UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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, 2005
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 0-23567
EARTHSHELL CORPORATION
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(Exact name of Registrant as specified in its charter)
Delaware 77-0322379
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1301 York Road, Suite 200
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Lutherville, Maryland 21093
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(Address of principal executive office) (Zip Code)
(410) 847-9420
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(Registrant's telephone number, including area code)
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
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(Title of each class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes [ ] No [X].
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X].
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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
Larger Accelerated Filer [ ] Accelerated Filer [ ] Non-accelerated Filer [X]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act). Yes [ ] No [X]
The aggregate market value of the voting stock held by non-affiliates of the
Registrant as of June 30, 2005 was $31,888,014. The number of shares outstanding
of the Registrant's Common Stock as of March 7, 2006 was 18,981,167.
DOCUMENTS INCORPORATED BY REFERENCE
None
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ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005
PART I....................................................................................................................1
ITEM 1. BUSINESS......................................................................................................1
ITEM 1A. RISK FACTORS..................................................................................................9
ITEM 1B. UNRESOLVED STAFF COMMENTS....................................................................................14
ITEM 2. PROPERTIES...................................................................................................14
ITEM 3. LEGAL PROCEEDINGS............................................................................................14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..........................................................15
PART II..................................................................................................................16
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY RELATED STOCKHOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES...............................................................................16
ITEM 6. SELECTED FINANCIAL DATA......................................................................................17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS........................17
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...................................................28
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.........................28
ITEM 9A. CONTROLS AND PROCEDURES......................................................................................28
ITEM 9B. OTHER INFORMATION............................................................................................28
PART III.................................................................................................................30
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT...........................................................30
ITEM 11. EXECUTIVE COMPENSATION.......................................................................................30
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS...............30
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS...............................................................30
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.......................................................................30
PART IV..................................................................................................................31
ITEM 15. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES.........................................................31
i
PART I
ITEM 1. BUSINESS
The Company
EarthShell Corporation ("EarthShell" or the "Company") was organized in
November 1992 to engage in the commercialization of 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 (collectively, "EarthShell Packaging"). 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 has determined that foodservice disposables made
of this material should offer certain environmental benefits, will have
performance characteristics, such as strength and rigidity, and it believes that
it should be able to commercially produce and sell these products at prices that
are competitive with comparable conventional paper and plastic foodservice
disposables.
The Company's objective is to establish EarthShell Packaging 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.
To date, the Company has licensed the technology to certain carefully
selected partners who are working to commercialize the technology. The Company
currently has three active licensees: one in the United States, one in Mexico
and one in Asia. In cooperation with its licensing partners, more than
50,000,000 units of EarthShell Packaging , including plates, bowls and sandwich
containers have been manufactured and sold to key customers within a variety of
market segments in order to demonstrate commercial product quality, customer
acceptance and demand. The Company has received support for its environmemtal
claims from a number of governmental and non-environmental organizations. In
addition, the Company has worked with a machinery manufacturer who has developed
turn-key manufacturing machinery for EarthShell plates and bowls. The Company's
primary focus is now on supporting its licensee in the United States, Renewable
Products Inc. ("RPI"), who has put in place a commercial production facility and
is commencing manufacturing and distribution operations. In addition, the
Company is supporting its Mexican licensee in acquiring and putting into service
manufacturing capacity to serve the Mexican market. Finally, the Company has
entered into various license agreements with EarthShell Asia, an Asian licensee,
to demonstrate and to exploit a new aspect of the EarthShell technology.
Industry Overview
Based on industry studies, the Company believes that the annual spending
on foodservice disposable packaging is approximately $13 billion in the United
States and over $30 billion globally. According to industry studies of the
market, approximately 54% of the total foodservice disposable packaging is
purchased by quick-service restaurants and 46% by other institutions such as
hospitals, stadiums, airlines, schools, restaurants (other than quick-service
restaurants), and retail stores. The Company believes that of the foodservice
disposables purchased in the United States by quick-service restaurants and
other institutions, approximately 45% are made of coated or plastic laminated
paper and 55% are made of non-paper materials such as plastic, polystyrene or
foil. A breakdown of the various components of the global market for foodservice
disposables is as follows:
1
Global Market Size
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$ %
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($ in millions)
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Commercial Products
Plates, Bowls $ 5,700 19
Hinged-Lid Containers 1,800 6
Commercial Prototypes
Wraps 2,000 7
Hot Cups 3,300 11
Concept Prototypes
Cold Cups 5,700 19
Containers, Trays 4,200 13
Straws, Cup Lids 3,300 11
Pizza Boxes 2,000 7
Cutlery 2,000 7
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Total $30,000 100
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In addition to the United States, 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
(EKI), the largest stockholder of the Company. 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: (i) laminated
foamed products, (ii) pellet technology products, (iii) paperboard substitutes
and (iv) flexible wraps. To date, the EarthShell technology has been used to
produce limited commercial quantities of laminated foam 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 United States 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.
2
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 plates, bowls, and hinged lid containers, meet the critical
performance requirements of the marketplace, including strength, graphic
capabilities, insulation, shipping, handling and packaging. Additionally, the
Company believes that its other product families, which are currently under
development, may be manufactured using the same basic raw materials as the foam
laminate disposables and should be readily accepted by the market when
available.
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 Commercialize the plate and bowl project operated at Renewable
Products, Inc. (RPI) and build initial brand awareness and share of
market;
o Accelerate market penetration/sales by current licensees with
shallow draw foam analog, e.g. dinnerware line extensions and other
related items;
o Establish and grow international business opportunities, as well as
development of pellet technology;
o Promote and support additional products with the greatest potential
for near term success: a.) deep draw foam analog products, hot cups
and lids, and b.) injection molded 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.
The Company has entered into new license agreements with RPI in the U.S. market
and EarthShell Hidalgo (ESH) for the Mexican market. In addition, the Company
has entered into an agreement with a new licensee, EarthShell Asia, granting
certain licenses to use a new embodiment of the EarthShell Technology for
various applications in certain Asian territories (the "EA License"). Under the
license agreements, the Company may receive a total of up to $1.7 million from
technology fees, plus an ongoing royalty. Prior to receiving the prepaid
technology fees, the Company must successfully demonstrate the commercial
viability of this new technology for certain applications.
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.
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.
3
Throughout the course of developing the manufacturing processes for
EarthShell Products, the Company worked with an equipment manufacturer, Detroit
Tool and Engineering (DTE), which has developed turn-key manufacturing lines for
EarthShell plates and bowls. One of the Company's more recent licensees,
Renewable Products, Inc. (RPI), has acquired 16 manufacturing modules and is in
the process of obtaining orders and ramping up its manufacturing and
distribution operations. The Company's primary focus is now on supporting its
licensees. 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 2006, EarthShell expects
its products to continue to gain acceptance in the marketplace and believes it
is well positioned 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, sale and distribution 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 to the
product commercialization phase, 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. With the
first turnkey commercial manufacturing equipment successfully 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 the performance of
EarthShell plates, bowls and hinged-lid containers is commercially competitive
and that there is a customer base that is willing to buy them. The Company
intends to promote the use of EarthShell Packaging in the U.S. and international
markets through agreements with additional licensed partners. The following is a
summary of the Company's current sublicensing relationships.
ReNewable Products, Inc. (RPI) The Company entered into the RPI Sublicense
coupled with the RPI Merger Agreement on June 17, 2005. Under these agreements,
EarthShell has granted to RPI the exclusive rights in the U.S. to produce
EarthShell plates, bowls, and other shallow-draw products for certain
distribution channels, including the retail and government market segments. In
return, RPI agreed to invest in excess of $12.0 million and purchase and install
the initial eight commercial modules that had been built by DTE and to order an
additional eight modules. The merger agreement gives RPI the right, ultimately,
to merge with EarthShell at such time as it has invested substantial capital in
building new EarthShell manufacturing capacity and the equipment is operational.
RPI currently has eight manufacturing modules in production and has recently
completed the installation of the additional eight modules. RPI has commenced
manufacturing and distribution operations and is actively selling EarthShell
plates and bowls. The RPI Sublicense requires RPI to pay to the Company a
royalty fee equal to 20% of RPI's net sales, not to exceed 50% of RPI's gross
margin. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Liquidity and Capital Resources."
EarthShell Hidalgo S.A. de C.V. (ESH) In November 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, ESH has paid to the Company a $1.0
million technology fee that will be credited against future royalty obligations.
Under the terms of the ESH License, 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.
4
EarthShell Asia, Limited (EA). On August 22, 2005, the Company entered
into an agreement with EA in connection with the granting of certain licenses to
use a new embodiment of the EarthShell Technology for various applications in
certain Asian territories (the "EA License"). Shortly after executing a letter
agreement, both the Company and EA decided to restructure the transaction. As
part of such restructuring, the Company has received a total of $800,000 from
the sale of 266,667 shares of its common stock and may receive an additional
$1.8 million from a combination of (i) prepaid technology fees (up to $1.7
million) and (ii) $0.1 million from the issuance of 1,033,333 warrants to
purchase shares of the Company's common stock at $3.90 per share. The
realization of the $1.7 million in technology fees is dependent on the Company
successfully demonstrating the commercial viability of its technology in certain
new applications.
Meridian Business Solutions, Ltd. (MBS) On May 13, 2004, the Company
entered into a 10 year license agreement with MBS and granted to MBS a priority
license to supply certain retail and government market segments in the United
States (the "MBS Sublicense") and initially paid EarthShell $0.5 million in
technology fees. On June 8, 2005, the Company entered into a letter agreement
with MBS terminating the MBS Sublicense. At the time the letter agreement was
executed, MBS had not yet implemented the sublicense granted to it under the MBS
Sublicense. The parties separately agreed that the effectiveness of the
termination would be conditioned upon the effectiveness of certain agreements
with RPI. The Company entered into additional sublicense agreements with MBS
covering non-competing technologies in other markets and territories than those
covered by the past MBS Sublicense and the present RPI Sublicense. However, the
effectiveness of such sublicense agreements was expressly conditioned upon the
satisfaction of certain conditions before July 31, 2005, including the receipt
by the Company of $2.6 million in technology fees and other payments. These
agreements expired under their own terms on July 31, 2005.
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. 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.
In prior 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. Having demonstrated the manufacturability of EarthShell
foam products, the Company has now concluded its commercial demonstration
production activities and is relying on its equipment manufacturing partners to
demonstrate and guarantee the long-term manufacturability of EarthShell
Packaging.
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 were sold to RPI and were moved from
DTE's fabrication floor and installed in an adjacent manufacturing facility
leased to RPI that is in close proximity to the fabrication facility. The
Company granted a license agreement to RPI as described above. Subsequently, RPI
ordered an additional 8 modules which have been installed in RPI's facility and
are being readied for operation.
5
Patents, Proprietary Rights And Trademarks
The technology that the Company licenses from EKI is the subject of
numerous issued and pending patents in the United States 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. Currently, EKI has 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 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.
The Company owns the EarthShell trademark and certain other associated
trademarks, and has been licensed by EKI to use the trademark ALI-ITE for the
composite material.
Relationship With EKI
The Company has an exclusive, worldwide, royalty-free license in
perpetuity to use and license 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 twenty-four hours). Mr.
Essam Khashoggi, Chairman of EKI, served as our Company's Chairman of the Board
of Directors since its organization in November 1992 through July 2005 when he
retired and resigned from the Board of Directors. Mr. Khashoggi, personally and
through affiliated entities, currently beneficially owns 7,933,603 shares of the
Company's common stock, which represents approximately 31.79% of the shares
outstanding as of December 31, 2005. On July 29, 2002, the Company entered into
an amendment to its previously Amended and Restated License Agreement with EKI
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 nominal 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.
Summary of EKI Agreements. During 2002 and January 2003, EKI made a series
of working capital loans (the "EKI Simple Interest Loans") to the Company
totaling approximately $5.8 million. The Simple Interest Loans were interest
bearing at a rate of seven percent or ten percent per annum, and were payable on
demand. In connection with the issuance and sale in March 2003 of the Company's
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 the Biotec Group agreed to subordinate certain payments
discussed below to which they were otherwise entitled under the EKI License
Agreement and the Biotec License Agreement 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 EKI License Agreement
or the Biotec License Agreement until such time as the Company's obligations
under the 2006 Debentures were satisfied in full. EKI and the Biotec Group also
agreed to allow the Company to pledge its interest in the EKI License Agreement
to secure its obligations under the 2006 Debentures, and certain additional
concessions were made by EKI and the Biotec Group to permit the Company greater
flexibility in selling its rights under the EKI License Agreement and the Biotec
License 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.
As part of the 2006 Debenture Settlements that EKI helped negotiate and
settle, EKI purchased the debentures for $1.0 million. On September 30, 2004,
EKI entered into an agreement with EarthShell to sell back to the Company the
2006 Debentures it had purchased for $1.0 million in cash, the cash price
originally paid by EKI. The Company retired the 2006 Debentures shortly
thereafter.
In October 2004, in connection with the settlement of the 2006 Debentures,
EKI converted all of its then outstanding loans to EarthShell ($2,755,000) into
unregistered common stock at $3.00 per share and $0.53 million of accumulated
interest at $4.00 per share for a total of 1,051,494 shares received by EKI.
These shares are not subject to registration rights. As of December 31, 2004,
the loans from EKI to EarthShell had all been retired.
6
In May of 2005, an additional 44,387 shares were issued to EKI pursuant to
a 90 day price protection provision, which provided for an adjustment in the
effective conversion price of the interest portions of the Simple Interest Loans
from $4.00 per share to $3.00 per share. The Company also granted a ten year
warrant to EKI to purchase one million shares of the Company's common stock at
$3.00 per share in consideration of EKI's continued support of the Company since
its inception, including providing bridge loans at below market terms from time
to time. This warrant was cancelled and subsequently a new warrant with similar
terms was reissued in August 2005 to Essam Khashoggi, beneficial owner of EKI.
On October 11, 2005, the Company entered into a loan arrangement (the
"2005 EKI Loan") with EKI pursuant to which the Company issued to EKI a
promissory note in the principal amount of $1.0 million. As of December 31,
2005, EKI had advanced $0.85 million with the balance being funded by the second
week of January 2006. Interest accrues on the principal balance of the 2005 EKI
Loan at a variable per annum rate, as of any date of determination, that is
equal to the rate published in the "Money Rates" section of The Wall Street
Journal as being the "Prime Rate", compounded monthly. All accrued but unpaid
interest and outstanding principal is due and payable on the earliest to occur
of the following: (i) the second anniversary of the date of the EKI Loan; (ii)
five days following the date the Company has received $3.0 million or more in
aggregate net cash proceeds from all financing transactions, equity
contributions, and transactions relating to the sale, licensing, sublicensing or
disposition of assets or the provision of services (including advance royalty
payments, proceeds from the sale of the Company's common stock and fees for
technological services rendered to third parties), measured from the date of the
EKI Loan and not taking into account the proceeds advanced under the EKI Loan;
or (iii) the occurrence of an Event of Default (as defined in the 2005 EKI
Loan).
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, the $100,000 per month minimum license fee. In December of 2004,
EarthShell paid to Biotec $125,000, leaving a balance of $875,000 as of December
31, 2004. During 2005, the balance was further reduced to $837,145 and assigned
to EKI. Also on October 11, 2005, the Company entered into the Debt Conversion
Agreement with EKI, pursuant to which the Company and EKI agreed that a payable
in an amount equal to $837,146 (previously owed to the Biotec Group but
subsequently assigned to EKI) be converted into 279,048 shares of common stock
of the Company. The conversion price equaled $3.00 per share. Pursuant to the
Debt Conversion Agreement, the Company and EKI released each other from any and
all claims in connection with the payable.
Under the terms of the EKI License Agreement and an amended and restated
Patent Agreement for the Allocation of Patent Costs by and between the Company
and EKI, EarthShell has the obligation to pay the patent prosecution and
maintenance costs for those patents which i) "directly relate to" its field of
use, and which ii) "primarily benefit" EarthShell. 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 EKI License Agreement with EKI and continues
to pay directly all relevant costs.
See Notes to Consolidated Financial Statements - Related Party
Transactions for a further discussion of the relationship with EKI and other
related party matters.
Biotec License Agreement. On July 29, 2002 the Company entered into a
license and information transfer agreement (the "Biotech License Agreement")
with bio-tec Biologische Naturverpackungen GmbH & Co. KG and bio-tec Biologische
Naturverpackungen Forschungs und Entwicklungs GmbH (the "Biotec Group") to
utilize the Biotec Group technology for foodservice disposable packaging
applications. EKI had previously granted to the Company priority rights to
license certain product applications on an exclusive basis from the Biotec Group
in consideration for the Company's payment of a $100,000 minimum monthly payment
to Biotec. In addition, in consideration for the monthly payment, the Biotec
Group agreed to render technical services to the Company at the Biotec Group's
cost plus five percent . The licensing fee and services arrangements were
continued in the Biotec License Agreement. Under the terms of the Biotec License
Agreement, the Biotec Group was entitled to receive 25% percent of any royalties
or other consideration that the Company receives in connection with the sale of
products utilizing the Biotec Group technology, after applying a credit for all
minimum monthly payments received. In connection with the issuance of the 2006
Debentures, the Biotec Group agreed to subordinate the licensee fee payments due
from EarthShell until the debentures were retired. During this period, the
license fees due to the Biotec Group were accrued.
7
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, the
amended Biotec License Agreement was further amended and EarthShell paid to
Biotech $125,000, leaving a balance owing of approximately $875,000, which was
subsequently reduced to approximately $837,000. On August 31, 2005, in
connection with the sale of Biotec by EKI, Biotec License Agreement was again
amended and restated (the "Amended and Restated Biotec License") and the minimum
monthly payment to retain exclusivity was completely eliminated and the balance
of approximately $837,000 owing to EarthShell was assigned by the Biotec Group
to EKI. Under the Amended and Restated Biotec License, the Company has a fully
paid up license to use the Biotec technology in the EarthShell fields of use,
with certain limited exclusions, exclusively through June 2008. The Company can
maintain its exclusivity provided it has been successful in commercializing the
Biotec technology and is making certain minimum royalty payments under the
license by June 2008. As of October 11, 2005, the Company has paid to the Biotec
Group $125,000 in cash, has converted approximately $1.475 million into 491,778
shares of unregistered stock, and has assigned the balance owing to the Biotec
Group of $837,000 to EKI. The $837,000 balance was ultimately converted by EKI
in October 2005 into shares of EarthShell common stock at $3.00 per share (see
"Relationship with EKI" above).
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.
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 the patents it licenses from EKI uniquely position the Company
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.
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, 2006, the Company had six employees. The Company's
employees are not represented by a labor union, and the Company believes it has
a good relationship with its employees.
8
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 100 F Street, NE, 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.
ITEM 1A. RISK FACTORS
Our business, results of operations and financial condition are subject to
a number of risks, including the risks set forth below. You should carefully
consider these risks. Additional risks and uncertainties, including those that
are not yet identified or that we currently think are insignificant, may also
adversely affect our business, results of operations and financial condition.
Our obligations under the December Debentures are secured by substantially all
of our Assets which could cause our operations to cease if we default.
Our obligations under the $4.5 million of secured convertible debentures
(the "December Debentures"), issued to Cornell Capital Partners on December 30,
2005 are secured by substantially all of our assets. As a result, if we default
under the terms of the December Debentures, Cornell Capital Partners could
foreclose its security interest and liquidate substantially all of our assets.
This would cause us to cease operations.
We have a limited operating history upon which you can evaluate our business.
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. The Company may not be successful in
addressing such risks. The limited operating history of the Company makes the
prediction of future results of operations difficult or impossible. To date,
production volumes of EarthShell Packaging products have been low relative to
intended and necessary capacity of the manufacturing lines.
The initial plates, bowls, and sandwich containers to be sold commercially
were produced on lab equipment, pilot machinery, or first generation commercial
equipment. Although we have produced and sold 40-50 million pieces, the
commercial equipment envisioned by the Company that will allow for the
manufacturing to be done profitably needed to be operated at higher speeds and
good part throughput rates than was experienced during the early stages of
production. Ultimately the Company discontinued production using the pilot and
first generation equipment to allow Detroit Tool and Engineering Company ("DTE")
to finish the machinery development to achieve the commercial levels of quality
and throughput.
As of December 31, 2005, the first modules of DTE equipment have been
purchased by ReNewable Products, Inc. ("RPI"), as EarthShell's U.S. licensee,
and are operational at commercial throughput rates. Production and distribution
has begun and commercial quality product is beginning to be re-introduced into
the market.
The success of future operations depends upon the ability of RPI and other
licensees to manufacture and sell EarthShell Packaging Products in sufficient
quantities so as to be commercially feasible and then to distribute and sell
those products at competitive prices. Consistent commercially feasible
production volumes had not been achieved and assured competitive price figures
had not yet been fully proven as of December 31, 2005. As a result of the
foregoing factors, the Company expects to incur losses for at least the next 12
months and, depending on the success of the Company's products and services in
the marketplace, for potentially an even longer period.
We have a working capital deficit, which means that our current assets at
December 31, 2005 were not sufficient to satisfy our current liabilities on that
date
9
For the year ended December 31, 2004, the Company had reported operating
revenues of $0.1 million and aggregate net losses of approximately $7.3 million.
In addition, for the year ended December 31, 2005, the Company had reported
operating revenues of $0.2 million and an aggregate net loss of approximately
$6.2 million. Although the Company hopes to achieve break-even cash flow by the
end of 2006, the Company does not expect to operate profitably during the
current fiscal year. Although the Company is actively seeking equity financing
to restructure the debt on its balance sheets and to meet its operating and
capital needs, additional funding may not 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 the Company is unable to obtain such additional capital, the
Company may be required to reduce the scope of its anticipated expansion, which
could adversely affect the Company's business, financial condition and results
of operations or cease operations.
We are the subject of a "Going Concern" Opinion from our Independent Auditors
The condensed 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 $11,458,467 at December 31, 2005. These factors,
along with others, raise substantial doubt as to whether the Company will be
able to continue as a going concern for a period of twelve months or less. The
Company will have to raise additional funds to meet its current obligations and
to cover operating expenses through the year ending December 31, 2006. If the
Company is not successful in raising additional capital, it may not be able to
continue as a going concern for a period of twelve months or less.
On August 22, 2005, the Company entered into an agreement with EarthShell
Asia (EA) in connection with the granting of certain licenses to use EarthShell
Technology for various applications in certain Asian territories (the "EA
License"). Shortly after executing a letter agreement, both the Company and EA
entered into negotiations to restructure the transaction and ultimately entered
into an amended and restated letter agreement dated December 9, 2005. As part of
such restructuring, the Company may receive a total of up to $2.6 million from a
combination of (i) prepaid technology fees (up to $1.7 million), (ii) the sale
of up to 266,667 shares of its common stock and (iii) the issuance of 1,033,333
warrants to purchase shares of the Company's common stock at $3.90 per share,
which, under certain circumstances, may be adjusted to an exercise price of not
less than $3.00 per share. The realization of the full potential of the
transaction is dependent on the Company successfully demonstrating the
commercial viability of its technology in certain new applications. The Company
received $0.5 million from EA as an initial partial payment and agreed to issue
166,667 shares of its common stock in connection with this payment. The Company
received an additional $0.3 million in December 2005 and $0.1 million in
February 2006 pursuant to the amended and restated agreement with EA dated
December 9, 2005, but which was not effective until February 10, 2006 when the
final cash payment was received. Under the amended and restated agreement, upon
receipt of the final payment, the Company issued a total of 266,667 shares and
the warrants to purchase the 1,033,333 shares.
On October 11, 2005, EKI entered into an agreement with the Company to advance
to it up to $1.0 million under the 2005 EKI Loan. On December 30, 2005, the
Company entered into a Purchase Agreement with Cornell Capital Partners whereby
the Company received aggregate proceeds of $4.5 million on January 6, 2006 from
the sale of the convertible debentures. Of the aggregate proceeds, approximately
$2.6 million were used to payoff the existing $2.5 million promissory note to
Cornell Capital Partners and others. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations." Additional financing may not
be available to the Company, or, if available, the terms may not be satisfactory
or if we may not receive any further technology fee payments in 2006 pursuant to
its sublicense agreements. Management also plans to continue in its efforts to
minimize expenses, but it may not be able to reduce expenses below current
levels. The condensed 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.
Management has identified the following material weaknesses in the
Company's internal controls over financial reporting:
o The Company has inadequate segregation of critical duties within
each of its accounting processes and a lack of sufficient monitoring
controls over these processes to mitigate this risk. The
responsibilities assigned to one employee include maintaining the
vendor master file, processing payables, creating and voiding
checks, reconciling bank accounts, making bank deposits and
processing payroll.
o There are weaknesses in the Company's information technology
controls which makes the Company's financial data vulnerable to
error or fraud. Specifically, there is a lack of documentation
regarding the roles and responsibilities of the IT function, lack of
security management and monitoring and inadequate segregation of
duties involving IT functions.
10
The departure of the Company's Controller in November 2004 resulted in the
accounting and reporting functions being centralized under the Chief Financial
Officer, with no additional personnel in the Company having an adequate
knowledge of accounting principles and practices throughout most of 2005. In
addition, the Company relocated its headquarters and accounting systems from
Santa Barbara, CA to Lutherville, MD in late 2005. As a result, some
transactions were not recorded in a timely manner and adjustments to the
financial statements were recorded that were considered material to the
financial position at December 31, 2005 and results of operations for the year
then ended.
The Company has begun taking remediation steps to enhance its internal
control over financial reporting and reduce control deficiencies in general,
including the material weaknesses enumerated above. In the 4th Quarter 2005, the
Company employed a new Controller, CPA, with 15 years' experience in public and
private accounting. The new Controller is in the process of developing revised
accounting systems and procedures that will strengthen the Company's controls
over financial reporting. The Company anticipates hiring an additional
accounting employee as resources become available.
We need additional capital to finance our operating deficit and to fund capital
requirements.
For the year ended December 31, 2005, the Company had reported operating
revenues of $0.2 million and aggregate net losses of approximately $6.2 million.
Although the Company hopes to achieve break-even cash flow by the end of 2006,
the Company does not expect to operate profitably during this fiscal year.
Although the Company is actively seeking equity financing to restructure the
debt on its balance sheets and to meet its operating and capital needs,
additional funding may not 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
the Company is unable to obtain such additional capital, the Company may be
required to reduce the scope of its anticipated expansion, which could adversely
affect the Company's business, financial condition and results of operations or
cease operations.
Our Common Stock is deemed to be a "Penny Stock," which may make it more
difficult for stockholders to sell their shares
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.
We are dependent on our licensees, which could have a material adverse effect on
our business
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, which could have an
adverse affect on our business.
We have not yet fully evaluated all of the EarthShell Packaging products and it
is possible that some of the products may not perform as well as conventional
products
Although we believe that we can engineer EarthShell Packaging products to
meet many of the critical performance requirements for specific applications,
individual products may not perform as well as conventional foodservice
disposables; for example, some consumers may prefer clear cups and clear lids on
take-home containers which are not available with our foam technology. We are
still developing many of our EarthShell Packaging products and we have not yet
evaluated the performance of all of them. If we fail to develop EarthShell
Packaging products that perform comparably to conventional foodservice
disposables, this could cause consumers to prefer our competitors' products.
11
Established manufacturers in the foodservice disposables industry could improve
their ability to recycle their existing products or develop new environmentally
preferable disposable foodservice containers, which could render our technology
obsolete and could negatively impact our ability to compete
Competition among existing food and beverage container manufacturers in
the foodservice industry is intense. Virtually all of the key participants in
the industry have substantially greater financial and marketing resources at
their disposal than we do, and many have well-established supply, production and
distribution relationships and channels. Companies producing competitive
products utilizing competitive materials 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 products. In
addition, some of the Company's licensees and joint venture partners manufacture
paper, plastic or foil packaging that may compete with EarthShell Packaging
products. 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. We
expect that many existing packaging manufacturers may actively seek competitive
alternatives to our products and processes. The development of competitive,
environmentally attractive, disposable foodservice packaging, whether or not
based on our products and technology, could render our technology obsolete and
could impair our ability to compete, which would have an adverse effect on our
business, financial condition and results of operations.
Our anticipated international revenues are subject to risks inherent in
international business activities
We expect sales of our products and services in foreign countries to
account for a material portion of our revenues. These sales are subject to risks
inherent in international business activities, including:
o any adverse change in the political or economic environments in
these countries;
o economic instability;
o any adverse change in tax, tariff and trade or other regulations;
o the absence or significant lack of legal protection for intellectual
property rights;
o exposure to exchange rate risk for revenues which are denominated in
currencies other than U.S. dollars; and
o difficulties in managing joint venture businesses spread over
various jurisdictions.
Our revenues could be substantially less than we expect if these risks
affect our ability to successfully sell our products in the international
market.
Our products may be perceived poorly by customers and/or environmental groups,
which could have an adverse affect on our business
Our success depends substantially on our ability to design and develop
foodservice disposables that are not as harmful to the environment as
conventional disposable foodservice containers made from paper, plastic and
polystyrene. EarthShell has used a life cycle inventory methodology in its
environmental assessment of EarthShell Packaging products and in the development
of associated environmental claims, and we have received support for the
EarthShell concept from a number of environmental groups. Although we believe
that EarthShell Packaging products offer several environmental advantages over
conventional packaging products, our products may also possess characteristics
that consumers or some environmental groups could perceive as negative for the
environment. In particular, EarthShell Packaging products may result in more
solid waste by weight and, in a dry environment, by volume, and manufacturing
them may release greater amounts of some pollutants and lesser amounts of other
pollutants than occurs with conventional packaging. Whether, on balance,
EarthShell Packaging products are better for the environment than conventional
packaging products is a somewhat subjective judgment. Environmental groups,
regulators, customers or consumers may not agree that present and future
EarthShell Packaging products have an environmental advantage over conventional
packaging.
12
Third parties may infringe the patents that we license, new products that we
develop may not be covered by our licensed patents and we could suffer an
adverse determination in a patent infringement proceeding, which could allow our
competitors to duplicate our products without having incurred the research and
development costs we have incurred and therefore allow them to produce and
market those products more profitably
Our ability to compete effectively with conventional packaging will
depend, in part, on our ability to protect our proprietary rights to the
licensed technology. Although EKI, the largest stockholder of the Company, and
EarthShell endeavor to protect the licensed technology through, among other
things, U.S. and foreign patents, the duration of these patents is limited and
the patents and patent applications licensed to us may not be sufficient to
protect our technology. The patents that EKI obtains and licenses to us may not
be validly held and others may try to circumvent or infringe those patents. We
also rely on trade secrets and proprietary know-how that we try to protect in
part by confidentiality agreements with our licensee manufacturers, proposed
joint venture partners, employees and consultants. These agreements have limited
terms and these agreements may be breached, we may not have adequate remedies
for any breach and our competitors may learn our trade secrets or independently
develop them. It is necessary for us to litigate from time to time to enforce
patents issued or licensed to us, to protect our trade secrets or know-how and
to determine the enforceability, scope and validity of the proprietary rights of
others.
We believe that we own or have the rights to use all of the technology
that we expect to incorporate into EarthShell Packaging products, but an adverse
determination in litigation or infringement proceedings to which we are or may
become a party could subject us to significant liabilities and costs to third
parties or require us to seek licenses from third parties. Although patent and
intellectual property disputes are often settled through licensing or similar
arrangements, costs associated with those arrangements could be substantial and
could include ongoing royalties. Furthermore, we may not obtain the necessary
licenses on satisfactory terms or at all. We could incur substantial costs
attempting to enforce our licensed patents against third party infringement, or
the unauthorized use of our trade secrets and proprietary know-how or in
defending ourselves against claims of infringement by others. Accordingly, if we
suffered an adverse determination in a judicial or administrative proceeding or
failed to obtain necessary licenses, it would prevent us from manufacturing or
licensing others to manufacture some of our products.
Failure of our licensees to produce EarthShell Packaging products profitably on
a commercial scale would adversely affect our ability to compete with
conventional disposable foodservice packagers
Production volumes of EarthShell Packaging products to date have been low
relative to the intended capacity of the various manufacturing lines, and, until
production volumes approach design capacity levels, actual costs and
profitability will not be certain. Since the actual cost of manufacturing
EarthShell Packaging products on a commercial scale has not been fully
demonstrated, they may not be manufactured at a competitive cost. As our
licensees and joint venture partners begin to commercially produce EarthShell
Packaging products, they may encounter unexpected difficulties that cause
production costs to exceed current estimates. The failure to manufacture
EarthShell Packaging products at commercially competitive costs would make it
difficult to compete with other foodservice disposable manufacturers.
Unavailability of raw materials used to manufacture our products, increases in
the price of the raw materials, or the necessity of finding alternative raw
materials to use in our products could delay the introduction and market
acceptance of our products
Although we believe that sufficient quantities of all raw materials used
in EarthShell Packaging products are generally available, if any raw materials
become unavailable, it could delay the commercial introduction and hinder market
acceptance of EarthShell Packaging products. In addition, our licensees and
joint venture partners may become significant consumers of certain key raw
materials such as starch, and if such consumption is substantial in relation to
the available resources, raw material prices may increase which in turn may
increase the cost of EarthShell Packaging products and impair our profitability.
In addition, we may need to seek alternative sources of raw materials or modify
our product formulations if the cost or availability of the raw materials that
we currently use become prohibitive.
If initial purchasers of the EarthShell Packaging products do not purchase
significant quantities, it could delay the introduction and market acceptance of
the products
13
It will be important for our licensees and joint venture partners to
identify and obtain contractual commitments from major customers for substantial
quantities of product. If initial purchasers of our products do not ultimately
purchase significant quantities or continue to purchase on a repeat basis, it
will delay our ability to realize meaningful royalty revenues from sales of
those products.
We do not own the technology necessary to manufacture EarthShell Packaging
EarthShell Packaging is based primarily on patented composite material
technology licensed on an exclusive worldwide basis from EKI, the largest
stockholder of the Company, and to a lesser extent, on a limited exclusive,
worldwide basis from the Biotec Group. The Company does not own the technology
necessary to manufacture EarthShell Packaging and is dependent upon a license
agreement with EKI (the "EKI Licensing 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 EKI License
Agreement with respect to U.S. patents; however, it is possible that steps could
be taken to terminate its rights under the EKI License Agreement with respect to
international patents. EKI is the largest 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 employees of EKI.
Our operations are subject to regulation by the U.S. Food and Drug
Administration
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. However, the FDA may not agree with these conclusions, which could
have a material adverse affect on our business operations.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not Applicable
ITEM 2. PROPERTIES
In November 2005, the Company consolidated its offices to its current
location at 1301 York Road, Suite 200, Lutherville, Maryland 21093. The Company
leases 3,353 square feet of office space on a month to month basis at a rate of
$5,780 per month.
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.
The Company is engaged in settlement discussions with Baltimore County,
Maryland (the "County") related to personal property taxes that are owed to the
County. The County holds a judgment against the Company in the amount of
$963,648 for personal property taxes for the years 1999 through 2005. However,
the amount of the taxes owed was calculated in error by the County. As a result,
the County has offered to reduce to judgment to $92,287 plus accrued interest
pending the Company entering into a satisfactory payment plan with the County.
The Company believes that it will execute a payment plan with the County by the
2nd quarter of 2006 and have the judgment reduced to the correct amount listed
above.
14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
15
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.
Quarterly Prices
-----------------------------------------------------------------------------
First Second Third Fourth Total Year
----- ------ ----- ------ ----------
2005
Market price per common share
High ...................... $2.52 $3.20 $2.96 $2.50 $ 3.20
Low ....................... 1.49 1.65 1.78 1.74 1.49
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
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
February 9, 2006 was 1,195. At March 24, 2006, Mr. Essam Khashoggi, directly or
indirectly, owned approximately 31.79% of the outstanding common stock of the
Company.
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.
The Company's ability to pay cash dividends is restricted under certain debt
obligations to which the Company is a party.
Recent Sales of Unregistered Securities
(1) In March 2005, EarthShell issued 143,550 shares of its common stock to
Cornell Capital Partners in connection with a financing transaction.
(2) In March 2005, EarthShell issued 6,450 shares of its common stock to
Sloan Securities Corporation in connection with services provided pursuant a
financing transaction with Cornell Capital Partners.
(3) In March 2005, EarthShell issued 6,450 shares of its common stock to
Crown Investment Banking, Inc. in consideration of the services rendered by
Crown in connection the Company obtaining financing.
(4) In May 2005, EarthShell issued 44,387 shares of its common stock to
EKI in conversion of interest due on a prior note payable to EKI.
(5) In October 2005, the Company issued 279,048 shares of its common stock
to EKI pursuant to a Debt Conversion and Mutual Release Agreement.
(6) In December 2005, in connection with a stock purchase agreement with
EarthShell Asia dated August 22, 2005, which was subsequently amended and
restated, the Company issued 266,667 shares of its common stock. The shares were
issued to and are held by various principals of EarthShell Asia as follows: Mr.
Ying Wang received 83,333 shares; Mr. Monty Waltz received 33,333 shares; Mr.
Greg C. Hoffman received 66,668 shares; and The Steven L. Galvanoni Trust
received 83,333 shares.
16
With respect to the sale of unregistered securities referenced above, all
transactions were exempt from registration pursuant to Section 4(2) of the
Securities Act of 1933, as amended (the "1933 Act"), and Regulation D
promulgated under the 1933 Act. In each instance, the purchaser had access to
sufficient information regarding the Company so as to make an informed
investment decision. More specifically, we had a reasonable basis to believe
that each purchaser was an "accredited investor" as defined in Regulation D of
the 1933 Act and otherwise had the requisite sophistication to make an
investment in our securities.
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
-------------------------------------------------------------
2005 2004 2003 2002 2001
--------- --------- --------- --------- ---------
Statement of Operations Data
Revenues .......................... $ 183 $ 138 $ -- $ -- $ --
Research and development expenses (1) 201 1,170 9,547 26,890 47,148
General and administrative expenses 5,485 3,749 5,786 9,590 9,634
Depreciation and amortization ..... 3 42 380 3,099 5,874
Gain on sale of property and
equipment ....................... (23) (168) (452) (441) --
Interest expense (income), net .... 696 1,068 1,791 132 (356)
Debenture conversion cost ......... -- -- 166 321 --
Net loss .......................... 6,179 7,257 18,517 39,591 62,302
Average shares outstanding ........ 18,503 15,047 13,267 11,277 9,353
Balance Sheet Data
Cash and cash equivalents ......... $ 348 $ 272 $ 1,902 $ 111 $ 828
Working capital (deficit) ....... (11,485) (7,289) (9,438) (8,315) (6,941)
Total assets ...................... 443 483 2,287 18,024 19,886
Total long-term obligations ....... 905 1,475 4,408 -- --
Deficit accumulated during
development stage ............... (321,669) (321,607) (314,351) (295,834) (256,243)
Stockholders' equity (deficit) .... (12,352) (8,755) (12,269) (3,473) 11,536
Shares outstanding ................ 18,981 18,235 14,129 12,055 9,860
Per Common Share
Basic and diluted loss per share .. $ 0.33 $ 0.48 $ 1.40 $ 3.51 $ 6.66
__________
(1) During 1998, the Company entered into a 5 year purchase commitment with a
supplier whereby the supplier would be entitled to a minimum fee of $3.5
million. The fee would be waived if supplier received an aggregate of $70
million in orders over the 5 year period from 1998 through 2003. As of
December 31, 2002, it was apparent that the purchase commitment would not
be met and the Company recorded the liability for the $3.5 million fee and
as a charge to Other Research and Development Expense. However, during the
4th quarter of 2003, the Company was able to negotiate a reduction of the
$3.5 million fee to approximately $1.7 million. Accordingly, the
difference of $1.8 million was recorded as a credit to Other Research and
Development Expense in 2003. See "Commitments" in the Notes to
Consolidated Financial Statements.
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, 2005 and the assets and
liabilities of the Company as of December 31, 2005 and 2004.
17
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.
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 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, 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 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 $0.5 million 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. The
Company has incurred significant losses since inception, has minimal revenues
and has a working capital deficit of $11,458,467 at December 31, 2005. These
factors, along with others, raise substantial doubt as to whether the Company
will be able 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, 2006. If the
Company is not successful in raising additional capital it may not be able to
continue as a going concern. 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 2006 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, or that it will receive any
royalty payments in 2006. 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.
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), as amended by SAB 104. 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.
18
Results of Operations
Year Ended December 31, 2005 Compared with the Year Ended December 31,
2004
The Company's net loss decreased $1.1 million to $6.2 million from $7.3
million for the year ended December 31, 2005 compared to the year ended December
31, 2004, respectively.
Revenues. The Company recorded revenues of $0.2 million for the year ended
December 31, 2005. These revenues reflect amortization of the technology fees
receivable under the sublicense agreements.
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 decreased $1.0 million
to $0.2 million from $1.2 million for the year ended December 31, 2005 compared
to the year ended December 31, 2004, respectively.
o Related party license fee and research and development expenses
decreased $0.8 million to $0 from $.8 million for the year ended
December 31, 2005 compared to the year ended December 31, 2004,
respectively. Prior to 2005, related party license fee and research
and development expenses were comprised a $0.1 million minimum
monthly licensing fee for the use of the EarthShell technology and
for technical services, both of which were payable to EKI, a
principal stockholder of the Company, or Biotec, a wholly-owned
subsidiary of EKI. The minimum monthly licensing fee to Biotec was
terminated in 2004.
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 $0.2 million to
$0.2 million from $0.4 million for the year ended December 31, 2005
compared to the year ended December 31, 2004, respectively. The
reduction is due to the Company focusing its efforts on the
licensing business model whereby licensees and future licensees will
install and run the equipment to produce EarthShell Packaging in
their 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 increased $1.7 million to $5.5 million from $3.8 million
for the year ended December 31, 2005 compared to the year ended December 31,
2004, respectively. This was due to increases in legal fees of $0.2 million,
investor relations fees of $0.6 million, financing costs of $0.2 million,
property taxes of $0.5 million (property taxes had a negative balance in 2004
due to a settlement of back taxes of $0.5 million), and bad debt expense of $0.2
million.
Depreciation and Amortization Expense. Depreciation and amortization
expense decreased $0.039 million to $0.003 million from $0.04 million for the
year ended December 31, 2005 compared to the year ended December 31, 2004,
respectively. The decrease in depreciation expense is attributable to the
continued write-off of discontinued manufacturing and development assets.
Interest Expense. Interest expense is comprised of related party interest
expense and other interest expense.
o Related party interest expense decreased $0.3 million to $0.1
million from $0.4 million for the years ended December 31, 2005 and
2004, respectively. Related party interest expense includes interest
accrued on outstanding loans made to the Company by EKI under the
Loan Agreement (see "Business - Relationship with EKI"), 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 "Business - Relationship with EKI"). During the
third quarter of 2004, agreements were negotiated with EKI to
convert the EKI Simple Interest 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 EKI").
o Other interest expense decreased $0.1 million to $0.6 million from
$0.7 million for the year ended December 31, 2005 compared to the
year ended December 31, 2004, respectively. Other interest expense
for 2005 is primarily comprised of accretion of the discount and
interest accrued on the CCP Notes. Other interest expense for 2004
was primarily comprised of accretion of discount on the 2006
Debentures.
19
Gain on Sale of Property and Equipment. Gain on the sale of property and
equipment decreased $0.18 million to $.02 million from $0.2 million for the year
ended December 31, 2005 compared to the year ended December 31, 2004,
respectively. The gains in both 2005 and 2004 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.
Premium due to Debenture Default. During the year ended December 31, 2004,
the Company accrued $1.7 million in premium due to a default under the 2006
Debentures. See the discussion below.
(Gain) Loss on Extinguishment of Debentures. There was no gain or loss on
extinguishment of debentures for the year ended December 31, 2005 compared to a
gain on extinguishment of debentures of $0.1 million for the year ended December
31, 2004. 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.
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. 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 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.
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 in their own facilities.
20
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.
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 Simple
Interest 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 "Business - Relationship with EKI").
During the third quarter of 2004, agreements were negotiated with
EKI to convert the EKI Simple Interest 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 EKI").
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 of $1.7
million.
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.
21
(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 of $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.
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.
Liquidity and Capital Resources
Cash Flow. The Company's principal uses of cash for the year ended
December 31, 2005 were to fund operations, repay notes, and pay accounts payable
and accrued expenses. Net cash used in operations was $3.4 million and $2.7
million for the years ended December 31, 2005 and 2004, respectively. The uses
for 2005 and 2004 were mainly from losses incurred offset by $2.1 million
increase in accounts payable and accrued expenses in 2005 changes in operating
assets and liabilities and premium due to debenture default in 2004. Net cash
provided by investing activities was $0.02 million and $0.2 million for the
years ended December 31, 2005 and 2004, respectively. Net cash provided by
financing activities was $3.4 million and $0.9 million for the years ended
December 31, 2005 and 2004, respectively. For 2005, the cash provided by
financing activities was comprised of $1.7 million from the issuance of common
stock, $2.5 million from the issuance of notes, (net of issuance costs of $0.4
million), and $0.9 million from the proceeds of notes payable to a related
party, net of principal payments on settlements of $0.3 million. As of December
31, 2005, the Company had cash and related cash equivalents totaling $0.3
million.
Capital Requirements. The Company only made minor capital expenditures
during the years ended December 31, 2005 and 2004 and does not anticipate
significant capital expenditures in 2006.
Contractual Obligations. The following table summarizes the Company's
known obligations to make future payments pursuant to certain contracts as of
March 31, 2006, as well as an estimate of the timing in which these obligations
are expected to be satisfied:
Payments due
by period
(in thousands) Less than 1-3
Contractual Obligations Total 1 year Years
-------------------------------------------------- ------------- --------- ------
Note payable to related party (including interest) $ 1,225 $ 75 $1,150
Note payable 2,600 2,600 --
Convertible Debenture 4,500 -- 4,500
Other long-term liability
427 307 120
Totals $ 8,507 $ 2,982 $5,770
Sources of Capital - Financing and Restructuring Transactions.
To date, the Company's operations have been financed through a series of
debt and equity issuances and to a lesser extent through the receipt of a
limited amount of technology and licensing fees. Since January 1, 2003, the
Company has received: (i) an aggregate of $2.9 million through private
placements of its capital stock and warrants; (ii) an aggregate of $16.9 million
through the sale of debentures other debt securities; and $0.3 million in
licensing and technology fees. The discussion below summarizes these financings
and arrangements and the terms of various restructuring transactions the Company
has undertaken to continue to finance its operations.
22
The 2006 Debentures. 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 5,
2006 (the"2006 Debentures"), for which the Company received proceeds of
approximately $9.0 million, net of financing costs of approximately $1.5
million. In connection with the March 2003 financing transactions, the Company
issued 54,167 shares of common stock to the lead purchaser of these 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. 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 a December 2001 shelf registration statement 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. During 2004, the Company sold $2.7
million of its common stock in a private equity transaction, received $1.5
million in prepaid technology fees related to the granting of new licenses, and
worked to negotiate settlements with each of the remaining holders of its 2006
Debentures to retire the 2006 Debentures, to resolve the defaults, and to
restructure its long-term debt.
2006 Debenture Settlements. As of September 30, 2004, the Company entered
into agreements with each of the holders of the 2006 Debentures to amend and
restate the secured debenture purchase agreements entered into in July 2004 by
and among 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) EKI to pay $1.0
million in 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 of EarthShell common stock and (iv) EarthShell to pay $2.3
million to SF Capital Partners 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 (as 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 that
EarthShell shall subsequently receive 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 have been included in a Form S-1 registration statement filed with the
Securities and Exchange Commission on February 14, 2006, which has not yet
become effective. The consideration for the repurchase of the 2006 Debentures
has been paid or issued, and the 2006 Debentures have been retired by
EarthShell.
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 agreements, the Company not filing
such a registration statement (or the registration statement not being declared
effective) within a required timeframe provided 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 a 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.
Agreements with MBS. On May 13, 2004, the Company entered into a ten year
license agreement with MBS and granted to MBS a priority license to supply
certain retail and government market segments in the United States (the "MBS
Sublicense"). MBS has paid EarthShell $0.5 million in technology fees to date.
On June 8, 2005, the Company terminated the MBS Sublicense as set forth herein
below.
On August 5, 2004, EarthShell and MBS entered into a stock purchase
agreement (the "MBS SPA") pursuant to which MBS agreed to fund $5.0 million to
EarthShell in exchange for EarthShell's issuance of 1,666,666 shares of common
stock at $3.00 per share. On August 20, 2004, EarthShell received $0.5 million
from MBS, for which the Company issued to MBS 166,666 shares of its common
stock. On October 1, 2004, EarthShell received an additional $1.2 million of the
$5.0 million commitment, and the Company issued to MBS 400,000 shares of its
common stock. On October 11, 2004, MBS purchased an additional 333,333 shares
for $1.0 million, of which it had paid $0.5 million as of December 31, 2004 and
$0.5 million was still due. During 2005, the unamortized balance of MBS'
deferred technology fee of $0.3 million was applied to the stock receivable. The
shares of common stock issued to MBS were not registered for resale under the
1933 Act. The cash received from MBS was used, in part, to fund the repurchase
of the 2006 Debentures and to restructure the Company's long-term debt.
23
On June 8, 2005, the Company entered into a letter agreement with MBS
terminating its sublicense agreement (the "MBS Sublicense"), dated as of May 13,
2004. At the time the letter agreement was executed, MBS had not yet implemented
the sublicense granted to it under the MBS Sublicense. The parties separately
agreed that the effectiveness of the termination would be conditioned upon the
effectiveness of the agreements with RPI as described herein below. The Company
entered into additional sublicense agreements with MBS covering non-competing
technologies in other markets and territories than those covered by the MBS
Sublicense and the present RPI Sublicense. The effectiveness of such sublicense
agreements was expressly conditioned upon the satisfaction of certain conditions
before July 31, 2005, including the receipt by the Company of $2.6 million in
technology fees and other payments. These agreements expired under their own
terms.
RPI Agreements. On June 17, 2005, EarthShell entered into a sublicense
agreement with RPI (the "RPI Sublicense"), a newly formed subsidiary of Thompson
Street Capital Partners ("Thompson Street"), pursuant to which the Company
granted to RPI an exclusive license to produce plates, bowls, and certain other
EarthShell products incorporating the Company's technology and to sell these
products in the retail and governmental market segments in the United States.
The Company has been advised that RPI has received the full $12.0 million
funding commitment from Thompson Street in order to begin production of
EarthShell Packaging products. The RPI Sublicense requires RPI to pay to the
Company a royalty fee equal to 20% of RPI's net sales, not to exceed 50% of
RPI's gross margin
On June 17, 2005, the Company, RPI and RPI's sole stockholder, Renewable
Products, LLC ("RPI LLC"), entered into an agreement and plan of merger (the
"RPI Merger"), which contemplates the Company's eventual acquisition of RPI in
exchange for 8.0 million shares of the Company's Series C Convertible Preferred
stock (the "Series C Preferred") at such time as the following conditions, among
others, are achieved: (i) RPI's procurement, installation and start-up of 16
manufacturing modules for producing the Company's product, which equipment is to
be designed to produce an aggregate of approximately $16.0 million of EarthShell
products per year, (ii) RPI's establishment of plant facilities to support the
full commercial operations of such machines, (iii) RPI's receipt of funding to
support additional working capital needs of $1.0 million, (iv) RPI's receipt of
at least $12.0 million of capital to purchase the machines described above, and
(v) the 20% royalty described above having become payable and either accrued or
paid to the Company pursuant to the RPI Sublicense. At such time as the
conditions to the transactions contemplated by the RPI Merger are met, RPI has
the right, through March 31, 2006, to call for the merger to occur. The parties
have mutually agreed to extend RPI's call date to December 31, 2006. At the time
the merger is triggered, a valuation of RPI will be obtained and the Company
will acquire RPI pursuant to the terms of the RPI Merger in exchange for 8.0
million shares of Series C Preferred, as described above. The Series C Preferred
will be convertible on a share for share basis into 8.0 million shares of the
Company's common stock which will be subject to registration rights.
EA License. On August 22, 2005, the Company entered into an agreement with
EA in connection with the granting of certain licenses to use a new embodiment
of EarthShell Technology for various applications in certain Asian territories
(the "EA License"). Shortly after executing a letter agreement, both the Company
and EA entered into negotiations to restructure the transaction and ultimately
entered into an amended and restated letter agreement dated December 9, 2005. As
part of such restructuring, the Company may receive a total of up to $2.6
million from a combination of (i) prepaid technology fees (up to $1.7 million),
(ii) the sale of up to 266,667 shares of its common stock for $0.5 million and
(iii) the issuance of 1,033,333 warrants to purchase shares of the Company's
common stock at $3.90 per share, which, under certain circumstances, may be
adjusted to an exercise price of not less than $3.00 per share. The realization
of the full potential of the transaction is dependent on the Company
successfully demonstrating the commercial viability of its technology in certain
new applications. The Company received $0.5 million from EA as an initial
partial payment and agreed to issue 166,667 shares of its common stock in
connection with this payment. The Company received an additional $0.3 million in
December 2005 and $0.1 million in February of 2006 pursuant to the amended and
restated agreement with EA dated December 9, 2005, but which was not effective
until February 10, 2006 when the final cash payment was received. Under the
amended and restated agreement, upon receipt of the final payment, the Company
issued a total of 266,667 shares and the warrants to purchase the 1,033,333
shares.
24
Financing Transactions and Arrangements with EKI. During 2002 and 2003,
EKI, an affiliated entity, made a series of Simple Interest Loans to the Company
totaling approximately $5.8 million. In addition, EKI purchased $1.0 million of
the Company's 2006 Debentures. On September 30, 2004, EKI entered into an
agreement with EarthShell to sell back to the Company the 2006 Debentures it had
purchased for $1.0 million in cash, the cash price originally paid by EKI. The
Company retired the 2006 Debentures shortly thereafter.
In October 2004, in connection with the settlement of the 2006 Debentures,
EKI converted all of its outstanding loans to EarthShell ($2,755,000) into
unregistered common stock at $3.00 per share and $532,644 of accumulated
interest at $4.00 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.
In May 2005, an additional 44,387 shares were issued to EKI pursuant to a
ninety day price protection in the clause, which provided for an adjustment in
the effective conversion price of the interest portions of the EKI loans from
$4.00 per share to $3.00 per share. The Company also granted a ten year warrant
to EKI to purchase one million shares of the Company's common stock at $3.00 per
share in consideration of EKI's continued support of the Company since its
inception, including providing bridge loans at below market terms from time to
time. This warrant was cancelled and subsequently a new warrant with similar
terms was reissued in August 2005 to Essam Khashoggi, beneficial owner of EKI.
On October 11, 2005, the Company entered into the 2005 EKI Loan with EKI
pursuant to which the Company issued to EKI a promissory note in the principal
amount of $1.0 million. As of December 31, 2005, EKI had advanced $0.85 million
with the balance being funded by the second week of January 2006. Interest
accrues on the principal balance of the 2005 EKI Loan at a variable per annum
rate, as of any date of determination, that is equal to the rate published in
the "Money Rates" section of The Wall Street Journal as being the "Prime Rate",
compounded monthly. All accrued but unpaid interest and outstanding principal is
due and payable on the earliest to occur of the following: (i) the second
anniversary of the date of the 2005 EKI Loan; (ii) five days following the date
the Company has received $3.0 million or more in aggregate net cash proceeds
from all financing transactions, equity contributions, and transactions relating
to the sale, licensing, sublicensing or disposition of assets or the provision
of services (including advance royalty payments, proceeds from the sale of the
Company's common stock and fees for technological services rendered to third
parties), measured from the date of the 2005 EKI Loan and not taking into
account the proceeds advanced under the 2005 EKI Loan; or (iii) the occurrence
of an Event of Default (as defined in the EKI Loan).
Also on October 11, 2005, the Company entered into a debt conversion and
mutual release agreement (the "Debt Conversion Agreement") with EKI. Pursuant to
the Debt Conversion Agreement, the Company and EKI agreed that a payable in an
amount equal to $837,145 (previously owed the Biotec Group, but which payable
was subsequently assigned to EKI) be converted into 279,048 shares of common
stock of the Company. The conversion price equals $3.00 per share. Pursuant to
the Debt Conversion Agreement, the Company and EKI released each other from any
and all claims in connection with the payable.
Cornell Capital Partners Financings. On March 23, 2005, the Company
entered into a financing arrangement with Cornell Capital Partners whereby the
Company issued promissory notes to, and entered into a security agreement with,
Cornell Capital Partners. Pursuant to the financing, the Company issued
promissory notes (collectively, the "CCP Notes") to Cornell Capital Partners
with a total principal amount of $2.5 million. Upon consummation of the December
Debenture Purchase Agreement with Cornell Capital Partners on January 6, 2006,
described below, the CCP Notes and all accrued interest thereon have been paid
in full.
On March 23, 2005, the Company entered into a Standby Equity Distribution
Agreement (the "SEDA") with Cornell Capital Partners whereby the Company was
entitled to, at its sole discretion, periodically sell to Cornell Capital
Partners shares of its common stock for a total aggregate purchase price of up
to $10.0 million. On June 9, 2005, the Company filed a registration statement on
Form S-1 with the SEC to register shares of its common stock underlying the
SEDA. On September 27, 2005, the registration statement was withdrawn and, on
December 30, 2005, the parties terminated the SEDA.
On May 26, 2005, the Company issued a common stock purchase warrant to
Cornell Capital Partners to purchase 625,000 shares of common stock of the
Company. This May Warrant expires on May 26, 2006, has an exercise price which
was adjusted to $3.00 per share of common stock and has "piggy back" and demand
registration rights. In August 2005 Cornell Capital Partners agreed to
consolidate the CCP Notes and to defer the commencement of repayment
installments. In consideration of this modification to CCP Notes, the Company
issued a warrant to Cornell Capital Partners to purchase 50,000 shares of common
stock of the Company. This Warrant expires on May 26, 2006, has an exercise
price, which was adjusted to $3.00 per share of common stock as of December 30,
2005, and has "piggy back" and demand registration rights.
25
December Debentures. On December 30, 2005, EarthShell entered into a
Securities Purchase Agreement with Cornell Capital Partners (the "December
Debenture Purchase Agreement") pursuant to which the Company issued and sold to
Cornell Capital Partners $4.5 million in principal amount of secured convertible
debentures (the "December Debentures") on the terms described below. This
agreement was consummated on January 6, 2006. The December Debentures are
convertible into shares of the Company's common stock on the terms discussed
below The Company received the aggregate proceeds of $4.5 million from the sale
of the December Debentures on January 6, 2006, of which approximately $2.6
million was used to payoff the CCP Notes.
The December Debentures are secured by (i) a Pledge and Escrow Agreement,
by and among the Company, Cornell Capital Partners, and David Gonzalez, Esq.,
(ii) an Insider Pledge Agreement and Escrow Agreement (the "IPEA"), by and among
the Company, Cornell Capital Partners, David Gonzalez, Esq. and Mr. Benton
Wilcoxon and (iii) an Amended and Restated Security Agreement, by and between
the Company and Cornell Capital Partners. The December Debentures are secured by
substantially all of the Company's assets, have a three year term and accrue
interest at 12% per annum. The December Debenture Purchase Agreement required
the Company to register the shares of the Company's common stock into which the
December Debentures are convertible under the Securities Act of 1933. On
February 14, 2006, the Company filed a registration statement on Form S-1 with
the Securities and Exchange Commission ("SEC") in order to register 6,700,000
shares of common stock that may be issuable to the holders of the December
Debentures upon conversion. Beginning 60 days after the SEC declares the
registration statement effective, Cornell Capital Partners is entitled, at its
option, to convert and sell up to $250,000 of the principal amount of the
December Debentures, plus accrued interest, into shares of the Company's common
stock, within any 30 day period at the lesser of (i) a price equal to $3.00 or
(ii) 88% of the average of the two lowest volume weighted average prices of the
common stock during the ten trading days immediately preceding the conversion
date, as quoted by Bloomberg, LP.
The holder of the December Debentures may not convert the December
Debentures or receive shares of the Company's common stock as payment of
interest thereunder to the extent such conversion or receipt of such interest
payment would result in the holder, together with any affiliate thereof,
beneficially owning (as determined in accordance with Section 13(d) of the
Securities Exchange Act of 1934, as amended, and the rules promulgated
thereunder) in excess of 4.9% of the then issued and outstanding shares of
common stock, including shares issuable upon conversion of, and payment of
interest on, the December Debentures held by such holder after application of
this 4.9% restriction. This 4.9% restriction may be waived by the holder (but
only as to itself and not to any other holder) upon not less than 65 days prior
notice to the Company.
The Company may redeem, with three business days advance written notice to
Cornell Capital Partners, a portion or all amounts outstanding under the
December Debentures prior to the maturity date provided that the closing bid
price of the of the Company's common stock, as reported by Bloomberg, LP, is
less than $3.00 at the time of the redemption notice. The Company shall pay an
amount equal to the principal amount being redeemed plus a redemption premium
equal to ten percent of the principal amount being redeemed, and accrued
interest, to be delivered to the Cornell Capital Partners on the third business
day after the redemption notice, provided, however, this redemption premium does
not apply until the outstanding principal balance of the December Debentures has
been reduced by $2.5 million. The amount that Cornell may convert in any 30 day
period will be reduced by the amount that the Company redeems.
In connection with the December Debenture Purchase Agreement, on December
30, 2005, the Company issued to Cornell Capital Partners the warrant to purchase
up to 350,000 shares of common stock (the "December Warrant"). This December
Warrant has an exercise price of $4.00 per share, which may be adjusted under
certain conditions to as low as $3.00 per share and expires two years from the
date it was issued. Furthermore, in connection with the Company's sale of
December Debentures, the Company issued to Mr. Benton Wilcoxon, in consideration
of his pledge of shares of common stock of Composite Technology Corporation
pursuant to the terms of the IPEA, a warrant to purchase up to 125,000 shares of
common stock. This warrant has an exercise price of $4.00 per share and expires
three years from the date it was issued.
The Company believes that as a result of (a) the $900,000 received
pursuant to the EA agreements (b) the $1.0 million received pursuant to the 2005
EKI Loan and (c) the $4,500,000 in proceeds received in connection with the
issuance and sale to Cornell Capital Partners of the December Debentures, the
Company has sufficient capital to fund its operations through the first several
months of 2006. The Company expects to receive additional technology fees in
connection with the granting of additional new licenses during 2006. In
addition, the Company expects to begin generating royalty revenues later in
2006. If the Company is not successful at generating royalty payments and/or
technology fees during 2006, the Company may have to raise additional funds to
meet its current obligations and to cover operating expenses through December
31, 2006. If the Company is not successful in raising additional capital it may
not be able to continue as a going concern for a reasonable amount of time.
Management expects to address this potential need in 2006 by generating cash
through the issuance of debt or equity securities. However, the Company cannot
assure that additional financing will be available to it, or, if available, that
the terms will be satisfactory to it. Management will also continue in its
efforts to reduce expenses, but cannot assure that it will be able to reduce
expenses below current levels. If the Company is not successful in raising
additional capital it may not be able to continue as a going concern.
26
Off-Balance Sheet Arrangements. The Company does not have any off-balance
sheet arrangements as of December 31, 2005, and has not entered into any
transactions involving unconsolidated, limited purpose entities.
27
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to interest rate risk on its obligations under the
2005 EKI Loan. Currently, the principal amount of the 2005 EKI Loan totals $1.0
million. The loan bears interest on the principal balance of $1.0 million at a
variable rate per annum, as of any date of determination, that is equal to the
rate published in the "Money Rates" section of The Wall Street Journal as being
the "Prime Rate", compounded monthly. In addition, 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.
Generally an increase in market interest rates will increase the Company's
interest expense on this debt and decreases in rates will have the opposite
effect.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Item 15(a)(1) of Part IV of this form 10-K.
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 were not 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.
(b) Changes in Internal Control Over Financial Reporting. The Company has
begun taking remediation steps to enhance its internal control over financial
reporting and reduce control deficiencies. In the 4th Quarter 2005, the Company
employed a new Controller, a CPA, with 15 years' experience in public and
private accounting. The new Controller is in the process of developing revised
accounting systems and procedures that will strengthen the Company's controls
over financial reporting. The Company anticipates hiring an additional
accounting employee as resources become available.
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).
28
Because this registration statement was not filed, in December 2005 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.
29
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information responsive to this item is incorporated herein by reference to
EarthShell's definitive proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the end of the fiscal year covered by
this Form 10-K with respect to our Annual Meeting of Shareholders.
ITEM 11. EXECUTIVE COMPENSATION
Information responsive to this item is incorporated herein by reference to
EarthShell's definitive proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the end of the fiscal year covered by
this Form 10-K with respect to our Annual Meeting of Shareholders.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
Information responsive to this item is incorporated herein by reference to
EarthShell's definitive proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the end of the fiscal year covered by
this Form 10-K with respect to our Annual Meeting of Shareholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information responsive to this item is incorporated herein by reference to
EarthShell's definitive proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the end of the fiscal year covered by
this Form 10-K with respect to our Annual Meeting of Shareholders.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Information responsive to this item is incorporated herein by reference to
EarthShell's definitive proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the end of the fiscal year covered by
this Form 10-K with respect to our Annual Meeting of Shareholders.
30
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, 2005, and 2004..........F-3
Consolidated Statements of Operations for the years ended
December 31, 2005, 2004 and 2003.......................................F-4
Consolidated Statements of Stockholders' Equity (Deficit) for the
years ended December 31, 2005, 2004 and 2003...........................F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 2005, 2004 and 2003.......................................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 3.3 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 4.3 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 (4.5) 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 4.6 purchasers identified on the
signature pages thereto.(13)
31
4.7 Exchange Agreement dated as of March 5, 2003 between the Company and
the institutional investor signatory thereto.(13)
4.8 Investor Rights Agreement dated as of December 9, 2005, by and among
EarthShell Corporation and the parties signatory thereto. (19)
4.9 Form of EarthShell Corporation Common Stock Warrant dated February 10,
2006 (19)
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 10.8 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 10.12 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 (10.17) 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)
32
10.24 Securities Purchase Agreement dated as of August 12, 2002 between the
Company and the investors 10.24 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.. (18)
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)
33
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)
10.55 Warrant, dated May 26, 2005, issued by the Company to Cornell Capital
Partners, LP (20)
10.56 Letter Agreement dated as of December 9, 2005, by and between
EarthShell Corporation and EarthShell Asia, Limited. (19)
10.57 Securities Purchase Agreement dated as of December 30, 2005, by and
between EarthShell Corporation and Cornell Capital Partners, LP (21)
10.58 Investor Registration Rights Agreement dated as of December 30, 2005 by
and between EarthShell Corporation and Cornell Capital Partners, LP
(21)
10.59 Secured Convertible Debenture dated as of December 30, 2005, issued to
Cornell Capital Partners, LP (21)
10.60 Amended and Restated Security Agreement dated as of December 30, 2005,
by and between EarthShell Corporation and Cornell Capital Partners, LP
(21)
10.61 Warrant dated as of December 30, 2005 issued to Cornell Capital
Partners,
10.62 Pledge and Escrow Agreement dated as of December 30, 2005 among
Corporation, Cornell Capital Partners, LP and David Gonzalez, Esq. (21)
10.63 Escrow Agreement dated December 30, 2005 among EarthShell Corporation,
Cornell Capital Partners, LP and David Gonzalez, Esq. (21)
10.64 Irrevocable Transfer Agent Instructions dated as of December 30, 2005,
by and between EarthShell Corporation and Cornell Capital Partners, LP
(21)
10.65 Insider Pledge and Escrow Agreement dated December 30, 2005 by and
among EarthShell Corporation, Cornell Capital Partners, LP, David
Gonzalez, Esq. and Benton Wilcoxon (21)
10.66 Termination Agreement dated December 30, 2005 by and between EarthShell
Corporation, Cornell Capital Partners, LP and Sloan Securities
Corporation (21)
10.67 Irrevocable Transfer Agent Instructions dated as of December 30, 2005
by and between EarthShell Corporation, Cornell Capital Partners, LP and
David Gonzalez, Esq. regarding the Convertible Debentures (21)
10.68 Form of Lockup Agreement (21)
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.
34
(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.
(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.
(18) Previously filed as an exhibit to the Company's annual report on Form 10-K
for the fiscal year ended December 31, 2004, and incorporated herein by
reference.
(19) Previously filed as an exhibit to the Company's current report on Form
8-K dated February 10, 2006
(20) Previously filed as an exhibit to the Company's current report on Form
8-K dated May 26, 2005
(21) Previously filed as an exhibit to the Company's current report on Form
8-K dated December 30, 2005
35
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, 2006.
EARTHSHELL CORPORATION
By: /s/ VINCENT J. TRUANT
--------------------------
Vincent J. Truant
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/ VINCENT J. TRUANT Chairman of the Board and March 31, 2006
------------------------------------
Vincent J. Truant Chief Executive Officer
/s/ D. SCOTT HOUSTON Chief Financial Officer and Secretary March 31, 2006
------------------------------------
D. Scott Houston (Principal Financial Officer)
/s/ HAMLIN JENNINGS Director March 31, 2006
------------------------------------
Hamlin Jennings
/s/ WALKER RAST Director March 31, 2006
---------------------------
Walker Rast
/s/ MICHAEL GORDON Director March 31, 2006
------------------------------------
Michael Gordon
36
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
Index to Consolidated Financial Statements and Schedules.................................................F-i
Report of Independent Registered Public Accounting Firm..................................................F-1
Consolidated Balance Sheets as of December 31, 2005 and 2004.............................................F-2
Consolidated Statements of Operations for the years ended December 31, 2005, 2004, and 2003 .............F-3
Consolidated Statements of Stockholders' Equity (Deficit) for the years ended December 31, 2005, 2004
and 2003 .......................................................................................F-4
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004, and 2003 .............F-5
Notes to Consolidated Financial Statements...............................................................F-8
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-i
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, 2005 and 2004, and the related
consolidated statements of operations, stockholders' (deficit) equity, and cash
flows for the years ended December 31, 2005, 2004 and 2003. 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. The Company is not required to,
nor were we engaged to perform, an audit of its control over financial reporting
as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the
effectiveness of the Company's internal control over financial reporting.
Accordingly we express no such opinion. An audit 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, 2005 and 2004, and the results of its operations and its cash
flows for the years ended December 31, 2005, 2004 and 2003, 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 $11,458,467
and a stockholders' deficit of $12,351,889 as of December 31, 2005. 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 Hurley & McEwen, LLP
Camarillo, California
March 10, 2006
F-1
EARTHSHELL CORPORATION
CONSOLIDATED BALANCE SHEETS
December 31,
------------------------------
2005 2004
------------- -------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents .................................................................... $ 347,812 $ 272,371
Prepaid expenses and other current assets .................................................... 83,473 201,467
------------- -------------
Total current assets ....................................................................... 431,285 473,838
PROPERTY AND EQUIPMENT, NET ..................................................................... 11,991 9,037
EQUIPMENT HELD FOR SALE ......................................................................... 1 1
------------- -------------
TOTAL ASSETS .................................................................................... $ 443,277 $ 482,876
============= =============
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Accounts payable and accrued expenses ........................................................ $ 5,908,670 $ 3,899,526
Current portion of settlements ............................................................... 300,786 313,743
Current portion of deferred revenues ......................................................... 100,000 300,000
Payable to related party, current ............................................................ 850,000 875,000
Debenture settlement ......................................................................... 2,375,000 2,375,000
Note payable, net of discount of $168,901 .......................................... 2,355,296 --
------------- -------------
Total current liabilities .................................................................. 11,889,752 7,763,269
DEFERRED REVENUES, LESS CURRENT PORTION ......................................................... 787,500 1,062,500
OTHER LONG-TERM LIABILITIES ..................................................................... 117,914 412,192
------------- -------------
Total liabilities ............................................................................ 12,795,166 9,237,961
------------- -------------
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, 2005 and 2004............. -- --
Common stock, $.01 par value, 40,000,000 shares authorized; 18,981,167 and 18,234,615 shares
issued and outstanding as of December 31, 2005 and 2004, respectively..................... 189,812 182,346
Additional paid-in common capital .......................................................... 315,306,825 313,196,905
Accumulated deficit ........................................................................ (327,786,868) (321,607,782)
Less note receivable for stock ............................................................. -- (500,000)
Accumulated other comprehensive loss ....................................................... (61,658) (26,554)
------------- -------------
Total stockholders' deficit .............................................................. (12,351,889) (8,755,085)
------------- -------------
TOTAL LIABILITES AND STOCKHOLDERS' DEFICIT ............................................... $ 443,277 $ 482,876
============= =============
See Notes to Consolidated Financial Statements.
F-2
EARTHSHELL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended December 31,
--------------------------------------------
2005 2004 2003
------------ ------------ ------------
Revenues ...................................................... $ 183,333 $ 137,500 $ --
Operating Expenses
Related party license fee and research and development expenses -- 800,000 1,312,374
Other research and development expenses ....................... 200,817 370,163 8,234,416
General and administrative expenses ........................... 5,485,358 3,753,902 5,790,473
Related party general and administrative (reimbursements) ..... -- (4,875) (4,074)
Depreciation and amortization ................................. 2,939 42,236 379,949
Gain on sales of property and equipment ....................... (23,477) (168,458) (451,940)
------------ ------------ ------------
Total operating expenses ...................................... 5,665,637 4,792,968 15,261,198
Operating Loss ................................................ 5,482,304 4,655,468 15,261,198
Other (Income) Expenses
Interest income ............................................... (5,022) (4,606) (95,176)
Related party interest expense ................................ 101,314 410,965 445,628
Other interest expense ........................................ 599,690 661,721 1,440,118
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
------------ ------------ ------------
Loss Before Income Taxes ...................................... 6,178,286 7,256,301 18,515,941
Income Taxes .................................................. 800 800 800
------------ ------------ ------------
Net Loss ...................................................... $ 6,179,086 $ 7,257,101 $ 18,516,741
============ ============ ============
Basic and Diluted Loss Per Common Share ....................... $ 0.33 $ 0.48 $ 1.40
Weighted Average Number of Common Shares Outstanding .......... 18,503,207 15,046,726 13,266,668
See Notes to Consolidated Financial Statements.
F-3
EARTHSHELL CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' (DEFICIT) EQUITY
Common Stock
----------------------------
Additional Accumulated
Paid-In Stock Other
Common Accumulated Purchase Comprehensive
Shares Amount Capital Deficit Receivable Loss Totals
------------- ------------- ------------- ------------- ------------- ------------- -------------
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)
============= ============= ============= ============= ============= ============= =============
Issuance of common
stock 266,667 2,667 797,333 -- 500,000 -- 1,300,000
Conversion of related
party note to common
stock 323,435 3,234 934,670 -- -- -- 937,904
Common stock and
common stock
warrants issued in
connection with
issuance of
convertible
debentures 156,450 1,565 377,917 -- -- -- 379,482
Net loss -- -- -- (6,179,086) -- -- (6,179,086)
Foreign currency
translation
adjustment -- -- -- -- -- (35,104) (35,104)
-------------
Comprehensive loss -- -- -- -- -- -- (6,214,190)
------------- ------------- ------------- ------------- ------------- ------------- -------------
BALANCE,
DECEMBER 31, 2005 18,981,167 $ 189,812 $ 315,306,825 $(327,786,868) -- $ (61,658) $ (12,351,889)
============= ============= ============= ============= ============= ============= =============
See Notes to Consolidated Financial Statements.
F-4
EARTHSHELL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31,
--------------------------------------------
2005 2004 2003
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss ........................................................... $ (6,179,086) $ (7,257,101) $(18,516,741)
Adjustments to reconcile net loss to net cash used in operating
activities
Bad debt expense ................................................ 183,333 -- --
Depreciation and amortization .................................... 2,939 42,236 379,949
Amortization and accretion of debenture issue costs
.............................................................. 633,490 592,316 955,574
Compensation related to restricted stock issuance to
directors ...................................................... 150,934 -- --
Interest paid in common stock .................................... 100,758 -- --
Premium due to debenture default ................................. -- 1,672,426 --
Debenture issuance and conversion costs .......................... -- -- 166,494
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 ...................................................... (23,476) (168,458) 3,548,059
Equity in the losses of joint venture ............................ -- -- 392,116
Accrued purchase commitment ...................................... -- -- (1,855,000)
Other non-cash expense items ..................................... (223,962) 180,171 50,198
Changes in operating assets and liabilities
Prepaid expenses and other current assets ........................ 117,994 120,549 264,153
Accounts payable and accrued expenses ............................ 2,054,721 (553,710) (2,339,720)
Payable to related party ......................................... (34,070) 1,043,869 1,214,683
Deferred revenues ................................................ (183,333) 1,362,500 --
Accrued purchase commitment ...................................... -- -- (1,645,000)
Other long-term liabilities ...................................... 28,914 378,859 33,333
------------ ------------ ------------
Net cash used in operating activities .......................... (3,370,844) (2,726,016) (15,694,223)
============ ============ ============
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 ...................... 30,280 187,708 487,691
Investment in joint venture ........................................ -- -- (26,104)
Purchases of property and equipment ................................ (12,697) (8,729) (1,320)
------------ ------------ ------------
Net cash provided by investing activities ...................... 17,583 178,979 3,960,267
============ ============ ============
F-5
Year Ended December 31,
--------------------------------------------
2005 2004 2003
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of common stock ............................ 800,000 2,086,755 --
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 note payable .................. 2,500,000 -- --
Proceeds from payment on stock purchase receivable ................ 25,000 -- --
Proceeds from release of restricted time deposit upon conversion of
convertible debentures into common stock......................... -- -- 1,800,000
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 ................................. (336,149) (66,387) --
Proceeds from issuance of notes payable to related party .......... 850,000 -- 1,010,000
Note payable issuance costs ....................................... (402,500) -- --
------------ ------------ ------------
Net cash provided by financing activities ....................... 3,436,351 910,074 13,521,844
Effect of exchange rate changes on cash and cash equivalents ...... (7,649) 7,695 2,736
------------ ------------ ------------
(DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS .................... 75,441 (1,629,268) 1,790,624
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ...................... 272,371 1,901,639 111,015
------------ ------------ ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD ............................ $ 347,812 $ 272,371 $ 1,901,639
============ ============ ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for
Income taxes .................................................... $ 800 $ 800 $ 800
Interest ........................................................ 410,772 111,353 21,058
Common stock warrants issued in connection with convertible
debentures ...................................................... 129,161 -- 745,562
Conversion of convertible debentures into common stock ............ 837,145 6,800,000 7,550,000
Interest paid in common stock ..................................... 100,758 532,644 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-6
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
In March of 2005, in consideration for a loan guarantee, the Company issued
warrants to Benton Wilcoxon to purchase 65,000 shares of common stock of the
Company at an exercise price of $ 3.00 per share. The warrants expire on March
23, 2008. Using the Black-Scholes pricing model, the warrants are valued at $34,
980. Also in March of 2005, in consideration for consulting services rendered in
connection with the company obtaining financing, the Company issued a warrant to
Douglas Metz for 80,000 shares of common stock of the Company at an exercise
price of $3.00 per share. The warrant expires on March 23, 2008. Using the
Black-Scholes pricing model, the warrant was valued at $43,048.
In May 2005, the Company issued a warrant to Cornell Capital Partners (CCP) to
purchase 625, 000 shares of common stock of the Company. The warrant expires on
the later of : (a) May 26,2006 or (b) the date sixty days after the date the
$2,500,000 in promissory notes issued to Cornell Capital are fully repaid. The
warrant has an exercise price of $4.00 per share of common stock. Using the
Black-Scholes pricing model, the warrant was valued at $47,345.
In August 2005, the Company issued a warrant to CCP to purchase 50,000 shares of
common stock of the Company in consideration for consolidating the two CCP
promissory notes and extending the date upon which amortization and repayment of
the notes is to begin. The warrant expires on the later of: (a) May 26, 2006 or
(b) the date sixty days after the date the $2,500,000 in promissory notes issued
to Cornell Capital are fully repaid. The warrant has an exercise price of $4.00
per share of common stock. Using the Black-Scholes pricing model, the warrant
was valued at $3,788.
On October 11, 2005, the Company entered into a debt conversion and mutual
release agreement (the "Debt Conversion Agreement") with EKI. Pursuant to the
Debt Conversion Agreement, the Company and EKI agreed that the remaining payable
of $837,145 (previously owed to Bio-Tec Biologische Naturverpackunger GmbH &
Co.KG, but which payable was subsequently assigned to EKI) be converted into
279,048 shares of common stock of the Company. The conversion price equals $3.00
per share. Pursuant to the Debt Conversion Agreement, the Company and EKI
released each other from any and all claims in connection with the receivable.
In connection with a Securities Purchase Agreement, on December 30, 2005,
the Company issued to Cornell Capital Partners a warrant to purchase up to
350,000 shares of common stock (the "December Warrant). This December Warrant
has an exercise price of $4.00 per share, which may be adjusted under certain
conditions to as low as $3.00 per share and expires two years from the date it
was issued. Furthermore, in connection with the Company's sale of December
Debentures, the Company issued to Mr. Benton Wilcoxon, in consideration of his
pledge of shares of common stock of Composite Technology Corporation pursuant to
the terms of the IPEA, a warrant to purchase up to 125,000 shares of common
stock. This warrant has an exercise price of $4.00 per share and expires three
years from the date it was 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.
See Notes to Consolidated Financial Statements.
F-7
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 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,
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 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 accounting principles generally accepted in the United States.
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 $11,458,467 at December 31, 2005. These factors, along with
others, indicate substantial doubt that the Company will be able to continue as
a going concern for a reasonable period of time.
Subsequent to December 31, 2005 the Company entered into a financing
transaction to borrow $4.5 million, of which, the Company netted $1.6 million
(See Subsequent Events). On January 6, 2006, the Company received this funding.
The Company will have to raise additional funds to meet its current obligations
and to cover operating expenses through the year ending December 31, 2006. If
the Company is not successful in raising additional capital it may not be able
to continue as a going concern. 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 2006 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, or that it will receive any
royalty payments in 2006. 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.
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.
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."
F-8
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 concluded 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.
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") and Renewable Products, Inc. ("RPI") in the U.S, as well as
EarthShell Hidalgo ("ESH") in Mexico and EarthShell Asia. During 2005, the
Company received technology fees from ESH. 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.
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.
On October 11, 2005, the Company entered into the 2005 EKI Loan with EKI
pursuant to which the Company issued to EKI a promissory note to EKI in the
principal amount of $1,000,000. As of the second week of January 2006, EKI has
advanced the full $1,000,000 to the Company. Interest accrues on the principal
balance of the 2005 EKI Loan at a variable per annum rate, as of any date of
determination, that is equal to the rate published in the "Money Rates" section
of The Wall Street Journal as being the "Prime Rate", compounded monthly. 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 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 January 1, 2006 as required.
F-9
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections--a replacement of APB Opinion No. 20 and FASB Statement No. 3" (SFAS
154). This Statement replaces APB Opinion No. 20, "Accounting Changes," and FASB
Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements,"
and changes the requirements for the accounting for and reporting of a change in
accounting principle by requiring retrospective application to prior periods'
financial statements of changes in accounting principle, unless it is
impractical to determine either the period-specific effects or the cumulative
effect of the change. It also applies to changes required by an accounting
pronouncement in the unusual instance that the pronouncement does not include
specific transition provisions. In addition, the Statement also requires that a
change in depreciation or amortization for long-lived assets be accounted for as
a change in accounting estimate effected by a change in accounting principle.
When a pronouncement includes specific transition provisions, those provisions
should be followed. SFAS 154 is effective for accounting changes and corrections
of errors made in fiscal years beginning after December 15, 2005. Consequently,
the Company will adopt provisions of SFAS 154 for the fiscal year beginning
January 1, 2006. Management currently believes the adoption of the provisions of
SFAS 154 will not have a material impact on its financial position or results of
operations.
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. The
authorized shares of common stock were increased in conjunction with the annual
meeting of the shareholders held on June 26, 2004, from 25 million to 40
million.
F-10
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, 2005 and 2004, 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.
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 ($433,514 on
deposit with one bank at December 31, 2005) are subject to market fluctuations
and there is no guarantee as to their ultimate value.
Reclassifications
Certain items in the 2003 and 2004 financial statements have been reclassified
to conform to the 2005 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.
Prepaid Expenses and Other Current Assets
The following is a summary of prepaid expenses and other current assets at
December 31:
2005 2004
-------- --------
Prepaid expenses and other current assets ..... $ 83,473 $ 83,583
Receivable on sale of equipment .............. -- 78,009
Related party receivable ...................... -- 12,875
Retainer for financing ........................ -- 27,000
-------- --------
Total Prepaid Expenses and Other Current Assets $ 83,473 $201,467
======== ========
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.
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. 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. The impairment charges were expensed to
"Other research and development" in the accompanying Statements of Operations.
F-11
The cost and accumulated depreciation of property and equipment and equipment
held for sale at December 31, 2005 were as follows:
2005 2004
--------- ---------
Property and Equipment
Office furniture and equipment .................. $ 158,854 $ 245,274
Less: accumulated depreciation and amortization (146,863) (236,237)
--------- ---------
Property and equipment--net ....................... $ 11,991 $ 9,037
========= =========
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 would 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 would 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 for 2003 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.
The Company sold non-essential machine shop equipment and excess office
furniture and equipment in 2004 and 2005, realizing gains on the sale.
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, 2005, 2004,
and 2003, the Company paid or accrued to EKI $0, $800,000, and $1,312,374 ,
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-12
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, the $100,000 per month minimum license fee. In December of 2004,
EarthShell paid to Biotec $125,000, leaving a balance of $875,000 as of December
31, 2004. During 2005, the balance was further reduced to $837,145 and assigned
to EKI. On October 11, 2005, the Company entered into a debt conversion and
mutual release agreement (the "Debt Conversion Agreement") with EKI. Pursuant to
the Debt Conversion Agreement, the Company and EKI agreed that the remaining
receivable of $837,145 (previously owed to Bio-Tec Biologische Naturverpackunger
GmbH & Co.KG, but which receivable was subsequently assigned to EKI) be
converted into 279,048 shares of common stock of the Company. The conversion
price equals $3.00 per share. Pursuant to the Debt Conversion Agreement, the
Company and EKI released each other from any and all claims in connection with
the receivable.
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 $3.00 per share and converted $532,644 of
accumulated interest into unregistered common stock at $4.00 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 paid the salary and benefits of the
executive assistant and charged EKI for the portion of her time that was spent
supporting EKI executives. The Company invoiced EKI $32,608 and $12,875 for the
years ended December 31, 2005 and 2004, respectively, for such support services.
This arrangement terminated in October 2005.
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, the then 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:
2005 2004
---------- ----------
Accounts payable and other accrued expenses $3,137,261 $1,333,101
Legal accruals ............................ 1,283,842 1,497,103
Deferred officer compensation ............. 453,544 298,194
Accrued property taxes .................... 116,002 112,159
Accrued salaries, wages and benefits ...... 281,288 258,691
Accrued legal fees ........................ 636,733 400,278
---------- ----------
Total accounts payable and accrued Expenses $5,908,670 $3,899,526
F-13
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.
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-14
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 reached 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 to 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 The Biotec Group 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 $0.3
million using the Black-Scholes option pricing model and was recorded as a
discount on the outstanding loans.
On October 11, 2005, the Company entered into the 2005 EKI Loan with EKI
pursuant to which the Company issued to EKI a promissory note to EKI in the
principal amount of $1.0 million. As of December 31, 2005, EKI had advanced
$0.85 million with the balance being funded by the second week of January 2006.
Interest accrues on the principal balance of the EKI Loan at a variable per
annum rate, as of any date of determination, that is equal to the rate published
in the "Money Rates" section of The Wall Street Journal as being the "Prime
Rate", compounded monthly. All accrued but unpaid interest and outstanding
principal is due and payable on the earliest to occur of the following: (i) the
second anniversary of the date of the 2005 EKI Loan; (ii) five days following
the date the Company has received $3.0 million or more in aggregate net cash
proceeds from all financing transactions, equity contributions, and transactions
relating to the sale, licensing, sublicensing or disposition of assets or the
provision of services (including advance royalty payments, proceeds from the
sale of the Company's common stock and fees for technological services rendered
to third parties), measured from the date of the EKI Loan and not taking into
account the proceeds advanced under the 2005 EKI Loan; or (iii) the occurrence
of an Event of Default (as defined in the 2005 EKI Loan).
F-15
Notes Payable
In March 2005, the Company entered into a promissory note and Security
Agreement with Cornell Capital Partners. Pursuant to the Security Agreement, the
Company issued promissory notes to Cornell Capital Partners in the original
principal amount of $2.5 million. The $2.5 million was disbursed as follows:
$1.15 million was disbursed on March 28, 2005 and on May 23, 2005 the remaining
$1.35 million was issued in a second closing. After origination costs, the
Company realized approximately $2.1 million of net proceeds. 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. In addition, the Company pledged
to the lender 100 shares of Series B convertible preferred stock which are
convertible in the event of default into approximately $3.3 million shares of
the Company's common stock. The promissory notes have a one-year term and accrue
interest at 12% per year .
In connection with the financing with Cornell Capital Partners, the
Company issued a warrant to Cornell Capital Partners to purchase 625,000 shares
of common stock of the Company. The warrant expires on the later of: (a) May 26,
2006 or (b) the date sixty days after the date the $2.5 million in promissory
notes issued to Cornell Capital Partners are fully repaid. The warrant has an
exercise price of $4.00 per share of common stock. The first installment payment
on the promissory notes was due on July 25, 2005. In August 2005 Cornell Capital
Partners agreed to consolidate the two notes and to defer the commencement of
repayment installments until October 1, 2005. In consideration of this
modification to the promissory notes, the Company issued a warrant to Cornell
Capital Partners to purchase 50,000 shares of common stock of the Company. The
warrant expires on the later of: (a) May 26, 2005 or (b) the date sixty days
after the date the $2.5 million in promissory notes issued to Cornell Capital
are fully repaid. The warrant has an exercise price of $4.00 per share of common
stock.
Also in March 2005, the Company entered into a Standby Equity Distribution
Agreement with Cornell Capital Partners. Pursuant to the Standby Equity
Distribution Agreement, the Company may, at its discretion, periodically sell to
Cornell Capital Partners shares of common stock for a total aggregate purchase
price of up to $10.0 million. For each share of common stock purchased under the
Standby Equity Distribution Agreement, Cornell Capital Partners 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 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 will also retain 5% of each advance under
the Standby Equity Distribution Agreement. Cornell Capital Partners' obligation
to purchase shares of the Company's common stock under the Standby Equity
Distribution Agreement is subject to certain conditions, including the Company's
registration statement for shares of common stock sold under the Standby Equity
Distribution Agreement being declared effective by the Securities and Exchange
Commission and is limited to $0.5 million per weekly advance. On June 9, 2005
the Company filed a registration statement on Form S-1 with the Securities and
Exchange Commission to register the shares of EarthShell common stock underlying
this transaction. On September 27, 2005, the registration statement was
withdrawn. The Company expects to filed a revised S-1 on February 14, 2006.
The notes above were fully repaid and refinanced through the December
Debentures. See "Subsequent Events" below.
Other Long Term Liabilities
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, 2006. Payments on such
settlements due in 2007 and 2008 total $0.18million and $0, respectively.
F-16
Commitments
During 2005,the company relocated its headquarters to its current location where
it 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. Rental expenses for the years ended December 31, 2005, 2004 and
2003 amounted to $98,885, $165,382, and $558,195 respectively. During 1998, EKI
entered into certain agreements with an equipment manufacturer providing for the
purchase by EKI of certain technology applicable to starch-based disposable
packaging. EKI licenses such technology to the Company on a royalty-free basis
pursuant to the License Agreement. In connection with the purchase, and pursuant
to the terms of a letter agreement with EKI, the Company agreed to pay the
seller of the technology $3.5 million on or about December 31, 2003, which
obligation was secured by a letter of credit. In the fourth quarter of 2002, the
Company established a liability for the $3.5 million commitment as of December
31, 2002 ("Accrued Purchase Commitment") and recorded a corresponding expense to
"Other research and development" in the Statements of Operations. In the fourth
quarter of 2003, the Company negotiated a reduction of the obligation to $1.6
million. Upon payment of the reduced obligation amount in the fourth quarter of
2003, the seller simultaneously released the letter of credit. Therefore, as of
December 31, 2003, the Accrued Purchase Commitment was considered fulfilled and
the excess $1.8 million recorded in 2002 was recorded as an offset to "Other
research and development" in the 2003 Statements of Operations.
Contingencies
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.
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 15% 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 $24,842 in 2005, $24,311
in 2004, and $44,057 in 2003.
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
1,250,000 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. Some of the options granted are subject to
approval by the shareholders of an increase in the number of shares reserved for
issuance under the Plans.
Stock option activity for 2005, 2004 and 2003 is as follows:
F-17
2005 2004 2003
------------------------------ ------------------------------ ------------------------------
Weighted-Average Weighted-Average Weighted-Average
Shares Exercise Price Shares Exercise Price Shares Exercise Price
---------- ---------------- ---------- ---------------- ---------- ----------------
Outstanding at beginning of
year .................... 1,043,245 $ 12.58 384,912 $ 38.24 320,924 $ 50.49
Granted ................... 1,341,520 2.00 762,498 0.78 121,699 4.87
Cancelled ................. -- -- (92,499) 15.00 (43,748) 34.02
Expired ................... (755,340) 6.52 (11,666) 68.95 (13,963) 42.14
---------- ---------------- ---------- ---------------- ---------- ----------------
Outstanding at end
of year ................. 1,629,425 $ 6.68 1,043,245 $ 12.58 384,912 $ 38.24
========== ================ ========== ================ ========== ================
Options exercisable at
year-end ................ 1,051,925 $ 7.41 141,162 $ 61.35 155,228 $ 61.70
========== ================ ========== ================ ========== ================
The following table summarizes information about stock options outstanding at
December 31, 2005:
Options Outstanding Options Exercisable
-------------------------------------------------------- --------------------------------------
Number Weighted-Average
Outstanding At Remaining Weighted-Average Number Exercisable Weighted-Average
Exercise Price 12/31/05 Contractual Life Exercise Price At 12/31/05 Exercise Price
-------------- -------------- ----------------- ---------------- ------------------ ----------------
$ 0.75 100,000 8.49 $ 0.75 -- $ --
1.85 800,000 6.53 1.85 800,000 1.85
2.10 350,000 9.67 2.10 -- --
2.15 115,000 9.18 2.15 85,000 2.15
2.55 4,166 3.58 2.55 4,166 2.55
2.85 75,000 4.56 2.85 75,000 2.85
4.80 41,666 7.72 4.80 -- --
5.64 4,471 2.42 5.64 4,471 5.64
15.00 8,334 0.19 15.00 8,334 15.00
36.00 55,834 6.53 36.00 -- --
44.04 16,666 5.36 44.04 16,666 44.04
60.00 41,667 3.79 60.00 41,667 60.00
91.56 10,371 0.08 91.56 10,371 91.56
252.00 6,250 2.38 252.00 6,250 252.00
-------------- ----------------- ---------------- ------------------ ----------------
1,629,425 7.26 $6.68 1,051,925 $ 7.41
============== ================= ================ ================== ================
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,
2005 2004 2003
----------------- ----------------- -----------------
Net Loss as reported ............................................. $ 6,179,086 $ 7,257,101 $ 18,516,741
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 .................. 745,441 472,267 776,018
----------------- ----------------- -----------------
Pro forma net loss ............................................... $ 6,924,527 $ 7,729,368 $ 19,292,759
Net loss per common share
As reported .................................................... $ 0.33 $ 0.48 $ 1.40
Pro forma ...................................................... 0.37 0.51 1.45
Average risk-free interest rate .................................. 3.38% 4.05% 4.53%
Average expected life in years ................................... 7.17 9.5 9.5
Volatility ....................................................... 71% 80% 102%
Average fair value of options granted during the year ............ $ 1.37 $ 0.64 $ 3.99
F-18
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 $3.90 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. When the 2006 Debentures were retired in 2004, the warrant to
purchase $1,055 million in the aggregate principal amount of the 2006 Debentures
converted to a warrant to purchase 175,833 shares of common stock at $7.20 per
share. Therefore, the total number of warrants now held by Roth Capital
Partners, LLC is 246,310. 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.
In connection with a Securities Purchase Agreement, on December 30, 2005, the
Company issued to Cornell Capital Partners a warrant to purchase up to 350,000
shares of common stock (the "December Warrant). This December Warrant has an
exercise price of $4.00 per share, which may be adjusted under certain
conditions to as low as $3.00 per share and expires two years from the date it
was issued. Furthermore, in connection with the Company's sale of December
Debentures, the Company issued to Mr. Benton Wilcoxon, in consideration of his
pledge of shares of common stock of Composite Technology Corporation pursuant to
the terms of the IPEA, a warrant to purchase up to 125,000 shares of common
stock. This warrant has an exercise price of $4.00 per share and expires three
years from the date it was issued. The related debt proceeds were received in
January 2006, accordingly, the fair value of the warrants will be recorded as a
debt discount in the fiscal quarter ended March 31, 2006.
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), as
amended by SAB 104. 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.
F-19
Deferred income taxes result from temporary differences in the recognition of
revenues and expenses for financial and tax reporting purposes. At December 31,
2005 and 2004, deferred income tax assets, which are fully reserved, were
comprised primarily of the following:
2005 2004
------------ ------------
Federal:
Depreciation ............................ $ 1,273,296 $ 1,375,770
Deferred compensation ................... 154,205 101,386
Deferred contributions .................. 361,117 361,117
Accrued management fees ................. -- 272,000
Accrued vacation ........................ 44,320 87,955
Other reserves .......................... 62,333 22,258
Net operating loss carryforward ......... 104,184,369 99,808,790
------------ ------------
TOTAL $106,079,640 $102,029,276
============ ============
Valuation allowance (106,079,640) (102,029,276)
------------ ------------
BALANCE 0 0
============ ============
The valuation allowance (decreased) increased by $4,050,364, ($1,843,850) and
$8,810,963 during the years ended December 31, 2005, 2004, and 2003,
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 $306,424,613 as of December 31, 2005 that expire through 2024.
For state income tax purposes, the Company has California net operating loss
carryforwards of $183,854,768 as of December 31, 2005 that expire through 2009,
and Maryland net operating loss carryforwards of $122,569,845 that follow the
federal treatment and expire through 2024. Additionally, the ultimate
utilization of net operating losses may be limited by change of control
provision under section 382 of the Internal Revenue Code.
Income tax expense for 2005, 2004, and 2003 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 2.1
million shares, 3.0 million shares, and 900,000 shares for the years ended at
December 31, 2005, 2004 and 2003, respectively.
Subsequent Events
On December 30, 2005, EarthShell entered into a Securities Purchase
Agreement with Cornell Capital Partners (the "December Debenture Purchase
Agreement") pursuant to which the Company issued and sold to Cornell Capital
Partners $4.5 million in principal amount of secured convertible debentures (the
"December Debentures") on the terms described below. This agreement was
consummated on January 6, 2006. The December Debentures are convertible into
shares of the Company's common stock on the terms discussed below The Company
received the aggregate proceeds of $4.5 million from the sale of the December
Debentures on January 6, 2006, of which approximately $2.6 million was used to
payoff the CCP Notes.
The December Debentures are secured by (i) a Pledge and Escrow Agreement,
by and among the Company, Cornell Capital Partners, and David Gonzalez, Esq.,
(ii) an Insider Pledge Agreement and Escrow Agreement (the "IPEA"), by and among
the Company, Cornell Capital Partners, David Gonzalez, Esq. and Mr. Benton
Wilcoxon and (iii) an Amended and Restated Security Agreement, by and between
the Company and Cornell Capital Partners. The December Debentures are secured by
substantially all of the Company's assets, have a three year term and accrue
interest at 12% per annum. The December Debenture Purchase Agreement required
the Company to register the shares of the Company's common stock into which the
December Debentures are convertible under the Securities Act of 1933. On
February 14, 2006, the Company filed a registration statement on Form S-1 with
the Securities and Exchange Commission ("SEC") in order to register 6,700,000
shares of common stock that may be issuable to the holders of the December
Debentures upon conversion. Beginning 60 days after the SEC declares the
registration statement effective, Cornell Capital Partners is entitled, at its
option, to convert and sell up to $250,000 of the principal amount of the
December Debentures, plus accrued interest, into shares of the Company's common
stock, within any 30 day period at the lesser of (i) a price equal to $3.00 or
(ii) 88% of the average of the two lowest volume weighted average prices of the
common stock during the ten trading days immediately preceding the conversion
date, as quoted by Bloomberg, LP.
F-20
The holder of the December Debentures may not convert the December
Debentures or receive shares of the Company's common stock as payment of
interest thereunder to the extent such conversion or receipt of such interest
payment would result in the holder, together with any affiliate thereof,
beneficially owning (as determined in accordance with Section 13(d) of the
Securities Exchange Act of 1934, as amended, and the rules promulgated
thereunder) in excess of 4.9% of the then issued and outstanding shares of
common stock, including shares issuable upon conversion of, and payment of
interest on, the December Debentures held by such holder after application of
this 4.9% restriction. This 4.9% restriction may be waived by the holder (but
only as to itself and not to any other holder) upon not less than 65 days prior
notice to the Company.
The Company may redeem, with three business days advance written notice to
Cornell Capital Partners, a portion or all amounts outstanding under the
December Debentures prior to the maturity date provided that the closing bid
price of the of the Company's common stock, as reported by Bloomberg, LP, is
less than $3.00 at the time of the redemption notice. The Company shall pay an
amount equal to the principal amount being redeemed plus a redemption premium
equal to ten percent of the principal amount being redeemed, and accrued
interest, to be delivered to the Cornell Capital Partners on the third business
day after the redemption notice, provided, however, this redemption premium does
not apply until the outstanding principal balance of the December Debentures has
been reduced by $2.5 million. The amount that Cornell may convert in any 30 day
period will be reduced by the amount that the Company redeems.
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 agreements, the Company not filing
such a registration statement (or the registration statement not being declared
effective) within a required timeframe provided 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 a 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.
In February 2006, the Company issued to Midsummer an additional 25, 000 shares
of its common stock in settlement of certain claims relating to the settlement.
In January 2006, SF Capital Partners converted a portion of the settlement
balance into shares of the Company' common stock. In addition, the Company has
agreed to register on behalf of SF Capital partners 1,000,000 shares of the
Company's common stock to be available for the conversion of the remaining
balance owed to SF Capital and to pay damages stemming the Company's
non-performance under the registration rights clause of the settlement
agreement.
F-21
QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
First Second Third Fourth Total Year
------------ ------------ ------------ ------------ ------------
2005
Revenues $ 75,000 $ 58,333 $ 25,000 $ 25,000 $ 183,333
Related party research and
development -- -- -- -- --
Other research and development 103,595 119,183 110,628 (132,589) 200,817
Related party general &
administrative 578 (4,218) (2,227) 5,867 --
Other general and administrative 1,048,384 1,804,774 1,810,481 1,497,963 6,161,602
Net loss common shareholders $ 1,077,557 $ 1,861,406 $ 1,893,882 $ 1,346,241 $ 6,179,086
Basic and diluted loss per
common share $ .06 $ .10 $ .10 $ .07 $ .33
Weighted average common shares
outstanding 18,250,260 18,394,967 18,507,916 18,853,010 18,503,207
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
F-22