complete Powerstation to the ultimate customer and operator. We purchase the turbines for the 250 kW Powerstations from an independent third party. The availability of these turbines is dependent on the current commercial backlog and financial stability of their manufacturers. A lengthy sub-component fulfillment timeframe could impact our ability to timely deliver a Powerstation and therefore could delay our revenues. The turbines are typically long lead time components and the pricing of these turbines could increase over time, causing the overall price of the integrated Powerstation to become commercially uncompetitive, which would hinder sales of our Power Oxidizer products or render them prohibitively expensive, which would result in decreased profit margins. Once operational, any issues in the reliability of the turbine, either due to issues with the Power Oxidizer or any inherent flaws in the turbine, could result in excessive warranty obligations for us and a level of operational reliability that is deemed unsatisfactory by our customers, which could hurt our relationships with our customers and materially and adversely affect our business, prospects, operating results and financial condition.

 

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We are dependent on our suppliers, some of which are single or limited source suppliers, and the inability or refusal of these suppliers to deliver necessary components at prices, volumes, and schedules acceptable to us would have a material adverse effect on our business, prospects, operating results, and financial condition.

 

We are continually evaluating, qualifying, and selecting suppliers for our gas-to-heat and electricity conversion systems. For our Power Oxidizer units, our raw materials generally consist of readily available pipes, tanks and machined metal products made of steel and other readily available commercial metals. We also purchase an integrated controls system that is configured from off-the-shelf units. However, for certain proprietary components, we use parts that are single-sourced from certain suppliers for machined parts designed and built to our specifications. For example, we purchase gas turbines for our EC250 units from a single supplier, FlexEnergy, and the Power Oxidizers used in our KG2/PO units are bundled with Dresser-Rand gas turbines as a single sourced supplier. We expect to move away from single-sourced suppliers as our production levels increase and with future modifications to our products. We also intend to source globally from a number of suppliers, some of whom may, however, be single source suppliers for these components, in particular for the gas turbine sub-component. While we attempt to maintain the availability of components from multiple sources, it may not always be possible to avoid purchasing from a single source. To date, we have no qualified alternative sources for any of our single-sourced components.

 

While we believe that we may be able to establish alternate supply relationships and can obtain or engineer replacements for our single-source components, we may be unable to do so in the short term or at all at prices or costs that are favorable to us. In particular, qualifying alternate suppliers or developing our own replacements for certain highly customized components may be time consuming and costly.

 

Our supply chain exposes us to potential delivery failures or component shortages. If we experience significant increased demand, or need to replace our existing suppliers, there can be no assurance that additional supplies of component parts will be available if or when required, on terms that are favorable to us, or at all, or that any supplier would allocate sufficient supplies to us in order to meet our requirements or fill our orders in a timely manner. The loss of any single- or limited-source supplier or the disruption in the supply of components from these suppliers could lead to delayed deliveries to our customers, which could hurt our relationships with our customers, result in negative publicity and materially adversely affect our business, prospects, operating results, and financial condition.

 

Commodity market factors impact our costs and availability of materials.

 

Our products contain a number of commodity materials from metals, including steel, special high temperature alloys, copper, nickel, and molybdenum, to computer components. The availability of these commodities could impact our ability to acquire the materials necessary to meet our production requirements. The cost of metals has historically fluctuated and we currently do not hedge against our materials inflation risk. An increase in materials pricing could impact the costs to manufacture our products. If we are not able to acquire commodity materials at prices and on terms satisfactory to us, or at all, our operating results may be materially adversely affected.

 

We may face risks from doing business internationally.

 

We have licensed, sold or distributed, and expect to continue to license, sell, or distribute, products outside of the United States and derive revenues from these sources. Our revenues and results of operations may be vulnerable to currency fluctuations, and we do not currently hedge any foreign currency. As of the date of this report, we have shipped one of our EC250 systems to a customer in the Netherlands. We will report our revenues and results of operations in United States dollars, but, in future reporting periods, a significant portion of our revenues may be earned outside of the United States. In such a case, we cannot accurately predict the impact of future exchange rate fluctuations on our revenues and operating margins. Such fluctuations could have a material adverse effect on our business, results of operations, and financial condition.

 

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Additionally, our business will be subject to other risks inherent in the international marketplace, many of which are beyond our control. These risks include:

 

  laws and policies affecting trade, investment, and taxes, including laws and policies relating to the repatriation of funds and withholding taxes, and changes in these laws;
     
  changes in local regulatory requirements, including restrictions on gas-to-heat and electricity conversions;
     
  longer accounts receivable payment cycles and difficulties in collecting accounts receivable;
     
  increased financial accounting and reporting burdens and complexities;
     
  differing degrees of protection for intellectual property;
     
  instability of foreign economies and governments; and
     
  war and acts of terrorism.

 

Any of the foregoing could have a material adverse effect on our business, financial condition, and results of operations.

 

As our products remain under development, they may not meet quality and cost expectations or may require costly improvements.

 

In order to achieve our goal of improving the quality and lowering the total costs of ownership of our products, we may require engineering changes. Such improvement initiatives may render existing inventories obsolete or excessive and there is no guarantee such changes will meet our customers’ expectations. Any quality issues with our products or those of our turbine manufacturing partners could have a material adverse effect on our rate of product adoption, results of operations, financial condition, and cash flow. Moreover, as we develop new configurations for our gas-to-heat and electricity conversion systems and as our customers place existing configurations in commercial use, our products may perform below expectations. Any performance below expectations could materially and adversely affect our operating results, financial condition, and cash flow and affect the marketability of our products.

 

If we are unable to adequately control the costs associated with operating our business, including our costs of sales and materials, our business, prospects, operating results, and financial condition will suffer.

 

If we are unable to achieve and/or maintain a sufficiently low level of costs for designing, marketing, selling and distributing our gas transforming systems relative to their selling prices, our business, prospects, operating results, and financial condition could be materially and adversely affected. We have made, and will be required to continue to make, significant investments for the design and sales of our system and technologies. There can be no assurances that our costs of producing and delivering our system and technologies will be less than the revenue we generate from sales, licenses and/or royalties or that we will achieve our currently expected gross margins.

 

We may be required to incur substantial marketing costs and expenses to promote our systems and technologies even though our marketing costs and expenses to date have been relatively limited. If we are unable to keep our operating costs aligned with the level of revenues we generate, our business, prospects, operating results, and financial condition will be harmed. Many of the factors that impact our operating costs are beyond our control. For example, the costs of our components could increase due to shortages if global demand for such components increases.

 

If we do not respond effectively and on a timely basis to rapid technological change, our business could suffer.

 

Our industry is characterized by rapidly changing technologies, industry standards, customer needs, and competition, as well as by frequent new product and service introductions. We must respond to technological changes affecting both our customers and suppliers. We may not be successful in developing and marketing, on a timely and cost-effective basis, new products that respond to technological changes, evolving industry standards or changing customer requirements. Our success will depend, in part, on our ability to accomplish all of the following in a timely and cost-effective manner:

 

  effective use and integration of new technologies;
     
  continual development of our technical expertise;
     
  enhancement of our engineering and system designs;
     
  retention of key engineering personnel, which have played a critical role in the development of our technology;
     
  development of products that meet changing customer needs;
     
  marketing of our products; and
     
  influence of and response to emerging industry standards and other changes.

 

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In particular, we plan to upgrade or adapt our gas-to-heat and conversion systems and technology in order to continue to provide customers with the latest technology. However, our products may not compete effectively if we are not able to develop, source and integrate the latest technology into our gas-to-heat and electricity conversion systems at a cost structure or on a timeframe acceptable to our customers or potential customers. Other parties’ future research and discoveries may make our products and solutions less attractive or even obsolete compared to other alternatives that may emerge. Any failure to keep up with advances in gas-to-heat and electricity conversion systems and technology would result in a decline in our competitive position that would materially and adversely affect our business, prospects, operating results, and financial condition.

 

Our customers operate in a highly regulated business environment, and non-compliance with such regulations or changes in regulations could impose significant costs on us or our customers.

 

Our customers are subject to federal, state, local and foreign laws, regulations and policies governing, among other things, emissions and occupational health and safety. Regulatory agencies may impose special requirements on our customers or on us for the implementation and operation of our products, some of which may significantly affect or even eliminate some of our target markets. We can provide no assurances that we or our customers will be able to obtain any approvals or permits that are or may become required in a timely manner, or at all. We may incur material costs or liabilities in complying with government regulations, whether applicable to our customers’ use of our products, due to additional development costs or indemnity costs, or to us directly. Potentially significant expenditures could be required in order to comply with evolving environmental and health and safety laws, regulations and requirements that may be adopted or imposed in the future. Non-compliance of our products or their performance with laws, regulations and other requirements applicable to our customers or to us, could result in fines, disputes or other business disruptions, which would have a material adverse effect on our operating results.

 

Deregulation, restructuring or other fundamental changes affecting the energy industry may make our products less economically beneficial to our customers, thereby affecting demand for our products.

 

We cannot determine how any deregulation or restructuring of the electric utility industry may ultimately affect the market for our products. Changes in regulatory standards or policies that currently support investment in more environmentally efficient power production could reduce the level of investment in the research and development of alternative power sources, including gas-to-heat and electricity conversion systems. Changes in the regulation or structure of the electric utility industry may result in rule changes that create challenges for our marketing and sales efforts. For example, as part of electric utility deregulation, federal, state, and local governmental authorities may impose transitional charges or exit fees, which would make it less economical for some potential customers to switch to our products, thereby materially adversely affecting our revenue and other operating results. Further, we are unable to predict the likely future course of relevant regulations and policies in the United States due to recent efforts by the current presidential administration and others to rescind or repeal certain existing goals, policies and regulations designed to address climate change and reduce certain gas emissions and the uncertain impact of such actions on both federal and state levels. Any successful efforts to rescind or repeal such goals, policies and regulations may negatively impact our value proposition and/or reduce or eliminate existing incentives to adopt our products.

 

Our business depends substantially on the continuing efforts of certain personnel whose absence or loss could materially disrupt our business.

 

Our future success depends substantially on the continued services of our executive officers, especially our Chief Executive Officer, Alain J. Castro, our Chief Financial Officer, Domonic Carney, our engineering vice president, Douglas Hamrin and our Director of Product Sales, Mark Owen. If one or more of these persons were to become unable or unwilling to continue in their present positions, we may not be able to replace them readily or timely, if at all. Therefore, our business may be severely disrupted, and we may incur additional expenses to recruit and retain their replacements, if any acceptable persons may be found. In addition, if any of our executive or engineering officers joins a competitor or forms a competing company, we may lose some of our customers or potential customers.

 

If we are unable to attract, train, and retain engineering and sales personnel, our business may be materially and adversely affected.

 

Our future success depends, to a significant extent, on our ability to attract, train, and retain engineering and sales personnel. Recruiting and retaining capable personnel, particularly those with expertise in our industry, is vital to our success. There is substantial competition for qualified technical and sales personnel with experience in our industry, and there can be no assurance that we will be able to attract or retain them. If we are unable to attract and retain qualified employees, our business may be materially and adversely affected. 

 

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We may not be able to effectively manage our growth, expand our production capabilities or improve our operational, financial and management information systems, which would impair our results of operations.

 

If we are successful in executing our business plan, we will experience growth in our business that could place a significant strain on our business operations, management and other resources. Our ability to manage our growth will require us to expand our production capabilities, continue to improve our operational, financial and management information systems, and to motivate and effectively manage our employees. We cannot provide assurance that our systems, procedures and controls or financial resources will be adequate, or that our management will be able to manage this growth effectively. 

 

We have identified material weaknesses in our internal control over financial reporting and ineffective disclosure controls and procedures that will require additional resources to mitigate.

 

The Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, requires that we report annually on the effectiveness of our internal control over financial reporting and that our principal executive officer and principal financial officer conclude as to the effectiveness of our disclosure controls and procedures on a quarterly basis. Among other things, we must perform systems and processes evaluation and testing. We must also conduct an assessment of our internal controls to allow management to report on our assessment of our internal control over financial reporting, as required by Section 404 of Sarbanes-Oxley. We have identified material weaknesses in our internal control over financial reporting as of December 31, 2016. As defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended, or the Exchange Act, a “material weakness” is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. Specifically, we determined that we had the following material weaknesses in our internal control over financial reporting: (i) we do not have full written documentation of all of our internal control policies and procedures; (ii) we do not have sufficient segregation of duties within accounting functions, which is a basic internal control; (iii) for the year ended December 31, 2016, we had inadequate controls over our costing and accounting for our capitalized inventory and project costing including a lack of a perpetual inventory system and (iv) for the year ended December 31, 2016, management concluded that (a) our management information systems and information technology internal control design was deficient because the potential for unauthorized access to certain information systems and software applications existed during 2016 in several departments, including corporate accounting, and (b) certain key controls for maintaining the overall integrity of systems and data processing were not properly designed and operating effectively, which increased the likelihood of potential material errors in our financial reporting.

 

As of December 31, 2016, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were ineffective at the reasonable assurance level. This conclusion was due to the presence of material weaknesses in our internal control over financial reporting, as described above.

 

Due to our size, we rely heavily on key management for day-to-day operations and for key cash and spending internal controls. Further, our size and correspondingly limited resources give rise to additional internal control weaknesses, including our information technology controls and disclosure controls.

 

We continue to review and develop controls and procedures that we believe to be sufficient to accurately report our financial performance on a timely basis, as well as mitigate our existing material weaknesses and significant deficiencies in our internal controls. As of the date hereof, however, while we have taken steps to remediate our material weaknesses, we have not remediated these material weaknesses in full. If we do not develop and implement effective controls and procedures, we may not be able to report our financial performance on a timely and materially accurate basis and our business and stock price may be adversely affected.

 

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If product liability claims are brought against us, we may incur substantial costs if our insurance coverage for such claims is inadequate. 

 

We may be exposed to product liability claims, other claims and litigation in the event that the use of our products results, or is alleged to result, in bodily injury and/or property damage or our products actually or allegedly fail to perform as expected. Although we maintain insurance coverage with respect to certain product liability and other claims, such claims are expensive to defend and our insurance coverage may not be sufficient to cover all of our product liability-related expenses or losses, if it applies at all. Moreover, insurance coverage is becoming increasingly expensive, and, in the future, we may not be able to maintain insurance coverage at a reasonable cost, in sufficient amounts or upon adequate terms to protect us against losses due to product liability. Any damages that are not covered by insurance or are in excess of policy limits could have a material adverse effect on our financial condition, results of operations and cash flows. In addition, product liability and other claims can divert the attention of management and other personnel for significant periods of time, regardless of the ultimate outcome. Further, claims of this nature could cause our customers to lose confidence in our products and us. As a result, an unsuccessful defense of a product liability or other claim could have a material adverse effect on our financial condition, results of operations and cash flows.

 

We may be vulnerable to disruption, damage and financial obligation as a result of information technology system failures.

 

Despite the implementation of security measures, any of the internal computer systems belonging to us or our third-party service providers are vulnerable to damage from computer viruses, unauthorized access, natural disasters, terrorism, war and telecommunication and electrical failure. Any system failure, accident or security breach that causes interruptions in our own or in third-party service vendors’ operations could result in a material disruption of our product development programs. Further, our information technology and other internal infrastructure systems, including firewalls, servers, leased lines and connection to the Internet, face the risk of systemic failure, which could disrupt our operations. To the extent that any disruption or security breach results in a loss or damage to our data or applications, or inappropriate disclosure of confidential or proprietary information, we may incur resulting liability, our product development programs and competitive position may be adversely affected and the further development of our products may be delayed. Furthermore, we may incur additional costs to remedy the damage caused by these disruptions or security breaches. We do not currently maintain insurance coverage that would potentially address such costs and are not certain whether we can obtain such coverage at an acceptable cost, if at all. Even if we were to obtain such insurance coverage, there can be no assurance that the policy obtained would cover some or all of the costs incurred by such disruptions or security breaches, and thus we may still incur significant financial losses upon such an event.

 

Additionally, certain confidential information, including nonpublic personal information and sensitive business data, including but not limited to data pertaining to certain public utilities, may be processed and stored on, and transmitted through, our computer systems and networks. In the event such information is jeopardized as a result of a disruption causing system failure, we may suffer significant losses, reputational damage, litigation, regulatory fines or penalties, or otherwise experience a material adverse effect on our business, financial condition or results of operations.

 

We are an “emerging growth company” and the reduced reporting requirements applicable to emerging growth companies may make our common stock less attractive to investors.

 

We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, and we may take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. Investors may find our common stock less attractive because we may rely on these exemptions, there may be a less active trading market for our common stock and our stock price may be more volatile.

 

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In addition, Section 107 of the JOBS Act also provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended, or the Securities Act, for complying with new or revised accounting standards. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. However, we are choosing to “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

 

As an emerging growth company, we have also chosen to take advantage of certain provisions of the JOBS Act that allow us to provide you with less information in this report than would otherwise be required if we are not an emerging growth company. As a result, this report includes less information about us than would otherwise be required if we were not an emerging growth company within the meaning of the JOBS Act, which may make it more difficult for you to evaluate an investment in us. 

 

We would cease to be an emerging growth company upon the earliest of: (a) the last day of the first fiscal year in which our annual gross revenues exceed $1.0 billion, (b) the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our shares that are held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, (c) the date on which we have issued, during the previous three-year period, more than $1.0 billion in nonconvertible debt, or (d) the last day of our fiscal year containing the fifth anniversary of the date of our first sale of our common equity securities pursuant to an effective registration statement in the United States, which will occur on December 31, 2017.

 

Risks Related to Our Intellectual Property

 

We may not be able to obtain, maintain, defend or enforce the intellectual property rights covering our products, which could adversely affect our ability to compete.

 

We utilize a variety of intellectual property rights in our products and technology. We use our portfolio of process and design technologies as part of our effort to differentiate our product offerings. Our commercial success depends, in large part, on our ability to obtain, maintain, defend or enforce our patents, trademarks, trade secrets and other intellectual property rights covering our technologies and products. We may not have sufficient resources or may otherwise be unable to preserve these intellectual property rights successfully in the future and such rights could be invalidated, circumvented, challenged, breached or infringed upon. If we are unable to protect and maintain our intellectual property rights, or if there are any successful intellectual property challenges or infringement proceedings against us, our ability to differentiate our product offerings would be substantially impaired. In addition, if our intellectual property rights or work processes become obsolete, we may not be able to differentiate our product offerings and some of our competitors may be able to offer more attractive products to our customers, which could materially adversely affect our competitive business position and harm our business prospects.

 

We may be unable to enforce our intellectual property rights throughout the world.

 

The laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Companies have encountered significant problems in protecting and defending intellectual property rights in certain foreign jurisdictions. To the extent that we have obtained or are able to obtain patents or other intellectual property rights in any foreign jurisdictions, it may be difficult to stop the infringement of our patents or the misappropriation of other intellectual property rights. For example, some foreign countries have compulsory licensing laws under which a patent owner must grant licenses to third parties. In addition, some countries limit the availability of certain types of patent rights and enforceability of patents against third parties, including government agencies or government contractors. In these countries, patents may provide only limited benefit or no benefit.

 

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Proceedings to enforce our patent rights in foreign jurisdictions could result in substantial costs and divert our efforts and attention from other aspects of our business. Accordingly, efforts to protect our intellectual property rights in such countries may be inadequate. In addition, future changes in the law and legal decisions by courts in the United States and foreign countries may affect our ability to obtain adequate protection for our technology and products and the enforcement of intellectual property. 

 

Developments or assertions by us or against us relating to intellectual property rights could materially impact our business.

 

We currently own or license significant intellectual property, including patents, and intend to be involved in future licensing arrangements. Patent laws afford only limited practical protection of our intellectual property rights.

 

Litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others or to defend against claims of invalidity. As we create or adopt new technology, we will also face an inherent risk of exposure to the claims of others that we have allegedly violated their intellectual property rights.

 

We might experience intellectual property claim losses in the future and we might also incur significant costs to defend such claims. Infringement or invalidity claims could materially adversely affect our business, results of operations and financial condition. Regardless of the validity or the success of the assertion of these claims, we could incur significant costs and diversion of resources in enforcing our intellectual property rights or in defending against such claims, which could have a material adverse effect on our business, results of operations and financial condition.

 

Confidentiality agreements with employees and others may not adequately prevent disclosure of our trade secrets and other proprietary information.

 

Our success depends upon the skills, knowledge, and experience of our technical personnel, our consultants and our advisors, as well as our licensees and contractors, and, as such, trade secrets are an important element of our overall intellectual property portfolio. However, trade secrets are difficult to protect. We enter, and currently expect that we will continue to enter, into confidentiality and intellectual property assignment agreements with our corporate partners, employees, consultants, outside scientific collaborators, developers, licensees and other advisors that may be breached or may not effectively assign intellectual property rights to us. Our trade secrets also could be independently discovered by our competitors, in which case we would not be able to prevent use of such trade secrets by these competitors. The enforcement of a claim alleging that a party illegally obtained and used our trade secrets could be difficult, expensive and time consuming, and we cannot predict the outcome. In addition, courts outside the United States may be less willing to protect trade secrets than will courts within the United States. The failure to obtain or maintain meaningful trade secret protection could adversely affect our competitive position.

 

Many of our competitors have significant resources and incentives to apply for and obtain intellectual property rights that could limit or prevent our ability to commercialize our current or future products in the United States or abroad.

 

Many of our existing and potential competitors, who have or may have significant resources and have made or may make substantial investments in competing technologies, have sought or may seek to apply for and obtain patents that prevent, limit or interfere or will prevent, limit or interfere with our ability to make, use or sell our products either in the United States or in international markets. Our current or future U. S. or foreign patents may be challenged or circumvented by competitors or others or may be found to be invalid, unenforceable or insufficient. Since patent applications are confidential until patents are issued in the United States or, in most cases, until after 18 months from filing of the application, or corresponding applications are published in other countries, and since publication of discoveries in the scientific or patent literature often lags behind actual discoveries, we cannot be certain that we were the first to file patent applications for inventions or that we would have priority rights with respect to inventions covered by our pending applications. 

 

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Risks Related to Our Securities

 

If an orderly and active trading market for our securities does not develop or is not sustained, the value and liquidity of your investment in our securities could be adversely affected.

 

An active or liquid market in our common stock or securities exercisable or convertible for our common stock does not currently exist and might not develop or, if it does develop, it might not be sustainable. The last reported sale price of our common stock on the OTCQB Marketplace on April 10, 2017 was $2.00 per share. The historic bid and ask quotations for our common stock, however, should not be viewed as an indicator of the current or historical market price for our common stock nor as an indicator of the market price for our common stock if our common stock were to be listed on a national securities exchange. The offering price for our securities as issued by the Company from time to time is determined through discussions between the Company and the prospective investor(s), with reference to the most recent closing price of our common stock on the OTCQB Marketplace, and may vary from the market price of our securities following any offering. Further, our trading volume on the OTCQB Marketplace has been generally very limited.

 

If an active public market for our common stock develops, we expect the market price may be volatile, which may depress the market price of our securities and result in substantial losses to investors if they are unable to sell their securities at or above their purchase price.

 

If an active public market for our common stock develops, we expect the market price of our securities to fluctuate substantially for the foreseeable future, primarily due to a number of factors, including:

 

 

  

our status as a company with a limited operating history and limited revenues to date, which may make risk-averse investors more inclined to sell their shares on the market more quickly and at greater discounts than would be the case with the shares of a seasoned issuer in the event of negative news or lack of progress;
     
  announcements of technological innovations or new products by us or our existing or future competitors;
     
  the timing and development of our products;
     
  general and industry-specific economic conditions;
     
  actual or anticipated fluctuations in our operating results;
     
  liquidity;
     
  actions by our stockholders;
     
  changes in our cash flow from operations or earnings estimates;
     
  changes in market valuations of similar companies;
     
  our capital commitments; and
     
  the loss of any of our key management personnel.

  

In addition, market prices of the securities of technology companies, particularly companies like ours without consistent revenues and earnings, have been highly volatile and may continue to be highly volatile in the future, some of which may be unrelated to the operating performance of particular companies. Further, our common stock is currently quoted on the OTCQB Marketplace, which is often characterized by low trading volume and by wide fluctuations in trading prices due to many factors that may have little to do with our operations or business prospects. The availability of buyers and sellers represented by this volatility could lead to a market price for our common stock that is unrelated to operating performance. Moreover, the OTCQB Marketplace is not a stock exchange, and trading of securities quoted on the OTCQB Marketplace is often more sporadic than the trading of securities listed on a national securities exchange like The NASDAQ Stock Market or the New York Stock Exchange. Even if we were to seek to list our securities on a national securities exchange, there is no assurance we will be able to do so, and if we do so, many of these same forces and limitations may still impact our trading volumes and market price in the near term. Additionally, the sale or attempted sale of a large amount of common stock into the market may also have a significant impact on the trading price of our common stock.

 

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Many of these factors are beyond our control and may decrease the market price of our common stock, regardless of our operating performance. In the past, securities class action litigation has often been brought against companies that experience high volatility in the market price of their securities. Whether or not meritorious, litigation brought against us could result in substantial costs, divert management’s attention and resources and harm our financial condition and results of operations.

 

We have a substantial number of options, warrants and convertible notes outstanding, which could give rise to additional issuances of our common stock, potential dilution of ownership to existing stockholders and volatility in the price of our securities.

 

As of April 13, 2017, we have outstanding options and warrants to purchase an aggregate of 6,004,818 shares of our common stock at exercise prices ranging from $2.50 to $50.00 per share. Of these, 645,937 represent shares underlying employee and director options with exercise prices ranging from $2.50 to $24.00 per share and 5,358,881 represent shares underlying warrants at exercise prices ranging from $3.00 to $50.00 per share. As of April 13, 2017, we also have outstanding convertible notes with an aggregate principal amount of $10.4 million, which are convertible into shares of our common stock in accordance with the terms of such notes at a conversion price of $2.50 per share. 

 

Further, the trading price of our securities could decline if there are substantial sales of our common stock, particularly sales by our directors, executive officers, employees and significant stockholders, or when there is a large number of shares of our common stock available for sale, as would occur in the event of an exercise of outstanding options and/or warrants or a conversion of our outstanding convertible notes.

 

We expect to seek additional funding and may issue new securities with terms or rights superior to those of our shares of common stock, which could adversely affect the market price (if any) of our securities and our business.

 

Our certificate of incorporation authorizes up to 200,000,000 shares of common stock with a par value of $0.0001 per share, and 50,000,000 shares of preferred stock with a par value of $0.0001 per share. Our board of directors may choose to issue some or all of such shares to fund our overhead and general operating requirements or to acquire one or more companies or properties. The issuance of any such shares may reduce the book value per share and may contribute to a reduction in the market price (if any) of the outstanding shares of our common stock or preferred stock. If we issue any such additional shares, such issuance could reduce the proportionate ownership and voting power of all current stockholders. Further, such issuance(s) may result in a change of control of our Company.

 

Our leadership and principal stockholders own or, upon exercise of outstanding convertible notes and warrants, could own, a large percentage of our voting stock, which would allow them to influence substantial control over matters requiring stockholder approval.

 

Currently, our executive officers, directors, Like Capital Limited, SAIL Exit Partners, LLC and its affiliates and Jeneration Capital Master Fund and its affiliates beneficially own approximately 55.6% of our outstanding common stock, based on the beneficial ownership at April 10, 2017. If these stockholders act together, they may be able to elect our board of directors, depending on stockholder participation at our annual meetings, and may significantly influence most other matters requiring approval by stockholders, including the approval of mergers, going private transactions, and other extraordinary transactions, as well as the terms of any of these transactions. Further, but for the application of blocker provisions in certain security instruments that subject the conversion or exercise of such instruments, as applicable, to 4.99% or 9.99% beneficial ownership limitations, a number of additional stockholders would beneficially own greater than ten percent of our outstanding common stock at April 10, 2017. If these stockholders were to exercise such instruments to the maximum extent possible, absent such blocker provisions, such stockholders would have the ability to also obtain a substantial interest in our Company. This concentration and potential further concentration of ownership could have the effect of delaying a change in our control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which could in turn have an adverse effect on the market price of our common stock or prevent our stockholders from realizing a premium over the then-prevailing market price for their shares of common stock.

 

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Certain provisions in our charter documents have anti-takeover effects.

 

Certain provisions of our certificate of incorporation and bylaws may have the effect of delaying, deferring or preventing a change in control of us. Such provisions, including those limiting who may call special stockholders’ meetings, together with the possible issuance of our preferred stock without stockholder approval, may make it more difficult for other persons, without the approval of our board of directors, to make a tender offer or otherwise acquire substantial amounts of our common stock or to launch other takeover attempts that a stockholder might consider to be in such stockholder’s best interest. See “Description of Capital Stock” for additional information.

 

Our operating results may fluctuate significantly, and these fluctuations may cause the price of our securities to fall.

 

Our quarterly operating results may fluctuate significantly in the future due to a variety of factors that could affect our revenues or our expenses in any particular quarter. You should not rely on quarter-to-quarter comparisons of our results of operations as an indication of future performance. Factors that may affect our quarterly results include:

 

  market acceptance of our products and those of our competitors;
     
  the sales and fulfillment cycle associated with our products, which is typically lengthy and subject to a number of significant risks over which we have little or no control, and the corresponding delay in our receipt of the associated revenue;
     
  our ability to complete the technical milestone tests associated with our commercial agreements;
     
  our ability to attract and retain key personnel;
     
  development of new designs and technologies; and
     
  our ability to manage our anticipated growth and expansion.

 

Until our common stock is listed on a qualified national securities exchange or our common stock price exceeds $5 per share, our common stock will be considered a “penny stock” and will not qualify for exemption from the “penny stock” restrictions, which may make it more difficult for you to sell your securities.

 

Historically, shares of our common stock have traded on the OTCQB Marketplace at a price of less than $5.00 per share and, as a result, our common stock is considered a “penny stock” by the SEC and subject to rules adopted by the SEC regulating broker-dealer practices in connection with transactions in “penny stocks.” The SEC has adopted regulations which generally define a “penny stock” to be any equity security that is not listed on a qualified national securities exchange and that has a market price of less than $5.00 per share, or with an exercise price of less than $5.00 per share, subject to certain exceptions. Our securities are covered by the penny stock rules, which impose additional sales practice requirements on broker-dealers who sell to persons other than established customers and accredited investors. The penny stock rules require a broker-dealer, prior to a transaction in a penny stock not otherwise exempt from the rules, to deliver a standardized risk disclosure document in a form prepared by the SEC which provides information about penny stocks and the nature and level of risks in the penny stock market. The broker-dealer also must provide the customer with current bid and offer quotations for the penny stock, the compensation of the broker-dealer and its salesperson in the transaction and monthly account statements showing the market value of each penny stock held in the customer’s account. The bid and offer quotations, and the broker-dealer and salesperson compensation information, must be given to the customer orally or in writing prior to effecting the transaction and must be given to the customer in writing before or with the customer’s confirmation. In addition, the penny stock rules require that prior to a transaction in a penny stock not otherwise exempt from these rules; the broker-dealer must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser’s written agreement to the transaction. These disclosure requirements may have the effect of reducing the level of trading activity in the secondary market for the security that is subject to these penny stock rules. Consequently, these penny stock rules may affect the ability of broker-dealers to trade our securities. We believe that the penny stock rules discourage investor interest in and limit the marketability of our securities.

 

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FINRA sales practice requirements may also limit a stockholder’s ability to buy and sell our securities.

 

In addition to the “penny stock” rules described above, the Financial Industry Regulatory Authority, or FINRA, has adopted rules that require that in recommending an investment to a customer, a broker-dealer must have reasonable grounds for believing that the investment is suitable for that customer. Prior to recommending speculative low priced securities to their non-institutional customers, broker-dealers must make reasonable efforts to obtain information about the customer’s financial status, tax status, investment objectives and other information. Under interpretations of these rules, FINRA believes that there is a high probability that speculative low priced securities will not be suitable for at least some customers. The FINRA requirements may make it more difficult for broker-dealers to recommend that their customers buy our securities, which may limit your ability to buy and sell our securities and have an adverse effect on the market for our securities.

 

We are a former “shell company” and, as such, are subject to certain limitations not applicable to other public companies generally.

 

Prior to our reverse merger transaction in July 2013, we were a public reporting “shell company,” as defined in Rule 12b-2 under the Exchange Act. Although we are no longer a “shell company,” the Rule 144 safe harbor available for the resale of our restricted securities is only available to our stockholders if we have filed all reports and other materials required to be filed by Section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months, other than current reports on Form 8-K, at the time of the proposed sale, regardless of whether the restricted securities were initially issued at the time we were a shell company or subsequent to termination of such status. Other reporting companies that are not former shell companies and have been reporting for more than 12 months are not subject to this same reporting threshold for non-affiliate reliance on Rule 144.

 

As a result of the restrictions applicable to former shell companies, we may be less successful in offering registered securities to investors and investors may have less interest in obtaining restricted securities, which may materially and adversely affect our ability to efficiently and timely raise additional financing, if we are able to do so at all.

 

Further, as shell companies and reverse merger transactions have been, and remain to some degree, subject to additional scrutiny by the SEC, FINRA and the national securities exchanges, our prior shell company status and the reverse merger transaction that terminated it may result in delays in the completion of any offering and our attempt to qualify for and list on a national securities exchange. Specifically, as a former shell company and subject of a reverse merger transaction, we are required to demonstrate the ability to maintain a threshold per share market price for an extended trading period in order to qualify for listing on a national securities exchange. If we are unable to do so, we will breach certain contractual obligations and may need to complete additional securities issuances on terms and at pricing that would be materially adverse to our financial condition and dilutive to our stockholders.

 

The indemnification rights provided to our directors, officers and employees may result in substantial expenditures by us and may discourage lawsuits against its directors, officers, and employees.

 

Our certificate of incorporation and bylaws contain provisions permitting us to enter into indemnification agreements with our directors, officers, and employees. We also have contractual obligations to provide such indemnification protection to the extent not covered by directors’ and officers’ liability insurance. The foregoing indemnification obligations could result in us incurring substantial expenditures to cover the cost of settlement or damage awards against directors and officers, which we may be unable to recoup. These provisions and resultant costs may also discourage us from bringing a lawsuit against our directors and officers for breaches of their fiduciary duties, and may similarly discourage the filing of derivative litigation by our stockholders against our directors and officers even though such actions, if successful, might otherwise benefit us and our stockholders.

 

To date, we have not paid any cash dividends and we do not anticipate paying any such dividends in the foreseeable future.

 

We have never paid cash dividends on our capital stock. We do not currently anticipate paying cash dividends on our common stock in the foreseeable future and we may not have sufficient funds legally available to pay dividends. Even if the funds are legally available for distribution, we may nevertheless decide not to pay any dividends. We presently intend to retain all earnings for our operations.

 

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ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

 

ITEM 2. PROPERTIES

 

For the year ended December 31, 2016 and through March 31, 2017, our headquarters were located at 9400 Toledo Way, Irvine, California 92618. The property consisted of a mixed use commercial office, production, and warehouse facility of 32,649 square feet and expired December 31, 2016. We extended the lease at a reduced rate until March 31, 2017.  The monthly rent was $26,825 for 2016 and reduced to $15,000 per month for the three months ending March 31, 2017. As of April 1, 2017, our headquarters is located at 8965 Research Drive, Irvine, CA 92618 and consists of a mixed use commercial office of 4,960 square feet. From January through March 2017, our monthly rent was $15,000 for the Toledo Way property holdover and, from April 1, 2017, our monthly rent is $10,168 per month, with annual escalations on April 1, 2018 to $10,473 per month and on April 1, 2019 to $10,787 per month for the Research Drive property. The Toledo Way lease terminated on April 1, 2017 and the Research Drive property lease expires on March 31, 2020.

 

As of March 31, 2017, our combined remaining minimum lease payments for both the residual three months at Toledo Way and the new lease at Research Drive through March 31, 2020 is $422,000.

 

We also leased space from the Regents of the University of California, Irvine, for the installation and demonstration of the EC250 equipment. The lease expired on January 31, 2015 and the monthly payment was $7,780 from August 1, 2013 through January 31, 2015. The university provided us with certain goods and services including certain research and development services. The lease became month-to-month after January 31, 2015.

 

ITEM 3. LEGAL PROCEEDINGS

 

We know of no material, existing or pending legal proceedings against us, nor are we involved as a plaintiff in any material proceeding or pending litigation. There are no proceedings in which any of our directors, officers or affiliates, or any registered or beneficial stockholder, is an adverse party or has a material interest adverse to our interest.

 

ITEM 4. MINE SAFETY DISCLOSURES

 

Not applicable.

 

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PART II

 

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

 

Market Information

 

Our common stock is currently quoted on the OTCQB Marketplace under the symbol “ENCR.” Our common stock commenced trading on the OTCQB Marketplace in the first quarter of 2013 under the symbol “ITTC.” On May 16, 2013, we changed our symbol to “ENCR.” The units and warrants offered hereby are not currently quoted on the over-the-counter markets or listed on a national securities exchange.

 

The following table sets forth, for each of the calendar periods indicated, the quarterly high and low bid prices of our common stock quoted on the OTCQB Marketplace. The prices in the table represent prices between dealers and do not include adjustments for retail mark-up, markdown or commission and may not represent actual transactions.

 

On May 6, 2013, we effected a 30-for-1 forward split of our issued and outstanding common stock, and on July 8, 2015, we effected a 1-for-50 reverse split of our issued and outstanding common stock. The table below gives effect to both the 30-for-1 forward split and 1-for-50 reverse split, retroactively.

 

   Closing Bid 
   High ($)   Low ($) 
Year ended December 31, 2015        
First Quarter   13.00    6.50 
Second Quarter   14.00    6.50 
Third Quarter   8.00    2.75 
Fourth Quarter   7.00    3.63 

 

   Closing Bid 
   High ($)   Low ($) 
Year ended December 31, 2016        
First Quarter   5.30    2.80 
Second Quarter   4.75    3.20 
Third Quarter   4.00    2.30 
Fourth Quarter   3.10    1.52 

 

Based on the records of our transfer agent, we had 4,063,660 shares of common stock issued and outstanding as of April 10, 2017.

 

Holders

 

Based on the records of our transfer agent, there were 130 stockholders of record of our common stock as of April 10, 2017 (not including beneficial owners who hold shares at broker/dealers in “street name”).

 

Dividends

 

While there are no restrictions that limit our ability to pay dividends, we have not paid, and do not currently intend to pay cash dividends on our common stock in the foreseeable future. Our policy is to retain all earnings, if any, to provide funds for operation and expansion of our business. The declaration of dividends, if any, will be subject to the discretion of our board of directors, which may consider such factors as our results of operations, financial condition, capital needs and acquisition strategy, among others.

  

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Securities Authorized for Issuance under Equity Compensation Plans

 

The information included under Item 12 of Part III of this report titled “Equity Compensation Plan Information” is hereby incorporated by reference into this Item 5 of Part II of this report.

 

Recent Sales of Unregistered Securities

 

On December 13, 2016, we issued 44,444 shares of our common stock to an accredited investor upon conversion by such investor of an outstanding convertible senior secured promissory note originally issued on May 9, 2015 at a conversion price of $2.50 per share.

 

ITEM 6. SELECTED FINANCIAL DATA

 

Not applicable.

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS 

 

The following discussion and analysis of our results of operations and financial condition for fiscal years ended December 31, 2016 and 2015, should be read in conjunction with our financial statements and the notes to those financial statements that are included elsewhere in this report. Our discussion includes forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth under the “Risk Factors” and “Description of Business” sections and elsewhere in this report. We use words such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” “predict” and similar expressions to identify forward-looking statements. Although we believe the expectations expressed in these forward-looking statements are based on reasonable assumptions within the bound of our knowledge of our business, our actual results could differ materially from those discussed in these statements. Factors that could contribute to such differences include, but are not limited to, those discussed in the “Risk Factors” section of this report. We undertake no obligation to update publicly any forward-looking statements for any reason even if new information becomes available or other events occur in the future.

 

Overview

  

Our proprietary and patented Power Oxidation technology is designed to create greater industrial efficiencies by providing the opportunity to convert low-quality organic waste gases generated from industrial processes into usable on-site energy, therefore decreasing both operating costs and significantly reducing environmentally harmful gaseous emissions. We design, develop, license, manufacture and market our Power Oxidizers, which, when bundled with an electricity generating turbine in the 250 kilowatt, or kW, and 2 megawatt, or MW, sizes, are called Powerstations. We currently partner and are pursuing partnerships with large established manufacturers to integrate our Power Oxidizer with their gas turbines, with the goal to open substantial new opportunities for our partners to market these modified gas turbines to industries for which traditional power generation technologies previously were not technically feasible. We currently manufacture our Powerstations in the 250 kW size and manufacture just the Power Oxidizer for the 2 MW size. Beginning in 2017, Dresser-Rand a.s., a subsidiary of Dresser-Rand Group Inc., a Siemens company, or Dresser-Rand, will manufacture the 2 MW Power Oxidizers under a manufacturing license and will pay us a non-refundable license fee for each unit manufactured by Dresser-Rand.

 

Historically, basic industries such as Petroleum, Plastics, Steel and Paper have consumed electricity in their manufacturing processes and created heat for their manufacturing processes through the burning of fossil fuels in a combustion chamber. Nearly all such combustion chambers use high quality premium fuels and burn those fuels at high temperatures, while low-quality waste gases were typically destroyed or vented into the atmosphere. Worldwide, these industrial processes collectively contribute approximately 32% of total global greenhouse gas emissions. Our technology utilizes these waste gases by modifying turbines with our gradual oxidation vessel. Inside this vessel, pressure and temperature are applied over time to destroy contaminants and return a substantially low emission source of energy in the form of heat. This heat then powers a turbine, spinning a generator and creating electricity. This technology can potentially unlock a new, global source of clean power generation (electricity, steam and/or heat energy) while reducing harmful emissions. Our goal is to enable industrial process facilities to generate clean energy from their existing waste gases, thereby reducing the amount of energy they purchase from their regional utilities, and simultaneously reducing the cost of compliance with local, state, and federal air quality regulations by avoiding the chemicals, catalysts and complex permitting required by existing pollution abatement systems.

 

Our Products and Value Proposition

 

We have developed a 250 kW Power Oxidizer that we integrate with a 250 kW gas turbine to produce 250 kW Powerstations. We have Powerstations currently in operation at a landfill site in the Netherlands and at the Irvine campus of the University of California, Irvine, and one additional Powerstation currently in the production phase expected to be installed at a landfill in southern California. We have also built a Power Oxidizer of a significantly larger size, capable of generating sufficient heat and airflow to power a KG2 turbine produced by Dresser-Rand. Together, the Power Oxidizer and KG2 turbine comprise a 2 MW KG2/PO unit. The initial unit was constructed in the first quarter of 2016 and was used in field tests during 2016 at a third party location in Southern California. We have sold two 2 MW KG2/PO units to Dresser-Rand, each of which were delivered to the Stockton, California biorefinery site owned by Pacific Ethanol in October 2016. In December 2016, we combined the 2 MW Power Oxidizers with KG2 turbines and installed the resulting KG2/PO units. Final commissioning has been delayed due to project changes outside of the scope of our deliverables under the larger project installation, although we expect final commissioning to occur in the second quarter of 2017. We believe this scaled-up version of our Power Oxidizer, once combined with the KG2 turbine, results in a Powerstation product that is better aligned with the scale of emissions (and energy requirements) observed at the industrial facilities that we believe stand to benefit most from this technology. As with the 250 kW Powerstation, the larger Powerstations are designed to provide an alternative to typical combustion-based power generation and enable industries to utilize their own waste gases to generate power.

  

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We also expect to integrate our Power Oxidizer technology into additional sized gas turbines as well as other applications that can use the heat generated by our Power Oxidizers to power other industrial applications. We believe other waste gas-to-heat opportunities, powered by an ultra-low pollution Power Oxidizer, include: (i) the generation of steam from coupling a Power Oxidizer with a traditional steam boiler, (ii) use in industrial grade dryers for kilns or industrial drying customer requirements, and (iii) use in industrial chiller units for customers requiring cold air or water in their processes.

 

We believe our Power Oxidizers provide a significantly lower fuel cost per kilowatt hour since they can operate using both premium and refined natural gas, a wide variety of lower quality, low hydrocarbon gases, traditionally considered to be “waste” gases, as well as certain volatile organic compounds, or VOCs, such as paint solvents. These gases and compounds are typically seen as a waste by-product of industrial processes, which often represent a source of pollution and, in turn, require expensive waste abatement equipment and significant recurring operating costs. As such, our Power Oxidizers are designed to serve as an opportunity for our industrial customers to reduce their fuel costs.

 

We also believe our Power Oxidizers provide a superior air pollution waste abatement solution for industrial customers. Typically, industrial customers require electricity and steam and generate industrial gases as a by-product of their facility operations. Prior to the introduction of our Powerstations, these customers would purchase or produce energy using a traditional gas turbine, which uses a combustion chamber to ignite natural gas and generates air pollution in the form of carbon dioxide, carbon monoxide and nitrogen oxides. The gas turbine and by-product gases generally require pollution control equipment and recurring costs in order to comply with existing pollution standards, which vary by geography. Since both the natural gas fuel and the industrial by-product gases oxidize in our Power Oxidizers over a much longer time than combustion heat sources, the Power Oxidizer reduces both the gas fuels and by-products to levels below substantially all of the existing and proposed air quality emission standards in most areas of the world.

 

Dresser-Rand 2 MW Integration

 

During the year ended December 31, 2016, we allocated a significant portion of our resources, including nearly all of our engineering staff and additional consultants, to the completion of our initial 2 MW Power Oxidizer, which we subsequently integrated with the Dresser-Rand KG2-3GEF turbine to create a 2 MW KG2/PO unit. The initial system was fully constructed in the second quarter of 2016 and began an initial test run in the third quarter of 2016. Final field tests were conducted on the initial system in the fourth quarter of 2016.

 

On November 14, 2014, we entered into a Commercial License Agreement, or, as amended, the CLA, with Dresser-Rand through our wholly-owned subsidiary, Ener-Core Power, Inc., which granted Dresser-Rand the right to market and sell the Dresser-Rand KG2-3GEF 2 MW gas turbine coupled with our Power Oxidizer, or a Combined System. The CLA grants Dresser-Rand exclusive rights to commercialize our Power Oxidizer, within the 1–4 MW range of power capacity, bundled with the Dresser-Rand KG2 gas-turbine product line. As part of the CLA, Dresser-Rand agreed to pay us a $1.6 million initial license fee, under the condition that we were able to successfully scale up the technology to a size of 2 MW. Dresser-Rand also agreed to achieve annual sales thresholds agreed to by both companies in order to retain the exclusivity of the commercial license. Upon payment of the initial license fee in full, Dresser-Rand obtained an exclusive license to sell our Power Oxidizer within the 1–4 MW range of power capacity, bundled with a gas-turbine to generate electricity.

 

The CLA called for a series of technical milestones. The first technical milestone involved the completion of a “Sub-Scale Acceptance Test,” or SSAT, which we successfully completed in July 2015. The second technical milestone was the “Full-Scale Acceptance Test,” or FSAT, which included a multitude of tests using a full, working Combined System. During the second half of 2015 and continuing into the first quarter of 2016, we constructed the Combined System, which was substantially complete as of September 30, 2016. We commissioned the Combined System in the second quarter of 2016 and began the FSAT procedures. We conducted an additional set of tests in November 2016 and provided the test results to Dresser-Rand in December 2016. As of April 2017, we had passed all required FSAT-related field tests conducted to date. We were unable to conduct one required test due to system issues beyond our control, but we expect to perform this final test in the second quarter of 2017.

 

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The CLA also requires the satisfaction of certain binding conditions, all fully satisfied in 2015, in order for Dresser-Rand to be obligated to perform its covenants under the CLA, which covenants include the payment of license fees into escrow, the acceptance of binding purchase orders from its customers for KG2/PO units, the issuance of binding purchase orders to us for Power Oxidizer units and the performance of additional engineering services required for the FSAT. In March 2015, the CLA was amended to revise the second binding condition. The revised binding condition eliminates the need for a bond but requires the $400,000 quarterly cash payments due from Dresser-Rand to be paid into a cash escrow account. In September 2016, we and Dresser-Rand mutually agreed to release the escrowed cash of $1.1 million in net license fees and, in October 2016, the escrow account was closed. In October 2016, we shipped the first two KG2/PO units to the Pacific Ethanol location in Stockton, California for further implementation with the Dresser-Rand KG2 turbines. These systems were installed and initially started up in December 2016. Final commissioning is expected in the second quarter of 2017 after project deliverables and tasks outside of the scope of our commissioning obligations are completed by other parties.

 

Dresser-Rand Commercial and Manufacturing Agreement

 

On June 29, 2016, we entered into a Commercial and Manufacturing License Agreement, or the CMLA, with Dresser-Rand, through our wholly-owned subsidiary, Ener-Core Power, Inc. In April 2017, we amended the terms of the CMLA to make the CMLA effective as of January 1, 2017, at which time it superseded and replaced the CLA.

 

Under the CMLA, as amended, Dresser-Rand will have a worldwide license to manufacture, market, commercialize and sell the Power Oxidizer as part of the Combined System within the 1 MW to 4 MW range of power capacity, or the License. Initially, the License will be exclusive, even as to us, and will remain exclusive for so long as Dresser-Rand sells a minimum of number of units of the Combined System in each Sales Threshold subject to certain conditions and exceptions. The Initial Sales Threshold shall begin on the earlier of the “Initial System Completion Date” or July 15, 2017 and shall be fifteen months long. The Initial System Completion Date is the date at which the final operational field test is accepted by D-R and is expected in the second quarter of 2017. Each subsequent Sales Threshold shall be one year in length thereafter. If Dresser-Rand does not meet either the initial or any subsequent Sales Threshold, and the Sales Threshold is not otherwise waived, Dresser-Rand may maintain exclusivity of the License by making a true-up payment to us for each unit that is in deficit of the Sales Threshold, or a True-Up Payment; provided, however, that Dresser-Rand may not maintain an exclusive License by making a True-Up Payment for more than two consecutive sales threshold periods. In the event Dresser-Rand does not meet the Sales Threshold, does not qualify for a waiver and elects not to make the True-Up Payment, the License will convert to a nonexclusive License. 

 

Upon a sale by Dresser-Rand of a Combined System unit to a customer, before any discounts, the CMLA requires Dresser-Rand to make a license fee payment to us equal to a percentage of the sales price of the Combined System purchased, in accordance with a predetermined fee schedule that is anticipated to result in a payment of between $370,000 and $650,000 per Combined System unit sold, or the License Fee. Payment terms to us from Dresser-Rand will be 50% of each License Fee within 30 days of order and 50% upon the earlier of the Combined System commissioning or twelve months after the order date.

 

In April 2017, we executed an amendment to the CMLA with Dresser-Rand, pursuant to which Dresser-Rand agreed to pay us $1.2 million in April 2017 in cash, which represents advance payments on license fees for KG2/PO units representing less than the required minimum number of licenses which would otherwise be required to maintain their exclusivity under the CMLA. In exchange for this payment, we have agreed to provide a total credit of $1,760,000 against future license payments associated for these KG2/PO units, consisting of a payment credit of $1,200,000 and an additional discount of $560,000.

 

Dresser-Rand may also request that we undertake design and development work on modifications to the Combined Systems, each referred to as a Bespoke Development. We and Dresser-Rand will negotiate any fees resulting from any such Bespoke Development on a case-by-case basis. Further, any obligation by us to undertake such Bespoke Development will be conditioned upon the execution of mutually agreed-upon documentation.

 

As long as the exclusive License remains in effect, we will provide certain ongoing sales and marketing support services, at no additional cost to Dresser-Rand, subject to certain restrictions. Any additional sales and marketing services agreed upon by us and Dresser-Rand will be compensated at an hourly rate to be upwardly adjusted annually.

 

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If we and Dresser-Rand so elect, we will manufacture a certain number of Power Oxidizers as part of a certain number of Combined System projects during a transition period, or the Transition Phase, beginning after execution of the CMLA and prior to the period in which Dresser-Rand manufactures its first three Power Oxidizers as part of at least two individual Combined System projects, or the Initial Manufacturing Phase, as mutually agreed by the parties. So long as the License remains exclusive during the Transition Phase, if any, and the Initial Manufacturing Phase, we will provide a mutually agreed upon number of hours of engineering support services. After the conclusion of the Initial Manufacturing Phase, we will, for so long as the License remains exclusive, continue providing up to an agreed upon number of hours of such support services on an annual basis at no additional cost to Dresser-Rand, subject to certain conditions. Any additional engineering support services agreed upon by us and Dresser-Rand will be compensated at an hourly rate, to be upwardly adjusted annually. During the Transition Phase, we must also develop the spare parts list pertaining to the scope of supply to allow Dresser-Rand to offer service agreements for the Combined System.

 

Under the CLA, we were required to maintain our existing backstop security, or the Backstop Security, in favor of Dresser-Rand in support of all products manufactured, supplied or otherwise provided by us during the period beginning on the execution date of the CMLA, or the Execution Date, and continuing through the expiration of the warranty period for the Combined System units sold to customers as of the Execution Date; Concurrent with the execution of the amendment to the CMLA in April 2017, we and Dresser-Rand modified the Backstop Security requirement. As modified, we are required to maintain a $500,000 Backstop Security, reduced from $2.1 million, and the Backstop Security was extended from June 2017 to March 31, 2018.

 

Dresser-Rand must also: (i) develop the controls strategy for the Dresser-Rand gas turbine control system and integrate it with the Power Oxidizer control system; (ii) with support from us, manufacture and commercialize the Combined System following the Transition Phase; (iii) with support from us, develop and prioritize sales opportunities for the Combined System; (iv) assume the sales lead role with respect to each customer; and (v) take commercial lead in developing sales to customers. In addition, Dresser-Rand will be primarily responsible for overall warranty and other commercial conditions to Combined System customers, as well as sole project and service provider and interface with customers. Dresser-Rand will also be responsible for warranty, service and after-sales technical assistance for all portions of Combined Systems that comprise Dresser-Rand products. We, however, will be responsible for warranty and service for all products manufactured or otherwise provided by us prior to or during the Transition Phase.

 

The CMLA prohibits us from, without the prior written consent of Dresser-Rand, permitting the creation of any encumbrance, lien or pledge of its intellectual property which would result in any modification to, revocation of, impairment of or other adverse effect on Dresser-Rand’s rights with respect to the exclusive License. In addition, all intellectual property rights that are owned by either us or Dresser-Rand as of the Execution Date will remain the sole property of such party, subject to the licenses described in the CMLA. The CMLA also contains provisions that govern the treatment of process and technology developments and any joint inventions that (i) relate to the subject matter of the CMLA and (ii) occur after the Execution Date and during the term thereof.

 

The CMLA also contains certain restrictions on publicity and obligates Dresser-Rand to use its commercially reasonable efforts to include our name and logo and otherwise promote our brand and Power Oxidizers in a mutually agreed-upon manner. We and Dresser-Rand have also mutually agreed to withhold disclosure of certain commercial and technologically sensitive terms of the CMLA including technical specifications, License Fee percentages, and the Sales Threshold minimum annual quantities to maintain exclusivity.

  

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Commercial Sales Efforts

 

We are entering the CHP market, which is highly competitive and historically conservative in its acceptance of new technologies. To date, we have sold and delivered one 250 kW commercial Powerstation unit to the Netherlands and have sold one additional 250 kW Powerstation unit to a landfill site in Southern California, which is scheduled for delivery in 2017. We have also sold two 2 MW Power Oxidizers to Dresser-Rand, which were delivered to a Stockton, California biorefinery site owned by Pacific Ethanol in October 2016 and installed in December 2016, but which remain subject to acceptance conditions that were not met as of December 31, 2016. These three systems, combined with the Dresser-Rand license fees of $1.6 million, represent our $4.6 million order backlog as of April 14, 2017. To date, we have billed $4.2 million and collected $4.1 million of our existing backlog.

 

In May 2016, we received a conditional purchase order for four 250 kW Powerstations expected to be installed on a landfill site in Southern California and scheduled for delivery in late 2017. This order is valued at approximately $4.0 million and is subject to additional pre-sales engineering and permitting requirements.

 

In April 2017, we executed an amendment to the CMLA with Dresser-Rand, pursuant to which Dresser-Rand agreed to pay us $1.2 million in April 2017. This payment represents an advance payment on future license fees for KG2/PO units to be sold under the CMLA. We have not, as yet, received a purchase order for any system subject to this license fee advance. As such, we do not consider the $1.2 million advance to be backlog as of April 13, 2017.

 

Dresser-Rand Initial Commercial Activity

 

In January 2015, Pacific Ethanol announced the first sale of the new KG2-3GEF/PO unit, which placed a two unit order with Dresser-Rand. Pursuant to the terms of the CLA, we began working on the initial phase of these two systems immediately after the announcement of the order received by Dresser-Rand from Pacific Ethanol. After receipt of formal acceptance of the successful completion of the SSAT, in August 2015, we received a binding purchase order from Dresser-Rand for two KG2/PO Power Oxidizer units rated for 1.75 MW for a total purchase price of $2.1 million. We received the entire $2.1 million purchase price in the fourth quarter of 2015 after we satisfied the Dresser-Rand performance security requirement in November 2015. In September 2016, we secured the release of the license fees payable from Dresser-Rand, which had previously been placed in an escrow account and which were contingent upon satisfaction of the FSAT. We received $1.1 million in cash, representing the $1.6 million license fee net of $500,000 paid to Dresser-Rand for engineering services. We have not recognized the license fees as revenues as of December 31, 2016, since the FSAT process was not completed at that time.

 

Other Commercial Efforts

 

In May 2015, we received an award for our second commercial EC250 Powerstation as part of a California Energy Commission award of $1.5 million to the University of California, Irvine’s Advanced Power & Energy Program. We received a formal purchase order of approximately $900,000 in the third quarter of 2015 and through September 30, 2016 we have billed and collected $815,000. We anticipate that delivery and commission of this Powerstation will occur in 2017. 

 

During 2016, our commercial sales and marketing focus was to work with the domestic and international sales and marketing teams from Dresser-Rand to facilitate additional KG2/PO unit sales in order to drive Power Oxidizer sales. While we expect to close multiple KG2/PO opportunities in 2017, some of our potential orders for KG2/PO units require the successful completion of the FSAT tests and the initial system commissioning, which we expect to occur in the second quarter of 2017. In parallel, our existing internal sales team has continued to advance commercial opportunities and enter new industrial markets with our EC250 product. We have also expanded our understanding of our greater, integrated Powerstation solution and are working towards value-added partnership relationships with key providers of products which can use our ultra-low emissions heat. We also intend to sell the Combined System, a full working KG2/PO unit described above, upon completion of the FSAT procedures. Several parties have expressed interest and we view the possible sale of the Combined System as a potential cash recovery later in 2017.

 

In April 2017, we executed an amendment to the CMLA with Dresser-Rand, pursuant to which Dresser-Rand agreed to pay us $1.2 million in April 2017, which represents advances on license fees for future KG2/PO systems (as described in greater detail above). We believe that Dresser-Rand’s decision to advance us such license fees future KG2/PO units represents a commitment to the commercial deployment of the KG2/PO units.

  

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Revenue, Order-to-Cash Cycle and Customer Order Cash Flows

 

Our order-to-cash cycle is lengthy and requires multiple steps to complete. As such, we utilize and evaluate certain metrics such as bookings, backlog, and billed backlog. The initial commercial phase involves our sales team identifying a suitable project and evaluating each site to determine whether our value proposition fits the potential customer’s needs. We evaluate potential industrial sites based on the amount, density and quality of the waste gas produced, the impacts of air quality penalties and required pollution abatement, and the expected cost savings or sales value of on-site power production. We also evaluate with the potential customer whether there are other financial considerations that could further strengthen the economic payback to the potential customer (which could include revenue increases that may result from pollution abatement benefits or emission credits or tax avoidance). As part of this evaluation, we work with potential customers to produce financial models, which seek to capture and quantify all of the various benefits of the potential project to determine the overall economic payback to the potential customer. If the potential customer determines to proceed after this evaluation, we enter into an agreement with the customer, which typically includes purchase order arrangements.

 

Customer orders, which are defined as firm commitments to purchase with fixed and determinable prices and contracted delivery terms, are considered bookings and are included as backlog. From the date of booking until the projected shipping date, we follow the standard practices that are typically followed by other power equipment producers, which include payment terms that involve customer advance payments designed to mirror our cash inventory outlays for sourcing parts and materials necessary to assemble the power plants to achieve a neutral customer order cash flow until delivery. All customer advance payments are recorded as billings, are reported as billed backlog and are represented on our balance sheet as deferred revenue or customer advances. As the Power Oxidizer plant assets are built, the costs are capitalized as inventory.

  

Powerstations are shipped to the customer locations and assembled on site. We supervise the assembly and commissioning of the Powerstations, which can take several months to complete. Once commissioning of the fully installed Powerstation(s) is/(are) concluded and title passes to the customer, we issue the final billings and recognize revenues and costs of revenues by decrementing deferred revenues and inventory respectively.

  

We also charge customers for commissioning services, post-sale support, and post-warranty service and maintenance on our Power Oxidizer units. We provide a standard warranty, which typically ends between nine months and one year after commissioning.

 

Operating Expense Reduction

 

Beginning in the first quarter of 2016, we evaluated our cash spending, including the costs incurred with our withdrawn underwritten public offering. Beginning in the second quarter of 2016 and continuing into the third quarter of 2016, we identified and implemented cost reductions, primarily the reduction of employee and consulting headcount and professional services, and we implemented additional cost reductions later in 2016 and into early 2017, including a further reduction of service provider cash spending and a reduction in our fixed overhead costs.

 

Reverse Merger

 

Prior to the reverse merger discussed below, pursuant to a contribution agreement dated November 12, 2012 by and among FlexEnergy, Inc., FlexEnergy Energy Systems, Inc., and Ener-Core Power, Inc., Ener-Core Power, Inc. (formerly Flex Power Generation, Inc.) was spun-off from FlexEnergy, Inc. as a separate corporation. As part of that transaction, Ener-Core Power, Inc. received all of the assets (including intellectual property) and liabilities pertaining to the Power Oxidizer business, which was the business carved out of FlexEnergy, Inc.

 

We were originally incorporated on April 29, 2010 in Nevada under the name Inventtech, Inc. On April 16, 2013, we entered into a merger agreement with Ener-Core Power, Inc. and a wholly-owned merger sub, pursuant to which the merger sub merged with and into Ener-Core Power, Inc., with Ener-Core Power, Inc. as the surviving entity. Prior to the merger, we were a public reporting “shell company,” as defined in Rule 12b-2 under the Exchange Act. On May 6, 2013, the pre-merger public shell company effected a 30-for-1 forward split of its common stock. All share amounts have been retroactively restated to reflect the effect of that stock split.

 

On July 1, 2013, we completed the reverse merger with Ener-Core Power, Inc., which remains our operating subsidiary. The merger was accounted for as a “reverse merger” and recapitalization. As part of the reverse merger, 120,520,000 shares of outstanding common stock of the pre-merger public shell company were cancelled (unadjusted for our July 8, 2015 reverse stock split). This cancellation has been retroactively accounted for as of the inception of Ener-Core Power, Inc. on November 12, 2012. Accordingly, Ener-Core Power, Inc. was deemed to be the accounting acquirer in the transaction and, consequently, the transaction was treated as a recapitalization of Ener-Core Power, Inc. Accordingly, the assets and liabilities and the historical operations that are reflected in the consolidated financial statements are those of Ener-Core Power, Inc. and are recorded at the historical cost basis of Ener-Core Power, Inc. Our assets, liabilities and results of operations were de minimis at the time of the reverse merger.

 

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Reverse Stock Split

 

Our April 2015 and May 2015 senior notes (see discussion below under “Financing Activities”) had three covenants, one of which was the requirement to enter into a reverse stock split in order to increase our share price above $5.00 per share in anticipation of an underwritten public offering. Our board of directors approved a reverse stock split of our authorized, issued and outstanding shares of common stock, as well as our authorized shares of preferred stock, par value $0.0001 per share, of which no shares are issued and outstanding, at a ratio of 1-for-50, or our Reverse Stock Split. On July 8, 2015, the Reverse Stock Split became effective and the total number of shares of common stock held by each stockholder of the Company converted automatically into the number of shares of common stock equal to: (i) the number of issued and outstanding shares of common stock held by each such stockholder immediately prior to the Reverse Stock Split divided by (ii) 50. We issued one whole share of the post-Reverse Stock Split common stock to any stockholder who otherwise would have received a fractional share as a result of the Reverse Stock Split, determined at the beneficial owner level by share certificate. As a result, no fractional shares were issued in connection with the Reverse Stock Split and no cash or other consideration was paid in connection with any fractional shares that would otherwise have resulted from the Reverse Stock Split. All share and per share amounts have been adjusted to reflect the reverse stock split.

 

Also on the effective date, all of our options, warrants and other convertible securities outstanding immediately prior to the Reverse Stock Split were adjusted by dividing the number of shares of common stock into which the options, warrants and other convertible securities are exercisable or convertible by 50 and multiplying the exercise or conversion price thereof by 50, all in accordance with the terms of the plans, agreements or arrangements governing such options, warrants and other convertible securities and subject to rounding to the nearest whole share. Such proportional adjustments were also made to the number of shares and restricted stock units issued and issuable under our equity compensation plans. The consolidated financial statements and notes to the consolidated financial statements included elsewhere in this report give retroactive effect to the Reverse Stock Split for all periods presented.

 

Reincorporation

 

Effective as of September 3, 2015, we changed our state of incorporation from the State of Nevada to the State of Delaware, or the Reincorporation, pursuant to a plan of conversion dated September 2, 2015, following approval by our stockholders of the Reincorporation at our 2015 Annual Meeting of Stockholders held on August 28, 2015. In connection with the Reincorporation, we filed articles of conversion with the State of Nevada and a certificate of conversion with the State of Delaware. Upon effectiveness of the Reincorporation, the rights of our stockholders became governed by the Delaware General Corporation Law, the certificate of incorporation filed in Delaware and newly adopted bylaws. As a Delaware corporation following the Reincorporation, which we refer to as Ener-Core Delaware, we are deemed to be the same continuing entity as the Nevada corporation prior to the Reincorporation, which we refer to as Ener-Core Nevada. As such, Ener-Core Delaware continues to possess all of the rights, privileges and powers of Ener-Core Nevada, all of the properties of Ener-Core Nevada and all of the debts, liabilities and obligations of Ener-Core Nevada, including all contractual obligations, and continues with the same name, business, assets, liabilities, headquarters, officers and directors as immediately prior to the Reincorporation. Upon effectiveness of the Reincorporation, all of the issued and outstanding shares of common stock of Ener-Core Nevada automatically converted into issued and outstanding shares of common stock of Ener-Core Delaware without any action on the part of our stockholders.

 

Financing Activities

 

March 2016 Debt Amendments

 

On March 31, 2016, we executed amendments to the convertible senior secured promissory notes originally issued in April and May 2015, or the 2015 Senior Notes, and related Securities Purchase Agreements, or, collectively, the March Amendments, each with certain investors holding the requisite number of conversion shares and warrant shares underlying the 2015 Senior Notes and warrants issued in April 2015 and May 2015 pursuant to the referenced Securities Purchase Agreements, or the April and May 2015 Warrants. The March Amendments (i) removed the requirement that we consummate a “Qualified Public Offering”; (ii) extended the deadline for us to commence trading on a Qualified Eligible Market (as defined in the March Amendments) to no later than April 14, 2016; provided that if we consummated a private offering of its securities resulting in gross proceeds to us of at least $3,000,000 after June 30, 2016 and prior to or on April 14, 2016, or a Qualified Private Offering, such deadline would be automatically extended to October 15, 2016; (iii) provided for the issuance of warrants to purchase up to 500,000 shares of our common stock, each with an exercise price of $5.00 per share, subject to adjustment as set forth within the warrants, or the March Warrants; and (iv) added an additional covenant on behalf of us that, on or prior to April 14, 2016, we would cause our net monthly cash flow directly associated with the CLA, taken together with our monthly capital expenditure spending associated with the CLA, and excluding expenditures associated with the FSAT requirements defined in the CLA, to be neutral or positive, to be accomplished by re-negotiation or termination of such CLA. On April 11, 2016, we consummated a $3 million private offering and thereby satisfied condition (ii) above. On March 31, 2016, we issued warrants to purchase 500,000 shares of our common stock, or the March Warrants, and remained in compliance with the net monthly cash flow covenant listed in (iv) above during all relevant times. On June 29, 2016, we entered into the CMLA with Dresser-Rand, which both companies intended would supersede and replace the CLA. In April 2017, we amended the terms of the CMLA to make the CMLA effective as of January 1, 2017, at which time it superseded and replaced the CLA . Additionally, upon execution of the September Amendments (as defined below), the monthly cash flow covenant listed in (iv) above was removed.

 

The March Amendments amended the terms of the 2015 Senior Notes to extend the conversion feature until the term of the 2015 Senior Notes and to provide for the issuance of additional warrants. Additionally, in February 2016, pursuant to the terms of the December 2015 amendments to the 2015 Senior Notes, we issued warrants to purchase up to 50,000 shares of our common stock at an exercise price of $12.50 per share, or the February Warrants, and subsequently adjusted the exercise price to $5.00 per share with the issuance of the March Warrants, to $4.00 per share upon the execution of the various warrant amendments on August 24, 2016 (as described below under “August Warrant Amendments”) and to $3.00 per share upon the execution of the amendment and restatement of the 2015 Senior Notes. We accounted for the February Warrants and the March Warrants as derivative liabilities and recorded an additional $148,000 of debt discount upon the issuance of the February Warrants and $1,497,000 of debt discount upon the issuance of the March Warrants.  The December 31, 2015 debt discount and the additional discount recorded in February 2016 and March 2016 is amortized over the expected remaining life of the debt.

 

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Underwritten Offering Withdrawal

 

On April 5, 2016, we formally requested that the SEC withdraw our registration statement, originally filed in July 2015. The underwritten public offering and a simultaneous listing on a national exchange was originally a requirement under our 2015 Senior Notes. After negotiating the March Amendments, our board of directors determined, with the consultation of our professional advisors, that market conditions in early 2016 were not conducive to a marketed underwritten public offering.

 

April 2016 Equity Financing

 

On April 11, 2016, we entered into a stock purchase agreement, pursuant to which we issued to an accredited investor an aggregate of 696,056 shares of our common stock in exchange for gross proceeds of approximately $3.0 million, or the April 2016 Private Placement. The closing of the April 2016 Private Placement satisfied the Qualified Private Offering requirement described in the March Amendments.

 

August 2016 Warrant Amendments

 

On August 24, 2016, we executed amendments to certain warrants issued in April and May 2015 Warrants, the additional warrants issued in December 2015, the warrants issued in connection with our equity financing in December 2015, the additional warrants issued in February 2016 and the additional warrants issued in March 2016. The amendments reduced the exercise price of such warrants to $4.00 per share and removed all remaining net cash settlement provisions, as applicable, in each warrant. For the warrants accounted for as derivative liabilities, we marked the warrants to market immediately prior to the change in the strike price to a value of $1,719,000. The removal of the warrant agreement provisions that required derivative accounting resulted in a reclassification of $1,719,000 from derivative liabilities to paid-in capital. The reduction in exercise price to $4.00 resulted in an additional discount to the 2015 Senior Notes of $206,000 which will be amortized to interest expense over the expected remaining life of the 2015 Senior Notes.

 

September and October 2016 Debt Amendments

 

Effective as of September 1, 2016, we executed amendments to the 2015 Senior Notes and related Securities Purchase Agreements, or the September Amendments, which are binding upon all of the 2015 Senior Notes. The September Amendments (i) extend the deadline for us to commence trading on a Qualified Eligible Market (as defined in the September Amendments) to no later than December 31, 2016; (ii) provide that we may, on or prior to September 1, 2016, issue to one or more investors up to an aggregate of $1,500,000 principal amount of one-year term unsecured notes and related warrants, and approve the forms of agreements to be executed in connection with the issuance of such unsecured notes and warrants; (iii) remove the covenant on behalf of us related to net monthly cash flow directly associated with the CLA; (iv) extend the earliest date on which the holders of the 2015 Senior Notes may require us to redeem all or any portion of such 2015 Senior Notes until December 31, 2016; and (v) extend the deadline for us to consummate a Further Private Offering (as defined in the 2015 Senior Notes) to December 31, 2016. Effective as of October 21, 2016, we executed amendments to the 2015 Senior Notes to clarify and conform the terms of such 2015 Senior Notes to the terms of previous amendments to such 2015 Senior Notes and the related Securities Purchase Agreements.

  

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September 2016 Convertible Unsecured Notes

 

On September 1, 2016, we entered into a securities purchase agreement and related note agreements and warrant agreements whereby we issued $1,250,000 in convertible unsecured promissory notes, or the Convertible Unsecured Notes, and detachable five-year warrants to purchase an aggregate of 124,999 shares of our common stock at an exercise price of $4.00 per share, or the September 2016 Financing. We received total gross proceeds of $1,250,000, less transaction expenses of $20,000 consisting of legal costs, for net proceeds of $1,230,000.

 

The Convertible Unsecured Notes bear interest at a rate of 12% per annum and mature on September 1, 2017; provided, however, that we may not prepay any portion of the outstanding principal and accrued and unpaid interest under the Convertible Unsecured Notes so long as any of the Senior Notes remain outstanding and in no event will the maturity date of such Convertible Unsecured Notes be earlier than at least ninety-one (91) days after the maturity date under the Senior Notes. The Convertible Unsecured Notes are subordinate to the Senior Notes. The Convertible Unsecured Notes were initially convertible at the option of the holder into common stock at a conversion price of $4.31 per share and will automatically convert into shares of common stock in the event of a conversion of at least 50% of the then outstanding (i) principal, (ii) accrued and unpaid interest with respect to such principal and (iii) accrued and unpaid late charges, if any, with respect to such principal and interest, under the 2015 Senior Notes. On November 23, 2016, in connection with the December 2016 Financing (as described below), the conversion price was reduced to $2.50 per share. The Convertible Unsecured Notes also contain a blocker provision that prevents us from effecting a conversion in the event that the holder, together with certain affiliated parties, would beneficially own in excess of 9.99% of the shares of common stock outstanding immediately after giving effect to such conversion. At any time after the issuance date of the Convertible Unsecured Notes, we may redeem all or any portion of the then outstanding principal and accrued and unpaid interest with respect to such principal, or the Company Optional Redemption Amount, at 100% of such aggregate amount; provided, however, that we may not redeem all or any portion of the Company Optional Redemption Amount so long as any of the Senior Notes remain outstanding without the prior written consent of the collateral agent with respect to such Senior Notes and certain investors holding the requisite number of conversion shares and warrant shares underlying the Senior Notes and related warrants.

 

The securities purchase agreement for the Convertible Unsecured Notes provides for the issuance of additional five-year warrants to purchase an aggregate of 62,500 shares at an exercise price of $4.00 per share on each of the 61st, 91st, 121st and 151st days after the closing of the September 2016 Financing, or, in each case, an Additional Warrant Date, but only in the event we have not consummated a further financing consisting of the issuance of common stock and warrants for aggregate gross proceeds of at least $3,000,000 prior to such respective Additional Warrant Date. As of January 30, 2017, we had not consummated a further financing and, as a result, issued warrants to purchase an aggregate of 250,000 shares of common stock, consisting of the issuance of an aggregate of 62,500 shares of common stock on each of November 1, 2016, December 1, 2016, December 31, 2016 and January 30, 2017.

 

December 2016 Convertible Senior Secured Promissory Notes and Warrants Financing

 

On November 23, 2016, we entered into a securities purchase agreement, pursuant to which we issued to 21 accredited investors unregistered convertible senior secured promissory notes with an aggregate principal amount of approximately $3.7 million, or the 2016 Senior Notes, and five-year warrants, or the December 2016 Financing Warrants, to purchase an aggregate of 1,498,622 shares of our common stock at an exercise price of $3.00 per share, or the December 2016 Financing Warrant Shares, with aggregate net proceeds to us after a ten percent original issue discount and placement agent fee of approximately $3.2 million, or the December 2016 Financing. In connection with the December 2016 Financing, we agreed to secure the listing of our common stock on a national securities exchange by no later than December 31, 2017.

 

The 2016 Senior Notes bear no ordinary interest, as the principal amount of the 2016 Senior Notes will include an original issue discount. Upon an Event of Default (as defined in the 2016 Senior Notes), however, the 2016 Senior Notes will bear interest at a rate of 10% per annum. The 2016 Senior Notes will mature on December 31, 2018. The 2016 Senior Notes rank pari passu with the 2015 Senior Notes and rank senior to the Convertible Unsecured Notes. The 2016 Senior Notes will be convertible at the option of the holder into common stock at an exercise price of $2.50 (as subject to adjustment therein) and will automatically convert into shares of common stock on the fifth trading day immediately following the date on which (i) the Weighted Average Price (as defined in the 2016 Senior Notes) of the common stock for each trading day during a twenty trading day period equals or exceeds $5.00 (as adjusted for any stock dividend, stock split, stock combination, reclassification or similar transaction) and no Equity Conditions Failure (as defined in the 2016 Senior Notes) has occurred. The 2016 Senior Notes also contain a blocker provision that prevents us from effecting a conversion in the event that the holder, together with certain affiliated parties, would beneficially own in excess of either 4.99% or 9.99%, with such threshold determined by the holder prior to issuance, of the shares of common stock outstanding immediately after giving effect to such conversion.

  

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Upon an Event of Default and delivery to the holder of the 2016 Senior Note of notice thereof, such holder may require us to redeem all or any portion of its 2016 Senior Note at a price equal to 115% of the Conversion Amount (as defined in the 2016 Senior Notes) being redeemed. Additionally, upon a Change of Control (as defined in the 2016 Senior Notes) and delivery to the holder of the 2016 Senior Note of notice thereof, such holder may also require us to redeem all or any portion of its 2016 Senior Note at a price equal to 115% of the Conversion Amount being redeemed. Further, at any time from and after January 1, 2018 and provided that we have not received either (i) initial deposits for at least eight 2 MW Power Oxidizer units or (ii) firm purchase orders totaling not less than $3,500,000 and initial payment collections of at least $1,600,000, in each case during the period commencing on the issuance date of the 2016 Senior Notes and ending on December 31, 2017, the holder of the 2016 Senior Note may require us to redeem all or any portion of its 2016 Senior Note at a price equal to 100% of the Conversion Amount being redeemed.

 

At any time, we may redeem all or any portion of the then outstanding principal and accrued and unpaid interest with respect to such principal under the 2016 Senior Notes, at 100% of such aggregate amount; provided, however, that the aggregate Conversion Amount to be redeemed pursuant to all 2016 Senior Notes must be at least $500,000, or such lesser amount as is then outstanding. The portion of the 2016 Senior Note(s) to be redeemed shall be redeemed at a price equal to the greater of (i) 110% of the Conversion Amount of the 2016 Senior Note being redeems and (ii) the product of (A) the Conversion Amount being redeemed and (B) the quotient determined by dividing (I) the greatest Weighted Average Price (as defined in the 2016 Senior Notes) of the shares of common stock during the period beginning on the date immediately preceding the date of the notice of such redemption by us and ending on the date on which the redemption by us occurs by (II) the lowest Conversion Price (as defined in the 2016 Senior Notes) in effect during such period.

 

The 2016 Senior Notes contain a provision that prevents us from entering into or becoming party to a Fundamental Transaction (as defined in the 2016 Senior Notes) unless the successor entity assumes all of our obligations under the 2016 Senior Notes and the related transaction documents pursuant to written agreements in form and substance satisfactory to at least a certain number of holders of the 2016 Senior Notes.

 

In connection with the execution of the purchase agreement for the December 2016 Financing and the issuance of the 2016 Senior Notes, Ener-Core Power, Inc. entered into a Guaranty, pursuant to which it has agreed to guarantee all of our obligations under the purchase agreement, the 2016 Senior Notes and the related transaction documents.

 

The December 2016 Financing Warrants are exercisable immediately in exchange for cash. In addition, unless all of the December 2016 Financing Warrant Shares that are subject to an exercise notice with respect to any December 2016 Financing Warrant are registered for resale pursuant to an effective registration statement and are issuable without any restrictive legend, such December 2016 Financing Warrant may also be exercised by way of a cashless exercise. The December 2016 Financing Warrants also provide that the exercise price of each December 2016 Financing Warrant will be adjusted upon the occurrence of certain events such as stock dividends, stock splits and other similar events. The December 2016 Financing Warrants include a blocker provision that prevents us from effecting any exercise in the event that the holder, together with certain affiliated parties, would beneficially own in excess of either 4.99% or 9.99%, with such threshold determined by the holder prior to issuance, of the shares of common stock outstanding immediately after giving effect to such exercise.

 

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December 2016 Amendments to 2015 Senior Notes

 

On November 23, 2016, we and certain investors holding 2015 Senior Notes executed amendment agreements, or the Amendment Agreements, to amend and restate the 2015 Senior Notes in order to (i) provide that the 2015 Senior Notes rank pari passu with the 2016 Senior Notes and (ii) adjust the terms of such 2015 Senior Notes, including without limitation the initial conversion price per share, to conform to the 2016 Senior Notes. Additionally, the Amendment Agreements provide for the issuance to the holders of the 2015 Senior Notes of additional warrants, or the December 2016 Additional Warrants, to purchase an aggregate of 2,222,217 shares of common stock at an exercise price of $3.00 per share, or the Additional Warrant Shares, in connection with the amendment and restatement of the 2015 Senior Notes. The Amendment Agreements also adjusted the exercise price of certain warrants held by the investors holding 2015 Senior Notes to $3.00 per share.

 

December 2016 Amendments to Convertible Unsecured Notes

 

On November 23, 2016, we and certain investors holding Convertible Unsecured Notes executed amendments to the securities purchase agreement for the Convertible Unsecured Notes, or the September 2016 SPA, to (i) extend the deadline for us to commence trading on a Qualified Eligible Market (as defined in the September 2016 SPA) to no later than December 31, 2017 and (ii) reduce the exercise price of certain warrants held by the investors holding Convertible Unsecured Notes to $3.00 per share. Additionally, we and certain investors holding Convertible Unsecured Notes executed amendments to such Convertible Unsecured Notes to reduce the initial conversion price per share of such Convertible Unsecured Notes to $2.50 and adjust certain definitions.

 

Critical Accounting Policies and Estimates

 

Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which we have prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of our financial statements, as well as the reported revenues and expenses during the reported periods. We evaluate these estimates and judgments on an ongoing basis. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

While our significant accounting policies are more fully described in the notes to our consolidated financial statements included elsewhere in this filing, we believe that the following accounting policies are the most critical to aid you in fully understanding and evaluating our financial condition and results of operations. 

 

Basis of Presentation

 

The accompanying consolidated financial statements include our accounts and our wholly-owned subsidiary, Ener-Core Power, Inc. All significant intercompany transactions and accounts have been eliminated in consolidation. All monetary amounts are rounded to the nearest $000, except for certain per share amounts.

 

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The accompanying financial statements have been prepared in accordance with GAAP.

 

Reclassifications

 

Certain amounts in the 2015 consolidated financial statements have been reclassified to conform to the current year presentation. These reclassifications have no effect on previously reported net loss.

 

Segments

 

We operate in one segment. All of our operations are located domestically.

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Significant items subject to such estimates and assumptions include but are not limited to: collectability of receivables; the valuation of certain assets, useful lives, and carrying amounts of property and equipment, equity instruments and share-based compensation; provision for contract losses; valuation allowances for deferred income tax assets; valuation of derivative liabilities; and exposure to warranty and other contingent liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

 

Foreign Currency Adjustments

 

Our functional currency for all operations worldwide is the U.S. dollar. Nonmonetary assets and liabilities are translated at historical rates and monetary assets and liabilities are translated at exchange rates in effect at the end of the year. Income statement accounts are translated at average rates for the year. At December 31, 2016 and 2015, we did not hold any foreign currency asset or liability amounts. Gains and losses resulting from foreign currency transactions are reported as other income in the period they occurred.

 

Concentrations of Credit Risk

 

Cash and Cash Equivalents

 

We maintain our non-interest bearing transactional cash accounts at financial institutions for which the Federal Deposit Insurance Corporation , or FDIC, provides insurance coverage of up to $250,000. For interest bearing cash accounts, from time to time, balances exceed the amount insured by the FDIC. We have not experienced any losses in such accounts and believe we are not exposed to any significant credit risk related to these deposits. At December 31, 2016, we had $1.1 million in excess of the FDIC limit.

  

We consider all highly liquid investments available for current use with an initial maturity of three months or less and are not restricted to be cash equivalents. We invest our cash in short-term money market accounts.

 

Restricted Cash

 

Collateral Account

 

Under a credit card processing agreement with a financial institution that was entered in 2013, we are required to maintain funds on deposit with the financial institution as collateral. The amount of the deposit, which is at the discretion of the financial institution, was $50,000 on December 31, 2016 and 2015.

  

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Dresser-Rand Escrow Account

 

Under the CLA, prepaid license fee payments of $400,000 per quarter were paid by Dresser-Rand into an escrow account with a financial institution beginning in August 2015. Dresser-Rand withdrew up to $125,000 per quarter from this escrow account for qualified engineering expenses incurred by Dresser-Rand under the terms and conditions of the CLA. Through September 26, 2016, Dresser-Rand funded $1,600,000 and withdrew $500,000. On September 26, 2016 substantially all of the remaining $1,100,000 was released to us from the escrow account and, in October 2016, the escrow account was closed. The balance in the escrow account was $0 and $150,000 on December 31, 2016 and 2015, respectively. See also “Note 8—Deferred Revenues and Customer Advances” to our consolidated financial statements included elsewhere in this report.

 

Accounts Receivable

 

Our accounts receivable are typically from credit worthy customers or, for international customers are supported by guarantees or letters of credit. For those customers to whom we extend credit, we perform periodic evaluations of them and maintain allowances for potential credit losses as deemed necessary. We generally do not require collateral to secure accounts receivable. We have a policy of reserving for uncollectible accounts based on our best estimate of the amount of probable credit losses in existing accounts receivable. We periodically review our accounts receivable to determine whether an allowance is necessary based on an analysis of past due accounts and other factors that may indicate that the realization of an account may be in doubt. Account balances deemed to be uncollectible are charged to the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.

 

As of December 31, 2016 and 2015, two customers accounted for 100% of net accounts receivable.

 

Accounts Payable

 

As of December 31, 2016 and 2015, eight and five vendors, respectively, collectively accounted for approximately 50% of our total accounts payable.

 

Inventory

 

Inventory, which consists of raw materials, is stated at the lower of cost or net realizable value, with cost being determined by the average-cost method, which approximates the first-in, first-out method. At each balance sheet date, we evaluate our ending inventory for excess quantities and obsolescence. This evaluation primarily includes an analysis of forecasted demand in relation to the inventory on hand, among consideration of other factors. Based upon the evaluation, provisions are made to reduce excess or obsolete inventories to their estimated net realizable values. Once established, write-downs are considered permanent adjustments to the cost basis of the respective inventories. At December 31, 2016 and 2015, we did not have a reserve for slow-moving or obsolete inventory.

 

Property and Equipment

 

Property and equipment are stated at cost, and are being depreciated using the straight-line method over the estimated useful lives of the related assets, ranging from three to ten years. Maintenance and repairs that do not improve or extend the lives of the respective assets are expensed. At the time property and equipment are retired or otherwise disposed of, the cost and related accumulated depreciation accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are reflected in the consolidated statements of operations.

 

Deposits

 

Deposits primarily consist of amounts incurred or paid in advance of the receipt of fixed assets or are deposits for rent and insurance.

  

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Accrued Warranties

 

Accrued warranties represent the estimated costs that will be incurred during the warranty period of our products. We make an estimate of expected costs that will be incurred by us during the warranty period and charge that expense to the consolidated statement of operations at the date of sale. We also reevaluate the estimate at each balance sheet date and if the estimate is changed, the effect is reflected in the consolidated statement of operations. We had no warranty accrual at December 31, 2016 or 2015. We expect that most terms for future warranties of our Powerstations and Power Oxidizers will be one to two years, depending on the warranties provided and the products sold. Accrued warranties for expected expenditures within one year are classified as current liabilities and as non-current liabilities for expected expenditures for time periods beyond one year.

  

Deferred Rent

 

We record deferred rent expense, which represents the temporary differences between the reporting of rental expense on the financial statements and the actual amounts remitted to the landlord. The deferred rent portion of lease agreements are leasing inducements provided by the landlord. Also, tenant improvement allowances provided are recorded as a deferred rent liability and recognized ratably as a reduction to rent expense over the lease term.

 

Intangible Assets

 

Our intangible assets represent intellectual property acquired during the reverse merger. We amortize our intangible assets with finite lives over their estimated useful lives.  

 

Impairment of Long-Lived Assets

 

We account for our long-lived assets in accordance with the accounting standards which require that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the historical carrying value of an asset may no longer be appropriate. We consider the carrying value of assets may not be recoverable based upon our review of the following events or changes in circumstances: the asset’s ability to continue to generate income from operations and positive cash flow in future periods; loss of legal ownership or title to the assets; significant changes in our strategic business objectives and utilization of the asset; or significant negative industry or economic trends. An impairment loss would be recognized when estimated future cash flows expected to result from the use of the asset are less than its carrying amount. As of December 31, 2016 and 2015, we do not believe there have been any impairments of our long-lived assets. There can be no assurance, however, that market conditions will not change or demand for our products will continue, which could result in impairment of long-lived assets in the future.

  

Fair Value of Financial Instruments

 

Our financial instruments consist primarily of cash and cash equivalents, restricted cash, accounts receivable, accounts payable, derivative liabilities, secured notes payable and related debt discounts and capital lease liabilities. Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of December 31, 2016 and 2015. The carrying amounts of short-term financial instruments are reasonable estimates of their fair values due to their short-term nature or proximity to market rates for similar items.

  

We determine the fair value of our financial instruments based on a three-level hierarchy established for fair value measurements under which these assets and liabilities must be grouped, based on significant levels of observable or unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect management’s market assumptions. This hierarchy requires the use of observable market data when available. These two types of inputs have created the following fair-value hierarchy:

 

  Level 1: Valuations based on unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. Currently, we classify our cash and cash equivalents as Level 1 financial instruments.
     
  Level 2: Valuations based on observable inputs (other than Level 1 prices), such as quoted prices for similar assets at the measurement date quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability. We do not currently have any accounts under Level 2.   
     
  Level 3: Valuations based on inputs that require inputs that are both significant to the fair value measurement and unobservable and involve management judgment (i.e., supported by little or no market activity). Currently, we classify our warrants and conversion options accounted for as derivative liabilities as Level 3 financial instruments.

 

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If the inputs used to measure fair value fall in different levels of the fair value hierarchy, a financial security’s hierarchy level is based upon the lowest level of input that is significant to the fair value measurement.

 

Derivative Financial Instruments

 

We issue derivative financial instruments in conjunction with its debt and equity offerings and to provide additional incentive to investors and placement agents. The Company uses derivative financial instruments in order to obtain the lowest cash cost-source of funds. Derivative liabilities are recognized in the consolidated balance sheets at fair value based on the criteria specified in Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, topic 815-40 “Derivatives and Hedging—Contracts in Entity’s own Equity.” The estimated fair value of the derivative liabilities is calculated using either the Black-Scholes-Merton or Monte Carlo simulation model method. 

 

We issued warrants to purchase common stock and secured debt with a conversion feature in April and May 2015, September 2016 and December 2016. We amended the 2015 Senior Notes to add a conversion feature in December 2015. We issued additional warrants to purchase common stock with price reset provisions in December 2015, February 2016 and March 2016. These embedded derivatives and warrants were evaluated under ASC topic 815-40. We determined that the conversion feature for the 2015 secured debt, the conversion feature for the September 2016 secured debt, and the warrants issued with price reset provisions should be accounted for as derivative liabilities. In August 2016, all outstanding warrants that we previously determined should be accounted for as derivative liabilities were amended and we determined that, after giving effect to the amendments, we were no longer required to account for the warrants as derivative liabilities. In December 2016, we modified the terms of the September 2016 secured debt and determined that, after giving effect to the amendments, we were no longer required to account for the conversion features as derivative liabilities. We determined that the conversion features of the warrants issued in April and May 2015, September 2016 and December 2016 should not be accounted for as derivative liabilities. Warrants and the debt conversion features determined to be derivative liabilities were bifurcated from the debt host and were classified as liabilities on the consolidated balance sheet. Warrants not determined to be derivative liabilities were recorded to debt discount and paid-in capital. We record the warrants and embedded derivative liabilities at fair value and adjust the carrying value of the warrants to purchase common stock and embedded derivatives to their estimated fair value at each reporting date with the increases or decreases in the fair value of such warrants and derivatives at each reporting date, recorded as a gain or (loss) in the consolidated statements of operations. The warrants issued in 2015 that we no longer account for as derivative liabilities were recorded to debt discount with a corresponding entry to paid-in capital. The warrants that were amended in 2016 such that we were no longer required to account for them as derivative liabilities were marked to market immediately prior to the amendment and the fair value was reclassified on the amendment date from derivative liabilities to paid-in capital.

 

Revenue Recognition

 

We generate revenue from the sale of our clean power energy systems and from consulting services. Revenue is recognized when there is persuasive evidence of an arrangement, product delivery and acceptance have occurred, the sales price is fixed or determinable and collectability of the resulting receivable is reasonably assured. Amounts billed to clients for shipping and handling are classified as sales of product with related costs incurred included in cost of sales.

 

Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related revenue is recorded. We defer any revenue for which the services have not been performed or are subject to refund until such time that we and our customer jointly determine that the services have been performed or no refund will be required.

 

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Revenues under long-term construction contracts are generally recognized using the completed-contract method of accounting. Long-term construction-type contracts for which reasonably dependable estimates cannot be made or for which inherent hazards make estimates difficult are accounted for under the completed-contract method. Revenues under the completed-contract method are recognized upon substantial completion—that is acceptance by the customer, compliance with performance specifications demonstrated in a factory acceptance test or similar event. Accordingly, during the period of contract performance, billings and costs are accumulated on the balance sheet, but no profit or income is recorded before completion or substantial completion of the work. Anticipated losses on contracts are recognized in full in the period in which losses become probable and estimable. Changes in estimate of profit or loss on contracts are included in earnings on a cumulative basis in the period the estimate is changed. As of December 31, 2016 and 2015, we had a $600,000 provision for contract losses. 

 

Research and Development Costs

 

Research and development costs are expensed as incurred.  Research and development costs were $3,628,000 and $3,412,000 for the years ended December 31, 2016 and 2015, respectively. 

 

Share-Based Compensation

 

We maintain an equity incentive plan and record expenses attributable to the awards granted under the equity incentive plan. We amortize share-based compensation from the date of grant on a weighted average basis over the requisite service (vesting) period for the entire award.

 

We account for equity instruments issued to consultants and vendors in exchange for goods and services at fair value. The measurement date for the fair value of the equity instruments issued is determined at the earlier of (i) the date at which a commitment for performance by the consultant or vendor is reached or (ii) the date at which the consultant’s or vendor’s performance is complete. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement.

 

In accordance with the accounting standards, an asset acquired in exchange for the issuance of fully vested, non-forfeitable equity instruments should not be presented or classified as an offset to equity on the grantor’s balance sheet once the equity instrument is granted for accounting purposes. Accordingly, we record the fair value of the fully vested, non-forfeitable common stock issued for future consulting services as prepaid expense in our consolidated balance sheets.

 

Income Taxes

 

We account for income taxes under the provisions of the accounting standards. Under the accounting standards, deferred tax assets and liabilities are recognized for the expected future tax benefits or consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided for significant deferred tax assets when it is more likely than not that such asset will not be realized through future operations. Our deferred tax assets and liabilities are primarily related to our Net Operating Losses and timing differences between book and tax accounting for depreciation and our net deferred tax assets were fully reserved as of December 31, 2016 and 2015.

 

The accounting guidance for uncertainty in income taxes provides that a tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. We recognize any uncertain income tax positions on income tax returns at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. As of December 31, 2016 and 2015 and there were no unrecognized tax benefits included in the consolidated balance sheets that would, if recognized, affect the effective tax rate. Our practice is to recognize interest and/or penalties related to income tax matters in income tax expense. We had no accrual for interest or penalties on our consolidated balance sheets at December 31, 2016 and 2015 and have not recognized interest and/or penalties in the consolidated statements of operations for the years ended December 31, 2016 or 2015.

 

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We are subject to taxation in the U.S. and various state and foreign jurisdictions.

 

We do not foresee material changes to our gross uncertain income tax position liability within the next twelve months.

 

Earnings (Loss) per Share 

 

Basic loss per share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares assumed to be outstanding during the period of computation.  Diluted loss per share is computed similar to basic loss per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential shares had been issued and if the additional common shares were dilutive. Approximately 9,808,000 and 1,084,000 shares of common stock issuable upon full exercise of all options and warrants at December 31, 2016 and 2015, respectively and all shares potentially issuable in the future under the terms of the Secured Notes Payable were excluded from the computation of diluted loss per share due to the anti-dilutive effect on the net loss per share.

 

   Year ended
December 31,
2016
   Year ended
December 31,
2015
 
         
Net loss  $(10,026,000)  $(13,107,000)
Weighted average number of common shares outstanding:          
Basic and diluted   3,594,026    2,405,147 
Net loss attributable to common stockholders per share:          
Basic and diluted  $(2.79)  $(5.45)

 

Comprehensive Income (Loss)

 

We have no items of other comprehensive income (loss) in any period presented. Therefore, net loss as presented in our Consolidated Statements of Operations equals comprehensive loss.

 

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Results of Operations for the Fiscal Years Ended December 31, 2016 and 2015

 

Ener-Core, Inc.

Consolidated Statements of Operations

 

   Year Ended
December 31,
   Year Ended
December 31,
 
   2016   2015 
         
Revenues  $   $ 
Cost of goods sold       600,000 
Gross profit (loss)       (600,000)
           
Operating expenses:          
Selling, general, and administrative   4,162,000    5,197,000 
Research and development   3,752,000    3,412,000 
Total operating expenses   7,914,000    8,609,000 
Operating loss   (7,914,000)   (9,209,000)
           
Other income (expenses):          
Interest income   1,000    2,000 
Loss on debt conversion   (91,000)    
Loss on exchange of warrants       (279,000)
Loss on modification of convertible debt   (1,429,000)    
Loss on debt extinguishment   (262,000)   (707,000)
Gain (loss) on revaluation of derivative liabilities, net   4,094,000    (198,000)
Interest expense   (4,422,000)   (2,716,000)
Total other income (expenses), net   (2,109,000)   (3,898,000)
Loss before provision for income taxes   (10,023,000)   (13,107,000)
Provision for income taxes   3,000     
Net loss  $(10,026,000)  $(13,107,000)
           
Loss per share—basic and diluted  $(2.79)  $(5.45)
Weighted average common shares—basic and diluted   3,594,026    2,405,147 

 

Revenue

 

Our revenue primarily consists of Power Oxidizer sales as well as engineering services. For the years ended December 31, 2016 and 2015, we recorded no revenue. Although we shipped our first two KG2/PO units, valued at $2.0 million, in 2016, and we received $1.1 million of license fees from Dresser-Rand in 2016, we determined that the revenue cycle was not completed by December 31, 2016 and these balances were recorded to deferred revenues as of December 31, 2016.

 

Cost of Goods Sold

 

We had no revenues or cost of goods sold for the year ended December 31, 2016. For the year ended December 31, 2015, we had $600,000 of cost of goods sold. Cost of goods sold for the year ended December 31, 2015 represents the estimated contract loss on the first two 2 MW Power Oxidizers sold to Dresser-Rand, which we delivered in 2016, with revenue deferred as described above. We reviewed our estimated contract loss as of December 31, 2016 and determined that no additional contract loss was required for the year ended December 31, 2016.

 

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Gross Profit (Loss)

 

Gross profit (loss) decreased from ($600,000) in 2015 to $0 in 2016, representing the $0.6 million contract loss provision for the first two 2 MW Power Oxidizers sold to Dresser-Rand, which we recorded in the year ended December 31, 2015, with no comparable contract loss for the year ended December 31, 2016.

 

Operating Expenses

 

Total operating expenses for the years ended December 31, 2016 and 2015 were $7.9 million and $8.6 million respectively. Our operating expenses consist of non-cash expenses including stock compensation charges and depreciation and cash-basis expenses, consisting of employee salaries and benefits paid in cash, rents and overhead, research and development materials, consulting expenses, professional services, and insurance.

 

The decrease was due to cash-basis expense reductions of $0.7 million due to:

 

  $0.6 million decrease in employee salaries and benefits due to the combination of $0.3 million for decreased research and development staff in 2016 to support the Dresser-Rand KG2 integration and $0.3 million of research and development expense capitalized into inventory or fixed assets.
     
  $0.6 million decrease in non-recurring professional fees primarily related to our Form S-1 filings with the SEC and related uplisting efforts.
     
  $0.2 million decrease in selling, general and administrative expenses, consisting of consulting and professional expenses related to restricting sales efforts in European markets as part of our 2016 cost cutting endeavors.
     
  $0.1 million decrease in travel-related costs.
     
  $0.7 million increase in expensed equipment, utilities and fuel costs for the KG2 integration testing, primarily for costs related to the FSAT testing.

 

Non-cash expenses were consistent between the years ended December 31, 2016 and 2015, due to an increase of $0.1 million of depreciation resulting from additional depreciation on the SSAT unit capitalized in mid-2015, offset by a $0.1 million decrease in share-based compensation charges due to reduced headcount.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses include officer compensation, salaries and benefits, stock-based compensation expense, consulting fees, legal expenses, intellectual property costs, accounting and auditing fees, investor relations costs, insurance, public company reporting costs and listing fees, and corporate overhead related costs. Total selling, general and administrative expenses for the year ended December 31, 2016 decreased $1,035,000 to $4,162,000 from $5,197,000 for the same period of the prior year.

 

The decrease for the year ended December 31, 2016 compared to 2015 is primarily due to the combined effect of a decrease of $0.6 million for legal and accounting fees incurred in the year ended December 31, 2015 associated with costs for a withdrawn public offering and a decrease in recurring expenses of $0.4 million, including consulting and employee headcount cost reductions of $0.2 million, travel and other expense reductions of $0.1 million, and stock-based compensation expense reduction of $0.1 million. In April 2016, we began an aggressive cost reduction effort to reduce selling, general and administrative headcount and other costs. During the year ended December 31, 2016, we reduced expenses by $0.4 million and have identified further selling, general and administrative expense reductions consisting of headcount costs and facility costs, including relocation of our headquarters, which we expect to save approximately $0.4 million per year.

  

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Research and Development Expenses

 

Research and development costs include development expenses for the Power Oxidizer and integration expenses related to our Power Oxidizer products with partners such as Dresser-Rand and include salaries and benefits, consultant fees, cost of supplies and materials for samples and prototypes, depreciation, as well as outside services costs. Research and development expenses for the year ended December 31, 2016 increased $340,000 to $3,752,000 from $3,412,000 for the year ended December 31, 2015.

 

The increase is due to an increase in non-recurring charges due to the FSAT test unit in 2016, offset by the net effect of lower recurring expenses due to lower headcount, an expense reduction due to an allocation of headcount costs to Power Oxidizers carried in fixed assets and inventory, and a decrease in non-recurring charges due to the SSAT testing in 2015.

 

The following tabular presentation sets forth in greater detail certain changes to research and development expenses for the years ended December 31, 2016 and 2015, respectively:

 

   Year ended December 31, 
   2016   2015 
Research and Development Expenses  (unaudited)   (unaudited) 
Recurring gross headcount, overhead, supplies and depreciation   3,045,000    3,235,000 
Less amount capitalized to FSAT and inventory units   (258,000)    
Net recurring research and development expenses   2,787,000    3,235,000 
Non-recurring FSAT equipment-related expenses   965,000     
Non-recurring SSAT-related expenses       177,000 
Total research and development expenses  $3,752,000   $3,412,000 

 

The decrease in the recurring gross expenses of $190,000 to $3,045,000 for the year ended December 31, 2016 is due to lower employee headcount, lower consulting costs and lower stock compensation charges compared to the year ended December 31, 2015, offset by $125,000 of greater depreciation in the year ended December 31, 2016 compared to 2015, which relates to depreciation on the SSAT equipment beginning in the third quarter of 2015.

 

The year ended December 31, 2016 included a reduction of $258,000 related to salaries, benefits, and consulting costs allocated to the buildout and completion of the FSAT unit and construction of the two 2 MW Power Oxidizers delivered in October 2016 to Pacific Ethanol.

 

The year ended December 31, 2016 included $965,000 of non-recurring expenses and charges related to the FSAT conducted in 2016, including $124,000 of non-recurring CLA settlement costs accrued as of December 31, 2016 and $350,000 of assets capitalized in 2015 as fixed assets but expensed in 2016. We determined that the underlying assets recorded in 2015 and certain similar assets recorded in 2016 were not likely to be recovered and therefore considered to be impaired. The year ended December 31, 2015 included non-recurring costs related to the SSAT, which was completed in 2015.

 

Other Income (Expenses)

 

Other income and expenses for the year ended December 31, 2016 of ($2,109,000) consisted primarily of combined interest paid in cash and non-cash amortization of debt discount of ($4,422,000), loss on debt modification of ($1,429,000), a loss on debt extinguishment of ($262,000), a loss on debt conversion of ($91,000), offset by a gain on the fair value adjustment of our derivative liabilities of $4,094,000. Of the ($4,422,000) of interest expense, ($322,000) was attributable to the 2016 Senior Notes issued in December 2016, ($287,000) was attributable to the Convertible Unsecured Notes, and ($416,000) was attributable to the combination of cash payments to the securing party of our backstop letter of credit and non-cash amortization of letter of credit fees. The remaining ($3,397,000) relates primarily to $600,000 of cash interest and $2,587,000 of amortization of debt discount and deferred financing costs for our 2015 Senior Notes. The loss on debt modification, loss on debt extinguishment, and substantially all of the gain on fair value adjustment of derivative liabilities pertain to the 2015 Senior Notes in existence until December 2, 2016. The loss on debt conversion of ($91,000) relates to the conversion of $111,111 of principal outstanding under a 2015 Senior Note into 44,444 shares of common stock in December 2016. 

 

Other income and expenses for the year ended December 31, 2015 of ($3,898,000) consisted primarily of combined interest expense and amortization of debt discount of ($2,716,000), loss on debt extinguishment of ($707,000) and a loss of ($198,000), all associated with our 2015 Senior Notes, with a further loss of ($279,000) related to the exchange of warrants issued in 2014 for shares of our common stock in April 2015.

 

Net Loss

 

For the year ended December 31, 2016, our net loss was approximately $10.0 million, primarily from operating expenses of $7.9 million and other expenses, net of $2.1 million.

 

For the year ended December 31, 2015, our net loss was approximately $13.1 million, primarily from $600,000 in negative gross profit, operating expenses of $8.6 million, and other expense of $3.9 million.

 

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The decrease in the net loss of $3.1 million from $13.1 million for the year ended December 31, 2015 to $10.0 million for the year ended December 31, 2016 was due to a decrease in other expenses, net of $1.8 million, and a decrease in the operating loss of $1.2 million, as described above.

 

Liquidity

 

Cash Flows Used in Operating Activities

 

Cash used in operating activities was approximately $7.6 million and $4.3 million for the years ended December 31, 2016 and 2015, respectively. Cash used in operating activities for the year ended December 31, 2016 resulted from a net loss of approximately $10.0 million, reduced by non-cash charges of $3.0 million and increased by $0.4 million of working capital used. The non-cash charges consisted of $3.1 million in non-cash amortization of debt discounts and deferred financing fees, $1.3 million for stock-based compensation, a $1.7 million loss due to the modification and extinguishment of the 2015 Senior Notes, and $0.5 million for depreciation offset by a $4.1 million gain on changes in the fair value of derivative liabilities. The $0.7 million change in working capital was primarily due to an increase of $2.0 million for inventory, offset by a $0.9 million increase in customer advances and a net decrease of $0.4 million in prepaid expenses and restricted cash. 

 

Cash used in operating activities for the year ended December 31, 2015 resulted from a net loss of approximately $13.1 million, reduced by non-cash charges of $6.0 million and $2.8 million of working capital. The non-cash charges consisted of $2.2 million in non-cash amortization of debt discounts and deferred financing fees, $1.5 million for stock-based compensation, a $0.7 million loss due to the modification of the 2015 Senior Notes recorded as a debt extinguishment loss, a $0.6 million provision for estimated contract losses on our first two commercial KG2/PO units, $0.2 million for losses on revaluation of derivative securities, and $0.4 million for depreciation. The $2.8 million change in working capital was primarily due to a $2.8 million increase in customer advances, an increase of $0.9 million in accounts payable, offset by an increase of $0.7 million for purchased inventory.

 

Cash Flows from Investing Activities

 

Cash used in investing activities for the year ended December 31, 2016 of $0.7 million consisted primarily of payments made to complete the full KG2/PO prototype used in the KG2 integration for the FSAT. Cash used in investing activities of $3.1 million for the year ended December 31, 2015 was attributable to the purchase of property and equipment consisting primarily of the MFTF, which was used to satisfy the SSAT for the CLA and payments made to construct the full KG2/PO prototype to be used in the KG2 integration for the FSAT.

 

Cash Flows Provided by Financing Activities

 

Cash provided by financing activities of $7.0 million for the year ended December 31, 2016 was attributable to $2.9 million in equity placements, net of offering costs and fees, $2.9 million in convertible senior secured notes, net of offering costs and fees and $1.2 million in convertible unsecured notes. Cash provided by financing activities of $7.8 million for the year ended December 31, 2015 was attributable to $3.3 million in equity placements and the $5.0 million of 2015 Senior Notes issued and sold in April and May 2015, net of offering costs and fees.

 

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Capital Resources and Going Concern

 

Our principal capital requirements are to fund our working capital requirements, invest in research and development and capital equipment and fund the continued costs of public company compliance requirements. We have historically funded our operations through debt and equity financings.

 

From our inception, we have incurred losses from operations. For the year ended December 31, 2016, we had a net loss of approximately $9.9 million and an accumulated deficit of approximately $40.0 million. For the year ended December 31, 2016, we used cash in operations of approximately $7.6 million, which raises substantial doubt about our ability to continue as a going concern.

 

We expect to continue to incur substantial additional operating losses from costs related to the continuation of product and technology development and administrative activities. Our cash on hand at December 31, 2016 was approximately $1.3 million.

 

On April 11, 2016, we issued and sold 696,056 shares of our common stock at a purchase price of $4.31 per share and received gross proceeds of approximately $3,000,000 from the sale of such shares. On September 1, 2016, we issued the Convertible Unsecured Notes with an aggregate principal amount of $1.25 million and warrants for the purchase of up to 124,999 shares of our common stock for gross proceeds of $1.25 million. In December 2016, we issued the 2016 Senior Notes with an aggregate principal amount of approximately $3.7 million and issued related warrants to purchase up to 1,498,622 shares of our common stock in exchange for gross proceeds of $3.4 million. In December 2016, we also amended and restated the 2015 Senior Notes such that, after giving effect to such amendment and restatement and the applicable original issue discount, the aggregate principal amount outstanding was approximately $5.6 million. In connection with the amendment and restatement of the 2015 Senior Notes, we issued related warrants to purchase up to 2,222,217 shares of our common stock. We paid $642,000 in offering costs and fees associated with these equity and debt financings.

 

On April 23, 2015, we issued and sold convertible senior secured promissory notes with an aggregate principal amount of $3.1 million and warrants to purchase up to 136,264 shares of our common stock. On May 1, 2015, we issued and sold 108,000 shares of our common stock at a purchase price of $7.50 per share and received gross proceeds of approximately $810,000 from the sale of such shares. On May 7, 2015, we issued and sold senior secured promissory notes with an aggregate principal amount of $1.9 million and warrants to purchase of up to 83,517 shares of our common stock. In December 2016, we amended and restated the 2015 Senior Notes issued on April 23, 2015 and May 7, 2015, as described above. On December 31, 2015, we issued and sold 625,000 shares of our common stock and warrants to purchase up to 312,500 shares of our common stock for gross proceeds of $2.5 million. We paid $550,000 in costs and fees associated with these equity and debt financings.

 

Our sales cycle can exceed 24 months and we do not expect to generate sufficient revenue in the next twelve months to cover our operating costs. We anticipate that we will pursue raising additional debt or equity financing to fund new product development and execute on the commercialization of our product plans. We cannot make any assurances that our strategies will be effective or that any additional financing will be completed on a timely basis, on acceptable terms or at all. Our inability to successfully implement our strategies or to complete any other financing will adversely impact our ability to continue as a going concern.

 

Until we achieve our product commercialization plans and are able to generate sales to realize the benefits of the strategy and sufficiently increase cash flow from operations, we will require additional capital to meet our working capital requirements, research and development, capital requirements and compliance requirements and will continue to pursue raising additional equity and/or debt financing.

 

Our principal source of liquidity is cash. As of December 31, 2016, cash and cash equivalents (including restricted cash) were $1.4 million, or 17.3% of total assets, compared to $2.8 million, or 37.2% of total assets, at December 31, 2015. The decrease in cash and cash equivalents during the year ended December 31, 2016 was due to the receipt of $7.0 million of cash from debt and equity financings, offset by cash used in operating activities of $7.6 million and $0.7 million of spending on fixed assets, primarily on the KG2/PO system used for the FSAT testing.

 

Through the end of 2015, our product sales were limited to initial system sales that were not profitable and required additional cash in excess of expected cash receipts. In addition, we incurred significant development and administrative expenses in order to develop our products with little or no cash contribution from sales. Beginning in 2016 we began to focus on reduction of our operating costs payable in cash through headcount and overhead cost reductions and saw an increase in cash collections from customers from sales transactions that are expected to be cash flow positive. During 2015, we received no cash from license fees. In 2016, we received $1.1 million of cash from license fees and we expect to receive additional license fees in 2017 from our CMLA agreement with Dresser-Rand including $1.2 million expected in the second quarter of 2017 and additional license payments upon receipt of firm purchase orders for licenses along with product sales receipts for 250kW unit sales expected to be profitable.

 

We have not yet achieved profitable operations and have yet to establish an ongoing source of revenue to cover operating costs and meet our ongoing obligations. Our cash needs for the next 12 months are projected to be in excess of $6.5 million, which we estimate to include the following:

 

  Employee, occupancy and related costs: $3.5 million
     
  Professional fees and business development costs: $0.5 million

 

  Research and development programs: $0.5 million
     
  Corporate filings: $0.5 million

 

  Working capital: $1.5 million

 

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Off-Balance Sheet Arrangements

 

In November 2015, we delivered to Dresser-Rand a $2.1 million letter of credit with an expiration date of June 30, 2017, which Dresser-Rand accepted as the backstop security required in support of the purchase order for the first two 2 MW Power Oxidizer units. Under the terms of the Dresser-Rand purchase order, the backstop security enables us to collect 50% of the order value in cash immediately with additional payments over time as we purchase materials for the Power Oxidizer units. In order to obtain the letter of credit to serve as the required backstop security, we executed a Backstop Security Support Agreement, or the Support Agreement, pursuant to which an investor agreed to provide us with financial and other assistance (including the provision of sufficient and adequate collateral) as necessary to obtain the letter of credit. If the investor is required to make any payments on the letter of credit, we will reimburse the investor the full amount of any such payment, subject to the terms of a Security Agreement and Subordination and Intercreditor Agreement executed concurrently with the Support Agreement.

 

Concurrent with the execution of the amendment to the CMLA in April 2017, we and Dresser-Rand modified the requirements for our existing backstop security. As modified, we are required to maintain a $500,000 backstop security, reduced from $2.1 million, and the backstop security was extended from June 2017 to March 31, 2018.

 

We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as stockholders’ equity that are not reflected in our financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.

 

Inflation

 

We believe that inflation has not had a material effect on our operations to date.

 

Recently Issued Accounting Pronouncements

 

In May, 2014, the FASB issued Accounting Standards Update, or ASU, 2014-09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 provides a framework for addressing revenue recognition issues and, upon its effective date, replaces almost all existing revenue recognition guidance, including industry-specific guidance, in current U.S. generally accepted accounting principles. ASU 2014-09 is effective beginning with the calendar year ended December 31, 2017. We have not yet assessed the impact ASU 2014-09 will have upon adoption on our financial position, results of operations or cash flows.

 

In July 2015, the FASB issued ASU 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory. ASU 2015-11 requires that entities measure inventory at the lower of cost and net realizable value. ASU 2015-11 is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years and early application is permitted. The Company has not yet assessed the impact ASU 2015-11 will have upon adoption.

 

In November 2015, the FASB issued ASU 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. ASU 2015-17 requires that entities’ deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. ASU 2015-17 is effective for fiscal years beginning after December 15, 2017 and interim periods within annual periods beginning after December 15, 2018. We have not yet assessed the impact ASU 2015-17 will have upon adoption.

 

In February 2016 the FASB issued ASU 2016-2, Leases (Topic 842). ASU 2016-2 affects any entity entering into a lease and changes the accounting for operating leases to require companies to record an operating lease liability and a corresponding right-of-use lease asset, with limited exceptions. ASU 2016-2 is effective for fiscal years beginning after December 15, 2019 and interim periods with annual periods beginning after December 15, 2010. Early adoption is allowed. We have not yet assessed the impact ASU 2016-2 will have upon adoption.

 

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JOBS Act

 

Section 107 of the JOBS Act also provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an “emerging growth company” can delay the adoption of new or revised accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards and, therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies.

 

For as long as we remain an “emerging growth company” under the recently enacted JOBS Act, we will, among other things:

 

  be exempt from the provisions of Section 404(b) of the Sarbanes-Oxley Act, which requires that our independent registered public accounting firm provide an attestation report on the effectiveness of our internal control over financial reporting;
     
  be permitted to omit the detailed compensation discussion and analysis from proxy statements and reports filed under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and instead provide a reduced level of disclosure concerning executive compensation; and
     
  be exempt from any rules that may be adopted by the Public Company Accounting Oversight Board requiring mandatory audit firm rotation or a supplement to the auditor’s report on the financial statements.

 

We intend to take advantage of some or all of the reduced regulatory and reporting requirements that remain available to us so long as we qualify as an “emerging growth company,” except that we have irrevocably elected not to take advantage of the extension of time to comply with new or revised financial accounting standards available under Section 102(b) of the JOBS Act. Among other things, this means that our independent registered public accounting firm will not be required to provide an attestation report on the effectiveness of our internal control over financial reporting so long as we qualify as an emerging growth company, which may increase the risk that weaknesses or deficiencies in our internal control over financial reporting go undetected. Likewise, so long as we qualify as an emerging growth company, we may elect not to provide you with certain information, including certain financial information and certain information regarding compensation of our executive officers, that we would otherwise have been required to provide in filings we make with the SEC, which may make it more difficult for investors and securities analysts to evaluate us. As a result, investor confidence in us and the market price of our common stock may be materially and adversely affected.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Not applicable.

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Our audited financial statements for the years ended December 31, 2016 and 2015, together with the report of the independent registered public accounting firm thereon and the notes thereto, are presented beginning at page F-1 and are incorporated by reference herein.

 

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

 

Not applicable.

 

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ITEM 9A. CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to our management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

As of December 31, 2016, the end of the fiscal year covered by this report, our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has performed an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act).

 

Based on the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2016, our disclosure controls and procedures were ineffective at the reasonable assurance level. Such conclusion is due to the presence of material weaknesses in internal control over financial reporting as described below. Management anticipates that our disclosure controls and procedures will remain ineffective until such material weaknesses are remediated.

 

Internal Control over Financial Reporting

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. Based on our evaluation, management concluded that our internal control over financial reporting was not effective as of December 31, 2016 due to the following material weaknesses:

 

  1. We do not have complete written documentation of all of our internal control policies and procedures. Management evaluated the impact of our failure to have written documentation of our internal controls and procedures on our assessment of our disclosure controls and procedures and has concluded that the control deficiency that resulted represented a material weakness.
     
  2. We do not have sufficient segregation of duties within accounting functions, which is a basic internal control. Due to our size and nature, segregation of all conflicting duties may not always be possible and may not be economically feasible. However, to the extent possible, the initiation of transactions, the custody of assets and the recording of transactions should be performed by separate individuals. Management evaluated the impact of our failure to have segregation of duties on our assessment of our disclosure controls and procedures and has concluded that the control deficiency that resulted represented a material weakness.
     
  3. For the year ended December 31, 2016, we did not have a sufficient, integrated purchasing and accounting system to allow for proper tracking, control and costing of our prototype KG2/PO unit costs carried as a fixed asset and Powerstations currently under construction for sale and carried in inventory. Although we believe that our costing is accurate, based on additional review and procedures, to the extent we sell additional units, we will need to enhance our controls over our inventory systems. Management evaluated the impact of our failure to have adequate inventory accounting systems, coupled with the risk associated with costing our inventory, and the expected future activity for our inventory costing system and has concluded that the control deficiency that resulted represented a material weakness.

 

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  4. For the year ended December 31, 2016, management concluded that the Company’s management information systems and information technology internal control design was deficient because the potential for unauthorized access to certain information systems and software applications existed during 2015 in several departments, including corporate accounting. Additionally, certain key controls for maintaining the overall integrity of systems and data processing were not properly designed and operating effectively. These deficiencies increased the likelihood of potential material errors in our financial reporting. Management evaluated the impact of our failure to have adequate information technology controls, on our assessment of our disclosure controls and procedures and has concluded that the control deficiency that resulted represented a material weakness.

 

Notwithstanding the assessment that our internal control over financial reporting was not effective and that there were material weaknesses as identified above, management has reviewed the financial statements and underlying information included herein in detail and believes the procedures performed are adequate to fairly present our financial position, results of operations and cash flows for the periods presented in all material respects.

 

This report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to exemptions available to issuers that are non-accelerated files or qualify as “emerging growth companies”, as defined in Section 2(a) of the Securities Act, as modified by the JOBS Act.

 

Changes in Internal Control over Financial Reporting

 

Remediation of Material Weaknesses

 

To address the material weaknesses described above, management performed additional analyses and other procedures to ensure that the financial statements included herein fairly present, in all material respects, our financial position, results of operations and cash flows for the periods presented.

 

We are attempting to remediate the material weaknesses in our disclosure controls and procedures and internal controls over financial reporting identified above by refining our internal procedures (see below). We have initiated the following corrective actions, which management believes are reasonably likely to materially affect our financial reporting as they are designed to remediate the material weaknesses as described above:

 

  We are in the process of further enhancing the supervisory procedures to include additional levels of analysis and quality control reviews within the accounting and financial reporting functions.

 

  We are in the process of strengthening our internal policies and enhancing our processes for ensuring consistent treatment and recording of reserve estimates and that validation of our conclusions regarding significant accounting policies and their application to our business transactions are carried out by personnel with an appropriate level of accounting knowledge, experience and training.

 

  We are evaluating additional analytical tools and accounting systems to address the inventory costing control weaknesses identified and enhance our internal controls over inventory and prototype capitalization.
     
  We have engaged and will continue to engage additional Information Technology consultants to improve and update our information technology systems and enhance our internal controls over information technology.

 

We do not expect to have fully remediated these material weaknesses until management has tested those internal controls and found them to have been remediated. We expect to continue to improve our internal controls and to test the improvements during our annual testing for the fiscal year ending December 31, 2017.

 

Limitations on Controls

 

Management does not expect that our disclosure controls and procedures or internal control over financial reporting will prevent or detect all errors and fraud. Any control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected.

 

ITEM 9B. OTHER INFORMATION

 

None.

 

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PART III

 

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

 

Executive Officers and Directors

 

Our directors and executive officers and their ages and positions as of April 10, 2017 are as follows:

 

Name   Age   Position(s)
Alain J. Castro   47   Chief Executive Officer and Director
Domonic J. Carney   50   Chief Financial Officer, Secretary and Treasurer
Douglas A. Hamrin   46   Vice President, Engineering
Michael J. Hammons(3)   47   Director
Jeffrey A. Horn(1)(2)   62   Director
Bennet P. Tchaikovsky(1)   47   Director
Ian Copeland(2)   54   Director
Stephen Markscheid(1)(2)   63   Director

 

(1) Member of the Audit Committee
   
(2) Member of the Compensation Committee
   
(3) Member of the Nominating and Corporate Governance Committee

 

Executive Officers

 

Alain J. Castro, Chief Executive Officer and Director

 

Mr. Castro has been the Chief Executive Officer and a director of Ener-Core Power, Inc., our wholly owned subsidiary, since May 2013 and our Chief Executive Officer and director since the merger of Ener-Core Power, Inc. and Flex Merger Acquisition Sub, Inc. effective as of July 1, 2013, or the Merger. He founded International Energy Ventures Limited, a United Kingdom-based investor of clean tech companies and renewable energy projects, in May 2003, and remains a controlling investor. Between February 2008 and June 2011, Mr. Castro served in various capacities (including president and a director) of the North and South America divisions of Akuo Energy, an international developer and operator of renewable energy projects. Prior to his career in the renewable energy sector, he was a partner at Ernst & Young Consulting (in the Mercosur region of Latin America), an international advisory services firm. Mr. Castro participated in the Sloan Executive Masters Program at the London Business School and received his B.S. in Industrial and Mechanical Engineering from the University of Texas. Mr. Castro brings to our board of directors experience with clean tech companies and renewable energy projects, as well as previous executive-level experience.

 

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Domonic J. Carney, Chief Financial Officer, Secretary, Treasurer

 

Mr. Carney was appointed as our Chief Financial Officer, Secretary and Treasurer in August 2014. Until his appointment, Mr. Carney was an independent consultant providing finance, accounting and business strategy services. From March 30, 2012 to October 2012, Mr. Carney served as the chief financial officer for T3 Motion, Inc. (TTTM.PK), an electric vehicle technology company. From March 2005 to February 2012, Mr. Carney served as Chief Financial Officer for Composite Technology Corporation (CPTC.OB), a manufacturer of high efficiency carbon composite electric transmission conductors and renewable energy wind turbines. Mr. Carney has a Masters in Accounting from Northeastern University and a Bachelor’s Degree in Economics from Dartmouth College.

 

Douglas A. Hamrin, Vice President of Engineering

 

Mr. Hamrin was appointed as an officer in March 2015. Since July 2013, Mr. Hamrin has been our Vice President of Engineering. From May 2008 to December 2012, Mr. Hamrin served as Director of Thermal Oxidizer Development for Flex Energy. Prior to joining Flex Energy, Mr. Hamrin held positions as Technical Manager, Applications and Principal Applications Engineer at Honeywell Turbo Technologies, Director of the Fuel Systems Group at Capstone Turbine Corporation and Engineer at Generals Motors Powertrain Division. Mr. Hamrin has an M.S. in Mechanical Engineering from the Massachusetts Institute of Technology and a BS in Mechanical Engineering from the Illinois Institute of Technology.

 

Non-Employee Directors

 

Michael J. Hammons, Chairman of our Board of Directors, Director and Chairman of the Nominating and Corporate Governance Committee

 

Mr. Hammons became Chairman of our board of directors as of the closing of the Merger in July 2013 and chairman of our Nominating and Corporate Governance Committee in July 2015. Commencing with the inception of Ener-Core Power, Inc. until the closing of the Merger, he served as its Chairman of the board of directors. From June 2009 to February 2014, Mr. Hammons was a partner at SAIL Venture Partners II, LLC, an investor in energy and water technology companies, which was the management company and general partner of SAIL Venture Partners II, LP. From September 2008 through March 2009, he was the chief executive officer of Vigilistics, Inc., a Mission Viejo, California-based software company and, from August 2007 to May 2008, the Chief Executive Officer of Nexiant, Inc., an Irvine, California-based provider of proprietary technology solutions for the maintenance, repair, and operations inventory space. From 2011 until March 2015, Mr. Hammons served as chairman and director of the board of directors of Enerpulse Technologies, Inc. Mr. Hammons received his B.S. in Industrial Engineering from California Polytechnic State University, San Luis Obispo, and his M.B.A. from Harvard Business School. Mr. Hammons brings to our board of directors experience as a partner in SAIL Venture Partners II, LLC, including with its investment portfolio, management expertise in respect of companies similarly situated, and familiarity with us, both prior and subsequent to the spin-off, and served as Chairman of Ener-Core Power, Inc.’s board prior to the closing of the Merger.

 

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Jeffrey A. Horn, Director

 

Mr. Horn became one of our directors in May 2014. Mr. Horn’s career spanned over 34 years at Caterpillar Inc., including most recently as Managing Director of Caterpillar Power Generation Systems in Houston beginning in January 2009, before retiring in January 2012. Mr. Horn received his B.S. degree in Economics from the University of Wisconsin, Madison, in 1977. Mr. Horn brings to our board of directors experience in the power equipment sector, and work experience in the mining industry, which is a target market for our products.

 

Bennet P. Tchaikovsky, Director and Chairman of the Audit Committee

 

Mr. Tchaikovsky became one of our directors and chairman of our Audit Committee in November 2013. Since August 2014, Mr. Tchaikovsky has been a full time Assistant Professor at Irvine Valley College where he teaches courses in financial and managerial accounting. From April 2010 through August 2013, Mr. Tchaikovsky served as the Chief Financial Officer of VLOV Inc., a China-based clothing designer and distributor that was also a U.S. publicly traded company. From September 2009 to July 2011, Mr. Tchaikovsky served as Chief Financial Officer of China Jo-Jo Drugstores, Inc., a U.S. public company operating a chain of pharmacies in China, where he also served as a director from August 2011 through January 2013. From May 2008 to April 2010, Mr. Tchaikovsky served as the Chief Financial Officer of Skystar Bio-Pharmaceutical Company, a U.S. public company that manufactures and distributes veterinary medicines and related products in China, which he performed on a part-time basis and assisted primarily with preparing its financial statements and other financial reporting obligations. From March 2008 through November 2009, Mr. Tchaikovsky was a director of Ever-Glory International Group, a U.S. public company and apparel manufacturer based in China, and served on the audit committee as chairman and on the compensation committee as a member. From December 2008 through November 2009, Mr. Tchaikovsky was a director of Sino Clean Energy, Inc., which was a U.S. public company that manufactured coal fuel substitute in China, and served on the audit committee as chairman and on both the compensation and nominating committees as a member. None of the foregoing companies is related to or affiliated with us. Mr. Tchaikovsky is a licensed Certified Public Accountant and an active member of the California State Bar. He received a B.A. in Business Economics from the University of California at Santa Barbara, and a J.D. from Southwestern University School of Law. Mr. Tchaikovsky brings to our board of directors experience with U.S. public companies, along with a legal and accounting background.

 

Ian C. Copeland, Director and Chairman of the Compensation Committee

 

Mr. Copeland became one of our directors in December 2014 and chairman of our Compensation Committee in July 2015. Mr. Copeland brings over 25 years of global experience in developing, financing and managing world-class projects and companies in the power, rail, water and mining markets. Before retiring at the end of 2012, Mr. Copeland was a Senior Vice President of Bechtel Corporation. During his 15-year tenure with Bechtel Corporation, he served in various capacities including President of the Fossil Power, Communications and Renewable Power businesses and Managing Director of Bechtel Enterprises. Previously, Mr. Copeland held senior management positions with Wärtsilä Corporation and Hannon Armstrong & Company. Mr. Copeland began his career with the utility consulting practice of Booz Allen Hamilton after graduating from Rutgers University with degrees in physics and mechanical engineering. Mr. Copeland brings to our board of directors his background in international business, including experience developing, financing, and managing projects in the power and infrastructure markets.

 

Stephen Markscheid, Independent Director

 

Mr. Markscheid became one of our directors on June 29, 2016. Mr. Markscheid brings over 30 years of corporate finance experience in the United States, Asia and Europe, including experience in mergers and acquisitions, strategic investments, joint ventures and new business development across industries in emerging markets. Mr. Markscheid has served as Chief Executive Officer of Synergenz BioScience Inc. since 2007, head of international business for Mammoth Industries since 2013 and partner of Wilton Partners since 2014. He has also been an independent member of the boards of directors of CNinsure, Inc. since 2007, Jinko Solar, Inc. since 2009, China Integrated Energy Corporation since 2011, China Ming Yang Wind Power Group since 2011 and ChinaCast Education Corporation since 2011. Mr. Markscheid was previously a representative of the US-China Business Council from 1978 to 1983, a vice president of Chase Manhattan Bank from 1984 to 1988, a vice president of First Chicago Bank from 1988 to 1993, a case leader of Boston Consulting Group from 1994 to 1997, a director of business development of GE Capital (Asia Pacific) from 1998 to 2001, a senior vice president of GE Healthcare Financial Services from 2003 to 2006 and the chief executive officer of HuaMei Capital Company, Inc. from 2006 to 2007. Mr. Markscheid received his bachelor’s degree in East Asian studies from Princeton University in 1976, a master’s degree in international affairs and economics from Johns Hopkins University (SAIS) in 1980 and an MBA from Columbia University in 1991. Mr. Markscheid brings to our board of directors extensive experience as an independent director and substantial corporate finance experience, particularly in the Asian marketplaces.

 

Family Relationships

 

There are no family relationships between or among any of the current directors, executive officers or persons nominated or charged to become directors or executive officers. There are no family relationships among our officers and directors and those of our subsidiaries and affiliated companies.

 

Board Composition

 

Our board of directors currently consists of seven members. Our bylaws provide that our directors will hold office until their successors have been duly elected and qualified. Our board of directors is responsible for the business and affairs of our company and considers various matters that require its approval.

 

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Our common stock is currently quoted on the OTCQB Marketplace under the symbol “ENCR.” The OTCQB Marketplace does not require issuers to comply with corporate governance listing standards that issuers listed on a national securities exchange, such as the New York Stock Exchange and The NASDAQ Stock Market LLC, are required to comply with. However, as a matter of corporate governance best practices, we have taken actions to improve our corporate governance, including establishing a board of directors with a majority of directors who are “independent” (as discussed below), and a standing Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee. We have also adopted Corporate Governance Guidelines, a Code of Ethics, an Insider Trading Policy and other similar corporate policies, which are available at http://ir.ener-core.com/governance-docs.

 

Code of Ethics

 

Our board of directors has adopted a Code of Ethics, which applies to all officers, directors and employees. Our Code of Ethics is available on our website at http://ir.ener-core.com/governance-docs. The contents of our website are not part of this report. We intend to disclose any amendments to our Code of Ethics, or waivers of its requirements, on our website or in filings under the Exchange Act.

 

Audit Committee

 

The Audit Committee currently consists of Messrs. Tchaikovsky (Chairman), Markscheid and Horn. The Audit Committee operates under a written charter, which is available at http://ir.ener-core.com/governance-docs. The purpose of the Audit Committee is to oversee the accounting and financial reporting processes of our company and the audits of our financial statements. In addition to other powers and responsibilities, the Audit Committee (i) is directly responsible for the appointment, compensation, retention, oversight and termination, if necessary, of the independent registered public accounting firm, (ii) reviews the independence and quality control procedures of the independent registered public accounting firm, (iii) reviews and discusses the annual audited financial statements with management and the independent registered public accounting firm, and (iv) reviews, and approves as appropriate, all related party transactions. Our board of directors has determined that Mr. Tchaikovsky is an “audit committee financial expert” as defined by the regulations promulgated by the SEC.

 

Section 16(a) Beneficial Ownership Reporting Compliance

 

Section 16(a) of the Exchange Act requires our directors and executive officers, and persons who own more than ten percent of a registered class of our equity securities, to file with the SEC initial reports of ownership and reports of changes in ownership of our common stock and other equity securities. Officers, directors and greater than ten percent stockholders are required by SEC regulations to furnish us with copies of all Section 16(a) reports they file. To our knowledge, based solely upon the review of copies of such reports furnished to us and written representations that no other reports were required during the year ended December 31, 2016 or prior fiscal years, all of our officers, directors and greater than ten percent stockholders have complied with all applicable Section 16(a) filing requirements.

 

ITEM 11. EXECUTIVE AND DIRECTOR COMPENSATION

 

Compensation Discussion and Analysis

 

This Compensation Discussion and Analysis describes the material elements of the compensation awarded to our current executive officers. This compensation discussion focuses on the information contained in the following tables and related footnotes and narrative for the last completed fiscal year.

 

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Our current executive compensation program may from time to time include the following principal components: (i) base salary; (ii) equity compensation plan awards; (iii) discretionary annual cash bonuses; and (iv) perquisites and benefits.

 

Our Compensation Philosophy and Objectives

 

Our philosophy regarding compensation of our executive officers includes the following principles:

 

  our compensation program should reward the achievement of our strategic initiatives and short- and long-term operating and financial goals;
     
  compensation should appropriately reflect differences in position and responsibility;
     
  compensation should be reasonable; and
     
  the compensation program should be understandable and transparent.

 

In order to implement such compensation principles, we have developed the following objectives for our executive compensation program:

 

  overall compensation levels must be sufficiently competitive to attract and retain talented leaders and motivate those leaders to achieve superior results;
     
  to the extent practicable, a portion of total compensation should be contingent on, and variable with, achievement of objective corporate performance goals, and that portion should increase as an executive’s position and responsibility increases;
     
  total compensation should be higher for individuals with greater responsibility and greater ability to influence our achievement of operating goals and strategic initiatives;
     
  the number of elements of our compensation program should be kept to a minimum, and those elements should be readily understandable by and easily communicated to executives, stockholders, and others; and
     
  executive compensation should be set at responsible levels to promote a sense of fairness and equity among all employees and appropriate stewardship of corporate resources among stockholders.

 

Determination of Compensation

 

The Compensation Committee was formed in July 2015 to be our primary authority to determine the compensation available to our executive officers. The Compensation Committee reviews market data on the compensation of directors and officers of comparable companies and may modify the compensation of our directors and executive officers in order to better align their compensation with our goals and objectives and ensure their compensation is competitive in the marketplace.

 

Compensation Benchmarking and Peer Group

 

In 2015, we took steps, including the engagement of a third party compensation consultant, to establish peer company comparisons to ensure that the Compensation Committee has an informed view of the compensation paid to our executives, with a goal toward total direct compensation for our executives that is on par with the median total direct compensation paid to executives in peer companies if annually established target levels of performance at our company and business segment levels are achieved. The Compensation Committee tabled this evaluation in 2016, but intends to revisit the issue in the first half of 2017. We expect the Compensation Committee’s recommendations to include a better alignment of management compensation with the achievement of key performance goals and objectives.

 

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Elements of Compensation

 

The principal elements of our current executive compensation program are:

 

  base salary; and
     
  Equity compensation plan awards.

 

While base salary is generally included as an element of compensation of our executive officers in every year, the granting of equity compensation awards, as well as bonuses and perquisites, is determined on a case-by-case basis. During the fiscal year ended December 31, 2016, our compensation program consisted solely of base salary. No equity compensation awards were granted and no cash incentive pay was provided in 2016. For fiscal 2017, we expect that our executive compensation will consist of base salary with additional incentive pay to be determined by the Compensation Committee based on the achievement of key performance goals and objectives.

 

Base Salaries

 

Base salary is used to recognize the experience, skills, knowledge and responsibilities required of our employees, including our named executive officers. When establishing base salaries for 2016, subject to the provisions of each person’s employment agreement, the Compensation Committee and our management considered a number of factors, including the seniority of the individual, the functional role of the position, the level of the individual’s responsibility, the ability to replace the individual, the base salary of the individual at their prior employment and the number of well-qualified candidates to assume the individual’s role. Generally, we believe that executive base salaries should be targeted near the median of the range of salaries for executives in similar positions at comparable companies.

 

Equity Compensation Plan Awards

 

Our current equity compensation plans, the 2013 Equity Incentive Plan (the “2013 Plan”), which our board of directors adopted on July 1, 2013, and the 2015 Omnibus Incentive Plan (the “2015 Plan”), which our board of directors adopted on July 14, 2015, were designed to provide long-term incentives to our executives and other employees and award recipients, and to increase stockholder value through competent, effective management. We believe that the ability to grant equity awards as a component of compensation will provide us with an advantage in attracting qualified management and employees. Equity compensation award decisions are evaluated on a case-by-case basis giving consideration to factors such as the recipient’s qualifications and abilities, the nature of the recipient’s position, and the recipient’s ability to contribute to the development and achievement of our business objectives.

 

Discretionary Annual Cash Bonuses

 

The Compensation Committee has discretion to recommend and approve the annual cash bonus for our Chief Executive Officer and each other named executive officer. Bonus awards generally will be based on our management’s recommendations and ultimately approved by the Compensation Committee. There were no annual bonuses granted for 2016. Annual bonuses, when awarded, are intended to compensate officers for individual performance, for our overall financial performance and for achieving important operational and financial milestones during the relevant fiscal year.

 

Perquisites and Other Compensation

 

Presently, we do not include perquisites or other benefits as a part of executive compensation, though we may do so in the future from time to time on a discretionary basis.

 

Management’s Role in the Compensation-Setting Process

 

Our management plays an important role in our compensation-setting process. The most significant aspects of management’s role are evaluating other executive officers’ performance, recommending business performance targets and objectives and recommending salary levels and equity compensation awards. Our management makes recommendations to our Compensation Committee regarding our executives’ compensation packages. During this process, management may be asked to provide the Compensation Committee with their evaluation of the executive officers’ performance, the background information regarding our strategic financial and operational objectives, and compensation recommendations as to the executive officers.

 

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Summary Compensation Table

 

The following table sets forth information regarding compensation for each of our 2016 “named executive officers” for SEC reporting purposes.

 

Name and Principal Position  Year  Salary
($)
   Bonus
($)
   Option Awards
($)(1)
   All Other Compensation
($)
   Total
($)
 
Alain J. Castro,  2016   200,000       —            200,000 
Chief Executive Officer(2)  2015   200,000                200,000 
Boris A. Maslov,  2016   225,000                 225,000 
President, COO and CTO(3)  2015   225,000                 225,000 
Domonic J. Carney,  2016   180,000                180,000 
Secretary/Treasurer Chief Financial Officer(4)  2015   180,000                180,000 
Douglas Hamrin  2016   180,000                180,000 
Vice President, Engineering(5)  2015   180,000                180,000 

 

(1)

The amounts shown in this column represent the aggregate grant date fair value of stock options granted in the year computed in accordance with FASB ASC Topic 718. These amounts are not paid to or realized by the officer. We did not grant any option awards to any executives during 2015 or 2016. See Note 12 of the accompanying notes to our audited consolidated financial statements for a discussion of valuation assumptions made in determining the grant date fair value and compensation expense of our stock options.

   
(2) Mr. Castro’s base salary was $200,000 per annum for 2016 and 2015.
   
(3) Dr. Maslov’s base salary was $225,000 per annum for 2016 and 2015. On January 31, 2017, Dr. Maslov resigned from the company and will continue to provide services under a separate services agreement.
   
(4) Mr. Carney’s base salary was $180,000 per annum for 2016 and 2015.
   
(5) Mr. Hamrin became our Vice President of Engineering effective March 15, 2015. His base salary was $180,000 per annum for 2016 and 2015.

 

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Employment Agreements, Termination of Employment and Change-in-Control Arrangements

 

Except as described below, we currently have no employment agreements with any of our executive officers, nor any compensatory plans or arrangements covering the resignation, retirement or any other termination of any of our executive officers.

 

Employment Agreements

 

We have entered into various employment and employment-related agreements with certain of our executive officers. Set forth below is a summary of many of the material provisions of such agreements, which summaries do not purport to contain all of the material terms and conditions of each such agreement. All share figures and exercise prices noted in these summaries are adjusted to give effect to the 1-for-50 reverse split of our issued and outstanding common stock on July 8, 2015, retroactively, unless otherwise noted.

 

Our Agreements with Mr. Castro and Dr. Maslov:

 

We employ Mr. Castro pursuant to an employment agreement, dated April 25, 2013, with Flex Power Generation, Inc., then known as Ener-Core Power, Inc., for the position of Chief Executive Officer, which agreement we assumed as of the closing of the Merger (as defined in Note 1 to our consolidated financial statements included elsewhere in this report). Under the agreement, the term of Mr. Castro’s employment is one year, renewing automatically for successive one-year terms unless either party gives the other party notice of non-renewal not less than 30 day prior to the end of the relevant term. We will pay Mr. Castro a base salary of $200,000 per year that may be increased but not decreased by our board of directors in its sole discretion. Mr. Castro is eligible (i) for an annual bonus and/or other annual incentive compensation in accordance with any applicable executive bonus plan as our board of directors may adopt in its sole discretion, and (ii) to participate in our equity incentive plan or incentive option plan, as applicable, with grants and vesting schedules as determined by the board of directors from time to time. In connection with Mr. Castro’s participation in our voluntary wage reduction plan from May 1, 2014 to July 31, 2014, on May 23, 2014, we entered into an amendment to the employment agreement with Mr. Castro, pursuant to which we issued Mr. Castro an option to purchase up to 15 shares of our common stock (pre-split) in exchange for $1.00 (pre-split) that he voluntarily forwent under the wage reduction plan. As a result, we entered into a stock option agreement with Mr. Castro on May 13, 2014, pursuant to which we granted Mr. Castro an option to purchase 6,460 shares of our common stock at an exercise price of $24.00 per share. All the shares subject to Mr. Castro’s option vested immediately on the date of grant.

 

We employ Dr. Maslov pursuant to an employment agreement, dated December 31, 2012, with Flex Power Generation, Inc., for the position of Interim Chief Executive Officer, which agreement we assumed as of the closing of the Merger. Under the agreement, the term of Dr. Maslov’s employment is one year, renewing automatically for successive one-year terms each year unless either party gives the other party notice of non-renewal not less than 30 day prior to the end of the relevant term. We will pay Dr. Maslov a base salary of $225,000 per year that may be increased but not decreased by our board of directors in its sole discretion. Dr. Maslov is eligible (i) for an annual bonus and/or other annual incentive compensation in accordance with any applicable executive bonus plan as our board of directors may adopt in its sole discretion, and (ii) to participate in our equity incentive plan or incentive option plan, as applicable, with grants and vesting schedules as determined by the board of directors from time to time. In connection with Dr. Maslov’s participation in our voluntary wage reduction plan from May 9, 2014 to June 15, 2014, on May 23, 2014, we entered into an amendment to the employment agreement with Dr. Maslov, pursuant to which we issued Dr. Maslov an option to purchase up to 15 shares of our common stock (pre-split) in exchange for $1.00 (pre-split) that he voluntarily forwent under the wage reduction plan. As a result, we entered into a stock option agreement with Dr. Maslov on May 13, 2014, pursuant to which we granted Dr. Maslov an option to purchase 1,514 shares of our common stock at an exercise price of $24.00 per share. All the shares subject to Dr. Maslov’s option vested immediately on the date of grant. On January 31, 2017, Dr. Maslov resigned from the company and will continue to provide services under a separate services agreement.

 

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The termination provisions for Mr. Castro’s and Dr. Maslov’s employment are substantially similar and are set forth below. If we terminate Mr. Castro’s or Dr. Maslov’s services for “cause” (as defined in the employment agreements), whether during or at the end of an employment year, then we are obligated to pay the sum of (i) the respective executive’s salary and bonuses, if any, through the date of termination, (ii) any earned but unused vacation time and paid time off (PTO), and (iii) any unreimbursed expenses.

 

If Mr. Castro’s or Dr. Maslov’s services are terminated upon death or disability, we are obligated to pay the respective executive or their respective estate (i) the same economic benefits as if his services were terminated for cause and (ii) upon a determination by our board of directors in its sole discretion, the respective executive or his respective estate may also be granted (A) additional vesting of then-unvested stock or stock options, (B) a proportional amount of any earned and unpaid annual bonus based on the respective executive’s performance through the date of termination, and/or (C) severance payments.

 

If we terminate Mr. Castro’s or Dr. Maslov’s services for any other reason, then we are obligated to pay the respective executive (i) the same economic benefits as if his services were terminated for cause, and (ii) monthly cash severance payments at his then-salary rate during the six-month period immediately following the termination date, subject to earlier termination in the event that he obtains new employment or engages (or assists any other person or entity to engage) in any activity competitive with our business. Further, if, during the six-month period immediately preceding or following a “change of control” (as defined in the employment agreements), we terminate his employment without cause, then all of the respective executive’s then-unvested outstanding options will immediately vest.

 

Mr. Castro or Dr. Maslov may terminate their respective employment relationships with us at any time and for any reason. Such resignation will not become effective until the earlier of (i) 90 days after the date the respective resignation notice is given to our board of directors or (ii) a date we specify. If Mr. Castro or Dr. Maslov chooses to do so, each has agreed to make himself available to us during the 30-day period following his termination, without any compensation, (i) to facilitate an efficient transition of his job-related responsibilities and duties, and (ii) to respond to questions from us regarding information and/or activities in which he had been engaged while employed by us.

 

During Mr. Castro’s or Dr. Maslov’s employment with us and for a period of the shorter of (i) 12 months after their respective termination or (ii) the number of months we employed Mr. Castro or Dr. Maslov, both are subject to restrictive covenants that provide each individual will not: (i) call on, solicit, divert, interfere with or take away (or attempt to call on, solicit, divert, interfere with or take away) any of our projects, business, clients, customers or prospects with whom or with which they had contact during their employment with us by promoting or selling services or products that compete with us or our affiliates; or (ii) solicit, influence or induce (or attempt to solicit, influence or induce) any employees as of the respective termination date with whom they had direct contact during their employment with us.

 

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Both Mr. Castro’s and Dr. Maslov’s employment agreement also contain other restrictive covenants further prohibiting: (i) disparagement of us or our affiliates during their employment and thereafter, and (ii) the use or disclosure of confidential business information during or at any time after termination of their employment.

 

On April 28, 2014, our board of directors approved the re-pricing and change of vesting schedules of outstanding stock options to purchase an aggregate of 172,600 shares of our common stock previously granted to our officers, directors, employees and consultants. As a result of this cancellation and reissuance of the options, we entered into a stock option cancellation agreement and concurrently entered into new stock option agreements with each of the officers, directors, employees and consultants who held shares as of that date, which included Mr. Castro and Dr. Maslov. The number of underlying shares subject to each award remained unchanged as a result of the re-pricing and vesting schedule change.

 

On November 28, 2014, we entered into stock option agreements with each of Mr. Castro and Dr. Maslov granting each an option to purchase up to 4,700 shares of our common stock, at an exercise price of $8.00 per share, the fair market value on the date that our board of directors approved the grant. The options vest as follows: (i) 1/4 of the total number of shares subject to the award vested one year after the grant date, and (ii) 1/36 of the remaining number of shares subject to the award vest on a monthly basis thereafter.

 

Our Agreements with Mr. Carney:

 

Our offer letter to Mr. Carney dated August 19, 2014 provided for an annual base salary of $180,000 and an option under the 2013 Plan to purchase 30,000 shares of our common stock at an exercise price equal to the per share closing price on August 19, 2014.

 

In addition to the offer letter, we entered into an employment agreement with Mr. Carney, dated as of August 19, 2014, for the position of Chief Financial Officer and Treasurer, which, in addition to his annual compensation as described in the offer letter, provides that he is eligible to receive an annual bonus and other annual incentive compensation that our board of directors may adopt, as well as benefits that we make available to other employees. We will also reimburse Mr. Carney for reasonable expenses that he incurs in performing his duties.

 

If we terminate Mr. Carney’s services for “cause” (as defined in his employment agreement), whether during or at the end of an employment year, we are obligated to pay him the sum of (i) his salary and bonuses, if any, through the date of termination, (ii) any earned but unused vacation time and paid time off (PTO), and (iii) any unreimbursed expenses.

 

If Mr. Carney’s services are terminated upon his death or disability, then (i) we are obligated to pay to him or his estate the same economic benefits as if his services were terminated for cause and (ii) he or his estate may also be granted (A) additional vesting of then-unvested stock or stock options, (B) a proportional amount of any earned and unpaid annual bonus based on his performance through the date of termination, and/or (C) severance payments.

 

If we terminate Mr. Carney’s services for any other reason, then we are obligated to pay him (i) the same economic benefits as if his services were terminated for cause, (ii) monthly cash severance payments at his then-salary rate, and (iii) continuation of our provided health insurance coverage, each to be paid during the six-month period immediately following the termination date, subject to earlier termination in the event that he obtains new employment or engages (or assists any other person or entity to engage) in any activity competitive with our business. Further, if during the six-month period immediately preceding or following a “change of control” (as defined in Mr. Carney’s employment agreement), we terminate his employment without cause, then all of his then-unvested outstanding options will immediately vest.

 

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Mr. Carney may terminate his employment relationship with us at any time and for any reason. Such resignation will not become effective until the earlier of (i) 90 days after the date resignation notice is given to our board of directors or (ii) a date we specify. If Mr. Carney does so, he has agreed to make himself available to us during the 30-day period following his termination, without any compensation (subject to exception): (i) to facilitate an efficient transition of his job-related responsibilities and duties and (ii) to respond to questions from us regarding information and/or activities in which he had been engaged while employed by us.

 

During his employment with us and for a period of 12 months after his termination, Mr. Carney is subject to restrictive covenants that provide he will not: (i) call on, solicit, divert, interfere with or take away (or attempt to call on, solicit, divert or interfere with or take away) any of our projects, business, clients, customers or prospects with whom or with which Mr. Carney had contact during his employment with us by promoting or selling services or products that compete with us or our affiliates; or (ii) solicit, influence or induce (or attempt to solicit, influence or induce) any employees as of his termination date with whom Mr. Carney had direct contact during his employment with us.

 

Mr. Carney’s employment agreement also contains other restrictive covenants further prohibiting: (a) disparagement of us or our affiliates during his employment and thereafter, and (b) the use or disclosure of confidential business information during or at any time after termination of his employment.

 

In connection with the option granted under his employment agreement, we entered into a stock option agreement with Mr. Carney, dated as of August 19, 2014. The agreement grants an option to purchase up to 30,000 shares of our common stock, at an exercise price of $7.50 per share, the fair market value on the date that our board of directors approved the grant. The agreement provides that the options vest as follows: (i) 1/8 of the total number of shares subject to the award vested six months after the grant date, (ii) 1/8 of the total number of shares subject to the award vested one year after the grant date and (iii) 1/48 of the total number of shares subject to the award vest on a monthly basis thereafter.

 

On November 28, 2014, we entered into a stock option agreement with Mr. Carney granting him an option to purchase up to 4,700 shares of our common stock at an exercise price of $8.00 per share, the fair market value on the date that our board of directors approved the grant. The options vest as follows: (i) 1/4 of the total number of shares subject to the award vested one year after the grant date and (ii) 1/36 of the remaining number of shares subject to the award vest on a monthly basis thereafter.

 

Our Agreements with Mr. Hamrin:

 

We entered into an employment agreement with Mr. Hamrin, dated as of June 29, 2016, for the position of Vice President of Engineering, which provides that he will receive an annual base salary of $180,000 and is eligible to receive an annual bonus and/or other annual incentive compensation in accordance with any applicable executive bonus plan applicable to Mr. Hamrin as may be adopted by the Board in its sole discretion. The employment agreement also provides that we will reimburse Mr. Hamrin for reasonable expenses that he incurs in performing his duties. During the term of his employment, Mr. Hamrin will also be entitled to up to 15 days of paid time off, or PTO, annually (adjusted annually based on years of service with us) and to participate in our benefit plans and programs. The initial term of the employment agreement is one year, which may be automatically extended for successive one year terms unless terminated by either party upon at least 30 days prior notice.

 

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If we terminate Mr. Hamrin’s services for “cause” (as defined in his employment agreement), whether during or at the end of an employment year, we are obligated to pay him the sum of (i) his salary and bonuses, if any, through the date of termination, (ii) any earned but unused vacation time/PTO, and (iii) any unreimbursed expenses.

 

If Mr. Hamrin’s services are terminated upon his death or disability, then (i) we are obligated to pay to him or his estate the same economic benefits as if his services were terminated for cause and (ii) he or his estate may also be granted (A) additional vesting of then-unvested stock or stock options, (B) a proportional amount of any earned and unpaid annual bonus based on his performance through the date of termination, and/or (C) severance payments.

 

If we terminate Mr. Hamrin’s services for any other reason, then we are obligated to pay him (i) the same economic benefits as if his services were terminated for cause, (ii) monthly cash severance payments at his then effective salary rate, and (iii) continuation of our provided health insurance coverage, each to be paid during the six-month period immediately following the termination date, subject to earlier termination in the event that he obtains new employment or engages (or assists any other person or entity to engage) in any activity competitive with our business. Further, if during the six-month period immediately preceding or following a “change of control” (as defined in Mr. Hamrin’s employment agreement), we terminate his employment without cause, then all of his then-unvested outstanding options will immediately vest.

 

Mr. Hamrin may terminate his employment at any time and for any reason. Such resignation will not become effective until the earlier of (i) 90 days after the date resignation notice is given to our board of directors or (ii) a date specified by us. If Mr. Hamrin terminates his employment, he has agreed to make himself available to us during the 30-day period following his termination, without any compensation (subject to exception): (i) to facilitate an efficient transition of his job-related responsibilities and duties and (ii) to respond to questions regarding information and/or activities in which he had been engaged while employed by us.

 

During his employment with us and for a designated period after his termination, Mr. Hamrin is subject to restrictive covenants that provide he will not: (i) call on, solicit, divert, interfere with or take away (or attempt to call on, solicit, divert or interfere with or take away) any of our projects, business, clients, customers or prospects with whom or with which Mr. Hamrin had contact during his employment with us by promoting or selling services or products that compete with us or our affiliates; or (ii) solicit, influence or induce (or attempt to solicit, influence or induce) any employees as of his termination date with whom Mr. Hamrin had direct contact during his employment with us.

 

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Mr. Hamrin’s employment agreement also contains other restrictive covenants further prohibiting: (a) disparagement of us or our affiliates during Mr. Hamrin’s employment and thereafter, (b) the improper solicitation of our customers following the expiration or termination his employment with us and (c) the use or disclosure of confidential business information during or at any time after termination of his employment. 

 

Outstanding Equity Awards at 2016 Fiscal Year-End

 

The following disclosure reflects all outstanding equity awards at the end of our 2016 fiscal year for each named executive officer, who served in such capacity as of December 31, 2016. All share figures and exercise prices noted in the following table and its footnotes are adjusted to give effect to the 1-for-50 reverse split of our issued and outstanding common stock on July 8, 2015, retroactively.

 

      Option Awards    
      Number of securities underlying unexercised options (#)    Option Exercise   Option Expiration
Name   Grant Date   Exercisable    Unexercisable    Price ($)   Date (1)
Alain Castro  4/28/14   38,939(2)   4,061    17.50   4/28/20
   5/13/14   6,460(3)       24.00   5/13/20
   11/28/14   2,448(4)   2,252    8.00   11/28/20
                      
Boris Maslov  4/28/14   14,489(2)   1,511    17.50   4/28/20
   5/13/14   1,514(3)       24.00   5/13/20
   11/28/14   2,448(4)   2,252    8.00   11/28/20
                      
Domonic J. Carney  8/19/14   17,500(4)   12,500    7.50   8/19/20
   11/28/14   2,448(4)   2,252    8.00   11/28/20
                      
Douglas A. Hamrin  4/28/14   14,489(2)   1,511    17.50   4/28/20
   5/1/14   948(3)       24.00   5/13/20
   10/3/14   5,625(6)   4,375    12.50   7/1/23

 

(1) All options granted in 2014 to officers expire six years from the grant date except that Mr. Hamrin’s October 2014 grant expires at the end of the option plan.

 

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(2) Options vest as follows: (i) 15% on the April 28, 2014 grant date and (ii) the remainder in equal monthly amounts over 36 months thereafter. All options may be exercised early for restricted shares that vest in accordance with the original option vesting schedule.
   
(3) Options vested 100% on the May 13, 2014 grant date.
   
(4) Options vest as follows: (i) 25% on November 28, 2015 and (ii) the remainder in equal monthly amounts over 36 months thereafter. All options may be exercised early for restricted shares that vest in accordance with the original option vesting schedule.
   
(5) Options vest as follows: (i) 12.5% on February 19, 2015, (ii) 12.5% on August 19, 2015 and (iii) the remainder vests in equal monthly amounts over 36 months thereafter. All options may be exercised early for restricted shares that vest in accordance with the original option vesting schedule.
   
(6) Options vest as follows: (i) 25% on October 3, 2015 and (ii) the remainder in equal monthly amounts over 36 months thereafter. All options may be exercised early for restricted shares that vest in accordance with the original option vesting schedule.

 

Employee Benefit Plans

 

2015 Omnibus Incentive Plan

 

Introduction

 

On July 14, 2015, our board of directors adopted the 2015 Plan. Our stockholders approved the 2015 Plan at our 2015 Annual Meeting of Stockholders held on August 28, 2015. As a result, the 2015 Plan replaced the 2013 Plan, and no new awards will be granted under the 2013 Plan. Any awards outstanding under the 2013 Plan as of August 28, 2015 remain subject to, and underlying shares will be issued under, the 2013 Plan, and any shares subject to outstanding awards under the 2013 Plan that subsequently cease to be subject to such awards (other than by reason of settlement of the awards in shares) will automatically become available for issuance under the 2015 Plan.

 

On August 22, 2016, our board of directors approved an amendment to the 2015 Plan to increase the number of shares of our common stock subject to the 2015 Plan to 600,000 shares. Our stockholders approved the amendment to the 2015 Plan at our 2016 Annual Meeting of Stockholders held on September 26, 2016.

 

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The principal features of the 2015 Plan are summarized below. This summary is qualified in its entirety by reference to the text of the 2015 Plan, which is filed as an appendix to the proxy statement for our 2015 Annual Meeting of Stockholders.

 

Share reserve

 

We have reserved 600,000 shares of our common stock for issuance under the 2015 Plan. In addition, any awards outstanding as of August 28, 2015 remain subject to and will be paid under the 2013 Plan and any shares then subject to outstanding awards under the 2013 Plan that subsequently expire, terminate or are surrendered or forfeited for any reason without issuance of shares will automatically become available for issuance under the 2015 Plan. Up to 600,000 shares may be granted as incentive stock options under Code Section 422. The shares of common stock issuable under the 2015 Plan will consist of authorized and unissued shares, treasury shares or shares purchased on the open market or otherwise.

 

If any award is canceled, terminates, expires or lapses for any reason prior to the issuance of shares or if shares are issued under the 2015 Plan and thereafter are forfeited to us, the shares subject to such awards and the forfeited shares will not count against the aggregate number of shares of common stock available for grant under the 2015 Plan. In addition, the following items will not count against the aggregate number of shares of common stock available for grant under the 2015 Plan: (1) the payment in cash of dividends or dividend equivalents under any outstanding award, (2) any award that is settled in cash rather than by issuance of shares of common stock, (3) shares surrendered or tendered in payment of the option price or purchase price of an award or any taxes required to be withheld in respect of an award or (4) awards granted in assumption of or in substitution for awards previously granted by an acquired company.

 

Administration

 

The 2015 Plan may be administered by our board of directors or the Compensation Committee. The Compensation Committee, in its discretion, selects the individuals to whom awards may be granted, the time or times at which such awards are granted and the terms and conditions of such awards.

 

Eligibility

 

Awards may be granted under the 2015 Plan to officers, employees, directors, consultants and advisors of our company and its affiliates. Incentive stock options may be granted only to employees of our company or its subsidiaries.

 

Awards

 

The 2015 Plan permits the granting of any or all of the following types of awards:

 

  Stock Options. Stock options entitle the holder to purchase a specified number of shares of common stock at a specified price (the exercise price), subject to the terms and conditions of the stock option grant. The Compensation Committee may grant either incentive stock options, which must comply with Code Section 422, or nonqualified stock options. The Compensation Committee sets exercise prices and terms and conditions, except that stock options must be granted with an exercise price not less than 100% of the fair market value of our common stock on the date of grant (excluding stock options granted in connection with assuming or substituting stock options in acquisition transactions). Unless the Compensation Committee determines otherwise, fair market value means, as of a given date, the closing price of our common stock. At the time of grant, the Compensation Committee determines the terms and conditions of stock options, including the quantity, exercise price, vesting periods, term (which cannot exceed 10 years) and other conditions on exercise.

 

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  Stock Appreciation Rights. The Compensation Committee may grant SARs, as a right in tandem with the number of shares underlying stock options granted under the 2015 Plan or as a freestanding award. Upon exercise, SARs entitle the holder to receive payment per share in stock or cash, or in a combination of stock and cash, equal to the excess of the share’s fair market value on the date of exercise over the grant price of the SAR. The grant price of a tandem SAR is equal to the exercise price of the related stock option and the grant price for a freestanding SAR is determined by the Compensation Committee in accordance with the procedures described above for stock options. Exercise of a SAR issued in tandem with a stock option will reduce the number of shares underlying the related stock option to the extent of the SAR exercised. The term of a freestanding SAR cannot exceed 10 years, and the term of a tandem SAR cannot exceed the term of the related stock option.

 

  Restricted Stock, Restricted Stock Units and Other Stock-Based Awards. The Compensation Committee may grant awards of restricted stock, which are shares of common stock subject to specified restrictions, and restricted stock units, or RSUs, which represent the right to receive shares of our common stock in the future. These awards may be made subject to repurchase, forfeiture or vesting restrictions at the Compensation Committee’s discretion. The restrictions may be based on continuous service with our company or the attainment of specified performance goals, as determined by the Compensation Committee. Stock units may be paid in stock or cash or a combination of stock and cash, as determined by the Compensation Committee. The Compensation Committee may also grant other types of equity or equity-based awards subject to the terms and conditions of the 2015 Plan and any other terms and conditions determined by the Compensation Committee.

 

  Performance Awards. The Compensation Committee may grant performance awards, which entitle participants to receive a payment from us, the amount of which is based on the attainment of performance goals established by the Compensation Committee over a specified award period. Performance awards may be denominated in shares of common stock or in cash, and may be paid in stock or cash or a combination of stock and cash, as determined by the Compensation Committee. Cash-based performance awards include annual incentive awards.

 

Awards to Non-employee Directors

 

No more than $500,000 may be granted in equity-based awards during any one year to a non-employee member of our board of directors, based on the grant date fair value for accounting purposes in the case of stock options or SARs and based on the fair market value of our common stock underlying the award on the grant date for other equity-based awards. This limit does not apply to shares received by a non-employee director at his or her election in lieu of all or a portion of the director’s retainer for service on our board of directors.

 

No Repricing

 

Without stockholder approval, the Compensation Committee is not authorized to (1) lower the exercise or grant price of a stock option or SAR after it is granted, except in connection with certain adjustments to our corporate or capital structure permitted by the 2015 Plan, such as stock splits, (2) take any other action that is treated as a repricing under generally accepted accounting principles or (3) cancel a stock option or SAR at a time when its exercise or grant price exceeds the fair market value of the underlying stock, in exchange for cash, another stock option or SAR, restricted stock, RSUs or other equity award, unless the cancellation and exchange occur in connection with a change in capitalization or similar corporate transactions.

 

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Clawback

 

All cash and equity awards granted under the 2015 Plan will be subject to all applicable laws regarding the recovery of erroneously awarded compensation, any implementing rules and regulations under such laws, any policies adopted by us to implement such requirements, and any other compensation recovery policies as may be adopted from time to time by us.

 

Change in Control

 

Under the 2015 Plan, in the event of a change in control (as defined in the 2015 Plan), outstanding awards will be treated in accordance with the applicable transaction agreement. If no treatment is provided for in the transaction agreement, each award holder will be entitled to receive the same consideration that stockholders receive in the change in control for each share of stock subject to the award holder’s awards, upon the exercise, payment or transfer of the awards, but the awards will remain subject to the same terms, conditions and performance criteria applicable to the awards before the change in control, unless otherwise determined by the Compensation Committee. In connection with a change in control, outstanding stock options and SARs can be cancelled in exchange for the excess of the per share consideration paid to stockholders in the transaction, minus the option or SARs exercise price.

 

Subject to the terms and conditions of the applicable award agreements, awards granted to non-employee directors will fully vest on an accelerated basis, and any performance goals will be deemed to be satisfied at target. For awards granted to all other service providers, vesting of awards will depend on whether the awards are assumed, converted or replaced by the resulting entity.

 

  For awards that are not assumed, converted or replaced, the awards will vest upon the change in control. For performance awards, the amount vesting will be based on the greater of (1) achievement of all performance goals at the “target” level or (2) the actual level of achievement of performance goals as of our fiscal quarter end preceding the change in control, and will be prorated based on the portion of the performance period that had been completed through the date of the change in control.
     
  For awards that are assumed, converted or replaced by the resulting entity, no automatic vesting will occur upon the change in control. Instead, the awards, as adjusted in connection with the transaction, will continue to vest in accordance with their terms and conditions. In addition, the awards will vest if the award recipient has a separation from service within two years after the change in control by us other than for “cause” or by the award recipient for “good reason” (each as defined in the applicable award agreement). For performance awards, the amount vesting will be based on the greater of (1) achievement of all performance goals at the “target” level or (2) the actual level of achievement of performance goals as of our fiscal quarter end preceding the change in control, and will be prorated based on the portion of the performance period that had been completed through the date of the separation from service.

 

Amendment and Termination of the 2015 Plan

 

Unless earlier terminated by our board of directors, the 2015 Plan will terminate, and no further awards may be granted, 10 years after the date on which it is approved by stockholders. Our board of directors may amend, suspend or terminate the 2015 Plan at any time, except that, if required by applicable law, regulation or stock exchange rule, stockholder approval will be required for any amendment. The amendment, suspension or termination of the 2015 Plan or the amendment of an outstanding award generally may not, without a participant’s consent, materially impair the participant’s rights under an outstanding award.

 

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2013 Equity Incentive Plan

 

Introduction

 

On July 1, 2013, our board of directors adopted the 2013 Plan, which was subsequently approved by our stockholders. We subsequently amended the 2013 Plan on August 23, 2013 and March 25, 2015. The 2013 Plan authorizes us to grant non-qualified stock options and restricted stock purchase rights to purchase up to 420,000 shares of our common stock with vesting to employees (including officers) and other service providers. To date, all issuances under the 2013 Plan have been stock options. No restricted shares have been issued under the 2013 Plan. The 2013 Plan provides that it will expire after 10 years, unless sooner terminated by the provisions therein. On April 28, 2014, our board of directors approved a re-pricing of all outstanding employee and non-employee director stock options outstanding under the 2013 Plan. We canceled options to purchase 172,600 shares of our common stock at exercise prices between $50.00 and $77.00 per share and replaced them with options to purchase 172,600 shares of our common stock at $17.50 per share. Our board of directors recently adopted the 2015 Plan and at the 2015 Annual Meeting of Stockholders held on August 28, 2015, our stockholders approved the 2015 Plan. Accordingly, we no longer will make award grants under plans in existence prior to the 2015 Plan, including the 2013 Plan.

 

The principal features of the 2013 Plan are summarized below. This summary is qualified in its entirety by reference to the text of the 2013 Plan, which is filed as an exhibit to the Annual Report on Form 8-K filed by us on March 30, 2015.

 

Share reserve

 

We initially reserved 280,000 shares of our common stock for issuance under the 2013 Plan. On March 25, 2015, we increased the number of shares of common stock available for issuance under the 2013 Plan from 280,000 to 420,000. The 2015 Plan replaced the 2013 Plan, and no new awards will be granted under the 2013 Plan. Any awards outstanding under the 2013 Plan as of August 28, 2015 remain subject to, and underlying shares will be issued under, the 2013 Plan, and any shares subject to outstanding awards under the 2013 Plan that subsequently cease to be subject to such awards (other than by reason of settlement of the awards in shares) will automatically become available for issuance under the 2015 Plan.

 

Administration

 

Our board of directors administers the 2013 Plan.

 

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Amendment and Termination of the 2013 Plan

 

Our board of directors may amend, alter, suspend or terminate the 2013 Plan. However, we will obtain stockholder approval of any amendment to the 2013 Plan to the extent necessary and desirable to comply with any applicable law, regulation or stock exchange rule. If not terminated earlier by the board of directors or a committee thereof, the 2013 Plan will terminate on the tenth anniversary of the date of its adoption by our board of directors, unless sooner terminated pursuant to the provisions thereof.

 

401(k) Plan

 

We maintain a defined contribution plan, or 401(k) Plan, for the benefit of employees. Participation in the 401(k) Plan is at the discretion of each employee and is subject to the rules and regulations of the Internal Revenue Service. The 401(k) Plan is administered by the trustees of the 401(k) Plan consisting of our President and CFO. We have the option, but not the obligation, to provide a matching contribution. To date, we have not made any matching contributions to the 401(k) Plan.

 

Limitation of Liability and Indemnification Matters

 

Our certificate of incorporation and our bylaws contain provisions indemnifying our directors and officers to the fullest extent permitted by law. Additionally, we have entered into indemnification agreements with each of our directors that may, in some cases, be broader than the specific indemnification provisions contained under Delaware law.

 

As permitted by Delaware law, our certificate of incorporation will provide that no director will be liable to us or our stockholders for monetary damages due to breach of certain fiduciary duties as a director. The effect of this provision is to restrict our rights and the rights of our stockholders in derivative suits to recover monetary damages against a director due to breach of certain fiduciary duties as a director, except that a director will be personally liable for:

 

  any breach of the director’s duty of loyalty to us or our stockholders;

 

  acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law;

 

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  the payment of dividends or the redemption or purchase of stock in violation of Delaware law; or

 

  any transaction from which the director knowingly derived an improper personal benefit.

 

To the extent that our directors, officers and controlling persons are indemnified under the provisions contained in our certificate of incorporation, Delaware law, or contractual arrangements against liabilities arising under the Securities Act we have been advised that in the opinion of the SEC such indemnification is against public policy as expressed in the Securities Act and is therefore unenforceable.

 

Director Compensation

 

The following table provides 2016 compensation information for our non-employee directors:

 

Name   Fees Earned or Paid in Cash
($)
   

Stock
Awards

($)

   

Option

Awards

($)(1)(2)

   

Total

($)

 
                         
Michael J. Hammons(3)                        
Bennet P. Tchaikovsky(4)     40,000                   40,000  
Jeffrey Horn(5)     40,000                   40,000  
Ian Copeland(6)     40,000                   40,000  
Eric Helenek(7)     10,000                   10,000  
Stephen Markscheid (8)     20,000             20,830       40,830  

 

(1) All share figures and exercise prices noted in the footnotes to this table are adjusted to give effect to the 1-for-50 reverse split of our issued and outstanding common stock on July 8, 2015, retroactively.

 

(2) The amounts shown in this column represent the aggregate grant date fair value of stock options granted in the year computed in accordance with FASB ASC Topic 718. These amounts are not paid to or realized by the Director. See Note 12 of the notes to our audited consolidated financial statements for a discussion of valuation assumptions made in determining the grant date fair value and compensation expense of our stock options.
   
(3) Mr. Hammons serves as our Chairman of our board of directors and has served as our Nominating and Corporate Governance Committee Chairman since July 14, 2015. On November 28, 2014, we entered into a stock option agreement with Mr. Hammons dated as of November 28, 2014 to purchase 6,000 shares of our common stock at an exercise price per share of $8.00. The agreement provides for the option to vest as follows: (i) 1/2 of the total number of shares on the grant date, and (ii) 1/18 of the total number of shares each month thereafter.

 

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(4) Mr. Tchaikovsky has served as a Director and as our Audit Committee Chairman since November 2013. Beginning in April 2014, we began to pay Mr. Tchaikovsky an annual fee of $40,000. On November 22, 2013, we issued Mr. Tchaikovsky an option to purchase 5,000 shares of our common stock at an exercise price per share of $76.00. On April 28, 2014, we cancelled these options and issued Mr. Tchaikovsky an option to purchase 5,000 shares of our common stock at an exercise price per share of $17.50, with 15% of the grant vesting on the grant date and the remainder vesting over 36 months.
   
(5) Mr. Horn has served as a Director since May 2014 and is paid an annual fee of $40,000. On May 28, 2014, we issued Mr. Horn an option to purchase 6,000 shares of our common stock at an exercise price per share of $22.00, vesting ratably over 36 months.
   
(6) Mr. Copeland has served as a Director since December 2014 and as our Compensation Committee Chairman since July 14, 2015 and is paid an annual fee of $40,000. On November 28, 2014, we issued Mr. Copeland an option to purchase 6,000 shares of our common stock at an exercise price per share of $8.00, vesting ratably over 36 months.
   
(7) Mr. Helenek served as a Director beginning May 2015 and was paid an annual fee of $40,000, which was prorated to $26,667 for his service in 2015 and $10,000 for his service in 2016. On May 18, 2015, we issued Mr. Helenek an option to purchase 6,000 shares of our common stock at an exercise price per share of $9.50, with 1/4 of the grant vesting on May 18, 2016 and 1/48 of the grant vesting ratably each month thereafter. Mr. Helenek resigned from our board of directors effective March 30, 2016. Mr. Helenek’s resignation from our board of directors was not the result of any disagreement with us on any matter relating to our operations, policies or practices. Mr. Helenek’s option to purchase common stock did not vest and was forfeited upon his resignation in 2016.
   
(8) Mr. Markscheid has served as a Director since June 2016 and was paid an annual fee of $40,000, which was prorated to $20,000 for his service in 2016. On July 1, 2016, we issued Mr. Markscheid an option to purchase 6,000 shares of our common stock at an exercise price per share of $4.31, with 1/4 of the grant vesting on June 30, 2017 and 1/48 of the grant vesting ratably each month thereafter.

 

We have the following agreements with our directors for their services on our board of directors. All share figures and exercise prices for our common stock (but not the share and per share amounts for the common stock of Ener-Core Power, Inc.) noted in the following summaries are adjusted to give effect to the 1-for-50 reverse split of our issued and outstanding common stock on July 8, 2015, retroactively:

 

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Our Agreement with Mr. Tchaikovsky:

 

On November 22, 2013, Mr. Tchaikovsky accepted his appointment to our board of directors and as Chairman of our Audit Committee pursuant to our offer letter dated November 10, 2013. The offer letter provides for the grant of an option under the 2013 Plan to purchase 5,000 shares of our common stock at an exercise price equal to the per share closing price on November 25, 2013 (as adjusted for the 1-for-50 reverse split), being the fair market value on such date. In addition to the shares granted, the offer letter contemplates an annual director’s fee of $40,000, subject to annual reviews by the Compensation Committee, approval by our board of directors and approval of the stockholders as appropriate. We also agreed to reimburse Mr. Tchaikovsky for reasonable travel expenses incurred to attend board of directors meetings, and to indemnify him in his capacity as a director to the fullest extent permissible.

 

In connection with the option granted under the offer letter, we entered into a stock option agreement with Mr. Tchaikovsky, dated as of November 25, 2013, pursuant to which we granted Mr. Tchaikovsky an option to purchase 5,000 shares of our common stock. The agreement provides that the option vests as follows: (i) 1/4 of the total number of shares subject to the award vested one year after the grant date, and (ii) 1/48 of the total number of shares subject to the award will vest on a monthly basis thereafter.

 

Our Agreement with Mr. Horn:

 

On May 28, 2014, Mr. Horn accepted his appointment to our board of directors pursuant to our offer letter dated May 19, 2014. The offer letter provides for the grant of an option under the 2013 Plan to purchase 6,000 shares of our common stock at an exercise price equal to the per share closing price on May 28, 2014 (as adjusted for the 1-for-50 reverse split), the fair market value on such date. In addition to the shares granted, the offer letter contemplates an annual director’s fee of $40,000 payable monthly, although such fee is not guaranteed. We also agreed to reimburse Mr. Horn for reasonable travel expenses incurred to attend board of directors meetings, and to indemnify him in his capacity as a director to the fullest extent permissible.

 

In connection with the option granted under the offer letter, we entered into a stock option agreement with Mr. Horn, dated as of May 28, 2014, pursuant to which we granted Mr. Horn an option to purchase 6,000 shares of our common stock, at an exercise price of $22.00 per share, the fair market value on the date our board of directors approved the grant. The agreement provides for 1/36 of the total number of shares subject to the award to vest each month beginning June 28, 2014.

 

Our Agreement with Mr. Copeland:

 

On December 1, 2014, Mr. Copeland accepted his appointment to our board of directors pursuant to our offer letter dated November 24, 2014. The offer letter provides for the grant of an option under the 2013 Plan to purchase 6,000 shares of our common stock at an exercise price equal to the per share closing price on November 28, 2014 (as adjusted for the 1-for-50 reverse split), the fair market value on such date. In addition to the shares granted, the offer letter contemplates an annual director’s fee of $40,000, payable monthly, although such fee is not guaranteed. We also agreed to reimburse Mr. Copeland for reasonable travel expenses incurred to attend board of directors meetings, and to indemnify him in his capacity as a director to the fullest extent permissible.

 

In connection with the option granted under the offer letter, we entered into a stock option agreement with Mr. Copeland, dated as of November 28, 2014, pursuant to which we granted Mr. Copeland an option to purchase 6,000 shares of our common stock, at an exercise price of $8.00 per share, the fair market value on the date our board of directors approved the grant. The agreement provides for 1/36 of the total number of shares subject to the award to vest each month beginning January 1, 2015.

 

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Our Agreement with Mr. Hammons:

 

As compensation for his services as a director and Chairman of our board of directors, on November 28, 2014, the board of directors granted Mr. Hammons an option under the 2013 Plan to purchase 6,000 shares of our common stock, at an exercise price equal to the per share closing price on November 28, 2014, the fair market value on such date. Immediately thereafter, we entered into a stock option agreement with Mr. Hammons, dated November 28, 2014, granting Mr. Hammons an option to purchase 6,000 shares of our common stock, at an exercise price of $8.00 per share, the fair market value on the date our board of directors approved the grant. The agreement provides that the option vests as follows: (i) 1/2 of the total number of shares subject to the award vested one year after the grant date, and (ii) 1/18 of the remaining number of shares subject to the award vest on a monthly basis thereafter, beginning January 1, 2015.

 

Our Agreement with Mr. Helenek:

 

On May 18, 2015, Mr. Helenek accepted his appointment to our board of directors pursuant to our offer letter of the same date. The offer letter provides for the grant of an option under the 2013 Plan to purchase 6,000 shares of our common stock at an exercise price equal to the per share closing price on May 18, 2015, the fair market value on such date. In addition to the shares granted, the offer letter contemplates an annual director’s fee of $40,000 payable monthly, although such fee is not guaranteed. We also agreed to reimburse Mr. Helenek for reasonable travel expenses incurred to attend board of directors meetings, and to indemnify him in his capacity as a director to the fullest extent permissible.

 

In connection with the option granted under the offer letter, we entered into a stock option agreement with Mr. Helenek, dated as of May 18, 2015, granting Mr. Helenek an option to purchase 6,000 shares of our common stock at an exercise price of $9.50 per share, the fair market value on the date our board of directors approved the grant. The agreement provides that the option vests as follows: (i) 1/4 of the total number of shares subject to the award vested one year after the grant date, and (ii) 1/36 of the remaining number of shares subject to the award will vest on a monthly basis thereafter. Mr. Helenek resigned from our board of directors effective March 30, 2016. None of the options granted were vested upon his resignation. Mr. Helenek’s resignation from our board of directors was not the result of any disagreement with us on any matter relating to our operations, policies or practices.

 

Our Agreement with Mr. Markscheid:

 

Effective as of June 29, 2016, our board of directors appointed Stephen Markscheid to fill a vacancy, which Mr. Markscheid accepted pursuant to an offer letter dated as of June 29, 2016, which provides for the grant of an option under the 2015 Plan, effective July 1, 2016, to purchase 6,000 shares of our common stock at an exercise price of $4.31 per share. In addition to the shares granted, the offer letter contemplates an annual director’s fee of $40,000, payable monthly, although such fee is not guaranteed. We also agreed to reimburse Mr. Markscheid for reasonable travel expenses incurred to attend board meetings, and to indemnify him in his capacity as a director to the fullest extent permissible.

 

In connection with the above-described option grant, we and Mr. Markscheid entered into a stock option agreement in the form provided by the 2015 Plan, which provides for 1/4 of the total number of shares to vest after 12 months and 1/48 of the total number of shares to vest each month commencing each month thereafter. The options granted will become fully vested and exercisable immediately prior to, and contingent upon, a “change in control” (as defined in the 2015 Plan).

 

ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

Equity Compensation Plan Information

 

The following table sets forth information as of December 31, 2016 with respect to compensation plans under which equity securities of the Company are authorized for issuance. For a description of the terms of our 2013 Plan and 2015 Plan, please see “Executive Compensation—Employee Benefit Plans”.

 

Plan Category  Number of securities to be issued upon exercise of outstanding options, warrants and rights   Weighted-average exercise price of outstanding options, warrants and rights   Number of securities remaining available for future issuance under equity compensation plans 
Equity compensation plans approved by security holders   273,550   $13.70    634,914 
Equity compensation plans not approved by security holders   80,794   $28.84     
Total   354,344   $17.15    634,914 

 

The securities issued pursuant to equity compensation plans not approved by security holders consist of warrants issued to various service providers between 2013 and 2015, as further described in “Note 14—Stock Options and Warrants—Warrants” to our consolidated financial statements included elsewhere in this report.

 

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Security Ownership of Certain Beneficial Owners and Management

 

The following table sets forth information with respect to the beneficial ownership of our common stock as of April 10, 2017 for: (i) each person known by us to own beneficially more than 5% of our common stock; (ii) each of our directors; (iii) each of our named executive officers; and (iv) all of our directors and executive officers as a group, as adjusted to give effect to the 1-for-50 reverse split of our issued and outstanding common stock on July 8, 2015, retroactively. Except as indicated by the footnotes below, we believe, based on the information furnished to us, that the beneficial owners named in the table below have sole voting and investment power with respect to all shares of our common stock that they beneficially own, subject to applicable community property laws.

 

Applicable percentage ownership is based on 4,063,660 shares of common stock outstanding as of April 10, 2017. 

 

The number of shares of common stock owned are those “beneficially owned” as determined under the rules of the SEC, including any shares of common stock as to which a person has sole or shared voting or investment power and any shares of common stock that the person has the right to acquire within 60 days of April 10, 2017 through the exercise of any option, warrant or right, subject to the effect of certain provisions in relevant notes and warrants that contractually block such acquisition. We did not deem those shares outstanding, however, for the purpose of computing the percentage ownership of any other person.

 

Name and Address of Beneficial Owner(1)  Shares of  Common Stock Beneficially  Owned   Percent of  Common Stock Beneficially  Owned 
Alain J. Castro(2)   211,756    5.33%
Boris A. Maslov(3)   18,927    * 
Domonic J. Carney(4)   102,323    2.63%
Michael J. Hammons(5)   16,188      * 
Bennet P. Tchaikovsky(6)   13,854    * 
Jeff Horn(7)   16,022      * 
Ian Copeland(8)   14,688      * 
Stephen Markscheid(9)   23,083      * 
Douglas A. Hamrin(10)   76,561    1.97%
All directors and executive officers as a group(11)   493,401    12.80%
           
Five Percent Beneficial Owners:          
Like Capital Limited(12)   696,056    18.06%
SAIL Exit Partners, LLC(13)   586,005    15.21%
SAIL Pre-Exit Acceleration Fund, LP(14)   5,232      * 
Blue Earth Fund, LP(15)   818,000    9.99%
Empery Asset Master, Ltd.(16)   685,317    9.99%
Empery Tax Efficient, LP(17)   516,333    9.99%
Empery Tax Efficient II, LP(18)   737,162    9.99%
Jeneration Capital Master Fund(19)   375,000    9.43%
Hudson Bay Capital Management, L.P.(20)   342,859    8.17%
Brio Capital Master Fund Ltd.(21)   333,066    7.96%

 

* Less than 1%

 

(1) Unless otherwise noted, the business address for each holder is c/o Ener-Core, Inc., 8965 Research Drive, Irvine, California 92618.

 

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(2) Consists of 94,667 shares of common stock, of which 87,500 shares are shares of restricted stock that remain subject to a risk of forfeiture as of April 10, 2017; 11,200 shares of common stock underlying a warrant that is exercisable within 60 days of April 10, 2017; 11,200 shares of common stock underlying a convertible note that is convertible within 60 days of April 10, 2017; and 94,689 shares of common stock underlying options that are exercisable within 60 days of April 10, 2017. Does not include 44,054 shares of common stock underlying options that are not exercisable within 60 days of April 10, 2017. These stock options were granted to Mr. Castro on April 15, 2014, May 13, 2014, November 28, 2014 and April 4, 2017.
   
(3) Consists of 18,927 shares of common stock underlying options that are exercisable within 60 days of April 10, 2017. These stock options were granted to Dr. Maslov on April 15, 2014, May 13, 2014 and November 28, 2014. On February 1, 2017, we and Dr. Maslov mutually agreed to terminate Dr. Maslov’s employment with us, as well as his positions as our President, Chief Operating Officer and Chief Technology Officer, along with any officer, director or employee positions with our subsidiaries and affiliates, effective as of January 31, 2017.
   
(4)

Consists of 4,000 shares of common stock issued to Charles Schwab & Co. Inc. FBO Domonic Carney IRA; 2,667 shares of common stock issued to Charles Schwab & Co. Inc. FBO Domonic Carney Roth IRA, as to which Mr. Carney holds voting and investment power; 60,167 shares of common stock owned by Mr. Carney, of which 52,500 shares are shares of restricted stock that remain subject to a risk of forfeiture as of April 10, 2017; and 42,156 shares of common stock underlying options that are exercisable within 60 days of April 10, 2017. Does not include 45,044 shares of common stock underlying options that are not exercisable within 60 days of April 10, 2017. These stock options were granted to Mr. Carney on August 19, 2014, November 28, 2014 and April 4, 2017.

 

(5) Consists of 1,334 shares of common stock and 14,854 shares of common stock underlying options that are exercisable within 60 days of April 10, 2017. Does not include 16,146 shares of common stock underlying options that are not exercisable within 60 days of April 10, 2017. These stock options were granted to Mr. Hammons on November 28, 2014 and April 4, 2017. Mr. Hammons’ business address is 1567 Buckeye Court, San Luis Obispo, CA 93401.
   
(6) Consists of 13,854 shares of common stock underlying options that are exercisable within 60 days of April 10, 2017. Does not include 16,146 shares of common stock underlying options that are not exercisable within 60 days of April 10, 2017. These stock options were granted to Mr. Tchaikovsky on April 15, 2014 and April 4, 2017. Mr. Tchaikovsky’s business address is 6571 Morningside Drive, Huntington Beach, California 92648.
   
(7) Consists 1,334 shares of common stock and 14,688 shares of common stock underlying options that are exercisable within 60 days of April 10, 2017. Does not include 16,313 shares of common stock underlying options that are not exercisable within 60 days of April 10, 2017. These stock options were granted to Mr. Horn on May 28, 2014 and April 4, 2017. Mr. Horn’s business address is 703 Hollybriar Lane, Naples, Florida 34108.
   
(8) Consists of 1,000 shares of common stock and 13,688 shares of common stock underlying options that are exercisable within 60 days of April 10, 2017. Does not include 17,313 shares of common stock underlying options that are not exercisable within 60 days of April 10, 2017. These stock options were granted to Mr. Copeland on November 28, 2014 and April 4, 2017. Mr. Copeland’s business address is 13007 Mimosa Farm Court, Rockville, Maryland 20850.
   
(9) Consists of 8,000 shares of common stock underlying a warrant that is exercisable within 60 days of April 10, 2017; 8,000 shares of common stock underlying a convertible note that is convertible within 60 days of April 10, 2017; and 7,083 shares of common stock underlying options that are exercisable within 60 days of April 10, 2017. Does not include 18,917 shares of common stock underlying options that are not exercisable within 60 days of April 10, 2017. These stock options were granted to Mr. Markscheid on June 29, 2016 and April 4, 2017. Mr. Markscheid’s business address is 419 Washington Avenue, Wilmette, Illinois 60091.

 

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(10) Consists of 40,550 shares of common stock, of which 35,000 shares are shares of restricted stock that remain subject to a risk of forfeiture as of April 10, 2017; and 36,011 shares of common stock underlying options that are exercisable within 60 days of April 10, 2017. Does not include 25,938 shares of common stock underlying options that are not exercisable within 60 days of April 10, 2017. These stock options were granted to Mr. Hamrin on April 15, 2014, May 13, 2014, October 3, 2014 and April 4, 2017.
   
(11) Includes 255,949 shares of common stock underlying options that are exercisable within 60 days of April 10, 2017 and 210,000 shares of restricted common stock that remain subject to a risk of forfeiture as of April 10, 2017.
   
(12) Ma Chi Wing Wendy is the Managing Director of Like Capital Limited and is deemed to have sole voting and investment power with respect to the shares of common stock owned by Like Capital Limited. Like Capital Limited’s business address is New World Tower 1, 23rd Floor, 18 Queens Road Central, Hong Kong.
   
(13) F. Henry Habicht II and Walter L. Schindler are the managers of SAIL Exit Partners, LLC and are deemed to have shared voting and investment power with respect to the shares of common stock owned by SAIL Exit Partners, LLC. SAIL Exit Partners, LLC’s business address is 3161 Michelson Drive, Suite 750, Irvine, California 92612.
   
(14) SAIL Capital Partners, LLC is the general partner and management company of SAIL Pre-Exit Acceleration Fund, LP. F. Henry Habicht II and Walter L. Schindler are the managing partners of SAIL Capital Partners, LLC and are deemed to have shared voting and investment power with respect to the shares of common stock owned by SAIL Pre-Exit Acceleration Fund, LP. SAIL Capital Partners, LLC’s business address is 3161 Michelson Drive, Suite 750, Irvine, California 92612.
   
(15) Consists of 384,000 shares of common stock underlying warrants that are exercisable within 60 days of April 10, 2017 and 434,000 shares of common stock underlying convertible notes that are convertible within 60 days of April 10, 2017. Brett Conrad, the manager of Blue Earth Fund, LP, may be deemed to have voting and investment power over these securities. The foregoing warrants and convertible notes held by Blue Earth Fund, LP include provisions that provide that conversion or exercise thereof, as applicable, is subject to a 9.99% beneficial ownership limitation, calculated to include holdings of its affiliates. Blue Earth Fund, LP’s business address is c/o Longboard Capital Advisors, LLC, 1312 Cedar St., Santa Monica, California 90405. This information is based on the Schedule 13G filed by Longboard Capital Advisors, LLC and Mr. Conrad with the SEC on February 17, 2017.
   
(16) Consists of 93,188 shares of common stock, 320,840 shares of common stock underlying warrants that are exercisable within 60 days of April 10, 2017 and 271,289 shares of common stock underlying convertible notes that are convertible within 60 days of April 10, 2017. Empery Asset Management LP, the authorized agent of Empery Asset Master Ltd. (“EAM”), has discretionary authority to vote and dispose of the shares held by EAM and may be deemed to be the beneficial owner of these shares. Martin Hoe and Ryan Lane, in their capacity as investment managers of Empery Asset Management LP, may also be deemed to have investment discretion and voting power over the shares held by EAM. EAM, Mr. Hoe and Mr. Lane each disclaim any beneficial ownership of these shares. The foregoing warrants and convertible notes held by EAM include provisions that provide that conversion or exercise thereof, as applicable, is subject to either a 4.99% or 9.99% beneficial ownership limitation, which limitation depends on the specific instrument, calculated to include holdings of its affiliates. EAM’s business address is 1 Rockefeller Plaza, Suite 1205, New York, NY 10020. This information is based on the Schedule 13G/A filed by EAM, Empery Tax Efficient, LP (“ETE”), Empery Tax Efficient II, LP (“ETE II”), Empery Asset Management, LP, Mr. Lane and Mr. Hoe with the SEC on January 24, 2017.
   
(17) Consists of 37,293 shares of common stock, 266,602 shares of common stock underlying warrants that are exercisable within 60 days of April 10, 2017 and 212,438 shares of common stock underlying convertible notes that are convertible within 60 days of April 10, 2017. Empery Asset Management LP, the authorized agent of ETE, has discretionary authority to vote and dispose of the shares held by ETE and may be deemed to be the beneficial owner of these shares. Martin Hoe and Ryan Lane, in their capacity as investment managers of Empery Asset Management LP, may also be deemed to have investment discretion and voting power over the shares held by ETE. ETE, Mr. Hoe and Mr. Lane each disclaim any beneficial ownership of these shares. The foregoing warrants and convertible notes held by ETE include provisions that provide that conversion or exercise thereof, as applicable, is subject to either a 4.99% or 9.99% beneficial ownership limitation, which limitation depends on the specific instrument, calculated to include holdings of its affiliates. ETE’s business address is 1 Rockefeller Plaza, Suite 1205, New York, NY 10020. This information is based on the Schedule 13G/A filed by EAM, ETE, ETE II, Empery Asset Management, LP, Mr. Lane and Mr. Hoe with the SEC on January 24, 2017.

 

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(18) Consists of 34,290 shares of common stock, 395,041 shares of common stock underlying warrants that are exercisa