UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF SECURITIES
EXCHANGE ACT OF 1934
For the Transition Period From to
Commission File Number 333-13287
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EARTHSHELL CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 77-0322379
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3916 State St. Ste. 110, Santa Barbara, California 93105
(Address of principal executive office) (Zip Code)
(805) 563-7590
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12 (b) of the Act:
None
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Securities registered pursuant to Section 12 (g) of the Act:
Common Stock $.01 par value
(Title of each class)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K 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. Yes |_|
Indicate by checkmark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes |X| No |_|
The aggregate market value of the voting stock held by non-affiliates of
the Registrant as of June 30, 2004 was $28,681,801.
The number of shares outstanding of the Registrant's Common Stock as of
March 31, 2005 was 18,391,065.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the Registrant's Annual Meeting of
Stockholders to be held on May 26, 2005 are incorporated by reference in Part
III of this Annual Report on Form 10-K.
ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004
PART I
ITEM 1. BUSINESS.................................................................... 1
ITEM 2. PROPERTIES.................................................................. 9
ITEM 3. LEGAL PROCEEDINGS........................................................... 9
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS......................... 9
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES....................................... 9
ITEM 6. SELECTED FINANCIAL DATA..................................................... 11
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.................................................................. 11
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.................. 23
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................................. 24
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.................................................................. 24
ITEM 9A. CONTROLS AND PROCEDURES..................................................... 24
ITEM 9B. OTHER INFORMATION........................................................... 24
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.......................... 24
ITEM 11. EXECUTIVE COMPENSATION...................................................... 24
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS......................................................... 24
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.............................. 24
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES...................................... 24
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES................................... 25
As used herein, the terms "EarthShell" and the "Company" shall mean
EarthShell Corporation unless the context otherwise indicates and the term
"Proxy Statement" shall mean the Proxy Statement for the Company's 2005 Annual
Meeting of Stockholders to be held on May 26, 2005.
i
PART I
ITEM 1. BUSINESS
The Company
EarthShell(R) Corporation ("EarthShell" or the "Company") was organized in
November 1992 to engage in the commercialization of a proprietary composite
material technology, designed with the environment in mind, for the manufacture
of disposable packaging to be used in the foodservice industry. Current and
future products include hinged-lid containers, plates, bowls, foodservice wraps,
cups, and cutlery ("EarthShell Packaging").
The EarthShell composite material is primarily made from abundantly
available and low cost natural raw materials such as limestone and starch from
annually renewable crops such as corn and potatoes. The Company believes that
foodservice disposables made of this material will offer certain significant
environmental benefits, will have comparable or superior performance
characteristics, such as greater strength and rigidity, and can be commercially
produced and sold at prices that are competitive with comparable conventional
paper and plastic foodservice disposables.
The Company's objective is to establish EarthShell Packaging(R) as the
preferred disposable packaging material for the foodservice industry throughout
the world based on comparable performance, environmental superiority and
competitive pricing. EarthShell's approach for achieving this objective has been
to: (i) license the EarthShell technology to strategically selected
manufacturing or operating partners to manufacture, market, distribute and sell
EarthShell Packaging; (ii) demonstrate customer acceptance and demand for
EarthShell Packaging through key market leaders and environmental groups; and
(iii) demonstrate the manufacturability and improved economics with initial
strategic partners.
Industry Overview
Based on industry studies, the Company believes that the annual spending
on foodservice disposable packaging is approximately $12 billion in the U.S. and
over $28 billion globally. According to industry studies of the U.S. market,
approximately 54% of the total foodservice disposable packaging is purchased by
quick-service restaurants and 46% by other institutions such as hospitals,
stadiums, airlines, schools, restaurants (other than quick-service restaurants),
and retail stores. The Company believes that of the foodservice disposables
purchased in the U.S. by quick-service restaurants and other institutions,
approximately 45% are made of coated or plastic laminated paper and 55% are made
of non-paper materials such as plastic, polystyrene or foil. A breakdown of the
various components of the global market for foodservice disposables is as
follows:
Market Size
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$ %
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($ in millions)
Commercial Products
Plates, Bowls ............................. $ 4,500 16%
Hinged-Lid Containers ..................... 1,750 6
Commercial Prototypes
Wraps ..................................... 2,000 7
Hot Cups .................................. 3,000 11
Concept Prototypes
Cold Cups ................................. 5,500 20
Containers, Trays ......................... 4,000 14
Straws, Cup Lids .......................... 3,000 11
Pizza Boxes ............................... 2,250 8
Cutlery ................................... 2,000 7
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Total ..................................... $28,000 100%
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1
In addition to the U.S., the Company believes the market opportunity for
EarthShell Packaging is particularly strong in Europe and parts of Asia due to
heightened environmental concerns and government regulations. In Europe,
environmental legislation, such as the so-called "Green Dot" laws have created
an opportunity for environmentally preferable products. Meanwhile, new
regulations in many Asian countries have mandated a reduction in polystyrene
production stimulating an increased demand for foodservice packaging
manufactured from acceptable alternative materials. Furthermore, improvements in
the Asian and European composting and recycling infrastructure are expected to
facilitate the use of environmentally preferable products.
Products
EarthShell Packaging is based on a patented composite material technology
licensed on an exclusive worldwide basis from E. Khashoggi Industries LLC, the
largest stockholder of the Company, and, on a limited exclusive, worldwide
basis, from its wholly-owned subsidiaries (collectively "EKI"). The Company's
licensed field of use of the technology is for the development, manufacture and
sale of disposable packaging for use in the foodservice industry and for certain
specific food packaging applications.
Traditional foodservice disposables, wraps, and paperboard are currently
manufactured from a variety of materials, including paper and plastic. The
Company believes that none of these materials fully addresses three of the
principal challenges facing the foodservice industry; namely performance, price,
and environmental impact. The Company believes that EarthShell Packaging
addresses the combination of these challenges better than traditional
alternatives and therefore will be able to achieve a significant share of the
foodservice disposable packaging market.
EarthShell Packaging can be categorized into four types: laminated foamed
products, flexible wraps, injection-molded products and paperboard substitutes.
To date, the EarthShell technology has been used to produce limited commercial
quantities of plates, bowls, and hinged-lid containers intended for use by all
segments of the foodservice disposable packaging market, including quick-service
restaurants, food and facilities management companies, the U.S. government,
universities/colleges, and retail operations. These products were developed
using detailed environmental assessments and carefully selected raw materials
and processes to minimize the harmful impact on the environment without
sacrificing competitive price or performance.
Environment
EarthShell's foodservice disposable products were developed over many
years based on environmental models to reduce the environmental concerns of
foodservice disposable packaging through the careful selection of raw materials,
manufacturing processes and suppliers. For example, EarthShell Packaging reduces
risk to wildlife compared to polystyrene foam packaging because it biodegrades
when exposed to moisture in nature and can be composted in a commercial facility
(where available) or even in consumers' backyards. EarthShell Packaging and the
designs approach for its manufacture and disposal has received support from many
governmental and non-governmental organizations.
Performance
The Company believes that it has demonstrated that its laminated foam
products, including hinged-lid containers, plates and bowls meet the critical
performance requirements of the marketplace, including strength, graphic
capabilities, insulation, shipping, handling and packaging. The Company believes
its foodservice wraps also meet critical performance requirements of the
marketplace, including flexibility, folding characteristics, graphic
capabilities, insulation, shipping, handling and packaging. Finally, the Company
believes that its paperboard substitute product, which is currently under
development, may be manufactured using the same basic raw materials as the foam
laminate disposables and wraps and will be readily accepted by the market when
available.
Some examples of where EarthShell Packaging plates, bowls, and hinged-lid
containers have been used include:
2
Quick-Service Restaurants McDonald's Corporation ("McDonalds")
Facilities Management Sodexho
Bon Appetit
Aramark
Government U.S. Department of the Interior
U.S. Department of Defense
Environmental Protection Agency
Universities University of California, Davis
Hampshire College
Allegheny College
Retail Wal-Mart Stores
Green Earth Office Supply
Cost
Since EarthShell Packaging is uniquely engineered from readily available,
low-cost natural raw materials such as limestone and starch, the Company
believes EarthShell products can be manufactured cost-effectively at commercial
production levels.
Business Strategy
The Company's objective is to establish EarthShell Packaging as the
preferred foodservice disposable packaging in the foodservice industry. The
Company's strategies to achieve this objective are to:
o Develop products which deliver comparable or greater performance,
are competitively priced and offer environmental advantages as
compared to traditional packaging alternatives
o Demonstrate customer demand as well as product performance and
positioning
o Educate the market and build awareness for the EarthShell brand
o Prove manufacturability and economics of EarthShell Packaging
o License the EarthShell technology to strategic manufacturing
partners to manufacture, market, distribute and sell EarthShell
Packaging
o Expand the business by replicating the EarthShell model across
multiple operating partners to increase capacity
The Company believes that the use of EarthShell Packaging by key
foodservice operators will accelerate the acceptance of the products by other
users. To this end, the Company has worked with major purchasers of foodservice
disposables in the development and testing of products in order to demonstrate
superior product performance, highlight cost-benefit and build demand for
EarthShell Packaging. The Company also expects that the EarthShell Packaging
brand name will appear on EarthShell products.
The Company's strategy includes licensing the EarthShell technology to, or
joint venturing with, strategically selected manufacturing or operating partners
for the manufacture, marketing, distribution and sale of EarthShell Packaging.
During 2004, the company terminated its license agreements with Sweetheart/Solo
and with Huhtamaki as those relationships had not progressed as planned. The
Company entered into three new license agreements -- with Meridian Business
Solutions ("MBS") for the U.S. market another with EarthShell Hidalgo S.A. de
C.V. ("ESH") for a segment of the Mexican market, and with Hood Pakaging
("Hood") to be The exclusive manufacturer of EarthShell food wraps for the North
American market. The Company is seeking additional qualified licensees and will
provide each of its licensees with technical and ongoing support to facilitate
the application of the EarthShell technology, further refine the manufacturing
processes and reduce production costs. The Company will monitor product quality
at licensee operations.
3
Over the past several years, the Company has garnered support and achieved
commercial validation for EarthShell Packaging from key environmental groups and
foodservice purchasers. The Company has also devoted resources to the
optimization of product design and the development of cost-effective
manufacturing processes. In cooperation with former manufacturing partners, the
Company financed and built initial commercial demonstration production capacity
and sold limited quantities of plates, bowls, and hinged-lid containers. Having
demonstrated the manufacturability of EarthShell foam products, the Company has
now ceased commercial demonstration production activities and is relying on its
equipment manufacturing partners to demonstrate and guarantee the long-term
manufacturability of EarthShell Packaging(R).
EarthShell believes it has a high quality and cost-effective product and a
profitable business model necessary to take advantage of a significant market
opportunity. With the introduction of commercial production capacity by its
licensees and commercial sales of its products in 2005, EarthShell expects its
products to continue to gain acceptance in the marketplace and believes it is
well-poised to support capacity expansion and market penetration by its
licensees leading to growth of the Company's royalty revenue.
Licensing Business Model
The licensing business model enables the Company to concentrate on the
continuing development of quality food service packaging products with reduced
impact on the environment. This approach contemplates that manufacturing,
marketing, distribution and sale of EarthShell Packaging will be the
responsibility of the Company's manufacturing licensees. EarthShell believes
that its licensing business model will enable it to generate a sustainable
royalty revenue stream. Beyond the revenue opportunities, the Company believes
the licensing business model has positive implications for the Company's cost
structure. As the Company has moved from product and process development toward
product commercialization phase and has reduced its investment in demonstration
manufacturing operations, it has been able to significantly reduce monthly
operating costs and reposition itself to take advantage of the operating
leverage provided by the licensing model.
EarthShell Packaging will be exclusively manufactured by licensed
manufacturing partners. Given the low cost of the raw materials required, these
strategic manufacturing partners should have a financial incentive to produce
EarthShell Packaging rather than comparable traditional paperboard/polystyrene
products even after making the required royalty payments to EarthShell. As the
first turnkey commercial manufacturing equipment is successfully placed in
service by its first licensee, the Company expects that other licensees will
then move quickly to invest to build additional new manufacturing capacity.
While the Company believes it will be successful in developing cost
competitive products with its partners, delays in developing such products could
adversely impact the introduction and market acceptance of EarthShell Packaging
and could have an adverse effect on the Company's business, financial condition
and results of operations.
Strategic Manufacturing and Distribution Relationships
The Company believes that it has demonstrated that EarthShell plates,
bowls and hinged-lid containers are commercially competitive in terms of
performance and that there is a customer base that is willing to buy them. The
critical task for 2005 is the installation and start-up of commercial
manufacturing capacity by the Company's licensees to supply EarthShell products
to the marketplace. The Company's current licensees are committing capital to
purchase equipment to provide EarthShell Packaging products or otherwise develop
the EarthShell products or production capacity. The Company intends to
proliferate the use of EarthShell Packaging in the U.S. and international
markets through agreements with additional licensed partners.
Meridian Business Solutions. In May 2004, the Company entered into a ten
year license agreement with MBS for the United States and granted to MBS a
priority license to supply certain retail and government market segments. MBS
has paid EarthShell $500,000 in technology fees to date. Under the terms of the
license agreement, in order to retain its priority in its market segments, MBS
must acquire manufacturing capacity to supply its market segments and meet other
minimum performance criteria. As the machinery orders are finalized and the
manufacturing equipment is built and put into service, MBS will pay an
additional $1.5 million in technology fees. All of the technology fees thus paid
will be credited against future royalties. At present, since EarthShell has a
limited number of initial licensees, MBS potentially represents more than 10% of
EarthShell's revenue base. Once MBS is in production and paying royalties to
EarthShell, loss of MBS as a licensee could have a material adverse consequence.
4
EarthShell Hidalgo. In November of 2004, the Company entered into a ten
year license agreement with ESH as the Company's exclusive licensee for the
country of Mexico. To date, they have paid the Company a $1,000,000 technology
fee that will be credited against future royalty obligations. Under the terms of
the license agreement, in order to retain its priority in its market segments,
ESH must acquire manufacturing capacity to supply its market segments and meet
other minimum performance criteria. At present, since EarthShell has a limited
number of initial licensees, ESH potentially represents more than 10% of
EarthShell's revenue base. Once ESH is in production and paying royalties to
EarthShell, loss of ESH as a licensee could have a material adverse consequence.
Hood Packaging. In February 2004, the Company entered into a definitive
license agreement with Hood Packaging under which Hood became the exclusive
manufacturer/distributor of EarthShell food wraps for the North American market,
subject to maintaining certain monthly and annual performance targets. Hood is
currently working on refining the manufacturing process prior to introducing
wraps into selected markets.
Manufacturing
The current EarthShell manufacturing process for laminated foamed products
consists of blending the component ingredients of a proprietary composite
material in a mixer, depositing the mixture into heated cavity molds, heating
the molded mixture for approximately one minute, removing the product, trimming
excess material, and applying functional coatings with desired graphics.
EarthShell Packaging uses readily available natural raw materials, such as
limestone, potato or corn starch, as well as natural fiber and functional
coatings. The Company believes that these raw materials are currently available
from multiple existing suppliers in quantities sufficient to satisfy projected
demand.
Over the past several years, the Company has devoted resources to develop
manufacturing machinery and to demonstrate the commercial viability of its
manufacturing processes to enable its operating partners to compete effectively
with conventional disposable foodservice packaging and to transfer the
operational and financial responsibility of its production lines to its
operating partners. In cooperation with former manufacturing partners, the
Company financed and built initial commercial production capacity. To date, the
Company has produced limited amounts of EarthShell Packaging bowls, plates and
hinged-lid containers at production volumes that are low relative to the
intended and necessary capacities of the manufacturing lines that are required
to achieve efficiencies and cost effectiveness. Although the manufacturing
processes currently being used to manufacture EarthShell Packaging are based on
generally available methods and equipment, it has taken much longer and has cost
much more than anticipated to integrate the machinery in an automated fashion
and to refine the manufacturing processes and equipment to operate at
commercially viable levels. Having demonstrated the manufacturability of
EarthShell foam products, the Company has now ceased commercial demonstration
production activities and is relying on its equipment manufacturing partners to
demonstrate and guarantee the long-term manufacturability of EarthShell
Packaging(R).
Detroit Tool & Engineering ("DTE"). DTE was one of the initial equipment
manufacturers to work with EarthShell in developing its first generation
commercial manufacturing equipment. In 2002, EarthShell granted a license to DTE
to become an approved EarthShell equipment supplier. In early 2005, the Company
extended the license through 2007 with exclusivity to manufacture equipment for
production of shallow draw products. Building on previous experience with
EarthShell manufacturing, DTE designed and built a modular and integrated,
turn-key manufacturing line for the production of EarthShell plates and bowls,
comprising four plate and four bowl manufacturing modules and has demonstrated
to EarthShell's satisfaction that this equipment is fully capable of continuous
commercial service. This equipment was planned for delivery, installation and
start-up in early 2004 with one of EarthShell's licensees. However, due to a
change in EarthShell licensees, as well as a reorganization of DTE that was
completed in late 2004, the placement of this equipment was delayed. As of early
2005, these first eight commercial modules have been moved from DTE's
fabrication floor and partially installed in a manufacturing hall owned by DTE
and in close proximity to the fabrication facility. The Company is negotiating a
license agreement with a new licensee which has expressed an interest in
acquiring this equipment from DTE and beginning manufacturing operations.
Currently, the Company expects that this equipment will be placed in service
during 2005.
Patents, Proprietary Rights and Trademarks
The technology that the Company licenses from EKI is the subject of
numerous issued and pending patents in the U.S. and internationally. The Company
believes the patents and pending patent applications provide broad protection
covering foam laminate EarthShell Packaging, material composition and the
manufacturing processes. As of December 31, 2004, EKI had over 130 U.S. and
international patents and has pending patent applications relating to the
compositions, products and manufacturing processes used to produce EarthShell
Packaging(R) food and beverage containers. Patents currently issued do not begin
to expire until 2012 and provide some protection until 2020. Pending patents, if
granted, would extend protection through 2022. Sixteen of the issued U.S.
patents and five of the pending U.S. patents relate specifically to molded food
and beverage containers manufactured from the new composite material, the
formulation of the new composite material used in virtually all of the
EarthShell Packaging are currently under development. The Company and EKI will
continue to seek domestic and international patent protection for further
developments in the technology and will vigorously enforce rights against any
person infringing on the technology.
5
The Company owns the EarthShell trademark and certain other trademarks,
and has been licensed by EKI to use the trademark ALI-ITE for the composite
material.
Relationship with and Reliance on EKI
The Company has an exclusive, worldwide, royalty-free license in
perpetuity to use and license the EKI technology to manufacture and sell
disposable, single-use containers for packaging or serving food or beverages
intended for consumption within a short period of time (less than 24 hours).
On July 29, 2002, the Company entered into an amendment to its Amended and
Restated License Agreement with EKI (the "License Agreement") expanding the
field of use for the EarthShell technology to include noodle bowls used for
packaging instant noodles, a worldwide market that the Company estimates to be
approximately $1 billion. Because the noodle bowl development was made at no
cost to EarthShell and is an incremental field of use, EarthShell will pay to
EKI 50% of any royalty or other consideration it receives in connection with the
sale of products within this particular field of use.
In addition, on July 29, 2002 the Company entered into a License &
Information Transfer Agreement with bio-tec Biologische Naturverpackungen GmbH &
Co. KG and bio-tec Biologische Naturverpackungen Forschungs und Entwicklungs
GmbH, together known as "Biotec", a wholly owned subsidiary of EKI, to utilize
the Biotec technology for foodservice applications, including food wraps and
cutlery used in foodservice applications (the "Biotec Agreement"). EKI had
previously granted to the Company priority rights to license certain product
applications on an exclusive basis from Biotec in consideration for the
Company's payment of a $100,000 monthly licensing fee to Biotec. In addition, in
consideration of the monthly payment, Biotec agreed to render technical services
to the Company at Biotec's cost plus 5%. The licensing fee and services
arrangements were continued in the Biotec Agreement. Under the terms of the
Biotec Agreement, Biotec is entitled to receive 25% of any royalties or other
consideration that the Company receives in connection with the sale of products
utilizing the Biotec technology, after applying a credit for monthly licensee
fee received to date. In connection with the issuance of EarthShell's 2006
Convertible Debentures, Biotec agreed to subordinate the licensee fee payments
due from EarthShell until the debentures were retired. During this period, the
license fees due to Biotec were accrued. In September of 2004, as part of an
overall restructuring of its debt, EarthShell and Biotec entered into an
agreement to convert $1.475 million of the $2.475 million of accrued license
fees as of September 1, 2004, plus accrued interest into 491,778 shares of
EarthShell common stock and to eliminate, for two years, the $100,000 per month
minimum license fee. In December of 2004, EarthShell paid to Biotec $125,000,
leaving a balance owing of $875,000.
During 2002 and January 2003, EKI made a series of loans to the Company
totaling approximately $5.8 million. These loans were used to pay operating
costs and accrued interest at 7% or 10% per annum. In connection with the
issuance and sale in March 2003 of the Company's 2% secured convertible
debentures due in 2006 (the "2006 Debentures") to a group of institutional
investors, EKI agreed to subordinate the repayment of these loans to the payment
in full of the Company's obligations under the 2006 Debentures. In addition, EKI
and Biotec agreed to subordinate certain payments referenced above to which they
were otherwise entitled under the License Agreement and the Biotec Agreement
(other than their respective percentages of any royalties received by the
Company) to the satisfaction in full of the Company's obligations under the 2006
Debentures. They further agreed not to assert any claims against the Company for
breaches of the License Agreement or the Biotec Agreement (other than the
assertion of certain equitable remedies to enjoin the Company from, for example,
selling products outside its field of use) until such time as the Company's
obligations under the 2006 Debentures were satisfied in full. EKI and Biotec
also agreed to allow the Company to pledge its interest in the License Agreement
to secure its obligations under the 2006 Debentures, and certain additional
concessions were made by EKI and Biotec to permit the Company greater
flexibility in selling its rights under the License Agreement and the Biotec
Agreement to third parties in an insolvency context. These rights terminated
upon the satisfaction in full of the obligations under the 2006 Debentures in
October of 2004. In consideration for its willingness to subordinate the
payments and advances that were owed to it, the Company issued to EKI in March
2003 a warrant to acquire 83,333 shares of the Company's common stock at a price
of $6.00 per share with a ten year term.
In October 2004, in connection with the settlement of the March 2006
Debentures, EKI converted all of its outstanding loans to EarthShell
($2,755,000) into unregistered common stock at $3 per share and $532,644 of
accumulated interest at $4 per share for a total of 1,051,494 shares received by
EKI. As of December 31, 2004, the loans from EKI to EarthShell had all been
retired.
6
Under the terms of the License Agreement and the Amended and Restated
Patent Agreement for the Allocation of Patent Costs between the Company and EKI,
any patents granted in connection with the EarthShell technology are the
property of EKI, and EKI may obtain a benefit therefrom, including the
utilization and/or licensing of the patents and related technology in a manner
or for uses unrelated to the license granted to the Company in the foodservice
disposables field of use. Effective January 1, 2001, EarthShell assumed direct
responsibility to manage and maintain the patent portfolio underlying the
License Agreement with EKI and continues to pay directly all relevant costs.
Competition
Competition among food and beverage container manufacturers in the
foodservice industry is intense. Virtually all of these competitors have greater
financial and marketing resources at their disposal than does the Company, and
many have established supply, production and distribution relationships and
channels. Companies producing competitive products may reduce their prices or
engage in advertising or marketing campaigns designed to protect their
respective market shares and impede market acceptance of EarthShell Packaging.
In addition, some of the Company's licensees and joint venture partners
manufacture paper, plastic or foil packaging that may compete with EarthShell
Packaging.
Several paper and plastic disposable packaging manufacturers and
converters and others have made efforts to increase the recycling of these
products. Increased recycling of paper and plastic products could lessen their
harmful environmental impact, one major basis upon which the Company intends to
compete. A number of companies have introduced or are attempting to develop
biodegradable starch-based materials, plastics, or other materials that may be
positioned as potential environmentally superior packaging alternatives. It is
expected that many existing packaging manufacturers may actively seek to develop
competitive alternatives to the Company's products and processes. While the
Company believes its patents uniquely position it to incorporate a proportion of
low cost, inorganic fillers with its material, which, relative to other
starch-based or specialty polymers, will result in lower material costs, the
development of competitive, environmentally attractive, disposable foodservice
packaging could render the Company's technology obsolete and could have an
adverse effect on the business, financial condition and results of operations of
the Company.
Certain Risk Factors
Although the Company earned its first revenues in 2004 and is no longer
classified as a "developmental stage company", it has limited operating history,
therefore, it remains subject to the inherent challenges and risks of
establishing a new business enterprise. To date, production volumes of
EarthShell Packaging products have been low relative to intended and necessary
capacity of the manufacturing lines. The success of future operations depends
upon the ability of licensees to manufacture products made with EarthShell
Packaging in sufficient quantities so as to be commercially feasible and then to
distribute and sell those products at competitive costs. Consistent commercially
feasible production volumes had not been achieved and assured competitive cost
figures had not yet been proven as of December 31, 2004.
As of December 31, 2004, the Company had reported operating revenues of
$.1 million and an aggregate net losses of approximately $7.3 million for this
year. Although the Company hopes to achieve break-even cash flow by the end of
the year, the Company does not expect to operate profitably during fiscal year
2005. Although the Company is actively seeking third party financing to meet its
operating and capital needs, there is no assurance that additional funding will
be available to the Company, and, even if it is available, such financing may be
(i) extremely costly, (ii) dilutive to existing stockholders and/or (iii)
restrictive to the Company's ongoing operations. If additional financing cannot
be obtained, the Company would have to cease business operations.
The Company's common stock is no longer traded on the NASDAQ Small Cap
Market. SEC regulations generally define a "penny stock" to be any non-Nasdaq
equity security that has a market price of less than $5.00 per share, subject to
certain exceptions. Based upon the price of EarthShell common stock as currently
traded, EarthShell common stock is subject to Rule 15g-9 under the Securities
and Exchange Act of 1934 which imposes additional sales practice requirements on
broker-dealers which sell securities to persons other than established customers
and "accredited investors." For transactions covered by this rule, a
broker-dealer must make a special suitability determination for the purchaser
and have received a purchaser's written consent to the transaction prior to
sale. Consequently, this rule may have a negative effect on the ability of
stockholders to sell common shares of the Company in the secondary market.
7
The Company's current business model is to license the manufacturing and
distribution of EarthShell Packaging foodservice disposables to licensees.
Agreements with the licensees permit them to manufacture and sell other
foodservice disposable packaging products that are not based on EarthShell
Packaging. The licensees may also manufacture paper or polystyrene packaging
which could compete with EarthShell products, and they may not devote sufficient
resources or otherwise be able successfully to manufacture, distribute or market
EarthShell Packaging. Their failure to do so would be grounds for termination of
exclusivity provisions in their license agreement, but might also delay the
rollout of EarthShell Packaging into the marketplace.
The success of the Company depends substantially on its ability to design,
develop and manufacture foodservice disposables that are not as harmful to the
environment as conventional disposable foodservice containers made from paper,
plastic and polystyrene. Although EarthShell Packaging offers a number of
environmental advantages over conventional packaging products, it may also
possess characteristics that consumers or environmental groups could perceive as
negative for the environment. In particular, EarthShell Packaging may result in
more solid waste by weight, and manufacturing them may release greater amounts
of some pollutants than the manufacture of some other packaging would release.
The Company does not own the technology necessary to manufacture
EarthShell Packaging and is dependent upon the License Agreement to use that
technology. The licensed technology is limited to the development, manufacture
and sale of specified foodservice disposables for use in the foodservice
industry, and there is no right to exploit opportunities to apply this
technology or improve it outside this field of use. If EKI were to file for or
be declared bankrupt, the Company would likely be able to retain its rights
under the License Agreement with respect to U.S. patents; however, it is
possible that steps could be taken to terminate its rights under the License
Agreement with respect to international patents. EKI is the controlling
stockholder of the Company, and conflicts could arise with regard to performance
under the license agreement, corporate opportunities or time devoted to the
business of the Company by officers and directors who are common to both EKI and
the Company.
As disclosed in Item 9A of this Annual Report on Form 10-K, as permitted
by the SEC, the Company plans to file Management's Annual Report on Internal
Control Over Financial Reporting and the related attestation report of its
independent registered public accounting firm by amendment to this Annual Report
on Form 10-K within 45 days after the date this Annual Report on Form 10-K is
required to be filed. While the Company is currently not aware of any material
weakness in internal control over financial reporting, any determination that
the Company has failed to achieve and maintain an effective system of internal
control over financial reporting in accordance with Section 404 of the
Sarbanes-Oxley Act and the SEC's related rules could have a material adverse
effect on our business and stock price.
Government Regulation
The manufacture, sale and use of EarthShell Packaging are subject to regulation
by the U.S. Food and Drug Administration (the "FDA"). The FDA's regulations are
concerned with substances used in food packaging materials, not with specific
finished food packaging products. Thus, food and beverage containers are in
compliance with FDA regulations if the components used in the food and beverage
containers: (i) are approved by the FDA as indirect food additives for their
intended uses and comply with the applicable FDA indirect food additive
regulations; or (ii) are generally recognized as safe for their intended uses
and are of suitable purity for those intended uses.
The Company believes that EarthShell Packaging plates, bowls and
hinged-lid containers and all other current and prototype EarthShell Packaging
products of the Company are in compliance with all requirements of the FDA and
do not require additional FDA approval. The Company cannot be certain, however,
that the FDA will agree with these conclusions.
Employees
As of January 1, 2005, the Company had 9 employees. The Company's
employees are not represented by a labor union, and the Company believes it has
a good relationship with its employees.
Available Information
The Company's internet website is www.earthshell.com. The Company makes
available free of charge on its website its annual report on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, reports filed
pursuant to Section 16 of the Securities Exchange Act of 1934, as amended (the
"Exchange Act") and amendments to those reports as soon as reasonably
practicable after such materials are electronically filed or furnished to the
SEC. Materials the Company files with the SEC may be read and copied at the
SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. This
information may also be obtained by calling the Securities and Exchange
Commission at 1-800-SEC-0330. The Securities and Exchange Commission also
maintains an internet website that contains reports, proxy and information
statements, and other information regarding issuers that file electronically
with the SEC at www.sec.gov. The Company will provide a copy of any of the
foregoing documents to shareholders upon request.
8
ITEM 2. PROPERTIES
In November 2004, the Company relocated its offices to its current
location at 3916 State Street in Santa Barbara, California. The office space is
shared with EKI under a month to month sublease. The Company's monthly lease
payment for approximately 2,000 square foor of office space and is approximately
$4,000. In addition, the Company leases 3,353 square feet of office space in
Lutherville, Maryland, on a month to month basis. The Company's monthly lease
payment with respect to this space is $5,780.
The Company believes it will be able to lease comparable space at a
comparable price when these leases expire.
ITEM 3. LEGAL PROCEEDINGS
The Company is engaged in litigation with two equipment suppliers seeking
to collect a total of approximately $600,000 for manufacturing equipment in
connection with the Company's former Goettingen, Germany manufacturing line that
is no longer in service. The entire amount claimed in the litigation has already
been accrued as part of the Company's accounts payable. The Company believes
that it has good defenses and counterclaims inasmuch as the equipment did not
reach the performance requirements specified in the purchase contracts, and
expects to settle the respective matters soon.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company's common stock is currently listed on the Bulletin Board
published by the National Quotation Bureau, Inc., and prior to March 8, 2004
traded on the Nasdaq SmallCap Market. The Company's common stock trades under
the symbol "ERTH.OB." For the periods indicated, the following table presents
the range of high and low closing sale prices for the Company's common stock.
Total
First Second Third Fourth Year
------------------------------------------------
2004
Market price per common share
High ...................... $ 2.52 $ 2.03 $ 3.75 $ 2.97 $ 3.75
Low ....................... 1.49 0.45 1.75 1.95 0.45
2003
Market price per common share
High ...................... $ 7.80 $ 7.08 $ 5.64 $ 4.56 $ 7.80
Low ....................... 4.20 4.32 3.72 1.33 1.33
The Company's common stock sales prices have been restated, where
applicable, to reflect the one-for-twelve reverse split of the Company's common
stock effective as of October 31, 2003. Quotations since the Company's stock
began trading on the OTC Bulletin Board may reflect inter-dealer prices, without
retail mark-up, mark-down or commission and may not necessarily represent actual
transactions.
The number of stockholders of record of the Company's common stock at
March 28, 2005 was 1,185. At March 31, 2005, Mr. Essam Khashoggi, directly or
indirectly, owned approximately 36% of the outstanding common stock of the
Company.
9
The Company does not intend to declare or pay cash dividends on its common
stock in the foreseeable future nor has it paid dividends in the past two years.
Recent Sales of Unregistered Securities
(1) In November 2004, as part of an overall restructuring of its debt,
EarthShell issued an aggregate of 491,778 shares of its common stock to
Biotec in exchange for the cancellation of $1.475 million of accrued
license fees EarthShell owed Biotec, which transaction computed to a $3.00
per share conversion price.
(2) In November 2004, in connection with the restructuring of its debt and
settlement of the 2006 Debentures, EarthShell issued an aggregate of
1,051,494 shares of its common stock to EKI of the 2006 Debentures in
exchange for the cancellation of $3.288 million of principal and interest
due under then outstanding loans.
(3) Pursuant to various agreements dated September 29 and 30, 2004 in
connection with the restructuring of its debt and settlement of the 2006
Debentures, EarthShell issued an aggregate of 512,500 additional shares of
its common stock to the holders of the 2006 Debentures in settlement of
the Company's default under the 2006 Debentures.
(4) In October 2004, as part of an overall restructuring of its debt,
EarthShell issued an aggregate of 900,000 shares of its common stock to
MBS at $3.00 per share for an aggregate offering price of $2.7 million.
EarthShell claimed an exemption from registration under the Securities Act
for the sales and issuance of its common stock in the transactions described in
paragraphs (1) through (4) above by virtue of Section 4(2) of the Securities Act
in that such sales and issuances did not involve a public offering. EarthShell
believed that the recipients of common stock in each of these transactions
intended to acquire the securities for investment only and not with a view to or
for sale in connection with any distribution thereof, and appropriate legends
were affixed to the share certificates and instruments issued in such
transactions. These sales and issuances were made without general solicitation
or advertising and each purchaser was a sophisticated investor. All recipients
had adequate access, through their relationships with the Company, to
information about the Company. There were no underwriters involved in any of
these sales and issuances.
10
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below should be read in conjunction
with the Company's Financial Statements and Notes thereto and "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included elsewhere in this Annual Report on Form 10-K.
Selected Financial Data
(in thousands, except per share data)
For the Year Ended December 31
-------------------------------------------------------------
2004 2003 2002 2001 2000
--------- --------- --------- --------- ---------
Statement of Operations Data
Revenues ....................... $ 138 -- -- -- --
Research and development
expenses ..................... 1,170 $ 9,547 $ 26,890 $ 47,148 $ 37,265
General and administrative
expenses ..................... 3,749 5,786 9,590 9,634 6,843
Depreciation and amortization .. 42 380 3,099 5,874 5,704
Gain on sale of property and
equipment .................... (168) (452) (441) -- --
Interest expense (income), net . 1,068 1,791 132 (356) (1,264)
Related party patent expenses .. -- -- -- -- 362
Debenture conversion cost ...... -- 166 321 -- --
Net loss ....................... 7,257 18,517 39,591 62,302 48,912
Average shares outstanding ..... 15,047 13,267 11,277 9,353 8,452
Balance Sheet Data
Cash and cash equivalents ...... $ 272 $ 1,902 $ 111 $ 828 $ 7,792
Working capital (deficit) ...... (7,289) (9,438) (8,315) (6,941) 2,107
Total assets ................... 483 2,287 18,024 19,886 48,474
Convertible debentures,
accounts payable to related
party, accrued interest and
accrued dividends ............ -- -- 10,190 -- 266
Total long-term obligations .... 1,475
Deficit accumulated during
development stage ............ (321,607) (314,351) (295,834) (256,243) (193,941)
Stockholders' equity (deficit) . (8,755) (12,269) (3,473) 11,536 42,296
Shares outstanding ............. 18,235 14,129 12,055 9,860 8,709
Per Common Share
Basic and diluted loss per share $ 0.48 $ 1.40 $ 3.51 $ 6.66 $ 5.79
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the Selected
Financial Data and the Company's Consolidated Financial Statements and Notes
thereto included elsewhere in this Annual Report on Form 10-K. Such consolidated
financial statements and information have been prepared to reflect the Company's
operations for the three years ended December 31, 2004 and the assets and
liabilities of the Company as of December 31, 2004 and 2003.
Information in this Annual Report on Form 10-K including but not limited
to "Management's Discussion and Analysis of Financial Condition and Results of
Operations" contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995, as amended. These statements
may be identified by the use of forward-looking terminology such as "may,"
"will," "expect," "anticipate," "estimate," or "continue," or the negative
thereof or other comparable terminology. Any one factor or combination of
factors could cause the Company's actual operating performance or financial
results to differ from those anticipated by management that are described
herein. Factors influencing the Company's operating performance and financial
results include, but are not limited to, changes in the general economy, the
availability of financing, governmental regulations concerning, but not limited
to, environmental issues, and other risks and unforeseen circumstances affecting
the Company's business which may be discussed elsewhere in this Annual Report on
Form 10-K.
11
Overview
Organized in November 1992 as a Delaware corporation, EarthShell
Corporation (the "Company") is engaged in the commercialization of composite
material technology for the manufacture of foodservice disposable packaging
designed with the environment in mind. EarthShell Packaging(R) is based on
patented composite material technology (collectively, the "EarthShell
Technology"), licensed on an exclusive, worldwide basis from E. Khashoggi
Industries LLC and its wholly owned subsidiaries.
The EarthShell Technology has been developed over many years in
consultation with leading material scientists and environmental experts to
reduce the environmental burdens of foodservice disposable packaging through the
careful selection of raw materials, processes, and suppliers. EarthShell
Packaging(R), including hinged-lid sandwich containers, plates, bowls,
foodservice wraps, and cups, is primarily made from commonly available natural
raw materials such as natural ground limestone and potato starch. EarthShell
believes that EarthShell Packaging(R) has comparable or superior performance
characteristics and can be commercially produced and sold at prices that are
competitive with comparable paper and plastic foodservice disposables.
EarthShell was a development stage enterprise through the first quarter of
2004. With the recognition of the Company's first revenues resulting from the
receipt of $500,000 in technology fees in connection with granting a license to
a strategic partner in the second quarter of 2004, the Company was no longer a
development stage enterprise.
Critical Accounting Assumptions
Going Concern Basis. The consolidated financial statements have been
prepared on a going concern basis, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of business. During the
period from November 1, 1992 (inception) to December 31, 2004, the Company has
incurred a cumulative net loss of $7,257,101 and has a working capital deficit
of $7,289,431 at December 31, 2004. These factors, along with others, may
indicate that the Company will be unable to continue as a going concern for a
reasonable period of time. The Company will have to raise additional funds to
meet its current obligations and to cover operating expenses through the year
ending December 31, 2005. If the Company is not successful in raising additional
capital it may not be able to continue as a going concern for a reasonable
period of time. Management plans to address this need by raising cash through
either the sale of licenses, the generation of royalty revenues or the issuance
of debt or equity securities. In addition, the Company expects cash to be
generated in 2005 through royalty payments from licensees. However, the Company
cannot assure that additional financing will be available to it, or, if
available, that the terms will be satisfactory, that it will receive any royalty
payments in 2005. Management will also continue in its efforts to reduce
expenses, but can not assure that it will be able to reduce expenses below
current levels. The consolidated financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or the amounts and classification of liabilities that might be necessary
should the Company be unable to continue as a going concern.
Estimated Net Realizable Value of Property and Equipment. The Company
evaluates the recoverability of property and equipment whenever events or
changes in circumstances indicate that the carrying value of an asset may not be
recoverable. If there is an indication that the carrying value of an asset may
not be recoverable and the estimated future cash flows (undiscounted and without
interest charges) from the use of the asset are less than the carrying value, a
write-down is recorded to reduce the related asset to its estimated fair value.
At one time, the Company had been engaged in the development of manufacturing
equipment to validate acceptance of EarthShell products and their pricing. To
this end, the Company previously developed manufacturing lines in Owings Mills,
Maryland, Goleta, California and in Goettingen, Germany. The Company recognized
impairment charges on its equipment amounting to $4.0 million and $9.8 million
in 2003 and 2002, respectively.
Revenue Recognition. The Company recognizes revenue when persuasive
evidence of an arrangement exists, the price is fixed or readily determinable
and collectibility is probable. The Company recognizes revenue in accordance
with Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial
Statements," (SAB 101). EarthShell's revenues consist of technology fees that
are recognized ratably over the life of the related agreements and royalties
based on product sales by licensees that are recognized in the quarter that the
licensee reports the sales.
12
Results of Operations
Year Ended December 31, 2004 Compared with the Year Ended December 31, 2003
The Company's net loss decreased $11.2 million to $7.3 million from $18.5
million for the year ended December 31, 2004 compared to the year ended December
31, 2003, respectively.
Revenues. The Company recorded revenues of $0.1 million for the year ended
December 31, 2004. These revenues reflect amortization of the $3.0 million of
technology fees payable under the sublicense agreements that were entered into
with MBS and with ESH in the second and fourth quarters of 2004 over the ten
years of the agreements. The amortization of the technology fees will result in
the recognition of $0.3 million in revenues per year during the lives of the
agreements. Prior to this, the Company had no recognized revenue as it was a
development stage company.
Research and Development Expenses. Total research and development expenses
are comprised of Related party license fee and research and development expenses
and Other research and development expenses. Total research and development
expenditures for the development of EarthShell Packaging(R) decreased $8.3
million to $1.2 million from $9.5 million for the year ended December 31, 2004
compared to the year ended December 31, 2003, respectively.
o Related party license fee and research and development expenses are
comprised of the $.1 million minimum monthly licensing fee for the
use of the EarthShell technology and for technical services, both of
which were payable to EKI, a stockholder of the Company, or Biotec,
a wholly-owned subsidiary of EKI. Related party license fee and
research and development expenses decreased $0.5 million to $0.8
million from $1.3 million for the year ended December 31, 2004
compared to the year ended December 31, 2003, respectively. The
decrease was primarily due to a decrease in the license fee as a
result of an agreement with Biotec to eliminate the $0.1 million per
month minimum licensing fee from September 2004 through August 2006.
o Other research and development expenses are comprised of personnel
costs, travel and direct overhead for development and demonstration
production, as well as impairment charges on manufacturing property
and equipment constructed for demonstration production purposes.
Other research and development expenses decreased $7.8 million to
$0.4 million from $8.2 million for the year ended December 31, 2004
compared to the year ended December 31, 2003, respectively. The
reduction was due to the non-recurrence of the following 2003
activities: the winding down of on-going demonstration manufacturing
in Goleta, California in the first quarter of 2003, the start-up in
mid-May of a new manufacturing line for plates and bowls built and
financed by Detroit Tool and Engineering Company (DTE) at their
Lebanon, Missouri facility, expenses incurred to vacate the
Company's demonstration manufacturing facility in Goleta at the
expiration of the lease on May 31, 2003, costs incurred in
connection with testing of the Goettingen, Germany manufacturing
equipment during the third quarter, the write down of the Goettingen
manufacturing equipment to $1 as of December 31, 2003 due to the
uncertainty of the proceeds to be realized upon sale of the
equipment, and the losses of the Company's joint venture. In early
August 2003, the Company discontinued its day-to-day support of
manufacturing activities at DTE. In keeping with its business model,
in 2004 the Company primarily focused on the licensing of its foam
analog material and other technologies to new licensees, and these
licensees and future licensees will install and run equipment to
produce EarthShell Packaging(R) in their own facilities.
Other General and Administrative Expenses. Other general and
administrative expenses are comprised of personnel costs, travel and direct
overhead for marketing, finance and administration. Total general and
administrative expenses decreased $2.0 million to $3.8 million from $5.8 million
for the year ended December 31, 2004 compared to the year ended December 31,
2003, respectively. This was primarily the result of efforts to significantly
reduce general and administrative expenses throughout 2003 and 2004, which
resulted in reductions in the following expenses: personnel costs by $0.7
million (due to a reduction in headcount from 14 employees at December 31, 2003
to 9 employees at December 31, 2004), professional fees and services by $0.8
million, facility and support costs by $0.3 million, business insurance costs by
$0.2 million, travel and entertainment expenses by $0.1 million and franchise
taxes by $0.1 million. In addition, the Company was able to reduce previously
provided expense accruals by approximately $0.6 million due to their favorable
resolution in the third quarter of 2004. Most of the credit to general and
administrative expenses related to the favorable resolution of property tax
disputes within the states of California and Maryland. The expense reductions
were partially offset by approximately $0.8 million of accounts payable
settlement gains in 2003. The settlement gains were the result of a program
began by the Company in the second quarter of 2003 to satisfy vendors for
outstanding aged invoices.
13
Depreciation and Amortization Expense. Depreciation and amortization
expense decreased $0.34 million to $0.04 million from $0.38 million for the year
ended December 31, 2004 compared to the year ended December 31, 2003,
respectively. The decrease in depreciation expense is primarily attributable to
taking the remainder of EarthShell's manufacturing and development assets out of
service as of the end of 2003.
Interest Expense. Interest expense is comprised of Related party interest
expense and Other interest expense.
o Related party interest expense was $0.4 million for both the year
ended December 31, 2004 and the year ended December 31, 2003.
Related party interest expense includes interest accrued on
outstanding loans made to the Company by EKI under the Loan
Agreement (see "Related Party Transactions"), accretion of the
discount related to the warrants issued to EKI in conjunction with
the March 2003 financing transactions, plus accrued interest payable
on amounts owed to EKI for monthly licensing fees that were accrued
rather than being paid in accordance with the terms of the
subordination agreements entered into in connection with the 2006
Debentures (see "Related Party Transactions"). During the third
quarter of 2004, agreements were negotiated with EKI to convert all
outstanding loans and accrued but unpaid interest into common stock
of the Company and to restructure the unpaid licensing fees under
the Biotec License Agreement (see "Item 1 Business Relationship with
and Reliance on EKI"). Therefore, there will be no Related party
interest expense for these items subsequent to December 31, 2004.
o Other interest expense decreased $0.7 million to $0.7 million from
$1.4 million for the year ended December 31, 2004 compared to the
year ended December 31, 2003, respectively. Other interest expense
for 2004 is primarily comprised of accretion of the discount and
interest accrued on the 2006 Debentures. Other interest expense for
2003 was primarily comprised of accretion of discount on the 2006
Debentures and a beneficial conversion charge in the amount of $0.4
million due to a change in the 2007 Debentures conversion price. In
addition, Other interest expense for 2003 also included accretion of
the discount on the 2007 Debentures and accrued interest payable on
the 2006 and 2007 Debentures.
Gain on Sale of Property and Equipment. Gain on the sale of property and
equipment decreased $0.3 million to $0.2 million from $0.5 million for the year
ended December 31, 2004 compared to the year ended December 31, 2003,
respectively. The gains in both 2004 and 2003 were realized due to the sale of
non-essential machine shop equipment and excess office furniture and equipment
over their net book value, most of which was fully depreciated. In addition,
2003 also included proceeds received from the sale of production line equipment
that was previously impaired and therefore had a net book value of zero.
Premium due to Debenture Default. At September 30, 2004, the Company was
in non-compliance with certain covenants of the 2006 Debentures. Two of the
debenture holders, including the debenture holder with the largest ownership
position, notified the Company in writing that the Company was in default and
requested that the Company repurchase the entire principal amount of the 2006
Debentures held at the price specified in the debenture, along with any accrued
and unpaid interest. The debenture contains a provision for repurchase of the
debenture at a premium if the repurchase is due to an event of default, and the
Company accrued the amount of the premium specified in the debenture.
Other Income. Other income for the year ended December 31, 2004 was zero
compared to $0.4 million for the year ended December 31, 2003. The 2003 other
income represents the net gain realized in the third quarter of 2003 from
reducing the balance of the warrant obligation to its estimated fair value of
zero. The warrant obligation was initially recorded in connection with the March
2003 financing transactions (see "Convertible Debentures").
(Gain) Loss on Extinguishment of Debentures. There was a gain on
extinguishment of debentures of $.1 million for the year ended December 31, 2004
compared to a loss on extinguishment of debentures was $1.7 million for the year
ended December 31, 2003. The $0.1 million gain for the year ended December 31,
2004 relates to interest payable on the 2006 Debentures that was not paid by the
Company upon conversion of the Debentures. In connection with the March 2003
financing transactions, the Company prepaid $5.2 million aggregate principal
amount of the 2007 Debentures, resulting in a prepayment penalty of
approximately $0.2 million. The Company also issued to the holders of the
prepaid 2007 Debentures 52,083 shares of common stock, valued at approximately
$0.2 million based upon the closing price of the Company's common stock of $4.56
per share on March 5, 2003. In addition, one of the holders of the 2007
Debentures exchanged $2.0 million aggregate principal amount of 2007 Debentures
for $2.0 million aggregate principal amount of 2006 Debentures. In connection
with the prepayment and exchange transactions, the Company incurred cash
transaction costs of approximately $0.3 million, excluding the prepayment
penalty. In addition, the Company incurred a charge of approximately $0.9
million for the prorated portion of the original discount attributed to the $7.2
million of the 2007 Debentures repaid and exchanged. Therefore, the Company
recognized a $1.7 million loss upon extinguishment of the 2007 debentures
through the prepayment and exchange (see "Convertible Debentures").
14
Debenture Conversion Cost. Debenture Conversion Cost was $0.2 million for
the year ended December 31, 2003. The expense represents the prorated portion of
the original discount attributed to the 2007 Debentures whose conversion was
forced by the Company in the respective periods.
Year Ended December 31, 2003 Compared with the Year Ended December 31, 2002
The Company's net loss decreased $21.1 million to $18.5 million from $39.6
million for the year ended December 31, 2003 compared to the year ended December
31, 2002, respectively.
Research and Development Expenses. Total research and development expenses
are comprised of Related party license fee and research and development expenses
and Other research and development expenses. Total research and development
expenditures for the development of EarthShell Packaging(R) decreased $17.4
million to $9.5 million from $26.9 million for the year ended December 31, 2003
compared to the year ended December 31, 2002, respectively.
o Related party license fee and research and development expenses are
comprised of the $100,000 minimum monthly licensing fee for the use
of the EarthShell technology and for technical services, both of
which were payable to EKI, a stockholder of the Company, or Biotec,
a wholly owned subsidiary of EKI. It should be noted that payment of
these related party expenses has been deferred pursuant to
subordination agreements entered into by the EKI entities in
connection with the convertible debenture financing concluded in
March of 2003. Related party license fee and research and
development expenses decreased $0.2 million to $1.3 million from
$1.5 million for the year ended December 31, 2003 compared to the
year ended December 31, 2002, respectively. The decrease was
entirely due to a decrease in technical services provided to the
Company by Biotec.
o Other research and development expenses are comprised of personnel
costs, travel and direct overhead for development and demonstration
production, as well as impairment charges on manufacturing property
and equipment constructed for demonstration production purposes.
Other research and development expenses decreased $17.2 million to
$8.2 million from $25.4 million for the year ended December 31, 2003
compared to the year ended December 31, 2002, respectively. The
decrease in other research and development expenses was primarily
due to concluding the demonstration manufacturing of hinged-lid
containers in Owings Mills, Maryland at the end of the second
quarter of 2002. While the majority of the expenses incurred in 2002
related to the Owings Mills demonstration manufacturing, it also
included expenses related to the commencement of demonstration
manufacturing of bowls and plates in Goleta, California. Other
research and development expenses incurred in 2003 primarily related
to the ongoing demonstration manufacturing in Goleta through
mid-April and to the start-up in mid-May of a new manufacturing line
for plates and bowls built and financed by Detroit Tool and
Engineering Company (DTE) at their Lebanon, Missouri facility. In
early August 2003, the company discontinued its day-to-day support
of manufacturing activities at DTE. In keeping with its business
model, the Company will hereafter focus primarily on the licensing
of its foam analog material and other technologies, and all future
manufacturing and production will be the responsibility of current
or new licensees as they install and run equipment to produce
EarthShell Packaging(R) in their own facilities. The decrease in
other research and development expenses was also due to a $5.8
million reduction in property and equipment impairment charges, to
$4.0 million in 2003 from $9.8 million in 2002.
Other General and Administrative Expenses. Other general and
administrative expenses are comprised of personnel costs, travel and direct
overhead for marketing, finance and administration. Total general and
administrative expenses decreased $3.8 million to $5.8 million from $9.6 million
for the year ended December 31, 2003 compared to the year ended December 31,
2002, respectively. This was primarily the result of efforts to significantly
reduce general and administrative expenses in 2003, which resulted in reductions
in the following expense categories: legal fees, including patent prosecution
and maintenance fees, by $0.9 million, personnel costs by $0.7 million,
professional fees and services by $0.4 million, travel costs by $0.3 million,
facility costs by $0.3 million and business insurance costs by $0.2 million. In
addition, in the second quarter of 2003 the Company began a program to satisfy
vendors for outstanding invoices and recognized gains from settling various old
trade accounts payable at a discount. As a result of negotiations, in 2003 the
Company settled and paid outstanding accounts payable of approximately $1.5
million at a discount of approximately $0.8 million.
15
Depreciation and Amortization Expense. Depreciation and amortization
expense decreased $2.7 million to $0.4 million from $3.1 million for the year
ended December 31, 2003 compared to the year ended December 31, 2002,
respectively. The decrease in depreciation expense is primarily attributable to
the decrease in property and equipment as a result of the impairment of
demonstration manufacturing property and equipment in 2002.
Interest Income. Interest income totaled $0.1 million for each of the
years ended December 31, 2003 and December 31, 2002.
Interest Expense. Interest expense is comprised of Related party interest
expense and Other interest expense.
o Related party interest expense increased $0.3 million to $0.4
million from $0.1 million for the year ended December 31, 2003
compared to the year ended December 31, 2002, respectively. The
increase was due to an increase in accrued interest payable on
outstanding loans made to the Company by EKI from September 2002
through January 2003 that were outstanding throughout all of 2003,
accretion in 2003 of the discount related to the warrants issued in
conjunction with the March 2003 financing transactions, plus accrued
interest payable on amounts owed to EKI for monthly licensing fees
that were not paid in accordance with the terms of the subordination
agreements entered into in connection with the 2006 Debentures (see
Related Party Transactions).
o Although the outstanding loans and monthly licensing fees will
accrue approximately $0.4 million in annual interest expense,
payment of the interest is subordinated to the 2006 Debentures.
Therefore, the related party interest expense will continue to
accrue but will not be paid in cash until the 2006 Debentures have
been converted or the obligation satisfied in full.
o Other interest expense increased $1.2 million to $1.4 million from
$0.2 million for the year ended December 31, 2003 compared to the
year ended December 31, 2002, respectively. Other interest expense
for 2003 is primarily comprised of accretion of the discount on the
2006 Debentures and a beneficial conversion charge in the amount of
$0.4 million due to a change in the 2007 Debentures conversion
price. In addition, Other interest expense for 2003 also included
accretion of the discount on the 2007 Debentures and accrued
interest payable on the 2006 and 2007 Debentures. Other interest
expense for 2002 was comprised of accretion of the discount and
accrued interest payable on the 2007 Debentures. Interest expense
from accretion of the discount and accrued interest payable for the
2006 Debentures will be approximately $0.8 million per year until
they are repaid or are converted into common stock.
Other Income. Other income was $0.4 million for the year ended December
31, 2003. This represents the net gain realized in the third quarter of 2003
from reducing the balance of the warrant obligation to its estimated fair value
of zero. Management believes the estimated fair value of the warrant at December
31, 2003 is zero. The warrant obligation was initially recorded in connection
with the March 2003 financing transactions (see Convertible Debentures).
Loss on Extinguishment of Debentures. Loss on extinguishment of debentures
was $1.7 million for the year ended December 31, 2003. In connection with the
March 2003 financing transactions, the Company prepaid $5.2 million aggregate
principal amount of the 2007 Debentures, resulting in a prepayment penalty of
approximately $0.2 million. The Company also issued to the holders of the
prepaid 2007 Debentures 52,083 shares of common stock, valued at approximately
$0.2 million based upon the closing price of the Company's common stock of $4.56
per share on March 5, 2003. In addition, one of the holders of the 2007
Debentures exchanged $2.0 million aggregate principal amount of 2007 Debentures
for $2.0 million aggregate principal amount of 2006 Debentures. In connection
with the prepayment and exchange transactions, the Company incurred cash
transaction costs of approximately $0.3 million, excluding the prepayment
penalty. In addition, the Company incurred a charge of approximately $0.9
million for the prorated portion of the original discount attributed to the $7.2
million of the 2007 Debentures repaid and exchanged. Therefore, the Company
recognized a $1.7 million loss upon extinguishment of the 2007 debentures
through the prepayment and exchange.
16
Gain on Sale of Property and Equipment. Gain on the sale of property and
equipment increased $0.1 million to $0.5 million from $0.4 million for the year
ended December 31, 2003 compared to the year ended December 31, 2002,
respectively. The gain in both 2003 and 2002 represents the excess of proceeds
received from the sale of non-essential machine shop equipment and excess office
furniture and equipment over their net book value. In addition, 2003 also
includes proceeds received from the sale of production line equipment that was
previously impaired and therefore had a net book value of zero.
Debenture Conversion Cost. Debenture Conversion Cost decreased $0.1
million to $0.2 million from $0.3 million for the year ended December 31, 2003
compared to the year ended December 31, 2002, respectively. The expense
represents the prorated portion of the original discount attributed to the 2007
Debentures whose conversion was forced by the Company in the respective periods.
17
The commercial production line in Goettingen, Germany was originally
financed and constructed by the Company for the Company's joint
venture with Huhtamaki. During 2001, $1.2 million of the Goettingen
line was written off to reflect equipment that had no further
application in the product development cycle. During the third
quarter of 2002 the Company concluded, after obtaining quotations
from various machinery suppliers for an identical line, that $1.7
million of the cost of the line will not be recoverable and
therefore the carrying value of the line was written down by this
amount, of which $1.6 million was recorded in the third quarter of
2002 and the remaining $0.1 million was recorded in the fourth
quarter of 2002.
During the fourth quarter of 2001 and the fourth quarter of 2002,
$5.9 million and $0.5 million, respectively, of equipment at the
Company's product development center was written off because it had
no further application in the product development activities at that
time.
Other General and Administrative Expenses. Other General and
Administrative Expenses are comprised of personnel costs, travel and direct
overhead for marketing, finance and administration. Other general and
administrative expenses were $9.6 million for both the year ended December 31,
2002 and the year ended December 31, 2001. Patent prosecution and maintenance
fees remained flat year over year. Reductions in headcount and legal expenses
were offset by an increase in insurance and Nasdaq fees, as well as increases in
investor and public relations programs.
Depreciation and Amortization Expense. Depreciation and amortization
expense decreased $2.8 million to $3.1 million from $5.9 million for the year
ended December 31, 2002 compared to the year ended December 31, 2001,
respectively. The decrease in depreciation expense is primarily attributable to
the decrease in fixed assets as a result of the impairment of property and
equipment to net realizable value during both 2002 and 2001.
Interest Income. Interest income decreased $0.3 million to $0.1 million
from $0.4 million for the year ended December 31, 2002 compared to the year
ended December 31, 2001, respectively. The decrease was the result of lower cash
balances available for investment for the comparative years.
Interest Expense. Interest expense is comprised of Related party interest
expense and Other interest expense.
o Related party interest expense was $0.1 million for the year ended
December 31, 2002. This represents accrued interest payable on
short-term working capital loans made to the Company by EKI
beginning in September 2002.
Other interest expense was $0.2 million for the year ended December 31,
2002. This represents accretion of the discount and accrued interest
payable on the 2007 Debentures issued in August 2002. Gain on Sale of
Property and Equipment.
Gain on the sale of property and equipment was $0.4 million for the year
ended December 31, 2002. The gain was primarily due to the Company selling
equipment no longer required to meet objectives, most of which was fully
depreciated.
Debenture Conversion Cost. Debenture Conversion Cost was $0.3 million for
the year ended December 31, 2002. This expense represents the prorated portion
of the original discount attributed to the $1.0 million of 2007 Debentures whose
conversion was forced by the Company in the third quarter of 2002.
Liquidity and Capital Resources
Cash Flow. The Company's principal uses of cash for the year ended
December 31, 2004 were to fund operations, repay convertible debentures, and pay
accounts payable and accrued expenses. Net cash used in operations was $2.7
million and $15.7 million for the years ended December 31, 2004 and 2003,
respectively. Net cash provided by investing activities was $.2 million and $4.0
million for the years ended December 31, 2004 and 2003, respectively. Net cash
provided by financing activities was $.9 million and $13.5 million for the years
ended December 31, 2004 and 2003, respectively. As of December 31, 2004, the
Company had cash and related cash equivalents totaling $.3 million.
Capital Requirements. Due to the fact that construction of the initial
commercial production lines was largely completed in 2002 and the Company
decided to discontinue all demonstration manufacturing activities in 2003, the
Company only made one minor capital expenditure during the year ended December
31, 2004. The Company does not expect to make significant capital expenditures
in the year 2005.
18
Contractual Obligations. The following table summarizes the Company's
known obligations to make future payments pursuant to certain contracts as of
December 31, 2004, as well as an estimate of the timing in which these
obligations are expected to be satisfied:
Payments due by period (in thousands)
------------------------------------
Contractual Obligations Less than 1-3
Total 1 year years
------------------------------------
Long-term debt - principal payments only
Capital leases -- -- --
Operating leases -- -- --
Other long-term liability $726 $314 $412
---- ---- ----
Totals $726 $314 $412
==== ==== ====
Sources of Capital. As part of the Company's initial public offering on
March 27, 1998, the Company issued 877,193 shares of common stock, for which it
received net proceeds of $206 million. On April 18, 2000 and January 4, 2001,
the Company filed shelf registrations statements for 416,667 and 1,250,000
shares, respectively, of the Company's common stock. During the years ended
December 31, 2002, 2001 and 2000 the Company sold approximately 0.1 million, 1.1
million and 0.4 million shares of common stock in private transactions under
such registration statements and received net proceeds from such sales of
approximately $2.3 million $30.6 million and $10.5 million, respectively. All
shares available under such registration statements had been sold as of December
2002.
In December of 2001 the Company filed an additional shelf registration
statement providing for the sale of up to $50 million of securities, including
secured or unsecured debt securities, preferred stock, common stock, and
warrants. These securities could be offered, separately or together, in distinct
series, and amounts, at prices and on terms to be set forth in the prospectus
contained in the registration statement, and in subsequent supplements to the
prospectus. On August 12, 2002, the Company issued $10 million in aggregate
principal amount of convertible debentures, due August 2007, (the "2007
Debentures") and warrants to purchase 0.2 million shares of common stock to
institutional investors for proceeds of $10.0 million. During the year ended
December 31, 2002, the Company sold 1.9 million shares of common stock under
such registration statement and received net proceeds from such sales of $19.6
million. During the year ended December 31, 2003, the Company issued 432,974
shares for the conversion of $1.8 million of 2007 Debentures. The remainder of
the 2007 Debentures were prepaid or exchanged for 2006 Debentures during 2003.
19
On March 5, 2003, the Company issued to a group of institutional investors
416,667 shares of common stock and $10.55 million in aggregate principal amount
of secured convertible debentures due in March 2006 (the "2006 Debentures"), for
which the Company received proceeds of approximately $9.0 million, net of
financing costs of approximately $1.5 million. The debentures were secured by
the Company's rights, title and interest to the technology and trademarks
covered by the EKI License Agreement, including all process and product
improvements of the Company, the Company's right to use and to sublicense the
technology, and all license fees, royalties and/or other forms of compensation
due to the Company from sublicenses under existing or future sublicenses. In
connection with the March 2003 financing transactions, the Company issued 54,167
shares of common stock to the lead purchaser of the 2006 Debentures and two
warrants to a placement agent, both of whom received the instruments as
compensation for their services rendered in connection with the transaction.
(See Stock Warrants) In 2003, $5.75 million principal amount of the 2006
Debentures was converted into 958,334 shares of common stock. At December 31,
2003, the outstanding principal balance of 2006 Debentures was $6.8 million. The
remaining shares under the December 2001 shelf registration described above were
used to secure shares potentially issuable upon conversion of the 2006
Debentures.
Although the Company was in compliance with all covenants of the 2006
Debentures at December 31, 2003, on March 8, 2004 the Company's common stock was
delisted from the Nasdaq Smallcap Market because the Company's market
capitalization failed to meet the minimum required standard for continued
listing. In addition, the Company did not make interest payments related to the
2006 Debentures as required on January 31, 2004. These actions put the Company
in non-compliance with its covenants under the 2006 Debentures. From July
through October 2004 the Company worked to negotiate settlements with each of
the remaining debenture holders to retire the debentures, to resolve the
defaults, and to restructure its long-term debt as follows.
20
Debenture Purchase Agreements. As of September 30, 2004, the Company
entered into agreements with each of the holders (collectively, the "Holders")
of the 2006 Debentures due March 5, 2006 to amend and restate the Debenture
Purchase Agreements entered into in July 2004 by EarthShell and the Holders (as
amended and restated, the "Debenture Purchase Agreements" and the transactions
contemplated therein, collectively, the "Debenture Transactions"). The 2006
Debentures were in default and their outstanding principal balance totaled $6.5
million prior to their repurchase. Collectively, the Debenture Purchase
Agreements required (i) E. Khashoggi Industries, LLC ("EKI") to pay $1 million
cash (EarthShell was obligated to reimburse EKI for this cash payment as
discussed below), (ii) the Holders to convert the 2006 Debentures in accordance
with their terms, resulting in the issuance by EarthShell of 1,091,666 shares of
its common stock, which shares were previously registered for resale by the
Company in connection with the issuance of the 2006 Debentures, (iii) EarthShell
to issue to the Holders an aggregate of 512,500 additional shares EarthShell
common stock and (iv) EarthShell to pay $2.3 million to one of the Holders from
33% of any equity funding received by the Company (excluding the first $2.7
million funded by MBS) or 50% of the royalties received by EarthShell in excess
of $250,000 per month (determined on a cumulative basis commencing July 1,
2004). EarthShell has the right to convert the unpaid portion of the $2.3
million into shares of the Company's common stock at a price equal to the lesser
of $3.00 per share or the price per share price that EarthShell subsequently
receives upon the issuance of its common stock (or other convertible security)
during the three year period commencing September 30, 2004. The 512,500 shares
of common stock issued to the Holders on October 6, 2004 are not registered for
resale under the Securities Act. The consideration for the repurchase of the
Debentures has been paid or issued, and the 2006 Debentures have been retired by
EarthShell.
Receipt of Proceeds from Sale of Common Stock to MBS. On August 5, 2004,
EarthShell and Meridian Business Solutions, LLC ("MBS") entered into a Stock
Purchase Agreement (the "Stock Purchase Agreement") pursuant to which MBS agreed
to fund $5 million to EarthShell in exchange for EarthShell's issuance of a
total of 1,666,666 shares of common stock at a price of $3.00 per share. On
August 20, 2004, EarthShell received $500,000 from MBS, for which the Company
issued 166,666 shares of its common stock to MBS. On October 1, 2004, EarthShell
received an additional $1.2 million of the $5 million committed by MBS, and the
Company issued 400,000 shares of its common stock to MBS. On October 11, 2004,
MBS purchased an additional 333,333 shares or which it had paid $.5 million as
of December 31, 2004 and $.5 million was still due. Subsequent to December 31,
2004, MBS paid an additional $25,000 leaving the balance due at March 31, 2005
of $.475 million. The shares of common stock issued to MBS are not registered
for resale under the Securities Act of 1933, as amended (the "Securities Act"),
and the Company has agreed to file a registration statement to register the
shares within 60 days of a request by MBS. The cash received from MBS was used,
in part, to fund the repurchase of the 2006 Debentures(as defined below) and to
restructure the Company's long-term debt.
EKI Agreements. In connection with its purchase of the 2006 Debentures
from the Holders, on September 30, 2004, EKI entered into an agreement with
EarthShell to sell the 2006 Debentures it purchased back to the Company for $1
million cash, the cash price paid by EKI for the purchased 2006 Debentures (the
"EKI Debenture Purchase Agreement"). In connection therewith, immediately after
its acquisition, EKI sold the purchased 2006 Debentures to the Company and, as
discussed above, the Company retired the 2006 Debentures shortly thereafter.In
addition, on September 30, 2004, the Company and EKI agreed to convert certain
existing loans from EKI to the Company into shares of EarthShell's common stock
(the "EKI Conversion Agreement"). This transaction closed after the closing of
the Debenture Transactions and, pursuant to the EKI Conversion Agreement, EKI
converted the $2,755,000 principal amount of such debt into shares of
EarthShell's common stock at a conversion price of $3 per share. In addition,
under the terms of the EKI Conversion Agreement, EKI converted the accrued and
unpaid interest on such loans into shares of EarthShell's common stock at a
conversion price equal to the greater of (i) $3 per share, and (ii) the maximum
per share price (not to exceed $4 per share) obtained by the Company upon the
sale of its common stock to any investor during the three month period following
the closing. The 1,051,494 shares of common stock issued to EKI will not be
registered for resale under the Securities Act.
21
Biotec Agreement. EarthShell also reached agreement to amend its existing
agreements with its affiliates, bio-tec Biologische Naturverpackungen GmbH & Co.
and bio-tec Biologische Naturverpackungen Forschungs und Entwicklungs GmbH
(collectively, "Biotec"; and such agreement, the "Biotec Amendment"). Under the
terms of the Biotec Amendment, EarthShell has agreed to satisfy the approximate
$2.5 million in indebtedness owed to Biotec by (i) paying $750,000 to Biotec in
2004 (ii) converting approximately $1.47 million principal amount of the Biotec
debt into shares of EarthShell's common stock at a conversion price of $3 per
share and (iii) at EarthShell's option, on the first anniversary of the closing,
pay $250,000 to Biotec or convert the remaining $250,000 Biotec debt into
133,333 shares of EarthShell's common stock at a conversion price of $3 per
share. In consideration for the above, Biotec also agreed to suspend the monthly
license fees payable by EarthShell for two years after the date of the closing.
The common stock to be issued pursuant to the Biotec Amendment will not be
registered for resale under the Securities Act. As of December 31, 2004, the
Company had paid to Biotec $125,000 in cash and converted approximately $1.48
million into 491,778 shares of unregistered commons stock, and the balance owing
to Biotec is $875,000 (see Relationship with and Reliance on EKI).
Pursuant to transactions described more fully in Item 5 under the
subheading "Recent Sales of Unregistered Securities" and in this Management's
Discussion and Analysis, in connection with the settlement of the 2006
Debentures and the related restructuring of the Company's debt, the Company
provided registration rights with respect to newly issued unregistered shares of
its common stock. Such registration rights required the Company to, among other
things, file a registration statement with the SEC in December 2004 registering
the resale of such shares of common stock. Under certain of the agreements, the
Company's not filing such a registration statement (or the registration
statement not being declared effective) within the required timeframe provides
the holders of the registrable securities with a right to liquidated damages
which, in the aggregate, may amount to approximately $50,000 per month until the
registration statement is filed. If the Company fails to pay such liquidated
damages, the Company must also pay interest on such amount at a rate of 10% per
year (or such lesser amount as is permitted by law).
Because this registration statement was not filed as planned, in December
2004 the Company became obligated on the direct financial obligation described
above. In light of the Company's current liquidity and financial position any
such claim could have a negative effect on the Company. While none of the
holders of registrable securities have made a formal claim for liquidated
damages to date, there can be no assurance that such holders will not do so in
the future. The Company plans to file an appropriate registration statement as
soon as practical following the filing of this Annual Report on Form 10-K.
22
During 2002 and 2003, the Company's largest shareholder, EKI, made various
simple interest working capital loans to the Company. These loans were interest
bearing at a rate of 7% or 10% per annum, and were payable on demand. As of
December 31, 2003, the outstanding principal balance of these loans was
$2,755,000. In connection with the sale of the March 2006 Debentures,
subordinated the payments and advances that were owed to it, and in
consideration, the Company issued to EKI a warrant in March 2003, expiring in
ten years, to acquire 83,333 shares of the Company's common stock for $6.00 per
share. As disclosed above, as part of the settlement of the March 2006
Debentures in October of 2004, EKI agreed tp convert all of its outstanding
loans to EarthShell ($2,755,000) into unregistered common stock at $3 per share
and $532,644 of accumulated interest into unregistered common stock at $4 per
share for a total of 1,051,494 shares received by EKI. As of December 31, 2004,
the loans from EKI were paid in full.
During 2004, the Company entered into license agreements for which it
received a total of $1.5 million in technology fees. In May 2004, the Company
entered into its license agreement with MBS, which calls for a total of $2.0
million in technology fees payable in $.5 million increments based on certain
milestones during the startup of manufacturing operations and prior to the
beginning of royalty generation. To date the Company has received $.5 million.
In November of 2004, the Company entered into a license agreement with ESH and
received technology fees of $1 million.
Subsequent to December 31, 2004, on March 23, 2005, the Company entered
into a Security Agreement with Cornell Capital Partners, LP. Pursuant to the
Security Agreement, the Company shall issue promissory notes to Cornell Capital
Partners, LP in the original principal amount of $2,500,000. The $2,500,000 will
be disbursed as follows: $1,150,000, within three days of the closing of all the
transaction documents with Cornell Capital Partners, LP and $1,350,000, two days
prior to the filing of a registration statement related to Standby Equity
Distribution Agreement. The promissory notes are secured by the assets of the
Company and shares of stock of another entity pledged by an affiliate of that
entity. The promissory notes have a one-year term and accrue interest at 12% per
year.
Subsequent to December 31, 2004 and on March 23, 2005, EarthShell entered
into a Standby Equity Distribution Agreement with Cornell Capital Partners, LP.
Pursuant to the Standby Equity Distribution Agreement, the Company may, at its
discretion, periodically sell to Cornell Capital Partners, LP shares of common
stock for a total purchase price of up to $10.0 million. For each share of
common stock purchased under the Standby Equity Distribution Agreement, Cornell
Capital Partners LP will pay the Company 98% of the lowest volume weighted
average price of the Company's common stock as quoted by Bloomberg, LP on the
Over-the-Counter Bulletin Board or other principal market on which the Company's
common stock is traded for the 5 days immediately following the notice date. The
price paid by Cornell Capital Partners, LP for the Company's stock shall be
determined as of the date of each individual request for an advance under the
Standby Equity Distribution Agreement. Cornell Capital Partners, LP will also
retain 5% of each advance under the Standby Equity Distribution Agreement.
Cornell Capital Partner's obligation to purchase shares of the Company's common
stock under the Standby Equity Distribution Agreement is subject to certain
conditions, including the Company obtaining an effective registration statement
for shares of common stock sold under the Standby Equity Distribution Agreement
and is limited to $500,000 per weekly advance.
The Company expects to generate additional cash in 2005 through royalty
payments from licensees. The Company believes that the cash from this borrowing,
combined with projected revenues, will be sufficient to fund its operations
through the year ending December 31, 2005. If the Company is not successful at
generating license revenues during the year, the Company will have to raise
additional funds to meet its current obligations and to cover operating
expenses. If the Company is not successful in raising additional capital it may
not be able to continue as a going concern for a reasonable period of time.
Management plans to address this need by raising cash through either the
issuance of debt or equity securities. However, the Company cannot assure that
it will receive any royalty payments in 2005, that additional financing will be
available to it, or, if available, that the terms will be satisfactory.
Management will also continue in its efforts to reduce expenses, but can not
assure that it will be able to reduce expenses below current levels.
Off-Balance Sheet Arrangements. The Company does not have any off-balance
sheet arrangements as of December 31, 2004 and has not entered into any
transactions involving unconsolidated, limited purpose entities.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's treasury function controls all decisions and commitments
regarding cash management and financing arrangements. Treasury operations are
conducted within a framework that has been authorized by the board of directors.
As of December 31, 2004, the Company had significantly reduced its
long-term debt obligations. There remain a few settlements of accounts payable
obligations that will be paid out over terms from 18 months to 36 months, the
long term portion of which may be exposed to interest rate risk. As of December
31, 2004, these long-term fixed rate debt obligations totaled approximately $.4
million. While generally an increase in market interest rates will decrease the
value of this debt, and decreases in rates will have the opposite effect, we are
unable to estimate the impact that interest rate changes will have on the value
of the substantial majority of this debt as there is no active public market for
this debt.
23
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Index to Consolidated Financial Statements and Schedules.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not Applicable.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. The Company's Chief
Executive Officer and Chief Financial Officer have evaluated the effectiveness
of the Company's disclosure controls and procedures (as such term is defined in
Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the
period covered by this Report (the "Evaluation Date"). Based on such evaluation,
such officers have concluded that, as of the Evaluation Date, the Company's
disclosure controls and procedures are effective in ensuring that (i)
information required to be disclosed by the Company in the reports that it files
or submits under the Exchange Act is recorded, processed, summarized and
reported, within the time periods specified in the SEC's rules and forms and
(ii) information required to be disclosed by the Company in the reports that it
files or submits under the Exchange Act is accumulated and communicated to the
Company's management, including its principal executive and principal financial
officers, or persons performing similar functions, as appropriate to allow
timely decisions regarding required disclosure.
On November 30, 2004, the SEC published Exchange Act Release No. 50754,
which allowed certain registrants that satisfy the conditions set forth in that
Release to file the required Management's Annual Report on Internal Control Over
Financial Reporting not later than 45 days after the date of this annual report
on Form 10-K is required to be filed. The Company satisfies the conditions set
forth in that Release and plans to file that Report and the related attestation
report of its independent registered public accounting firm by amendment to this
Form 10-K within the specified period. Currently, the Company is not aware of
any material weaknesses in the Company's internal control over financial
reporting.
(b) Changes in Internal Control Over Financial Reporting. No changes in
the Company's internal control over financial reporting have come to
management's attention during the Company's last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
ITEM 9B. OTHER INFORMATION
Pursuant to transactions described more fully in Item 5 under the
subheading "Recent Sales of Unregistered Securities" and in Management's
Discussion and Analysis, in connection with the settlement of the March 2006
Debentures and the related restructuring of the Company's debt, the Company
provided registration rights with respect to newly issued unregistered shares of
its common stock. Such registration rights required the Company to, among other
things, file a registration statement with the SEC in December 2004 registering
the resale of such shares of common stock. Under certain of the agreements, the
Company's not filing such a registration statement (or the registration
statement not being declared effective) within the required timeframe provides
the holders of the registrable securities with a right to liquidated damages
which, in the aggregate, may amount to approximately $50,000 per month until the
registration statement is filed. If the Company fails to pay such liquidated
damages, the Company must also pay interest on such amount at a rate of 10% per
year (or such lesser amount as is permitted by law).
Because this registration statement was not filed, in December 2006 the
Company became obligated on the direct financial obligation described above. In
light of the Company's current liquidity and financial position any such claim
could have a negative effect on the Company. While none of the holders of
registrable securities have made a formal claim for liquidated damages to date,
there can be no assurance that such holders will not do so in the future. The
Company plans to file an appropriate registration statement as soon as practical
following the filing of this Annual Report on Form 10-K.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item will be contained in the Company's
Proxy Statement for its 2005 annual meeting of stockholders, which will be filed
on or before April 29, 2005 and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item will be contained in the Company's
Proxy Statement for its 2005 annual meeting of stockholders, which will be filed
on or before April 29, 2005 and is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information required by this item will be contained in the Company's
Proxy Statement for its 2005 annual meeting of stockholders, which will be filed
on or before April 29, 2005 and is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item will be contained in the Company's
Proxy Statement for its 2005 annual meeting of stockholders, which will be filed
on or before April 29, 2005 and is incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item will be contained in the Company's
Proxy Statement for its 2005 annual meeting of stockholders, which will be filed
on or before April 29, 2005 and is incorporated herein by reference.
24
PART IV
ITEM 15. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES
(a) Index to Consolidated Financial Statements
1. Consolidated Financial Statements:
Report of Independent Registered Public Accounting Firm......................... F-2
Consolidated Balance Sheets as of December 31, 2004, and 2003................... F-3
Consolidated Statements of Operations for the years ended December 31, 2004
2003 and 2002................................................................... F-4
Consolidated Statements of Stockholders' Equity (Deficit) for the years ended
December 31, 2004, 2003 and 2002,............................................... F-5
Consolidated Statements of Cash Flows for the years ended December 31, 2004,
2003 and 2002................................................................... F-6
Notes to the Consolidated Financial Statements.................................. F-9
2. Consolidated Financial Statement Schedules:
All schedules have been omitted because they are not required, not
applicable, or the information required to be set forth therein is
included in the Company's Consolidated Financial Statements or the
Notes therein.
(b) Exhibits
3.1 Amended and Restated Certificate of Incorporation of the Company.(1)
3.2 Amended and Restated Bylaws of the Company.(1)
3.3 Certificate of Designation, Preferences Relative, Participating,
Optional and Other Special Rights of the Company's Series A
Cumulative Senior Convertible Preferred Stock.(1)
4.1 Specimen certificate of Common Stock.(1)
4.2 Form of Warrant to purchase Common Stock dated August 12, 2002.(9)
4.3 Form of Note under Loan Agreement dated as of September 9, 2002
between the Company and E. Khashoggi Industries, LLC.(11)
4.4 Form of Secured Convertible Debenture due March 5, 2006.(13)
4.5 Intellectual Property Security Agreement dated as of March 5, 2003
among the Company, E. Khashoggi Industries, LLC and the investors
signatory thereto.(13)
4.6 Waiver and Amendment to Debentures and Warrants dated as of March 5,
2003 among the Company and the purchasers identified on the
signature pages thereto.(13)
4.7 Exchange Agreement dated as of March 5, 2003 between the Company and
the institutional investor signatory thereto.(13)
25
10.1 Amended and Restated License Agreement dated February 28, 1995 by
and between the Company and E. Khashoggi Industries("EKI").(1)
10.2 Registration Rights Agreement dated as of February 28, 1995 by and
between the Company and EKI, as amended.(1)
10.3 EarthShell Container Corporation 1994 Stock Option Plan.(1)
10.4 EarthShell Container Corporation 1995 Stock Incentive Plan.(1)
10.5 Form of Stock Option Agreement under the EarthShell Container
Corporation 1994 Stock Option Plan.(1)
10.6 Form of Stock Option Agreement under the EarthShell Container
Corporation 1995 Stock Incentive Plan.(1)
10.7 Warrant to Purchase Stock issued July 2, 1996 by the Company to
Imperial Bank.(1)
10.8 Amended and Restated Technical Services and Sublease Agreement dated
October 1, 1997 by and between the Company and EKI.(1)
10.9 Amended and Restated Agreement for Allocation of Patent Costs dated
October 1, 1997 by and between the Company and EKI.(1)
10.10 Warrant to Purchase Stock issued October 6, 1997 by the Company to
Imperial Bank.(1)
10.11 Warrant to Purchase Stock dated December 31, 1997 by the Company to
Imperial Bank.(1)
10.12 Letter Agreement re Haas/BIOPAC Technology dated February 17, 1998
by and between the Company and EKI.(1)
10.13 Second Amendment to 1995 Stock Incentive Plan of the Company.(1)
10.14 Amendment No. 2 to Registration Rights Agreement dated as of
September 16, 1993.(1)
10.15 Amendment No. 2 to Registration Rights Agreement dated February 28,
1995.(1)
10.16 Employment Agreement dated April 15, 1998 by and between the Company
and Vincent J. Truant.(3)
10.17 First Amendment dated June 2, 1998 to the Amended and Restated
License Agreement by and between the Company and E. Khashoggi
Industries("EKI").(4)
10.18 First Amendment to 1995 Stock Incentive Plan of the Company.(5)
10.19 Third Amendment to 1995 Stock Incentive Plan of the Company.(6)
10.20 Fourth Amendment to 1995 Stock Incentive Plan of the Company.(6)
10.21 Lease Agreement dated August 23, 2000 by and between the Company and
Heaver Properties, LLC.(7)
10.22 Settlement Agreement with Novamont dated August 3, 2001.(8)
10.23 Amendment to Common Stock Purchase Agreement dated March 28,
2001.(8)
10.24 Securities Purchase Agreement dated as of August 12, 2002 between
the Company and the investors signatory thereto.(9)
10.25 Amendment #1 to Employment Agreement dated as of May 15, 2002 by and
between the Company and Vince Truant.(10)
10.26 Loan Agreement dated as of September 9, 2002 between the Company and
E. Khashoggi Industries, LLC.(11)
10.27 Second Amendment dated 29 July, 2002 to Amended and Restated License
Agreement between E. Khashoggi Industries, LLC and the Company.(12)
10.28 License and Information Transfer Agreement dated 29 July, 2002
between the Biotec Group and the Company.(12)
10.29 Loan and Securities Purchase Agreement dated as of March 5, 2003
between the Company and the investors signatory thereto.(13)
10.30 Sublicense Agreement dated February 20, 2004 by and between the
Company and Hood Packaging Corporation. (15)
10.31 Operating and Sublicense Agreement dated October 3, 2002 by and
between the Company and Sweetheart Cup Company, Inc. (15)
10.32 First Amendment to Operating and Sublicense Agreement dated July
2003 by and between the Company and Sweetheart Cup Company, Inc.
(15)
10.34 Lease Agreement dated July 2003 between the Company and Sweetheart
Cup Company, Inc. (15)
10.35 First Amendment to Lease Agreement dated December 16, 2003 between
the Company and Sweetheart Cup Company, Inc. (15)
10.37 Sublicense Agreement dated November 11, 2004 by and between the
Company and EarthShell Hidalgo S.A. de C.V..
26
10.38 Standby Equity Distribution Agreement dated as of March 23, 2005
between the Company and Cornell Capital Partners, LP. (16)
10.39 Registration Rights Agreement dated as of March 23, 2005 between the
Company and Cornell Capital Partners, LP. (16)
10.40 Placement Agent Agreement dated as of March 23, 2005 by and among
the Company, Cornell Capital Partners, LP and Sloan Securities
Corporation. (16)
10.41 Security Agreement dated as of March 23, 2005 between the Company
and Cornell Capital Partners, LP. (16)
10.42 Promissory Note dated as of March 23, 2005 issued to Cornell Capital
Partners, LP. (16)
10.43 Meridian Business Solutions Sublicense Agreement dated May 13, 2004.
(17)
10.44 Amended and Restated Debenture Purchase Agreement by and among the
Company, EKI and SF Capital Partners, Ltd. dated September 30, 2004.
(17)
10.45 Amended and Restated Debenture Purchase Agreement by and among the
Company, EKI and Omicron Master Trust dated September 29, 2004. (17)
10.46 Amended and Restated Debenture Purchase Agreement by and among the
Company, EKI and Islandia, Ltd. dated September 29, 2004. (17)
10.47 Amended and Restated Debenture Purchase Agreement by and among the
Company, EKI and Midsummer Investment, Ltd. dated September 29,
2004. (17)
10.48 Conversion Agreement by and among the Company, EKI and RHP Master
Fund, Ltd. dated July 20, 2004. (17)
10.49 Amended and Restated Debenture Purchase Agreement by and among the
Company, EKI and Straus-GEPT L.P. dated September 29, 2004. (17)
10.50 Amended and Restated Debenture Purchase Agreement by and among the
Company, EKI and Straus Partners L.P. dated September 29, 2004. (17)
10.51 Amended and Restated Debenture Purchase Agreement by and among the
Company and EKI dated September 30, 2004. (17)
10.52 Agreement with EKI dated July 16, 2004 to convert debt to equity.
(17)
10.53 Agreement dated September 1, 2004 for conversion of Biotec
indebtedness. (17)
10.54 Stock Purchase Agreement between the Company and Meridian Business
Solutions, LLC dated August 5, 2004. (17)
14.1 EarthShell Corporation Code of Ethics for Directors, Officers and
Employees (15)
16.1 Letter from Deloitte & Touche LLP to the Securities and Exchange
Commission dated July 9, 2003, regarding change in certifying
accountant. (14)
31.1 Certification of the CEO pursuant to Rules 13a-14 and 15d-14 under
the Exchange Act, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of the CFO pursuant to Rules 13a-14 and 15d-14 under
the Exchange Act, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
----------
(1) Previously filed, as an exhibit to the Company's Registration Statement on
Form S-1 and amendments thereto, File no. 333-13287, and incorporated
herein by reference.
(2) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q, for the quarter ended March 31, 1998, and incorporated herein by
reference.
(3) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q, for the quarter ended June 30, 1998, and incorporated herein by
reference.
(4) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q, for the quarter ended September 30, 1998, and incorporated herein by
reference.
(5) Previously filed as an exhibit to the Company's annual report on Form
10-K, for the fiscal year ended December 31, 1998, and incorporated herein
by reference.
(6) Previously filed as part of the Company's definitive proxy statement on
Schedule 14A, file no. 000-23567, for its 1999 annual meeting of
stockholders, and incorporated herein by reference.
(7) Previously filed as an exhibit to the Company's annual report on Form
10-K, for the fiscal year ended December 31, 2000, and incorporated herein
by reference.
(8) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q, for the quarter ended June 30, 2001, and incorporated herein.
(9) Previously filed as an exhibit to the Company's current report on Form 8-K
dated August 12, 2002, and incorporated herein by reference.
(10) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q for the quarter ended June 30, 2002, and incorporated herein by
reference.
(11) Previously filed as an exhibit to the Company's current report on Form 8-K
dated September 17, 2002, and incorporated herein by reference.
27
(12) Previously filed as an exhibit to the Company's quarterly report on Form
10-Q for the quarter ended September 30, 2002, and incorporated herein by
reference.
(13) Previously filed as an exhibit to the Company's current report on Form 8-K
dated March 5, 2003, and incorporated herein by reference.
(14) Previously filed as an exhibit to the Company's current report on Form 8-K
dated July 11, 2003, and incorporated herein by reference.
(15) Previously filed as an exhibit to the Company's annual report on Form
10-K, for the fiscal year ended December 31, 2003, and incorporated herein
by reference.
(16) Previously filed as an exhibit to the Company's current report on Form 8-K
dated March 29, 2005, and incorporated herein by reference.
(17) Previously filed as part of the Company's quarterly report on Form 10-Q
for the quarter ended September 30, 2004, and incorporated herein by
reference.
28
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on March 31, 2005.
EARTHSHELL CORPORATION
By: /s/ SIMON K. HODSON
-------------------------------------
Simon K. Hodson
Vice Chairman of the Board and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated.
Signature Title Date
--------- ----- ----
/s/ ESSAM KHASHOGGI Chairman of the Board March 31, 2005
-------------------------------
Essam Khashoggi
Vice Chairman of the Board and Chief
/s/ SIMON K. HODSON Executive Officer (Principal Executive March 31, 2005
------------------------------- Officer)
Simon K. Hodson
/s/ D. SCOTT HOUSTON Chief Financial Officer and Secretary March 31, 2005
------------------------------- (Principal Financial Officer)
D. Scott Houston
/s/ LAYLA KHASHOGGI Director March 31, 2005
-------------------------------
Layla Khashoggi
/s/ HAMLIN JENNINGS Director March 31, 2005
-------------------------------
Hamlin Jennings
/s/ WALKER RAST Director March 31, 2005
-------------------------------
Walker Rast
29
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
Index to Consolidated Financial Statements and Schedules.............................F-1
Report of Independent Registered Public Accounting Firm..............................F-2
Consolidated Balance Sheets as of December 31, 2004 and 2003.........................F-3
Consolidated Statements of Operations for the years ended December 31, 2004, 2003,
and 2002 ..........................................................................F-4
Consolidated Statements of Stockholders' Equity (Deficit) for the years ended
December 31, 2004, 2003, and 2002 .................................................F-5
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003,
and 2002 ..........................................................................F-6
Independent Auditors' Report.........................................................F-8
Consolidated Financial Statement Schedules:
None.
All schedules have been omitted because they are not required, not
applicable, or the information required to be set forth therein is included in
the Company's Consolidated Financial Statements or the Notes therein.
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of EarthShell Corporation:
We have audited the accompanying consolidated balance sheets of EarthShell
Corporation (the "Company") as of December 31, 2004 and 2003, and the related
consolidated statements of operations, stockholders' (deficit) equity, and cash
flows for the years ended December 31, 2004, 2003 and 2002. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, based on our audits, such consolidated financial
statements present fairly, in all material respects, the financial position of
the Company as of December 31, 2004 and 2003, and the results of its operations
and its cash flows for the years ended December 31, 2004, 2003 and 2002, in
conformity with accounting principles generally accepted in the United States of
America.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed in the
notes to the consolidated financial statements, the Company has incurred
significant losses, has minimal revenues and has a working capital deficit of
approximately $7,289,000 at December 31, 2004. These matters raise substantial
doubt about the Company's ability to continue as a going concern. Management's
plans concerning these matters are also described in the notes to the
consolidated financial statements. The consolidated financial statements do not
include any adjustments that might result from the outcome of this uncertainty.
/s/ Farber & Hass LLP
Camarillo, California
March 4, 2005
F-2
EARTHSHELL CORPORATION
CONSOLIDATED BALANCE SHEETS
December 31,
------------------------------
2004 2003
------------------------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents ................................................... $ 272,371 $ 1,901,639
Prepaid expenses and other current assets ................................... 201,467 323,680
------------------------------
Total current assets ...................................................... 473,838 2,225,319
PROPERTY AND EQUIPMENT, NET ................................................... 9,037 61,794
EQUIPMENT HELD FOR SALE ....................................................... 1 1
------------------------------
TOTALS ........................................................................ $ 482,876 $ 2,287,114
==============================
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Accounts payable and accrued expenses ....................................... $ 3,899,526 $ 4,853,413
Current portion of settlements .............................................. 313,743 --
Current portion of deferred revenues ........................................ 300,000 --
Payable to related party .................................................... 875,000 1,839,108
Debenture settlement ........................................................ 2,375,000 --
Convertible debentures, net of discount of $1,505,755 ....................... -- 5,294,245
------------------------------
Total current liabilities ................................................. 7,763,269 11,986,766
DEFERRED REVENUES, LESS CURRENT PORTION........................................ 1,062,500 2,535,790
OTHER LONG-TERM LIABILITIES ................................................... 412,192 33,333
------------------------------
Total liabilities ......................................................... 9,237,961 14,555,889
------------------------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' DEFICIT
Preferred Stock, $.01 par value, 10,000,000 shares authorized; 9,170,000
Series A shares designated; no shares issued and outstanding as of December
31, 2004 and 2003 ......................................................... -- --
Common stock, $.01 par value, 40,000,000 shares authorized;
18,234,615 and 14,128,966 shares issued and outstanding as
of December 31, 2004 and 2003, respectively ............................... 182,346 141,290
Additional paid-in common capital ........................................... 313,196,905 302,033,746
Accumulated deficit ......................................................... (321,607,782) (314,350,681)
Less note receivable for stock .............................................. (500,000) --
Accumulated other comprehensive loss ........................................ (26,554) (93,130)
------------------------------
Total stockholders' deficit ............................................... (8,755,085) (12,268,775)
------------------------------
TOTALS ........................................................................ $ 482,876 $ 2,287,114
==============================
See Notes to Consolidated Financial Statements.
F-3
EARTHSHELL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended December 31,
--------------------------------------------
2004 2003 2002
--------------------------------------------
Revenues .............................. $ 137,500 $ -- $ --
Operating Expenses
Related party license fee and
research and development
expenses .......................... 800,000 1,312,374 1,488,070
Other research and development
expenses ............................ 370,163 8,234,416 25,401,869
Related party general and
administrative (reimbursements) ... (4,875) (4,074) (24,444)
Other general and administrative
expenses ............................ 3,753,902 5,790,473 9,614,037
Depreciation and amortization ....... 42,236 379,949 3,099,367
--------------------------------------------
Total operating expenses .......... 4,961,426 15,713,138 39,578,899
Operating Loss ........................ 4,823,926 15,713,138 39,578,899
Other (Income) Expenses
Interest income ..................... (4,606) (95,176) (134,391)
Related party interest expense ...... 410,965 445,628 66,599
Other interest expense .............. 661,721 1,440,118 199,880
Gain on sales of property and
equipment ......................... (168,458) (451,940) (441,413)
Premium due to debenture default .... 1,672,426 -- --
Other income ........................ -- (399,701) --
(Gain) Loss on extinguishment of
debentures ........................ (139,673) 1,697,380 --
Debenture conversion costs .......... -- 166,494 320,970
--------------------------------------------
Loss Before Income Taxes .............. 7,256,301 18,515,941 39,590,544
Income Taxes .......................... 800 800 800
--------------------------------------------
Net Loss .............................. $ 7,257,101 $ 18,516,741 $ 39,591,344
============================================
Basic and Diluted Loss Per Common Share $ 0.48 $ 1.40 $ 3.51
Weighted Average Number of Common
Shares Outstanding .................. 15,046,726 13,266,668 11,277,170
See Notes to Consolidated Financial Statements.
F-4
EARTHSHELL CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' (DEFICIT) EQUITY
Additional Accumulated
Common Stock Paid-In Stock Other
-------------------- Common Accumulated Purchase Comprehensive
Shares Amount Capital Deficit Receivable Loss Totals
-------------------- -------------- --------------- ----------------------- --------------
BALANCE, DECEMBER 31, 2001 .......... 9,860,255 $ 98,602 $ 267,680,051 $(256,242,596) $ -- $ -- $ 11,536,057
Issuance of common stock ............ 2,025,686 20,257 21,881,459 -- -- -- 21,901,716
Common stock warrants issued in
connection with convertible
debentures ...................... -- -- 1,521,046 -- -- -- 1,521,046
Conversion of convertible debentures
to common stock ................. 168,696 1,687 998,313 -- -- -- 1,000,000
Debenture conversion costs .......... -- -- 176,471 -- -- -- 176,471
Net loss ............................ -- -- (39,591,344) -- -- (39,591,344)
Foreign currency translation
adjustment ...................... -- -- -- -- -- (16,632) (16,632)
-------------
Comprehensive loss .................. -- -- -- -- -- -- (39,607,976)
-------------------- -------------- --------------- ----------------------- --------------
BALANCE, DECEMBER 31, 2002 ..........12,054,637 120,546 292,257,340 (295,833,940) -- (16,632) (3,472,686)
Issuance of common stock ............ 137,264 1,373 811,267 -- -- -- 812,640
Common stock and common stock
warrants issued in connection
with issuance of convertible
debentures ...................... 624,747 6,248 2,921,594 -- -- -- 2,927,842
Conversion of convertible
debentures to common stock ...... 1,312,318 13,123 7,536,877 -- -- -- 7,550,000
Debenture conversion costs .......... -- -- (1,493,332) -- -- -- (1,493,332)
Net loss ............................ -- -- -- (18,516,741) -- -- (18,516,741)
Foreign currency translation
adjustment ...................... -- -- -- -- -- (76,498) (76,498)
-------------
Comprehensive loss .................. -- -- -- -- -- -- (18,593,239)
-------------------- -------------- --------------- ----------------------- --------------
BALANCE, DECEMBER 31, 2003 ..........14,128,966 141,290 302,033,746 (314,350,681) -- (93,130) (12,268,775)
Issuance of common stock ............ 2,443,272 24,432 7,181,970 -- (500,000) -- 6,706,402
Conversion of convertible debentures
to common stock ................. 1,662,377 16,624 4,970,508 -- -- -- 4,987,132
Debenture conversion costs .......... -- -- (989,319) -- -- -- (989,319)
Net loss ............................ -- -- -- (7,257,101) -- -- (7,257,101)
Foreign currency translation
adjustment ...................... -- -- -- -- -- 66,576 66,576
-------------
Comprehensive loss .................. -- -- -- -- -- -- (7,190,525)
-------------------- -------------- --------------- ----------------------- --------------
BALANCE, DECEMBER 31, 2004 ..........18,234,615 $182,346 $ 313,196,905 $(321,607,782) $ (500,000) $(26,554) $ (8,755,085)
==================== ============== =============== ======================= ==============
See Notes to Consolidated Financial Statements.
F-5
EARTHSHELL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31,
2004 2003 2002
--------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss ............................................. $ (7,257,101) $(18,516,741) $(39,591,344)
Adjustments to reconcile net loss to net cash used
in operating activities
Depreciation and amortization ..................... 42,236 379,949 3,099,367
Amortization and accretion of debenture issue
costs .......................................... 592,316 955,574 144,500
Premium due to debenture default .................. 1,672,426 -- --
Debenture issuance and conversion costs ........... -- 166,494 320,970
Gain on change in fair value of warrant obligation -- (399,701) --
(Gain) Loss on extinguishment of debentures ....... (139,673) 1,697,380 --
Beneficial conversion value due to change in
debentures conversion price .................... -- 360,000 --
(Gain) Loss on sale, disposal or impairment of
property and equipment ......................... (168,458) 3,548,059 9,340,375
Equity in the losses of joint venture ............. -- 392,116 20,263
Accrued purchase commitment ....................... -- (1,855,000) 3,500,000
Other non-cash expense items ...................... 180,171 50,198 --
Changes in operating assets and liabilities
Prepaid expenses and other current assets ......... 120,549 264,153 9,670
Accounts payable and accrued expenses ............. (553,710) (2,339,720) (444,851)
Payable to related party .......................... 1,043,869 1,214,683 578,779
Deferred revenues ................................. 1,362,500 -- --
Accrued purchase commitment ....................... -- (1,645,000) --
Other long-term liabilities ....................... 378,859 33,333 --
--------------------------------------------
Net cash used in operating activities .......... (2,726,016) (15,694,223) (23,022,271)
============================================
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from release of restricted time
deposit upon settlement of purchase commitment .... -- 3,500,000 --
Proceeds from sales of property and equipment ........ 187,708 487,691 477,566
Investment in joint venture .......................... -- (26,104) --
Purchases of property and equipment .................. (8,729) (1,320) (2,802,371)
--------------------------------------------
Net cash provided by (used in) investing
activities ................................... 178,979 3,960,267 (2,324,805)
============================================
F-6
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of common stock ............... 2,086,755 -- 21,901,716
Proceeds from issuance of common stock and convertible
debentures, net of issuance costs and discounts
amounting to approximately $3.4 million .......... -- 8,711,844 --
Proceeds from issuance of convertible debentures ..... -- -- 10,000,000
Purchase of restricted time deposit in connection with
issuance of convertible debentures ................ -- -- (10,000,000)
Proceeds from release of restricted time deposit upon
conversion of convertible debentures into common
stock ............................................. -- 1,800,000 1,000,000
Proceeds from release of restricted time deposit upon
exchange of convertible debentures ................ -- 2,000,000 --
Proceeds from release of restricted time deposit for
repayment of convertible debentures ............... -- 5,200,000 --
Repayment of convertible debentures .................. (1,110,294) (5,200,000) --
Principal payments on settlements .................... (66,387) -- --
Proceeds from issuance of notes payable to related
party ............................................. -- 1,010,000 4,825,000
Repayment of notes payable to related
party ............................................ -- -- (3,080,000)
--------------------------------------------
Net cash provided by financing activities ...... 910,074 13,521,844 24,646,716
Effect of exchange rate changes on cash and cash
equivalents ....................................... 7,695 2,736 (16,632)
--------------------------------------------
(DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS ..... (1,629,268) 1,790,624 (716,992)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ....... 1,901,639 111,015 828,007
--------------------------------------------
CASH AND CASH EQUIVALENTS,
END OF PERIOD ........................................ $ 272,371 $ 1,901,639 $ 111,015
============================================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for
Income taxes ...................................... $ 800 $ 800 $ 800
Interest .......................................... 111,353 21,058
Common stock warrants issued in connection with
convertible debentures ............................ -- 745,562 1,521,046
Conversion of convertible debentures into common stock 6,800,000 7,550,000 1,000,000
Transfer of property from EKI ........................ -- -- --
Conversion of preferred stock into common stock ...... -- -- --
Interest paid in common stock ........................ 532,644 95,339 --
Commission paid in common stock ...................... -- 29,500 --
Common stock issued to service providers in connection
with the March 2003 financing ..................... -- 484,500 --
F-7
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
In 2004, no warrants were issued.
In 2003, warrants for the purchase of $1.055 million in aggregate
principal amount of convertible debentures and 70,477 shares of common stock
were issued in connection with the issuance of convertible debentures. The
estimated fair value of the warrants of $442,040, based upon the Black-Scholes
method of valuation, was recorded as an original issue discount thereby reducing
the carrying value of the convertible debentures and as an increase in
additional paid-in common capital.
In 2003, warrants for the purchase of 83,333 shares of common stock were
issued to EKI, in connection with the issuance of convertible debentures, in
consideration for its willingness to subordinate amounts owed to it. The
estimated fair value of the warrants of $303,522, based upon the Black-Scholes
method of valuation, was recorded as an original issue discount thereby reducing
the carrying value of the notes payable to EKI and as an increase in additional
paid-in common capital.
In 2003, 137,264 shares of common stock were issued to satisfy accounts
payable and accrued interest payable of $812,640.
In 2002, warrants for the purchase of 208,333 shares of common stock were
issued in connection with the issuance of convertible debentures. The estimated
fair value of the warrants of $1,521,046, based upon the Black-Scholes method of
valuation, was recorded as an original issue discount thereby reducing the
carrying value of the convertible debentures and as an increase in additional
paid-in common capital.
See Notes to Consolidated Financial Statements.
F-8
EARTHSHELL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Overview of Operations
Organized in November 1992 as a Delaware corporation, EarthShell
Corporation (the "Company") is engaged in the commercialization of composite
material technology for the manufacture of foodservice disposable packaging
designed with the environment in mind. EarthShell Packaging(R) is based on
patented composite material technology (collectively, the "EarthShell
Technology"), licensed on an exclusive, worldwide basis from E. Khashoggi
Industries LLC and its wholly owned subsidiaries.
The EarthShell Technology has been developed over many years in
consultation with leading material scientists and environmental experts to
reduce the environmental burdens of foodservice disposable packaging through the
careful selection of raw materials, processes, and suppliers. EarthShell
Packaging(R), including hinged-lid sandwich containers, plates, bowls,
foodservice wraps, and cups, is primarily made from commonly available natural
raw materials such as natural ground limestone and potato starch. EarthShell
believes that EarthShell Packaging(R) has comparable or superior performance
characteristics and can be commercially produced and sold at prices that are
competitive with comparable paper and plastic foodservice disposables.
EarthShell was a development stage enterprise through the first quarter of
2004. With the recognition of the Company's first revenues in the second quarter
of 2004, the Company was no longer a development stage enterprise.
BASIS OF PRESENTATION OF FINANCIAL INFORMATION
The foregoing financial information has been prepared from the books and
records of EarthShell Corporation. EarthShell Corporation's consolidated
financial statements include the accounts of its wholly-owned subsidiary,
PolarCup EarthShell GmbH. All significant intercompany balances and transactions
have been eliminated in consolidation. In the opinion of management, the
financial information reflects all adjustments necessary for a fair presentation
of the financial condition, results of operations and cash flows of the Company
in conformity with generally accepted accounting principles. All such
adjustments were of a normal recurring nature for interim financial reporting.
The accompanying consolidated financial statements have been prepared on a
going concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. The Company has
incurred significant losses since inception, has minimal revenues and has a
working capital deficit of $7,289,431 at December 31, 2004. These factors, along
with others, may indicate substantial doubt that the Company will be unable to
continue as a going concern for a reasonable period of time.
Subsequent to December 31, 2004 the Company entered into a financing
transaction to borrow $2.5 million (See Subsequent Events). On March 28, 2005,
the Company received $1.15 million of this funding. The Company expects to
receive the remaining $1.35 million prior to April 30, 2005. The Company expects
to generate additional cash in 2005 through royalty payments from licensees. The
Company believes that the cash from this borrowing, combined with projected
revenues, will be sufficient to fund its operations through the year ending
December 31, 2005. If the Company is not successful at generating license
revenues during the year, the Company will have to raise additional funds to
meet its current obligations and to cover operating expenses. If the Company is
not successful in raising additional capital it may not be able to continue as a
going concern for a reasonable period of time. Management plans to address this
need by raising cash through either the issuance of debt or equity securities.
However, the Company cannot assure that it will receive any royalty payments in
2005, that additional financing will be available to it, or, if available, that
the terms will be satisfactory. Management will also continue in its efforts to
reduce expenses, but cannot assure that it will be able to reduce expenses
below current levels.
The consolidated financial statements do not include any adjustments
relating to the recoverability and classification of recorded asset amounts or
the amounts and classification of liabilities that might be necessary should the
Company be unable to continue as a going concern. The Company's continuation as
a going concern is dependent upon its ability to generate sufficient cash flow
to meet its obligations on a timely basis, to obtain additional financing or
refinancing as may be required, and ultimately to attain successful operations.
F-9
In January 2004, the Company announced that it was not in compliance with
a Nasdaq SmallCap Market minimum requirement. On March 8, 2004 the Company's
common stock was de-listed by the Nasdaq SmallCap Market and trading was moved
to the over-the-counter (OTC) [Pink Sheets Electronic Quotation Service]. Since
June 21, 2004, the Company's common stock has been listed through the OTC
Bulletin Board. The Company's common stock trades under the symbol "ERTH.OB."
Operations and Financing
The Company was engaged in initial concept development from 1993 to 1998.
During this period, the Company focused on enhancing the material science
technology licensed from EKI, initial development of the Company's foam
packaging products (primarily, its hinged-lid sandwich containers, which are
referred to as "hinged-lid containers"), and the development of relationships
with key licensees and end-users.
Since 1998, the Company has been primarily engaged in commercial
validation of EarthShell Packaging for plates, bowls, hinged-lid containers, and
sandwich wraps, and other market development activities. During this stage, the
Company has worked to demonstrate the commercial viability of its business model
by optimizing product design, garnering support from key members of the
environmental community, expanding validation of the environmental profile
through third party evaluations, developing commercially viable manufacturing
processes, establishing and refining licensing arrangements with the Company's
licensees, and validating product performance and price acceptance through
commercial contracts with influential purchasers in key segments of the
foodservice market. In cooperation with its operating partners, the Company
financed and built initial commercial demonstration production capacity and has
sold limited quantities of plates, bowls, and hinged-lid containers. In 2003,
the Company ceased commercial demonstration production activity and is relying
on its equipment and manufacturing partners to demonstrate and to guarantee the
long-term manufacturability of EarthShell Packaging(R).
As demonstration of the business fundamentals to licensees is
accomplished, the Company expects that its operating partners will build
production capacity. The Company intends to expand the use of EarthShell
Packaging in the U.S. and in international markets through agreements with
additional licensees. By leveraging the infrastructure of its licensees, the
Company believes the go-to-market strategy will accelerate the market
penetration of EarthShell Packaging.
Currently, the Company's strategic relationships include Detroit Tool and
Equipment ("DTE"),Hood Packaging Corporation ("Hood"), and Meridian Business
Solutions ("MBS") all in the U.S, as well as EarthShell Hidalgo ("ESH") in
Mexico. During 2004, the Company received technology fees from MBS and ESH, and
recorded it first revenues since its inception. During prior years, proceeds
from initial sales of plates, bowls and hinged-lid containers were not
significant and were recorded as an offset to the costs of its demonstration
manufacturing operations.
As part of the Company's initial public offering on March 27, 1998, the
Company issued 877,193 shares of common stock, for which it received net
proceeds of $206 million. On April 18, 2000 and January 4, 2001, the Company
filed S-3 shelf registration statements for 416,667 and 1,250,000 shares,
respectively, of the Company's common stock. During the years ended December 31,
2002, 2001, and 2000 the Company sold approximately 0.1 million, 1.1 million and
0.4 million shares of common stock under such registration statements and
received net proceeds from such sales of approximately $2.3 million, $30.6
million and $10.5 million, respectively. All shares available under such
registration statements had been sold as of December 2002.
In December of 2001, the Company filed an additional shelf registration
statement providing for the sale of up to $50 million of securities, including
secured or unsecured debt securities, preferred stock, common stock, and
warrants. These securities could be offered, separately or together, in distinct
series, and amounts, at prices and terms to be set forth in the prospectus
contained in the registration statement, and in subsequent supplements to the
prospectus. During the year ended December 31, 2002, the Company sold 1.9
million shares of common stock under such registration statement and received
net proceeds from such sales of $19.6 million.
On August 12, 2002, the Company issued $10.0 million in aggregate
principal amount of convertible debentures, due August 2007, (the "2007
Debentures") and warrants to purchase 0.2 million shares of common stock to
institutional investors for proceeds of $10.0 million (see Convertible
Debenture). The terms of the debentures required the proceeds be held in
restricted cash accounts linked to irrevocable letters of credit in favor of
each debenture holder such that unrestricted access to the proceeds from the
sale of the debentures generally occurred only upon conversion of the debentures
into shares of the Company's common stock (see Restricted Cash). In 2002 and
2003, $2.8 million of the debentures were converted to common stock. In March
2003, the Company issued $10.55 million in aggregate principal amount of
convertible debentures, due March 2006 (the "2006 Debentures"), and 0.5 million
shares of common stock to a group of institutional investors for net proceeds of
approximately $9.0 million. In connection with this transaction, the Company
repaid $5.2 million of the remaining balance of the 2007 Debentures, and
exchanged $2.0 million of the 2007 Debentures for the 2006 Debentures. This
transaction provided the Company with net proceeds of approximately $11.0
million. The Company's use of these proceeds was subject to a number of
restrictions. In 2003, $5.75 million of the 2006 Debentures were converted to
common stock. The remaining shares under the December 2001 shelf registration
described above have been used to secure shares potentially issuable upon
conversion of the remainder of the 2006 Debentures.
F-10
During 2004, as a result of its stock price dropping below $3 per share
for an extended period of time, the Company was de-listed from NASDAQ.
Consequently, it became in default on its 2006 Debentures. In the 4th quarter of
2004, the Company sold $2.7 million of unregistered stock, negotiated a
settlement with each of its debenture holders, and retired all of the
outstanding debentures.
During 2002 and 2003, the Company's largest shareholder, EKI, made various
simple interest working capital loans to the Company. These loans bear interest
at a rate of 7% or 10% per annum, and are payable on demand. As of December 31,
2003, the outstanding principal balance of these loans was $2,755,000. In
connection with the March 2003 convertible debenture financing the remaining
outstanding balance of these loans was subordinated to the 2006 Debentures, with
strict covenants governing their repayment. In October 2004, these related party
loans, including accrued interest were converted to unregistered shares of
EarthShell common stock. (See Related Party Transactions).
Recent Accounting Pronouncements
The FASB recently issued the following statements:
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs-an
amendment of ARB. No. 43, Chapter 4". This Statement amends the guidance in ARB
No. 43, Chapter 4, "Inventory Pricing," to clarify the accounting for abnormal
amounts of idle facility expense, freight, handling costs, and wasted material
(spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that "... under
some circumstances, items such as idle facility expense, excessive spoilage,
double freight, and rehandling costs may be so abnormal as to require treatment
as current period charges...." This Statement requires that those items be
recognized as current-period charges regardless of whether they meet the
criterion of "so abnormal." In addition, this Statement requires that allocation
of fixed production overheads to the costs of conversion be based on the normal
capacity of the production facilities. The Company does not believe that this
recent accounting pronouncement has had or will have a material impact on their
financial position or results of operations.
In December 2004, the FASB issued SFAS No. 152, "Accounting for Real
Estate Time-Sharing Transactions - an amendment of FASB statements no. 66 and
67". This Statement amends FASB Statement No. 66, Accounting for Sales of Real
Estate, to reference the financial accounting and reporting guidance for real
estate time-sharing transactions that is provided in AICPA Statement of Position
(SOP) 04-2, Accounting for Real Estate Time-Sharing Transactions. This Statement
also amends FASB Statement No. 67, Accounting for Costs and Initial Rental
Operations of Real Estate Projects, to state that the guidance for (a)
incidental operations and (b) costs incurred to sell real estate projects does
not apply to real estate time-sharing transactions. The accounting for those
operations and costs is subject to the guidance in SOP 04-2. The Company does
not believe that this recent accounting pronouncement has had or will have a
material impact on their financial position or results of operations.
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary
assets - an amendment of APB Opinion No. 29". This Statement amends APB Opinion
29 to eliminate the exception for non-monetary exchanges of similar productive
assets and replaces it with a general exception for exchanges of non-monetary
assets that do not have commercial substance. A non-monetary exchange has
commercial substance if the future cash flows of the entity are expected to
change significantly as a result of the exchange. The Company does not believe
that this recent accounting pronouncement has had or will have a material impact
on their financial position or results of operations.
In December 2004, the FASB issued SFAS No. 123R, "Share Based Payment".
This Statement is a revision of FASB Statement No. 123, Accounting for
Stock-Based Compensation. This Statement supersedes APB Opinion No. 25,
Accounting for Stock Issued to Employees, and its related implementation
guidance. This Statement establishes standards for the accounting for
transactions in which an entity exchanges its equity instruments for goods or
services. It also addresses transactions in which an entity incurs liabilities
in exchange for goods or services that are based on the fair value of the
entity's equity instruments or that may be settled by the issuance of those
equity instruments. This Statement focuses primarily on accounting for
transactions in which an entity obtains employee services in share-based payment
transactions. This Statement does not change the accounting guidance for
share-based payment transactions with parties other than employees provided in
Statement 123 as originally issued and EITF Issue No. 96-18, "Accounting for
Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services." This Statement does not address
the accounting for employee share ownership plans, which are subject to AICPA
Statement of Position 93-6, Employers' Accounting for Employee Stock Ownership
Plans. This statement will require the Company to recognize the fair value of
employee services received in exchange for awards of equity instruments in
current earnings. The Company will adopt this pronouncement July 1, 2005 as
required.
F-11
Other Comprehensive Income
The Company has reflected the provisions of SFAS No. 130, "Reporting
Comprehensive Income", in the accompanying consolidated financial statements for
all periods presented. The accumulated comprehensive loss and other
comprehensive loss as reflected in the accompanying consolidated financial
statements, respectively, consists of foreign currency translation adjustments,
which historically have been insignificant to the Company's operations.
Foreign Currency Translation
Assets and liabilities of the Company's foreign subsidiary, PolarCup
EarthShell GmbH, are translated into United States dollars at the exchange rate
in effect at the close of the period, and revenues and expenses are translated
at the weighted average exchange rate during the period. The aggregate effect of
translating the financial statements of PolarCup EarthShell GmbH is included as
a separate component of stockholders' equity. Foreign exchange gains/losses have
been insignificant.
Reverse Stock Split
Effective as of October 31, 2003, the Company's Board of Directors
("Board") approved an amendment to the Company's Certificate of Incorporation to
effect a reverse split of the Company's common stock. This action by the Board
followed approval by 88% of the stockholders of a proposal at the 2003 Annual
Meeting of the Company that authorized the Board to take such action. The
decision by the Board was prompted by the need to maintain compliance with
certain covenants of the Company's 2006 debentures that require the Company to
retain its listing on a national market.
After careful analysis, the Board approved the final ratio for the split
at one-for-twelve (1:12), whereby each twelve shares of the company's issued and
outstanding common stock was automatically converted into one share of new
common stock. The percentage of the Company's stock owned by each shareholder
remained the same. No fractional shares were issued, and instead, the Company's
transfer agent aggregated and sold any fractional shares on the open market and
distributed the pro rata share of the cash proceeds to the holders of fractional
share interests.
The reverse split has been retroactively reflected in these financial
statements.
In conjunction with the reverse split, the authorized shares of common
stock were reduced from 200 million to 25 million as of October 31, 2003.
Increase in authorized shares of common stock in conjunction with the annual
meeting of the shareholders held on June 26, 2004. The authorized shares of
common stock were increased from 25 million to 40 million.
Disclosure About Fair Value of Financial Instruments
The Company has financial instruments, none of which are held for trading
purposes. The Company estimates that the fair value of all financial instruments
at December 31, 2004 and 2003, as defined in FASB 107, does not differ
materially from the aggregate carrying values of its financial instruments
recorded in the accompanying balance sheet. The estimated fair value amounts
have been determined by the Company using available market information and
appropriate valuation methodologies. However, the fair value of payables to
related parties and notes payable to related party cannot be determined due to
their related party nature. In addition, it is impractical for the Company to
estimate the fair value of the convertible debentures because a market for such
debentures does not readily exist. Considerable judgment is required in
interpreting market data to develop the estimates of fair value, and
accordingly, the estimates are not necessarily indicative of the amounts that
the Company could realize in a current market exchange.
F-12
Concentration of Risk - Financial Instruments
Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of Cash and Cash Equivalents.
The Company places its excess cash in reputable federally insured financial
institutions and in high quality money market fund deposits. Money market fund
deposits ($210,428 on deposit with one bank at December 31, 2004) are subject to
market fluctuations and there is no guarantee as to their ultimate value.
Reclassifications
Certain items in the 2002 and 2003 financial statements have been
reclassified to conform to the 2004 presentation.
Cash and Cash Equivalents
Cash and cash equivalents include cash, funds invested in money market
funds and cash invested temporarily in various instruments with maturities of
three months or less at the time of purchase. The money market fund deposits
have an investment objective to provide high current income to the extent
consistent with the preservation of capital and the maintenance of liquidity
and, therefore, are subject to minimal risk.
Restricted Cash
As of December 31, 2004, the Company had no restrictions on its cash.
Prepaid Expenses and Other Current Assets
The following is a summary of prepaid expenses and other current assets at
December 31:
2004 2003
----------------------
Recoverable foreign taxes - VAT ...................... $ -0- $158,491
Prepaid expenses and other current assets ............ 83,583 165,189
Receivable on sale of equipment....................... 78,009 -0-
Related party receivable.............................. 12,875 -0-
Retainer for financing................................ 27,000 -0-
----------------------
Total Prepaid Expenses and Other Current Assets ...... $201,467 $323,680
======================
Evaluation of Long-Lived Assets
The Company evaluates the recoverability of long-lived assets whenever
events or changes in circumstances indicate that the carrying value of an asset
may not be recoverable. If there is an indication that the carrying value of a
long-lived asset may not be recoverable and the estimated future cash flows
(undiscounted and without interest charges) from the use of the asset are less
than the carrying value, a write-down is recorded to reduce the related asset to
its estimated fair value (see Property and Equipment).
Property and Equipment and Equipment Held for Sale
Property and equipment are carried at cost. Depreciation and amortization
is provided for using the straight-line method for financial reporting purposes
based upon the estimated useful lives of the assets, which range from three to
seven years. The cost of assets sold or retired and the related amounts of
accumulated depreciation are eliminated from the accounts and the resulting gain
or loss is included in income. As described further below, the Company wrote
down property and equipment related to commercialization of the EarthShell
Packaging products technology by $4.0 million in 2003 and $9.8 million in 2002.
The impairment charges were expensed to "Other research and development" in the
accompanying Statements of Operations.
The cost and accumulated depreciation of property and equipment and
equipment held for sale at December 31, 2004 were as follows:
F-13
2004 2003
--------------------------
Property and Equipment
Product Development Center ..................... $ -0- $ 1,175,394
Office Furniture and Equipment ................. 245,274 356,339
--------------------------
Total cost ....................................... 245,274 1,531,733
Less: accumulated depreciation and amortization .. (236,237) (1,469,939)
--------------------------
Property and equipment--net ...................... $ 9,037 $ 61,794
==========================
Equipment held for sale .......................... $ 1 $ 1
==========================
The Company has fully depreciated equipment (original cost of $893,657)
and a commercial production line which are being held for sale. The commercial
production line in Goettingen, Germany was financed and constructed by the
Company for the Company's joint venture (see Investment in Joint Venture) with
Huhtamaki. During 2001, $1.2 million of the Goettingen line was written off to
reflect equipment that had no further application in the product development
cycle. During the third quarter of 2002 the Company concluded, after obtaining
quotations from various machinery suppliers for an identical line, that $1.7
million of the cost of the line will not be recoverable and therefore the
carrying value of the line was written down by this amount, of which $1.6
million was recorded in the third quarter of 2002 and the remaining $0.1 million
was recorded in the fourth quarter of 2002. At December 31, 2003, the Company
was negotiating to sell the line to a party who would become a licensee with
rights to produce foodservice disposables. However, because the Company was
unable to determine with certainty the proceeds that will be realized upon sale
of the equipment, the Company wrote the line down to $1 as of December 31, 2003
and reclassified it to the long-term asset account "Equipment held for sale."
The $4.0 million impairment charge was expensed to "Other research and
development" in the accompanying Statements of Operations. If the equipment is
sold, the Company will record a gain equal to the proceeds received for the
equipment.
As the Company sold non-essential machine shop equipment and excess office
furniture and equipment in 2003 and 2004, the related cost and accumulated
depreciation were removed from the applicable asset account and accumulated
depreciation, respectively.
Investment in Joint Venture
On May 24, 1999, the Company entered into a joint venture agreement with
Huhtamaki to commercialize EarthShell Packaging throughout Europe, Australia,
New Zealand, and, on a country by country basis, Asia. The Company and Huhtamaki
formed Polarcup EarthShell ApS ("PolarCup"), a Danish holding company, for the
purpose of establishing operating companies to manufacture, market, sell and
distribute EarthShell Packaging.
The Company contributed approximately 10,000 Euros as nominal share
capital and 500,000 Euros for start-up capital. The Company paid for the
development of the initial commercial production line to be located at the
Huhtamaki facility at Goettingen, Germany (see Property and Equipment). In
January 2004, the Company announced the conclusion of its joint venture
structure with Huhtamaki. During 2003 and 2002 the Company recorded its equity
in the losses of the joint venture of $392,117 and $20,263 respectively,
including the write off of its remaining investment as of December 31, 2003.
Related Party Transactions
In connection with the formation of the Company, the Company entered into
a License Agreement (the "License Agreement") with EKI, a stockholder of the
Company. Pursuant to the license agreement, as amended, the Company has an
exclusive, worldwide, royalty-free license to use and license the EKI technology
to manufacture and sell disposable, single-use containers for packaging or
serving food or beverages intended for consumption within a short period of time
(less than 24 hours) and to use certain trademarks owned by EKI in connection
with the products covered under the License Agreement. The license continues to
be in effect during the life of the patents licensed under the License Agreement
covering the technologies. Patents currently issued do not begin to expire until
2012 and provide some protection through 2020. Pending patents, if granted,
would extend protection through 2022. On July 29, 2002, the License Agreement
was amended to expand the field of use for the EarthShell technology to include
noodle bowls used for packaging instant noodles. The Company will pay to EKI 50%
of any royalty or other consideration it receives in connection with the sale of
products within this particular field of use. In addition, on July 29, 2002 the
Company entered into a License & Information Transfer Agreement with Biotec, a
wholly owned subsidiary of EKI, to utilize the Biotec technology for foodservice
applications, including the food wraps used in foodservice applications (the
"Biotec Agreement"). Effective January 1, 2001, EKI had previously granted to
the Company priority rights to license certain product applications on an
exclusive basis from Biotec in consideration for the Company's payment of a
$100,000 monthly licensing fee to Biotec. In addition, in consideration of the
monthly payment, Biotec agreed to render technical services to the Company at
Biotec's cost plus 5%. The licensing fee and services arrangements were
continued in the Biotec Agreement. Under the terms of the Biotec Agreement,
Biotec is entitled to receive 25% of any royalties or other consideration that
the Company receives in connection with the sale of products utilizing the
Biotec technology. As part of the convertible debenture financing completed in
March 2003 (see Convertible Debentures), payment of amounts due to EKI under the
License Agreement or the Biotec Agreement were subordinated to the 2006
Debentures with strict covenants governing their repayment. However, any amounts
deferred pursuant to this subordination requirement shall accrue interest at the
rate of 10% per annum until paid. For the years ended December 31, 2004, 2003,
and 2002, the Company paid or accrued to EKI $800,000, $1,312,374, and
$1,488,070 , respectively, under the License Agreement and Biotec Agreement,
consisting of the $100,000 per month licensing fee, materials and services
provided by EKI, which vary based on the Company's given requirements, and
interest payable on outstanding balances.
F-14
In September of 2004, as part of an overall restructuring of its debt,
EarthShell entered into an agreement with Biotec to convert $1.475 million of
the $2.475 million of accrued license fees owing to Biotec as of September 1,
2004, plus accrued interest into 491,778 shares of EarthShell common stock and
to eliminate, for two years, the $100,000 per month minimum license fee. In
December of 2004, EarthShell paid to Biotec $125,000. Subsequent to December 31,
2004, leaving a balance of $875,000.
In connection with the settlement of the March 2006 Debentures in October
of 2004, EKI converted all of its outstanding loans to EarthShell ($2,755,000)
into unregistered common stock at $3 per share and converted $532,644 of
accumulated interest into unregistered common stock at $4 per share for a total
of 1,051,494 shares received by EKI.
In September 2004, the Company hired an executive assistant who supports
both EKI and Company executives. The Company pays the salary and benefits of the
executive assistant and charges EKI for the portion of her time that was spent
supporting EKI executives. Through December 31, 2004, the Company invoiced EKI
$12,875 for such support services.
In May 2004, the Company sold non-essential machine shop equipment and
excess office furniture and equipment with a net book value of approximately
$19,122 to EKI for $78,409.
On September 22, 2004, Simon K. Hodson, Chief Executive Officer of the
Company, loaned $50,000 to the Company on a short-term basis at an annual
interest rate of 7%, and on September 29, 2004 Mr. Hodson loaned the Company an
additional $86,000. During the fourth quarter of 2004, the Company repaid both
short-term loans.
Accounts Payable and Accrued Expenses
The following is a summary of accounts payable and accrued expenses at
December 31:
2004 2003
-------------------------
Accounts payable and other accrued expenses ...... $2,830,204 $3,516,736
Deferred officer compensation .................... 298,194 -0-
Accrued property taxes ........................... 112,159 655,000
Accrued salaries, wages and benefits ............. 258,691 338,402
Accrued legal fees ............................... 400,278 343,275
-------------------------
Total Accounts Payable and Accrued Expenses ...... $3,899,526 $4,853,413
=========================
Convertible Debentures
On August 12, 2002, the Company issued $10.0 million in aggregate
principal amount of the 2007 Debentures to institutional investors. These
debentures bore interest at a rate of 1.5% per annum, payable quarterly in
arrears on each January 31, April 30, July 31 and October 31. The holders of
these debentures had the right to convert the debentures into the Company's
common stock at an initial conversion price of $15.60 per share, which was
reduced to $8.40 per share in November 2002 and then to $6.00 per share in March
2003 as a result of anti-dilution adjustments. Based on the conversion price
relative to the fair market value of the common stock at the date of issue, the
debentures were deemed to have no beneficial conversion feature. In March 2003,
the conversion price of the 2007 Debentures was adjusted downward, resulting in
a beneficial conversion charge of $360,000 that is included in Other interest
expense in the Statements of Operations. During the third quarter of 2002, the
Company forced conversion of $1.0 million principal amount of the debentures for
168,696 shares of common stock, resulting in the release to the Company of $1.0
million of restricted cash. During 2003, the Company forced conversion of an
additional $1.3 million principal amount of the debentures and debenture holders
voluntarily converted $0.5 million principal amount of the debentures, for a
total of 353,985 shares of common stock, resulting in the release to the Company
of $1.8 million of restricted cash.
F-15
In connection with the issuance of the 2007 Debentures, the Company issued
to the debenture holders warrants to purchase 208,333 shares of the Company's
common stock at $14.40 per share. A value of $1,521,046 was ascribed to the
warrants and recorded as an original issue discount based on the Black-Scholes
method of valuation. During 2002, non-cash interest expense of $144,500 and
debenture conversion costs of $320,970 were recognized in the Statements of
Operations to reflect amortization of the original issue discount associated
with the warrants and to reflect the 15% discount to the market price of the
Company's common stock resulting from the forced conversions of the 2007
Debentures. During 2003, non-cash interest expense of $74,927 was recognized in
the Statements of Operations to reflect amortization of the original issue
discount associated with the warrants. In addition, $59,747 of the original
issue discount associated with the debentures voluntarily converted was charged
to additional paid in common capital.
In March 2003, as part of a new convertible debenture financing, the
Company prepaid $5.2 million principal amount of the 2007 Debentures, resulting
in a prepayment penalty of $208,000. The Company also issued to the holders of
the 2007 Debentures, 52,083 shares of common stock, valued at $237,500 based
upon the closing price of the Company's common stock on the Nasdaq SmallCap
Market of $4.56 per share on March 5, 2003. In addition, one of the holders of
the 2007 Debentures exchanged $2.0 million aggregate principal amount of 2007
Debentures for $2.0 million aggregate principal amount of 2006 Debentures and
78,989 shares of common stock valued at approximately $360,000 based upon the
closing price of the Company's common stock of $4.56 per share on March 5, 2003.
In connection with the prepayment and exchange transactions, the Company
incurred cash transaction costs of approximately $296,000, excluding the
prepayment penalty. The Company recognized a $1.7 million loss upon
extinguishment of the 2007 Debentures through the prepayment and exchange. The
exchange of $2.0 million of the 2007 Debentures for 2006 Debentures resulted in
the release to the Company of $2.0 million of restricted cash. There were no
outstanding 2007 Debentures as of December 31, 2003.
On March 5, 2003, the Company issued to a group of institutional investors
416,667 shares of common stock and $10.55 million in aggregate principal amount
of secured convertible debentures due in March 2006 (the "2006 Debentures"), for
which the Company received proceeds of approximately $9.0 million, net of
financing costs of approximately $1.5 million. The 2006 Debentures bore interest
at a rate of 2.0% per annum, payable quarterly in arrears on each January 31,
April 30, July 31 and October 31.
In accordance with Accounting Principles Board Opinion No. 14, "Accounting
for Convertible Debt and Debt Issued with Stock Purchase Warrants," the Company
allocated the net proceeds of $9.0 million to the 2006 Debentures and the common
stock based upon their relative fair values. A discount on the 2006 Debentures
of $3.4 million and a discount on the common stock of $604,000 resulted from the
fair value allocation. Based on the conversion price of the 2006 Debentures
relative to the fair market value for a share of the Company's common stock at
the date of issue, the 2006 Debentures were deemed to have no beneficial
conversion feature.
In addition to the $1.5 million of financing costs, the Company also
incurred approximately $646,000 of non-cash costs attributable to 54,167 shares
of common stock issued to the lead purchaser of the 2006 Debentures and two
warrants issued to a placement agent, both of whom received the instruments as
compensation for their services rendered in connection with the transaction. The
fair value of the 54,167 shares of common stock issued to the lead purchaser was
determined to be $247,000, based on the closing price of $4.56 per share of the
Company's common stock on the Nasdaq SmallCap Market on March 5, 2003. The fair
value of approximately $42,000 of the first of the two warrants issued to the
placement agent, which would expire in March 2006 and was immediately
exercisable by the placement agent to purchase 28,810 shares of the Company's
common stock for $10.08 per share, was estimated using the Black Scholes
option-pricing model and is reflected in the accompanying financial statements
as an increase in additional paid-in capital and as a component of the $4.0
million aggregate discount on the 2006 Debentures and common stock issued in the
March 2003 transaction. The second of the two warrants issued to the placement
agent, which would expire in March 2006, was immediately exercisable by the
placement agent to purchase $1.055 million in aggregate principal amount of the
2006 Debentures and 41,667 shares of the Company's common stock. At September
30, 2003, the Company evaluated the current value of this warrant, considering
the Company's current cash flow projections, continued operating losses, the
prospects of raising additional equity capital, the significant excess of the
conversion price to the current stock price and the volatility in the Company's
stock price. Based upon these factors, the Company determined that the warrant
had no value as of September 31, 2003 and December 31, 2003 and therefore
reduced the balance of the warrant obligation to zero as of September 30, 2003,
resulting in a $0.5 million gain that is reflected in "Other (income) expense"
in the Statements of Operations.
F-16
In 2003, $5.75 million principal amount of the 2006 Debentures was
converted into 958,334 shares of common stock resulting in the approximately
$4.4 million carrying amount of the 2006 Debentures being transferred to common
stock.
At December 31, 2003, the Company was in compliance with all covenants of
the 2006 Debentures. However, on March 8, 2004, the Company's common stock was
delisted from the Nasdaq Smallcap Market because the Company's market
capitalization failed to meet the minimum required standard. In addition, the
Company did not make interest payments related to the 2006 Debentures as
required on January 31, 2004. These actions put the Company in non-compliance
with its covenants under the 2006 Debentures. The Company negotiated with the
various debenture holders to resolve the defaults. From July through October
2004, the Company reach settlements with each of the remaining debenture holders
to retire the entire $6.8 million outstanding at the end of 2003. Taken
together, the debenture holders converted their debenture holdings into
1,149,877 shares of registered stock, received a total of $1.11 million in cash
payments, and received an additional 512,500 shares of unregistered common
stock. One of the debenture holders also received a settlement payable of $2.375
million, which may be converted to common stock at the option of the holder at
$3 per share. This holder also has the right to elect be paid from up to 1/3 of
the proceeds of future equity capital transactions or from up to 1/3 of future
revenues until he has received a total of $2.375 million, less any portion that
has already been converted. As of December 31, 2004, 100% of the outstanding
debentures had been retired, the security interest held by the 2006 Debenture
Holders had been released, and any and all defaults under these debentures had
been waived. Because the $2.375 million settlement payable is payable only from
future proceeds, it is classified on the balance sheet under Current Liabilities
as a Debenture Settlement.
In connection with the March 2003 financing transactions, EKI agreed to
subordinate the repayment of its outstanding loans totaling $2.755 million to
the Company's payment obligations under the 2006 Debentures. In addition, EKI
and Biotec agreed to subordinate certain payments to which they were otherwise
entitled under the Biotec License Agreement (other than their respective
percentages of any royalties received by the Company) to the satisfaction of the
Company's payment obligations under the 2006 Debentures. In consideration for
its willingness to subordinate the payments and advances that are owed to it, in
March 2003 the Company issued to EKI a warrant, expiring in ten years, to
acquire 83,333 shares of the Company's common stock for $6.00 per share. The
fair value of the warrant was estimated to be approximately $303,522 using the
Black-Scholes option pricing model and was recorded as a discount on the
outstanding loans.
Other Long Term Liabilites
The Company has negotiated settlements with a number of its trade payable
vendors comprised of payment plans of up to 36 months. These settlements have
been reclassified on the balance sheet from trade payables to Current Portion of
Settlements for payments due within the current reporting year and Other Long
Term Liabilities for payments due after December 31, 2005. Payments on such
settlements due in 2006 and 2007 total $275,786 and 136,406, respectively.
Commitments
In September 2003, the Company leased 4,000 square feet of office and
research and development space in Santa Barbara, California, under a lease that
expired on December 31, 2003. In January 2004, the lease was extended through
April 2004, and thereafter on a month-to-month basis. The Company's monthly
lease payment with respect to this space was $5,000. In November 2004, the
Company relocated to its current location that it sublets from and shares with
EKI. The Company pays to EKI approximately $4,000 per month for its share of the
rent and common area costs. In addition, the Company leases 3,353 square feet of
office space in Lutherville, Maryland, on a month-to-month basis. The Company's
monthly lease payment with respect to this space is $5,780. Future minimum lease
payments required under these leases as of December 31, 2004 are $0. Rental
expenses for the years ended December 31, 2004, 2003 and 2002 amounted to
165,382, $558,195, and $927,386 respectively.
F-17
The Company is periodically involved in litigation and administrative
proceedings primarily arising in the normal course of its business. In the
opinion of management, the Company's gross liability, if any, and without any
consideration given to the availability of indemnification or insurance
coverage, under any pending or existing litigation or administrative
proceedings, other than those separately addressed above, would not have a
material adverse impact upon the Company's financial statements.
Retirement Benefits
The Company established a qualified 401(k) plan for all of its employees
in 1998. The 401(k) plan allows employees to contribute, on a tax-deferred
basis, up to fifteen percent of their annual base compensation subject to
certain regulatory and plan limitations. The Company uses a discretionary
matching formula that matches one half of the employee's 401(k) deferral up to a
maximum of six percent of annual base compensation. The 401(k) employer match
was $24,311 in 2004, $44,057 in 2003, and $74,853 in 2002.
Stock Options
In 1994 the Company established the EarthShell Corporation 1994 Stock
Option Plan (the "1994 Plan"). In 1995 the Company subsequently established the
EarthShell Corporation 1995 Stock Incentive Plan (the "1995 Plan") which
effectively superseded the 1994 Plan for options issued on or after the date of
the 1995 Plan's adoption. The 1994 and 1995 Plans as amended (the "Plans")
provide that the Company may grant an aggregate number of options for up to
833,333 shares of common stock to employees, directors and other eligible
persons as defined by the Plans. Options issued to date under the Plans
generally vest over varying periods from 0 to 5 years and generally expire 10
years from the date of grant.
Stock option activity for 2004, 2003 and 2002 is as follows:
2004 2003 2002
-----------------------------------------------------------------------------
Weighted- Weighted- Weighted-
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
-----------------------------------------------------------------------------
Outstanding at beginning of year 384,912 $ 38.24 320,924 $ 50.49 231,333 $ 73.44
Granted .................. 762,498 0.78 121,699 4.87 168,811 34.44
Cancelled ................ (92,499) 15.00 (43,748) 34.02 (73,105) 74.52
Expired .................. (11,666) 68.95 (13,963) 42.14 (6,115) 189.24
-----------------------------------------------------------------------------
Outstanding at end of year . 1,043,245 $ 12.58 384,912 $ 38.24 320,924 $ 50.49
=============================================================================
Options exercisable at
year-end ................. 141,162 $ 61.35 155,228 $ 61.70 162,476 $ 63.72
=============================================================================
The following table summarizes information about stock options outstanding at
December 31, 2004:
Options Outstanding Options Exercisable
------------------------------------------------------------------------------------
Number
Outstanding Weighted-Average Number
Exercise At Remaining Weighted-Average Exercisable Weighted-Average
Prices 12/31/04 Contractual Life Exercise Price At 12/31/04 Exercise Price
------------------------------------------------------------------------------------------------
$ 0.75 715,000 9.46 $ 0.75 -- $ --
2.55 12.498 9.57 2.55 6,249 2.55
4.80 83,333 8.72 4.80 -- --
5.64 11,283 3.42 5.64 11,283 5.64
15.00 8,334 1.19 15.00 8,334 15.00
16.68 8,332 2.41 16.68 8,332 16.68
36.00 97,501 7.53 36.00 -- --
44.04 17,979 6.07 44.04 17,979 44.04
45.36 6,249 0.36 45.36 6,249 45.36
45.60 6,249 1.35 45.60 6,249 45.60
60.00 43,750 4.79 60.00 43,750 60.00
91.56 23,471 1.05 91.56 23,471 91.56
182.40 2,183 2.90 182.40 2,183 182.40
252.00 7,083 3.42 252.00 7,083 252.00
------------------------------------------------------------------------------------
1,043,245 8.43 $12.58 141,162 $61.35
=====================================================================================
F-18
The Company accounts for the Plans in accordance with the provisions of
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued
to Employees," and complies with the disclosure provisions of Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock- Based
Compensation." Under APB Opinion No. 25, compensation expense is based on the
difference, if any, on the date of grant, between the fair value of the
Company's common stock and the exercise price of the option. For disclosure
purposes, to measure stock-based compensation in accordance with SFAS No. 123,
"Accounting for Stock-Based Compensation", the fair value of each option grant
is estimated on the date of grant using the Black-Scholes option-pricing model.
The fair value of each option grant will be amortized as pro forma compensation
expense over the vesting period of the options. The following table sets forth
the assumptions used and the pro forma net loss and loss per share resulting
from applying SFAS No. 123:
Year Ended, Year Ended, Year Ended,
December 31, December 31, December 31,
2004 2003 2002
---------------------------------------------------
Net Loss as reported ............................. $ 7,257,101 $ 18,516,741 $ 39,591,344
Deduct: Stock-based employee compensation expense
included in reported net loss, net of tax ...... -- -- --
Add: Total stock-based employee compensation
determined under fair value based method for all
awards, net of tax ............................. 472,267 776,018 2,136,323
---------------------------------------------------
Pro forma net loss ............................... $ 7,729,368 $ 19,292,759 $ 41,727,667
Net loss per common share
As reported .................................... $ 0.48 $ 1.40 $ 3.51
Pro forma ...................................... 0.51 1.45 3.70
Weighted average risk-free interest rate ......... 4.05% 4.53% 4.54%
Weighted average expected life in years .......... 9.5 9.5 9.6
Volatility ....................................... 80% 102% 182%
Weighted average fair value of options granted
during the year ................................ $ 0.64 $ 3.99 $ 11.91
Stock Warrants
In connection with the issuance of the convertible debentures on August
12, 2002 (see Convertible Debentures), the Company issued to the debenture
holders warrants to purchase 208,333 shares of the Company's common stock at
$14.40 per share. A value of $1,521,046 was ascribed to the warrants and
recorded as an original issue discount based on the Black-Scholes method of
valuation. The exercise price and number of common shares issuable upon exercise
of the warrants are subject to adjustment under certain circumstances, such as
the occurrence of stock dividends and splits, distributions of property or
securities other than common stock, equity issuances for less than the warrant
exercise price and a change in control of the Company. In March 2003, in
connection with the issuance of the 2006 Debentures, the exercise price of the
warrants was reduced to $6.00 per share, but the number of shares of common
stock issuable upon exercise remained fixed at 357,143. At the same time, the
warrant agreement was amended such that any subsequent reduction in the exercise
price of the warrants will not result in any increase in the number of shares of
common stock issuable under the warrants. The warrants expire on August 12,
2007.
In connection with the issuance of the convertible debentures in March
2003 (see Convertible Debentures), the Company issued to the placement agent
warrants to purchase $1.055 million in aggregate principal amount of the 2006
Debentures at $1,200 per $1,000 of principal amount, 28,810 shares of the
Company's common stock at $10.08 per share, and 41,667 shares of the Company's
common stock at $7.20 per share. A value of $484,500 was ascribed to the
warrants and recorded as an original issue discount based on the Black-Scholes
method of valuation. The exercise price and number of common shares issuable
upon exercise of the warrants are subject to adjustment under certain
circumstances, such as the occurrence of stock dividends and splits,
distributions of property or securities other than common stock and a change in
control of the Company. The warrants expire in March 2006.
F-19
On March 5, 2003, the Company issued to EKI a warrant to purchase 83,333
shares at $6.00 per share in connection with the subordination of loans of
$2.755 million made to the Company and the elimination of the conversion
feature. The warrants expire on March 4, 2010.
Revenue Recognition Policy
The Company recognizes revenue when persuasive evidence of an arrangement
exists, the price is fixed or readily determinable and collectibility is
probable. The Company recognizes revenue in accordance with Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements," (SAB 101).
EarthShell's revenues consist of technology fees that are recognized ratably
over the life of the related agreements and royalties based on product sales by
licensees that are recognized in the quarter that the licensee reports the
sales.
Income Taxes
Deferred income tax assets and liabilities are computed annually for
differences between the financial statement and income tax bases of assets and
liabilities. Such deferred income tax asset and liability computations are based
on enacted tax laws and rates applicable to periods in which the differences are
expected to reverse. Valuation allowances are established, when necessary, to
reduce deferred income tax assets to the amounts expected to be realized. Income
tax expense is the tax payable or refundable for the period plus or minus the
change during the period in deferred income tax assets and liabilities.
Deferred income taxes result from temporary differences in the recognition
of revenues and expenses for financial and tax reporting purposes. At December
31, 2004 and 2003, deferred income tax assets, which are fully reserved, were
comprised primarily of the following:
2004 2003
--------------------------------
Federal:
Depreciation ............................. $ 1,375,770 $ 6,510,014
Deferred compensation .................... 101,386 1,091,917
Deferred contributions ................... 361,117 361,117
Accrued management fees .................. 272,000 --
Accrued vacation ......................... 87,955 110,415
Other reserves ........................... 22,258 20,945
Capitalized operating expenses ........... -- 3,198,684
Net operating loss carryforward .......... 99,808,790 92,580,034
--------------------------------
$102,029,276 $103,873,126
================================
F-20
The valuation allowance (decreased) increased by $(1,843,850), $8,810,963
and $20,523,501 during the years ended December 31, 2004, 2003, and 2002,
respectively, as a result of changes in the components of the deferred income
tax items.
For federal income tax purposes, the Company has net operating loss
carryforwards of $302,487,919 as of December 31, 2004 that expire through 2024.
For state income tax purposes, the Company has California net operating loss
carryforwards of $64,504,022 as of December 31, 2004 that expire through 2009,
and Maryland net operating loss carryforwards of $120,893,526 that follow the
federal treatment and expire through 2024. Additionally, the ultimate
realizability of net operating losses may be limited by change of control
provision under section 382 of the Internal Revenue Code.
Income tax expense for 2004, 2003, and 2002 consists of the minimum state
franchise tax.
Loss Per Common Share
Basic loss per common share is computed by dividing net loss available to
common stockholders by the weighted-average number of common shares outstanding
during the period, including Common stock to be issued. Diluted loss per common
share is computed by dividing net loss available to common stockholders by the
weighted-average number of common shares outstanding (including Common stock to
be issued) plus an assumed increase in common shares outstanding for potentially
dilutive securities, which consist of options and warrants to acquire common
stock and convertible debentures. Potentially dilutive shares are excluded from
the computation in loss periods, as their effect would be anti-dilutive. The
dilutive effect of options and warrants to acquire common stock is measured
using the treasury stock method. The dilutive effect of convertible debentures
is measured using the if-converted method. Basic and diluted loss per common
share is the same for all periods presented because the impact of potentially
dilutive securities is anti-dilutive.
The dilutive effect of potentially dilutive securities was approximately
3.0 million shares, 900,000 shares, and 39,000 shares for the years ended at
December 31, 2004, 2003 and 2002, respectively.
Subsequent Events
On March 23, 2005, Earthshell Corporation (the "Company"), entered into a
Standby Equity Distribution Agreement with Cornell Capital Partners, LP.
Pursuant to the Standby Equity Distribution Agreement, the Company may, at its
discretion, periodically sell to Cornell Capital Partners, LP shares of common
stock for a total purchase price of up to $10.0 million. For each share of
common stock purchased under the Standby Equity Distribution Agreement, Cornell
Capital Partners LP will pay the Company 98% of the lowest volume weighted
average price of the Company's common stock as quoted by Bloomberg, LP on the
Over-the-Counter Bulletin Board or other principal market on which the Company's
common stock is traded for the 5 days immediately following the notice date. The
price paid by Cornell Capital Partners, LP for the Company's stock shall be
determined as of the date of each individual request for an advance under the
Standby Equity Distribution Agreement. Cornell Capital Partners, LP will also
retain 5% of each advance under the Standby Equity Distribution Agreement.
Cornell Capital Partner's obligation to purchase shares of the Company's common
stock under the Standby Equity Distribution Agreement is subject to certain
conditions, including the Company obtaining an effective registration statement
for shares of common stock sold under the Standby Equity Distribution Agreement
and is limited to $500,000 per weekly advance.
On March 23, 2005, the Company entered into a Security Agreement with
Cornell Capital Partners, LP. Pursuant to the Security Agreement, the Company
shall issue promissory notes to Cornell Capital Partners, LP in the original
principal amount of $2,500,000. The $2,500,000 will be disbursed as follows:
$1,150,000, within three days of the closing of all the transaction documents
with Cornell Capital Partners, LP and $1,350,000, two days prior to the filing
of a registration statement related to Standby Equity Distribution Agreement.
The promissory notes are secured by the assets of the Company and shares of
stock of another entity pledged by an affiliate of that entity. The promissory
notes have a one-year term and accrue interest at 12% per year beginning on the
3rd month anniversary.
In connection with the ESH sub-license, ESH agreed to purchase shares of
the Company's stock, which is planned to occur in conjunction with their scale
up of manufacturing capacity.
In January 2005, the Company entered into an agreement with a non-US based
prospective licensee for a new product family. At such time as the Company
demonstrates the commercial manufacturability of this new product family, the
prospective licensee may take a license on terms substantially similar to its
other licenses.
In February of 2005, the Board of Directors of the Company granted to its
Chairman an option to purchase up to 1 million shares of common stock at $2.30
per share in consideration for his many contributions and support of the Company
since its inception.
F-21
First Second Third Fourth Total Year
-------------------------------------------------------------------
2004
Revenues ................................. $ -- $ 25,000 $ 50,000 $ 62,500 $ 137,500
Related party research and development ... 300,000 300,000 200,000 -- 800,000
Other research and development ........... 222,538 42,913 64,121 40,591 370,163
Other general and administrative ......... 1,173,855 1,071,116 99,162 1,409,769 3,753,902
Net loss common shareholders ............. $ 2,066,857 $ 2,264,383 $ 1,645,931 $ 1,279,930 $ 7,257,101
Basic and diluted loss per common share .. $ 0.15 $ 0.16 $ 0.12 $ 0.07 $ 0.48
Weighted average common shares outstanding 14,128,966 14,128,966 14,223,402 17,659,043 15,046,726
2003
Related party research and development ... $ 353,800 $ 304,667 $ 353,907 $ 300,000 $ 1,312,374
Other research and development ........... 1,896,986 1,707,507 1,287,516 3,342,407 8,234,416
Other general and administrative ......... 1,853,702 1,193,342 1,361,900 1,381,529 5,790,473
Net loss common shareholders ............. $ 6,770,727 $ 3,608,184 $ 2,920,797 $ 5,217,033 $18,516,741
Basic and diluted loss per common share .. $ 0.55 $ 0.28 $ 0.21 $ 0.37 $ 1.40
Weighted average common shares outstanding 12,358,967 13,013,462 13,595,973 14,013,965 13,266,668
F-22